U.S. Tax Treatment Of A Foreign Pension
Many U.S. taxpayers are confused about the reporting requirements for foreign pension plans. Although the IRS has posted information on this topic, the average taxpayer may still have questions. Because the reporting requirements are complex and the associated penalties are harsh, it is important for every affected taxpayer to understand these laws.
Participation In A Foreign Pension
U.S. taxpayers who participate in a foreign pension plan are subject to additional reporting requirements on their U.S. income tax return and FinCEN Form 114 (the FBAR), if applicable. A foreign pension is generally any retirement plan established and managed outside of the United States. A foreign pension plan does not include ‘Social Security’ type program benefits provided by a foreign government.
U.S. retirement plans typically enjoy many benefits, such as tax-free contributions, deferral of accrued income within the plan, ability to rollover the funds in a tax-free transaction, and reduced reporting requirements for the participant. Many Americans abroad simply assume their foreign pension qualifies for the same benefits. However, this is not necessarily the case.
In most cases, the IRS will view a foreign pension plan as a trust. The definition of a trust under the internal revenue code is “an arrangement if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.”
Actual U.S. Tax Treatment
The first step in figuring out how the foreign pension will affect U.S. taxes is to determine whether it qualifies as an exempt trust for U.S. tax purposes. To qualify for tax benefits as an exempt trust, a trust must be “created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries.” This requirement will prevent any foreign pension plan from gaining exempt status using this part of the code.
Other requirements for exempt trusts include:
- Limitations on contributions
- Participation and coverage rules
- Minimum distribution requirements
- Certain prohibited transactions
- Minimum vesting and funding standards
Exempt trusts must also satisfy minimum participation standards and nondiscrimination requirements. In general, these standards require that the plan must pass one of the following tests:
- The plan benefits at least seventy percent of the employees who are not highly compensated employees (percentage test).
- The plan benefits a percentage of non highly compensated employees which is at least 70 percent of the percentage of highly compensated employees benefiting under the plan (ratio test).
- The plan must benefit a classification of employees that does not discriminate in favor of highly compensated employees (nondiscriminatory classification test) and the average benefit percentage of the non highly compensated employees must be at least 70 percent of the average benefit percentage of the highly compensated employees (average benefit percentage test).
Exceptions to the Rule
Some foreign pension plans may qualify for exemption from tax if they meet certain requirements. However, it is very rare for a foreign pension plan to satisfy all of these requirements.
Specifically, “a stock bonus, pension, or profit-sharing trust which would qualify for exemption from tax under section 501(a) except for the fact that it is a trust created or organized outside the United States shall be treated as if it were a trust exempt from tax under section 501(a).” Although it initially seems like this exception would apply to foreign pensions, most foreign pensions do not consider U.S. requirements during their formation. In addition, the other requirements are complex, and it would be difficult or even impossible for an individual to certify that they have been met.
Thus, it is safe to assume that the IRS will consider the vast majority to be non-exempt trusts.
The taxability of non-exempt trusts depends on a few factors, with the owner of the trust being the most important determinate. In the case of a foreign pension plan with both employee and employer contributions, “a beneficiary of a trust… may not be considered to be the owner under subpart E, part I, subchapter J, chapter I of the Code of any portion of such trust which is attributable to contributions to such trust made by the employer after August 1, 1969, or to incidental contributions made by the employee after such date.” This means that the employee participant would not be considered the owner as long as their contributions to the trust are incidental, which means that they do not exceed the employer’s contributions. The IRS considers the employer to be the owner of such trusts, rather than the U.S. beneficiary. These trusts are known as “employees’ trusts.”
Employees’ Trust and U.S. Taxation
A non-exempt employees’ trust is the classification that most foreign pensions typically qualify for. The major requirements to be considered an employees’ trust with reduced reporting requirements are:
- Employee contributions must not exceed fifty percent
- The individual is not a highly compensated employee (see above) and
- The plan must not be discriminatory (as determined under Section 401(a)(26) or 410(b)).
If the trust fails to meet these general requirements, it will likely be considered a foreign grantor trust, and the U.S. owner would subject to additional reporting requirements and income recognition for the portion of the trust they own. A U.S. owner of a foreign grantor trust is subject to reporting requirements on Form 3520, 3520-A, FinCEN Form 114, Form 8938, and potentially Form 8621 if the trust invests in foreign mutual funds. The topic of foreign mutual funds and the rules that relate to passive foreign investment companies (PFIC) is complex. Since many investment vehicles come in the form a fund, participants in a foreign pension likely have some ownership of a foreign mutual fund.
An employees’ trust has a few of the tax benefits a qualified exempt trust enjoys. The major benefits being:
- Deferral of tax on the accrued income until distribution.
- Fewer reporting requirements.
Unlike a qualified retirement plan, participants in a employees’ trust must include their employer’s contributions in their gross income on their U.S. tax return. It important to note that these employer contributions may not be included in foreign earned income for the purposes of the foreign earned income exclusion. In addition, contributions made by the employee are not tax deductible. An exception exists for contributions that have not been funded or vested. Distributions are ultimately taxed as annuity income when amounts are distributed or made available. Amounts are generally made available when the participant reaches retirement age, becomes disabled, or dies.
Foreign Grantor Trust and U.S. Taxation
A foreign grantor trust generally has no benefits of a qualified exempt trust and is potentially subject to significant reporting requirements and compliance costs. There is no tax deferral on the income accrued within the trust nor deduction of contributions. The U.S. owner must generally file Form 3520 and 3520-A annually to report ownership, contributions, and distributions. The IRS has stated that these reporting requirements apply to any foreign pension scheme classified as a trust for U.S. tax purposes. Form 8621 would generally be required for any investments that fall under the passive foreign investment company (PFIC) definition. The tax treatment of PFICs is punitive, complex, and requires disclosure on Form 8621 for each investment that meets the definition and does not qualify for an exemption. These investments are proportionally attributed to and considered owned by the trust beneficiaries. The attribution does not apply to participants in an employees’ trust.
The FBAR and Form 8938
A foreign pension plan typically qualifies as a foreign financial account for the purposes of the FBAR and a specified foreign financial asset subject to FATCA and reporting on Form 8938. Many taxpayers overlook the balance of their foreign pension(s) when applying the thresholds related to the FBAR and Form 8938. Guidance is not clear from the IRS on whether an employees’ trust is required to be reported on the FBAR and Form 8938. As a result, it is generally recommended to include these foreign pensions on the FBAR and Form 8938 if applicable thresholds are exceeded. The penalties for failing to include such assets can be substantial and the inclusion will not generate income tax. The additional time and effort taken to gather the necessary information to report on the FBAR and Form 8938 is insignificant in comparison to the potential penalties.
International Tax Treaties
The IRS currently has tax treaties with a number of foreign countries. Not all tax treaties are the same, so careful examination of the specific treaty that applies to your situation is necessary. Depending on the treaty and other factors, a foreign pension can be subject to U.S. taxation in different ways. Some treaties allow participants to obtain the same benefits as if the plan was a U.S. qualified plan, while others allow partial or no benefits. Article 18 of the Model Treaty allows a participant in a foreign pension to defer income accrued, deduct contributions from income, and exclude employer contributions from income.
All treaties include a Savings Clause, which protects the United States’ right to tax its citizens as if the tax treaty was not applicable. This Savings Clause can typically be found in Article 1 of the treaty. Article 18 in the Model Treaty regarding foreign pension benefits is exempted from the Savings Clause. It is important to thoroughly read the tax treaty and applicable Savings Clause since the Model Treaty does not apply consistently across all income tax treaties and there are generally variations.
IRC § 301.7701-4(a)
IRC § 401(a)
IRC § 410(b)
IRC § 402(d)
Treasury Regulation 1.402(b)-1(b)(6)
IRC § 911(b)(1)(B)
IRC § 402(b)(2)
IRC § 83(a)
IRC § 72
IRS Release 2011-0096 (October 31, 2011)
IRC § 1.1291-1(b)
IRC § 1.1298-1T(b)(3)(ii)