Tax Implications of Foreign Pension Plan Participation
James Cassidy, CPA
As a result of IRS offshore compliance initiatives, recently enacted legislation, and new informational reporting requirements, tax preparers and U.S. participants in foreign pension plans must carefully evaluate how a foreign-based retirement plan is structured and valued. Because many U.S. citizens who have repatriated or are currently residing and working abroad, as well as foreign nationals currently residing in the United States, either have retirement assets abroad or are currently participating in a foreign plan, practitioners and taxpayers should evaluate the reporting requirements, follow guidance for preparing accurate tax and information returns and strive to minimize both taxes and onerous penalties.
Practitioners who have individual clients with an interest in a foreign pension plan will be required to obtain detailed information to do the following to avoid substantial penalties:
- Report the annual income in the plan (trust) on Form 1040.
- Report any contributions or distributions on Form 3520.
- Report the plan as an asset on Form 8938.
- Report the plan on a Foreign Bank Account Report (FBAR).
(Exempted are those who are based in one of the few countries that have a comprehensive pension article included in a treaty with the United States, such as Canada, the United Kingdom and Belgium.)
Practitioners should ask the following questions and obtain the following information from a U.S. taxpayer participating in a foreign retirement plan:
- Whether any contributions are being made to the plan.
- To what extent is the participant fully vested in the plan.
- Location of the trust or custodian of retirement funds.
- The amount of control as to investment decisions and distributions.
- Determine whether the plan is mandated under foreign social security rules.
- Requirements for future distributions.
- Agreements or any documentation governing a foreign retirement or deferred compensation plan.
U.S. Tax Treatment of Contributions to a Foreign Retirement Plan
Generally, a foreign pension or retirement savings plan is not considered a “qualified plan” under U.S. tax rules because a foreign retirement plan is usually not structured to conform to the complex rules for qualification under IRC section 401. Also, the requirement that the trust holding the plan assets be a trust created or organized in the United States will most likely not be met.
Therefore, any participant contributions to the plan would not be deductible, and any contributions made by an employer may be considered taxable compensation. If an employee’s beneficial interest in a trust is either transferable or not subject to a substantial risk of forfeiture (vested) at the time a contribution is made by an employer, the contribution is currently subject to tax.
Tax treaties may provide exceptions to the above rules and provide a participant in a foreign pension plan with the benefits provided under a U.S.-qualified plan. For example, Article 18 of the U.S./U.K. Income Tax Treaty allows transferred employees to remain in their respective home country pension plans without having employer contributions to these plans taxed as imputed income by their host countries. In addition, both employer and employee contributions to the home country pension plan will be tax-deductible in the host country. But these rules only apply if the following conditions are met:
- The tax relief granted by the host country for employee contributions to home country plans is limited to the amount of relief that would have been available under a pension plan established in the host country; for example, a U.K. national assignee temporarily employed in the U.S. who continues to participate in a U. K pension plan would not be able to deduct more than the 401(k) limit proscribed under IRC section 402(g) (for 2012, $17,000).
- The employee must have already been a member of, and participating in, the home country pension plan before moving to the host country.
- If the employee is only taxed on the amount remitted or received in the host country, the available tax relief will be reduced proportionally.
- The pension plan must be accepted as a generally “corresponding pension scheme” (as described below) by appropriate authorities in the host country.
Generally corresponding pension schemes include—
- Qualified plans under IRC section 401(a), such as 401(k) plans,
- Individual Retirement Accounts (including traditional, SEP and Roth IRA),
- Qualified plans under IRC Section 403(a) and (b), and
- U.K.-approved employment-related retirement benefit schemes (for purposes of Chapter 1 of Part XIV of the Income and Corporation Taxes Act of 1988) and personal pension schemes approved under Chapter IV of Part XIV of the act).
Foreign privatized social security contributions. Unless the foreign country has entered into a totalization agreement with the United States, foreign social security taxes are a creditable foreign tax. Under the Regulations (1.901-2[a][ii][C]), a foreign levy imposed on individuals to finance retirement, old age, death, survivor, unemployment, illness, disability benefits, or some substantially similar purpose is not a requirement of compulsory payment in exchange for a specific economic benefit, as long as the amounts required to be paid by the individuals subject to the levy are not computed on a basis reflecting the respective ages, life expectancies or similar characteristics of such individuals. Therefore, mandatory social security contributions that are based upon a percentage of income are a creditable tax even though the funds are transferred to private accounts.
Tax Treatment of Earnings in a Foreign Plan
U.S. taxpayers are generally subject to current taxation on income earned in a foreign retirement plan unless the plan is considered an employer-sponsored plan under IRC section 402(b) and the individual is not considered a highly compensated employee (IRC section 414[q]).
If a foreign trust is not considered an employer-sponsored plan or employee benefit trust, the foreign trust is generally considered a grantor trust under IRC section 671.
For example, a Canadian RRSP is considered to be a simple grantor trust, and unless an election is made under the U.S./Canada Income Tax Treaty (Article 18), the earnings of the plan are subject to tax.
For both U.S. and U.K. citizens, the tax treaty provides that earnings under the home country pension plan or scheme (while the employee resides in the host country) will not be taxed until a distribution is made from the applicable pension plan or scheme. For example, a U.S. citizen who contributed to a 401(k) plan will not be taxed by the U.K. on the earnings and build-up of the 401(k) account if he subsequently becomes a U.K. resident. Therefore, if a foreign retirement plan does not meet the exceptions as an employer plan or under an income tax treaty, the earnings in the plan are currently subject to U.S. tax.
Tax Treatment of Distributions
Most tax treaties reserve taxation of pension and social security distributions to the country of residence of the recipient. If an employee paid tax on some or all of the contributions and earnings in a trust, the employee will have a basis in the trust that will be recovered tax-free pursuant to the rules under IRC section 72. Generally a broad range of payments (including lump sum payments), if acceptable under the laws of the country where the pension is located, are accepted as a pension. Foreign social security payments that are subject to U.S. taxation under a treaty should be reported on Form 1040 as social security on the appropriate line and taxed in the same manner as a U.S. Social Security payment.
Many foreign pension plans allow transfers to other foreign equivalent plans. For example, under U.K. tax rules, a “Qualifying Recognized Overseas Pension Scheme” (QROP) is a plan that offers former U.K. residents the ability to transfer (roll-over) retirement funds on a U.K. tax-exempt basis to an offshore plan. Also, under the Peruvian AFP social security regime, fund balances can be transferred to a foreign pension plan or private social security plan should an employee permanently relocate from Peru. Generally a transfer from a foreign plan is treated as a taxable distribution under U.S. tax rules.
There are a number of reporting requirements that may apply in addition to the individual's income tax return.
FBAR. Form TD F 90-22.1 must be filed when foreign accounts (when combined together at their highest balances during the year) exceed $10,000; this covers not only bank accounts but also arrangements outside the United States that are virtually any type of financial account. Generally, an individual would not have to report a plan that was an employer-administered plan or a traditional defined benefit plan because the individual neither owns the account nor has signatory authority over it; however, foreign owned personal pension plans such as RRSPs must be reported.
Form 3520. The consequences of Form 3520 violations are severe, given the penalties involved. Generally, foreign personal pension plans are considered grantor trusts and must be reported. According to the instructions to Form 3520, Notice 97-34, and IRC section 679, non-qualified deferred compensation trusts (IRC section 402[b] plans) and most foreign employer owned pension plans (e.g., defined benefit plan) are exempt from reporting.
Practitioners need only look to the instructions to Form 8891 (RRSP), as the instructions clearly indicate that taxpayers who are required to file Form 8891 are not required to file Form 3520.
Form 8938. Based upon the newly issued instructions, “other specified foreign financial assets” includes an interest in a foreign trust, foreign pension plan and a deferred compensation plan. An individual who is considered an owner under the grantor trust rules of any part of a trust is considered to have an interest in any specified foreign financial asset held by the part of the trust owned.
Form 8891. Form 8891 is required to report contributions to and distributions from Canadian Registered Retirement Plans (RRSPs and RRIFs) and to make the treaty deferral election.
Form 8833. Generally a treaty exception such as the deduction for contributions to a foreign pension plan is not required to be reported on IRS Form 8833 (Reg sec. 301.6114(1)(c)(iv)).
U.S. Tax Planning
If there is no deduction or deferral of pension contributions permitted under an income tax treaty or if a U.S. taxpayer resides in a country that does not have a treaty with the United States, then the current U.S. tax on the contribution may be partially or fully offset by a foreign tax credit. (Consider freezing contributions to home country plans.)
Consideration may be given to making investments that would supplement a foreign retirement plan such as a U.S. or offshore (U.S. tax compliant) life insurance policy. Generally, investment income that accumulates (“inside build-up/cash value”) up to the date of the insured’s death in a non-term life insurance policy may be permanently exempt from tax (IRC section 101[a]). Also the owner has access to the accumulated investment income in a non-term policy through the ability to borrow against these funds.
James Cassidy, CPA, is a senior tax director with the BDO Expatriate Tax Services Group in New York. He has spent over 22 years in public accounting and over four years on assignment providing expatriate tax services in Toronto and Mexico City. Mr. Cassidy has experience in international tax with an emphasis on effective planning strategies for U.S. expatriates and foreign national assignees, investors and entertainers in the United States. He has also managed international assignee engagements for clients in diverse industries. Mr. Cassidy is a frequent speaker and contributor of articles for the NYSSCPA and the International Tax Journal, and is the treasurer of the U.S.-Mexico Chamber of Commerce. He can be reached at firstname.lastname@example.org or 212-885-7310.