Pensions Create Yet Another Tax Trap For U.S. Expatriates
Think your taxes are confusing? Ha! Try living and working abroad as a U.S. citizen. As the following guest column details, even something as seemingly ordinary as participating in a pension plan can create huge tax complications. (For less esoteric advice on preparing your 1040 for 2013 and minimizing your taxes in 2014 and beyond, check out the Forbes 2014 Tax Guide. )
A Pension Tax Trap Complication For U.S. Expatriates
By David J. Wasserstrum, Partner at WeiserMazars LLP
Expatriates working abroad often participate in a funded foreign pension plan of a foreign company. In order to avoid double taxation, these individuals should beware of the tax treatment of both contributions to, and distributions from, these foreign plans. To select the most tax effective approaches, one needs to know the general rules, the availability of foreign tax credits, and treaty provisions which may exist between the US and a foreign government.
While a foreign pension plan usually provides favorable tax treatment within its national jurisdiction, the general rule is that it is not a qualified retirement plan (“QRP”) under the Internal Revenue Code (“IRC”) for US income tax purposes and thus, any contributions are not deductible by the employer or employee on their US tax returns. In contrast, the IRC provides numerous tax benefits for participants in US QRPs, including an exclusion or deduction from gross income for contributions, investment in a tax-exempt trust, and favorable distribution rules, such as a tax free rollover.
US expatriates covered by a funded foreign pension plan, however, are treated as participants in a “nonqualified” deferred compensation plan, and not in a QRP, absent any special exemptions from outside the IRC. The US taxes its citizens and residents on their worldwide income, notwithstanding the source thereof. Add to this the IRC’s general rules applicable to the taxation of funded non-qualified plans, and an expatriate may end up losing the benefits of deferred income recognition. The general rules require a US expatriate who participates in a foreign plan to currently include in gross income the amount of the contributions made by the employer and the employee, to the extent vested. In addition, the expatriate may be required to include in gross income his or her share of the earnings on plan assets. Possibly, the expatriate may also be required to pay tax to the foreign country upon distribution from the plan. Thus, the same amounts may be taxed twice, but at different times, and double taxation may occur due to the mismatch of income and foreign tax credits.
Beyond the general income tax treatment of coverage in a non-qualified deferred compensation plan is IRC §409A, which imposes constraints upon the timing and manner of distributions. Failure to comply with this section could lead to disastrous results, such as the acceleration of deferred compensation income recognition into the year of non-compliance, an additional 20 percent income tax on the amount accelerated, plus an interest penalty calculated from the date of deferral until the date of income inclusion. Fortunately, the statute and regulations exclude a variety of foreign plans from the definition of non-qualified deferred compensation, including amounts excludable from US gross income pursuant to a tax treaty, or under a broad-based foreign retirement plan.
Expatriates subject to US taxation on foreign retirement plan participation may be able to offset some or all of their US federal tax liability (states are generally not covered by US Tax Treaties) by utilizing foreign tax credits for taxes paid to foreign governments. Certain US Tax Treaties have provisions which provide relief from double taxation by making available the foreign tax credit or an exemption for income earned in the foreign country. However, the treaty provisions apply only to the extent of the limitations applicable to a US QRP. These include, among others, the limitations on annual contributions, annual benefits, and compensation.
In addition, certain treaties also explicitly exclude contributions to a foreign employer’s pension plan from the expatriate’s gross income, in both the US and the foreign country, if the foreign employer’s pension plan is generally exempt from income taxation in its jurisdiction and is operated principally to administer or provide pension or retirement benefits. For example, the US-UK tax treaty provides that if an US expatriate works in the UK, and he or she participates in an exempt pension plan established in the UK, then contributions by or on behalf of that expat are deductible or excludable from his or her US taxable income. The same would be true for a UK foreign national working in the US. Among the countries with which the US has tax treaties containing these favorable pension provisions are Germany, the Netherlands, and Belgium.
In the case of a distribution from a plan, so that it is covered by treaty’s pension article, the plan must qualify as a “pension” under the terms of the treaty. Almost all tax treaties define the term “pension” to include the receipt of periodic (e.g., monthly) payments. Lump sum distributions, on the other hand, may be excluded from the definition of “pension” and are generally taxed in the foreign country from which the distribution is sourced. The terms of each relevant tax treaty must always be analyzed when distributions are to occur.
In addition to providing tax credits, exemptions, and exclusions, tax treaties may provide for reduced rates of withholding on taxable distributions. For example, while distributions subject to tax in the source country will generally have income tax withheld at a rate of 30 percent, the US tax treaty with Canada may reduce the tax rate to 15 percent in certain circumstances. Sometimes such distributions are even exempt from withholding.
There are also a number of reporting requirements that may apply in addition to inclusion on the individual’s income tax return. This may include certain foreign trust reporting returns (Form 3520 and 3520A), as well as the Treasury report on Foreign Bank and Financial Accounts which is Form TD F 90-22.1. Other Forms may include 8938 and 8606, depending on the taxability of the plan.
Tax planning for foreign retirement plan coverage is not simple. The country specific rules and treaties must be closely studied to determine the expatriate’s optimum retirement savings strategy The issue of the timing of income inclusion and foreign tax credit offset are critical, in addition to not running afoul of the local reporting requirements.
David J. Wasserstrum is a partner at WeiserMazars LLP