It is not uncommon for American expats working abroad and recent immigrants to the U.S. to have an interest in a non-U.S. retirement, pension or social security type plan. Indeed, it is not even uncommon for such persons to have multiple foreign pensions. Under foreign laws, these non-U.S. pension plans typically receive tax-beneficial treatment. Additionally, these plans enjoy very little foreign tax compliance costs. As such, they are great vehicles for saving for retirement. Unfortunately, these pension plans do not necessarily enjoy the same tax-beneficial treatment under U.S. law. Moreover, they may require complex U.S. tax return reporting.
The exact U.S. tax treatment of a foreign pension plan held by a U.S. person depends on several different factors. Pension plans vary from one country to another in terms of legal forms and financial flows. Indeed, myriad international tax issues arise precisely due to the large variety of pension plans in the world today. Add to this the fact that international tax treaties and specific IRS administrative rulings provide further guidance or modifications as to the default U.S. taxation of foreign pensions.
The default U.S. tax scenario for foreign pensions involves TTE, i.e., (1) Taxation upon employer contributions, (2) Taxation upon income accruing within the plan and (3) Exemption from taxation upon receipt of distributions. This is because most foreign pensions are not tax-deferred “qualified” plans within the meaning of IRC § 401. On the other hand, the most common foreign tax scenario for foreign pensions is EET, i.e., (1) employer contributions are Exempt from taxation, (2) income accruing within those plans is Exempt from taxation while (3) distributions received from the plans are Taxable.
Mismatched U.S./foreign taxation of pension plans produces tax timing differences, double taxation and higher compliance costs. However, fortunately many tax treaties modify domestic laws in very taxpayer-friendly ways, usually by deferring taxation of the foreign pensions. Some examples that readily come to mind include UK Personal Pension Plans (PPP), Self-Invested Pensions Plans (SIPP) and a whole slew of Canadian retirement accounts including Registered Retirement Savings Plans (RRSP), Registered Retirement Income Fund (RRIF) and Locked-In Retirement Accounts (LIRA) to name just a few. From a reporting standpoint, it is very important to disclose to the IRS a tax treaty-based return position on your tax return by filing Form 8833. Failure to do so is grounds for a $1,000 penalty. Other possible international information reporting requirements, depending on the specific facts, could include the filing of a Foreign Bank Account Report (FBAR) and Form 8938.
Perhaps, most importantly, many foreign pension and retirement plans are organized as foreign trusts which trigger very specific U.S. tax return filing requirements. Even foreign social security arrangements could potentially be classified as trusts under U.S. principles. (A notable example would be a 2008 private letter ruling from the IRS suggesting that Australian superannuation funds would be treated as trusts.) Specifically, the U.S. beneficiary is required to file annual disclosure tax returns (Forms 3520 and 3520-A) for each foreign pension plan classified as a trust under U.S. tax law. This is the case even if an applicable tax treaty articulates tax exemption. Failure to file the appropriate trust tax returns could result in very harsh penalties to the tune of $10,000 per year per pension plan.
International tax is a complex area and improper compliance or noncompliance can trigger severe penalties. Luckily, for taxpayers that did not receive the proper international tax advice in years past, the IRS currently has voluntary disclosure programs in place that allow U.S. taxpayers to become compliant with their tax obligations without incurring severe penalties. At Point Square Consulting, it is our experience that it is typically well-meaning, general tax practitioners who unknowingly get their clients in problems with the IRS in this arena. As such, we recommend taxpayers to always seek the assistance of only international tax specialists when dealing with cross-border compliance matters.