An Overview of U.S. Taxation Foreign Pensions

In the last 20 years, there has been a significant upward trend of highly skilled foreign workers moving to the United States for temporary assignments. For foreigners planning to move to the United States for a temporary work assignment, pre-immigration tax planning is crucial. Whether the goal is to minimize the tax effects of the move or to structure the foreigner worker’s holdings to optimize tax consequences after the move, pre-immigration planning must be undertaken. One of the keys to developing strategies for minimizing U.S. federal tax in pre-immigration context is to understand that many foreign workers accepting a work assignment in the United States will become a U.S. person for U.S. federal tax purposes.

Under Internal Revenue Code Section 7701(a)(3)(A), an individual is a U.S. person if he or she is either a citizen or a resident of the United States. Under Internal Revenue Code Section 7701(b), an individual who is not a U.S. citizen may be a U.S. resident for U.S. income tax purposes (i.e., a “resident alien”) under either the “permanent residence” test (i.e., “green card” test) or the “substantial presence” test. In addition, in certain circumstances, a foreign worker may elect to be treated as a U.S. resident.

Once an individual becomes a U.S. resident for U.S. income tax purposes, he or she will be subject to U.S. income taxation with respect to his or her worldwide income. Additionally, such an individual will be subject to various special income tax consequences with regards to interests in foreign pension plans. A foreign pension has three separate components that need to be considered for U.S. income tax purposes: 1) contribution to the plan; 2) foreign employer’s contribution; and 3) any investment income. Each of these separate components can be subject to U.S. tax. This article will discuss the U.S. tax consequences of foreign pensions.

U.S. Taxation of Foreign Pension Contributions

In order for a contribution to a pension plan to avoid U.S. tax, the construction must be made to a “qualified plan” “deferred compensation plan.” Internal Revenue Code Subpart A of Pt 1 of Subchapter D of Chapter 1 contains the rules pertaining to the taxation of “deferred compensation” (pension plans) in the U.S. In order for a pension plan to be tax-exempt, the plan must satisfy the requirements contained in Section 401 of the Internal Revenue Code. Section 401(a) specifically provides that, for a pension plan to be a “qualified plan” (and therefore exempt from tax under Section 501 of the Internal Revenue Code, it must be organized in the United States.

Accordingly, this means that no foreign pension plan can be a “qualified plan.” The amount of the contribution that will be taxable is determined under Section 402(b)(1).
Generally, any contributions made by a taxpayer to a non-exempt trust will be taxable as compensation to the taxpayer in the U.S. if the benefits are “substantially vested.” The benefits will be substantially vested if the contributions are not subject to a substantial risk of forfeiture. Most contributions made to foreign retirement plans will not be subject to a substantial risk of forfeiture because the plan will be payable to the taxpayer upon retirement, incapacity or to a nominated beneficiary upon the death of the taxpayer. Therefore, generally, if contributions are made to foreign pension plans after a foreign individual becomes a U.S. person, the contributions will be taxable under Section 402(b)(1) of the Internal Revenue Code.

U.S. Taxation of Foreign Employer’s Contribution

Whether or not a foreign employer’s contribution is taxable in the U.S. often depends on how the plan is taxed for purposes of the U.S. grantor trust rules. The grantor trust rules are designed to attribute the income tax liability associated with income derived by a trust (whether domestic or foreign) to the person that is considered to be the “controller” of the trust, regardless of who the income has been distributed to. Under the grantor trust rules, a grantor trust is any trust in which the grantor retains one or more of the following powers:

1. A reversionary interest of more than 5 percent of the trust property or income;
2. The power to revoke the trust;
3. The power to distribute income to the grantor or grantor’s spouse;
4. Power over the beneficial interest in the trust;
5. Administrative powers over the trust permitting the grantor to benefit.

A grantor is defined as a person who either creates a trust, or directly or indirectly makes a gratuitous transfer of property or money to a trust. The grantor trust rules are designed to attribute the income tax liability associated with the income derived by a trust to the person that is considered to be the “controller” of the trust. If a foreign pension plan can be classified as a grantor trust, employer contributions to a foreign pension plan could potentially trigger a U.S. tax consequence during the tax year the contribution is made. It is therefore critical that an individual assessment of the circumstances of each foreign pension plan with a U.S. beneficiary be undertaken to determine the tax consequences of an employer’s contribution to the plan. This should particularly be the case with Australian superannuation plans due to the fact that many of these plans can be classified as grantor trusts under U.S. tax law. Although the grantor trust rules can potentially tax employer contributions, there are provisions in the Internal Revenue Code such as Section 402(b)(3) that exclude the application of the grantor trust rules to the beneficiaries of foreign pension plans. In certain cases, Section 402(b)(3) could defer the U.S. taxation to a foreign pension plan of a U.S. beneficiary.

U.S. Taxation of Investment Income

Earnings accumulating in a foreign pension plans that are classified as grantor trusts are typically taxed in the U.S. as ordinary income on an annual basis. Earnings accumulated in a foreign pension plan that is classified as a non-grantor trust is not typically subject to U.S. taxation until distributed to the U.S. beneficiary. U.S. beneficiaries of foreign pension plans should be mindful of the investments contained in the plan. Foreign pensions often invest in foreign stocks or foreign foreign mutual funds. Investment income in foreign mutual funds is typically subject to a special tax known as the Passive Foreign Investment Company of “PFIC” tax regime. A PFIC is a foreign corporation that satisfies either the “income test” or the “asset test.” Under the income test, a foreign corporation is a PFIC if 75% or more of its gross income is passive. See IRC Section 1297(a). Under the asset test, a foreign corporation is a PFIC if 50% or more of the average value of its assets consists of assets that would produce passive income. See IRC Section 1297(a)(2). For purposes of the income test and asset test, passive income means any income which is of a kind which would be foreign personal holding company income under Internal Revenue Code Section 954(C). There is no minimum threshold for ownership by U.S. persons under the PFIC regime. Hence, any percentage of PFIC stock owned by a U.S. person through a foreign pension plan may implicate the PFIC regime with respect to that shareholder.

The tax consequence to holding foreign corporate stock that are PFICs is extremely punitive. Under the PFIC rules, the U.S. person holding stock in the PFIC pays tax when they receive a distribution from the PFIC or sell their shares of PFIC stock. The individual must also pay an interest charge attributable to the value of the tax deferral when he or she receives an unusually large distribution (called an “excess distribution”) or when he or she has gains from the disposition of the PFIC stock. If the holder of the PFIC receives a usually large distribution (called an “excess distribution”) or has gain from the disposition of the PFIC stock they are subject to special tax which will be discussed below.

An excess distribution includes the following:

1. A gain realized on the sale of PFIC stock, and
2. Any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer for the year exceeds 125 percent of the average actual distribution received by the taxpayer in the preceding three taxable years. The amount of an excess distribution is treated as if it had been realized pro rata over the holding period of the foreign share and, therefore, the tax due on an excess distribution is the sum of the deferred yearly tax amounts. This is computed by using the highest tax rate in effect in the years the income was accumulated, plus interest. Any actual distributions that fall below the 125 percent threshold are treated as dividends. This assumes they represent a distribution of earnings and profits, which are taxable in the year of receipt and are not subject to the special interest charge.

Below, please see Illustration 1. and Illustration 2. which demonstrates a typical sale of PFIC stock.

Illustration 1.

Jim is an engineer and a citizen of Germany. Jim moved to California and became a U.S. green card holder. Jim likes to invest in foreign mutual funds. On the advice of his German broker, on January 1, 2016, Jim buys 1 percent of FORmut, a mutual fund incorporated in a foreign country for $1. FORmut is a PFIC. During the 2016, 2017, and 2018 calendar years, FORmut accumulated earnings and profits. On December 31, 2018, Jim sold his interest in FORmut for $300,001. To determine the PFIC excess distribution, Jim must throw the entire $300,000 gain received over the entire period that he owned the FORmut shares – $100,000 to 2016, $100,000 to 2017, and $100,000 to 2018. For each of those years, Jim will pay tax on the throw-back gain at the highest rate in effect that year with interest.

It is easy to envision significantly more complex scenarios. Such a scenario is described in Illustration 2 which is based on an example in Staff of Joint Comm. On Tax’n, 100 Cong., 1st Sess., General Explanation of Tax Reform of 1986, at 1027-28(1987).

Illustration 2.

On January 1 of year 1, Samatha, a U.S citizen, acquired 1,000 shares in FC, a foreign corporation that is a PFIC. She acquired another 1,000 shares of FC stock on January 1 of year 2. During years 1 through 5, Samatha receives the following dividend distribution from FC:

Date of Distribution / Amount of Distribution

Dec. 31 of year 1 $500
Dec. 31 of year 2 $1,000
Dec. 31 of year 3 $1,000
Dec. 31 of year 4 $1,000
Apr. 1 of year 5 $1,500
Oct. 1 of year 5 $500

Under Internal Revenue Code Section 1291, none of the distributions received before year 5, are excess distributions since the amount of each distribution with respect to a share is 50 cents. However, with respect to distributions during year 5, the total distribution to each share is 37.5 cents ($1 minus 62.5 cents (1.25 times 50 cents)).

Accordingly, the total excess distribution for FC’s tax year ending December 31 of year 5 is $750 (37.5 per share times 2,000 shares). This excess distribution must be allocated ratably between the two distributions during year 5. Thus, $562.50 (75 percent of the excess distribution, i.e., $750 times $1,500/$2,000) is allocated to the April 1 distribution and $187.50 (the remaining 25 percent of the excess distribution, i.e. $750 $500/$2,000) is allocated to the October 1 distribution. These amounts are then ratably allocated to each block of stock outstanding on the relevant distribution date. For the distribution on April 1 of year 5, $281.25 of the excess distribution is allocated to the block of stock acquired on January 1 of year 1 and $281.25 is allocated to the block of stock acquired on January 1 of year 2 and $281.25 is allocated to the block of stock acquired on January 1 of year 3. The $187.50 excess distribution on October 1 of year 5 is also allocated evenly between the two blocks of stock outstanding on the date of the distribution. Finally, the excess distribution for each block of stock is in accordance with Internal Revenue Code Section 1291(a)(1).

The federal tax due in the year of disposition (or year of receipt of an excess distribution) is the sum of 1) U.S. tax computed using the highest rate of U.S. tax for the shareholder (without regard to other income or expenses the shareholder may have) on income attributed to prior years (called “the aggregate increase in taxes” in Section 1291(c)(1)), plus 2) U.S. tax on the gain attributed to the year of disposition (or year of receipt of the distribution) and to years in which the foreign corporation was not a PFIC (for which no interest is due). Items (1) and (2) together are called the “deferred tax amount” in Section 1291. Item (2), the interest charge on the deferred tax, is computed for the period starting on the due date for the prior year to which the gain on distribution or disposition is attributed and ending on the due date for the current year in which the distribution or disposition occurs.

If a foreign pension plan holds foreign stocks or foreign mutual funds, the U.S. beneficiary could be subject to the PFIC tax regime. In certain cases it may be possible to mitigate the harsh consequences of the PFIC regime by making a timely Qualified Electing Fund election or mark to market election.

Treaty Considerations

As discussed above, earnings accumulating in a foreign pension plan that is classified as a grantor trust is taxed annually. In certain cases a tax treaty can aborage the general rules governing the U.S. taxation of a foreign pension plans. For example, Article 18 of the United States-United Kingdom Income Tax Treaty changes this general rule by providing that income earned by a pension scheme may be taxed as income of the individual only when distributed. This means, distributions from U.K. pension plans are only subject to U.S. tax when a distribution is made from the plan to the beneficiary. However, Article 18 of the United States-United Kingdom Income Tax Treaty must be read in tandem with the “savings clause” contained in Article 1 of the treaty. Article 1 may prevent U.S. citizen beneficiaries of U.K. pension plans from deferring the U.S. taxation of investment income generated by the foreign pension plan. When determining the U.S. tax consequences of a foreign pension plan, any applicable treaty should be carefully reviewed.

U.S. Filing Requirements

A U.S. beneficiary of a foreign pension plan will likely have to disclose the pension plan to the IRS on a number of information returns such as a FinCen 114, Form 3520, Form 3520-A, and Form 8938. Failure to timely disclose a foreign pension plan on a U.S. tax return and information returns could result in significant penalties.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. As an international tax attorney, Anthony Diosdi provides international tax advice to closely held entities and publicly traded corporations. Anthony Diosdi also represents closely held entities and publicly traded corporations in IRS examinations. Anthony Diosdi is a member of the California and Florida bars. Diosdi & Liu, LLP has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: [email protected].

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.