Did John Castro (or His Related Party AITAX.com) Advise you a Treaty can be used to Exclude Australian Superannuation Funds from U.S. Taxation? Here is How a Superannuation Fund is Taxed in the U.S.

On May 24, 2024, John Castro, the managing partner of Castro & Company was convicted of 33 counts of assisting in the preparation of fraudulent tax returns. According to a United States Attorney’s Office Press Release, John Castro marketed himself to clients around the world and claimed to be an “international tax expert” and “federal practitioner.” Between 2017 and 2019, John Castro filed more than 1,900 tax returns on behalf of individuals from all over the world.

John Castro allegedly promised his clients a significantly higher refund than they would receive from other preparers. During trial, John Castro admitted that the positions he took on tax returns were extreme, outlandish, and not supported by the law. John Castro advised a number of his clients that Australian Superannuation Funds could be excluded from U.S. taxation under the U.S.-Australian income tax treaty. This article discusses how an Australian Superannuation fund is taxed in the United States.

What is a Superannuation Fund

There are currently more than 100,000 Australian-born people living in the United States. Many of these individuals have an Australian Superannuation account. A superannuation is an Australian pension program created by a company to benefit its employees. Funds deposited in a superannuation account will grow through appreciation and contributions until retirement or withdrawal. As with many foreign pension plans, the U.S. federal taxation of superannuation accounts is a gray area. The most common type of superannuation is the Self-Managed Superannuation Funds. This article will focus on Self-Managed Superannuation Funds. This is because Self-Managed Superannuation Funds are the most common type of superannuation.

Many tax professionals consider a superannuation fund to be a foreign grantor trust for U.S. tax purposes. If a superannuation fund can be classified as a grantor trust, all contributions and all growth income is taxed in the U.S. Many issues arise if a superannuation fund is treated as a foreign grantor trust. Other tax professionals take the position that a superannuation fund should be treated as an exempt foreign social security plan for U.S. tax purposes.

The Department of Treasury and the Internal Revenue Service or (“IRS”) has not officially classified the Australian superannuation for U.S. tax purposes. In order to better understand how a superannuation fund is taxed, it is important to discuss the domestic and international treaty law that govern foreign retirement accounts such as the Australian superannuation Fund.

The Australian Social Security System and Superannuation Funds

The U.S. Social Security Administration’s 2010 publication titled “Social Security Programs Throughout the World” analyzes Australia’s overall comprehensive social security system. The publication identifies the 1908 Invalid and Old-Age Pensions and the 1942 Widows’ Pensions Act as the first set of laws that formed Australia’s first social security system. The current regulatory framework of Australia’s overall comprehensive social security system is the 1991 Social Security Act, the 1992 Superannuation Guarantee Administration Act, and the 1999 New Tax System Family Assistance Act 1999. The 1991 Social Security Act provides the traditional, minimal, and basic means-tested social assistance, but it also introduced the concept of “superannuation guarantees” to replace the general social security contributions that started with the 1945 Social Services Contribution Act. See Australia Social Security Act, Section 9(1).

The 1999 Superannuation Guarantee Administration Act mandated compulsory employer contributions to state-mandated occupational pensions that are privately managed. Under current Australian law, employers must contribute 10% of an employer’s salary to state-mandated occupational pension funds called “superannuation funds.” These state-mandated employer contributions are referred to as the “superannuation guarantee.” Additional employee contributions to superannuation funds are optional, but, when contributed, they are treated no different; fully preserved, restricted, and inaccessible until retirement. Thus, regardless of whether the contribution is a “superannuation guarantee” or a “concessional contribution,” they both form a part of the same fully preserved and restricted fund. There are no longer any social security contributions to publicly managed social security accounts in Australia due to Amending Acts from 1945 to 1969 and the final 2014 Repeal Act; they have been entirely replaced by the superannuation guarantee. This represents the privatization of Australia’s traditionally government-run social security pensions.

There are various types of superannuation schemes identified in the 1991 Social Security Act, including, but not limited to, public sector funds established for federal and state government employees, corporate funds established by medium to large private sector companies for their employees, industry or multiemployer funds, retail fund public offer funds, and self-managed superannuation funds. Australia’s current social security system has two components: a means-tested Age Pension funded through general revenue; and the superannuation guarantee funded through compulsory employer contributions to state-mandated superannuation funds, which are similar to compulsory contributions under U.S. Federal Insurance Contributions Act.

In Australia, the Superannuation Guarantee Act of 1992 was adopted in recognition of the fact that Australia, along with many other industrialized nations, had and would continue to experience significant increases to life expectancy due to advances in the field of medicine, which would slowly make their social security system insolvent over time. The proposed solution was the privatization of their social security system that included a very basic need-based age pension system that served as a safety net, private savings generated by state-mandated employer contributions to a superannuation fund that served as the centerpiece of the privatization proposed, and the option for voluntary quasi-after-tax contributions to a superannuation fund. Australian superannuation funds can be characterized as state-mandated occupational pensions with the primary purpose of providing for benefits at retirement.

The U.S. Taxation of an Australian Superannuation Account

Under current U.S. tax law, a distribution from an Australian superannuation fund to a U.S. beneficiary may either be taxed either a distribution from a grantor trust or as a distribution from a foreign social security plan.

We will begin this section of our article by discussing the tax consequences of an Australian superannuation fund being treated as a grantor trust. A superannuation fund can be thought of as a foreign deferred compensation plan. Subchapter D of the Internal Revenue Code contains the rules pertaining to the taxation of “deferred compensation” plans. In order for a deferred compensation plan to be tax-exempt from U.S. tax, the plan must satisfy requirements stated in Internal Revenue Code Section 401. Section 401(a) provides that for a pension plan to be a “qualified plan” and exempt from U.S. tax, it must be organized in the United States.

An Australian superannuation fund cannot be established in the United States. Since an Australian superannuation fund cannot be established in the United States, an Australian superannuation will never be treated as a “qualified plan” under Section 401 of the Internal Revenue Code. As a result, contributions to Australian superannuation funds become taxable in the U.S. once the beneficiary of such a fund becomes a U.S. person. A U.S. person is defined as a U.S. citizen or U.S. green card holder. As a general rule, contributions made by a U.S. person to a non-exempt trust will be taxable as compensation to the U.S. person if the benefits are “substantially vested.” The benefits will be substantially vested if the contributions are not subject to a substantial risk of forfeiture. See IRC Section 83.

Most (if not all) contributions made to superannuation funds will not be subject to a substantial risk of forfeiture because the superannuation fund will be payable to the beneficiary upon a specific event taking place such as retirement or death of the beneficiary of the fund. As a result, if contributions are made to a superannuation fund after an Australian citizen becomes a U.S. person, these contributions made to the superannuation fund will be taxable in the United States under Internal Revenue Code Section 402(b)(1).

The grantor trust rules are included in the Internal Revenue Code to attribute income tax liabilities associated with income received by a trust to the person that is considered to control a trust. The grantor trust rules attribute income tax to trust income regardless if the income has been distributed. Unless a specific provision of the Internal Revenue Code excludes the application of the grantor trust rules, the annual earnings accumulated in Australian superannuation funds will be attributed to the U.S. owners of such plans and are taxable in the U.S. under Section 671 through 679 of the Internal Revenue Code.

Under U.S. tax law, it may also be possible to classify an Australian superannuation as a distribution from foreign social security. Superannuation funds are unique in that they are mandated by the Australian government with the primary purpose of providing for benefits at retirement and as a result, arguably, superannuation funds should be recognized as social security for U.S. tax purposes. A state-mandated “occupational pension scheme” such as a superannuation fund seems to fit the precise definition of social security. For reasons discussed below, if a superannuation distribution can be treated as social security.

The U.S.-Australian Totalization Agreement

Whether or not a superannuation fund can be classified as grantor trust or social security for U.S. tax purposes depends largely on one’s interpretation of the U.S.-Australia Totalization Agreement. A totalization agreement is an international tax treaty that seeks to eliminate dual taxation with regards to social security taxes. The United States signed the Totalization Agreement with Australia that went into effect on October 1, 2002. The Totalization Agreement specifically recognizes “superannuation guarantee” contributions as being social security contributions since the funds are part of Australia’s larger, comprehensive national social security system. For Australia, the Totalization Agreement covers Superannuation Guarantee contributions that employees must make to retirement plans for their employees.

Some tax professionals take the position that the U.S. has acknowledged that a superannuation distribution should be treated as social security. This is because the totalization agreement specifically states that a superannuation contribution is the same or similar to social security contributions. Other tax professionals believe that the goal of the U.S.-Australian Totalization Agreement was to avoid having a taxpayer income withheld in each jurisdiction for employment.Thus, the U.S.-Australian Totalization Agreement should not be interpreted to mean an Australian Superannuation Fund falls under the definition of social security.

An Overview of the Rules Governing Tax Treaties and Federal Law

Most income tax treaties have special rules for social security payments. Under Article 18, Paragraph 2, of the U.S.- Australian income tax treaty, “social security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first mentioned State.” In other words, the country of source has exclusive taxing rights to social security income. Under Article 18, Paragraph 2, of the U.S. Australian income tax treaty, if an Australian superannuation fund can be classified as a public pension or social security, Australia would have exclusive taxing rights to the income.

In order to determine if Article 18 can encompass a superannuation fund, the term public “social security” must be defined. The U.S.-Australia does not define this term. Since the treaty or its technical explanations do not define this term, it may be possible to refer to definitions provided by the Organization for Economic Cooperation and Development (“OECD”).  The OECD publishes guidance in the form of commentaries, which are intended to aid in interpreting the provisions of the tax treaties. The OECD Commentaries are updated from time to time to reflect evolving consensus among the member OECD countries regarding the meaning of particular Model Treaty provisions. If both the U.S. and a treaty partner were members of the OECD when the treaty was drafted, U.S. courts may refer to OECD commentary to interpret terms in that income tax treaty. See Podd v. C.I.R., 76 T.C.M. 906 (1998) (citing U.S. v. A.L. Burbank & Co., 525 F.2d 9, 15 (2d Cir. 1975); North W. Life Assurance Co of Canada v. C.I.R., 107 T.C. 363 (1996); Taisei Fire & Marine Ins. Co. v. C.I.R., 104 T.C. 535, 546 (1995) (construing the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, Mar. 8, 1971, U.S.-Japan, 23 U.S.T. 969, with reference to the Model Treaty and its commentary).

The United States joined the OECD in 1961 while Australia joined in 1971. The U.S.-Australia income tax treaty was signed in 1982 and went into effect in 1983 with an amending protocol in 2001. Therefore, U.S. courts may defer to the OECD with regard to interpreting treaty terms. According to the OECD, the term “social security” generally “refers to a system of mandatory protection that a state puts in place in order to provide its population with … retirement benefits.” See 2014 OECD Commentary, Art 18, 28. However, the OECD Model Income Tax Treaty does not specifically cover social security; it merely suggests that “payments under a social security system… could fall under Article 18, 19 or 21,” which reference pensions from government services, private sector service, or other income, respectively. See 2014 OECD Commentary, Art 15, 2.14. On the other hand, the U.S.-Australia income tax treaty, unlike the OECD Model Income Tax Treaty, does specifically have a provision addressing taxing rights with regard to social security. Nevertheless, the OECD commentary broadly interprets “payments under a social security system” to include payments under a “worker’s compensation fund,” which is not considered “social security” in the United States. The OECD has also impliedly recognized Australian superannuation as a part of Australia’s social security system. See Pensions at a Glance 2013: Country Profiles – Australia. (Although the report refers to superannuation as a private pension, the report seems to be referring to the fact that superannuation funds are privately managed).

The OECD takes a very broad and inclusive approach as to what constitutes “social security.” The Australian state-mandated superannuation system fits the precise definition of social security as provided by the OECD. Under the OECD definition of “social security,” a superannuation account can be classified as social security for purposes of Article 18, Paragraph 2 of the U.S.-Australia income tax treaty.

Even though a compelling argument can be made that the definition of “social security” is broad enough to encompass a superannuation fund, Article 18, Paragraph 2 of the U.S.-Australian income tax treaty provides an implicit (or indirect) definition of “social security” as being a kind of “public pension.” A superannuation fund could be considered “privatized social security.” Defining a superannuation account as “privatized social security” may remove it from Article 18, Paragraph 2 of the treaty. An IRS Chief Counsel Memorandum characterizes Australian superannuation funds as private retirement plans. See IRS CCA 200604023 (October 24, 2005).

At this point, it is unclear if an Australian superannuation fund can be treated as a public pension or social security under the U.S.-Australia income tax treaty. There is a case pending before the United States Tax Court that may eventually offer guidance in this area.  In Dixon v. Commissioner, No. 13874-19 (2019), Dixon argued that his superannuation funds were exclusively taxable under Article 18, Paragraph 2 of the U.S.-Australia income tax treaty. The IRS challenged this position. The case has been continued and it remains to be seen if the Tax Court will issue an opinion on this issue. In the meantime, we can take a closer look at how a U.S. citizen or resident that receives a distribution from a superannuation fund could potentially exclude the distribution under the treaty.

The “Savings Clause” Contained in the U.S.-Australia Income Tax Treaty and its Application to Superannuation Distributions

Anytime a U.S. citizen or resident attempts to claim an favorable tax treaty position, the U.S. citizen or resident must consider the application of a Savings Clause. A Savings Clause contained in an income tax treaty allows the United States to “tax its residents..[and] citizens as if the Convention had not entered into force.” See U.S.-Australia Income Tax Treaty, Art 1, 1 paragraph 3. In other words, the U.S. may disregard most treaty claims by U.S. citizens and U.S. tax residents. It should be understood that the Savings Clause is merely a reserved right and does not automatically apply to prevent treaty claims by U.S. citizens and tax residents. See U.S.-Australia Income Tax Treaty, Art 1, paragraph 3. Although the U.S.-Australia income tax treaty contains a Savings Clause, the Savings Clause in the U.S.-Australia income tax treaty does not apply to Article 18, Paragraph 2 of the treaty as the article specifically states “Social Security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.”

If a superannuation fund can be classified as public social security, the Savings Clause would be inapplicable to claims by U.S. citizens and U.S. tax residents with regard to gains, distributions, or any other income associated with an Australian Superannuation Fund.

Australian Superannuation Funds Can Potentially be Subject to a Worse Cause Scenario for U.S. Tax Purposes
Superannuation Funds often contain mutual funds. This can subject U.S. holders of Australian Superannuation Funds to a worse case scenario if these retirement accounts are subject to U.S. taxation. Foreign mutual funds contained in an Australian Superannuation Fund will likely be taxed under the Passive Foreign Investment (“PFIC”) provisions of the Internal Revenue Code. The objective of the PFIC provisions of the Internal Revenue Code is to deprive a U.S. taxpayer of the economic benefit of deferral of U.S. tax on a taxpayer’s share of the undistributed income of a foreign investment company that has predominantly passive income. Although the PFIC provisions were aimed at U.S. persons holding stock in foreign investment funds, the PFIC provisions have a much broader impact. The PFIC provisions of the Internal Revenue Code may apply to any U.S. person holding stock in any foreign corporation, even one engaged in an active foreign business such as manufacturing, for any tax year in which the corporation derives enough passive income or owns enough passive assets to meet the definition of a PFIC.

A shareholder of a PFIC is subject to the Section 1291 excess distribution rules in which shareholders must allocate excess distributions and gains realized upon the sale of their PFIC shares pro rata to their holding period. See IRC Section 1291(a)(1)(A).

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.

Interest charges are assessed on taxes deemed owed on excess distributions allocated to tax years prior to the tax year in which the excess distribution was received. All capital gains from the sale of PFIC shares are treated as ordinary income for federal tax purposes and thus are not taxed at favorable long-term capital gains rates. See IRC Section 1291(a)(1)(B). In addition, the Proposed Regulations state that shareholders cannot claim capital losses upon the disposition of PFIC shares. See Prop. Regs. Section 1.1291-6(b)(3).

If a Superannuation Fund contains a mutual fund, the interest charged on excess distributions will significantly erode the value of the retirement account over time. In certain cases it may be possible to mitigate the PFIC tax regime on a Superannuation Fund by making a Qualified Electing Fund Election or Mark-to-Market Election. However, these elections come with a significant tax cost.

Australian Superannuation Funds Need to be Disclosed on U.S. Information Returns

Regardless how an Australian Superannuation Fund is taxed in the United States, U.S. persons that are beneficiaries of Australian Superannuation Funds have a number of filing requirements with the IRS. U.S. persons that have signature authority or a financial interest in a financial account located in a foreign country valued at more than $10,000 are required to disclose the financial account to the IRS on FinCEN 114 (“FBAR”). An Australian Superannuation Fund is a financial account located in a foreign country. A U.S. person that has a signature authority or beneficial interest in a Superannuation Fund that surpasses the $10,000 threshold has an obligation to timely disclose it on an FBAR. Failure to timely disclose an Australian Superannuation Fund on an FBAR can result in a minimum annual penalty of $10,000.

U.S. beneficiaries of Australian Superannuation Funds may also need to disclose the retirement account on Form 8938 to the IRS. Form 8938 is used to report interests in specified foreign financial assets and is filed with a U.S. taxpayer’s income tax return. The Form 8938 reports much of the same information as an FBAR but has different and higher reporting thresholds than an FBAR. The reporting thresholds depend on whether a taxpayer is married or unmarried, and whether the taxpayer resides inside or outside the United States. The reporting thresholds generally range between $50,000 and $150,000. Specified foreign financial assets include: 1) financial accounts maintained by a foreign financial institution; 2) stock or securities issued by someone that is not a U.S. person; 3) any interest in a foreign entity; and 4) any financial instrument or contract that has an issuer or counterparty that is not a U.S. person. An Australian Superannuation Fund can easily satisfy one of elements to be considered a specified foreign financial asset. Consequently, an Australian Superannuation Fund should be disclosed on a Form 8938 if it satisfies the threshold requirements. The failure of a U.S. beneficiary of an Australian Superannuation Fund on a Form 8938 can trigger a minimum annual penalty of $10,000 from the IRS.

In some cases, an Australian Superannuation Fund needs to be disclosed on Forms 3520 and 3520-A to the IRS. U.S. persons who own, are a beneficiary of, or interact with, a foreign trust, generally must file Forms 3520 and 3520-A with the IRS. The penalty for failing to file timely file a Forms 3520 can result in a penalty of the greater of 1) $10,000; 2) 35% of the gross value of any property transferred to a foreign trust; 3) 35% of the gross value of the distribution received from a foreign trust; or 4) 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules. The penalty for failing to timely file a Form 3520-A is the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person. A careful analysis should be made by a qualified international tax attorney of each superannuation account held by a U.S. person to determine if there is a Form 3520 and Form 3520-A filing requirement.

In some cases, U.S. beneficiaries of Australian Superannuation Funds will need to file Form 8621 with the IRS. A Form 8621 is used by U.S. persons that are a direct or indirect shareholder of a PFIC if they” 1) receive certain direct or indirect distributions from a PFIC; 2) recognize a gain on a direct or indirect disposition of a PFIC stock; or 3) are reporting information with respect to a QEF or Mark-to-Market election.

Conclusion

Any U.S. beneficiary of an Australian Superannuation Fund should carefully examine their options for U.S. tax purposes. U.S. beneficiaries or holders of Australian Superannuation Funds should also make sure the retirement account is properly disclosed to the IRS to avoid IRS reporting penalties.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony has assisted many former clients of John Castro to become compliant with their U.S. filing obligations.

Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or [email protected].