How Tax Treaties Can Reduce U.S. Tax Consequences Associated With Foreign Pensions

Many U.S. taxpayers are beneficiaries of foreign pension plans. The rules governing the taxation of foreign pension plans are both confusing and complicated. In certain cases, U.S. participants of foreign pension plans may utilize favorable tax treaty positions with respect to the U.S. taxation of their foreign pension plans. This article discusses the applicability of tax treaties to reduce U.S. tax consequences associated with foreign pension plans.

The Impact of a Savings Clause on the Use of Tax Treaties

The United States has tax treaties with approximately 60 countries. Tax treaties can be an important tool to eliminate double taxation. Most U.S. tax treaties that the United States is a party contains a “saving clause”. A “saving clause” is an article or provision in a tax treaty that guarantees the right of the United States to impose taxation on its residents as if the tax treaty did not exist. Savings clauses contained in tax treaties essentially invalidates many of the benefits of the treaty. However, of “savings clauses” contained in tax treaties do not apply to pensions. In certain cases, this allows U.S. residents that are beneficiaries of foreign pensions to reduce or defer U.S. tax consequences associated with a foreign pension plan. Below, is a discussion of a sample of treaties and treaty articles that permit U.S. persons with foreign pensions to reduce, defer, or eliminate U.S. taxation associated with a foreign pensions.

Treaty Provisions that Permit Deferral of Plan Earnings Received from Foreign Pension Plans Until there is a Distribution

Many participants in foreign pension plans are subject to annual U.S. taxation even if the participant did not receive an actual distribution from the foreign pension plan. A number of tax treaties permit U.S. beneficiaries of foreign pension plans to defer or delay U.S. income tax liability in connection with a foreign pension until such time distributions are paid to the U.S. beneficiary by the foreign pension.

Income tax treaties and applicable articles in the treaty that permit U.S. participants of foreign pensions to defer the income tax consequences associated with a foreign pension until distributions are paid are as follows.

U.S.-Belgium Income Tax Treaty

Article 17(6) of the U.S.-Belgium income tax treaty provides as follows:

“If a resident of a Contracting State participates in a pension fund established in the other Contracting State, the State of residence will not tax the income of the pension fund with respect to that resident until a distribution is made from the pension fund. For example, if a U.S. citizen contributes to a U.S. qualified plan while working in the United States and then establishes residence in Belgium, Article 17(6) prevents Belgium from taxing the plan’s earnings and accretions with respect to that individual.”

The “savings clause” to the United States-Beligium tax treaty is contained in Article 1(5).
Article 1(5) sets forth exceptions to the savings clause that would typically prevent a U.S. participant of a foreign pension plan from utilizing Article 17(6) to defer U.S. income tax associated with a foreign pension. Article 1(5)(a) exempts pensions from the savings clause. Since Article 1(5) exempts pensions from the savings clause. Article 17(6) permits U.S. participants of foreign pensions established in Belgium to defer the recognition of income tax until the funds of the plan are distributed to the U.S. resident.

U.S.-Bulgaria Income Tax Treaty

Article 17(5) of the U.S.-Bulgaria income tax treaty provides as follows:

“if a resident of a Contracting State participates in a pension fund established in the other Contracting State, the State of residence will not tax the income of the pension fund with respect to that resident until a distribution is made from the pension fund.”

The “savings clause” to the United States-Bulgaria income tax treaty is contained in Article 1(5)(a). Article 1(5)(a) sets forth exceptions to the savings clause that would typically prevent a U.S. participant of a foreign pension plan from utilizing Article 17(5) to defer U.S. income tax associated with a foreign pension. Article 1(5)(a) exempts pensions from the savings clause. Since Article 1(5)(a) exempts pensions from the savings clause. Article 17(5) permits U.S. participants of foreign pensions established in Bulgaria to defer the recognition of income tax until the funds of the plan are distributed to the U.S. resident.

U.S.-Canada Income Tax Treaty

Under the U.S.-Canada income tax treaty, the general rule is:

“Pensions and annuities from a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State, but the amount of any pension included in income for the purpose of taxation in the other State shall not exceed the amount that would be included in the first-mentioned State of the recipient were a resident thereof.” See Article XVIII(7).

Under Article XVIII(7) of the U.S.-Canada income tax treaty, if a person was a resident of the first country and earned pension income from a source within the second country, then both countries could tax the pension income but only to an extent. Pension income from a Canadian source and paid to a resident of the United States is subject to both Canadian tax and U.S. tax. However, the Canadian tax is limited to 15 percent of the gross amount (periodic pension) or of the taxable amount (annuity). Canadian pensions paid to a U.S. citizen or resident can be taxed by the United States, but the amount in U.S. taxable income cannot be greater than the amount that would be included in Canadian income of the recipient were a Canadian citizen or resident. However, a U.S. citizen or resident can elect to defer the U.S. tax on the accrued income of a Canadian pension until the income is distributed. Under Rev. Proc 2014-55, 2014 IRB 1, a U.S. citizen or resident by making an election to defer the accrued income from a Canadian pension.

In order to qualify to make the election under Rev. Proc 2014-55, the U.S. participant in a Canadian pension must satisfy the following requirements:

1) The participant must have been a U.S. citizen or resident while he or she was a beneficiary of the pension plan;

2) The participant must satisfy requirements for filing a U.S. federal income tax return for each year during which the individual was a U.S. citizen or resident;

3) The participant has not reported as gross income on a U.S. federal income tax return the earnings that accrued in, but were not distributed by, the plan during any tax year in which the individual was a U.S. citizen or resident; and

4) The participant has reported all distributions received from the plan if the individual made an election under Article XVIII(7) of the treaty for all years during which the individual was a U.S. citizen or resident.

If a U.S. participant of a Canadian pension plan is eligible to make an election under Rev. Proc 2014-55, that person can make the deferred election on the Canadian pension income by reporting the income from the pension when it is first distributed.

U.S.-Iceland Income Tax Treaty

Article 17(4) of the U.S.-Iceland income tax treaty provides:

“Paragraph 4 provides that, if a resident of a Contracting State participates in a pension fund established in the other Contracting State, the State of residence will not tax the income of the pension fund with respect to that resident until a distribution is made from the pension fund.”

The “savings clause” to the United States-Iceland income tax treaty is contained in Article 1(5)(2). Article 1(5)(2) sets forth exceptions to the savings clause that would typically prevent a U.S. participant of a foreign pension plan from utilizing Article 17(4) to defer U.S. income tax associated with a foreign pension. Article 1(5)(2) exempts pensions from the savings clause. Since Article 1(5)(2) exempts pensions from the savings clause. Article 17(4) permits U.S. participants of foreign pensions established in Iceland to defer the recognition of income tax until the funds of the plan are distributed to the U.S. resident.

U.S.-Malta Income Tax Treaty

Article 18 of the U.S.-Malta income tax treaty provides:

“This Article provides that, if a resident of a Contracting State participates in a pension fund established in the other Contracting State, the State of residence will not tax the income of the pension fund with respect to that resident until a distribution is made from the pension fund.”

The “savings clause” to the United States-Malta income tax treaty is contained in Article 1(5)(3). Article 1(5)(3) sets forth exceptions to the savings clause that would typically prevent a U.S. participant of a foreign pension plan from utilizing Article 18 to defer U.S. income tax associated with a foreign pension. Article 1(5)(3) exempts pensions from the savings clause. Since Article 1(5)(3) exempts pensions from the savings clause. Article 18 permits U.S. participants of foreign pensions established in Malta to defer the recognition of income tax until the funds of the plan are distributed to the U.S. resident.

U.S.-United Kingdom Income Tax Treaty

Article 18(1) of the United States- United Kingdom income tax treaty provides:

“Paragraph 1 provides that if a resident of a Contracting State participates in a pension scheme established in the other Contracting State, the State of residence will not tax the income of the pension scheme with respect to that resident until a distribution is made from the pension scheme.”

The “savings clause” to the United States-United Kingdom income tax treaty is contained in Article. Article 1(5)(3) sets forth exceptions to the savings clause that would typically prevent a U.S. participant of a foreign pension plan from utilizing Article 18(1) to defer U.S. income tax associated with certain United Kingdom pensions. Article 1(5)(3) exempts pensions from the savings clause. Since Article 1(5)(3) exempts certain pensions from the savings clause. Article 18(1) permits U.S. participants of certain foreign pensions established in the United Kingdom to defer the recognition of income tax until the funds of the plan are distributed to the U.S. resident.

Besides the treaties discussed above, a U.S. person may also be able to utilize the U.S.-Germany income tax treaty and the U.S.-Netherlands income tax treaty to defer U.S. taxation on pensions established in Germany and the Netherlands.

Deduction of Plan Contribution and Exclusion of Certain Accrued Benefits for U.S. Citizenship to Non-U.S. Plans

U.S.-Belgium Income Tax Treaty

In many cases, contributions to foreign pension plans are not deductible for U.S. tax purposes. Some tax treaties that the U.S. is a party contain provisions which permit U.S. persons to claim a deduction for U.S. income tax purposes in connection with a foreign pension contribution. For example, Article 17(9) of the U.S.-Belgium income tax treaty provides “U.S. tax treatment for certain contributions by or on behalf of U.S. citizens resident in Belgium to pension funds established in Belgium (or a similar fund that is a resident of a comparable third State) that is comparable to the treatment that would be provided for contributions to U.S. funds. Under subparagraph (a), a U.S. citizen resident in Belgium may exclude or deduct for U.S. tax purposes certain contributions to a pension fund established in Belgium. Qualified contributions generally include contributions made during the period the U.S. citizen exercises an employment in Belgium if expenses of the employment are borne by an employer or permanent establishment in Belgium. Similarly, with respect to the U.S. citizen’s participation in the pension fund in Belgium, accrued benefits and contributions during that period generally are not treated as taxable income in the United States.”

U.S.-Germany Income Tax Treaty

Similarly, Article 18A(5) of the U.S.-Germany income tax treaty specifically addresses the tax treatment of pension plan contributions and benefits for U.S. citizens reading and working in Germany. Article 18A(5) further provides that U.S. residents can deduct contributions made to German pension plans for U.S. tax purposes. In addition, Article 18A(5) provides that benefits accrued under a German pension plan, and employer contributions, are not considered taxable income in the United States. Article 1(5)(a) of the savings clause contained in the U.S.-Germany income tax treaty excludes pensions.

Thus, a U.S. citizen who is a resident in Germany exercises employment for a German employer who is also resident in Germany. The employment income is taxable in Germany. The U.S. citizen participates in a German benefit plan established under Section 1 of the German law on employment-related provisions. The German employer makes plan contributions for the benefit of the U.S. citizens that are excluded from income in Germany and the employee makes contributions that are deductible for German tax purposes. Both the employer and employee contributions are below the maximum contributed levels permitted under German and U.S. law. Pursuant to Article 18A(5) of the U.S.-German income tax treaty the employee contributions are deductible for U.S. tax purposes and the employer contributions are excludable from U.S. taxable income.

U.S.-Canada Income Tax Treaty

Article XVII(13) of the United States-Canada income tax treaty discusses the deductibility of contributions made to a qualifying retirement plan in Canada by a U.S. citizen or resident. Article XVII(13) permits U.S. citizens or residents residing in Canada to deduct or exclude contributions to a qualifying Canadian retirement plan for U.S. income tax purposes. The savings clause contained in Article XXIX of the U.S.-Canada income tax treaty does not prevent a U.S. citizen or resident from deducting contributions to a qualified Canadian retirement plan.

U.S.-United Kingdom Income Tax Treaty

Article 18(5) of the U.S.-United Kingdom income tax treaty addresses the U.S. tax treatment of U.S. citizens or residents participating in United Kingdom pension schemes. Article 18(5) permits a deduction or exclusion of contributions made by U.S. citizens or residents working in the United Kingdom that make contributions to United Kingdom pension schemes for U.S. income tax purposes. The savings clause contained in Article 1 of the U.S.-United Kingdom income tax treaty does not prevent a U.S. citizen or resident from deducting contributions to a qualified United Kingdom pension plan.

As a general rule, in order to qualify for a treaty provision that excludes contributions and/or accrued benefits from a foreign pension plan, the U.S. participant must:

1. The U.S. citizen is resident in the foreign country;
2. The U.S. citizen is exercising employment which is taxable in the foreign country;
3. Employer contributions are borne by an employer resident in the foreign country, or by a permanent establishment in the foreign country; and
4. The U.S. citizen is a beneficiary of, or participating in, a pension fund that is a resident of the foreign country.

Deduction of Plan Contribution and Exclusion of Certain Accrued Benefits

Some tax treaties permit individuals who are residents (but not nationals) of one contracting state and working in the other contracting state to deduct or exclude contributions made to a pension plan established in their country of residence, as if it were a retirement plan in their country of employment. Many treaties contain these benefits for a period of time. (e.g., U.S.-Switzerland income tax treaty has a 5-year limit,
the U.S.-Canada treaty is limited to the performance of services for the same (or related) employer for 60 of the 120 months preceding the current tax year, the U.S. -Ireland treaty has a 5-year limit, and the U.S.Switzerland treaty has a 5-year limit).

The U.S. tax treaties with Austria, Belgium, Canada, France, Germany, Ireland, Italy, Netherlands, South Africa, Sweden, Switzerland, and the United Kingdom contain such provisions.

Unusual Provision Contained in the U.S.-France Income Tax Treaty

Article 18 of the U.S.-France income tax treaty discusses the taxation of pensions and social security. Article 18 of the U.S.-France income tax treaty provides that pension payments, whether paid periodically or in a lump sum, are taxable only in the country where the payment originates. Thus, if a U.S. citizen or resident receives a payment from a pension plan located in France as a result of past employment in France, the payments from the French pension are not taxed in the United States. The savings clause is contained in Article 29 of the U.S.-Franch income tax treaty. Article 29(3) of the treaty specifically excludes pensions. Consequently, the savings clause contained in the U.S.-France income tax treaty will not prevent a U.S. participant of a French pension plan from excluding payments received from the plan for U.S. income tax purposes. That is, as long as the pension plan was funded through past employment in France.

Conclusion

The foregoing is intended to provide the reader with basic tax treaty considerations regarding foreign pension plans. It should be evident from this article that this is a relatively complex subject. As a result, it is crucial that U.S. participants of foreign pension plans review his or her particular circumstances with a qualified international tax attorney.

We have substantial experience advising clients that are beneficiaries of foreign pension plans.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

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.

Under current and developing law, expatriation can be costly for both those expatriating and for those who may receive gifts or bequests from those who have expatriated. However, in certain cases, there are planning opportunities to reduce these potential tax consequences.

We have substantial experience advising clients expatriating from the United States. We assist clients that wish to expatriate from the United States and provide exit tax planning advice.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

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.