The Complete Guide to U.S. Taxation of Foreign Pension Plans

Many U.S. taxpayers struggle with how to determine the U.S. tax consequences of their foreign pensions. This article will explore the U.S. income tax rules applied to foreign pensions that cross national borders. There are a number of factors that cause U.S. taxation of foreign pensions to be a difficult topic, not only from the perspective of how to properly report and measure foreign pension-related transactions, but also from a planning and tax efficiency perspective. In addition, the process is further complicated by a number of factors, including the following:

The Difficulties of Applying Source of Income Rules and Foreign Tax Credits Limitations to Foreign Pensions

The United States taxes U.S. persons on all their income, from whatever source derived. Therefore, the source of income generally has no effect on the computation of a U.S. person’s taxable income. Sourcing can have a significant effect, however, on the computation of a U.S. person’s foreign tax credit limitation, which equals the portion of the pre-credit U.S. tax that is attributable to foreign source income. The limitation establishes a ceiling on the amount of foreign taxes that can offset U.S. taxes and is designed to prevent U.S. persons operating in high-tax foreign countries from offsetting those higher foreign taxes against the U.S. tax on domestic income.

The limitation is important to the extent it prevents U.S. taxpayers from crediting all of their foreign income taxes. When a U.S. taxpayer’s creditable foreign taxes are less than the limitation, the cost of paying foreign income taxes is entirely offset by the U.S. tax savings associated with the credit and, therefore, foreign taxes do not represent an out-of-pocket tax cost for the U.S. taxpayer. In contrast, when a U.S. taxpayer’s creditable foreign taxes exceed the limitation, the noncreditable foreign income taxes increase the U.S. taxpayer’s total tax burden beyond what it would have been if only the United States had taxed the foreign-source income. Creditable foreign taxes in excess of the limitation cannot be taken in the current year. Instead, creditable foreign taxes are typically carried back one year and carried forward up to ten years, and taken as a credit in a year in which the limitation exceeds the amount of creditable foreign taxes. See IRC Section 904(c).

In the case of foreign pensions, the computation of the foreign credit limitation determines whether foreign taxes have an incremental effect on a U.S. person’s worldwide tax costs. A U.S. person participating in a foreign pension may have unique issues when it comes time to determine creditable foreign taxes. For example, U.S. participants of foreign pensions may not be taxed in the foreign jurisdiction when a contribution to the plan is made, but may not be taxed in the foreign jurisdiction until distribution. On the other hand, the U.S. participant may be taxed on the contribution to the foreign pension plan. This may result in the U.S. participant in a foreign pension plan not being able to utilize foreign tax credits to reduce U.S. taxes on foreign pensions.

Types of Foreign Pensions

Foreign pensions can be broadly categorized as follows:

Qualified Retirement Plans

Section 401 of the Internal Revenue Code provides that a “qualified” pension must be created or organized in the United States and must be for the exclusive benefit of employees or their beneficiaries. In addition, the pension or retirement trust must satisfy a myriad of other requirements, e.g., it must meet the minimum participation standards of Section 401, must not discriminate in contributions or benefits in favor of highly compensated employees, must meet minimum vesting standards of Section 401, must comply with the limitations on contributions and benefits set forth in Section 415, must prohibit assignment or alienation of benefits, and satisfy minimum standards of Section 412. See Boris I. Bititker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts (2d ed. 1990 & Supp. 1 1996).

Nonexempt Employees’s Trust Contribution Plans

In a “defined contribution plan,” each participant has a separate account. The account reflects contributions as well as trust income, expenses, and gains or losses, and it serves as the basis for determining the participant’s benefits. All employer’s contribution to this type of plan is currently includible by the employee pursuant to Section 402(b)(1) of the Internal Revenue Code and, as a consequence, is currently under Section 404(a)(5), provided that amounts contributed to the plan are nonforfeitable. The trust is treated as a separate taxable entity (rather than as a grantor trust of the employer), and the trust’s investment income is taxed under the rate schedule for trusts, except to the extent of certain current distributions to beneficiaries. The eventual distribution to the employee is taxable to the individual upon receipt pursuant to Section 72 of the Internal Revenue Code. In addition, if the employee is a highly compensated employee and the trust fails to meet certain requirements of a qualified plan for broad coverage and participation of employees, then, according to the Internal Revenue Service (“IRS”), the employee must additionally include his or her vested accrued benefit on an annual basis. See IRC Section 402(b)(4)(A); Priv. Ltr. Rul. 95-030 (Oct 13, 1994) (ruling (6)); Riv. Ltr. Rul. 94-17-013 (Jan. 24, 1994) (ruling (5)); Priv. Ltr. Rul. 92-12-019 (Dec. 20, 1991)(ruling (4)). In order for a foreign pension plan to be classified as a “defined contribution plan,” for U.S. tax purposes, the plan must satisfy the above discussed rules.

Individual Retirement Plans

Under U.S. tax law, individuals may receive favorable tax treatment by contributing to an individual retirement account (“IRA”) or simplified employee pension (“SEP”). Typically, no U.S. tax is assessed on these plans until a distribution from the plan is made. See IRC Section 408(d)(1). A number of foreign countries have individual retirement plans similar to U.S. individual retirement plans. These include certain Australian Superannuation funds, Canadian Registered Retirement Savings Plans (“RRSPs’) and Registered Retirement Income Funds (“RRIFs”), and certain United Kingdom Self Invested Personal Pensions (“SIPPs”) and Individual Savings Accounts (“ISAs”), and Swiss Third Pillar plans. See U.S. Taxation of Foreign Pensions, Retirement Accounts, and Similar Plans (2024), Christopher Callahan.

How Foreign Pensions are Taxed

Once it has been determined that a U.S. person is a participant of foreign pension, a determination must be made as to how the foreign pension plan will be taxed in the United States. Below is a discussion regarding the different methods as to how a foreign pension plan could be taxed in the U.S.

U.S. Tax Concepts Applied to Foreign Pension Plans Classified as a Qualified Pension Plan Under Section 401(a)

If a plan is qualified, then the plan, the employer, and the employees all receive favorable tax treatment with respect to their plan-related income or expenses. To be qualified under U.S. tax law, a plan must comply with an elaborate set of standards. A plan will not be a qualified plan under Section 401(a) of the Internal Revenue Code unless its participation, vesting, and accrual standards meet the requirements of Title 1 of ERISA. Title 1 covers only plans established or maintained by: employers engaged in commerce or whose industry or activity affects commerce; unions representing employees engaged in commerce or in any industry or activity affecting commerce. See ERISA Section 4(a)(1). The most important rule for a plan to be classified as a qualified pension plan is the nondiscriminatory rules. These rules prohibit a plan from favoring highly paid employees and insiders of the business with respect to coverage and benefits. See IRC Sections 401(a)(4)-(5); 410(b).

Under these rules, the minimum coverage standards limit discrimination in favor of highly compensated employees or, correlatively, against nonhighly compensated employees. The concept of a highly compensated employee is a fundamental one for the nondiscriminatory rules. In general, an employee is highly compensated for any given year (the determination year) if he or she: (A) was a 5-percent owner in that year or the preceding one; or (B) in the preceding year received compensation from the employer in excess of a sum indexed for inflation ($160,000 in 2025) and, if the employer elects, was in the top-paid group of employees for that year. See IRC Section 414(g)(1).

A 5-percent owner of a corporation in a given year is a person who at any time in the year owns more than 5% of the outstanding stock or stock possessing more than 5% of the combined voting power. A 5 percent owner of a non-corporate employer in a given year is a person who at any time in the year owns more than 5% of the capital or profit interest. Ownership includes constructive ownership. See IRC Sections 414(q)(4); 415(c)(3). Generally, a foreign pension plan will not satisfy the Section 401(a) qualification rules because these types of pensions must be created or organized in the United States. Thus, the vast majority of foreign pension plans cannot be taxed as a “qualified plan” for U.S. tax purposes. If a foreign pension plan could be taxed as a qualified plan, the employer’s contribution to the plan would be deductible, up to specified limits. See IRC Section 404(a)(1). The deduction is limited to the amount necessary to fund the plan properly under actuarial method and assumptions used. The income of the pension plan or trust would be tax-exempt pursuant to Section 501(a) of the Internal Revenue Code. Investments in the pension plan would accumulate free of any tax. The participant would only be taxed when he or she received distributions from the pension plan. See IRC Section 402(a). Premature distributions would be subject to a 10% federal penalty. See IRC Section 72(t).

U.S. Tax Concepts Applied to the U.S. Taxation of Foreign Pension Plans Tax as a Nonexempt Employee Trust Under Section 402(b)

As discussed above, most foreign pension plans cannot be classified as a qualified plan. Although the vast majority of foreign pension plans cannot be characterized as qualified plans for U.S. tax purposes, some foreign pension plans can be classified as nonexempt plans under Section 402(b) of the Internal Revenue Code.

Section 402(b) governs the taxation of funded employee benefit trusts that are not exempt from tax under Section 501(a), which exempts trusts that satisfy the requirements of Section 401. Section 402(b) typically applies to funded nonqualified deferred compensation arrangements. Section 402(b)(1) provides that employer contributions to a nonexempt employees’ trust are included in an employee’s gross income in accordance with Section 83 of the Internal Revenue Code, except that the value of the employee’s interest is substituted for the property’s fair market value in the first year in which the contributions are transferable or no longer subject to substantial risk of forfeiture. The presence of a substantial risk of forfeiture is determined under Section 83 and its regulations.

Internal Revenue Code Section 402(a)(1) specifies that distributions from a qualified plan (other than rollovers and certain lump sum distributions) are taxable in the year in which they are made, in accordance with Section 72 of the Internal Revenue Code. Section 72 deals with the taxation of annuities, including annuities from plans. Its basic rule is that amounts received in the form of annuity is that amounts are taxed as ordinary income. See IRC Section 72(a). Section 402(b)(2) provides that amounts held in a Section 402(b) trust are not taxed until they are distributed or more available to the individual and taxed under Section 72, with the exception that distributions of income before the annuity starting date (as defined in Section 72) are included in the individual’s gross income without regard to Section 72(e)(5) (relating to special rules for amounts not received as annuities). This means that the amounts are taxed as an annuity; i.e., a portion of the amounts is treated as nontaxable basis recovery, and the remainder is treated as taxable income.

U.S. taxation under Section 402(b) depends on whether the nonexempt trust is discriminatory. A Section 402(b) trust is considered discriminatory if one of the reasons it is not an exempt trust under Section 501(a) is the plan’s failure to satisfy the requirements of either Section 401(a)(26) (participation requirement for qualified defined benefit plans) or Section 410(b) (coverage requirements for qualified defined contribution and defined benefit plans). If the Section 402(b) trust is not discriminatory, employees who participate in the underlying plan are taxed under Sections 402(b)(1) and (2). In contrast, if the trust is discriminatory, highly compensated employees (as described in Section 414(q) are taxed under Section 402(b)(4), which provides that they are taxed each year on the employee’s vested accrued benefits as of the close of the trust’s tax year, less the employee’s investment in the contract.

The concept of “highly compensated employee” is a fundamental one for the nondiscrimination rules. In general, an employee is highly compensated for a given year (the determination year) if he: (A) was a 5-percent owner in that year or the preceding one; or (B) in the preceding year received compensation from the employer in excess of a sum indexed for inflation ($160,000 in 2025) and, if the employer elects, was in the top-paid group of employees for that year. See IRC Section 414(q)(1). A 5-percent owner of a corporation in a given year is a person who at any time in the year owns more than 5% of the outstanding stock or stocks possessing more than 5% of the combined voting power. A 5-percent owner of a non-corporate employer in a given year is a person who at any time in the year owns more than 5% of the capital or profit interest. Ownership includes constructive ownership. Section 318 is one of several sets of constructive ownership rules in the Internal Revenue Code. Its principal role is to treat a taxpayer as “owning” stock that is actually owned by various related parties. The attribution rules in Section 318 fall into the following four categories:

Family Attribution. An individual is considered as owning stock owned by his or her spouse, children, grandchildren, and parents. See 318(a)91).

Entity to Beneficiary Attribution. Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in proportion to their beneficial interests. See IRC Section 318(a)(2)(A). Stock owned by a corporation is considered owned proportionately (comparing the value of the shareholder’s stock to the value of all stock) by a shareholder who owns, directly or through the attribution rules, 50 percent or more in value of that corporation’s stock. See IRC Section 318(a)(2)(C).

Option Attribution. A person holding an option to acquire stock is considered as owning that stock. See IRC Section 318(a)(3)(B).

Compensation includes not only wages, salary, commission, and other items includable in gross income, but as well elective deferrals and elective contributions to other deferred compensation plans. A top-paid employee for a year is an employee in the top 20% for that year, ranked by compensation. See IRC Section 414(q)(3). In determining the number of employees equal to 20%, the following employees are not counted: those who normally work less than 17 ½ hours per week; those who normally work no more than 6 months during any year; those younger than 21; certain employees covered by a collective bargaining agreement; and certain nonresident aliens. See IRC Section 414(q)(5) & (8). An employer may elect less stringent exclusions. Or none at all. Then, the so-called “top 20%” may consist of fewer than 20% of all employees. The exclusions just described are only for purposes of determining the size of the top 20%, not its membership. A top-paid employee may, for example, have completed only 3 months of service. Section 414(q)(6) states that “A former employee shall be treated as a highly compensated employee if he or she separated from service before the determination year and was a highly compensated employee either for the year of separation or any year after he or she reached 55. See IRC Section 414(q)(6).

After the determinations are made regarding whether or not the plan is discriminatory

and whether or not the participant is highly compensated the tax treatment can be

narrowed based on: (1) plans that are not discriminatory, or plans that are discriminatory

but the participant is not highly compensated, and (2) plans that are discriminatory and

the participant is highly compensated.

Taxation of Foreign Pension Under Section 402(b) If the Plan is Not Discriminatory

If a U.S. taxpayer is fully vested (The term “vesting” in a retirement plan means ownership) in a foreign pension plan that is not discriminatory, the amount contributed to the plan is included in U.S. taxable income. See IRC Section 402(b)(1). However, plan earnings are not included in U.S. taxable income until the funds are distributed or made available to the U.S. participant under Section 72. See 402(b)(2). Section 72 deals with the taxation of annuities, including annuities from plans. Section 72 is complex. Its complexities, though, result mainly from the need to exclude portions of annuity payments on which the participant has already been taxed- for example, portions attributable to her own after-tax contributions. Of course, where only non-taxable employer contributions were made on behalf of the participant, the rule is very simple: the annuity payments are taxable in full.

The basic exclusion rule of Section 72 deals with amounts received as an annuity. An annuity payment are defined as amounts payable at regular intervals, over a period of more than one full year from the annuity starting date, for which the total amount payable can be determined as the annuity starting date, either from the terms of the annuity contract or from actuarial tables. See Treas. Reg. Section 1.72-4(b)(1). For amounts received as an annuity, the following proportion- the exclusion ratio – is excluded from gross income: investment in the contract as of the annuity starting date/expected return under the contract as of that date. See IRC Section 72(b)(1). Thus, if an annuity pays $500 per month, and the exclusion ratio is 10%, $50 of each monthly payment is excluded from U.S. gross income.

The investment in the contract is the total of the participant’s after-tax considerations plus any amount of the participant’s contributions that were includible in the participant’s gross income, less the amount received to date under the annuity contract to the extent it was excludible from gross income. See IRC Sections 72(c)(1) & (f). It is essentially the undistributed amount that has already been taxed. The expected return is the total amount expected to be received under the annuity contract, either as fixed by the terms of the contract or from actuarial tables. See IRC Section 72(c)(3). The exclusion continues until the participant’s investment in the contract has been distributed to her. See IRC Section 72(b)(2). After that time, the entire amount of the annuity payment is subject to U.S. tax.  As a result, the amount ultimately excluded from taxable income

for U.S. tax purposes will be equal to the taxpayer’s investment in the contract. The U.S. participant’s investment in the contract or foreign pension plan will generally include contributions and earnings that were previously included in the participant’s U.S. taxable

income, as well as amounts that were previously included in the participant’s

non-U.S. taxable income during a period when the taxpayer was a nonresident

alien of the U.S.

If contributions to a U.S. participant’s foreign pension that is treated as a non-exempt trust, the contributions for U.S. purposes because these amounts are non-vested (i.e., the participant has a substantial risk of forfeiture pursuant to Section 83), but such amounts become vested in a later period, then the vested amount is included in the

taxpayer’s taxable income pursuant to the rules of Treas. Reg. Section 1.402(b)-1(b). For purposes of Section 83, a substantial risk of forfeiture exists when the employee’s right to property or compensation is contingent upon the performance of substantial services or the occurrence of other significant conditions, and there is a real risk of losing those benefits if the conditions are not met.

An example of a foreign pension taxed under Section 402(b)(1) is a Singaporean Central Provident Fund. As per IRS Memorandum PMTA 2007-00173, for an employee who is taxed under the rules of Section 402(b)(1), contributions paid by the employer to the Fund are taxable pursuant to Section 402(b)(1). This is because non-elective contributions are withheld from an employee’s salary without the consent of the employee. Because contributions to the pension are withheld without consent of the employee, the contributions to the plan are not constructively received by the employee for U.S. tax purposes and as a result, these contributions are considered employer contributions and are taxed under Section 401(b)(1).

Taxation of Foreign Pensions if Plan is Discriminary or if Plan is Not Discriminatory, but the Participant is Highly Compensated

If a U.S. taxpayer is fully vested in a foreign pension plan that is discriminatory, the amount contributed to the plan is included in U.S. taxable income the amount to be reported as income in a given year is equal to the vested accrued benefit, less the taxpayer’s investment in the contract (i.e., amounts previously included in income). The net effect of these provisions is that the taxpayer essentially marks the foreign pension to market each year and includes the net vested increase in value in income. In the event the value of the foreign pension decreases for a given year (e.g., the decrease

in value for the year exceeds any current year contributions) the taxpayer would not be entitled to a current deduction, but the taxpayer’s investment in the contract would exceed the vested accrued benefit and additional income would not be reportable until such time as the vested accrued benefit exceeded the investment in the contract.

Assuming the U.S. participant is fully vested in the plan, current earnings are effectively included in U.S. taxable income since current earnings would factor into the taxpayer’s vested accrued benefit. Distributions are taxed in the year distributed or made available to the taxpayer in accordance with the rules for taxation of annuities pursuant to Internal Revenue Code Section 72. As a result, the amount ultimately excluded from taxable income for U.S. tax purposes will be equal to the taxpayer’s investment in the contract. The U.S. participant’s investment in the contract will generally include contributions and earnings that were previously included in the participant’s U.S. taxable income, as well as amounts that were previously included in the participant’s contributions before the individual became a U.S. resident for income tax purposes under Section 7701(b) of the Internal Revenue Code.

If a foreign pension plan participant is not highly compensated (regardless of whether the plan is discriminatory), the U.S. tax implications of fully vested contributions are included in U.S. gross income. However, non-elective contributions to the foreign pension are not included in U.S. gross income for income tax purposes. Foreign pension plan earnings are not subject to U.S. income tax until distributed. Distributions from the foreign pension plan are taxed under the annuity rules of Section 72 of the Internal Revenue Code. See U.S. Taxation of Foreign Pensions, Retirement Accounts, and Similar Plans (2024), Christopher R. Callahan.

If the participant of a foreign pension plan is highly compensated (and the plan is discriminatory), the U.S. participant includes in U.S. gross income the “vested accrued benefit” for the applicable year. A vested accrued benefit is the portion of a retirement benefit that a participant owns and has a non-forfeitable right to, even if they leave the company before they retire. It represents the portion of the retirement benefit that has been earned and is guaranteed.  The participant’s vested accrued benefit may be expressed in the form of an annual benefit payable at normal retirement age. Mathematically, a participant’s accrued benefit is multiplied by the applicable vesting percentage (based on the plan’s vesting schedule). The plan’s vesting schedule should be at least as favorable as one of the vesting schedules identified in Section 411(a)(2) and 416(b). A participant’s vested accrued benefits are typically expressed as annual (or monthly) benefits payable over the life of the participant (life annuity), payable at normal retirement age. As a result, the U.S. participant “mark-to-mark,” effectively including contributions and earnings in the taxable year on a current basis. See Id.
If contributions to the foreign pension plan are not taxable in the year of contribution because such amounts are non-vested (i.e., the taxpayer has a substantial risk of forfeiture pursuant to Internal Revenue Code Section 83), but such amounts become vested in a later period, then the vested amount is included in the U.S. participant’s U.S. taxable income.

Consequence of Foreign Pension Plan Being Classified as a Foreign Grantor Trust

If a foreign pension cannot be classified as a qualified or nonqualified plan for U.S. tax purposes, the U.S. participant of such a plan may be taxed under the grantor trust rules. As discussed in more detail below, foreign pensions taxed under the foreign grantor trust rules could be subject to the harsh PFIC tax provisions. In addition, U.S. participants of foreign pension plans that are taxed under the foreign grantor trust rules may have requirements to file Forms 3520 and 3520-A with the IRS.

A foreign pension can be characterized as a foreign grantor trust for U.S. tax purposes if it does not satisfy the “court” and “control test.” See IRC Section 7701(a)(30)(e).

To satisfy the court test, a court within the U.S. must be able to exercise primary supervision over the administration of the trust.  See Treas. Reg. Section 301.7701-7(a)(i). This means, more specifically, a (i) a U.S. court has authority to render orders or judgment concerning administration, (ii) a U.S. court has authority to determine substantially all issues regarding administration and (iii) the trust does not contain an automatic migration clause. See Treas. Reg. Section 301.7701-7(a)-(e). The control test is satisfied if the only persons that can exercise “substantial decisions” over the trust are either U.S. citizens, U.S. federal income tax residents or U.S. state-based companies (“U.S. persons”). See Treas. Reg. Section 301.7701-7(a)(ii). In other words, if at least one- U.S. person can make or veto a “substantial decision,” the trust fails the control trust. “Substantial decisions” include (but are not limited to) the following: (i) the timing or amount of distributions; (ii) selection of beneficiary; (iii) allocation of receipts between income and principal; (iv) whether to terminate a trust; (v) whether to sue or defend the trust; (vi) whether to remove or add a trustee; and (vii) and investment decisions. See Treas. Reg. Section 301.7701-7(d)(ii).

The vast majority of foreign pensions will not satisfy the “court” and “control test.” For U.S. tax purposes most foreign pensions can be classified as trusts. Under U.S. law, trusts are classified as either grantor or non-grantor trusts. The grantor-owner of a grantor trust is generally required to file a federal tax return to report and pay tax on the trust’s income during the grantor-owner lifetime, if otherwise required to do so. See Treas. Reg. Section 1.671-4(a). In contrast, to the extent a trust was classified as a non-grantor trust, it would generally be treated as a separate entity for federal tax purposes and subject to federal income taxation on its U.S. source income unless such income is distributed to a trust beneficiary as current trust income. See IRC Sections 641(b) and 871.

If a trust (or foreign pension) is considered a grantor trust, then all of the trust’s income, deductions, credits, and other U.S. tax effects (if any) will flow through to the owner of the trust for U.S. income tax purposes. See IRC Section 671. The grantor trust rules generally only apply to a “grantor” who is treated as the “owner” of the assets of a trust. For purposes of the application of the grantor trust rules, a “grantor” includes any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust. 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.

As indicated above, 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 is treated as a grantor trust for U.S. tax purposes, contributions to the foreign pension will be includable in U.S. gross income for income tax purposes. Any annual gains from the foreign pension plan accrued on behalf of a U.S. participant  will also be includable in U.S. taxable income.

U.S. beneficiaries of foreign pension plans taxed as grantor trusts 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.

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.

Definition of PFIC

A foreign corporation is a PFIC if it satisfies either an income or asset test. Under the income test, a foreign corporation is a PFIC if 75% or more of the corporation’s gross income for the taxable year is defined as “foreign personal holding company” for purposes of Subpart F provisions of the Internal Revenue Code, with certain adjustments. Internal Revenue Code Section 954(c) defines “foreign personal holding company income” to include most types of passive income, such as interest, dividends, rents, annuities, royalties and gains from the sale of stock, securities or other property that produces interest, dividends, rents, annuities or royalties. See IRC Section 954(c)(1)(A) and (c)(1)(B)(i). The adjustments include exclusions for income derived from the active conduct of a banking, insurance, or securities business, as well as any interest, dividends, rents, and royalties received from a related person to the extent such income is properly allocable to nonpassive income of the related person. A “related person” is defined in Internal Revenue Code Section 954(d)(3). An individual, corporation, partnership, trust or estate that controls or is controlled by a controlled foreign corporation (“CFC”) is a “related person.” Control means, in the case of a corporation, direct or indirect ownership of more than 50 percent of the total voting power or value of the stock of the corporation.

For purposes of the income test, passive income is subject to four exceptions. The first two exceptions relate to income from the active conduct of a banking or insurance business. See IRC Section 1297(b)(2)(A) and (B). The third covers interest, dividend, rent or royalty income received from a related person to the extent that such income is properly allocated to income of such related person that is not passive income. See IRC Section 1297(b)(2)(C). The fourth covers certain foreign trade income subject to special treatment under two preferential tax regimes for export sales.

Under the asset test, a foreign corporation is a PFIC if the average market value of the corporation’s passive assets during the taxable year is 50% or more of the corporation’s total assets. An asset is characterized as passive if it has generated (or is reasonably expected to generate) passive income in the hands of the foreign corporation. See IRC Section 1297. Assets that generate both passive and nonpassive income in a tax year are treated as partly passive and partly nonpassive to the proportion to the relative amounts of the two types of income generated by those assets in that year. See IRC Notice 88-22. Both the IRS and taxpayers may apply a PFIC test using the adjusted bases of its assets (as determined for earnings and profits purposes) in lieu of their value. However, a publicly traded corporation is required to use the value of its assets in applying the asset test. A PFIC that is also a CFC but is not publicly traded is required to use the adjusted bases of its assets in applying the asset test for PFIC status with no option to use the value of its assets.

Taxation 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).

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 with the IRS.

Nonexempt Employees’ Trusts under IRC Section 402(b)- Employee-Related Pensions

Whether or not a foreign trust is classified as nonexempt employees’ trust taxed under Section 402(b) compared to a grantor foreign trusts rules is not always clear. Certain foreign pension schemes clearly fall into one category or the other, while the proper classification of other foreign pension schemes is difficult to determine. However, where the foreign employer makes most if not all contributions to the plan will probably not be classified as a foreign grantor trust. On the other hand, foreign pension schemes similar in nature to domestic individual retirement accounts (e.g., Canadian RRSPs and RRIFs, U.K. Individual Savings Accounts (“ISAs”), and certain Australian superannuation funds consisting of elective deferrals and controlled by the individual contributor) would almost

certainly be classified as foreign grantor trusts. The classification of other foreign retirement plans are less certain. See U.S. Taxation of Foreign Pensions, Retirement Accounts, and Similar Plans (2024), Christopher R. Callahan.

Foreign Pension Reporting Requirements

Foreign retirement plans can be classified as foreign financial accounts under U.S. law. Consequently, a U.S. beneficiary of a foreign pension plan may need to disclose the pension on an information return to the IRS. There are two categories of international information returns used to disclose interests in foreign financial accounts, those filed with the Financial Crimes Enforcement Network (or “FinCEN”) and those filed with the IRS. Regardless of which agency the returns are filed with, it is the IRS that enforces the filing requirements through the assertion of penalties. We begin with the only one of the listed returns to be filed with FinCEN, the FBAR. And while the FBAR is not a “return” per se, this correspondence refers to it as such for ease of discussion. The FBAR filing requirements are not found in the Internal Revenue Code but rather are found in the Bank Secrecy Act of 1970, codified in Title 31 of the United States Code (31 U.S.C. Sections 5311-5332, with exception of Section 5315). However, many of the specific requirements are found in regulations, for example 31 C.F.R. 1010.350. In general, U.S. persons having a financial interest in, or signature authority over, a bank, securities, or other financial account in a foreign country, whose aggregate balance exceeds $10,000 on any given day of the tax year, must file an FBAR.

A U.S. person has a “financial interest” in a foreign financial account for which he or she is the owner of record or holder of legal title, regardless of whether the account is maintained for the benefit of the U.S. person or for the benefit of another person. A U.S. person has a “financial interest” in each account where the titleholder or owner of the account falls into one of the following categories: (1) the U.S. person’s agent, nominee, or attorney; (2) a corporation whose shares are owned, directly or indirectly, more than 50 percent by the person, (3) a partnership in which the person owns greater than a 50 percent profits interest, (4) a trust of which the person derives in excess of 50 percent of the current income or in which the person has a present beneficial interest in more than 50 percent of the assets, or (5) any other entity in which the U.S. person owns directly or indirectly more than 50 percent of the voting power.

A person has “signature authority” over an account if the person can control the disposition of assets held in a foreign financial account by direct communication (whether in writing or otherwise) to the bank or other financial institution that maintains the financial account.

If a U.S. participant of a foreign pension has a “financial interest” or “signature authority” over the pension and the total value of the U.S. person’s foreign financial accounts exceeds $10,000 at any time that year, the U.S. participant must timely disclose the foreign pension on an FBAR to FinCEN.

The penalties which the IRS can impose for an individual’s failure to timely file an FBAR vary significantly based on the degree of culpability of the individual and is based on all of the facts and circumstances relating to the individual’s noncompliance. But this culpability boils down to simply willful and non-willful (including negligent) in their failure to timely file an FBAR, the penalty to $10,000 per violation. If the IRS believes that the failure to file an FBAR was “willful,” the penalty is the greater of $100,000 or 50% of the balance of the account at the time of the violation, whichever is greater. There is currently a significant amount of uncertainty regarding the definition of “willful” for purposes of the FBAR penalty provisions. The IRS generally takes the position that a person can “willfully” fail to file an FBAR if the person acts with a reckless disregard of a statutory duty, i.e., they can act “willfully” even if they did not know about the requirements of the law.

A foreign pension may also need to be disclosed to the IRS on a Form 8938. Form 8938 is used to report interests in specific financial assets and is filed with an individual’s income tax return. The Form 8938 reports much of the same information as an FBAR but has different and higher thresholds than an FBAR. The reporting thresholds depend on whether an individual is married or unmarried, and whether the individual resides inside or outside the United States. But the reporting thresholds generally range between $50,000 and $150,000. Under Section 6038D of the Internal Revenue Code, the penalty for not timely filing a Form 8938 is $10,000 per year.

If a U.S. person holds a foreign pension that can be classified as a grantor foreign trust, the U.S. person may be required to timely file Form 3520 and Form 3520-A with the IRS. A U.S. person must file a Form 3520 with the IRS in connection with a foreign pension classified as a grantor trust if: 1) a reportable event occurred during the tax year; 2) a U.S. person transferred property to a foreign trust in exchange for an obligation; 3) the person is deemed an owner of the trust based on the grantor trust rules discussed above; 4) the person received a distribution from a foreign trust and in the current year the person or a person related to the person received a loan of cash or securities directly or indirectly from the trust, or the uncompensated use of trust property; and 6) the person is a U.S. person who is a U.S. owner or beneficiary of a foreign trust holds an outstanding qualification of the U.S. person. The penalty for failing to timely file Form 3520 with regard to a foreign trust is the greater of 1) $10,000; 2) 35% of the gross value of any property transferred to the foreign trust; 3) 35% of the gross value of the distributions received from the 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.

Form 3520-A is used to report information on a foreign trust with at least one U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules and is responsible for ensuring that the trust files a Form 3520-A with the IRS. The penalty for failure to file 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 at the close of that tax year.

Finally, if a foreign trust is treated as a grantor trust and contains PFICs, the U.S. owner of the foreign grantor trust will be required to file a Form 8621 with the IRS. The Form 8621 is used to report PFICs and PFIC transactions to the IRS.

Conclusion

The foregoing is intended to provide the reader with basic U.S. tax 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.