By Anthony Diosdi
In an increasingly global economy, workers are experiencing unprecedented mobility. As such, foreigners living in America, even for a limited time, often participate in a pension or retirement plan in the United States; participation might even be mandatory. In most cases, pretax money is contributed into retirement accounts where it accumulates tax-free until retirement. U.S. retirement such as 403(b) plans, 401(k) plans, and Individual Retirement Accounts (“IRAs”) are commonly encountered by foreigners who are employed in the United States. Whether contributions, earnings, and distributions are includible in a foreign worker’s U.S. taxable income depends on how the worker is classified for U.S. tax purposes and whether a tax treaty exempts an event that is otherwise taxable.
U.S. Retirement Plans in General
The most common U.S. retirement plans, for U.S. tax purposes are 401(k) plans, 403(b) plans, and individual retirement accounts. The applicable classification depends on the employer, contributions, and other factors.
401(k) Plans
A 401(k) plan is an employer-sponsored defined-contribution account defined in Section 401(k) of the Internal Revenue Code. Employee funding comes directly from their paycheck and contributions may be matched by the employer. Income taxes on pre-contributions and investment earnings are tax deferred. . For pre-tax contributions, the employee does not pay federal income tax on the amount of current income he or she transfers to a 401(k) account, but does still pay the 7.65 percent payroll taxes (social security and medicare). Employees of a business with a 401(k) are allowed to contribute up to $19,500 for 2021. For U.S. tax purposes, the participant pays income taxes on the plan distribution when funds are withdrawn from the plan. If an individual needs to access 401(k) funds before the year the participant turns 59 1/2, the participant will be assessed a 10 percent penalty on any withdrawals made in addition to income taxes owed on the withdrawal. In some cases, participants can withdraw funds from a 401(k) plan at age 55 without incurring the 10 percent penalty.
403(b) Plans
403(b) plans resemble 401(k) plans but they serve employees of public schools and tax-exempt organizations rather than private sector workers. Contributions made to a 403(b) plan are not taxed until money is withdrawn from the plan. For 2021, the most an employee can contribute to a 403(b) account is $19,500 in 2021. For U.S. tax purposes, the participant pays income taxes on the plan distribution when funds are withdrawn from the plan. If an individual needs to access 403(b) funds before the year the participant turns 59 1/2, the participant will be assessed a 10 percent penalty on any withdrawals made in addition to income taxes owed on the withdrawal. In some cases, participants can withdraw funds from a 401(k) plan at age 55 without incurring the 10 percent penalty.
Individual Retirement Accounts
An individual retirement account or (“IRA”) is a form of individual retirement plan, provided by many financial institutions, that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with an individual’s earned income for the individual’s eventual retirement. For the 2021 tax year, the total contributions an individual may make to a traditional IRA is $6,000 ($7,000 if the individual is age 50 or older). For U.S. tax purposes, the participant pays income taxes on the plan distribution when funds are withdrawn from the plan. If an individual needs to access IRA funds before the year the participant turns 59 1/2, the participant will be assessed a 10 percent penalty on any withdrawals made in addition to income taxes owed on the withdrawal.
Taxation of Retirement Contributions and Grown of Plan and an Introduction to Tax Treaties
As noted above, earnings invested and earnings accumulated in U.S.-based retirement plans are taxable in the U.S. when the funds are received by the participant. However, U.S. tax treaties with various countries may alter this general rule for certain nonresidents. As a result of a number of tax treaties, in certain cases, if a non-resident came to the U.S. on an E-3 or L-1 Visa for a short-term assignment, the non-resident may be able to withdraw funds from a 403(b), 401(k), or IRA when they return to their home country without being subject to U.S. tax consequences.
Typically, an individual is subject to U.S. tax when he or she withdrawals from a 401(b), 403(b), IRA, or similar U.S.-based retirement fund. In order to discourage the early withdrawal of funds, Section 72(t) of the Internal Revenue Code imposes a 10 percent additional income tax on distributions which fails to satisfy certain criteria. (Unless otherwise specified, all sections are to the Internal Revenue Code of 1986 (“IRC” or “Section”) or the regulations thereunder, both as amended through the date of this article. All references to U.S. taxes herein are to federal taxes, unless otherwise specified). Federal law provides for a 20 percent withholding tax on distributions from many U.S.-based retirement accounts. This withholding rate is increased to 30 percent for non-residents.
Sometimes the Internal Revenue Code is not the only law that governs the taxation of U.S.-based retirement accounts. Section 894(a)(1) states that the provisions of the Internal Revenue Code “shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer.” This means that tax treaties that bilateral tax treaties that the United States has entered into with foreign countries may provide an additional legal forum for tax planning purposes. In many cases, tax treaties alter the general rule which provides that the U.S.-based retirement accounts are sourced in the same manner as personal employment services. We will discuss how this is possible in more detail below.
The Effect of Income Tax Treaties on Federal Tax Law
The tax treaties advance a series of objectives, usually on a reciprocal basis. Their fundamental rationale is to prevent taxes from interfering with the free flow of international trade and investment. Their basic trust is the avoidance of double taxation of income from international transactions by limiting the jurisdiction that each treaty country may exercise to tax income from domestic sources realized by residents of the other country. Most provide clarification in certain respects of areas in which the application of the tax laws of the treaty partners may be ambiguous or unpredictable.
From time to time the Treasury Department will publish its Model Treaty. In general, the Model Treaty reflects the current position of U.S. representatives in negotiating treaty arrangements with other countries. It does not reflect the specific provisions of any treaty actually in force. The U.S. Model Treaty is not the only prototype that has been devised and used. The Organization for Economic Cooperation and Development (“OECD”) (whose members include virtually all of the major industrialized countries) has published a series of model treaties for the elimination of double taxation, together with particularly useful commentaries on the model treaty provisions.
Under the U.S.-Constitution, the U.S. Executive Branch has the exclusive province to negotiate all treaties (including tax treaties) as part of its authority to conduct U.S. foreign relations. Although the State Department has the primary jurisdiction over foreign relations within the Executive Branch, it is the Treasury Department, acting through its Assistant Secretary for Tax Policy and its International Tax Counsel, that actually negotiates tax treaties with the appropriate authorities of the foreign country. If agreement on the treaty is reached with the foreign country, the President signs the treaty on behalf of the United States and sends it to the U.S. Senate for its advice and consent. The Senate then refers the treaty to its Foreign Relations Committee which holds hearings on the matter. If the Senate Foreign Relations Committee approves the treaty, it sends the treaty to the full Senate for its consideration. Once the Senate approves the treaty by a two-thirds vote of its members, the treaty actually becomes effective only if and when the U.S. Executive Branch exchanges instruments of ratification with the foreign treaty country.
A U.S. tax treaty typically specifies the taxes of the foreign treaty partner to which the treaty applies. The treaty also typically provides that it applies only to federal income taxes and to certain federal taxes in the United States and to “identical or substantially similar taxes” of the foreign treaty partner or the United States that may be enacted after the treaty is signed.
The treaty benefits of clarification and the tax reductions are generally made available to “residents” of the parties to the treaty. For U.S. purposes, under Internal Revenue Code Section 7701(a)(30)(A), an individual is a U.S. person if he or she is either a citizen or resident of the United States. Under Section 7701(b), an individual who is not a citizen (i.e., an alien) may be a U.S. resident for U.S. income tax purposes (i.e., a “resident alien”) under either the “permanent residence” test (hereinafter referred to as the “green card” test) or the “substantial presence” test. Additionally, an alien may, in certain circumstances, elect to be treated as a U.S. resident (known as a “First Year Election”).
Section 7701(b) of the Internal Revenue Code provides that a nonresident may be a U.S. resident for U.S. federal income tax purposes under either the “green card” or the “substantial presence” tests. Under the green card test, a lawful permanent resident (green card holder) for any part of a calendar year for U.S. immigration purposes is a U.S. resident for U.S. federal income tax purposes until the green card status is rescinded or administratively or judicially determined to have been abandoned. Under Treasury Regulation Section 301.7701(b)-1(b)(2), rescission occurs through a final, non-ap[peable order of exclusion or deportation. An administrative or judicial determination of abandonment can be initiated by the alien.
Under the substantial presence test of the Internal Revenue Code, an alien present in the United States 183 or more in a single taxable year, including partial days, is a U.S. resident for that year. Furthermore, an alien may also be considered a U.S. tax resident for the current calendar year under the substantial presence test if present at least 31 days in the testing year and the following formula amounts to 183 days or more: add all of the days present in the year being tested, one-third of the days present in the first preceding year, and one-sixth of the days present in the second preceding year. An exception to U.S. residency applies if the alien is not present in the United States for 183 days or more in the testing year and can prove that he or she has a “tax home” in a foreign country and that he or she has a “closer connection” to that foreign country than to the United States.
Because each country to a bilateral tax treaty has its own unique definition of residency, a person may qualify as a resident in more than one country. For example, a nonresident who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of a foreign country under its definition of residency. To resolve this issue, tax treaties typically contain so-called “tie-breaker” rules, which specify how residence is to be determined if an individual is regarded as a resident of both countries under their respective laws and the general tests in the treaty. Tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. For example, Article 4(3) of the U.S. Model Treaty provides the following tie-breaker rules for individuals:
1) The taxpayer is a resident of the country in which he or she has available a permanent home.
2) If the taxpayer has a permanent home available in both countries, the taxpayer is a resident of the country in which his or her personal and economic relations are closer (center of vital interests).
3) If the country in which the taxpayer’s center of vital interests cannot be determined or if the taxpayer does not have a permanent home available to him or her in either state, the taxpayer is a resident of the country in which he or she has a habitual abode.
4) If the taxpayer has a habitual abode in both countries or in neither country, the taxpayer is a resident of the country in which he or she is a citizen.
5) If the taxpayer is a citizen of both countries or of neither country, the competent authorities of the two countries will settle the matter by mutual agreement.
As long as a non-resident can qualify as a resident of a foreign country which the United States currently has an income tax treaty with under that foreign country’s law or under a treaty-tie breaker provision, the non-resident may potentially utilize a tax treaty to escape the U.S. tax imposed on the withdrawal of a U.S.-based retirement plan. However, it should be noted that there is an exception to the principle that residence determines the availability of treaty benefits. Under so-called savings clause provisions, a treaty country saves the right to tax its own citizens as though the treaty did not exist. Due to the savings clause, a U.S. citizen who is a resident of a foreign country and receives a pension or retirement plan payment will be subject to U.S. tax.
It is important to understand that often terms of a U.S. tax treaty modify the tax results that one would otherwise obtain under the Internal Revenue Code. Internal Revenue Code Section 7852(d)(1) provides that “[f]or purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.” This rather enigmatic formulation is another (albeit convoluted) way of stating a basic principle of U.S. jurisprudence with respect to the posture of treaties: under the U.S. Constitution (art. VI, cl. 2), U.S. treaties and federal statutes have equal status as the supreme law of the land and, thus, whenever there is a conflict between the two, the later in time prevails. See Restatement (Third) of the Foreign Relations Law of the United States Section 115 (A.L.I. 1986). Thus, as long as a treaty does not conflict with the Constitution, laws passed by Congress and treaties ratified by the Senate will have equal weight. Consequently, if a tax treaty was ratified by the Senate after an Internal Revenue Code was enacted by Congress, any conflicted provisions of the Code will be superseded by the tax treaty. In other words, when an individual elects to apply the provisions of an income tax treaty, the income tax treaty may overrule the applicable provision of the Internal Revenue Code. The converse of the rule above is also true. If a U.S. statute is enacted that is inconsistent with an existing treaty provision, the statute, being later in time, will prevail and the benefits of the treaty will not be available.
In the context of the taxation of the distributions from a U.S.-based retirement plan, income tax treaties may alter sourcing rules of the Internal Revenue Code. An income tax treaty may not only overrule the sources rules, a treaty may also require legally bound the U.S. to apply OECD commentary to define the terms of a tax treaty. The OECD publishes commentary every four years to interpret terms of income tax treaties. The U.S. joined the OECD in 1961 and the U.S. must apply the OECD definitions to interpret certain tax treaty terms.
Consequently, if both the U.S. and a treaty partner were members of the OECD when a treaty was drafted, U.S. courts are legally required to refer to OECD commentary to interpret certain terms obtained in an income tax treaty. The Internal Revenue Service (“IRS”) has agreed with this interpretation in private letter rulings. Thus, unless enacted later in time from when Treasury Regulations and Treasury Technical Explanations cannot supersede international law. The OECD takes a very broad approach as to what constitutes a “pension distribution” under international treaty law with which the IRS and U.S. courts are legally bound to recognize.
Applying the Income Tax Treaty to a U.S.-Based Retirement Plan Distribution
Below please find an example as to how a tax treaties can be used to eliminate the U.S. income tax consequences associated with the distribution of a U.S. based retirement plan.Let’s assume that Tom is an Italian national that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Tom contributed money to an IRA. Tom has returned to Italy and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. federal 30 percent withholding tax and the 10 percent early withdrawal penalty.
Since Tom is a citizen of Italy, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States-Italy Income Tax Treaty to avoid the 30 percent withholding tax and the early withdrawal penalty. The United States and Italy are both members of the OECD. The U.S.-Italy- Income Tax Treaty was enacted when both countries were members of the OECD.
Under Article 18, Paragraph 1, of the United States- Italian Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explains that “paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment..shall be taxable only in the State [of residency].” This means that under the applicable provisions of the U.S.-Italian Tax Treaty, the country of residence has the sole taxing rights over pension distributions. Since Tom is a resident of Italy, that country would have the sole authority to tax Tom, not the United States. However, the terms “pensions and other remuneration” is not defined in the United States- Italy Income Tax Treaty. Since these terms are not defined in the treaty or its technical explanations, the OECD commentary must be utilized to interpret these terms. The OECD defines the word “pension” under the ordinary meaning of the word that covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 18. See OECD 2014 Commentary, Art 18. Thus, in this case, since Tom received a periodic payment from an “pension plan” as a lump sum payment, the payment received from Tom’s U.S. based IRA would be covered under the United States- Italy Income Tax Treaty.
The results would be the same if Tom was a citizen of Australia. This is because under Article 18, Paragraph 1, of the United States-Australian Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explain that “Paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment… shall be taxable only in that State [of residency].” In other words, under the provisions of the United States- Australia Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Since Tom is a resident of Australia, only that country has a right to tax the retirement plan distributions. In addition, Article 18, Paragraph 4, makes a reference to “periodic payments.” The IRS has clarified that the word ‘periodic’ in Article 18(4) does not preclude the application of the benefits of a tax treaty to lump sum distributions from U.S.-based retirement plans.
The United States currently has income tax treaties with 58 countries, including all of our major trading partners. There are several basic treaty provisions contained common to most income tax treaties to which the United States is a party. In many cases, these provisions are patterned after or similar to the United States- Italy and United States- Australia Income Tax Treaties, which reflects the baseline for how cross-border pensions are taxed. Because the verbiage of these treaties reflects the general pattern of many treaties, it is used as the reference point for a discussion regarding typical treaty provisions. Keep in mind, however, that each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, one must consult the applicable treaty. Below is a sample of a few tax treaties have language similar to the United States- Italy Income Tax Treaty and the United States- Australia Income Tax Treaties regarding the taxation of U.S.-based pension distributions:”
United States- United Kingdom Income Tax Treaty.
United States- Israel Income Tax Treaty.
United States- Republic of China Income Tax Treaty.
United States- Republic of South Korea.Income Tax Treaty.
United States- Arab Republic of Egypt Income Tax Treaty.
United States- Greece Income Tax Treaty.
United States- Canada Income Tax Treaty.
United States- Hungary Income Tax Treaty.
United States- Mexico Income Tax Treaty.
United States- France Income Tax Treaty.
United States- Japan Income Tax Treaty.
The United States joined the OECD in 1961. If both the U.S. and the treaty partner were members of the OECD when each of the above treaties were drafted or revised, citizens of the countries stated above may utilize a tax treaty to avoid the U.S. income tax due on the distribution of a U.S.-based retirement plan.
Whether contributions, earnings, and distributions are includible in a non-resident U.S. income depends on the type of U.S. retirement account and whether a tax treaty exempts an event that is otherwise taxable by the United States. Planning for the U.S. income taxation of a U.S.-based retirement account should include a review of the retirement plan and the applicable tax treaty by a qualified international tax attorney. Special attention should be given to OECD and the treaty at issue is bound to defer to the OECD with regard to interpreting the treaty terms.
Anthony Diosdi is an international tax attorney with the firm of Diosdi Ching & Liu, LLP. Anthony Diosdi is a member of the California and Florida bars. He provides international tax advice to individuals, closely held entities, and publicly traded corporations. Anthony Diosdi has written numerous articles and spoken on a number of panels discussing international taxation at continuing education programs.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.