- Commercial Litigation
- Criminal Tax Representation
- Cross-Border Mergers and Acquisitions
- Cryptocurrency Tax Matters
- Estate and Gift Tax for Foreign Investors
- Estate Tax Planning
- Expatriation
- FBAR Preparation and Penalty Defense
- FIRPTA
- Independent Contractor Disputes
- International Penalties
- International Tax Planning and Advice
- IRS Offshore Voluntary Disclosure Representation
- IRS Representation and Compliance
- Preparation of Form 3520
- Preparation of Form 5471
- Preparation of Form 5472
- Preparation of Form 8621 and PFIC Reporting
- State Tax Planning and Litigation
- Tax Audits, Controversies, and Litigation
- Tax Planning and Opinions
- Tax Planning of Cross-Border Cloud Computing Transactions
- Tax Preparation
- Tax-Exempt and Nonprofit Organizations
- Taxation of Foreign Pensions

Taxation of Foreign Pensions

In the last 20 years, there has been a significant upward trend of highly skilled foreign workers moving to the United States for temporary assignments. For foreigners planning to move to the United States for a temporary work assignment, pre-immigration tax planning is crucial. Whether the goal is to minimize the tax effects of the move or to structure the foreigner worker’s holdings to optimize tax consequences after the move, pre-immigration planning must be undertaken. One of the keys to developing strategies for minimizing U.S. federal tax in pre-immigration context is to understand that many foreign workers accepting a work assignment in the United States will become a U.S. person for U.S. federal tax purposes.
Under Internal Revenue Code Section 7701(a)(3)(A), an individual is a U.S. person if he or she is either a citizen or a resident of the United States. Under Internal Revenue Code Section 7701(b), an individual who is not a U.S. citizen may be a U.S. resident for U.S. income tax purposes (i.e., a “resident alien”) under either the “permanent residence” test (i.e., “green card” test) or the “substantial presence” test. In addition, in certain circumstances, a foreign worker may elect to be treated as a U.S. resident.
Once an individual becomes a U.S. resident for U.S. income tax purposes, he or she will be subject to U.S. income taxation with respect to his or her worldwide income. Additionally, such an individual will be subject to various special income tax consequences with regards to interests in foreign pension plans. A foreign pension has three separate components that need to be considered for U.S. income tax purposes: 1) contribution to the plan; 2) foreign employer’s contribution; and 3) any investment income. Each of these separate components can be subject to U.S. tax. This article will discuss the U.S. tax consequences of foreign pensions.
U.S. Taxation of Foreign Pension Contributions
In order for a contribution to a pension plan to avoid U.S. tax, the construction must be made to a “qualified plan” “deferred compensation plan.” Internal Revenue Code Subpart A of Pt 1 of Subchapter D of Chapter 1 contains the rules pertaining to the taxation of “deferred compensation” (pension plans) in the U.S. In order for a pension plan to be tax-exempt, the plan must satisfy the requirements contained in Section 401 of the Internal Revenue Code. Section 401(a) specifically provides that, for a pension plan to be a “qualified plan” (and therefore exempt from tax under Section 501 of the Internal Revenue Code, it must be organized in the United States.
Accordingly, this means that no foreign pension plan can be a “qualified plan.” The amount of the contribution that will be taxable is determined under Section 402(b)(1).
Generally, any contributions made by a taxpayer to a non-exempt trust will be taxable as compensation to the taxpayer in the U.S. if the benefits are “substantially vested.” The benefits will be substantially vested if the contributions are not subject to a substantial risk of forfeiture. Most contributions made to foreign retirement plans will not be subject to a substantial risk of forfeiture because the plan will be payable to the taxpayer upon retirement, incapacity or to a nominated beneficiary upon the death of the taxpayer. Therefore, generally, if contributions are made to foreign pension plans after a foreign individual becomes a U.S. person, the contributions will be taxable under Section 402(b)(1) of the Internal Revenue Code.
U.S. Taxation of Foreign Employer’s Contribution
Whether or not a foreign employer’s contribution is taxable in the U.S. often depends on how the plan is taxed for purposes of the U.S. grantor trust rules. The grantor trust rules are designed to attribute the income tax liability associated with income derived by a trust (whether domestic or foreign) to the person that is considered to be the “controller” of the trust, regardless of who the income has been distributed to. Under the grantor trust rules, a grantor trust is any trust in which the grantor retains one or more of the following powers:
- A reversionary interest of more than 5 percent of the trust property or income;
- The power to revoke the trust;
- The power to distribute income to the grantor or grantor’s spouse;
- Power over the beneficial interest in the trust;
- Administrative powers over the trust permitting the grantor to benefit.
A grantor is defined as a person who either creates a trust, or directly or indirectly makes a gratuitous transfer of property or money to a trust. The grantor trust rules are designed to attribute the income tax liability associated with the income derived by a trust to the person that is considered to be the “controller” of the trust. If a foreign pension plan can be classified as a grantor trust, employer contributions to a foreign pension plan could potentially trigger a U.S. tax consequence during the tax year the contribution is made. It is therefore critical that an individual assessment of the circumstances of each foreign pension plan with a U.S. beneficiary be undertaken to determine the tax consequences of an employer’s contribution to the plan. This should particularly be the case with Australian superannuation plans due to the fact that many of these plans can be classified as grantor trusts under U.S. tax law. Although the grantor trust rules can potentially tax employer contributions, there are provisions in the Internal Revenue Code such as Section 402(b)(3) that exclude the application of the grantor trust rules to the beneficiaries of foreign pension plans. In certain cases, Section 402(b)(3) could defer the U.S. taxation to a foreign pension plan of a U.S. beneficiary.
U.S. Taxation of Investment Income
Earnings accumulating in a foreign pension plans that are classified as grantor trusts are typically taxed in the U.S. as ordinary income on an annual basis. Earnings accumulated in a foreign pension plan that is classified as a non-grantor trust is not typically subject to U.S. taxation until distributed to the U.S. beneficiary. U.S. beneficiaries of foreign pension plans should be mindful of the investments contained in the plan. Foreign pensions often invest in foreign stocks or foreign foreign mutual funds. Investment income in foreign mutual funds is typically subject to a special tax known as the Passive Foreign Investment Company of “PFIC” tax regime. A PFIC is a foreign corporation that satisfies either the “income test” or the “asset test.” Under the income test, a foreign corporation is a PFIC if 75% or more of its gross income is passive. See IRC Section 1297(a). Under the asset test, a foreign corporation is a PFIC if 50% or more of the average value of its assets consists of assets that would produce passive income. See IRC Section 1297(a)(2). For purposes of the income test and asset test, passive income means any income which is of a kind which would be foreign personal holding company income under Internal Revenue Code Section 954(C). There is no minimum threshold for ownership by U.S. persons under the PFIC regime. Hence, any percentage of PFIC stock owned by a U.S. person through a foreign pension plan may implicate the PFIC regime with respect to that shareholder.
The tax consequence to holding foreign corporate stock that are PFICs is extremely punitive. Under the PFIC rules, the U.S. person holding stock in the PFIC pays tax when they receive a distribution from the PFIC or sell their shares of PFIC stock. The individual must also pay an interest charge attributable to the value of the tax deferral when he or she receives an unusually large distribution (called an “excess distribution”) or when he or she has gains from the disposition of the PFIC stock. If the holder of the PFIC receives a usually large distribution (called an “excess distribution”) or has gain from the disposition of the PFIC stock they are subject to special tax which will be discussed below.
An excess distribution includes the following:
- A gain realized on the sale of PFIC stock, and
- Any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer for the year exceeds 125 percent of the average actual distribution received by the taxpayer in the preceding three taxable years. The amount of an excess distribution is treated as if it had been realized pro rata over the holding period of the foreign share and, therefore, the tax due on an excess distribution is the sum of the deferred yearly tax amounts. This is computed by using the highest tax rate in effect in the years the income was accumulated, plus interest. Any actual distributions that fall below the 125 percent threshold are treated as dividends. This assumes they represent a distribution of earnings and profits, which are taxable in the year of receipt and are not subject to the special interest charge.
Below, please see Illustration 1. and Illustration 2. which demonstrates a typical sale of PFIC stock.
Illustration 1.
Jim is an engineer and a citizen of Germany. Jim moved to California and became a U.S. green card holder. Jim likes to invest in foreign mutual funds. On the advice of his German broker, on January 1, 2016, Jim buys 1 percent of FORmut, a mutual fund incorporated in a foreign country for $1. FORmut is a PFIC. During the 2016, 2017, and 2018 calendar years, FORmut accumulated earnings and profits. On December 31, 2018, Jim sold his interest in FORmut for $300,001. To determine the PFIC excess distribution, Jim must throw the entire $300,000 gain received over the entire period that he owned the FORmut shares – $100,000 to 2016, $100,000 to 2017, and $100,000 to 2018. For each of those years, Jim will pay tax on the throw-back gain at the highest rate in effect that year with interest.
It is easy to envision significantly more complex scenarios. Such a scenario is described in Illustration 2 which is based on an example in Staff of Joint Comm. On Tax’n, 100 Cong., 1st Sess., General Explanation of Tax Reform of 1986, at 1027-28(1987).
Illustration 2.
On January 1 of year 1, Samatha, a U.S citizen, acquired 1,000 shares in FC, a foreign corporation that is a PFIC. She acquired another 1,000 shares of FC stock on January 1 of year 2. During years 1 through 5, Samatha receives the following dividend distribution from FC:
Date of Distribution Amount of Distribution
Dec. 31 of year 1 $500
Dec. 31 of year 2 $1,000
Dec. 31 of year 3 $1,000
Dec. 31 of year 4 $1,000
Apr. 1 of year 5 $1,500
Oct. 1 of year 5 $500
Under Internal Revenue Code Section 1291, none of the distributions received before year 5, are excess distributions since the amount of each distribution with respect to a share is 50 cents. However, with respect to distributions during year 5, the total distribution to each share is 37.5 cents ($1 minus 62.5 cents (1.25 times 50 cents)).
Accordingly, the total excess distribution for FC’s tax year ending December 31 of year 5 is $750 (37.5 per share times 2,000 shares). This excess distribution must be allocated ratably between the two distributions during year 5. Thus, $562.50 (75 percent of the excess distribution, i.e., $750 times $1,500/$2,000) is allocated to the April 1 distribution and $187.50 (the remaining 25 percent of the excess distribution, i.e. $750 $500/$2,000) is allocated to the October 1 distribution. These amounts are then ratably allocated to each block of stock outstanding on the relevant distribution date. For the distribution on April 1 of year 5, $281.25 of the excess distribution is allocated to the block of stock acquired on January 1 of year 1 and $281.25 is allocated to the block of stock acquired on January 1 of year 2 and $281.25 is allocated to the block of stock acquired on January 1 of year 3. The $187.50 excess distribution on October 1 of year 5 is also allocated evenly between the two blocks of stock outstanding on the date of the distribution. Finally, the excess distribution for each block of stock is in accordance with Internal Revenue Code Section 1291(a)(1).
The federal tax due in the year of disposition (or year of receipt of an excess distribution) is the sum of 1) U.S. tax computed using the highest rate of U.S. tax for the shareholder (without regard to other income or expenses the shareholder may have) on income attributed to prior years (called “the aggregate increase in taxes” in Section 1291(c)(1)), plus 2) U.S. tax on the gain attributed to the year of disposition (or year of receipt of the distribution) and to years in which the foreign corporation was not a PFIC (for which no interest is due). Items (1) and (2) together are called the “deferred tax amount” in Section 1291. Item (2), the interest charge on the deferred tax, is computed for the period starting on the due date for the prior year to which the gain on distribution or disposition is attributed and ending on the due date for the current year in which the distribution or disposition occurs.
If a foreign pension plan holds foreign stocks or foreign mutual funds, the U.S. beneficiary could be subject to the PFIC tax regime. In certain cases it may be possible to mitigate the harsh consequences of the PFIC regime by making a timely Qualified Electing Fund election or Mark-to-Market election. We have significant experience in determining if a foreign pension plan that contains PFICs can be mitigated for U.S. tax purposes.
Treaty Considerations
As discussed above, earnings accumulating in a foreign pension plan that is classified as a grantor trust is taxed annually. In certain cases a tax treaty can arbitrage the general rules governing the U.S. taxation of a foreign pension plans. For example, Article 18 of the United States-United Kingdom Income Tax Treaty changes this general rule by providing that income earned by a pension scheme may be taxed as income of the individual only when distributed. This means, distributions from U.K. pension plans are only subject to U.S. tax when a distribution is made from the plan to the beneficiary. However, Article 18 of the United States-United Kingdom Income Tax Treaty must be read in tandem with the “savings clause” contained in Article 1 of the treaty. Article 1 may prevent U.S. citizen beneficiaries of U.K. pension plans from deferring the U.S. taxation of investment income generated by the foreign pension plan. When determining the U.S. tax consequences of a foreign pension plan, any applicable treaty should be carefully reviewed.
U.S. Filing Requirements
A U.S. beneficiary of a foreign pension plan will likely have to disclose the pension plan to the IRS on a number of information returns such as a FinCen 114, Form 3520, Form 3520-A, and Form 8938. Failure to timely disclose a foreign pension plan on a U.S. tax return and information returns could result in significant penalties.
Specific Examples of Usual Cases Involving Foreign Pensions
Does the U.S.-Australian Income Tax Treaty Exclude Superannuation Funds from U.S. Taxation?
There are currently more than 100,000 Australian-born people living in the United States. Many of these individuals have an Australian Superannuation account. A superannuation is an Australian pension program created by a company to benefit its employees. Funds deposited in a superannuation account will grow through appreciation and contributions until retirement or withdrawal. As with many foreign pension plans, the U.S. federal taxation of superannuation accounts is a gray area. The most common type of superannuation is the Self-Managed Superannuation Funds. This article will focus on Self-Managed Superannuation Funds. This is because Self-Managed Superannuation Funds are the most common type of superannuation.
Many tax professionals consider a superannuation fund to be a foreign grantor trust for U.S. tax purposes. If a superannuation fund can be classified as a grantor trust, all contributions and all growth income is taxed in the U.S. Many issues arise if a superannuation fund is treated as a foreign grantor trust. Other tax professionals take the position that a superannuation fund should be treated as an exempt foreign social security plan for U.S. tax purposes.
The Department of Treasury and the IRS has not officially classified the Australian superannuation for U.S. tax purposes. In order to better understand how a superannuation fund is taxed, it is important to discuss the domestic and international treaty law that govern foreign retirement accounts such as the Australian Superannuation Fund.
The Australian Social Security System and Superannuation Funds
The U.S. Social Security Administration’s 2010 publication titled “Social Security Programs Throughout the World” analyzes Australia’s overall comprehensive social security system. The publication identifies the 1908 Invalid and Old-Age Pensions and the 1942 Widows’ Pensions Act as the first set of laws that formed Australia’s first social security system. The current regulatory framework of Australia’s overall comprehensive social security system is the 1991 Social Security Act, the 1992 Superannuation Guarantee Administration Act, and the 1999 New Tax System Family Assistance Act 1999. The 1991 Social Security Act provides the traditional, minimal, and basic means-tested social assistance, but it also introduced the concept of “superannuation guarantees” to replace the general social security contributions that started with the 1945 Social Services Contribution Act. See Australia Social Security Act, Section 9(1).
The 1999 Superannuation Guarantee Administration Act mandated compulsory employer contributions to state-mandated occupational pensions that are privately managed. Under current Australian law, employers must contribute 10% of an employer’s salary to state-mandated occupational pension funds called “superannuation funds.” These state-mandated employer contributions are referred to as the “superannuation guarantee.” Additional employee contributions to superannuation funds are optional, but, when contributed, they are treated no different; fully preserved, restricted, and inaccessible until retirement. Thus, regardless of whether the contribution is a “superannuation guarantee” or a “concessional contribution,” they both form a part of the same fully preserved and restricted fund. There are no longer any social security contributions to publicly managed social security accounts in Australia due to Amending Acts from 1945 to 1969 and the final 2014 Repeal Act; they have been entirely replaced by the superannuation guarantee. This represents the privatization of Australia’s traditionally government-run social security pensions.
There are various types of superannuation schemes identified in the 1991 Social Security Act, including, but not limited to, public sector funds established for federal and state government employees, corporate funds established by medium to large private sector companies for their employees, industry or multiemployer funds, retail fund public offer funds, and self-managed superannuation funds. Australia’s current social security system has two components: a means-tested Age Pension funded through general revenue; and the superannuation guarantee funded through compulsory employer contributions to state-mandated superannuation funds, which are similar to compulsory contributions under U.S. Federal Insurance Contributions Act.
In Australia, the Superannuation Guarantee Act of 1992 was adopted in recognition of the fact that Australia, along with many other industrialized nations, had and would continue to experience significant increases to life expectancy due to advances in the field of medicine, which would slowly make their social security system insolvent over time. The proposed solution was the privatization of their social security system that included a very basic need-based age pension system that served as a safety net, private savings generated by state-mandated employer contributions to a superannuation fund that served as the centerpiece of the privatization proposed, and the option for voluntary quasi-after-tax contributions to a superannuation fund. Australian superannuation funds can be characterized as state-mandated occupational pensions with the primary purpose of providing for benefits at retirement.
The U.S. Taxation of a Australian Superannuation Account
Under current U.S. tax law, a distribution from an Australian superannuation fund to a U.S. beneficiary may either be taxed either a distribution from a grantor trust or as a distribution from a foreign social security plan.
A Superannuation Fund can be thought of as a foreign deferred compensation plan. Subchapter D of the Internal Revenue Code contains the rules pertaining to the taxation of “deferred compensation” plans. In order for a deferred compensation plan to be tax-exempt from U.S. tax, the plan must satisfy requirements stated in Internal Revenue Code Section 401. Section 401(a) provides that for a pension plan to be a “qualified plan” and exempt from U.S. tax, it must be organized in the United States.
An Australian Superannuation fund cannot be established in the United States. Since an Australian superannuation fund cannot be established in the United States, an Australian superannuation will never be treated as a “qualified plan” under Section 401 of the Internal Revenue Code. As a result, contributions to Australian Superannuation Funds become taxable in the U.S. once the beneficiary of such a fund becomes a U.S. person. A U.S. person is defined as a U.S. citizen or U.S. green card holder. As a general rule, contributions made by a U.S. person to a non-exempt trust will be taxable as compensation to the U.S. person if the benefits are “substantially vested.” The benefits will be substantially vested if the contributions are not subject to a substantial risk of forfeiture. See IRC Section 83.
Most (if not all) contributions made to superannuation funds will not be subject to a substantial risk of forfeiture because the superannuation fund will be payable to the beneficiary upon a specific event taking place such as retirement or death of the beneficiary of the fund. As a result, if contributions are made to a superannuation fund after an Australian citizen becomes a U.S. person, these contributions made to the superannuation fund will be taxable in the United States under Internal Revenue Code Section 402(b)(1).
The grantor trust rules are included in the Internal Revenue Code to attribute income tax liabilities associated with income received by a trust to the person that is considered to control a trust. The grantor trust rules attribute income tax to trust income regardless if the income has been distributed. Unless a specific provision of the Internal Revenue Code excludes the application of the grantor trust rules, the annual earnings accumulated in Australian superannuation funds will be attributed to the U.S. owners of such plans and are taxable in the U.S. under Section 671 through 679 of the Internal Revenue Code.
Under U.S. tax law, it may also be possible to classify an Australian superannuation as a distribution from foreign social security. Superannuation funds are unique in that they are mandated by the Australian government with the primary purpose of providing for benefits at retirement and as a result, arguably, superannuation funds should be recognized as social security for U.S. tax purposes. A state-mandated “occupational pension scheme” such as a superannuation fund seems to fit the precise definition of social security. For reasons discussed below, if a superannuation distribution can be treated as social security.
The Totalization Agreement
Whether or not a superannuation fund can be classified as grantor trust or social security for U.S. tax purposes depends largely on one’s interpretation of the U.S.-Australia Totalization Agreement. A totalization agreement is an international tax treaty that seeks to eliminate dual taxation with regards to social security taxes. The United States signed the Totalization Agreement with Australia that went into effect on October 1, 2002. The Totalization Agreement specifically recognizes “superannuation guarantee” contributions as being social security contributions since the funds are part of Australia’s larger, comprehensive national social security system. For Australia, the Totalization Agreement covers Superannuation Guarantee contributions that employees must make to retirement plans for their employees.
Some tax professionals take the position that the U.S. has acknowledged that a superannuation distribution should be treated as social security. This is because the totalization agreement specifically states that a superannuation contribution is the same or similar to social security contributions. Other tax professionals believe that the goal of the U.S.-Australian Totalization Agreement was to avoid having a taxpayer income withheld in each jurisdiction for employment.Thus, the U.S.-Australian Totalization Agreement should not be interpreted to mean an Australian Superannuation Fund falls under the definition of social security.
An Overview of the Rules Governing Tax Treaties and Federal Law
Most income tax treaties have special rules for social security payments. Under Article 18, Paragraph 2, of the U.S.- Australian income tax treaty, “social security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first mentioned State.” In other words, the country of source has exclusive taxing rights to social security income. Under Article 18, Paragraph 2, of the U.S. Australian income tax treaty, if an Australian superannuation fund can be classified as a public pension or social security, Australia would have exclusive taxing rights to the income.
In order to determine if Article 18 can encompass a superannuation fund, the term public “social security” must be defined. The U.S.-Australia does not define this term. Since the treaty or its technical explanations do not define this term, it may be possible to refer to definitions provided by the Organization for Economic Cooperation and Development (“OECD”). The OECD publishes guidance in the form of commentaries, which are intended to aid in interpreting the provisions of the tax treaties. The OECD Commentaries are updated from time to time to reflect evolving consensus among the member OECD countries regarding the meaning of particular Model Treaty provisions. If both the U.S. and a treaty partner were members of the OECD when the treaty was drafted, U.S. courts may refer to OECD commentary to interpret terms in that income tax treaty. See Podd v. C.I.R., 76 T.C.M. 906 (1998) (citing U.S. v. A.L. Burbank & Co., 525 F.2d 9, 15 (2d Cir. 1975); North W. Life Assurance Co of Canada v. C.I.R., 107 T.C. 363 (1996); Taisei Fire & Marine Ins. Co. v. C.I.R., 104 T.C. 535, 546 (1995) (construing the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, Mar. 8, 1971, U.S.-Japan, 23 U.S.T. 969, with reference to the Model Treaty and its commentary).
The United States joined the OECD in 1961 while Australia joined in 1971. The U.S.-Australia income tax treaty was signed in 1982 and went into effect in 1983 with an amending protocol in 2001. Therefore, U.S. courts may defer to the OECD with regard to interpreting treaty terms. According to the OECD, the term “social security” generally “refers to a system of mandatory protection that a state puts in place in order to provide its population with … retirement benefits.” See 2014 OECD Commentary, Art 18, 28. However, the OECD Model Income Tax Treaty does not specifically cover social security; it merely suggests that “payments under a social security system… could fall under Article 18, 19 or 21,” which reference pensions from government services, private sector service, or other income, respectively. See 2014 OECD Commentary, Art 15, 2.14. On the other hand, the U.S.-Australia income tax treaty, unlike the OECD Model Income Tax Treaty, does specifically have a provision addressing taxing rights with regard to social security. Nevertheless, the OECD commentary broadly interprets “payments under a social security system” to include payments under a “worker’s compensation fund,” which is not considered “social security” in the United States. The OECD has also impliedly recognized Australian superannuation as a part of Australia’s social security system. See Pensions at a Glance 2013: Country Profiles – Australia. (Although the report refers to superannuation as a private pension, the report seems to be referring to the fact that superannuation funds are privately managed).
The OECD takes a very broad and inclusive approach as to what constitutes “social security.” The Australian state-mandated superannuation system fits the precise definition of social security as provided by the OECD. Under the OECD definition of “social security,” a superannuation account can be classified as social security for purposes of Article 18, Paragraph 2 of the U.S.-Australia income tax treaty.
Even though a compelling argument can be made that the definition of “social security” is broad enough to encompass a superannuation fund, Article 18, Paragraph 2 of the U.S.-Australian income tax treaty provides an implicit (or indirect) definition of “social security” as being a kind of “public pension.” A superannuation fund could be considered “privatized social security.” Defining a superannuation account as “privatized social security” may remove it from Article 18, Paragraph 2 of the treaty. An IRS Chief Counsel Memorandum characterizes Australian superannuation funds as private retirement plans. See IRS CCA 200604023 (October 24, 2005).
At this point, it is unclear if an Australian superannuation fund can be treated as a public pension or social security under the U.S.-Australia income tax treaty. There is a case pending before the United States Tax Court that may eventually offer guidance in this area. In Dixon v. Commissioner, No. 13874-19 (2019), Dixon argued that his superannuation funds were exclusively taxable under Article 18, Paragraph 2 of the U.S.-Australia income tax treaty. The IRS challenged this position. The case has been continued and it remains to be seen if the Tax Court will issue an opinion on this issue. In the meantime, we can take a closer look at how a U.S. citizen or resident that receives a distribution from a superannuation fund could potentially exclude the distribution under the treaty.
The “Savings Clause” Contained in the U.S.-Australia Income Tax Treaty and its Application to Superannuation Distributions
Anytime a U.S. citizen or resident attempts to claim an favorable tax treaty position, the U.S. citizen or resident must consider the application of a Savings Clause. A Savings Clause contained in an income tax treaty allows the United States to “tax its residents..[and] citizens as if the Convention had not entered into force.” See U.S.-Australia Income Tax Treaty, Art 1, 1 paragraph 3. In other words, the U.S. may disregard most treaty claims by U.S. citizens and U.S. tax residents. It should be understood that the Savings Clause is merely a reserved right and does not automatically apply to prevent treaty claims by U.S. citizens and tax residents. See U.S.-Australia Income Tax Treaty, Art 1, paragraph 3. Although the U.S.-Australia income tax treaty contains a Savings Clause, the Savings Clause in the U.S.-Australia income tax treaty does not apply to Article 18, Paragraph 2 of the treaty as the article specifically states “Social Security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.”
If a superannuation fund can be classified as public social security, the Savings Clause would be inapplicable to claims by U.S. citizens and U.S. tax residents with regard to gains, distributions, or any other income associated with an Australian superannuation fund.
Questions Regards U.S. Federal Tax Consequences of India’s Provident Fund
Schemes Under the U.S.-India Income Tax Treaty
India has a national pension plan that is similar to a social security system. The normal pension age for earnings-related pension benefits from the Employees’ Pension Scheme is 58 years of age with a minimum of ten years of contribution. The pension age for the earnings-related Employees Provident Fund scheme is 55 years of age. Covered individuals belong to the organized sectors and are employed by the government, government enterprises, public and private sector enterprises, which are mandatorily covered by the Employees Provident Fund Organization (“EPFO”). Employees with 20 or more employees are covered by EPFO. The remaining 88 percent of the workforce are mainly self-employed, daily wage workers, farmers, etc and are covered by the EPFO. For this share of the Indian workforce the Public Provident Fund (“PPF”) and Postal Saving Schemes have traditionally been the main long-term instruments.
Employees Provident Fund Schemes (EPT)
For employees with basic wages less than or equal to INR 15 000 per month, the employee contributes 12 percent of the monthly salary and the employer contributes 3.67 percent. This combined 15.67 percent accumulates as a lump-sum. For employees with basic wages greater than INR 15 000 per month, the employee contributes 12 percent of the monthly salary while the employer also contributes 12 percent. This combined 24 percent accumulates as a lump sum. There is no annuity and full accumulations are paid after attaining 55 years of age. For comparison with other countries, for replacement rate purposes the pension is shown as a price-indexed annuity based on a mortality table.
Employees’ Pension Scheme (EPS)
From September 2014, individuals with a basic wage above 15 000 per month no longer have the option of contributing to the EPS. For participants in the EPS, employers contribute 8.33 percent of the INR 15 000 on a monthly basis and the government contributes a subsidy of 1.16 percent of the salary into the EPS. This accumulation is used to pay various pension benefits on retirement or early termination. The kind of pension a member receives under the pension scheme depends on the age at which they retire and the number of years of eligible service.
Monthly pension = (pension salary x pension service)
The pension salary is calculated on the average monthly pay for the contribution period of the last 60 months preceding the date of termination of membership.
The maximum possible replacement rate is roughly 50 percent.
The EPS can be claimed from age 50 with ten years of contributions and the benefits are reduced by 3 percent per year for early retirement. If a member leaves his or her job before rendering at least ten years of service, he or she is entitled to a withdrawal benefit. The amount he or she can withdraw is a proportion of his or her monthly salary at the date of exit from employment. This proportion depends on the number of years of eligible services he or she has rendered. In regards to the EPF, there are multiple scenarios, which allow for early access to benefits. Partial withdrawals related to marriage, housing, financing life insurance, and illness of a family member are permitted.
U.S. Tax Consequences of India’s Provident Fund Schemes
As a general rule, U.S. citizens and residents are taxed on their worldwide income. As a general rule, U.S. citizens and residents are taxed on their worldwide income. Thus, U.S. persons with Indian Employee Provident Fund Accounts would appear to be subject to U.S. tax on the distribution of such a fund. The rules regarding compulsory contributions to Provident Fund are somewhat similar to U.S. Social Social Security. Consequently, under U.S. law, an Indian Employee Provident Fund Account can potentially be considered “social security.” Although it is possible that an Indian Provident Fund can be classified as social security for U.S. tax purposes, there are no rules, regulations, or case law directly on point addressing this issue.
The characterization of the Indian Employee Provident Fund Account is important for U.S. income tax purposes. Under Article 20, Paragraph 2, of the U.S.-Republic of India Income Tax Treaty, “social security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first mentioned State.” In other words, the country of source has exclusive taxing rights to social security income.
This means if an India Employee Provident Fund Account can be classified as social security, India would have exclusive taxing rights to the income and for federal income tax purposes, the U.S. would not have the ability to tax Provident Fund Scheme.
Anyone taking a tax treaty position must consider an article known as a “saving clause.” A saving clause preserves or “saves” the right of each country party to a tax treaty to tax its own residents as if no treaty existed. This typically means that a U.S. citizen or resident attempting to take advantage of a treaty that the U.S. has with a foreign country will be taxed as if the treaty did not exist. Article 20 of the U.S.-India income tax treaty contains a saving clause. However, Article 20, Paragraph 2 specifically excludes social security income from the saving clause. As a result, the saving clause prevents U.S. citizens and residents from being taxed from social security received from India. Consequently, if an Employee Provident Fund Account can be classified as Social Security, an India Provident Fund Schedule will escape U.S. taxation.
Anyone wishing to take a position that a Provident Fund Scheme is not subject to U.S. tax under the U.S.-India tax treaty must timely claim a treaty position. Anyone considering taking such a treaty position also must understand that this area is somewhat unsettled.
The attorneys at Diosdi & Liu, LLP have significant experience determining the U.S. tax consequences of foreign pension plans and properly reporting the foreign pension on U.S. tax returns. If you are the beneficiary of a foreign pension plan and need guidance regarding the U.S. tax consequence of such a pension, please contact us.
- Commercial Litigation
- Criminal Tax Representation
- Cross-Border Mergers and Acquisitions
- Cryptocurrency Tax Matters
- Estate and Gift Tax for Foreign Investors
- Estate Tax Planning
- Expatriation
- FBAR Preparation and Penalty Defense
- FIRPTA
- Independent Contractor Disputes
- International Penalties
- International Tax Planning and Advice
- IRS Offshore Voluntary Disclosure Representation
- IRS Representation and Compliance
- Preparation of Form 3520
- Preparation of Form 5471
- Preparation of Form 5472
- Preparation of Form 8621 and PFIC Reporting
- State Tax Planning and Litigation
- Tax Audits, Controversies, and Litigation
- Tax Planning and Opinions
- Tax Planning of Cross-Border Cloud Computing Transactions
- Tax Preparation
- Tax-Exempt and Nonprofit Organizations
- Taxation of Foreign Pensions

Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
