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. This article will discuss how tax treaties can potentially be utilized by non-U.S. citizens to avoid the U.S. tax on the distribution from a U.S. based retirement account when the non-U.S. citizen returns to his or her home country.
I. U.S Based Retirement Accounts Overview
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. Below, these retirement accounts are discussed in more detail.
401(k) Plans
A 401(k) plan is an employer-sponsored defined-contribution account defined in Section 401(k) of the Internal Revenue Code. (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).
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 For U.S. tax purposes, the participant pays income taxes on the plan distribution when funds are withdrawn from the plan.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 the Taxation of the Accumulated Earnings in a U.S. Based Retirement Plan
The U.S. tax consequences of distributions from a U.S. based retirement account depends on whether a non-U.S. citizen is classified as nonresident or resident for U.S. income tax consequences. We will begin first with discussing the income tax consequences to non-U.S. citizens who are not “U.S. residents” for income tax purposes. Foreign persons that are not “U.S. residents” are only taxed on their U.S. source income. For U.S. source income, foreign persons are subject to two different U.S. taxing regimes. One regime applies to income that is connected with the conduct of a trade or business in the United States. The other regime applies to certain types of nonbusiness income from U.S. sources. If a foreign person conducts a trade or business in the United States, the net income effectively connected with the U.S. business activity will be taxed at the usual tax rates. At present, the top nominal marginal rate paid by individual taxpayers is 37 percent. The determination of whether a foreign person is engaged in the conduct of a trade or business in the United States generally. However, appropriate deductions and credits will apply in the determination of U.S. tax liability.
Most of the forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received. Section 871(a) of the Internal Revenue Code imposes the 30-percent tax on “interest * * * dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.” The collection of such taxes is affected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the Internal Revenue Service (“IRS”). Distributions from U.S.- based retirement accounts are subject to the 30 percent withholding rules discussed above. Thus, when a non-U.S. resident for tax purposes receives a distribution from a U.S.-based retirement account, unless treaty applies, he or she will be subject to a 30 percent withholding. A nonresident may also be subject to a 10 percent penalty for early withdrawal from the U.S.-based retirement account.
The tax rules are different for non-U.S. citizens that are taxed as “U.S. residents.” U.S. residents are subject to federal income tax on their worldwide income regardless of the country from which the income derives, the country in which payment is made or the currency in which the income is received. On the other hand, all U.S. source income received by U.S. residents is taxed at U.S. prgressive ordinary income or capital gain rates. When a U.S. resident withdraws funds from a U.S.-based retirement account, he or she is taxed at progressive ordinary rates. In order to discourage the early withdrawal of funds, Section 72(t) of Internal Revenue Code imposes a 10 percent additional income tax on distributions which fails to satisfy certain criteria- such as early withdrawal. U.S. residents are also subject to a 20 percent withholding tax on distributions from U.S.-based retirement accounts. However, a U.S. resident can receive a refund from the IRS any overpayment of tax.
Current Law for Determining U.S. Residency “Green Card” and “Substantial Presence” Tests
We will next discuss how residency is determined for U.S. income tax purposes.
Under Section 7701(b) of the Internal Revenue Code, 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.
A third way for an alien to be treated as a resident of the United States under Section 7701(b) is the so-called first-year election. An alien may make an election to be taxed as a U.S. resident if a number of requirements are met.
Consequences of Resident Alien Classification
Classification as a resident alien of the United States may not necessarily bring solely bad tax news. There are a number of potential advantages to being taxed as a resident of the U.S. resident aliens are not subject to the 30 percent FDAP withholdings. In addition, in certain cases, resident aliens may utilize a treaty tie-breaker contained in many U.S. bilateral income tax treaties if they are dual residents. A treaty-tie breaker position may permit dual residents (individuals that are residents of the U.S. and and a foreign country) to exclude foreign source income from taxation. In certain cases, it may also permit the dual resident to exclude distributions from a U.S.-based retirement account from U.S. taxation.
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.
Example of a Tax Treaty Tie-Breaker
Tom is a citizen of South Korea and a green card holder. South Korea has a tax treaty with the United States similar to the U.S. Model Treaty. Tom owns a luxury condominium in Seoul, South Korea. Tom owns a home in San Francisco, California. However, Tom’s wife and children reside in South Korea. Tom spent the entire year of 2021 in South Korea and that Tom’s only source of U.S. income was a $500,000 distribution from a 401(k) plan. Under Internal Revenue Code Section 7701(b), an individual in possession of a green card that has not been revoked is classified as a U.S. resident for income tax purposes unless an exception applies.
Paragraph 2, Article 3 of the United States- South Korea Tax Treaty contains a treaty tie-breaker position similar to the Model Treaty discussed above. Paragraph 2, Article 3(2) of the United States-South Korea Income Tax Treaty states “[W]here by reason of the provisions of paragraph (a) an individual is a resident of both Contracting States: a) he shall be deemed to be a resident of that Contracting State in which he maintains his permanent home; (b) if he has a permanent home in both Contracting States or in neither of the Contracting States, he shall be deemed to be a resident of that Contracting State with which his personal and economic relations are closest (center of vital interests); (c) if his center of vital interests is in neither of the Contracting States or cannot be determined, he shall be deemed to be a resident of that Contracting State in which he has a habitual abode; d) If he has a habitual abode in both Contracting States or in neither of the Contracting States, he shall be deemed to be resident of the Contracting State of which he is a citizen; and e) if he is a citizen of both Contracting States or of neither Contracting State the competent authorities of the Contracting States shall settle the question.
Because Tom is considered a resident of both the United States and South Korea, we must analyze the treaty tie-breaker procedures to determine which country has primary taxing jurisdiction. With a home in the United States and a condominium in South Korea, he has a permanent home available in both countries. With Tom’s wife and children in South Korea as opposed to the United States, Tom has a center of vital interests in South Korea. Furthermore, because Tom spends more time in South Korea in 2021, he has a habitual abode in South Korea. As a result, under the treaty tie-breaker, Tom should be considered a resident of South Korea. If the United States- South Korea Income Tax Treaty specifically provides for an exclusion of U.S. tax, the distribution that Tom received from his 401(k) in 2021 will only be subject to income tax in South Korea and not the United States.
Any noncitizen considering claiming residency under a treaty must understand that such a position is a double-edged sword. If a treaty tie-breaker position is claimed more than eight years after a noncitizen has become a lawful permanent resident, a treaty-tie breaker position could trigger an expatriation pursuant to Internal Revenue Code Section 877A. See IRC Section 7706(b)(6).
II. International Law Governing Tax Treaties
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.
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.
U.S. Courts Interpretation of the OECD Rules
As indicated above, tax treaties are often poorly worded and confusing. As a result, each tax tax treaty contains a Technical Explanation which reflects the policies behind each provision of the treaty. Technical Explanations also interpret tax treaties. When Technical Explanations do not explain the intent of a tax treaty, the OECD may be consulted to interpret the treaty. The OECD publishes commentary every four years to interpret terms of income tax treaties.
U.S. courts will refer to OECD commentary as meaningful guidance and in divining the probable intent of the party-countries. However, U.S. courts are not bound by OECD commentaries (the only legally binding instruments are the Conventions signed by Member Countries). While a court will give deference to the consistent interpretation of a treaty advanced by the agencies of the United States charged with its administration, their interpretation is not conclusive and will not be adopted by the court if it is not supported by the treaty language or the intent of the party countries. See Nat’l Westminster v. U.S, 58 Fed Cl. 491 (2003). Nat’l Westminster states in relevant part, “for each of the Articles in the Convention there is a detailed Commentary which is designed to illustrate or interpret the provisions….Although the present Commentaries are not designed to be annexed in any manner to the Conventions to be signed by member countries, which alone constitute legally binding international instruments, they can nevertheless be of great assistance in the application of the Conventions and, in particular, in the settlement of eventual disputes.”
Nat’l Westminster indicates that if the U.S. and a treaty partner were members of the OECD at the time the treaty was enacted, the U.S. may apply the OECD definitions to interpret certain tax treaty terms. As long as the OECD terms are not contrary to the intent of the party-countries. The IRS has agreed with this interpretation in private letter rulings. Thus, unless an Internal Revenue Code (U.S. tax law) is enacted later in time from that of a tax treaty, U.S. tax law cannot supersede a tax treaty. Many tax treaties take a very broad approach as to what constitutes a “pension distribution” under international treaty law with which the IRS and U.S. courts may be legally bound to recognize.
III. A Closer Look At How Tax Treaties Are Applied to Distributions of U.S. Based Retirement Accounts
The U.S. currently has income tax treaties with approximately 58 countries. Each tax treaty is different and has its own unique definitions. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed.This subsection of this article will discuss the implications of a few select tax treaties when applied to the distributions to non-U.S. citizens from U.S. based retirement accounts. This article will examine the bilateral treaties with Italy, Australia, United Kingdom, France, Germany, Mexico, Japan, China, Egypt, India, South Korea, Greece, and Estonia.
Applying the U.S- Italy Tax Treaty to a U.S. Retirement Account Distribution
Let’s assume that Tom is an Italian citizen that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, 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 U.S.- Italy Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty. 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. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Italy, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.-Italy Income Tax Treaty. Next, the terms “pension or other similar renunciation” must be defined under the treaty to determine if Tom’s IRA distribution can be excluded from U.S. income taxation. The treaty does not define the terms “pension or other similar renunciation.” The Technical Explanations to the treaty must therefore be consulted.
The Technical Explanation for the U.S.-Italy Income Tax Treaty define U.S. “pensions and other similar renunciation” as:
“In the United States, the plans encompassed by Paragraph 1 [to] include qualified plans under Section 401(a), individual retirement plans (including retirement plans that are part of a simplified employee pension plan that satisfies Section 408(k), individual retirement accounts, individual retirement annuities, Section 408(p) accounts, and Roth IRAs under Section 408(a), non-discriminatory Section 457 plans, Section 403(a) qualified annuity plans, and Section 403(b) plans.” See Technical explanation to U.S.-Italy Tax Treaty (1999), page 60 as to Article 18, par 1. Since the Technical Explanations to the treaty specifically includes individual retirement accounts or IRAs in the definition of a “pension and other similar renunciations,” Tom can potentially utilize the U.S.-Italy Income Tax Treaty to avoid U.S. tax consequences and early withdrawal penalties from the distribution of his IRA.
Applying the U.S- Australia Tax Treaty to a U.S. Retirement Account Distribution
Let’s assume that Tom is an Australian citizen that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Australia 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 Australia, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the U.S.- Australia Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty. The U.S.- Australia Income Tax Treaty went into effect in 1983 with an amended protocol signed in 2001. The United States joined the OECD in 1961. Australia joined the OECD in 1971. Since both countries joined the OECD prior to the enactment of the U.S.- Australia Income Tax Treaty, U.S. courts can defer to the OECD with regard to interpreting treaty terms if the relevant term is not defined in the treaty or its Technical Explanations.
Article 18, Paragraph 1, of the United States- Australian Income Tax Treaty, states that “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 provides that “Article 18, Paragraph 1 means 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].” Under the provisions of the U.S.- Australia Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Australia, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- Australia Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension or remuneration” under the treaty. The Technical Explanations to the U.S.- Australia Income Tax Treaty to Article 18, Paragraph 4, makes a reference to “periodic payments.” However, the terms “pensions and other remuneration” is not defined in the treaty or its Technical Explanations. Since these terms are not defined in the treaty or its Technical Explanations, the OECD commentary can be utilized to interpret the definitions of “pensions or other similar remuneration.” 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 of the treaty. See OECD 2018 Commentary, Art 18. Assuming that Tom took a lump sum distribution from his IRA on or after the cessation of employment in the United States, Tom can take the position that his IRA distribution falls within the OECD’s definition of a “pension” and as a result, Tom’s U.S. based IRA distribution should fall under the scope of the treaty.
Applying the U.S- United Kingdom Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a United Kingdom citizen that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to the United Kingdom 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 the United Kingdom, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States- United Kingdom Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
Under Article 17 of the United States- United Kingdom Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. Under the provisions of the U.S.- United Kingdom Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of the United Kingdom, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- United Kingdom Income Tax Treaty.
Since Tom is a resident of the United Kingdom, the treaty provides that the United Kingdom will have a right to tax the “lump-sum payment derived from a pension scheme.” We must next define the terms “pension distributions.”
The U.S.- United Kingdom Income Tax Treaty and its Technical Explanations define “pension distributions” as follows:
“it is understood for this purpose that U.S. pension schemes eligible for the benefits of paragraph 2 include qualified plans under Section 401(a), individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies Section 408(k)), individual retirement accounts, individual retirement annuities, Section 408(p) accounts and Roth IRAs under Section 408(A), Section 403(a) qualified annuity plans, and Section 403(b) plans.”
Since the Technical Explanations to the treaty specifically includes individual retirement accounts or IRAs in the definition of a “pension and other similar renunciations,” Tom can potentially utilize the U.S.- United Kingdom Income Tax Treaty to avoid U.S. tax consequences and early withdrawal penalties from the distribution of his IRA.
Applying the U.S- France Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of France that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to France 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 France, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States- France Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
The U.S.- France Income Tax Treaty went into effect in 1994 with an amended protocol signed in 2009. The United States joined the OECD in 1961. France joined the OECD in 1961. Since both countries joined the OECD prior to the enactment of the U.S.- France Income Tax Treaty, U.S. courts can defer to the OECD with regard to interpreting treaty terms if the relevant term is not defined in the treaty or its Technical Explanations. Article 18 of the U.S.- France Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remuneration” as follows-
Under subparagraph 1(a), pensions and other similar remuneration derived and beneficially owned by a resident of a Contracting State in consideration of past employment are taxable only in the State of residence of the recipient. This rule applies to both periodic and lump-sum payments. The rule applies to pension payments in consideration of past employment that are paid to a resident of the other Contracting State, whether to the employee or to his or her beneficiary. The Technical Explanations to the treaty provides that “Article 18, Paragraph 1(a) means 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].” Under the provisions of the U.S.- France Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of France, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- France Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension or remuneration” under the treaty. The Technical Explanations to the U.S.- France Income Tax Treaty to Article 18 makes a reference to “periodic payments.” However, the terms “pensions and other remuneration” is not defined in the treaty or its Technical Explanations. Since these terms are not defined in the treaty or its Technical Explanations, the OECD commentary should be utilized to interpret the definitions of “pensions or other similar remuneration.” 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 of the treaty. See OECD 2018 Commentary, Art 18. Assuming that Tom took a lump sum distribution from his IRA on or after the cessation of employment in the United States, Tom can take the position that his IRA distribution falls within the OECD’s definition of a “pension” and as a result, Tom’s U.S. based IRA distribution should fall under the scope of the treaty.
Applying the U.S- German Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Germany that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Germany 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 Germany, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States- Germany Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
The U.S.- German Income Tax Treaty went into effect in 1989 with an amended protocol signed in 2006. The United States joined the OECD in 1961. Germany joined the OECD in 1961. Since both countries joined the OECD prior to the enactment of the U.S.- Germany Income Tax Treaty, U.S. courts can defer to the OECD with regard to interpreting treaty terms if the relevant term is not defined in the treaty or its Technical Explanations. Article 18 of the U.S.- Germany Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remuneration” as follows-
“Paragraph 1 provides that private pensions and other similar remuneration derived and beneficially owned by a resident of a Contracting State in consideration of past employment are taxable only in the State of residence of the recipient. This rule applies to both periodic and lump-sum payments.”
Under Article 18, Paragraph 1, of the United States- German Income Tax Treaty means that under the applicable provisions of the treaty, the country of residence has the only right to tax the pension. Under Article 18 of the United States- Germany Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions. Under the provisions of the U.S.- Germany Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Germany, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- Germany Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension or remuneration” under the treaty. The U.S.- German Tax Treaty or its Technical Explanations do not define the terms “pension or remuneration.” Since these terms are not defined in the treaty or its Technical Explanations, the OECD commentary should be utilized to interpret the definitions of “pensions or other similar remuneration.” 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 of the treaty. See OECD 2018 Commentary, Art 18.
Assuming that Tom took a lump sum distribution from his IRA on or after the cessation of employment in the United States, Tom can take the position that his IRA distribution falls within the OECD’s definition of a “pension” and as a result, Tom’s U.S. based IRA distribution should fall under the scope of the treaty.
Applying the U.S- Canada Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Canada that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Canada 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 Canada, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States- Canada Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
Article 13 of the U.S.- Canada Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions” as follows-
“Pensions and annuities arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State, but the amount of any pension included in income for the purposes of taxation in that other State shall not exceed the amount that would be included in the first-mentioned State if the recipient were a resident thereof. However: (a) Pensions may also be taxed in the Contracting State in which they arise and according to the laws of that State; but if a resident of the other Contracting State is the beneficial owner of a periodic pension payment, the tax so charged shall not exceed 15 percent of the gross amount of such payment”
Under the provisions of the U.S.- Canada Income Tax Treaty,” the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Canada, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- Canada Income Tax Treaty. Next, we will need to determine if Tom’s IRA falls under the definition of a “pension” under the U.S.- Canada Income Tax Treaty. The Technical Explanation to Article 13 of the treaty defines the term “pensions” to include pensions paid by private employers (including pre-tax and Roth 401(k) arrangements) as well as any pension paid in respect of government services. The definition of “pensions” also includes payments from IRAs. Since the Technical Explanations to the treaty specifically includes individual retirement accounts or IRAs in the definition of a “pension” Tom can potentially utilize the U.S.- Canada Income Tax Treaty to avoid the early withdrawal of U.S. penalties and reduce his U.S. tax liability.
Applying the U.S- Mexico Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Mexico that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Mexico 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 Mexico, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States- Mexico Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
The U.S.- Mexico Income Tax Treaty went into effect in 1992 with an amended protocol signed in 2003. The United States joined the OECD in 1961. Mexico joined the OECD in 1994. Although Mexico was not a member of the OECD in 1992 when the treaty was enacted, Mexico was a member of the OECD in 2003 when the protocol for the treaty was enacted.
Article 19 of the U.S.- Mexico Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remunerations” as follows-
“Pensions and other similar remuneration derived and beneficially owned by a resident of a Contracting State in consideration of past employment by that individual or another individual resident of the same Contracting State shall be taxable only in that State.” Under the provisions of the U.S.- Mexico Income Tax Treaty,” the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Mexico, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- Mexico Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension or similar remuneration” under the treaty. The treaty or its Technical Explanations do not provide any meaningful guidance as to defining the terms “pensions or similar remunerations.” Since the terms “pensions and other similar remuneration” are not defined in the U.S.- Mexico Income Tax Treaty or its Technical Explanations, the OECD commentary may potentially be utilized to interpret these terms. However, since Mexico was not a member of the OECD at the time the original tax treaty was enacted, it is uncertain if a U.S. court can use OECD guidance to define the terms “pension or similar remunerations” and include Tom’s IRA within the meaning of these terms. Even if the treaty, Technical Explanations to the treaty, or the OECD cannot be used to define the term “pension,” Tom could still potentially use the U.S.- Mexico Income Tax Treaty to shield his IRA distribution from U.S. income tax. Tom could take the position that it was the intent of the U.S.- Mexico Income Tax Treaty to exclude his IRA distribution from U.S. tax. Just because the term “pension” is not defined in the treaty or its Technical Explanations should not prevent Tom from taking a treaty position. In other words, just because the treaty does not define the term “pension,” the IRS should define the term “pension” broadly and include an IRA in the definition of the term “pension.”
Applying the U.S- Japan Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Japan that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Japan 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 Japan, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the United States- Japan Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
The U.S.- Japan Income Tax Treaty went into effect in 1972 with amended protocols signed in 2003 and 2013. The United States joined the OECD in 1961. Japan joined the OECD in 1964. Since both countries joined the OECD prior to the enactment of the U.S.- Japan Income Tax Treaty, U.S. courts can defer to the OECD with regard to interpreting treaty terms if the relevant term is not defined in the treaty or its Technical Explanations. Article 23 of the U.S.- Japan Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remuneration” as follows-
Article 23 of the U.S.- Japan Income Tax Treaty provides-
“(1) Except as provided in Article 21, pensions and annuities paid to an individual who is a resident of a Contracting State shall be taxable only in that Contracting State. (2) The term “pensions”, as used in this article, includes periodic payments made after retirement or death in consideration for services rendered, or by way of compensation for injuries received, in connection with past employment, including United States and Japanese social security payments.”
Under the provisions of the U.S.- Japan Income Tax Treaty,” the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Japan, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- Japan Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension” under the treaty. The Technical Explanations to the U.S.- Japan Income Tax Treaty to Article 18 makes a reference to “periodic payments.” However, the term “pension” is not defined in the treaty or its Technical Explanations. Since the term is not defined in the treaty or its Technical Explanations, the OECD commentary should be utilized to interpret the definition of “pension.” 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 23 of the treaty. See OECD 2018 Commentary, Art 18. Assuming that Tom took a lump sum distribution from his IRA on or after the cessation of employment in the United States, Tom can take the position that his IRA distribution falls within the OECD’s definition of a “pension” and as a result, Tom’s U.S. based IRA distribution should fall under the scope of the treaty.
Issues that Must be Considered with Older Treaties and Treaties that Were Enacted before Treaty Partners Where Admitted to the OECD
Applying the U.S- China Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of China that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to China 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 China, a country that the U.S. has a bilateral income tax treaty, Tom may attempt to utilize the United States- Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty.
The U.S.- China Income Tax Treaty went into effect in 1980. The United States joined the OECD in 1961. China is not a member of the OECD. Since China is not a member of the OECD, U.S. courts cannot defer to the OECD to interpret the treaty terms.
Article 17 of the U.S.- China Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remuneration” as follows-
“This article deals with the taxation of private pensions and social security benefits. Pensions in consideration of government employment are covered under Article 18.”
Article 18 also provides that “pensions in respect of private employment derived by a resident of a Contracting State may be taxed only in that State.”
Article 18 of the U.S.- China Income Tax Treaty, the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of China, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- China Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension” under the treaty. The Technical Explanations to the U.S.- China Income Tax Treaty to Article 17 makes a reference to “pensions.” However, the term “pension” is not defined in the treaty or its Technical Explanations. Since the term “pension” is not defined in the treaty or the treaty’s Technical Explanations, it is uncertain if Tom can utilize the U.S.- China Income Tax Treaty to shield him from U.S. tax once he receives a distribution from his IRA. As with the U.S.- Mexico Income Tax Treaty, Tom could take the position that it was the intent of the U.S.- China Income Tax Treaty to exclude his IRA distribution from U.S. tax. Just because the term “pension” is not defined in the treaty or its Technical Explanations should not prevent Tom from taking a treaty position. Thus, the IRS should define the term “pension” broadly and include an IRA in the definition of the term “pension.”
Tom will have difficulties utilizing the U.S.- China Income Tax Treaty other than the definition of the term “pension.” Remember that U.S. treaties and federal statutes have equal status as the supreme law of the land and whenever there is a conflict between the two, the later in time prevails. Here, the U.S.- China Income Tax Treaty was enacted in 1980. However, the tax law governing the taxation of U.S.-based retirement plans were mostly enacted after the 1986 Tax Reform Act. Thus, the favorable provisions contained in the U.S.- China Income Tax Treaty regarding the U.S. based-retirement accounts may potentially not supersede U.S. tax law on point. This could result in Tom not being able to use the U.S.- China Income Tax Treaty to shield the distribution from his IRA from U.S. tax.
Applying the U.S- Arab Republic of Egypt Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Egypt that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Egypt 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.
The U.S.- Egypt Income Tax Treaty went into effect in 1980. The United States joined the OECD in 1961. Egypt is not a member of the OECD. Since Egypt is not a member of the OECD, U.S. courts cannot defer to the OECD to interpret the treaty terms.
Article 19 of the U.S.- Egypt Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remuneration” as follows-
“Except as provided in Article 21 (Governmental Functions), pensions and other similar remuneration paid to an individual will be taxable under paragraph (1) only in the Contracting State of which he is a resident. Thus, private pensions and similar remuneration derived from sources within one Contracting State by an individual resident of the other Contracting State are exempt from tax in the first-mentioned Contracting State. Pensions for Government service are dealt within Article 21 (Governmental Functions). The term “pensions and other similar remuneration” is defined in paragraph (4) as periodic payments, other than social security payments covered in Article 20 (Social Security Payments), made by reason of retirement or death and in consideration for services rendered, or by way of compensation for injuries or sickness received in connection with past employment.”
Under the provisions of the U.S.- Egypt Income Tax Treaty,” the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Egypt, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- Egypt Income Tax Treaty. However, since the U.S.- Egypt Income Tax Treaty was enacted in 1980, Tom will have the same difficulties utilizing the U.S.- Egypt Income Tax Treaty as discussed with the United States- China Income Tax Treaty.
Applying the U.S- India Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of India that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to India 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.
The U.S.- India Income Tax Treaty went into effect in 1989. The United States joined the OECD in 1961. India is not a member of the OECD. Since India is not a member of the OECD, U.S. courts cannot defer to the OECD to interpret the treaty terms.
Article 20 of the U.S.- India Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remuneration” as follows-
“[T]his Article deals with the taxation of private (i.e., non-government) pensions, annuities, alimony payments, and child support payments. The rules of this Article do not apply to items of income which are dealt within Article 19 (Remuneration and Pensions in Respect of Government Service), including pensions or social security benefits in respect of government service. Paragraph 1 provides that private pensions and any annuities derived by a resident of a Contracting State from sources within the other Contracting State are taxable only in the State of residence of the recipient. Paragraph 2 provides a different rule for social security benefits and other public pensions (other than those which are dealt within Article 19) paid by a Contracting State to a resident of the other Contracting State or a citizen of the United States. Such payments are taxable only in the Contracting State that pays them. Paragraph 3 defines the term “pension” for purposes of meaning a periodic payment made in consideration of or by way of compensation for injuries received in performance of services. Thus, the definition of the pension defines a single lump-sum payment.”
Under the provisions of the U.S.- India Income Tax Treaty,” the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of India, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- India Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension” under the treaty. The Technical Explanations to the U.S.- India Income Tax Treaty to Article 20 makes a reference to “pensions.” However, the term “pension” is not defined in the treaty or its Technical Explanations. Since the term “pension” is not defined in the treaty or the treaty’s Technical Explanations, it is uncertain if Tom can utilize the U.S.- India Income Tax Treaty to shield him from U.S. tax once he receives a distribution from his IRA. However, the term “pension” is not defined in the treaty or its Technical Explanations. Since the term “pension” is not defined in the treaty or the treaty’s Technical Explanations, it is uncertain if Tom can utilize the U.S.- India Income Tax Treaty to shield him from U.S. tax once he receives a distribution from his IRA. As with the U.S.- Mexico Income Tax Treaty, Tom could take the position that it was the intent of the U.S.- India Income Tax Treaty to exclude his IRA distribution from U.S. tax. Just because the term “pension” is not defined in the treaty or its Technical Explanations should not prevent Tom from taking a treaty position. Thus, the IRS should define the term “pension” broadly and include an IRA in the definition of the term “pension.”
Applying the U.S- Pakistan Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Pakistan that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Pakistan 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.
The U.S.- Pakistan Income Tax Treaty went into effect in 1957. Since the U.S.- Pakistan Income Tax Treaty was enacted in 1957, Tom will have the same difficulties utilizing the U.S.- Pakistan Income Tax Treaty as discussed above.
Applying the U.S- Israel Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Israel that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Israel 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.
The U.S.- Israel Income Tax Treaty went into effect in 1975. The United States joined the OECD in 1961. Israel became a member of the OECD in 2010. Since Israel was not a member of the OECD at the time the U.S.- Israel Income Tax Treaty was enacted, U.S. courts cannot defer to the OECD to interpret the treaty terms. The U.S.- Israel Income Tax Treaty went into effect in 1975. Since the U.S.- Israel Income Tax Treaty was enacted in 1975, Tom will have the same difficulties utilizing the U.S.- Israel Income Tax Treaty as discussed above.
Applying the U.S- South Korea Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of South Korea that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to South Korea 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.
The U.S.- South Korea Income Tax Treaty went into effect in 1979. The United States joined the OECD in 1961. Korea became a member of the OECD in 1996. Since South Korea was not a member of the OECD at the time the U.S.- South Korea Income Tax Treaty was enacted, U.S. courts cannot defer to the OECD to interpret the treaty terms.
Article 23 of the U.S.- South Korea Income Tax Treaty and the treaty’s Technical Explanations define the term “pensions and other similar remuneration” as follows-
“Except as provided in Article 22 (Governmental Functions), pensions and other similar remuneration paid to an individual who is a resident of a Contracting State in consideration of past employment will be taxable under paragraph (1) only in that Contracting State. Thus, private pensions and similar remuneration derived from sources within one Contracting State by an individual resident of the other Contracting State in consideration of past employment are exempt from tax in the first-mentioned Contracting State. The term “pensions and other similar remuneration” is defined in paragraph (3) as periodic payments made after retirement or death in consideration for services rendered, or by way of compensation for injuries received in connection with past employment. The term does not include social security payments covered in Article 24 (Social Security Payments).”
Under the provisions of the U.S.- South Korea Income Tax Treaty,” the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of South Korea, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- South Korea Income Tax Treaty.
Next, we must determine if an IRA can be classified as a “pension” under the treaty. The Technical Explanations to the U.S.- South Korea Income Tax Treaty to Article 23 makes a reference to “pensions.” The term “pension” is defined in paragraph (3) as periodic payments made after retirement or death in consideration for services rendered, or by way of compensation for injuries received in connection with past employment. It is uncertain if this definition would apply to an IRA. Even if somehow an IRA could be classified as a “pension” under the U.S.- South Korea Income Tax Treaty, since the treaty was enacted in 1979, Tom would have the same difficulties utilizing the U.S. – South Korea Income Tax Treaty to shield his IRA from U.S. tax as the U.S. treaties with China, Egypt, Pakistan, and Israel.
Applying the U.S- Greece Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Greece that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Greece 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.
The U.S.- Greece Income Tax Treaty went into effect in 1950. The United States joined the OECD in 1961. Since the treaty was enacted in 1950, Tom would have the same difficulties utilizing the U.S.- Greece Income Tax Treaty to shield his IRA from U.S. tax as the U.S. treaties with China, Egypt, Pakistan, Israel, and South Korea.
Applying the U.S- Estonia Tax Treaty to a U.S. Retirement Account Distribution
Assume that Tom is a citizen of Estonia that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money to an IRA. Tom has returned to Estonia 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.
The U.S.- Estonia Income Tax Treaty went into effect in 1998. The United States joined the OECD in 1961. Estonia became a member of the OECD in 2010. Since Estonia was not a member of the OECD at the time the U.S.- Estonia Income Tax Treaty was enacted, U.S. courts cannot defer to the OECD to interpret the treaty terms.
Article 18 of the U.S.- Estonia Income Tax Treaty and its Technical Explanations define the term “pensions and other similar remuneration” as follows-
Paragraph 1 provides that pensions and other similar remuneration derived and beneficially owned by a resident of a Contracting State in consideration of past employment are taxable only in the State of residence of the beneficiary. The paragraph makes explicit the fact that the term “pensions and other similar remuneration” includes both periodic and lump sum payments. The phrase “pensions and other similar remuneration” is intended to encompass payments made by private retirement plans and arrangements in consideration of past employment. In the United States, the plans encompassed by Paragraph 1 include: qualified plans under section 401(a), individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies section 408(k), individual retirement accounts and section 408(p) accounts), nondiscriminatory section 457 plans, section 403(a) qualified annuity plans, and section 403(b) plans. The competent authorities may agree that distributions from other plans that generally meet similar criteria to those applicable to other plans established under their respective laws also qualify for the benefits of Paragraph 1. In the United States, these criteria are as follows: (a) The plan must be written; (b) In the case of an employer-maintained plan, the plan must be nondiscriminatory insofar as it (alone or in combination with other comparable plans) must cover a wide range of employees. including rank and file employees, and actually provide significant benefits for the entire range of covered employees; (c) In the case of an employer-maintained plan the plan must contain provisions that severely limit the employees’ ability to use plan assets for purposes other than retirement, and in all cases be subject to tax provisions that discourage participants from using the assets for purposes other than retirement; and (d) The plan must provide for payment of a reasonable level of benefits at death, a stated age, or an event related to work status, and otherwise require minimum distributions under rules designed to ensure that any death benefits provided to the participants’ survivors are merely incidental to the retirement benefits provided to the participants. In addition, certain distribution requirements must be met before distributions from these plans would fall under paragraph 1.
To qualify as a pension distribution or similar remuneration from a U.S. plan the employee must have been either employed by the same employer for five years or be at least 62 years old at the time of the distribution. In addition, the distribution must be made either (A) on account of death or disability, (B) as part of a series of substantially equal payments over the employee’s life expectancy (or over the joint life expectancy of the employee and a beneficiary), or (C) after the employee attained the age of 55. Finally, the distribution must be made either after separation from service or on or after attainment of age 65. A distribution from a pension plan solely due to termination of the pension plan is not a distribution falling under paragraph 1.
Pensions in respect of government service are not covered by this paragraph. They are covered either by paragraph 2 of this Article, if they are in the form of social security benefits, or by paragraph 2 of Article 19 (Government Service). Thus, Article 19 covers section 457, 401(a) and 403(b) plans established for government employees. If a pension in respect of government service is not covered by Article 19 solely because the service is not “in the discharge of functions of a governmental nature,” the pension is covered by this article. Unlike most U.S. treaties, paragraph 1 provides that, although the State of residence of the beneficiary is given exclusive taxing rights of pension benefits, that State is required to exempt from taxation the amount of any pension that would be excluded from taxable income in the State of source if the recipient were a resident of that State. Thus, if a $10,000 pension payment arising in Estonia is paid to a resident of the United States, and $5,000 of such payment would be excluded from taxable income as a return of capital in Estonia if the recipient were a resident of Estonia, the U.S. will exempt from tax $5,000 of the payment. Only $5,000 would be so exempt even if Estonia would also grant a personal allowance as a deduction from gross income if the recipient were a resident thereof.”
Under the provisions of the U.S.- Estonia Income Tax Treaty,” the country of residence has taxing rights over pension distributions. Residency for tax treaty purposes is determined under domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile. Since Tom is a resident of Estonia, he can potentially take a treaty position that his U.S. IRA should be taxed according to the provisions of the U.S.- Estonia Income Tax Treaty.
Since the Technical Explanations to the treaty specifically includes individual retirement accounts or IRAs in the definition of a “pension and other similar renunciations,” Tom can potentially utilize the U.S.- Estonia Income Tax Treaty to avoid U.S. tax consequences from the distribution of his IRA. However, in order for Tom to avoid U.S. taxation on the IRA distribution, Tom must have been employed by the same employer for five years or be at least 62 years old at the time of the distribution. In addition, the distribution must be made either (1) on account of death or disability, (2) as part of a series of substantially equal payments over Tom’s life expectancy (or over the joint life expectancy of Tom and his spouse), or (3) after Tom attained the age of 55. Finally, the distribution must be made either after separation from service or on or after attainment of age 65.
IV. Required Disclosure of Treaty-Based Return Positions on U.S. Tax Returns
Any noncitizen that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
Conclusion
The U.S. currently has income tax treaties with approximately 58 countries. Each tax treaty is different and has its own unique definitions. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed before treaty position is taken. Tax planning associated with any treaty should begin as early as possible.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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.
