By Anthony Diosdi
In an increasingly global economy, workers are experiencing unprecedented mobility. As such, foreigners living in America, even for a limited time, often participate in a pension or retirement plan in the United States; participation might even be mandatory. In most cases, pretax money is contributed into retirement accounts where it accumulates tax-free until retirement. U.S. retirement such as 403(b) plans, 401(k) plans, and Individual Retirement Accounts (“IRAs”) are commonly encountered by foreigners who are employed in the United States. In the alternative, Americans who are employed abroad often contribute to foreign retirement plans. 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 the United States- Canada Tax Treaty can potentially be utilized to minimize the income tax consequences on U.S. and Canada based retirement plans.
Taxation of U.S. Based Retirement Distributions
We will begin our discussion with a discussion of U.S. based retirement accounts and how foreigner participants are taxed under U.S. law. 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) Plan
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.
Applying the U.S- Canada Tax Treaty to Retirement Account Distributions
The United States- Canada Income Tax Treaty discusses retirement accounts. The treaty refers to retirement accounts as “pensions.” Article 13 paragraph 1 of the treaty includes pensions paid by private U.S. employers (including pre-tax 401K and Roth 401k arrangements), Section 403(b) plans, as well as any pensions paid in respect of government services. The definition of “pensions” also includes payments from IRAs in the United States and from registered retirement savings plans (“RRSPs”) and registered retirement income funds (“RRIFs”) in Canada. In addition, Article 13 subparagraph 3(b) provides that the term “pensions” generally includes a Roth IRA, within the meaning of Internal Revenue Code Section 408A. Consequently, under paragraph 1 of Article 13, distributions from a Roth IRA to a resident of Canada generally continues to be exempt from Canadian tax to the extent they would have been exempt from U.S. tax if paid to a resident of the United States. In addition, residents of Canada generally may make an election under paragraph 7 of Article 13 to defer any taxation in Canada with respect to income accrued in a Roth IRA, until such time as and to the extent that a distribution is made from the Roth IRA or any plan substituted therefore. Because distributions will be exempt from Canadian tax to the extent they would have been exempt from U.S. tax if paid to a resident of the United States, the effect of these rules is that, in most cases, no portion of the Roth IRA will be subject to taxation in Canada.
However, subparaph 3(b) of Article 13 also provides that if an individual who is a resident of Canada makes contributions to his or her Roth IRA while a resident of Canada, other than rollover contributions from another Roth IRA, the Roth IRA will cease to be considered a persian at that time with respect to contributions and accretions from such time and accretions from such time will be subject to tax in Canada in the year of accrual. Furthermore, following a rollover contribution from a Roth 401(k) arrangement to a Roth IRA, the Roth IRA will continue to be treated as a pension subject to the rules of Article 13.
Assume, for example, that Mr. X moves to Canada on July 1, 2008. Mr. X has a Roth IRA with a balance of 1,100 on july 1, 2008. Mr. X elects under paragraph 7 of Article 13 to defer any taxation in Canada with respect to income accrued in his Roth IRA while he is a resident of Canada. Mr. X makes no additional contributions to his Roth IRA until July 1, 2010, when he makes an after-tax contribution of 100. There are accretions of 20 during the period of July 1, 2008 through June 30, 2010, which are not taxed in Canada by reason of the election under paragraph 7 of Article 13. There are additional accretions of 50 during the period July 1, 2010 through June 30, 2015, which are subject to tax in Canada in the year of accrual. On July 1, 2015, while Mr. X is still a resident of Canada, Mr. X receives a lump-sum distribution of 1,270 from his Roth IRA. The 1,120 that was in the Roth IRA on June 30, 2010 is treated as a distribution from a pension plan that, pursuant to paragraph 1 of Article 13, is exempt from tax in Canada provided it would be exempt from tax in the United States under the Internal Revenue Code if paid to a resident of the United States. The remaining 150 comprises the aftertax contribution of 100 in 2010 and accretions of 50 that were subject to Canadian tax in the year of accrual.
Paragraph 7 of Article 13 provides a rule with respect to the taxation of a natural person on income accrued in a pension or employee benefit plan in the other Contracting State. Thus, paragraph 7 of Article 13 applies where an individual is a citizen or resident of a Contracting State and is a beneficiary of a trust, company, organization, or other arrangement that is a resident of the other Contracting State, where such trust, company, organization, or other arrangement is generally exempt from income taxation in that other State, and is operated exclusively to provide pension, or employee benefits. In such cases, the beneficiary may elect to defer taxation in his State of residence on income accrued in the plan until it is distributed from the plan (or from another plan in that other Contracting State to which the income is transferred pursuant to the domestic law of that other Contracting State).
For example, let’s assume that Tom is a Canadian 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 into a 401K plan. Tom has returned to Canada and would like to withdraw money from his U.S. based 401K. 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 U.S.- Canada Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty. Paragraph 3(a) of Article 13 defines the term pension to include a 401K plan. Paragraph 7 of Article 13 of the U.S.- Canadian Income Tax Treaty defers taxation in Tom’s State of residence until it is distributed from the plan. Residency for tax treaty purposes is determined under domestic law of each country. Since Tom has returned to Canada and is presumably taxed in that country, Tom is a resident of Canada. If Tom makes a timely election under paragraph 7 of Article 13 of the United States- Canada Income Tax Treaty to defer taxation of the 401K plan distribution until he re-establishes residency in Canada, Tom can potentially avoid U.S. withholding tax and early withdrawal penalties on the distributions he receives from the U.S. based 401K plan.
The U.S.- Canada Income Tax Treaty can also be utilized by a U.S. citizen or resident that is a beneficiary of a Canadian tax-free pension or employee benefit plan. The IRS promulgated Rev. Proc. 2014-55 which discusses how a U.S. person can elect to defer U.S. taxes on any accrued but undistributed income until the income is distributed. Rev. Proc. 20-14-55 applies to a U.S. person who is a beneficiary of an RRSP, RRIF, a Canadian registered pension plan, or a Canadian deferred profit sharing plan.
Workers on Short-Term Assignments in the Other Contracting State
Paragraphs 8 and 9 of Article 13 address the case of a short-term assignment where an individual who is participating in a “qualifying retirement plan” on one Contracting State (the “home State”) performs services as an employee for a limited period of time in the other Contracting State (the “host State”). If certain requirements are satisfied, contributions made to, or benefits accrued under, the plan by or on behalf of the individual will be deductible or excludable in computing the individual’s income in the host State. In addition, contributions made to the plan by the individual’s employer will be allowed as a deduction in computing the employer’s profits in the host State.
Paragraph 8 of Article 13 promotes uniform deductibility of United States and Canadian based pension contributions. For example, this provision of the U.S. -Canada Tax Treaty provides that citizens and residents of the United States who become Canadian residents may benefit from the treaty if 1) they move back to the United States to work as an employee and 2) they were Canadian residents immediately before they began performing those services in the United States. These individuals could deduct, for U.S. income tax purposes, contributions to preexisting Canadian retirement plans or plan from their U.S. taxable income.
In order for paragraph 8 to apply, the remuneration that the individual receives with respect to the services performed in the host state must be taxable in the host State. This means, for example, that where the United States is the State, paragraph 8 would not apply if the remuneration that the individual receives with respect to the services performed in the United States is exempt from taxation in the United States under Internal Revenue Code Section 893.
The individual also must have been participating in the plan, or in another similar plan for which the plan was substituted, immediately before he began performing services in the host State. The rule regarding a successor plan would apply if, for example, the employer has been acquired by another corporation that replaces the existing plan with its own plan, transferring membership in the old plan over to the new plan. In addition, the individual must not have been a resident of the host State immediately before he began performing services in the host State.
Benefits are available under paragraph 8 of Article 13 only so long as the individual has not performed services in the host State for the same employer (or a related employer) for more than 60 of the 120 months preceding the individual’s current taxable year. If the individual continues to perform services in the host State beyond this time limit, he is expected to become a participant in a plan in the host State. Canada’s domestic law provides preferential tax treatment for employer contributions to foreign pension plans in respect of services rendered in Canada by short-term residents, but such treatment ceases once the individual has been a resident in Canada for at least 60 of the preceding 72 months.
The contributions and benefits must be attributable to services performed by the individual in the host State, and must be made or accrued during the period in which the individual performs these services. This rule prevents individuals who render services in the host State for a very short period of time from making disportionately large contributions to home State plans in order to offset the tax liability associated with the income earned in the host State. In the case where the United States is the host State, contributions will be deemed to have been made on the last day of the preceding taxable year if the payment is on account of such taxable year and is treated under U.S. law as a contribution made on the last day of the preceding taxable year.
If an individual receives benefits in the host State with respect to contributions to a plan in the home State, the services to which the contributions relate may not be taken into account for purposes of determining the individual’s entitlement to benefits under any retirement plan of the host State. The purpose of this rule is to prevent double benefits for contributions to both a home State plan and a host State plan with respect to the same services. Thus, for example, an individual who is working temporarily in the United States and making contributions to a qualified retirement plan in Canada with respect to services performed in the United States may not make contributions to an individual retirement account (within the meaning of Internal Revenue Code Section 408(a)) in the United States with respect to the same services. Paragraph 8 of Article 13 states that it applies only to the extent that the contributions or benefits would qualify for tax relief in the home State if the individual were a resident of and performed services in that State. Thus, benefits would be limited in the same fashion as if the individual continued to be a resident of the home State.
Where the United States is the home State, the amount of contributions that may be excluded from the employee’s income under paragraph 8 of Article 13 for Canadian purposes is limited to the U.S. dollar amount specified in Internal Revenue Code Section 415 or the U.S. dollar amount specified in Section 402(g)(1) to the extent contributions are made from the employee’s compensation. For this purpose, the dollar limit specified in Section 402(g)(1) means the amount applicable under Internal Revenue Code Section 402(g)(1)(C)) or, if applicable, the parallel dollar limit applicable under Internal Revenue Code Section 457(e)(15) plus the age 50 catch-up amount under Section 414(v)(2)(B)(i).
Where Canada is the home State, the amount of contributions that may be excluded from the employee’s income under paragraph 8 of Article 13 for U.S. purposes is subject to the limitations specified in subsections 146(5), 147(8), 147.1(8) and (9) and 147.2(1) and (4) of the Income Tax Act paragraph 8503(4) of the Income Tax Regulations, as applicable. If the employee is a citizen of the United States, then the amount of contributions that may be excluded is the lesser of the amounts determined under the limitations specified in the previous sentence and the amounts specified in the previous paragraph. The amount of the allowable deduction is to be determined under the laws of the home State. Thus, where the United States is the home State, the amount of the deduction that is allowable in Canada will be subject to the limitations of Internal Revenue Code Section 404 (including Section 401(a)(17) and 415 limitations). Where Canada is the home State, the amount of the deduction that is allowable in the United States is subject to the limitations specified in subsections 147(8), 147.1(8) and (9) and 147.2(1) of the Income Tax Act, as applicable.
Cross-Border Commuters
Paragraphs 10, 11, and 12 of Article 13 address the case of a computer who is a resident of one Contracting State (the “residence State”) and performs services as an employee in the other Contracting State (the “services State”) and is a member of a “qualifying retirement plan” in the services State.
In order for paragraph 10 of Article 13 to apply, the individual must perform services as an employee in the services State the remuneration from which is taxable in the services State and is borne by either an employer who is a resident of the services State or by a permanent establishment that the employer has in the services State. The contributions and benefits must be attributed to those services and must be made or accrued during the period in which the individual performs those services. Paragraph 10 of Article 13 states that it applies only to the extent that the contribution or benefits qualify for tax relief in the services State. Where the United States is the services State, the amount of contributions that may be excluded under paragraph 10 is the U.S. dollar amount specified in Internal Revenue Code Section 415 or the U.S. dollar amount specified in Internal Revenue Code Section 402(g)(1) to the extent contributions are made from the employee’s compensation. Where Canada is the services State, the amount of contributions that may be excluded from the employee’s income under paragraph 10 is subject to the limitations specified in subsections 146(5), 147(8), 147.1(8) and (9) and 147.2(1) and (4) of the Income Tax Act and paragraph 8503(4) of the Income Tax Regulations, as applicable.
Paragraph 11 of Article 13 provides that where Canada is the residence State, the amount of contributions otherwise allowable as a deduction under paragraph 10 may not exceed the individual’s deduction limit for contributions to RRSPs remaining after taking into account the amount of contributions to RRSPs deducted by the individual under the law of Canada for the year. The amount deducted by the individual under paragraph 10 will be taken into account in computing the individual’s deduction limit for subsequent taxation years contributions to RRSPs. The rule prevents double benefits for contributions to both RRSP and a qualifying retirement plan in the United States with respect to the same services.
Paragraph 12 of Article 13 provides that if the United States is the residence State, the benefits granted to an individual under paragraph 10 may not exceed the benefits that would be allowed by the United States to its residents for contributions to, or benefits otherwise accrued under, a generally corresponding pension or retirement plan established in and recognized for tax purposes by the United States. For purposes of determining an individual’s eligibility to participate in and receive tax benefits with respect to a pension or retirement plan or other retirement arrangement in the United States, contributions made to, or benefits accrued under, a qualifying retirement plan in Canada by or on behalf of the individual are treated as contributions or benefits under a generally corresponding pension or retirement plan established in and recognized for tax purposes by the United States.
Reporting Requirements
Anyone that claims the benefits of the U.S.- Canada Income Tax Treaty for U.S. tax purposes must disclose the position on their U.S. tax return. See IRC Section 6114. 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
Often the terms of a U.S. tax treaty modify the tax results that one would otherwise obtain under the Internal Revenue Code. Correctly taking a treaty position can result in substantial tax savings. On the other hand, taking an incorrect treaty position can result in the assessment of significant penalties and interest by the IRS. If you are considering taking a treaty position regarding a U.S. or Canada based retirement account, you should consult with an experienced international tax attorney to assist you. We have advised a substantial number of clients regarding taking income tax treaty positions in connection with U.S. based and foreign retirement plans.
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.