There are currently more than 100,000 Australian-born people living in the United States. Many of these individuals have an Australian Superannuation account. A superannuation is an Australian pension program created by a company to benefit its employees. Funds deposited in a superannuation account will grow through appreciation and contributions until retirement or withdrawal. As with many foreign pension plans, the U.S. federal taxation of superannuation accounts is a gray area. The most common type of superannuation is the Self-Managed Superannuation Funds. This article will focus on Self-Managed Superannuation Funds. This is because Self-Managed Superannuation Funds are the most common type of superannuation.
Many tax professionals consider a superannuation fund to be a foreign grantor trust for U.S. tax purposes. If a superannuation fund can be classified as a grantor trust, all contributions and all growth income is taxed in the U.S. Many issues arise if a superannuation fund is treated as a foreign grantor trust. Other tax professionals take the position that a superannuation fund should be treated as an exempt foreign social security plan for U.S. tax purposes.
The Department of Treasury and the Internal Revenue Service or (“IRS”) has not officially classified the Australian Superannuation for U.S. tax purposes. This article attempts to discuss how the Australian Superannuation may potentially be taxed under U.S. federal law and under international treaty law. In order to better understand how a superannuation fund is taxed, it is important to discuss the domestic and international treaty law that govern foreign retirement accounts such as the Australian Superannuation Fund.
The Australian Social Security System and Superannuation Plans
In 1992, the compulsory employer contribution scheme became law in Australia. Under this framework the Superannuation Guarantee Administration Act was enacted. Superannuation Guarantee Administration Act mandated compulsory employer contributions to state-mandated occupational pensions that are privately managed.
Superannuation is compulsory for all employed people working and residing in Australia. Australian law dictates minimum amounts that employers must contribute to the superannuation accounts of their employees. Self-employed individuals may also make contributions to superannuation funds. There are various types of superannuation schemes, including, but not limited to, public sector funds established for federal and state government employees, corporate funds established by medium to large private sector companies for their employees, industry or multiemployer funds, retail fund or public offer funds, and self-managed superannuation funds.
The Australian Government outlines a set percentage of employee income that should be paid into a superannuation account. Since July 2002, this rate has increased from 9 percent to 10 percent in July 2021, and will stop increasing to 12 percent in July 2025. Employees are also encouraged to supplement compulsory superannuation contributions with voluntary contributions, including diverting their wages or salary income into superannuation contributions under so-called salary sacrifice arrangements.
There is no standard retirement age in Australia. As of July 2023, individuals can start to draw some money from their superannuation once they reach 60 years of age. Upon reaching age 65 or ceasing employment after age 60, individuals have total access to their superannuation accounts.
Australian superannuation funds may be classified as state-mandated occupational pensions with the primary purpose of providing for benefits at retirement. A state-mandated “occupational pension scheme” fits the precise definition of social security according to the OECD. Under Australian law, any contribution to an Australian superannuation fund is inaccessible until death, disability, or retirement; a classific trait of traditional, publicly-managed social security.
Australia has also set up a social security system. Australia has no social security taxes. Instead, Social Security is funded through general tax revenues. Australian social security provides monthly retirement benefits. Australia’s current social security system has two components: a means-tested Age Pension funded through general revenue; and the superannuation guarantee funded through compulsory employer contributions to state-mandated superannuation funds, which are similar to compulsory contributions under U.S. Federal Insurance Contributions Act. This is supported by a report published by the United States Joint Committee on Taxation, which stated, “The social security system in Australia is composed of two tiers. The first tier is called the ‘age pension’ benefit and the second tier is called the ‘superannuation guarantee.’
The U.S. Taxation of a Australian Superannuation Account
The basic rule of the U.S. income tax system is that a U.S. citizen or resident alien is subject to tax on his or her 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. Under this general rule, a U.S. citizen or U.S. resident could potentially be subject to U.S. tax on any growth with a superannuation account and from any distributions received from a superannuation account. In addition, if a superannuation account is treated as a foreign pension, the superannuation may be viewed as a foreign grantor trust (for U.S. tax purposes) as the U.S. beneficiary has a certain level of control over the investments and distributions and is considered the plan “owner.” The taxation of pensions invested in foreign entities is a dangerous minefield that could be subject to the harsh “throwback tax” or passive foreign investment company (or “PFIC”) rules. In addition, U.S. beneficiaries who receive a distribution from a foreign grantor trust must file Form 3520 and Form 3520-A with the IRS by the due date.
Superannuation accounts are unique in that they are mandated by the Australian government. As such, Australian Superannuation accounts can potentially be classified as social security. For U.S. tax purposes, foreign social security is not taxed as a distribution from a foreign grantor trust. Instead, foreign social security is taxed as an annuity. Gains within annuities are tax-deferred until the contract annuitizes and payments begin or when the owner takes a lump some from the annuity. See IRC Section 72. If a superannuation distribution can be treated as a lump sum annuity, the harsh throwback tax or PFIC regimes can be avoided. In addition, treating a superannuation distribution as foreign social security rather than a distribution from a grantor trust would also eliminate the need to file the complicated Form 3520 and Form 3520-A with the IRS.
The Totalization Agreement
Whether or not a superannuation fund can be classified as grantor trust or social security for U.S. tax purposes depends largely on one’s interpretation of the U.S.-Australia Totalization Agreement. A totalization agreement is an international tax treaty that seeks to eliminate dual taxation with regards to social security taxes. The U.S.-Australia totalization agreement has been in effect since October 1, 2002. Some tax professionals take the position that the U.S. has acknowledged that a superannuation distribution should be treated as social security. This is because the totalization agreement specifically states that a superannuation contribution is the same or similar to social security contributions. Other tax professionals believe that the goal of the U.S.-Australian Totalization Agreement was to avoid having a taxpayer income withheld in each jurisdiction for employment.Thus, the U.S.-Australian Totalization Agreement should not be interpreted to mean an Australian Superannuation Fund falls under the definition of social security.
While the U.S.-Australian Totalization Agreement covers the guaranteed portion of superannuation accounts, it is still unknown if this coverage expands the definition of “social security” to include such portions of superannuation accounts.
An Overview of the Rules Governing Tax Treaties and Federal Law
Most income tax treaties have special rules for social security payments. In many cases, foreign social security payments. Unless a tax treaty allows it (see, e.g., the U.S.-Australia tax treaty), they are not eligible for exclusion from taxable income the way U.S. social security might be. Before we discuss the application of the U.S.-Australia income tax treaty to superannuation accounts, it is important to have an understanding of rules governing tax treaties and U.S. law.
Often the 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), however, provides that “[f]or purposes of determining the relationship between a provision of a treaty and any law of the U.S. 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 way of stating a basic principle of U.S. jurisprudence with respect to the posture of treaties: under the U.S. Constitution, 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).
The obvious application of this principle occurs normally when a new tax treaty is concluded that reduces U.S. tax burdens for foreign persons. Because the treaty is later in time, the courts in the U.S. will apply the treaty and the U.S. tax burdens of a resident of the foreign treaty partner will be lowered. 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. A U.S. court will apply this principle even though the result is to place the United States in violation of the treaty and is therefore in violation of international law. This practice differs from that of many countries where a treaty is considered to be a higher source of law than a statute. It should be noted, however, that as a rule of interpretation, U.S. courts generally strive to construe U.S. treaties and federal statutes so not to conflict with each other.
In Dixon v. Commissioner, No. 13874-19 (2019), Dixon argued that his superannuation funds were exclusively taxable under Article 18, Paragraph 2 of the U.S.-Australia income tax treaty. The IRS challenged this position. The case has been continued and it remains to be seen if the Tax Court will issue an opinion on this issue. In the meantime, we can take a closer look at how a U.S. citizen or resident that receives a distribution from a superannuation fund could potentially exclude the distribution under the treaty.
As discussed above, the U.S. citizens and U.S. residents are subject to tax on worldwide income. The U.S. taxation of the worldwide income of U.S. citizens and residents obviously opens the door to taxation of superannuation distributions. Article 18, Paragraph 2 of the U.S.-Australian income tax treaty provides as follows:
“Social Security payments and other public pensions paid by one of the Contracting States to an Individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.”
Article 18, Paragraph 2 refers to “social security and other public pensions.” There is no mention of Superannuation earned by the fund, and on benefits paid by the fund. Below, we will discuss how the term “social security” can be interpreted for purposes of the U.S.-Australia income tax treaty.With that said, the Organization for Economic Co-operation and Development or (“OECD”) publishes guidance in the form of commentaries, which are intended to aid in interpreting the provisions of the tax treaties. The OECD Commentaries are updated from time to time to reflect evolving consensus among the member OECD countries regarding the meaning of particular Model Treaty provisions. The United States and Australia are both members of the OECD. According to the OECD, the term “social security” generally “refers to a system of mandatory protection that a State puts in place in order to protect its population with…retirement benefits.” See Model Tax Convention on Income and Capital, art 18 (OECD). The Australian superannuation system is a state mandated employer contribution system to provide for retirement. The Australian state-mandated superannuation system fits the precise definition of social security as provided by the OECD. Under the OECD definition of “social security,” a superannuation account can be classified as social security for purposes of Article 18, Paragraph 2 of the U.S.-Australia income tax treaty.
Even though a compelling argument can be made that the definition of “social security” is broad enough to encompass a superannuation fund, Article 18, Paragraph 2 of the U.S.-Australian income tax treaty provides an implicit (or indirect) definition of “social security” as being a kind of “public pension.” A superannuation fund could be considered “privatized social security.” Defining a superannuation account as “privatized social security” may remove it from Article 18, Paragraph 2 of the treaty.
The “Savings Clause” Contained in the U.S.-Australia Income Tax Treaty and its Application to Superannuation Distributions
Paragraph 3 of Article 1 of the U.S.-Australian income tax treaty contains a savings clause. (All U.S. treaties contain such a savings clause). A Savings Clause preserves or “saves” the right of each country to tax its own residents as if no treaty existed. In other words, the U.S. may disregard most treaty claims made by U.S. citizens and U.S. tax residents. Although the U.S.-Australia income tax treaty contains a Savings Clause, the Savings Clause in the U.S.-Australia income tax treaty does not apply to Article 18, Paragraph 2 of the treaty as the article specifically states “Social Security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.”
Conclusion
Until the Australian Superannuation Fund gets its proverbial day in court, tax professionals are going to be kept guessing how these plans should be treated for U.S. tax purposes. Any U.S. beneficiary of an Australian Superannuation fund should carefully examine their options for U.S. tax purposes.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
