Cross-Border Pension Rollover Creates U.S. Taxable Income

Editor: Anthony S. Bakale, CPA, M. Tax.

Foreign Income & Taxpayers

As the global workforce becomes increasingly mobile, more and more workers must wade through the intricacies of cross-border taxation. One of these more common cross-border situations is discussed in Chief Counsel Advice (CCA) 201231010. The situation described in this CCA is likely to arise more and more for taxpayers who take an employment assignment overseas.

Facts

The taxpayer was a university professor and had worked most of his career at various universities in the United Kingdom. While working at these universities, he contributed to qualified pension plans under U.K. law.

However, for a period, he worked at a U.S. university and contributed to a Sec. 403(b) pension account. After he completed the U.S. work assignment, he sought professional advice regarding the ability to roll over the balance in his U.S. plan to his U.K. pension plan. The U.K. tax authorities advised the taxpayer to consult the administrators of the U.S. plan on whether the proposed transfer would be permitted under the plan rules.

While the taxpayer was again a resident of the U.K. and a nonresident alien for U.S. income tax purposes, the U.S. plan issued a lump-sum check made payable to the U.K. plan. The funds went directly from the U.S. pension plan to the U.K. pension plan. The taxpayer was issued a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting the gross distribution. The taxpayer believed that the rollover was a “good” tax-deferred rollover. Therefore, he neither filed a U.S. tax return nor paid any U.S. income tax on the distribution. Unfortunately, the IRS disagreed with the taxpayer’s position for the reasons discussed below.

Code Sections

Sec. 403(b)(8) provides that if (1) any portion of an employee’s balance in an annuity contract is paid to the employee in an eligible rollover distribution (within the meaning of Sec. 402(c)(4)); (2) the employee transfers any portion of the property he or she receives in that distribution to an eligible retirement plan described in Sec. 402(c)(8)(B); and (3) in the case of a distribution of property other than money, the transferred property consists of the property distributed, then the distribution (to the extent transferred) will not be includible in the employee’s gross income for the tax year in which it is paid.

Sec. 402(c)(8)(B) provides that the term “eligible retirement plan” includes an annuity contract described in Sec. 403(b).

Sec. 894(a)(1) provides that the provisions of the Code are to be applied to any taxpayer with due regard to any treaty obligation of the United States that applies to that taxpayer.

U.K.-U.S. Income Tax Treaty

Pension distributions: Paragraphs 1 and 2 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support) of the United Kingdom-United States income tax treaty provide:

(1) a) Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that State.

b) Notwithstanding sub-paragraph a) of this paragraph, the amount of any such pension or remuneration paid from a pension scheme established in the other Contracting State that would be exempt from taxation in that other State if the beneficial owner were a resident thereof shall be exempt from taxation in the first-mentioned State.

(2) Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum payment derived from a pension scheme established in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the first-mentioned State.

According to the Treasury Department’s technical explanation of the U.K.-U.S. treaty, paragraph 1 establishes the general rule that the country where the beneficial owner resides “has the exclusive right to tax pensions and other similar remuneration.” However, that country of residence “must exempt from tax any amount of such pensions or other similar remuneration that would be exempt from tax in the State in which the pension scheme is established if the recipient were a resident of that State.”

However, lump-sum payments are not subject to the general rule established in paragraph 1. Under paragraph 2, lump-sum payments from a pension plan are taxable in the country where the pension plan is established. Treasury’s technical explanation says that this was done to avoid “double non-taxation” that would arise because the United Kingdom does not tax lump-sum distributions from pension plans.

In this case, if the transfer from the U.S. plan to the U.K. plan was treated as a lump-sum distribution from the U.S. plan to the taxpayer rather than as a tax-free rollover, the distribution would be taxable in the United States, notwithstanding the fact that the taxpayer was a resident of the United Kingdom.

Pension plans: Paragraph 1 of Article 18 (Pension Schemes) of the treaty provides:

Where an individual who is a resident of a Contracting State is a member or beneficiary of, or participant in, a pension scheme established in the other Contracting State, income earned by the pension scheme may be taxed as income of that individual only when, and, subject to paragraphs 1 and 2 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support) of this Convention, to the extent that, it is paid to, or for the benefit of, that individual from the pension scheme (and not transferred to another pension scheme).

The Treasury Department’s technical explanation of the treaty explains that under Article 18(1), a taxpayer’s country of residence may not tax the earnings and accretions of a pension plan established in the other country until those amounts are distributed to the taxpayer. Thus, under Article 18(1), the United Kingdom may not tax the earnings and accretions of a U.S. pension plan with respect to an individual who is a resident of the United Kingdom until such amounts are distributed to that individual.

CCA Discussion

In discussing the above statute and income tax treaty, CCA 201231010 quotes the Joint Committee on Taxation’s explanation of the treaty:

The proposed treaty provides that neither country may tax residents on pension income earned through a pension scheme in the other country until such income is distributed. For purposes of this provision, roll-overs [sic] to other pension plans are not treated as distributions. When a resident receives a distribution from a pension plan, such distribution is generally subject to residency country taxation in accordance with Article 17 (Pension, Social Security, Annuities, Alimony, and Child Support). [Emphasis added by the CCA.]

According to the CCA, Article 18(1):

merely provides that a transfer of earnings and accretions from one pension scheme to another pension scheme will not be treated as a distribution for purposes of Article 18(1) if the transfer qualifies as a rollover. It does not provide an independent basis for treating a transfer as a tax-deferred rollover distribution; i.e., for U.S. tax purposes, it does not provide an independent basis for treating a transfer as an eligible rollover distribution. To qualify as a tax-deferred rollover distribution, a transfer would have to satisfy the rollover requirements under the domestic laws of both the transferor pension scheme and the transferee pension scheme.

The CCA holds that, in this case, because the taxpayer’s transfer of funds from his U.S. plan to his U.K. plan did not satisfy the rollover requirements under U.S. law, Article 18(1) does not apply, and the transfer counts as a lump-sum distribution, taxable in the United States. The transfer does not satisfy the rollover requirements because the U.K. pension plan is not an eligible retirement plan under Sec. 402(c)(8)(B).

Conclusions

At first glance, one might think that the above transaction should have qualified as a tax-deferred rollover, if only under the premise that the taxpayer was doing a direct transfer from a U.S. pension plan to a U.K. pension plan. Unfortunately, the taxpayer had to first meet the U.S. statutory requirement in Sec. 402(c)(8)(B) that the transfer be made to an eligible retirement plan. Without a specific provision in the U.K.-U.S. treaty that would include a U.K. pension scheme as an eligible retirement plan under the U.S. statute, the transfer could not meet the eligible retirement plan requirement. However, even though the taxpayer in this instance was a U.S. nonresident, he could have completed a tax-deferred rollover from one U.S. eligible retirement plan to another U.S. eligible retirement plan without being subject to immediate taxation in either the United States or the United Kingdom. Thus, a rollover to a U.S. IRA may have been a preferable simplification strategy in these circumstances.

So is there any solution to this pension plan complexity for the average taxpayer? Under certain situations, it may be possible, if a taxpayer is transferred from the United Kingdom to the United States on a short-term assignment, to continue to contribute to his or her U.K. pension while on the U.S. assignment if certain conditions are satisfied. However, every situation is slightly different, so a tax adviser should be consulted in advance of any overseas assignments to determine whether the taxpayer can benefit from certain pension contribution provisions of the U.K.-U.S. income tax treaty.

EditorNotes

Anthony Bakale is with Cohen & Co. Ltd., Baker Tilly International, Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.