Editor: Kevin D. Anderson, CPA, J.D.
In an increasingly global economy, workers are experiencing unprecedented mobility. As such, Americans living abroad, even for a limited time, often participate in a pension or retirement plan in the foreign country; participation might even be mandatory. In most cases, the model resembles the one in the United States: Pretax money is contributed into retirement accounts where it accumulates tax-free until retirement. Foreign pension plans commonly encountered by Americans who are employed abroad include U.K. employer-sponsored pensions, Canadian registered retirement savings plans, and Australian superannuation arrangements, to name a few. Foreign nationals living or working in the United States may have foreign pension plans, too.
Whether contributions, earnings, and distributions are includible in the taxpayer's income depends on the type of foreign pension plan and whether a tax treaty exempts an event that is otherwise taxable.
Foreign pension plans in general
The most common classifications of foreign pension plans, for U.S. tax purposes, are as an employees' trust (under Regs. Sec. 1.402(b)-1), a grantor trust (under Secs. 671-679), or a trust bifurcated between those two categories. The applicable classification depends on contributions and other factors.
- Employees' trust: If a pension plan is more than 50% funded by the employer and the plan does not favor highly compensated employees, the foreign pension is considered a nonexempt employees' trust and governed by Sec. 402(b). In that case, employer contributions are generally taxable income to the employee, but growth inside those plans is tax-deferred until distribution. Upon distribution, the fund functions like an annuity under Sec. 72, and the taxpayer would be allowed to recover his or her basis (contributions) as a return of capital. However, if one of the reasons a trust is nonexempt from income tax is a failure of the plan to meet the participation requirements of Sec. 401(a)(26) or the coverage requirements of Sec. 410(b), then a highly compensated employee shall, in lieu of the contribution amount to the plan under Sec. 402(b)(1) and distributions from the plan under Sec. 402(b)(2), include in gross income an amount equal to the vested accrued benefit as of the close of the tax year of the trust. Thus, the highly compensated taxpayer will end up including in gross income the incremental increase in the value of the plan as of the end of each year. The meaning of "highly compensated" for these purposes is set forth in Sec. 414(q). This amount is adjusted for inflation each year and for 2020 equals $130,000.
- Grantor trust: If a retirement trust is funded entirely by the taxpayer rather than an employer, then the trust will be a grantor trust for U.S. income tax purposes. All items of income, deduction, and credit would appear on the taxpayer's individual income tax return as if the taxpayer owned directly the assets of the retirement trust.
- Bifurcated trust: Generally, by definition, an employees' trust is not a grantor trust as to the employee participant. However, if more than 50% of the contributions are made by the employee, the trust is considered to be bifurcated for U.S. tax purposes: The amounts contributed by the employer constitute an employees' trust, and the rest of the contributions made by the employee participant are classified as a foreign grantor trust.
In addition, depending on the type of underlying assets of the pension plan (e.g., foreign mutual funds), passive foreign investment company (PFIC) rules may apply.
While the United States generally taxes its residents on their worldwide income regardless of their citizenship or the source of the income, an income tax treaty to which the United States is a party could modify the usual rules and mitigate some of the disadvantages of participating in a foreign pension plan.
The tax treaty between the United States and the United Kingdom, which this item focuses on, is one of the most comprehensive when it comes to pensions. Pension provisions are set forth in Articles 17 and 18.
Taxation of retirement plan contributions
Generally, because a foreign pension plan is not a "qualified" plan under Sec. 401, the employee's contributions to the plan are not deductible by the employee, and any employer contributions are taxable compensation to the employee.
However, the U.S.-U.K. tax treaty offers a rare exception to these rules. For example, if a U.S. national is living and working in the U.K. and is contributing to a qualified U.K. pension, he or she could receive a tax deduction in the United States for the contribution to the U.K. plan. This deduction would be available only for so long as the U.S. person resides in the U.K. and may not exceed the tax relief that would be allowed in the United States under Sec. 402(g) (U.S.-U.K. Income Tax Treaty, Art. 18, ¶5).
Alternatively, the U.S. national, while living and working in the U.K., can continue to contribute on a pretax basis to his or her U.S. 401(k) plan, provided that the individual was already enrolled in the U.S. plan prior to his or her departure (Art. 18, ¶¶2a and 3a). Furthermore, under the tax treaty, employer contributions to the employee's pension do not constitute compensation and are considered a business expense in computing the employer's profit and loss (Art. 18, ¶2b).
The treaty thus allows transferred employees to continue to contribute to their home country pension plans without having the employer portion of the contribution be considered taxable income in the host country. Additionally, both employer and employee contributions to the home country pension plan are tax-deductible in the host country (Art. 18, ¶¶2a and 2b).
Certain conditions apply:
- The limits of the host country govern. For example, if a U.K. national works in the United States and continues to participate in a U.K. pension plan, he or she cannot deduct more than the limit prescribed in the United States (the host country) under Sec. 402(g).
- The employee must have already been participating in the home country pension plan before moving to the host country.
- The pension plan must be accepted as a generally corresponding pension scheme by the appropriate authorities in the host country (Art. 18, ¶2, 3).
Taxation of retirement earnings/growth
As noted above, earnings accumulating in a foreign pension plan that is deemed to be a foreign grantor trust ordinarily must be included in income. This would apply, for instance, to earnings inside a U.K. self-invested personal pension (SIPP), given that it is fully funded by the employee.
However, the U.S.-U.K. tax treaty alters this rule by clearly indicating that income earned by the pension scheme may be taxed as income of that individual only when distributed, meaning that earnings inside the plan are tax-deferred (Art. 18, ¶1).
What about rollovers?A U.K. national is allowed rollovers from one approved pension plan to another U.K. plan. Similarly, a rollover from a U.S. 401(k) plan is allowed to another, say, 401(k) or traditional IRA. By contrast, an individual cannot make a rollover from a U.K. to a U.S. plan and vice versa (see Chief Counsel Advice Memorandum AM2008-009, advising that a transfer from a U.K.-registered pension outside of the original state (the U.K.) is not an "eligible rollover distribution" under Sec. 402(c)(4)).
Special attention should be given to U.K. pension rollovers to offshore plans, such as the qualifying recognized overseas pension scheme (QROPS) and the recognized overseas pension scheme (ROPS) plans, which are offshore plans that are sometimes set up in countries such as Malta, Gibraltar, and the Isle of Man. Even though these are permitted under U.K. law, once these rollovers occur, they are no longer governed by the provisions of the U.S.-U.K. tax treaty.
Taxation of retirement distributions
According to Article 17 of the U.S.-U.K. tax treaty, the country of residence at the time of distribution has the sole right to tax the distribution (Art. 17, ¶1a).
However, this provision must be read in tandem with the "saving clause" found in Article 1 (General Scope), under which the United States and the U.K. each reserve a broad right to tax their own citizens "as if this Convention had not come into effect" (Art. 1, ¶4). Due to the saving clause, a U.S. citizen who is a resident of the U.K. and receives a pension payment will be subject to U.S. tax, notwithstanding the language in Article 17.
Under a separate provision of the tax treaty that is expressly not subject to the saving clause, if an individual would have enjoyed tax-exempt status for all or a portion of the distributions in the home country, the host country will confer the same benefit (Art. 17, sub ¶1(b)).
Review all retirement plans and tax treaties
Planning for income taxation of pension schemes when countries outside the United States are involved should include a review of all retirement plans and applicable tax treaties as well as taxpayers' long-term retirement goals. Special attention should be given in these situations, as some classifications in the Code and Treasury regulations leave room for interpretation.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.