While income taxation may be deferred in the country where a foreign pension plan is established, this has no bearing on the U.S. federal tax treatment of the plan. Many U.S. citizens living abroad are unaware of this distinction and mistakenly think that their foreign pensions are not currently taxable in the U.S. because they are not currently taxable in their foreign country of residence.
The U.S. Internal Revenue Code and accompanying Treasury regulations have provisions that allow for full U.S. tax deferral of pension plan contributions and earnings until withdrawal upon retirement (e.g., Section 401 of the Code and the regulations thereunder), but most foreign pension plans do not qualify for this beneficial treatment and therefore trigger tax in the year that contributions are made or earnings are generated.
Foreign Pensions as Trusts
An important starting point in analyzing the taxation of a foreign pension plan is determining whether the plan should be classified as a trust for U.S. federal income tax purposes. This is because Section 402(b) of the Code provides helpful rules for employees’ trusts that do not qualify for full U.S. tax deferral. In this regard, the IRS has ruled in a number of instances that particular foreign pension plans (including so-called “superannuation funds”) should be treated as trusts for U.S. tax purposes.
Assuming trust classification, the taxation of employer contributions and earnings will then depend on whether the foreign pension plan is “discriminatory” or not. This is determined based on the plan coverage ratio of highly-compensated employees to non-highly compensated employees. Highly-compensated employees are defined to include those with certain employer ownership interests or employees that have an annual compensation of $120,000 or more (an inflation-adjusted amount for 2018).
As a general rule, under Section 402(b), in the case of non-discriminatory pension plans, employees must currently include employer contributions in income but can defer tax on pension earnings until withdrawal upon retirement. In the case of discriminatory plans, the highly-compensated employees may need to currently include both contributions and earnings in income. Such employees can at least take solace in the fact that paying tax currently generally means that they will not have to pay tax on a future withdrawal upon retirement.
A number of additional factors further complicate the above rule, including whether an employee’s interest in a pension plan is considered “vested” for tax purposes, and whether the pension plan is actually funded with employer and/or employee contributions.
On top of all this, the general U.S. tax treatment of a pension plan may be overridden by the provisions of a relevant tax treaty that contains a pension provision.
For instance, the U.S.-U.K. tax treaty generally exempts employer contributions and earnings associated with qualifying pension schemes. Other treaties, such as the U.S.-Australia tax treaty, exempt the employer contributions but not the earnings associated with qualifying pension schemes.
Each treaty should be analyzed as relevant for your particular circumstances, as the provisions can differ significantly depending on the particular treaty.
Tax Filing Implications
In terms of U.S. tax return compliance, foreign pension plans can potentially trigger the obligation to file a number of international tax forms, including Form 8938 (Statement of Specified Foreign Financial Assets), otherwise known as the FATCA form, and the Report of Foreign Bank and Financial Accounts (the “FBAR” form).
In the case of foreign pension plans that qualify as employees’ trusts, Forms 3520 and 3520-A, which deal with foreign trust reporting, may be triggered if employee contributions to the plan exceed employer contributions. In such case, the employee is considered the owner of the employee contribution portion of the trust under the “grantor” trust rules, and the trust is bifurcated into two pieces. The piece qualifying as a grantor trust has an annual filing requirement on Forms 3520 and 3520-A and may have additional reporting requirements depending on the pension’s underlying investments (e.g., PFIC reporting). If the employer contributions exceed the employee contributions, the entire plan is generally treated as a “non-grantor” trust that does not trigger an annual 3520 or 3520-A filing obligation.
In a very recent publication (Revenue Procedure 2020-17), the IRS announced plans to issue regulations that could provide significant relief to taxpayers in respect of foreign pension reporting. The new rule would exempt so-called "tax-favored foreign retirement" plans as well as "tax-favored foreign non-retirement savings" plans from 3520 and 3520-A reporting. The rule contains a number of requirements and conditions, and more guidance is expected to help taxpayers and their advisors understand which foreign pension plans do and do not qualify for the new reporting exemption.
The complexities of foreign pension plans, both from a substantive tax perspective and a reporting perspective, make U.S. citizens abroad participating in such plans particularly susceptible to tax return omissions and errors that can prove very costly if penalties are imposed by the IRS. Given these complexities, it is important to give foreign pension plans their proper analytical due before reporting them to the IRS.