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US Citizens Participating in a Foreign Pension Plan

US citizens working for foreign employers may participate in foreign pension plans. These plans normally have beneficial tax treatment under local law. Unfortunately, these foreign arrangements generally do not meet the US “qualification rules”. As a result, the beneficial treatment under local law is often “lost” on US citizens because the US will subject its citizens to current income tax on both the contributions and earnings of the foreign plan.

US Qualified Deferred Compensation

US employer-sponsored pension plans qualify for special tax treatment under the Internal Revenue Code: tax-deductible contributions for the employer; earnings in the plan are tax exempt; and the employee is not taxed until the benefits are received. These tax benefits are not available unless the plan meets the specific requirements of the Internal Revenue Code.

Non-Qualified Deferred Compensation

The determination of when amounts deferred under a nonqualified deferred compensation arrangement can be included in the gross income of the taxpayer depends on the facts and circumstances of the arrangement and which Code section applies to those facts.

IRC § 402(b) Plans

Employer-sponsored non-qualified funded deferred compensation plans are generally governed by the provisions of IRC § 402(b). As a general statement, US employees who participate in such a plan are taxed on the amount of the contributions made by the employer (once the benefits are vested or not subject to a substantial risk of forfeiture). Further, if the employee is a “highly compensated” (compensation exceeds $100,000), the employee is taxed on both the contribution and the growth in the plan each year (to the extent the benefits are vested. (Non-highly compensated employees are not taxed on the growth in the plan, but are taxed when the benefits are distributed.)

IRC § 409A

The provisions of IRC § 409A apply to deferred compensation plans not covered by IRC § 402(b), plans covered by a tax treaty or foreign pension plans that are available on a broad base to the employer’s employees (but only to the extent of non-elective deferrals and employer contributions as limited by US rules). Under IRC § 409A if the deferred compensation arrangement does not meet the requirements of IRC § 409A, the employee will be subject to normal income tax, a 20% penalty tax and an interest charge. To meet the rules of IRC § 409A the plan must provide that distributions from the deferred compensation plan are only allowed on separation from service, death, a specified time (or under a fixed schedule), change in control of a corporation, occurrence of an unforeseeable emergency, or if the participant becomes disabled.

The plan may not allow for the acceleration of benefits, except as provided by regulations. The plan must provide that compensation for services performed during a tax year may be deferred at the participant’s election only if the election to defer is made no later than the close of the preceding tax year, or at such other time as provided in regulations. Finally, the time and form of distributions must be specified at the time of initial deferral.

Income Tax Treaty–Pensions

The normal US income tax rules may be altered by applicable treaty provisions; for example, the US and the UK Income Tax Treaty. While the treaty does not specifically provide that each country’s qualified plans will be treated as qualified plans by the other country, the treaty effectively provides for such a result, subject to certain limits.

In the context of a US citizen employed in the UK and participating in a pension plan established by the UK employer, the rules are that the employee may deduct (or exclude) contributions made by or on behalf of the individual to the plan; and benefits accrued under the plan are not taxable income.

The Treaty further provides that the deduction (or exclusion) rule only applies to the extent the contributions or benefits qualify for tax relief in the UK and that such relief may not exceed the reliefs that would be allowed in the US under its domestic rules. With respect to distributions the general rule under the Treaty is that a pension received by a resident of one country is only taxable by the country of residence. For lump sum payments, the general rule is that only the country of the situs of the pension plan may tax the distribution.

However, as in most US treaties, the US retains the right to tax its citizens as if the treaty were not in force; with the result that the US retains its right to tax its citizens on both periodic distributions as well as lump-sum distributions. Double taxation is avoided through the use of the foreign tax credit rules and the Treaty’s “resourcing” rules.

Which Rules Apply?

Where a US citizen employee participates in a foreign pension plan it is likely that the plan will not have met the US qualification rules. Thus, the employee will be subject to US tax on the contributions to the plan and the growth in the plan. For employees that live in a jurisdiction that imposes an income tax at rates higher than the US rate, it is likely that the employee will have generated a pool of “excess foreign tax credits”. These credits may be used to offset the US tax on foreign-sourced income and therefore may be used to reduce (or eliminate) the US tax that may currently arise on the deferred compensation.

In either case, if the employee has “excess foreign tax credits”, (and provided the deferred compensation is “foreign-sourced income”), the current US tax on such income may be partially or fully offset. Another possibility is for the US taxpayer to make a claim under an applicable treaty. Provided that the contributions to the plan have not exceeded the US plan limitations, the contributions to the plan and the growth in the plan should not be subject to current US income tax.

Thus, the individual has the choice of using excess foreign tax credits or invoking an applicable tax treaty to avoid having to pay current US income tax on contributions and the growth in the foreign deferred compensation scheme. Whether to use excess credits or to invoke the treaty will depend on a number of factors: does the individual have excess credits; where does the individual intend to retire. For example, if the individual has excess foreign tax credits and intends to retire in the US, it may be more beneficial to use the foreign tax credit option.

This is because the contributions have been subject to US tax (even though no tax was owed because of the excess foreign tax credits) and the individual will not be taxed on those amounts later when distributed from the plan. On the other hand, if the individual intends to retire in the foreign jurisdiction, the use of the foreign tax credits may be of little benefit to them as the benefit will be subject to tax in the foreign jurisdiction not in the US. This obviously requires some “guessing about the future”, but it is an issue that must be considered.

For more information, contact:
Andrew Aldridge,
Director of International Tax Planning,
US Tax & Financial Services, Ltd
Magdalen House
136 Tooley Street
London
SE1 2TU
United Kingdom
Tel: +44 (0) 20 7357 8220
E-mail: a.aldridge@ustaxonline.com

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