I. Summary

This article presents a summary of the U.S. tax and reporting obligations with which a U.S. citizen must comply in connection with his or her interest in a foreign defined contribution plan that is organized by active companies with numerous employees.[1] Any references in this article to a “foreign plan,” a “foreign pension,” or similar phrases are meant to describe such plans. As the U.S. government increasingly receives information regarding foreign pension plans and seeks to take action to bring taxpayers into compliance, U.S. citizens and income tax residents (“U.S. Persons” or “taxpayers”) and their tax professionals are under growing pressure to comply with the applicable (and highly complex) tax and information reporting rules. In this regard, the U.S. taxation and information reporting of foreign pensions is at an inflection point, much as foreign bank accounts and the related Report of Foreign Bank and Financial Accounts (“FBAR”) form were a mere decade ago. Foreign pension classification and reporting missteps that were overlooked in the past are being swept up in the fervor for foreign asset reporting consistency and accuracy. In fact, many people reading this article likely have clients who have received IRS penalty notices related to foreign pension reporting.                                                 

Despite this IRS crusade, the U.S. government has failed to provide taxpayers and tax practitioners with substantial guidance in this area of tax law. This has directly resulted in pervasive negative taxpayer outcomes—with many taxpayers overreporting the related tax owed and filing information returns that may not be required, whilst other taxpayers still fail to report their offshore plans altogether (perhaps due to opacity of the rules discussed herein).  As a result, U.S. citizens working abroad, as well as foreign nationals who have moved to the United States on assignment for their employer (or more permanently for business or personal reasons) and who retain an interest in a foreign plan, are at risk of paying more U.S. tax, interest, and penalties than they may have to under the law. Furthermore, to the extent a taxpayer relies on U.S. income tax treaties and/or Social Security totalization agreements to remedy the inequitable treatment of U.S. citizens with interests in foreign pensions, retirement plans, and Social Security programs, they may be disappointed when they discover these instruments often fail to provide relief (or certainly sufficient relief).                                                     

This publication is intended for general information purposes only; it does not constitute legal advice. The reader should consult with knowledgeable legal counsel to determine how applicable laws apply to specific facts and situations. This publication is based on the most current information at the time it was written. Because it is possible that the laws or other circumstances may have changed since publication, please call your tax advisor to discuss any action you may be considering as a result of reading this publication.

II. Classification of Foreign Pensions for U.S. Tax Purposes.

Pursuant to Internal Revenue Code Section (“IRC § or IRC Section”) 401(a), a pension plan must be created or organized in the United States to be a “qualified” plan. Thus, by definition, a foreign pension plan generally will not be a qualified plan.[2] Instead, a U.S. citizen participant of a foreign nonqualified plan may be treated for U.S. tax purposes as a beneficiary of one of the following: (1) a nonexempt employees’ trust under IRC § 402(b); (2) a grantor trust under IRC §§ 671-679; or (3) a bifurcated trust, with a portion of the plan being taxable as an employee grantor trust under Treasury Regulations Section (“Treas. Reg. §”) 1.402(b)-(1)(b)(6) and the remaining portion being taxable as an nonexempt employees’ trust.[3].

A taxpayer should examine “who” made the contributions to the plan to determine which of the above classifications should be the proper reporting position.[4] As a practical note, tax professionals may be able to obtain this valuable information related to their clients by reaching out directly to the pension administrator to request copies of the contribution reports (that delineate which contributions were made by the employer and which were made by the employee). If all contributions to the plan are considered “employee contributions,” then grantor trust treatment may be applicable.[5] In contrast, if the “employer contributions” are equal to or greater than the employee contributions,  then the entirety of the plan may be treated as a nonexempt employees’ trust under IRC § 402(b).[6] Finally, a U.S. citizen participant may be deemed the beneficiary of a bifurcated trust when both the employer and employee are treated as having contributed to the plan and the employee contributions are ‘‘not incidental’’[7] when compared to the employer contributions.[8] In such a bifurcated trust scenario, the taxpayer may be treated differently with regard to separate portions of the plan assets–the not incidental contributions being treated as contributions to and subsequently as assets of a grantor trust,[9]  and the remaining contributions being treated as contributions to and subsequently as assets of a nonexempt employees’ trust.[10]

Taxpayers and their tax professionals often find it difficult to properly classify contributions for this purpose due to the lack of guidance regarding what constitutes an employee's contribution, an employer’s contribution, and a nonincidental contribution for purposes of IRC § 402(b) and the regulations thereunder, as well as practical challenges obtaining information from foreign pension administrators. As a result, contributions are often misclassified as employee contributions (based on a surface level review of the pension administrator’s records) and the related pensions are thus misreported as grantor trusts.[11]  This reporting misclassification may result in the loss of tax deferral, foreign tax credit timing issues, over taxation, and unnecessary information reporting.[12]  Instead, as discussed below, it may be more accurate (and potentially more taxpayer friendly) for a taxpayer to report his or her interest in the plan as being an interest in a nonexempt employees’ trust under IRC § 402(b).

III. U.S. Taxation of Contributions to, Earnings of, Growth Within, and Distributions from Foreign Pensions.

As discussed below, a foreign plan’s classification for U.S. tax purposes may have a significant impact on the related tax and information reporting at the participant level. In order to avoid over taxation (and reporting), taxpayers should seek to better understand their rights under the pension plan, the tax laws in the foreign jurisdictions where the pension is located and/or where the taxpayer is a tax resident, and any other relevant factors. This often requires coordination with foreign counsel, foreign pension administrators, and sometimes a translator (to translate the foreign pension documents into English, when applicable).

A. Taxation of Contributions to the Foreign Plan                                                               

Employer contributions to a nonexempt employees’ trust are generally included in the employee’s gross income once “vested” in accordance with IRC § 83.[13]  In addition, employer and employee contributions may be taxable in the year the contribution is made either under (1) the constructive receipt doctrine, (2) economic benefit rule under IRC § 402(b), and/or (3) the employee grantor trust rules of Treas. Reg. § 1.402-1(b)(6).[14]  To the extent a portion or all of the contributions are treated as non-incidental employee contributions, these contributed amounts may be considered immediately taxable income and noncompensatory.[15]  Includible contributions (whether employer or employee contributions) are generally subject to the Federal Insurance Contributions Act (FICA)[16] and the Federal Unemployment Tax Act (FUTA)[17]^,[18]; however, please note that the earnings and growth within the plan may escape FICA and FUTA taxation (even once distributed).[19]

B. Taxation of Earnings of and Growth within the Foreign Pension, and Certain Information Reporting Issues

Earnings within a plan treated as a “nondiscriminatory” employees’ trust are generally includible in income when distributed or made available.[20]  In contrast, a highly compensated employee[21] (HCE) of a “discriminatory”[22] employees’ trust plan may have to annually include in gross income an amount equal to the “vested accrued benefit” under the trust in excess of the employee's “investment in the contract” (i.e., tax basis) as determined under IRC § 72 (to the extent not previously includible).[23] The value of such vested accrued benefit includes the contributions, earnings, and growth of the plan, and this value is essentially subjected to a mark-to-market regime.[24] 

In contrast to the tax results described above, U.S. citizen participants in plans taxed under the grantor trust rules may need to annually include in gross income any realized income of the plan (e.g., dividends, interest, proceeds from sales of positions).[25] That being said, it is often difficult for taxpayers to obtain the financial records needed to determine what percentage of a plan’s growth relates to “realized income.” Thus, in practice, many taxpayers reporting their interest in plans as interests in grantor trusts simply report the entire growth of the plan as having resulted from realized income (thus essentially mimicking the vested accrued benefit regime applicable to the discriminatory employees’ trusts). Secondly, participants in such “grantor trust plans” may be treated as indirect owners of passive foreign investment company (PFICs) interests held through the pension plan.[26] This can result in additional reporting obligations (i.e., Form 8621) and significant tax implications.[27] Thirdly, participants in such grantor trust plans may be required to annually file Forms 3520 and 3520-A,[28] unless they qualify for relief under Revenue Procedure 2020-17.  

C. Taxation of Distributions from the Foreign Plan.

The U.S. taxation of distributions from a foreign pension plan that is treated as an employees’ trust are governed by IRC §§ 72 and 402(b). In this regard, amounts distributed are includible in gross income and are taxable except to the extent the amount received represents an investment in the contract (i.e., the employee's basis).[29] The application of IRC § 72 in this context provides some interesting twists and turns; however, when the facts are aligned with its provisions, taxpayers may receive preferable tax treatment. A taxpayer may be well served carefully reviewing how the IRC § 72 rules apply in their case to ensure they do not under report their foreign pension tax basis and over report their U.S. tax on foreign pension distributions.

IV. Conclusion

The failure of most foreign plans to be qualified for purposes of IRC § 401, and instead generally be governed under IRC § 402(b), creates a level of tax complexity that could only arise from the intersection of U.S. pension tax law and U.S. cross-border tax law. Whether this outcome was intended by Congress during the enactment of IRC § 402(b) (or subsequently) may be relevant for certain academic pursuits (including seeking additional government guidance or legislation regarding this subject); however, in practice, it is incumbent upon tax practitioners to educate themselves and their clients regarding the issues discussed herein.

Christopher Callahan, Esq., LLM, JD, is the Co-Chair of the International Tax and Wealth Planning practice group for Fox Rothschild LLP.  Mr. Callahan is licensed to practice law in New York and Florida, and splits his time between his firm’s New York and Florida offices. He earned his LL.M., MBA. and JD, magna cum laude, as the founder of and first participant in the University of Miami’s J.D./M.B.A./Tax LL.M. Four-Year Triple Degree Program.