U.S. citizens or green card holders who worked outside of the U.S., or resident alien individuals who worked in another country, may have an account balance or accrued benefit in non-U.S. pension plans.1 Many of those plans provide tax advantages and benefits in the country where they are established. For example, income taxation may be deferred for foreign purposes until the individual receives payment from the plan. However, the majority of foreign plans do not meet U.S. tax qualifications for beneficial tax treatment. In addition, assessing U.S. reporting and tax obligations resulting from an individual’s interest in foreign pension plans may be challenging as the U.S. tax law dealing with pension plans is very complex, and many foreign plans do not fit neatly into the U.S. legal framework.
Depending on how the plan is established and operated, it may be considered a foreign trust for U.S. tax purposes that could trigger additional U.S. filing requirements on IRS Forms 3520 and 3520-A. Foreign trusts covered under section 402(b) are excepted from this reporting, though. section 402(b) governs many pension plans that do not meet the rigorous U.S. qualification standards, and many foreign pension plans fall into this category because foreign employers do not consider U.S. tax laws when designing a foreign pension plan. Additionally, depending on the value of the plans, they may also need to be disclosed on FinCEN Form 114 and IRS Form 8938.
There are generally two types of pension plans – (1) plans that are established through the employer and (2) plans established through an arrangement between the individual and a financial institution. When a foreign plan is established by an employer, the amount of contributions put into the plan by the employer versus the employee is important in determining whether the plan may have U.S. reporting obligations. When the aggregate employer contributions are put into an employer-sponsored plan exceed the employee’s aggregate contributions, the plan generally falls under section 402(b) and does not need to be disclosed on IRS Forms 3520 and 3520-A.
The income taxation of plans that fall under section 402(b) depends on whether the plan is considered discriminatory and whether the employee is highly compensated. The plan is not discriminatory when it meets the requirements of sections 410(b) and 401(a)(26), if applicable. Meeting those requirements depends in general on the coverage ratio for non-highly compensated employees versus highly compensated employees. When the entity offering the plan is part of a controlled group with locations in different countries, all employees of the controlled group must be considered for purposes of meeting this threshold, although nonresident aliens with no U.S. source income are excluded from the definition of employee.
Under section 414(q), an employee is considered highly compensated when he or she is either a 5 percent owner of the corporation or has compensation of at least $120,000 annually (2015 limit adjusted periodically). Taking into account additional allowances that are usually offered to employees during foreign assignments, the majority of them would likely exceed this threshold.
In a nondiscriminatory plan, the employee is taxed on vested employer contributions to the plan, and the income recognized becomes the employee’s basis in the plan. Distributions from nondiscriminatory plans are taxable to the extent the distribution exceeds a pro rata portion of the basis the employee has in the pension plan, which generally consists of previously taxed employer contributions and employee contributions to the plan made on a post-tax basis. If the plan is discriminatory but the employee is not highly compensated, the same taxation rules would apply. However, a highly compensated employee participating in a discriminatory plan must recognize the difference between the current year ending value of the account and the previously taxed amounts as compensation income each year. As a result, not only is the current year realized income subject to tax, but also any unrealized appreciation in the plan is taxed. The previously taxed amount becomes the employee’s basis in the pension plan; therefore, future distributions are subject to minimal additional tax, if any. These employer-sponsored plans are compensation so all income is reported as ordinary income, regardless of the underlying nature of the investments held in the plan.
When the employee contributions exceed the employer contributions to an individual’s plan, the employee is considered the owner of the employee contribution portion of a trust under the grantor trust rules. In this case, the trust is bifurcated into two pieces, and the piece qualifying as a grantor trust likely has a filing requirement on IRS Forms 3520 and 3520-A.
Similarly, many contractual pension arrangements with financial institutions that are not employer-sponsored may be considered grantor trusts, depending on the terms of the arrangement. It is often difficult to determine if a foreign plan is a trust because they may not be structured using the same terms as U.S. plans and the employee may not have enough knowledge about exactly how the plan works. Likewise, U.S. 401(k) plans are set up in trusts, but many U.S. employees participating in a 401(k) plan do not know the funds are actually held in a trust. It is easy to see why employees may be unaware of whether a foreign plan involves a trust arrangement as well. The main indicia of a trust for federal income tax purposes include:
- The account is overseen by a person or entity on the individual’s behalf (a trustee).
- The person or entity overseeing the account has limited power to vary the investment.
- The person or entity has power to exercise authority and control over the assets, per a legal document. This power would include the ability to protect the assets and oversee their administration and distribution per the agreement, without additional approval by the individual.
In contrast, a standard checking account would not meet the above characteristics of a trust because the individual owner of the account retains complete access and control over the account at all times.
When a pension plan constitutes a foreign grantor trust, there may be a filing requirement to report contributions to, and distributions from, the foreign grantor trust on IRS Forms 3520 and 3520-A. The employee (beneficiary) must report the annual income earned in the plan on his or her U.S. income tax return. Ordinary income is taxed at ordinary income tax rates and capital gains are taxed at capital gain rates. Many non-U.S. pension plans invest in foreign mutual funds, which may trigger a requirement to file IRS Form 8621 if the funds qualify as passive foreign investment companies.
Some U.S. income tax treaties with certain countries provide for relief from the above mentioned taxation rules, which would allow the plan to be taxed similar to U.S. 401(k) plans. In cases where such a treaty provision applies, employer contributions are not included in the employee’s current taxable income, and the employee contributions may be made on a pre-tax basis for U.S. income tax purposes up to the U.S. 401(k) deferral limits. Also, any increase in the value of the account is not subject to tax currently; instead, the account is taxable upon distribution to the employee. While these treaty rules may result in beneficial income tax treatment, they do not usually exempt the plan from the trust reporting rules, if otherwise applicable.
Pension plans operate differently in every country. Therefore, the facts and circumstances of each plan must be analyzed under U.S. rules in order to determine the appropriate plan reporting and taxation for U.S. purposes. This article provides a summary of the applicable rules, but the analysis can be extremely complicated in some cases. Failure to report the ownership and taxable income resulting from the pension plan may result in significant penalties. Initial penalties for late or non-filing of applicable forms start at $10,000 but may be imposed up to 50 percent of the account value and in some cases may include criminal prosecution. Therefore, any U.S. taxpayers participating in foreign pension plans should be sure to disclose such plans to their tax advisors.