Tax planning for international assignments is not simple. There are many challenges that globally mobile employees and their employers face when making decisions about a foreign assignment. One of the big issues for employees and multinational companies is the complicated U.S. tax reporting related to foreign pensions.
Foreign nationals coming to the United States on assignment are usually covered by a retirement program in their home country. Not many realize that their home country pension plans which enjoy beneficial tax treatment in their national jurisdiction, can create complicated tax issues in the United States. It is essential for international employees and their employers to plan ahead before considering a foreign assignment so that they fully understand the U.S. tax law and filing requirements in relation to their foreign pensions. Companies with international assignment programs should also be aware of the additional compliance cost arising from the foreign pension reporting requirements imposed by the United States.
There are a number of U.S. reporting requirements that may apply with respect to a U.S. taxpayer’s interest in a non-U.S. pension plan. Filings may include any of the following:
- Foreign Bank Account form (Form 114)
- Foreign trust reporting forms (Form 3520 and 3520-A)
- Statement of Specified Foreign Financial Assets (Form 8938)
- Passive foreign investment company (PFIC) form (Form 8621)
- Form 8833 to claim the income tax treaty exemption from U.S. taxation on contributions to the plan and/or benefits accrued income under the plan.
Non U.S. Pension Plan and PFIC Reporting
The majority of non-U.S. pension plans are generally held in investments that the United States considers PFICs. A PFIC is any foreign corporation if 75 percent of the corporation’s income is passive or 50 percent, or more, of its assets produce passive income such as interest, dividends or capital gains.
Individuals who own pension plans that the United States treats as grantor trusts (employee/beneficiary is considered an owner of the foreign pension plan) generally must report income earned in the plan during the year on their U.S. income tax return. In addition, if the plan invests in foreign mutual funds, the income may be taxed under the PFIC regime and the taxpayer may be required to file IRS Form 8621. Even though the foreign pension is treated as a grantor trust, the earnings generated by the plan can be deferred until distributed in certain situations. Deferral may be possible where a treaty between the United States and the country of the foreign pension allows for treatment of the plan as a qualified plan for U.S. tax purposes. In this case, neither the PFIC or the individual is required to file Form 8621.
U.S. persons are not generally considered the owners of the assets held by employee’s trusts (plans governed by the provision of IRC 402(b)), unless the employee contributions exceed the employer contributions to an individual’s plan. For these non-grantor employee trusts there is no clear IRS guidance on PFIC reporting requirements.
The U.S. tax treatment of PFICs is extremely punitive. Foreign investments subject to the PFIC taxation regime are taxed at much higher rates (generally ordinary rates apply in lieu of capital gain rates) than similar investments incorporated in the United States. The other significant concern is that compliance with PFIC reporting requirements may be difficult and time consuming.
For example, regulations published by the U.S. tax authorities on Dec. 31, 2013, require all U.S. taxpayers that directly or indirectly own shares in a PFIC to file Form 8621, regardless of income earned during the year. There are certain exceptions to the reporting requirements that may be relevant to taxpayers with foreign pension plans.
Temporary Regulation section1.1298-1T(b)(3)(ii) – “special rules for estates and trusts” refers to foreign pension plans where a U.S. person is treated as the owner of any portion of the foreign trust. The Temporary Regulation provides an exception to the annual filing requirement in situations where a tax treaty allows for the deferral of income in foreign pension. The final regulations revise the treaty-based exception for PFIC held by a U.S. person through certain pension funds to eliminate the requirement that the foreign pension fund be treated as a foreign trust. The final regulations expand the exception to PFIC held through all foreign pension funds covered by a treaty, regardless of the entity classification for U.S. tax purposes. However, the treatment of pension plans under U.S. income tax treaties is not uniform and taxpayers must examine the relevant provisions carefully to determine whether they are entitled to treaty benefits.
Another exception to PFIC reporting that may be relevant to taxpayers with foreign pension plan is provided under section 1.1298-1T(c)(2)(i). The regulation provides that the PFIC owner is not required to file Form 8621 if the year-end value of all PFICs owned by the individual does not exceed $25,000 ($50,000for joint returns) or the value of the indirectly owned PFIC is $5,000 or less and there was no income received from the plan during the year.
Taxpayers that are required to report a PFIC must file Form 8621 on an annual basis with the U.S. individual income tax return for each PFIC. Annual PFIC reporting requirements may cause the taxpayer to incur significant compliance costs for preparing and filing a Form 8621 for each foreign mutual fund held in the plan. There are significant penalties for noncompliance with foreign pension and PFIC rules. Very often this cost is an additional burden to the employer who assumes compliance costs for their foreign assignees. Employers frequently fail to add these additional costs to their budgets when planning a foreign assignment and they do not take it into consideration in their policies.
Non U.S. pensions may trigger current tax costs
Along with additional reporting requirements, non-U.S. pensions can also come with hefty tax burdens. Consider the different elements of a pension and how the United States treats them for tax purposes. Generally, employee contributions are a pre-tax benefit, employer contributions are tax-free at time of contribution, and growth in the pension plan is tax-free until distribution.
Many countries around the world offer the same benefits to their approved local pension plans. However, when an assignee works in a different location their home pension may not be taxed in the same way in the host location; contributions may become post-tax deductions, employer contributions become taxed at time of contribution, and growth in the plan may now be taxed as it grows. All of this puts the assignee in a negative tax situation, which if they are tax-equalized adds an additional burden to the company. The United States is a good example of this issue. The United States does not recognize non-U.S. plans and under domestic law would tax all three of the items mentioned above for a non-U.S. plan. There are a handful of income tax treaties with the United States that under certain circumstances, put the individual back into the positive tax situation. The U.S. tax treaties with the U.K. and Netherlands are two such examples. However, there are more U.S. tax treaties that do not provide enough protection, such as the treaty with South Africa, and some that have no protections at all, such as the treaty with Australia.
Under the U.S. – Australia treaty, an individual who comes from Australia to the United States could end up in a very burdensome tax and reporting position. The majority of Australian pension funds are held in superannuations, which are trusts under Australian law. With regards to the Australian pension plan for a U.S. tax resident, taxation depends on how the plan is set up. If the superannuation is an “employees’ trust” (established through the employer and falls under section 402(b)), the employee contributions are not pre-tax, employer contributions are taxed currently, and growth in the funds are taxed on a current basis because the treaty does not protect the Australian pension. If the superannuation is considered a grantor trust, the employee is taxed on all current income, even if not distributed, and most likely would be subject to the punitive PFIC regime. Adding to the financial burden, foreign trust reporting requirements may also be required (Forms 3520 and 3520A). The superannuation that is treated as a grantor trust more than likely triggers PFIC reporting for the employee. If certain thresholds are exceeded, FBARs and Form 8938’s may be required as well.
Being aware of these tax and reporting burdens prior to the assignee’s move can allow for successful pre-planning. The ability to prepare for the information needed in the reporting process can reduced stress and allow the assignee to focus on the assignment without feeling overwhelmed. Companies with globally mobile employees should be aware of the reporting requirements and taxation of foreign pension plans before sending an employee abroad, or bringing a foreign national to the United States on assignment. It is very important for individual workers to consult with their tax advisors on the U.S. and foreign tax rules before accepting a foreign assignment to avoid unpleasant surprises in the future.