United States

Recently ratified treaty protocols impact taxation of pension plans

INSIGHT ARTICLE  | 

After several years of delays, the U.S. Senate approved four treaty protocols with Japan, Luxembourg, Switzerland and Spain this past summer. Republican Senator Rand Paul of Kentucky had placed a hold on each of these protocols in the Senate Foreign Relations Committee for several years because of objections over concerns about the privacy of taxpayer information.

Generally, all four protocols modernize provisions in the respective tax treaties, conforming them to more recent U.S. bilateral tax treaties as well as U.S. law and international standards. The protocols generally conform to provisions in the 2006 U.S. Model Treaty, which was the most recent U.S. model treaty at the time these protocols were under negotiation.

While the protocols address a number of different provisions of the existing U.S. treaties with these countries, they also have an impact on pension plans and we will briefly examine this impact below.

Foreign pensions

A foreign pension or retirement savings plan does not generally constitute a “qualified plan” for U.S. tax purposes because such plans are usually not structured to conform to the rules for qualification under section 401 of the Internal Revenue Code. Accordingly such plans, assuming they are both funded and vested, may not qualify for a U.S. tax exemption under section 501(a). Consequently, these foreign plans would be currently taxable in the U.S. under section 83, unless the U.S. has ratified a tax treaty with the foreign country where the plan is based and the relevant treaty includes a comprehensive pension article -- covering either contributions and earnings, or both.

However, most employees on an expatriate assignment would like to remain on their home country pension or retirement savings programs, and continue to contribute and accumulate a retirement nest egg on a tax deferred basis while on assignment. The notion that a host country (such as the U.S.) would tax such plans on a current basis catches most employees, as well as their employers, by surprise.

Tax treaties to the rescue? Well, Maybe.

There are only a handful of U.S. treaties that include an article addressing cross-border pensions, and even fewer with comprehensive language covering multiple scenarios where coverage might be needed, such as the treaties with Germany, the Netherlands and the United Kingdom.

For instance, the Swiss treaty includes favorable language providing tax exemption in the host country for home country pension contributions, but only for assignments up to five years. The recently signed protocol with Switzerland does not alter such treatment or add anything new, such as, for example, U.S. tax relief for a U.S. citizen local hire in Switzerland participating in a Swiss pension plan.

The Swiss protocol however does make a change in the pension area, by expanding the types of pension plans that may qualify for treaty relief.  The Swiss-U.S. treaty provides that dividends paid to a pension plan situated in the other country are exempt from tax in the home country, provided the Internal Revenue Service and the Swiss taxing authority (the “competent authorities”) agree that the plan generally corresponds to a pension plan in the other country.  Prior to amendment by the protocol, the treaty granted this exemption to certain U.S. plans such as 401(k), 403(b) and 457(b) plans, however, individual retirement accounts were not entitled to the zero rate of tax under the treaty for dividends.  The protocol extends this exemption for dividends paid to individual retirement accounts, provided the competent authorities issue new guidance confirming the specific individual plans covered.  As of the time of this writing, a new competent authority agreement, while expected, has yet to be issued.  Accordingly, a U.S. resident investing in a Swiss company via their U.S. 401(k) plan would not be subject to Swiss withholding at source on any dividends paid, and with a new competent authority agreement this benefit may be extended to IRAs and ROTHs as well.  This exemption from source country taxation would not be available if the pension plan controls the company paying the dividend.

In addition, the protocol with Spain added similar language with respect to dividends paid to a pension plan situated in the other country, and specifically identifies IRAs as eligible for relief.  Accordingly, dividends paid to IRAs and Roth IRAs may be subject to a zero rate of withholding tax.  Thus, for example a U.S. resident receiving a dividend from a Spanish company would be exempt from Spanish tax withholding whether the investment was held in a 401(k) or IRA/Roth IRA (unless such dividends are derived from the carrying on of a business, directly or indirectly, by the pension fund or through an associated enterprise).

The Spanish Protocol also adds a new paragraph to the pension article (Article 20). It provides for a resident country tax exemption with respect to the earnings accumulating in a pension fund established in the other country, until such time as a distribution is made from the pension fund. Thus, for example, if a U.S. citizen contributes to a U.S. qualified plan while working in the U.S. and then establishes residence in Spain, the added paragraph prevents Spain from currently taxing the plan's earnings with respect to that individual. Subsequent distributions from the plan would taxable by the U.S. citizen’s country of residence at the time of the distribution.  It should be noted that the treaty does not contain language exempting contributions from tax.

Lastly, the protocols with Japan and Luxemburg contain no related provisions regarding pensions.

Protocol key dates:

  • Japan: The Protocol was signed Jan. 2013, and entered into force Aug. 30, 2019, and applies to withholding taxes on dividends or interest paid or credited on or after Nov. 1, 2019.
  • Luxembourg: The Protocol was signed May 2009, and entered into force Sept. 9, 2019.
  • Switzerland: The Protocol was signed Sept. 2009, and entered into force Sept. 20, 2019, and applies to withholding taxes on amounts paid or credited on or after the Jan. 1, 2020.
  • Spain: The Protocol was signed Jan. 2013, and will enter into force on Nov. 27, 2019, and applies to withholding taxes on amounts paid or credited on or after that date.

How does this impact global mobility programs?

The entry into force of these treaty protocols will have significant consequences for globally mobile persons who participate in pension plans.  In addition new treaties (with Hungary, Chile and Poland) that are awaiting Senate approval may also have an impact.  As a result, companies may wish to revisit their mobility programs and update how they handle home country pension contributions and their overall tax equalization policies. The absence of a uniform tax treatment from country to country makes this a challenging issue for many company payroll departments.

Have more questions? Contact your local RSM professional or a global employer services representative for more information.

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