In an increasingly global economy, workers are experiencing unprecedented mobility. As such, Americans living abroad, even for a limited time, often participate in a pension or retirement plan in the foreign country; participation might even be mandatory. In most cases, the model resembles the one in the United States: Pretax money is contributed into retirement accounts where it accumulates tax - free until retirement. Foreign pension plans commonly encountered by Americans who are employed abroad include U.K. employer - sponsored pensions, Canadian registered retirement savings plans, and Australian superannuation arrangements, to name a few. Foreign nationals living or working in the United States may have foreign pension plans, too.
Whether contributions, earnings, and distributions are includible in the taxpayer's income depends on the type of foreign pension plan and whether a tax treaty exempts an event that is otherwise taxable.
The most common classifications of foreign pension plans, for U.S. tax purposes, are as an employees' trust (under Regs. Sec. 1.402(b)- 1 ), a grantor trust (under Secs. 671-679), or a trust bifurcated between those two categories. The applicable classification depends on contributions and other factors.
In addition, depending on the type of underlying assets of the pension plan (e.g., foreign mutual funds), passive foreign investment company (PFIC) rules may apply.
While the United States generally taxes its residents on their worldwide income regardless of their citizenship or the source of the income, an income tax treaty to which the United States is a party could modify the usual rules and mitigate some of the disadvantages of participating in a foreign pension plan.
The tax treaty between the United States and the United Kingdom, which this item focuses on, is one of the most comprehensive when it comes to pensions. Pension provisions are set forth in Articles 17 and 18.
Generally, because a foreign pension plan is not a "qualified" plan under Sec. 401, the employee's contributions to the plan are not deductible by the employee, and any employer contributions are taxable compensation to the employee.
However, the U.S.-U.K. tax treaty offers a rare exception to these rules. For example, if a U.S. national is living and working in the U.K. and is contributing to a qualified U.K. pension, he or she could receive a tax deduction in the United States for the contribution to the U.K. plan. This deduction would be available only for so long as the U.S. person resides in the U.K. and may not exceed the tax relief that would be allowed in the United States under Sec. 402(g) (U.S.-U.K. Income Tax Treaty, Art. 18, ¶5).
Alternatively, the U.S. national, while living and working in the U.K., can continue to contribute on a pretax basis to his or her U.S. 401(k) plan, provided that the individual was already enrolled in the U.S. plan prior to his or her departure (Art. 18, ¶¶2a and 3a). Furthermore, under the tax treaty, employer contributions to the employee's pension do not constitute compensation and are considered a business expense in computing the employer's profit and loss (Art. 18, ¶2b).
The treaty thus allows transferred employees to continue to contribute to their home country pension plans without having the employer portion of the contribution be considered taxable income in the host country. Additionally, both employer and employee contributions to the home country pension plan are tax - deductible in the host country (Art. 18, ¶¶2a and 2b).
Certain conditions apply:
As noted above, earnings accumulating in a foreign pension plan that is deemed to be a foreign grantor trust ordinarily must be included in income. This would apply, for instance, to earnings inside a U.K. self - invested personal pension (SIPP), given that it is fully funded by the employee.
However, the U.S.-U.K. tax treaty alters this rule by clearly indicating that income earned by the pension scheme may be taxed as income of that individual only when distributed, meaning that earnings inside the plan are tax - deferred (Art. 18, ¶1).
What about rollovers?A U.K. national is allowed rollovers from one approved pension plan to another U.K. plan. Similarly, a rollover from a U.S. 401(k) plan is allowed to another, say, 401(k) or traditional IRA. By contrast, an individual cannot make a rollover from a U.K. to a U.S. plan and vice versa (see Chief Counsel Advice Memorandum AM2008 - 009 , advising that a transfer from a U.K.- registered pension outside of the original state (the U.K.) is not an "eligible rollover distribution" under Sec. 402(c)(4)).
Special attention should be given to U.K. pension rollovers to offshore plans, such as the qualifying recognized overseas pension scheme (QROPS) and the recognized overseas pension scheme (ROPS) plans, which are offshore plans that are sometimes set up in countries such as Malta, Gibraltar, and the Isle of Man. Even though these are permitted under U.K. law, once these rollovers occur, they are no longer governed by the provisions of the U.S.-U.K. tax treaty.
According to Article 17 of the U.S.-U.K. tax treaty, the country of residence at the time of distribution has the sole right to tax the distribution (Art. 17, ¶1a).
However, this provision must be read in tandem with the "saving clause" found in Article 1 (General Scope), under which the United States and the U.K. each reserve a broad right to tax their own citizens "as if this Convention had not come into effect" (Art. 1, ¶4). Due to the saving clause, a U.S. citizen who is a resident of the U.K. and receives a pension payment will be subject to U.S. tax, notwithstanding the language in Article 17.
Under a separate provision of the tax treaty that is expressly not subject to the saving clause, if an individual would have enjoyed tax - exempt status for all or a portion of the distributions in the home country, the host country will confer the same benefit (Art. 17, sub ¶1(b)).
Planning for income taxation of pension schemes when countries outside the United States are involved should include a review of all retirement plans and applicable tax treaties as well as taxpayers' long - term retirement goals. Special attention should be given in these situations, as some classifications in the Code and Treasury regulations leave room for interpretation.
Editor Notes
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.