“Foreign” pension or similar plans are a very common feature in the lives of US expats residing and working abroad. As used here, the word “pension” is only a general term. While pensions in the United States often refer to defined benefit retirement plans, my use in today’s blog post refers to a pension as a general term for an employee savings plan that typically sets aside current income for use in the future (e.g., upon retirement, end of service, or upon incapacity).
Unfortunately, foreign pension/workplace savings plans involve a myriad of complex US tax considerations that typically vary significantly from plan to plan (let alone from country to country). On account of this diversity and the extreme complexity of the US tax rules in this entire area, foreign pension plans are often misunderstood. As a result, it is common that they are not properly handled on the expat’s US income tax return and frequently, are not properly reported on the various US tax information returns that may be required. Since enactment of the Foreign Account Tax Compliance Act (FATCA), there is an increased focus on reporting foreign trusts and foreign assets which makes the disclosure and treatment of such foreign plans more transparent to the Internal Revenue Service (IRS). Given the tax exposure and harsh penalties, it is critical that US expatriates understand the tax treatment of these plans and understand how to properly report them.
For many US taxpayers residing abroad, retirement savings is often very difficult. US expatriates often struggle with retirement planning simply because they are working for foreign employers and thus not eligible for contributions being made into the US Social Security program. Many are not given a pension plan by their employers (this is especially so in the United Arab Emirates where, as discussed below, the “End of Service Gratuity” has historically been the norm). Expats are often forced to devise a way to save for retirement. Unfortunately, many make the mistake of investing in foreign mutual funds, life policies, savings plans, portfolio bonds and similar fund arrangements to save money for retirement. Such investments typically are a tax disaster due to US tax rules under the so-called PFIC regime. The PFIC rules will often eat up this type of foreign investment in punitive taxes and interest charges, leaving the expat with very little savings and big tax problems.
All of these issues are more closely examined in this 2-part post.
The United Arab Emirates – Special Concerns
Employers in the United Arab Emirates (UAE) have no legal obligation to provide a pension for members of the employer’s expatriate workforce. Instead, expatriate employees have legal entitlement to what is commonly referred to as an “End of Service Gratuity” (EOSG). This is a statutory payment based on the employee’s salary which is linked to the employee’s length of service. The problem for US expats receiving the EOSG, is that the full lump sum amount is includible in the taxpayer’s US tax return filed for the year the EOSG is received. Since the EOSG amount is often quite substantial, the tax hit can be quite harsh.
The so-called “foreign earned income exclusion” (FEIE) will typically be of little or no help to mitigate the US tax bite associated with the EOSG, since the individual will often have fully used the exclusion amount for salary otherwise earned in the same year as the year in which the EOSG is paid. The amount of foreign earned income that can be excluded for the 2020 calendar year is $107,600 (for 2019, the amount was $105,900. This is the amount available for 2019 tax returns which are due this year, 2020). More information on the FEIE is here. In a nutshell, by the time Uncle Sam takes his cut, the dollar value of the EOSG has been diminished quite significantly much to the dismay of the hapless expat. In addition, if the expat has not been carefully planning his tax life, he may incur penalties for underpayment of estimated taxes arising on account of the large EOSG payment.
Many expats do not realize the EOSG is taxable and may have omitted it from their tax returns. Depending on the precise facts, this omission can lead to liability for unpaid tax, interest and penalties. The so-called statute of limitations may not have run leaving the expat in a potentially messy situation. Please see my blog post here explaining the different statutes of limitations rules. It is possible to rectify matters for previously unreported EOSG amounts. This can often be done without imposition of any penalties. Contact me if you need help with respect to an unreported EOSG.
New in the UAE! The DEWS Plan and Predicted Progeny
For expatriate employees based in the Dubai International Financial Center (DIFC) a very new legal scheme changes the status quo; employee participation in the new scheme is mandatory if the employer is participating. The DIFC Employee Workplace Savings (“DEWS”) Plan replaces the EOSG effective February 1, 2020. Employers will continue to contribute to the new scheme at the same level as the existing EOSG (i.e., annual equivalent to 21 days of basic salary when the employee’s service is under five years, which increases to 30 days of basic salary when service is beyond five years). The new scheme will also allow employees to make voluntary contributions on an ongoing basis. The scheme is regulated by the Dubai Financial Services Authority and involves a master trust structure based in the DIFC with key roles played by the trustee and administrator.
Once an employee is enrolled in the DEWS Plan he or she will have direct 24/7 access to the value of his or her funds, including investment options for five different funds. The employee can select an investment risk profile from “low” to “high” for investment in the various funds; default risk profiles are low/moderate but employees may switch at no cost to one or more other funds. When the employee leaves his DIFC employment, he may cash out of the scheme, or can choose to defer divesting until a later date.
More information on the DEWS Plan can be obtained here. The DEWS Plan has prompted speculation that similar schemes may soon be rolled out across the UAE, thus raising US tax issues for more and more US expatriates working in the Emirates.
Other UAE Employee Workplace Plans
An increasing number of companies in the UAE have, or are considering putting into place, employee workplace savings schemes. These companies are usually American- or European- based businesses and not local or regional companies. Typically, enrollment in the scheme takes place once the employee reaches a certain level within the company.
Emirates Airlines, for example, has had the Emirates Provident Scheme in place for almost 30 years; it is a workplace saving scheme set up for certain employees of Emirates Airlines. The Emirates Scheme has three accounts – one into which Emirates Airlines contributes a certain percentage of the employee’s basic salary; the other into which the employee is required to contribute a certain percentage of his/her basic salary, and the third which is entirely optional. No contributions are made into this third account by Emirates Airlines; employees can decide to make additional contributions into this account only if they choose to do so. Monies contributed into each account are then invested in various funds.
US Tax Problems with “Foreign” Pension Plans/ “Foreign” Workplace Savings Schemes
US citizens or green card holders working outside of the US may have an account balance or accrued benefit in a non-US pension plan or workplace savings scheme. Often, these plans will provide certain tax advantages in the country where they are created. For example, income taxation may be deferred for purposes of the foreign country’s income tax, until the individual actually receives a payment from the plan. (Since the UAE has no income tax, this is not an issue with UAE-based plans). The tax benefits available in the foreign country, however, have no bearing whatsoever on how the US will tax the US individual participating in the plan. Sadly, many US persons abroad are unaware of this distinction and mistakenly believe that their foreign pensions are not currently taxable by the US since their country of residence does not tax them on the plan! Many mistakenly think they can “roll-over” their foreign plan into a qualified US plan or US IRA without tax consequences.
When it comes to the US tax treatment of such schemes, the area becomes highly complex for the simple reason that the foreign plans do not fit within the US framework. Understandably, these “foreign” plans are not designed to meet the US tax rules! I have seen many professionals struggle with how to treat these foreign schemes from a US tax perspective. The complexity of the problems often means some uncertainty with the ultimate tax position chosen and significant compliance costs for the US expatriate. Given the high tax and penalty stakes, however, proper compliance is essential.
Part II of this blog post (next week) will look at some of the general US tax issues associated with such foreign plans, guiding readers through the difficult maze and suggesting how any noncompliance might be addressed.
Posted: February 13, 2020
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