Part I of this blog post introduced the topic of the “foreign” pension or employee workplace savings plan, and examined in some detail how these plans are becoming more and more popular in the United Arab Emirates. The plans, however, give US expatriate employees some serious US tax headaches. Today’s post focusses on these thorny US tax issues and what to do if you have not been US tax compliant with regard to your foreign plan.
Compare — US v. Foreign Plans
As a comparison, let’s first look at how the US tax system would work for a typical US plan designed to meet the US tax rules for beneficial tax treatment. With a “qualified” US plan (See IRC Section 401 and implementing Treasury Regulations), the employee contributions are deducted from salary on a pre-tax basis. This means that by contributing to a US qualified plan the employee lowers the amount he or she will pay in current income taxes. In addition, there is full US tax deferral on both employer and employee contributions made to the plan. In addition, earnings can grow tax free until withdrawal. Since the typical foreign pension plan will not qualify for any of this beneficial treatment, the plan participant must pay US income tax in each year that contributions are made and perhaps, when earnings are generated. Most expats do not realize this and blissfully exclude these contributions and earnings from income on their tax returns, setting themselves up for interest on unpaid taxes and of course, penalties. In addition, in all likelihood, they do not file the required tax information returns that may be needed with regard to their interest in the foreign plan. More penalties can be assessed for missing these filings.
Tax Treaty? Trust? PFIC?
When analyzing the taxation of a foreign pension plan or savings scheme, one of the first issues to tackle is whether the plan is governed by a tax treaty negotiated with the US, putting it on par with a US qualified plan. Most countries that are popular expat destinations (including France, Hong Kong, Singapore and the UAE) lack such a treaty. Without a comprehensive tax treaty, an American expat participating in a foreign pension plan cannot deduct contributions from his gross income and he or she must include the employer’s contributions and perhaps the investment earnings in income. In addition, careful steps must be taken to properly report the employee’s interest in the foreign plan.
Assuming no tax treaty applies, the next issue to address is whether the plan should be classified as a “trust” for US federal income tax purposes. If a foreign plan is considered a trust arrangement and, due to employee contributions treated as a foreign “grantor” trust (under which the US participant is treated as an “owner” of the trust), then it must be determined if US participants are required to report their trust interest on IRS Form 3520. To enable this reporting, the trustee of the plan must issue a Form 3520-A to the US participant in the year following the tax year-end providing specific details about the US participant’s interest in the plan. This will not be an easy task or one undertaken lightly by the foreign trustee!
To complicate matters further, many foreign plans are invested in passive foreign investment companies (PFIC) and this may raise additional filing requirements on IRS Form 8621. If the foreign plan may be treated as a “grantor” trust with the US employee considered an “owner” of the trust for US tax purposes, one must look to whether he must file Form 8621.
With luck, the form of the plan is likely to be what is called a funded employee benefit trust governed by Internal Revenue Code Section 402(b), which may specifically exempt the trust from being treated as a foreign “grantor” trust. Consequently, the above filing requirements may be dispensed with in certain circumstances. Generally, if the employer contributions to the plan exceed the employee contributions, the entire plan can escape treatment as a “grantor” trust and the Forms 3520, 3520-A and 8621 filing obligations are possibly not triggered. If the personal contributions made by a taxpayer exceed the employer contributions, however, this special grantor trust exclusion set out in Section 402(b) will not apply and harsh tax treatment can result.
“Discriminatory” v. “Non-Discriminatory” Plans
Even though Internal Revenue Code Section 402(b) may provide helpful rules for foreign employees’ trusts there are still US tax issues to address. The US tax implications for these plans depend on 2 main considerations: whether the plan is “discriminatory” and whether the employee is considered to be “highly compensated”. These are terms of art and exacerbate the difficulties in analyzing the plan from a US tax perspective.
Whether a plan is “discriminatory” depends in general on the coverage ratio for non-highly compensated employees versus “highly compensated employees” (HCE). Even if a plan is broad-based and covering many employees, the US tax rules work in such a manner so as to exclude from the definition of “employee” nonresident alien individuals who have no US source income. This of course, will skew the ultimate determination regarding whether the plan is “discriminatory”.
Generally, in the case of “non-discriminatory” plans, employees must currently include in income employer contributions that have “vested”, but they can defer tax on earnings until later withdrawal. When tax is paid on that income, the income is “recognized” for tax purposes and becomes the employee’s basis in the plan. When actual distributions are made from nondiscriminatory plans, they are taxable to the extent the distribution exceeds a pro rata portion of the basis the employee has in the plan, which generally consists of previously taxed employer contributions and employee contributions to the plan made on an after-tax basis.
In the case of “discriminatory” plans, if the employee is not highly compensated, the same taxation rules would apply. However, if the employee is a HCE, the individual may need to currently include in his income tax return both contributions and earnings. As a result, not only is the current year realized income subject to tax, but unrealized appreciation in the plan is also taxed. Since these plans are considered to be compensation to the employee, all income is reported as ordinary income, without regard to the underlying nature of the investments held in the plan. On the upside, the previously taxed amount will then become the employee’s basis in the pension plan and so, by paying tax currently the employee generally need not pay tax upon a later withdrawal of the funds.
For the sake of completeness and to demonstrate the complexity of all of this, one must ask who qualifies as a HCE.
A Highly Compensated Employee is an individual who:
Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
For the preceding year, received compensation from the business of more than US$125,000 (if the preceding year is 2019 and US$130,000 if the preceding year is 2020), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
After a careful analysis of the individual’s situation considering all of the aforementioned complicating factors, it may in fact be the case that it is not at all tax efficient for an American abroad to participate in a foreign pension or savings scheme, or for the individual to simply maximize his contributions to the plan! Participation in some schemes, however may be mandatory (e.g., the DEWS Plan in the UAE), so while an employee may have no choice, it is imperative that careful planning be undertaken to minimize the tax bite and not fall foul of the required tax information reporting.
Tax Information Reporting
There are a number of US tax information reporting requirements that may apply with respect to a US taxpayer’s interest in a foreign plan. If required to be filed but not filed by the taxpayer, the penalties can be very steep.
- Foreign Bank and Financial Account form (Form 114)
- Foreign trust reporting forms (Forms 3520 and 3520-A)
- Statement of Specified Foreign Financial Assets (Form 8938)
- Passive foreign investment company (PFIC) form (Form 8621)
- Form 8833 to claim an income tax treaty exemption from US taxation on contributions to the plan and/or benefits accrued income under the plan. (not applicable for UAE as there is no treaty between the USA and UAE).
Past Noncompliance – There’s a Fix!
Given the extreme complexity in this entire area, it is unsurprising that many taxpayers have failed to properly report foreign plans on their US tax or information returns. Depending on the taxpayer’s precise circumstances, there are various options to regain tax compliance, including the IRS delinquent international information return submission procedure; the IRS delinquent FBAR submission procedures or the IRS Streamlined Filing Compliance Procedures.
In all cases, bringing the taxpayer’s foreign plan into compliance means that professional advice with an experienced tax practitioner is more than “advisable”; given the complexity in this area, professional help is mandatory! Dealing with the US tax issues involved with such foreign plans is very different from working on other types of US tax matters. Hire an experienced tax professional and make sure he or she is addressing all of the issues and providing you with full information about your options to rectify past noncompliance. It may be more expensive initially, but it will be much cheaper in the long run. I am here to help – contact me by email firstname.lastname@example.org
UPDATE (March 4 2020)
The IRS may be starting to see some light with respect to “foreign” pension plans and just announced some possible relief. More details here.
Posted: February 20, 2020
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