Form 8938 (Statement of Foreign Financial Assets), introduced in 2011 as part of the Foreign Account Tax Compliance Act (FATCA), requires taxpayers to report their foreign assets, subject to minimum values, and indicate where the related income is picked up on their tax return.
One asset often misunderstood and likely overlooked in many cases is a taxpayer's interest in a foreign pension plan. Foreign nationals who move to the United States or U.S. citizens who have spent significant time overseas are likely to have some form of foreign pension arrangement.
In many cases, there is uncertainty as to the reporting requirements and the application of U.S. tax rules and/or tax treaties to such plans but, in general, for senior level participants it is likely that employer contributions will be taxable as compensation and the growth in the value of the pension will create taxable income annually. Furthermore, the plan will generally need to be reported by the taxpayer on Form 8938, Foreign Bank Account Report (FBAR), and possibly Form 3520 relating to U.S. owners of foreign trusts.
Foreign pension plans will almost certainly not qualify under IRC Sec. 401, which defines 'Qualified Plans' for U.S. tax purposes and includes a requirement that the plan has to be created or organized in the United States. To understand the tax treatment of these plans, it is necessary to first understand the type of plan being addressed. Generally, there are four main types of plans: 1) defined contribution plans funded by the employer and possibly employee; 2) defined benefit plans, typically funded by employer contributions only; 3) personal pension plans, funded by individuals; and 4) unfunded plans which are maintained on the company's books.
A common misconception is that most foreign pension plans would be considered tax-exempt under a tax treaty. While this may be true in some cases, the exemption is generally limited to only those plans that would be correspondingly approved by both governments and any tax benefits are limited to those available to a U.S. qualified plan (e.g., a 401(k) plan).
It is possible that a foreign plan is considered a trust arrangement and, consequently, treated as a foreign grantor trust requiring U.S. participants to report their interest in the trust on a Form 3520. To enable this reporting, the pension trustee must issue a Form 3520-A to the U.S. participant by March 15 following the tax year-end proving specific details of the participant's interest. However, for senior executives, the form of pension is likely to be a funded employee benefit trust governed by IRC Sec. 402(b), which specifically exempts the trust from being treated as a foreign grantor trust and, consequently, the above filing requirements.
The tax treatment of the pension (or deferred compensation plan) under IRC Sec. 402(b) depends on whether the trust is discriminatory towards highly compensated employees. A highly compensated employee is defined broadly as a 5% owner of a company, one who meets a compensation limit ($115,000 in 2013), or an employee whose pay is in the top 20% of compensation for that company. If the IRC Sec. 402(b) trust is discriminatory, highly compensated employees who participate in the underlying plan are taxed each year on the employee's "vested accrued benefit," less the employee's investment in the contract or the value of the previously taxed portion of that benefit. In other words, if the plan is discriminatory, the employee would effectively be taxed on the increase in the pension value each year.
Within these rules lies a potentially disastrous scenario. A foreign national who moves to the U.S. could find herself fully taxed on any distribution, even if the contributions were made to the foreign plan long before she set foot in the U.S. For distribution purposes, IRC Sec. 72(w) provides that a U.S. resident receiving a distribution will not have any 'basis' for any foreign source contributions made during a period as a non-resident alien if those contributions were not previously subject to income tax and would have been subject to income tax if paid as cash compensation. This generally should be creditable against the U.S. tax to the extent any distributions are subject to foreign withholding tax.
With the recent passing of FATCA, the increased focus on reporting foreign trusts and foreign assets makes the disclosure and treatment of such foreign deferred compensation plans more transparent to IRS. Given the potential tax exposure and onerous penalties, it is important to plan ahead to understand the tax treatment of these plans and to understand how to correctly report them.
Originally published April 2013
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