A. Income in General
Most individuals receiving compensation for their services are taxed on a current basis. Normally, current compensation does not pose tax problems for an individual who changes his or her residence. However, individuals who perform services may not have received all their compensation at the time of emigration. As a result, unpaid income earned before departure, but received after departure, may not have been taxed by the former country of residence.
There are two possible reasons that the income may not have been taxed. One is that the income is taxed on a cash basis. Despite the individual's fixed right to receive payment in the future, as "vested compensation," payment was not received prior to the change in residence. A second possibility is that the compensation may have not been fully earned or vested; it may be "contingent compensation." For example, payment may be contingent on future services, such as a bonus payable after five years of service or meeting other company goals that were not satisfied prior to the change in residence. Countries may treat these two situations differently. In addition, some countries distinguish between ordinary deferred compensation and severance and pension payments, although the distinction is frequently a difficult factual issue because all three types of payments are paid for the same consideration, past services.
B. Vested Deferred Compensation
This section discusses compensation that has been earned, but payment of which has been deferred. The issues are: (1) will the country of former residence tax on receipt; (2) will the country of new residence tax on receipt; and (3) will either grant a tax credit or exemption.
A permanent Japanese resident will be taxed on receipt of deferred compensation earned prior to immigration. A nonpermanent Japanese resident (most resident aliens) will be taxed on deferred compensation from a Japanese source when received, but on foreign-source income only if remitted to Japan. If the foreign-source income is subject to tax, Japan will grant a credit for the foreign taxes paid.
Germany taxes employment income on the basis of the cash method. Nevertheless, recurring payments received shortly after the calendar year to which they relate are taxed in that year.1
In Sweden and the United Kingdom, although compensation is taxed on a cash basis, the taxability of compensation income generally is determined by reference to the circumstances at the time the income is earned, although the tax is not imposed until receipt. Income earned before an individual ceases to be resident, but received afterwards, is subject to Swedish tax (if paid by a Swedish employer) or United Kingdom tax. Income earned before the taxpayer became a resident is not taxable upon receipt in Belgium or the United Kingdom, although it is taxable in Sweden.
The United Kingdom's taxation of employment income is complicated by the fact that, in addition to an individual's residence, his domicile and "ordinary residence" are also relevant. In some cases, the employer's residence is also relevant to the taxation of the income. If income is earned outside the U.K. while the individual is not a U.K. resident, and not ordinarily resident, there will be no tax, even if the compensation is paid after he or she becomes a resident. If the income is earned outside the United Kingdom while the taxpayer is a U.K. resident, but not ordinarily resident in the U.K., the compensation may be taxed on receipt with a credit for foreign taxes paid. The same rule applies to income of a nondomiciled U.K. resident or of an ordinarily resident individual earning income wholly abroad from a non-U.K. resident employer. If the income is earned in the United Kingdom while the taxpayer is a U.K. resident or ordinarily resident, it will be taxable when received, regardless of the taxpayer's residential status. Other possible combinations of circumstances are not dealt with here.
In Canada, an individual is deemed to dispose of all property at fair market value, with certain exceptions, immediately before ceasing to be a resident of Canada.2 The right to deferred compensation would apparently be treated in the same manner, with the result that the fair market value of the compensation is taxable at the time of emigration. To the extent the amount earned is less than the amount received, the excess is taxable when received.3
France will tax any vested compensation on departure. Australia, the Netherlands, Switzerland, and the U.S. tax compensation for services rendered prior to departure on receipt. These countries do not accelerate taxation of deferred compensation due to departure, but tax such income when received by a former resident at their normal graduated tax rates, rather than apply nonresident withholding rates.4 Italy, on the other hand, defers but taxes the compensation at nonresident tax rates. In all cases, there may be enforcement problems when the payor is a nonresident. If a country does not tax deferred compensation currently, accelerate taxation due to departure, or tax when the former resident receives payment, there is the possibility of complete exemption.
In the case of deferred compensation received by a new immigrant, absent a treaty exemption, each of the countries covered herein (except Belgium, Canada, Italy,5 Japan, and the United Kingdom) would impose a tax on the new resident, notwithstanding that the services were performed prior to becoming a resident. Canada would tax the payment to the extent the receipt exceeds the fair market value at the date of immigration. In the absence of a foreign tax credit or exemption, this could lead to double taxation. Australia, Italy, Sweden, and the U.S. grant credits for current foreign taxes paid. The Netherlands permits an exemption for employment in a treaty country or a qualifying non-treaty country. Under the OECD Model Treaty, since the country of source is granted the right to tax, the country of residence must grant a credit or an exemption,6 unless the services were performed in the new country of residence. It should be noted that where the services were rendered in a non-treaty country, there is the possibility for double exemption or double taxation in the absence of unilateral tax relief.
C. Contingent Compensation
This section discusses income that is not unconditionally earned at the time an individual emigrates. The tax results described above may change when an individual is entitled to compensation for services partially rendered in the country of former residence, but such compensation is contingent on an event that has not occurred prior to the change in residence,7 e.g., completion of the services or attainment of a specific level of sales or profits. The tax issues are similar to those relating to stock options.8
In Italy and Switzerland, if compensation is contingent on an event that has not occurred prior to the individual ceasing his or her residence, none of the compensation will be subject to tax. The arrangement has the potential for complete or partial exemption if the new country of residence does not impose tax, such as in Canada, where only the increase in the value of the deferred compensation would appear to be subject to tax when received.9 Arguably, the result may be the same in the U.S. based on an analogy to the subchapter S changeover rules.10 The examples provided under the U.S. tax regulations appear to adopt a strict accrual method rule.11 For example, U.S. Internal Revenue Code (IRC) section 864(c)(6) provides that income attributable to prior services and received after a change in residence should be taken into account in such other year. This rule could be limited to income accrued prior to the change in residence. Contingent deferred compensation, however, would not accrue in the period prior to the change of residence. This situation could result in double exemption, although the U.S. Internal Revenue Service is unlikely to agree.
Under Belgian domestic law, all salary paid by a Belgian employer to a nonresident is taxable in Belgium, in the absence of a treaty.
If a country taxes the portion of compensation "attributable" to services performed therein, how is that portion determined? If not all conditions have been satisfied, is any portion of the compensation attributable to prior years? And if so, how much? If the country of former residence and the country of residence both tax the amount attributable to services performed within their jurisdictions, the determinations of the amounts allocable to each country may differ.
D. Severance Payments
Australia, Belgium, Japan, and Switzerland each impose considerably lower tax rates on severance payments attributable to services within their own countries. The lower rate is applicable to the type of payment, rather than as a result of a change in residence. In Italy, the tax rate on severance payments depends on a number of factors, the most important being the number of years of employment and the average personal tax rate in the two years preceding termination. The United Kingdom grants an exemption for up to £30,000 of severance payments. Additional relief may be available if a portion of the services were performed abroad. If the payments are made after the change of residence, the treatment should be similar to the taxation for vested compensation.
Severance payments received after a change of residence will normally be covered, if at all, by article 15 (dependent personal services) or article 18 (pensions) of the OECD Model Treaty. It should be noted that some countries do not regard severance payments as "remuneration for services performed" but as "other income" falling under article 21.12 Most treaties do not specifically determine which provision is applicable, so the characterization of payments could be made by the country of source and the country of residence in an inconsistent manner. The pending U.S.-Italy treaty addresses this ambiguity and provides that severance or lump-sum payments made on the termination of employment and received after a change of residence are taxable only in the country where services were rendered.13 Several Belgian courts have held that severance payments are governed by article 15 of the OECD Model Treaty.14 The German and Swiss tax administrations have concluded a mutual agreement categorizing severance payments as payments for services, also covered by article 15.
In several countries, such as the Netherlands, the issue has arisen whether severance payments are "derived" from former employment. The outcome may depend on the juridical basis for the severance payment. The severance pay could be a contractual penalty, or a payment in lieu of wages to which the former employee would otherwise be entitled, or in settlement of punitive damages for wrongful dismissal, or as a quasi-pension for a person unlikely to get another job. Obviously, the outcome has a significant bearing on whether the country of the former employer has a right to tax the payments.
E. Cross-Border Services and the OECD Model Treaty
Before the OECD Model Treaty was amended earlier this year, personal services were addressed in two separate provisions, article 15 (dependent personal services) and article 14 (independent personal services). It also addressed related services in articles 16 (directors' fees), article 17 (artists and athletes), article 18 (pensions), article 19 (government service), and article 20 (students).
1. Dependent Personal Services
Article 15 of the OECD Model Treaty deals with the case of an individual employee who worked in his country of residence, accrued deferred compensation that does not qualify for treatment as a pension, and then moved to another country of residence where he received the deferred compensation. The article provides:
1. Subject to the provisions of Articles 16 (Directors' fees), 18 (Pensions), and 19 (Government Service), salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State.
2. Notwithstanding the provisions of paragraph 1, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if:
a) the recipient is present in the other State for a period or periods not exceeding in the aggregate 183 days in any twelve month period commencing or ending in the fiscal year concerned, and
b) the remuneration is paid by, or on behalf of, an employer who is not a resident of the other State, and
c) the remuneration is not borne by a permanent establishment or a fixed base which the employer has in the other State.
3. Notwithstanding the preceding provisions of this Article, remuneration derived in respect of an employment exercised aboard a ship or aircraft operated in international traffic, or aboard a boat engaged in inland waterways transport, may be taxed in the Contracting State in which the place of effective management of the enterprise is situated.
A number of fact patterns are possible under article 15. One consists of an employee who worked in the country of former residence (FR) for a resident employer, or a nonresident employer who has a permanent establishment (PE), and who deducted the payments in computing income. The employee then relocates to a new country of residence (R) prior to receiving compensation. Under article 15, FR can tax the income, and R must grant a tax credit or an exemption under articles 23A or 23B. Another issue could arise when the nonresident employer ceases to have a PE on the date of payment. If the employer is on an accrual basis, as most businesses are, the payments are borne by the PE and should be treated the same way: FR can tax the income, and R should grant a credit or exemption.15
A second situation occurs when the facts are reversed -- the individual, while resident in FR, was employed in R by a PE that bore the deduction for the compensation under the accrual method. The income is later paid when the individual becomes a resident of R. Here, if FR does not tax the income while the individual remains a resident, it may not have the right to tax the subsequent payment under article 15. FR may tax the later payment only when it specifically reserves the right to do so by treaty. Absent this reservation, taxation appears to be ceded to R. For example, an alien resident of the U.S. works in Japan, settles there, and later receives compensation for the services performed in Japan. Under the OECD Model Treaty, only Japan, not the United States, can tax the payment for services made after the taxpayer's change of residence.
A third situation is presented when employment occurs in a third country, which raises the difficult triangular problem. The result is probably the same as in the second situation. Under the OECD Model Treaty, FR may not have a right to tax the income after the taxpayer's change in residence. For example, an alien resident of the U.S. works in Japan, retires to the United Kingdom, and then receives the compensation. The U.S. may not be able to tax the income under article 15. The United Kingdom can probably tax the payment under article 15, but chooses not to do so under domestic U.K. law. Again, only Japan may tax the payment.
Notwithstanding the provisions of the OECD Model Treaty, a country with an exit tax may tax the individual on departure. The country of new residence may also impose a tax on receipt of payment. Thus, there will be double taxation unless the applicable treaty requires a credit or exemption, or unless a credit or exemption is provided for under internal law. Canadian internal tax law would apply a credit, as the payment would be considered foreign-source income if it were earned outside Canada. The issue would probably not arise in Australia because gains brought to tax under the Australian capital gains tax regime (CGT), including the exit tax, are reduced by amounts that would otherwise be assessable or exempt from income (foreign-source income of nonresidents is exempt). It is not perfectly clear whether this reduction mechanism would operate in this case. Canada would grant a fair market value basis to a new resident for the amount receivable as deferred compensation, and to that extent would not seem to tax the amount when received. Countries with trailing taxes will generally not tax the later receipt.
In the United States, if the services were rendered outside of the country, receipt would not be subject to tax, because they would not be U.S.-source income.16 The Netherlands provides for a similar result. Belgium would tax the income upon receipt, even if the services were performed abroad, leading to potential double taxation. Canada would also tax the former resident on receipt if the income was earned from duties performed outside Canada while the taxpayer was a Canadian resident.17 If, and to the extent that, the fair market value of the deferred remuneration was taxed on departure, double taxation is avoided under subsection 248(28) of the Income Tax Act, so only the excess is taxed when received. It is not clear whether Germany would attempt to tax the income (see the discussion below under independent personal services).
These contradictory rules may, in certain circumstances, result in complete exemption or double taxation.
Deferred compensation, contingent compensation programs, and severance payments are becoming more prevalent in today's economy. The OECD Model Treaty should address the issue of a change of residence made after the performance of service and before the receipt of payment, and takes a position as to which country has the right to tax the payment, and in what amount, and whether any tax credit or exemption is available. Also, the commentaries to the OECD Model Treaty should discuss the criteria for determining when a payment is considered to be deferred compensation, severance, or pension.18
These issues are important and should be analyzed, and the definitions should override local law to the contrary. Although a payment may indisputably arise from the rendering of services, the characterization of the payment may nevertheless lead to different tax consequences. If the income is characterized as deferred compensation, article 15 of the OECD Model Treaty grants the right to tax to the source state. If the income is categorized as a pension payment, article 18 grants the right to tax to the state of residence. A conflict in interpretation could lead to complete exemption or multiple taxation.
1. Independent Personal Services 19
A similar situation may exist for individuals performing services of an independent character. These situations will be less frequent, because many countries require the income from these activities to be taxed currently on an accrual basis.20 This is, generally, the rule in Japan, the Netherlands, and Sweden, so long as the payment is regarded as income from exercising an independent profession. The United Kingdom changed its law in 1998 to prevent professions, except for barristers in their first seven years, from accounting on the cash or bills-delivered basis from 1999-2000. The United Kingdom also imposed a catching-up charge spread over 10 years.21 Canada has taxed professionals on a billed basis since 1972, and Australia has taxed professionals (except for single person practices) since a court decision in 1970. Japan, the Netherlands, and the United Kingdom tax unbilled work in process. The United States, on the other hand, does not tax all independent personal service businesses on an accrual basis. For example, promoters, financial advisors, attorneys, accountants or brokers, and small partnerships may be cash basis taxpayers. In Italy, income from independent personal services is taxable on a cash basis.
Prior to its deletion earlier this year, article 14 of the OECD Model Treaty provided:
1. Income derived by a resident of a Contracting State in respect of professional services or other activities of an independent character shall be taxable only in that State unless he has a fixed base regularly available to him in the other Contracting State for the purpose of performing his activities. If he has such a fixed base, the income may be taxed in the other State but only so much of it as is attributable to that fixed base.
2. The term "professional services" includes especially independent scientific, literary, artistic, educational or teaching activities as well as the independent activities of physicians, lawyers, engineers, architects, dentists and accountants.
Article 14 allocated the power to tax the income derived from professional services or other activities of an independent character only to the country of residence, unless the individual had a fixed base regularly available to him in the country of source for the purpose of performing his activities, and then only so much income as was attributable to that fixed base.22
An assumption of article 14 was that a person performing independent personal services would probably not, as a general rule, have a fixed base in any state other than that of his or her residence.23
The issues presented by treaties that followed the OECD Model Treaty before its recent amendment are analogous to those discussed in the commentary on article 7 for a taxpayer conducting a business, except the nexus required for source-country taxation is a fixed base rather than a permanent establishment.24 Must the fixed base exist at the time of payment if the taxpayer is taxed on a cash basis, or at the time of billing if the taxpayer is taxed on a billed basis? Or, is the existence of a fixed base at the time the independent personal services are performed sufficient to permit the country of source to tax the income? The OECD Model Treaty is silent on this point. If both the activity and the receipt must coincide, there is potential for tax avoidance in the case of income earned prior to disposing of the fixed base for independent services performed in the country of residence and billed or paid subsequent to the change.
Under Italian internal law, the existence of a fixed base is not a requirement for the taxation of income from personal services. Under Italian tax treaties, a fixed base is required, but only during the time that services are rendered, and not at the time of receipt. Canada deals with the issue by wording articles 7 and 14 of its tax treaties so to allow source taxation of income that later arises if the taxpayer has or had a permanent establishment or fixed base. The Netherlands has a similar provision in some of its treaties, including the U.S.-Netherlands Treaty, but the income must be earned within three years of termination. An independent professional or businessperson frequently has the ability to control whether the fixed base continues to exist. If the former resident never had, or no longer has, a fixed base in the country of former residence, it is arguable that, under the OECD Model Treaty the income may be taxed, if at all, only by the new country of residence. Although many countries, such as Canada, specifically cover this tax issue in their treaties, others nations do not, such as Belgium25 and the Netherlands.
Another method of taxing appreciation or accrued income is to tax the termination of a business. In addition to those countries that have a general exit tax, many countries such as France, Germany, Italy, the Netherlands, Sweden, and Switzerland, tax a business enterprise when it terminates. In countries that treat the relocation of the fixed base to another jurisdiction (a change of residence of the fixed base) as a termination, there is the equivalent of an exit tax.
In Canada, Germany, and the United Kingdom, a deemed disposition of business assets occurs when a nonresident ceases to use such assets in the business.26 Expatriation is treated as a deemed cessation of the business, which triggers a deemed disposition of any ordinary income items.27
No treaty relief appears in any of the treaties entered into by these countries, although if the United Kingdom were the residence country, it would provide relief under internal law. Fortunately, the situation rarely occurs. Germany and the United States, on the other hand, will not tax the gain until the assets are sold, and then will tax the gain only if the sale occurs within 10 years after the cessation of the business.28 This seems contrary to the general exemption for capital gains realized by a nonresident, but is consistent with the 10-year trailing tax imposed on former residents in these countries if the trade or business is viewed as a separate resident enterprise. Treaties may limit the time during which the source state is permitted to tax such gains following the termination of the permanent establishment or fixed base. For example, Canada and the U.S. limit the time following the termination.29 Treaties should also provide for a credit for the taxes paid to the foreign country.30
The U.S. taxes the receipt of deferred payments subsequent to a change of residence or abandonment of a trade or business if the amount received is attributable to a sale or exchange of property or the performance of services in the United States (or any other transaction) in a prior taxable year. The determination of whether this income or gain is taxable when collected is made as if the income or gain were taken into account in the prior taxable year, and without regard to the requirement that the taxpayer be engaged in a trade or business within the U.S. during the year of collection.31
The rule in Germany is unclear. It may tax the accrued income from independent services on exit. Under a number of cases decided in the 1970s, German courts held that appreciated assets could be taxed as if they had been disposed of immediately before the German taxpayer moved abroad to a treaty jurisdiction where, under the applicable tax treaty, Germany could no longer tax the gain. One case concerned a self-employed inventor who moved to Italy. A similar rule could apply to an artist who composes music while resident in Germany and, thereafter, surrenders the German residence and moves to a treaty jurisdiction. Nevertheless, in all of these cases, the court stated there was no general principle that all events that could terminate the German jurisdiction to tax a particular asset should give rise to an exit tax.32
Where the income has not accrued as of the date of departure, but the services were performed in Japan, the Japanese government will attempt to tax the income regardless of whether the taxpayer had a fixed base in Japan.
Sweden has a special rule that permits a resident to defer taxation for royalties on literary or artistic works. The deferred income is taxed when the individual changes her residence.
There are a number of methods to deal with the taxation of income of an independent character when an individual changes residence. The methods are not mutually exclusive.
One method is to tax the individual on an accrual basis. This alone may not be sufficient because contingent income is normally not accrued. Similarly, any unrealized appreciation of assets has not yet been realized.
A second method is to tax income or gain on receipt or realization, notwithstanding that the individual is no longer a resident. This approach would require a change in the wording of the treaties that adopt the OECD Model Treaty to permit the source country to tax any nonresident who "has or had" a fixed base. The country of residence would then grant a credit or exemption pursuant to article 23.
A third method is to impose an exit tax on the change of residence, taxing all of the accrued income, the contingent income, and the appreciation in the assets of the independent business. This method would lead to the same credit/exemption problem discussed earlier for exit taxes.
No matter which course a country utilizes to solve the issue, it is incumbent upon that country to assist its former residents in avoiding or reducing multiple taxation. A country with an exit tax or a termination tax, for example, should negotiate for the new country of residence to grant an exemption or a tax credit to avoid double taxation. Since an exit tax is imposed immediately before the individual ceases to be a resident, it is unlikely the exit tax would otherwise be eligible for credit in the other country as the tax was imposed before the individual became a resident.33
On the other hand, unless there is an equivalent of an exit tax, it appears that third country-source income that has been earned, but not accrued, may escape taxation in many situations.
II. Nongovernmental Pensions and Annuities
Similar to other areas treated in this article, there are many variations of retirement schemes that could be covered. Some programs are government sponsored and administered, such as social security schemes. The international elements of social security programs are frequently treated in so-called "totalization agreements," which are executive agreements between governments. Some governmental pension programs cover only government employees and are paid out from pension funds created by the government. These pension payments are dealt with in article 19(2) of the OECD Model Treaty. This article will not deal with other programs limited to employees of nonprofit institutions.34 This article deals only with private pension schemes for the benefit of employees of nongovernmental, profit-seeking businesses.
As many employers, employees, and governments realize that state-funded plans will be inadequate to fund retirement, private pension plans are of growing importance in all developed countries. An important method of encouraging participation in private pension plans is to promote them through tax incentives. Each country represented by the authors of this article has some form of tax incentive for qualified retirement programs that exempts earnings of pension plans from full taxation and permit employers, and sometimes employees, a current deduction for contributions, while deferring tax on the employees until retirement.
A. Deduction and Deferral -- Funded Plans
Deductions for employer and employee contributions vary in each country. Employer contributions are deductible in Australia, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States, although the scope of the deduction is frequently subject to a ceiling. Employee contributions are deductible in Belgium, Canada, France, Italy, the Netherlands, Switzerland, and the United Kingdom, and also may be subject to a ceiling. In all of these countries, except for Australia, Italy, and Japan, pension funds are exempt from tax on their earnings, with limited exceptions for business income. Australia imposes a 15 percent tax on the earnings of a pension fund, while Japan imposes a 1 percent tax on earnings of a pension fund. Italy recently introduced a tax on fund earnings at a reduced rate. During the time the pension is earned, individuals are generally not subject to tax, but it is assumed they will be taxed later after retirement. This may not be the case, however, since employees may retire somewhere other than the country of residence during the period of work.
An exception to the general rule of not taxing an employee currently on contributions to and earnings of a pension scheme can occur in cross-border employment situations when the tax-exempt pension program of the country of residence differs from that of the country of employment. In these scenarios, the employer or the employee's pension contributions may not qualify for relief under the domestic laws of either the country of residence or the country of employment. The text of the OECD Model Treaty does not deal with this problem. The commentaries, however, include a draft of an article to deal with the issue. This article, which should be considered in all treaty negotiations, provides as follows:
a) Contributions borne by an individual who renders dependent personal services in a Contracting State to a pension scheme established in and recognized for tax purposes in the other Contracting State shall be deducted, in the first- mentioned State, in determining the individual's taxable income, and treated in that State, in the same way and subject to the same conditions and limitations as contributions made to a pension scheme that is recognized for tax purposes in that first-mentioned State, provided that:
(i) the individual was not a resident of that State, and was contributing to the pension scheme, immediately before he began to exercise employment in that State; and
(ii) the pension scheme is accepted by the competent authority of that State as generally corresponding to a pension scheme recognized as such for tax purposes by that State.
b) For the purposes of sub-paragraph a):
(i) the term "pension scheme" means an arrangement in which the individual participates in order to secure retirement benefits payable in respect of the dependent personal services referred to in sub-paragraph a); and
(ii) a pension scheme is recognized for tax purposes in a State if the contributions to the scheme would qualify for tax relief in that State.35
B. Taxation of Participants
The participants covered by a pension plan will ultimately receive their deferred compensation in the form of a lump sum, a series of periodic payments, or an annuity payable by a third party after retirement. As the amounts increase and individuals become more mobile, the issue of the tax treatment of such cross-border payments becomes more significant. For example, if the former president of a Canadian company retires to Florida and receives payments from the company or from a pension fund established by the company, are the payments subject to tax in Canada or the United States? If the payments are taxable in both countries, will the U.S. permit a credit for Canadian taxes paid, or will Canada allow a credit for U.S. taxes paid?
The source of the payments will either be the former employer, an insurance company, a funded trust, the government, or a combination thereof. Belgium, Canada, France, Germany, Italy, the Netherlands (to the extent of services performed there), Sweden, Switzerland, and the U.S. would, in the absence of a treaty, tax the nonresident on the receipt of the pension payment. In some countries, including Australia and the United Kingdom, the treatment may vary if retirement payments are received in a lump sum.
1. OECD Model Treaty
Article 18 of the OECD Model Treaty provides:
Subject to the provisions of paragraph 2 of Article 19, pensions and other similar remuneration paid to a resident of a Contracting State in consideration of past employment shall be taxable only in that State.
Under the OECD Model Treaty, the country of source surrenders its right to tax to the country of residence. The countries represented by the authors normally follow the OECD Model Treaty, with the exception of Canada, the Netherlands, and Sweden.
Australia's tax treaties generally adopt exclusive residence taxation, extending it to all pensions and annuities including government and private employment, self-employment, and purchased annuities. This means that if a person changes residence before or during the receipt of an occupational pension, in or out of Australia, the taxing right changes. There is no safeguarding in the treaty to cover what may be regarded as tax induced changes of residence.
Under Australian domestic law, tax is imposed at each stage in the process including contributions, fund income, and payments out, but with quite low tax rates. Australia limits the preferential treatment internationally, so that the low rates are only enjoyed by people with fairly permanent Australian connections. Top marginal tax rates apply in other cases with Australian connections, such as for contributions and fund income. If a person immigrates to Australia and receives a foreign pension, the pension is taxed at normal rates, whereas a person within the low-tax bracket who receives a domestic pension is entitled to a 15 percent credit against tax payable on the pension. The individual is given credit for prior contributions that have already been taxed to the contributor on contribution.36
If the person receives a lump sum from a foreign pension fund after becoming an Australian resident, an exemption is available for payments within six months of becoming a resident, so long as the payment relates entirely to a period of employment when the person was a nonresident. In other cases, Australia allows an exemption for the entitlements of the person as of the time he became a resident, and it taxes the rest at somewhat higher rates than payments within the low-tax bracket. Foreign taxes are credited in this process, but the payments form a foreign tax credit "basket" of their own, and there can be no averaging with other foreign taxes. If there are no foreign taxes in these cases, a full or partial double exemption can result.
If a person emigrates from Australia and takes up residence elsewhere, the Australian Taxation Office regards the source of lump-sum payouts as determined by the residence of the fund or its relevant branch. Australia will tax the lump sum if it is paid from an Australian fund, but not if it is from a nonresident fund. Treaties do not matter in this case, because article 21 applies and would permit source taxation under Australia's treaties. Australia may pick up considerable tax from the fund in such a case, however. The residence of a fund depends in part on where its members reside. If more than 50 percent of entitlements in a fund are attributable to nonresidents, the fund loses its resident status. It would then be taxed at the top marginal rate on its assets, less contributions on which contributors have already been taxed as part of their income. Small funds may be affected by the change of residence of an individual, but not large funds.
Belgium taxes its former residents who earned the right to nonstatutory pensions before transferring their domicile abroad, notwithstanding article 18 of the OECD Model Treaty. The pensions are deemed collected the day immediately before the transfer of domicile, similar to an exit tax. The Belgian Revenue recently announced that in situations involving a treaty provision similar to the OECD Model Treaty, it will refrain from assessing the exit tax on pensions that will be taxed by the new country of residence. If the individual moves to a country that has a treaty with Belgium and later moves again to a non-treaty country, there is the possibility the receipts may never be subjected to tax.
Canada does not follow the OECD Model Treaty, nor does it accelerate the tax on the value of the pension rights upon emigration if it is payable by a Canadian registered pension plan. Instead, it taxes pension payments that arise in Canada when distributed and allows and negotiates a credit for foreign taxes paid.37 Canada normally subjects such payments to a 25 percent withholding tax under internal law, unless the payments are made under a plan administered by a non-Canadian entity, such as the nonresident corporate parent of a Canadian employer. In this case, however, the value of the taxpayer's rights under the plan is subject to the general deemed disposition rules and is taxed at the time of emigration. Although article 18 of the OECD Model Treaty restricts taxation of nongovernmental pensions and other similar remuneration for private employment to the country of residence, Canadian internal law preserves source taxation. Canada may reduce the tax rate from 25 to 15 percent by treaty, however, and negotiate a credit for its former residents.
France normally taxes private pension payments to a nonresident on a gross basis, under the withholding system that applies to other French-source income paid to a nonresident. Private pension payments are treated as having a French source if the payor is domiciled in France, irrespective of the place the services were performed. Under its treaties, France follows the OECD Model Treaty and restricts taxation to the country of residence.38
Pension payments to a nonresident can be taxed only if a withholding tax is imposed on such payments.39 As no such withholding tax exists, no German tax is imposed under German law. Nevertheless, Germany follows the OECD Model Treaty in its treaties.
Under Italy's new regime for taxing pensions, a substitute tax will be applicable to earnings of pension funds in lieu of regular taxes. Any payments out of earnings already taxed at the level of the pension fund will be exempt from tax upon receipt by a beneficiary, subject to a transitional rule on previously untaxed earnings.
Where the earnings of the pension fund have not been taxed, distributions from an Italian pension fund to a nonresident for services in Italy will be taxable, and distributions to a resident will always be taxable, regardless of where the services were rendered or where the fund is resident. Distributions from nonresident pension funds to a nonresident beneficiary for services rendered in Italy are not taxable, nor are the contributions deductible.
In Japan, the cost of funding a private pension is shared by the company and its employees, and both are entitled to deduct the payments from their income. The fund is taxed at the rate of 1 percent. A resident of Japan is taxable on the pension upon receipt.40 If the individual who was a resident of Japan has emigrated, taxation of the pension depends on the residence of the employer. If the employer was a resident of Japan and the services were performed in Japan, the payments are taxable and subject to withholding tax. If the employer was a nonresident of Japan, the receipts are not taxable.
The Netherlands modifies article 18 of the OECD Model Treaty in its treaties. For example, the U.S.-Netherlands treaty provides that the source country may tax pensions and similar remuneration paid in consideration of employment exercised in that country if: (a) the individual deriving this remuneration was a resident of the source country at some time during the five-year period preceding the date of payment; and (b) the remuneration is paid in a form other than periodic payments, or paid as a lump sum in lieu of the right to receive an annuity. United States-Netherlands article 19. Other Dutch treaties do not contain the five- year criterion. The treaties also provide the source country may not tax the portion of the remuneration or lump sum contributed to a pension plan or retirement account under such circumstances that, had the amount been contributed by a payor in the recipient's new country of residence, that country's tax on the payment would be deferred until the amount of the payment was withdrawn from the pension plan or retirement account to which it was contributed. To avoid nontaxation or multiple taxation on lump-sum distributions, the Netherlands negotiated for a foreign tax credit, a source-state credit, and also granted a credit for foreign taxes in treaties that it retained the right to tax.
The Netherlands will introduce an exit tax for accrued pension rights on January 1, 2001. As with substantial interest shareholdings, the new exit tax will be contingent on the taxpayer conducting "tainted" transactions within 10 years from the date of emigration. Examples of tainted transactions include transfers of pension claims to a nonresident insurance company, redeeming the pension, or borrowing against security of the pension. Security must be provided in order to obtain the deferral. If no tainted transaction takes place, the tax is waived after 10 years.
Commentators have raised considerable doubt as to whether the new system is consistent with the European Commission's rules regarding the free movement of individuals, and whether it constitutes a hidden override of existing treaty obligations. Under the new system, the Netherlands will continue to impose tax on nonresidents receiving a pension "earned" with employment in the Netherlands. To the extent the tax is imposed, the outstanding contingent exit tax is waived. Under most treaties, no tax could be imposed on regular, periodic pension receipts. The new "contingent exit tax" follows the model of a contingent exit tax introduced in 1992 for annuity policies for which tax-deductible premiums have been paid in the past. Under most treaties, regular periodic annuity payments are taxable only in the new country of residence. The contingent exit tax is designed to protect the claim against lump-sum redemptions that may not be taxed in the new country of residence.
The Netherlands has, for some years, advocated a revision of treaties and is proposing a new EU directive that would attribute more taxing rights over pension payments to the state in which the contributions have been deducted. The new policy is visible in the most recent Dutch tax treaties, including its 1999 agreement with Portugal. The basic idea is that the source state retains its taxing rights, unless the country of residence taxes the pension receipts in full at ordinary rates. Lump-sum payments are taxable in the source state, which will allow a "source state" credit for any tax paid in the new country of residence.
In Sweden, both employers' and employees' contributions to a pension fund are deductible, subject to a ceiling. Swedish pension funds are taxed not on their actual earnings, but on a percentage of their assets. Pension payments to former residents are subject to tax and pension receipts by immigrants are also subject to tax. Sweden does not normally follow article 18 of the OECD Model Treaty.
Switzerland normally taxes pension payments to a nonresident on a gross basis, under the taxation at source system that applies to other Swiss-source income paid to a nonresident. Pension payments are treated as having a Swiss source if the payor is domiciled in Switzerland, irrespective of where services were performed. Switzerland follows the OECD Model Treaty and restricts taxation to the country of residence.41 Generally, controversies arise as to the proper characterization of the sums paid upon termination of an employee, in particular whether article 18 is applicable.
12. United Kingdom
If the recipient of a pension payment is a U.K. resident, the pension is taxable, although the remittance basis will apply if the recipient is not domiciled in the United Kingdom and the payor is a nonresident.42 If taxed, the U.K. will grant a credit. If the pension is payable by a United Kingdom resident to a nonresident, it is taxable under internal law, but most U.K. treaties follow the OECD Model and exempt the income. Where the services were rendered is irrelevant if the payor is a U.K. resident, unlike the rule for deferred compensation.
13. United States
In the absence of a treaty, the U.S taxes pension income paid to an emigrant nonresident former employee at normal progressive tax rates, if the pension or annuity was earned for services performed in the United States.43 Where there is a treaty, the U.S. follows the OECD Model Treaty.
For immigrants, the U.S. gives an individual who receives a pension for services rendered outside of the United States, when the individual was a nonresident alien, a tax basis (an investment in the contract) for the future pension benefits earned if the pension is received from an insurance company, foundation, trust, or entity other than an unfunded payment received from his employer, regardless of whether the funded amount was taxed by the U.S. when earned.44 This amount will never be taxable in the United States.
In computing the aggregate amount of premiums or other consideration paid by the employee, the amounts contributed by the employer are included, even if such amounts would not have been includable in the gross income of the employee because the compensation was for services rendered outside of the U.S.45 The portion of the annuity payments received that is allocated to the investment in the contract, and that may be excluded by the recipient from gross income, is determined by an exclusion ratio determined on the annuity starting date. The numerator of the ratio is the individual's investment in the contract, and the denominator is the total expected return. The expected return is the total amount the individual can expect to receive under the contract, determined with reference to life- expectancy tables prescribed by the IRS.
These actuarial tables provide a multiple that is applied to the annual payments to obtain the expected return under the contract. The exclusion ratio is then applied to each payment received. The premiums the taxpayer contributed to the pension plan and the premiums the employer contributed to the group pension plan are part of the "investment in the contract." These premiums will not be taxable on subsequent distribution. If the interest in the pension plan vested prior to arrival in the U.S., then the income accrued within the insurance contract or other funding vehicle is added to the "investment in the contract." The tax cost for the policy would be the fair market value of the policy on the date the individual's interest vested. Thus, the immigrating taxpayer may be exempt from tax in the former country of residence by the OECD Model Treaty and is substantially exempt in the United States.
The problem is not unique to the international transfers of residence. In the United States, where it is common for individuals to work in one area of the country and retire to another, a major tax issue among the states is the taxation of retirement and pension payments made to these retired employees.
Can the states where the individual was employed tax the retirement income? Can they require withholding from former employers or trustees of funded retirement plans? Does it impinge on the right of individuals to freely move among the states? The states to which these individuals have retired have economic and political reasons to object to taxation as retirement patterns are not reciprocal. Retirees from the north frequently retire to the south. U.S. Congress recently ended the dispute. The new state of residence, not the former state of residence, has exclusive taxing authority.
C. Current Taxation of Emigrants on Earnings of the Fund
As discussed briefly above,46 the OECD Model Treaty covers the taxation of pensions when amounts are distributed. It does not deal with the earnings of the pension plan prior to payment. A country might not defer the tax on these earnings or an increase in benefits to plans that do not meet the technical requirements under domestic legislation. This is the case in Australia, Italy, Japan, and the United States, which tax such income currently.
Canada and the U.S. have worked out a solution to the issue. Prior to the 1995 protocol to the U.S.-Canada treaty, a one-time election could be made to defer pension taxation until distribution only in limited circumstances. Under the protocol, a broader election is now provided by the treaty.47 When the participant changes residence, the plan normally continues to retain the assets until the participant reaches retirement age or dies. During the interim period, the country of residence may impose a tax on the increasing values of the plan, because the plan may not qualify for exemption in the country of residence. Canada and the United States recognized the issue. They now provide, in article 18(7) of their treaty, that the participant can elect to defer taxation of income accrued in the plan until receipt.48 Other countries should consider this type of solution in their treaties.
D. Conflicts and Discussion
The above discussion assumed the payments in question were a pension. The characterization of the payment is crucial. If characterized as deferred compensation, it would appear that article 15 of the OECD Model Treaty would apply, and the payment would be subject to tax in the country where the services were rendered. If the payment is a pension payment, article 18 of the OECD Model Treaty provides that it is the country of residence that has exclusive tax jurisdiction.49 The payment may also fall under article 21 (Other Income).50
Assuming that a distinction can be drawn between deferred compensation and a pension payment, which law would govern? If one country treated the payment as a pension payment, and the other treated it as deferred compensation, would the recipient avoid tax in both countries or be subject to double taxation? Suppose the payments are not paid by the same employer or fund to which the funds were contributed?
Not all post-employment income is paid by the employer. Many countries have retirement schemes for individuals funded solely by the taxpayer. Generally, it may be considered socially desirable to enable residents to save for their post-employment years. Most arrangements are based on deferral of tax for current income paid to such plans and tax-free accumulation of investment income. For example, in the U.S. and Canada, individuals can save for their retirement by deducting from taxable income limited contributions to an individual retirement account (IRA) and a registered retirement savings plan, deferring the tax on their contributions and the income earned until distributed.
The United Kingdom has a similar scheme, known as individual savings accounts, with similar economic effects. Because no deduction is given for contributions, no tax is charged on withdrawal, and no tax is imposed on the fund. The U.K. scheme is similar to a new alternative in the United States, the Roth IRA, which does not involve a current deduction for contributions, but offers a complete exemption of the income earned on distribution. None of these schemes falls within the ambit of articles 14 or 15 of the OECD Model Treaty, because payments to the contributors are not income in respect of professional services or salaries, wages, and other similar remuneration. To the extent that a country permits a deduction for contributions to these plans, it is permitting the income conversion of income from services to income from investments. Article 18 is not applicable since the payments are not paid to a resident "in consideration of past employment." The conversion can lead to tax avoidance, as discussed below.
Assuming that the distinction between a pension and deferred compensation is clear, and both countries characterized the payments as pensions, article 18 of the OECD Model Treaty on pensions would apply. Article 18 should be modified, however, because it presently permits tax avoidance in some instances, and multiple taxation in others.
Where the new country of residence would not have permitted a deduction for contributions to a plan, or would have taxed the earnings to individuals who were residents prior to retirement, it is likely the contribution and the income accrued in the fund will not be taxed upon payment to the taxpayer -- the employee will have a tax basis, notwithstanding that the country of residence has not taxed those amounts. If contributions were deducted and income was not taxed currently to the individual in the former country of residence, the pension distribution may completely escape tax under article 18. To avoid that situation, we recommend that article 18 of the OECD Model Treaty provide that the country of source retains the right to tax pension distributions to the extent that the distributions are not taxable in the country of residence.
Where the recipient has not deducted all or a portion of the plan contributions, and the income earned has been taxed currently, the country of residence should not subject the contributions or income to tax again when the plan distributes retirement benefits to the taxpayer.51 If the taxpayer moves to a country that taxes such amounts, because it allows deductions and does not tax the investment income of the plan, tax will be imposed on the distributions under article 18. To avoid that result, we recommend amending article 18 to provide for taxation by the country of residence solely to the extent that the contributions were deductible, and earnings of the fund or plan were not included in taxable income in the other contracting state prior to the distribution.52
A similar problem concerning the receipt of a pension after a change in residence occurs where the country of residence taxes the earnings of a pension fund when distributed while the earnings would have been exempt or subject to reduced tax in the country of source. For example, when a country imposes a tax on the pension fund and an exemption or reduced tax on the recipient, such as in Australia, Italy, and Japan while the new residence taxes the receipt.
1Section 11(1) ES&G.
2Subsection 128.1(4) of the Income Tax Act.
3Subparagraph 115(1)(a)(i) of the Income Tax Act.
4Australia will tax at the special rates applied to nonresidents if the income is sourced in Australia. The U.S. will tax only if the services were performed in the United States. IRC section 864(c)(6).
5If received prior to December 31, 2000.
7A related area is the taxation of restricted property. In the United States, if property, such as stock, is transferred to any person in connection with the performance of services, then the difference between the fair market value of such shares and the amount paid for the property is includible in ordinary taxable income in the first taxable year that the property is generally transferable or is not subject to a substantial risk of forfeiture, as spelled out in IRC section 83. When the individual changes residence prior to the property becoming transferable or not subject to a substantial risk of forfeiture, issues similar to those related to stock options result.
8See discussion at p. 755.
9Stock option benefits are expressly excluded from the deemed disposition and deemed acquisition rules on both emigration and immigration.
10IRC section 1374.
11Treas. reg. section 1.1374-4(b)(3), examples 2 and 3.
12Bundes Finanz Hof, 18 July 1973, BFHE Bank 100, p. 43, par. 1; Danish Landsesskatteritten, 10 July 1998, IBFD News no. 51/2, p. 432.
13Article 18(3) United States-Italy.
14Fiskoloog, No. 6; Liege; Court of Appeals Brussels, May 8, 1982, F.J.F. 83/165.
15Under the laws of most of the countries represented in this article, source is determined based on the circumstances at the time the income accrued, such as IRC section 864(c)(6). See discussion below.
16Cf. IRC section 864(c)(6).
17Proposed section 115(1)(a)(i) Income Tax Act.
18See discussion infra, p. 748.
19The Committee on Fiscal Affairs of the OECD has eliminated article 14, which used the use of the term "fixed base," and has independent services covered by article 7, business profits.
20Many countries require the acceleration of income and create a deemed sale when a business migrates to another country. See discussion on p. 747.
21FA 1998 S 42, 43.
23Article 14, commentary paragraph 4.
24As noted above, the OECD has now combined articles 7 and 14.
25Official Commentary on Tax Treaties 14/14.
26Proposed subsections 10(12) to (14) and subsections 13(7) and (9) and 45(1) ITA; TCGA 1992, S 25.
27TA 1998 S 110A. For Canada, see proposed subsections 10(12) to (14) and subsection 13(7) and (9) of the Income Tax Act.
28IRC section 864(c)(7).
29United States-Canada, articles XIII(2) and XIII(4). It should be noted that, with respect to gains from the alienation of property forming part of a permanent establishment or fixed base more than 12 months after the permanent establishment had existed or the fixed base was available, article XIII(2) would not apply. A former resident does not obtain the benefit of article XIII(4), however, until he has been a nonresident for at least 10 years, according to article XIII(5). Therefore, there is an effective 10-year lookback, rather than a 1-year lookback, as implied by article XIII(2).
30See United States-Germany article 23(1).
31IRC section 864(c)(6) for post-1986 services.
32See, e.g., BFH decision of January 26, 1976, BStBl. 1977 II, 283.
33The United Kingdom does give credit in these circumstances. See infra, p. 11. Australia would not apply its exit tax in this case, for the same reason, as in relation to article 15.
34E.g., IRC section 403(b).
35This article does not address the issues of temporary transfers. See the commentaries to article 18 of the OECD Model Treaty for a greater discussion of this problem.
36Similar to the United States system, discussed infra.
37E.g., United States-Canada art. XVIII.
38E.g., United States-France, article 18(a).
39Section 49(1)(7) ES&G.
40See previous discussion under vested deferred compensation.
41E.g., United States-Switzerland article 18(a).
42TA 1998 S 19, 58. As mentioned above, a lump sum is not taxable in the hands of a resident if it is paid in respect of employment outside the United Kingdom.
43IRC section 864(c)(6).
44Compare rev. rul. 79-388, 1979-2 C.B. 270, PLR 904041 and PLR 8904035 with GCM 36344 with respect to plan earnings.
45IRC section 72(f)(2).
46On p. 749.
47United States-Canada art. XVIII(7).
48The United States, however, will not permit a resident of the U.S. to roll over the assets in a Canadian qualified plan without a tax, notwithstanding that Revenue Canada had agreed to consider exempting the distribution from Canadian nonresident withholding tax if the Internal Revenue Service would exempt the roll- over. PLR 9833020.
49Canada's Income Tax Convention Interpretations Act provides a definition of purposes of its treaties.
50See text at footnote 12.
51Since the individual would not have obtained a deduction, and the earnings would not have been taxed under a Roth IRA in the United States, multiple taxation is not an issue.
52See United States Model article 18.
"1. For purposes of this Convention, where an individual who is a participant in a pension plan that is established and recognized under the legislation of one of the Contracting States performs personal services in the other Contracting State:
"a) Contributions paid by or on behalf of the individual to the plan during the period that he performs such services in the other State shall be deductible (or excludible) in computing taxable income in that State. Any benefits accrued under the plan or payments made to the plan by or on behalf of the employer during that period shall not be treated as part of the employee's taxable income and shall be allowed as a deduction in computing the profits of the employer in that other State.
"b) Income earned but not distributed by the plan shall not be taxable in the other State until such time and to the extent that a distribution is made from the plan.
"c) Distributions from the plan to the individual shall not be subject to taxation in the other Contracting State if the individual contributes such amounts to a similar plan established in the other State within a time period and in accordance with any other requirements imposed under the laws of the other State.
"d) The provisions of this paragraph shall not apply unless:
"(i) contributions by or on behalf of the individual to the plan (or to another similar plan for which this plan was substituted) were made before he arrived in the other State; and
"(ii) the competent authority of the other State has agreed that the pension plan generally corresponds to a pension plan recognized for tax purposes by that State.
"The benefits granted under this paragraph shall not exceed the benefits that would be allowed by the other State to its residents for contributions to, or benefits otherwise accrued under a pension plan recognized for tax purposes by that State." Compare U.S.-France, article 18(2).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.