US expatriates working for foreign employers may participate in foreign pension plans. These plans normally have beneficial tax treatment under local law. Unfortunately, these foreign arrangements generally do not meet the US "qualification rules". As a result, the beneficial treatment under local law is often not available to US citizens working abroad..
US QUALIFIED DEFERRED COMPENSATION
US employer sponsored pension plans qualify for special tax treatment under the Internal Revenue Code: tax deductible contributions for the employer; earnings in the plan are tax exempt; and the employee is not taxed until the benefits are received upon retirement or withdrawal of those pension funds. These tax benefits are not available unless the plan meets the specific requirements of the Internal Revenue Code.
NON-QUALIFIED DEFERRED COMPENSATION
The determination of when amounts deferred under a non-qualified deferred compensation arrangement are includible in the gross income of the taxpayer depends on the facts and circumstances of the arrangement and which Code section applies to those facts.
IRC § 402(b) Plans
Employer sponsored non-qualified funded deferred compensation plans are generally governed by the provisions of IRC § 402(b). US employees who participate in such a plan are taxed on the amount of the contributions made by the employer (once the benefits are vested or not subject to a substantial risk of forfeiture). If the employee is a "highly compensated" (compensation exceeds $105,000 or part of the top 20% of employees) the employee is taxed on both the contribution and the growth in the plan each year (to the extent the benefits are vested. (Non-Highly compensated employees are not taxed on the growth in the plan, but are taxed when the benefits are distributed.)
IRC § 409A
The provisions of IRC § 409A apply to deferred compensation plans not covered by IRC § 402(b), plans covered by a tax treaty or foreign pension plans that are available on a broad base to the employer's employees (but only to the extent of non-elective deferrals and employer contributions as limited by US rules).
Under IRC § 409A, if the deferred compensation arrangement does not meet the requirements of IRC § 409A, the employee will be subject to normal income tax, a 20% penalty tax and an interest charge. To meet the rules of IRC § 409A, the plan must provide that distributions from the deferred compensation plan are only allowed on separation from service, death, a specified time (or under a fixed schedule), change in control of a corporation, occurrence of an unforeseeable emergency, or if the participant becomes disabled.
The plan may not allow for the acceleration of benefits, except as provided by regulations. The plan must provide that compensation for services performed during a tax year may be deferred at the participant's election only if the election to defer is made no later than the close of the preceding tax year, or at such other time as provided in regulations.
The actual time and manner of distributions must be specified at the time of initial deferral.
INCOME TAX TREATY-PENSIONS
The normal US income tax rules may be altered by applicable treaty provisions; for example, the United States and the United Kingdom Income Tax Treaty. While the treaty does not specifically provide that each country's qualified plans will be treated as qualified plans by the other country, the treaty effectively provides for such a result with tax deferrals and tax reductions, but subject to certain limits.
In the context of a US citizen employed in the UK and participating in a pension plan established by the UK employer, the rules are that the employee may deduct (or exclude) contributions made by or on behalf of the individual to the plan; and benefits accrued under the plan are not taxable income. The Treaty further provides that the deduction (or exclusion) rule only applies to the extent the contributions or benefits qualify for tax relief in the UK and that such relief may not exceed the reliefs that would be allowed in the US under its domestic rules.
With respect to distributions the general rule under the Treaty is that a pension received by a resident of one country is only taxable by the country of residence. For Lump Sum payments, the general rule is that only the country of the situs of the pension plan may tax the distribution. However, as in most US treaties, the US retains the right to tax its citizens as if the treaty were not in force; with the result that the US retains its right to tax its citizens on both periodic distributions as well as lump sum distributions. Double taxation is avoided through the use of the foreign tax credit rules.
HOW TO TREAT CONTRIBUTIONS TO YOUR FOREIGN PENSION PLAN
Where a US citizen employee participates in a foreign pension plan, it is likely that the plan will not have met the US qualification rules. Thus, the employee will be subject to US tax on the contributions to the plan and the growth in the plan. For employees that live in a jurisdiction that imposes an income tax at rates higher than the US rate, it is likely that the employee will have generated a pool of "excess foreign tax credits". These credits may be used to offset the US tax on foreign sourced income and therefore may be used to reduce (or eliminate) the US tax that may currently arise on the deferred compensation.
If the employee has "excess foreign tax credits", (and provided the deferred compensation is "foreign sourced income"), the current US tax on such income may be partially or fully offset. Another possibility is for the US taxpayer to make a claim under an applicable treaty (if the country of employment has a Tax Treaty with the US).. If there is a treaty with proper pension provisions, and the contributions to the plan have not exceeded the US plan limitations, the contributions to the plan and the growth in the plan should not be subject to current US income tax. If there is no treaty with the country the expat is living in, then there is no deferral of pension contributions by a foreign employer.
An expat taxpayer has the choice of using excess foreign tax credits or invoking an applicable tax treaty to avoid having to pay current US income tax on contributions and the growth in the foreign deferred compensation scheme. Whether to use excess credits or to invoke the treaty will depend on a number of factors such as which may vary each particular situation.
TAX REPORTING:
There are a number of reporting requirements that may apply in addition to the individual's income tax return. This may include certain foreign trust reporting returns (form 3520 and 3520A), as well as the Treasury report on Foreign Bank and Financial Accounts which is form TD F 90-22.1. This report must be filed when your foreign accounts(when combined together at their highest balances during the year) exceed $10,000 and covers not only bank accounts but arrangements outside the US that are virtually any type of financial account. This form must be filed by June 30 of each year, and there are no extensions. Substantial penalties (including criminal penalties) may apply.
US expatriates working for foreign employers may participate in foreign pension plans. These plans normally have beneficial tax treatment under local law. Unfortunately, these foreign arrangements generally do not meet the US "qualification rules". As a result, the beneficial treatment under local law is often not available to US citizens working abroad..
US QUALIFIED DEFERRED COMPENSATION
US employer sponsored pension plans qualify for special tax treatment under the Internal Revenue Code: tax deductible contributions for the employer; earnings in the plan are tax exempt; and the employee is not taxed until the benefits are received upon retirement or withdrawal of those pension funds. These tax benefits are not available unless the plan meets the specific requirements of the Internal Revenue Code.
NON-QUALIFIED DEFERRED COMPENSATION
The determination of when amounts deferred under a non-qualified deferred compensation arrangement are includible in the gross income of the taxpayer depends on the facts and circumstances of the arrangement and which Code section applies to those facts.
IRC § 402(b) Plans
Employer sponsored non-qualified funded deferred compensation plans are generally governed by the provisions of IRC § 402(b). US employees who participate in such a plan are taxed on the amount of the contributions made by the employer (once the benefits are vested or not subject to a substantial risk of forfeiture). If the employee is a "highly compensated" (compensation exceeds $105,000 or part of the top 20% of employees) the employee is taxed on both the contribution and the growth in the plan each year (to the extent the benefits are vested. (Non-Highly compensated employees are not taxed on the growth in the plan, but are taxed when the benefits are distributed.)
IRC § 409A
The provisions of IRC § 409A apply to deferred compensation plans not covered by IRC § 402(b), plans covered by a tax treaty or foreign pension plans that are available on a broad base to the employer's employees (but only to the extent of non-elective deferrals and employer contributions as limited by US rules).
Under IRC § 409A, if the deferred compensation arrangement does not meet the requirements of IRC § 409A, the employee will be subject to normal income tax, a 20% penalty tax and an interest charge. To meet the rules of IRC § 409A, the plan must provide that distributions from the deferred compensation plan are only allowed on separation from service, death, a specified time (or under a fixed schedule), change in control of a corporation, occurrence of an unforeseeable emergency, or if the participant becomes disabled.
The plan may not allow for the acceleration of benefits, except as provided by regulations. The plan must provide that compensation for services performed during a tax year may be deferred at the participant's election only if the election to defer is made no later than the close of the preceding tax year, or at such other time as provided in regulations.
The actual time and manner of distributions must be specified at the time of initial deferral.
INCOME TAX TREATY-PENSIONS
The normal US income tax rules may be altered by applicable treaty provisions; for example, the United States and the United Kingdom Income Tax Treaty. While the treaty does not specifically provide that each country's qualified plans will be treated as qualified plans by the other country, the treaty effectively provides for such a result with tax deferrals and tax reductions, but subject to certain limits.
In the context of a US citizen employed in the UK and participating in a pension plan established by the UK employer, the rules are that the employee may deduct (or exclude) contributions made by or on behalf of the individual to the plan; and benefits accrued under the plan are not taxable income. The Treaty further provides that the deduction (or exclusion) rule only applies to the extent the contributions or benefits qualify for tax relief in the UK and that such relief may not exceed the reliefs that would be allowed in the US under its domestic rules.
With respect to distributions the general rule under the Treaty is that a pension received by a resident of one country is only taxable by the country of residence. For Lump Sum payments, the general rule is that only the country of the situs of the pension plan may tax the distribution. However, as in most US treaties, the US retains the right to tax its citizens as if the treaty were not in force; with the result that the US retains its right to tax its citizens on both periodic distributions as well as lump sum distributions. Double taxation is avoided through the use of the foreign tax credit rules.
HOW TO TREAT CONTRIBUTIONS TO YOUR FOREIGN PENSION PLAN
Where a US citizen employee participates in a foreign pension plan, it is likely that the plan will not have met the US qualification rules. Thus, the employee will be subject to US tax on the contributions to the plan and the growth in the plan. For employees that live in a jurisdiction that imposes an income tax at rates higher than the US rate, it is likely that the employee will have generated a pool of "excess foreign tax credits". These credits may be used to offset the US tax on foreign sourced income and therefore may be used to reduce (or eliminate) the US tax that may currently arise on the deferred compensation.
If the employee has "excess foreign tax credits", (and provided the deferred compensation is "foreign sourced income"), the current US tax on such income may be partially or fully offset. Another possibility is for the US taxpayer to make a claim under an applicable treaty (if the country of employment has a Tax Treaty with the US).. If there is a treaty with proper pension provisions, and the contributions to the plan have not exceeded the US plan limitations, the contributions to the plan and the growth in the plan should not be subject to current US income tax. If there is no treaty with the country the expat is living in, then there is no deferral of pension contributions by a foreign employer.
An expat taxpayer has the choice of using excess foreign tax credits or invoking an applicable tax treaty to avoid having to pay current US income tax on contributions and the growth in the foreign deferred compensation scheme. Whether to use excess credits or to invoke the treaty will depend on a number of factors such as which may vary each particular situation.
TAX REPORTING:
There are a number of reporting requirements that may apply in addition to the individual's income tax return. This may include certain foreign trust reporting returns (form 3520 and 3520A), as well as the Treasury report on Foreign Bank and Financial Accounts which is form TD F 90-22.1. This report must be filed when your foreign accounts(when combined together at their highest balances during the year) exceed $10,000 and covers not only bank accounts but arrangements outside the US that are virtually any type of financial account. This form must be filed by June 30 of each year, and there are no extensions. Substantial penalties (including criminal penalties) may apply.
