Are Provident Funds Taxable in the United States – International Tax Lawyers
A common question we receive at Golding & Golding is: “Are Provident Funds Taxable in the United States?”
Employment Provident Funds are a very common retirement tool in many different countries outside of the United States – but for U.S. Persons, having a foreign retirement fund such as an EPF, CPF, or MPF can be a major IRS Tax, FATCA and FBAR Reporting Liability concern.
U.S. Tax & Reporting Basics
For U.S. Persons (aka U.S. Citizens, Legal Permanent Residents, Foreign Nationals who meet the Substantial Presence Test), even if they are not receiving the benefit of the Provident Fund yet, they may still have a U.S. Tax Liability and FBAR/FATCA/8621 reporting requirement.
Some of the key Provident Fund issues we deal with on a near daily basis include the following:
- FBAR Flings
- FATCA Form 8938
- U.S. Tax on Accrued/Undistributed Earnings
- Form 8621
- Form 3520
Employment Provident Funds – The Basics
A Provident Fund earned from employment is somewhat similar to a 401(k), except that in many countries, such as Singapore, the Provident fund is mandatory. In these countries, the Provident fund is like a hybrid 401(k) and Social Security, wherein both the employer and employee contribute a certain amount of money annually to the fund. And, like a 401(k) in the U.S., the contributions by the employer (Under Foreign Tax laws) are generally not considered “currently” taxable income to the employee. In addition, the Employee’s contributions may be deducted from their tax current income.
While Provident Funds are not utilized in the United States, the majority of Asian countries have some form of Provident Fund which is geared toward retirement. While each provident fund may be somewhat different, they are all alike in the sense that they are used for the purpose of generating a nest egg for an individual in order to prepare for retirement.
One of the biggest issues and questions we receive is whether a Provident Fund is taxed in the United States before the earnings within the fund are distributed. Unfortunately, the majority of the time (while there may not be a concrete answer by the IRS, there are usually IRS Memos and PLRs floating around) the funds (Contributions and Earnings) are going to be taxable in the United States at the time the earnings are being accrued, even if they are not distributed.
Different types of Provident Funds
There are many different types of provident funds, depending on which country you work in. Some of the more common types of funds include:
- CPF – Central Provident Fund (Singapore)
- CPF – Central Provident Fund (South Africa)
- EPF – Employees Provident Fund (Malaysia)
- EPF – Employees Provident Fund (Nepal)
- TPF – Thailand Provident Fund (Thailand)
- MPF – Mandatory Provident Fund (Hong Kong)
U.S. Taxation of a Provident Fund
Even though the Provident Fund may receive tax-deferred treatment in its country of origin, that does not mean the United States recognizes that tax-deferred treatment as well.
Example: David is a Permanent Resident of Singapore and therefore is required to contribute to his CPF. The Singapore CPF is one of the largest Provident Funds in the world with extremely high contribution rates. David is a Highly Compensated Employee (“HCE”), with a salary upwards of $400,000. As such, David has a large portion of his salary diverted into CPF through employer contributions. In addition, David contributes a significant portion of his own salary into the CPF.
David is also a US citizen and has to report the CPF each year to the United States.
What about the CPF Tax Liability (Contributions, Deductions and accrued Growth) to David?
Provident Funds – Employer Contributions
Since the mid-1990s, the IRS has taken the position that employer contributions to the CPF on behalf of the employee are not deductible by the employer and must be considered to be income. For example, if an employer was to contribute $30,000 of David’s salary into the CPF, that $30,000 is to be considered income by David, and David would therefore have to pay U.S. tax on the employer contribution portion to the Provident Fund now — as opposed to the U.S. recognizing tax-deferred treatment in which that income which was diverted into the CPF would not currently be taxed, such as when a U.S. Employer contributes to an employee 401K plan.
Provident Funds – Employee Contributions
Moreover, unlike a 401(k) in which an employee can contribute to the 401(k) and receive tax-deferred treatment on the contributions — (since a 401(k) is tax-deferred and the recipient does is not taxed until the money is distributed) — David does not receive a tax-deferred benefit.
In other words, if David decides to contribute $25,000 of his pretax salary towards the CPF, he still needs to report the the contributed amount as part of his current income (aka he cannot “deduct” the pretax contributions from his overall current tax liability)
Provident Funds – Accrued Earnings
This is a very complex issue.
The reality is, because the United States does not recognize tax-deferred status on a CPF (employer or employee contributions), and there is no tax treaty with many of the countries which utilize Provident Funds as a retirement vehicle – the going theme is that the non-distributed accrued earnings are presently taxable.
In other words, if David’s CPF earned $7,000 in dividends and interest — even though David cannot access the money now, he would still have to pay tax on the non-distributed earnings. The theory is that because the United States does not recognize tax-deferred treatment of either the employer or employee contributions to the fund, then by default the accrued but not distributed earnings should be taxed (and not receive tax-deferred treatment either).
It should be noted, that once David pays tax on the non-distributed earnings, it will increase his basis in so far as he will not be paying double-tax in the future, on the same income.
Example: Let’s say David was properly paying U.S. tax on all of his employer contributions, employee contributions and accrued earnings, to the tune of $500,000. Once David begins to withdraw his money, David will not be taxed on the first $500,000 – or whichever amount David has already paid taxed on. In addition, future distributions based may be taxed as a hybrid, to ensure that the portion of the distribution which is “principal” is not taxed, versus the portion that is income generated on the principal – which has not yet been taxed.
In other words, it is not as it David is being double taxed (save for the fact that many provident funds are not taxed at distribution), but rather, David is being taxed now while the earnings accumulate – as opposed to later when the earnings are distributed (as to the portion of the distributions which is considered to have been already taxed).
Reporting of a Provident Fund
A Provident Fund must be reported on an FBAR, along with other forms if it meets the minimum threshold requirements.
Even though a Provident Fund is a retirement fund, and despite the fact that under many FATCA IGA (intergovernmental agreements) that the United States has entered into, a Foreign Financial institution may not have to report the Provident fund (excluded from the reporting) to the United States – you, as an individual still have a reporting requirement..
Therefore, each year when it is time for you to complete a tax return, there are a number of different forms you may have to file, depending on the facts and circumstances of your Provident Fund.
Two of the more common forms a person has the file are below:
FBAR (FinCEN 114)
We start off with the FBAR, because it is one of the IRS International Reporting forms that receives the most amount of press. The FBAR is used to Report Foreign Bank and Financial Accounts on an annual basis.
The form has a relatively low threshold requirement of $10,000. In other words, if you have an annual aggregate total of foreign accounts (including life insurance or retirement funds) that on any day of the year exceeds $10,000, then you are required to report this form. It does not matter if the money is in one account or spread over numerous accounts. And, it does not matter if the account is in your home country of citizenship or if you opened the account before relocating to the United States.
The US government does not look into the semantics that deeply; rather, if you meet the threshold requirement then you have to file the form. Starting in 2017 (to report 2016 maximum balance), the due date coincides with your tax return filing date (including extension).
When it comes to the FBAR, one of the main concerns are the FBAR Penalties.
A penalty for failing to file FBARs. United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
Form 8938 is a byproduct of FATCA (Foreign Account Tax Compliance Act). It is a form that is required to be filed with the tax return each year when a person meets the threshold requirements for filing. Unlike the FBAR, which is an electronic form which is submitted directly to the Department of Treasury (The FBAR is not submitted with your tax return), Form 8938 is part of your tax return.
Form 8938 requires you to provide extensive information regarding foreign accounts and specified foreign assets. For example, with the FBAR, reporting is limited to accounts and insurance policies (although those terms can have a very broad meaning). Conversely, with form 8938, the person must report Income — along with assets and accounts.
Therefore, if you were to own stock of a foreign company, that would be considered a Specified Foreign Asset that would need to be reported on a Form 8938 — but would not be reported on an FBAR.
Moreover, with the FBAR, a person is required to report the maximum balance in the account, but is not required to report any income that is generated from the accounts. The 8938 is more depth than that. Rather, with form 8938, a person must report the account balance along with the annual income that is generated from form 8938 accounts or assets.
Additionally, the income must be broken down by type of income earned (such as royalties, dividends, interest, capital gains) and/or whether the income was earned through a custodial or deposit account and/or it was earned through one of the specified foreign assets.
Form 8938 Penalties
Beginning with the 2011 tax year, a penalty for failing to file Form 8938 reporting the taxpayer’s interest in certain foreign financial assets, including financial accounts, certain foreign securities, and interests in foreign entities, as required by IRC § 6038D. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
Is my Foreign Provident Fund a PFIC?
This is another very common and scary question we receive. If you have not been introduced to the term PFIC, it stands for “Passive Foreign Investment Company.” At Golding & Golding we have written numerous articles on this concept, and it always boils down to the following: if your foreign provident fund is considered to be a PFIC, then you may be in for some serious tax consequences.
With that said, it should be noted that under most circumstances as long as the Employer contributions exceed the Employee contributions, chances are the fun is not going to be a PFIC.
But, once the fund has accumulated more employee contributions that employer contributions, then the fund may become more of a Grantor Trust (at least to the portion of the employee contributions) vs. a Non-Exempt Employee Trust, and then the fund must be split for tax purposes –and the employee contributions will be considered to be a PFIC and a form 3520 or form 8621 may be required.
Why Care if Your Provident Fund is considered a PFIC?
Because with most provident funds you cannot access the money until you reach a certain age. During all the while, the fund continues to grow and get larger. Meanwhile, you have not received any distributions that and therefore by time you receive the first distribution, it will probably be considered to be an excess distribution.
PFIC excess distributions are taxed at an extraordinarily high tax rate, and depending how long the fund has been growing and how long the fund’s been in existence from the initial contribution, through the time of withdrawal — the tax liability can reach upwards of 75% to 100% of the value of the distribution.
* For an example of Excess Distributions, you can click here.
**If your Provident Fund invests in Foreign Mutual Funds, it may be considered a PFIC.
Never Reported the Provident Fund?
If you have never reported the Provident Fund, and/or the prior employer contributions or employee contributions to the United States government you can be considered out of compliance and subject to extreme high fines and penalties. With that said, you may be able to get back into compliance relatively safely by entering one of the approved IRS offshore voluntary disclosure programs.
A summary of the different programs are provided below:
IRS Voluntary Disclosure of Offshore Accounts
Offshore Voluntary Disclosure Tax law is very complex. There are many aspects that go into any particular tax calculation, including the legal status, marital status, business status and residence status of the taxpayer.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that if you are required to file a U.S. tax return and you don’t do so timely, then you are out of compliance.
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.” It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts.
The Devil is in the Details…
If you do have money offshore, then it is very important to ensure that the money has been properly reported to the U.S. government. In addition, it is also very important to ensure that if you are earning any foreign income from that offshore money, that the earnings are being reported on your U.S. tax return.
It does not matter whether your money is in a country that does not tax a particular category of income (for example, many Asian countries do not tax passive income). It also does not matter if you are a dual citizen and/or if that money has already been taxed in the foreign country.
Rather, the default position is that if you are required to file a U.S. tax return and you meet the minimum threshold requirements for filing a U.S. tax return, then you have to include all of your foreign income. If you already paid foreign tax on the income, you may qualify for a Foreign Tax Credit. In addition, if the income is earned income – as opposed to passive income – and you meet either the Bona-Fide Resident Test or Physical-Presence Test, then you may qualify for an exclusion of that income; nevertheless, the money must be included on your tax return.
What if You Never Report the Money?
If you are in the unfortunate position of having foreign money or specified foreign assets that should have been reported to the U.S. government, but which you have not reported — then you are in a bit of a predicament, which you will need to resolve before it is too late.
As we have indicated numerous times on our website, there are very unscrupulous CPAs, Attorneys, Accountants, and Tax Representatives who would like nothing more than to get you to part with all of your money by scaring you into believing you are automatically going to be arrested, jailed, or deported because you have unreported money. While that is most likely not the case (depending on the facts and circumstances of your specific situation), you may be subject to extremely high fines and penalties.
Moreover, if you knowingly or willfully hid your foreign accounts, foreign money, and offshore assets overseas, then you may become subject to even higher fines and penalties…as well as a criminal investigation by the special agents of the IRS and/or DOJ (Department of Justice).
Getting into Compliance
There are five main methods people/businesses use to get into compliance. Four of these methods are perfectly legitimate as long as you meet the requirements for the particular mechanism of disclosure. The fifth alternative, which is called a Quiet Disclosure a.k.a. Silent Disclosure a.k.a. Soft Disclosure, is ill-advised as it is illegal and very well may result in criminal prosecution.
We are going to provide a brief summary of each program below. We have also included links to the specific programs. If you are interested, we have also prepared very popular “FAQs from the Trenches” for FBAR, OVDP and Streamlined Disclosure reporting. Unlike the technical jargon of the IRS FAQs, our FAQs are based on the hundreds of different types of issues we have handled over the many years that we have been practicing international tax law and offshore disclosure in particular.
After reading this webpage, we hope you develop a basic understanding of each offshore disclosure alternative and how it may benefit you to get into compliance. We do not recommend attempting to disclose the information yourself as you may become subject to an IRS investigation insofar as you will have to answer questions directly to the IRS, which you can avoid with an attorney representative.
If you retain an attorney, then you will get the benefit of the attorney-client privilege which provides confidentiality between you and your representative. With a CPA, there is a relatively small privilege which does provide some comfort, but the privilege is nowhere near as strong as the confidentiality privilege you enjoy with an attorney.
Since you will be dealing with the Internal Revenue Service and they are not known to play nice or fair – it is in your best interest to obtain an experienced Offshore Disclosure Attorney.
OVDP is the Offshore Voluntary Disclosure Program — a program designed to facilitate taxpayer compliance with IRS, DOT, and DOJ International Tax Reporting and Compliance. It is generally reserved for individuals and businesses who were “Willful” (aka intentional) in their failure to comply with U.S. Government Laws and Regulations.
The Offshore Voluntary Disclosure Program is open to any US taxpayer who has offshore and foreign accounts and has not reported the financial information to the Internal Revenue Service (restrictions apply). There are some basic program requirements, with the main one being that the person/business who is applying under this amnesty program is not currently under IRS examination.
The reason is simple: OVDP is a voluntary program and if you are only entering because you are already under IRS examination, then technically, you are not voluntarily entering the program – rather, you are doing so under duress.
Any account that would have to be included on either the FBAR or 8938 form as well as additional income generating assets such as rental properties are accounts that qualify under OVDP. It should be noted that the requirements are different for the modified streamlined program, in which the taxpayer penalties are limited to only assets that are actually listed on either an FBAR or 8938 form; thus the value of a rental property would not be calculated into the penalty amount in a streamlined application, but it would be applicable in an OVDP submission.
An OVDP submission involves the failure of a taxpayer(s) to report foreign and overseas accounts such as: Foreign Bank Accounts, Foreign Financial Accounts, Foreign Retirement Accounts, Foreign Trading Accounts, Foreign Insurance, and Foreign Income, including 8938s, FBAR, Schedule B, 5741, 3520, and more.
What is Included in the Full OVDP Submission?
The full OVDP application includes:
- Eight (8) years of Amended Tax Return filings;
- Eight (8) Years of FBAR (Foreign Bank and Account Reporting Statements);
- Penalty Computation Worksheet; and
- Various OVDP specific documents in support of the application.
Under this program, the Internal Revenue Service wants to know all of the income that was generated under these accounts that were not properly reported previously. The way the taxpayer accomplishes this is by amending tax returns for eight years.
Generally, if the taxpayer has not previously reported his accounts, then there are common forms which were probably excluded from the prior year’s tax returns and include 8938 Forms, Schedule B forms, 3520 Forms, 5471 Forms, 8621 Forms, as well as proof of filing of FBARs (Foreign Bank and Financial Account Reports).
The taxpayer is required to pay the outstanding tax liability for the eight years within the disclosure period – as well as payment of interest along with another 20% penalty on that amount (for nonpayment of tax). To give you an example, let’s pick one tax year during the compliance period. If the taxpayer owed $20,000 in taxes for year 2014, then they would also have to include in the check the amount of $4,000 to cover the 20% penalty, as well as estimated interest (which is generally averaged at about 3% per year). This must be done for each year during the compliance period.
Then there is the “FBAR/8938” Penalty. The Penalty is 27.5% (or 50% if any of the foreign accounts are held at an IRS “Bad Bank”) on the highest year’s “annual aggregate total” of unreported accounts (accounts which were previously reported are not calculated into the penalty amount).
For OVDP, the annual aggregate total is determined by adding the “maximum value” of each unreported account for each year, in each of the last 8 years. To determine what the maximum value is, the taxpayer will add up the highest balances of all of their accounts for each year. In other words, for each tax year within the compliance period, the application will locate the highest balance for each account for each year, and total up the values to determine the maximum value for each year.
Thereafter, the OVDP applicant selects the highest year’s value, and multiplies it by either 27.5%, or possibly 50% if any of the money was being held in what the IRS considers to be one of the “bad banks.” When a person is completing the penalty portion of the application, the two most important things are to breathe and remember that by entering the program, the applicant is seeking to avoid criminal prosecution!
2. Streamlined Domestic Offshore Disclosure
The Streamlined Domestic Offshore Disclosure Program is a highly cost-effective method of quickly getting you into IRS (Internal Revenue Service) or DOT (Department of Treasury) compliance.
What am I supposed to Report?
There are three main reporting aspects: (1) foreign account(s), (2) certain specified assets, and (3) foreign money. While the IRS or DOJ will most likely not be kicking in your door and arresting you on the spot for failing to report, there are significantly high penalties associated with failing to comply.
In fact, the US government has the right to penalize you upwards of $10,000 per unreported account, per year for a six-year period if you are non-willful. If you are determined to be willful, the penalties can reach 100% value of the foreign accounts, including many other fines and penalties… not the least being a criminal investigation.
Reporting Specified Foreign Assets – FATCA Form 8938
Not all foreign assets must be reported. With that said, a majority of assets do have to be reported on a form 8938. For example, if you have ownership of a foreign business interest or investment such as a limited liability share of a foreign corporation, it may not need to be reported on the FBAR but may need to be disclosed on an 8938.
The reason why you may get caught in the middle of whether it must be filed or not is due largely to the reporting thresholds of the 8938. For example, while the threshold requirements for the FBAR is when the foreign accounts exceed $10,000 in annual aggregate total – and is not impacted by marital status and country of residence – the same is not true of the 8938.
The threshold requirements for filing the 8938 will depend on whether you are married filing jointly or married filing separate/single, or whether you are considered a US resident or foreign resident.
Other Forms – Foreign Business
While the FBAR and Form 8938 are the two most common forms, please keep in mind that there are many other forms that may need to be filed based on your specific facts and circumstances. For example:
- If you are the Beneficiary of a foreign trust or receive a foreign gift, you may have to file Form 3520.
- If you are the Owner of a foreign trust, you will also have to file Form 3520-A.
- If you have certain Ownerships of a foreign corporation, you have to file Form 5471.
- And (regrettably) if you fall into the unfortunate category of owning foreign mutual funds or any other Passive Foreign Investment Companies then you will have to file Form 8621 and possibly be subject to significant tax liabilities in accordance with excess distributions.
Reporting Foreign Income
If you are considered a US tax resident (which normally means you are a US citizen, Legal Permanent Resident/Green-Card Holder or Foreign National subject to US tax under the substantial presence test), then you will be taxed on your worldwide Income.
It does not matter if you earned the money in a foreign country or if it is the type of income that is not taxed in the country of origin such as interest income in Asian countries. The fact of the matter is you are required to report this information on your US tax return and pay any differential in tax that might be due.
In other words, if you earn $100,000 USD in Japan and paid 25% tax ($25,000) in Japan, you would receive a $25,000 tax credit against your foreign earnings. Thus, if your US tax liability is less than $25,000, then you will receive a carryover to use in future years against foreign income (you do not get a refund and it cannot be used against US income). If you have to pay the exact same in the United States as you did in Japan, it would equal itself out. If you would owe more money in the United States than you paid in Japan on the earnings (a.k.a. you are in a higher tax bracket), then you have to pay the difference to the U.S. Government.
3. Streamlined Foreign Offshore Disclosure
What do you do if you reside outside of the United States and recently learned that you’re out of US tax compliance, have no idea what FATCA or FBAR means, and are under the misimpression that you are going to be arrested and hauled off to jail due to irresponsible blogging by inexperienced attorneys and accountants?
If you live overseas and qualify as a foreign resident (reside outside of the United States for at least 330 days in any one of the last three tax years or do not meet the Substantial Presence Test), you may be in for a pleasant surprise.
Even though you may be completely out of US tax and reporting compliance, you may qualify for a penalty waiver and ALL of your disclosure penalties would be waived. Thus, all you will have to do besides reporting and disclosing the information is pay any outstanding tax liability and interest, if any is due. (Your foreign tax credit may offset any US taxes and you may end up with zero penalty and zero tax liability.)
*Under the Streamlined Foreign, you also have to amend or file 3 years of tax returns (and 8938s if applicable) as well as 6 years of FBAR statements just as in the Streamlined Domestic program.
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