402(b) Foreign Pension Plans & the IRS

402(b) Foreign Pension Plan & U.S. Tax: In general, two of the more complex aspects of IRS international tax law are trusts and foreign pensions. When it comes to foreign pensions, the analysis is complicated for many reasons. Namely, most foreign countries do not have an identical Pillar 1 social security system similar to the United States.

Rather, most countries have individual accounts and/or a multi-tier pension system, which is a hybrid of pension and social security.

Therefore, even if the intended goal of the foreign pension is to provide social assistance – as with many of the foreign provident funds – the IRS views them as foreign pension accounts.

The resulting tax treatment and reporting can be very onerous.

We will summarize 402(b) Foreign Pension Plan & U.S. Tax

402(b) Foreign Pension Plan & U.S. Tax

402(b) Foreign Pension Plan & U.S. Tax

Foreign Pension Employment Trusts

Presuming foreign pensions are “trusts,” which by definition they would be, the next issue is to determine how the trust is taxed, since a foreign trust is not be per se “qualified” under 401/402.

IRC 401 and 402

IRC 401 and 402 describe employment trusts. A common employment trust is a 401K

IRC 401 (a) Requirements for qualification

“A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section—”

Explanation: This section explains that in order to become a qualified trust for bonus, pension, and profit sharing, it must meet the requirements contained in the subsections. A common example of a private employer 401, is the 401 (k) in which tax on the pre-tax contributions and growth within the fund is tax-deferred until distribution.

401(k) Cash or deferred arrangements

“Cash or deferred arrangements

(1)General rule

A profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan shall not be considered as not satisfying the requirements of subsection (a) merely because the plan includes a qualified cash or deferred arrangement.

IRC 402 (a) Taxability of Beneficiary of Employees’ Trust

“Except as otherwise provided in this section, any amount actually distributed to any distributee by any employees’ trust described in section 401(a) which is exempt from tax under section 501(a) shall be taxable to the distributee, in the taxable year of the distributee in which distributed, under section 72 (relating to annuities).”

Explanation: When a trust is qualified, it is exempted from tax on the contributions and the growth. If the trust is not qualified, it fails the 402(a) test and then falls prey to 402(b).

IRC 402(b) Taxability of Beneficiary of Nonexempt Trust

“(1) Contributions

Contributions to an employees’ trust made by an employer during a taxable year of the employer which ends with or within a taxable year of the trust for which the trust is not exempt from tax under section 501(a) shall be included in the gross income of the employee in accordance with section 83 (relating to property transferred in connection with performance of services), except that the value of the employee’s interest in the trust shall be substituted for the fair market value of the property for purposes of applying such section.

(2) Distributions

The amount actually distributed or made available to any distributee by any trust described in paragraph (1) shall be taxable to the distributee, in the taxable year in which so distributed or made available, under section 72 (relating to annuities), except that distributions of income of such trust before the annuity starting date (as defined in section 72(c)(4)) shall be included in the gross income of the employee without regard to section 72(e)(5) (relating to amounts not received as annuities).

(3) Grantor trusts

A beneficiary of any trust described in paragraph (1) shall not be considered the owner of any portion of such trust under subpart E of part I of subchapter J (relating to grantors and others treated as substantial owners).”

Explanation: When a trust is not exempt, the contributions, distributions and “amounts available” are subject to tax. 

Summary of 401/402 Employment Trusts

If a trust qualifies under 401, then it will receive tax deferred treatment under 402(a)/501.

402 (a): Exempt Trust

  • The Beneficiary (employee) of an exempt trust is not taxed on pre-tax contributions or growth within the fund. Rather, the Beneficiary is taxed on the income in the year of distribution.

If it is not qualified, then the Beneficiary does not receive “exempt” treatment.

402 (b): Non-Exempt trust

  • Contributions are includable in the Employees income in the year contributed.
  • Growth (made available) is taxed in year it is made available
  • Distributions are taxed when distributed.

If a trust is not exempt, then contributions and available growth (along with any distributions) do not receive tax deferred treatment.

Can a Foreign Pension be “Qualified”?

Yes.

402(d) Taxability of Beneficiary of Certain Foreign Situs Trusts

“For purposes of subsections (a), (b), and (c), a stock bonus, pension, or profit-sharing trust which would qualify for exemption from tax under section 501(a) except for the fact that it is a trust created or organized outside the United States shall be treated as if it were a trust exempt from tax under section 501(a).”

Explanation: If a foreign employment trust would qualify under 401/501, it is not disqualified solely because it is “organized” outside of the U.S.

Analysis of Foreign Pension and 401, 402 and 501

Our analysis of Foreign Pension employment trusts:

Is a Foreign Pension a Trust?

Yes.

Foreign Pensions are Trusts.

Since the pension plans are developed through an Employer (Trustor) and managed by an Administrator (Trustee) on behalf of the Employee (Beneficiary), they are by default, a trust.

Potential Tax Consequences of Foreign Pension

Depending on how the Trust is categorized, there are a few potential outcomes:

  1. Social Security and non-taxable under the Treaty
  2. Foreign Trust but qualified so not taxed on contributions or growth
  3. Foreign Trusts not qualified. Taxed on Contributions and possible growth (aka “what is made available.”) Treaties may alter the tax outcome
  4. Foreign Trusts not qualified: treaty or rev prov. 2020-17 and issue of +50%

Treatment as Social Security Instead of Pension

Social Security is a government mandated and operated type of social assistance.

The World Bank describes Pillar 1 as:

“Public (government) pension (social security) schemes to provide for basic needs; contributory, redistributive, and typically financed on a pay-as-you-go basis”

If the foreign retirement is actually public social security then the foreign trust rules would not apply.

Social security would be the preferred treatment, especially with treaty countries. This is because most tax treaties exempt the non-sourced country of residence of the beneficiary from taxing the taxpayer on the social security, even if the taxpayer is a resident of the “other” country.

For example, A person of country A, who receives public social security in country A but resides in Country B is only taxed (if at all) in country A.

Generally, this is not the case for foreign pensions.

Most foreign pensions straddle between Pillar 2 and Pillar 3 instead of Pillar 1.

Here are some examples which are generally treated as Foreign Pension:

Qualified Foreign Trust 

In order to qualify for all the bells and whistles of a 401 plan, the trust must be “qualified,” and meet the requirements of 26 U.S. Code §401.

Foreign Employment Trusts

Even though IRC 401 requires trust to be created in the U.S, there is an exception:

402(d) Taxability of Beneficiary of Certain Foreign Situs Trusts

“For purposes of subsections (a), (b), and (c), a stock bonus, pension, or profit-sharing trust which would qualify for exemption from tax under section 501(a) except for the fact that it is a trust created or organized outside the United States shall be treated as if it were a trust exempt from tax under section 501(a).”

Is this feasible?

Usually, not.

The code section explains that if the Trust is the type of 401 trust that would qualify for exemption under 501, then it is not per se disqualified. But, the foreign trust must meet all the requirements of the U.S. 401/501 protocols.

Therefore, presuming the foreign trust does not qualify (if for no other reason than because the trust has not completed any of the proper certification requirements), the next step is to presume it is not a qualified trust, and therefore move on to Form 402(b).

Non-Qualified Foreign Trust  

Presuming the foreign trust is not qualified and therefore non-exempt, the analysis will oftentimes be determined by whether or not there is a tax treaty in place.

Non-Exempt & No Tax Treaty

When the trust is non-exempt, the key issues involve the taxation of the contributions, growth and distributions.

(1) Contributions

“Contributions to an employees’ trust made by an employer during a taxable year of the employer which ends with or within a taxable year of the trust for which the trust is not exempt from tax under section 501(a) shall be included in the gross income of the employee in accordance with section 83 (relating to property transferred in connection with performance of services), except that the value of the employee’s interest in the trust shall be substituted for the fair market value of the property for purposes of applying such section.”

What does this Mean?

This means that contributions made to a non-exempt employment trust are not exempted.

Why?

Because since the trust is not qualified under 401, it does not enjoy the deferred tax treatment of 402(a).

As a result, the contributions made to the trust are taxable when they are contributed.

Therefore, even if your foreign pension acts like a 401K, and may even have stricter requirements in the foreign country, this alone does not mean the contributions receive tax deferred treatment.

As a result, Pre-Tax Contributions made by the Employer are not exempt.

(2) Distributions

“The amount actually distributed or made available to any distributee by any trust described in paragraph (1) shall be taxable to the distributee, in the taxable year in which so distributed or made available, under section 72 (relating to annuities), except that distributions of income of such trust before the annuity starting date (as defined in section 72(c)(4)) shall be included in the gross income of the employee without regard to section 72(e)(5) (relating to amounts not received as annuities).”

This is where it gets more complicated.

When it comes to distributions, that is straightforward (relatively speaking).  If you have a foreign retirement plan and receive distributions, then the distributions are taxed when distributed.

What is considered made available?

Generally, with a foreign retirement, the amount is made available when retirement is reached, or disability. But with many Provident Funds for example, availability is also reached if the person is no longer a citizen or permanent resident of the country — such as with a CPF and Singapore.

Conversely, with a 401K, just giving up residence and moving overseas does not entitle a person to a full payout without penalty.

As a result, with many foreign employment trusts, the IRS can take the position that the amount is available when accrued, and no deferral treatment is provided.

In other words, just because the taxpayer may be “penalized” when they withdraw early, does not mean the money in the pension has not “vested” and “available”

Result: The accrued non-distributed growth may be taxed, since technically it is vested (presuming it is vested), and “available.”

Stated another way: Under 402(a) an exempt trust avoids tax on the growth, and is only taxed at distribution – subject to RMD.  But, under 402(b), it would presume that a non-exempt trust does not receive tax exemption status once it has vested within the fund, and the growth (pre-distribution amount) may be taxable, depending on the definition of the term “available.”

Treaty Country & Non-Exempt Trust

When an international tax treaty is involved, it can change the outcome of certain taxation rules.

Generally, the going theme is that with treaty countries, an employment trust is not taxed on the growth — and is only taxed when it is distributed.

Therefore, if United States is entered into a treaty with a country that includes reference to pension, and makes reference tax rules for taxation at distribution, most practitioners take the position that the money has to be actually distributed before the country of residence (absent some exception) can tax the income.

This generally does not cover contributions, but some treaties do have exceptions.

For example, the US/UK tax treaty has a very robust section on the issue of pensions. And, as long as certain prerequisites are met, then a US person that works in the United Kingdom, and  who is contributing to  an employment trust in the UK can deduct those contributions to the UK employment trust on their US tax return (Vice versa for a UK person residing in the US).

Result: If a foreign trust is not qualified, employees are taxed on Contributions and possible growth (aka “what is made available”) but a treaty may alter the tax outcome.

Reporting Foreign Trusts

An Employment Trust is generally reported on an FBAR and Form 8938. Sometimes, it may also require a Form 8621 (PFIC).

Generally, a grantor trust is reported on the Form 3520 and 3520-A.

Since an employment trust (even non-exempt) would not necessarily qualify as a grantor trust (since there is not a U.S. Owner of the trust) this may not be necessary – unless the employee becomes an owner of the trust.

As provided in the Form 3520-A Instructions:

“Purpose of Form

Form 3520-A is the annual information return of a foreign trust with at least one U.S. owner. The form provides information about the foreign trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust under the grantor trust rules (sections 671 through 679).

Who Must File A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements under section 6048(b).

Each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules (sections 671 through 679) is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.”

Some practitioners will always include a foreign pension on these two forms, but that may be a bit of an overkill.

Even the IRS agreed (sort of) and issued Revenue Procedure 2020-17, which limits reporting for certain retirement and non-retirement tax deferred trusts.

Grantor Trust instead of Employment Trust

When a trust is actually a grantor trust and not an employment trust, it can get even more complicated.

Generally, the owner of a grantor trust reports as income the portion attributed to their ownership in the trust and files a Form 3520-A.

So, if an employment trust is transmuted into a grantor trust (or otherwise deemed a grantor trust), there would be significant tax consequences.

HCE (Highly Compensated Earners)

HCE refers to Highly Compensated Employees.

In most situations, the HCE rules apply to a trust which fails the non-discriminatory trust test. This can add some complication to the foreign trust analysis.

Feasibly, if a foreign trust was qualified under 401 or if the trust was non-discriminatory and the funds were not made “available,” then the growth within the employment trust may avoid tax until actually available or distributed.

But, if the trust is (or becomes) discriminatory, then the HCEs would lose their tax-deferral status — and pay income tax on the gain each year.

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