The Taxation of Foreign Pension and Annuity Distributions

 

International Tax Gap Series

A foreign pension or annuity distribution is a payment from a pension plan or retirement annuity received from a source outside the United States. You might receive it from a:

  • foreign employer
  • trust established by a foreign employer
  • foreign government or one of its agencies (including a foreign social security pension)
  • foreign insurance company
  • foreign trust or other foreign entity designated to pay the annuity

Just as with domestic pensions or annuities, the taxable amount generally is the Gross Distribution minus the Cost (investment in the contract). Income received from foreign pensions or annuities may be fully or partly taxable, even if you do not receive a Form 1099 or other similar document reporting the amount of the income.

Treaty Benefits for Pensions/Annuities – General Rule

As a general rule, the pension/annuity article of most income tax treaties allow for exclusive taxation of pensions or annuities under the domestic law of the resident country (as determined by the residence article). This is generally true unless a treaty provision specifically amends that treatment. For example, some treaties provide that the country of residence may not tax amounts that would not have been taxable by the other country if you were a resident of that country. There also may be special rules for lump-sum distributions.

With respect to government pensions/public pensions/annuities (typically covered under the Government Service article) or social security payments, generally the payments are only taxable by the country in which the government is making the payments. Note that what constitutes a government pension or public pension is dictated by the treaty, and the rule may apply narrowly.

If you reside in a foreign country and receive a pension/annuity paid by a U.S. payor, you may claim an exemption from withholding of U.S. Federal Income Tax (FIT) under a tax treaty by completing Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting , and delivering it to the U.S. payor. You must report your U.S. Taxpayer Identification Number (TIN) on Form W-8BEN for it to be valid for treaty purposes.

If you live in the United States and receive a pension/annuity paid by a foreign payor, you must claim the appropriate treaty withholding exemption on the form, and in the manner specified by the foreign government. If the foreign government, and/or the foreign withholding agent, refuses to honor the treaty claim, make the treaty claim on your income tax return, or other prescribed form, filed with the foreign country. Additionally, you may be able to claim a Foreign Tax Credit on your U.S. federal individual income tax return for any foreign income tax withheld from your foreign pension or annuity. Be aware that a Foreign Tax Credit generally would not be permitted for tax withheld that is in excess of the liability under foreign law, taking into consideration applicable income tax treaties.

Always ensure you read each treaty's relevant articles in their entirety as there may be special provisions which affect the taxability of your income. In addition, ensure that you read any Protocols (amendments) to the treaty as they may revise the relevant articles of the treaty and affect your eligibility for benefits or the taxability of your income. The Technical Explanation accompanying the treaty may also provide insight, in particular, with respect to what meets the treaty's definition of a pension, public pension, or a pension paid in connection with government service. You need to look at each treaty carefully as benefits vary from treaty to treaty – just because one treaty allows a certain treatment does not mean another treaty will allow the same treatment.

Tax Treaty Residency Issues

When determining whether you are eligible for benefits under a tax treaty, you will need to identify your tax residency. (Article 4 under most treaties) provides the definition of a resident.

Apply the domestic law of each country to identify your residency, IRC § 7701(b) in the case of the United States (see Chapter 1 of Publication 519, U.S. Tax Guide for Aliens , for the Green Card Test , Substantial Presence Test , or First Year Choice). Your residency determines how the treaty article on pensions/annuities will be applied.

If you determine you are a resident of one of the countries to the treaty, then you should refer to the benefits provided under the relevant treaty article dealing with pensions, annuities, government service, or social security payments.

If, after applying the domestic law of each country, you are a resident of both countries (i.e., a dual resident), you may determine a single country of residence by applying the Tiebreaker Rules (Article 4 under most treaties). The rules are applied in the order in which they appear in the treaty, typically as follows (some treaties follow a different order or do not have all these rules):

  • In which country do you have a Permanent Home available to you?
  • With which country do you have closer personal and economic relations?
  • In which country do you have an Habitual Abode?
  • Of which country are you a Citizen/National?

If any of the above rules results in the determination of a single country of residency, then there is no need to continue with the remaining rules. On the other hand, if none of the above rules results in a single country of residency, then residency should be decided by the Competent Authorities of each country upon request by the taxpayer. Refer to Competent Authority Assistance for information on how to make a competent authority assistance request. Note that some treaties do not provide tiebreaker rules for determining the residency status of dual residents and you must request Competent Authority assistance to make a determination.

Treaty Benefits and the "Saving Clause"

If you are a U.S. citizen or resident, in addition to the requirements set forth in the relevant treaty article, you will also need to consider the so-called "saving clause" (typically found in Article 1). The saving clause preserves the right of the United States to tax its citizens and residents (subject to certain exceptions) on their worldwide income, as provided under U.S. law, as if there were no treaty. If there is no exception to the saving clause for the relevant Pension/Annuity article and paragraph, then as a U.S. citizen or resident, your distribution would be taxable in the United States.

Foreign Social Security Pensions

Absent application of a particular treaty provision, foreign social security pensions are generally taxed as if they were foreign pensions or foreign annuities. They are not eligible for exclusion from taxable income the way a U.S. social security pension might be, unless a tax treaty provides for an exclusion.

Most income tax treaties have special rules for social security payments. Generally, U.S. treaties provide that social security payments are taxable by the country making the payments. However, a foreign social security payment may also be taxable in the United States if you are a U.S. citizen or resident, as a result of the saving clause. And remember, not all treaties have the same provisions for foreign social security pensions, so always refer to the specific treaty at issue.

Foreign Government Pensions

Income tax treaties may also contain special rules for pensions paid in respect of government service (typically found under the Government Service article). Many U.S. tax treaties provide that a pension received for government services will only be taxable by the payor country if the person is a citizen/national of the country to which government services are provided and is not a citizen or green card holder in the country where the services were performed. Benefits with respect to government pensions may vary from this treatment, so you should refer to the specific treaty at issue for deviations. In addition, it is important to remember that foreign government pensions received by a U.S. citizen or resident may be subject to the saving clause.

Foreign Employer Contributions

If you worked abroad, your Cost might include amounts contributed by your employer that were not includible in your gross income. This applies to contributions made either:

  • before 1963 by your employer for that work,
  • after 1962 by your employer for that work if you performed the services under a plan that existed on March 12, 1962, or
  • after 1996 by your employer on your behalf if you were a foreign missionary (a duly ordained, commissioned, or licensed minister of a church or a lay person).

Foreign Contributions While a Nonresident Alien

Your contributions and your employer's contributions are not part of your Cost if the contribution was based on compensation for services performed outside the United States while you were a nonresident alien and not subject to income tax under the laws of the United States or any foreign country (but only if the contribution would have been taxable if paid as cash compensation when the services were performed).

Treaty Benefits for Pension Contributions

There are relatively few U.S. treaties which provide benefits for cross border pension contributions (typically found under the Pension Schemes articles). Benefits may allow a U.S. citizen that is a resident in a foreign country to obtain favorable tax treatment in the foreign country for contributions made to a U.S. pension plan or may allow a U.S. citizen that is a resident in a foreign country to obtain favorable tax treatment in the U.S. for a contribution made to a foreign pension plan. Since the benefits are limited with respect to pension fund contributions, you should always refer to the specific treaty as issue to see what, if any, benefits are available.

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The International Tax Gap Series