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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.

Foreign pension and retirement plans, including self-funded plans and some employer-sponsored plans, may meet the definition of a grantor trust to the extent the foreign pension plan vehicle is a foreign trust and the individual (plan member) contributes property to the plan.  Such individual, who contributes property to a foreign trust for their own benefit, is treated as the owner of the plan under the grantor trust rules even if the individual does not retain any level of control over plan investments and distributions. See the grantor trust rules in sections 671 through 679.

As a U.S. person engaged in transactions with a foreign trust, you are responsible for filing Form 3520 to report ownership of, transfer(s) to and distribution(s) from the foreign retirement plan.  If you are treated as the owner of a foreign trust under the grantor trust rules you must ensure that the foreign trust files a Form 3520-A or must file a substitute Form 3520-A attached to your Form 3520 on behalf of the trust. 

Note: Form 3520 does not have to be filed to report the following transactions:

  • Transfers to a funded nonqualified deferred compensation arrangement described in section 402(b)
  • Transfers to a stock, bonus, pension, or profit-sharing trust that would qualify for exemption section 501(a) except for the fact that it is a trust created or organized outside the United States described in section 404(a)(4)
  • Amounts paid or accrued by an employer under a qualified foreign plan described in section 404A
  • Transfers to, ownership of, and distributions from a Canadian registered retirement savings plan (RRSP), a Canadian registered retirement income fund (RRIF), or any other Canadian retirement plan that is within the meaning of section 3 of Revenue Procedure 2014-55. See Revenue Procedure 2014-55, 2014-44 I.R.B. 753, at irs.gov/IRB/2014-44_IRB#RP-2014-55
  • Certain eligible individuals’ transfers to, ownership of, and distributions from certain tax-favored retirement trusts as described in section 5 of Revenue Procedure 2020-17. See Revenue Procedure 2020-17, 2020-12 I.R.B. 539, at irs.gov/IRB/2020-12_IRB#RP-2020-17
  • Certain eligible individuals’ transactions with, and ownership of, certain tax-favored foreign trusts that are established and operated exclusively or almost exclusively to provide pension or retirement benefits, or to provide medical, disability, or educational benefits, as described in proposed regulations under section 6048. You may rely on these proposed regulations for any tax year ending after May 8, 2024, and beginning on or before the date that final regulations are published in the Federal Register, provided you and all related persons (within the meaning of sections 267(b) and 707(b)(1)) apply the proposed regulations in their entirety and in a consistent manner for all tax years beginning with the first tax year of reliance until the applicability date of the final regulations. See Proposed Regulations section 1.6048-5 as published in the Federal Register at govinfo.gov/content/pkg/FR-2024-05-08/pdf/2024-09434.pdf

See the Instructions for Form 3520 for more detailed information regarding exclusions from reporting.

Caution: Revenue Procedure 2020-17, Revenue Procedure 2014-55, and the Proposed 6048 Regulations do not provide relief from any other required information reporting of such trusts (such as Form 8938, Statement of Specified Foreign Financial Assets and FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

Form 3520 is due on the 15th day of the 4th month following the end of the taxpayer’s tax year; for a calendar year individual this is generally the same day as the filer’s income tax return is due. Some taxpayers living and working outside the United States have until the 15th day of the 6th month to file the form. Remember to check box 1k and include the form number of the tax return to be filed if an extension of time to file has been requested. See the “When and Where to File” in the Instructions for Form 3520 for more detailed information.

Caution: A penalty applies if Form 3520 is not filed timely or if the information is incomplete or incorrect. Generally, the initial penalty is equal to the greater of $10,000 or the following (as applicable):

  • 35% of the gross value of property you transferred to the foreign trust for failure to report the creation of or transfer to the foreign trust in Part I
  • 35% of the gross value of distributions you received from the foreign trust for failure to report receipt of such distributions in Part III 

Note: Additional penalties will be imposed if the noncompliance continues. 

Caution: If a complete Form 3520 is not filed by the due date, including extensions, the time for assessment of any tax imposed with respect to any event or period to which the information required to be reported in Parts I through III of such Form 3520 relates will not expire before the date that is 3 years after the date on which the required information is reported. See section 6501(c)(8).

Form 3520-A is due by the 15th day of the 3rd month after the end of the trust’s year. If you are the owner of a foreign trust and the foreign trust fails to file Form 3520-A, you must complete a substitute Form 3520-A to the best of your ability and attach it to your Form 3520 by the due date of your Form 3520. Be sure to check the “Substitute Form 3520-A” box at the top of the Form 3520-A that is attached to your return. 

Note: Form 3520 is not eligible for e-filing; mail it and an attached substitute Form 3520-A, if applicable, to the address under “When and Where to File” in the Instructions for Form 3520.

Caution: You may be liable for a penalty equal to the greater of $10,000 or 5% of the gross value of the portion of trust assets that you are treated as owning if the trust you are treated as owning fails to file Form 3520-A and you do not submit the substitute Form 3520-A completed to the best of your ability. There are additional penalties for continuing failure to file after notice by the IRS.

Treaty benefits for pensions/annuities – general rules

As a general rule, the pension/annuity article of most income tax treaties allows for exclusive taxation of pensions or annuities under the domestic law of the country in which you are treated as a resident (as determined by the residence article). This is generally true unless a treaty provision specifically amends that treatment or provides for alternative 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 relevant payments are only taxable by the country of the payor 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 under an applicable 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 your claim for exemption from withholding pursuant to a treaty, 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 for purposes of the treaty. (Article 4 under most income tax treaties provides the definition of a resident for purposes of that treaty).

Start by applying 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 only one of the countries to the treaty under that country’s domestic law, 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 determine that 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, and you generally continue through the list until you can break the tie. Typically the order is as follows (some treaties follow a different order or do not have tiebreaker 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 a 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, in those cases, 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 by the United States.

Foreign social security pensions

Absent application of a particular treaty provision, foreign social security pensions made to a U.S. individual are generally taxed as if they were foreign pensions or foreign annuities. They are generally 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 receiving the payment is a citizen/national of the country to which government services are provided and is not a citizen or lawful permanent resident (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

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 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 U.S. 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 at issue to see what, if any, benefits are available.

References and links:

Return to: The International Tax Gap Series