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By Thomas St.G. Bissell
In a previous commentary on the requirement in the §6038D regulations that U.S. individuals report interests in foreign deferred compensation plans and foreign pension plans, this author commented that there appeared to be no statutory basis for requiring foreign deferred compensation plans to be reported, but that the statute does seem to give the IRS authority to require reporting of foreign pension plans - at least where the plan is maintained by an "entity" that is juridically separate from the foreign employer, and not a "book reserve" plan that is merely maintained on the books of the employer.1 This commentary questions in more detail the propriety of requiring foreign pension plans to be reported on Form 8938, even though in most cases the IRS seems to have authority to require this. A future commentary will discuss some of the practical problems in reporting foreign pension plans.
Neither the regulations nor the Instructions to Form 8938 clarify what is a "foreign deferred compensation plan" and what is a "foreign pension plan." Clearly, there is overlap between these two terms,2 but because both are required to be reported, distinguishing between the two will usually not matter in practice. This commentary will use the term "foreign pension plan" in its colloquial sense, to mean a plan that is primarily intended to provide cash benefits to an employee following his "retirement" and that is tax-qualified in some manner under foreign law.
Generally speaking, foreign pension plans can be classified into the following four types:
(1) Self-directed plans that are funded entirely by an employee without involvement on the part of his employer, or by a self-employed individual. Comparable U.S. plans are Individual Retirement Accounts (IRAs) and Keogh plans. Similar plans under foreign law are Canadian "RRSPs," U.K. "personal pension plans," and Swiss "third pillar" plans.
(2) "Defined contribution" (DC) plans that have no actuarial component, and that are funded with contributions from the employer, or from the employee, or both. Comparable plans are U.S. profit-sharing plans, U.S. "money purchase" plans, and 401(k) plans.
(3) "Defined benefit" (DB) plans that have actuarially determined benefits for an employee's retirement, often funded only with employer contributions.
(4) Unfunded "top-up" plans that may supplement an employer's tax-qualified DC and/or DB plans, but which because of funding limitations under the applicable tax law are maintained only on the books of the employer with no plan assets protected from creditors. It is quite common for U.S. companies to maintain these plans for their senior executives.
Because it is extremely rare for a foreign pension plan to qualify for tax-exemption under §§401 ff. of the Code, participation in a foreign pension plan by a U.S. citizen or resident alien (i.e., by an individual who is potentially required to file Form 8938) where benefits vest annually often requires an inclusion in the individual's gross income for U.S. income tax purposes, even though no distributions have been received from the plan. Thus, self-directed plans are typically classified as "grantor trusts" under §§671 ff., resulting in current taxation of income that is realized annually by the plan. If a foreign employer makes current contributions to either a DC or DB plan, the U.S. individual's vested allocable portion may be taxed currently under §402(b)(1) even if the plan is not a grantor trust for U.S. purposes. In addition, if the foreign plan does not meet certain anti-discrimination requirements in the Code (i.e., it is a so-called "top-heavy" plan), a "mark-to-market" rule can apply under §402(b)(4) for highly compensated employees so as to tax the U.S. individual on both the realized and unrealized increase in the value of his account. However, an individual's interest in an unfunded "top-up" plan should not be taxed currently, unless the plan runs afoul of the rules of either §409A or §457A.
If a U.S. individual receives distributions from a foreign plan, §402(b)(2) provides that the annuity rules of §72 are applied in calculating his gross income. To the extent that an individual's account in a foreign plan has already been taxed under the rules described above, therefore, that portion of a distribution would be a tax-free return of capital.
Notwithstanding the rules in the Code that can tax undistributed income in a foreign plan currently, Article 18 of the U.S. Treasury's "model" income tax treaty contains a broad U.S. tax exemption for U.S. residents (as defined for purposes of the treaty) who participate in a pension plan based in the treaty country and who do not receive current distributions from the plan. These rules have been included in a number of treaties in recent years.
It is unclear to what extent the various IRS international reporting forms that have been in existence prior to the issuance of Form 8938 also require a U.S. individual to report on the above plans, whether or not he is required to include an amount relating to the plan in gross income. Where a self-directed foreign plan is classified as a foreign grantor trust, the U.S. individual is required to furnish detailed information about the plan annually on Form 3520-A; the only exception is for certain Canadian plans, if the individual elects to defer income from the plan under the U.S.-Canada Income Tax Treaty by filing IRS Form 8891. However, if a U.S. individual realizes gross income under §402(b)(1) (for current employer contributions) or 404(b)(4) (mark-to-market rule for foreign "top-heavy" plans), Form 3520 (reporting on transactions with foreign trusts) is not required to be filed.3 However, if the U.S. individual receives distributions from a foreign plan, reporting on Form 3520 may be required, although the IRS instructions to the form provide a confusing exception for distributions of "compensation."4 In any event, the fact that participation in a foreign pension plan may have to be reported on a different IRS form does not excuse the individual from filing Form 8938, if the relevant monetary threshold is met, but only from reporting information about the plan on Form 8938 itself.
Because participation by a U.S. individual in a foreign pension plan that is both vested and "funded" typically results in U.S. income taxation in one or more years before actual distributions are received (unless a treaty exemption applies), it could be argued that requiring the individual to report his participation in the plan on Form 8938 might encourage him to report amounts that are taxable under the Code but that he might not otherwise report on Form 1040 - often out of ignorance of the U.S. tax rules or lack of available data. Certainly if a U.S. individual who meets the §6038D monetary threshold knows that he must provide information on Form 8938 on his participation in foreign pension plans (as well as information on other "specified foreign financial assets" (SFFAs)), he is much more likely to seek tax advice on whether income related to the plan must also be include in his gross income. In this regard, it should be stressed that the U.S. income tax rules relating to foreign pension plans (primarily §§671 ff. and 402(b)) are not well understood by many tax professionals, and it has only been in recent years that international tax specialists have begun to discuss these rules widely with international executives for whom they prepare U.S. tax returns. Indeed, the principal reason why §6038D was enacted was to encourage U.S. individuals with non-U.S. financial accounts and non-U.S. securities to report income from those items on their Form 1040 where, for whatever reason, income had not been reported in the past. Thus, there may in fact be a valid "policy" reason for treating foreign pension plans as SFFAs as well, even though that was apparently not intended by Congress, and most U.S. international tax advisors were stunned when the IRS decided to include them.
In view of the above, therefore, a much more equitable rule might be for the IRS to require foreign pension plans to be reported on Form 8938, but to exempt from reporting: (1) any plans that do not give rise to current gross income (whether under the Code or under a treaty); and (2) any plans that do give rise to current gross income, but where all such income was reported on the return.
Such an exception would in effect limit the reporting of foreign pension plans on Form 8938 to "protective" filings, where the individual may not be certain that the income (if any) that was reported on his return was calculated correctly. An exception of this type is similar to the exception from the "FBAR" penalty for foreign financial accounts that are not reported on Treasury Form TD 90-22.1, but where the relevant income has been reported on the individual's Form 1040.5 It must be conceded that there is no similar rule that excuses a U.S. individual from reporting foreign securities and foreign brokerage accounts on Form 8938 where it is shown that all of the income from the SFFAs (primarily dividends, interest, and capital gains) was reported on the return (although including such an exception in the regulations may also be appropriate in view of the tax policy behind the enactment of §6038D). Given the absence of supportive legislative history and the often arcane U.S. income tax rules that relate to foreign pension plans, however, a set of rules along these lines definitely would be appropriate.6
An additional "policy" reason for granting the exemption just suggested is that there are no doubt thousands of middle-level executives from foreign countries who are transferred each year to work temporarily in the United States, and whose only substantial SFFA is their account in their foreign employer's pension plan. If the value of their account (together with their other SFFAs, if any) exceeds the relevant monetary threshold of §6038D (usually $50,000, or $100,000 for joint return filers), their temporary "resident alien" status requires them to file Form 8938. It seems especially egregious to expose those individuals to the $10,000 penalty for failure to file Form 8938 if any income from the plan that is currently taxable under §402(b) is either reported on the individual's Form 1040, or is exempt from U.S. tax under an income tax treaty.
This commentary also will appear in the September 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Blum, Canale, Hester, and O'Connor, 947 T.M., Reporting Requirements Under the Code for International Transactions, and in Tax Practice Series, see ¶7170, U.S. International Withholding and Reporting Requirements.
1 See "Form 8938 and the Requirement to Report Foreign Deferred Compensation and Foreign Pension Plans," 41 Tax Mgmt. Int'l. J. 193 (4/13/12).
2 Indeed, most foreign pension plans can probably be included within the term "deferred compensation plans." See §§404A and 409A.
3 Section 6048(a)(3)(B)(ii) exempts from reporting on Form 3520 contributions to foreign trusts that are covered by §402(b). However, this exception does not apply to distributions from a foreign trust described in §402(b). See §6048(c).
4 The instructions provide for a reporting exception for "distributions from foreign trusts that are taxable as compensation for services rendered (within the meaning of §672(f)(2)(B) and its regulations), so long as the recipient reports the distribution as compensation income on its applicable federal income tax return." However, in most cases a distribution from a foreign pension plan that is taxable under §402(b)(2) will include not only "compensation," but also accrued investment income. Section 672(f)(2)(B) and the underlying regulations (Regs. §1.672(f)-3(c)) do not clarify the issue.
5 See also the instructions to Form 3520, cited above, which provide for an exception from reporting the distribution of compensation from a foreign trust on Form 3520 if the distribution is reported on the individual's Form 1040.
6 If the IRS were to adopt the rules that are proposed in this commentary, it would be difficult to avoid also applying them to the rules that require a U.S. individual to report an interest in a foreign deferred compensation plan. As noted in a previous commentary, however, this author can find no statutory basis for requiring reporting of foreign deferred compensation plans that are maintained only on the books of the foreign employer itself. Even if there were such a basis, the arguments in favor of only requiring reporting of plans that give rise to current gross income that was not reported on Form 1040 as required are equally compelling with respect to foreign deferred compensation plans, because such plans almost never give rise to gross income for U.S. tax purposes until actual cash distributions are made from the plans.
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