Are you a US taxpayer with a foreign pension? Know your PFICs!

Posted on March 10, 2020. By Marina Hernandez

Last week I wrote a post about a new IRS Revenue Procedure that provides relief from foreign trust reporting to US participants of certain foreign pensions.

Near the end of the post I wrote the following:

Before anyone goes rushing into investing in a Pillar 3 or other individual foreign pensions, though, one final comment about PFICs. Swiss ETFs or mutual funds, and other foreign investment funds that are the typical investment vehicles used in foreign individual retirement accounts, are generally classified as PFICs for US tax purposes. PFICs are taxed punitively and have extensive filing requirements of their own, and this Rev. Proc. provides no relief from those PFIC requirements.

My comment was specifically about Pillar 3as, which are type of Swiss individual retirement accounts, but the concept applies to any non-qualified foreign pension that it is not an employees trust: If you are a US taxpayer and you have a non-qualified foreign pension that is not an employees trust, you may have a PFIC issue.

Confused? Let’s break this down.

When is a foreign pension a non-qualified pension?

I like to look at this starting from the basics. First, the pension must be foreign. If a pension is foreign, you must understand the default assumption. This is key. What is the default assumption for foreign pensions? The default assumption is that they non-qualified.

Simple. If you have a foreign pension, odds are, it’s non-qualified.

As you may have assumed, a qualified pension is better than a non-qualified pension. Why? Many reasons, but the one that matters to us today is that qualified foreign pensions don’t have to worry about PFICs.

Is qualified better than non-qualified?

You bet.

Qualified pensions have certain benefits. Certain superpowers. One of those superpowers is that their investments are not treated as PIFCs. Even if they otherwise would be PFICs. By virtue of being qualified,  the pension income is automatically treated as regular income, therefore losing its PFIC character.

To be qualified, pensions need to meet certain legal requirements. And to meet any legal requirements, the first thing you need is a law. In the case of US pensions, that law is our Internal Revenue Code, most commonly known as the Tax Code.  In the case of foreign pensions, that law is an income tax treaty between the USA and the foreign country where the pension was established.

Is your foreign pension from a country that does not have an income tax treaty with the USA? Look no further, your pension is non-qualified.

Is your pension from a country with an income tax treaty with a USA? You pension MAY be qualified. Why just MAY? Because unfortunately, many tax treaties don’t provide comprehensive pension benefits.

Examples of treaties with comprehensive pension benefits include Canada and the UK. There are others, but Canada and the UK are the most comprehensive.

Examples of treaties with limited pension benefits include, you guessed it, Switzerland… and Spain, Portugal, Mexico, Australia, and unfortunately most countries with which the US has an income tax treaty.

Conclusion: unless you have a UK, Canadian, Dutch, German or perhaps a Belgian pension, your pension is probably non-qualified. If you are not sure, you may need to ask a professional.

Can a non-qualified foreign pension be an employees trust?

Yes!

Is that a good thing?

Yes!

How come?

Because employees trusts have a similar superpower that qualified pensions have: they make PFICs disappear! If your foreign pension is an employees trust, it doesn’t matter that it is non-qualified and it doesn’t matter how it is invested. It does not matter if it has foreign mutual funds.

It. Does. Not. Matter.

Unlike qualified pensions, the income earned annually is probably taxable, but it is not taxable as PFIC income, it is taxable as plain ordinary income. And plain ordinary income is, in the vast majority of cases, taxed a lot better than PFIC income.

How can I know if my foreign pension is an employees trust?

These are three things you should consider:

  1. Your pension must have been established by your foreign employer. This automatically eliminates individual foreign pensions. If the foreign pension was opened by you, the US taxpayer, with your own money, your pension is NOT an employees trust.
  2. Your pension must be managed by your foreign employer or by a pension fund manager hired by your employer that provides this service to your employer. If you can choose the pension manager, your pension is NOT an employees trust.
  3. Your employer contributed AT LEAST half the money in your foreign pension account. You are allowed to make contributions from your salary, but 50% or more of the total contributions need to come directly from your employer. If you contributed more than 50% of the total contributions made to your foreign pension account, your pension is NOT an employees trust.

In summary, your foreign pension needs to have been established by a foreign employer, managed by it or by a pension manager selected by it, and funded mostly by your employer’s own money and not with a portion of your wages, in order to meet the requirements of an employees trust.

If you have an employees trust, you avoid the PFIC issue.

What if your pension is non-qualified and it is not an employees trust? Then we circle back to the question that got you reading this post.

What is a PFIC and why should I care?

Foreign pensions need to make the money grow for their savers, the value of the account needs to grow so there is money for you to draw from in your retirement. In order to achieve growth, foreign pensions invest their money. And because the pensions are in a foreign country, they will likely invest it in mutual funds and ETFs registered and regulated in that foreign country, ie, PFICs.

PFIC stands for Passive Foreign Investment Company: in simple terms, foreign companies that make passive investments. Passive investments include rental income, income from copyrights (unless you are the artist that generated the copyright), dividend income, capital gains from stocks, interest from bonds or mortgages, etc.

The most common types of PFICs are foreign mutual funds and foreign exchange traded funds (ETFs).

What’s the big deal with PFICs?

Each foreign mutual fund or ETF is a separate PFIC. Foreign pensions are typically invested in multiple foreign funds, so you will likely have multiple PFICs in each of your foreign pensions.

Each separate PFIC requires its own PFIC tax return, Form 8621. Yep, you will need to file a 6 page tax return per FUND in your foreign pension. Retail tax preparation software does not generally carry this form, so you can’t use it to prepare and report your PFICs. You will either need to download the forms from the IRS website and complete them manually (not recommended, the calculations are complex and chance of error extremely high!) or you will need to hire a professional to do it for you, which will NOT be inexpensive.

To top it off, PFICs are taxed punitively. There are three different ways in which PFICs can be taxed, but mostly, they are taxed under Mark to Market, or MTM rules, or the default Excess Distribution Rules. As most default taxation rules, the Excess Distribution Rules are usually the most punitive.

Punitive = you pay a lot more tax than otherwise.

What are some of the bad ways in which PFICs can be taxed?

  1. Reduced rate qualified dividend treatment is not available under the MTM and Excess Distribution rules. Dividends are always taxed at ordinary rates and potentially at the highest ordinary tax rate.
  2. Reduced long term capital gains tax rates are also not available.
  3. Under the default excess distribution rules, there is an additional interest charge on top of the highest marginal tax rate applied to the income. The effective tax rate can therefore exceed 50%!
  4. Unlike with US ETFs and mutual funds, where losses in one fund can be netted against gains in another fund and only the net gain is taxed, PFIC losses cannot be used to offset gains by a different PFIC. The loss is suspended and the gross gain is taxed in full.

Conclusion

If your foreign pension is non-qualified, it’s not an employees trust and it holds foreign investment funds, you have to deal with the PFIC rules.

Beyond the additional cost of having to prepare and file a Form 8621 tax return for each PFIC in your foreign pension, the PFIC income will typically be taxed at a much higher rate than otherwise. It could even be taxed at rates that exceed the highest marginal US tax rates when there is also a PFIC interest charge.

These extraordinary costs can eat up the income provided by the PFICs and then some, and as a result, drastically reduce the benefits of saving for retirement through a foreign pension.

My example was about Swiss Pillar 3s. Pillar 3s have similar contribution limits to traditional IRAs, therefore these accounts are rarely large. The reporting cost can be relatively very high due to the small size of the account, and can exceed multiple times over the investment income earned by the PFIC.

Swiss Pillar 3s are tax deductible in Switzerland. If the Swiss marginal tax rate is higher than the US marginal tax rate, the Pillar 3 will likely reduce the combined income taxes of the Pillar 3 participant. This situation can occur with high-income earners in Switzerland, especially after the US tax rates were lowered by the Tax Cuts and Jobs Act in 2018.

However, if the Pillar 3 investment horizon is long enough, the recurring PFIC reporting and tax cost can more than offset any tax savings provided by the Pillar 3 contribution.

The tax savings are a one-off event. The cost of PFIC reporting and their punitive taxation is a recurring annual expense.

These are just the pure tax cost considerations.

Many other considerations come into play in the decision to participate in a foreign pension, whether sponsored by an employer or not. Sometimes you may not even have a choice about it and you’ll just have to deal with US tax consequences. Do not lose sight of this and don’t let the tax tail wag the dog. There are situations when a foreign pension makes sense despite potential onerous US taxation.

Before signing off, the usual disclaimer: this is not legal tax advice intended for anyone in particular. This is general information to help you understand how to think about things. Do not rely on this information to draw any conclusions about your situation and your specific foreign pension. If you do so, understand that you are doing it at your own risk and that you may reach the wrong conclusion. 😉

Until the next post!

Marina

Are you a US taxpayer with a foreign pension?

Don’t miss this new IRS relief!

Posted on March 3, 2020. By Marina Hernandez

Dear US taxpayers with foreign pensions,

I’m normally too busy to write during tax season, but today something significant enough happened to merit an exception.

The IRS released Revenue Procedure 2020-17, which will be published in the Internal Revenue Bulletin on March 16th, and could have implications for your 2019 tax return.

By the way, if you have not started working on your 2019 tax return yet, you should!

What’s the big deal about this new Rev. Proc?

It provides relief to US participants of foreign pensions and other tax favored foreign accounts. I’m going to focus this newsletter on the relief on foreign pension reporting, which can be one of the biggest headaches for US taxpayers who are working or have worked abroad.

As you are likely already aware, the IRS generally considers foreign pensions to be foreign trusts. Foreign trusts have special reporting requirements, including Form 3520 – Annual Report to Report Transactions with Foreign Trusts and Receipts of Certain Foreign Gifts and Form 3520-A – Annual Information Return of Foreign Trust with a U.S. Owner. They may also need to be reported on the FBAR, Form FinCEN 114 and on the FATCA Form 8938 – Statement of Specified Foreign Financial Assets.

That’s a load of reporting requirements…..

To add insult to injury, penalties for reporting errors or omissions on any of these forms can be quite steep. Form 3520 and 3520-A, for example, carry failure to file penalties of the greater of $10,000 or 35% of the unreported amount…. per infraction!

These two forms are precisely the forms for which this Rev. Proc. provides relief, so that’s nice.

Let’s explore the extent of the relief, who can benefit, and how.

Who can benefit?

Any US taxpayer, such as a US Citizen, green card holder or a resident of the USA, who is a beneficiary in a foreign pension or owns a foreign retirement account can benefit from this procedure.

If you are an American who worked or works abroad, you likely have at least one foreign retirement accounts, so this will matter to you. If you are immigrant in the USA, you may also have these types of accounts.

What relief is provided?

Form 3520 and Form 3520-A are no longer required if certain conditions, reasonable in my opinion, are met.

 

 

What are those conditions?

There are several. 

One of the most important ones applies to you, the taxpayer. In order to benefit from the procedure, you are required to be a compliant taxpayer. This means that you must have fully reported and paid taxes, when relevant, on your contributions, distributions, and income earned in or from your foreign pensions or foreign retirement accounts. If you are not sure if you have reported this correctly, you may need to consult a qualified tax professional.

Another important requirement is with respect to the pension or retirement account itself. There are contribution limitations and other conditions. The contribution limitations are $50,000/year or $1,000,000 per lifetime. Other conditions include that the pension is set up under the laws of a foreign country to provide tax advantaged retirement savings to its domestic workers, that the amounts contributed are known and based on earnings from personal services, that distributions are allowed at retirement or due to death or disability, etc.

It would be too lengthy to list all the conditions, but other than the contribution limitations, which may be an issue in countries with generous employer pensions and strong currencies, most foreign retirement accounts and pensions should qualify.

What about FBAR and FATCA reporting?

I’m afraid those requirements still apply. Form FinCEN 114 and Form 8938 are not impacted by this Rev. Proc., just Forms 3520 and 3520-A. Please do not forget to file your FBAR and Form 8938 if you meet the filing thresholds!

The FBAR are Form 8938 may not be nearly as complex and daunting to prepare as Forms 3520 and 3520-A, but the failure to file penalties are still quite high.

Is that all?

No, there’s more.

Some of you may have been imposed penalties for failure to file Form 3520 or 3520-A to report contributions, distributions or income from foreign pensions. There has been a recent spike in the assessment of these penalties, which created a lot of ruckus in the tax professional community, which is likely to have influenced the decision of the IRS to provide this relief.

If you have been unfortunate enough to have been assessed these penalties, and the pensions in question meet the relevant criteria, plus the statute of limitations for refund on the relevant returns is still open, you can request abatement or refund of those penalties.

You can do this by filing Form 843 – Claim for Refund and Request for Abatement, indicating on the form that relief is requested pursuant to Rev. Proc. 2020-17 and mailing the form to the IRS in Ogden, UT 84201-0027. With penalties so high for trust reporting issues, a lot of money could be at stake for you.

 

Final considerations

Many foreign employer pensions qualify as Employees Trusts, which are special kinds of trusts under US tax law. Foreign pensions that qualify as Employees Trusts were already exempted from Form 3520 reporting under Treasury Regulations or prior IRS guidance.

Describing in detail when a foreign pension qualifies as an Employees Trusts exceeds the scope of this newsletter, but an example I’m very familiar with, because I work with many US taxpayers with Swiss ties, are Swiss Pillar 2 occupational pensions.

Pillar 2s are employer pensions that would most resemble 401ks in the USA, although they have significant differences. US Swiss Pillar 2s generally qualify as Employees Trusts, if the participant has not made significant buy-ins into their Pillar 2 accounts. Form 3520 or 3520-A reporting was therefore already not required for most Swiss Pillar 2 participants, so this Rev. Proc. isn’t likely to changed much for them.

With respect Pillar 3a owners, though, this is different. Pillar 3as are a type of individual retirement account in Switzerland that resembles a Traditional IRA in the USA. Many other foreign countries offer individual retirement accounts that can resemble Swiss Pillar 3s or US IRAs.

It is quite likely that the IRS considers Pillar 3as foreign grantor trusts, which normally requires Form 3520-A, and potentially Form 3520, to be filed annually. There was no specific guidance about this potential requirement until now. There was therefore a risk that having a Pillar 3a and not filing Form 3520 and 3520-A annually could eventually cause a big headache with the IRS. Thanks to this Rev. Proc., this concern is now gone.

Pillar 3as should easily meet all the relevant requirements to be exempt from reporting under the Rev. Proc, and this merits a small celebration. Woo hoo!

Before anyone goes rushing into investing in a Pillar 3 or other individual foreign pensions, though, one final comment about PFICs. Swiss ETFs or mutual funds, and other foreign investment funds that are the typical investment vehicles used in foreign individual retirement accounts, are generally classified as PFICs for US tax purposes. PFICs are taxed punitively and have extensive filing requirements of their own, and this Rev. Proc. provides no relief from those PFIC requirements.

Even if Form 3520 and 3520-A are no longer required for many foreign individual retirement accounts, don’t forget about reporting the PFICs that they may hold. This should be a topic for another discussion! I will leave it here for now.

As a final note, I must remind you that the purpose of this letter is to inform you about tax law changes and new IRS guidance, and not to provide tax advice specifically for you. Your individual facts and circumstances impact how laws, regulations and revenue procedures apply to your situation. How this guidance applies to your case, which I am not familiar with, is for you or your tax advisor to determine.

I hope you found the letter informative. Please share it with your advisor, colleagues, friends or anyone who you believe may find it helpful.

Until next time!

Marina