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June 1, 2016 - Haoshen Zhong

PFIC Look-through for Foreign Pensions

Greetings from Haoshen Zhong.

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Do I have to annually report PFICs held in a UK pension scheme?

This week’s newsletter topic came by way of a reader I will refer to as Vic:

We see a lot of UK employer funded pension schemes are heavily invested in PFICs – most UK pension schemes fall into this category. Does the US-UK income tax treaty protect the employee from annual filing requirements related to the PFIC investments?

For this newsletter, I assume that the employee is a US citizen who works in the UK, who is a resident of the UK under the US-UK income tax treaty, and who has an approved pension scheme under UK law that his employer funded for work he performed in the UK.

The PFIC annual reporting requirements

In general, if a US person owns a PFIC, he has annual reporting requirements even if he has no income from the PFIC. IRC §1298(f). The IRS has authority to adopt waivers of the reporting requirement. More details on the requirements and the waivers are found in Reg. §1.1298-1T.

Background on pensions: They are also trusts

When looking for rules that apply to pensions, it is also useful to look for rules related to trusts. This is because the US generally considers pensions to be trusts: A settlor (the employer) transfers property to a trustee (the pension manager) for the purpose of protecting it (for retirement) for a beneficiary (the employee) under rules similar to those imposed on trustees. Reg. §301.7701-4(a).

US pension rules are considered similar enough to trustee rules that US pensions and IRAs are trusts. IRC §§401(a), 408(a). The IRS generally takes the same view of foreign pensions, and this is perfectly reasonable for a UK pension: A UK pension scheme is a trust under UK law.

When pension specific rules do not exist in the Code or the Regulations, we also turn to trust rules to supplement them. The rules related to foreign trusts are found in Reg. §1.1298-1T(b)(3)(ii) and (iii).

Section 1.1298-1T(b)(3)(ii) refers to a foreign trust where a US person is treated as the owner. Section 1.1298-1T(b)(3)(iii) refers to a foreign trust where a US beneficiary is treated as the indirect owner of a PFIC owner by reason of PFIC attribution rules only. It is necessary to decide which applies to the UK pension in question.

The employee is not the owner of the pension

When tax law refers to a person as the owner of a trust, it means that the person is taxed as if he owned the assets in the trust. IRC §671. These trusts are known as grantor trusts.

In general, an employee will not be treated as the owner of an employees’ trust if employee contributions are incidental compared to employer contributions. Reg. §1.402(b)-1(b)(6). In Vic’s scenario, the pensions are employer funded, so there is no employee contribution. The employee is not the owner of the pension.

This means we do not use Reg. §1.1298-1T(b)(3)(ii). We use (iii). The result is ironic, because (ii) refers to pensions and treaties specifically, while (iii) does not mention either at all.

No specific mention of treaty interaction

Parsing through section 1.1298-1T(b)(3)(iii) tells us this: If all the following conditions are satisfied, then a US person does not have to file Form 8621 annually to report a PFIC held in a foreign trust:

  1. The US person is an indirect owner of a PFIC
  2. He is an indirect owner only because he is a beneficiary of a foreign trust that directly or indirectly owns the PFIC
  3. No special election has been made for the PFIC
  4. The US person is not treated as having received an excess distribution from the PFIC or as having a gain treated as an excess distribution from the PFIC

If all 4 conditions are met, then the US person does not have to file Form 8621.

It is very likely that the UK pension scheme has received distributions from a PFIC during any given year, has sold at least 1 PFIC for a gain during the year, or both. It is very likely that, without a treaty, the US employee would have excess distribution or gain attributed to him in any given year. This means the UK pension fails condition 4. Reg. §1.1291-1T(b)(8)(iii)(C). The result is that he would have to file Form 8621 annually.

For this newsletter, let us take it as an article of faith that the US-UK income tax treaty protects a US citizen from US taxes on the UK pension’s income until the UK pension is actually distributed. This is not true of every treaty–in fact, almost all US income tax treaties contain a “saving clause” that permits the US to tax a US citizen’s pension’s income, even when the pension has not distributed the income.

The US does not get to tax the income because of the treaty, but it is not clear whether the treaty also protects the employee from having to file information returns. The Regulations do not specifically say.

Our position: No tax means no reporting requirement

We prefer to divine IRS’s intention by reading the purpose of the law.

For this purpose, it is useful to turn back to section 1.1298-1T(b)(3)(ii) and see what the IRS said when an employee is treated as the owner of a foreign pension itself under trust rules (rather than just the owner of PFICs in the pension).

Section 1.1298-1T(b)(3)(ii) says: If all of the following conditions are satisfied, then a US person does not have to file Form 8621 annually to report a PFIC held in a foreign trust:

  1. The US person is treated as the owner of a foreign trust
  2. The foreign trust is a foreign pension fund or primarily exists to provide retirement benefits
  3. Under a treaty, the US cannot tax the pension’s income to the employee until the pension distributes the income to the employee

This does not apply directly to the employee who has an employer funded pension scheme in the UK, because he is not treated as the owner of the pension scheme. But consider this: When a person is treated as the owner of a foreign trust, he is taxed on all income from the foreign trust as if he owned the assets directly. The Regulation says that even when the US citizen is taxed on all trust assets without a treaty, if a treaty protects the US person from US taxes, then he does not need to report the PFIC in the trust annually. It would be bizarre to turn around and say that when a person is not treated as the owner of a foreign trust, then he must report the PFIC held in the trust even when the treaty protects him from US taxes.

Based on this reasoning, we prefer to say that if a treaty protects a US person from being taxed on PFICs held in his pension, he has no annual reporting requirement for PFICs in the pension.

Take this position at your own risk

The alternative way to understand the IRS intention is that section 1.1298-1T(b)(3)(ii) is simply a way to avoid duplicative reporting requirements. When a US person is treated as the owner of a foreign trust, he must either ensure that the trustee files Form 3520-A annually to report the trust’s income or file a substitute Form 3520-A himself.

Form 3520-A contains a section that report’s trust’s income under US income tax rules, which would also report PFIC income. Because the IRS expects Form 3520-A to report the information, it is not useful to also require the taxpayer to report the information on Form 8621 when the US cannot tax the income at all.

We think this interpretation is incorrect, because the IRS requires the same duplicative information reporting if there is no treaty, even when there is no income to report.

This is just how we prefer to interpret the juxtaposition of the 2 rules. The IRS has not made it clear whether our preferred interpretation is correct or incorrect. You will have to make a decision on whether to incur the cost of reporting.

Summary

There is no clear guidance on whether there is annual reporting requirements for PFICs held in a pension, when a US income tax treaty protects the employee from US tax on the pension’s income until the pension is distributed.

So it is not clear whether the US citizen with an employer funded UK pension scheme has annual reporting requirements for the PFICs in the pension.

Our practice is to not file Form 8621 annually.

Thank you

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Haoshen

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