Greetings from Haoshen Zhong.
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This week’s newsletter is a question we get frequently:
I have a US citizen client who is living and working in country X. Country X has an income tax treaty with the US. The employer provides a retirement plan where the employee contributes, and the employer matches some percent of the employee contributions. The retirement plan invests in a foreign mutual fund. If the retirement plan has income from the mutual fund, does the employee have to report the income as income from a PFIC?
Our last 2 posts addressed 2 scenarios where the plan was established in Hong Kong, a jurisdiction that does not have an income tax treaty with the US (the US-China income tax treaty does not apply to Hong Kong, because Hong Kong is not subject to the PRC’s tax law. See US-China income tax treaty, art. 3.1(a)). Today’s post looks at what happens when the retirement plan is established in a treaty country.
A passive foreign investment company (PFIC) is a foreign corporation where 75% or more of its income is passive income, or 50% or more of its assets are assets that produce passive income. IRC §1297(a). These are known as the income test and the asset test.
Some mutual funds are not organized as corporations, but they are nevertheless classified as foreign corporations. I addressed this in a previous post in the context of unit trusts, but the reasoning is generally true: Mutual funds are organized for investment purposes, so they are business entities. When they are organized outside the US, they are foreign business entities. They are usually organized so that the investors do not have personal liability for the debts of the mutual fund, so they are by default foreign corporations for US tax law.
Passive income includes income such as dividends, interest, rent, royalties, and gains from the sale of property that produce dividends, interests, etc. IRC §§1297(b), 954(c). Mutual funds’ income consists almost entirely of dividends, interest, and gains, and their assets produce these types of income.
Because mutual funds are foreign corporations that receive almost all passive income and hold almost all passive assets, they are PFICs.
If you look at the Code sections that provide for US based retirement arrangements (§§401, 402, 408, 408A), you will see that the sections refer to qualified retirement plans–401(k)s, IRAs, etc–as trusts. See IRC §§401(a), 402(b), 408(a), 408A.
We tend to not think of our retirement plans as trusts but the classification is not surprising when you consider how a trust is defined under tax law: A grantor (the employer, employee, or both) gives property (cash for retirement funds) to a trustee (the account manager) to protect or conserve (for retirement) for a beneficiary (the employee) under rules applied to fiduciaries (ERISA and analogous foreign pension laws). Reg. §301.7701-4(a).
Because retirement plans are also trusts, we also look at trust rules for PFICs when deciding whether PFIC lookthrough occurs.
The trust lookthrough rules under the US internal laws are straightforward: A beneficiary must look through the trust and take into account the trust’s PFIC income, unless the trust is a qualified retirement plan under section 401(a). Reg. §1.1291-1T(b)(8)(iii). I have covered these plans in more detail in previous posts. The short version is that under US internal laws, the employee almost certainly must look through a foreign pension to take into account income from PFICs held in the pension on an annual basis, because it is unlikely that the foreign pension is a qualified plan.
Regulations sections 1.1291-1 and 1.1291-1T provide rules for when to look through a trust (or a retirement plan that is treated as a trust) to the underlying PFICs. These regulations do not mention treaties or conventions at all.
This leaves us with a situation where the Code and the regulations do not provide us with guidance. We have to look at the treaties themselves to determine what the benefits are for PFICs held in retirement plans.
Since we addressed Hong Kong in the last 2 posts, let us move out of the peninsula and into mainland China for one example of how pensions are treated under a treaty. For contrast, we will also look at the treaty with Germany, which has a different tax result.
If you look at the treaty between the US and China, you will see pension related benefits in Articles 17 and 18. These articles do not address the taxation of the income of a pension at all, so they do not modify how and when the US and China tax the income of a pension to the employee for whom the pension was established.
This result is unsurprising: The US-China treaty was signed in 1984 and modified by protocols in 1986, and the provisions of the treaty were limited to what the countries cared to address at the time.
In 1986, China did not have an individual income tax, so the US did not care to negotiate a provision about when China can tax the income of a pension to the employee-beneficiary.
In 1986, China did not have funded pensions–all Chinese pensions were simply contractual rights to receive pension payments from the former employer; the employer did not set aside a pool of funds to invest and pay the pension payments. Under these types of non-funded pensions, there was no “income of a pension” at all. It should not be surprising that China did not care to negotiate a provision about when the US can tax the income of a pension to the employee-beneficiary.
The US-China income tax treaty confers no benefits for PFICs held inside a retirement plan. The lookthrough rules are the same as if there were no treaty: The employee must look through the pension to take into account income from PFICs held in the pension on an annual basis.
The US-Germany income tax treaty is rather messy to read. It was originally signed in 1989, but a protocol adopted in 2006 overhauled many of the treaty provisions. It is in the 2006 protocol that pension-related treaty benefits are found.
You can find the treaty benefit provisions in Article IX of the 2006 protocol, which adds an Article 18A to the treaty. I will use the treaty article number, 18A, in this newsletter.
Specifically, under Article 18A.5(bb) of the treaty, as amended by the protocol, the following criteria must be true for the US to not tax the income of the pension to the US citizen employee-beneficiary annually:
In our scenario, our US citizen is living and working in Germany. I assume he is working for a German resident employer, and that employer established a German pension. He meets the basic requirements for treaty relief.
Article 18A.5(d) of the treaty says that the pension benefits do not apply unless “the competent authority of the United States has agreed that the pension plan generally corresponds to a pension established in the United States”.
The Treasury Department’s technical explanation of the protocol tells us what type of German pensions the US has agreed generally correspond to a pension established in the US: “retirement benefit plans under section 1 of the German law on employment related pensions (Betriebsrentengesetz)”. US-Germany income tax treaty 2006 protocol technical explanation, 29.
Section 1 of the Betriebsrentengesetz generally describes a plan that an employer agrees to sponsor. There are probably significantly more details than just that, but let us assume for the purpose of this post that the German employer in question conscientiously followed all the rules and established a proper pension described in section 1 of the Betriebsrentengesetz
Our hypothetical employee’s pension is the right type of pension to qualify for treaty benefits.
The Internal Revenue Code and the regulations require lookthrough of a trust without an exception for treaties. The US-German income tax treaty purports to protect a US citizen from US tax on the income of the pension until the pension is distributed. How do we resolve the conflict between the internal US laws and the treaty?
The rule of thumb is that treaties are given the same weight as Congressional statutes. Usually, they follow a “last-in-time” rule, meaning whichever was last passed controls. See e.g. Whitney vs Robertson, 124 US 190 (1888). Code sections 1291 and 1298 were enacted in 1986. PL 99-514, §1235(a); 100 Stat 2566, 2573. This was well before the 2006 protocol to the US-German income tax treaty. The treaty should control.
Almost all US treaties contain a clause that the Treasury Department describes as a “saving clause”. The saving clause generally says that if you are a US citizen, you cannot use the treaty benefits against the US. Usually, the saving clause is found toward the end of Article 1 of the treaty, but it can be hidden elsewhere.
The saving clause is usually followed by a list of exceptions to the saving clause. If a treaty benefit falls under one of these exceptions, then a US citizen may be able to use the benefit against the US. Fortunately, Article 18A.5, which provides relief to a US citizen with a German pension, is one of the exceptions to the saving clause. US-Germany income tax treaty art. 1.5(a). The US citizen employee-beneficiary of the German pension can use the treaty benefit.
In many other treaties, the article providing benefits regarding pension income is subject to the saving clause, so the treaty is not useful for US citizens.
The PFIC rules in the Code and regulations do not specifically override or defer to income tax treaties. You will need to examine the benefits under each treaty closely to see if the treaty protects the US citizen from having to look through the retirement plan to the underlying PFIC investments.
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