The IRS typically taxes contributions to foreign plans, the income that has been generated in those plans (growth) but has not yet been distributed, and payouts from such plans. The extensive list of information-reporting obligations and the severe penalties for infractions should draw your attention if the lack of tax deferral is insufficient to do so.
Background
How might one end up in trouble with the IRS over a foreign retirement plan?
This is a common scenario. Joe, an expat who was born in the United States, accepts a new position and relocates abroad. When he gets his first job there, he asks about the company’s retirement plan, makes plans to make the maximum annual contribution to the plan, and starts a local savings account to put even more money away for his later years.
In order to ensure that the accumulated but undivided income that the plan generates is not subject to yearly taxes in the foreign country and that he is typically not allowed to withdraw money from the plan until he reaches the specified retirement age, Joe hires tax advisors in the foreign country. Local tax experts confirm his comprehension, assist him in completing all required paperwork, and assist him in making all required payments, either directly or through withholding, to ensure complete tax compliance in the foreign nation.
Joe speaks with his accountant in the United States and gives him all the pertinent information about his new employment, retirement plan, and savings account in an effort to maintain U.S. tax compliance while traveling.
The American accountant tries his best to help Joe abide by all U.S. regulations despite lacking extensive experience with international tax matters by (1) timely filing Forms 1040 (U.S. Individual Income Tax Return) reporting the wages from the foreign company; (2) disclosing the existence and location of the foreign savings account on Form 1040 Schedule B (Interest and Ordinary Dividends); (3) reporting the interest income from the foreign savings account on Schedule B; and (4) claiming t Joe’s U.S. accountant is under the incorrect impression that the international retirement plan is comparable to a Section 401(k) plan in the country, so he won’t have to worry about U.S. taxes or reporting until he begins receiving distributions after retirement.
The accountant explains this to Joe, who is similarly uninformed about U.S. international tax issues and for many years fails to inform the IRS about the overseas retirement plan. The money in the plan continues to increase as a result of contributions and earnings from passive investments, and Joe continues to make the maximum annual commitment.
When Joe learns that his parents are experiencing significant medical issues, he decides to come back to the United States. He leaves the foreign employer, shuts his foreign account, moves the money back to a U.S. account, and believes he can easily roll over the sizable balance in the overseas retirement account to an active Section 401(k) plan or IRA. To confirm his grasp of the intended transfer’s impact on U.S. taxes, Joe talks to his U.S. accountant.
The U.S. accountant is unfamiliar with this subject, so he conducts some research and finds out after a few clicks that Joe accidentally broke U.S. tax rules with regard to his international retirement plan and that he cannot transfer the money to a Section 401(k) plan or an IRA tax-free.
A U.S. accountant calls Joe, explains the situation, and suggests that he hire U.S. international tax attorneys to investigate the options for resolving the issue on the best terms possible. Of course, the U.S. accountant is worried about a malpractice lawsuit, but he is smart enough to realize that he should not compound his problems.
Summary of Information Reporting Duties
When they have a reportable interest in a foreign financial account, Americans generally have three obligations: To disclose the existence and location of a foreign account, you must: (1) check the “yes” box in Part III (Foreign Accounts and Trusts) of Form 1040 Schedule B; (2) report the account on Form 8938 (Statement of Specified Foreign Financial Assets), which is enclosed with Form 1040; and (3) submit an FBAR electronically.
The IRS will probably require the U.S. person to submit supplementary overseas information returns if he has a stake in a foreign employment retirement plan. The key information-reporting obligations for Americans with overseas workplace retirement plans are summarized here. This background knowledge is crucial because, in order to fully appreciate the issues and solutions covered in this essay, it is necessary to comprehend these responsibilities.
Form 1040—duty to report foreign accounts and related income
Part III of Form 1040 Schedule B contains an FBAR inquiry and a cross-reference. e IRS has modified and expanded this language slightly over the years, with the 2017 Schedule stating the following: At any time during 2017, did you have a financial interest in or a signature authority over a financial account (such as a bank account, securities account, or brokerage account) located in a foreign country?
If “Yes,” are you required to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), to report that financial interest or signature authority? See FinCEN Form 114 and its instructions for filing requirements and exceptions to those requirements. If you are required to file a FinCEN Form 114, enter the name of the foreign country where the financial account is located.
FBAR—duty to report foreign financial accounts
The Bank Secrecy Act was passed by Congress in 1970. One goal was to mandate the submission of specific reports, such as the FBAR, where doing so would facilitate criminal, tax, and regulatory investigations by the US government.
The relevant statute, along with the corresponding regulations and FBAR instructions, generally mandates the filing of an annual FBAR when (1) a U.S. person, including U.S. citizens, U.S. residents, and domestic entities, (2) had a direct or indirect financial interest in, or signature or other type of authority over, (3) one or more financial accounts (4) that are located abroad, and (5) the aggregate value of which exceeded $10,000 (6) at any point during the reporting year. 5 In recent years, the U.S. government has taken action due to concerns regarding widespread FBAR noncompliance.
Notably, in 2003, Treasury gave the IRS jurisdiction to enforce FBAR obligations. Since then, the IRS has been given the authority to look into possible FBAR infractions, send out summonses and administrative decisions, impose fines, and take “any other action reasonably necessary” to enforce the FBAR regulations.
In 2004, the Congress passed new FBAR punishment laws. Any American who does not submit an FBAR when needed will now be subject to penalties from the IRS. The maximum fine for non-willful offenses is $10,000, however the IRS cannot levy this fine if the violation was brought about by “reasonable cause.” 10 If there is willfulness, the penalties are increased.
The IRS can impose a fine of $100,000 or 50% of the account balance at the time of the violation, whichever is greater, when a taxpayer willfully fails to file an FBAR. 11 Because some undeclared accounts have significant balances, FBAR penalties can be very costly.
Form 8938—duty to report foreign financial assets
The Foreign Account Tax Compliance Act included Section 6038D, which requires the submission of Form 8938. (FATCA). 12 can be broken down into the following sections: (1) Any specified person (SP), which is now defined to include American citizens, American residents, specific domestic entities, and others Whoever or whatever (2) holds an interest (3) in a specified foreign financial asset (SFFA) during any time during a tax year (4) is required to (5) attach a timely tax return (6) and a full and accurate Form 8938 (7) if the aggregate value of all SFFAs (8) exceeds the applicable filing threshold. 13 In various situations, having an interest in an asset might signify different things.
If any income, gains, losses, deductions, credits, gross proceeds, or distributions attributable to the holding or disposition of the SFFA are (or should be) reported, included, or otherwise reflected on the SP’s annual tax return, the SP generally holds an interest in the SFFA for the purposes of Form 8938. The 14 e Regulations make it clear that an SP has an interest in the SFFA even if there are no earnings, gains, losses, credits, deductions, gross proceeds, or dividends for the year that the SFFA is held or sold. The 15 e Regulations further state that an SP must submit a Form 8938 even though none of the SFFAs that must be disclosed have any bearing on the SP’s annual U.S. tax liability.
Foreign financial accounts and other foreign financial assets kept for investment reasons are considered to be SFFA for the purposes of Section 6038D. For the purposes of Form 8938, the idea of “financial account” is difficult to define because neither the relevant statute, Section 6038D, nor the accompanying regulations contain it. Instead, it is included in Section 1471 of the Internal Revenue Code and its extremely detailed Regulations. For the purposes of this article, it is sufficient to state that Forms 8938 normally treats tax-favored overseas retirement funds and foreign pension accounts as “financial accounts.”
Notably, these retirement assets will still be regarded as “financial accounts” for the purposes of Form 8938 even if they have been excluded from the definition of “financial account” under an intergovernmental agreement between the United States and a foreign nation to implement FATCA. In other words, even while certain foreign governments and financial institutions are exempt from FATCA’s requirement that they give information to the IRS regarding specific retirement-type accounts, Americans who own these accounts will not profit from such a concession.
The IRS typically imposes a $10,000 fine per violation on SPs who fail to submit Form 8938 in a timely manner. If the SP takes too long to fix the issue after the IRS contacts them, the penalty rises to a maximum of $50,000. 23 If an SP can show that an unintentional failure to submit a Form 8938 in a timely, correct, and full manner was caused by reasonable cause rather than willful neglect, penalties may not apply.
Form 8833—duty to report positions taken pursuant to treaty
Taxpayers must normally inform the IRS on Form 8833 of their stance that a U.S. tax treaty supersedes or otherwise alters U.S. tax law (Treaty-Based Return Position Disclosure). 34 For each infraction, corporate taxpayers that fail to report treaty-based return positions are subject to a $10,000 fine. At $1,000 per omission, the 35 e penalty for individual taxpayers is less severe. 36 If the taxpayer demonstrates that there was a valid reason, they acted in good faith, and the failure was not the result of deliberate neglect, the IRS will, however, waive the penalty.
Distinct U.S.tax treatment of domestic and foreign plans
The GAO Report begins by highlighting the scope of the issue: there are about nine million American citizens residing abroad, many of whom have interests in local retirement products. The treatment of domestic vs foreign retirement plans under the U.S. tax system is then discussed in detail. A “qualified” retirement plan’s passive earnings, such as interest, dividends, and capital gains, are not typically subject to taxation in the United States until the employee actually receives payments from the plan, according to a GAO report. 39 Contrarily, according to the GAO Report, overseas workplace retirement plans are typically not regarded as “qualified” plans under the Internal Revenue Code. As a result, Americans working abroad do not enjoy the same benefits as their peers who have “qualified” domestic plans. U.S. citizens who participate in foreign retirement plans may be subject to current taxation on the following items: (1) employer or self-made contributions to the plans; (2) accrued but undistributed earnings in the plans; and (3) distributions from the plans that they have not actually received, such as transfers of assets between or among various plan participants. This is dependent on a number of factors, including the nature of the plan, local law, and the provisions in the applicable bilateral treaty.
IRS guidance is insufficient and unclear
The GAO Report acknowledges that the IRS has provided some limited guidance about foreign work place retirement plans, such as the International Tax Gap Series and Publication 54 (“Tax Guide for U.S. Citizens and Resident Aliens Abroad”). However, the GAO Report says that neither of these“ describes in detail how taxpayers are to determine if their foreign work place retirement plan is eligible for tax-deferred status, or how to account for contributions, earnings, or distributions on their annual U.S tax return, particularly whether and when contributions and earnings should be taxed as income.”
The GAO Report also indicates that, while the IRS directs taxpayers to review the relevant bilateral tax treaties for any provisions related to foreign pensions, even IRS officials admit that “these treaties can vary from country to country and … can be difficult for non-experts to understand.” Consistent with IRS rulings discussed elsewhere in this article, the GAO Report confirms the IRS positions that foreign work place retirement plans are not generally considered “qualified” plans for U.S. tax purposes and thus are not entitled to the corresponding tax benefits.
The GAO Report says in this regard: IRS officials told us that U.S. tax law generally does not recognize foreign retirement plans as tax-qualified and IRS does not recognize any retirement accounts outside the United States as having tax-qualified status. IRS officials we spoke to said that only plans meeting the specific requirements of [Section] 401(k) or other requirements describing retirement plan qualification may achieve tax-qualified status in the United States.
As a result, according to IRS guidance, U.S. individuals participating in foreign workplace retirement plans generally cannot deduct contributions to their account from their income on their U.S. tax return. This is true even if the retirement account is considered a tax-deferred retirement account in the country where the individual works, and even if the account is similar in nature to those found in a U.S.-type retirement plan, such as a [Section] 401(k) plan. 43 Everybody has an opinion, and this is certainly true in the tax community, fueled too often by unfounded theories posted on endless blogs, chat rooms, web pages, client alerts, and the like. Such a high rate of information dissemination, coupled with the lack of clarity from the IRS, has created disagreement among U.S. tax practitioners about how to treat foreign plans. According to the GAO Report, some practitioners advise their clients to report them as passive foreign investment companies (PFICs) on Forms 8621 (Return by U.S. Shareholder of a Passive Foreign Investment Company). Others recommend disclosing them as foreign financial accounts on FBARs and Forms 8938, while still others suggest that they should be treated as foreign trusts and reported on Forms 3520 and 3520-A. 44 To exacerbate matters, the GAO Report, citing warnings from the National Taxpayer Advocate, says that the IRS might abate penalties related to erroneous treatment of foreign plans in situations involving reasonable reliance by a taxpayer on a qualified, informed, U.S. tax professional. However, “receiving incorrect tax advice from a foreign tax preparer may not be a sufficient mitigating circumstance to avoid penalties for reporting a foreign retirement account incorrectly on a tax return [because] tax preparers in other countries are usually not considered qualified preparers by IRS.”
The GAO Report also says that the IRS sticks to its normal mantra when it comes to international tax issues, which is that taxpayers are ultimately liable for getting things right, notwithstanding the complexity of the issues, lack of IRS guidance, and the confusion among tax professionals about how to treat foreign retirement plans: “IRS officials told us that individual taxpayers are responsible for understanding their filing requirements and for determining how to correctly file their tax returns, regardless of whether they live in a foreign country or the United States.”
Transfers generally trigger immediate taxation
The GAO Report addressed a significant issue that is unknown to many Americans and tax professionals: switching jobs and moving money (“rolling over”) from one foreign workplace retirement plan to another are likely to result in immediate U.S. taxes. The IRS admits that these financial transactions often do not jeopardize the tax-deferred status of the plan in the foreign country where it is located, but this does not change the fact that the U.S. tax system has a different perspective: According to IRS representatives, the Internal Revenue Code does not recognize foreign retirement plans as tax-qualified plans. As a result, tax-deferred transfers or rollovers may not be feasible unless a tax treaty specifically states otherwise. Regular administrative transfers of retirement assets that take place between or within foreign retirement plans are typically viewed by the IRS as distributions to the participant and as such, taxable income. The transfers would often count as the participant’s “constructive receipt of monies,” making them taxable and reportable. As a result, when a U.S. citizen participates in a foreign retirement plan and transfers their account to another account within the plan or to another workplace retirement plan after leaving their job, they may be required to pay U.S. tax on the whole amount of their retirement assets. According to the GAO Report, Treasury officials have been aware of this issue for many years, have brought it up during treaty negotiations with other nations, and have incorporated a provision into the most recent version of the U.S. model income tax treaty that would generally exempt transfers between foreign workplace retirement plans from immediate U.S. income tax, provided that such transfers preserve tax-deferred status under local law. Positive news, yes, but the fact is that many nations do not currently have tax treaties with the United States or their treaties are out of date and do not particularly cover the effects of transferring retirement plans on U.S. citizens. Lest anyone be uncertain about the severity, the GAO Report goes into additional detail concerning the effects on US taxes under existing law: According to IRS representatives, there is typically no transfer that will qualify for U.S. income tax deferral if there is no treaty between the United States and the nation where the U.S. individual is taking part in a foreign workplace retirement plan or if the treaty does not specify how to treat these transfers. According to IRS experts, there is no way for the plan to structure the transfer in these circumstances such that the U.S. person moving assets within or between foreign plans doesn’t get a distribution and incur tax obligations. Even when a tax treaty is in place, the transfer of retirement assets may not qualify for special treatment under the treaty. This would be the situation in at least two of the five case study regions that we looked at, where despite the existence of a tax treaty, we were unable to locate any provisions that dealt with these kinds of transfers. According to the IRS, in these circumstances, the U.S. person must rely on the [Internal Revenue Code], which does not offer tax-deferral on such transfers. As a result, any tax deferrals on the transfer would be forfeited by a U.S. person who takes part in a foreign workplace plan. There aren’t many solutions, at least not right away. Renegotiating a tax treaty takes time, according to the GAO Report, and is typically not done to address a single problem, like how foreign workplace retirement funds are taxed in the United States. It implies that having Congress pass suitable legislation would be the best approach to offer “more immediate relief.” According to the Report, U.S. citizens who participate in foreign workplace retirement plans must abide by current law, which does not allow for tax deferral for transfers within or between foreign plans, even those that might be qualified for tax-deferred contributions and earnings in the foreign country.
Suggestions and future actions
Three of the recommendations made in the GAO Report centered on the difficulty of complying with international tax laws and the perceived injustice of the way foreign employer retirement plans are taxed in the United States.
To reduce the difficulty of compliance and prevent unintended violations, the IRS should first provide clear guidance about U.S. tax and information-reporting requirements. The IRS was asked to perform a systematic study of the information about overseas retirement plans that is now revealed on Form 8938 in order to decide whether it would be appropriate to waive this information-reporting requirement in the future.
Third, it recommended that Congress take into account helping Americans who take part in overseas workplace retirement plans by allowing them to be regarded as “qualified” retirement plans in the US, similar to a Section 401(k) plan. Although the IRS did not concur with the entirety of the GAO Report, there were several encouraging developments for taxpayers, arguably the most significant of which is as follows:
Due to complicated federal requirements and treaty provisions governing the taxation of foreign retirement accounts, the IRS further stated that U.S. citizens taking part in foreign retirement plans frequently lack knowledge of how to properly report foreign retirement accounts and associated income. IRS accepted our suggestion to make it clearer how Americans should declare their overseas retirement accounts, including how to report contributions, earnings, and distributions from the account.