Considering the Pension Issues Related to Withdrawal for Foreign Nationals
by Elaine Blum, KPMG LLP, New York
(KPMG LLP in the United States is a KPMG International member firm)
Frequently, a company's 401(k) plan allows participation by foreign national employees who are working in the U.S. or who are working in a foreign branch of a U.S. company. The financial opportunity offered by the deferral of income tax on employee contributions, the employer matching of employee contributions (if applicable), and the deferral of income tax on earnings has a strong appeal to the foreign national. However, the foreign national must recognize the onerous nature of the rules regarding pensionsfor example, the withdrawal rules. In addition, many countries do not recognize deferrals into a U.S. plan and thus will tax the contribution even though made into a U.S. retirement plan.
Typically, the question has been raised regarding whether a distribution from the trust (qualified plans under Internal Revenue Code (Code) Section 401 are usually U.S. trusts maintained by an employer) can be made when these individuals have returned overseas. This article will focus on this issue as well as describe the pitfalls raised by the withdrawal rules.
A 401(k) plan is a qualified cash or deferred arrangement. It is generally part of a profit sharing or stock bonus plan that meets all the regulations under Code Section 401(a). Qualified plans under Section 401(a) are usually U.S. trusts maintained by an employer for the exclusive benefit of the employer's employees. In addition, a Section 401(k) plan must satisfy the special requirements (Section 401(k)(2) and (4)) set forth below.
- The participant must be given the right to elect between cash compensation and a pre-tax contribution to the plan
- Distributions of amounts attributable to elective contributions earlier than one of the following events are prohibited: (a) separation from service, retirement, death, or long term disability; (b) termination of the plan without establishment of a successor plan; (c) attainment of age 59 ½; (d) corporate employer's disposition of substantially all of its assets or its interest in a subsidiary if the participant continues in the service of the purchaser or subsidiary; or (e) hardship
- The participant is fully vested in the value of the account that is attributable to elective contributions
- Maximum service that can be required as a condition of participation is one year
- No other benefit programs can be made conditional on an employee's election to participate or not participate in a 401(k) plan.
The plan must also generally satisfy a non-discrimination test. If the plan fails the test, the employer is required to send back the pre-tax contributions to certain highly compensated employees. Such refunds are taxable to the employee.
Distributions, Separation of Service, and Withdrawal Rules
Code Section 402(a) states that distributions made to a beneficiary of an employee's exempt trust are taxable in the taxable year of the distributee in which the amount was distributed. Furthermore, 402(e) describes the circumstances that would allow a valid distribution from an exempt trust: employee's death; after employee attains age 59 ½; separation from service; or after employee becomes disabled. To separate from service is defined under Code Section 402(e) as retirement, resignation, or discharge from employment. To determine whether an employment relationship has been terminated, the employer is defined in Code Section 414(b), (c) and (m) as all members of a controlled group (parent, subsidiaries, branches, and related companies). Revenue Ruling 2000-27, 2000-21 IRB 1016 (which specifically addresses the term "separation from service" as it relates to 401(k) plans) states that a transfer among members of a controlled group does not constitute separation from service. These withdrawal rules are the same regardless of the nationality of the participant. In the Fujinon case (Tax Court, 1981), the Tax Court agreed that two U.S. companies that were owned by related Japanese companies were part of a controlled group.
If distributions are made that deviate from these parameters (which are similar to those stated under 401(k)(2)), one would risk disqualifying the plan. Therefore, if a foreign national, after a few years overseas, wants to receive a distribution from the plan while still an employee of any member of the controlled group, the distribution cannot be made.
If the individual qualifies for the distribution under the above-mentioned withdrawal rules while he or she remains overseas, a review of U.S. domestic law, host country domestic law, as well as any treaty provisions that might apply would be appropriate.
This article will postulate residence in the United Kingdom, Germany, France, Hong Kong, Japan, or Spain upon distribution of the payout of the U.S. 401(k) plan.
U.S. Domestic Law
Generally, pensions and other retirement allowances are taxable upon receipt under U.S. law. If the distribution is made after the U.S. residency period has ended (in the case of a foreign national without lawful permanent residence status in the United States, i.e., a green card holder), only the portion of the distribution that would be considered as U.S. source income would be taxable to a nonresident. The pension distribution would be sourced as follows: the portion of the distribution that represents the contributions would be sourced based on the months of U.S. service over total service; while the investment earnings of the plan would be treated as 100-percent U.S. sourced. Similar to the treatment of compensation for a nonresident, the U.S. source portion of the distribution attributable to the contributions would be considered effectively-connected U.S. income subject to tax at graduated rates. In contrast, the plan earnings would be considered not-effectively-connected income subject to tax at a 30-percent tax rate (Revenue Ruling 79-388). Additionally, distributions from a qualified plan are subject to a special 10-percent additional tax under Code Section 72(t) if they are made before the participant reaches age 59 ½, unless the distribution is made upon death or disability or after separation from service after age 55.
When dealing with a distribution of income that was earned in one jurisdiction while the individual was resident in another, one must view the domestic law of both countries and the treaties, which, in effect, prevent double taxation.
The U.S. Model Treaty defines a pension as a payment in consideration of past employment. Various Internal Revenue Service (IRS) Private Letter Rulings (PLR)expand this definition as "periodic payments made in consideration for services rendered" and list the general U.S. pension rules. Furthermore, a lump-sum payment, although not periodic, does not preclude a payment from qualifying as a pension as it is only the payment method (see PLR 9041041).
U.K. Domestic Treatment
The determinative factor under U.K. taxation is the form of the payment under the plan. If the payments are made in periodic payments or in the form of an annuity, the U.K. will tax it at ordinary income rates. If, however, the distribution is made in a lump sum and the pension scheme is a U.K.-approved scheme, the distribution could be made tax-free provided it falls within certain limits. If the scheme is not an approved U.K. scheme, current U.K. law would tax it as additional income at the highest rate of tax.
Current U.S.U.K. Treaty
The current U.S.-U.K. tax treaty taxes pension distributions, including distributions from 401(k) plans, under article 18 as taxable in the country of residence (that is, the U.K.). No distinction is made based on the type of distribution: article 18 covers annuities, periodic payments, and lump-sum distributions. Distributions from Individual Retirement Accounts (IRA) (unless a pure 401(k) rollover) would fall under the "Other Income" article (article 22) which would also make them taxable in the country of residence (again, the U.K.).
Therefore, under the current treaty, a distribution received by a foreign national resident in the United Kingdom would be subject to tax there, not in the U.S.
New U.S.U.K. Treaty
A new tax treaty between the U.S. and the U.K. was signed on July 24, 2001, but not ratified. The treaty's related Exchange of Notes recognizes a 401(k) plan as a valid "pension scheme"; therefore, look to article 17 for guidance on the taxation of the distribution. As valid "pension schemes," they will be treated in the same manner as approved U.K. schemes.
Article 17 of the new treaty states that a pension distribution is generally taxable only in the country of residence; however, if the distribution is paid out as a lump sum, it will be taxed only in the country where the scheme is established. Therefore, the form and the timing of the distribution will determine which country's tax laws would apply. In summary:
- Periodic paymentstaxed in the country of residence
- Annuitiestaxed in the country of residence
- Lump sumtaxed in the source country.
While it is not yet clear how the new treaty will interact with U.K. domestic law, it is likely that the periodic payments and the annuity element of the pension would be taxed in the U.K. if upon receipt, the individual were a U.K. resident. However, the United States would have taxing jurisdiction if the form of the distribution were as a lump-sum payment.
German Domestic Treatment
Germany does not recognize the deferred nature of the 401(k) contributions and therefore taxes both the employee and employer contributions when they are made. Consequently, any distributions from the 401 (k) plan would not be considered taxable income for German tax purposes. The amount earned during the U.S. employment period would be exempt from German taxation. However, if the distribution were made on a regular basis, i.e., monthly pension payments, an argument might be made that these distributions (up to 32 percent of the payout if payments would begin at age 60) are taxable as ordinary income in Germany. In that case, the taxation is governed by article 18 of the U.S.-Germany treaty which determines the taxing jurisdiction.
Article 18 of the U.S.-Germany tax treaty states that pensions derived by a resident of Germany in consideration of past employment would be taxable only in the state of residence. No distinction is made in the treaty regarding the form of the payments (periodic, lump sum, or annuities); the Technical Explanation to the treaty clearly states this fact. The treaty relief applies to both the regular tax as well as the 10-percent additional tax under 72(t) as they are both income taxes.
In short, receipt of a 401(k) distribution by a foreign national resident in Germany would subject the payout to taxation under German domestic law.
French Domestic Treatment
Currently, France allows a deduction for the 401(k) contributions under article 18(2) of the U.S.-France tax treaty. That article states that if the U.S. pension plan or retirement plan can be considered to correspond to a similar French arrangement, contributions made to a U.S. pension plan or other retirement plan by a resident in France would not constitute taxable income. Therefore, upon distribution, France would treat the entire distribution as taxable income. Under the sourcing rules, the contributions and accretions earned during the U.S. assignment period might be exempt from taxation but would be includible to determine the tax rate. This interpretation allowing the 401(k) deduction has recently been under scrutiny and therefore the position might change.
Article 18 of the U.S.-France tax treaty provides that a resident of France would be taxed on the distributions from a pension plan or other retirement arrangement in the country of residence. In determining jurisdiction under the treaty, it is immaterial whether the payment is made periodically or in a lump sum.
Hong Kong Domestic Treatment
Code Section 401(k) contributions made by an individual resident in Hong Kong would not be used to reduce his or her gross wages reported. In contrast, the employer's contributions to the plan made while the individual was rendering services in Hong Kong are not considered taxable income. Therefore, upon distribution only the employer contribution portion (as it related to Hong Kong services) would be subject to Hong Kong salaries tax since the employee contribution had been previously taxed. Hong Kong does not subject investment income to tax, so the distribution of the earnings in the plan would be tax-free for Hong Kong salaries purposes.
As the distribution consists of contributions made while performing services in the United States as well as in Hong Kong, and since there is no treaty with Hong Kong, the distribution would be taxed in part by the U.S. as described above under U.S. domestic treatment and in part by Hong Kong. Since each jurisdiction is taxing only a portion of the distribution which would relate to services performed in that particular situs, there is no potential for double taxation.
Japanese Domestic Treatment
As Japan does not recognize the deferral of both the employer and the employee contributions, the portion of the distribution that relates to contributions previously taxed in Japan would not be taxable. However, the earnings accrued in the plan while the individual worked in Japan would be taxable at resident rates of up to 50 percent upon receipt of the distribution.
Article 23 of the U.S.-Japan tax treaty provides that pensions and annuities received by a resident of a state would be taxable only in that state. The treaty defines a pension as a periodic payment made by reason of retirement or death or by way of compensation for injuries received in connection with employment. This definition also includes social security payments from either country.
Therefore, if the individual were resident in Japan upon receipt of the distribution, Japan would have taxing jurisdiction and would tax only the earnings accruing in the plan.
Spanish Domestic Treatment
Under Spanish domestic law, employee and employer contributions to a pension plan established (i.e., incorporated and registered) in accordance with Spanish pension law are deductible up to certain limits. If the 401(k) plan does not correspond to a Spanish plan, the contributions would be fully taxable when made. Therefore, the portion of the distribution that relates to these previously taxed contributions would not be taxable in Spain. Remittance or recharge to the Spanish entity of the portion of the distribution that related to the U.S. assignment period would trigger Spanish tax at ordinary income rates. The portion of the distribution that relates to the earnings accrued in the plan would be fully taxable.
Similar to the other treaties discussed, the U.S.-Spain tax treaty in article 20 provides that the country of residence will have the taxing power over a pension owned by a resident in consideration for past employment.
Therefore, in light of this treaty provision, a resident in Spain receiving a distribution from his or her 401(k) plan would be taxable in Spain on only the portion remitted that related to U.S. services or the amount recharged to the Spanish company and the earnings accrued in the plan.
It is important to:
- View pension distributions as consisting of three distinct pieces: the employee contributions, the matching employer contributions, and the earnings accruing within the plan, and
- Determine the treatment of all three elements in order to accurately determine the total tax exposure.
It should be clear that for cases involving income earned in two or more jurisdictions, a complete review must be made of the domestic laws of the pertinent jurisdictions as well as the relevant treaty provisions. With the exception of Hong Kong, which has not entered into an income tax treaty with the United States, the current pension articles of all of the respective countries reviewed above follow the language of the OECD and U.N. Model treaties: "pensions paid to a resident of a Contracting state in consideration of past employment shall be taxable only in that state." The U.N. Model Treaty predicates the taxation in the state of residence only to the extent that the home country did not previously tax the income. This concept was not adopted by any of the jurisdictions reviewed.
Furthermore, several of the jurisdictions do not recognize the deferral of the contributions into the plan (Germany, Hong Kong, Japan, and Spain), so that upon distribution, most of the payout would consist of after-tax income and would be exempt from taxation to that extent.
In summary, the foreign national must understand that due to the withdrawal rules surrounding the 401 (k) plan, the contributions should be viewed in light of a more long-term investment opportunity. In the case of the countries reviewed, distributions received while resident in those countries generally result in a "good" tax answer.
This article sets forth views based upon the relevant provisions of the Internal Revenue Code of 1986, as amended, the regulations thereunder, and judicial and administrative interpretations thereof, which are subject to change or modification by subsequent legislative, regulatory, administrative, or judicial decisions. The views also take on board current overseas domestic laws and the current treaties.
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.