Foreign Pensions of US Expats and Inbound Foreign Nationals: IRS Simplifies Reporting Rules For Certain Foreign Trusts But There Is More to Consider

Summary

The Internal Revenue Service (IRS) released on March 2, 2020, Revenue Procedure 2020-17, which exempts certain U.S. citizens and residents from foreign trust information reporting requirements relating to certain tax-favored foreign retirement as well as non-retirement savings trusts. Such individuals who are otherwise required to filed Form 3520 and/or Form 3520-A will no longer need to file these information returns provided all the stipulated conditions are met. In addition, the revenue procedure provides that such eligible individuals may request abatement of penalties that have been assessed, or refund of penalties that have been paid, for failure to comply with the information reporting requirements regarding these foreign trusts.

Foreign Pension Plans are Generally Treated as Foreign Trusts for US Tax Purposes

It is not uncommon for U.S. expats and foreign nationals residing in the U.S. (or inpats) to have one or more foreign pension plan accounts. Participation in these foreign pension plans is most often not driven by US tax planning considerations but necessitated by local regulations of the countries in which these individuals are or were employed. While these plans are typically structured to be tax efficient under local tax laws, such plans, notwithstanding treaty protection for specific countries, are not accorded similar treatments under the Internal Revenue Code (IRC). Aside from disparate tax treatment, the IRC places onerous reporting requirements on U.S. participants of these plans, which are generally deemed foreign trusts for U.S. tax purposes. Failure to comply with these reporting requirements could result in not only substantial civil monetary and criminal penalties but also suspension of statute of limitations on the entire return, not just those items associated with the failure unless the taxpayer can demonstrate reasonable cause.

It is no wonder that the Government Accountability Office (GAO) reported in 2018 that U.S. participants in foreign pension plans face multiple challenges with tax reporting requirements on their retirement savings.

What are the Reporting Requirements Related to Foreign Pension Plans?

Outlined below are some of the forms related to foreign pension plans. U.S. expats and inpats may be required to file one or more of these, depending on a number of factors:

FinCEN Form 114 (FBAR): Report of Foreign Bank and Financial Accounts
Form 8938 (FATCA): Statement of Specified Foreign Financial Assets
Form 3520: Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
Form 3520-A: Annual Information Return of Foreign Trust with a U.S. Owner
Form 8621: Information return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund
Form 8833: Treaty-Based Return Position Disclosure Under IRC Section 6114 or 7701(b)

It is important to understand the reporting and filing requirements of each since the relief for filing Form 3520 and/or Form 3520-A is contingent on the taxpayer being in full compliance, as you will read here. At the end of this newsletter, we will also briefly touch on some common misconceptions that could cause taxpayers to be incompliant, albeit inadvertently, and become ineligible for the relief.

Form 3520 and Form 3520-A Reporting and Filing Requirements

U.S. expats and inpats are generally subject to annual information reporting requirements on Form 3520, with few exceptions[1], for transfers of money or other property to, ownership of, and distributions from, foreign trusts[2]. This information return must be filed separately by the due date (including extensions) of the taxpayer’s individual income tax return.

A foreign trust with a U.S. owner must also file Form 3520-A[3] by the 15th day of the 3rd month after the foreign trust’s tax year end (or by the extended due date) each year in order for the U.S. owner to satisfy the applicable annual information reporting requirements. Each U.S. expat and inpat treated as an owner of any portion of a foreign trust under the grantor trust rules is responsible, under a penalty provision[4], for ensuring that the foreign trust files this return and furnishes the required annual statements.[5]

If the foreign trust fails to file the Form 3520-A (which is most likely), the taxpayer will be required to complete a substitute Form 3520-A, to the best of one’s ability, for the foreign trust and attach it to the Form 3520 in order to avoid the assessment of penalty.[6]

Eligible taxpayers will be exempt from these reporting and filing requirements provided the conditions stipulated under this revenue procedure are satisfied.[7]

Conditions for Exemption

The exemption applies only to (a) any eligible individual who would otherwise be required to file a Form 3520 and/or Form 3520-A in relation to (b) an applicable tax-favored foreign trust[8]. The Department of Treasury and the IRS have determined the exemption is appropriate on account that such trusts generally are subject to written restrictions under the laws of the country in which these trusts are established and that eligible individuals may already be required to separately report information about these trusts on Form 8938.

Are You an Eligible Individual?

You are an eligible individual if[9]:

You are, or at any time were, a U.S. citizen or resident alien;
You are compliant (or come into compliance) with all U.S. federal income tax return (or returns) filing requirements; and
You have reported as income any contributions to, earnings of, or distributions from an applicable tax-favored foreign trust on the applicable original or amended tax return(s).

Is Your Foreign Pension Plan an Applicable Tax-Favored Foreign Trust?

For a foreign pension plan to qualify, it must be a tax-favored foreign retirement trust[10]:

Created, organized, or otherwise established under the laws of a foreign jurisdiction (the trust’s jurisdiction) as a trust, plan, fund, scheme, or other arrangements; that
Operates exclusively or almost exclusively to provide, or to earn income for the provision of, pension or retirement benefits and ancillary or incidental benefits; and that
Meets all of the following requirements established by the laws of the trust’s jurisdiction –
1. The trust is generally exempt from income tax or is otherwise tax-favored under the laws of the trust’s jurisdiction by meeting either or both of the following conditions:
  1. Contributions to the trust that would otherwise be subject to tax are deductible or excluded from income, are taxed at a reduced rate, give rise to a tax credit, or are otherwise eligible for another tax benefit (such as a government subsidy or contribution); and
  2. Taxation of investment income earned by the trust is deferred until distribution or the investment income is taxed at a reduced rate.
2. Annual information reporting with respect to the trust (or of its participants or beneficiaries) is provided, or is otherwise available, to the relevant tax authorities in the trust’s jurisdiction.
3. Only contributions with respect to income earned from the performance of personal services are permitted.
4. Contributions to the trust are limited by a percentage of earned income of the participant, are subject to an annual limit of $50,000 or less to the trust, or are subject to a lifetime limit of $1,000,000 or less to the trust.[11]
5. Withdrawals, distributions, or payments from the trust are conditioned upon reaching a specified retirement age, disability, or death, or penalties apply to withdrawals, distributions, or payments made before such conditions are met. A trust that otherwise meets these requirements, but that allows withdrawals, distributions, or payments for in-service loans or for reasons such as hardship, educational purposes, or the purchase of a primary residence, will be treated as meeting these requirements.
6. In the case of an employer-maintained trust, the trust is nondiscriminatory with regard to the range of employees who are eligible to participate, it actually provides significant benefits for a substantial majority of eligible employees, and the benefits actually provided under the trust to eligible employees are nondiscriminatory.

Such a trust that permits rollover of assets or funds transferred from another tax-favored foreign retirement trust established and operated under the laws of the same jurisdiction will not fail to be treated as a tax-favored foreign retirement trust, provided that the trust transferring assets or funds also meets the requirements.

Other Non-Retirement Foreign Trusts May Qualify

In addition to tax-favored foreign retirement trusts, the revenue procedure provides that a tax-favored foreign non-retirement savings trust that meets all of the following conditions may qualify[12]:

Created, organized, or otherwise established under the laws of a foreign jurisdiction (the trust’s jurisdiction) as a trust, plan, fund, scheme, or other arrangements; that
Operates exclusively or almost exclusively to provide, or to earn income for the provision of, medical, disability, or educational benefits; and that
Meets all of the following requirements established by the laws of the trust’s jurisdiction –
1. The trust is generally exempt from income tax or is otherwise tax-favored under the laws of the trust’s jurisdiction.
2. Annual information reporting with respect to the trust (or about the beneficiary or participant) is provided, or is otherwise available, to the relevant tax authorities in the trust’s jurisdiction.
3. Contributions to the trust are limited to $10,000 or less annually or $200,000 or less on a lifetime basis.
4. Withdrawals, distributions, or payments from the trust are conditioned upon the provision of medical, disability, or educational benefits, or apply penalties to withdrawals, distributions, or payments made before such conditions are met.

Similar to tax-favored foreign retirement trusts, such a trust that permits rollover of assets or funds transferred from another tax-favored foreign non-retirement trust established and operated under the laws of the same jurisdiction will not fail to qualify, provided that the trust transferring assets or funds also meets the requirements.

Other Information Reporting Requirements for Foreign Pension Plans Not Affected

The exemption granted for the filing Form 3520 and Form 3520-A does not relieve eligible individuals of obligations to report information related to foreign pension plans under other provisions of U.S. law.[13] Neither does this revenue procedure affect exceptions provided under previous guidance for distributions from certain compensatory trusts[14] and with respect to certain Canadian retirement plans[15].

Request for Abatement or Refund of Penalties

Eligible individuals who have been assessed a penalty for failing to file Form 3520 and/or Form 3520-A with respect to an applicable tax-favored foreign trust (without regard to whether such failure was due to reasonable cause) may request an abatement or refund of the penalty by filing a Form 843 in accordance with the process outlined in this revenue procedure.[16] Any such abatement and refund will, however, be subject to the statute of limitations[17] and credit offset[18].

Effective Date

This revenue procedure will be effective from the date of publication in the Internal Revenue Bulletin on March 16, 2020 and apply to all open tax years.[19]

Watch for Updates

The Department of Treasury and the IRS intend to issue proposed regulations that would exclude eligible individuals’ transactions with, or ownership of, these applicable tax-favored foreign trusts from information reporting.[20] It should be noted that provisions set forth in this revenue procedure may be subject to change with the promulgation of these proposed regulations.

Actions Recommended

U.S. expats and inpats who have any foreign pension plan should:

Review each of their foreign pension plans to determine whether all the conditions for applicable tax-favored foreign retirement plan can be met;
Ensure they are compliant with their tax reporting and filing requirements for all U.S. returns; and, if not
Consider amending prior year returns and/or filing the delinquent returns to correct any such incompliance.

Reconsider Whether You Are Truly Compliant

Ensuring U.S. tax compliance is easier said than done. For a start, nonexempt employees’ trusts and employee grantor trusts are treated differently for U.S. tax purposes.[21] (And, yes, a foreign pension plan can be a combination of both.) Most taxpayers, however, would have difficulty identifying these trusts, let alone applying the correct tax treatments. For taxpayers who look to bilateral income tax treaties for protection, these agreements with comprehensive terms customized for each convention’s partner add another dynamic to the complexity of international tax compliance.

A GAO report published in 2018 cited complex tax requirements and the lack of clear guidance from the IRS as the reasons U.S. taxpayers find it challenging to correctly report their foreign retirement accounts.

Below are some of the common misconceptions among U.S. expats and inpats which may cause them to be incompliant with their reporting and/or filing obligations:

Foreign Pension Plan Contributions: Employee contributions may not be deductible on the U.S. tax return but are always eligible for foreign earned income exclusion. Employer contributions are also not currently taxable on the U.S. tax return until distribution occurs.
Foreign Pension Plan Earnings: Similar to employer contributions, these are not currently taxable on the U.S. tax return until distribution occurs.
Transfer of Assets Between Foreign Pension Plans Within the Same Country: Routine transfer of assets incidental to change of employment has no U.S. tax ramifications since these assets remain inaccessible until distribution occurs.
Asset Appreciation Within Foreign Pension Plan: Gains and losses whether from changes in asset value or disposition of holdings are not taxable until distribution occurs.
Foreign Pension Plan Under Foreign Employer: Employer plans do not need to be reported on FinCEN Form 114 for FBAR since these are not bank or financial accounts per se.

While most U.S. expats and inpats attempt, in good faith, to file complete and accurate returns, in spite of various misconceptions, few understand the implications of or are even aware of the existence of the four-letter word, PFIC. PFIC stands for Passive Foreign Investment Company and refers to any foreign corporation with certain percentages of income or holdings in assets with respect to passive income.[22] Burdensome compliance requirements and punitive tax regimes (that includes subjecting PFIC income to tax at the highest marginal rate – regardless of one’s taxable income – and assessing interest charge on such taxes) were implemented under a complex set of rules, enacted as part of the 1986 Tax Reform Act, to stop U.S. taxpayers from deferring current taxation and converting ordinary income into capital gain by investing in foreign instead of domestic funds.[23] Since foreign mutual funds generally constitute PFIC and it is common for foreign pension plans to invest in foreign mutual funds, U.S. expats and inpats could be deemed shareholders of one or more PFIC and should carefully review the application of these rules to their accounts. In the absence of proper planning, unsuspecting taxpayers could find their hard-earned retirement savings eroded by additional compliance costs related to Form 8621, substantial penalties for failure to comply, and the PFIC tax regimes.

[1] See Exception To Filing in the filing instructions of Form 3520
[2] IRC §6048
[3] Which sets forth a full and complete accounting of all trust activities, trust operations and other relevant information
[4] IRC §6677(b)
[5] IRC §6048(b)(1)
[6] Form 3520-A filing instructions and CCA 201150029
[7] Pursuant to the authority granted to the Secretary under IRC §6048(d)(4)
[8] Rev. Proc. 2020-17, Section 4
[9] Rev. Proc. 2020-17, Section 5.02
[10] Rev. Proc. 2020-17, Section 5.03
[11] As determined using the U.S. Treasury Bureau of Fiscal Service foreign currency conversion rate on the last day of the tax year
[12] Rev. Proc. 2020-17, Section 5.04
[13] Rev. Proc. 2020-17, Section 3
[14] Notice 97-34, Section V
[15] Rev. Proc. 2014-55
[16] Rev. Proc. 2020-17, Section 6
[17] IRC §6511
[18] IRC §6402
[19] Rev. Proc. 2020-17, Section 7
[20] Rev. Proc. 2020-17, Section 1
[21] IRC §402(b) and Treas. Reg. 1.402(b)-1
[22] IRC §1297(a)
[23] Tax Reform Act of 1986 Conference Report, Title XII, D7, page II-640; 104th Congress Senate Finance Committee Hearing, July 21, 1995, Appendix, Page 28

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