Using Income Tax Treaties to Convert Taxable Income Into Nontaxable Distributions
The United States imposes federal income tax on its top-earning taxpayers at a rate of 39.6 percent. In addition, unlike any other country in the world, the United States taxes its citizens, regardless of where they live — on a world-wide basis.1 For these reasons, where U.S. citizens or “residents” (including green card holders) have income from foreign sources that is not subject to substantial foreign income tax, the principal focuses of U.S. international tax planning generally are minimizing or eliminating current U.S. federal income tax on income earned offshore, and the subsequent “repatriation” of those foreign earnings to the United States at the lowest tax rates possible.
While the above worldwide taxation principle is the general rule for U.S. taxpayers, there are various exceptions built into the Internal Revenue Code in the cross-border setting that permit what would otherwise be taxable income to be exempted from U.S. federal income tax. These exemptions include the I.R.C. §911 earned-income exclusion and the exclusion available under I.R.C. §933 for certain “bona-fide residents” of Puerto Rico.2 In the domestic context, and of more relevance to this article, a similar exclusion exists under I.R.C. §408A(d)(1) for distributions from a Roth IRA.
A Roth IRA is a type of tax-favored retirement account, under which contributions to the Roth are made with after-tax dollars (and, thus, are not tax deductible). All earnings accumulate tax-free, and subsequent distributions, regardless of amount, generally are not subject to U.S. federal income tax. Access to Roth IRAs, like traditional IRAs, is restricted to certain taxpayers who fall below certain modified adjusted gross income thresholds. Thus, taxpayers in the highest U.S. tax brackets generally cannot use Roth IRAs. Additionally, those who are eligible to contribute to such Roth IRAs are limited to a maximum contribution of only $5,500 per year ($6,500 for taxpayers age 50+). Notably, because of the “prohibited transaction” provisions, it generally is not possible for U.S. taxpayers to transfer non-cash property (whether appreciated or not) to a Roth without triggering certain taxes (i.e., excise tax as well as income tax on any built-in gain). Therefore, while the tax benefits of Roths are potentially substantial, they are not available to all taxpayers and they are significantly limited in amount.
The above benefits generally are extended only to U.S.-based “qualified” plans and accounts.3 Thus, U.S. federal income tax generally is imposed on contributions to and/or distributions from foreign plans (which, by definition cannot be “qualified” for this purpose).4 Where a U.S. citizen, for example, makes contributions to a non-U.S. pension plan or other foreign retirement plan, the above U.S. federal income tax benefits typically will be inapplicable, and, thus, the beneficiary will not receive a deduction for the contributed amounts. Similarly, if contributions are made by the U.S. person’s employer to a foreign plan, those contributions may be taxable to the U.S. beneficiary. United States federal income tax also may apply to earnings of the foreign retirement plan, unless both 1) the plan is an employer-sponsored plan for purposes of §402(b) and 2) the employee is not a “highly-compensated employee” for this purpose. It is important to note that, if the foreign plan is characterized as a trust for U.S. federal income tax purposes and does not meet the foregoing standards under §402(b), the trust will be characterized as a grantor trust.5 Finally, on distribution of assets from a foreign retirement plan, a portion of the distribution may again be taxable, just as if it was made by a domestic pension plan.
As noted above, the U.S. federal income tax burdens imposed on U.S. persons who participate in foreign pensions can be severe. Income tax treaties may, however, significantly alter the taxation of such cross-border pension plans and other retirement arrangements, and may in some cases ultimately prevent any tax from being imposed at all.
Treaty Provisions Relating to Pensions, Generally
Almost all income tax treaties concluded by the United States contain pension provisions that give the country of residence the right to tax distributions from pension and other retirement plans, even where the payments are in consideration for past performance that may have occurred in the other country. This right may be made subject to the right that the United States reserves, under the so-called “saving clause” of its treaties, to tax its citizens (and in some cases, “residents”) wherever they reside. There are carve-outs from the saving clause of most treaties, with each treaty differing as to what provisions are subject to the saving clause.
The U.S. Treasury employs a model income treaty, which it publishes roughly every 10 years, and which it uses as its starting point in negotiating its bilateral income tax treaties. Most treaties generally contain several provisions that are identical to the model that was in force at the time the treaty was negotiated. Importantly, Roth IRAs were created by the Taxpayer Relief Act of 1997. Thus, when the Treasury released its 2006 U.S. Model Treaty, it contained a new provision relating to pensions, which had not appeared in the prior, 1996 U.S. Model Treaty.
This new provision of the 2006 Model was presumably intended to advance the new goal of preserving the rights of its citizens and residents to receive Roth distributions tax-free. To this end, the provision provided that, notwithstanding the general right of the residence country to tax distributions, if the source state would have provided an exemption of such amounts when distributed to one of its own residents, the country of residence must likewise exempt the distributions from tax (the “equivalent taxation provision”).6 Many modern income tax treaties (including the 2006 U.S.-Belgium income tax treaty, the 2008 U.S.-Malta income tax treaty, the 2010 U.S.-Chile income tax treaty, the 2010 U.S.-Hungary income tax treaty, and the 2013 U.S.-Poland income tax treaty) include the equivalent taxation provision.7 This provision also appears in the 2016 Model.
The Technical Explanations to the treaties that contain this provision, including the 2006 Model, typically include an example involving a Roth IRA. The example notes that “a distribution from a U.S. Roth IRA to a resident of [the foreign country] would be exempt from tax in [such foreign country] to the same extent the distribution would be exempt from tax in the United States if it were distributed to a U.S. resident.” The equivalent taxation provision works both ways, however, such that if a U.S. citizen or resident is a beneficiary of a foreign pension in a country that has a treaty with the United States that contains this provision, when distributions are made from that foreign pension plan to the U.S. beneficiary, the United States may only tax the distribution to the extent the foreign treaty country would have taxed its own residents on such a distribution under its domestic law.
In addition to the equivalent taxation provision, modern treaties generally include a separate provision that prevents both countries from imposing tax on the income realized by the pension until a distribution is made to the beneficiary (the “deferral provision”). Like the equivalent taxation provision, the deferral provision also is included in the 2016 U.S. Model Treaty (the “2016 Model”).8 This provision, thus, provides the taxpayer beneficiary with deferral from tax in both countries until distributions are made from the plan.
As noted briefly above, the saving clause of most U.S. income tax treaties generally allows the United States to continue to tax its citizens (and, in some cases, its green card holders and/or former citizens and long-term green card holders), as though the treaty had not come into effect. In the 2006 Model, for instance, this clause is found in Article 1(5). The saving clauses of these treaties also provide for various carve-outs, such that the United States is required to respect the treaty provisions as to these excepted areas, even when taxing its citizens. For example, the saving clause of the 2006 Model states that the saving clause “shall not affect the benefits conferred by [one country] under…paragraphs 1 b), 2, and 5 of Article 17 (Pensions…),… [and] paragraphs 1 and 4 of Article 18….” These specific carve-outs mean that the United States cannot proceed to tax its citizens and residents as though the treaty did not exist as to pension distributions, but, rather, it must respect both the deferral and equivalent taxation provisions. Consequently, the United States is prevented from imposing tax on foreign pensions that are covered by such treaty provisions until a distribution is made to a U.S. taxpayer; and even then, the United States may only tax the distribution to the extent it would have been taxable in the foreign country if made to a resident of that country. In this sense, the U.S. taxing powers ultimately are a function of foreign law in these cases, and this can generate some surprising results.
U.S.-Hungary Income Tax Treaty Provisions and Relevant Hungarian Law
The income tax treaty between the United States and Hungary was renegotiated in 2010, though it is not yet effective. Article 17(1)(b) of the Hungary Treaty contains the equivalent taxation provision, while Article 17(3) contains the deferral provision. Both provisions of the Hungary Treaty are carved out from the saving clause pursuant to Article 1(5)(a) of the Hungary Treaty. As a result, if a U.S. citizen or resident (as defined for purposes of the treaty) participates in a Hungarian pension plan,9 neither country can tax the income of the pension until a distribution is made, and when such a distribution is made, the United States may only tax the distribution to the extent that it would be taxable under Hungarian domestic law if made to a Hungarian resident individual.
Under Hungarian domestic law it is possible that the distributions would never be taxable if made to a Hungarian resident retiree. Generally, if the Hungarian taxpayer participates in the pension for at least 20 years before a distribution is made, all distributions (including lump-sum distributions) are completely exempt from income tax in Hungary. If the pension is held for between 10 and 20 years before the distribution is made, some portion of the lump-sum distribution will be subject to a 16 percent flat tax rate (the taxable portion decreases ratably as the pension is held longer than 10 years). And if the pension is held for less than 10 years before a lump sum distribution comes out, all of the income associated with the distribution is subject to Hungarian tax at 16 percent. In addition, as long as the Hungarian plan has been held for at least 10 years, all “investment income” can be distributed tax-free, and the remaining amounts can be distributed without tax over the subsequent 10-year period. Thus, if a U.S. citizen were to participate in a Hungarian pension plan and to hold that plan for 20 years, he or she could effectively distribute all of the assets from the plan tax-free in both Hungary and the United States during that period, thanks to a combination of the relevant provisions of the Hungary Treaty and local Hungarian law.
While several other treaties, including the U.S. income tax treaties with Poland, Belgium, and Chile,10 also contain the equivalent taxation provision and the deferral provision, in each of these cases, either relevant foreign law limits the benefits of such arrangements or the relevant treaty provisions are not excepted from the treaty’s saving clause, and, thus, the U.S. taxing power is not limited by the treaty as to U.S. citizens and residents. For example, in the case of Poland, the saving clause of the treaty only applies to the deferral provision of the treaty but not to the equivalent taxation provision. Therefore, the United States can continue to tax the income accumulated within a Polish pension plan, but cannot tax the distributions made to U.S. beneficiaries of such plan. In the cases of Chile and Belgium, distributions generally are taxable (at least in part) under local law, and, thus, the United States also may tax the distributions to that extent based on the equivalent taxation provisions of the treaties. The only other country whose treaty with the United States includes the relevant treaty provisions discussed above and also has extremely favorable local law provisions is Malta. As will be illustrated below, the combination of these factors (i.e., favorable treaty provisions as well as favorable tax treatment of pensions in Malta) provides some extremely tax-efficient results.
U.S.-Malta Income Tax Treaty Provisions
The current income tax treaty between the United States and Malta was signed in 2008 and has been effective since January 2011. Under Article 22(2)(e) of the Malta Treaty, a pension plan that is resident in one of the treaty countries satisfies the limitation on benefits (LOB) provision as long as more than 75 percent of the beneficiaries, members, or participants of the pension fund are individuals who are residents of either the United States or Malta.11 Thus, as long as a Maltese pension is formed pursuant to relevant Maltese law and more than 75 percent of its members are U.S. and/or Maltese residents, the pension plan should be eligible for treaty benefits.
Article 18 of the Malta Treaty comprises the deferral provision, which contains no restrictions on the types of income that are covered, and, thus, is generally considered to apply broadly to all income (including, for example, income arising in connection with interests in U.S. real estate, PFIC stock, and assets connected to a U.S. trade or business).12
Article 17(1)(b) of the Malta Treaty then contains the equivalent taxation provision, which limits the right of the United States to tax distributions from Maltese pension plans to the amount that would have been taxable under Maltese law if distributed to a Maltese individual. Article 1(5) of the Malta Treaty provides that Articles 17(1)(b) and 18 are excepted from the saving clause. Consequently, the saving clause of the Malta Treaty should not prevent a U.S. citizen or resident member of a Maltese pension from qualifying for treaty benefits under relevant provisions of Articles 17 and 18.
The inclusion of the equivalent taxation provision, coupled with the failure to carve such provision out of the saving clause of the Malta Treaty, may indeed prove very valuable to certain U.S. taxpayers, and suggests that in negotiating these pension-related provisions of the Malta Treaty (like the Hungary Treaty, above), relevant persons at Treasury had perhaps not done all their homework.13
Relevant Maltese Law Relating to Pensions
In contrast to the stringent limitations imposed on contributions to Roths under U.S. law, unlimited contributions may be made to a Maltese pension plan. A Maltese pension plan generally is classified as a foreign grantor trust from a U.S. federal income tax perspective because of the retained interest of the grantor/member in the pension fund (assuming the plan is formed as a trust, which typically is the case). Thus, contributions to such a pension fund (including contributions of appreciated property) generally are ignored from the U.S. income tax perspective and should not trigger any adverse U.S. federal income tax consequences.14
There also appears to be almost no limit on what types of assets can be contributed to a Malta pension, including, for example, stock in private or publicly traded companies (including PFICs and CFCs), partnership and LLC interests (including so-called “carried interests”), and interests in U.S. or non-U.S. real estate (other than Maltese real estate).
While the specific terms of each pension plan vary, Malta law generally permits distributions to be made from such plans beginning at age 50. Under domestic Maltese law, the initial lump-sum payment from a Maltese pension (up to 30 percent of the total value of the relevant pension fund) generally is not taxable in Malta. The same Maltese exemption also applies to further lump-sum payments (of up to 50 percent of the remaining value of the pension fund) made to Maltese resident beneficiaries in certain subsequent years (generally, distributions can be made tax-free beginning three years after the initial lump-sum distribution is made). Any required annual (or more frequent) periodic payments are taxable in Malta (and, thus, also in the United States, per the treaty), but these distributions generally are tied to minimum wage and are relatively insignificant.15
Assume Cristina, a 49-year-old U.S. citizen, owns both highly appreciated U.S. real estate and founders’ shares of a valuable start-up that is about to go public. In combination, the interests are worth approximately $200 million, and the aggregate tax basis of the assets is $5 million. As part of her retirement planning, Cristina decides to contribute these assets to a Maltese pension fund.16 Assume that in the same tax year, the real estate is sold for fair market value and the start-up has its IPO (further assume Cristina is subject to a six-month lock-up period before the shares may be sold). During the same tax year, after her lock-up period expires, Cristina sells her shares for fair market value, leaving her portion of the pension plan holding proceeds of $200 million. The following year, when Cristina is at least 50 years of age, assuming the terms of the pension plan permit her to begin withdrawing assets at age 50, Cristina can receive a distribution during that tax year of $60 million from the pension without the imposition of any income tax, either in Malta or the United States.
Cristina then waits until year four, at which time she can make additional tax-free distributions. To calculate how much can be distributed free of tax, it is necessary to first determine the pension holds “sufficient retirement income.” This amount, in turn, is based under Maltese law on the “annual national minimum wage” in the jurisdiction in which the member is a resident. To the extent the pension plan balance exceeds the member’s “sufficient retirement income” (computed on a lifetime basis), 50 percent of the excess can be withdrawn tax-free each year. Assuming the $140 million remaining assets (after accounting for the initial lump sum distribution) had increased in value to $160 million by year four, and further assuming it was determined that the individual needed $1 million as her sufficient retirement income, 50 percent of the $159 million excess, or $79.5 million, could be distributed to Cristina that year free of tax. Such calculations could likewise be performed in each succeeding tax year, with 50 percent of the excess being available for tax-free receipt by the beneficiary each year. Consequently, while it is not possible to distribute 100 percent of the proceeds of the pension tax-free, a very substantial portion of any income generated in the pension (including gains realized by the pension and attributable to appreciation accrued prior to contribution of assets to the pension) can be distributed without any Maltese or U.S. federal income tax liability.
Some have suggested that the benefits of such foreign pension plans, including Malta pensions, are too good to be true. These substantial benefits, however, result from the intersection of local foreign law with specific treaty provisions negotiated and agreed to by Treasury and approved by Congress. In fact, not only were these favorable treaty provisions initially included in the 2006 Model, they also have been included in the recently negotiated income tax treaties with Belgium, Chile, Hungary, Malta, and Poland. Consequently, it is likely that these rather extreme results probably arose from imperfect treaty negotiation, and a failure of the United States to fully appreciate the implications (or relevant foreign law) at the time of agreeing on certain treaty terms. Regardless, these provisions were included at the request of the United States, and therefore, the United States should continue to respect them.
1 Eritrea also taxes its citizens regardless of where they live, but under a special tax regime applicable only to such nonresident citizens, which carries a flat tax of 2 percent. No other country currently taxes on the basis of citizenship alone.
2 Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury regulations promulgated under the Code.
3 See I.R.C. §§401(a), 501(a).
4 See I.R.C. §402(b).
5 I.R.C. §671. The IRS informally confirmed this result in IRS Release 2011-0096 (October 31, 2011), which dealt with the treatment of a rollover of a U.K. pension plan to a Maltese pension plan. In that IRS release, the IRS indicated that foreign pension plans that are classified as trusts are subject to the grantor trust reporting requirements (required to file IRS Form 3520).
6 Article 17(1)(b) of the 2006 Model Treaty.
7 Of these treaties, only the treaties with Malta and Belgium are currently effective (the others remain held up in Congress awaiting ratification).
8 See Article 17(2)(a) of the 2016 Model; Article 18(1) of the 2006 Model.
9 Note that in order for the pension plan itself to qualify for treaty benefits based on the limitation of benefits provision of the Hungary Treaty, it must be true that more than 50 percent of the beneficiaries, members, or participants are residents of the United States or Hungary.
10 As already noted, the treaties with Poland and Chile are not currently effective. The discussion of these treaties, like that of the Hungary Treaty, would apply only when such treaties are finally ratified and become applicable.
11 For this purpose, the term “resident” includes a U.S. citizen. Article 4(1) of the Treaty.
12 It should be noted that the FIRPTA provisions of §897 and §1445 should not be applicable because the pension plan is treated as a foreign grantor trust for U.S. tax purposes.
13 Note that in the cases of Bulgaria and the Slovak Republic, which have incredibly favorable domestic law provisions on the taxation of pensions, the U.S. income tax treaties with these countries do not contain the equivalent taxation provision, and, thus, the U.S. taxing right is preserved in both instances. Perhaps this should not come as a surprise in the Slovak Republic treaty since this treaty was negotiated before the Roth provisions were enacted.
14 Note, however, that U.S. information filing obligations may be triggered to the U.S. transferor member pursuant to §6048.
15 Under §72, a portion of each payment represents tax-free return of basis.
16 Note that, as discussed above, there should be no U.S. federal income tax implications on contribution of the assets (for example, under §684), as the pension plan should be classified as a grantor trust for U.S. federal income tax purposes.
Jeffrey L. Rubinger is a tax partner at Bilzin Sumberg in Miami and heads its international tax practice. He received his J.D. from the University of Florida Levin College of Law and an LL.M. in taxation from New York University School of Law. He is admitted to the Florida and New York bars.
Summer Ayers LePree is a tax partner at Bilzin Sumberg in Miami. She received her J.D. and her LL.M. in taxation from the University of Florida Levin College of Law. She is a member of The Florida Bar.
This column is submitted on behalf of the Tax Law Section, Joseph B. Schimmel, chair, and Christine Concepcion, Michael D. Miller, and Benjamin A. Jablow, editors.