Killing trusts softly: When the relocation mystique becomes a retirement mistake

As discussed in our paper, “Long Overdue: Definitive Guidance on U.S. Tax Classification and Reporting Requirements for Cross-Border Retirement Contributions, Earnings and Distributions in Countries with Hybrid Social Security Regimes”¹⁴:
There are many types of retirement savings plans¹⁵ worldwide which make up the cross-border pension landscape. However, there is no comprehensive scheme providing a uniform global classification of such plans for all tax purposes in all countries. Over the past 100 years,¹⁶ in the U.S. at least, a survey of publications by the Treasury Department and the Internal Revenue Service (“IRS”) yields a plethora of guidance on the tax treatment of domestic retirement plans, and more recently, foreign pension plans.¹⁷ Published guidance with respect to the former appears to have been issued on an as needed basis, thereby resulting in the application of provisions under the I.R.C and the Treasury Regulations (“Treas. Regs”) promulgated thereunder, which when strung together, provide a tax classification that supports adverse tax treatment of the foreign plan for U.S. income tax purposes. Indeed, relief from the unfavorable tax consequences to U.S. participants in foreign plans has been sought time and again through applicable treaty provisions negotiated between the U.S. and the treaty country.¹⁸ Due to the inherent political nature of the treaty making process, the ratification and amendment of tax treaties remains in a “lengthy hiatus,”¹⁹ subject to the changing priorities of the U.S. government. Acknowledging the evolving nature of foreign pension plans and adapting our existing domestic tax frameworks to keep pace with these changes, such that U.S. Persons with beneficial interests in these plans are not disadvantaged, must be urgently prioritized to keep the U.S. competitive with the rest of the world.

In general, foreign pension plans around the world have now shifted to fully funded private individual accounts that can be accessed by individuals who are who are employees through their employer or by social partners (i.e.: “Occupational Pensions”) or directly without any involvement of their employers and established directly by a pension fund or a financial institution acting as a pension provider (i.e.: “Personal Pensions”). Occupational Pensions are either Defined Benefit (“DB”) or Defined Contribution (“DC”). In DC plans, benefits offered are directly linked to the extent of contributions made by the participants, but participants bear the brunt of the risk and are ultimately responsible for managing their investment decisions for retirement. In contrast, in traditional DB plans, sponsoring employers assume all of the risks. However, some countries have also developed hybrid and mixed DB plans, which come in different forms but all result in spreading the risks between employers and employees. Both types of pensions co-exist in 33 out of the 38 countries that report to the OECD.²⁰

The OECD reports that DC and Personal Pensions have been gaining prominence at the expense of DB plans even in countries where there has historically been a high proportion of assets in DB plans, such as the U.S.²¹ Indeed, this same observation was reiterated in the August 2022 report by the U.S. Government and Accountability Office (“GAO”) on Retirement Security,²² noting that traditional pensions have become less common, with more individuals managing their own retirement savings. This is attributable to pension reforms instituted in many OECD countries since the 1980s to restructure their public pension programs to address future financial shortfalls that was imminent with the traditional Pay-As- You-Go (“PAYG”) pension system,²³ which meant reducing entitlement to benefits under the public pension and increasing incentives for fully funded and mandatory individual account-based savings²⁴ (“Fully Funded Private Pension Plans”). This included (1) requiring automatic enrollment by employers of their employees in retirement savings plans to increase program participation;²⁵ (2) mandatory employer contributions and government contributions to incentivize participants to remain in their plans^;26 (3) use of default contribution rates of 3 to 5 percent of a participant’s salary to facilitate savings by simplifying key investment decisions of how much to contribute;²⁷ and (4) providing participants with flexibility in terms of plan options when changing employers, ability to pause or stop contributions; early withdrawals, and draw-down of funds.²⁸ Fully Funded Private Pension Plans are intended to complement existing public pension plans, so much so that in some countries like Australia, Canada, the Netherlands, the United Kingdom and Chile, funded private pension plans have overtaken public pensions as the main source of retirement funding.²⁹

U.S. statutory guidance for U.S. and foreign retirement plans

As reported in our second installment,³⁰ most countries that U.S. persons relocate to are among the top-ranked in the world for fully funded private pension plan assets, as of 2026. These are: Canada (US $3.4 trillion); the United Kingdom (US $2.8 trillion); Australia (US $2.4 trillion); the Netherlands (US $1.8 trillion); Switzerland (US $1.5 trillion); and Japan (US $1.1 trillion).³¹ Similarly, immigration to the United States has contributed to the world’s largest pension market, with pension assets totaling $44.8 trillion. Accordingly, foreign nationals who transfer their fully funded private pension plans to U.S. qualified retirement plans are also subject to similar tax leakage arising from transfers between foreign and U.S. retirement plans.

Through the U.S. retirement scheme, individuals can accumulate savings through both occupational (employer-sponsored) and personal retirement plans. Historically, the U.S. retirement savings plan system consisted mostly of plans that were primarily funded through voluntary contributions by employers and employees. Unlike many other countries, participation in occupational plans remains largely voluntary in the United States for both employers and employees. Since 2000, Congress has advanced pension reform starting with the Pension Protection Act of 2006,³² which provided the first statutory authority for employers to automatically enroll employees in defined contribution plans. Pension reform continued in 2019 with the passage of the Setting Every Community Up for Retirement Enhancement Act of 2019,³³ which expanded on the recalibration of traditional U.S. domestic retirement vehicles (such as 401(k)s and IRAs), bringing them one step closer to the global models that rely on mandatory employer-sponsored retirement plans.

Major changes introduced by the SECURE Act included: 
1. Expanding 401(k) eligibility to long-term part-time employees who do not meet the traditional 1,000 hours test initially required for participation in a company plan. Now, employees aged 21 years can participate in 401(k) plans if they have worked 500 hours for 2 consecutive years regardless of part-time status; 2. Introducing portability for lifetime income options by allowing eligible plans (403(b) plans, qualified defined contribution plans, and governmental 457(b) plans) to make direct trustee-to-trustee transfers of lifetime income investments to other employer-sponsored retirement plans and IRAs, eliminating surrender charges and fees; and 3. Simplifying the safe harbor rules for 401(k) plans to ease plan administration for employers, including allowing greater flexibility in the timing of vesting of employer contributions, reducing compliance costs, and raising the automatic enrollment contributions rate from 10 percent to 15 percent of compensation.³⁴

Altogether, these changes expanded mandatory participation in certain U.S. retirement plans. This was further expanded upon the passage of the SECURE 2.0 Act of 2022.³⁵ SECURE 2.0 added provisions for new retirement plans that automatically enroll employees at a starting rate between 3 percent and 10 percent of their compensation, increased yearly until it reaches at least 10 percent, with an option to escalate up to 15 percent.³⁶ SECURE 2.0 also increased the starting age for mandatory required minimum distributions, allowing U.S. workers to make retirement contributions and defer the time to make required minimum distributions for an additional three years.³⁷

Section 401(a) confers tax-qualified treatment to an employees’ trust that is created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the benefit of its employees or beneficiaries. In the aforementioned. delegation paper³⁸ that we presented before the tax-writing committees of Congress and U.S. Treasury (Tax Policy) almost three years ago, we stated:
However, there is no definition under the Code or regulations of what would constitute an “employees’ trust” for this purpose. Moreover, even if one were somehow able to divine that a particular retirement or pension plan is an employees’ trust, it would still most definitely have to be a domestic trust to obtain tax-qualified status under section 401(a).

The tax-deferral benefits enjoyed by a U.S. employee who is covered under a tax plan extends even after that individual relocates to work [in] another country.³⁹
However, unless that country has a bilateral tax treaty with the United States, the participant’s retirement contributions, earnings, and withdrawals from the U.S. tax qualified plan will be subject to foreign tax.⁴⁰ Our survey of U.S. tax treaties with applicable relief provisions reveals that there is no uniformity of relief to be found.⁴¹

U.S. persons working abroad

U.S. persons who must participate in another country’s foreign retirement and savings plans (foreign plans) while working overseas have limited ability to claim tax deferral on contributions, income accruals, and distributions from those plans because they are not U.S. tax-qualified plans. As previously noted, most foreign plans will not meet the requirements for U.S. tax-qualified plans under section 401(a) because the code does not provide a definition of employees’ trust. Even if there were a definition, section 501(a) requires an employees’ trust to be a U.S. domestic trust.⁴² Hence, the U.S. tax treatment of foreign plans falls under section 402(b), which was enacted in its current form in 1969,⁴³ to govern contributions and earnings made within a nonexempt employees’ trust. This default treatment of foreign plans as nonexempt trusts can disadvantage U.S. persons by imposing harsher tax consequences than those faced by non-U.S. persons, including U.S. taxation of accumulated but undistributed earnings accrued within foreign pension plans.

Section 402(b)

Preliminarily, section 402(a) provides an exemption for amounts received by a beneficiary of an employees’ trust that meets the requirements of section 401(a) as a “qualified employees’ trust,” and that is exempt from tax under section 501(a) as an “exempt employees’ trust.” Setting aside the elephant in the room, there is no statutory definition for “exempt employee’s trust.” Foreign trusts that benefit employees will not satisfy section 501(a) because foreign trusts are not obviously domestic trusts. In the most recent D.C. delegation paper that we presented in May before the Congressional tax-writing committees, IRS National Office and U.S. Treasury (Tax Policy), we addressed the inadequacy of existing tax legislation commonly used by tax practitioners in reporting cross border pensions⁴⁴:

Enter section 402(b). Foreign trusts that fall under section 402(b) are typically created when an employer enters a trust arrangement wherein the trustee is the legal owner of the trust assets and the employer is the settlor contributing cash or shares on behalf of an employee. The employee has a beneficial ownership interest in the trust. The right in this interest may be subject to service or performance conditions that must be satisfied for the employee’s right to be nonforfeitable and for the employee to receive a future distribution of trust assets from the trustee. If the amounts contributed are vested⁴⁵ upon contribution, then such amounts are treated as taxable compensation income to the employee under section 402(b)(1).⁴⁶ However, if the benefits vest some time after the contribution is made, then the employee’s inclusion into income is equivalent to the fair market value of his interest in the trust as of the vesting date.⁴⁷ Eventual distributions from the trust to the employee would be taxable upon receipt under section 72 which allows for the amount already taxed at the time of contribution (if applicable) to be considered part of such employee’s basis and therefore excluded from additional tax.

Section 402(b)(2) provides that (1) contributions made to the foreign plan by a foreign employer would be includible as gross income of a U.S. person who is an employee with a beneficial interest in such plan (a U.S. beneficiary) and taxed currently, to the extent such amounts meet the requirements of section 83;⁴⁸ and (2) income accretions in the foreign plan that are actually distributed or made available for distribution to the U.S. beneficiary are taxable to such U.S. person in that same year, to the extent provided for under section 72.⁴⁹ As discussed below, there are two significant issues with the foregoing application of section 402(b)(2). First, many of these foreign plans do not qualify for deferred taxation. Second, transfers between these foreign plans are excluded from section 402(b)(2) which applies only to transfers between a U.S. plan and foreign plan. 

Many foreign plans do not qualify for deferred taxation

To claim the benefits of section 402(b)(2), contributions in a foreign plan must already be substantially vested in the participant. What constitutes substantial vesting is provided under section 1.83-3(b). In the same unpublished D.C. delegation paper,⁵⁰ we also noted:
To be includible in the U.S. person’s income, the employer contributions must meet the conditions of reg. section 1.83-3(b) requiring “substantial vesting.” Once the employer contributions are vested and taxed, income earned by the trust is deferred until it is distributed or actually made available to the employee under section 402(b)(2), unless the U.S. person is a highly compensated employee under such plan.

If the U.S. person is a “highly compensated employee” under the plan, vested earnings are instead included in the employee’s income each year under section 402(b)(4). Since (1) most foreign employer contributions to foreign retirement plans are mandatory and irrevocable, and (2) almost all foreign retirement plans with a U.S. employee would fail the discrimination test under section 410(a), it follows that a U.S. person would be taking these employer contribution amounts into income and taxed currently. There would be no tax deferral extended to such amounts. As discussed above, the application of section 402(b)(2) to cross-border pensions results in a timing mismatch between the U.S. beneficiary’s foreign income taxes, under which no taxes are imposed on the foreign employer’s contributions or vested earnings until distributed and U.S. income taxes, under which taxes are imposed currently on the foreign employer contribution and vested earnings. The timing mismatch is fatal because it denies the U.S. beneficiary the opportunity to mitigate his global taxes through the foreign tax credit mechanism under section 901.

Tax-free distributions under section 402(b) exclude foreign plans

While not initially apparent, distributions under section 402(b) exclude transfers between foreign nonexempt plans because such arrangements are not U.S. trusts. In fact, transfers from one foreign plan to another (colloquially referred to as tax-free rollovers) are treated as taxable distributions for U.S. tax purposes unless a specific exemption applies to foreign-to-foreign plan transfers under this section.

We are hard pressed to conclude that section 402(b) operates in the best interests of a U.S. beneficiary because that individual would likely be subject to U.S. tax on contributions made by a foreign employer, rollovers or transfers of accounts between foreign plans, and income accretions that are made available without actual distribution. A U.S. beneficiary of a foreign plan under section 402(b) would generally expect to be taxed on nearly all components of a foreign plan without any recourse for treating the plan as a foreign grantor trust,⁵¹ such that future distributions from the plan would not be subject to additional U.S. tax.⁵² In the absence of statutory authority governing the transfer of assets between foreign plans, we considered an alternative classification of such foreign plan which, from our perspective, produced a result that was truly the lesser of two evils:
To mitigate the risk of double taxation with respect to these foreign plans, a U.S. beneficiary may opt to treat the foreign plan as a foreign grantor trust under reg. section 1.402(b)-1(b)(6). Doing so would exempt future distributions from the plan (including rollovers and transfers between foreign plans) from additional U.S. taxation. However, this provision can only be applied if the U.S. beneficiary’s employee contributions are “not incidental when compared to employer contributions” and the “applicable requirements of subpart E are satisfied.”⁵³
Whether a foreign plan can satisfy the requirements of section 1.402(b)-1(b)(6) is a matter of personal conviction (or strict adherence to an early retirement strategy). For U.S. person beneficiaries of foreign plans in countries with mandatory employer contributions, making employee contributions that substantially exceed employer contributions can be a herculean feat! Even if some U.S. beneficiaries of foreign plans contribute more of their pre-tax compensation to their own plans than their employers contribute through mandatory contributions, “[N]o further guidance is provided under this subsection of the Treasury Regulations to enlighten U.S. taxpayers and their advisers. From our perspective, taking a position under this obscure subsection of regulatory guidance could be quite the gamble given the overall lack of clarity in how these provisions actually operate.”⁵⁴

Section 679

For U.S. beneficiaries of foreign plans, a better option is to report the plan as a foreign grantor trust under section 679 of the grantor trust rules under subchapter J. As aforementioned, this option only becomes available as an exception to the exception under reg. section 1.402(b)-1(b)(6).⁵⁵ We noted in our prior installment⁵⁶ that, for the perplexed and beleaguered U.S. beneficiaries of these cross-border plans, classifying a foreign plan under section 679 yields more palatable results than the outcome achieved under section 402(b)(2):
A deliberate classification of a foreign plan as a foreign grantor trust under subchapter J rather than as an exception to the exception under reg. section 1.402(b)-1(6) would subject all contributions and income accruals to current U.S. taxation but would eliminate U.S. taxation on future distributions. Moreover, the U.S. beneficiary could claim some FTCs under this strategy, as U.S. income taxes paid on contributions and earnings in the plan can likely be offset with foreign income taxes paid on those same components in the foreign country. In essence, the foreign plan would be treated as a post-tax plan, operating similarly to a U.S. Roth IRA.⁵⁷ It is better than a Roth IRA because the only monetary limits to savings under such a foreign plan would be the limits placed on it by the foreign country’s laws.

Notwithstanding that section 679 reporting may enable a U.S. beneficiary to align foreign tax credits with concurrent U.S. tax liabilities arising from a foreign plan, many practitioners avoid classifying a foreign plan as a foreign grantor trust under section 679 because doing so may trigger additional tax consequences that may require more detailed disclosure and reporting of assets beyond the foreign plan itself. For example, foreign plans investing in foreign equities and mutual funds may trigger annual U.S. tax reporting obligations for a U.S. beneficiary treating the plan as a foreign grantor trust because those investments are often treated as passive foreign investment companies or, in the case of certain Australian unit trusts, as foreign controlled corporations under the U.S. antideferral rules.

Australian superannuation funds

One example of a favorable U.S. tax result arising from classification as a foreign grantor trust involves a U.S. beneficiary of an Australian self-managed superannuation fund (SMSF) (super fund). In the absence of foreign grantor trust treatment, the U.S. beneficiary would generally report his interest in an SMSF either under section 402(b)(2) or as a foreign non-grantor trust. Neither option is optimal.

As a beneficiary of a foreign non-grantor trust, the U.S. person would be subject to U.S. trust attribution rules and potentially burdensome taxation on income earnings generated by foreign entities held within the SMSF that are classified as PFICs or foreign-controlled corporations. More importantly, undistributed income would likely be subject to the U.S. throwback tax regime applicable to undistributable net income. 

A U.S. beneficiary would clearly benefit from treating an interest in a super fund as a foreign grantor trust because this would eliminate potential U.S. throwback tax issues. Moreover, the U.S. person may be able to offset U.S. income tax on accrued earnings within the SMSF with actual taxes paid by the SMSF on income earned during the contribution and accumulation phases,⁶⁰ as well as Australian income taxes paid on non- SMSF income such as wages and salary, which are generally imposed at a higher marginal rate than in the United States. However, this favorable outcome is not sustainable under the following scenarios.

Transfer between super funds

The Australian super fund industry is a significant player in the Australian retirement scheme, with superannuation assets totaling AUD 4.486 trillion at the end of the March 2026 quarter,⁶¹ and with significant growth in pension mandates from globally listed equities, Australian listed shares, and Australian fixed interest.⁶² More notably, certain commentators have attributed the continued and accelerating transfer of money from super fund industry funds into SMSFs.⁶³ Technically there are six types of super funds available to Australians: industry funds, corporate funds,⁶⁴ retail funds, public sector funds, SMSFs, and small Australian Prudential Regulatory Authority funds. It is not uncommon for Australian workers to rollover from one super fund to another when (1) changing employers (a compulsory rollover) or (2) maximizing earnings or engaging in speculative investments (a voluntary rollover).

While a rollover⁶⁵ in either situation does not constitute a taxable event under Australian tax law,⁶⁶ it does trigger a deemed sale of assets subject to U.S. taxes under section 684 because the super funds are generally treated as foreign trusts. Accordingly, a U.S. beneficiary who rolls over assets in an SMSF to another super fund (or another SMSF) would be required to report the rollover as a taxable sale on his U.S. tax return, resulting in a timing mismatch in the FTC mechanism because corresponding Australian taxes would not arise. This is a common issue among U.S. persons who live and work in Australia and those who keep investments in Australian super funds while residing in the United States.

Division 296 tax planning

Commencing on July 1, 2026, an additional 15 percent tax will apply to earnings attributable to a portion of a super fund exceeding AUD 3 million (increasing to 25 percent if the balance exceeds AUD 10 million).⁶⁷ The additional 15 percent tax will be assessed after the close of the fiscal year, based on the fund’s account balance as of June 30, 2027.⁶⁸ A U.S. beneficiary seeking to reduce or eliminate the tax liability may withdraw assets from the SMSF before the tax takes effect. However, this may trigger penalties for early withdrawals made before retirement age and may lead to reinvestment in alternative structures, such as investment bonds — properties outside the super fund that may be subject to U.S. anti-deferral rules.

Departing Australia for the United States

Lastly, because super funds are tax-advantaged retirement vehicles in Australia, they must satisfy certain conditions to retain that favorable tax treatment. A super fund must be a complying superannuation fund⁶⁹ and maintain Australian tax residency. A super fund with a U.S. beneficiary that departs Australia risks becoming a noncomplying fund.

To avoid this outcome, super fund owners often transfer their super funds to Australian t ax-resident custodians or convert the fund to another type of super fund administered by Australian tax resident trustees. In either case, maintaining the complying super fund status of a U.S. beneficiary’s super fund following departure from Australia may trigger section 684, under which the U.S. beneficiary is deemed to sell the SMSF assets (treated as a foreign grantor trust) to another super fund (a foreign non-grantor trust), resulting in U.S. tax liability without corresponding Australian tax to offset it.

Nonresident persons moving to the United States

Similarly, nonresident persons who relocate to the United States and participate in U.S. retirement plans are entitled to the same tax-deferral benefits on contributions and income accruals as U.S. persons. As we discussed in our last installment: While there is a U.S. taxation exemption option under section 72(w), for any contributions made to a pre-existing foreign retirement plan prior to relocating to the United States,⁷⁰ there does not appear to be any relief from current U.S. taxation of foreign employer contributions made to the foreign plan (as discussed in the prior section), as well as income and gains accrued in the foreign plan (from both foreign employer and employee contributions) once the beneficiary of such a plan has become a U.S. tax resident.⁷¹ The result is that a substantial portion of the corpus and all of the income and gains accrued in such plan become subject to U.S. taxation once the conditions are satisfied for penalty-free withdrawals and distributions to commence.⁷²

Section 72(w)

Section 72(w) provides general rules for the income inclusion of amounts received as an annuity. However, when a section 402(b) trust is involved, the principles under section 72 are applied to distributions received by the employee such that only the portion of each distribution that exceeds amounts previously included in income is includible in the distributee’s gross income. This allocation applies on a pro rata basis to each distribution. Therefore, taxation should be reduced on amounts distributed after a foreign employee becomes a U.S. resident. In addition, section 72(b) provides for the exclusion from gross income of the portion of each payment that constitutes a return of the distributee’s investment in the contract:
Gross income does not include that part of any amount received as an annuity under an annuity, endowment or life insurance contract which bears the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date).

The term “investment in the contract” is defined under section 72(c)(1) as: The investment in the contract as of the annuity starting date is (A) the aggregate amount of all premiums and other consideration paid for the contract, minus (B) aggregate amounts received under the contract before such date, to the extent that such amount was excludable from gross income under this subtitle or prior income tax laws. 
The House conference report accompanying H.R. 4520, the American Jobs Creation Act of 2004,⁷³ which codified section 72(w), expressly stated Congress’s intent to remain consistent with the U.S. model tax treaty provisions providing for exclusive residence-based taxation of pension distributions to the extent that those distributions had not been included in taxable income in the other country.⁷⁴ The codified version of section 72(w) excludes from a taxpayer’s basis certain contributions and earnings that were not previously taxed while the taxpayer was a nonresident alien employee. The conference report⁷⁵ states:
The following example provides how the conference agreement could affect the amount of distribution that may be taxed by the United States pursuant to a tax treaty.

Assume the following facts. A, a nonresident alien individual performs services outside the United States, in A’s country of residence, Country Z. A’s employer makes contributions on behalf of A to a pension plan established in Country Z. For U.S. tax purposes, no portion of the contributions or earnings are included in A’s income (and would not be included in income if the amounts were paid as cash compensation when the services were performed) because such amounts related to services performed outside the United States. Later in time, A retires and becomes a permanent resident of the United States.

Under the conference agreement, the employer contributions to a pension plan would not be taken into account in determining A’s basis if A was not subject to income tax on the contributions by the foreign country and the contributions would have been subject to tax by a foreign country if the contributions had been paid to A as cash compensation when the services were performed. Thus, in those circumstances, A would be subject to U.S. tax on the distribution of all contributions, as such distributions are made. However, if the contributions would not have been subject to tax in the foreign country if they had been paid to A as cash compensation when the services were performed, under the conference agreement, the contributions would be included in A’s basis. Earnings that accrued while A was a non-resident alien would not result in basis if not taxed under U.S. or foreign law. Earnings that accrued while A was a permanent resident of the United States would be subject to present-law rules.
The conference agreement authorizes the Secretary of the Treasury to issue regulations to carry out the purposes of the conference agreement, including regulations treating contributions as not subject to income tax under the laws of any foreign country under appropriate circumstances. For example, Treasury could provide that foreign income tax that was merely nominal would not satisfy the “subject to income tax” requirement.

The conference also changes the rules for determining basis in property received in connection for the performance of services in the case of an individual who was a non-resident alien at the time of the services if the property is treated as income from sources outside the United States. In that case, the individual’s basis in the property does not include any amount that was not subject to income tax (and would have been subject to income tax if paid as cash compensation when the services were performed) under the laws of the United States or any foreign country. [Emphasis added.]

Based on the above passage, foreign income tax under section 72(w) would merely exclude nominal taxes (for example, those imposed in zero- or low-tax jurisdictions).

The conference report also illustrates that section 72(w) relief is only available if the foreign income taxes on contributions and earnings are imposed on the nonresident alien, not the foreign trust. This presents a substantial hurdle for many foreign plans on which taxes are levied (for example, the Australian superannuation fund is a foreign trust that pays its own tax) rather than the individual. This would render those foreign plans ineligible for section 72(w) relief, such as the Canadian retirement compensation arrangements (RCAs) and super funds. A brief analysis of section 72(w)’s application to these two foreign plans is provided below.

Canadian retirement compensation arrangements (RCAs)

In our 2022 article providing technical analysis of Canadian RCAs,⁷⁶ we noted that applying the above section 72(w)(2)(A) to a Canadian person’s RCA before they became a U.S. person (a U.S. resident for tax purposes) is not an issue. After all, the RCA is an arrangement between a Canadian resident and their Canadian employer regarding services performed in Canada. Under these circumstances, U.S. tax should not apply. Only Canadian tax applies to 50 percent of the employer contributions to the RCA at the time the contribution is made. This is referred to as the “refundable tax.”

The primary issue arises when the Canadian resident becomes a U.S. tax resident, the RCA is no longer funded, but the RCA trust continues to accrue earnings in Canada under a Canadian trust. Now that the Canadian resident has become a U.S. tax resident, section 72(w)(2)(B) must be applied to determine whether any portion of the RCA trust (employer contributions made before the Canadian resident moved to the U.S. or earnings accruing in the trust thereafter) is exempt from U.S. tax.

Section 72(w)(2)(B) exempts from U.S. tax the portion of the RCA trust that can be attributed to contributions made by the foreign employer already subject to Canadian tax (hence, a “nontaxable contribution” under 72(w)(2)(B) because it was subject to a foreign tax already). Arguably, 50 percent of the Canadian employer contributions in an RCA trust would constitute a nontaxable contribution under section 72(w)(2)(B) because it was already subject to the Canadian refundable tax. However, this tax is not a permanent tax at all. Indeed, the Canadian refundable tax is ultimately returned by the Canadian Revenue Agency to the RCA trust once distributions from the RCA are made to the former Canadian resident (now a U.S. tax resident). Therefore, it is unclear whether the Canadian refundable tax constitutes a foreign income tax for purposes of section 72(w)(2)(B) and (3)(C) such that Canadian employer contributions and earnings accruing thereafter in the RCA trust would be classified as previously taxed contributions and earnings.

We doubt that the Canadian refundable tax would constitute an income tax for U.S. tax purposes. We note, however, that the refundable tax applicable to an RCA differs from the special refundable tax that the IRS previously characterized as a compulsory loan, rather than an income tax, as in Rev. Rul. 67-187, 1967-1 C.B. 185. In that ruling, the IRS concluded that that the Canadian special refundable tax then in effect was not an income tax because it was repayable with interest, within a specified period. By contrast, the RCA refundable tax does not bear interest — an important indicium of a loan, whether compulsory or otherwise — and the timing of the any refund depends on the RCA’s pattern of contributions, investment income, and benefit distributions, rather than occurring within a prescribed repayment period. The refundable tax is closer to a deposit⁷⁷ than a true income tax because the 50 percent tax imposed on contributions and accrued earnings is ultimately refunded to the RCA trust as trust funds are distributed to the employee, the trust’s sole beneficiary. Therefore, the refundable tax mechanism operates so that the U.S. beneficiary ultimately receives the full amount initially contributed by the Canadian employer, together with all earnings accrued on those amounts. If, however, the Canadian refundable tax constitutes a true foreign income tax, then Canadian employer contributions to an RCA trust for the benefit of a U.S. beneficiary cannot be treated as part of the beneficiary’s “investment in the contract.” As a result, those contributions cannot be used to determine the portion of a subsequent distribution that is excludable from U.S. tax.⁷⁸

We further noted in our 2022 article⁷⁹ that the term “foreign income tax” as interpreted under section 72(w) excludes merely nominal tax (for example, those taxes imposed in low- or zero-tax jurisdictions). If the Canadian refundable tax constitutes an income tax, the corollary argument is that it is, at most, a nominal tax because the tax is ultimately refunded to the RCA trust as the trust makes distributions to the U.S. beneficiary.⁸⁰
We further note that a U.S. person who migrates to Canada to work for a Canadian employer and establishes an RCA during that employment is at a competitive disadvantage with Canadian residents who have RCAs. This is because such a U.S. person would not meet the conditions of section 72(w)(2)(B) and (3)(C) to include contributions and earnings in the RCA as part of his “investment in the contract.” This is because notwithstanding the status of the Canadian refundable tax as a foreign income tax for U.S. FTC purposes, the U.S. person would be subject to U.S. tax on his worldwide income (which would include the contributions and earnings in an RCA trust established for his benefit by the Canadian employer).

Our review of the legislative history of section 72(w) supports our conclusion that both contributions and earnings accrued in an RCA trust would be subject to U.S. tax upon distribution to both (1) a Canadian resident if they were to relocate to the United States prior to distributions and (2) a U.S. person who relocates to Canada and works for a Canadian employer who establishes an RCA trust with the U.S. person as sole beneficiary. 

Section 402(b)(4)

In our prior article in 2022, we also pondered whether section 402(b)(4) would provide more definitive guidance to the U.S. tax treatment of distributions received by a U.S. resident from a foreign plan than section 72(w)such as an RCA. We concluded that if a U.S. person receives distributions from the RCA trust that was established (a) for the benefit of such person prior to relocating to the United States;(b) for services performed in Canada, then the distribution from the RCA trust would not be subject to U.S. tax provided the foreign plan was a funded foreign nonexempt trust.⁸¹

Classification as deferred compensation under section 409A

In our 2022 article,⁸² we also contemplated the potential application of section 409A to an RCA trust. Specifically, we stated:
There remains the risk that accrued earnings in that foreign plan that remain undistributed may be taxable to the U.S. beneficiary as current income. This risk arises if the foreign plan constitutes a nonqualified deferred compensation plan under section 409A. This statutory provision⁸³ provides for certain requirements that, if violated, would cause the U.S. beneficiary to recognize all earnings accrued in the foreign plan as currently includible in U.S. person’s gross income to the extent that those amounts are not subject to a substantial risk of forfeiture.⁸⁴ Consequently, the U.S. beneficiary’s exclusive right to receive the assets (which likely constitute compensation income) in the foreign plan as the sole beneficiary may constitute deferred compensation, which would cause the U.S. beneficiary to recognize those accrued earnings as current gross income subject to tax.⁸⁵
Our 2022 article also provided an extensive discussion of the two exemptions under the section 409A regulations for arrangements that would otherwise be treated as deferred compensation:
Indeed, there are two exemptions in reg. section 1.409A-1(b)(6)(i) that may apply to prevent the inclusion of accrued earnings in a foreign plan as current gross income for U.S. tax purposes. Section 1.409A-1(b)(6)(i) states:
If a service provider receives property from, or pursuant to, a plan maintained by a service recipient, there is no deferral of compensation merely because the value of the property is not includible in income by reason of the property being substantially nonvested (as defined in Section 1.83-3(b)), or is includible in income solely due to a valid election under section 83(b). For purposes of this paragraph (b)(6)(i), a transfer of property includes the transfer of a beneficial interest in a trust or annuity plan, or a transfer to or from a trust or under an annuity plan, to the extent such a transfer is subject to section 83, section 402(b) or section 403(c). In addition, for purposes of this paragraph (b), a right to compensation income that will be required to be included in income under section 402(b)(4)(A) is not a deferral of compensation. [Emphasis added.]

We concluded that the transfer of property to a trust that constitutes a right to compensation income is not considered a deferral of compensation under section 409A if it is already subject to the income inclusion rules of section 402(b)(4)(A).⁸⁶ However, it is unlikely that a U.S. beneficiary of a foreign plan could claim this exemption if the foreign plan is not likely to be subject to section 402(b)(4).

Substantially nonvested

The second exemption to section 409A under the 409A regulations involves the transfer of property, such as a right to compensation, to a foreign trust that is a section 402(b) plan. Under reg. section 1.409A-1(b)(6)(i), amounts contributed by a foreign employer to a foreign plan with a U.S. beneficiary would not be treated as deferred compensation under section 409A if the U.S. beneficiary’s right to that property is substantially nonvested under section 1.83-3(b).

We also concluded in our 2022 article⁸⁷ that a U.S. beneficiary’s beneficial interest in a foreign plan that is fully funded would not be substantially nonvested because of the below reasons.
First, the assets in most foreign plans are not subject to a substantial risk of forfeiture. Under reg. section 1.83-3(c)(1), property is subject to a substantial risk of forfeiture if the transfer has conditions directly or indirectly related to the (1) future performance (or lack of performance) of substantial services by any person, or (2) the occurrence of a condition related to the transfer that, if not satisfied, would result in forfeiture. ⁸⁸
In a typical foreign plan, the foreign employer would make a mandatory contribution to the plan for the U.S. beneficiary’s benefit upon her retirement or in the event of loss of employment. There are no conditions that would divest the U.S. beneficiary of her right to receive the property before or upon her retirement. The only implicit condition to the transfer of the property is the passage of time until her retirement or departure from the foreign employer, and the mere passage of time does not constitute a risk of substantial forfeiture.⁸⁹

Second, a U.S. beneficiary’s right to receive the foreign plan assets is transferable because such rights can generally be sold, assigned, or pledged to another person (except the foreign employer). Reg. section 1.83-3(d) provides that “the rights of a person in property are transferable if such a person can transfer any interest to any person other than the transferor of the property, but only if such rights in the property are not subject to a substantial risk of forfeiture.” Therefore, property is transferrable if the person receiving the property can sell, assign, or pledge (as collateral for a loan or security or any other purpose) their interest in the property to any person other than the transferor. Based on this definition, a U.S. beneficiary’s right to receive the foreign plan assets is transferable.
In our 2022 article, we concluded that there was a risk that the foreign plan could be treated as deferred compensation under section 409A because a U.S. beneficiary’s right to receive the foreign plan assets is not substantially nonvested under section 83 and the related regulations. Therefore, the earnings accruing in the foreign plan would be currently includible in the U.S. beneficiary’s gross income under section 409A and subject to U.S. tax. We would, however, take the position that any accrued earnings potentially subject to U.S. tax would cover only earnings accrued in the foreign plan, starting on the date the U.S. beneficiary first became a U.S. resident under U.S. tax laws.⁹⁰

IRS guidance on rollovers

The United States has not released any definitive guidance on the U.S. tax classification and treatment of foreign pension and retirement plan rollovers. However, over the past decade, Treasury and the IRS have had several opportunities to address the tax classification and treatment of foreign countries’ retirement and savings plans. For example, as early as 2000, the IRS issued a series of administrative notices clarifying the U.S. tax classification and treatment of registered retirement savings plans and other Canadian registered plans such as registered 86 retirement income funds, registered education savings plans, and registered disability savings plans. Moreover, since the Canadian government introduced the tax-free savings account in 2008, the IRS has released two revenue procedures addressing Canadian registered plans, which could have included tax-free savings accounts along with other administrative guidance to simplify the U.S. tax reporting obligations of U.S. persons, but they did not. These revenue procedures are discussed below.

In Rev. Proc. 2014-55,⁹¹ the IRS provided guidance for applying paragraph 7 of article XVIII of the convention.⁹² The guidance eliminated previous requirements for U.S. person beneficiaries⁹³ and annuitants⁹⁴ of a Canadian retirement plan⁹⁵ to report contributions to, distributions from, and ownership of Canadian retirement plans under the simplified reporting regime of IRS Notice 2003-75 (obsoleting as a consequence Form 8891)⁹⁶ or under the reporting obligations imposed by section 6048 (Form 3520).⁹⁷ It did not, however, affect any reporting obligations for Form 8938 under section 6038D or FinCEN Form 114 imposed by 31 U.S.C. section 5314.⁹⁸ Most importantly, Rev. Proc. 2014-55 made clear that distributions received by any U.S. beneficiary or annuitant from a Canadian retirement plan must be included in the gross income of the beneficiary or annuitant for U.S. tax purposes (including the portion thereof that constitutes income accrued in the plan and not previously taxed in the United States) under section 72.⁹⁹

In March 2020 the IRS issued Rev. Proc. 2020-17, further exempting certain U.S. persons from information reporting requirements imposed by section 6048 on Canadian Registered Education Savings Plans (RESPs) and Registered Disability Savings Plans (RDSPs),¹⁰⁰ to the extent that those plans constituted “certain tax-favored foreign retirement plans” and “certain tax-favored foreign nonretirement savings trusts” (collectively, “applicable tax-favored foreign trusts”). However, the exemption only applies to U.S. persons with a prior record of full compliance regarding trust related income taxes. It also provided an exemption for rollovers from one foreign plan to another if both plans meet the requirements of Rev. Proc. 2020-17¹⁰¹:
It appears that the IRS recognized that the administrative burden of reviewing every single Form 3520 or Form 3520-A filed to disclose interests of U.S. persons in foreign trusts could not be justified, particularly because the existence of these foreign trusts were likely already subject to annual tax reporting under section 6038D as specified foreign financial assets.¹⁰²

In rendering applicable tax-favored foreign trusts exempt from the annual foreign trust reporting requirements, the IRS pointed out that section 6048(d)(4) “authorizes the Secretary to suspend or modify any requirement under section 6048 if the United States has no significant tax interest in obtaining requirement information.”¹⁰³ The IRS stated:
The Treasury Department and IRS have determined that, because applicable tax-favored foreign trusts generally are already subject to written restrictions, such as contribution limitations, conditions for withdrawal, and information reporting, which are imposed under the laws of the country in which the trust is established, and because U.S. individuals with an interest in these trusts may be required under section 6038D to separately report information about their interests in accounts held by, or through these trusts, it would be appropriate to exempt U.S. individuals from the requirement to provide information about these trusts under section 6048.¹⁰⁴
As discussed in a previous article, “Bringing Home the (Canadian) Bacon: U.S. Tax and Canadian Retirement Plans”¹⁰⁵:  Based on the narrow definition of tax-favored foreign nonretirement savings trust provided in section 5.04 of Rev. Proc. 2020-17, tax practitioners were not hard-pressed to ascertain that Canadian RESPs and RDSPs would fall within the exemption from section 6048 reporting, because these trusts are organized in Canada exclusively for providing income for medical, disability, or educational benefits, and have limited contribution amounts of $10,000 or less annually or $200,000 or less on a lifetime basis. Moreover, Canadian RESPs and RDSPs are already subject to strict conditions for withdrawal and annual information reporting by the Canadian government to maintain their status for Canadian tax purposes. The administrative burdens posed by such foreign trusts on IRS resources far outweigh the benefits generated from IRS enforcement efforts directed at delinquent foreign trust filings for U.S. person interests in such assets. Such assets are low-balance depositary accounts that would be an unlikely offshore vehicle for U.S. tax avoidance by U.S. persons resident in Canada.¹⁰⁶ However, tax-free savings accounts and RCAs are not low-value accounts.

As we discussed in our last installment: While Rev. Proc. 2020-17 has provided some degree of relief to foreign plans not previously exempted from U.S. taxation under prior IRS guidance,¹⁰⁷ such as Canadian RESPs and RDSPs, it does not go far enough to cover other foreign plans that should receive the same exemption. The very narrow parameters for determining “Tax-Favored Retirement Plans” or tax-favored nonretirement savings plans in Rev. Proc. 2020-17 left out other foreign plans which also needed IRS guidance, such as Australian superannuation funds and Canadian tax-free savings accounts. Indeed, the parameters are so narrow that perhaps only Canadian savings plans above would even qualify for the foreign trust reporting exemption under Rev. Proc. 2020-17.

In addition to providing narrow parameters for exempting foreign plans from foreign trust reporting, Rev. Proc 2020-17 did not provide a solution to alleviate U.S. income taxation of income accruals and employer contributions in such plans. While the procedure did eliminate the annual tax reporting requirement for qualifying foreign trusts that are foreign plans, and as a corollary, avoid substantial penalties for noncompliance, the revenue procedure did not go far enough to provide effective relief for foreign plans in countries that are either not legally structured as trusts in such foreign country,¹⁰⁸ or do not tolerate such low contribution thresholds for savings as in the United States. In light of this, many U.S. international tax practitioners who deal regularly with superfunds, some of whom are IRS attorneys, agree that Rev. Proc. 2020-17 cannot be applied to exempt Australian superannuation funds from foreign trust reporting.

IRS enforcement action

The severe limitations on a U.S. taxpayer’s ability to invest in a foreign retirement plan without adverse U.S. tax consequences are best illustrated in recent Treasury and IRS actions¹⁰⁹ against U.S. taxpayers who established Malta individual retirement plans and claimed that earnings in, and distributions from, personal retirement schemes established under Maltese law were exempt from U.S. income tax under the pension provisions of the U.S.-Malta tax treaty.¹¹⁰ Typically, the transaction is intended to permanently avoid U.S. tax on (1) the built-in gain of appreciated property transferred to personal retirement schemes established in Malta,¹¹¹ (2) income earned by and accumulated in such schemes, and/or (3) distributions from such schemes.

The U.S. individuals who participate in these transactions generally lack any connection to Malta other than their participation in these arrangements. These individuals may also fail to comply with their U.S. information reporting requirements, including those provided in section 6048. In proposing rules to treat the Malta personal retirement scheme as a listed transaction, the IRS stated¹¹²:
In this transaction, the taxpayer (Taxpayer A), a U.S. citizen or a U.S. resident alien, establishes a personal retirement scheme under Malta’s Retirement Pension Act of 2011. In Year 1, Taxpayer A transfers cash, appreciated property (annuities, securities, digital assets, partnership interests, etc.), or a combination thereof, to the scheme without recognizing gain on the transfer under section 684(b). In Year 2 or later, Taxpayer A takes the position on a U.S. income tax return that the income earned by the scheme (including gain on the sale or other disposition of appreciated property initially transferred to the scheme) is exempt from U.S. tax under Articles 18 and 1(5)(a) of the Treaty because the scheme is a “pension fund” for purposes of the Treaty. In Year 3 or later, Taxpayer A receives a distribution from the scheme and takes the position on a U.S. income tax return that such distributions are exempt from U.S. tax by reason of Articles 17(1)(b) and 1(5)(a) of the Treaty. Additionally, Taxpayer A may not comply with U.S. information reporting requirements related to these transactions, including under section 6048. Articles 17(1)(b) and 18 of the Treaty, which are both listed as exceptions to the saving clause,¹¹³ provide U.S. citizens and U.S. resident aliens an exemption from U.S. income tax on (1) “pensions and other similar remuneration” arising in Malta to the extent such pensions or remuneration would be exempt from tax under Maltese law if the beneficial owner were a resident of Malta (Article 17(1)(b)), and (2) income earned by a “pension fund” established in Malta until such income is distributed (Article 18). ¹¹⁴ . . . On December 27, 2021, the IRS published in the Internal Revenue Bulletin a Competent Authority Arrangement (the “CAA”) between the United States and Malta. In the CAA,¹¹⁵ the U.S. and Maltese competent authorities agreed that individual retirement arrangements established under Malta’s Retirement Pensions Act of 2011 are not considered “pension funds” for purpose of relevant provisions of the Treaty. The CAA also confirmed that distributions from these types of arrangements are not “pensions or other similar remuneration” in consideration of past employment for purposes of paragraph 1(b) of Article 17. The CAA “reflects the original intent [of the United States and Malta] regarding the definition of `pension fund’ for purposes of the Treaty.”¹¹⁶

According to the IRS, the U.S. taxpayer’s positions in the Maltese personal retirement plan are incorrect: 
First, the Treaty benefits claimed with respect to personal retirement schemes established in Malta are not available because these schemes are not “pension funds,” and their distributions are not “pensions or other similar remuneration,” as explained in the CAA. Second, under Article 3(2) of the Treaty, the undefined terms “pension” and “retirement” are interpreted according to the tax law of the United States, which is the country that is applying the Treaty. Under U.S. law applicable to individual retirement arrangements, Malta personal retirement schemes are neither “pensions”, nor do they provide “retirement benefits” for purposes of the Treaty.
Maltese law does not condition the tax benefits it provides for these arrangements upon reasonably analogous requirements of U.S. law. Those requirements include that an individual’s contributions to an individual retirement arrangement (other than qualified rollovers from a pension or retirement arrangement that is tax-favored under the same country’s laws) must be made in cash and must be based on income earned from employment or self-employment activities. See sections 219, 408, and 408A. Third, in appropriate fact patterns, the transaction viewed as a whole may be disregarded under relevant judicial doctrines, including the step-transaction doctrine, the substance-over-form doctrine, and the assignment of income doctrine, in order to give effect to the general purpose of the Treaty to mitigate double taxation but not improperly create instances of non-taxation, especially in cases in which the person establishing the retirement arrangement has no other connection to the treaty jurisdiction.¹¹⁷

The IRS further noted that the U.S. taxpayer disregarded international tax reporting requirements in relation to the formation and maintenance of a Malta personal retirement scheme. Specifically: 
Section 6048 generally requires annual information reporting of a U.S. person’s transfers of money or other property to, ownership of, and distributions from, foreign trusts. Section 6677 imposes penalties on a U.S. person for failing to comply with section 6048.¹¹⁸ . . . Under section 6048(d)(4), the Secretary may suspend or modify any requirement under section 6048 if the United States has no significant tax interest in obtaining the required information. Although Treasury and the IRS have previously issued guidance under Revenue Procedure 2020-17 providing that reporting is not required under section 6048(a), (b), and (c) for certain U.S. citizen and resident individuals regarding their transactions with, and ownership of, certain tax-favored foreign retirement trusts and certain tax-favored foreign nonretirement savings trusts,¹¹⁹ Malta personal retirement schemes are not eligible for this relief from section 6048 reporting because contributions to these arrangements are not limited to income earned from the performance of services, subject to a certain annual or lifetime limit, or subject to a limit based on a percentage of the participant’s earned income.¹²⁰ Section 6048 information reporting is provided on Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner (Under section 6048(b)) . . . Section 6038D may also apply to a U.S. person’s interest in a Malta personal retirement scheme. Under section 6038D, a specified person, which includes a U.S. citizen or resident alien, must report any interest in a specified foreign financial asset provided that the aggregate value of all such assets exceeds certain thresholds.¹²¹ Section 6038D(d) imposes a penalty for failing to comply. Section 6038D information reporting is provided on Form 8938, Statement of Specified Foreign Financial Assets. A specified person who is required to report information under section 6038D on Form 8938 may also be required to report similar identifying information under section 6048 on Form 3520 or Form 3520-A. It remains to be seen whether the IRS audits on Malta pension plans will result in prosecutions.¹²²

Conclusion

At first glance, for U.S. residents, relocating abroad and increasing savings through a foreign plan may appear to be a straightforward solution to the geopolitical uncertainty facing the United States today. Yet individuals who hastily moved abroad without proper tax planning for the treatment of their U.S. retirement accounts and savings overseas may have learned that such haste makes waste. Likewise, individuals who relied on the limited relief provided by Rev. Proc. 2020-17 and transferred their U.S. retirement and savings arrangements into foreign plans overseas may now be realizing that such reliance was misplaced.

Unfortunately, no immediate relief is available for either group of taxpayers. Unless Congress and Treasury devote sufficient resources to addressing the disparate tax treatment between U.S. persons with foreign retirement plans and those with domestic qualified retirement plans, relocating abroad may impose tax costs that are too significant for many prospective expatriates to bear.

In summary, it may be too late to “click your heels” and return home — or, in Dorothy’s case, to Kansas. For those abroad who discover that the promise of relocation has become a retirement miscalculation, unwinding foreign retirement plans and related structures can be as discombobulating as being caught in a metaphorical tornado. You may just find yourself wishing you’d borrowed Dorothy’s magical ruby slippers for the trip.