The United State Income Tax Treatment of Australian Superannuation Funds Owned by U.s. Persons (part 1 of 2)

• Publication year: 2016
• Author: By Roy A. Berg & Marsha-laine Dungog

The United State Income Tax Treatment of Australian Superannuation Funds Owned by U.S. Persons (Part 1 of 2)1

By Roy A. Berg² & Marsha-laine Dungog³

SUMMARY OF PAPER4

The United States ("U.S.") tax consequences to U.S. person participants in non-U.S. social security programs ("foreign social security programs") generally mirror the consequences to participants in the U.S. Social Security programs: contributions and accretions are not taxed however distributions are subject to tax. When inconsistencies arise, income tax conventions and social security totalization agreements generally resolve these inconsistencies. However under current U.S. law, when the foreign social security program is fundamentally different than it is in the U.S. (as in the case of Australia), the older income tax conventions and social security totalization agreements to do not resolve the adverse U.S. tax consequences to affected individuals. Our paper analyzes these differences in the context of Australia's Social Security program, and suggests ways to resolve them.

Over the past several years the United States has considered, and rejected, numerous different proposals to modify its Social Security programs.⁵ The social security programs as they currently exist bear the following hallmarks that are important to the analysis that follows: First, payment into the system is mandatory for all those who are employed or self-employed. Second, a participant's benefits are unfunded and unsecured: they are simply a promise (though not a binding promise) by the State to pay some amount (which is subject to change) at some time (which is also subject to change) in the future.⁶ Third, since a participant's ultimate benefit under the program is unfunded and unsecured, the participant can expect to receive her benefit (whatever that may be) whenever U.S. law entitles her to receive it. In sum, it is mandatory, publically administered, unfunded and unsecured ("Unfunded and Unsecured").

While the social security programs of many countries remain Unfunded and Unsecured, in the past two decades approximately 32 countries have modified their mandatory social security programs to provide that the mandatory withholding is deposited into a State-regulated account over which the participant has at least some investment control.⁷ Australia and eight other members of the Organisation for Economic Co-operation and Development ("OECD") have modified their social insurance programs in this manner.⁸ In sum, these social insurance programs are mandatory, publically regulated (though not publically administered as in the United States) funded and secured ("Funded and Secured").

While there are a multitude of differences between the U.S. Social Security programs and the Australian Social Security programs, our paper focuses on the U.S. tax differences that result from the Unfunded and Unsecured nature of the U.S. Social Security program and the Funded and Secured nature of the Australian Superannuation program. In particular this paper identifies the overlaps and gaps between the U.S. - Australia Income Tax Treaty⁹ (the "Tax Treaty") and Social Security Totalization Agreement¹⁰ (the "Totalization Agreement") with respect to the Australian Superannuation Fund,¹¹ and provides recommendations for Treasury and the Internal Revenue Service ("IRS") to issue clarifying guidance to affected parties.¹²

There is considerable U.S. tax uncertainty for individuals subject to both programs regarding contributions to the Australian Superannuation, accretions therein and distributions therefrom. Income tax conventions and social security totalization agreements ("SSTAs") between the United States and other foreign countries¹³ endeavor to eliminate double taxation and harmonize the qualification of individuals for benefits of both systems, however, the evolutionary patchwork of such, combined with a similar patchwork of U.S. domestic law, results in a body of law that can be nearly impenetrable in its complexity and, at best, result in uncertain tax liability (on the part of the taxpayer) and tax entitlement (on the part of the sovereign), and withholding requirements (on the part of the employer).

When analyzing the U.S. tax consequences of State-mandated social insurance programs it is tempting to classify such programs as deferred compensation arrangements and analyze them with the broad brush of Section 83 (Property transferred in connection with performance of services), Sections 401-436 (Deferred Compensation, Etc.), and Sections 3101-3128 (Federal Insurance Contributions Act), and related sections of the Internal Revenue Code ("IRC")¹⁴ and Code of Federal Regulations ("C.F.R."). However, we believe to do so (without the recommendations set forth herein) would be to overlook the purpose of the SSTAs and income tax conventions. Instead, such programs should be analyzed in a manner consistent with their true nature: the equivalent to the U.S. Social Security.

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While we focus on Australian Superannuation law, our analysis applies in equal measure to all countries whose State-mandated social insurance programs are covered by an SSTA, regardless of the similarity or difference between such programs and U.S. Social Security.

In order to harmonize the U.S. tax treatment of the Australian Superannuation Fund (and all social insurance programs subject to an SSTA) with the U.S. tax treatment of U.S. Social Security tax we respectfully submit the following suggestions:

Suggestion 1: 26 C.F.R. section 1.402 should be amended to clarify that arrangements subject to an SSTA are excluded from the application of the statute.
Suggestion 2: 26 C.F.R. section 1.83 should be amended to clarify that arrangements to an SSTA are excluded from the application of the statute.
Suggestion 3: 31 C.F.R. section 1010.350(c) (4) should be amended to clarify that arrangements subject to an SSTA are excluded from reporting on the Form FinCEN 114.
Suggestion 4: 26 C.F.R. section 1.6048 should be amended to clarify that arrangements subject to an SSTA are exempt from reporting on the Forms 3520 and 3520-A.
Suggestion 5: 26 C.F.R. section 31.3111 should be amended to clarify that accretions of benefits under Social Insurance Programs subject to an SSTA are excluded from an individual's income in a manner similar to the exclusion of income found in IRC 3111(c). ¹⁵
Suggestion 6: 26 C.F.R. section 1.1298-1T (b) (3) (ii) should be amended to clarify that passive foreign investment companies ("PFICs") owned by an arrangement subject to an SSTA be exempt from reporting on the Form 8621.
Suggestion 7: In the event the foregoing suggestions are not possible, 26 C.F.R. sections 1.901 and 1.960 should be amended to clarify that a taxpayer beneficiary of a Super be allowed a direct or indirect foreign tax credit for the Australian taxes paid by such individual.

It is our belief that the U.S. Treasury and the IRS could affect the foregoing recommendations in a General Legal Advice Memorandum or Memorandum of Understanding between the competent authorities.¹⁶ Doing so would afford Treasury the time to make the recommended changes to the regulations while providing affected U.S. persons certainty of their tax and reporting positions without the fear of civil and criminal action for failing to file the aforementioned forms.

Several areas of the IRC and Treasury Regulations already exempt social insurance programs of foreign governments from either reporting obligations or taxation. In particular:

First, the Preamble to the regulations under 26 C.F.R. section 6038D¹⁷ provides that an interest in social security, social insurance or similar program of a foreign government is not considered a specified foreign financial asset and is therefore not reportable on the Form 8938.

Further, the same section of the Preamble contains a hyperlink to a chart that compares Form 8938 filing requirements with those required by the FinCEN 114 (Formerly TD F 90-22.1, commonly referred to as the Foreign Bank Account Report "FBAR").¹⁸ The chart referenced therein indicates that such accounts are reportable on neither the FBAR nor the Form 8938 though, as noted in Proposal three above, the regulations do not reflect this conclusion.

Second, 26 C.F.R. section 1.1298-1T(b)(3)(ii) provides that PFICs that are directly or indirectly held by trusts exempt from taxation as foreign pension funds exempt from tax under an income tax treaty are likewise exempt from reporting on the Form 8621.

Third, 26 C.F.R. section 301.6114-1(c)(1)(vii) provides that filing of the Form 8833 is not required to invoke the benefits of an SSTA.

Fourth, 26 C.F.R. section 1.409A-1(a)(3)(iv) provides that arrangements subject to an SSTA are exempt from the application of the statute.

Fifth, IRC section 3111(c) exempts wages paid by employers from the imposition of the tax imposed by that section when an SSTA is in place.¹⁹

DISCUSSION

I. CURRENT LAW AND REASON FOR SUGGESTED CHANGES

Pension reform has been an active topic of discussion in nearly all OECD countries for more than a decade. The OECD published its first comprehensive survey of pensions across the 34 member countries in Pensions at a Glance: 2005 Public Policies across OECD Countries.²⁰ In that survey the OECD separated each member country's national retirement system into three tiers and analyzed the differences across these tiers.

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First tier pensions within a country's pension scheme are mandatory programs designed to ensure that pensioners are afforded some absolute, minimum standard of living. Second tier pensions comprise mandatory earnings-based programs designed to achieve a targeted standard of living compared to the standard of living experienced while the individual was working. Third tier pensions comprise voluntary programs designed to encourage savings for retirement. Second tier pensions, and specifically the U.S. tax classification of Australia's second tier pension (the "Superannuation...