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 worldwide 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. [section]911 earned-income exclusion and the exclusion available under I.R.C. [section]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. [section]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 [section]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 [section]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...