On March 2, 2020, the IRS announced two new “safe harbors” for certain US citizens, green card holders, and other US tax residents who own foreign pensions, retirement accounts, and savings trusts (see Rev. Proc. 2020-17). It also offered relief from certain penalties for US taxpayers who hadn’t completed past filings of specific forms (namely, Forms 3520 and 3520-A). These measures were then published and went into effect on March 16, 2020.
Taxpayers whose pensions or retirement accounts meet the safe harbor requirements can obtain more favorable US tax treatments for their foreign retirement accounts. They can also skip certain time-consuming annual informational filings and seek forgiveness of past penalties.
In Part 1 of our three-part series, we explained why this new development was such a big deal for US taxpayers who have foreign pensions and retirement accounts. We explained why US tax law is so problematic for owners of foreign retirement accounts. We also explained how the new safe harbor can reduce taxpayers’ annual tax and reporting requirements, saving them time and money.
In this, Part 2 of our series, we cover the eligibility requirements for Section 5.03, the safe harbor that applies to pension and retirement accounts held outside the US.
Then later, in Part 3, we explore the penalty relief that the IRS is now offering to taxpayers who haven’t appropriately filed certain forms to report their foreign retirement accounts.
Does this article apply to you?
Before we dive in further to your foreign retirement accounts and whether they qualify for the safe harbors, let’s first take a look at whether Rev. Proc. 2020-17 and the safe harbors apply to you at all. In general, Rev. Proc. 2020-17 and this article apply to US tax residents who have pension or retirement accounts outside the US.
Who is affected by this new guidance:
- US citizens and green card holders, no matter where they live in the world
- US tax residents (those on resident visas or who meet the Substantial Presence Test of US residency)
- US nonresidents (including G-4 visa holders) who file a 6013(g) election to file jointly with their US citizen or resident spouse
If this is you AND you have foreign retirement accounts or pensions, we encourage you to read on. This series is meant for you.
Who is not affected by this new guidance:
- US tax nonresidents who file Form 1040NR
- US exempt individuals (e.g., diplomats on A visas and international organization individuals on G-4 visas who file Form 1040NR)
- Any individuals who only have US pensions and retirement accounts
- Any individuals who only have international organization pensions (from The World Bank, IMF, and IDB) or Canadian RRSPs
If you fit into any of the above categories, you can skip the rest of this three-part series (unless, of course, you have a serious interest in US tax law).
Part 2 – Do your foreign retirement accounts qualify for the new safe harbors under Rev. Proc. 2020-17?
Rev. Proc. 2020-17 introduced two “safe harbors”:
- Safe harbor for “Tax-Favored Foreign Retirement Trusts (TFFRT)” (Section 5.03)
- Safe harbor for “Tax-Favored Non-Retirement Savings Trust (TFNRST)” (Section 5.04)
In this series, we focus largely on the first safe harbor, Section 5.03, which applies to retirement and pension accounts that are deemed to be foreign trusts under US tax law (i.e., most foreign retirement accounts).
The second safe harbor pertains primarily to tax-favored savings accounts that can be used only for specific purposes. Examples include accounts designated solely for medical, education, or disability purposes. The requirements for these accounts are strict. If safe harbor eligibility requirements are met, the tax advantages are comparable to those described below for retirement accounts.
Eligibility Requirements for “Tax-Favored Foreign Retirement Trusts (TFFRT)” (Safe Harbor under Section 5.03)
Requirement #1: To take advantage of the safe harbor, you must be in full compliance with all IRS reporting requirements.
This generally means you have filed your past tax returns and any required foreign asset informational disclosures. If you haven’t done these filings, but are currently in the process of using one of the IRS’s amnesty programs to fix the past issues, you may be able claim the safe harbor (see discussion of uncertainties below).
The requirement to be in full compliance also means that (1) if the safe harbor exempts you from filing certain forms to report your foreign retirement accounts, but (2) you should have been filing those forms in the past, then (3) you need to fix your past filings of those forms before you can use the safe harbor to be exempt going forward.
Typically, you need to be up to date on any filings that are still considered open by the IRS. The test for this will be either under IRC 6501 (statute of limitations for assessment) or IRS Policy Statement 5-133. If you aren’t sure, you should consult with your tax adviser to determine whether you meet these requirements before trying to claim the safe harbors.
Requirement #2: Your foreign pension or retirement account must be deemed a foreign trust under US tax law.
As explained in Part 1 of our series, most foreign pensions and retirement plans will be considered foreign trusts under US tax law. For purposes of this article, we assume that your foreign pension or retirement account is a trust.
In some cases, it may be worth the fees and time to have your foreign pension or retirement analyzed to determine whether, under US tax law, the structure will be considered a trust or something else. If the pension or retirement plan is not a trust, then the US tax treatment will be totally different, and the safe harbors here will not apply.
Requirement #3: Your foreign pension or retirement plan must meet the additional criteria below.
- The foreign pension or retirement plan must operate to earn income primarily for the benefit of retirement.
- The foreign pension or retirement plan must provide annual reports to the tax authorities of its jurisdiction.
- Contributions made to the foreign pension or retirement plan must be from “earned income from the performance of personal services” (e.g., salary, wages, compensation for services).
Criterion 3 – Example
Assume Anne is a US citizen living and working in Zurich, Switzerland. Anne is a participant in a Swiss Pillar 2 employer pension plan. Anne sells real property and obtains a capital gain of $100,000. Anne then takes the $100,000 and conducts a “buy-back” of additional years by voluntarily contributing the money to the Pillar 2 employer pension plan. Since the contribution is not from salary or earned income, the Pillar 2 employer pension plan would not meet the requirements for the Section 5.03 safe harbor. Instead, the plan would be classified as a Foreign Grantor Trust. As such, Anne would be required to file Forms 3520, 3520-A, 8621, 8938 Part IV (if applicable), and FinCEN Form 114 (FBAR).
- Contributions to the plan must be limited as follows:
a. Annual limitation of $50,000 USD or less OR
b. Lifetime limit of $1,000,000 or less
- All withdrawals or distributions from the foreign pension or retirement plan must meet certain conditions that are documented in the plan. The conditions can be any of the following:
d. Early withdrawal penalty
Criterion 5 – Example
The Brazilian pension system has three pillars. The third pillar, known as the “RPC” or Private Pension Regime, allows some products that have no restrictions on age, disability, death, or early withdrawal penalties. Therefore, a US taxpayer that an interest in a Brazilian PRC may fail the safe harbor section 5.03. As a result, the taxpayer will be required to report the plan as a Foreign Grantor Trust and file Forms 3520, 3520-A, 8621, 8938 Part IV (if applicable), and FinCEN Form 114 (FBAR).
- If the foreign pension or retirement plan is an employer plan, then the following must also apply:
- The plan must be “nondiscriminatory” to non-highly compensated employees in regard to the following:
- Benefits actually provided
- The plan must offer the same if not all the same benefits to a majority of the employees.
- The plan must be “nondiscriminatory” to non-highly compensated employees in regard to the following:
An “in-country” rollover from one TFFRT to another TFFRT will not disqualify the foreign pension or retirement plan from the Section 5.03 safe harbor.
Benefits of Meeting the Section 5.03 Safe Harbor
If you meet the requirements of Section 5.03, then:
- Your pension or retirement account largely retains the tax-favored status it enjoys in the home country. The safe harbor eliminates the current US taxation on your account. This means that just like in the country of origin, the US taxes are generally deferred until you take distributions or otherwise make a change to the account.
- You will not be required to file IRS Forms 3520 and 3520-A to report the foreign pension or retirement plan. This is a great benefit because these forms require significant amounts of information. To complete them, taxpayers must respond to informational items and checklists, provide income statement and balance sheet data for the account, and separate out annual income and current values. This must be done every year.
- You can avoid filing annual IRS Forms 8621 to report the individual investments in the account. This saves owners from having to track down hard-to-obtain details every year. It also prevents them from owing current tax on the investments in the account. Plus, it saves them from the high tax rates that apply to investments reported on this form.
- You can avoid the time, cost, and headache of the more burdensome annual reporting requirements. Forms 3520, 3520-A, and 8621 are the more time consuming (and thus costly) forms that taxpayers generally need to complete to report their foreign pensions and retirement accounts. Avoiding these forms makes information-gathering much easier each year. Plus, it cuts down significantly on the size and cost of your annual tax filings.
Be careful! Some foreign asset reporting requirements remain. Although the safe harbor eliminates the most time-consuming foreign asset reporting requirements, some minor (but still serious) requirements remain. Typically, you would still need to report your foreign pensions and retirement accounts on IRS Form 8938 and/or FinCEN Form 114 (FBAR) if certain thresholds are met. These forms shouldn’t be overlooked, as they carry steep penalties for not filing (see our foreign asset reporting information for more details). Plus, we would also urge you to look at Form 1040 Schedule B, Part III, Question 8.
Uncertainties Related to the Section 5.03 Safe Harbor
At first blush, the retirement safe harbor under Rev. Proc. 2020-17 goes a long way in lowering the burden of reporting a foreign pension or retirement plan. But it may create more questions and issues than it solves. Here is our laundry list of open items for the IRS regarding this section:
- What happens if the taxpayer is not in full compliance with all IRS filing requirements but is in the process of submitting an amended or delinquent tax return, perhaps under an IRS amnesty program such as Streamlined Filing? Can the taxpayer still take advantage of the Section 5.03 safe harbor on their current tax return?
- For the $50,000 annual limit of contributions, does the taxpayer need to look back to the beginning of their participation in the plan? What if the taxpayer were a non-US person who became a US tax resident but had contributed more than $50,000 during their non-US period?
- If the taxpayer has previously filed IRS Form 3520 and 3520-A to report the plan but now qualifies under Section 5.03, should the taxpayer file “final” Forms 3520 and 3520-A to notify the IRS that they qualify and that they will no longer be filing the forms? If so, should the taxpayer send documentation to the IRS “proactively” along with the final Forms 3520 and 3520-A to document their qualification? What if the taxpayer registered for an Employer Identification Number (EIN) for the foreign pension or retirement plan? Will the IRS provide a method to show that there will not be further filings?
- If the taxpayer was previously reporting the underlying assets of the foreign pension or retirement plan as a “PFIC” on IRS Form(s) 8621, should the taxpayer file a “final” form 8621 (although there is no ability to notate this on the form)? Technically speaking, would the taxpayer list the number of shares held at the end of the years “0” in Part I of Page 1? Does the foreign pension or retirement plan then default to the 2016 regulations under TD 9806, 1.1298–1T(b)(3)(ii)? In this case, the foreign pension or retirement plan is opaque for the purposes of PFIC reporting. The taxation of the plan defaults to IRC 402(b)(2) and 402(b)(4). Would this now be the default method of taxation for pensions that qualify under the Section 5.03 safe harbor?
- What if the taxpayer previously filed Forms 3520 and 3520-A and paid the 5% title miscellaneous penalty on their foreign pension or retirement plan but accurately reported it on Form 8938 and FinCEN Form 114? Can the taxpayer now file an amended Streamlined Filing to request the 5% penalty to be refunded if they qualify under Section 5.03?
- If a taxpayer conducts an in-country rollover and can show that both the originating and designating plans meet the requirements of Section 5.03 but the amount rolled over is more than the $50,000 or $1,000,000 limits, will this vitiate the safe harbor of Section 5.03? We assume that this would not in any way make the rollover non-taxable if the foreign country did not have an in-country rollover provision their tax treaty. Will the IRS provide guidance on how this procedure will work in conjunction with tax treaties?
- What if the taxpayer is unable to obtain records and trace all the contributions to the plan from earned income? Will a properly executed affidavit attesting to the earned income contributions suffice?
- For employer-related plans, the non-discrimination rules under IRCs 401(a)(26) and 410(b)(1) generally exclude nonresident aliens from the testing pool. This notice seems to now override these provisions and allows all employee participants in a foreign pension or retirement plan (regardless of whether they are a US tax resident or nonresident) to be counted. Is this correct? In many cases, the employee cannot obtain the information from the pension plan administrator to properly determine if the plan is discriminatory or not. Will the IRS provide additional guidance on what documentation will suffice for this purpose (also consider time and money to obtain such information and analyze it)?
Refund and Abatement of Penalties
What if you would have benefited from the safe harbors in the past (had they existed then) but instead were assessed penalties for problems filing Forms 3520 and 3520-A? Can you get those penalties refunded or abated?
In most cases, the answer is yes. Part 3 of our series addresses penalty relief and walks you through the steps to get your penalties refunded or abated.
Do you have further questions? Contact us.
The Wolf Group has 37 years of International Tax experience, including audit defense and penalty abatement representation. Our firm has represented taxpayers in a wide variety of international tax-based audits including but not limited to FBAR examinations, Streamlined Filing audits, foreign tax credit redeterminations, and IRS “wealth squad” audits/examinations. We are well versed in all the fundamental rules and regulations related to the classification, reporting, and taxation of foreign pension, retirement, and savings plans.