Retiring To America? - DAVID M TREITEL EA, ATII, ATT explains possible tax advantages under United States and treaty tax rules.

Retiring To America?

David M Treitel EA, ATII, ATT explains possible tax advantages under United States and treaty tax rules.

We all know how to pay no tax. It is easy – just have no income! Unfortunately, this method does not suit most people. Over recent years it has become increasingly common for non-Americans (aliens in American tax lingo) to move to the United States on retirement. The United States Internal Revenue Service issued a technical advice memorandum (TAM 200105005) on 2 February 2001 explaining the position that the Internal Revenue Service took in just such a case.

The discussion by the Internal Revenue Service is extraordinary because it fails to mention several possible tax breaks. Many of us have clients who, while resident in the United Kingdom, similarly expect to retire to the United States. With a careful review of United States and treaty tax rules it may be possible in these circumstances to achieve that happy state of zero tax liability.

United States tax system

Before looking at the details it is worth explaining a little about the United States tax system. Rules are contained in the Internal Revenue Code, which, taken together with decisions of the Supreme Court, is binding. To supplement the Code, the Internal Revenue Service issues regulations, plus other guidance such as Internal Revenue bulletins and taxpayer advice memoranda. The amount of income chargeable on a United States tax return will depend on the residence status of the individual. Citizens and resident aliens are taxed on their worldwide income, while non-residents are taxed only on United States source income.

Taxpayer advice memorandum

The facts of the case in TAM 200105005 relate to an individual who was a civil servant employed outside the United States. He moved to the United States and was regarded as resident for tax purposes from the day that he moved there. After three years of residence he became a United States citizen. He claimed that his non-United States civil service pension should be exempt from United States tax because section 871(f)(1) of the Internal Revenue Code exempts income received under a qualified annuity plan for non-residents.

The Internal Revenue Service rejected this claim because section 871(f)(1) only exempts pension income for non-residents and once the individual had become a United States citizen he was automatically a United States resident.

Tax basis

The Internal Revenue Service does not discuss whether the individual had any 'tax basis' in the pension under section 72(f)(2). While section 72(f)(2) has been entirely overlooked in TAM 200105005, it almost always makes a significant difference. The United States normally recognises that individuals who receive pensions for services outside of the United States (when a non-resident alien), have a tax basis (an investment in the contract) as at the day that they move to the United States. This amount will never be taxable in the United States.

If the concept of 'tax basis' is new to you, it may be helpful to think of the United Kingdom tax treatment of purchased life annuities. With a purchased life annuity, some part of each month's annuity is regarded as a return of capital, while the remainder is a taxable investment return. The tax basis (or investment in the contract) for a purchased life annuity is, therefore, the amount originally invested. Similarly, with a non-United States pension fund the tax basis should, at least, be equal to the individual's own contributions.

In computing the tax basis, the amounts contributed by the former employer should also have been included, even if such amounts had not been included in income taxable in the United States because the former employment took place outside of the United States.

The portion of annuity payments that are allocated to the investment in the contract, and that may be excluded from gross income, is determined by an exclusion ratio determined on the annuity starting date. The numerator of the ratio is the individual's investment in the contract, and the denominator is the total expected return. The expected return is the total amount the individual can expect to receive under the contract, determined with reference to life-expectancy tables drawn up by the Internal Revenue Service. These actuarial tables provide a multiple that is applied to the annual payments to obtain the expected return under the contract. The exclusion ratio is then applied to each payment received. The premiums the taxpayer contributed to the pension plan and the premiums the employer contributed to the pension plan are part of the 'investment in the contract'. These premiums will not be taxable on subsequent distribution.

Early growth

In addition to employee and employer contributions, it is possible to argue that all of the growth in value vested in years prior to arrival in the United States can be added to the tax basis as at the date of arrival in the United States. This conclusion is drawn from the results of two cases: Biddle v Commissioner [1938] and Goodyear Tyre & Rubber Co, et al v United States [1989]. The decision in these cases was that in determining United States tax consequences, United States tax law must be applied to wholly foreign events.

To explain this, it is necessary to recognise that a United States resident who is a member of a non-United States pension plan would typically have to include growth in value on annual tax returns. Accordingly, an individual who had been a United States resident during prior years, would have had to include growth in value in a non-United States pension plan in United States taxable income under section 402(b) of the Internal Revenue Code in those prior tax years.

There is, therefore, a strong argument that the tax basis for an arriving alien includes any growth in value in the plan on the day that United States residency begins, in accordance with section 402(b). Additionally, following section 72(f)(2), the tax basis will include all previous employee and employer contributions.

Assuming that all growth accumulated prior to United States residence can be added to tax basis following the rules of section 402(b) is much less certain than whether section 72(f)(2) provides a tax basis equal to employee and employer contributions. Because of this, filing a United States tax return on this basis would require judgment as to whether the tax involved was material in each individual circumstance. The Internal Revenue Service has not ruled in this area.

Tax treaties

The Organisation for Economic Co-operation and Development model treaty covers the taxation of pensions when amounts are distributed. It does not deal with the earnings of the pension plan prior to payment. For pension payments, Article 18 of the treaty provides that it is the country of residence that has exclusive tax jurisdiction.

In the United States/United Kingdom treaty, Article 18 similarly states that pensions are taxable in the country where the individual is resident. Article 19(2)(b) deals with pensions for government service in a similar fashion. So, for example, a long term United Kingdom employee retiring in the United States would find that the treaty mandates that any pension would be entirely taxable in the United States, which leaves no United Kingdom tax payable.

Using sections 72(f)(2) and 402(b), it is possible to argue that some or all of any pension accrued prior to United States residence represents the individual's tax basis and thus some part of any pension is not taxable in the United States. Almost certainly, in TAM 200105005, the Internal Revenue Service failed to mention the opportunities under sections 72(f)(2) and 402(b) because this did not suit its case!

There are some unresolved issues. Article 18 only exempts pensions 'in respect of past employment'. A former employer's pension scheme produces pensions that fit this description. Additional voluntary contribution schemes, free-standing additional voluntary contribution schemes, self-invested personal pensions, retirement annuities and personal pensions may not fit squarely into Article 18. Stakeholder plans established by parents on behalf of minor children certainly will not produce pensions 'in respect of past employment'!

In addition, the United States/United Kingdom treaty is currently being renegotiated. Most commentators expect changes to Article 18 that will provide that the country of source retains the right to tax pension distributions to the extent that the distributions are not taxable in the country of residence. Seeing the new wording will be crucial in learning whether it will continue to be beneficial to use sections 72(f)(2) and 402(b) to establish a tax basis in a non-United States pension plan.

Where does all this leave those advising individuals who wish to move to the United States on retirement? As things stand for now it may indeed be possible to receive a pension free of both United Kingdom and United States tax. Long may this continue!

David M Treitel is a senior United States tax manager with US Tax & Financial Services in London and specialises in advising Americans working in the United Kingdom as well as those moving to the United States. He can be contacted on 020 7357 8220 or by e-mail at david@ustaxfs.co.uk.

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