Trusts are often treated as a conduit, with income flowing through the trust to the beneficiaries. (see generally Subchapter J of Chapter 1 of the Internal Revenue Code and specifically Code §§651 thru 662. The income received by a beneficiary retains the same character in the hands of the beneficiary as in the hands of the trust. Code §§652(b) and 662(b). Attribution rules often apply to treat the beneficiaries of the trust as the owners of certain types of assets of the trust (e.g., Code §§318(a)(2)(B) and 958(b)).
A trust may own shares in a passive foreign investment company (“PFIC”). A PFIC is generally defined as a foreign corporation if 75% or more of its gross income for the taxable year consists of passive income, or 50% or more of its assets consists of assets that produce, or are held for the production of, passive income. PFIC stock owned by a trust is generally considered as being owned proportionately by its beneficiaries. Code §1298(a)(3).
“Opaque” Doctrine for Employee Trusts
Clayton v. U.S., 33 Fed. Cl. 628 (1995), aff’d, 91 F.3d 170 (Fed. Cir. 1996), provides that it is “well established I.R.S. policy * * * that the pass-through rules relevant to Subchapter J do not apply to employee trusts.” Treas. Reg. §1.641(a)-0(a) provides in part:
[T]he provisions of Subchapter J do not apply to employee trusts subject to Subchapters D and F, Chapter 1 of the Code . . . .”
The I.R.S.’s policy, as articulated through revenue rulings since 1955, is that the conduit theory of taxation embodied in Subchapter J does not apply to distributions from qualified employee plans. Rev. Rul. 55-61 provides that the portion of a qualified trust distribution consisting of interest on tax-exempt securities received by the trust is not excludable from gross income, but instead is taxable under Code §402(a).
In Rev. Rul. 72-99, the I.R.S. ruled that dividends paid on common stock allocated to an employee’s profit-sharing trust account and distributed to the employee were taxable under Code §402(a) and did not qualify for the dividend exclusion under Code §116. The I.R.S. specifically stated:
The fact that part of the distribution is derived from dividends, or any other specific type of income, has no bearing on the treatment of the distribution for purposes of those sections. The cash dividends in this case became part of the trust assets when they were paid to the trustee and as such lost their identity as dividends.
Rev. Rul. 55-61 and Rev. Rul. 72-99 confirm that, unlike Subchapter J, the character of income earned by an employee trust does not pass from the trustee to the beneficiary upon distribution. For convenience purposes, we will call this concept the “Opaque Doctrine” of employee trusts.
7/4/14 Update: Rev. Rul. 74-299 is also consistent with the Opaque Doctrine, noting: "For the purpose of determining the taxability of beneficiaries of employees’ trusts that are not exempt from tax under section 501(a) of the Code, the specific provisions of section 402(b) apply, rather than the general provisions of section 662(a). In the instant case, the fact that the provisions of section 662(a) do not apply to the employee, as beneficiary of the trust, does not preclude the application of the provisions of section 661(a) to the trust itself."
See also Rev. Rul. 2007-48.
Foreign Pensions as Employees’ Trusts
Most foreign pension plans are likely characterized as trusts for U.S. tax purposes. Neither the statute nor the regulations define the term “employees’ trust.” However, if a foreign pension (i.e., the trust): (i) was created by a foreign employer, (ii) is administered by the foreign employer, and (iii) is more than half funded by the foreign employer, it seems likely that the foreign pension/trust would be considered an “employees’ trust.” Code §402(b).
Note that a portion of the trust may not be treated as an employees’ trust if the employee contributions have been more than the employer contributions. Treas. Reg. §1.402(b)-1(b)(6). In this case, the trust is bifurcated and the portion related to the employee contributions is treated as a grantor trust and the portion related to the employer contributions is treated as an employees’ trust. Id.
Application of the Opaque Doctrine to Foreign Pensions
As described above, the character of income earned by an employees’ trust does not pass from the trustee to the beneficiary upon distribution. Instead, Code §402(b)(2) provides that distributions from employees’ trusts are taxable under Code §72 (relating to annuities). Of course, the Opaque Doctrine would not apply to the extent that the employees’ trust was treated as a grantor trust under Treas. Reg. §1.402(b)-1(b)(6). Under the grantor trust rules, the income earned by the trust is treated as directly earned by the grantor and the assets held by the trust are treated as held directly by the grantor.
PFIC Annual Reporting Rules
The 2010 HIRE Act added paragraph (f) to Code §1298. Code §1298(f) requires a United States person that is a shareholder of a PFIC to file an annual report with respect to the PFIC. New Code §6501(c)(8) extends the statute of limitations for assessment of tax for a shareholder that fails to comply with the reporting requirements.
In December 2013, the I.R.S. issued temporary regulations (T.D. 9650) providing guidance on determining ownership of a PFIC and on the annual filing requirements for shareholders of PFICs. Temp. Treas. Reg. §1.1298-1T(b)(3)(ii), under the title “Special rules for estates and trusts,” provides an exception to the annual filing requirement for foreign pensions where a treaty allows the income in the foreign pension trust to be deferred. Temp. Treas. Reg. §1.1298-1T(b)(3)(ii) provides in part:
A United States person that is treated as the owner of any portion of a [foreign] trust * * * that owns, directly or indirectly, any interest in a PFIC is not required * * * to file Form 8621 * * * with respect to the PFIC if the foreign trust is a foreign pension fund (including a foreign pension fund that is an individual retirement plan) operated principally to provide pension or retirement benefits, and, pursuant to an income tax convention to which the United States is a party, income earned by the pension fund may be taxed as the income of the owner of the trust only when and to the extent the income is paid to, or for the benefit of, the owner.
At first glance, one might be led to believe that if a treaty does not provide rules to defer the income earned by a foreign pension fund until the income is paid to the owner, PFICs held by all the foreign pension funds must be annually reported on Form 8621.
However, it is important to note that the regulations apply this rule where the U.S. person “is treated as the owner of” the foreign pension. As discussed above, under the Opaque Doctrine U.S. beneficiaries of employees’ trusts are generally not considered the owners of the assets held by the trusts. It is only where the pension is treated as a grantor trust (i.e., when the employee has contributed more funds into the plan than the employer) that the U.S. beneficiary is considered the owner of the assets of the foreign pension. Thus, no Form 8621 would be necessary for a foreign pension fund that is treated as an employees' trust, regardless of whether the pension was covered by a treaty.
Foreign Individual Retirement Plan
Temp. Treas. Reg. §1.1298-1T(b)(3)(ii) specifically refers to a foreign pension fund that is “an individual retirement plan.” It is not clear whether foreign pension funds that are individual retirement plans could be considered “employees’ trusts.” However, even if individual retirement plans could in principle be considered employees’ trusts, they would not be considered employees' trusts if the employee (or the self-employed individual) contributed more into the plan than the employer. In this case, the U.S. employee/beneficiary would be “treated as the owner of” the foreign pension under the grantor trust rules.
Even though the individual retirement plan might be treated as a grantor trust under U.S. tax rules, a treaty may apply to allow the earnings generated by the plan to be deferred until distributed. See, for example, Article 18, Paragraph 1 of the U.K.-U.S. Income Tax Treaty.
In this context, the treaty deferral exception to annually filing Form 8621 (quoted above) for individual retirement plans makes sense because under the treaty the income of the plan will not be taxable to the U.S. beneficiary until distributions are made from the plan.
Unfortunately, there is no similar treaty exception to filing Forms 3520 and 3520-A with respect to a foreign pension fund treated as a grantor trust. Code §6048 generally requires that the U.S. grantor file Form 3520 and that the trustee file Form 3520-A. There can be substantial penalties for failing to file either of these forms. See Penalties.
The I.R.S. has provided an exception to filing Forms 3520 and 3520-A for Canadian registered retirement savings plans (“RRSPs”) and registered retirement income funds (“RRIFs”). See Notice 2003-75 and Form 8891. However, we are not aware of a similar exception for individual retirement plans of any other country.
6/10/14 UPDATE: To summarize, foreign pensions fall into two categories: 1) Employees’ Trusts and 2) Grantor Trusts. The Opaque Doctrine applies to Employees’ Trusts and no look-thru applies. Therefore, no annual or other Form 8621 should be required for a U.S. beneficiary of an Employees’ Trust.
For Grantor Trusts, a look-thru rule applies and Form 8621 must generally be filed on an annual basis. However, there is an exception to the annual Form 8621 requirement for Grantor Trusts where the income can be deferred under a treaty. Thus, a U.S. beneficiary of a foreign pension that is treated as a Grantor Trust would not need to annually file Form 8621 if the foreign pension is located in one of the countries that has a treaty with the U.S. allowing deferral of the pension income.