One of the most common inquiries we get from Australian nationals is how to handle their IRA or 401(k) fund when they are planning leave. For example, you came to the U.S. on an E-3 or L-1 Visa for a short-term assignment. Now you’re planning to or already did return to Australia, and you want to withdrawal funds from your 401(k), Individual Retirement Account (IRA), 403(b), or similar U.S.-based retirement fund.
You’re told there’s a generally applicable 20% withholding tax. This may increase to 30% if the retirement fund discovers you’re a nonresident non-U.S. citizen. You’ve also been told there’s a 10% early withdrawal penalty if you’re under the age of 59.
All of that is true except there’s a solution under the U.S.-Australia Income Tax Treaty that avoids any and all U.S. tax. Pay close attention.
View our U.S.-Australia Tax Guide by clicking here.
Taxation of Pension Distributions Under U.S.Tax Law
Under the Internal Revenue Code, any distribution from a qualified plan to any participant is an eligible rollover-distribution unless it is paid over the life expectancy of the participant or the joint life expectancies of the participant and the beneficiary, or as part of a substantially equal series of payments that were paid in excess of 10 years, or is made solely to satisfy the minimum distribution requirements of Internal Revenue Code section 401(a)(9).[1] If an eligible rollover distribution is not rolled over, it is generally subject to a mandatory 20% income tax withholding.[2]
The rationale for providing preferential tax status to the various retirement savings vehicles is to encourage current saving for consumption after retirement. In order to discourage the taking of early distributions, Internal Revenue Code section 72(t) imposes a 10% additional income tax on the distributions which fail to meet certain requirements.[3] The additional tax is imposed on the portion of a distribution that is included in gross income, and it does not apply to any portion of a distribution that is a return of employee contributions or nondeductible contributions or any amount rolled over into another retirement plan. The additional tax is in addition to any income tax due on the distribution.
The Effect of Income Tax Treaties
The Internal Revenue Code is not the only body of law that is applicable. The Internal Revenue Code provides that all provisions “shall be applied to any taxpayer [but] with due regard to any treaty obligation of the United States which applies to such taxpayer.”[4] In other words, tax treaties provide an additional legal forum for tax planning. Treaties typically reduce or eliminate the rate of tax on certain articles of income. When a taxpayer elects to apply the provisions of an income tax treaty, the election applies to all of the taxpayer’s activities and articles of income covered by the treaty; at that point, the treaty overrules the provisions of the Internal Revenue Code.[5]
Under the Internal Revenue Code, retirement benefits and pension distributions are sourced in the same manner as personal employment services; the situs of the income-producing services.[6] In the context of distributions from a retirement plan, the source is the area of performance which gave rise the benefit and pension payments.[7] Under income tax treaties, however, the rules are different.
Treaties and Federal Laws
The Internal Revenue Code (the “Code”) states that “neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.”[8] As the United States Court of Appeals for the D.C. Circuit has explained, Congress intended to codify the so-called “later-in-time” principle when it enacted Code section 7852(d)(1), which focuses on timing to find which controls regardless of whether there is a conflict.[9] Thus, it’s not the character that controls; it’s the timing.
The D.C. Circuit’s position of an Absolute “Later-in-Time” Rule even in the absence of a conflict or express intent to supersede has led some to believe that it is inconsistent with international law, which generally requires a conflict or clear intent to supersede a treaty.[10] However, although international law generally requires a conflict or intent to supersede, these commentators fail to comprehend another principle of international law: a treaty cannot supersede a nation’s constitution.[11] Pursuant to the Supremacy Clause of the U.S. Constitution, federal laws passed by Congress and treaties ratified by the Senate have equal weight and authority.[12]
In other words, if one views a treaty just like any other law passed by Congress and signed into law by the President, it becomes clear that a future law will only supersede a prior law to the extent that it is more specific than the previous or cannot be reconciled with the prior law.
International Treaty Law and Pensions
If both the U.S. and a treaty partner were members of the Organization for Economic
Cooperation and Development (“OECD”) when a treaty was drafted, U.S. courts are legally bound to mandatorily refer to OECD commentary, which is published every four years, to interpret terms in that income tax treaty.[13] The United States joined the OECD in 1961 while Australia joined in 1971. The U.S.-Australia Income Tax Treaty was signed in 1982 and went into effect in 1983 with an amending protocol signed in 2001. Therefore, U.S. courts are legally bound to defer to the OECD with regard to interpreting treaty terms, which promotes international consistency.
According to the OECD, “while the word ‘pension,’ under the ordinary meaning of the word, covers only periodic payments, the words ‘other similar remuneration’ are broad enough to cover non-periodic payments. For instance, a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the Article.”[14] The IRS has agreed with this interpretation in private letter rulings.[15] Treasury Regulations and Treaty Technical Explanations cannot supersede international law.[16]
Therefore, the OECD takes a very broad approach as to what constitutes a “pension distribution” under international treaty law, which the U.S. is legally bound to recognize.
The U.S.-Australia Income Tax Treaty
Under Article 18, Paragraph 1, of the U.S.-Australia Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.”[17] The Technical Explanations to the treaty further explain that “Paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment… shall be taxable only in that State [of residency].” In other words, under the provisions of the U.S.-Australia Income Tax Treaty,” the country of residence has exclusive taxing rights over pension distributions.[18] Furthermore, the IRS has clarified that Individual Retirement Accounts (IRAs) are covered by the pensions article in U.S. income tax treaties.[19]
Although Article 18, Paragraph 4, makes a reference to “periodic payments,” the IRS has clarified that the “word ‘periodic’ in Article 18(4) does not preclude the application of Article 18(1) to lump sum distributions.[20] Again, although it sounds counterintuitive, the IRS has issued a Private Letter Ruling clarifying that, under international treaty law, the “word ‘periodic’ in Article 18(4) does not preclude the application of Article 18(1) to lump sum distributions.”[21]
Residency for tax treaty purposes is determined under the domestic law of each country. A tax resident is a person that is “liable to tax” in that country on the basis of residency or domicile.[22] When the domestic law of two countries results in claimed residency by both countries, however, the taxpayer must apply the treaty’s “residency tie-breaker” provisions. The reason it is important is because residency determines the taxation of many important types of income, such as dividends, interest, royalties, capital gain, pension distributions, retirement pay, annuities, and alimony. In other words, the country of residence generally gets the vast majority of exclusive taxing rights.
When an individual is determined to be a tax resident under the domestic law of two countries that have an income tax treaty with one another, there are a set of factors that “break the tie.” The first tie-breaker provision to apply will determine which country is the true country of residence. If one is undeterminable or too close to call, the analysis should continue until one of the factors clearly controls.[23]
Under the U.S.-Australia Income Tax Treaty, the first residency tie-breaker provision favors the country in which the taxpayer “maintains [his or her] permanent home.”[24] If the taxpayer “has [his or her] permanent home in both Contracting States or in neither of the Contracting States,” the second residency tie-breaker provision favors the country in which the taxpayer “has an habitual abode,”[25] which is generally where the taxpayer spend more time throughout the tax year.[26] If the taxpayer “has an habitual abode in both Contracting States or in neither of the Contracting States,” the third and final residency tie-breaker provision favors the country “with which [his or her] personal and economic relations are closer.”[27]
The Concern for Financial Institutions
The Internal Revenue Code explains that all persons, in any capacity, that have control, receipt, custody, disposal, or payment of any class of income items of any nonresident alien individual shall deduct and withhold tax at a rate of either 30 or 14 percent.[28] The classes of income include interest, dividends, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical income, such as pension income.[29]
Financial institutions don’t have the best legal departments. For that reason, they can be difficult to work with. Our firm has extensive experience in supplying the necessary documentation to alleviate their concerns and legally relieve them of liability.
If you’re a non-U.S. citizen planning to depart to or currently residing in Australia, contact us today for a free consultation.
[1] See IRC § 402(c)(4).
[2] See IRC § 3405.
[3] See IRC § 72(t).
[4] IRC § 894(a)(1).
[5] See Rev. Rul. 84-17.
[6] See IRC § 871(b).
[7] See Treas. Reg. § 1.861-4(b)(2)(ii)(G) (Exs.1–6).
[8] See IRC § 7852(d).
[9] See Kappus v. C.I.R., 337 F.3d 1053, 1057 (D.C. Cir. 2003) (citing S. Rep. No. 100-445, at 316-28 (1988).
[10] See Whitney v. Robertson, 124 U.S. 190 (1888); The Chinese Exclusion Cases, 130 U.S. 581 (1889); The Cherokee Tobacco, 78 U.S. 616 (1871); Diggs v. Schultz, 470 F.2d 461 (D.C. Cir. 1972); also see Restatement (Third) of Foreign Relations Law of the United States, § 115(1)(a) (“An act of Congress supersedes an earlier… international agreement as law of the United States if the purpose of the act to supersede the [treaty] is clear or… cannot be fairly reconciled [due to a conflict].”).
[11] See Restatement (Third) of Foreign Relations Law of the United States, § 115(3).
[12] See Ware v. Hylton, 3 U.S. 199 (1796) (because a treaty is the equivalent of a law passed by Congress, a state law conflicting with the treaty was nullified by the U.S. Supreme Court). Although treaty protocols relate-back to the original adoption of the treaty, regulations do not relate-back to the original adoption of the statute, so it’s not possible for treasury to promulgate regulations inconsistent with treaty obligations.
[13] See Podd v. C.I.R., 76 T.C.M. 906 (1998) (citing U.S. v. A.L. Burbank & Co., 525 F.2d 9, 15 (2d Cir. 1975); North W. Life Assurance Co. of Canada v. C.I.R., 107 T.C. 363 (1996); Taisei Fire & Marine Ins. Co. v. C.I.R., 104 T.C. 535, 546 (1995) (construing the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, Mar. 8, 1971, U.S.-Japan, 23 U.S.T. 969, with reference to the Model Treaty and its commentary)).
[14] See OECD 2014 Commentary, Art. 18, ¶ 5.
[15] See PLR 200416008 (“The word ‘periodic’ in Article 18(4) does not preclude the application of Article 18(1) to lump sum distributions.”).
[16] See Ware v. Hylton, 3 U.S. 199 (1796) (because a treaty is the equivalent of a law passed by Congress, a state law conflicting with the treaty was nullified by the U.S. Supreme Court). Although treaty protocols relate-back to the original adoption of the treaty, regulations do not relate-back to the original adoption of the statute, so it’s not possible for treasury to promulgate regulations inconsistent with treaty obligations.
[17] U.S.-Australia Income Tax Treaty, Art. 18, ¶ 1.
[18] Technical Explanation to U.S.-Australia Income Tax Treaty, Art. 18, ¶ 1.
[19] See PLR 200209026.
[20] PLR 200416008.
[21] PLR 200416008.
[22] See Rev. Rul. 2000-59; also see CCA 200145041.
[23] See U.S.-Australia Income Tax Treaty, Art. 4(2)(a)-(c).
[24] U.S.-Australia Income Tax Treaty, Art. 4(2)(a).
[25] U.S.-Australia Income Tax Treaty, Art. 4(2)(b).
[26] See OECD 2010 Commentary, Art. 4, ¶ 17.
[27] U.S.-Australia Income Tax Treaty, Art. 4(2)(c).
[28] See IRC § 1441(a).
[29] See IRC § 1441(b).