U.S. Tax Treatment of Estonian Mandatory Individual Accounts

by John Anthony Castro, J.D., LL.M.

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Executive Summary

Income within and distributions from an Estonian Mandatory Individual Retirement Account in Estonia are exempt from U.S. tax pursuant to the U.S.-Estonia Income Tax Treaty if and only if the benefits of the treaty are properly claimed and reported on your U.S. federal income tax return. Contact our firm today to schedule a free consultation by clicking here to submit your information online and be contacted by our firm.

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.”[1] 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.[2] 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.[3] 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.[4] 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.[5]

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.

The Estonian Social Security System

The U.S. Social Security Administration’s 2010 publication titled “Social Security Programs Throughout the World” analyzes Estonia’s overall comprehensive social security system. The first set of laws addressing social security were enacted in 1924.

Estonia’s current social security system are based on laws passed in Old-Age Pensions under Unfavorable Conditions Act of 1992 with numerous amendments enacted between 1993 and 2012, the Superannuated Pensions Act of 1992 with numerous amendments enacted between 1993 and 2013, the Social Benefits for Disabled Persons Act of 1999 with amendments, the State Funeral Benefit Act of 2000 with amendments enacted between 2001 and 2014, the State Pension Insurance Act of 2001 with annual amendments, the Funded Pensions Act of 2004 that created individual accounts with annual amendments, the Investment Funds Act of 2004 with annual amendments, and the Work Ability Allowance Act of 2014. These laws are all similar to compulsory contributions under the U.S. Federal Insurance Contributions Act.[6] All of these Estonian laws support two primary programs: the Universal, Social Insurance, and Social Assistance system and the Mandatory Individual Account system.

In Estonia, the Universal, Social Insurance, and Social Assistance system covers permanent residents of Estonia, noncitizens residing temporarily in Estonia, and legal refugees. The Mandatory Individual Account system covers persons born after December 31, 1982, who are covered by social insurance, including self-employed persons. Coverage is voluntary for persons born between the beginning of 1942 and the end of 1982.

Estonia Mandatory Individual Accounts can most aptly be characterized as state-mandated individual accounts with the primary purpose of providing for income at retirement, and it is specifically recognized as social security by the U.S. Social Security Administration.[7] Furthermore, the International Social Security Association, of which Estonia and the United States are members, also recognizes Estonia Mandatory Individual Accounts as forming part of Estonia’s overall comprehensive social security system.[8]

Therefore, based on the foregoing substantial and compelling authorities, it is indisputable that Estonia Mandatory Individual Accounts are social security accounts forming a part of Estonia’s overall comprehensive social security system.

International Treaty Law and Social Security

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.[9] The United States joined the OECD in 1961 while Estonia joined in 2010. The U.S.-Estonia Income Tax Treaty was signed in 1998 and went into effect in 1999. 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, the term “social security” generally “refers to a system of mandatory protection that a State puts in place in order to provide its population with… retirement benefits.”[10] However, the OECD Model Income Tax Treaty does not specifically cover social security; it merely suggests that “payments under a social security system… could fall under Article 18, 19 or 21,” which reference pensions from government service, private sector service, or other income, respectively.[11] On the other hand, the U.S.-Estonia Income Tax, unlike the OECD Model Income Tax Treaty, does specifically have a provision addressing taxing rights with regard to social security. Nevertheless, the OECD commentary broadly interprets “payments under a social security system” to include payments under a “worker’s compensation fund,” which is not considered “social security” in the United States, which is proof that the United States’ definition of “social security” is not the controlling factor.

Therefore, the OECD takes a very broad and inclusive approach as to what constitutes “social security” under international treaty law, which the U.S. is legally bound to recognize.

U.S. Tax Treatment of Social Security Payments

Under domestic U.S. tax law, with regard to informational reporting requirements for contributions to a nonqualified deferred compensation plan, Congress specifically exempted contributions to a foreign social security account.[12] This clearly evidences Congressional intent to disregard contributions to foreign social security for U.S. informational reporting purposes on IRS Form 3520 and 3520-A.[13] Moreover, the IRS has specifically stated that, under domestic U.S. tax law, “foreign social security benefits… are taxable as annuities.”[14] Gains within annuities are tax-deferred until the contract annuitizes and payments begin or when the owner cashes out the annuity and takes a lump sum.[15]

Although some practitioners have asserted that Estonia Mandatory Individual Accounts are reportable as foreign grantor trusts on IRS Forms 3520 and 3520-A, doing so would subject the gains within the fund to immediate U.S. taxation, which is contrary to IRS guidance.[16] However, because gains will still be subject to U.S. taxation at maturity of the Estonia Mandatory Individual Accounts based on disability or retirement, one must still consider the application of the U.S.-Estonia Income Tax Treaty and the outcome thereunder.[17]

Under Article 18, Paragraph 2, of the U.S.-Estonia Income Tax Treaty, “social security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.” In other words, the country of source has exclusive taxing rights to social security income. With regard to an Estonia Mandatory Individual Account, Estonia would have exclusive taxing rights to the income.

The Saving Clausefor U.S.Citizens and U.S.Tax Residents

With regard to treaty claims by U.S. citizens and U.S. tax residents, however, one must consider the application of the Saving Clause, which allows the United States to “tax its residents… [and] citizens as if this Convention had not entered into force.”[18] Put plainly, the U.S. may disregard most treaty claims made by U.S. citizens and U.S. tax residents. It should be noted that the Saving Clause is merely a reserved right and does not automatically apply to prevent claims by U.S. citizens and U.S. tax residents.[19] The Saving Clause, however, has a few specifically enumerated exceptions; one of which is claims by made U.S. citizens and U.S. tax residents pursuant to Article 18, Paragraph 2, which covers social security gains and reserves exclusive taxing rights to the country of source.[20] Therefore, the Saving Clause is inapplicable to claims by U.S. citizens and U.S. tax residents with regard to gains, distributions, or any other income associated with an Estonia Mandatory Individual Accounts. Even the plain language of Article 18, Paragraph 2, unmistakably allows U.S. citizens to make claims under that provision.[21]

Proper Reporting Method for U.S.Tax Purposes

Code section 6114 requires any person relying on a tax treaty to disclose such position on his or her federal income tax return unless an exception applies.[22] IRS Form 8833 is used to make a disclosure regarding a treaty-based return position.[23] A separate form is required for each treaty-based return position taken by the taxpayer. If the treaty position results in no taxation whatsoever, then IRS Form 8833 must be filed along with a federal income tax return that only includes the taxpayer’s name, address, taxpayer identification number, and signature under the penalty of perjury. This effectively creates a de facto treaty election procedure.

If a taxpayer “fails in a material way to disclose one or more” treaty-based return positions, then a penalty is imposed on each separate payment of income or article of income even if “received from the same” payor.[24] For individuals, there is a $1,000 penalty for each non-disclosure.[25]

There are several items for which reporting is specifically waived.[26] A position by a taxpayer that a treaty reduces or modifies the taxation of income from social security or other public pensions is exempt from disclosure regardless of the amount.[27]

Furthermore, payments or the rights to receive social security benefits, the foreign equivalent of social security, or another similar program of a foreign government are not specified foreign financial assets subject to reporting on IRS Form 8938 or FinCEN Form 114.[28]

Conclusion

In conclusion, Estonian Mandatory Individual Retirement Accounts are covered under Paragraph 2 of Article 18 as privatized individual social security accounts that are exclusively taxable in the country of source, Estonia. As such, it is properly excludible from their U.S. tax return with proper disclosure on IRS Form 8833.

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Contact our firm today to schedule a free consultation by clicking here to submit your information online and be contacted by our firm.


About the Author

John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English as well as International Estate Planning in Plain English, an esteemed graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Miami, Chicago, Dallas, and Washington DC.

To provide feedback on this article or suggest an idea for a future article, please contact Tiffany Michelle Hunt, J.D., LL.M., Director of Tax Planning at Castro & Co., at T.Hunt@CastroAndCo.com.


Bluebook Citation: John Anthony Castro, U.S. Tax Treatment of Estonian Mandatory Individual Account, Castro Int’l Tax Blog (Dec. 5, 2019) url.


[1] See IRC § 7852(d).

[2] 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).

[3] 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].”).

[4] See Restatement (Third) of Foreign Relations Law of the United States, § 115(3).

[5] 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.

[6] See IRC §§ 3101, 3111.

[7] See Social Programs Throughout the World, U.S. Social Security Administration’s Office of Retirement and Disability Policy; also see Individual Accounts in Other Countries, U.S. Social Security Administration’s Office of Policy, http://www.ssa.gov/policy/docs/ssb/v66n1/v66n1p31.html (Sep. 1, 2015).

[8] See Social Security Country Profiles, International Social Security Association, https://www.issa.int/countrydetails?countryId=EE&regionId=EUR.

[9] 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)).

[10] See 2014 OECD Commentary, Art. 18, ¶ 28.

[11] See 2014 OECD Commentary, Art. 15, ¶ 2.14.

[12] See Treas. Reg. § 1.409A-1(a)(3)(iv).

[13] See Dominion Res., Inc. v. U.S., 681 F.3d 1313 (Fed. Cir. 2012) (Treasury cannot interfere with the unambiguously expressed intent of Congress).

[14] See IRS Publication 17, Page 84; also see The International Tax Gap Series, “Most income tax treaties have special rules for social security payments. In many cases, foreign social security payments are taxable by the country making the payments. Unless specified otherwise in an income tax treaty, foreign social security pensions are generally taxed as if they were foreign pensions or foreign annuities. Unless a tax treaty allows it (see, e.g., the USA-Canada treaty), they are not eligible for exclusion from taxable income the way a U.S. social security pension might be.” https://www.irs.gov/businesses/the-taxation-of-foreign-pension-and-annuity-distributions

[15] See IRC § 72.

[16] If Estonia Mandatory Individual Accounts were foreign company-sponsored private pension plans, they would certainly be subject to reporting on IRS Forms 3520 and 3520-A. However, being social security, they are not subject to reporting since they constitute foreign social security, which is taxable in the same manner as an annuity in accordance with IRS Publication 17.

[17] Even the IRS issued a revenue ruling indicating that due regard must be given to an applicable income tax treaty to determine whether foreign social security is exempt from U.S. tax. See Rev. Rul. 66-34. Therefore, any assertion that the U.S. would not acknowledge a foreign social security system contradicts the fact that it’s addressed in more than 60 bilateral income tax treaties and specifically required in accordance with the aforementioned revenue ruling as well as Treasury regulations. See Treas. Reg. § 1.894-1 (“Income of any kind is not included in gross income and is exempt from tax... to the extent required by any income tax convention to which the United States is a party.”).

[18] See U.S.-Estonia Income Tax Treaty, Art. 1, ¶ 3.

[19] See Technical Explanation of the U.S.-Estonia Income Tax, Art. 1, ¶ 3.

[20] See U.S.-Estonia Income Tax Treaty, Art. 1, ¶ 4(a).

[21] “Social security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.” U.S.-Estonia Income Tax Treaty, Art. 18, ¶ 2.

[22] See IRC § 6114.

[23] See Treas. Reg. § 301.7701(b)-7.

[24] See Treas. Reg. § 301.6712-1(a).

[25] See Treas. Reg. § 301.6114-1(a)(1)(ii).

[26] See Treas. Reg. § 301.6114-1(c)(1)-(8).

[27] See Treas. Reg. § 301.6114-1(c)(1)(iv).

[28] See Treas. Reg. § 1.6038D-3; 31 C.F.R. § 1010.350; also see “FATCA – FAQs General,” Internal Revenue Service, http://www.irs.gov/Businesses/Corporations/Frequently-Asked-Questions-FAQs-FATCA--Compliance-Legal (Sep. 1, 2015).

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