Cross-border Taxation of 401(k) Distributions to a Russian Non-resident Professional

 

Читать на русском языке: Налогообложение выплат из пенсионных накоплений, сформированных в рамках пенсионной программы 401(k) во время работы российского специалиста в США

 

Many professionals with no U.S. citizenship or “green card” work for U.S. corporations on a temporary basis participating in optional retirement saving plans provided by their U.S. employers. One of the most popular types of such plans is a qualified profit-sharing plan implemented under section 401(k) of the U.S. Internal Revenue Code (called a “401(k) plan”).

When an employee who is not a U.S. resident alien for tax purposes based on the citizenship or “green card” test quits her U.S. employer and, then, moves to another country she encounters the issue of what tax consequences may be triggered by an early withdrawal of her 401(k) money. Some aspects of the above issue are reviewed in this publication using a Russian non-resident professional as an example.

401(k) Plan

A traditional 401(k) plan suggests accumulation of retirement funds on an employee’s special individual account from: i) elective contributions made by the employee from his wages, ii) employer contributions (so called “match” or “employer matching contributions”; in most cases, employers make contributions under 401(k) plans; however, this is a right, not an obligation of the employer) and (iii) investment income generated by the retirement savings.

The amounts of contributions within the limit provided by law and all the future investment income gained on contributed amounts are excluded from the employee’s current taxable income and included in her taxable income in the year when she will actually use them (in the actually distributed amount). The U.S. income tax rates are progressive (the higher is the income, the higher is the tax rate; currently, the lowest federal individual income tax rate is 10% and the highest one equals 39.6%[1]) and it is assumed that, after retirement, the employee’s taxable income will drop significantly. Therefore, participation in a traditional 401(k) plan makes it possible to save on the difference between the amount of income taxes that the employee would have paid on her contributions in the year when they were made and the amount of income taxes that she would pay on the retirement money withdrawn after she reaches the retirement age.

There are other versions of 401(k) plan, including a Roth 401(k) plan, under which an employee makes contributions from his individual after-tax funds and, subject to certain conditions, earnings on the retirement contributions and withdrawals of the retirement money are not taxable at the federal level. This article reviews a case with the traditional 401(k) plan only.

The use of 401(k) money is restricted. They may be utilized with no penalties after the employee has reached the age of 59.5 unless there is an exceptional life situation (such as disability or hardship). An additional federal tax of 10% is imposed on the retirement savings early withdrawn in violation of that restriction.

When an employee changes his employer, his 401(k) funds may be either transferred to a retirement plan of the new employer or deposited on an individual retirement account (IRA) opened  with an entity entitled to maintain such accounts (so called rollover) or left in the retirement plan of the former employee (subject to some conditions) or cashed out with payment of all applicable taxes including 10% additional federal tax for early withdrawal.

Practice Case

After 5-year employment with a U.S. corporation in the State of Washington based on an employment visa, a professional with Russian citizenship returned to Russia. During his U.S. employment, he was participating in the U.S. employer’s 401(k) plan and accumulated, on his retirement account, $70,000 total, including $30k from his individual contributions, $30k from employer contributions, and $10k of the periodically compounded investment earnings on the savings. The retirement money was invested in securities. The Russian professional left the U.S. on the October 18, 2014, and cashed out his retirement savings and received a lump-sum distribution from a U.S. manager on November 19, 2015, with no U.S. taxes withheld, having provided the U.S. payer with a W8-BEN form indicating that he was a tax resident of the Russian Federation. At the time of distribution, he was 45 years old.

Situation through the Lens of the U.S. Tax Laws

The professional is neither a U.S. citizen nor a U.S. permanent resident; therefore, he is not a U.S. resident alien individual for tax purposes based on the citizenship or “green card” test. Assuming that he was present in the United States 320 days in 2012, 300 days in 2013, 255 days in 2014, and 7 days in 2015, the professional remained a U.S. tax resident until the end of 2014 based on the substantial presence test. He was present in the United States on at least 31 days in 2014 г. and at least 183 days during last 3 years, including 2014 and counting all the days he was present in the U.S. in 2014, 1/3 of the days he was present in the U.S. in 2013 and 1/6 of the days he was present in the U.S. in 2012[2]. However, in 2015 he became a non-resident alien individual for the U.S. tax purposes because he was present in the country on less than 31 days.

The distribution of the retirement savings is income received by the Russian professional from a U.S. source in 2015 subject to the U.S. federal income tax unless an applicable income tax treaty sets forth other rules.

Retirement money distributions are income not effectively connected with a trade or business in the United States combined into a general notion of fixed, determinable, annual or periodic income. FDAP income of a non-resident alien individual is subject to the U.S. federal tax at a flat rate of 30% of the distributed amount unless a lower or zero rate is provided by an effective income tax treaty between the United States and country where the payee is a tax resident (hereinafter – “ITT”). Moreover, there is 10% additional tax on early withdrawal of retirement money unless such withdrawal is made on a valid ground provided by law[3]. The regular tax is withheld at the source by a U.S. payer. If a U.S. payer has not withheld the tax or the amount of tax withheld is insufficient or there is 10% additional tax due for early withdrawal not withheld under a voluntary instruction of the distribution recipient the latter must file a federal tax return after the end of the corresponding tax year and pay the underpaid tax[4].

If a U.S. payer has fully withheld the federal tax from FDAP and non-resident alien individual does not have other income taxable in the United States, then, the non-resident alien individual is not required to file a federal tax return for the year when he received such income.

However, it is often the case that the amount of tax withheld at the source on early withdrawal of 401(k) funds to a non-resident alien individual is reduced or withholding is totally eliminated based on a documentary evidence submitted by the non-resident alien that a lower withholding rate or exemption from withholding must be applied based on an ITT.

In the practice case in question, the Russian professional avoided the withholding of the U.S. federal income tax based on the Convention between the U.S.A. and Russia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital of June 17, 1992 (hereinafter – “the U.S.-Russia ITT”) because at the time of distribution (November 19, 2015) he was a tax resident of the Russian Federation. Pursuant to Article 17 (a) “Pensions” of the U.S.-Russia ITT, pensions and other similar remuneration derived and beneficially owned in consideration of past employment may be taxed only in the state where the recipient thereof is a tax resident. Had the professional received his retirement money in 2014 immediately after termination of his employment with the U.S. corporation when he remained a U.S. tax resident he would not have been able to enjoy the benefits provided by the U.S.-Russia ITT.

Nevertheless, relieving a U.S. tax agent of liability to withhold the U.S. federal income tax based on an ITT does not automatically mean exemption of the non-resident alien individual who received the relevant income from liability to pay such tax. In this connection, in assessing potential risks one should take into account several gray areas.

First, there is uncertainty regarding whether a non-resident alien individual who received an early distribution of retirement money and who does not have any other U.S. income, is required to file a federal tax return for the year in which such distribution was made.

On the one hand, a non-resident alien individual is not required to file the return if she does not have any other income taxable in the United States because distribution is made and reported to IRS by a U.S. financial institution. On the other hand, according to the IRS guidelines a nonresident alien individual who is not engaged in a trade or business in the United States and has U.S. income on which the tax liability was not satisfied by the withholding of tax at the source must file a federal tax return[5]. Financial institutions do not withhold the 10% additional tax upon early distribution of retirement funds to a non-resident alien individual. It is not clear whether a non-resident alien individual is liable to pay such additional tax and whether it may be reduced or waived by an ITT. One of the possible options in such situation might be filing a federal tax return in the U.S. indicating zero with a confirmation of the professional’s Russian tax residency for the purposes of the U.S.-Russia ITT issued by a competent Russian tax authority and documents evidencing payment of the Russian individual income tax on such distribution.

Second, some U.S. tax consultants mention the risk that ITT application to early distributions from 401(k) money to a non-resident alien individual may be blocked if IRS interprets such distributions as effectively connected income because the retirement savings were accumulated during the period of the professional’s employment in the United States. Such approach would result in application of the general U.S. federal taxation rules set forth for U.S. tax residents to the distribution[6]. However, the exposure to that risk is deemed to be low.

The above aspects and associated risks should be assessed given all the circumstances of a specific case.

No tax consequences arise for the professional in the State of Washington because it is one of the seven states not imposing individual income tax[7]. If the professional had worked in a state with state individual income tax possible tax consequences of the retirement money distribution should have been analyzed at the state level as well. The tax rules applicable to 401(k) contributions and distributions vary from state to state. It is important to remember that the provisions of the U.S.-Russia ITT do not apply to the state income taxes.

Situation through the Lens of the Russian Tax Laws

According to article 208(3)(7) of the Tax Code of the Russian Federation (hereinafter – “TCRF”), income derived from participation in a 401(k) plan provided by a U.S. company is income from sources outside the Russian Federation.

Pursuant to articles 207(1) and 209 of TCRF, income from sources outside the Russian Federation is subject to the Russian individual income tax (hereinafter – “RIIT”) if the recipient of such income is a Russian tax resident only.

The primary test used to determine whether an individual is a tax resident of the Russian Federation is the actual number of days she is present in Russia during each calendar year. If a person is present in the Russian Federation on more than 183 days during a calendar year she is deemed to be a tax resident of the Russian Federation. There are some additional criteria for disputable situations.

For simplicity sake, let us assume that the Russian professional moved to the United States to work in the beginning of 2009 and ceased to be a Russian tax resident in the first year of his U.S. employment although a real-life situation may be more complicated.

In such a case, in the Russian tax laws perspective, the professional was a non-resident alien during all five year of his employment in the United States; therefore, he was not required to report his 401(k) plan related income received during those five years or pay RIIT on such income.

However, the situation was opposite in 2015 when the professional became a tax resident of the Russian Federation.

No special RIIT rate is set forth in respect of income received by a Russian tax resident individual as his retirement money distribution from a foreign source. According to article 210(1),(3) and (4) of the TCRF, in determining the basis (for the RIIT purposes) to be taxed at a regular  rate of 13%, there must be taken into account all the income of the taxpayer, whether received in cash or in kind, reduced by the amount of deductions provided by articles 218-221 of the CTRF.

Retirement distributions are not included in the list of income types exempt from the RIIT provided in article 217 of the TCRF.

As a result, in 2016 the professional incurred liability to report the retirement distribution from 401(k) money he received in 2015 to the Russian tax authorities and pay RIIT from such distribution at a rate of 13% (article 224(1) of the TCRF).

The situation could be more complicated if, after returning home, the professional decided not to cash out his 401(k) funds, hold them (provided that such an opportunity was available) on his individual retirement account in the United States, continue making contributions to that account from his individual funds and/or receive investment earnings on those savings in the capacity of a Russian tax resident.

In the latter case, it would be required to analyze, in addition, a number of sophisticated issues such as whether the professional would be entitled to exclude the amounts contributed to the foreign retirement account from her tax basis for the RIIT purposes, how the RIIT should be imposed on the investment income generated by the retirement money held in the United Stated and owned by a Russian tax resident, etc.

 

[6] 401(k) for Foreign Nationals: What to Do as a Permanent Resident or Visa Holder (https://captain401.com/blog/401k-for-foreign-nationals-what-to-do-as-a-permanent-resident-or-visa-holder/); Strategies for Canadians with U.S. retirement plans by Stuart L. Dollar. March 2015.  P.3 (https://www.sunnet.sunlife.com/files/advisor/english/PDF/IRA_401k_to_RRSP.pdf).

[7] Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.