crossing the pond

Articles and adverts espouse the use of Qualifying Recognised Overseas Pension Schemes (QROPS) in a number of territories, and the reasons for making a transfer vary from attempts to escape the UK tax charge on death, to the potential for easier distribution.

This article does not seek to rehash those areas, and indeed the new flexi­ble drawdown ability in the UK perhaps removes the second consideration. In the US taxpayer market, a host of other considera­tions must form part of the discussion process.

Who and what?

So who should we be con­cerned with, and what are the considerations? The ‘who’ will include US citi­zens and Green Card hold­ers, wherever they reside, but also non-US individu­als moving to the US and acquiring US residency by virtue of the amount of time they spend there.

The ‘what’ is a complex series of interlinked tax issues that will be specific to almost every single case, and which could make a transfer good, bad or just ugly. We first need to look at the broad US domestic tax rules applying to indi­viduals’ pension distribu­tions in particular, and then how these are impacted by tax treaties.

·         A US tax resident (a citi­zen, Green Card holder or someone who spends sufficient time physically in the US) is subject to worldwide taxation.

·         The US considers all non-US interests from its own perspective. UK pensions and QROPS are not regarded as qualifying pensions for US purposes, which may mean all underlying appreciation is currently taxable.

·         Everything is considered in terms of the dollar, therefore gains or losses may be inflated simply by virtue of a change in the exchange rate before acquisition or disposal.

·         A transfer from a UK plan to a US plan is not allowed for US purpos­es. Some US plans do have QROPS status but can only accept transfers from other US plans.

·         As will be discussed later, a transfer from a UK pension plan to a QROPS would be a tax recognition event for US tax purposes – that is, a US tax charge would arise based on the dif­ference between the value of the transfer, compared with the indi­vidual’s basis (the por­tion already taxed) in the UK plan for US tax purposes. In contrast, a transfer from one UK pension to another UK pension would also be a US tax recognition event on the same grounds, but the provisions of the UK/US double tax treaty provides that transfers between UK plans are not currently taxable.

·         There are differences in the treatment between UK employer sponsored plans and personal pen­sions or Sipps.

·         The US allows a credit against US taxes for foreign taxes paid in respect of the same type of foreign income. The US refers to “baskets” of income. UK taxes are generally higher than US taxes, and this can give rise to “excess foreign tax credits” that cannot be used in the current tax year but potentially could be used in the prior year, or the suc­ceeding ten tax years. Excess credits in one basket cannot be used against US taxes gener­ated in a separate basket of foreign income. Following on from the second point, a US indi­vidual who is a member of a UK pension scheme needs to consider both company contributions and growth in value.

·         For ‘highly compensat­ed’ individuals generally, both of these will be cur­rently taxable. There is of course no deduction for the individuals’ own contri­butions. So it would be possible that they may have effectively paid full US tax on the value of their UK pensions.

·         However, in practice this income may not have been picked up in error, or since 2004 the taxpayer may have been claiming benefits under the ‘new’ UK/US tax treaty.

US tax treatment

Keeping with the domestic US theme a little longer, any US taxpayer receiving a distribution from a for­eign pension needs to con­sider the US tax treatment of distribution and the resultant sourcing of the different components.

For example, a lump sum or pre-annuity distri­bution will generally be deemed to come out of the top slice of the pension – that is, the piece consid­ered income for US tax purposes. Whereas annuity or annuity-like distribu­tions will include a return of any basis in the plan, any remaining untaxed growth, plus part of the annuitised future growth in value of the pot.

UK/US treaty impact

The UK/US treaty that came into force in 2004 contains a number of helpful provi­sions in respect of pen­sions; the exact meaning of a number of which are still subject to some debate.

·         The treaty provides that the growth in value of a UK plan is not US-taxed until ultimately distrib­uted from the plan.

·         Individual contributions into a UK plan may be US tax-deductible, up to equivalent US plan limits.

·         Employer contributions into a UK plan may be non-US taxable until dis­tribution, again within US plan limits.

Unfortunately the actual application of those points is not quite that simple. The most argued provision relates to the US taxation of the UK tax-free lump sum. A literal reading of the treaty seems to suggest the US cannot tax. That falls away as the treaty contains a ‘saving clause’ that allows the US to ignore relief on lump sums, but then another section appears to give some hope after all.

Treaties, of course, are not to be read entirely liter­ally, and recourse can be had to other materials and commentary written by the

treaty teams at the time of negotiation. The net result is that there must be some doubt that the US will in fact exempt the UK tax-free lump sum.

The taxpayer may choose not to claim the treaty benefits of course. So they may not try to exempt company contribu­tions, rather they may be able to cover any potential US tax liability with their excess foreign tax credits. They may even be able to do the same with the growth in value of the plan and many individuals will have actively planned their treatment, balancing their foreign tax position from one year to the next.

What about QROPS?

A transfer from a UK scheme to a QROPS is not a tax-free event in the US, but, if the individual has full basis in the original UK plan, there may be little or no current charge.

Even if full basis does not exist, the recognition on transfer may generate foreign income that may be covered by any remain­ing excess foreign tax cred­its, so no additional US taxes become due. Note this final point will depend on the nature of the UK plan and is unlikely to pro­tect the growth in value in a Sipp, for example.

So for a current US tax­payer, a QROPS transfer may, or may not, be pretty bad. For an individual who is not yet a US taxpayer, there would be no immedi­ate US effect; it does not create a mysterious step-up in basis for US tax purpos­es, so there are no windfall benefits here.

Reducing the impact

However, further issues could arise in the future. The growth in value in the QROPS will not be pro­tected from current US tax under the UK/US tax treaty – which could cause prob­lems. A dry tax liability can arise in addition to some potentially complex addi­tional US tax reporting, and furthermore the under­lying investments may fall into penal US anti-deferral treatment. Fortunately there may be a couple of techniques to minimise that impact:

n The underlying invest­ments may be placed into US insurance wrap­pers that themselves may defer the US tax recognition point.

n Another treaty may be available to provide relief.

People have been look­ing at the Malta/US treaty that was brought into force earlier this year. This also defers the tax recognition of the growth in value in a Malta pension, just like the UK/US treaty, and in addi­tion does appear to pro­vide exemption from a lump sum from a Maltese plan (typically up to 30%).

There may even be a better chance that this lump sum exception actu­ally works. But equally, there could be circum­stances where some distri­butions from a Maltese QROPS appear abusive, or at least generate questions of treaty shopping and so unfair benefit.

The years ahead will show whether such fears are warranted. But it is helpful that these potential reliefs may closely mirror the potential reliefs from the UK treaty, and certainly the annuity that comes out of a Maltese pension would normally be Maltese taxable even to a non-resident.

In summary, the com­plex world of QROPS is only made more so by the introduction of a US tax ele­ment. Any taxpayer facing these issues should certain­ly seek professional advice. QROPS may provide cer­tain advantages over UK schemes. But, as always, individuals will need to carefully consider the addi­tional costs associated with such structures.