A detailed explanation of the intricacies of the Australian superannuation system for US expat clients and how it interacts with the US tax system.
The battle to attract and retain world-class talent continues to escalate with the decline of the working age population at the cusp of the First Industrial Revolution. Recent surveys by industry experts confirm that more workers are undertaking international assignments, from long-term, short-term, one-way transfers to locally hired personnel. US companies are revising their global mobility strategies and programs to provide best practices for transferring their employees overseas, including voluntary tax equalisation policies that are intended to prevent their US employees from incurring additional tax liabilities while abroad.
For US employees contemplating a foreign assignment, tax equalisation policies are an important piece of the relocation package that can incentivise the employee to work overseas. After all, a US employee's employment income overseas, at the very least, should not be subject to foreign taxes that are higher than taxes he would have otherwise incurred if he had opted to stay in the home country. Tax equalisation operates to shift the burden of paying additional foreign taxes on employment income earned overseas from the US employee (i.e. the US expatriate or US expat) to his US employer.
For US expats working in Australia, an important cost that should be factored into hypothetical tax equalisation calculations pertains to Australian Superannuation Funds (ASF or Supers). These funds are established by legislation to provide Australian workers with an alternative source of retirement income by applying low tax rates to contributions and income accruals in the ASF while in accumulation phase; and exempting distributions from the fund from Australian income taxes when the Australian worker reaches retirement. Tax equalisation formulas must include US tax costs to be likely incurred by the US expat arising from employer and employee contributions, accruals, and distributions from the fund, which are attributable to the US expat as taxable gross income notwithstanding Australian superannuation and tax laws that would provide otherwise. A tax calculation that fails to take ASF contributions, income, and future distributions into account unduly exposes the US expat to potential double taxation currently and years later when the US expat retires and receives distributions from the ASF.
The continuing lack of authoritative guidance from the Department of Treasury or Internal Revenue Service on the US tax treatment of ASFs in which US persons are members gives rise to inconsistent US and Australian tax results. The absence of a single definitive approach to the classification, reporting and taxation of ASFs for the US tax purposes provides the US expat with unclear options for tax compliance. US expatriates should be cognisant of how these ASFs are structured, how they operate, and their options for achieving US tax compliance with respect to these interests to fully understand that the tax costs of a foreign assignment extend beyond payroll withholding taxes.
WHAT IS AN AUSTRALIAN SUPERANNUATION PLAN?
Nationalised Private Social Security
US persons working in Australia are subject to a very different national pension system than the United States. Australia's pension system is comprised of privately administered individual accounts that are mandatory for all Australian workers. This system, generally referred to as the Australian Superannuation System, was introduced in 1992 as a substitute or supplement to Australia's publicly administered social security program, which consists of retirement, survivor, and disability benefits (Age Pension) and voluntary savings that are funded from public revenues.
To date, there are numerous different types of superannuation entities, such as funds and trusts that operate under the Superannuation System. For example, the Australian Superannuation Fund (ASF), the Approved Deposit Fund (ADF), and Pooled Superannuation Trust (PST) are superannuation entities that are regulated pursuant to the Superannuation Industry (Supervision) Act of 1993 (SISA) and its Regulations (SISR) (collectively, SIS Legislation) that arise under the pension and corporation powers of the Australian Constitution. Therefore, these funds and trusts that are regulated under such powers are eligible for tax concessions if they constitute a “complying superannuation fund.” To be one, it must have
- Either a constitutional corporate trustee or its governing rules must provide that the sole or primary purpose of the fund is the provision of “old age pensions,” and;
- The trustee of the fund must file an irrevocable election with Australian Prudential Regulatory Authority (APRA) or Australian Tax Office (ATO) for the fund to be regulated under SISA
A majority of superannuation funds operate under a trust structure that is mandated by Australian law. The sole purpose of each trust is investment superannuation assets to provide monetary benefits to an Australian worker (the “member”) upon retirement, death, or termination of employment. The trust is settled by an initial transfer of money or other property from an employer to the trustee to be held in trust for its member, followed by the execution of a trust deed that gives the trustee additional powers and duties to make sure that the fund abides by Superannuation, legislative, or state trustee laws. Lastly, the trustee must give APRA or ATO an irrevocable election for the trust to fall under SISA regulations and constitute a “complying superannuation fund.” A complying superannuation fund that is at all times a “resident regulated superannuation fund” during the year is classified for Australian income tax purposes as an ASF within the meaning of the Australian Income Tax Assessment Act of 1997.
Investments by the Fund
Contributions received by the ASF from employer and employees, as well as earnings accrued on such amounts from investments made while in the ASF, are taxed at low concessional rates. However, an Australian worker who is a member of the ASF cannot access its assets until either “preservation age,” death, or disability. At that time, the benefits accrued in the ASF may be distributed to the member on a lump sum or periodic basis (or combination of both) without incurring additional Australian tax on such distributions. Until preservation age is reached (or such other conditions of release), investment activities by the ASF are strictly regulated by an interlocking web of SISA legislation and other regulatory regimes that impose “quite rigorous regulatory standards” on its operations and investment activities. In this regard, scholars have identified a number of broad investment principles that govern how funds are invested, and specific prohibitions with respect to fund investments. For example, borrowing by the ASF is strictly prohibited by SISA legislation and can only be done under certain circumstances. This has resulted, of course, in a variety of creative investment strategies utilised by fund advisors to maximise earnings. Notwithstanding the variety of investment strategies available to an ASF these days, it has been observed that a majority of ASF members do not exercise the choice to diversify and instead end up investing in default strategies investment by the fund. As a result, a majority of the ASFs in Australia are combined in defined contribution schemes such that financial risks are borne by the fund members and not covered by the ASF.
Concessional Tax Rates
While ASFs are generally trusts in Australia, general principles of Australian tax laws applicable to trusts are intentionally modified to carve out a preferential tax scheme for ASFs rather than impose ordinary trust tax law provisions applicable to ordinary and public trusts. This departure from the application of general Australian tax laws applicable to ordinary trusts seem warranted for ASFs because these trusts are mandated by Australian legislation and do not arise out of private contractual arrangements between employer and employee, grantor trustee and beneficiary.
All contributions and earnings accrued in the ASF are taxed at concessional rates of 15 per cent. However, a change in the residency of the ASF's active member would cause the ASF to lose its status as a “complying superannuation fund,” which would in turn, trigger Australian tax consequences. This scenario is likely to occur when the Australian worker relocates back to the US before retirement, in which case central management and control of the ASF also changes from Australia to the United States. To avoid a premature and inadvertent loss of ASF status, the ASF is often transferred to a bigger corporate fund, retail fund, or another SMSF with a corporate trustee that is based in Australia and can exercise central management and control in Australia. Otherwise, a change of residency by the member to a location outside of Australia on a permanent basis would result in an exit of the ASF itself from the Superannuation System, resulting in the taxation of the entire balance in the fund at non-concessional tax rates for ASF monies to be disbursed to the non-resident member.
PRIVATE AUSTRALIAN SUPERANNUATION PLANS
Many private ASFs are accumulation funds, most of which bear similarities to a defined contribution fund in the United States. In an accumulation fund, a member's superannuation benefits in retirement are based on the amount contributed by the employers, the amount contributed voluntarily by the member, and the amount earned by the superannuation fund investing the contributions.
Contributions to private ASFs are primarily from mandatory employer contributions referred to as the Superannuation Guarantee (SG) and voluntary employee contributions. The SG component varies, yet the minimum percentage of employer contributions to date is 9.5 per cent of the employee's gross compensation. SG contributions are taxed to the ASF at a rate of 15 per cent upon transfer to the ASF, plus another 15 per cent on income accruals while in the ASF. Voluntary employee contributions to the ASF can be made on a pre-tax and after-tax basis. Payment of the voluntary pre-tax amounts, which are deductible to the Australian worker, are taxed at 15 per cent upon transfer to the ASF and another 15 per cent on accruals to such amounts thereafter. No further tax is imposed on the pre-tax and after-tax contributions upon distribution.
US Tax Treatment
The main issue with respect to private ASFs with members who are US persons is whether the contributions, accruals, and distributions from the ASF constitute gross income to the US person; and if so, whether such gross income should be reported by that US person on his US tax return and taxed on a current basis and how. This is a stark departure from Australian Superannuation and tax laws, which generally do not treat contributions, accruals, and distributions from an ASF as assessable income to the Australian worker that would subject such worker to personal taxation in Australia. Rather, the ASF itself is taxed on amounts contributed and accrued on the fund. Currently, it would appear that a US person who is also an Australian worker would have to classify amounts contributed, accrued, and distributed from his ASF differently for US tax purposes and Australian tax purposes. For US tax purposes, such amounts constitute part of his worldwide gross income, subject to US income taxes on a current basis. For Australian tax purposes, such amounts constitute non-assessable income that is exempt from Australian income taxes. This divergent United States and Australian tax treatment of amounts contributed, accrued, and distributed from an ASF creates pitfalls and challenges for a US person working in Australia. The reason for this divergence is discussed below.
Generally, the account balance in a private ASF cannot be accessed until reaching “preservation age,” death, or disability. At that time, the superannuation benefits accrued in the ASF in an accumulation account are transferred over to the pension account, which can be accessed by the Australian worker as a pension distribution. The distribution is payable in lump sum, periodically or both. Regardless of manner of distribution, the ASF's accrued benefits in a pension account are generally distributed tax-free.
IRS Private Letter Rulings: ASFs as Trusts
Generally, the foreign classification of an entity does not control its classification under US law. Thus, the treatment of ASFs as trusts in Australia is not determinative of its US tax classification. Indeed, to date neither the Treasury Department nor IRS has issued any authoritative guidance on how ASFs are classified for US tax purposes. Nonetheless, the IRS has published three private letter rulings (PLRs) that hold a foreign trust providing superannuation benefits to its members constitutes a trust for US federal income tax purposes. In determining the US classification of the foreign trust as a trust under US tax laws, the IRS is asked to assume that the foreign trusts are employee trusts per se. Therefore (based solely on our conjecture and without affirmation or confirmation from IRS), the conclusion reached in the PLRs is not dependent on an analysis of whether the underlying arrangements are in fact employee trusts. The fact that the IRS assumed that the foreign trusts are employee trusts instead of determining whether such trusts are employee trusts has influenced the de facto classification of ASFs as employee trusts in the United States without further diligent inquiry on the basis for such treatment.
Section 402(b) Employee Trusts
Under existing US domestic tax laws, a US person who participates in a funded, foreign pension plan may be subject to taxation under §402(b). Some tax practitioners have taken the position that ASFs are funded and secured foreign pension plans and should be subject to §402(b) treatment.
Under §402(b), a US person participating in a non-exempt foreign employee trust must include in income an amount calculated under §402(b)(4). This provision taxes the US person on his “entire vested accrued benefit” in a non-exempt foreign employees trust at the close of the taxable year in which the foreign employee's trust is not exempt under §501(a). Under an alternative provision for foreign employees trusts, §402(b)(1), a US person will be taxed on his employer's contributions (and not employee contributions) to the foreign employee's trust to the extent that the employee's interest in the foreign non-exempt trust is “substantially vested.” If, however, it was determined that the employee contributions to the trust were “not incidental” when compared to the employer contributions, then Reg. §1.402(b)-1(b)(6) would treat the portion of the foreign employees trust that constituted the employee contributions as if such portion were a grantor trust. This would mean that all employee contributions made by the employee himself would be considered individual income and non-compensatory. The US person would be subject to current tax on the portion of the foreign employee trust that is reclassified as a grantor trust to the extent of such employee contributions pursuant to Reg. §1.402(b)-1(b)(6). Tax practitioners have been perplexed on how to apply Reg. §1.402(b)-1(b)(6) to ASFs without any further guidance on what would constitute an employee's contribution and an employer's contribution for purposes of this regulation, and, more importantly, what would constitute a “not incidental” employee contribution.
If any of the §402(b) provisions discussed are applied to the ASF, a US person would be required to report and pay taxes on either:
-His entire vested accrued benefit in the ASF under §402(b)(4);
-All employer contributions made on his behalf to the extent such US person's interests in the ASF are “substantially vested” under §402(b)(2); or
-All employee contributions made to the ASF as if the ASF were an employee grantor trust under Reg. §1.402(b)-1(b)(6)
Grantor Trust Under §679
As previously stated, treatment of the ASF as a grantor trust in cases where the employee contributions are “not incidental” to employer contributions under Reg. §1.402-1(b)(6) results in a partial grantor trust treatment of the ASF with respect to the employee contributions. However, other tax practitioners have treated the entire ASF as a foreign grantor trust based on the grantor trust rules in §671–§679, resulting in a full attribution of all contributions and earnings accrued in the ASF to the US person member. Consequently, foreign-sourced income from the ASF is fully included in the US person's gross income for US tax purposes. A corollary result of foreign grantor trust treatment is the attribution of stock ownership of foreign corporations directly held by the ASF to the US person, which would trigger passive foreign investment company (PFIC) reporting obligations and potential PFIC taxes. Indeed, extending foreign grantor trust treatment to the entire ASF effectively creates an ongoing tax burden to the US expat in the form of likely double taxation of contributions and income accruals from corporate distributions received by the ASF from PFICs. It also causes the US person to incur more professional fees to fully comply with these complex US tax reporting obligations.
Article 18 of the Australia-US Tax Treaty
If either §402(b) or §679 were to apply to both the SG and employee components of the ASF, which we do not believe to be the correct conclusion, it would lead to double taxation of contributions and income accrued in the ASF, as well as distributions. In general, tax practitioners would look to the Australia-US Tax Treaty to resolve any incidence of double taxation.
However, Article 18 of the current Australia-US Tax Treaty fails to reconcile the occurrence of double taxation on contributions, accruals, and distributions from an ASF to its US expat member. The pension-relevant provisions of the Tax Treaty under Article 18 have not been significantly updated since it was ratified in 1983, notwithstanding the Protocol, which was signed in 2001. Consequently, it does not sufficiently address the taxation of contributions, accrued income, and distributions from an ASF.
In its current version, Article 18(1) of the Tax Treaty provides that pensions and other similar remuneration paid to a resident of Australia in consideration for past employment shall be taxable only in Australia. The term “pensions and other similar remuneration” under Article 18(4) covers periodic payments made by reason of retirement or death, in consideration for services rendered in connection with past employment.
Indeed, one could take the position that amounts disbursed from the ASF to a US expat would constitute distributions from a foreign pension subject to tax in Australia and not the United States. This position must be considered in light of Article 1(3), under which the United States reserves the right to tax its citizens on a worldwide basis as if the Tax Treaty were not in force (the Saving Clause).
The result could be that a US person, who is a resident of Australia and member and beneficiary of an ASF, is subject to tax in Australia and the United States on income from wages constructively received from: (1) SG contributions and concessional employee contributions to the ASF, and (2) income accrued to the ASF.
If the Tax Treaty were revised to incorporate Article 18 of the 2006 and 2016 US Model Income Tax Conventions (US Model Treaties), then none of the SF or employee contributions to the ASF or income accruals thereafter would be taxable to the US Person.
Articles 18(2) and 18(4) of the 2006 Model Treaty and Article 18(3) of the 2016 Model Treaty apply to situations where the individual is a US citizen and resident of the host country. It provides that contributions attributable to employment paid by or on behalf of the individual during the employment period to a pension fund are deductible or excludible in computing the individual's US tax; further, any accrued pension benefits or employer contributions attributable to employment made by the US person's employer are not treated as taxable to the individual in the US Article 18(2) and 18(4) of the 2006 Model Treaty and Article 18(3) of the 2016 Model Treaty that are excepted from the Saving Clause of both US Model Treaties.
Foreign Social Security
Absent authoritative IRS guidance to date on the US tax classification of ASFs, it would be incomplete to reference §402(b) and §671–§679 as the only domestic tax provisions in the code that may be applied to ASF. We have previously noted that the Australian Superannuation System bears striking similarities to the US social security and likely functions as its foreign equivalent. Indeed, recent legislative reforms to Australian Superannuation laws effective 1 July 2017 include a formal legislated objective provision for the superannuation regime, which is to provide retirement income to Australians that would substitute or supplement the Age Pension for Australians. This supports US classification of ASFs as neither non-exempt foreign employee trusts nor grantor trusts, as acknowledged in the Australia-US Totalisation Agreement.
The Superannuation Guarantee (SG) portion of the ASF, which comprises a part of the mandatory employer contributions to ASFs to supplement benefits payable under the Social Security program, falls squarely within this category of social security. The Superannuation Guarantee is a privatised mandatory savings scheme that pre-specifies a minimum amount of contributions from employers on behalf of their employees. All contributions are portable, fully funded and fully preserved (i.e. they must be kept together with investment earnings in the ASF until the statutory access age is reached) (Funded and Secured). Once received by the ASF, contributions are placed entirely in the private sector in individual accounts and invested on behalf of the employee individuals. Fund investment earnings are added to superannuation assets that may be withdrawn upon reaching the statutory eligibility age, and also used to compute eligibility for the Age Pension, which is intended to operate as a safety net for those who cannot provide for themselves in retirement. At the time of its implementation, the belief was that the Superannuation scheme would eventually build up and reduce the Age Pension to a simple welfare measure by the Commonwealth to pay a destitute payment or supplement only. Indeed, it was anticipated that, by 2005, payments from Australia's social security network would decrease substantially as payments from the Superannuation funds increased.
Australia's intent to replace the Age Pension with the Superannuation System is reflected in the Social Security (International Agreements) Act of 1999 (SSIA), which was enacted in March 2000 shortly before the implementation of the Superannuation Scheme in the same year. The SSIA's scope explicitly references Australia's existing social security laws and the Australian SGAA as the two primary regimes in Australia that would be subject to an international agreement on social security with another country (a “scheduled international social security agreement” or “totalisation agreement”) that would override Australia's domestic social security law.
Closer scrutiny of the SG Contribution amounts payable by an Australian employer under the SGAA Scheme shows substantial similarities between the US social security taxes FICA, SECA, and the Superannuation Guarantee. The similar nature of these taxes has been acknowledged and placed within the scope of coverage of the Australia-US SSTA.
Indeed, FICA and SECA explicitly do not apply during a period when employee wages are subject to the social security system of a foreign country pursuant to a totalisation agreement between the United States and such other foreign country. Here, FICA and SECA do not apply when a US person is subject to Australia's Superannuation Guarantee Scheme. This in effect means that the Superannuation Guarantee is, in fact, equivalent to the US social security taxes FICA and SECA.
If the SG portion of the mandated employer contributions to the ASF were to be treated as foreign social security taxes, then such contributions would be excluded from the US person's gross income and therefore exempt from US taxation under Article 18(2) of the Tax Treaty. It would also be logical to conclude that income accretions in the ASF and distributions there from should likewise be exempt from taxation by the US because the United States has ceded its ability to tax social security benefit payments under Article 18(2) of the Tax Treaty. It is important to note that the Saving Clause does not apply to social security (as defined in the Tax Treaty) received by a US citizen resident in Australia.
PUBLIC SECTOR SUPERANNUATION FUNDS
Similar to private ASFs, public-sector Superannuation funds are publicly administered, fully-funded schemes for government employees. US persons employed as federal or state workers of the Australian government, who have public-sector superannuation funds, also face the dilemma of determining whether such funds constitute “government remuneration,” which is exempt from US taxes under Article 19 of the Australia-US Tax Treaty. The exemption, however, is contingent on whether the US saving clause applies, as discussed below.
What are Public Sector Funds
Australian workers that are employed at the federal government or the state government level are members of government-administered public superannuation schemes to benefit them. Public sector employees work in local government, the Commonwealth, state public services, public healthcare, emergency services, and the defence forces. Some public sector funds are defined benefit funds that may be taxed or untaxed.
Federal employees participate in the Commonwealth Superannuation Scheme (ComSuper), which is a public pension funded by the Australian government for its employees. In 1990, the ComSuper was closed to new members and replaced with the Public Sector Superannuation Scheme (PSS). The PSS was established exclusively for employees of the Australian government and other participating employers. Membership in the PSS closed to new members on 1 July 2005, as is the case with other public sector superannuation funds. The PSS, like most corporate or public sector superannuation funds, is a defined benefit plan. This means that, unlike defined contribution funds, the value of the retirement benefits due to the Australian worker participating in the PSS is determined by the fund itself. Therefore, the risk of funding the retirement benefit falls on the government employer or the fund exclusively. The PSS is also a complying superannuation fund in Australia and therefore subject to concessional tax rates on contribution, accrual and distribution.
Australian workers employed by a state government participate in a number of state government-based superannuation schemes. For example, the State Superannuation Scheme (State Plus) is a fund established for the benefit of employees of the government of the State of New South Wales, while the Emergency Services and State Super (ESSS) is a superannuation scheme administered by the State of Victoria. Unlike State Plus, ESSS has both defined benefit and accumulation fund (i.e. defined contribution) components. For purposes of this article, our discussion is limited to the PSS fund.
Components of the PSS Fund
A Member's PSS benefit has three components:
- A member component;
- A productivity component; and
- An employer-financed component. These are discussed below.
The Member Component is made up of voluntary member contributions from after-tax income and fund earnings. Member contributions are between 2 per cent and 10 per cent of their bi-weekly (once every two weeks) salary and not generally subject to contributions tax of 15 per cent when deposited into the fund (the Employee Non-Concessional Contributions). Members cannot technically elect to make salary deferrals into PSS, although they are able to elect to make salary deferrals into an accumulation fund that is adjacent to the PSS.
The Productivity Component is made up of employer bi-weekly compulsory contributions and fund earnings less tax. Employer productivity contributions are taxed 15 per cent upon contribution to the fund (concessional contributions). Employer concessional contributions are mandatory productivity contributions paid by the government employer which are equivalent to 9.5 per cent of the employee's salary. These employer concessional contributions constitute assessable income to the fund itself and are subject to a 15 per cent tax upon contribution (contributions tax) in Australia, and another 15 per cent tax on earnings generated by the fund on an annual basis (accumulation tax). These employer concessional contributions, which are made at least at the rate required under the SG of 9.5 per cent, effectively comply with the Superannuation Guarantee or SG contributions required to be paid by private employers to a private ASF.
Australian Taxation of Earnings and Distributions Investment earnings and undistributed benefits in the fund are taxed at concessional rates of 15 per cent to the fund. The defined part of a contributing member's superannuation benefit is unaffected by fund earnings and investment performance.
However, investment performance can impact the way in which the three components of the PSS work and how the superannuation defined benefits may be taxed to the member upon withdrawal. The principal benefit to contributing members is defined by their final average salary and accrued benefit multiple (Superannuation defined benefit). The Superannuation defined benefit can be taken by a member upon reaching retirement age as either a CPI-indexed pension or a lump sum amount or a combination of both. The Superannuation defined benefit may be taxable to a member upon distribution, contingent on age, type of benefit, and whether benefits are sourced from taxed sources (earnings and Employee Non-Concessional Contributions) or untaxed sources.
Preserved and Associate Amounts
Members who leave employment with the Australian government or participating employers preserve all or part of their benefits with the PSS but can no longer contribute (Preserved Member). Members whose interest in a PSS are split by agreement or court order receive a new or separate superannuation interest called an Associate Interest. Splitting would typically occur under Family Law provisions and is given effect by the trustee of the fund following a court order. The accumulation component of both the Preserved and Associate Member's interest can be affected by fund earnings based on their decision to invest in a default fund or a cash investment option, which is made up of cash, fixed interest and equities. Contributing members have their accumulation components invested in the default fund alone.
United States Taxation of Public Sector Funds
Treatment of Employer Contributions under Article 19 of the Australia-US Tax Treaty unlike private ASFs, which do not have any definitive treatment under the Australia-US Tax Treaty, contributions, accruals, and distributions from Australian public sector superannuation funds to US persons, fall under the category of “government remuneration,” which is exempt from US taxation under Article 19 of the Australia-US Tax Treaty (Governmental Remuneration Exemption). Article 19(1) explicitly provides:
Wages, salaries and similar remuneration, including pensions paid from funds of one of the Contracting States of a state or other political subdivision thereof or of any agency or authority of any of the foregoing for labour or personal services performed as an employee of any of the above in the discharge of governmental functions to a citizen of that State shall be exempt from tax by the other Contracting State.
Saving Clause under Article 2
The above exemption from US taxation of amounts contributed, accrued and distributed from an Australian public superannuation fund [because it is technically a government Pension under Article 19(1)] is not absolute. Article 2(3) of the Australia-US Tax Treaty carves out an exception from the Governmental Remuneration Exemption that provides:
Notwithstanding any provision of this Convention, except paragraph 4 of this article, a Contracting State may tax its residents (as determined under Article 4 (Residence)) ... and by reason of citizenship may tax its citizens, as if this Convention had not entered into force....
Article 2(3), known as the Saving Clause, imposes US taxing jurisdiction on remuneration and similar pensions earned by US citizens who performed services for the Australian government. The scope of the Saving Clause is however also further limited by Article 2(4)(b), which excludes from US tax certain government remuneration received by individuals who are citizens of the employing government. This subsection squarely addresses the government pension received by a US person for work performed for the Australian government as an Australian citizen and resident, before acquiring US residency.
Article 2(4)(b) explicitly states: (4) The provisions of paragraph (3) shall not affect:
- The benefits conferred by a Contracting Sate under .... paragraph (2) or (6) of Article 18 (Pensions, Annuities, Alimony and Child Support); or
- The benefits Conferred by a Contracting State under Article 19 (Governmental Remuneration) ... upon individuals who are neither citizens of, nor have immigrant status in, that State (in the case of benefits conferred by the United States), or who are not ordinarily resident in that State (in the case of benefits conferred by Australia).
Treasury Technical Explanation
The Treasury Technical Explanation to the Australia-US Tax Treaty confirms the interpretation that remuneration and related pension earned by a US person as an Australian citizen and resident working for the Australian government, and prior to establishing US residency, would not be subject to tax by the United States. Indeed, the Treasury Explanation of Article 19 elaborated that remuneration, including pensions, paid by the Employing State (or a political subdivision, local authority, or agency) to a citizen of that State for the performance of governmental functions is exempt from tax by the other Contracting State. However, remuneration that is paid to an individual that is a resident, but not a citizen of the Employing State, whether or not it may be taxed by the other Contracting States, is determined under other provisions of the Treaty (Article 14, Article 15, Article 17 or Article 18) as applicable.
Hence, government remuneration paid by the Australian government to a US person, who is also a citizen of Australia, and more importantly, was a citizen of Australia (and not the United States) while employed by the Australian government, is exempt from US tax under Article 2(4)(b). The extension of this rule to government pensions paid for past services rendered to the Australian government is supported by the US Joint Committee on Taxation's explanation of Article 19 which states:
Under the proposed treaty, compensation paid by one country, its political subdivisions or their agencies or authorities, to one of its citizens for labour or services rendered in discharge of governmental functions is taxable only by the paying country. Thus, for example, Australia would not tax the compensation of a US citizen who is in Australia to perform services for the US government in the discharge of governmental functions. This rule also applies to pensions paid in respect of past services. This provision is generally excluded from the Saving Clause for persons who are not citizens of or immigrants in the source country.
Based on the above analysis, it is more likely that Article 19 of the Australia-US Tax Treaty would exclude Employee Non-Concessional Contributions and earnings accrued on such amounts from US taxation provided that such amounts are paid by the Australian government to the US person as pension for past services rendered prior to establishing US residency.
Treatment of Employee Non-Concessional Contributions
At this point, we have established that:
-Public sector superannuation funds constitute governmental remuneration under Article 19 of the Australia-US Tax Treaty;
-Contributions, accruals, and distributions from such funds to Australians in the United States, who worked for the Australian government, are exempt from US taxes under the government
Exemption under Article 19(1); and (3) the Governmental Remuneration Exemption extends to contributions, accruals and distributions from such funds to US citizens, who worked for the Australian government prior to attaining US citizenship under Article 2(4)(b). What remains to be addressed is how Employee Non-Concessional Contributions, accruals and distributions from the public sector fund are taxed for US purposes when the US person was already a US citizen at the time they worked for the Australian government. Clearly, such amounts are not exempt from US tax because this situation would fall within the scope of the Saving Clause of the Australia-US Tax Treaty.
Under such circumstances, we would recommend bifurcating the US tax treatment of employer contributions from Employee Non-Concessional Contributions under Article 18 of the Australia-US Tax Treaty. Employer contributions, which are essentially government contributions equivalent to the SG, would be exempt from US tax as social security taxes under Article 18(2) of the Tax Treaty. As corollary, accruals and distributions from the public sector fund would constitute social security benefit payments to the extent such amounts are attributable to the SG portion of the fund.
Employee Non-Concessional Contributions to the public sector fund made by the US person would be treated substantially similar to investments made by US citizens into an after-tax IRA under §408(a). Specifically, both the contribution and investment earnings accrued from such after-tax contributions constitute gross income to the US person subject to US income tax.
Treatment of Distributions
Similarly, retirement benefit distributions from public sector funds operated by the federal and state governments of Australia would be excluded from US taxation under Article 19 of the Australia-US Tax Treaty. This treatment of public pension distributions departs from Article 18 provisions, which would subject such amounts to US taxation if the US person was already a U.S. citizen working for the Australian government at the time the public sector superannuation account for such US person was established. If such were the case, US taxation of their Australian pension distributions would be subject to a foreign tax credit offset under Articles 22 and 24 of the Australia-US Tax Treaty to prevent retirement benefits from being double taxed.
By Roy Berg JD, director and Marsha-Laine F. Dungog, director, Moodys Gartner Tax Law
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