Taxation of IRA distribution to a treaty country resident.

A deductible individual retirement account (IRA) contribution often can be an interesting investment for foreign nationals working in the U.S., not only because they usually are not allowed to participate in a U.S. company's pension plan, but because they may receive favorable U.S. tax treatment if living in a treaty country on receipt of an IRA distribution. Treaties frequently state that a pension distribution is taxable only in the taxpayer's country of residence. However, the determination of which treaty article to apply to a distribution is sometimes troublesome. In the U.S.-Canadian tax treaty, it is clear that the pension article is used. However, Letter Ruling 9253049 stated that, generally, an IRA is not a pension, but could be treated as one if the IRA amounts came from a pension rollover and the recipient was at least 59 1/2 years old. If the IRA failed to be classified as a pension, the "Other Income" article of the treaty was to be used to determine the treatment. (This ruling involved a U.K. citizen and resident who previously resided in the U.S.)

Letter Ruling 9806012 seems to indicate a change in the IRS's approach, particularly when the treaty does not specifically refer to IRAs. Under this ruling, if the treaty does not specifically address IRAs, the "Pension" article is used, provided certain conditions are met.

In the ruling, a U.S. citizen had an IRA established through a rollover from a Sec. 401(k) plan and others created with deductible contributions. On her death, her beneficiary was a German resident.

The IRA distributions were income in respect of a decedent; if the estate was required to distribute the income currently, the beneficiary would pay the tax. If there were no treaty, there would be 30% withholding under Secs. 871(a) and 1441(a), because the income from an IRA is fixed and determinable.

Article 18(1) of the German Convention and Protocol states:

Subject to the provisions of Article 19 (Government Service; Social Security), pensions and other similar remuneration derived and beneficially owned by a resident of a Contracting State in consideration of past employment shall be taxable only in that state.

The Service had to determine whether the IRA payments were pension distributions. The Treasury's Technical Explanation of the U.S.-German Treaty states that both periodic and lump-sum payments qualify as pension payments under Article 18(1), but otherwise no specific definition of pensions appears.

In 1996, the new U.S. Model Income Tax Convention was published, along with a Technical Explanation. One of its purposes, as stated in the Technical Explanation, is "to provide a basic explanation of U.S. Treaty policy for all interested parties...."

The phrase "pension distributions and other similar remuneration" in the Model Treaty (Article 18, paragraph 1) is intended to encompass payments made by private retirement plans and arrangements in consideration of past employment. In the U.S., these plans include (among others) IRAs and Sec. 401(k) plans. Accordingly, the payments in the letter ruling were pension payments.

Under the Technical Explanation, certain distribution requirements must be met before distributions from private retirement plans qualify as pension distributions under the Treaty. To qualify as a pension distribution or similar remuneration from a U.S. plan:

[T]he employee must have been either employed by the same employer for five years or be at least 62 years old at the time of the distribution. In addition, the distribution must be made either (A) on account of death or disability, (B) as part of a series of substantially equal payments over the employee's life expectancy (or over the joint life expectancy of the employee and a beneficiary) or (C) after the employee attained the age of 55. Finally, the distribution must be made either after separation from service or on or after attainment of age 65. Because the payments to the beneficiary qualified under Article 18(1) of the German Treaty as a pension payment, the payments were exempt from U.S. tax.

Interestingly, the IRS uses the Technical Explanation, published in 1996, to interpret language in a treaty signed in 1989. If the Service continues this approach, it appears that if an employee does not work in the U.S. for five years, he must be at least 62 years old to treat an IRA distribution as a pension. Even if the five-year employment requirement is met, the distribution must be spread over the employee's life expectancy or made after age 55. If the distribution does not meet these tests, however, Letter Ruling 9253049's rationale should treat the distribution under the "Other Income" article, which may provide similar treatment. While taking advantage of this tax break in the U.S., the adviser should also determine the distribution's treatment by the taxpayer's country of residence.

FROM ERIC S. FLETCHER, CPA, CHARLOTTE, NC