FLORIDA TAX REVIEW
VOLUME 3 1996 NUMBER 6

U.S. Income Taxation of Cross-Border Pensions
Cynthia Blun"

I. INTRODUCTION ................................ 262

II. U.S. TAXATION OF DEFERRED COMPENSATION
IN A DoMESTIc CONTEXT .......................... 263
A. Swnmary of Current Tax Rules ................ 263

1. Unfunded Deferred Compensation ........ 264
2. Qualified Retirement Plans ............. 265
3. Funded Nonqualified Plans ............. 266
4. Individual Retirement Accounts .......... 269

B. Rationale for U.S. Tax Treatment of Qualified
Retirement Plans .......................... 270

C. Taxation of Pensions in Other Developed
Countries ............................... 272

D. New Considerations in Cross-Border Context ...... 273

m. SOURCE-BASED TAXATION BY U.S. OF DEFERRED
COMPENSATION PAID TO NONRESIDENT ALIENS ........ 275
A. Background: U.S. Taxation of Current Compensation

and Investment Income of Nonresident Aliens ...... 275
B. U.S. Taxation of Deferred Compensation Received

by a Nonresident Alien ..................... 277
1. Unfunded Deferred Compensation ........ 277
2. Qualified Pension Plan ................ 278
3. Funded But Nonqualified Plans .......... 282
4. Employee Contributions to Retirement

Arrangements ...................... 283
5. Period of U.S. Residence and Exit Tax

Proposals ......................... 284
C. Treaty Position ........................... 285

* Professor of Law, Rutgers, the State University of New Jersey, School of Law-

Newark. B.A., 1972, Yale College; J.D., 1976, Harvard Law School. The author wishes to
thank Thomas St.G. Bissell for reading an earlier draft of the manuscript and to thank Tracy
A. Kaye for her helpful comments.



Florida Tax Review

1. Pension Distributions ................. 285
2. Pension Contributions ................ 300

D. Rationale for Source-Based Taxation ............ 303
1. Unfunded Deferred Compensation ........ 303
2. Different Treatment of Funded Deferred

Compensation ...................... 304
E. Rationale for Treaty Relinquishment of Source-Based

Jurisdiction Over Pensions ................... 306
1. Eliminating Difficulties Created by

Inconsistent Source Rules .............. 308
2. Administrative Difficulties of Source-Based

Taxation .......................... 308
a. Elimination of Administrative

Difficulties by Eliminating
Source-Based Taxation .......... 308

b. Alternative Means of Easing
Administrative Difficulties ........ 312

3. Determination of Overall "Ability to Pay" . . 313
4. Reliance on Residence-Based Taxation ..... 315

F. Proper Scope of Source-Based Exemption ........ 316
G. Source-Based Taxation of Contributions to

Foreign Pension Plans ...................... 318

IV. RESIDENCE-BASED U.S. TAXATION OF DEFERRED
COMPENSATION PAID TO U.S. CITIZENS OR RESIDENTS ... 322
A. U.S. Citizen Who Works in Foreign Country

Before Retirement in the U.S. .................. 322
1. Imposition of U.S. Tax ................ 322
2. Foreign Tax Credit Considerations ....... 327
3. Treaty Provisions .................... 328
4. Possibilities for Manipulation of Timing

Differences ........................ 332
5. Lack of Citizenship Jurisdiction in

Most Countries ..................... 334
B. Alien Performs Services Outside the U.S. and

Receives Payments of Deferred Compensation
After Becoming U.S. Resident ................. 335
1. Results Under the Internal Revenue Code ... 335
2. Results Under Treaties ................ 338

a. Treatment by Country X ......... 338
b. Treatment by United States ....... 339

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1996] U.S. Income Taxation of Cross-Border Pensions 261

C. The Problems Associated with U.S. Residence-Based
Taxation of Participants in Foreign Plans ........ 341

D. U.S. Residence-Based Taxation of U.S. Multinational
Employer ............................... 343

E. Possible Improvements of U.S. Residence-Based
Taxation of Beneficiaries of Foreign Plans ........ 349

V. A MORE COMPREHENSIVE U.S. TREATY POLICY ........ 352

V1. CONCLUSION .................................. 366



Florida Tax Review

I. INTRODUCTION

This article will explore the U.S. income tax rules applied to deferred
compensation transactions that cross national borders; it will consider whether
the rules that the U.S. has developed, as a source country and as a residence
country, constitute both a coherent and administrable approach and one that
meshes harmoniously with the laws of other countries. One objective in this
context is to avoid erecting barriers to the free movement of employees
across borders. Others are to avoid creating unwarranted loopholes for
employees and to insure that the U.S. obtains its rightful share of tax
revenues. This topic is of increasing significance because of the growth in
cross-border movements of employees in recent years.

There are a number of troubling features of the U.S. rules for taxing
cross-border deferred compensation that suggest the need for this exploration.
The rules for U.S. source-based taxation are often complex and difficult to
administer. In stark contrast to its stringent source-based taxation under the
Code, the U.S. in its treaties completely surrenders source-based jurisdiction
over "pensions." However, no such treaty relief is provided for other forms
of deferred compensation; yet the term "pension" has not been defined by the
IRS in an authoritative form, and the rationale for the special treatment of
"pensions" remains unclear.

It seems doubtful that U.S. residence-based jurisdiction over
"pensions" is exercised effectively, at least when the employer is not
affiliated with a U.S. multinational. U.S. tax concepts employed in a domestic
context are employed to characterize foreign retirement schemes even though
the effects of such characterizations probably were not foreseen when the
concepts were developed. The U.S. residence-based rules, even as supple-
mented by treaty, fail to take into account the manner of taxation by the
source-country so as to guard against double taxation or inadvertent tax
exemption.

Part II of this article is a brief introduction, reviewing the U.S.
income taxation of deferred compensation in a domestic context and the
rationale for these rules.

Parts III and IV will examine the use of these concepts in the
development by the U.S. of its rules for cross-border transactions. Part III will
first describe the U.S. assertion of source-based jurisdiction over cross-border

1. See Richard E. Andersen, New OECD Model Updates Employment, Self-
Employment Provisions, 4 J. Int'l Tax'n 94 (1993). Andersen states that "[aiccompanying the
globalization of financial capital during recent decades has been a somewhat less publicized,
but no less significant, increase in the volume of cross-border movement of Human capital,
i.e., international transfers of employees in the public and private sector, as well as a
heightened degree of global activity by self-employed persons .. " Id.

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U.S. Income Taxation of Cross-Border Pensions

deferred compensation transactions. It will then explore the rationale for
source-based taxation of deferred compensation and the disadvantages and
difficulties associated with such taxation by the U.S., concluding with a
discussion of the basis for U.S. treaty policy surrendering source-based
taxation of pensions (as most recently expressed in the U.S. Treasury
Department's 1996 Model Tax Convention and Technical Explanation2). Part
IV first describes the U.S. assertion of residence-based jurisdiction over cross-
border deferred compensation transactions. It will then explore the difficulties
associated with U.S. residence-based taxation of deferred compensation and
how they are occasioned by the U.S. attempt to apply its own tax concepts
to a large variety of foreign retirement schemes. This part will then analyze
the potential for "mismatching" of U.S. and foreign tax rules, with resulting
under- or over-taxation.

Part V will consider alternatives that might improve the current U.S.
rules governing cross-border deferred compensation. These alternatives will
include unilateral revisions of the U.S. treatment under the Code and
refinements of the U.S. treaty policy.

I. U.S. TAXATION OF DEFERRED COMPENSATION IN A
DOMESTIC CONTEXT

A. Summary of Current Tax Rules

A wage-earner who receives a current salary and invests it in a
savings account is taxed on his salary upon receipt and then taxed on his
interest income from the bank as it is earned.3 This treatment is generally
consistent with the ideal of a comprehensive income tax, i.e., a definition of
income that includes both amounts consumed and amounts devoted to
saving.

4

However, there are a number of alternative means for a wage-earner
to save for retirement. These generally involve an arrangement with the
employer to defer payment of compensation to the employee. The tax

2. See Treasury Department, United States Model Income Tax Convention, Sept.
20, 1996, 96 TNT 186-6 (Sept. 23, 1996) (LEXIS, FEDTAX library. TNT file) (hereinafter
1996 U.S. Model]; Treasury Department Technical Explanation for United States Model
Income Tax Convention of Sept. 20, 1996, 96 TNT 186-7 (Sept. 23. 1996) (LEXIS, FEDTAX
library, TNT file) [hereinafter 1996 Treasury Explanation].

3. Cf. Andrew Dilnot, The Taxation of Private Pensions, in Securing Employer-
Based Pensions-An International Perspective 213, 215 (Zvi Bodie, ct al, 1996) (noting that
a regime in which contributions are taxed, fund earnings are taxed, and payment of retirement
benefits is tax-free is "basically that applied to interest-bearing short-term saving in most
OECD countries").

4. See David F. Bradford and the U.S. Treasury Tax Policy Staff, Blueprints for
Basic Tax Reform 2 (2d ed. rev. 1984); see also Dilnot, supra note 3, at 220.

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Florida Tax Review

treatment of these alternative arrangements, under the Internal Revenue Code,
depends upon whether they are funded (i.e., whether the employee's rights
under the plan are of a type to attract current taxation under the cash method
of accounting),5 and, if so, whether taxation is nevertheless deferred because
the plan is a qualified plan.

1. Unfunded6 Deferred Compensation.-Under the cash method of
accounting, an employee who receives merely an unsecured promise of his
employer to pay deferred compensation generally defers taxation until
payment. The tax deferral is unaffected by the employer setting aside assets
for purposes of paying the deferred compensation in a so-called "rabbi trust"
meeting IRS guidelines;8 under these guidelines, the employee's rights must
be limited to "mere unsecured contractual rights" against the employer, and
the trust assets must be subject to the claims of the employer's general
creditors in the event of insolvency. 9

5. See John H. Langbein & Bruce A. Wolk, Pension and Employee Benefit Law 180
(2d ed. 1995) (stating that "[tihe basic difference between funded and unfunded plans is that
under a funded plan the employee may be taxed on contributions to the plan before the
employee actually receives distributions," pursuant to IRC § 83 or 402(b)). See also discussion
at infra note 6.

6. The term "unfunded" is used in this article to describe nonqualified deferred
compensation arrangements that achieve tax deferral for a cash method employee. See
Langbein & Wolk, supra note 5, at 190 (explaining that "[t]he key feature of the rabbi trust"
described at infra notes 8-9, "is that the trust assets remain subject to the claims of the
employer's creditors in the event of the employer's bankruptcy or insolvency," and "[lt is this
feature that makes the trust 'unfunded' for tax purposes, avoiding both constructive receipt and
the application of the economic benefit doctrine").

7. See Rev. Rul. 60-31, 1960-1 C.B. 174; 2 Boris I. Bittker & Lawrence Lokken,
Federal Taxation of Income, Estates and Gifts 60.2.1 (2d ed. 1990 & Supp. 1 1996). In
addition, see Rev. Proc. 92-65, 1992-2 C.B. 428 (providing IRS guidelines for obtaining a
ruling that the doctrine of constructive receipt is inapplicable to an unfunded deferred
compensation arrangement). Under IRS guidelines, an election to defer payment of
compensation must (with two specified exceptions) "be made before the beginning of the
period of service for which the compensation is payable." Id. Further, "[tihe plan must provide
that a participant's rights to benefit payments under the plan are not subject in any manner to
anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or
garnishment by creditors of the participant". Id.

8. See Rev. Proc. 92-64, 1992-2 C.B. 422 (providing a model form for a rabbi
trust). Following IRS guidelines insures that "an employee wili not be in constructive receipt
of income or incur an economic benefit solely on account of the adoption or maintenance of
the trust." Id. § 3. See discussion of "rabbi trusts" in Daniel I. Halperin, Special Tax Treatment
for Employer-Based Retirement Programs: Is it 'Still' Viable as a Means of Increasing
Retirement Income? Should It Continue? 49 Tax L. Rev. 1, 26 & nn.82-84 (1993). see also
Yale D. Tauber, Funding Non-Qualified Deferred Compensation Benefits, 1 ERISA & Benefits
L.J. 177, 179, 182-89 (1992).

9. Rev. Proc. 92-64, 1992-2 C.B. 422, § 5.02, Model Trust § I(d).

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U.S. Income Taxation of Cross-Border Pensions

When nonqualified deferred compensation is structured so as to defer
the employee's tax until receipt of payment, the employer's deduction is also
deferred until that time but includes the entire amount eventually paid to the
employee.1° Any investment return earned during the period of deferral is
taxed currently to the employer (under the grantor trust rules, in the case of
a rabbi trust)."

This type of deferred compensation results in overall tax savings to
the employer and employee only to the extent that the employer's tax rate
(applied to the investment return during the period of deferral) is less than the
tax rate that would have applied to the investment return earned by the
employee and to the extent that the employee's marginal tax rate at the time
of pay-out is less than it would be at the time when the compensation was
earned.

12

2. Qualified Retirement Plans.-When an employer sets aside funds
in a retirement trust for employees that is beyond the reach of the employer's
creditors (and thus not a "rabbi trust"), 3 the treatment depends upon
whether the trust is "qualified" under the pension provisions of the Code.

As provided in section 401 of the Internal Revenue Code, a
"qualified" pension trust must be "created or organized in the United States,"
and must be "for the exclusive benefit of ... employees or their beneficia-
ries."'14 In addition, the trust must satisfy a myriad of other requirements,
e.g., it must meet the minimum participation standards of section 410, must
not discriminate in contributions or benefits in favor of highly compensated
employees, must meet minimum vesting standards of section 411, must
comply with the limitations on contributions and benefits set forth in section
415, must prohibit assignment or alienation of benefits, and satisfy minimum
funding standards of section 412."

If the plan is qualified, the employer's contribution to the plan is
currently deductible, up to specified limits. 6 The income of the pension

10. See IRC § 404(a)(5); Bittker & Lokken, supra note 7. 1 60.2.2.
11. See IRC §§ 671-679. To meet the IRS guidelines for a model "rabbi trust," the

trust agreement must provide that it is intended to be a grantor trust of the employer as
grantor. Rev. Proc. 92-64, 1992-2 C.B. 422, § 5.02, Model Trust § 1(c).

12. See Halperin, supra note 8, at 13 & n.45. 23-24, 27; Daniel I. Halperin, Interest
in Disguise: Taxing the "Time Value of Money," 95 Yale LJ. 506. 520-23 (1986).

13. See supra notes 6, 8-9 and accompanying text.
14. IRC § 401(a).
15. Id.; see Bittker & Lokken, supra note 7, U 61.2-61.10.
16. See IRC § 404(a)(1). The deduction is "limited to the amount necessary to fund

the plan properly under the actuarial method and assumptions used." Bittker & Lokken, supra
note 7, 61.14.1.

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trust is tax-exempt pursuant to section 501(a). 7 The employee is taxed only
when he or she receives distributions from the trust. 8 Certain premature
distributions (i.e., withdrawals not used for retirement) are subject to a 10%
penalty tax.9

In the case of a qualified plan, the investment return accumulates free
of any tax.20 This is consistent with the consumption tax model, under
which amounts set aside for future consumption should accumulate at a
before-tax rate of return.2 1

3. Funded Nonqualified Plans.-Until recently, employers have not
deliberately sought to establish a funded nonqualified plan,22 and thus the
precise tax consequences have gone largely unexamined. Recently, however,
employers have sought and obtained private rulings regarding the tax
consequences of such arrangements. 23 The simplest case is a "defined
contribution plan," in which each participant has a separate account; the
account reflects contributions as well as trust income, expenses, and gains or

17. See IRC § 501(a); Bittker & Lokken, supra note 7, 61.15.
18. See IRC § 402(a); Bittker & Lokken, supra note 7, 61.13. A further advantage

is that "most pensions (but not employee contributions to 401(k) plans) are exempt from
payroll taxes." Eric M. Engen & William G. Gale, Comprehensive Tax Reform and the Private
Pension System, 96 TNT 137-82, para. 9 (July 15, 1996) (LEXIS, FEDTAX library, TNT file)
[hereinafter Engen & Gale].

19. See IRC § 72(t); infra note 117. In addition, see Gene Steuerle, Tax Reform and
Private Pensions, 70 Tax Notes 1693 (Mar. 18, 1996) (explaining that this penalty "might be
viewed as an attempt to 'recapture' some of the tax benefits that may have accrued" in light
of the fact that "the taxpayer turns out not to have saved for retirement"). He explains that
"[t]he government's penalty tax might also be viewed as its attempt to save welfare or transfer
payments down the road." Id. Similarly, the penalty on early withdrawal has been described
as "ensur[ing] that the tax break for pensions is only given for retirement saving." Engen &
Gale, supra note 18, para. 39.

20. See Halperin, supra note 8, at 13.
21. See Dilnot, supra note 3, at 214, 220 (noting that this "treatment confers a post-

tax rate of return on saving equal to the pre-tax rate of return," and that, under this approach,
"both present and future consumption are taxed on the same basis").

22. For a discussion of the tax treatment of "secular trusts," see Deborah Walker
and Sallie Olson, Maximizing the Benefits of Deferred Compensation Plans Funded Through
Secular Trusts, 77 J. Tax'n 90 (1992); Stuart M. Lewis, Secular Trusts-IRS Rulings Form
New Pentateuch, 33 Tax Mgmt. Memo (BNA) 301 (1992) (discussing Priv. Ltr. Ruls. 88-41-
023, 88-43-021, 92-06-009, 92-07-010, 92-12-019, and 92-12-024); Halperin, supra note 8, at
24-33; see also Washington Items: The Climate of Current Thinking on New Developments,
"Tax Consequences of Distributions from Nonexempt Trusts Unclear," 35 Tax Mgmt. Memo
(BNA) 268 (1994) (discussing Priv. Ltr. Rul. 94-17-013 (Jan. 24, 1994)); Internal Revenue
Service, Notice of Proposed Rulemaking, Application of Grantor Trust Rules to Nonexempt
Employees' Trusts [REG-209826-96], 96 TNT 190-4 (Sept. 27, 1996) (LEXIS, FEDTAX
library, TNT file) [hereinafter 1996 Proposed Rulemaking].

23. See, e.g., Priv. Ltr. Rul. 95-02-030 (Oct. 13, 1994).

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U.S. Income Taxation of Cross-Border Pensions

losses, and it serves as the basis for determining the participant's benefits."4

An employer's contribution to this type of plan is currently includible by the
employee pursuant to section 402(b)(1)5 and, as a consequence, is currently
deductible by the employer under section 404(a)(5), provided that amounts
contributed to the plan are nonforfeitable (notwithstanding early termination
of employment).2 The trust is treated as a separate taxable entity (rather
than as a grantor trust of the employer), and the trust's investment income is
taxed under the rate schedule for trusts,27 except to the extent of certain
current distributions to beneficiaries.2 The eventual distribution to the
employee is taxable to him upon receipt pursuant to section 72, which allows
for the amount already taxed at the time of contribution.-

24. The term "defined contribution plan" is defined in § 414(i). For a further
discussion, see Bittker & Lokken, supra note 7. 61.1.2.

25. Under § 402(b)(1), the contributions are included in income in accordance with
§ 83, except that the value of the employee's interest in the trust is substituted for the
property's fair market value in applying § 83. See Priv. Ltr. Rul. 95-02-030 (Oct. 13, 1994j.
However, an exception to this current inclusion is provided for a non-highly-compensated
employee if the sole reason the trust fails to qualify for exemption under § 501(a) is failure
to meet the requirements of § 401(a)(26) or § 410(b). See IRC § 402(b)(4)(B); see. e.g.. Priv.
Ltr. Rul. 92-12-019 (Dec. 20, 1991) (ruling (5)).

26. Under § 83, the employee's inclusion is in the first year in which his rights are
transferrable or are not subject to a substantial risk of forfeiture. See IRC §§ 83(a). 402(b)t 1).

27. See Priv. Lr. Rul. 92-12-019 (Dec. 20, 1991) (ruling (1)) (stating that "[tihe
rules of sections 402(b) and 404(a)(5) of the Code preclude a section 402(b) employees' trust
from being treated as owned by the employer under subpart E." and ruling that "the tax
imposed by section 1(e) of the Code will apply to the taxable income of the Trust pursuant
to section 641"); Priv. Ltr. Rul. 95-02-030 (OcL 13, 1994) (rulings (1) & (2)) (giving a similar
ruling); Halperin, supra note 8, at 30 & n.94. See also 1996 Proposed Rulemaking, supra note
22, U 34, 37. Under the proposed regulations, "an employer is not treated for federal income
tax purposes as an owner of any portion of a nonexempt employees' trust described in section
402(b) that is part of a deferred compensation plan, and that is not a foreign trust within the
meaning of section 7701(a)(31)." Id. 37.

28. See Priv. Ltr. Rul. 92-12-019 (Dec. 20, 1991) (ruling (3)) (ruling that "[flor any
taxable year, the Trust is entitled to a deduction under section 661(a) for amounts distributed
to a participant or a participant's beneficiary ... during that taxable year," with the deduction
limited "with respect to each participant's account" to the "amount of distributable net income
computed for each account as if each account were a separate trust"); see also Priv. Ltr. Rul.
94-17-013 (Jan. 24, 1994) (ruling (3)); Priv. Ltr. Rul. 95-02-030 (Oct. 13. 1994) (rulings (4)-
(5)). A trust's distributable net income ("DN') is its taxable income, determined with
modifications described in § 643(a). See IRC § 643(a).

29. See IRC § 402(b)(2); see, e.g., Priv. Ltr. Rul. 92-12-024 (Dec. 20, 1991) (rulings
(5) and (6)); Priv. Ltr. Rul. 95-02-030 (Oct. 13. 1994) (ruling (8)). Because no credit is given
for the tax paid by the trust, investment income is double taxed, see Halperin. supra note 8.
at 29-30 & n.94, except to the extent of the trust's distribution deduction (limited to DNI). Id.
at 32 & n.105. For purposes of determining a participant's "investment in the contract,"
amounts previously taxed to the recipient under § 402(b) are classified as "premiums or other

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If the plan deviates from this simple example there are additional
complications. If the benefits become nonforfeitable only some time after the
contribution is made, then the employee's inclusion is of the value of his
interest when that occurs.3" The employer's deduction is delayed to the time
of the employee's inclusion but cannot exceed the original contribution.3'
No deduction is allowed to the employer at any time unless separate accounts
are maintained for the various covered employees.32 Thus, no deduction is
generally allowed for contributions to a nonqualified "defined benefit plan"
because a defined benefit plan does not maintain such accounts.33 A defined
benefit plan is a pension plan that provides for definitely determinable
benefits, determined, for example, by reference to an employee's years of
service or rate of compensation.'

Moreover, if the employee is a highly compensated employee35 and
the trust fails to meet certain requirements of a qualified plan for broad
coverage and participation of employees,36 then, according to the IRS, the

consideration paid for the contract." See Priv. Ltr. Rul. 92-12-024 (Dec. 20, 1991) (rulings (10)
and (11)). See generally 1996 Proposed Rulemaking, supra note 22, 23-24 (describing the
treatment of the beneficiary and employer in respect of a nonexempt employees' trust).

30. See IRC § 402(b)(1) (stating that benefits are includible in accordance with
§ 83); Yale D. Tauber, Funding Non-Qualified Deferred Compensation Benefits, I ERISA &
Benefits L.J. 177, 190 (1992); Halperin, supra note 8, at 26 n.87; Bittker & Lokken, supra note
7, 60.3 (Supp. 1 1996).

31. See Halperin, supra note 8, at 30 & nn.95-96; Regs. § 1.404(a)-12(b)(1); Priv.
Ltr. Rul. 94-17-013 (Jan. 24, 1994); see also Priv. Ltr. Rul. 95-02-030 (Oct. 13, 1994). In the
case where there is a delay in the employer's deduction because the benefit is forfeitable, the
employer is in effect taxed on the "after-tax income of the trust," with the result that this
portion of the investment income is double taxed. See Halperin, supra note 8, at 30-31 & n.97.

32. IRC § 404(a)(5).
33. See IRC § 414(j) (defining a "defined benefit plan" as a plan which is not a

defined contribution plan); supra note 24 and accompanying text (defining a "defined
contribution plan"). But cf. Priv. Ltr. Rul. 92-12-019 (Dec. 20, 1991) (ruling that an employer
was entitled to deduct contributions to the participants' accounts of a trust that secured the
benefits for a nonqualified defined benefit plan and maintained separate accounts).

34. Regs. § 1.401-1(b)(1)(i); see Bittker & Lokken, supra note 7, T 61.1.2
(explaining that Regs. § 1.401-1(b)(l)(i) is applicable because a defined benefit plan is a
pension plan). An example of a defined benefit plan is "an annual pension equal to two thirds
of the employee's average annual compensation during the last five years of employment." Id.
In this example, the "employees ... are not affected by the earnings actually realized by the
trust fund, mortality experience, or employee turnover." Id.

35. The term "highly compensated employee" is defined for this purpose in
§ 414(q). See IRC § 402(b)(4)(C).

36. These requirements are contained in IRC §§ 410(b) and 401(a)(26), respectively,
and are designed "to restrain discrimination in favor of highly compensated employees." See
Bittker & Lokken, supra note 7, 61.3.1. See also id. U 61.3.3-61.3.4 for a detailed
description of these requirements.

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U.S. Income Taxation of Cross-Border Pensions

employee must additionally include his vested accrued benefit "7 (other than
his investment in the contract) on an annual basis.38 In that situation, the
amount taxable to the employee at the time of eventual distribution is
unclear.39 Some commentators have argued, however, that this unfavorable
treatment of highly compensated employees was intended by Congress only
for pension plans that originally had, but then lost, qualified status. 0

These unfavorable results4' of a nonqualified funded plan may be
avoided to the extent that the arrangement is structured so that the trust is a
grantor trust of the employee.42 In that case, the results are the same as for
current compensation invested by the employee."

4. Individual Retirement Accounts.-The favorable treatment
accorded a qualified pension plan is also available for individual savings of
a limited amount contributed to an individual retirement account (IRA)."
That is an individual who either does not participate in an employer pension
plan or whose income falls below certain limits may contribute up to $2,000

37. See IRC § 402(b)(4)(A); cf. Halperin, supra note 8, at 31 & n.99 (noting that
the effect is that the "employee is forced to include as income both the unrealized appreciation
and income as it accrues instead of at the time of distribution").

38. For IRS applications of § 402(b)(4)(A). reflecting its view that § 402(b)(4flA)
applies to any nonqualified funded plan, see, e.g.. Priv. Ltr. Rul. 95-02-030 (Oct 13, 1994)
(ruling (6)); Priv. Ltr. Rul. 94-17-013 (Jan. 24. 1994) (ruling (5))- Priv. Ltr. Rul. 92-12-019
(Dec. 20, 1991) (ruling (4)).

39. See Washington Items, supra note 22 (discussing Priv. Ltr. Rul. 94-17-013 (Jan.
24, 1994)). In that ruling, the IRS states that "[s]ection 402(b)(4)(A) of the Code in its current
form does not apply section 402(b)(2) to trigger application of section 72 to distributions to
a highly compensated employee from a nonexempt trust to which section 402(bJ(4f(A)
applies." Priv. Ltr. Rul 94-17-013 (Jan. 24, 1994) (ruling (a)). However, the IRS notes that this
would have been accomplished by a "technical correction contained in H.R. 11, 102d Cong.,
2d Sess. section 6102(j)(1)(A) (1992)" which was passed by both houses of Congress "'but
never signed into law by the presidenL" Id. As a result, the IRS does not rule on this issue in
Priv. Ltr. Rul. 94-17-013. Id.; see also Priv. Ltr. Rul. 95-02-030 (Oct. 13, 1994) (ruling (11)).

40. Halperin argues "the legislative history... implies that this rule was intended
to apply only if the plan had been previously qualified." Halperin, supra note 8, at 31 & n.100
(citing S. Rep. No. 445, 100th Cong., 2d Sess. 159-60 (1988) and H.R. Rep. No. 795, 100th
Cong., 2d Sess. 152-53 (1988)). This view, however, has not been accepted by the IRS. See
supra note 38.

41. The portion of a distribution includible in income may also be subject to the
10% penalty tax under § 72(q) if the distribution is premature. See Priv. Ltr. Rul. 92-12-024
(Dec. 20, 1991) (ruling (12)).

42. See Halperin, supra note 8, at 32 (noting that this can be done by "giv[ing] the
employee an option as to whether to receive cash or to contribute to a trust for her benefit");
Walker & Olson, supra note 22, at 91; Priv. Ltr. Rul. 8843-021 (July 29, 1988).

43. See Halperin, supra note 8, at 32.
44. See generally Bittker & Lokken, supra note 7, 62.3.

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per year to such an account on a tax deductible basis.45 The IRA itself is
exempt from tax.' No tax is imposed on the employee until distributions are
made from the account.47

B. Rationale for U.S. Tax Treatment of Qualified Retirement Plans48

The tax treatment that the U.S. accords to current compensation
invested by an employee in a bank account is in accord with the norm of a
comprehensive income tax, with a base including both consumption and
savings. 49 As discussed above, the overall tax treatment to the employer and
employee of unfunded deferred compensation is comparable except to the
extent of variation between the employer and employee's tax rate and any
decline in the employee's tax rate at retirement.50 By contrast, the tax
treatment that the U.S. accords to qualified pension plans and IRA accounts
(holding deductible contributions) is in accord with the norm of a cash flow
tax, in which the tax base is limited to consumption.5

Many commentators view this favorable treatment of qualified
pension plans as justifiable under an income tax only as a tax incentive to
encourage workers to save for retirement52 so as to reduce the need for

45. See IRC § 219(a), (b), (g); Bittker & Lokken, supra note 7, 62.3.2.
46. See IRC § 408(e)(1).
47. See IRC § 408(d)(1); Bittker & Lokken, supra note 7, % 62.3.4.
48. See generally Edward A. Zelinsky, Tax Policy v. Revenue Policy: Qualified

Plans, Tax Expenditures, and the Flat, Plan Level Tax, 13 Va. Tax Rev. 591 (1994)
[hereinafter Zelinsky, Flat, Plan Level Tax]; Halperin, supra note 8; General Accounting
Office, Tax Policy: Effects of Changing the Tax Treatment of Fringe Benefits, reprinted in 92
TNT 76-16 (Apr. 7, 1992) (LEXIS, FEDTAX library, TNT file) [hereinafter GAO Report];
Norman P. Stein, Qualified Plans and Tax Expenditures: A Reply to Professor Zelinsky, 9 Am.
J. Tax Pol'y 225 (1991) [hereinafter Stein]; Edward A. Zelinsky, Qualified Plans and
Identifying Tax Expenditures: A Rejoinder to Professor Stein, 9 Am. J. Tax Pol'y 257 (1991)
[hereinafter Zelinsky, Rejoinder]; Joseph Bankman, Tax Policy and Retirement Income: Are
Pension Plan Anti-Discrimination Provisions Desirable, 55 U. Chi. L. Rev. 790 (1988); Edward
A. Zelinsky, The Tax Treatment of Qualified Plans: A Classic Defense of the Status Quo, 66
N.C. L. Rev. 315 (1988) [hereinafter Zelinsky, Status Quo]; Nancy J. Altman, The
Reconciliation of Retirement Security and Tax Policies: A Response to Professor Graetz, 136
U. Pa. L. Rev. 1419 (1988); Michael J. Graetz, The Troubled Marriage of Retirement Security
and Tax Policies, 135 U. Pa. L. Rev. 851 (1987).

49. See supra notes 3-4 and accompanying text.
50. See supra note 12 and accompanying text.
51. See Bradford, supra note 4, at 54, 118; Dilnot, supra note 3, at 220. For

discussion of the possible effects on pension savings if the current income tax is replaced with
a form of consumption tax, see Gene Steuerle, Tax Reform and Private Pensions (pts. 1 & 2),
70 Tax Notes 1693 (Mar. 18, 1996), 70 Tax Notes 1831 (Mar. 25, 1996); Engen & Gale, supra
note 18.

52. See, e.g., GAO Report, supra note 48, ch. 2 (stating that "Congress uses tax
preferences to encourage employers to sponsor pension plans and employees to provide savings

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U.S. Income Taxation of Cross-Border Pensions

government to provide direct support to the elderly. 3 The favorable tax
treatment of qualified plans may accomplish this by making such plans
attractive to relatively well-compensated employees, while the nondiscrimina-
tion rules insure that the pension benefits are not limited to such employ-
ees. 4 The minimum vesting and funding requirements and the fiduciary
standards applied to qualified plans insure that a participant will in fact
receive benefits." The penalty for premature distributions assures that
benefits will not be withdrawn before retirement.'

Some have expressed doubt that these goals are effectively achieved,
either because the tax advantage of a qualified plan over a nonqualified plan
is not sufficiently large" or because the nondiscrimination requirements are
not in fact well-tailored to insuring broad coverage of employees.58 And
some have proposed eliminating the tax advantage by imposing a flat tax
(designed to approximate the average tax rate of participants in the plan) on
the earnings of qualified pension trusts.59

By contrast, Professor Zelinsky has argued that the current treatment
of qualified retirement plans should not be characterized as a "tax expendi-

for their future retirement"); Janet G. Stotsky & Emil M. Sunley, The Tax System of the
United States, 9 Tax Notes Int'l 1755, 1765 (Dec. 5, 1994) (noting that "[tihere are various
incentives in the tax code intended to increase retirement savings.").

53. See, e.g., Gene Steuerle, Tax Reform and Private Pensions, 70 Tax Notes 1693,
1693 (Mar. 18, 1996) (noting that the penalty for early pension withdrawals "might also be
viewed as [the government's] attempt to save welfare or transfer payments down the road").

54. The reduction in the overall pre-tax compensation accepted by the well-
compensated employees, as a result of the tax benefits, is used by the employer to partially
fund an increase in overall pre-tax compensation for rank-and-file employees, who would not
be willing to substitute deferred compensation for current compensation. See Halperin, supra
note 8, at 13-15.

55. See Bittker & Lokken, supra note 7, 61.2, 61.5, 61.10, 61.16 (discussing the
antidiversion requirements of § 401(a)(2), minimum vesting standards, funding requirements
and prohibited transactions).

56. See supra note 19.
57. See Halperin, supra note 8, at 6-7, 15-21. Professor Halperin has suggested the

possibility of a harsher treatment of nonqualified plans to preserve the relative attractiveness
of qualified plans (with their prospect of greater rank-and-file coverage). Id. at 43-44.

58. See Bankman, supra note 48, at 805-13, 821-24, 828-30.
59. The tax advantage offered by the qualified pension plan, as compared to current

compensation invested by the employee, is the exemption provided for the income of the
pension trust. See supra text accompanying note 20. Under one proposal, a 15% flat tax would
be imposed both on employer contributions and on pension trust earnings; however, no further
tax would be imposed on employees receiving pension distributions. See GAO Report, supra
note 48, chapter 2 & n.24; Zelinsky, Flat, Plan Level Tax, supra note 48, at 591-92 & nn.1-6.
Zelinsky sharply criticizes this proposal. Id. at 591-608.

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ture." 6 He emphasizes that a pure income tax treatment of a defined benefit
pension plan (i.e., attribution of accrued benefits to employees) is impractical
due to problems of valuation, liquidity and comprehensibility to the public.6'
He argues that the alternative of the flat tax on earnings in a qualified
pension trust is not sufficiently accurate (since it would not reflect the
individual tax rates of the individuals for whom the benefits are accrued). 62

The favorable treatment of an IRA is viewed as an incentive for
retirement savings for those who are not provided pension coverage by their
employers.63 The fairly small amounts permitted to be contributed and the
denial of deductions to higher income individuals covered by an employer
plan prevent the IRA incentive from undermining the incentive to participate
in a qualified employer-sponsored plan.'

C. Taxation of Pensions in Other Developed Countries

The scholar Andrew Dilnot has recently compared the tax regimes
applied to pensions in a number of developed countries. 65 "Almost all" of
the fourteen countries studied "impose upper limits on the level of contribu-
tion and/or benefits that can be paid, although typically these limits affect
only a small proportion of the workforce. 66 The dominant tax regime was
found to be the same as that applied by the U.S. to tax-qualified plans, i.e.,
exemption from tax at the point of contribution and when earnings are
derived, but full taxation on distribution, which is described by Dilnot as
"exemption, exemption, taxation" or "EET."67 By contrast, New Zealand has
recently adopted the approach of taxing contributions as well as earnings as

60. See Zelinsky, Status Quo, supra note 48, at 326-34; Zelinsky, Rejoinder, supra
note 48, at 259-71.

61. See Zelinsky, Status Quo, supra note 48, at 334-47.
62. See id. at 358-60; Zelinsky, Flat, Plan Level Tax, supra note 48, at 602-07.
63. See, e.g., Stotsky & Sunley, supra note 52, at 1755, 1765.
64. See generally Graetz, supra note 48, at 895-96 (noting when the IRA deduction

was enacted in 1974, it was opposed by "organized labor ... because of fear that such a
deduction would deter employers from establishing pension plans for employees"). Graetz
observes that "the relatively small $2,000 limit ... seems to have been quite significant in
reducing the potential threat of IRAs to employer-provided plans." Id. at 896. He concludes
that "by limiting availability of IRAs ... the 1986 legislation should provide some protection
for employer-provided pension plans from accelerating encroachment by more individualized
retirement savings vehicles." Id. at 901.

65. See Dilnot, supra note 3, at 213-231.
66. Id. at 216.
67. Id. at 214, 217 (explaining that the tax treatment of pensions used by "the bulk

of [the] countries" is "most like" the regime of "EET"). Dilnot explains that this regime is
clearly followed by Canada, Ireland, the Netherlands, the U.K., and the U.S., and less clearly
so by France, Germany, Greece, and Portugal. Id. at 217 tbl. 2.

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U.S. Income Taxation of Cross-Border Pensions

they accrue, described by Dilnot as "taxation, taxation, exemption" or
'TrE,''6s which is the approach applied in the U.S. to wages invested in
ordinary savings accounts; Australia has also "moved in a similar direc-
tion."'69 Sweden and Denmark do not tax contributions to pension plans but
do tax earnings as they accrue. ° In Japan, the earnings of a pension fund
are taxed at a low rate and distributions are also taxable."

D. New Considerations in Cross-Border Context

A number of new considerations arise in the context of cross-border
employment because of a need to coordinate the treatment of a single
employment and retirement arrangement under more than one country's
laws.72 There might be complications even if every other country in the
world adopted exactly the same tax rules as the U.S.; the fact that they do not
causes the complications to multiply. Other countries' laws may differ not
only in the treatment accorded pension plans in a domestic context but also
in the rules applied to deal with cross-border transactions.

If cross-border deferred compensation is to attract an overall tax
burden similar to that applied in an entirely domestic situation, taxation on
the basis of source needs to be coordinated (both in respect of amount and
timing) with taxation on the basis of residence. This task is complicated by
the fact that there are two potential bases for a claim to impose source-based
taxation: (a) the location where the services are performed and (b) the situs
of the retirement plan. In addition, since a long time may often elapse
between the time that contributions are made to a pension plan and the time
of eventual payout, there may also be more than one country with a potential
claim to impose residence-based tax. Because of the potential number of
interested countries, more than one treaty may be applicable to the transaction

68. Id. at 215, 217 tbl. 2.
69. Id. at 217.
70. See id. at 217 tbl. 2.
71. See id.
72. See generally James P. Klein, International Benefits Planning, U.S. Income Tax

Treaties and Deferred Compensation Plans, 14 Int'l Tax J. 379 (1988); Thomas St.G. Bissell
& Alfred Giardina, International Aspects of U.S. Retirement Plans, Deferred Compensation
and Equity-Based Compensation Plans: An Overview. 25 Tax Mgmt. Int'l J. 275 (1996)
[hereinafter Bissell & Giardina]; David W. Ellis et al., Structuring International Transfers of
Executives, RIA Tax Advisors Plan. Series I (Sept. 1994) [hereinafter Ellis & Navin]; Arthur
A. Feder, Pension Planning in the International Context, in International Tax Problems of
Charities and Other Private Institutions with Similar Tax Treatment, 39th Congress of the
International Fiscal Association, 41-56 (1985) [hereinafter Feder]; Henry Ordower. A Theorem
for Compensation Deferral: Doubling Your Blessings By Taking Your Rabbi Abroad. 47 Tax
Law. 301 (1994); Leif Muten, International Experience of How Taxes Influence the Movement
of Private Capital, 8 Tax Notes Int'l 743 (1994).

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(at the same or different times). Finally, taxation of cross-border pensions (by
other than the country where the plan is situated) requires that pension plan
administrators be required to provide tax information that may not be relevant
under their own country's laws.

Part EE of this article will focus on the U.S. assertion of source-based
jurisdiction over cross-border pension income, i.e., U.S. claims to tax pension
income derived by an individual who is not a U.S. citizen or resident.
Consideration will be given to the following situations,73 depicted in the
corresponding rows of Table 1, pages 358-59:

A nonresident alien performs services in the U.S., and:

(1) he earns unfunded deferred compensation; or
(2) his employer contributes to a qualified U.S. pension plan;74

or
(3) his employer contributes to a nonqualified funded pension

plan located in the U.S.; or
(4) his employer contributes to a funded pension plan located in

a foreign country.

Alternatively, a nonresident alien performs services in his country of
residence, and:

(5) his employer contributes to a qualified U.S. pension plan; or
(6) his employer contributes to a nonqualified funded pension

plan located in the U.S.

Part IV of this article will focus on the U.S. assertion of residence-
based jurisdiction over cross-border deferred compensation, i.e., jurisdiction
to tax such income earned by a U.S. citizen or resident. Consideration will
be given to the following situations, depicted in the corresponding rows in
Table 2, pages 360-61:

A U.S. citizen or resident performs services abroad, and

(7) earns unfunded deferred compensation; or
(8) his employer contributes to a funded pension plan located in

a foreign country.75

73. Cf. Feder, supra note 72, at 55-56 (describing a number of common situations).
74. See, e.g., Priv. Ltr. Rul. 92-53-049 (Oct. 6, 1992).
75. See Feder, supra note 72, at 43-48, 51-53 (discussing Germany and U.K.). In

many cases, however, a U.S. multinational may send a U.S. citizen employee to work in a
foreign branch or subsidiary and may continue making contributions on behalf of the employee
to a U.S. based pension plan. See, e.g., Rev. Rul. 79-389, 1979-2 C.B. 281 (employee retired
abroad). See also Feder, supra, at 48-50.

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U.S. Income Taxation of Cross-Border Pensions

A foreign national performs services abroad, and later becomes a U.S.
resident before receiving payments:

(9) from an unfunded deferred compensation arrangement; or
(10) from a funded pension plan located in a foreign country.76

m. SOURCE-BASED TAXATION BY U.S. OF DEFERRED COMPENSATION

PAID TO NONRESIDENT ALIENS

A. Background: U.S. Taxation of Current Compensation and Investment
Income of Nonresident Aliens

A U.S. citizen or an alien classified by U.S. tax law as a "resident"
(by virtue of "substantial presence" or immigration status as a permanent
resident) is taxed by the U.S. on worldwide income.7 By contrast, U.S.
taxation of a nonresident alien extends only to income considered to have a
sufficient nexus with the U.S. A nonresident alien is taxed at the usual U.S.
individual rates on income considered to be effectively connected with a U.S.
trade or business, and at a flat 30% rate on certain categories of U.S.-source
income, such as fees, dividends and interest. 78

Apart from a fairly narrow exception for short-term commercial
travelers to the U.S., compensation for services performed in the U.S. is
treated as from U.S. sources and as effectively connected income;' thus, it
is taxed to a nonresident alien at usual U.S. rates~o and subject to withhold-
ing; such withholding is even required of foreign employers, although
compliance is apparently poor."' Compensation paid for services performed

76. See, e.g., Tech. Adv. Mem. 89-11-001 (Sept. 27, 1988) (pre-retirement
distributions to Canadian citizen who became U.S. resident alien).

77. See Regs. § 1.1-1(b); cf. IRC § 2(d) (special rules for nonresident alien
individuals). In some cases, an alien classified as a resident under the Code will also be
classified as a resident m another country. Such a conflict may be resolved in a treaty tic-
breaker clause.

78. See IRC §§ 2(d), 871-874.
79. See IRC §§ 861(a)(3) (source rule for compensation), 864(b) (defining "U.S.

trade or business"), 864(c) (defining "effectively connected income"); Regs. § 1.864-4(c)(6)
(effectively connected income involving personal services). For taxable years beginning after
December 31, 1975, if the services are performed partly within and partly outside the U.S.,
the allocation between U.S. and foreign sources is "determined on the basis that most correctly
reflects the proper source of income under the facts and circumstances of the particular case."
Regs. § 1.861-4(b)(1)(i).

80. See Rev. Rul. 92-106, 1992-2 C.B. 258 (Situations 3 and 4); Thomas St.G.
BisseU, IRS Rules on International Payroll Tax Issues, 22 Tax Mgmt. Int'l J. 145, 147 (1993).

81. Whether or not an alien's employer is a U.S. person or a foreign person, wages
paid in respect of services performed in the U.S. (and not qualifying under the exception) are
subject to income tax withholding under § 3402(a) and withholding of FICA taxes under
§ 3101(a) and (b). Rev. Rul. 92-106, supra note 80 (Situations 3 and 4). Such employers are

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outside the U.S., whether or not paid by an American employer, is not subject
to U.S. tax in the hands of a nonresident alien employee.

The exception from U.S. tax for compensation received by a short-
term commercial traveler applies only if (1) the employee is present in the
U.S. for no more than 90 days during the year, (2) the compensation does not
exceed $3,000, and (3) either the employer is a foreign person not engaged
in a U.S. trade or business or, if the employer is a U.S. person, the services
are performed for the employer's foreign office.s2 Treaties entered into by
the U.S.83 commonly expand upon the "business traveler" exemption in the
Code,84 by eliminating the dollar limitation and extending the permitted
period of presence to 183 days. Such treaties, however, do not otherwise limit
U.S. taxation of compensation for services performed in the U.S. by
employees.8 5

subject to FICA taxes imposed under § 3111(a) and (b) and FUTA taxes imposed under
§ 3301. Id. According to Thomas St.G. Bissell, "it is quite common [however,] for a foreign
employer who employs a NRA working in the United States not to establish a U.S. payroll
system and thus to fail to withhold FICA, FUTA and wage withholding tax." Bissell, supra
note 80, at 147. This may be because the employee, who has a temporary business visitor visa,
"normally cannot obtain a U.S. Social Security number"; "more commonly" this situation is
due to the employer's "concern that the filing of U.S. payroll tax forms may be likely to elicit
inquiries from the IRS and/or from the relevant state tax authorities as to whether the employer
is engaged in trade or business in the United States ... and/or is 'doing business' for state
corporate income tax purposes." Id. Where a nonresident alien is employed by a foreign
employer in the U.S., "the IRS enforcement of all three payroll taxes ... tends to be quite
spotty." Id.

82. See IRC § 861(a)(3)(A)-(C).
83. Such a provision is included in the 1996 U.S. Model. See 1996 U.S. Model,

supra note 2, art. 15; see also U.S. Treasury Department Model Income Tax Treaty, art. 15
(1981), 85 TNI 42-33 (April 21, 1990) (LEXIS, FEDTAX library, TNI file) [hereinafter 1981
U.S. Model]. The 1981 U.S. model was withdrawn in July 1992. See Treasury Announces
Review of Model Income Tax Treaty, July 17, 1992, reprinted in 92 TNI 31-29 (July 29,
1992) (LEXIS, FEDTAX library, TNI file) (announcing withdrawal and undertaking of project
for revision). See also Organization for Economic Cooperation and Development, Comm. on
Fiscal Affairs, Model Tax Convention on Income and Capital, art. 15 (1992) [hereinafter 1992
OECD Model] (requiring that the recipient be present not more than 183 days, the
remuneration be paid by or on behalf of a nonresident employer, and the remuneration not be
borne by either a permanent establishment or fixed base of the employer in the source state);
Jacques Sassesville, The OECD Model Tax Convention is Revised, 4 J. Int'l Tax'n 129, 131-
32 (1993) (describing changes in the 183-day rule in the 1992 OECD Model); see generally
IRS Publication 901, U.S. Tax Treaties at 2-10 (Revised Nov. 1995) (discussing how
"residents" of other countries are taxed on personal service income under various treaties).

84. See Andersen, supra note 1, at 94.
85. These treaties also generally contain a separate article for compensation for

independent services, which provides exemption unless the services are performed in
connection with a fixed base in the host country. See 1992 OECD Model, supra note 83, art.
14; IRS Publication 901, supra note 83, at 2-10.

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U.S. Income Taxation of Cross-Border Pensions

If a nonresident alien who performs services in the U.S. during the
taxable year also receives investment income, the treatment of the investment
income is generally separate from the treatment of the compensation
income. 6 Dividends and interest from U.S. sources are subject to a flat 30%
withholding tax, 7 subject to treaty reductions. However, much interest is
exempted by the exception for portfolio interest and the exception for interest
on bank deposits.8 A nonresident alien would generally be taxed on capital
gains89 only if the individual is present in the U.S. for more than 183 days
during the year9" and has a tax home in the U.S.9'

B. U.S. Taxation of Deferred Compensation Received by a Nonresident Alien

1. Unfunded Deferred Compensation.-When compensation for
services performed in the U.S. is deferred by an employer in an unfunded
arrangement, the full amount eventually paid is treated as compensation for
services; thus, upon receipt, the full amount is from U.S. sources and is taxed
to the nonresident alien as effectively connected income (absent satisfaction
of the business traveler exception). 92 Prior to the Tax Reform Act of 1986,
such compensation paid in a year that the nonresident alien was no longer
performing services in the U.S. was treated as not effectively connected with
a trade or business.93 However, section 864(c)(6), enacted in the Tax

86. See Regs. § 1.864-4(c)(6)(i) (U.S.-source income or gain derived from an asset
by a nonresident alien who is engaged in a U.S. trade or business, by virtue of performing
personal services in the U.S., is not treated as effectively connected "unless there is a direct
economic relationship between his holding of the asset ... and his trade or business of
performing the personal services").

87. See IRC § 871(a)(l)(A).
88. See IRC § 871(h), (i)(2)(A).
89. Gains from the disposition of U.S. real property interests by nonresident aliens

are, however, taxed and treated as effectively connected income. IRC § 897.
90. See IRC § 871(a)(2) (taxing U.S.-source capital gains for such taxpayers).
91. Income from the sale of personal property is generally U.S.-sourccd only if

derived by a U.S. resident. IRC § 865(a). A nonresident alien is classified as a U.S. resident
only if he or she has a tax home (as defined in § 91 l(d)(3)) in the U.S. IRC § 865(g)l).

92. See Bissell & Giardina. supra note 72, at 280-82 (describing the tax
consequences for a nonresident alien receiving distributions from an unfunded retirement plan
for executives (referred to as a "SERP")). Bissell & Giardina state that "[ulpon the payment
of benefits from the SERP upon retirement or the termination of employment, the entire
distribution would be treated as compensation and would be sourced in accordance with where
the individual worked during the years that the accruals to the plan were made." Id. at 281;
cf. Rev. Rul. 78-227, 1978-1 C.B. 242 (ruling that the portion of a foreign service retirement
annuity representing payments from a current Congressional appropriation is attributable to an
employer's contribution and thus treated as foreign source income to the extent allocable to
services performed abroad).

93. See IRC § 864(c)(1)(B); Regs. § 1.864-3(b), ex. 3.

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Reform Act of 1986,95 changed this rule by requiring that the categorization
of the income as effectively connected be made by reference to the year in
which services are performed.96 (This result is depicted at row 1 of Table
1, page 358.) By contrast, many foreign countries are said to impose
immediate taxation upon vested, but unfunded retirement benefits. 9

2. Qualified Pension Plan.-A different and more complex treatment
applies to a funded plan for deferred compensation.9" In the case of a
qualified 9 U.S. plan, there are no tax consequences to the employee until

94. Section 864(c)(6) provides that:
in the case of any income or gain of a nonresident alien... which-(A) is
taken into account for any taxable year, but (B) is attributable to... the
performance of services ... in any other taxable year, the determination
of whether such income or gain is taxable under section 871(b) ... shall
be made as if such income or gain were taken into account in such other
taxable year and without regard to the requirement that the taxpayer be
engaged in a trade or business within the United States during the taxable
year referred to in subparagraph (A).

For a detailed discussion of § 864(c)(6) and its relationship to treaties, see Meenakshi
Ambardar, Comment: The Taxation of Deferred Compensation Under I.R.C. 864(c)(6) and
Income Tax Treaties: A Rose is Not Always Arose [Sic], 19 Fordham Int'l L.J. 736 (1995).

95. Pub. L. No. 99-514, § 1242, 100 Stat. 2580. The Staff of the Joint Committee
explained that "Congress believed that foreign persons should not be able to avoid U.S. tax
on their income from performance of services in the United States where payment of the
income is deferred until a subsequent year in which the individual is not present in the United
States." Staff of the Joint Comm. on Taxation. 100th Cong., 2d Sess., General Explanation of
the Tax Reform Act of 1986, at 1048 (1987).

96. Apparently, under § 864(c)(6) "effectively connected" treatment results whether
the individual was a nonresident alien or resident alien at the time the U.S. services were
performed. See Priv. Ltr. Rul. 89-04-035 (Oct. 31, 1988) (dealing with "German citizens
working in the United States" who participate in a U.S. company's 401(k) plan and then retire,
whereby § 864(c)(6) applies to the distributions in excess of employee contributions, excluding
earnings and accretions, "[b]ecause the [e]mployees' income would have been taxed on a net
basis at graduated rates in the performance years").

97. See Bissell & Giardina, supra note 72, at 281 (noting that some "countries arc
often more lax ... if the accrual consists of benefits under an actuarially based defined benefit
plan, rather than under a defined contribution or salary reduction plan").

98. See generally Thomas St.G. Bissell, U.S. Pension Plan Distributions to NRAs:
PLRs 9143067 and 9253049, 23 Tax Mgmt. Int'l J. 77 (1994); Charles M. Bruce & Martin
A. Culhane, Qualified Plan Distributions to Nonresident Aliens Treated as "Effectively
Connected" Income, 18 Tax Mgmt. Int'l J. 335 (1989); Barbara N. Seymon-Hirsch, IRPAC
Discussion Paper on Nonresident Alien Withholding and Pension Payment Reporting, 95 TNI
91-11 (May 22, 1995) (LEXIS, FEDTAX library, TNI file) [hereinafter IRPAC Paper].

99. In many cases, an alien individual may work in the U.S. as a resident and
become a nonresident only at a later point when pension distributions are being made. See,
e.g., Rev. Rul. 79-388, 1979-2 C.B. 270. For a discussion of reasons why an "inbound execu-
tive" would participate in a U.S. qualified plan, see Ellis & Navin, supra note 72, at 82-83.

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U.S. Income Taxation of Cross-Border Pensions

the time of a distribution. A distribution is disaggregated into (a) the
contribution by the employer, classified as compensation, and (b) the
investment return earned on the contributions (of employer or employee),
referred to as "earnings and accretions."'" With respect to the former
component, contributions in respect of services performed in the U.S. are
taxable as effectively connected income'o' (or as U.S. source fixed and
determinable income in the case of pre-1986 Act contributionst02). Assum-
ing that the pension plan is located in the United States,'"3 the earnings and
accretions are treated as U.S. source noneffectively connected income,'"4

subject to a flat 30% tax collected by withholding."5 This treatment applies
even if the contributions were in respect of services performed outside the
U.S. Moreover, the fact that the pension trust invests in a form that would
have been free of U.S. tax in the hands of a nonresident alien investor is
considered irrelevant because the trust is not viewed as a conduit.16

100. See Rev. Rul. 79-388, 1979-2 C.B. 270.
101. See Priv. Ltr. Rul. 90-41-041 (July 13. 1990) (discussing a distribution made

from a § 401(k) plan). The IRS ruled that "section 864(c)(6) applie[d] to the portion of each
[d]istribution that consists of the Participant's deductible contributions and Employer's
matching contributions to the extent the contributions are attributable to services performed
after December 31, 1986 as long as the Participant's income would have been treated as
effectively connected with the conduct of a U.S. trade or business in the years of perfor-
mance." Priv. Ltr. Rul. 90-41-041 (July 13, 1990). See also Priv. Ltr. Rul. 89-04-035 (Oct. 31.
1988); Bruce & Culhane, supra note 98, at 335-42; Bissell, supra note 98. at 78 (Priv. Ltr. Rul.
89-04-035 "was apparently the first PLR in which the IRS ruled that § 864(c)(6) would be
applied to non-treaty-exempt pension distributions."); T.D. 8288, 1990-1 C.B. 163. 164,
Explanation of Temp. Regs. § 1.1441-4(b)(1)(ii) (explaining that § 864(c)(6) applies to
pensions, because "[pl]ensions are treated as compensation for services under 31.3401(a)-
1(a)(2)").

102. Thus, this portion of the payment is subject to taxation under § 871(a)(l)(A)
and withholding under § 1441(a). See Rev. Rul. 79-388, 1979-2 C.B. 270.

103. See IRC § 401(a) (defining a qualified trust as being "[a] trust created or
organized in the United States").

104. See Rev. Rul. 79-388, 1979-2 C.B. 270: see also Priv. Ltr. Rul. 90-41-041
(July 13, 1990) (stating that § 864(c)(6) does not apply to distributions from § 401(k) plan
attributable to earnings and accretions of the plan). But cf. Bissell & Giardina. supra note 72,
at 278 (stating that "the rules at the moment are unclear" as to whether "the investment
income portion will be subject to tax either at the 30% rate under § 87 1. or as wages taxable
under § 1").

105. See Rev. Rul. 79-388, 1979-2 C.B. 270; Priv. Ltr. Rul. 89-04-035 (Oct. 31,
1988); Priv. Ltr. Rul. 90-41-041 (July 13, 1990); see also Rev. Rul. 79-389, 1979-2 C-B. 281
(similar analysis in application of § 901 to U.S. citizen retiring abroad); Rev. Rul. 84-144,
1984-2 C.B. 129 (application of § 901 to distribution from IRA established by a qualifying
rollover distribution from a qualified U.S. pension plan).

106. See Clayton v. United States, 95-2 U.S. Tax Cas. (CCH) 1 50,391, 89.232. 76
A.F.T.R.2d (RIA) at 95-5197 (Cl. Ct. 1995) (endorsing IRS policy that "conduit theory of
taxation embodied in Subchapter J does not apply to distributions from qualified employee

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Rows 2 and 5 of Table 1, pages 358-59, depict the case of a
nonresident alien participating in a U.S. qualified plan. In each case, tax is
imposed only at the time of distribution. In row 2 where services are
performed in the U.S., the "compensation" element is taxed as effectively
connected income, and the "accretions" element is taxed at a 30% flat rate.
In row 5, where the services are performed abroad, only the "accretions"
element is taxed by the U.S.

This treatment of "earnings and accretions" was approved by the IRS
in a 1952 pronouncement"° that was later declared obsolete in 1970."' s

This approach was again adopted by the IRS in a 1979 Revenue Ruling after
objections put forward by the IRS Chief Counsel in a 1975 General Counsel
Memorandum were put aside."° Just recently, the U.S. Court of Federal
Claims and the Court of Appeals for the Federal Circuit confirmed this
approach in Clayton v. United States,"10 which involved the U.S. tax
treatment of Canadians who were employed by Chrysler's subsidiaries
operating in Canada and who received distributions on termination of
Chrysler's employee stock ownership plan taking the form of cash proceeds
of sales of Chrysler stock. Both courts endorsed the IRS position that U.S.
taxation of earnings and accretions of a U.S. pension trust was intended by
Congress. 1'

plans"), affd, 96-1 U.S. Tax Cas. (CCH) 50,314,77 A.F.T.R.2d (RIA) at 96-2484 (Fed. Cir.
1996). See also Priv. Ltr. Rul. 87-21-006 (Jan. 30, 1987) (holding that a distribution from a
decedent's IRA, consisting of a deposit at a savings bank, made to a nonresident alien
beneficiary could not be treated as foreign-source income pursuant to § 861(c)(2) because an
IRA trust is governed by subchapter D rather than subchapter J).

107. IR-Mim. 71, 1952-2 C.B. 170.
108. Rev. Rul. 70-278, 1970-1 C.B. 281.
109. See Rev. Rul. 79-388, 1979-2 C.B. 270; Gen. Couns. Mem. 36,344 (July 23,

1975); Gen. Couns. Mem. 38,007 (July 10, 1979).
110. 95-2 U.S. Tax Cas. (CCH) 50,391, 76 A.F.T.R.2d (RIA) at 95-5197, aff'd,

96-1 U.S. Tax Cas. (CCH) 50,314, 77 A.F.T.R.2d (RIA) at 96-2484 (Fed. Cir. 1996).
111. The Claims Court first concluded that the capital gains characterization at the

level of the trust did not pass through to the trust beneficiaries because the conduit rules of
subchapter J do not apply to employer trusts. The Court further held that the treatment of the
earnings and accretions component of distributions from qualified plans as U.S.-sourced based
on the situs of the trust was a "long-standing [IRS] policy" that "Congress has repeatedly
approved ... by enacting narrow exclusions to the general tax rule." 95-2 U.S. Tax Cas.
(CCH) at 89,232. The Claims Court noted Congress's 1960 enactment of § 402(a)(4) (the
predecessor of § 402(e)(2)), containing an exception for certain distributions paid by the U.S.
Government as employer. Id. at 89,233. The court further cited Congress's enactment in 1966
of § 871(f), providing an exclusion for certain amounts received as an annuity under a
qualifying plan if services were performed outside the United States and the broadening of this
provision in 1980. Id. at 89,234; see 96-1 U.S. Tax Cas. (CCH) 50,391, at 84,152 (approving
Claims Court's analysis). The Senate Finance Committee noted, in approving § 871(0 in 1966,
that "[u]nder present law a nonresident alien receiving pension or annuity income from a plan

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U.S. Income Taxation of Cross-Border Pensions

Prior to the enactment of section 864(c)(6), the portion of the pension
payment attributable to contributions with respect to U.S. services was
noneffectively connected income if the pensioner was no longer engaged in
the conduct of a U.S. business." 2 However, the IRS now takes the position
that payments attributable to contributions made with respect to U.S. services
in years beginning after December 31, 1986, are treated by reason of section
864(c)(6) as effectively connected income. ' 3

An exception to U.S. source-based taxation of distributions from a
U.S. pension trust is contained in section 871 (f) (which is viewed by some
as an implicit acknowledgement by Congress of the general rule that the 30%
U.S. tax applies to the accretion element of a distribution from a U.S. pension
trust).' 4 Under this provision, first enacted in 1966,' any amount re-
ceived as an annuity by a nonresident alien from a qualified annuity plan
described in section 403(a)(1) or from a qualified trust described in section
401(a) is excluded from gross income if all the alien's services were
performed outside the United States and 90% of the employees benefitting

located in the United States is subject to U.S. tax (flat 30% or lower treaty rate) on the interest
portion of the pension income notwithstanding the fact that the services qualifying the
nonresident alien for the pension were entirely rendered outside the United States." S. Rep.
No. 1707, 89th Cong., 2nd Sess. (1966), reprinted in 1966-2 C.B. 1059, 1077. By contrast.
Chief Counsel argued that this legislative statement merely reflects IR-Mim. 71. which was
obsoleted in 1970, and indicates Congress's "dissatisfaction with the rule of taxing the interest
element at least under the circumstances covered by the section." Gen. Couns. Mem. 36344
(July 23, 1975). See also discussion in Gen. Couns. Mem. 38,007 (July 10. 1979).

112. See Rev. Rul. 79-388, 1979-2 C.B. 270.
113. See supra notes 93-95 and accompanying teXL
114. See supra note 11 and accompanying texL
115. The provision was added to the Foreign Investors Tax Act by the Senate

Finance Committee. See S. Rep. No. 1707, 89th Cong., 2d Sess. (1966). reprinted in 1966-2
C.B. 1059, 1077. There is no explicit rationale presented for the provision. The report states
that "[u]nder present law, a nonresident alien receiving pension or annuity income from a plan
located in the U.S. is subject to U.S. tax... on the interest portion of the pension income not
withstanding [sic] the fact that the services qualifying the nonresident alien for the pension
were entirely rendered outside the United States." Id. The report then explains: "Your
committee has added an amendment to this provision of the bill which would exempt from
U.S. tax the type of pension income described above if 90 percent of the persons under the
plan were U.S. citizens." Id. In the Miscellaneous Revenue Act of 1980, Congress expanded
this exemption to make "it available to an individual if (I) the recipient's country of residence
grants a substantially equivalent [exemption] ... or (2) the recipient's country of residence
is a beneficiary developing country under section 502 of the Trade Act of 1974." S. Rep. No.
96-1036, 2d Sess. (1980), reprinted in 1980-2 C.B. 723, 724. The committee reasoned "that
a pension paid to a nonresident alien should be exempt from withholding where his country
of residence has unilaterally... enacted a provision granting the same relief to U.S. citizens
and residents." Id. at 727. It further explained that "employers should be encouraged to provide
pensions for their employees in certain developing countries." Id.

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from the plan are U.S. citizens or residents."l 6 (Thus, row 5 of Table 1,
page 359, notes that where section 871(f) applies, no U.S. tax is imposed.)

Distributions from a qualified U.S. plan, if otherwise subject to U.S.
tax, may also be subject to the penalty tax on premature distributions.. 7 and
the 15% excise tax on excess distributions."'

3. Funded But Nonqualified Plans.-If an employer makes
contributions to a funded deferred compensation plan in respect of U.S.
services performed by a nonresident alien and the plan is not a qualified U.S.
plan, then the employee is taxed pursuant to section 402(b)(1) on the value
of his interest in the plan once it has vested. This could occur when contribu-
tions are made either to a U.S.-based nonqualified plan or to a foreign-based
plan, which may be qualified under the foreign country's law, but not under
U.S. law." 9 Thus, an alien performing services in the U.S. (not satisfying
the exemption for short-term business travelers) is currently taxable on vested
employer contributions made to a pension plan in his home country. 2

If the plan has a U.S. situs, then the U.S. also has a claim to tax
accretions on the contributions, which are classified as U.S. source noneffec-
tively connected income. If the individual is a "highly compensated

116. See IRC § 871(f)(1)(A), (B). The latter requirement need not be met if "the
recipient's country of residence grants a substantially equivalent" exemption to U.S. citizens
and residents. IRC § 871(f)(2)(A). For a recent application of this provision, involving
interpretation of the phrase "received as an annuity," see Priv. Ltr. Rul. 95-37-028 (June 21,
1995).

117. See, e.g., Priv. Ltr. Rul. 92-53-049 (Oct. 6, 1992) (ruling that a distribution
from a rollover IRA to a nonresident alien was not subject to the 10% additional tax of § 72(t)
because the distribution was excluded from U.S. gross income under the "other income" article
of the U.S.-U.K. Income Tax Convention). See also Priv. Ltr. Rul. 88-37-009 (June 2, 1988)
(ruling that § 72(t) was applicable to earnings and accretions distributed from a 401(k) plan
to a nonresident alien to the extent the amounts were includible in gross income).

118. See Priv. Ltr. Rul. 88-37-009 (June 2, 1988) (ruling that the 15% excise tax
on certain excess distributions is potentially applicable to a distribution to a nonresident alien
from a § 401(k) plan, except to the extent of the investment in the contract as defined in
§ 72(0). The IRS noted that "[t]here is nothing in the statute, the regulations or the legislative
history to indicate that NRA employees should be exempt from this tax." Id. See also Priv.
Ltr. Rul. 92-53-049 (Oct. 6, 1992) (ruling that a distribution that was excluded from U.S.
income tax under the U.S.-U.K. Income Tax Convention was not thereby protected from the
excise tax imposed by § 4980A); Bissell, supra note 98, at 79.

119. See 1996 Proposed Rulemaking, supra note 22, 23 (stating that "[t]he rules
of section 402(b) apply to a beneficiary of a nonexempt employees' trust regardless of whether
the trust is a domestic trust or a foreign trust"); see also infra notes 266-267 and accompanying
text.

120. See Ellis & Navin, supra note 72, at 88; see also Bissell & Giardina, supra note
72, at 279.

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U.S. Income Taxation of Cross-Border Pensions

individual," then the tax might be imposed as the accretions are earned. 2'
Otherwise the tax would be imposed by withholding at the time of distribu-
tion. When a distribution is made from a funded but nonqualified plan, the
income element is determined under section 72 for a nonresident alien
recipient (as for a U.S. citizen)." All contributions by the employer are
treated as investment in the contract pursuant to section 72 (f.'2-' Any
amount of the distribution in excess of investment in the contract would
apparently be considered to be earnings and accretions and would be
classified as U.S. source noneffectively connected income subject to the 30%
withholding tax of sections 871 and 1441. These results are depicted in Table
1, page 358; row 3 deals with a nonqualified U.S. plan, and row 4 deals with
a foreign plan.

4. Employee Contributions to Retirement Arrangements.-When a
nonresident alien performs services in the U.S., the portion of his compensa-
tion that he elects to defer in a 401(k) plan is not currently taxable to
him." Similarly, an amount contributed by him to an IRA account" is
eligible to be deducted in computing his effectively connected income (e.g.,

121. Tax is imposed under § 871(a) on an "amount received." IRC § 871(a); cf.
Central de Gas de Chihuahua S.A. v. Commissioner, 102 T.C. 515 (1994) (discussing § 482
allocation).

122. See IRC § 402(b)(2).
123. Contributions made in respect of services performed in the U.S. or as a resident

alien would already have been taxable to the employee. See IRC § 402(b)(1). Contributions
made in respect of services performed outside the U.S. as a nonresident alien would not have
been taxable even if paid directly to the nonresident alien. See IRC § 72(f0; Ellis & Navin.
supra note 72, at 88. In the case of a highly compensated employee in a plan not satisfying
the nondiscrimination requirements, the investment in the contract would presumably also

include the accrued benefits prior to the distribution. See infra notes 322-329 and accompany-
ing text.

124. See IRC § 402(e)(3) (providing that "contributions made by an employer on
behalf of an employee to a... qualified cash or deferred arrangement" are not treated as made
available to the employee even though the employee has an election to receive the amounts
in cash); Bittker & Lokken, supra note 7, 1 61.8.1.

125. Section 219(a) allows any individual a deduction of up to $2,000 for the
amount of his "qualified retirement contributions." which include cash payments to an
individual retirement account. See IRC § 219(a), (e). Under § 873, a nonresident alien is
allowed deductions for purposes of § 871(b) to the extent that such deductions are connected
with effectively connected income. See IRC § 873(a). It has been suggested that an IRA might

be an attractive investment for U.K. employees working temporarily in the U.S. See Artemis
Velahos Koch, IRA Contributions by Foreign Nationals: Long-Term Investments with Short-
Term Returns, 25 Tax Adviser 141, 142 (1994) [hereinafter Koch]; see also Bissell. supra note
98, at 77 (noting that aliens "on temporary U.S. assignments [if] excluded from U.S. retirement
plans,.. . may often make fully tax-deductible IRA contributions even if their income exceeds
the limits prescribed in § 219").

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from services performed in the U.S.). However, the portion of a nonresident
alien's compensation contributed by him (or by the employer on his behalf)
to a foreign retirement arrangement is taxed by the U.S. as current compensa-
tion (whether or not the foreign retirement arrangement is qualified in the
home country or is an employer-based or personal retirement arrange-
ment).' 26 Thus, the result is the same as if the employer makes a contribu-
tion to a funded foreign retirement plan (as in row 4 of Table 1, page 358).

5. Period of U.S. Residence and Exit Tax Proposals.-A foreign
national working in the U.S. for an extended period will often be classified
as a resident alien for U.S. tax purposes. The fact of U.S. residence may have
little impact on the treatment of his participation in a U.S. qualified'27 plan,
however. No tax will be imposed on the employee with respect to such
participation prior to distributions being made to him. The entire amount of
the distributions from the plan (assuming that the U.S. was the place of
employment) would be taxable by the U.S. either on a source basis (if the
individual has returned to his home country) or on a residence basis if he has
not. See Table 1, row 2, page 358.

U.S. resident status may have greater significance for a foreign
national working in the U.S. if he is participating in a foreign pension plan.
See Table 1, row 4, page 358. The accretion element in a foreign plan has a
foreign source and thus would be taxed by the U.S. only if the alien is a U.S.
resident at the time when the accretion is properly subject to U.S. tax.'28

Thus, in this situation, a resident alien would generally seek to terminate U.S.
resident status before the accretion is subject to tax.

It would be possible for the U.S. to counteract such tax planning by
imposing U.S. tax on previously untaxed amounts of accrued foreign pension
benefits at the time when an alien's long-term residence is terminated. Thus,
the Senate recently approved an "exit tax" on appreciation in the worldwide

126. An IRA is defined as "a trust created or organized in the United States for the
exclusive benefit of an individual or his beneficiaries." IRC § 408(a). In addition, the written
instrument creating the trust must meet certain requirements in order for the trust to qualify
as an IRA. See id.

127. If the individual is performing services in the U.S. and participating in a
nonqualified U.S. plan (see Table 1, row 3, page 358), temporary U.S. residence also may be
irrelevant because the contributions to a U.S. plan and earnings accrued thereon could be taxed
either on a source basis or on a residence basis. However, in the absence of residence
jurisdiction, taxation of the accretion might be delayed because § 871 requires an "amount
received." See supra note 121.

128. The time for taxing the accretion element in a foreign pension plan may be as
benefits accrue if the individual is a highly compensated employee. See supra note 38. Current
taxation might also occur under § 679. See infra notes 272, 277-278 and accompanying text.
Otherwise, tax would await the time of distribution.

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U.S. Income Taxation of Cross-Border Pensions

assets of departing long-term residents,' including foreign pension plan
interests, at least to the extent their value exceeds $500,000.'"" However,
the Senate's "exit tax" was replaced in conference with a provision that
subjects departing long-term residents (and expatriating citizens) for a period
of ten years to expanded U.S. source-based jurisdiction;' 3' and this expand-
ed jurisdiction does not extend to foreign pension assets.13 2

C. Treaty Position

1. Pension Distributions.-The treatment of deferred compensation
under U.S. treaties depends upon whether a payment is classified as a
"pension" under the pension article of the treaty.

The preferred U.S. treaty position, embodied in the 1981 U.S. Model
and most (old and new) U.S. treaties, is to include a pension article providing
that pension payments are taxable only in the residence country.'" This
same position has now been endorsed by the Treasury in the 1996 U.S.

129. See H.R. Rep. No. 736, 104th Cong., 2nd Sess. (1996), partially reprinted in
96 TNT 151-7 (Aug. 2, 1996) (LEXIS, FEDTAX library, TNT file) [hereinafter H.R. Rep. No.
736]. For discussion of "exit taxes" imposed by other countries, see infra notes 334-336 and
accompanying text. Under the Senate Amendment, expatriating U.S. citizens and departing
long-term U.S. residents "are treated as having sold all of their property at fair market value
immediately prior to the [expatriating event]." H.R. Rep. No. 736. supra, 1 256. "The net gain,
if any, on the deemed sale ... is subject to U.S. tax at such time to the extent it exceeds
$600,000 ... " Id. The rule "generally applies to all property interests held by the individual
[at that time] provided that the gain on such property interest would be includible in the
individual's gross income if such property interest were sold for its fair market value on such
date." Id. 257. For discussion of earlier versions of this proposal, see Staff of the Joint
Comm. on Tax'n, 104th Cong., 1st Sess., Issues Presented by Proposals to Modify the Tax
Treatment of Expatriation (JCS-17-95) (1995), reprinted in 37 Highlights & Documents 3351
(June 5, 1995) [hereinafter JCT Report on Expatriation].

130. See H.R. Rep. No. 736, supra note 129, 257 (noting that the Senate
Amendment contained an exclusion for "interests in qualified retirement plans and, subject to
a limit of $500,000, interests in certain foreign pension plans as prescribed by regulations.").
See also JCT Report on Expatriation, supra note 129, at 3367. noting similar exclusion in
earlier version.

131. See H.R. Rep. No. 736, supra note 129, 1 230-51, 280. The conference report
follows the House bill, which "expands and substantially strengthens in several ways the
present-law provisions" in §§ 877, 2107, and 2501(a)(3). Id. 1 230. These existing provisions
are applied to "certain long-term residents of the United States," and are applied in some
situations "without inquiry as to... motive." Moreover, the conference report "expands the
categories of income and gains that are treated as U.S. source." Id.

132. For a discussion of the types of income covered in the House Bill, see H.R.
Rep. No. 736, supra note 129, U91 236-42.

133. See, e.g., 1981 U.S. Model, supra note 83, art. 18, I. Article 15, dealing with
dependent personal services, is made "[s]ubject to the provisions of Articl[el 18." Id. art. 15,

1.

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Model (although with a new limitation on taxation by the residence
country)." 4 Thus, in rows 2 and 5 of Table 1, pages 358-59, where a
distribution is received by a nonresident alien from a U.S. qualified plan, this
treaty rule would bar imposition of U.S. tax on the distribution.'35

This treaty position is consistent with the 1963, 1977 and 1992
OECD 136 Model treaties, 137 although reservations to this aspect of the

134. The 1996 U.S. Model provides that "pension distributions... beneficially
owned by a resident of a Contracting State, whether paid periodically or as a single sum, shall
be taxable only in that State, but only to the extent not included in taxable income in the other
Contracting State prior to the distribution." 1996 U.S. Model, supra note 2, art. 18, $ 1; 1996
Treasury Explanation, supra note 2, 241-46. See infra text accompanying notes 296-301
(discussing the new limitation imposed on the residence country).

135. The savings clause of treaties would, however, generally preserve the U.S. right
to tax pension income of a U.S. citizen even if he or she is resident in another country at the
time of retirement. See, e.g., 1981 U.S. Model, supra note 83, art. 1, U 3, 4(a). This may
result in double international taxation of pension income derived by a U.S. citizen resident in
another country, even though that country is a U.S. treaty partner. In the recent treaty with
France, special provisions are included to avoid such double taxation. Convention Between the
Government of the United States of America and the Government of the French Republic for
the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion with Respect
to Taxes on Income and Capital, Aug. 31, 1994, art. 24, 2, reprinted in Tax Treaties (CCH)

3001.04, 27005-13 [hereinafter U.S.-France Income Tax Treaty]. First, in the case of a
pension distribution attributable to services performed while the principal place of employment
was in the U.S., France agrees to provide an effective exemption from French tax for a U.S.
citizen resident in France. Id. art. 24, I 2(a)(i), 2(b)(iv). Second, the U.S. agrees generally that
where U.S. tax is imposed solely on the basis of citizenship, the U.S. will provide credit for
French tax imposed on the basis of residence (e.g., on pension income derived by a French
resident/U.S. citizen with respect to employment outside the U.S.). Id. art. 24, l(b). See
Treasury Department Technical Explanation of the U.S. France Income Tax Treaty, reprinted
in Tax Treaties (CCH) 3058, 27,197-5, discussing art. 24 [hereinafter Treasury Explanation
of U.S.-France Treaty].

136. The model tax treaties prepared under the auspices of the League of Nations
varied in their approach to the treatment of pensions. Draft Conventions Ia and Ic provided
that "[p]ublic or private pensions shall be taxable in the State of the debtor of such income."
League of Nations, Report Presented by the General Meeting of Government Experts on
Double Taxation and Tax Evasion, (C.562.M. 178.1928.11) Oct. 31, 1928, Official Journal, Jan.
1929, at 205, 208, 215. The commentary states that "[iut appeared both right and practical that
all pensions should be made subject to the same rules." Id. at 211. It then explains: "In the
special case of private pensions, however, the country of the debtor may be taken to be that
in which the activity was carried on within the meaning of article 7 [dealing with salaries], or
that in which the parties concerned subsequently established their domicile." Id. By contrast,
in Draft Convention Ib, source taxation is limited to income from immovable property, income
from a industrial, commercial or agricultural undertaking, fees of managers, salaries and
wages, or public pensions. Id. at 213. In the "Mexico draft convention" of 1943, the Fiscal
Committee of the League of Nations provided that private pensions and life annuities should
be taxed exclusively "in the State where the debtor has his fiscal domicile." Fiscal Committee,
League of Nations, London and Mexico Model Tax Conventions, Commentary and Text

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U.S. Income Taxation of Cross-Border Pensions

1992 OECD model were noted by Canada, Finland and Sweden.' 8 By
contrast the 1980 U.N. Model includes two alternative provisions, one
consistent with the OECD model and the other allowing source-based taxation
of a pension payment "made by a resident of that ... State or a permanent
establishment situated therein."'39 A U.S. treaty that exempts a pension
payment from U.S. tax is viewed as also precluding application of section
72(t) (penalty on premature distributions). However, section 4980A, imposing
an excise tax on certain excess distributions from a qualified pension plan,
may nevertheless be applicable."t

Only two major U.S. treaties, those with Canada and the Netherlands,
and a few treaties with less important' 4' trading partners (Indonesia,4 '

(C.88M.88.1946.]I.A.) Nov. 1946, at 66-67. However, in its 1946 "London draft." the Fiscal
Committee provided for exclusive taxation of such items "in the State where the recipient has
his fiscal domicile." Id. The commentary explains that the Mexico draft's treatment of private
pensions is "according to the principle of taxation by origin" and is consistent with the draft's
treatment of income from movable capital as taxable only in the country where the capital is
invested. Id. at 28, 62. The commentary states that, in the London draft. jurisdiction to tax
pensions is given to "the country of fiscal domicile of the creditor, as in the case of interest
from debts." Id. at 28. For further discussion of the history of the "pension" article in treaties,
see Albert A. Ehrenzweig and F.E. Koch, Income Tax Treaties, 180 (1949).

137. See 1992 OECD Model, supra note 83. art. 18 (entitled "Pensions"). Article
18 provides that "pensions and other similar remuneration paid to a resident of a Contracting
State in consideration of past employment shall be taxable only in that State." Id. art. 18. This
provision was also included in the 1963 and 1977 OECD Models. See Organization for
Economic Cooperation and Development Model for the Avoidance of Double Taxation with
Respect to Taxes on Income and Capital, Tax Treaties (CCH) 1 201. at 10,525-8; Model
Income Tax Treaties 58 (Kees van Raad ed.. 1983) (comparing the 1963 and 1977 OECD
Model Treaties). This provision is subject to an exception provided for pensions paid in respect
of government service in article 19. Id. art. 19, T 2. A pension paid by a Contracting State in
respect of services to that State is taxable only by that State; however, where the individual
is a resident and national of the other State, the other State is given the exclusive right to tax.
Id.

138. The Commentary to the 1992 OECD Model notes that "Canada reserves its
position on [article 18]"; its negotiating position is to "propose that the country in which the
pensions arise be given a limited right to tax." Commentary on the Organization for Economic
Co-Operation and Development Model Tax Convention on Income and Capital [ 19921 [herein-
after 1992 OECD Commentary], at C(18)-12. Finland and Sweden. when negotiating conven-
tions, will attempt to "retain the right to tax pensions paid to non-residents, where such pen-
sions are paid in respect of past services rendered mainly within their respective territory." Id.

139. U.N. Dep't of Int'l Economics & Social Affairs, U.N. Model Double Taxation
Convention Between Developed and Developing Countries at 33-34, U.N. Dce. ST/ESA/102,
U.N. Sales No. E.80.XVI.3 (1980) [hereinafter U.N. Model]. The commentary notes that the
parties were unable to reach a consensus between the two alternative guidelines. Id. at 171-72.

140. See supra notes 117-118 and accompanying text.
141. The U.S.-U.S.S.R. Income Tax Treaty, signed on June 20, 1973, did not

contain a pension article. See Priv. Ltr. Rul. 87-21-006 (Jan. 30. 1987) (noting that the treaty

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Jamaica, 4 3 the Philippines'" and Poland'45), depart from the U.S. pre-
ferred treaty position on pensions. Under the U.S. treaty with Canada, source-
based taxation is permitted (in addition to residence-based taxation) but may
not exceed 15% of the gross amount of a periodic pension payment.146 The
new treaty with the Netherlands 47 provides that in the case of a private

does not provide an exemption or lower rate for private pensions). However, the new treaty
between the U.S. and the Russian Federation, signed June 17, 1992, contains a provision
(article 17) exempting private pensions from source country tax. See Senate Foreign Relations
Comm., Report on the 1992-U.S.-Russia Income Tax Treaty and Protocol Nov. 18, 1993,
reprinted in 31 Highlights & Documents 3175, 3192, (Nov. 29, 1993).

142. The U.S. treaty with Indonesia provides that both countries may tax "pensions
and other similar remuneration in consideration of past employment derived from sources
within one of the Contracting States by a resident of the other Contracting State." Convention
Between the Government of the United States of America and the Government of the Republic
of Indonesia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
Respect to Taxes on Income, July 11, 1988, art. 21, 1. However, the source country's tax
is limited to 15% of the gross amount. Id. For source rules, see id. art. 7, T 6, art. 21, T 4. The
Treasury's Technical Explanation provides that this "rule ... is a concession to Indonesia's
interest, as a developing country, in preserving source-basis taxation." Tax Treaties (CCH)

4350, at 31,536-37. The recently signed protocol to the treaty does not affect the treatment
of pensions. See Protocol Amending the Convention Between the Government of the United
States of America and the Government of the Republic of Indonesia for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, July
24, 1996, reprinted in Tax Treaties (CCH) 4345, 31,523, 31,523-2.

143. The U.S. treaty with Jamaica provides that a pension received by a resident
of the one state in consideration of "past employment ... performed in the other Contracting
State while such person was a resident of that other State" may be taxed by the latter as well
as the former State. Convention Between the Government of the United States of America and
the Government of Jamaica for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with Respect to Taxes on Income, May 21, 1980, art. 19, 1, T.I.A.S. 10206. See
also Report of the Senate Foreign Relations Committee, Tax Treaties (CCH) 5055, at 33,571.

144. The U.S. treaty with the Philippines provides that "pensions and other similar
remuneration paid to an individual in consideration of past employment shall be taxable by the
Contracting State where the service is rendered." Convention Between the Government of the
United States of America and the Government of the Republic of the Philippines with Respect
to Taxes on Income, Oct. 1, 1976, art. 18, 1, T.I.A.S. 10417.

145. The U.S. treaty with Poland does not contain a pension article. See Convention
Between the Government of the United States of America and the Government of the Polish
People's Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with Respect to Taxes on Income, Oct. 8, 1974, T.I.A.S. 8486. Article 5 provides, in general,
for source country taxation. See id. art. 5.

146. Convention Between the United States of America and Canada for the
Avoidance of Double Taxation on Income, Sept. 26, 1980, T.I.A.S. 11087, 27 art. 18, %T 1,
2, [hereinafter U.S.-Canada Income Tax Treaty]. The treaty does not seek to define the source
of a pension, but simply allows taxation of pensions "in the Contracting State in which they
arise." Id. art. 18, 2. This aspect of the treaty is not changed by the March 1995 Protocol.

147. See Treasury Department Technical Explanation of the Convention Between
the United States of America and the Kingdom of the Netherlands for the Avoidance of

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U.S. Income Taxaion of Cross-Border Pensions

pension that is not paid in the form of periodic payments, the country where
the employment is exercised may tax the payment (with allowance of a credit
for residence country tax) provided that the individual was a resident of the
source country at any time during the preceding 5-year period; 4 8 this
source-based tax does not apply, however, to certain qualified rollovers of the
lump sum into a residence country retirement account.'4 9

The contours of the term "pension"'" have not been established

Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income,
signed Dec. 18, 1992, and Protocol signed Oct. 13, 1993. reprinted in 31 Highlights &
Documents 1631, 1653-54, (Nov. 2, 1993) [hereinafter Treasury Explanation of Netherlands
Treaty]; Sen. Comm. on Foreign Relations, 103d Cong.. Ist Sess.. Exec. Rept. 103-19. Report
on the Tax Convention with the Kingdom of the Netherlands (1993).

148. See Convention Between the United States of America and the Kingdom of
the Netherlands for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with Respect to Taxes on Income, Dec. 18, 1992. S. Treaty Doc. No. 6, 103d Cong.. 1st Sess.
(1992), art. 19, 1-2, art. 25, T 7 [hereinafter U.S.-Neth. Treaty]; see also Treasury
Explanation of Netherlands Treaty, supra note 147, at 1631, 1653. Article 25 of the
Convention provides that for purposes of allowing the credit for residence-based tax, the U.S.
is to treat the lump sum payment as arising in the Netherlands. U.S.-Ncth. Treaty. supra, art.
25, 1 7. An example of the application of article 19 is provided in Priv. Ltr. Rul. 96-26-055
(Apr. 11, 1996), reprinted in 96 TNI 128-24 (July 2. 1996) U 6-13 (LEXIS. FEDTAX library,
TNI file).

149. The U.S.-Netherlands Tax Convention exempts from source-country tax "the
portion of the.., lump sum.., that is contributed to a pension plan or retirement account
under such circumstances that, if the ... lump sum had been received from a payer in the
State of the recipient's residence, the imposition of tax on the payment by the State of the
recipient's residence would be deferred until the amount of the payment was withdrawn from
the pension plan or retirement account to which it was contributed." U.S.-Neth. Treaty, supra
note 148, art. 19, 1 3. See also Treasury Explanation of Netherlands Treaty. supra note 147.
at 1653 (explaining that, for example. a lump sum payment from a Netherlands pension plan
that was invested in a U.S. IRA would be exempt from Netherlands tax. In this case, explains
the Treasury, "the tax avoidance concerns of the Netherlands would not be present.").

150. The commentary to the 1992 OECD model states that article 18 applies to
"pensions paid in respect of private employment" as well as "widows' and orphans' pensions
and other similar payments such as annuities paid in respect of past employment." 1992 OECD
Commentary, supra note 138, at C(18)-1. It is further noted that "a common solution" was not
reached regarding "amounts paid to an employee on the cessation of his employment." Id.
These amounts are viewed as "a pension. . .. paid as a lump sum" in some countries. "as the
final remuneration for the work performed" by others, and in some cases "as a bonus . ..
subjected to a gift tax." Id. at C(I 8)-I-(l 8)-2. For a discussion of article 18 of the 1992 OECD
Convention, see Manfred Gunkel, The Taxation of Pensions (Article 18). 1992/12, Intertax
690. According to Gunkel, to come within this article "the pension has to be paid by the
former employer himself or by a separate organization, e.g. an employer's pension fund." Id.
at 691. Gunkel explains that article 18 "does not apply to social security pensions [which] are
not paid in consideration of past employment" but rather are dealt with under article 21
pertaining to other income. Id. (citing Klaus Vogel on Double Taxation Conventions,
Commentary, December 1991, Article 18, annotation 12 and Article 21. annotation 12).

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very clearly in the treaty language itself or in technical explanations of the
treaties. 5 ' Private'52 letter rulings have been an important source of law
in this area, an approach disconcerting to taxpayers and withholding
agents. 53 The Treasury Department's Technical Explanation of the 1996
U.S. Model provides useful insight into the Treasury's current negotiating

151. See, e.g., Convention Between the Government of the United States of America
and the Government of the United Kingdom of Great Britain and Northern Ireland for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes
on Income and Capital Gains, Dec. 31, 1975, art. 18, 1, T.I.A.S. 9682 [hereinafter U.S.-U.K.
Treaty] (exempting "any pension in consideration of past employment and any annuity");
Technical Explanation of the [U.S.-U.K. Treaty, supra], Tax Treaties (CCH) $ 10,941, at
44,553-54 (stating that "[t]he term 'pension' includes payments from qualified retirement plans
as well as other forms of retirement benefits paid for services rendered, or by way of
compensation for injuries or sickness incurred in connection with past employment."); U.S.-
France Income Tax Treaty, supra note 135, art. 18, $ 1 (exempting "pensions and other similar
remuneration, including distributions from pension and other retirement arrangements ... in
consideration of past employment, whether paid periodically or in a lump sum"); Treasury
Explanation of the U.S.-France Treaty, supra note 135, Tax Treaties (CCH) 3058, at 27,197-
31 (explaining that the provision "applies to both periodic and lump-sum payments" and to
"pension payments in consideration of past employment that are paid to a resident of the other
Contracting State, whether to the employee or to his or her beneficiary.").

152. For published rulings, see Rev. Rul. 56-446, 1956-2 C.B. 1065, 1066 (lump
sum distribution from U.S. qualified pension plan to Canadian resident, paid on death or other
separation from service, treated as capital gain under § 402(a)(2), was exempt from U.S. tax
under article VI A of U.S.-Canada Income Tax Convention, as a pension, or under article VIII,
as a capital gain), modified by Rev. Rul. 58-247, 1958-1 C.B. 623, 24 (treaty exemption in
latter situation is under article VIII, and not article VI A); Rev. Rul. 58-248, 1958-1 C.B. 621,
622 (similarly, article XII(1) of the U.S.-Australia Income Tax Convention, dealing with
pensions and annuities, does not apply to such a distribution treated as capital gain under
§ 402(a)(2)); Rev. Rul. 71-478, 1971-2 C.B. 490, 490-91 (the term "pension" as used in the
U.S.-U.K. Income Tax Convention, article XII, refers to "a stated allowance or stipend paid
by an employer in consideration of services rendered, to a retired employee, payment being
conditioned on retirement"; thus, bonuses paid in periodic installments as "compensation for
services rendered in specific prior years" did not qualify); Rev. Rul. 72-12, 1972-1 C.B. 440,
441 (under U.S.-Sweden Income Tax Convention, article X, the term "private pension" means
a pension paid by a private person (in contrast to a government) either directly or through the
medium of a trust); Rev. Rul. 72-460, 1972-2 C.B. 659, 660 (supplemental annuity payments
in excess of guaranteed minimum payments under retirement annuity contracts qualify as
"pensions" under U.S.-Canada Income Tax Treaty, article VI A).

153. See Bissell, supra note 98, at 77 (noting that "virtually all of the IRS' views
[on pension or IRA distributions to nonresident aliens] have been expressed in PLRs, which
may not formally be relied upon by anyone except the taxpayer to whom the ruling was
issued"); IRPAC Paper, supra note 98, issue I (recommending that, "for purposes of promoting
certainty and uniformity among payors concerning income tax withholding, the Service publish
guidance, upon which payors may rely, concerning the treatment of nonperiodic pension and
annuity payments under foreign tax treaties which exempt 'periodic' payments from
taxation.").

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U.S. Income Taxation of Cross-Border Pensions

position regarding the definition of the treaty term "pension"; M but it is not
an authoritative interpretation of any particular treaty.!5 ' This 1996 Techni-
cal Explanation is discussed after analysis of the materials interpreting
existing treaties.

There is no direct guidance as to whether a payment from an
unfunded deferred compensation plan may qualify as a pension; overall, the
failure of the IRS or Treasury 56 to refer to "funding" as a requirement
leaves the impression that it is not required.'" However, if an unfunded
plan is not designed to provide benefits that are dependent on retirement, it
seems unlikely that the treaty article will apply. If the pension article is not
applicable, the entire amount paid to the employee is viewed as compensa-
tion, and treaty benefits, if any, are under the provision dealing with
dependent services.' The "183 day" rule of that provision is applied by

154. See 1996 Treasury Explanation, supra note 2, U 242-245.
155. Id. 6 (explaining that "a principal function of the Model is to facilitate

negotiations by helping the negotiators identify differences between income tax policies in the
two countries," and that "[a]nother purpose... is to provide a basic explanation of U.S. treaty
policy for all interested parties").

156. Id. 1 243. The Treasury states that the term "pension" in the 1996 U.S. Model
includes "qualified plans under section 401(a), individual retirement plans ... , non-
discriminatory section 457 plans, section 403(a) qualified annuity plans, and section 403(b)
plans." Id. 1 243. All these examples are funded plans, except that § 457 plans are required
to be "unfunded." See IRC § 457(b)(6); Bittker & Lokken, supra note 7, q1 60.2.3. The
Treasury then states that "competent authorities may agree that distributions from other plans
that generally meet similar criteria to those applicable to other plans established under their
respective laws also qualify for the benefits of" the treaty. 1996 Treasury Explanation, supra
note 2, T1 243. The Treasury then lists a series of criteria for U.S. plans that does not include
any requirement of funding. Id. See discussion of these criteria at infra notes 181-186.

157. See Bissell & Giardina, supra note 72. at 282 (stating that payments from an
unfunded supplemental executive retirement plan (a "SERP") would often qualify as a pension
for purposes of U.S. treaties). Bissell and Giardina consider that a lump sum payment from
a SERP that complies with the requirements of IRS private letter rulings, described infra in
notes 166-167 and accompanying text, might also qualify. Id. However, they note that "the
PLRs only deal with distributions from qualified plans. and the IRS has apparently never been
faced with the question of whether to apply the same rules to unfunded plans such as a
SERP." Id.

158. See Priv. Ltr. Rul. 93-32-038 (May 18, 1993), reprinted in 94 TNI 22-17 (Feb.
2, 1994) (LEXIS, FEDTAX library, TNI file), where despite a lack of compliance with the
model "rabbi" trust format of Rev. Proc. 92-64. 1992-2 C.B. 422, the IRS ruled that
contributions made by a Canadian employer to a trust to provide deferred compensation
benefits to a U.S. citizen key employee were not includible in the employee's income until
amounts are actually distributed or made available to him. The IRS further ruled that payments
made by the employer to the employee pursuant to the arrangement "shall be treated as
dependent personal services income" under article 15 of the U.S.-Canada Income Tax Treaty.
Id.

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reference to the year in which the services were performed.'59 Thus, in row
1 of Table 1, page 358, the treaty bars imposition of U.S. tax on unfunded
deferred compensation received by a nonresident alien only if the payment
qualifies as a "pension" or if the "183 day" rule is met.

The IRS has not indicated that a funded deferred compensation plan
must be tax-qualified for distributions to come under the "pension" article of
treaties, and the Treasury's September 1996 explanations of the treaties with
Luxembourg and Austria state explicitly that these treaties do not contain
such a requirement.' 6° Thus, in rows 3 and 6 of Table 1, pages 358-59,
involving a U.S. nonqualified funded plan, any U.S. tax that would otherwise
be imposed on the accretion element at the time of distribution is apparently
barred.

In addition, even though some treaties define pensions as "periodic
payments" made in consideration for services, the IRS 16' has recently stated
in a series of private letter rulings that "the term 'periodic' is simply
descriptive of a pension payment generally, not a restriction on the manner
of payment."' 62 The Treasury's Technical Explanation of the U.S.-Nether-

159. See Rev. Rul. 86-145, 1986-2 C.B. 297, 298 (ruling that in applying article 15
(dealing with dependent personal services) of the U.S.-U.K. Income Tax Convention to
compensation earned in the U.S. by a U.K. resident in 1985 but received in 1986, the "183
day" test applies to 1985, the year in which the services were performed); see also 1996
Treasury Explanation, supra note 2, 212.

160. See Treasury Department Technical Explanation of the Convention Between
the Government of the United States of America and the Grand Duchy of Luxembourg for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes
on Income and Capital, 96 TNT 185-13 (Sept. 20, 1996), 184 (LEXIS, FEDTAX library,
TNT file); Treasury Department Technical Explanation of the Convention Between the United
States of America and the Republic of Austria for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with Respect to Taxes on Income, 96 TNT 185-15 (Sept. 20,
1996), 234 (LEXIS, FEDTAX library, TNT file). See also infra note 178 (discussing the
U.S.-Canada Income Tax Treaty).

161. Under the U.S.-Canada Income Treaty, only "periodic" payments qualify for
the 15% reduced tax rate. U.S.-Canada Income Tax Treaty, supra note 146, at 21,018. One
commentator has noted that Revenue Canada applies a narrower definition of the term
"periodic" under the treaty than does the IRS. Peat Marwick Urges Renegotiation of Tie-
Breaker Rules in U.S.-Canada Income Tax Treaties, 90 TNI 24-18 (April 30, 1990) (LEXIS,
FEDTAX library, TNI file) [hereinafter KPMG Letter].

162. Priv. Ltr. Rul. 90-41-041 (July 13, 1990), reprinted in 90 TNT 211-92 (Oct.
16, 1990) (LEXIS, FEDTAX library, TNT file) (interpreting art. I1, 3 of the U.S.-Swiss
Income Tax Convention, which defines a pension as periodic payments made in consideration
for services rendered). The IRS ruled that a distribution from a 401(k) plan (whether in a
single lump sum or in equal quarterly installments over two years) would be treated as a
pension payment, provided that "it meets general United States pension rules," as described
infra in the text accompanying note 166. Priv. Ltr. Rul. 90-41-041; see also Priv. Ltr. Rul. 89-
04-035 (Oct. 31, 1988), reprinted in 89 TNI 6-5 (Feb. 8, 1989) (LEXIS, FEDTAX library, TNI

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U.S. Income Taxation of Cross-Border Pensions

lands Income Tax Convention, signed in 1992, states that "[i]t is preferred,
though not uniform, U.S. treaty policy not to distinguish in treatment between
periodic and lump-sum pensions.' 63 The proposed treaty with Turkey refers
specifically to a pension "whether paid periodically or in a lump-sum.""

In recent letter rulings, the IRS has instead provided its own quite
specific guidelines for defining the term "pension" (at least in the case of a
qualified plan). For example, Private Letter Ruling 95-41-043, interpreting the
pension article of the U.S.-India tax treaty, 65 states that:

file) (applying exemption for pension amounts, under art. II. T 2 of the U.S.-Germany Income
Tax Treaty, defined in art. I1, 3 as "periodic payments made in consideration for services
rendered"). See discussion in Bissell, supra note 98, at 77 (stating that "[the major
development in the IRS' interpretation of tax treaties has been the IRS' willingness to treat a
lump-sum distribution from a tax-qualified U.S. retirement benefits plan as exempt from U.S.
tax under a tax treaty-although it has not taken a consistent stance on which theory to rely
on"). Bissell cites Priv. Ltr. Rul. 89-34-025 (interpreting the U.S.-U.K. Income Tax
Convention) as well as the rulings listed above. Id. at 77-78. He notes that "these rulings mark
a clear change from the prior IRS position, even if they cannot be officially relied upon." Id.
at 78. Bissell cites, as an example of the IRS' former position, Gen. Couns. Mem. 37,899
(Mar. 26, 1979), where "the Chief Counsel's Office concluded that a lump-sum distribution
from a U.S. plan was fully taxable because it violated the 'periodic payment' requirement in
the Denmark-U.S. treaty." Bissell, supra note 98, at 79 n.4. See also IRPAC Paper, supra note
98, issue 1, (further citing Priv. Ltr. Rul. 89-01-053, interpreting the U.S.-Swiss Income Tax
Convention, as an example of the new IRS position).

163. Treasury Explanation of Netherlands Treaty. supra note 147, at 1653. The
Treasury notes that "[i]t is the policy of the Netherlands, however, to preserve by treaty the
right of the Netherlands to tax any lump-sum pension payment made in consideration of
employment in the Netherlands." Id.

164. Proposed Agreement Between the Government of the Republic of Turkey and
the Government of the United States of America for the Avoidance of Double Taxation and
the Prevention of Fiscal Evasion with Respect to Taxes on Income, art. 18. 1 1. reprinted in
Tax Treaties (CCH) 10,103, 43,647-63 [hereinafter Proposed U.S.-Turkey Income Tax
Treaty]. However, the recently proposed treaties with Austria and Luxembourg do not contain
this language. See Proposed Convention Between the Republic of Austria and the United
States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with Respect to Taxes on Income, art. 18, reprinted in Tax Treaties (CCH) q 14.017-033
[hereinafter Proposed U.S.-Austria Income Tax Treaty]; Proposed Convention Between the
Government of the Grand Duchy of Luxembourg and the United States of America for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes
on Income and Capital, art. 19, I. reprinted in Tax Treaties (CCH) 5701. 35,02140
[hereinafter Proposed U.S.-Luxembourg Income Tax Treaty].

165. Article 20(3) of that treaty provides that "[t]he term 'pension' means a periodic
payment made in consideration of past services or by way of compensation for injuries
received in the course of performance of services." Convention Between the Government of
the United States of America and the Government of the Republic of India for the Avoidance
of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income,
Sept. 12, 1989, art. 20, T 3, reprinted in Tax Treaties (CCH) T 4203. 31.007-023 (hereinafter
U.S.-India Income Tax Treaty]. The explanation of the treaty upon which Senate approval was

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Florida Tax Review

It is the position of the Service that distributions from a
qualified retirement plan will be treated as pension amounts
for treaty purposes provided that:

(1) the employee had been employed for 5 years or
more prior to the time the benefit is paid, or, if
employed for less than 5 years, first employed by the
employer (or a related employer) on or after reaching
age 60;

(2) the benefit is:
(A) paid on or after attainment of Social Security

retirement age as defined in section 216(1) of
the Social Security Act,

(B) paid on account of the employee's death or
disability,

(C) paid either 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 his or her beneficiary),
or paid for the life of the employee (or for
the life of the employee and his or her
beneficiary), or

(D) paid after separation from service after
attaining age 55; and

(3) all distributions are made after the employee has
separated from service with the employer maintain-
ing the plan, except for distributions made on or
after the employee attains age 70 and 1/2.166

based stated that the treaty definition of a pension as a periodic payment "excludes a lump-
sum pension benefit, which is generally understood to be covered by the corresponding article
of the U.S. model treaty." Staff of Joint Comm. on Tax'n, 101st Cong., 2d Sess., Explanation
of Proposed Income Tax Treaty (and Proposed Protocol) Between the United States and the
Republic of India (JCS-20-90) 59 (Joint Comm. Print 1990). Thus, it seems inconsistent for
the IRS to interpret the pension article of this treaty in a way that could apparently allow for
coverage of a lump sum distribution.

166. Priv. Ltr. Rul. 95-41-043 (Oct. 13, 1995) (involving application of art. 20, I 1,
of the U.S.-India Income Tax Convention to distributions from qualified U.S. retirement plans
to a resident of India). The IRS found that the requirements quoted in the text accompanying
this note were satisfied because "Taxpayer was employed by Corp X for over five years and
the monthly distributions from [the plan] will be paid after Taxpayer separated from service
with Corp X after attaining age 55." Id.

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U.S. Income Taxation of Cross-Border Pensions

The separation from service requirement would be violated if the employee
begins work for a related employer within five years.'67

One commentator has questioned "what basis (if any) these tests may
have in the Code, the regulations, or in non-tax statutory law or regula-

,,16S h R a tssfrations. The IRS has stated that these tests for classification as a pen-
sion169 "ensure that the Distributions will occur upon retirement after long-
continued and faithful service."'170 In the recent Clayton decision, 7 ' the
U.S. Court of Federal Claims treated the "pension" article of the U.S.-Canada
treaty as inapplicable to the U.S.-sourced "accretion" portion of a 1986
distribution on termination of Chrysler's employee stock ownership plan paid

167. See Priv. Ltr. Rul. 89-04-035 (Oct. 31, 1988) (ruling applying U.S.-Germany
Income Tax Treaty). This will result in disqualification from the point of rehiring and in
retroactive disqualification if the rehiring was intended by the employer at the point of
cessation. Id.

168. Bissell, supra note 98, at 78. In a recent private ruling, the IRS noted that
requirement (2) described in the text accompanying note 166 is similar to the requirements of
§ 72(t)(2)(A) of the Code. Priv. Ltr. Rul. 96-26-055 (Apr. 11, 1996), at 9-10.

169. The IRS has addressed the treaty definition of a "pension" most recently in
Priv. Ltr. Rul. 96-26-055 (Apr. 11, 1996), which interprets the U.S.-Netherlands Income Tax
Treaty signed in 1992. A provision of that treaty permits the U.S. to tax a lump sum pension
distribution in respect of U.S. employment made to a Netherlands resident who had been a
U.S. resident within the previous five years. Id. at 6. The IRS determined that this provision
applied to a lump sum payment made out of a "pure rollover" IRA. which was created from
funds distributed upon the termination of a qualified section 401(a) retirement plan and
transferred to a spouse pursuant to a Qualified Domestic Relations Order. Id. at 7-9. In
addition, the IRS held that the payment did not qualify for exemption as "other income" under
the treaty. Id. at 10-11. The IRS reasoned that "[wihile a pension is not specifically defined
under the Code, it is considered to be a payment in consideration of services rendered and
conditioned on retirement." Id. at 7. The IRS further explained that "[a] payment from a
qualified retirement plan under section 401(a) of the Code is a payment in consideration of
services and is conditioned upon retirement and is commonly referred to as a pension for U.S.
tax purposes." Id.

170. Priv. Ltr. Rul. 89-04-035 (Oct. 31, 1988) (ruling applying U.S.-Germany
Income Tax Treaty). As support for its ruling, the IRS states: "See Rev. Rul. 71-478. 1971-2
C.B. 490; Staff of Joint Comm. on Tax'n, 99th Cong., General Explanation of the Tax Reform
Act of 1986, 713 (Joint Comm. Print 1987) (explaining Congress' intent not to penalize under
section 72(t) distributions the timing or character of which reflect a genuine intent to retire);
cf. Schellfeffer v. U.S., 343 F.2d 936, 941 (Ct. Cl. 1965) (employee not 'retired' within the
intendment of a law increasing federal pensions, if he or she resigns early in his or her
career)." See also Priv. Ltr. Rul. 89-34-025 (May 25, 1989) (applying exemption under article
18 of U.S.-U.K. Income Tax Treaty to lump sum distribution; and providing identical
explanation). In Revenue Ruling 71-478, interpreting the term "pension" under article 12 of
the predecessor U.S.-U.K. Income Tax Treaty, the IRS explained that payment of a pension
is "deferred until after retirement in order to induce 'long-continued and faithful service.'"

171. Clayton v. United States, 95-2 U.S. Tax Cas. (CCH) '1 50,391, 76 A.F.T.R.2d
(RIA) 95-5197 (Cl. Ct. 1995), aff'd, 96-I U.S. Tax Cas. (CCH) 1 50,314 (Fed. Cir. 1996).

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to Canadians employed by Chrysler's Canadian subsidiaries. 72 It agreed
with IRS reasoning that "payment of a pension for purposes of the Treaty
must be contingent on retirement." '173

The IRS apparently views a distribution from an IRA as outside the
scope of the term "pension" as used in "most treaties."'74 However,
distributions from IRA's containing solely rollover distributions from
qualified plans (and earnings thereon) may in some cases 175 be treated as
a pension, 7 6 although application of this rule by withholding agents may

172. The Clayton court stated that "[t]he distribution at issue is neither a pension
nor an annuity under United States tax law, but a distribution from a stock bonus plan." Id.
at 89,240, 76 A.F.T.R.2d at 95-5224.

173. Priv. Ltr. Rul. 86-33-081 (May 27, 1986) (cited in Clayton, 95-2 U.S. Tax Cas.
at 89,240, 76 A.F.T.R.2d at 95-5224). According to the ruling, the ESOT plan provided that
"distributions ... may be made on the employee's separation from service and are thus not
contingent on an employee's age or retirement." Priv. Ltr. Rul. 86-33-081 (May 27, 1986).

174. See IRPAC Paper, supra note 98, (issue (8)) (citing Priv. Ltr. Rul. 92-53-049,
Priv. Ltr. Rul. 91-43-067, and Priv. Ltr. Rul. 89-04-036). The IRPAC Paper states that: "it
appears that the Service may take the position that an IRA is not a 'pension' within the
meaning of most treaties, unless it is a 'pure' pension rollover IRA .... [The Service might
adopt this position] notwithstanding the fact that such vehicles may be used for retirement
savings." Id. In the first of the rulings cited above, the IRS stated: "Generally, an IRA is not
a pension. However, in certain circumstances a distribution from an IRA that consists solely
of amounts rolled over from a qualified pension plan and earnings thereon will be treated as
a pension distribution for purposes of the pension article in a treaty." Priv. Ltr. Rul. 92-53-049
(Oct. 6, 1992). In Priv. Ltr. Rul. 91-43-067 (July 31, 1991), discussed in Bissell, supra note
98, at 78, the IRS stated that the treatment of "withdrawals from [IRAs] that do not qualify
as a pure rollover IRA is currently under study." See also KPMG Letter, supra note 161
(stating that the IRS interprets the term "pension" in the Canadian treaty to refer to "pensions
paid by private employers" or the U.S. or Canada). KPMG concludes that an IRA would not
qualify "[s]ince the individual may establish these plans on their own account and receive a
distribution from the plan upon demand prior to retirement .... ). Id.

175. Recently, the IRS stated its position that the term "pensions" includes a
distribution in compliance with requirement (2), quoted in the text accompanying note 166,
that is made from a "pure rollover IRA," i.e., an IRA that "contain[s] only distributions from
qualified retirement plans (plus earnings thereon) that meet the above requirements and are
themselves treated as pensions." Priv. Ltr. Rul. 95-41-043 (Oct. 13, 1995) (applying pension
article of U.S.-India Income Tax Convention to periodic distributions from an IRA created by
a rollover from two qualified defined contribution plans sponsored by a U.S. employer). See
also Priv. Ltr. Rul. 89-04-036 (Oct 31, 1988) (pension article of U.S.-Italy Income Tax Treaty
exempted distributions from an IRA, into which lump sum distributions from U.S. qualified
retirement plans had been rolled over). In the latter ruling, the IRS stated that "amounts
otherwise qualifying as pension payments ... which are rolled over into a segregated IRA and
which qualify as 'rollover contributions' under section 408(d)(3) . . ., will continue to qualify
as pension payments under the Treaty, including interest earned while in the IRA." Id.

176. See Priv. Ltr. Rul. 96-26-055 (Apr. 11, 1996), where the IRS ruled that a lump
sum distribution from a "pure rollover" IRA that had been transferred to a Netherlands resident
pursuant to a Qualified Domestic Relations Order was pension income and thus taxable under

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U.S. Income Taxation of Cross-Border Pensions

be difficult.'" Moreover, the March 17, 1995 protocol to the U.S.-Canada
Income Tax Treaty expands the coverage of the pension article to include an
IRA 178

In its explanation of the 1996 U.S. Model, the Treasury has set forth
its current negotiating position regarding the definition of a "pension" (which
is not necessarily its interpretation of existing treaties). The text of article 18
of the 1996 U.S. Model refers to "pension distributions and other similar
remuneration... whether paid periodically or as a lump sum." '79 The
Treasury's Explanation specifies that this provision applies to "qualified plans
under section 401, individual retirement plans .... nondiscriminatory section

art. 19, 2 of the U.S.-Netherlands Income Tax Treaty. See supra note 169. The IRS
explained that "certain conditions must be met for a distribution from a 'purc-rollovcr' IRA
to be treated as a pension for purposes of a treaty, in order to ensure that the distribution is
made as a retirement benefit." Priv. Ltr. Rul. 96-26-055. "Thesc conditions arc similar to those
prescribed under section 72(t)(2)(A) ... for avoiding the 10 percent additional tax upon an
early withdrawal .. " Id. The Service reasoned that because the "additional tax does not
apply in the case of a distribution to a divorced spouse pursuant to a QDRO (by reason of the
exception in section 72(t)(2)(C)], such distributions ... are to be treated as retirement benefits
in all events." Id. The IRS will not, it explained, "impose conditions for treaty purposes that
are not otherwise required to affect the U.S. tax consequences of the distribution." Id.

177. See IRPAC Paper, supra note 98, issue 8. The IRPAC Paper points out that
"[tihe original source of funding for an IRA is not always clear to a payor of IRA
distributions, especially where the IRA was established pursuant to a rollover or direct transfer
from another IRA at a different institution." Id. Accordingly, the Paper suggests, "the different
withholding rules that apply to IRAs, based on the original source of such funds, leads [sic]
to confusion and undue administrative burdens to the payor." Id. Bissell recommends that
taxpayers "discuss the U.S. tax and treaty rules in advance with the IRA fiduciary, so as to
anticipate whether the fiduciary will withhold tax." Bissell, supra note 98, at 80.

178. Revised Protocol Amending the 1980 Tax Convention with Canada. Mar. 17,
1995, art. 9, 11 (replacing art. 18, T1 3 of the U.S.-Canada Income Tax Treaty, signed
September 26, 1980) reprinted in Tax Treaties (CCH) 1 1946 [hereinafter 1995 Revised
Protocol]. The reference in the 1980 treaty to a "superannuation, pension or retirement plan"
was changed to a "superannuation, pension or other retirement arrangement." See id. This
change "clarifies that the definition of pensions includes, for example, payments from [an IRA
or a Canadian registered retirement savings plan or registered retirement income fundl." Joint
Comm. on Tax'n, Explanation of Proposed Protocol to the Income Tax Treaty Between the
United States and Canada (JCS-15-95), May 23, 1995, (Joint Comm. Print 1995). See also
Treasury Department Technical Explanation of the Protocol Amending the Convention
Between the United States of America and Canada (June 13, 1995). 95 TNT 115-64 (June 14,
1995) (LEXIS, FEDTAX library, TNT file) [hereinafter Treasury Explanation of Revised
Protocol to U.S.-Canada Treaty]. The Treasury Explanation further states: "The term 'pensions'
also would include amounts paid by other retirement plans or arrangements, whether or not
they are qualified plans under U.S. domestic law; this would include, for example. plans and
arrangements described in section 457 or 414(d) of the Internal Revenue Code." Id.

179. See 1996 U.S. Model, supra note 2, art. 18. 9 1. The Treasury states that "'[t~he
same result is understood to apply in U.S. treaties that do not make this point explicitly." 1996
Treasury Explanation, supra note 2, 1 242.

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457 plans, section 403(a) qualified annuity plans, and section 403(b) plans."
All these examples of included plans are funded plans, except that section
457 plans are required to be "unfunded."'80

The Treasury further explains that "Competent Authorities may agree
that distributions from other plans that generally meet similar criteria to those
applicable to other plans established under their respective laws also qualify
for the benefits of' the treaty. The criteria listed for the U.S. by Treasury'
are that the plan

(a) be "written";
(b) be "nondiscriminatory" in the case of an employer-sponsored

plan;
82

(c) contain restrictions on non-retirement use of assets by
participants; 183 and "in all cases be subject to tax provi-
sions that discourage participants from using the assets for
purposes other than retirement;" and

(d) require minimum distributions so that death benefits to
survivors are merely incidental."8

It would seem that the second part of criteria (c) would not be met by most
plans that are ineligible for tax-qualified treatment under the Code.

Finally Treasury in its explanation of the 1996 U.S. Model restates
the position previously announced in private rulings that "certain distribution
requirements" (essentially those set forth in the private rulings)' "must be
met before distributions from these plans would fall under" the treaty
provision.

86

180. See IRC § 457(b)(6); Bittker & Lokken, supra note 7, 60.2.3.
181. See 1996 Treasury Explanation, supra note 2, 243.
182. Treasury states that "[i]n the case of an employer-maintained plan, the plan

must be nondiscriminatory insofar as it (alone or in combination with other comparable plans)
must cover a wide range of employees including rank and file employees, and actually provide
significant benefits for the entire range of covered employees." Id.

183. Treasury states that "[i]n the case of an employer-maintained plan the plan
must contain provisions that severely limit the employees' ability to use plan assets for
purposes other than retirement." Id.

184. Treasury states that "[tihe plan must provide for payment of a reasonable level
of benefits at death, a stated age, or an event related to work status, and otherwise require
minimum distributions under rules designed to ensure that any death benefits provided to the
participants' survivors are merely incidental to the retirement benefits provided to the
participants." Id. 243.

185. See supra notes 166-168 and accompanying text.
186. These are that "the 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"; and "the
distribution must be either (A) on account of death or disability, (B) as part of a series of

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U.S. Income Taxation of Cross-Border Pensions

Payments of funded deferred compensation that do not qualify under
the "pension" article of a treaty may come under the "other income" article.
For example, in its recent decision in Clayton, the U.S. Court of Federal
Claims agreed with the IRS position that the "accretion" element of a 1986
distribution to Canadian employees working in Canada in termination of
Chrysler's employee stock ownership plan was subject to article 22 of the
U.S.-Canada Treaty, dealing with "other income."'87 Similarly, the IRS has
ruled that a distribution from a rollover IRA made before age 59-1/2 (and
thus not classified as a "pension") was to be classified as "other income"
under the U.S.-U.K. treaty; as a result the distribution was exempted from
U.S. tax. 18 1 This treaty classification may not be available, however, to the
extent that distributions are subject to section 864(c)(6) (because they are
attributable to deductible contributions made with respect to services
performed after 1986)."9 In addition, some treaties, such as the U.S.-

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"; and finally that "the distribution must be made either after separation from service or on
or after attainment of age 65." 1996 Treasury Explanation, supra note 2, q 244. And the
distribution cannot be "solely due to termination of the pension plan." Id.

187. Clayton, 95-2 U.S. Tax Cas. (CCH) at 89,241, 76 A.F.T.R.2d (RIA) at 95-
5226. Under art. 22, 1, other income arising in the U.S. can be taxed by the U.S. Id. The
Clayton court held that paragraph two of article 22, providing a maximum rate of 15% for
distributions from a trust resident in one country to a resident of the other country, was
applicable. Id. The taxpayer had unsuccessfully argued that the distribution represented
"remuneration" for services rendered outside the U.S., and, therefore, was exempt under article
15 (dependent personal services). Id. at 89,239-40. 76 A.F.T.R.2d (RIA) at 95-5223-24. This
argument was also rejected on appeal. See Clayton v. United States, 96-1 U.S. Tax Cas. (CCH)
150,314, 77 A.F.T.R.2d (RIA) 96-2484 (Fed. Cir. 1996).

188. See Priv. Ltr. Rul. 92-53-049 (OcL 6. 1992). The IRS further ruled that the
second sentence of art. 22,9 11, denying an exemption for income from trusts, was inapplicable
to an IRA trust. See discussion in Bissell, supra note 98, at 79-80. The IRS had applied this
article of the U.S.-U.K. Income Tax Convention to a distribution from a non-rollover IRA
annuity in a 1984 private letter ruling. Id. (citing Priv. Ltr. Rul. 84-22-069). By contrast, in
Priv. Ltr. Rul. 96-26-055 (Apr. 11, 1996), the IRS treated a lump-sum distribution from a
"pure rollover" IRA, transferred to a spouse pursuant to a QDRO, as "pension income," and
thus rejected the taxpayer's argument that the distribution qualified for a treaty exemption as
"other income." See supra notes 169 & 176.

189. Bissell points out that in Priv. Ltr. Rul. 92-53-049 (Oct. 6, 1992). the IRS
noted that no U.S. services were performed by the employee after August 1984, for which
pension contributions were made, and it concluded that § 864(c)(6) does not apply to
distributions from the rollover IRA. Bissell, supra note 98, at 79. Bissell states that "[tihere
is an implication in these comments that if the individual had worked in the United States after
1986 .... to that extent the Article 22 exemption might not have been available." Id. (footnote
omitted). In that case, Bissell concludes, the distributions might have been classified as "the
payment of deferred U.S. source compensation under § 864(c)(6) that is subject to U.S. tax
under the 'dependent personal services' article of the relevant tax treaty." Id. at 80.

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Mexico treaty, do not provide an exemption from source-based taxation for
"other income."'"

2. Pension Contributions.-The basic treaty provision providing for
exclusive residence taxation of pensions (just discussed) is applicable only to
pension distributions and not to pension contributions. In the 1981 U.S.
Model and in most U.S. treaties, there is no limitation on source-based
taxation of pension contributions. Thus, in rows 3 and 4 of Table 1, page
358, involving a U.S. nonqualified funded plan and a foreign funded plan,
respectively, the 1981 U.S. Model does not block the U.S. source-based tax
on contributions in respect of U.S. services performed by a nonresident alien.

The commentary to the 1992 OECD Model Treaty does, however,
suggest a provision T9 that would ameliorate the treatment of employee
contributions to home country pension plans for employees assigned to work
abroad. 192

Such a provision was added to the treaty between the U.S. and France
by a 1984 protocol, 93 and was again included in the revised treaty signed
on August 31, 1994. Under the 1994 provision, for example, contributions
paid by or on behalf of a French citizen who is a U.S. resident to a retirement
arrangement established in France and qualifying for tax relief (with respect
to contributions) in France is to be treated in the same way by the U.S. as a
U.S. retirement arrangement qualifying for tax relief (with respect to
contributions) in the U.S. provided that the U.S. competent authority agrees
that the French arrangement corresponds to an arrangement qualifying for tax

190. The 1996 U.S. Model does provide for exclusive taxation by the residence
country of income not dealt with in other articles of the Model. 1996 U.S. Model, supra note
2, art. 21, 1.

191. Under the proposed provision in the 1992 OECD Commentary, the host state
is to accord the employee relief for contributions made by him to a pension scheme in the
home country comparable to that accorded contributions to a pension plan in the host country.
To achieve this, the employee must not have been a resident of the host country and must have
been contributing to the home country pension scheme before taking up employment in the
host country, and the home country scheme must be "accepted by the competent authority"
of the host country "as generally corresponding to a pension scheme recognised as such for
tax purposes by [the host country]." 1992 OECD Commentary, supra note 138, at C(18)4. See
also Andersen, supra note I, at 95-96; Sassesville, supra note 83, at 129, 135 (1993); Gunkel,
supra note 150, at 690-93.

192. 1992 OECD Commentary, supra note 138, at C(18)-2.
193. See Protocol to the Convention Between the United States of America and the

French Republic with Respect to Taxes on Income and Property of July 28, 1967, signed Jan.
17, 1984, art. 8, (adding 5 to article 19 of the 1967 treaty), reprinted in Tax Treaties (CCH)

3038, 27,073.

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U.S. Income Taxation of Cross-Border Pensions

relief in the U.S. 94 A similar provision was also included in article 19 of
the U.S.-Sweden Tax Convention, signed on September 1, 1994, and in the
proposed treaties with Austria and Switzerland, signed in 1996.'" The
Treasury Department's Technical Explanation of the French and Swedish
provisions suggests that (as in the Commentary to the 1992 OECD Mod-
el196

) they provide only for deductions of employee contributions, and not
an exclusion for employer contributions. 97

194. U.S.-France Income Tax Treaty, supra note 135, ar. 18. 7 2(a), (b)(iii). Tax
Treaties (CCH)1 3001.04,27,005-13; see also Treasury Explanation of the U.S.-France Treaty.
supra note 135, Tax Treaties (CCH) 1 3058, 27,197-31 (noting that this provision is "based
on... the suggested provision set forth in the Commentaries to Article 19 of the 1992 OECD
Model").

195. Convention Between the Government of Sweden and the Government of the
United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with Respect to Taxes on Income, Sept. 1. 1994. an. 19. 1 4. Tax Treaties (CCH)
§ 8801,41,505-11 [hereinafter U.S.-Sweden Tax Convention]; Treasury Technical Explanation
of 1994 U.S.-Sweden Income Tax Treaty, Tax Treaties (CCH) 9I 8802A, 41.505-66 [hereinafter
Treasury Explanation of U.S.-Sweden Treaty]. Proposed U.S.-Austria Income Tax Treaty.
supra note 164, art. 18, 91 5. Proposed Convention Between the United States of America and
the Swiss Confederation for the Avoidance of Double Taxation with Respect to Taxes on
Income, signed Oct. 2, 1996, art. 28, 91 4. 96 TNI 194-41 (Oct. 4, 1996) (LEXIS. FEDTAX
library, TNI file). The Swedish provision differs from the provision in the French treaty by
requiring that "contributions [be] paid by, or on behalf of. such individual to [the home
country] arrangement before [the individual becomes] a resident of the [host countryl." U.S.-
Sweden Tax Convention, supra, art. 19, 1 4(a)(i), Tax Treaties (CCH) 91 8801. 41.505-11.

196. The 1992 OECD Commentary states that the proposed provision's reference
to "[c]ontributions borne by an individual" is intended to include only an employee's
contributions, and that the provision "is silent on the treatment of' an employer's contribu-
tions. However, the Commentary suggests that "Member countries may wish to extend" the
provision "to ensure that employers contributions in the context of the employees' tax liability
are accorded the same treatment that such contributions to domestic schemes would receive."
1992 OECD Commentary, supra note 136, at C(18)-4. C(18)-10.

197. The language of the treaties with Sweden and France refers to "contributions
paid by, or on behalf of," an individual to a home country plan being "treated in the same way
for tax purposes" as contributions to a host country plan. U.S.-France Income Tax Treaty,
supra note 135, art. 18, 1 2(a); U.S.-Sweden Tax Convention. supra note 195. art. 19.4(a). But
the Treasury's Technical Explanation states that the provision "permits" the employee "to
deduct contributions ... that are made by or on his behalf' to certain home country plans "to
the same extent that deductions would be permitted" for contributions to a host country plan.
Treasury Explanation of the U.S.-France Treaty, supra note 135 (discussing art. 18); see
Treasury Explanation of the U.S.-Sweden Treaty. supra note 195 (discussing art. 19 (similar
language)). But cf. Letter of Price Waterhouse to Cynthia Beerbower, International Tax
Counsel, dated June 7, 1994, 94 TNI 136-20 (July 15. 1994) (LEXIS, FEDTAX library. TNI
file), recommending that a provision like art. 19(5) of 1967 U.S.-France Treaty be added to
U.S. Model Treaty [hereinafter PW Letter]; and Section of Taxation, ABA, Comments on
Income Tax Treaty Between Finland and the United States, dated Nov. 1. 1990.90 TN1 48-71,
(Nov. 28, 1990) (LEXIS, FEDTAX library, TNI file). recommending inclusion of a provision

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The Treasury has now indicated that its policy is to negotiate for
inclusion of such a provision in future treaties in order to "ensure that certain
differences between the two Contracting States' laws regarding pension
contributions and pension plans will not inhibit the flow of personal services
between the Contracting States."'9 8 The 1996 U.S. Model Treaty contains
a provision of this nature that is in some ways broader in scope than the
provisions in the French and Swedish treaties. Under the provision in the
1996 Model,' 99 an individual performing services in the U.S. who has
already participated2 "° in a pension plan recognized under the legislation of
the other country and generally corresponding to a tax-qualified U.S. pension
plan is eligible for three treaty benefits:2"' (1) contributions to the plan are
deductible (if made by the employee) or excludable if made by the employer,
up to the limits applied by the U.S. to U.S. tax-qualified plans;2" (2) the
U.S. may not tax earnings in the plan prior to distribution; and (3) the U.S.
may not tax distributions rolled over into a U.S. tax-qualified plan pursuant
to U.S. rules.20 3 Moreover, the 1996 Model's provision also allows the
employer in such a case to deduct contributions in computing taxable income
in the U.S., subject to the limits that would be applied to a U.S. plan. °4

like art. 19, T 5 of the 1967 U.S.-France Treaty [hereinafter ABA Comments]. Price
Waterhouse suggests that this provision would "ensure that employees do not lose the
opportunity to continue sharing in benefit programs and are not unduly burdened with income
tax on employer contributions during the period of residency in the country in which the
employee is not a citizen." PW Letter, supra. The ABA Tax Section suggests that art. 19, 5
of the 1967 French treaty is an example of "a provision for mutual recognition by each
Contracting State of the qualification of a retirement plan under the other Contracting State's
rules, both for the purposes of deductions by employers and timing of inclusion by
employees." ABA Comments, supra.

198. 1996 Treasury Explanation, supra note 2, 251.
199. 1996 U.S. Model, supra note 2, art. 18.6.
200. The Treasury states that "the individual ... must be a visitor to the host

country," in that the provision applies "only if he was contributing to the plan in his home
country." 1996 Treasury Explanation, supra note 2, 257.

201. These benefits are not denied by the savings clause to U.S. residents who are
neither U.S. citizens nor permanent residents. 1996 U.S. Model, supra note 2, art. 1.5(b).

202. See 1996 Treasury Explanation, supra note 2, $ 252-254. Treasury explains
that "the exclusion of employee contributions from the employee's income ... is limited to
elective contributions not in excess of the amount specified in section 402(g)." Id. 254. The
Treasury further explains that "the benefits [under art. 18, 6] are limited to the benefits that
the host country accords under its law, to the host country plan most similar to the home
country plan." Id. 258.

203. Id. 256.
204. See 1996 U.S. Model, supra note 2, art. 18, 6; 1996 Treasury Explanation,

supra note 2, 253-254. The Treasury explains that the employer's deduction "is subject to
the limitations of sections 415 and 404." Id. 254.

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U.S. Income Taxation of Cross-Border Pensions

D. Rationale for Source-Based Taxation

1. Unfunded Deferred Compensation.-It is clearly within interna-
tional norms for the U.S. to tax current salary paid to a nonresident alien
performing services in the U.S. as effectively connected income. The OECD
Model provides for such source-based taxation of compensation for dependent
services, subject to a "short-term business travel" exception (which is
incorporated in U.S. treaties, as well as in the Internal Revenue Code in a
narrower version). Presumably, the host country is viewed as providing valu-
able benefits to the employee by providing the situs for his employment.'

Unfunded deferred compensation is viewed by the U.S. as merely a
delayed substitute for current compensation in that it comes directly from the
employer. Thus, the U.S. considers it appropriate to apply the same treatment
to eventual payments of unfunded deferred compensation as to current
payment of compensation. The enactment of section 864(c)(6) (taxing
deferred compensation as effectively connected income) apparently does not
conflict with any treaty obligations of the U.S.'

Presumably, it would be permissible under international norms for the
U.S. to adopt a broader concept of constructive receipt or economic benefit
that would result in current taxation of the present value of unfunded deferred
compensation. 2 7 The generosity of the U.S. in not taxing currently does not
seem a valid reason for precluding it from taxing at a later date more
convenient to the employee.05

205. See, e.g., David Gliksberg, The Effect of the Statist-Political Approach to
International Jurisdiction of the Income Tax Regime-The Israeli Case. 15 Mich. J. Int'l L
459, 472 (1994) (proposing that "[llustification for imposing [tax on foreign taxpayers on a
territorial basis] is centered on the connection between income and governmental expenditure
incurred in creating a working environment to enable the production of that income").

206. See ABA, Section of Tax'n, Issues Paper on Technical Corrections to the Tax
Reform Act of 1986 Relating to Tax Treaties at nn.63-66 (July 1, 1988), available in 88 TNT
146-39, (July 15, 1988) (LEXIS, FEDTAX library, TNT file) (indicating general agreement
that § 864(c)(6) added by the 1986 Act is not inconsistent with any treaties).

207. For example, in 1978, the IRS published proposed regulations providing that
"if a taxpayer ... individually chooses to have payment of some portion of his current
compensation... deferred and paid in a later year, the amount will nevertheless be treated
as received by the taxpayer in the earlier taxable year." Notice of Proposed Rulemaking,
Deferral Tax Treatment of Amounts of Compensatory Payments lLR-194-771, 43 Fed. Reg.
4638 (1978) (IRS explanation of proposed regulation). The Revenue Act of 1978 barred the
Treasury from implementing this proposal. Pub. L. No. 95-600, § 132(a), 92 Stat. 2763, 2782-
83 (1978).

208. This argument has been made in the context of state taxation of pensions of
nonresidents. See Walter Hellerstein & James C. Smith, State Taxation of Nonresidents'
Pension Income, 56 Tax Notes 221, 224 (July 13, 1992) [hereinafter Hellerstein]. They argue
that the fact that the state as "a matter of legislative grace" accorded deferral when pension

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2. Different Treatment of Funded Deferred Compensation.-A
distribution to an employee from a funded pension plan can be conceptualized
in the same way as a payment of unfunded deferred compensation, i.e., as a
substitute for current compensation. 2' The amount to be received by the
employee on a deferred basis should be greater than the amount he would
receive on a current basis because the funds can be invested in the interim.
Thus, under this approach, the full amount of the deferred payment would be
classified as compensation.

Such an approach was advocated by the Chief Counsel in 1975 with
respect to a qualified U.S. pension plan,20 but was eventually rejected by
the IRS in favor of a "bifurcated" approach. Under the bifurcated approach,
only the amount contributed by the employer (or by the employee on a tax-
deferred basis) to a funded plan is viewed as compensation to be sourced on
the basis of the place of performance of services. The "accretions" earned in
the retirement trust by investment of the contributions is viewed as a separate
element of investment income for the employee, which is sourced to the U.S.
if the trust has a U.S. situs.

rights were earned should not be used as a basis for "prevent[ing] a state from taxing income
earned within its borders." Id.; see also Jean M. Klaiman, Note: Take the Money and Run:
State Source Taxation of Pension Plan Distributions to Nonresidents, 14 Va. Tax Rev. 645,
664 (Winter 1995) [hereinafter Klaiman]. Nevertheless, the recent federal legislation barring
state taxation of pensions paid to nonresidents does appear to apply to unfunded deferred
compensation that qualifies as an executive excess benefit plan or is paid in periodic
installments for at least 10 years. See Pub. L. No. 104-95, 104th Cong., 1st Sess. § l(a),
(1996) (adding 4 U.S.C. § 114); Amy Hamilton, Clinton Signs Source Tax Bill, 96 TNT 8-4
(Jan. 11, 1996) (LEXIS, FEDTAX library, TNT file) [hereinafter Hamilton].

209. Gen. Couns. Mem. 36,344 (July 23, 1975) at *9; Gen. Couns. Mem. 38,007
(July 10, 1979) at *4-5. It was the Chief Counsel's position that "[e]xemptions in treaties for
pensions have always been applied to pensions as a whole." Gen. Couns. Mem. 36,344 at * 11
(July 23, 1975). In addition, Chief Counsel cited Rev. Rul. 72-3, 1972-1 C.B. 105, for the
proposition that a "pension is a substitute for current compensation." Id. As yet further support,
Chief Counsel cited Gen. Couns. Mem. 35,894 (July 11, 1974), "in which a lump sum
payment from a qualified employee's profit-sharing plan in excess of the employee's own
contributions is [treated as] business income for purposes of computing a net operating loss."
Id. at *6, *11. Counsel also pointed to: H.R. Rep. No. 2, 70th Cong., 1st Sess. 22 (1927) ("to
the effect that distributions from a pension trust are taxed as compensation"); and Rev. Rul.
73-252, 1973-1 C.B. 337 (holding that "supplemental unemployment benefits paid to [a NRA]
who performed all his services outside the United States from a tax-exempt trust operated by
a domestic voluntary employee's association constitutes income from" foreign sources). Id. at
* 12-13.

210. Gen. Couns. Mem. 36,344, supra note 209. In 1979, Chief Counsel, although
restating the same objections, acquiesced in ITC's approach and concurred in the adoption of
Rev. Rul. 79-388. Gen. Couns. Mem. 38,007, supra note 209. See also supra notes 108-111
and accompanying text.

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U.S. Income Taxation of Cross-Border Pensions

International Tax Counsel criticized the Chief Counsel's approach of
sourcing the entire distribution based upon the place of performance of
services as:

represent[ing] an unwarranted transmutation of a provision for tax
deferral into one which unilaterally concedes primary tax jurisdiction
on certain U.S. source income to foreign taxing authorities."'

Thus, International Tax Counsel apparently supported bifurcation as
a means to strengthen U.S. source-based jurisdiction: i.e., to allow the U.S.
to impose tax on the accretion portion of a distribution to a nonresident alien
from a U.S. pension plan even if the employee performed all his services
outside the U.S. This situation could occur, for example, when the employer
is a U.S. multinational. International Tax Counsel apparently did not believe
that an employee should have the advantage of investing in U.S. assets
through a tax-exempt U.S. pension trust and at the same time avoid U.S. tax
on the distribution of such investment earnings. The statement by Internation-
al Tax Counsel may also suggest that a strong assertion of source-based
jurisdiction over pensions might be a useful tool in bilateral negotiations for
a reciprocal source-country exemption for pensions.

These policies are undercut, however, by enactment of section 871 (f)
exempting from U.S. tax any amounts received as an annuity from a qualified
pension trust by a nonresident alien if all of the services were performed
outside the U.S. and at least 90% of the employees benefitting under the plan
are U.S. citizens or residents.1 2 It is hard to explain how the ceding of U.S.
jurisdiction with respect to "accretions" earned in a U.S. pension trust
becomes more or less warranted in principle depending on what percentage
of the beneficiaries under the plan are nonresident aliens.

Overall, it seems advisable for Congress to amend the Internal
Revenue Code so as to treat the entire amount of a distribution from a U.S.
qualified pension plan as compensation (to be sourced to the place where the
services were performed). This change would greatly simplify U.S. source-
based taxation of distributions from U.S. qualified pension plans (when there
is no treaty bar to taxation); with this change, it would no longer be
necessary to separately identify the "accretions" element of a distribution or
to determine whether the requirements of section 871 (f) are met. The source-
based jurisdiction that the U.S. would thereby surrender has already been

211. Gen. Couns. Mem. 38,007. supra note 209, at *6-7.
212. See supra notes 114-116 and accompanying text. As noted there a further

exemption is provided even though the 90% requirement is not met when the recipient's
country of residence grants a substantially equivalent exclusion to residents and citizens of the
United States. IRC § 871(f)(2)(A).

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largely abandoned as a result of the operation of section 871(f). The
simplifying effects of this proposal are depicted in bold print in Table 1-A,
rows 2 and 5, pages 362-63.

Whether the IRS should continue to apply a bifurcated approach to
distributions from a nonqualified funded plan (domestic or foreign) is a
harder question. Since the U.S. treats contributions to such a plan as taxable
compensation (at the point of vesting), pursuant to section 402(b)(1), it is
harder to conceptualize the eventual distribution from the trust as merely a
substitute for current compensation.

In the case of a U.S. secular trust, the bifurcation approach may not
add much complexity in that separation of the contributions element from the
earnings element may be necessary in any event to determine the proper time
for taxing. Moreover, in the case of a foreign retirement trust with a
nonresident alien beneficiary, the bifurcation rule has the simplifying effect
of treating the accretion element as foreign and thus not subject to U.S. tax;
this may be a worthwhile concession to the limits of IRS enforcement ability.

These considerations suggest that bifurcation should be retained in the
taxation of a nonresident alien participant in a funded nonqualified retirement
plan.

213

E. Rationale for Treaty Relinquishment of Source-Based Jurisdiction Over
Pensions

Why does the U.S., while making a strong assertion of jurisdiction
over deferred compensation (particularly after the 1986 Act), simultaneously
embrace a treaty policy of complete relinquishment of source-based taxation
over pension payments (whether or not made in a lump sum)? Somewhat
inconsistently, the U.S. does not relinquish by treaty its source-based taxation,
on a current basis, of compensation for U.S. services that is contributed (by
the employer or employee) to a foreign retirement arrangement or to a
nonqualified U.S. funded plan.

213. See Table 1-A, rows 3, 4, and 6, page 362-63. But cf. infra Part IV.E
(proposing a different treatment of foreign defined benefit plans). The IRS also applies the
bifurcation approach in determining the source of a pension distribution for purposes of
computing the foreign tax credit of a U.S. citizen or resident. See supra note 105. If the
proposal described in the text to eliminate bifurcation of a distribution from a U.S. qualified
plan is implemented for this purpose as well, the aggregate effects are likely to be fairly
modest. The only change would be that a U.S. citizen or resident who performed services
abroad could treat the entire distribution (and not just the original contribution) from a U.S.
qualified plan as having a foreign source. This would simplify the task of the plan trustee,
particularly in the case of a defined benefit plan.

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U.S. Income Taxation of Cross-Border Pensions

The U.S. treaty policy is obviously consistent with international
norms, as it is also embodied in the OECD Model Tax Conventions for 1963,
1977 and 1992.214 However, one commentator from the U.K. has argued
that the bar to source country taxation of pensions under the OECD Model
is "outdated, having been designed in an era when there were fewer privately
funded pensions and less costly tax-deductible pension reserves.... and the
mobility of individuals not so marked."2 5 She notes that "[tihose states,
such as the United Kingdom and the Netherlands, that allow generous
deductions to pension reserves, are high-tax, developed nations vith strong
welfare systems.,,2

11 The author further notes that this tax break is "justified
only in relation to keeping down future welfare costs and substituting a
stream of taxable income when employment has ceased. 2

1
7 She believes

that "high-earning 'mobiles' will draw their pensions as (technical) residents
of havens where the sun shines and the taxes are low; [while] the mid- to
lower-income sector and the poor needing welfare [will] stay behind in high-
tax countries. 2 8

A main purpose of bilateral tax treaties is to avoid "tax barriers to the
free international exchange of goods and services. ' Thus, a major goal
is avoidance of double taxation of cross-border transactions, which obviously
is a discouragement to such transactions. However, this goal is generally
achieved to a large extent by a country's internal tax rules giving priority to
source-based tax; thus, for example, the U.S. allows a credit for foreign taxes
paid in respect of foreign source income, while some other countries provide
an exemption for foreign source income.= By contrast, treaties generally
operate by reducing or eliminating source-based taxation.2-

In some cases, however, the internal rules of the two countries may
not be effective to avoid double taxation because of inconsistent treatment

214. In fact, this policy seems to have gained acceptance prior to 1963 since official
commentary for the three OECD model treaties do not provide any explanation of the rationale
for this treatment. For the treatment of pensions in draft model conventions prepared under the
auspices of the League of Nations, see supra note 136. See also Muten, supra note 72, at 750
(noting that "we Swedes have learned by experience that this rule is extremely hard to get
prospective treaty partner countries to modify").

215. Jill C. Pagan, United Kingdom: Momentum for Change in Approach to
Taxation Gathers Pace, II Tax Notes Int'l 802, 805 (Sept. 18, 1995).

216. Id.
217. Id.
218. Id. at 805-06.
219. American Law Institute, International Aspects of United States Income

Taxation II, Proposals on United States Income Tax Treaties. 1991 A.L.I. Fed. Income Tax
Project 1 (May 13) [hereinafter ALl].

220. See id. at 5-6.
221. See id. at 2.

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accorded a transaction by two countries, e.g., in their application of source
rules.222 Moreover, in some cases, source taxation may be considered
"burdensome" either in amount or in enforcement, even if "not duplica-
tive."2" Thus, a treaty provision may be needed to prevent either "double"
or "burdensome" taxation.

1. Eliminating Difficulties Created by Inconsistent Source
Rules.-The pension article of the U.S. model treaty eliminates problems of
double taxation that are created if more than one country seeks to impose
source-based tax on the same pension income. At least three possible sourcing
rules could be applied to a distribution from a pension plan:224 as under the
Code, the distribution could be sourced to the situs of the plan to the extent
of the accretion element and to the place of services to the extent of the
compensation element; alternatively, the entire amount could be sourced to
the situs of the plan (as under the UN Model) or the entire amount could be
sourced to the place of services (as for unfunded deferred compensation). The
U.S. Model, by providing for taxation of a pension payment exclusively in
the residence country, effectively eliminates conflicts between different views
of the source of a pension payment.2 5

Another way of achieving this goal, however, would be to specify by
treaty which sourcing rule should prevail. This suggests that there may be
additional reasons for the U.S. treaty policy regarding pensions payments.

2. Administrative Difficulties of Source-Based Taxation

a. Elimination of Administrative Difficulties by Eliminating
Source-Based Taxation.-The most obvious rationale for U.S. treaty policy

222. See id. at 6-8.
223. See id. at 9. ALI offers the example of "source-based withholding taxes on

investment income." Id. ALI notes the further "objective" of "exempt[ing] income entirely at
the source in cases in which the contact of the foreign taxpayer with the jurisdiction is
relatively weak and the compliance burden on the taxpayer is large by comparison." Id. at 10.
ALI cites as examples "[t]reaty provisions exempting income derived from international
shipping and air transport," and the "permanent establishment" limitation on the taxation of
business profits. Id.

224. See id. at 8 (noting that "[t]wo countries may assert source jurisdiction to tax
the same income of a taxpayer that is not a resident of either country," for example, because
of the "application of inconsistent source rules").

225. See Reuven S. Avi-Yonah, The Structure of International Taxation: A Proposal
for Simplification, 74 Tex. L. Rev. 1301, 1311 (1996) (arguing that one "pragmatic" reason
"for preferring residence over source taxation for individuals" is that "individuals can only be
in one place at any given time," whereas "determining the source of income is a highly
problematic endeavor, and in most cases, income will have more than one source").

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U.S. Income Taxation of Cross-Border Pensions

regarding pensions is the serious administrative difficulties associated with
source-based taxation of distributions from U.S. qualified plans. As in the
case of unfunded deferred compensation, the withholding agent first must
characterize contributions to the plan as made with respect to services
performed outside the U.S., services performed within the U.S. before 1987,
or services performed within the U.S. after 1986. But also, in contrast to the
case of unfunded deferred compensation, the withholding agent for a U.S.
qualified plan must allocate each distribution between the amount contributed
by the employer (and thus treated as compensation) and the accretion
element.' Chief Counsel noted the special difficulty of this task-'  with
respect to a defined benefit plan' in that, for such a plan, "the amount of
the pension ... does not depend on the amount of earnings."'  These

226. See Gen. Couns. Mem. 38,007, supra note 209, at *4 (referring to the "almost
overwhelming administrative difficulty (in many cases) in allocating a trust distribution
between employer contributions and trust accretions").

227. The Chief Counsel also viewed identification of the earnings element of a
pension payment as inconsistent with the treatment of the trust as a separate entity. He argued
that, because of the trust's separate status, "whatever increment may be paid out loses its
character in the hands of the distributee"; thus, for example. the employee cannot claim an
exemption under § 103 for municipal bond interest received by the trust or a dividends
received exclusion for dividends received by the trust. Gen. Couns. Mem. 36,344. supra note
209, at *10. But see Clayton v. United States, 95-2 U.S. Tax Cas. (CCH) 1 50.391, 76
A.F.T.R.2d (RIA) 95-5197 (Cl. CL 1995). affd, 96-1 U.S. Tax Cas. (CCH) 7 50,314 (Fed. Cir.
1996). In Clayton, the U.S. Court of Federal Claims approved the separate identification of the
"increment" in a distribution on termination of an ESOP. while rejecting the argument that
capital gains recognized by the trust could pass through to the beneficiary. Id. at 89,231-
89,232. The court noted that the conduit rules of subchapter J do not apply to employer trusts.
Id. at 89,232 (citing Rev. Rul. 72-99, 1972-1 C.B. 115, and Rev. Rul. 55-61, 1955-1 C.B. 40).

228. A recent report of the IRS Information Reporting Program Advisory Committee
states that "it is unclear whether Rev. Rul. 79-388 is applicable to distributions from defined
benefit plans and, if applicable, how its methodology would apply." IRPAC Paper. supra note
98, issue 5. The report adds that "[i]t is unclear, for payments made under a defined benefit
plan, how a plan administrator would identify contributions from earnings and, with respect
to contributions, distinguish between benefits attributable to services performed both [sic]
before or after a specified date for a specific employee." Id. The report recommends that "[the
Service should clarify whether the principles contained in Rev. Rul. 79-388 apply to pensions
paid from defined benefit plans"; and, if they do apply, it should "provide guidance that any
reasonable method may be used by payorslplan administrators" for making this determination.
Id.

229. Chief Counsel noted further that "in many cases it would be difficult, if not
impossible, to determine the amount of earnings that are allocated, or should be treated as
allocated, to each employee's account." Gen. Couns. Mem. 36,344. supra note 209, at $9. See
also Gen. Couns. Mem. 38,007, supra note 209 (Chief Counsel acquiesced to the approach
taken in Rev. Rul. 79-388, 1979-2 C.B. 270). In Gen. Couns. Mem. 38,007. Chief Counsel
pointed out that "[a] similar allocation problem was involved in the original lump-sum
distribution provisions of section 402," requiring identification of "any part of a lump-sum

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problems of allocation are compounded when the distribution is made in a
series of payments, 23' rather than a lump sum, and have been empha-
sized23 in a recent report by the Information Reporting Program Advisory
Committee to the IRS. 2

The U.S. and OECD model treaty provision for pensions allows these
administrative difficulties to be completely sidestepped. Because only the
state of residence of the recipient may tax a pension payment, there is no
need for the plan administrator to make the allocation between compensation
and earnings.

Similar administrative concerns are the most convincing justification
for federal legislation enacted in 1996 that bars an individual state of the
United States from imposing tax2

1
3 on pension payments made to an

distribution which represented employer contributions accrued after 1969." Id. at *5. Chief
Counsel confessed that "[i]t was found difficult if not impossible to administer this provision";
thus, in 1974 ERISA replaced it with "a relatively simple averaging." Id. at *5-6.

230. IRPAC Paper, supra note 98, issue 6 ("It is unclear how the principles
contained in Rev. Rul. 79-388 would apply to pensions, other than lump sum distributions,
which are attributable to services performed both within and outside the United States.").

231. The IRPAC report also criticized "current rules that may require the application
of three distinct withholding methodologies to a single pension payment to a nonresident alien"
for promoting "undue hardship" and "confusion." Id. at issue 3. Under the current withholding
rules: (1) "[t]hat portion of [a distribution] attributable to pension contributions for U.S.
services performed after 1986... is [generally] subject to the 10% withholding requirement
under IRC section 3405(b) unless [the beneficiary] elects out of withholding in which case
30% withholding under section 1441 would apply"; (2) however, "the 20% withholding
requirement under section 3405(c)" would apply mandatorily to any such amount "in excess
of the minimum required distribution under section 401(a)(9)"; and (3) "that portion of [a
distribution] attributable to contributions for U.S. services performed before 1987 plus all plan
earnings would apparently be subject to 30% withholding under section 1441." Id. The report
notes that payors may have to "issue and process several different types of information returns
and... apply different withholding methodologies with respect to the same payee in any one
calendar year" because of the payee's ability to "freely elect in or out of IRC section 3405
withholding." Id. The report recommends that the law be clarified and simplified by a
replacement of Temp. Regs. § 1.1441-4(b)(1)(ii); under the proposed replacement, withholding
for effectively connected pension payments made to nonresident aliens from qualified pension
plans would be exclusively under § 1441, and never under § 3405. Id. The IRPAC Paper's
recommendation was adopted in a proposed regulation issued by the Treasury in 1996. Under
this proposed regulation, "payments to a nonresident alien individual from a trust described
in section 401(a) are subject to withholding under section 1441 and not under section 3405 or
3406." Prop. Regs. § 1.1441-4(b)(1)(ii).

232. See IRPAC Paper, supra note 98, at issues 5 and 6.
233. States have generally conformed to federal income tax rules deferring

recognition of pension income. See Hellerstein, supra note 208, at 221, 222; Hamilton, supra
note 208; Richard Reichler, State Taxation of Executive and Employee Compensation, 35 Tax
Mgmt. J. 275 (Sept. 5, 1994) (LEXIS, FEDTAX library, TMJNL file). In the event that the
individual enjoying this deferral becomes a resident of another state before retirement, most

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U.S. Income Taxation of Cross-Border Pensions

individual currently resident in another stateYz-u Because the source-based
jurisdiction of a state extends to intangibles only if they have a "business
situs" in the state, states that sought to tax pension payments paid to
nonresidents had to allow exclusion of an amount "reflect[ing] accumulations
after the taxpayer's change of residence." 5 Thus, the pension trust would

states do not seek to tax the pension income, adopting a "de facto policy of tax forgiveness."
Hellerstein, supra note 208, at 223. Reichler notes that "27 states have no explicit statement
of policy on this issue," and that "nine states do not impose a personal income tax that would
apply to pensions or retirement annuities distributed from qualified plans." Reichler, supra, at
text accompanying nn.26-27. Further, eight states do have an explicit policy of not taxing such
income. Id. at text accompanying n.28. See also Klaiman, supra note 208, at 647 & nn.3-4
(stating that of 13 states with tax codes authorizing such taxation, five indicated in a 1991
survey that they do not enforce the tax; however, some states, particularly California. have
sought to tax pension income of former residents); Hamilton, supra note 208 ("California has
been notably aggressive in pursuing source tax...; Kansas, Louisiana and Oregon also have
the statutory right to tax all types of nonresident pension income."): Reichler, supra, at nn.29
& 30 and accompanying text (stating that California, Idaho and Oregon "explicitly do impose
such a tax" and that Kansas, Massachusetts and New York "do so under some circumstances");
Klaiman, supra note 208, at 647 & n.4 (stating that only California. New York and Vermont
"have systems in place to pursue nonresidents" receiving such income).

234. See Hamilton, supra note 208 (noting that President Clinton signed H.R. 394

on January 10, 1996). For the statutory language, see 95 TNT 252-50 (Dec. 28, 1995) (LEXIS,
FEDTAX library, TNT file). For a description of earlier efforts to pass such legislation, see
Klaiman, supra note 186, at 659-662. Professors Walter Hellerstein and James Charles Smith,
leading commentators on state taxation issues, label as "ludicrous" the arguments of former
Senator Harry Reid of Nevada that state taxation of nonresident pensions is taxation "without
representation" and without reciprocal benefits. Hellerstein, supra note 208, at 223-24. See also
Letter from Carolyn Joy Lee, Chair, Tax Section, N.Y.S.B.A., to Rep. Sam Gibbons (Nov. 9,
1995) 95 TNT 227-6 (Nov. 21, 1995) (LEXIS, FEDTAX library, TNr file) (criticizing as "not
... persuasive" the "[a]rgument that the [federal legislation] is necessary to correct unfair
State taxation"). For further description of such arguments by Reid and others, see Klaiman,
supra note 208, at 663-64. However, Hellerstein and Smith "remain agnostic" as to the
desirability of such proposed legislation limiting states' taxation of pension income of
nonresidents because of the "serious practical complication[s]" resulting from such taxation.
Hellerstein, supra note 208, at 230, 226. See also Letter of Carolyn Joy Lee, supra (stating that
"[t]he complexities of multistate compliance and the risks of multiple taxation may be factors
that warrant federal intervention"). Ms. Lee suggests that "[it also might be fruitful to
consider more limited forms of restriction, for example federal rules that allocate deferred
income among the States in which an individual has lived or worked." Id.

235. Hellerstein, supra note 208, at 226. Hellerstein and Smith note, however, that

in 1989 "a New Jersey court held a nonresident taxable on the payout from a profit-sharing
plan from his former New Jersey employer over the objection that New Jersey was taxing
dividends, interest, and appreciation in the value of a nonresident's intangible assets." Id. at
n.32 (citing McDonald v. Director, Division of Tax'n, 10 NJ. 556 (1989), modified in part,
aff'd in part, 589 A.2d 186 (NJ. Super. Ct. App. Div. 1991). Hellerstein and Smith note that
the N.J. legislature provided a statutory exemption in that same year. Id. Determining the
amount that may be taxed becomes particularly complicated when "[a] taxpayer has worked
in more than one state prior to retirement or has earned income in a state other than his state

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have to make a separate determination of that amount.236

b. Alternative Means of Easing Administrative Difficul-
ties.-Recognition of the administrative difficulties of source-based taxation
of pension payments does not lead inexorably to the current treaty policy.
Instead, the U.S. rules for source-based taxation might be revised in order to
ease these difficulties. A statutory change in U.S. source-based taxation would
have the advantage of completely freeing withholding agents from the
administrative difficulties created by the current rules, even where the
recipient of a pension payment is not protected by a treaty.

For example, as urged by the IRS Chief Counsel in 1975 and as
recommended above for qualified U.S. pension plans, pension payments could
be sourced entirely to the place where the services were performed to avoid
the need to separately identify the "accretions" element. This approach would
not preclude the need to identify multiple source countries where services are
performed in more than one country; however, this same problem also exists
for payments of unfunded deferred compensation that are not classified as
"pensions," and is not considered unworkable in that context.

A second approach to simplifying source-based taxation would be to
treat a pension payment as sourced entirely to the situs of the payor trust.
Thus, the entire amount distributed by a U.S. pension trust would be
classified as from U.S. sources (even if services were performed abroad as in
Table 1, row 5, page 359); no amount distributed by a foreign pension trust
would be classified as from U.S. sources (even if services were performed in
the U.S., as in Table 1, row 4, page 358). A similar approach is suggested by
the U.N. Model Treaty, which contains two alternative provisions for
pensions (one allowing source-based taxation and the other precluding it). In
the former provision, source-based taxation is permitted when a pension
payment is "made by a resident.., or a permanent establishment situated"
within a treaty state. The commentary explains that this approach was
directed at avoiding problems in the situation where employees have
"performed services consecutively in several different countries." The
commentary concluded:

of residence." Id. at 227. Hellerstein & Smith note that if a resident of New Jersey performs
services in Pennsylvania and then moves to Florida upon retirement, "[logically New Jersey
has jurisdiction to tax the full amount of the deferred compensation, together with any
accumulations thereto up to the date of the taxpayer's relinquishment of New Jersey
residence." Id. However, New Jersey's statute would not require filing of a resident return in
the year of retirement when the individual is not a N.J. resident. Id.

236. Cf. supra note 226; Letter of Carolyn Joy Lee, supra note 234 (noting that
"taxation of deferred income requires the allocation of pension distributions between deferred
compensation and deferred investment income, as well as allocation among the States where
income was earned or where an individual resided").

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U.S. Income Taxation of Cross-Border Pensions

[I]t would be very difficult for the head office of a company
to allocate each pension among the various countries in
which the pensioner had worked during his years of employ-
ment. It was generally agreed, therefore, that taxation of
pension at source should be construed to mean taxation at the
place in which the pension payments originated, not the place
in which the services had been performed. " '

If the U.S. were to unilaterally redefine the source of a pension
payment as the situs of the pension trust, then consistency would seem to
require that it disclaim source-based taxation of contributions to foreign
pension plans in respect of U.S. services (see Table 1, row 4, page 358).
However, for the U.S. to amend the Code to relinquish this claim to source-
based tax would seem to create a huge loophole for nonresident aliens
performing services in the U.S. Such aliens could avoid U.S. tax permanently
by having their employers set up nonqualified pension trusts for them outside
the U.S., even though the employees were never subject to a significant home
country tax with respect to such plans.

3. Determination of Overall "Ability to Pay. "-A third rationale for
relinquishment of source-based taxation of pensions by treaty is that "the
country of residence [is] probably in a better position than the source country
to structure its taxation of pensions to the taxpayer's ability to pay."" s This
argument may be based on the concern that source country taxation will lead
to hardship. 239 Thus, a country taxing on the basis of source may be unable

237. U.N. Model, supra note 139, Commentary on Article 18B, at 172.
238. Id. This argument was presented by members from developed companies in

connection with drafting of the U.N. Model Treaty. Members from developed countries also
argued that "since the amounts involved were generally not substantial, developing countries
would not suffer measurably if they agreed to taxation in the country of residence." Id. at 172.
See also Julie Roin, Rethinking Tax Treaties in a Strategic World With Disparate Tax
Systems, 81 Va. L. Rev. 1753, 1761 (1995). Professor Roin notes that, in general. "[residence-
country taxation is thought to be preferable because it enables greater inter-taxpayer equity."
Id. at 1761. She explains that this "argument stems in part from concerns about the
implementation of a progressive rate schedule when taxation is split between the country of
residence and country of source." Id. at 1761 n.27. See also Gliksberg, supra note 205. at 473
(noting that "the principle of ability to pay ... examines the income of the taxpayer from
every source, including that produced abroad").

239. Cf. The Commission of the European Communities. Commission Recommen-
dation of 21 December 1993 on the Taxation of Certain Items of Income Received by Non-
residents in a Member State Other Than That In Which They Are Resident, 94 TNI 61-22
(Mar. 30, 1994) (LEXIS, FEDTAX library. TNI file). The Commission recommended that
when a resident of one member state derives at least 75% of his taxable income in the form
of compensation for dependent or independent services (or from industrial or commercial
activities) in another member state in which he is not resident, the latter country should not

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to provide remedial measures designed to insure that an elderly individual's
sole source of income is not subjected to excessive tax (e.g., a special rate
schedule, standard deduction, or credit for retirees). The residence country's
mechanism to avoid double tax (whether a credit system or exemption
system) will not serve to remedy excessive tax in the source country.24

On the other hand, such a concern could be addressed by requiring
source countries to exempt a generous amount of pension income received by
each recipient. For example, the developing countries participating in
discussions of the 1980 U.N. Model proposed exclusive source-based taxation
but with an exemption "for amounts equivalent to the personal exemptions
allowable in the source country. ' 24'

Alternatively, this rationale for the current U.S. treaty policy might
be based on the concern that source-based taxation may be inappropriately
low. Thus, if the pension is the only item of U.S.-source income of a
nonresident alien and it is (to the extent of the compensation element) taxed
as effectively connected income,242 the applicable U.S. tax rate may be
quite low. 243 However, this concern does not seem very serious as long as
residence-based tax is not precluded.2"

impose any heavier burden of tax than if the individual were a resident. Id. At the same time,
the residence country "may decide not to grant deductions or other tax reliefs which it
normally grants to residents" if such deductions would be duplicative. Id. Similarly, some
countries have entered into bilateral arrangements providing for taxation of frontier workers
by the residence country only.

240. See ALI, supra note 219, at 9-10.
241. See U.N. Model, supra note 139, Commentary to Article 18B, at 172.
242. Ironically, § 864(c)(6) treating deferred compensation as effectively connected

income, rather than fixed or determinable income subject to a 30% withholding rate, may have
a favorable effect on the treatment of nonresident aliens.

243. Thus, it has been suggested that an IRA might be an attractive investment for
U.K. employees working temporarily in the U.S. because the eventual distribution may not be
subject to U.K. tax and the rate of U.S. taxation may be low if this is the only effectively
connected income. See Koch, supra note 125, at 141-42. Koch notes that a nonresident alien
would be eligible for a $2,350 personal exemption, and might well be taxed at a 15% rate. Id.
at 141. See also Roin, supra note 238, at 1761 n.27 (noting that "the source country typically
treats the income earned by the taxpayer in that country as the taxpayer's only income, and
computes the applicable rate starting at the bottom of the rate schedule").

244. But see Avi-Yonah, supra note 225, at 1311-12 (arguing that "because most
individuals have only one residence jurisdiction and are part of only one society, distributional
concerns can be effectively addressed only in the country of residence"). Professor Avi-Yonah
points to the "vertical equity problem in taxing an investor with low domestic earnings and
high foreign earnings that are not taxed abroad in the same way that a person with only low
domestic earnings is taxed." Id. at 1312. He notes that "[tihis problem can be resolved if the
residence jurisdiction is allowed to tax on a residual basis only foreign source income that is
not taxed abroad (or is taxed at lower effective rates) and allows a credit for foreign taxes."
Id. He concludes, however, that "it is much simpler to address the issue if the residence

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U.S. Income Taxation of Cross-Border Pensions

4. Reliance on Residence-Based Taxation.-Each of the arguments
for relinquishment of source-based taxation (described above) rests on the
implicit assumption that the residence country will in fact impose a tax on a
pension payment derived from another country, and that such a tax will be
enforceable. Otherwise, individuals who earn a pension in one country and
retire to another would have the opportunity for achieving complete tax
exemption by virtue of a treaty. Such complete tax exemption is a concern
in the context of state taxation of pensions within the United States. Thus, for
example, now that California is barred by federal law from imposing its tax
on pensions earned in California and paid to former California residents who
retire in Florida, such pensions will be free of any state income tax (since
Florida has no income tax).245 A desire to limit such abuses by the wealthy
(who are often more mobile) was behind failed proposals to limit the federal
legislation to pensions from qualified plans.2

By contrast, in the context of a bilateral treaty relationship, it should
be possible for the U.S. and its treaty partner to assure themselves that
residence-based taxation at a reasonable rate will in fact be imposed on
recipients of pension payments exempted from source-based tax. This
assumption is discussed further in Part IV of this article, dealing with
residence-based taxation. If so, a country such as the U.S. that (unlike a
developing country)247 could expect to have a fairly balanced position (as
a residence country and a source country) with other developed countries,
may see no disadvantage to entering bilateral agreements that entail giving
up source-based jurisdiction while preserving residence-based jurisdiction
over pensions.2' Therefore, even if the U.S. adopts this article's recommen-

jurisdiction is given the exclusive right to tax all income of its residents." Id. Professor Avi-
Yonah further notes that "taxation based on residence is a useful, though far from perfect,
proxy for taxation with representation." Id.

245. Some predict that the federal legislation could lead to "substantial abuses of
the pension system" on the part of wealthy taxpayers with the ability to shift considerable
compensation to the form of a pension and to move to a low tax state on retirement. See
Klaiman, supra note 208, at 667-68. This outflow of wealthy taxpayers could lead states to
lower their top marginal rates to be more attractive to such taxpayers. Id. at 668.

246. Id.; see id. at 660-62 (describing legislative proposals).
247. In the discussions leading to the U.N. Model Treaty. developing countries

"observed that pension flows between some developed and developing countries were not
reciprocal and in some cases represented a relatively substantial net outflow for the developing
country." U.N. Model, supra note 139, Commentary to Article 18B, at 172. Developed
countries responded with the argument that "since the amounts involved were generally not
substantial, developing countries would not suffer measurably if they agreed to taxation in the
country of residence." Id. at 172.

248. The recent opinion by the Court of Justice of the European Communities in
the Wielockx case reflects this view. See Case C-80/94, G.H.EJ. Wielockx v. Inspecteur der
Directe Belastingen, 95 TNI 216-11 (Nov. 8, 1995) (preliminary ruling) (LEXIS, FEDTAX

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dation to simplify the U.S. statutory rules for source-based taxation, there is
no great incentive to change the long-standing treaty policy of barring source-
based taxation of pension payments.

F. Proper Scope of Source-Based Exemption

If the treaty exemption from source-based taxation of pensions is to
be maintained, then it seems appropriate to delineate more clearly, and in an
authoritative manner, the payments to which it applies.

As the IRS has noted, the term "pension" generally refers to a
payment or series of payments that is "contingent on retirement," i.e., a
separation from service due to reaching retirement age, death or disability.
The IRS may reason that the refinements in measurement of ability to pay
that are possible in the residence country (but not the source country) are
most important for individuals who are no longer in the workforce and may
be completely dependent on a pension. A focus on this aspect of "pensions"
suggests that lump-sum payments during retirement are at least as deserving
of treaty protection as periodic payments (even though periodic payments
may present greater administrative difficulties in respect of segregating the
"compensation" and "accretion" elements).

The "contingent on retirement" criterion might further suggest that the
treaty exemption for pension payments should apply to payments from
unfunded, as well as funded, arrangements, provided that the payments are
contingent on retirement. On the other hand, one might argue that only pay-
ments from funded plans should qualify for the treaty exemption because only
payments from funded plans present the administrative difficulty of separating
the "compensation" element from the "accretions" element. To the extent that
this administrative problem is eased by eliminating the distinction under U.S.
internal law between the "compensation" and "accretions" element of a
pension payment, this argument would have less force. Perhaps, most unfund-
ed plans are not "contingent on retirement" in any event; thus, as a practical
matter, unfunded deferred compensation (even if not specifically excluded

library, TNI file); see also Kees van Raad, EC Court of Justice Decides Wielockx Case,
Restricting the Scope of Bachmann Decision, 11 Tax Notes Int'l 779 (Sept. 18, 1995)
[hereinafter van Raad]; Jill C. Pagan, United Kingdom: Momentum for Change in Approach
to Taxation Gathers Pace, II Tax Notes Int'l 802, 803-06 (Sept. 18, 1995). In the Wielockv
case, the court held that the Netherlands' refusal to allow a Belgium resident working full-time
in the Netherlands to establish a deductible pension reserve violated the "freedom of
establishment" article of the EC treaty. See van Raad, supra, at 779-80. The court concluded
that allowance of such a deduction by the Netherlands would not disrupt the "cohesion" of its
tax system, even though the Netherlands had relinquished its right to tax distributions from the
pension reserve under its treaty with Belgium. Id. at 780. The court found that overall
"cohesion" was achieved through the reciprocity in the obligations under the treaty. Id.

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U.S. Income Taxation of Cross-Border Pensions

from "pension" classification) would generally not qualify for the treaty
exemption.

The IRS should provide guidance in an authoritative form regarding
the scope of the term "pension" in treaty provisions being applied to limit the
assertion of U.S. tax. The current use of private letter rulings to delineate the
term (and even then, only in respect of "qualified plans") creates serious
problems for U.S. plan administrators, who face substantial penalties for
failure to withhold when required.

Some of the requirements that the IRS has set forth in private letter
rulings seem to be appropriate guidelines for determining whether a payment
is "contingent on retirement." For example, the IRS requirement that pay-
ments be made only after the employee has reached Social Security retire-
ment age, has separated from service after attaining age 55, or has died or
become disabled (unless the payments are to be spread over the employee's
entire life or life expectancy) may be useful for this purpose. On the other
hand, it is not clear why the IRS further requires that payments be made
"after the employee has been employed for 5 years or more" or alternatively,
if the employee was "first employed ... on or after reaching age 60." It
seems ironic that the source country would condition giving up its jurisdiction
to tax a pension upon the pensioner having a long-term relationship with the
employer and thus in many cases a longer relationship with the source
country.

Distributions from an IRA are not directly contingent on retirement,
even though lump-sum distributions prior to age 59 and 1/2 (and absent death
or disability) are subject to penalty. However, the age threshold of 59 and 1/2
assures that a large portion of distributions from IRAs are in fact made during
retirement. In addition, it seems appropriate for a distribution from an IRA
that is attributable to a rollover from a qualified pension plan to qualify for
the pension exemption. Creating a different treatment for a distribution from
an IRA to the extent not attributable to a rollover would create serious
administrative difficulties for the IRA trustee.

Certain types of payments that might otherwise be classified as
"pensions" might nevertheless be excluded from this category if the task of
ensuring adequate residence-based tax is particularly difficult with respect to
such payments. For example, the Netherlands' policy of preserving source-
based taxation of lump sum pension payments in its treaties is apparently
based upon concern about avoidance of residence-based tax. 49 That the

249. See Treasury Explanation of Netherlands Treaty, supra note 147. at 1653. The
treaty allows taxation of a lump sum pension payment by the country where services were per-
formed if the employee was resident in that country at any time in the previous five years. See
U.S.-Neth. Treaty, supra note 148, art. 19, T 2. The Treasury explains that the U.S. sought to
accommodate the Netherlands "concern ... that the lump-sum payment might avoid tax

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Netherlands is willing to accept the superiority of the residence country's
claim to tax is suggested by the fact that the source-country taxing a lump
sum pension payment is required to give a credit for residence-based tax.

G. Source-Based Taxation of Contributions to Foreign Pension Plans

As just discussed, the U.S. is willing to surrender source-based
taxation of pension payments from a U.S. qualified pension plan in the
context of a bilateral treaty (where residence country taxation and a relatively
balanced movement of employees between the two countries is assured).
Should it be equally willing to give up by treaty its source-based taxation of
compensation derived by a nonresident alien from U.S. services and contri-
buted by his employer (or by the employee himself) to a plan qualified in a
foreign country that is a U.S. treaty partner? (See Table 1, row 4, page 358).
In either case, even though services have been performed in the U.S., the
combination of such a treaty provision with the applicable provisions of the
Code would result in complete elimination (rather than merely deferral) of
U.S. tax.

Until recently, a policy of relinquishing source-based tax on contribu-
tions to foreign pension plans has had relatively little acceptance among the
U.S. and its treaty partners. Such a rule is suggested only in the commentary
of the 1992 OECD Model, and the rule suggested is quite limited in scope.
The suggested rule applies only to employee contributions (which do not
present the valuation issues of some employer contributions), only to an
individual who is a resident but not a national of the country where services
are performed, and only where an employee has previously been contributing
to the home country pension plan prior to taking up a work assignment in the
other country. The Court of Justice of the European Community has ruled
that the Treaty of Rome's provision guaranteeing freedom of movement of
workers does not require an EC member country to permit a national of
another member country to deduct contributions made to a pension plan
entered into in the latter country prior to arrival in the former country."

altogether, or be subject to only a low rate of tax, even though the contributions on which the
payment is based had been deductible for Netherlands tax purposes." Treasury Explanation of
Netherlands Treaty, supra note 147, at 1653. Under the treaty, however, taxation of a lump
sum payment by the country where the services were performed is barred when the lump sum
payment is contributed to a pension plan or retirement account under circumstances that would
have qualified for tax deferral in the residence country if the payor were also resident in that
state. See U.S.-Neth. Treaty, supra note 148, art. 19, 3. The Treasury explains that in this
case "the tax avoidance concerns of the Netherlands would not be present." Treasury
Explanation of Netherlands Treaty, supra note 147, at 1653. See also supra note 163.

250. In the Bachmann case, Belgium refused to allow a German national working
in Belgium to claim a deduction from his Belgium income for contributions paid to pension

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U.S. Income Taxation of Cross-Border Pensions

The U.S. has included a rule similar to that in the OECD commentary
only in its treaties with Sweden and France and in its proposed treaties with
Austria and Switzerland. The French provision applies to an employee who
is a U.S. resident but not a U.S. national; but the employee is not required to
have previously contributed to the French plan. However, the inclusion of
such a provision in the 1996 U.S. Model suggests that such a provision may
be included in U.S. treaties more frequently in the future.

The hesitancy of the U.S., until recently, and the hesitancy of other
countries to give up imposition of source-based tax on contributions made to
a foreign plan seems odd given the disadvantages that may be involved in
imposition of such a tax. First, imposition of a current tax under section
402(b)(1) on contributions to a foreign pension plan in respect of U.S.
services involves serious administrative difficulties (particularly if the plan is
a defined-benefit plan). If the foreign country where the plan is located does
not impose an immediate tax on contributions to this type of plan, then the
foreign tax authorities may not require the types of computations that would
be required to determine the U.S. tax (i.e., determination of the employee's
interest in the trust, and determination of the portion of the services
performed in the U.S. before or after 1986). It seems questionable whether
the U.S. tax in this situation has been uniformly enforced.

Further, imposition of a source-based tax on contributions to a foreign
pension plan may create burdens for the employee that discourage his
acceptance of a work assignment in the U.S. particularly when the country
where the plan is situated accords tax-favored treatment to the plan. For
example, the U.S. tax on contributions may create liquidity problems that
would have been avoided if the employee had instead continued to work in
his home country. In addition, double taxation may result because generally
treaties have not barred further taxation by the country where the employee
resides at the time of distribution. If that country uses a foreign tax credit
mechanism, it may not grant credit for a tax paid to a source-country so
many years before. Finally, source-based tax may not provide as accurate a
determination of ability to pay as a residence-based tax.

(and other) insurance plans entered into in Germany prior to his arrival in Belgium. Case C-
204/90, Bachmann v. Belgian State, 94 TNI 50-15 (Jan. 28, 1992) (LEXIS. FEDTAX library,
TNI file). The court found that, notwithstanding provisions guaranteeing freedom of movement
of workers in the Treaty of Rome, Belgium's position was "justified by the need to ensure the
cohesion of [its] tax system." Id. 28. That is, the court believed that Belgium should not be
required to allow a deduction for contributions to a plan the distributions from which would
not be subject to Belgium tax. Id. For a subsequent limitation imposed by the court on the
principle of "cohesion," see discussion of the Wielockx case. supra note 248. The Bachmann
case is further discussed in Muten, supra note 72.

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The past reluctance of the U.S. to relinquish source-based tax over
pensions in this context can perhaps be attributed to the following factors.
Because a foreign plan is ordinarily not a qualified plan under the Internal
Revenue Code, the appropriate time for the U.S. to impose its tax is when
contributions are made (or, if later, when they are vested). Even if the plan
situs is a country having a treaty with the U.S., the U.S. may not be able to
determine at that time whether any country will ultimately impose a
residence-based tax on the pension income. At the time of the contributions,
the employee may be a resident of the U.S. for tax purposes. The U.S. cannot
be sure that the employee will retire in the country of the plan's situs. That
country may impose tax only at the time of distributions from the plan and
only if the employee is resident at that time (because the underlying services
were performed elsewhere). (By way of analogy, when the only nexus of the
U.S. with a pension is the situs of the pension trust, the U.S. taxes only the
accretions element of a distribution and forgives that tax in many cases under
section 871(f)). It is possible that the employee will retire in the Cayman
Islands, or some other country not having a treaty with the U.S. Thus, if the
U.S. forbears from immediate imposition of source-based tax, it cannot be
assured that residence tax will ever be imposed.

This concern may perhaps be addressed by the U.S. providing merely
a deferral of its source-based tax at the time of the contributions to the
foreign plan and only if the situs of the plan is a U.S. treaty partner and
provides for deferral with respect to such a plan. Under this approach, the
U.S. would retain jurisdiction to impose source-based tax on an eventual dis-
tribution from the plan if residence jurisdiction is not claimed at that time by
a treaty partner of the U.S." 1 The country of the plan situs, as a U.S. treaty
partner, would be able to facilitate the U.S. obtaining the necessary informa-
tion to impose tax at the time of distribution. If the U.S. eventually surrenders
its source-based tax because the individual retires as a resident of a treaty
partner of the U.S., the U.S. is giving up its tax as part of a reciprocal
arrangement. Provided that limits on the dollar amounts contributed to the
pension plan are similar to those applied by the U.S. for contributions to a
U.S. qualified pension plan, some parity in the revenues surrendered is
preserved.

Nevertheless, some may question why the U.S. should allow deferral
of U.S. tax for contributions to a foreign pension plan that is not subject to
U.S. standards for vesting, funding, rank-and-file participation, and fiduciary
behavior. Allowing the deduction may be seen as undermining the incentive

251. However, the total amount subject to tax would be reduced in terms of present
value unless the U.S. were to treat the entire distribution (including the accretions element) as
U.S. source.

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U.S. Income Taxation of Cross-Border Pensions

effect of the tax-favored treatment of U.S. qualified pension plans because the
same U.S. tax advantage can be obtained without all the detailed restrictions
of a U.S. qualified plan.

It is not clear whether this concern is valid, however. The true
advantage of a tax-favored pension plan (exemption of the investment return
from tax in the country where the plan is located) is not being granted by the
U.S. in this situation; in fact, the country in which the plan is situated may
not even grant complete exemption from tax for investment income of the
plan. Moreover, in the case of contributions made directly by the employer,
if the U.S. defers the tax on the employee, it would presumably also defer the
allowance of a U.S. tax deductione 2 for the employer.2-3

Further, the employee's decision to make contributions in respect of
U.S. services to a pension plan situated outside the U.S., but in a country that
is a U.S. treaty partner, is more likely to be based upon his expected,
continuing relationship with that country, than upon avoidance of the
requirements of a U.S. qualified plan. This would seem to be especially true
where the employee is a national of (or has been a long-term resident of) the
country where the plan is situated. Moreover, if the employee has already
contributed to the foreign plan prior to his U.S. work assignment, there may
be significant advantages in continuing with the same plan.' In addition,
it seems reasonable for the U.S. to entrust a country with which the employee
has had significant ties with the responsibility to assure the adequacy and
safety of his retirement arrangements.

Thus, this innovation in the 1996 U.S. Model is to be commended.
The U.S. should provide more generally in treaties for the giving up of
source-based tax on contributions to pension plans situated in the other treaty
country where the other treaty country also provides employee tax deferral
with respect to plan contributions. This treaty policy is especially compelling
if limited to cases where the employee is a national (or prior resident) of the

252. The restrictions of § 404(a)(5) would apply because the plan would not be a
qualified plan for U.S. tax purposes. The more lenient rules of § 404A are inapplicable to "any
item to the extent such item is attributable to services... performed in the United States the
compensation for which is subject to tax under this chapter." IRC § 404A(g)(1)(B).

253. However, if the employee is treated as receiving compensation and then
making a deductible contribution to the foreign pension plan, there would be no deferral of
the employer's deduction for U.S. tax purposes.

254. It has been suggested that the "right of deduction [be limited] to persons with
legitimate reasons for requesting deductions-say, having moved internationally"; in other
words, limited to "cases where it is required to safeguard the principle of mobility of labor."
See Muten, supra note 72, at § VIII. Bissell & Giardina point out that "many U.S. plans
exclude foreign nationals who retain [home country pension] coverage"; they explain that
"because such groups are relatively small, and/or highly compensated, usually no prohibited
'discrimination' results." Bissell & Giardina, supra note 72, at 279.

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treaty country where the plan is situated, and the employee has previously
contributed to the plan in that country.

IV. RESIDENCE-BASED U.S. TAXATION OF DEFERRED COMPENSATION
PAID TO U.S. CITIZENS OR RESIDENTS

If the U.S. treaty policy of relinquishing source-based taxation of
pensions is based upon the assumption that residence-based taxation is
preferable and will be asserted by the U.S. and its treaty partner, then further
examination is warranted of residence-based taxation. Two principal scenarios
for U.S.-residence-based tax will be described. In the first, a U.S. citizen
performs services in another country in respect of which contributions are
made by him or his employer to a foreign retirement arrangement; the
individual remains a U.S. citizen (though perhaps resident outside the United
States) when distributions are eventually made to him from the foreign
retirement arrangement. See Table 2, row 8, page 360. In the second scenario,
a nonresident alien performs services in a foreign country in respect of which
contributions are made to a foreign retirement arrangement; the individual
retires in the U.S. and is a U.S. resident at the time of receiving retirement
distributions from the foreign plan. See Table 2, row 10, page 361.

A. U.S. Citizen Who Works in Foreign Country Before Retirement in the U.S.

1. Imposition of U.S. Tax.-Unlike almost all other countries, 5

the U.S. taxes its citizens on their worldwide income, regardless of where
they may be resident.5 6 However, a U.S. citizen or resident present in a
foreign country for an extended time may exclude from income up to $70,000
of foreign earned income annually pursuant to section 911.257 Foreign
income taxes paid by a U.S. citizen with respect to compensation for services

255. Apparently, the only other countries taxing worldwide income on the basis of
citizenship are the Philippines and Eritrea; however, Mexico had such a regime prior to 1981.
See JCT Report on Expatriation, supra note 129, app. at B-1.

256. See supra note 77.
257. Remuneration paid to a U.S. citizen for services rendered abroad to a U.S. or

foreign employer are subject to income tax withholding to the extent the remuneration exceeds
the allowable § 911 exclusion and is not subject to foreign withholding. Rev. Rul. 92-106,
1992-2 C.B. 258 (situations 1 and 2). The exemption from withholding for the § 911 exclusion
amount is not available to a U.S. resident. Id. at 259. If the remuneration is paid by an
"American employer," as defined in §§ 3121(h) and 3306(j)(3), it is also subject to FICA and
FUTA taxes. Id.; see Bissell, supra note 80, at 146-47; see also supra note 81 and accompany-
ing text. As explained by Bissell, "[iut is believed that the IRS does not actively enforce [the
requirement that a foreign employer perform U.S. wage withholding] except possibly where
the foreign employer is a payroll subsidiary owned by a U.S. company and located in a foreign
tax haven." See Bissell, supra note 80, at 146.

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U.S. Income Taxation of Cross-Border Pensions

performed abroad may be creditable against U.S. tax under section 901.
However, no credit is allowable with respect to foreign taxes attributable to
income excluded by section 911.2's

A U.S. citizen working overseas may be able to continue making
contributions to a U.S. deferred compensation plan.S9 Whereas taxation of
contributions to a qualified U.S. pension plan will be deferred for U.S. tax
purposes, there may be a current tax in the country where the services are
performed.26 In addition, no exemption is available from U.S. tax under
section 911 for the eventual distributions"' from the plan because section
911 is inapplicable to deferred compensation ' (although some wish to

258. IRC § 911(d)(6); Regs. § 1.911-6(c)(1).
259. For example, the worker's employer may be a U.S. corporation with a qualified

plan who sends the employee to a foreign branch operation. A U.S. multinational employer
may arrange for the employee to be "seconded" to a foreign subsidiary (so that the employee's
employment relationship and pension plan coverage remain with the U.S. parent company).
See Ellis & Navin, supra note 72, at 9, 18-24 (discussing this possibility for an "outbound
executive"); see also Bissell & Giardina, supra note 72. at 276-78.

260. See Ellis and Navin, supra note 72, at 24 ("[T]he local tax rules may provide
for taxation when the contribution is made to the plan, allocated to a plan account on the
executive's behalf or when the executive vests in the contribution." The "vesting date" is "the
most likely date" for "a number of countries (e.g., Brazil, Germany and Spain)." whereas in
the U.K. it is "when [the executive] first becomes entitled to receive payment under the
plan."). See also Bissell & Giardina, supra note 72, at 277-78 ("As a general rule, most foreign
countries do not attempt to tax employer contributions to an actuarially-based defined benefit
pension plan located in an employee's home country. In contrast, most foreign countries do
not respect the salary reduction portion of a U.S. § 401(k) plan, and will tax the employee on
his own contributions to the plan if they know about it.").

261. Similarly, it cannot be argued that the employee has an investment in the
contract in the amount of employer contributions that would have been excludable under § 911
if paid directly to the employee. See IRC § 72(f); Rev. Rul. 72-149, 1972-1 C.B. 218. This
rule applies only to services performed after 1962. Id.

262. Section 911 does not apply to: (1) any compensation "received after the close
of the taxable year following the taxable year in which the services are performed," (2) any
amounts "received as a pension or annuity" and (3) any amounts "included in gross income
by reason of § 402(b) (relating to ... nonexempt trusts)." IRC § 911 (b)(1 (B)(i). (iii), (iv).
These restrictions were added to the Code in 1962. See H.R. Rep. No. 1447, 87th Cong., 2d
Sess. 54 (1962), reprinted in 1962-3 C.B. 405, 458. Congress denied the § 911 exclusion for
an amount paid as a pension because "Congress thought it discriminatory to allow [an
employee who worked abroad] to retire in the United States next to another individual who
had worked in the United States for the same employer and who was fully taxable on the
contributions made by the employer." Gen. Couns. Mem. 36.345 (July 23, 1975) (citing S.
Rep. No. 1881, 87th Cong., 2d Sess. 74-75 (1962). reprinted in 1962-3 C.B. 780-81); see also
H.R. Rep. No. 1447, 87th Cong., 2d Sess. 54-55 (1962), reprinted in 1962-3 C.B. 405,458-59.
Congress denied the § 911 exclusion for deferred compensation (received after the end of the
taxable year following the year of performance of the services) because it saw "no reason...
to provide [a] special inducement for overseas employment long after the period in which the

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change this).263

A U.S. citizen working abroad may alternatively2l participate in a
foreign deferred compensation plan.265 A foreign retirement plan is almost
certain to be a nonqualified plan for U.S. tax purposes.266 As a result,
employer contributions to a funded plan are taxed under section 402(b) 267

employment occurred." Id. at 55. The committee report further noted that "this will treat
deferred compensation under the exclusion the same as qualified pensions." Id.

263. Legislation introduced by Representative Bill Alexander in 1992 would expand
the scope of § 911 to reach deferred compensation income. H.R. 4562, 102d Cong., 2d Sess.
(1992). Under the proposal, "[a]mounts received after the close of the taxable year in which
the services to which the amounts are attributable are performed shall be excluded ... without
regard to the taxable year in which they are received." Id. § 2(a) (adding new § 911 (c)(3), and
in effect repealing § 911(b)(1)(B)(iv)). Further, the current law's denial of a § 911 exclusion
for a pension or amount included in income under § 402(b) is in effect reversed; the § 911
exclusion is not denied for "so much of any amounts received as a pension ... as is
attributable to personal service rendered outside the United States during the periods for which
the taxpayer met" the eligibility requirements; nor is the exclusion denied for "amounts
received or otherwise includible in gross income under a foreign pension, annuity, or trust
(except to the extent that such amounts are attributable to personal services rendered within
the United States .... Id. (adding new § 911 (c)(5)(A), (B), and in effect repealing current
§ 91 1(b)(1)(B)(i) and (iii)).

264. See Ellis & Navin, supra note 72, at 30-31 for a discussion of "reasons" for
participating in foreign deferred compensation plans.

265. Assuming that the foreign deferred compensation plan is not a U.S. qualified
plan, then an employee's participation in it will not be a barrier to making deductible
contributions to an IRA. Id. at 31 (citing IRC § 219(g)(1), (5)).

266. Id. They consider it "highly unlikely that a foreign retirement plan would ever
satisfy the tax qualification requirements set forth in IRC § 401(a)." Id. They note that "very
few jurisdictions in the world [have] private pension requirements as complicated" as these,
and, even though there are "similar schemes" in Canada, U.K., and Australia, "few rules are
the same." Id. See also Letter from Raymond J. Wiacek to Leonard B. Terr, International Tax
Counsel, (Aug. 10, 1988), reprinted in 88 TNI 38-32 (Sept. 21, 1988) (LEXIS, FEDTAX
library, TNI file) [hereinafter Wiacek Letter to Terr] (noting that although Canadian pension
arrangements may be "analogous to U.S. retirement vehicles" a Canadian registered pension
plan "does not constitute a 'qualified' plan for U.S. purposes, because Canadian requirements
are different from those set forth in section 401 of [the] Code."). The fact that the pension
trust is not organized under U.S. law is not in itself disqualifying if all of the other
requirements of § 401(a) are met. See § 402(e)(5), which was repealed and reinstated as
§ 402(d), by Small Business Job Protection Act of 1996, Pub. L. No. 104-188, § 1401(b)(13),
110 Stat. 1755 (effective for tax years after December 31, 1999).

267. See Walker & Olson, supra note 22, at 98:
[Section 402(b) will] generate a tax liability for resident aliens accruing
benefits in a foreign plan that is funded, whether or not the foreign plan
is a tax-preferred vehicle for accumulating retirement savings in the
foreign country. To avoid this result, the foreign employer needs to
consider delaying the funding of benefits ... or make the benefit that is
being funded subject to a substantial risk of forfeiture until the individual
is no longer a U.S. resident.

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U.S. Income Taxation of Cross-Border Pensions

when made, if they are vested; otherwise, the value of the employee's interest
at the time of vesting is included ; the amounts so included are not
eligible for section 911 exclusion.m9 One might anticipate problems in
applying these provisions when separate accounts are not maintained for each
employee, for example in a defined benefit plan.270 Moreover, if the
employee is a "highly compensated employee" and the plan fails to meet
certain "participation" or "coverage" requirements of a qualified plan,"' he
or she is taxed currently under section 402(b)(4)(A) on the amount of his
vested accrued benefit.272

Id. Walker & Olson state that "[w]hile the effect of Section 402(b) on aliens most likely was
not considered when the statute was enacted, the provisions do not exclude such employees."
Id. at 95 n.28. They suggest that "[i]n an increasingly global economy, the adverse
consequences will be more noticeable." Id. See also Letter from Raymond J. Wiacek to Peter
Barnes, Associate International Tax Counsel (Jan. 25, 1990). reprinted in 90 TNI 8-54 (Feb.
21, 1990) (LEXIS, FEDTAX library, TNI file) [hereinafter Wiacek Letter to Barnes] ("Because
[Canadian] registered plans are not qualified plans under the Code, Canadian citizens resident
in the U.S. and U.S. citizens (wherever resident) who are covered by registered plans are
required under Section 402(b) to include in their income contributions by their employer...
to the extent the employees' benefits under the plan are vested"); KPMG Letter, supra note
161 ("Section 402(b) will subject a U.S. citizen to U.S. income tax as the individual becomes
vested in the benefits of a Canadian pension... plan.").

268. See Regs. § 1.402(b)-l(a)(l), (b) (when interest that was nonvested becomes
vested, the employee must include the value of his interest in the trust at the time of change);
Ellis & Navin, supra note 72, at 31-32.

269. See IRC § 91 l(b)(l)(B)(iii) (IRC § 911 is inapplicable to amounts included in
gross income under § 402(b)); Ellis & Navin, supra note 72, at 33.

270. See Regs. § 1.402(b)-1(b)(2)(ii) (providing that in such a case "the value of
an employee's interest in such trust shall be determined in accordance with the formula
described in § 1.403(b)-l(d)(4) or any other method utilizing recognized actuarial principles
that are consistent with the provisions of the plan.., and the method adopted by the employer
for funding the benefits .. "); Ellis & Navin, supra note 72, at 32; Wiacek Letter to Barnes,
supra note 267; Wiacek Letter to Terr, supra note 266. See also infra note 346 for a discussion
of Wiacek Letter to Terr.

271. See §§ 402(b)(4)(A), 401(a)(26). 410(b); Ellis & Navin, supra note 72, at 31
(explaining that most foreign retirement plans will attract the application of § 402(b)(4)(A) for
an employee who is a "highly compensated employee" as defined in § 414(q)). They comment
that:

Even if a foreign retirement plan covers the lesser of 50 employees or
40% of all employees (§ 401 (a)(26)), it probably will not cover a
percentage of non-highly compensated employees which is at least 70%
of the percentage of highly compensated employees covered by the plan
(or satisfy alternative coverage requirements), and there are likely to be
several other § 401(a) qualification requirements that will not be met.

Id.
272. In a 1996 amendment to the foreign trust rules, Congress made clear that § 679

(dealing with foreign trusts having a U.S. beneficiary) is not applicable to a trust described in
§ 402(b). See §§ 679(a) and 6048(a)(3)(B)(ii), amended by Small Business Job Protection Act

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If a foreign retirement arrangement is unfunded by U.S. stan-
dards,273 then U.S. tax is delayed until payment of the deferred compensa-
tion.274 See Table 2, row 7, page 360. This may be true of a foreign
pension plan meeting the foreign country's requirements for an immediate
employer deduction.275 Although U.S. standards are necessarily applied, the
IRS recently showed some flexibility in applying its usual ruling guidelines
for classifying a deferred compensation arrangement as unfunded in order to
take into account the fact that the arrangement had to "comply with Canadian
tax law as well as United States tax law. 276

of 1996, Pub. L. No. 104-188, § 1901(a), 1903(b), 110 Stat. 1755, 1904-10 (effective for
transfers after Feb. 6, 1995).

273. See Ellis & Navin, supra note 71, at 32 (suggesting that "it may be possible
to argue that § 402(b) is inapplicable where the foreign retirement plan is financed through
book reserve accruals or other arrangements that do not constitute typical U.S. employee
benefit plan trusts"; noting the absence of a definition of "employee's trust" in § 402(b) or the
regulations thereunder; suggesting that reference should be made to the definition of a trust
in Regs. § 301.7701-4, and further noting that "an outbound executive may be taxable with
respect to his interest in a foreign retirement plan pursuant to § 83 if it is funded but not
otherwise subject to taxation under § 402 or § 403").

274. See Priv. Ltr. Rul. 93-32-038 (May 18, 1993), where the IRS ruled that a
deferred compensation agreement and trust established in Canada (and modelled according to
Canada's Income Tax Act as an Employee Benefit Plan Trust) by a Canadian employer for
a U.S. citizen employee did not result in any income for the employee until amounts were
actually distributed or otherwise made available to the employee. The IRS ruled that there was
no transfer of property under § 83, no contribution to an employee's trust under § 402(b), and
no inclusion under the economic benefit or constructive receipt doctrine prior to that time. Id.
See also Ellis & Navin, supra note 72, at 33 ("[To the extent that a foreign retirement plan
is unfunded and participants receive benefits on a 'pay as you go' basis, the outbound
executive is not taxable on the foreign retirement benefit until receipt.").

275. See Feder, supra note 72, at 43-44 (Most German pension plans are unfunded,
with "[a]nnual additions to reserves for pension expenses deductible for German income tax
purposes under a precise set of actuarial assumptions."). Feder further notes that a U.S.
executive participating in such a plan does not recognize income for U.S. tax purposes "until
payment is actually made" to him. Id. at 47.

276. Priv. Ltr. Rul. 93-32-038 (May 18, 1993) (confirming unfunded status for a
trust formed by a Canadian sports team for the benefit of a U.S. citizen key employee). The
IRS considered that the formation of the trust in Canada and the need to "comply with
Canadian tax law as well as United States tax law" was a "rare and unusual circumstance"
justifying a ruling notwithstanding failure to follow the model format. Id. The trust agreement
provided that the employee "has the status of a general unsecured creditor," and the "material
terms and provisions of the Trust ... are enforceable" under Canadian law. Id. The ruling states
as a proviso that "the provision in the Trust requiring use of the Trust assets to satisfy the
claims of general creditors in the event of insolvency is enforceable by the general creditors
of the Employer under Canadian as well as ... provincial law." Id. (The trust at issue in that
ruling followed the IRS's model language but not its model format for a rabbi trust. Rev. Proc.
92-64, 1992-2 C.B. 422.)

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U.S. Income Taxation of Cross-Border Pensions

When a U.S. citizen or resident working overseas contributes to an
individual retirement savings trust organized under foreign law, the conse-
quences are similar to those of participating in a foreign employer-sponsored
plan. Contributions to such plans are not deductible for U.S. tax purposes.
Moreover, such plans may be viewed as grantor trusts under section 679 of
the Code,2" with the result that trust earnings are taxable to the beneficiary
pursuant to section 671.278

2. Foreign Tax Credit Considerations.-U.S. taxation of deferred
compensation of a U.S. citizen who works overseas may be duplicative of the
host country's tax. In some cases, the host country will be prevented from
imposing source-country taxation by the dependent services article of a treaty
(where the "commercial traveler" test is met) or by the pension article of a
treaty (if source-based tax would otherwise be imposed at the time of the
pension payment). At the same time, the host country may seek to impose a
residence-based tax; even if a treaty applies, the treaty tie-breaker rule may
classify the individual as a resident of the host country, rather than the
U.S.279 Under the French or Swedish treaties, employee contributions to a
U.S. qualified retirement arrangement may be deductible in the host
country.

280

As the residence country, the U.S. undertakes to mitigate international
double taxation by the allowance of a credit under section 901 for foreign
taxes paid with respect to foreign source income." Assuming that all
services are performed abroad, the entire amount of unfunded deferred
compensation is treated as foreign source income (when paid); the entire
amount of income arising from contributions to a foreign pension plan or
from distributions from the plan would also be foreign source. In the case of
a distribution from a U.S. qualified pension plan, only the amount represent-

277. See Wiacek Letter to Barnes, supra note 267 (concluding that a Canadian
registered savings plan created as a trust by a U.S. citizen or resident would be subject to
§ 679); see also Wiacek Letter to Terr, supra note 266.

278. See Wiacek Letter to Barnes, supra note 267 (Wiacek notes that if a Canadian
citizen with a RRSP trust establishes U.S. residence, the application of § 679 would be
triggered. Under the U.S.-Canada Income Tax Treaty, supra note 146. prior to the effective
date of the 1995 protocol, the election to defer U.S. tax on the earnings pursuant to art. 29,

5 was not available to a Canadian citizen.) Wiacek argued that "[n]oncompliance here" is
"potentially serious." Wiacek Letter to Terr, supra note 266. On the other hand, "if. before
establishing a U.S. residence, the Canadian citizen uses his RRSP/RRIF assets to purchase an
annuity contract ... the U.S. trust taxation rules would never apply." and the purchase price
of the contract would be the "investment in the contract" for purposes of § 72. Id.

279. See Ellis & Navin, supra note 72, at 48-49.
280. See supra notes 193-200 and accompanying text.
281. See IRC § 901.

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Florida Tax Review

ing contributions in respect of services abroad is foreign source; the amount
representing "accretions" is from U.S. sources.282

However, effective use of the foreign tax credit may be hindered by
timing differences under U.S. and foreign tax rules.283 Thus, for example,
contributions to, or accretions in, a foreign funded pension plan may be
eligible for deferral under foreign law;' in that case, U.S. taxation of the
employee will precede foreign taxation. In the year that foreign taxation is
imposed, the employee may have no foreign source taxable income for
purposes of the section 904 credit fraction. A carryback of the credit is
permitted only to the two preceding years.285

3. Treaty Provisions.-The recently negotiated treaties with France
and Canada provide some relief for such mismatching.286 Under Canadian
tax rules, taxation of the earnings of a Canadian registered retirement savings
plan is deferred until distribution; however, the failure of such a savings plan
to qualify as an IRA under section 408(a) results in immediate U.S. taxation
of the earnings to a beneficiary who is a U.S. citizen or resident. Under
article 29, paragraph 5 of the U.S. tax treaty signed with Canada in 1980,287

282. See Rev. Rul. 79-389, 1979-2 C.B. 281 (A distribution to a U.S. citizen from
a U.S. pension plan is treated as U.S. source for purposes of § 904 to the extent of
"accretions" and contributions made with respect to services performed in the U.S.); Rev. Rul.
78-227, 1978-1 C.B. 242 (Distributions from a Foreign Service retirement annuity that were
attributable to current Congressional appropriations were considered to be "employer
contributions" and thus sourced for purposes of § 904 on the basis of the place where services
were performed.); Rev. Rul. 84-144, 1984-2 C.B. 129 (Amounts withdrawn from an IRA
established by a rollover from a qualified pension plan were foreign source, for purposes of
§ 904, only to the extent attributable to employer contributions with respect to wages earned
abroad.). See also Bissell & Giardina, supra note 72, at 277 (noting that § 402(d)(7) creates
a separate foreign tax credit basket for a "lump sum distribution from a qualified plan").

283. See Rev. Proc. 89-45, 1989-2 C.B. 596 (implementing provision of U.S.-
Canada Income Tax Treaty designed to avoid such a "mismatch"). See also Penny Mavridis,
A Cross-Border View: Election to Defer U.S. Income Tax on Earnings of Canadian Registered
Savings Plan, 24 Tax Mgmt. Int'l J. 382 (1995).

284. See supra notes 66-71 and accompanying text for a discussion of the tax
treatment of pensions in other countries.

285. IRC § 904(c). Section 904(c) also allows carryover to the five succeeding
years.

286. See U.S.-France Income Tax Treaty, supra note 135, at 3001.04, 27005-13;
U.S.-Canada Income Tax Treaty, supra note 146, at T.I.A.S. 11087, 27.

287. See U.S.-Canada Income Tax Treaty, supra note 146, art. 29, 5; see also
Treasury Department Technical Explanation of the Convention Between the United States of
America and Canada With Respect to Taxes on Income and on Capital, Signed at Washington,
D.C. on Sept. 26, 1980, as amended by the Protocol Signed at Ottawa on June 14, 1983 and
the Protocol Signed at Washington on Mar. 28, 1984, 1986-2 C.B. 295, reprinted in Tax
Treaties (CCH) 1950, 21,089 (explaining that the intent is to "resolve conflicts between the
Canadian and U.S. treatment of individual retirement accounts") [hereinafter Treasury

[Vol 3:6



U.S. Income Taxation of Cross-Border Pensions

the beneficiary of an RRSP can make an election' to defer U.S. tax on the
earnings until distribution 9 to the extent the earnings are attributable to
contributions made during a period of Canadian residency.' The March
17, 1995 protocol to the Canadian treaty extends this election to allow defer-
ral of Canadian tax by beneficiaries of U.S. retirement plans, and includes
any retirement plan exempt from taxation in its residence country and oper-
ated exclusively to provide pension, retirement or employee benefits."'

Similar relief is provided in the U.S. treaty with France.' Article
18, paragraph 2(c) provides that payments received by a beneficiary resident
in one Contracting State in respect of a pension or other retirement arrange-
ment established in and recognized for tax purposes by the other Contracting
State shall be included in income in the Contracting State of the beneficiary's

Department Technical Explanation of the U.S.-Canada Income Tax Treaty]; Klein. supra note
72, at 382.

288. See Rev. Proc. 89-45, 1989-2 C.B. 596 (establishing procedure under which
beneficiary elects deferral); Mavridis, supra note 283, at 382-84.

289. The eventual distribution is taxed pursuant to § 72. Rev. Proc. 8945, 1989-2
C.B. 596. Under Rev. Proc. 89-45, the investment in the contract in the case of a 'person who
is a U.S. citizen in all years for which contributions are made to the plan ... is the sum of:
(i) [e]mployee contributions from after-tax (that is, after U.S. tax) earnings, and (ii) [elmployer
contributions included in the U.S. gross income of the employee. . ." If the person

is not a U.S. citizen or a U.S. resident in any years for which contributions
are made to the plan, the gross investment in the contract ... is equal to
the lesser of (a) the fair market value of the assets in the plan at the time
the beneficiary became a U.S. citizen or resident, or (b) the sum of
contributions to the plan plus earnings accrued in the plan at the time the
beneficiary became a U.S. citizen or resident.

Id.
290. See Protocol Amending U.S.-Canada Income Tax Treaty, June 14, 1983, art.

13, 4, T.I.A.S. 11087,72 [hereinafter 1983 Protocol] (stating that the deferral privilege "shall
not apply to income which is reasonable [sic] attributable to contributions made to the plan
by the beneficiary while he was not a resident of Canada"). But see 1995 Revised Protocol
supra note 178, art. 9, 1 3, and art. 17, 9 2, reprinted in Tax Treaties [CCHJ 11946, 21,043-6,
21,043-11 (eliminating the residence requirement).

291. See 1995 Revised Protocol, supra note 178, art. 9. j 3 (adding new 7 7 to art.
18 of the U.S.-Canada Income Tax Treaty) and art. 17, 1 2 (replacing art. 29, 1 5 of the
Treaty); Joint Comm. on Tax'n, Explanation of Proposed Protocol to the Income Tax Treaty
Between the United States and Canada, supra note 178; Treasury Explanation of Revised
Protocol to U.S.-Canada Treaty, supra note 178, 1 1952, 21,091-5 (discussing art. 9 of the
Protocol); see also Notice 96-31, 1996-22 I.R.B. I (May 28, 1996) (specifying that the
provisions of the Protocol apply to a RRSP or RRJF).

292. U.S.-France Income Tax Treaty, supra note 135, art. 18, j 2(c). A similar
provision was added to the 1967 U.S.-France Income Tax Treaty by a Protocol signed Jan. 17,
1984; the provision originally arose in a "side letter to the 1978 Protocol for the purpose of
providing French benefits to U.S. citizens resident in France." Treasury Department Technical
Explanation of U.S.-France Income Tax Treaty, supra note 135, j 3058, 27,197-31.

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residence "when and to the extent such payments are considered gross income
by the other Contracting State." Thus, for example, if a U.S. citizen came to
work in France as a French resident,293 but contributed to a U.S. qualified
pension plan, the contribution would be deductible (pursuant to paragraph
2(a) of article 18) for French tax purposes, and France would not tax accrued
benefits in the plan until such benefits would be taxed by the U.S.294

The treaty with Canada contains a further provision, which is
designed to prevent mismatching in the situation where the source country
imposes tax earlier than the residence country. Under this provision, the
residence country must exempt "the amount of any ... pension that would
be excluded from taxable income" in the source country if the recipient were
resident there.295 Thus, if Canada as the source country had imposed a

293. Staff of the Joint Comm. on Tax'n, Explanation of Proposed Protocol to the
Tax Treaty Between the United States and France, JCS 22-84, Apr. 26, 1984, reprinted in 87
TNI 53-44 [hereinafter Staff of the Joint Comm. on Tax'n, Explanation of 1984 Protocol to
the U.S.-France Income Tax Treaty]; Report of the Senate Foreign Relations Committee on
the Protocol Signed on Jan. 17, 1984 to Amend the Income Tax Treaty with France (CCH)

3053, 27,163 ("[A] U.S. citizen residing in France... may be required to include benefits
received from a U.S. retirement plan in income for French tax purposes when distributed since,
under U.S. internal law, an employee's benefits from or under a qualified plan ... generally
are includible in income when distributed.") [hereinafter Senate Foreign Relations Comm.
Report on the 1984 Protocol to U.S.-France Income Tax Treaty].

294. Paragraph 2, subparagraph (c) of art. 18 refers back to "an arrangement
referred to in subparagraph (a) that satisfies the requirements of this paragraph.. . ." This may
mean that relief is limited to the situation where, as described in subparagraph (a), a national
of one country who is working and resident in the other country contributes to a plan in his
country of nationality. However, the provision is apparently potentially applicable to the case
of a U.S. citizen who contributes to a U.S. plan while his principal place of employment is in
the U.S. and later resides in France; this can be inferred from the fact that the provision is
made "subject to" art. 24, which provides in such a case for France to grant a credit (in the
amount of the French tax otherwise due) with respect to such pension income. U.S.-France
Income Tax Treaty, supra note 146, art. 24, 2(b)(iv); see also Senate Foreign Relations
Comm. Report on the 1984 Protocol to U.S.-France Income Tax Treaty, supra note 293,

3053, 27,163-64 (stating that if a U.S. citizen residing in France receives benefits from a
U.S. retirement plan attributable to services while his principal employment "was in the United
States (rather than in France or a third country), then the benefits will not be included in
income for French tax purposes because such benefits are exempt from French tax under the
treaty's double taxation relief article"). It is not as clear that the provision could be applied
to defer U.S. tax for a U.S. citizen who works in France and makes contributions to a French
plan, and then resumes residence in the U.S.

295. 1983 Protocol, supra note 290, art. 9, I, replacing art. 18, $ 1 of the treaty.
As signed on Sept. 26, 1980, the provision stated that the "amount of any pension included
in income for the purposes of taxation" in the residence country "shall not exceed the amount
that would be included" in the source country if the recipient were a resident there. U.S.-
Canada Income Tax Treaty, supra note 146, art. 18, 1. This language apparently left the
implication that the residence country would have to grant a "personal allowance" granted by

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U.S. Income Taxation of Cross-Border Pensions

current tax on contributions or accrued benefits in a pension plan and there-
after granted basis for such amounts, the U.S. could not, as the residence
country, impose a tax on such amounts at a later time.

A similar provision has been included as a limitation on the residence
country in the 1996 U.S. Model." Article 18, paragraph 1 of this model
provides that "pension distributions... shall be taxable only in" the
residence state, "but only297 to the extent not included in taxable income in
the other Contracting State prior to the distribution.""5 The Treasury
explained that "[t]he exclusive residence-based taxation provided under...
[article 18, paragraph 1] is limited to taxation of amounts that were not
previously included in taxable income in the other Contracting State."' 99
Thus, "if a Contracting State had imposed tax on the resident with respect to
some portion of a pension plan's earnings, subsequent distributions to a
resident of the other State would not be taxable in that State to the extent the
distributions were attributable to such amounts. '"10°

This provision will affect U.S. residence-based taxation of a pension
only if U.S. tax is delayed until the time of the pension's distribution.
Therefore, this provision's impact will be only on (a) distributions from a
U.S. qualified plan or an unfunded pension plan, or (b) in the case of

the source country. To counter, this language was revised by the Protocol of June 14, 1983,
art 9, 1. 1983 Protocol, supra note 290, art. 9, 9 1. Under the revised version. if S5,000 of
a $10,000 pension payment arising in the source country "would be excluded from taxable
income as a return of capital" in the source country "if the recipient were a resident," then the
$5,000 should be exempted by the residence country; at the same time, the fact that the source
country "would also grant a personal allowance as a deduction from gross income if the
recipient were a resident" would not result in an increase in the amount to be exempted by the
residence country. Treasury Department Technical Explanation of the U.S.-Canada Income Tax
Treaty, supra note 287, S 1950, 21,069. See also Klein, supra note 72, at 382 (stating that the
provision is "believed... to make any basis in the pension created in one country recoverable
tax-free in the other country.").

296. 1996 U.S. Model, supra note 2. This provision is not exempted from the
savings clause. Id. art. 1, 91 4; 1996 Treasury Explanation. supra note 2 1 259. This result is
perhaps unintended.

297. 1996 U.S. Model, supra note 2, art. 18, $ 1. This language is ambiguous due
to the double use of the term "only." The language could be interpreted to mean that the
residence country can tax the full amount in all cases, but that its jurisdiction to tax is not
exclusive when the other country has previously taxed. However, the Treasury's Technical
Explanation does not adopt this interpretation. See infra notes 299-300 and accompanying text.

298. 1996 U.S. Model, supra note 2, art. 18, 1.
299. 1996 Treasury Explanation, supra note 2, 1 246.
300. Id. Treasury states that "[i]n determining the amount of a distribution that is

attributable to previously taxed amounts, the ordering rules of the residence State will be
applied." Id. In particular, "[t]he United States will treat any amount that has increased the
recipient's 'investment in the contract' (as defined in Section 72) as having been previously
included in taxable income." Id.

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distributions from a funded nonqualified plan (U.S. or foreign), only to the
extent benefits have avoided earlier U.S. taxation because the benefits are
forfeitable or the individual is not a highly compensated individual.

For example, suppose a U.S. citizen, who is resident and performing
services in a treaty country, were to participate in a U.S. qualified pension
plan and the treaty country were to impose a current tax on contributions and
plan earnings (notwithstanding the 1996 Model's rules limiting source
taxation of home country pensionsa"1); upon retirement, the individual
becomes a U.S. resident. Under the 1996 U.S. Model, the U.S. would be
barred from taxing the distribution since that amount was already taxed by
the other country.3°2 A further example would be the case of a U.S. citizen
who performs services in a treaty country and participates in a pension plan
located there, and who is not a highly compensated employee. The U.S.
would impose a current tax on nonforfeitable contributions to the plan, but
not on plan earnings. Assume that the foreign country imposes a current tax
on plan earnings and that, prior to the time of distribution, the individual
becomes a U.S. resident. In that case, the U.S. would not tax any part of the
distribution from the foreign plan. The contributions were previously taxed
by the U.S.; and, under the 1996 U.S. Model, the U.S. is barred from taxing
the earnings because they were previously taxed by the other country.

4. Possibilities for Manipulation of Timing Differences.-In an
entirely domestic context, deferral of an employee's tax liability with respect
to nonforfeitable retirement benefits is conditioned upon compliance with the
rules for qualified pension plans (or IRAs) or upon deferral of the employer's
deduction for compensation and treatment of the employer as continued
owner of the pension assets. These conditions can be avoided in some cases
when a foreign employer creates a hybrid retirement arrangement for a U.S.
citizen employee.303

For example, the foreign employer may establish a Cayman Islands
trust to secure the employer's liability to pay deferred compensation to the
U.S. citizen employee; the Cayman Islands trust may be viewed as a grantor
trust by the U.S., but as a separate taxpayer by the employer's home country.
In that case, the employee is not subject to U.S. tax on the deferred
compensation until it is distributed to him. Assuming that the employer is not
engaged in the conduct of a U.S. trade or business, the employer is

301. See 1996 U.S. Model, supra note 2, art. 18, 6; see also supra notes 190-203
and accompanying text.

302. This example and the subsequent example assume an exception to the savings
clause. See supra note 296.

303. Ordower, supra note 72, at 322-35 (analyzing this type of arrangement and its
tax consequences for employer and employee).

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U.S. Income Taxation of Cross-Border Pensions

indifferent to the deferral for U.S. tax purposes of the allowance of a
deduction for compensation. Nor will the employer be subject to U.S. tax on
the investment income derived from the trust assets, provided that the assets
are invested outside the U.S. or in bank deposits or bonds yielding portfolio
interest.3° At the same time, the home country of the employer may allow
the employer an immediate deduction for assets contributed to the trust, and
may not seek to impose any tax on the income of the Cayman Islands
trusL

3 5

However, the situations where such benefits are fully available may
be fairly limited.3° If the U.S. citizen is employed outside the U.S. (e.g.,
in the home country of the employer), he may be subject to an immediate
foreign tax on the deferred compensation; the employee will subsequently
incur the U.S. tax without any possibility of a section 911 exemption and
with a risk that the foreign tax credit will be lost because of delay in the
inclusion of the foreign source income for U.S. tax purposes.m

If the employee performs his services for the foreign employer in the
U.S., the employee avoids foreign tax liability. On the other hand, if services
are performed by the employee in the U.S. in connection with a U.S. business
of the employer, the employer will not be indifferent to the U.S. tax treatment
of the trust.3c)' Those in the best position to benefit from such a hybrid
arrangement may be (a) an offshore investment company employing a U.S.
citizen employee to perform services in the U.S. as its investment advisor or
broker,3 9 or (b) a foreign employer employing a U.S. citizen employee to
temporarily provide business or engineering expertise with respect to non-
U.S. activities of the employer.1

The Clinton Administration's February 1995 proposal 311 to curb

304. Id. at 322-26. Moreover, the U.S. citizen employee avoids the impact of
§§ 551-558, 951, or 1291-1295. Id. at 325, 329 & n.157.

305. Id. at 323.
306. Id. at 328-29.
307. Id. at 329-33.
308. Id. at 333-35.
309. Id. at 329. The employee's performance of services in the U.S. can be arranged

in such a way as to avoid "U.S. business" status for the employer. Id. (citing § 864(b)).
310. Id.
311. Treasury Explanation of Clinton's Proposals to "Curb Foreign Tax Avoidance":

Tax Responsibilities of Americans Renouncing U.S. Citizenship, 95 TNI 26-24 (Feb. 8. 1995)
(LEXIS, FEDTAX library, TNI file). The Treasury stated concern with "[wlealthy foreign
families [who] set up foreign trusts which benefit a U.S. family member." Id. The Treasury
explained that "income generated by foreign trust assets frequently is not taxed in any
country;" this occurs because "[mlany foreign jurisdictions do not consider the foreign grantor
to be the owner of the trust assets, and trusts are normally established in jurisdictions which
do not impose tax on trust income." Id. Because the U.S. treats the trust assets as owned by
the foreign family, the U.S. views the "distribution of trust income to the U.S. beneficiary...

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abuses involving foreign trusts might have interfered with the desired effects
of such an arrangement. Under the proposal, the grantor trust rules would not
be applied unless the effect would be to require current income inclusion by
a U.S. citizen or resident or a domestic corporation.3 2 However, the version
finally enacted in 1996 provides an exception for trusts used to pay
compensation. 3

5. Lack of Citizenship Jurisdiction in Most Countries.-As noted,
hardly any of the trading partners of the U.S. impose tax on the basis of
citizenship.1 4 Thus, nationals of other countries who earn deferred compen-
sation while living and working in the U.S. can avoid any risk of current
taxation in their country of nationality if they are considered resident in the
U.S. For example, Canada does not impose its tax on an individual who is
a Canadian citizen-U.S. resident with respect to employer contributions to, or
accrued earnings of, a qualified U.S. pension plan or a Canadian registered
pension plan because Canadian taxation is based on residency." 5 In many
cases, deferred compensation payments made to such individuals after
reestablishing residence in their country of nationality may also be exempt
from tax in such country.316

as a nontaxable gift." Id. Under the Administration's proposal, the "trust income would be
taxed" by the U.S. "when distributed to U.S. beneficiaries." Id.

312. H.R. Rep. No. 981, 104th Cong., 1st Sess. (1995) (Section 204 of the bill
amends IRC § 672(f)(1) to provide that subpart E (the grantor trust rules) "only apply to the
extent such application results in an amount being included in gross income of a citizen or
resident of the United States or a domestic corporation.").

313. Conference Report for Small Business Job Protection Act of 1996, H.R. Rep.
No. 3448, 104th Cong., 2d Sess. (1996) (enacted). Under the final version, § 672(f)(2)(B) is
amended to state that: "Except as provided in regulations, paragraph (1) shall not apply to any
portion of a trust distributions from which are taxable as compensation for services rendered."
Id. § 1904(a)(1). Apparently Congress concluded that if the trust distributions are subject to
U.S. tax as compensation, the type of abuse of concern to Treasury was not present.

314. See supra note 255.
315. See Letter from Raymond J. Wiacek to Peter Barnes, Office of Int'l Tax

Counsel (Oct. 3, 1988), reprinted in 88 TNI 43-40 (Oct. 26, 1988) (LEXIS, FEDTAX library,
TNI file). See also Bissell & Giardina, supra note 72, at 282 ("[A] foreign national working
in the United States would usually not be subject to foreign tax on current accruals in a U.S.-
based SERP because most foreign countries do not impose personal income tax on their
citizens who are resident in another country.").

316. See Ellis & Navin, supra note 72, at 88 ("Many foreign countries (e.g., the
U.K.) will exempt deferred compensation payments from tax if they were earned during a
period of U.S. residence" although "some foreign countries (e.g., Italy and Switzerland) may
tax these payments."). See also E.A. Nicholson & Thomas St.G. Bissell, Tax Planning for
Foreign Nationals Working in the United States, 1992 Intertax 55, 58 (placing Belgium,
Germany and U.K. in the former category and Italy, Switzerland, and Sweden in the second).

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U.S. Income Taxation of Cross-Border Pensions

B. Alien Performs Services Outside the U.S. and Receives Payments of
Deferred Compensation After Becoming U.S. Resident

1. Results Under the Internal Revenue Code.-Assume that a citizen
of Country X spends his working years employed in Country X by a Country
X employer who makes contributions for the employee to a Country X
qualified pension plan. Assume, however, that this individual takes up
permanent residence in Florida at the time of his retirement and is treated by
the U.S. as a resident alien and is no longer classified as a resident by
Country X tax authorities.1 7 See Table 2, row 10, page 361. If the Country
X tax rules regarding pensions are the same as in the U.S., then Country X
would defer taxation of amounts contributed to the plan until distributed to
the employee. Country X tax rules may or may not provide for taxation of
the eventual distribution. This would depend upon whether Country X seeks
to retain jurisdiction to tax items that have accrued to a long-term resident
prior to his departure; it also depends upon whether Country X asserts a
source-based tax over pensions by reason of the location of the services or
the situs of the trust. 31

In this situation, even though the U.S. taxes its residents on world-
wide income, U.S. taxation of the entire distribution is not assured. If the
pension plan in Country X is classified by U.S. standards as an unfunded plan
(despite the contrary result under Country X law),319 then the U.S. will treat
distributions from the plan as foreign-source compensation income, taxable
in full and ineligible for section 911 relief (because it is deferred). See Table
2, row 9, page 361.Yt If, however, the U.S. agrees with Country X's

317. See, e.g., Tech. Adv. Mem. 89-11-001 (Sept. 27, 1988). reprinted in 89 TNI
13-42 (Mar. 29, 1989) (LEXIS, FEDTAX library, TNI file) (involving a Canadian citizen who
receives pre-retirement distributions from a Canadian pension plan after becoming a U.S.
resident alien).

318. For example, Norway imposes its income tax on "[all remuneration (including
pension distributions) derived from employment in Norway or paid to a manager or member
of the Board of Directors of [a] company resident in Norway ... " ICT Report on
Expatriation, supra note 129, at B-5. "A business... distributing pension benefits is
responsible for withholding taxes on such income regardless of the individual's country of
residence," e.g., even if he is a former resident. Id. Denmark imposes its income tax on
"[p]ension distributions received by nonresidents from Danish pension plans ... but many tax
treaties effectively override this provision of Danish law." Id. at B-8.

319. See supra note 276 and accompanying text. For example, the plan may be a
"rabbi trust," for U.S. tax purposes, but Country X may view a plan secured by such a trust
as a funded plan.

320. In Priv. Ltr. Rul. 96-28-024 (Apr. 16, 1996), the IRS ruled that an individual,
who becomes a resident alien after performance of services and before payment, is taxable as
a resident on the compensation paid, regardless of its source. The results in the ruling were
not affected by the relevant treaty because of the applicability of the savings clause. Id.

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characterization of the plan as funded, then the distribution will be viewed as
a return of capital at least to the extent of amounts previously contributed to
the plan (by employee or employer). See Table 2, row 10, page 361.

Because the foreign plan would in all likelihood be "nonqualified" for
U.S. tax purposes, distributions from the plan would be subject to the rules
of section 402(b) and thus the rules of section 72.32' For this purpose,
investment in the contract takes account not only of employee contributions,
but also of contributions made by the employer that either (a) were includible
in the employee's gross income for U.S. tax purposes at an earlier time or (b)
would not have been so includible if paid directly to the employee at the time
of contribution. 22

In the example given, the employer contributions do not meet
condition (a) since they were not includible in gross income of the employee
for U.S. tax purposes when made; however, the employer contributions do
meet condition (b); that is, even if the employer contributions had been paid
directly to the employee, they would not be includible because the employee
was a nonresident alien receiving compensation for services performed
outside the U.S. 323 Thus, these contributions are, pursuant to section 72(t),
considered part of the investment in the contract (even though not yet taxed
in the U.S. or in country X).

32 4

Thus, only the portion of the distribution representing "earnings and
accretion" is treated as income by the U.S. This income would apparently be
foreign source income (as coming from a foreign situs trust) for purposes of
determining a foreign tax credit.325

321. See Tech. Adv. Mem. 89-11-001, supra note 317.
322. IRC § 72(0. See Tech. Adv. Mem. 89-11-001, supra note 317 (citing Rev. Rul.

58-236, 1958-1 C.B. 37).
323. See Tech. Adv. Mem. 89-11-001, supra note 317; Walker & Olson, supra note

22, at 98 (discussing exclusion under IRC § 872); Rev. Rul. 58-236, 1958-1 C.B. 37, 38-39.
324. Tech. Adv. Mem. 89-11-001, supra note 317 (citing Rev. Rul. 58-236, 1958-1

C.B. 37). See Walker & Olson, supra note 22, at 98; see also Bissell & Giardina, supra note
72, at 278-79.

Walker & Olson argue that this analysis is supported by the Supreme Court's
opinions in Biddle v. Commissioner, 302 U.S. 573 (1938) and United States v. Goodyear Tire
& Rubber Co., 493 U.S. 132 (1989) (requiring application of U.S. tax principles in applying
the foreign tax credit rules). See also KPMG Letter, supra note 161 ("[A] Canadian citizen
resident in the U.S. will be subject to U.S. income tax to the extent vesting [in a Canadian
pension plan] occurs after the U.S. residence is established."); Michael J. Canan, Qualified
Retirement and Other Employee Benefit Plans § 23.6, at 1094-95 n.3 (practitioner ed. 1995)
(noting that the fact that basis is granted for employer contributions made to a foreign pension
plan on behalf of a nonresident alien "may open the door for planning opportunities with
respect to deferred compensation or retirement income paid while the individual was a
nonresident alien.").

325. See supra note 282 and accompanying text.

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U.S. Income Taxation of Cross-Border Pensions

It has been suggested that the U.S. will in many cases not tax even
the "earnings and accretion" portion of the distribution. If the employee is
considered under U.S. tax rules to be a "highly compensated employee" and
the pension plan does not meet the nondiscrimination rules applied to U.S.
qualified plans, then the investment in the contract might include the entire
amount of the vested accrued benefits.3" If the individual had been a U.S.
citizen or resident throughout his employment, he would have been taxed
annually pursuant to section 402(b)(4)(A) on the amount of his vested
accrued benefit (other than his investment in the contract); presumably for
this purpose, amounts once included under this provision would thereafter be
treated as investment in the contract. 327

In support of this result, one might argue by analogy to section 72(f)
(which deals only with employer contributions) that investment in the contract
should also include amounts that would have been taxed annually to an alien
under section 402(b)(4)(A) but for his status at the time as a nonresident and
the foreign source of the income.31 More generally, one might argue that
under U.S. timing rules, the appropriate time to tax would have been as the
vested benefit accrued; thus, as the benefits accrued, basis is created (even
though the U.S. was in fact unable to tax because of the individual's
nonresident alien status).329 Under this theory, the fact that the U.S. did not

326. See Walker & Olson, supra note 22, at 98 (stating that the Biddle. 302 U.S.
573 (1938), and Goodyear, 493 U.S. 132 (1989), decisions by the Supreme Court "and the
enactment of Section 402(b)(2) arguably enable the noncitizen taxpayer who is an HCE
participant in a plan that does not satisfy the rules of Sections 410(b) or 401(a)(26) to count
as investment in the contract any earnings that accrued during a period of nonresidency.").

327. See Regs. § 1.402(b)-l(b)(5) ("The basis of any employee's interest in a trust
to which this section applies shall be increased by the amount included in his gross income
under this section."). See also Ellis & Navin, supra note 72, at 32. However, this is not clearly
a reference to inclusions pursuant to § 402(b)(4)(A), which are not discussed in Regs.
§ 1.402(b)-i). As noted above, the IRS is unwilling to rule on the treatment of distributions
to a highly compensated employee, in the absence of a technical correction to § 402(b)(4)(A).
See supra note 39.

328. See Walker & Olson, supra note 22, at 98 (suggesting that § 72(f)'s "focu[s]
on contributions rather than accrued benefits" is due to the fact that "it was enacted before
Section 402(b)(2)."). (Section 402(b)(2) was relocated at § 402(b)(4)(A), as a result of the
Unemployment Compensation Amendments of 1992, Pub. L. No. 102-318, § 521(a), 106 Stat.
300, 301 (1992)).

329. Walker & Olson, supra note 22, at 98 n.26 (citing Tech. Adv. Mem. 87-49-008
(Aug. 18, 1987)). In that Technical Advice Memorandum, the IRS National Office ruled on
the proper determination of the adjusted basis of a foreign corporation's depreciable property
that was placed in service in a foreign country in 1967 but then used in a business in the U.S.
beginning in 1975. Tech. Adv. Mem. 87-49-008 (Aug. 18, 1987). The National Office
concluded that the adjusted basis should reflect depreciation allowable under U.S. principles
beginning in 1967, even though no U.S. tax return was required to be filed prior to 1975 and
the depreciation was attributable to income not subject to U.S. tax. Id. See also Gen. Couns.

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have jurisdiction (either source or residence-based) to tax at that time should
not permit it to tax at a later time when it acquires residence jurisdiction.

A similar approach seems to be accepted by the IRS in implementing
article 29, paragraph 5 of the U.S.-Canada Treaty, providing for deferral of
U.S. tax with respect to certain earnings accrued in a Canadian registered
retirement savings plan (RRSP).33° The IRS has taken the position that
when a person becomes a U.S. resident or citizen only after making all
contributions to a RRSP, the gross investment in the contract under section
72(c)(1)(A) is "the sum of the contributions to the plan plus earnings accrued
in the plan at the time the beneficiary became a U.S. citizen or resident" (or,
if lesser, "the fair market value of the assets in the plan at the time the
beneficiary became a U.S. citizen or resident").33'

2. Results Under Treaties

a. Treatment by Country X.-If a treaty (following the
OECD or U.S. model) were in effect between the U.S. and Country X in the
above-described situation, Country X would surrender its right to assert
source-based tax jurisdiction over the pension payments because its national
had become a U.S. resident.

It is possible, however, that Country X would assert a residence-based
tax, focusing on the employee's continued citizenship in Country X or on his
long-term residence in Country X, and seek to protect this jurisdiction in its

Mem. 34,572 (Aug. 3, 1971), where the Chief Counsel concluded that when "a nonresident
alien acquires property before becoming a U.S. resident and then sells the property after such
date ... the general statutory basis provisions set forth in sections 1001 and 1011 ... are
applicable .... General Counsel acknowledged "that a strictly 'equitable' approach ... might
possibly dictate use of a 'special basis' . . . such as, a basis equal to the fair market value...
upon taxpayer's initial entry into the United States .... Id. However, it explained that: "the
present basis provisions of the Code cannot be so interpreted .. " Id. In support of this
interpretation, Chief Counsel cited the case of Gutwirth v. Commissioner, 40 T.C. 666 (1963),
acq. in result, 1966-2 C.B., where the Tax Court had to determine the loss to be claimed for
war damage occurring in 1945 to a factory in Antwerp that was owned by alien individuals
who took up U.S. residence in 1939. The court held that the adjusted basis of the property
included the original investment made in 1922 and 1923, increased by "subsequent capital
additions" notwithstanding that "these additions were treated as expenses in Belgium." Id. at
678. The court held that the basis should also reflect downward adjustment for depreciation
so as to avoid "discriminat[ing] in favor of resident aliens owning property abroad as against
resident taxpayers in identical situations." Id. at 679.

330. See supra notes 287-291 and accompanying text. The March 17, 1995 protocol
has moved this provision to art. 18, 7 of the treaty. See 1995 Revised Protocol, supra note
290, art. 9, 3.

331. Rev. Proc. 89-45, supra note 283 (stating "[t]his amount does not include
unrealized appreciation in the plan assets."). See Mavridis, supra note 283, at 383-84 n.12.

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U.S. Income Taxation of Cross-Border Pensions

treaty with the U.S. Such an approach is taken to some extent by Finland,
Germany, the Netherlands, Norway, and Sweden.332 For example, in
Finland, a Finnish citizen who is also a permanent resident of that country is
taxed by Finland for three years after departing Finland unless he maintains
no "essential ties" with Finland.33

In addition, a few countries may impose a form of "exit tax" on
departing residents. 3

3 In particular, beginning in 1987, Denmark imposes
an exit tax on departing individuals who have been "resident for at least five
of the preceding 10 years," with respect to "certain unrealized capital gains"
and "certain pension contributions made in the five years prior to" the depar-
ture.335 In addition, since 1995, the Netherlands imposes tax on the "fair
market value of pension assets" at any time that they are removed from the
Netherlands, unless "the pension distributions will be taxed in the foreign
jurisdiction in which a former resident lives at the time of the distribu-
tion.

' 6

b. Treatment by United States.-On the other hand, pension
articles in most treaties would not impose any limitation on the pension's
taxation by the U.S. as the taxpayer's residence country. The lack of treaty
impact is suggested in a 1989 technical advice memorandum, in which

332. See JCT Report on Expatriation, supra note 129, at B-2 - B-6. For example,
"Germany imposes a so-called 'extended limited tax liability' on German citizens who
emigrate to a tax-haven country or do not assume residence in any country and who maintain
substantial economic ties with Germany .. " Id. at B-3. Under this rule, the emigrating
citizen is taxed for 10 years "as a German resident on all income that is not treated as foreign
source income for German tax purposes." Id. However. "tax treaties generally take precedence"
over this rule. Id. Under its treaty with Monaco, France treats its citizens residing in Monaco
as residents for French income tax purposes. Id. at B-2. The Netherlands in its treaties seeks
"to secure the right to tax the sale of substantial interests in Netherlands' companies for a
period of five years after emigration." Id. at B-4. In Norway, "[a] former resident may still be
considered resident for purposes of the income tax if he keeps a home in Norway which is not
let out and is unable to prove that he is considered resident for tax purposes in the country in
which he is living." Id. at B-5.

333. Id. at B-2. However, the treaty with the U.S. precludes application of this rule.
Id. at B-2, n.4. A citizen or resident of Sweden cannot shed his resident status if he maintains
"essential ties" with Sweden; an individual who has been a resident of Sweden for at least 10
years is presumed to remain a resident for five years after departing, unless he proves that he
has not kept "essential ties." Id. at B-6.

334. The Staff of the Joint Committee has identified Australia, Canada. and
Denmark as falling in this category. Id. at B-7-B-8. The Australian exit tax applies to the
appreciation in non-Australian assets at the time residence is ended. Id. at B-7. An individual
giving up Canadian residence "is deemed to have disposed of all capital gain property at its
fair market value .. " Id.

335. Id. at B-8.
336. Id. at B-5.

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section 402(b) and section 72(t) were applied to a distribution from a
Canadian pension plan to a Canadian citizen who retired in the U.S. There
the IRS stated that the treaty in effect with Canada as of 1983 did not address
these issues.337

The current U.S. treaty with Canada does, however, provide a
limitation on the taxation of pensions by the residence country; i.e., the
residence country is required to exempt the amount of any pension that would
be excluded from income in the source country if the recipient were resident
there.338 The 1996 U.S. Model contains a similar provision, barring the
residence country from taxing a pension distribution to the extent attributable
to amounts previously taxed by the other country.339 But these provisions
do not seem relevant to a case where the source country (Country X in the
example above) has allowed deferral of tax on contributions and accrued
benefits until distribution.

Of possibly greater relevance is article 18, paragraph 2(c) in the U.S.-
France treaty.' The Staff of the Joint Committee describes this article as
"provid[ing] that the timing and extent of taxation of pension benefits is
determined under the laws of the source country."' This provision clearly
applies to delay imposition of U.S. tax when contributions to a French
pension plan are made on behalf of a French citizen working and residing in
the U.S.34 2 It is not as clear, however, that this provision would apply if a
French citizen working and residing in France and contributing to a French
pension plan became a U.S. resident immediately before receiving distribu-
tions from the French plan. Absent the treaty, the U.S. would never have
imposed a tax on the French citizen, assuming that he or she is a "highly
compensated employee" and all contributions are nonforfeitable. In that case,
the proper time to tax, under U.S. timing rules, is as benefits accrue. Because
the individual was not a U.S. resident at that time and the income is from

337. Tech. Adv. Mem. 89-11-001, supra note 317. The Treaty signed Sept. 26,
1980, did not go into force until Aug. 16, 1984.

338. See U.S.-Canada Income Tax Treaty, supra note 146, art. 18, 1.
339. See 1996 U.S. Model, supra note 2, art. § 18, 1, and supra notes 296-302 and

accompanying text.
340. See supra notes 292-294 and accompanying text.
341. Staff of the Joint Comm. on Tax'n, Explanation of Proposed Income Tax

Treaty Between the United States and the French Republic, JSC 10-95, 32 (Joint Comm.
Print 1995) [hereinafter Joint Comm. on Taxn's Explanation of Proposed U.S.-France Income
Tax Treaty].

342. See supra text accompanying notes 292-294; Staff of the Joint Committee on
Taxation, Explanation of 1984 Protocol to the U.S.-France Income Tax Treaty, supra note 293
(stating that the protocol would "make reciprocal rules similar" to those applied to "Americans
in France" by the 1978 side note "so that French citizens resident in the United States, as well
as U.S. citizens resident in France, can benefit").

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U.S. Income Taxation of Cross-Border Pensions

French sources, no U.S. tax would be imposed. Thus, if the treaty provision
were applied to delay the U.S. tax until the time of distribution, when the
individual had become a U.S. resident, the effect of the treaty provision
would be to impose a U.S. tax that would never have been imposed by the
Internal Revenue Code. Yet the French treaty (like most others) provides that
the treaty "shall not restrict in any manner any ... allowance ... accorded
by... the laws of... the United States."4 3

C. The Problems Associated with U.S. Residence-Based Taxation of
Participants in Foreign Plans

The U.S. rules for taxing its citizens and residents who participate in
foreign pension plans involve application of U.S. tax concepts to such plans
to determine if they are "funded" or "unfunded" and "qualified" or "nonquali-
fled." If the plans are funded but nonqualified, U.S. tax concepts must be
applied to determine the amount to be taxed at the time of vesting, whether
the employee is a "highly compensated employee," and, if so, the annual
amount of accrued benefits. This creates at least four potential problems.3

First, particularly if the employer is a foreign person, not affiliated
with a U.S. company, it may be difficult for the employee to obtain informa-
tion about the foreign plan sufficient to categorize the plan under U.S. tax
standards and to determine the amount and timing of any income inclusion.
The plan documents may not be in English, and the employer may have no
need for local tax purposes to draw the distinctions made under U.S. law.3 5

343. U.S.-France Income Tax Treaty, supra note 135, art. 29, 1 1; see 1996 U.S.
Model, supra note 2, art. 1, T 2 (referring to the "laws of either Contracting State-). See also
1996 Treasury Explanation, supra note 2 ("[This provision] also means that the Convention
may not increase the tax burden on a resident of a Contracting States (sic] beyond the burden

determined under domestic law. Thus, a right to tax given by the Convention cannot be
exercised unless that right also exists under internal law."). The Treasury further explains that
"a taxpayer's liability to U.S. tax need not be determined under the Convention if the Code
would produce a more favorable result." Id. See also ALI. supra note 219, at 81.

344. For a similar catalogue of problems in the context of a U.S. citizen or resident
participating in a Canadian registered pension plan, see Wiacek Letter to Barnes, supra note

267, and Wiacek Letter to Terr, supra note 266. See generally Avi-Yonah. supra note 225, at
1336 (noting that "even developed countries find it hard to effectively enforce residence-based
taxation on the global income of individuals." He further explains that "[slource-based taxation
of passive income is much more effective than residence-based taxation because the source
country has the information needed to enforce the tax if it wishes to do so.").

345. See Wiacek Letter to Barnes, supra note 267 (making this point with regard
to U.S. citizens or residents participating in Canadian registered plans). In this letter, Wiacek
states that "determining the correct amount to include in an individual's income can be
extremely difficult, especially in the case of a defined benefit plan. Not only can the task be
difficult, but Canadian employers simply may not perform the calculations necessary to
determine the includible amount, imposing a significant burden on individual employees." Id.

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Second, whereas in the case of a U.S. plan, employers ordinarily
structure deferred compensation arrangements to obtain desired tax results
under U.S. tax law for the beneficiaries, such structuring generally would not
occur for a pension plan organized in a foreign country with more than a few
participants. Most of the participants would generally be nonresident aliens
of the U.S. who would not be subject to U.S. tax (assuming services are
performed abroad). Moreover, it might not be possible to conform the plan
to U.S. tax requirements and local tax requirements at the same time since the
two sets of requirements may be inconsistent. Thus, given these factors and
the enormous complexity of the requirements for qualification under section
401(a), it is virtually impossible that a foreign plan would meet the U.S.
requirements for a qualified pension plan.

Third, the treatment of funded but nonqualified plans under U.S. law
will generally be applicable to foreign pension plans, but such treatment is
difficult to administer (even in an all "domestic" context), particularly for
defined benefit plans. 46 As Zelinsky points out, in arguing that the treat-
ment accorded to qualified plans should be considered the norm, 7 current
taxation of accruing pension benefits creates problems of valuation and of
liquidity and understandability for the employee." s

In a domestic context, difficulties in applying the rules for nonquali-
fied plans may be tolerated since taxpayers have the option of complying
with the qualified plan rules. In fact, one commentator suggested that the
treatment of nonqualified plans should be "punitive" in order to encourage
creation of qualified plans.349 Even those who favor increasing the present
value of tax imposed on qualified plan benefits have generally proposed
doing so, not by extending the current rules for nonqualified plans to all
plans, but rather by imposing a new flat tax on pension income.

346. See Wiacek Letter to Terr, supra note 266 (noting the difficulty for Canadian
defined benefit plans, "where the employer makes a contribution based on the ages, probability
of vesting, and salary levels of the employee group as a whole, and the U.S. rules ... require
a calculation of the 'annual incremental projected normal retirement benefit' as a proxy for
the employer contribution per employee.").

347. See supra notes 60-62 and accompanying text.
348. See Wiacek Letter to Barnes, supra note 267 (noting that "includability in

income of amounts contributed to a trust from which the employee cannot withdraw the
contributions creates a cash flow problem for the employee when the tax is assessed"); KPMG
Letter, supra note 161 (noting that a U.S. citizen participating in a Canadian pension plan
"may be required to make a cash payment of tax based on a vesting of benefits, even though,
by operation of Canadian income tax law or by virtue of the restrictions of the plan, the
individual is not yet entitled to a cash distribution.").

349. See Halperin, supra note 8, at 43-44; see also supra note 57 and accompanying
text.

350. See supra note 59 and accompanying text.

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U.S. Income Taxation of Cross-Border Pensions

Fourth, because U.S. taxation of its residents or citizens participating
in foreign plans does not take account of foreign tax rules, the potential for
inconsistency in the timing of taxation under the two countries' rules is great.
This may lead to a situation where no tax is imposed by either country, or
two taxes are imposed, but at different times, creating problems for
application of the U.S. foreign tax credit. For example, many foreign
countries allow participants in local pension plans to defer taxation until
distribution (as in a U.S. qualified plan); however, since the U.S. will
generally classify the foreign pension plan as nonqualified, deferral of U.S.
tax will not be available for a U.S. citizen.35' Moreover, an alien who
retires to the U.S. may avoid taxation in the country where he worked and yet
avoid significant U.S.-residence based taxation because the distribution is
treated as a return of capital.

D. U.S. Residence-Based Taxation of U.S. Multinational Employer

The difficulty of applying U.S. rules for taxing deferred compensation
arrangements to foreign plans has been demonstrated very clearly in
connection with the U.S. tax treatment of the employer. Although Congress
acted in 1980 to make U.S. rules more easily applicable to foreign plans in
this context, the Treasury has had difficulty in adopting regulations that
would simplify and clarify the rules in this area.

A U.S. corporation with a foreign branch may establish a foreign
pension plan for local employees, which is structured to satisfy local tax and
labor requirements. The U.S. corporation will wish to currently deduct
contributions to the plan on its U.S. tax return. Prior to 1980, U.S. tax rules
were applied without modification to this foreign context; thus assuming that
the foreign plan did not meet the requirements of section 401(a),352 a U.S.
corporation's deduction was governed by section 404(a)(5), dealing with
contributions to nonqualified plans. Under that provision, the deduction must

351. See Wiacek Letter to Barnes, supra note 267 ("IFlor U.S. citizens working in
Canada, U.S. income tax liability and foreign tax credits are mismatched twice: frust, upon the
inclusion of amounts in income for U.S. tax purposes as contributions are made to the plan
when there is no corresponding inclusion in income for Canadian tax purposes: and second,
upon the full includability in income for Canadian tax purposes of distributions from the plan
when there is only partial includability for U.S. tax purposes... [due to] ... the basis
recovery rules of Section 72 .... ").

352. If the U.S. employer were to establish a funded pension plan that complied
with all U.S. requirements for a qualified pension plan, except that the trust was foreign, then
the U.S. employer could deduct contributions to the pension plan under § 404(a) subject to the
same restrictions on overfunding applied to a domestic plan. See IRC § 404(a)(4). The
beneficiary's treatment would also be the same as for a qualified plan. See supra note 266.

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await the year of inclusion by the employee353 and is conditioned on
maintaining separate accounts for each employee (a condition generally not
met by defined benefit plans).3"

A similar issue arises when a U.S. corporation's foreign subsidiary
creates a local pension plan for local employees. The proper timing of the
subsidiary's reduction of earnings and profits to reflect pension contributions
will be a factor in applying section 902 and the subpart F rules to the U.S.
parent. The IRS took the position prior to 1980 that the requirements of
section 404 were also applicable in this context.355

In response to the IRS position in this context,356 Congress in 1980
enacted section 404A357 allowing an electing employer to deduct certain
contributions to a "qualified foreign plan." A "qualified foreign plan" is not
required to meet all the requirements of section 401(a); rather, it is defined
simply as "any written plan of an employer for deferring the receipt of
compensation" as to which an employer makes an election, provided that the
plan is "for the exclusive benefit of the employer's employees or their
beneficiaries," and meets a requirement that 90% of the benefits represent
compensation to nonresident aliens that is not taxable by the U.S. 35s

Pursuant to section 404A, contributions to qualified foreign plans are
deductible when paid, either to a trust (or the equivalent of a trust) meeting
section 401(a)(2)'s requirement of exclusive benefit to employees, for a
retirement annuity, or to a participant or beneficiary; 359 alternatively,
"reserve plan" treatment may be elected so that the employer may take into
account "the reasonable addition for such year to a reserve for the taxpayer's
liability under the plan.' '36

0 The deduction for funded plans is, in the case

353. It is not clear how this rule is applied when the employee is a nonresident alien
not subject to U.S. taxation on the contribution. See Letter from Mark J. Ugoretz, infra note
367.

354. See Priv. Ltr. Rul. 79-04-042 (Oct. 25, 1978) (applying § 404(a)(5) to defined
benefit plans maintained by U.S. subsidiaries for local employees so as to permanently deny
a deduction for contributions if separate accounts are not maintained).

355. Tech. Adv. Memo. 78-39-005 (June 21, 1978). The IRS ruled that the earnings
and profits of an accrual basis German subsidiary could be reduced "only by the amount of
payments actually made under its pension plan, and not by the liabilities accrued under its
pension plan" in light of the "emphasis of section 404(a)... on actual payment... ." Id. The
subsidiary was entitled to a current deduction for the accrued liability under German tax law
even though the plan was not funded. Id.

356. See S. Rep. No. 1039, 96th Cong., 2d Sess. 10-12 (1980) [hereinafter 1980
Senate Report].

357. Act of Dec. 28, 1980, Pub. L. No. 96-603, § 2, 94 Stat. 3503, 3505 (1980).
358. See IRC § 404A(e).
359. Id. § 404A(b)(1), (5).
360. Id. § 404A(c)(1), (f). Some limitations on the determination of the addition to

the reserve are set forth in § 404A(c)(1)-(4).

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U.S. Income Taxation of Cross-Border Pensions

of a defined benefit plan, subject to the limits on overfunding in section
404(a)(1) and in the case of a defined contribution plan, subject to the 15%
of compensation limit of section 404(a)(3)."6 In any case, the taxpayer's
deduction may not exceed, on a cumulative basis, "the aggregate amount
allowed as a deduction under the appropriate foreign tax laws."32

The Senate Finance Committee explained its reason for enacting
Section 404A as follows:

The committee believes that the provisions of present law
generally applicable to deferred compensation plans are ill-
suited to plans maintained for the benefit of foreign employ-
ees. These plans must frequently comply with provisions of
foreign law which are either inconsistent with U.S. law or
can be made consistent only through the surrender of major
tax benefits under the foreign system ..... It is unnecessary
to burden qualification for these tax benefits with many of
the provisions intended to protect employees and their
beneficiaries applicable to domestic plans. 6'

Similarly, Congressman Barber Conable, Jr., stated that foreign plans for
foreign employees should not have to "comply with those U.S. deduction
rules that are motivated by U.S. social policy concerns rather than general
U.S. tax policy with respect to the appropriate calculation of taxable income
for the period."3"

Perhaps not surprisingly, the diversity of foreign rules regarding
pension plans has made it difficult and controversial to apply even the
stripped-down requirements of section 404A to foreign pension plans.
Proposed regulations issued in 1985"6 were withdrawn and replaced by

361. IRC § 404A(b)(3).
362. Id. § 404A(d). In order that the IRS may monitor satisfaction of this

requirement, the employer is required to furnish "a statement from the foreign tax authorities
specifying the amount of the deduction allowed in computing taxable income under foreign
law for such year," a copy of the foreign tax return showing the deduction "as a separate
identifiable item," or some other evidence of the amount of the deduction that is viewed as
sufficient under regulations. Id. § 404A(g)(2).

363. 1980 Senate Report, supra note 356, at 12.
364. Minor Tax Bills: Hearings Before the Subcommittee on Select Revenue

Measures of the Committee on Ways and Means, 96th Cong., 2d Sess. 143, 162 (1980)
(statement of Rep. Barber Conable, Jr.). See generally Gliksberg, supra note 205. at 472
(noting that "the objects of social policy are, as a rule, local residents or citizens"). Gliksberg
argues, for example, that "it is substantially right that redistribution of income within society
should apply to all the income of the members of that society, because they, and not foreign
residents, are the object of the redistribution." Id. at 473.

365. See 50 Fed. Reg. 13,821 (1985) (to be codified at 26 C.F.R. pt. 1) (proposed
Apr. 8, 1985).

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new proposed regulations in 1993.3' 6 Both sets of regulations have aroused
considerable criticism from U.S. multinationals. 67 Some have argued that

366. See 58 Fed. Reg. 27,219 (1993) (to be codified at 26 C.F.R. pt. 1) (proposed
May 7, 1993). In September 1996, the IRS supplemented these proposed regulations with
proposed regulations specifying the limited circumstances in which an employer is treated as
owner of a foreign employees' trust. See 1996 Proposed Rulemaking, supra note 22, 38-54.
Generally, these circumstances are (a) when the employer is a U.S. employer or a foreign
employer that is a CFC and plan funding is excessive, or (b) where a foreign employer transfer
assets to the trust "with a principal purpose of avoiding the PFIC rules." Id. H 35-36, 45-46.

367. For criticism of the 1993 regulations at the public hearing on Oct. 5, 1993, see
IRS' Proposed Foreign Deferred Plan Rules May Be Costly, Perpetuate "Ugly American,"
BNA Pensions & Benefits Daily (Oct. 7, 1993) (LEXIS, BNA library, BNAPEN file); Meegan
M. Reilly, Imposing U.S. Pension Concepts on Foreign Plans "Smacks of Ugly-Americanism,"
IRS Told, 93 TNI 194-1 (Oct. 7, 1993); Unofficial Transcript of IRS Hearing on Nonresident
Pensions, 93 TNI 197-10 (Oct. 5, 1993) (LEXIS, FEDTAX library, TNI file). For criticism of
the 1985 regulations, see e.g., Sam Goodley, IRS Hears Unanimous Criticism of "All or
Nothing" Election Rule in Sec. 404A Foreign Plan Regs., 85 TNI 33-4 (Sept. 25, 1985)
(LEXIS, FEDTAX library, TNI file).

For further criticism of the 1993 proposed regulations, see, e.g., Comments of
Thomas A. Rowley of William M. Mercer, Inc. (Dec. 4, 1994), reprinted in 95 TNI 9-14 (Jan.
13, 1995) (LEXIS, FEDTAX library, TNI file); Comments of Kevin W. Johnson of Dow
Chemical Company (Aug. 30, 1994), reprinted in 94 TNI 182-38 (Sept. 15, 1994) (LEXIS,
FEDTAX library, TNI file); Draft of Comments on Proposed Regulations Under Section 404A
of the Internal Revenue Code of American Bar Association, Section of Taxation (June 23,
1994), reprinted in 94 TNI 156-18 (Aug. 12, 1994) (LEXIS, FEDTAX library, TNI file); Letter
from Tom McMahon of Financial Executives Institute on behalf of Committee on Employee
Benefits (Apr. 13, 1994), reprinted in 94 TNI 81-28 (Apr. 27, 1994) (LEXIS, FEDTAX library,
TNI file) [hereinafter Letter from Tom McMahon]; Comments of Tax Executives Institute, Inc.
(Jan. 6, 1994), reprinted in 94 TNI 13-24 (Jan. 20, 1994) (LEXIS, FEDTAX library, TNI file);
Letter from Towers Perrin on behalf of a Group of Companies with Foreign Pension Plans
(Oct. 5, 1993), reprinted in 93 TNI 198-6 (Oct. 14, 1993) (LEXIS, FEDTAX library, TNI tile)
[hereinafter Letter from Towers Perrin]; Letter from William L. Sollee of Ivins, Phillips &
Barker (Oct. 5, 1993), reprinted in 93 TNI 198-4 (Oct. 14, 1993) (LEXIS, FEDTAX library,
TNI file); Comments of American Institute of Certified Public Accountants (Oct. 1, 1993),
reprinted in 93 TNI 199-3 (Oct. 13, 1993) (LEXIS, FEDTAX library, TNI file); Letter from
Lynn D. Dudley, on behalf of Association of Private Pension and Welfare Plans (Sept. 30,
1993), reprinted in 93 TNI 199-4 (Oct. 15, 1993) (LEXIS, FEDTAX library, TNI file);
Comments of E.I. Du Pont De Nemours on the Proposed Regulations Under Internal Revenue
Code Section 404A (Sept. 30, 1993), reprinted in 93 TNI 198-5 (Oct. 14, 1993) (LEXIS,
FEDTAX library, TNI file); Letter from Mark J. Ugoretz on behalf of The ERISA Industry
Committee (Sept. 24, 1993), reprinted in 93 TNI 195-10 (Oct. 8, 1993) (LEXIS, FEDTAX
library, TNI file) [hereinafter Letter from Mark J. Ugoretz]; Statement of the United States
Council for International Business to the Internal Revenue Service Regarding Proposed
Regulations Under Section 404A of the Internal Revenue Code (Sept. 24, 1993), reprinted in
93 TNI 193-16 (Oct. 6, 1993) (LEXIS, FEDTAX library, TNI file) [hereinafter Statement of
the United States Council for International Business]; Letter of Joseph W. Tierney, Jr. on
behalf of Digital Equipment Corp. (Sept. 23, 1993), reprinted in 93 TNI 193-14 (Oct. 6, 1993)
(LEXIS, FEDTAX library, TNI file) [hereinafter Letter from Joseph W. Tierney, Jr.]; Letter

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U.S. Income Taxation of Cross-Border Pensions

the IRS is using section 404A "as the vehicle for exporting U.S. ERISA type
rules and protections to employees" of qualified foreign plans;' s this, it is
contended, will "penalize US based multi-nationals and... also smacks of
ugly Americanism." '369

Thus, for example, critics argue that the requirements for qualifica-
tion of a fund as a "trust equivalent" under the Proposed Regulations' 0 "are
based on Anglo-American trust law," and will lead to "significant confusion
because of the different types of funding vehicles utilized throughout the
world."371 They argue that "it might be difficult in many countries to create
a legally enforceable duty of prudence in the holder of the fund, or to provide
absolute priority for creditors," 3 as required by the proposed regulations.
Some argue that the "strict impossibility of reversion requirement" imposed
by the Proposed Regulations may preclude section 404A qualification even
with respect to "trusts established under [such] English-speaking countries as
the United Kingdom, Canada and Australia, which follow the common law
system and recognize the trust concept.. . ."'3 Critics note that in some

from Marian A. Campbell on behalf of Exxon Corporation (Sept. 22, 1993), reprinted in 93
TNI 193-15 (Oct. 6, 1993) (LEXIS, FEDTAX library, TNI file); Letter from Norbert Rossier
on behalf of International Pension Consultants (July 1, 1993), reprinted in 93 TNI 134-16 (July
14, 1993) (LEXIS, FEDTAX library, TNI file).

368. Letter from Joseph W. Tierney, Jr., supra note 367.
369. Unofficial Transcript of IRS Hearing on Nonresident Pensions, supra note 367

(Statement of Robert Heitzman). Barbara Felker from the Office of Associate Chief Counsel.
International, asked Mr. Heitzman whether his view could be reconciled with the general
"requirement of US law ... that earnings and profits be computed under US principles," as
exemplified in the Goodyear case. Id. Mr. Weitzman replied that "pension law ... involves
balancing ... social goals versus revenue goals-and every country strikes its own balance."
Id. He further explained that "what we're really trying to do. I think, with this law is to
prevent manipulation of taxes and not to impose social policy that we in the US seem to have
deemed to be correct on foreign jurisdiction." Id.

370. See Prop. Regs. § 1.404A-I(e), imposing four requirements for a fund to be
treated as "equivalent of a trust": "(i) The corpus and income [of the fund] is separately
identifiable and segregated, through a separate legal entity, from the general assets of the
employer, (ii) The corpus and income... is not subject, under the applicable foreign law, to
the claims of the employer's creditors prior to the claims of employees... under the plan; (iii)
The corpus and income. . ., by law or by contract, cannot at any time prior to the satisfaction
of all liabilities with respect to employees under the plan be used for... any purpose other
than providing benefits under the plan; (iv) The corpus and income.. . is held by a person
who has a legally enforceable duty to operate the fund prudently." 58 Fed. Reg. 27,219,
27,230 (1993) (to be codified at 26 C.F.R. pt. 1) (proposed May 7, 1993).

371. ABA Section of Tax'n, Foreign Pension Task Force Subcommittee of the
Committee on Employee Benefits, Comments on Proposed Regulations Under Code Section
404A (Nov. 2, 1994), reprinted in 94 TNI 232-7 (Dec. 2, 1994) (LEXIS, FEDTAX library,
TNI file) [hereinafter ABA Comments].

372. Letter from Towers Perrn, supra note 367.
373. Statement of United States Council for International Business, supra note 367.

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countries withdrawals of surplus assets are permitted or even "required" under
local law.374 Among the important pension vehicles that may not meet the
requirements of the Proposed Regulations are the so-called Security Con-
tract3 75 under German law and funds covering a number of different

374. Withdrawals of surplus assets are said to be "required," in some cases, in the
United Kingdom and Japan and to be permitted in Mexico, the Netherlands and Ontario. See
Comments of Tax Executives Institute, Inc., supra note 367 (mentioning UK and Mexico);
Comments of The Dow Chemical Company, supra note 367 (discussing Dow plans in Canada
and the Netherlands); Letter from Tom McMahon, supra note 367 (in the UK, "surplus
reversion is a commonly utilized method of complying with... [the] requirement" that surplus
assets be reduced; also discussing requirement of returning surplus assets in Japan); Letter
from Towers Perrin, supra note 367, ("The laws of some countries, such as the United
Kingdom, . . . allow surplus assets to revert to the employer, and in some cases require it.");
Letter from C. Frederick Oliphant IlI, of Miller & Chevalier (Feb. 6, 1995), reprinted in 95
TNT 36-14 (Feb. 23, 1995) (LEXIS, FEDTAX library, TNT file) (under qualified Canadian
pension plans subject to the local law of Ontario, the employer may be permitted to withdraw
surplus assets even though no settlement has been made of existing pension liabilities). The
ERISA Industry Committee stated that "the impossibility-of-reversion requirement is virtually
impossible to satisfy in any country except the United States, and in many countries would
either be illegal or contrary to accepted business and actuarial practice." Letter of Mark J.
Ugoretz, supra note 367. The Committee of ERISA Industry states that "in the United
Kingdom, plans that do not permit reversions of surplus assets ... are at a serious tax
disadvantage" because "[f]unding practices are conservative and, should large surpluses result
... the Inland Revenue will require them to be eliminated." Id. Moreover, "[s]ettling the
liabilities would generally not be permitted, or be practical in terms of the local insurance
market." Id. The committee states more generally that "Itihe capital markets in foreign
countries are often not sufficiently well-developed to annuitize participants' accrued benefits
on plan termination, or even reliably to determine the amount that would be necessary to
satisfy those benefits." Id. See also Statement of United States Council for International
Business, supra note 367 ("[M]any countries with advanced legal systems generally thought
to be protective of employees permit or even require pension trusts or funds to revert money
to the employer ... if the plan is overfunded," including "United Kingdom, Canada, Australia
and Holland .... [I]t is not clear whether in all these countries an employer can modify the
trust instrument to negate this possibility.").

375. In a security contract arrangement, assets funding pension liabilities are
transferred to a wholly-owned subsidiary that "pledges its assets to a custodian who then gives
a guaranty to the employees." Comments of Tax Executives Institute, Inc., supra note 367. The
proposed regulations decline to approve this arrangement because of uncertainty as to whether
the pledged assets are in fact "protected from the claims of an employer's creditors in the
event of bankruptcy." Preamble to Proposed Regulations, 58 Fed. Reg. 27,219, at 27,221 (to
be codified at 26 C.F.R. pt. 1) (proposed May 7, 1993). The Tax Executives Institute
recommends that the regulations approve such arrangements "perhaps on the basis of an
opinion of German counsel that the pension assets are protected from claims of the employer's
creditors." Comments of Tax Executives Institute, Inc., supra note 367. See also Letter of
Mark J. Ugoretz, supra note 367 ("[In Germany,. . . there exists no [other] legal vehicle...
that can prevent a reversion to the employer without also resulting in the current taxation of
plan participants.").

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U.S. Income Taxation of Cross-Border Pensions

employers under the laws of France, the Netherlands, and Sweden. 6

One suggestion offered to the Treasury to better accommodate foreign
law is to allow a foreign plan to be "qualified" despite gaps in foreign law
protections provided that the plan "make[s] certain representations which
would have the effect of protecting the integrity of the funded investment
vehicle."3" Others propose that any detailed attempt to apply U.S. concepts
to foreign plans should be abandoned; instead the IRS should "publish a list
of foreign countries whose laws adequately protect the employees' pension
funds," and accept plans "complying with a foreign country's laws and
regulations.9

378

The experience with section 404A demonstrates the difficulties of
applying U.S. tax rules to foreign pension plans. These difficulties are at least
somewhat eased by the fact that the pension plan is created by a U.S.
corporation or its foreign subsidiary. By contrast, when the U.S. seeks to tax
a U.S. citizen or resident participant in a foreign plan, and the employer has
no contact with the U.S., the difficulties of obtaining information about
foreign law and the operation of the plan would likely be much greater.

E. Possible Improvements of U.S. Residence-Based Taxation of Beneficiaries
of Foreign Plans

Present law's approach for taxing U.S. participants in foreign pension
plans is to apply U.S. pension standards and, consequently, classify virtually
all foreign plans as nonqualified; therefore, current taxation of contributions
to the plan and accrued earnings (in the case of an HCE) is required. As
noted, this approach presents serious problems of enforcement, valuation,

376. In these countries, employers "may be required by law or by union agreements.
to contribute to a nongovernmental fund covering many different companies under a full or
partial cross-subsidies between the various participating companies." Unofficial Transcript of
IRS Hearing on Nonresident Pensions, supra note 367 (statement of Thomas Rowley of
William M. Mercer, Inc.). Thus, these plans are not "for the exclusive benefit of the employees
of the employer .. " Id.

377. ABA Comments, supra note 371. The representations, relating to trust
equivalence, are that "(A) the corpus and income of the fund shall be segregated from the
assets of the employer and shall be separately accounted for," (B) generally, "the corpus and
income shall not, any time prior to the satisfaction of all liabilities with respect to employees
under the plan be used for, or diverted to, any purpose other than providing benefits under the
plan"; and "(C) the Administrator holding the corpus and income shall agree to operate the
fund prudently." Id. There would be further contractual undertakings to insure compliance with
the exclusive benefit rule, i.e., "there shall be no reversions of assets from the plan to the
employer unless-(i) the reversion shall leave in the plan assets having a fair market value
equal to 125% of the accrued benefit obligation under the plan ... : and (ii) the reversion is
permitted under local law or regulation." Id.

378. Comments of Tax Executives Institute, Inc., supra note 367.

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liquidity, and mismatching of U.S. and foreign tax (with resulting double or
under-taxation).

Yet there are at least two alternative approaches available: (1) The
U.S. might treat all foreign pension plans as qualified plans (or, to the same
effect, as unfunded). Thus, all taxation of the employee would be deferred
until the time of distribution. (2) The U.S. might follow the tax treatment
accorded in the place where the plan is situated; that is, if the plan is eligible
for deferral of employee tax on contributions, the U.S. would also allow such
deferral. Thus, it is worth examining the justifications for the present law.

The logic behind the present law is that deferral of the employee's
tax on deferred compensation should depend upon the quid pro quo that
either (a) the arrangement satisfies the requirements of section 401, or (b) the
employer's deduction is also deferred (as in the case of an unfunded
plan).379 Since foreign plans do not satisfy all the detailed requirements of
section 401, this quid pro quo is viewed as not being present. Requirements
for pension plans in other developed countries may be designed to achieve
similar goals, but are considered to be insufficiently similar to substitute for
the requirements of section 401. If a U.S. citizen or resident can achieve the
same U.S. tax results in a foreign plan as in a U.S. qualified plan, the
incentive to participate in a qualified plan is undermined. As long as an
individual is a U.S. citizen or resident, the U.S. has the responsibility to apply
its own standards to pension plans in which the individual participates (in part
for his or her own protection).380

The logic of this "quid pro quo" theory is not, however, as compel-
ling in a cross-border context as in a domestic context.

First, if the employer is a foreign corporation without U.S. business
activities or a U.S. affiliate, the employer will not offer the employee the
option of participating in a qualified U.S. pension plan. Thus, there is no
point in denying deferral to the employee as an incentive to channel his
retirement savings to a U.S. qualified plan (unless the intent is to encourage
him not to work abroad for a foreign employer).

Second, in many cases, pension plans organized in a foreign country
may meet the objectives behind the requirements of section 401 even if the
foreign law does not embody all the requirements of section 401. At the same
time, it is not realistic to expect a foreign employer to design a plan that is
primarily for employees working outside the U.S. so as to meet the precise
requirements of section 401.

379. See supra notes 303-313 and accompanying text.
380. As explained by Professor Gliksberg, residence-based jurisdiction "focus[es]

... on the connection between the resident and the State, and the taxpayer's general duty to
contribute to government expenditure since he or she benefits from the full range of its
services, in all spheres of life .... Gliksberg, supra note 205, at 473.

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U.S. Income Taxation of Cross-Border Pensions

Third, in many cases, deferral of employee taxation by the U.S. may
not lead to any overall advantage to the employee. The overall effect will also
depend upon foreign law, which is outside the U.S.'s control. Foreign law
may tax the employee on contributions to the plan when made. The foreign
law may impose a tax on the pension trust's investment income (thereby
eliminating the advantage of a qualified plan under U.S. law), or the foreign
law may defer the employer's deduction.

Fourth, in a case where an alien's U.S. residence begins only after
contributions are made to a foreign pension plan, a deferral of the employee's
tax will close an existing loophole rather than opening a new one. In
situations where the foreign country defers its tax on the employee and then
forgives it if the employee retires abroad, deferral by the U.S. has the effect
of insuring that some tax will be imposed on the deferred compensation.

On the other hand, it is not clear that either of the two alternative
treatments should be adopted by the U.S. by unilateral action. The first
alternative (deferral for all foreign pension plans) has the advantage of
eliminating the problems of valuation, liquidity, and understandability entailed
by current taxation. Since the actual distribution to the employee is always
the taxable event, the employee is in a position to determine the amount
subject to U.S. tax without the assistance of the foreign plan administrator or
foreign tax authorities. On the other hand, it would not insure much greater
coordination with the foreign law treatment than does the current approach.
Moreover, especially outside the context of a treaty, the U.S. might be
concerned that delaying imposition of tax might make enforcement more
difficult. This approach might be viewed as particularly unwarranted in a
situation where a U.S. citizen or resident works in a low-tax or tax-haven
country, and thus is subject to little or no foreign tax.

The second alternative (following the foreign law treatment) would
eliminate current taxation with its associated problems in many cases. Under
this alternative, U.S. tax would be imposed currently only to the extent that
the situs of the plan would also tax currently. Thus, the plan administrators
would be in a position to determine the amount to report as current income
for U.S. tax purposes; problems of liquidity and understandability would not
be exacerbated by the U.S. treatment. However, this approach would be
difficult to administer outside the context of a treaty relationship because it
would require characterization of the pension plan under the law of the situs
country and would require the cooperation of the plan administrator.

These considerations suggest that unilateral change in U.S. law should
be relatively limited, and that, in general, the needed improvements should
be by treaty. However, there are two changes that the U.S. should adopt
unilaterally. First, the U.S. should unilaterally close off opportunities for a
foreign national who retires in the U.S. to avoid all tax on distributions from
a pension plan in a foreign country; the other country, where the foreign

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Florida Tax Review

national previously worked and resided, may not assert jurisdiction to tax
such distributions. The U.S. can insure that U.S. tax is imposed in such a case
by amending section 72 so that an individual's investment in the contract for
pension distributions includes only amounts shown to have been already
subjected to tax either by the U.S. or by the country where the services were
performed or where the pension fund is located. The U.S. should not in its
role of residence country provide a tax haven for foreign nationals, regardless
of whether the country of nationality has a treaty with the U.S. To ease
administrative burdens for the IRS, the taxpayer should have the burden of
establishing that foreign taxation has previously been imposed. See Table 2-
A, row 10, page 365.

Second, the U.S. should amend the Code to treat all foreign defined
benefit plans as unfunded. Under this change, a U.S. resident or citizen who
participates in a defined benefit plan in a foreign country would be taxable
only when actual distributions are made from the plan; the distributions, when
made, would be sourced entirely to the place where the services were
performed. See Table 2-A, row 8, page 364. The U.S. should make this
change unilaterally because the current rules applied to foreign defined
benefit plans are uncertain in application and too difficult to administer. It
seems highly unlikely that a satisfactory level of enforcement is, or could
ever be, achieved. If this "unfunded" treatment is considered too alluring an
opportunity for U.S. tax planning, then it could be limited to situations where
the structure is likely determined by foreign tax or other considerations. For
example, this "unfunded" treatment could be reserved for foreign plans for
which at least 90% of the benefits accrue to nonresident aliens.

This treatment of foreign defined benefit plans as unfunded should
also be applicable to nonresident aliens who participate in a foreign defined
benefit plan in respect of services performed in the U.S. See Table l-A, row
4, page 363. Administrative problems of imposing the U.S. source-based tax
on a current basis are equally severe in this context. Allowing income of a
nonresident alien to be deferred to the time of retirement when the individual
may have no further connection to the U.S. in itself greatly lessens the
likelihood of enforcement. Nevertheless, the likely advantage in enforcement
from imposing tax while the individual is still conducting activities in the
U.S. does not seem sufficient to outweigh the burden of computing current
tax with respect to a foreign defined benefit plan.

V. A MORE COMPREHENSIVE U.S. TREATY POLICY

The treaty policy for pensions embodied in most existing U.S.
treaties, the 1981 U.S. Model and the OECD Model, i.e., that pension
payments should be taxed exclusively in the residence country, does not
resolve all of the complex issues of coordination presented by the taxation of
cross-border pensions.

[VoL 3:6



U.S. Income Taxation of Cross-Border Pensions

The term "pension" as used in existing treaties does not have an
authoritative and clear-cut definition; this makes the position of a withholding
agent extremely difficult. Most existing U.S. treaties address only the
treatment of payments from pension plans: they do not address taxation of
contributions when made or earnings when accrued in a plan. Thus,
apparently, the country where services are performed, the country where the
plan is located, or the country where the pensioner resides prior to retirement
are all authorized to impose tax on pension benefits prior to distribution (even
though such taxation may be very difficult to administer). This creates the
potential for overlapping taxation at different times. In addition, there is no
attempt to assure that residence taxation will in fact be imposed in situations
where source-base taxation is foregone. Thus, further refinements of the U.S.
treaty policy are clearly required.

A few treaties entered into by the U.S., i.e., those with Canada,
France and Sweden, as well as the proposed treaty with Austria, do contain
provisions beyond those contained in the 1981 U.S. Model. Thus, the French
and Swedish treaties, as well as the proposed treaties with Austria and
Switzerland, include a variation of the provision of the OECD commentary
dealing with contributions to a home country plan. The treaties with Canada
and France, moreover, provide for some coordination of residence-based tax
with the timing rules in the source country.

The 1996 U.S. Model has commendably embraced this kind of
broadening of U.S. treaty policy. The 1996 U.S. Model has provided further
elaboration of the term "pension" in its Technical Explanation, has adopted
a somewhat expanded variation of the OECD commentary provision dealing
with contributions to a home country plan, and has provided for the residence
country to relinquish tax on distributions to the extent previously taxed in the
source country. These provisions should be adopted more widely and be
expanded upon to create a more comprehensive treaty policy for pensions.

The following proposal for a new treaty policy attempts to address
the concerns described above. Under this proposal,

(a) A pension plan would be defined as an arrangement created by an
individual or his employer to provide a separate fund for his
retirement, provided that the country where the fund is located treats
the fund as a tax-favored pension arrangement with respect to which
employee tax is deferred until distribution, and establishes limits on
the amount of tax-favored contributions or benefits. Neither the
pension article nor the "other income" article would protect any other
form of deferred compensation from source-based tax; however, the
"dependent services" article would potentially be applicable.

(b) No country having a treaty with the country in which the pension
plan has its situs would tax amounts contributed to the pension plan

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Florida Tax Review

(by employee or employer) or earnings accrued in the plan, prior to
distribution to the employee (or beneficiary). See Table 1-A, row 4,
page 363; Table 2-A, row 8, page 364. However, the pension plan
would be required to report the eventual distribution to tax authorities
in the country where the services are performed, the country where
the plan is located, and the country in which the employee then
resides."'

(c) When a pension is distributed in a manner permitted under the laws
of the plan's situs (whether by lump sum or periodic payments), any
country where the services were performed or where the plan is
situated would refrain from taxation if such country has a treaty with
the country of the pensioner's then residence. The residence country
would be required382 to tax the full amount of the distribution;
except that (as in the 1996 U.S. Model) the residence country would
be barred from taxing amounts previously taxed by a country that is
its treaty partner. See Table 2-A, row 10, page 365. However,
because of paragraph (b) above, the likelihood of previous taxation
would be reduced.

The proposed policy (if widely adopted in U.S. treaties) would
achieve much greater coordination in the taxation of cross-border pensions.
For any particular pension, one country's laws would control the timing of
the imposition of tax (including the amount to be taxed at any particular
time). The country where the plan is located is the most logical choice to
serve in this role. This place (unlike the place of residence) ordinarily would
not change over time. Moreover, this rule assures that the plan administrator
would be familiar with the controlling law; thus, he would be in a position
to issue information reports at the correct time and showing the correct
amount. Reliance on the timing rules of the country where the plan is situated

381. See Avi-Yonah, supra note 225, at 1336-37 (suggesting two ways to make
residence-based taxation of passive income more effective: "to enhance the information
exchange programs under tax treaties" and "for developed countries to establish a concerted
program of withholding taxes at the source of income for the benefit of the residence
country."). This withholding tax could be remitted to the residence country if "the investor
furnishes documentation showing that the income has been declared in his or her residence
country." Id. at 1337.

382. If necessary, an explicit exception could be made to the statement in most
treaties, e.g., in 1996 U.S. Model, art. 1, 2, that the treaty will not restrict a benefit accorded
by internal law. See supra note 343. The proposal in text should be viewed as merely
providing for a treaty to change the timing of a tax under internal law and not as providing
for the treaty to impose a tax that does not exist under internal law.

[Vol. 3:6



U.S. Income Taxation of Cross-Border Pensions

is already accepted in treaties with France,383 Canada,3 and Sweden.3 s

Under this proposal, an employee would not be discouraged from
working away from the country of his permanent residence by the prospect
of losing favored pension treatment. Thus, for example, a U.S. citizen
working abroad would not need to be concerned about immediate U.S.
taxation if he participated in a foreign qualified plan; nor would he be
concerned about immediate foreign taxation if he participated in a U.S.
qualified plan.

This policy (if adopted widely) would also insure that only one
country has jurisdiction to tax pension benefits, i.e., the residence country,
determined at the time of the distribution. For example, assume that an
employee is a participant in a pension plan, located in a country that allows
taxation of contributions to the plan to be deferred. If the country where the
plan is located has entered into a treaty with the employee's country of then
residence and the country where services are performed, then the treaties
would prevent current taxation of contributions to the plan or accruals of
earnings in the plan. Since the agreed time to tax would be the time of
distribution, the country of residence at the time of distribution would have
exclusive tax jurisdiction (assuming that it had a treaty with each of those
countries having potential source-based jurisdiction).

This proposal also seeks to insure that treaties will not have the effect
of rendering pension income completely exempt from any significant tax.
Thus, this proposal requires that the country of residence at the time of
distribution may not decline to tax the distribution received by a resident on
the grounds that the distribution is merely a return of capital or income
previously earned at a time when residence was not established, except to the
extent that the pension benefit has already been subject to tax by a country
that is a treaty partner of the residence country. In this way, the countries that
relinquish source-based taxation can be assured that the pension benefits will
not completely escape taxation.

If the place of the employee's residence at the time of distribution is
not a treaty partner of the source countries, source-based taxation would be
preserved. Assume that a country X national, residing and working in the
U.S., contributes to a country X qualified pension plan and that country X
defers employee taxation with respect to a qualified pension plan until the

383. See supra text accompanying note 341 (the Staff of the Joint Committee on
Taxation describes the French treaty provision as looking to the "source" country to determine
the time and extent of taxation). The "source" country for this purpose seems to be the place
where the plan is located, i.e., France, where a French national living and working in the U.S.
contributes to a French plan.

384. See supra text accompanying note 295.
385. See supra text accompanying note 195.

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Florida Tax Review

time of distribution. Under the treaty between the U.S. and X, the U.S. would
defer imposition of tax (whether residence-based or source-based) until the
time of distribution (in conformity with country X law). If the employee
ultimately received distributions while residing in country X, country X (but
not U.S.) tax would be imposed at that time. If, however, the employee
retired in the Cayman Islands, neither the U.S. nor X would be precluded by
any treaty from taxing the eventual distribution. The plan administrators
would have to insure that the plan provides information about distributions
to the U.S. and country X tax authorities.

If the country where the plan is located has not entered into income
tax treaties (e.g., the Cayman Islands), the special treaty treatment for
pensions described above would be inapplicable. Contributions to the pension
plan could be taxed as compensation either by the country of the employee's
residence and/or by the country where the services were performed (unless
taxation by the latter country is precluded under the dependent services article
of a treaty between the two countries).

Similarly, the above-described treaty provisions would not apply if
the country where the plan is located does not treat the type of plan as
eligible for deferral of employee tax (e.g., a U.S. nonqualified plan), whether
or not that country actually has a basis for source- or residence-based taxation
of the employee. In that case, however, treaties would subject the plan to
information-reporting requirements. Thus, the plan administrator would be
required to provide information regarding the amount treated as current
income (under the situs country's rules) to the tax authorities in the country
where services are performed and the tax authorities in the country of the
employee's residence.

This proposal may be criticized as surrendering too much of the
currently claimed U.S. tax jurisdiction over pensions. In contrast to the 1981
and 1996 U.S. Model, this proposal may block U.S. imposition of a current
tax on contributions to a foreign plan by an employee resident in the U.S. or
performing services in the U.S., even if the foreign plan is not a home
country plan in which the employee has previously participated (as required
by 1996 U.S. Model, article 18 paragraph 6). However, this effect may not
be as significant as it first appears. The U.S. would retain the opportunity to
tax the eventual distribution from the plan unless the participant's residence
at that time is in a foreign country that is a treaty partner. Moreover, the
savings clause could preserve U.S. taxation at the time of distribution if the
participant is a U.S. citizen.

This proposal and the proposals for improvement of U.S. residence-
based taxation of beneficiaries of foreign pension plans386 are depicted in

386. See supra Part IV.E.

[Vol 3:6



1996] U.S. Income Taxation of Cross-Border Pensions 357

bold (to contrast with the depiction of current law) in Tables 1-A, page 362,
and 2-A, page 364.



Florida Tax Review

TABLE 1"

NONRESIDENT ALIEN EMPLOYEE: SERVICES PERFORMED IN THE U.S.

Type of Plan

1. Unfunded
deferred
compensation

2. U.S.
qualified plan

3. U.S.
nonqualified
funded plan

4. Foreign
funded plan

Treatment Under Code

EET.* Entire distribution
treated as effectively
connected income.

EET.* At time of
distribution, compensation
element is taxed as
effectively connected
income, and accretion is
taxed at 30% rate.

TET.* Contributions
taxed as effectively
connected income;
accretion taxed at 30%
on distribution (or
on accrual if highly
compensated employee).

TEE.* Contributions
taxed as effectively
connected income.

Treatment Under
U.S. Models
No change (except
that distribution is
exempt if it qualifies
as pension or meets
business traveler
exemption of
dependent services
article).

EEE.* The pension
article bars U.S. tax
on distribution.

TEE.* The pension
article may bar U.S.
taxation of accretion
on distribution.

No change under
1981 Model. Under
1996 Model, contribu-
tions to home country
plan may be exempt,
if employee already
participated in plan.

* In the terminology of Andrew Dilnot, see supra notes 67-71 and accompanying

text, a pension tax regime can be described by a three letter acronym, referring to its status
as "exempt" (E) or "taxable" (T) at each of three points in time: the time of contribution, the
time when earnings are derived in the plan, and the time of distribution. Thus, for example,
"EET" refers to a tax regime of exemption from tax at time of contribution; exemption when
earnings are derived, and full taxation at the time of distribution; "EEE" refers to a regime of
exemption throughout; 'TB" refers to a regime of taxation at the point of contribution and
at the time of distribution.

[Vol 3:6



1996] U.S. Income Taxation of Cross-Border Pensions

(TABLE 1 CONTINUED)

NONRESIDENT ALIEN EMPLOYEE: SERVICES PERFORMED OUTSIDE U.S.

Type of Plan

5. U.S.
qualified plan

6. U.S.
nonqualified
funded plan

Treatment Under Code

EET.* Accretion taxed
on distribution, unless
exempted by § 871(f).

EET.* Accretion taxed
on distribution (or
on accrual, if highly
compensated employee).

Treatment Under
U.S. Models
EEE.* Treaty bars
U.S. taxation of
distribution.

EEE.* Treaty may
bar taxation of
accretion on
distribution.



Florida Tax Review

TABLE 2

U.S. CITIZEN OR RESIDENT AT TIME OF DISTRIBUTION:
SERVICES PERFORMED OUTSIDE U.S.

U.S. CITIZEN OR RESIDENT AT ALL TIMES

Type of Plan

7. Unfunded
deferred
compensation

8. Foreign
funded plan

Treatment Under Code

EET.* Distribution is
taxable as foreign
source compensation.

TET.* Because plan is
nonqualified,
contributions are taxed;
accretion taxed on
distribution (or on
accrual, if highly
compensated employee).

Treatment Under
U.S. Models
No change under
1981 Model. Under
1996 Model, any
payment classified
as pension is exempt
to extent previously
taxed by other
country.

No change under
1981 Model. Under
1996 Model, on dis-
tribution U.S. tax is
barred to extent of
amount previously
taxed by other
country.

[Vol 3:6



U.S. Income Taxation of Cross-Border Pensions

(TABLE 2 CONTINUED)

NONRESIDENT ALIEN AT TIME OF ACCRUAL;
RESIDENT ALIEN AT TIME OF DISTRIBUTION OF BENEFITS

Type of Plan

9. Unfunded
deferred
compensation

10. Foreign
funded plan

Treatment Under Code

EET.* Entire
distribution is
taxable as foreign
source compensation.

EEE.* Distribution
is exempt as return
of capital, except
that accretion element
is taxed if not highly
compensated employee.

Treatment Under
U.S. Models
No change under
1981 Model. Under
1996 Model, any
payment classified
as pension is exempt
to extent previously
taxed by other
country.

No change under
1981 Model. Under
1996 Model, accretion
element not taxed to
extent previously
taxed by other
country.

* See footnote to Table 1, page 358.

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Florida Tax Review

TABLE 1-A

NONRESIDENT ALIEN EMPLOYEE: SERVICES PERFORMED IN THE U.S.

Type of Plan

1. Unfunded
deferred
compensation

2. U.S.
qualified plan

3. U.S.
nonqualified
funded plan

Treatment Under Code

EET.* Entire distribution
treated as effectively
connected income.

EET.* At time of
distribution,
compensation element is
taxed as effectively
connected income,
and accretion is
taxed at 30% rate.
Proposal: Entire distri-
bution taxed as effec-
tively connected income.

TET.* Contributions
taxed as effectively
connected income;
accretion taxed at 30%
on distribution (or on
accrual if highly
compensated employee).

Treatment Under
U.S. Models
No change (except
that distribution
is exempt if it
qualifies as pension
or meets business
traveler exemption
of dependent services
article).

EEE.* The pension
article bars U.S. tax
on distribution.

TEE.* The pension
article may bar U.S.
taxation of accretion
on distribution.
Proposal: Treaty
inapplicable since
situs country does
not defer employee
taxation.

[Vol 3:6



U.S. Income Taxation of Cross-Border Pensions

(TABLE 1-A CONTINUED)

Type of Plan

4. Foreign
funded plan

Treatment Under Code

TEE.* Contributions
taxed as effectively
connected income.
Proposal: In case of
defined benefit plan,
treatment in row 1
applies, i.e., EET.*

Treatment Under
U.S. Models
No change under
1981 Model. Under
1996 Model, contribu-
tions to home country
plan may be exempt,
if employee already
participated in plan.
Proposal: EEF.* US.
does not tax at time
of contribution if
plan's situs provides
deferral of taxation
for employee.

NONRESIDENT ALIEN EMPLOYEE: SERVICES PERFORMED OUTSIDE U.S.

Type of Plan

5. U.S.
qualified plan

6. U.S.
nonqualified
funded plan

Treatment Under Code

EET.* Accretion taxed
on distribution,
unless exempted by
§ 871"(f).
Proposal: EEE.*
Accretion not taxed.

EET.* Accretion taxed
on distribution (or
on accrual, if highly
compensated employee).

Treatment Under
U.S. Models
EEE.* Treaty bars
U.S. taxation of
distribution.

EEE.* Treaty may
bar taxation of
accretion on
distribution.
Proposal: Treaty
inapplicable since
situs country does
not defer employee
taxation.

* See footnote to Table 1, page 358.

1996]



Florida Tax Review

TABLE 2-A

U.S. CITIZEN OR RESIDENT AT TIME OF DISTRIBUTION'
SERVICES PERFORMED OUTSIDE THE U.S.

U.S. CITIZEN OR RESIDENT AT ALL TIMES

Type of Plan

7. Unfunded
deferred
compensation

8. Foreign
funded plan

Treatment Under Code

EET.* Distribution is
taxable as foreign
source compensation.

TET.* Because plan is
nonqualified,
contributions are taxed;
accretion taxed on
distribution (or on
accrual, if highly
compensated employee).
Proposal: In case of
defined benefit plan,
treatment in row 7 avplies.

Treatment Under
U.S. Models
No change under
1981 Model. Under
1996 Model, any
payment classified
as pension is exempt
to extent previously
taxed by other
country.

No change under
1981 Model. Under
1996 Model, on
distribution, U.S.
tax is barred to
extent of amount
previously taxed by
other country.
Proposal: EET.* U.S
does not tax at time
of contribution if
plan's situs provides
deferral of tax for
emplo.e. As in 1996
Model, on distribu-
tion, U.S. does not
tax amount
previously taxed by
other country.

[Voi. 3:6



U.S. Income Taxation of Cross-Border Pensions

(TABLE 2-A CONTINUED)

NONRESIDENT ALIEN AT TIME OF ACCRUAL;
RESIDENT ALIEN AT TIME OF DISTRIBUTION OF BENEFITS

Type of Plan

9. Unfunded
deferred
compensation

10. Foreign
funded plan

Treatment Under Code

EET.* Entire
distribution is
taxable as foreign
source compensation.

EEE.* Distribution
is exempt as return
of capital, except
that accretion element
is taxed if not highly
compensated employee.
Proposal: EET.* No
basis recovery allowed
except for amounts
subjected to tax by
other country.

Treatment Under
U.S. Models
No change under
1981 Model. Under
1996 Model, any
payment classified
as pension is exempt
to extent previously
taxed by other
country.

No change under
1981 Model. Under
1996 Model,
accretion element
not taxed to extent
previously taxed
by other country.
Proposal: EET.*
Residence country
to tax any amount
of distribution not
previously subjected
to tax by other
country.

* See footnote to Table 1, page 358.

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Florida Tax Review

V. CONCLUSION

The growth in the number of employees who move across national
borders makes this an opportune time for the U.S. to examine its tax
treatment of deferred compensation paid to such employees. The current U.S.
statutory rules governing these transactions together with the U.S. treaty
network do not assure a coherent and administrable approach for taxing such
compensation.

This article proposes three changes that the U.S. should unilaterally
make in its statutory treatment of these transactions to meet these concerns.
The first change is to simplify the U.S. assertion of source-based jurisdiction
over pension distributions from a U.S. qualified plan by eliminating separate
identification of the "accretions" element. The second change is to adjust U.S.
basis rules to close off existing opportunities for a foreign national to use the
U.S. as a tax haven on retirement. The third change is for the U.S. to
relinquish its impractical assertion of current taxation of a U.S. resident's
contributions to foreign defined benefit plans.

More generally, this article recommends that the U.S. should promote
a more comprehensive treaty policy dealing with these transactions. If this
policy were widely adopted, it would lead to better coordination of the
taxation of an employee's deferred compensation by the potentially large
number of countries that may assert source-based or residence-based
jurisdiction. This would prevent employees from suffering unwarranted
double taxation or from seeking out unwarranted tax exemption, and would
simultaneously assure that the U.S. and its trading partners receive their
rightful share of tax revenues.

[Vol. 3:6