February 15, 2021 / North America
In recent years, foreign pension funds have been steadily increasing their investments in US alternative investment funds, such as private equity, real estate, and infrastructure funds. Many pension fund managers are surprised at the complexity of the US tax rules, and even more surprised at the difficulties associated with the preparation and filing of US income tax returns.
US-based pension funds are generally exempt from US federal income tax (except, for example, if they invest in an active trade or business or have debt-financed investment returns). This broad exemption does not apply to foreign pension funds, although US income tax treaties provide some relief. In addition, some government-sponsored pension arrangements may be exempt from US tax under provisions that apply to foreign governments.
Ordinarily, foreign investors are subject to tax under the Foreign Investment in Real Property Tax Act (FIRPTA) with regard to their investments in US real estate. Under this regime, gains from the sale of US real estate (and certain entities holding US real estate) are generally subject to US income tax at applicable tax rates (as well as a 15% withholding tax on gross proceeds). Many foreign pension trusts can qualify for an exemption from FIRPTA.
That said, many foreign pension funds will be considered to be a foreign trust for US income tax purposes. As a result, they are generally taxed under rules that apply to nonresident individuals. Under those rules, ordinary business income is subject to federal tax at a rate that can be as high as 37% (but the tax on long-term capital gains is capped at 20%). (That said, it should be noted that it is very possible that these rates will be increased under the Biden Administration.) In addition, foreign pension trusts can be subject to state and local income taxes at varying rates. (The federal deduction for state and local income taxes is limited to $10 thousand per year.)
What will come as a bigger surprise to many fund managers, is that the IRS has not developed an income tax return/reporting form for foreign trusts. As such, the federal income tax returns of foreign trusts require an ad hoc combination of forms developed for nonresident individuals and domestic trusts. This creates a “Frankenstein’s monster” of an income tax return (see the below picture of one such US tax return for a foreign pension trust).
To add insult to injury, this piecemeal/ad hoc return cannot be prepared using existing tax software products and the return cannot be filed electronically. This causes foreign trusts returns, in most cases, to be significantly more expensive to prepare and file than a similar return for, e.g., a domestic trust. (In general, the state returns are prepared using forms specifically designed for trusts and do not have similar form preparation complexities, but have similar electronic filing limitations.)
Lee Zimet recently submitted comments to the IRS requesting that foreign trusts (including foreign pension funds) be allowed to use IRS Form 1041, the form currently used by domestic trusts. A copy of Mr. Zimet’s comments are available to view here. If adopted, the compliance difficulties (and costs) associated with filing returns for foreign pension funds would be dramatically decreased.
As a result of the stitched together nature of the income tax return currently used by foreign trusts, and as noted above, taxpayers are not permitted to file their tax returns for foreign trusts electronically. This results in voluminous returns having to be filed by mail in paper form. There is a hope that if the IRS permits foreign trusts to file returns using the form for US/domestic trusts (Form 1041), that the IRS will also permit foreign trust returns to be filed electronically.
In the meantime (at least for the 2020 tax return filing season), foreign trusts (and foreign pension funds in particular) will continue to have to apply the existing/unduly complicated US tax compliance regime. The international tax specialists of Alvarez & Marsal Taxand, LLC are very conversant with this regime and would be more than happy to help you navigate its complexities.
To view Lee Zimet’s comments in regards to IRS Form 1041, click here.