Since the passage of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, interest in the use of qualified retirement plans has increased. However, qualified retirement plans are not without their limitations and complications. For the closely held business owner, the controlled group and affiliated service group rules serve to limit the ability of business owners to discriminate in favor of the business owner or create duplicate pension arrangements to multiply the benefit of pre-tax contributions and tax deferral.
U.S. taxpayers are taxed on their worldwide income. Complex tax rules limit the ability of U.S. taxpayers to generally achieve tax deferral through the use of foreign corporations. Even if you could achieve tax deferral, the funds would generally be taxable when distributed back to the taxpayer. IRC Sec 911 allows a U.S. tax payer to exclude $104,000 of foreign earned income in 2018. IRC Sec 933 allows bond fide residents of Puerto Rico to exclude foreign income for federal tax reporting purposes. However, there is a “catch” here. You have to live outside of the United States.
As a result, the challenge of identifying a tax strategy that provides for tax deferral and tax-favored distributions, is a difficult planning proposition. This article discusses the planning utility of Malta pension schemes as a planning vehicle that provides tax deferral and tax-favored distributions in a manner that is more powerful than a Roth IRA.
Overview of the U.S. – Malta Tax Treaty
The U.S.-Malta Income Treaty was executed in 2008 and became effective in 2011. Article 4, paragraph 2 of the Treaty provides that a pension fund established in either the United States or Malta is a “resident” for purposes of the Treaty, allowing all or part of the income or gains of such a pension may be exempt from tax under the domestic laws of the relevant country.
Article 22 (2)(e)provides that a pension plan in one of the treaty country satisfies the limitation on benefits provision providing more than 75 percent of the plan participants or beneficiaries are individuals who are resident of the either the United States or Malta. As a result, a pension plan should be eligible for treaty benefits as long as more than 75 percent of its participants are either Maltese or American.
Article 18 of the treaty provides for the deferral of income and applies to all income including U.S. real estate or income that is effectively connected to a U.S. trade or business.
Article 17(1)(b) of the treaty provides for equivalent taxation limiting the right of the United States to tax distributions from Maltese pension plans to the amount that would have been taxable if distributed to a Maltese individual. Article 1(5) provides that Articles 17(1)(b) and Article 18 are exempt from the savings clause. As a result, the treaty does not prevent a U.S. taxpayer from qualifying for treaty benefits.
The savings clause of most income tax treaties would allow the U.S. tax its citizens as though the tax treaty had not come into effect. Article 1(5) provides a carve-out for pensions. Consequently, the United States is prevented from imposing tax on foreign pensions that are covered by such treaty provisions until a distribution is made to a U.S. taxpayer; and even then, the United States may only tax the distribution to the extent it would have been taxable in the foreign country if made to a resident of that country.
Thus, the U.S. is prevented from imposing a tax on the foreign pension until a distribution is made and only to the extent that the distribution would have been taxable to a Maltese resident. This concept of taxation was added as a result of the 2006 Model Tax Treaty which intended to preserve the right of foreign treaty recipients to receive tax-free Roth distributions. Therefore, if a foreign country (Malta) would have provided an exemption on distributions, the United States must also an exemption on taxation of the distribution.
Roth IRA Overview
One of the major limitations regarding the Roth IRA is eligibility for the Roth IRA. A taxpayer that files jointly is able to contribute to a Roth IRA if the taxpayer’s modified adjusted gross income (AGI) does not exceed $173,000. The contribution phases out between $189,000-198,999. The contribution limit is only $5,500. Individuals age 50 and over can contribute up to $1,000 extra per year to “catch up” for a total of $6,500. A non-working spouse can open a Roth IRA based on the working spouse’s earnings.
Contributions to the Roth IRA must be made in cash. The prohibited transaction guidelines applicable to the traditional IRA. The unrelated business taxable income (UBTI) (UBTI) rules also apply to Roth IRAs. The combination of the prohibited transaction and UBTI rules limit the ability of the taxpayer to own the taxpayer’s business interests within the Roth IRA.
The primary difference between the Roth IRA and IRA or qualified plan is that the Roth IRA does not have required minimum distributions. Distributions from the Roth IRA are not subject to income taxation. However, the distribution from the Roth IRA must be a “qualified” distribution. Qualified distributions require five years of “seasoning” within the plan unless the taxpayer is at least age 59 ½.
Distributions before age 59 ½ are subject to a 10 percent early withdrawal penalty as well as normal tax treatment on the distribution (as if it were a traditional IRA). Like the IRA, exceptions to these rules exist for a distribution for a first-time home buyer; distribution to a disabled taxpayer, or a distribution to a beneficiary on account of the taxpayer’s death.
The account balance is included in the taxpayer’s taxable estate. At death, the remaining distribution of the account is subject to the same rules as the traditional IRA. A surviving spouse as the beneficiary of the Roth IRA can treat the Roth IRA as her own. Other beneficiaries must distribute the balance over their life expectancies.
Overview of Malta Pension Schemes (MPS)
The Malta Pension Scheme in many respects is a surrogate to the Roth IRA. A taxpayer can make an unlimited contribution to the Malta Pension Scheme. Unlike the Roth IRA, the taxpayer may make in kind contributions to the MPS through the contribution of the asset or an interest in an entity holding the asset.
The MPS is treated as a non-grantor trust from a federal perspective. As a result, the contribution of an appreciated asset will not trigger any tax consequences on the transfer of an asset. The contribution to the MPS is not deductible. FIRPTA (IRC Sec 897) and effectively connected income to a U.S. trade or business (IRC Sec 1445) is not applicable because the trust is treated as a foreign grantor trust for tax purposes.
Malta law permits distributions to be made from such plans as early as age 50.The rules allow an initial lump sum payment of up to 30% of the value of the member’s pension fund to be made free of Maltese tax. Based on treaty provisions, distributions that are non-taxable for Malta tax purposes are also non-taxable in the United States.
Under Malta law, three years must pass after the initial lump sum distribution before additional lump sum distributions could be made to a resident of Malta tax-free. In Year 4, the MPS may distribute additional funds to the participant without triggering a tax liability. The amount that may be distributed tax-free is based on the annual national minimum wage where the participant resides. Fifty percent of the excess of the difference between the plan balance and the participant’s lifetime retirement income can be withdrawn tax-free each year.
To calculate how much can be distributed free of tax, it is necessary to first determine the pension holds “sufficient retirement income.” This amount in turn is based, pursuant to Maltese law, on the “annual national minimum wage” in the jurisdiction where the member is resident. To the extent the pension plan balance exceeds the member’s “sufficient retirement income” (on a lifetime basis), 50% of the excess can be withdrawn tax-free each year.
Additional periodic payments generally must then be made from the pension at least annually thereafter, and while such payments may be taxable to the recipient, they are usually significantly limited in amount (generally being tied to applicable minimum wage standards in the recipient’s home jurisdiction). Beyond those minimum wage amounts, excess lump sum distributions of up to 50 percent of the balance of the plan generally can be made free of Malta tax.
Participation in the MPS requires compliance with the FinCEN reporting requirements for foreign bank and financial accounts. FinCEN Form 114 (Report of Foreign Bank and Financial Accounts) must be filed annually with the Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury.
Code Section 6038D, also enacted as part of FATCA, requires that any individual who holds any interest in a “specified foreign financial asset” must disclose such asset if the aggregate value of all such assets exceeds $50,000 (or such higher dollar amounts as may be prescribed).IRS Form 8938 is used to report specified foreign financial assets if the total value of all the specified foreign financial assets in which you have an interest is more than the appropriate reporting threshold. The filing threshold for a married taxpayer filing a joint tax return if the specified financial assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year. As a foreign grantor trust, the taxpayer will most likely be required to file Form 3520.
The Malta Pension Plan is a powerful vehicle to provide for substantial tax deferral in a manner similar to the Roth IRA. However, it has planning benefits that far exceed the Roth IRA. Namely, the plan is not handcuffed by the contribution limits of the Roth IRA or prohibited transaction rules that would otherwise limit the ability to own an interest in the taxpayer’s business. Additionally, the unrelated business taxable income rules do not apply. FIRTPA for real estate holdings does not apply. The taxpayer may also contribute assets or business interests in kind. At distribution a substantial portion of the deferred income may be distributed without taxation in Malta or the United States. In the wake of tax reform, the Malta Pension Scheme may provide excellent opportunities for tax deferral and conversion to tax-exempt income. Future articles on the Malta Pension Scheme will focus on case studies.