Pension income for a Non-Resident Alien

Technical topics regarding tax preparation.
#1
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Is pension income received by a non-resident alien from his former US employer (a university) FDAP or ECI income?
 

#2
Smktax  
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I am not sure, but I think that pensions should be considered FDAP and not ECI.

A pension would be FDAP unless Sec. 864(c)(6) applies to it. Sec. 864(c)(6) provides in part:
[I]n the case of any income * * * of a nonresident alien individual * * * 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 * * * is taxable under section 871(b) [as ECI] * * * shall be made as if such income * * * 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).


Sec. 864(c)(6) was enacted in 1986 in response to taxpayers deferring payments until the year after they ceased to engaged in a U.S. trade or business. By deferring the income, the payments were treated as FDAP and not ECI. FDAP was better for these taxpayers because the 30% rate on FDAP was lower than the highest rate on ECI. Taxpayers were typically deferring income by one or a couple years.

Is pension income “attributable to * * * the performance of services”? At one extreme, if the services were performed 30 (or more) years ago and the pension is now being distributed, much of the pension value is attributable to the investment earnings generated over the years. Perhaps only a small amount of that pension is attributable to the contribution by the employer/employee. In this case, it would seem that the pension is not primarily attributable to the performance of services. Instead, it would seem that the pension would be primarily attributable to investment earnings.

Various U.S. tax treaties have been updated since the enactment of Sec. 864(c)(6), and some of those treaties have specifically been updated to address Sec. 864(c)(6). However, to my knowledge, none of the treaties that have implemented this rule attempt to reclassify income from the pension article of the treaty to a services article. Instead, the treaties simply provide that services income paid in a year after ceasing to be engaged in a U.S. trade or business (or having a permanent establishment in the U.S.), can be taxed as services income under the treaty.

I don’t think that Sec. 864(c)(6) was targeted towards pensions. I also don’t think that Congress anticipated that pension income would be treated as attributable to the performance of services for purposes of Sec. 864(c)(6). Therefore, my vote would be that pension income would be FDAP and not ECI.

Having said that, it appears that at least one commentator feels otherwise. https://www.thetaxadviser.com/issues/2015/jul/hollingsworth-jul15.html ("Consequently, pension or retirement payments attributable to personal services performed in the United States are treated as effectively connected income in the year received, even if the recipient is not engaged in a U.S. trade or business in that year.")

If you do decide to treat the pension income as ECI, you need to decide whether it is all ECI or only a portion is ECI. As described above, a portion of the pension income is likely from investment earnings. Do you “look through” the pension income to bifurcate it into partly ECI (the part attributable to the employer/employee contributions) and partly FDAP (the investment earnings)? Note that for purposes of determining the SOURCE of pension income, this is exactly what the IRS does (they look through and bifurcate). See Rev. Rul. 79-388, Rev. Rul. 79-389, and Rev. Rul. 2007-37.
 

#3
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Joy,
To rule out a possible easy answer, are we confident that there is no treaty? For reference, the current US model provides:
Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that Contracting State.


Smk,
Rev. Rul. 79-388 did opine on the character not just the source. The payments would have been ECI but because there was no current year trade or business, they weren't. As a result, they were taxed as FDAP:
Because A is a nonresident alien who is not engaged in a trade or business in the United States in 1979, the year A received the pension payments under consideration, the portion of the payments that is from United States sources is not effectively connected with the conduct of a trade or business within the United States and therefore is subject to the imposition of tax under section 871 (a) (1) (A) of the Code,

The ruling predates 864(c)(6), which as you point out was enacted to overturn this result.
 

#4
Smktax  
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So do you feel the pension should be bifurcated, with a portion as ECI and a portion as FDAP?
 

#5
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Smk - you’d prefer to dispose of this under the treaty but seems the position to bifurcate also has support.
 

#6
Smktax  
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This issue seems to come up often when an individual has worked in the U.S. for a while, leaves the U.S., and then wants to take an early withdrawal from their U.S. pension. The IRS seems to feel that these types of distributions (i.e., distributions before turning age 55) don’t qualify as “pension” distributions for purposes of treaties. See, for example, PLR 8904035. Thus, it is often not possible to dispose of this under a treaty (or at least not under the pension article of the treaty).
 


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