Kiwisaver and US tax

I am often asked the question “How does my Kiwisaver fund get treated by the US”.  The answer is unfortunately quite complex.

The first thing to note about this article is that it contains only one piece of advice which is this “Do not base your financial decisions on an article that you read on the internet. Go talk with a suitably qualified person about your particular facts”.

Every other item in this article should only be read as commentary and we accept no responsibility for actions that you take as a consequence of reading the article. These are simply musings based on nearly 30 years of providing US tax advice to US citizens outside of the US.

Now that the disclaimer is over, where to start? Well, how do I find a suitably qualified person to talk to?

The link below is to the US embassy website in New Zealand, which outlines how to find a list of US tax qualified advisers in NZ (and indeed the world).

When perusing the list, just be mindful that not every in the world of course is familiar with Kiwisaver.

Kiwisaver schemes must all adhere to the legislation set out in the Kiwisaver Act 2006.

The purpose of the Act is to encourage a long-term savings habit and asset accumulation by individuals who are not in a position to enjoy standards of living in retirement similar to those in pre-retirement.

The Act provides the framework for all Kiwisaver schemes, and some of the key provisions are set out below:

  • You are automatically enrolled in the scheme by an employer upon commencing employment as long as you are eligible (and you have to take active steps to opt out of Kiwisaver with given timeframes if you wish to do so).
  • You do not need to be an employee to have a Kiwisaver scheme.
  • As a member, you can switch between different Kiwisaver funds at your discretion.
  • There are hurdles to you accessing funds that have been contributed to the fund (such as reaching retirement age, financial hardship, purchase of first home etc).
  • Funds generally have three parties involved, you, the scheme manager, the scheme supervisor.
  • The fund manager’s role is to invest your funds and ensure that this is done in accordance with the scheme rules.
  • The Kiwisaver scheme rules set out in Schedule 1 of the Kiwisaver Act 2006 are implied in every trust deed that establishes a Kiwisaver scheme.

And here we get to an important point.  Given that Kiwisaver schemes are for long-term savings, a trust is generally involved to ensure that your money has some degree of being safe-guarded.

Your funds are not an asset of the Kiwisaver provider that you sign up to, rather, they are held on-trust and the Kiwisaver provider has a role of simply trying to increase the value of your asset whilst charging you reasonable fees (in accordance with the Kiwisaver Act, the fees must be reasonable).

There are a myriad of ways in which your funds can be invested (on your behalf) by the scheme provider, ranging from having you own specific stocks, to owning some stocks, some cash, some mutual funds or by buying into a fund set up by the scheme provider.

The way in which Kiwisaver funds work is therefore critical to understanding how the US will tax them.

Tax rule 101 - Everybody wants to tax you if they can

As a US citizen you may/will/should be aware that you have a lifetime filing requirement.  The rationale of why this is the case leads back to the civil war, but I will not bore you with that tale here.

US tax law is enacted by Congress and the IRS are then empowered to administer the law. 

The law provides for various reliefs and tax advantages for long-term savings.  The Internal Revenue code section 401(k) sets out the rules for pension plans often referred to colloquially as 401(k) plans.  There are of course IRA plans, 403b plans (for those in the education sector) and others which also benefit from tax advantages on the basis that they are designed for long-term savings.

One of the key legislative provisions for such tax advantage status is that these plans are set up within the US. The legislation in code section 401(a) sets out a number of rules that should be met to qualify for tax advantage status, including the requirement for a plan to be ‘created or organised in the US’ to qualify for tax advantages in the US.

A number of countries have an income tax treaty with the US, and whilst there is typically a clause within the treaty that deals with how the pension will be taxed when it is received (usually at retirement) only a few of the treaties (the more modern ones) have a clause that refers to how contributions to a fund or how the growth of the fund should be taxed.  New Zealand is not one of those countries that has such a clause.

There is also provision within the Internal Revenue Code for reduced reporting and tax deferral where an employer has put in place a plan which has certain characteristics similar to some New Zealand superannuation plans.  These rules are set out in code section 402(b) and are somewhat useful for New Zealand employer sponsored superannuation schemes.  Although a Kiwisaver is a New Zealand superannuation plan, it is not an employer sponsored one (since you do not need to be an employee to be in Kiwisaver).  Further, there are contribution limits whereby the employer must fund at least 50% of the scheme to meet the criteria of code section 402(b).  Because of the way in which ESCT (employer superannuation contribution tax) is deducted from an employer contribution prior to funding the scheme, even where an employer matches an employee’s contribution, the employee will always be providing more funding than the employer.

So, if we cannot rely on any US domestic law or tax treaty provision to guide the way in relation to how Kiwisaver is taxed, then what?

US law does set out how to report and tax income that has arisen within a foreign (non-US) trust that has been established by a US person.  “Established by a US person” is quite a broad concept, since although a Kiwisaver fund itself is not set up by the average taxpayer, a contribution to the trust can be enough to meet that definition.

For some, it is a bit of a leap to consider that a Trust that has been set up in New Zealand would meet the definition of a trust for US tax law purposes.  Guidance can be found however in the US regulations (‘the Regs), which are the ‘lay-persons’ explanation of the Internal Revenue code at §301.7701-4(a)

There are 4 key elements

  • trustee takes title to property
  • for the purpose of protecting or conserving it
  • for beneficiaries
  • under chancery or probate court rules

Funds contributed to Kiwisaver schemes are held in trust by a trustee who has an obligation to preserve it on your behalf.   Although you have the beneficial ownership of the funds, the legal title is elsewhere, and you do not have direct access to those funds. You require the permission of the trustee to access the funds (who acts in accordance with the trust rules – e.g. reaching retirement age).

A trust? So what?

The taxation and reporting obligations of trusts is a complex area.  The first step is to understand what type of trust relationship exists.

Foreign trust

Per 301.7701-7(a), any trust that is not a US trust is a foreign trust.

As US courts do not have jurisdiction over Kiwisaver schemes, it is not a US trust and must therefore be a foreign trust.

Grantor trust

The term grantor trust is not defined in the Code or Regs, but the applicable law to help determine the position is found in the Code sections IRC 671 – 679.

IRC 679 is a very wide ‘catch all’ section, which (paraphrasing) applies when a US person has transferred property (including cash) to a trust which has a US beneficiary.

A Kiwisaver is therefore a grantor trust.

A foreign grantor trust has an annual filing requirement to file form 3520A.  The responsibility for the filing is with the Trustee of the trust. 

In the absence of specific legislation or guidance in this area, it is fair to say that Tax advisers take different approaches when managing this reporting obligation.  There is some disagreement around who is the trustee of the trust (related to a very technical argument relating to the existence of the trust).

One approach is to use the trustees who are identified on the register of Kiwisaver schemes, who can be found by first searching for the scheme name and then the participants via the Disclose Register, per below:

We are not aware of any Trustees that are preparing form 3520A in relation to the US citizen participants within the funds that they administer (it may be occurring; we are just not aware of it).

It should be noted that New Zealand has an Inter-Governmental Agreement in place with the US which relates to the reporting of information under the FATCA rules.  This agreement provides from an exemption from reporting under the FATCA rules for New Zealand pension schemes.  The interaction between this Inter Governmental Agreement and the obligation under the Internal Revenue Code section 6048 (which is where form 3520A must be filed) is complex and beyond the scope of this document. 

There are substantial penalties for failing to file form 3520A, and further, the legislation also advises that the owner of the fund (the taxpayer) is responsible for making the Trustee file the form!

Some taxpayers take on the responsibility of filing form 3520A as the trustee. This pragmatic approach ensures that the form is filed, and the taxpayer can avoid the non-filing penalties (provided that the form is filed on time etc).

In the event that the Trustee does not file the form, then the taxpayer is however able to file a Substitute Form 3520A which contains the taxpayers best effort to report the income of the trust as it relates to their investment in it.

The instructions to form 3520A and the Internal Revenue Manual set this out clearly.

(IRM) Section "If the foreign trust does not file Form 3520-A, but the U.S. owner completes and attaches a substitute Form 3520-A for the foreign trust to the U.S. owner's timely filed Form 3520 in accordance with the instructions for Form 3520, the U.S. owner will not be subject to the penalty for failure to file Form 3520-A."

As noted above, the taxpayer is also required to file another form (form 3520).  This form serves the purpose of advising the IRS that they have a ‘relationship’ with a non-US trust.  Again, this form has a significant penalty attached to it for non-compliance.

Anything else?

To add insult to injury.  If the fund is invested in a mutual fund (or if the fund itself is a mutual fund), then there is the need to ensure that the Passive Foreign Investment Company (PFIC) rules are also factored into the calculations.  The detail of these rules are outside the scope of this (already very long) note, but as a brief precis, PFIC’s create additional reporting and taxation considerations.

It is all a bit too hard!

It really is.  For a person to have to contend with all the above requires a serious amount of time investment or compliance fees to an expert.  Let us also bear in mind that the above has a focus on Kiwisaver funds, there are similar funds in almost every other country on the planet, how does the IRS cope with all this reporting!

Clearly it does not.  The IRS largely ignored this as a problem for many years (despite the legislation being in place since 1986.  In 2018 however, as a part of the initiative of trying to track down assets of US persons outside of the US, it started implementing the penalty provisions within the legislation.

The level of training on the technical aspects has predictably been sub-standard and the number of errors occurring by the IRS has been astronomical. 

It is unreasonable to expect the IRS person who ‘processes these forms to be a technical expert in the matter’.   As such, that person simply follows the ‘script’ that is set out within the Internal Revenue Manual (IRM) on how to process returns.  The problem is that the manual has several areas where it contradicts not only the legislation, but it contradicts itself, which has led to a number of penalties being erroneously issued.

Earlier this year, the IRS published a Revenue-Procedure (which was resurrected from a paper from 2009) which at first blush seemed to provide welcome relief.

The Revenue procedure is indeed welcome, and its intent is really clear, the IRS simply does not want to be processing forms 3520A and 3520 for foreign pensions.  The problem is that the Revenue procedure has been written in a way that means that Kiwisaver (along with a significant number of other pension schemes around the world) cannot rely on it.  The (IRS technical) authors of the procedure had sought feedback on the document, and plenty has been given, but unfortunately, since March this year, there have been plenty of other priorities arise for the IRS, and thus the Revenue Procedure does still not adequately address the issues for Kiwisaver schemes.

The procedure can be found here, and if the restriction at 5.03 can be removed, then Kiwisaver owners should be able to rely on it, and the need to worry about forms 3520 and 3520A disappears.

There is great hope that the comments will be listened to, and that the Revenue Procedure adjusted.

The language of the Procedure suggests that as long as all tax has been paid appropriately then even if the form 3520 or 3520A were not filed in the past, then all sins will be forgiven / no penalties will apply.  If that language continues into any updated version of the Procedure it will be welcome relief indeed.

However, as a taxpayer a tough decision has to be made:

  1. Rely on the fact that the procedure may be adjusted to enable Kiwisaver to qualify (and not file form 3520 or 3520A-substitue) in the interim (and as long as all tax is paid, then no penalties may arise), or
  2. Take the prudent approach of filing the forms and hope that they are not mis-processed by the IRS (on the basis that no reliance will be placed on the Procedure being updated)

As a final word on this point.  Any penalties that are imposed for failure to file forms 3520 and 3520A (or 3520-substitue) can be challenged on the basis of ‘reasonable cause’. 

Whether or not relief is given for reasonable cause does depend on the facts of every case.  Surely however, although the very existence of the Revenue procedure suggests that IRS is aware that taxpayers are confused by the legislation in this area.  How then can it be reasonable for taxpayers to be able to get their reporting right?

“Interestingly”, the IRS has only ever provided definitive comment on two foreign pension schemes (a Canadian scheme and a Mexican scheme). In both instances, the IRS did not require members of these schemes to file form 3520/3520A

So, no problems then?

If the Revenue Procedure is written in a way that would exclude the reporting for Kiwisaver schemes on form 3520 and 3520A (or substitute), taxpayers will still have the obligation to report their Kiwisaver on form 8938 (if applicable) or their FBAR. There may also be PFIC considerations and form 8621 if applicable.  Lastly, there is the need to understand the treatment where funds are eventually withdrawn from Kiwisaver (at retirement, hardship or for first home loan), and how does PFIC taxation tie-in at that point?

There are also some changes to the application of PIE tax for Kiwisaver schemes in New Zealand from the 2020-21 year onward as a direct result of unfavourable double-taxation events that currently occur (within the PFIC context).  Our understanding is that NZ IRD officials believe that the changes will deal with the double taxation, however, there has not yet been an official paper on the matter.