The United States Government has not officially classified the Australian Superannuation for U.S. tax purposes. Therefore, exactly how the IRS taxes contributions, growth, distributions, and reporting is still up for debate. Nevertheless, there are some general accepted positions on U.S. Taxation of Australian Superannuation Funds.
In this article, we will touch on some of the frequently asked questions like:
- US taxation of Australian Superannuation Fund
- Is Australian Superannuation taxable in the US
- What is contributions tax in relation to Australian Superannuation Fund
1. What is the Australia Superannuation Fund?
In Australia, superannuation, or just “super”, is compulsory for all people who have worked and reside in Australia. The balance of a person’s superannuation account, or for many people, accounts, is then used to provide an income stream when retiring. Federal law dictates minimum amounts that employers must contribute to the super accounts of their employees, on top of standard wages or salaries.
The Australian Government outlines a set percentage of employees income that should be paid into a super account. Since July 2002, this rate has increased from 9 per cent to 9.5 per cent in July 2020, and will stop increasing at 12 per cent in July 2027. Employees are also encouraged to supplement compulsory superannuation contributions with voluntary contributions, including diverting their wages or salary income into superannuation contributions under so-called salary sacrifice arrangements.
An individual can withdraw funds out of a superannuation fund when the person meets one of the conditions of release, such as retirement, terminal medical condition, or permanent incapacity, contained in Schedule 1 of the Superannuation Industry (Supervision) Regulations 1994. As of July 1, 2018, members have also been able to withdraw voluntary contributions made as part of the First Home Super Saver Scheme (FHSS).
As of 30 June 2018, Australians have AU$2.7 trillion in superannuation assets, making Australia the 4th largest holder of pension fund assets in the world. As of 30 June 2019, the balance was AU$2.9 trillion.
2. How is it taxed in Australia?
Superannuation in Australia is taxed by the Australian taxation system at three points: on contributions received by a superannuation fund, on investment income earned by the fund, and on benefits paid by the fund.
Superannuation contributions are either concessional or non-concessional contributions.
– Concessional contributions (sometimes referred to as “before-tax” contributions) are contributions for which someone (such as an employer) has or will receive a tax deduction. Concessional contributions include superannuation guarantee (SG) contributions, salary sacrifice contributions, other employer contributions and contributions claimed as a personal tax deduction. Concessional contributions are taxed in the fund. While taxable components do not change the tax payable by the superannuation fund, they may be a factor in calculating the tax payable on withdrawals from a super fund.
– Non-concessional contributions (also referred to as “undeducted” or “after-tax” contributions) are contributions for which no-one has or will receive a tax deduction. Non-concessional contributions are, generally, not taxed in the fund.
Where an investment or other asset is sold or otherwise disposed, the profit on sale is subject to a capital gains tax.
Superannuation funds can claim a capital gains tax discount where the asset has been owned for at least 12 months. The discount applicable to superannuation funds is 33%, reducing the effective tax rate on capital gains from 15% to 10%.
No discount or adjustment is available if an asset is sold at a loss. Capital losses can only be applied against capital gains and cannot be claimed against other income, but may be carried forward to the next year and applied against the later year’s capital gains.
The taxable income of a superannuation fund is the fund’s assessable income less allowable deductions. Assessable income includes concessional (i.e., taxable) contributions received, net investment income and discounted capital gains. It does not include exempt income and undeducted contributions. Undeducted contributions are those which the employer or the member cannot or has chosen not to claim as a deduction from their respective assessable income.
The taxable income of a superannuation fund is taxed at a flat rate of 15%; however, concessional contributions of those members whose taxable income exceeds $300,000 are subject to a rate of 30%. In reality, the actual average tax rate can be lower than this, typically around 6.5%,[because:
- the dividend imputation system allows a credit for imputation credits on Australian shares, which may result in a tax refund.
- capital gains on assets held more than 12 months may be entitled to a capital gain tax discount.
- other tax credits such as foreign tax credits may apply.
Additional taxes are payable if contributions received exceed the applicable contribution caps.
Taxation of benefits is very complex and depends on whether:
- the benefit is received as a lump sum or a pension
- the benefit is received for retirement, death or disability
- the benefit is paid to a dependent or non-dependent
- the tax payer was a member of a fund prior to 1983
For recipients of social security payments, pension amounts are taxed as normal income through the PAYG system except where there is a deduction for the portion of the benefits funded by undeducted contributions (the “deductible amount”) or at a 15% rebate on the pension amount less the deductible amount.
3. What about the Australia – US Treaty
There are two separate and distinct bodies of law that could potentially apply to the issue.
First, there is domestic U.S. tax law; Title 26 of the United States Code, which is known as the Internal Revenue Code.
Second, there is international treaty law; the Convention Between the Government on the United States of America and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, which is more commonly known as the U.S.-Australia Income Tax Treaty. Domestic U.S. tax law applies by default unless a taxpayer affirmatively elects to apply the treaty and explains the application on IRS Form 8833. A taxpayer that takes a treaty position without disclosing it on IRS Form 8833 will be liable for civil tax penalties for which there is no statute of limitations. You may also be exposed to criminal tax penalties if your failure to file IRS Form 8833 was intentional.
As provided by the U.S. Australia Tax Treaty, Article 18(2)
(2) Social Security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.
At the present time, the Social Security referred to in the tax treaty refers to “social security and other public pensions.” There is no mention of Superannuation.
Is Superannuation Social Security?
*Australia already has its own Public Social Security, and the term “Social Security Payments” in the tax treaty is further clarified as “and other public pensions…”
Is Superannuation a Public Pension?
It is employer funded and even though the government may make matching contributions for lower income wage earners, that does not make it a public pension.
4. The U.S.-Australian Social Security Totalization Agreement
Totalization Agreements, also referred to as bilateral agreements, eliminate dual social security coverage (the situation that occurs when a person from one country works in another country and is required to pay social security taxes to both countries on the same earnings).
Each Totalization Agreement includes rules intended to assign a worker’s coverage to the country where the worker has the greater economic attachment.
The agreements generally ensure that the worker pays social security taxes to only one country, provided the worker and the employer meet the procedural requirements under the agreement for obtaining an exemption from the other country’s social security taxes.
5. Is it treated as Social Security?
The goal of a Totalization Agreement: To avoid a taxpayer from having income withheld in each jurisdiction for employment.
For Australia, the agreement covers “Superannuation Guarantee” (SG) contributions that employers must make to retirement plans for their employee. But, this statement in the agreement comes with an important clarification by the SSA, on Page 1 of the Totalization Agreement:
“Australia’s Social Security program, which is separate from the SG program, is supported by general tax revenues not covered by the agreement.”
The above referenced clarification relates to the fact that the totalization agreement refers to Australia Superannuation Contributions and not Australian Social Security, since the Australian Social Security is not employment funded.
Unlike the U.S. Social Security Program, the Australian Social Security Program is not funded through employment. Rather, it is funded through general tax revenue.
By including this reference to Social Security in the Totalization Agreement, it serves to reiterate that the purpose of the Totalization Agreement is to avoid duplicate withholding for employees — not to make any general statement about whether SG contributions are considered Social Security of U.S. tax purposes outside for the Totalization Agreement.
Thus, the social security program in Australia is not covered by the totalization agreement, and the agreement does not expand the definition of social security to include superannuation.
As a result, the fact that the SSA refers to Superannuation as being privatized social security would not expand the definition to include social security and other public pensions as referenced in the U.S. and Australia tax treaty Article 18.
6. Are contributions taxable to the US?
Contributions to Superannuation do not receive the same tax deferred treatment outright as it would under other treaties, such as the UK Treaty, and are presumably taxable.
That is because the treaty does not per se eliminate it as it does in the UK Tax Treaty (subject to limitations).
7. Is growth in the fund taxable income to the US?
While the Pension is growing in a retirement fund with a treaty country, the treaty should protect the growth, since the pension is not being “paid to an individual” as the language provides in the Tax Treaty.
The general proposition is that the growth is not taxable, unless distributions are being taken, or the person is an HCE.
If the employee is considered to be an HCE (Highly Compensated Employee), the rules are different, and the growth may be taxable.
8. Are distributions taxable to the US?
Generally, they are taxable — subject to issues of withdrawing corpus or principal, which is a return of basis — and not taxed, since it is not income.
If you became a U.S. person after your contributions began, you may require a forensic analysis to assist with which portion of each withdrawal is taxable, or not — and if there will be any U.S. on Australian Superannuation Funds.
A person will gross-up their retirement income as regular income, and then their taxes due will be based on their progressive tax rate.
Foreign Tax Credits may apply.
IRS Form 8833 must be filed to fully disclose to the Internal Revenue Service that the taxpayer is excluding gains within and/or distributions from their Australian Superannuation Fund
9. How is it reported on US returns?
Generally speaking, you include an Australian Super on your tax return. Reporting the Superannuation on the FBAR, FATCA, PFIC, etc. The U.S. may tax – Contributions, Growth, and Withdrawals.
10. Is it Treated as Foreign Grantor Trust (Form 3520)?
Generally, a superannuation such as an Australian Superannuation is not considered a foreign grantor trust. However, a superannuation can become a foreign grantor trust.
How? If the individual grantor contributes more than 50% to the trust, the IRS may deem the superannuation a foreign grantor trust. This requires the filer to now submit a Form 3520-A.
11. Is it Treated as a Form 8621 PFIC?
Generally, the Super is not considered a PFIC, but depending on various different factors, the Super can transform into a PFIC, and then may require a Form 8621 and/or 3520 and 3520-A.
Dixon: A cautionary case of U.S.-Australian tax issues
This article presents a cautionary tale of cross-border tax compliance complexities for Americans and Australians who file and pay taxes in two countries with different tax regimes. It is an extract from an article originally published in Tax Notes Federal and Tax Notes International on February 8, 2021 – https://marketing.withersworldwide.com/reaction/emsdocuments/Dixon_A_Cautionary_Case_of_U.S.-Australian_Tax_Issues.pdf
DAG-Australia, known as “Australia’s most high-profile promoter of self-managed super funds” was a Canberra-based asset management and financial advisory firm that in 2017 merged with Evans & Partners, a high-end stockbroking firm based in Melbourne. The merger produced Evans Dixon, an AUD 18 billion financial services firm that listed on the Australia Securities Exchange (ASX) in May 2018 as a public company. It was the fourth-largest self-managed superannuation fund (SMSF) provider in the country. Both Alan Dixon and his father, Daryl Dixon, were on its investment committee. It was reported by the Australian news media that the investment committee recommended that its 4,700 SMSF clients invest in the U.S. Masters Residential Property Fund (URF), the biggest in-house Dixon investment that was listed as a closed-end fund on the ASX in 2012. At that time, a strong Australian dollar made investing in U.S. assets attractive, with the U.S. dollar and U.S. property market weak. The URF manages more than 600 homes in New York and New Jersey that constitute distressed and not-so-distressed residential properties in those states. It was reported that URF “loaded up on debt to amass a billion-dollar portfolio of New York and New Jersey real estate, charging hundreds of millions of dollars in fees and renovation costs along the way.” By the time the U.S. lawsuits were filed, the URF had fallen 90 percent in value over five years. And along with it were the superannuation investments of middle-class Australians with reasonable wealth accumulated over decades in white-collar professions.
Dixon appeared to be waging war on both sides of the Pacific Ocean. His company, Evans Dixon, was subject to Australian regulatory scrutiny concerning its dealings with the URF and the Australian clients who invested their superannuation monies in it. In the United States, he was subject to an IRS examination of his amended U.S. tax returns that claimed, among other things, entitlement to FTCs on Australian taxes paid by DAG-Australia on franked dividends issued to him.
His first tax problem was that he received dividends from DAG-Australia that were subject to U.S. tax without any FTC entitlement for franking credits attached to those dividends. His original U.S. returns for tax years 2013, 2014, and 2015 as initially prepared and filed by PwC-Sydney did not claim franking credits attached to the franked dividends he received. As a result, he paid approximately $658,985 in federal income taxes for 2013, and $2,131,553 for 2014. His original U.S. tax returns for 2015 reported $6,527,412 in franked dividends received as a shareholder of DAG-Australia for tax year 2015 with approximately $2,388,627 of attached franking credits that he could not claim. Instead, the franked dividends were classified as qualified dividends and subject to U.S. income tax at a rate of 20 percent. As a U.S. individual taxpayer, he could claim only foreign taxes that he directly paid or accrued as FTCs against his U.S. tax liability.
Next, Dixon was the beneficial owner of four SMSFs in Australia that were accruing earnings that were already subject to tax in Australia at a preferential rate of 15 percent. This tax was paid by the SMSFs directly and not by Dixon. Neither was he subject to Australian income tax on the earnings accrued in these funds. There is nothing equivalent to a superannuation fund in the United States. However, it is a widely held view among tax practitioners that an SMSF, which is a type of super, would be treated as a foreign grantor trust under the foreign entity classification regulations. By implication, the SMSF itself would be subject to reporting on Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner,” and earnings accrued within the fund would constitute taxable income to the U.S. taxpayer who is a beneficial owner, and therefore subject to U.S. tax at ordinary rates. Moreover, investments by the SMSFs in foreign corporations that constituted passive foreign investment companies for U.S. tax purposes would be subject to reporting on Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.”
PwC-Sydney reported Dixon’s proportional share in the earnings accrued in his SMSFs as part of his U.S. taxable income. This filing position combined with the unclaimed franking credits resulted in quite a substantial U.S. tax bill for Dixon (or anyone for that matter) to pay.
Enter John Anthony Castro, an international tax attorney and founder of Castro & Co. LLC. For years, Castro has issued legal opinions and filed tax returns for U.S. citizens living in Australia who excluded their supers’ earnings from U.S. taxable income. In early 2016 Castro replaced PwC-Sydney as Dixon’s U.S. tax return preparer and representative.
Castro’s first move was to file an application with the IRS to obtain a U.S. employer identification number for DAG-Australia. Although DAG-Australia filed corporate tax returns in Australia and was classified as a corporation under Australian law, Castro classified DAG-Australia as a foreign partnership with 50 partners when he filed the Form SS-4, “Application for Employer Identification Number (EIN),” with the IRS. Doing so would solve the FTC issue for Dixon. Interestingly, Castro appears to have taken the position that the EIN filing, by itself, somehow effectuated an election under the foreign entity classification regulations for DAG-Australia to be classified as a partnership. A partnership classification would cause the dividends to be reclassified as business income to Dixon, and he would be able to claim FTCs for Australian franking credits attached to the franked dividends that were paid by DAG-Australia. Indeed, Castro claimed that when the IRS approved the EIN application to be classified as a foreign partnership on February 9, 2019, it also approved Castro’s classification of DAG-Australia as a foreign partnership retroactive to DAG-Australia’s date of formation on May 30, 1986. The IRS denies this allegation. In this regard, we note that entity classifications require the filing of a Form 8832, “Entity Classification Election,” rather than a Form SS-4. Further, the preamble to the foreign entity classification regulations states that, “No election, whenever filed, will be effective before January 1, 1997.”
Castro amended Dixon’s U.S. tax returns for 2013, 2014, and 2015 to claim the FTCs on Australian franking credits attached to the franked dividends received by Dixon. His multimillion-dollar U.S. tax liability was now a multimillion-dollar tax refund of approximately $3,268,930.
B. The lawsuits
1. The Court of Federal Claims refund actions
Rather than approving Dixon’s amended returns, the IRS issued a notice of deficiency assessing additional taxes, interest, and penalties on his amended 2013 tax return and commenced an examination of his 2014 amended return. The IRS also seized the tax refund claimed on his 2017 federal return to cover his additional tax liabilities for 2013. Castro, acting for Dixon, sued the IRS in the U.S. Court of Federal Claims to recover the 2013 and 2014 tax refunds. He sought a refund of $326,985.96 for the 2013 tax year and $1,588,653 for the 2014 tax year on grounds that Dixon is entitled to take FTCs on taxes paid by DAG-Australia on the franked dividends he received. In doing so, Castro was trying to get a dollar-for-dollar credit for franking credits attached to the dividends that Dixon never paid for.
2. The Tax Court protest
Three days after Dixon filed his lawsuit, the IRS commenced an examination of the 2015 amended tax return and requested his consent to extend the tax assessment period pending the examination. Dixon refused, so the IRS issued an examination report proposing adjustments to his 2015 amended tax returns and advised Dixon and Castro that a notice of deficiency would be issued for additional tax, interest, and penalties due of $1,490,948, for a total corrected tax liability of $2,091,916. The notice of deficiency was dated April 30, 2019. Castro protested the assessment and filed a petition for Dixon with the Tax Court on July 25, 2019.
On February 21, 2020, almost a year since the filing of the lawsuits, Judge Richard A. Hertling of the Court of Federal Claims granted the IRS’s motion to dismiss on a technicality Dixon’s lawsuit to recover his 2013 and 2014 tax refunds. The court held that Dixon did not personally sign nor submit a valid power of attorney for Castro to sign his 2013 and 2014 amended returns. Consequently, the court did not have jurisdiction over the lawsuit and dismissed Dixon’s complaint. Incredibly, Australian newspapers erroneously reported the dismissal of the lawsuits as a substantive win by Castro, proving that Australian super funds were foreign social security.
C. IRS plot twist
Unlike with the refund lawsuits filed in the Court of Federal Claims, the IRS did not file any motion to dismiss the Tax Court petition contesting the notice of deficiency issued for Dixon’s amended 2015 tax returns. In a plot twist of epic magnitude, the IRS sought to amend its answer to the original petition and seek an increased tax deficiency for SMSF earnings that were excluded from Dixon’s U.S. taxable income as privatized foreign social security. The IRS reasoned that Dixon had neither identified nor substantiated any social security or other public pension payments that he received from Australia during 2015, and therefore was not eligible to claim a benefit under the Australia-U.S. tax treaty. In its amended answer, the IRS identified Dixon’s interests in three SMSFs that had generated taxable income in 2015 that he failed to report as taxable income on his returns.
The case was set for trial on September 28, 2019. However, pending resolution of the motion to stay proceedings, the case was sent to the IRS Independent Office of Appeals sometime in early February 2020. Because of the pandemic’s effect on the operations of Appeals, an Appeals officer had not been assigned as of July 27 when both the IRS and Dixon filed a joint motion for continuance, which was granted two days later.
Sometime around August 27, 2020, Dixon disposed of all his shares in Evans Dixon that were held through his Australian private company for approximately AUD 18.6 million. A week later, on September 4, the Australian Securities and Investment Commission (ASIC), one of several government agencies with oversight over super funds, filed a multimillion-dollar Australian Federal Court claim action against Dixon Advisory & Superannuation Services, a wholly owned subsidiary of Evans Dixon, alleging Dixon Advisory failed to act in its clients’ interests or provide appropriate advice in recommending investments as it purportedly steered its clients to invest in its largest fund, URF. Later that month, Dixon left the United States and resumed residence in New South Wales, Australia. In November 2020 the shareholders of Evans Dixon voted to approve the rebranding of the company from Evans Dixon to E&P Financial Group.
III. Classifying superannuation funds
Even if the worst-case scenario were to play out in the U.S. Tax Court for Dixon, it would still not come close to the massive financial losses suffered by DAG-Australia’s clients, a majority of whom are middle-class Australians in white-collar professions with reasonable wealth accumulated over decades in superannuation investments. The super industry is a significant player in the Australian retirement scheme, with superannuation assets totaling AUD 2.9 trillion at the end of the June 2020 quarter. Approximately 50 percent of the total assets are allocated between Australian listed and international shares, and the rest among property, cash, and Australian and international fixed interests. At the core of this superannuation industry are six types of super funds available to Australians: industry funds, corporate funds, retail funds, public sector funds, SMSFs, and small Australian Prudential Regulation Authority (APRA) funds. Of these, the SMSF category has the largest number of funds, comprising AUD 735 billion of total assets. It comes as no surprise therefore that the clients of DAG-Australia opted to invest their SMSF monies in an international fund such as the URF.
And this is where the rubber meets the road for many U.S. expats and Australian nationals in the United States, such as Dixon. Because superannuation funds do not exist in the United States, they must run the gamut of the foreign entity classification regime. SMSFs in particular are susceptible to adverse U.S. tax treatment, resulting in double taxation in the United States and Australia.
A. U.S. tax classification regime
Foreign entities that are foreign trusts are subject to a different entity classification framework. Under reg. section 301.7701-4, a foreign trust is either an ordinary trust or a business trust for U.S. tax purposes. An ordinary trust exists to preserve assets, whereas a business trust is used to engage in a trade or business. If the latter, it would be treated as either a partnership or corporation based on specified characteristics.
Foreign trusts like the Australian super funds continue to evade definitive U.S. tax classification and treatment. In Australia the government encourages investment in a super to increase the level of savings for retirement by providing tax concessions, which also act as an offset to the fact that a super cannot be accessed until retirement. Therefore, owners of a super fund are given incentives to contribute to the super and engage in active investments that will grow the assets with those tax-favored rates. Those investments range from bonds and equities to partnership interests in business operations. Because U.S. tax laws are applied to determine the treatment of the super fund and as a corollary, income and gains generated by its underlying assets, the results are often incongruent and adverse to the preferential treatment applied in Australia. Thus, an Australian’s investment in his or her super, which is the third pillar in Australia’s retirement system, could be at risk in the United States depending on its classification.
B. Australian perspective
From an Australian perspective, super funds are trusts created under superannuation laws to provide for an employee’s retirement and they therefore receive tax-favored treatment to encourage savings and asset growth. Unlike traditional retirement funds, contributions and earnings generated by investments held by a super fund are taxed at a low flat rate of 15 percent. Broadly, when a super fund has derived a capital gain from the disposal of an asset held in the fund, any net capital gain, after deducting any capital losses, will be included in the fund’s taxable income and will attract tax of 15 percent, which may be further reduced to 10 percent. Contributions and earnings cannot be accessed by its beneficial owner (the employee) until retirement age. On retirement, distributions from the super fund are generally tax-free.
When superannuation reforms were enacted in 2017, Australia’s Parliament made clear its intent to continue providing tax-favored treatment for the super so that it would eventually replace money paid out of the old age pension funded by government. In short, one could say it is almost Australian social security. This explains why Australians are perplexed and astounded at how the United States could tax contributions, earnings, and distributions from a super simply because the beneficiary of that super is also an American. More importantly, a super fund’s investment in U.S.-based assets (such as real estate, U.S. start-up companies, or businesses) could be taxed by the United States not as a foreign pension fund, subject to preferential rates, but just like any other foreign investor, subject to full U.S. tax rates and withholding taxes.
To be fair, super funds do not exist nor resemble any entity or structure in the U.S. tax world. This explains in large part why, until the IRS issues definitive guidance on this issue, there is not one U.S. tax perspective on what a super fund is for U.S. tax purposes. One on hand, it is a foreign pension that would not be subject to any tax-deferred treatment extended to a U.S. 401(k) account or IRA. It could also be a foreign grantor trust if it has a U.S. taxpayer contributor and a U.S. individual beneficiary designated to receive tax-free distributions from the super upon satisfaction of statutory conditions of release (that is, it upon reaching retirement age). Either classification leads to some degree of U.S. taxation on contributions, earnings, and distributions received by a U.S. taxpayer from the super. And because a super is a foreign asset, it also adds to the complexity of a U.S. taxpayer’s international reporting obligations.
IV. Superannuation funds up close
The super fund most susceptible to adverse U.S. tax treatment as a foreign grantor trust is the same type of super that is at issue in Dixon; that is, an SMSF that has a U.S. grantor and a U.S. beneficial owner. When it does, it is most prone to treatment as a foreign grantor trust, which would mean that all contributions and earnings in the SMSF, including its assets, are attributed directly as owned by its U.S. beneficial owner. Assets that are foreign equities would be further subject to burdensome treatment as PFICs, which would require annual tax filings and at worse, payment of PFIC taxes. Preparing a U.S. tax return to disclose income, gains, and assets held by the SMSF as if the SMSF did not exist poses a substantial financial burden to the U.S. taxpayer. The SMSF’s unique structure lends itself to this diabolical outcome.
A. SMSF Structure
The regime for SMSFs was introduced under the Superannuation Legislation Amendment Act (No. 3) 1999. An SMSF is essentially a trust structure that provides benefits to its members, the beneficiaries, upon their retirement. An SMSF is established broadly by creating the trust fund and drafting a trust deed that sufficiently describes the purposes of the fund and specifies the regulations to be followed by the trustee.
A trust is established when the settlor settles property on trust for the benefit of the beneficiaries. The trustee must then administer the trust in accordance with the terms of the trust deed. The settlor is generally a person unrelated to the beneficiaries and has no further involvement in the trust following the initial settlement of property on trust. For SMSFs, the trustee effectively assumes the role of settlor.
In Australia, a settlor is prohibited from receiving trust distributions and is usually excluded from the class of beneficiaries because of legislative restrictions on revocable trusts. An SMSF is essentially a revocable trust, given that members (that is, the beneficiaries) are also trustees; however, it is unique in that the SMSF member structure is accepted.
Members can contribute to their SMSFs in several different ways, and trustees must follow regulations in this regard. Contributions may be concessional or non-concessional. Broadly, concessional contributions made to an SMSF are included in the SMSF’s assessable income and taxed at the concessional rate of 15 percent. Non-concessional contributions are after-tax amounts that members contribute into their SMSFs that are not taxed in the superannuation fund. A non-concessional contributions cap of AUD 100,000 annually applies to members 65 or over but under 75. In some circumstances, members may make noncash contributions into their funds. Generally, such contributions are restricted to the transfer of listed securities or business real property.
For an SMSF to qualify for concessional tax treatment, it must be a complying fund under sections 42A and 45 of the Superannuation Industry (Supervision) Act 1993 (SISA), section 10(1). Broadly, an SMSF will be a complying resident fund if the Australian Taxation Office has not issued the fund with a notice of noncompliance. Such a notice may be issued when there is a serious contravention of the SISA.
B. SMSFs as foreign grantor trusts
SMSFs are unique in Australia’s superannuation system and differ from other funds, because members are in control and have sole responsibility for their retirement savings and, therefore, all investment decisions. At the same time, trustees must abide by all regulatory requirements and responsibilities. An SMSF from an Australian perspective is essentially a revocable trust, given that its members (that is, the beneficiaries) are also trustees.
From a U.S. tax perspective, an SMSF could be treated as a foreign grantor trust that would be disregarded for U.S. tax purposes if there is a U.S. person who contributes and a U.S. person who benefits from the trust. Some SMSFs fall squarely within these guidelines when a U.S. person makes voluntary concessional and non-concessional contributions to the fund, and another U.S. person (or the same one) is entitled to receive retirement distributions from the same fund. Treatment as a foreign grantor trust means that all the income, gains, deductions, and credits accrued in the SMSF are immediately attributed to the U.S. person who made contributions to the fund. However, the U.S. person would also be able to claim FTCs for Australian taxes paid by the SMSF on its Australian tax returns. Theoretically, because contributions and earnings accrued in the SMSF would have already been subject to U.S. tax, any distributions received from the fund would constitute post-tax money and be tax-free.
Many issues arise if the SMSF is treated as a foreign grantor trust for U.S. tax purposes. For one, Australian employers who are non-U.S. persons must make mandatory contributions to the fund as superannuation guarantee payments. Therefore, only that portion of the fund that directly correlates to the U.S. person’s contributions (and arguable earnings on those amounts) should be subject to U.S. tax. The other portion, which is paid by the Australian employer for the benefit of its U.S. person-employee, would be likely treated as a foreign non-grantor trust for U.S. tax purposes. That treatment would not be in the best interests of the U.S. person who is the member-beneficiary of that trust. This is because U.S. beneficiaries of a foreign trust may incur additional tax liabilities for distributable net income that is allocable to them. Because an SMSF must accumulate investment earnings and gains in the fund until the member reaches retirement age (or otherwise satisfies a condition of release), it is very likely that those amounts would constitute undistributed net income for U.S. tax purposes, which would be subject to U.S. throwback taxes. to the U.S. person as the beneficiary of the foreign trust. This outcome is indeed unfavorable to that U.S. person. On one hand, the SMSF is subject to preferential treatment in Australia, and yet in the United States, it seems as if the SMSF is treated adversely to the detriment of its U.S. owner.
V. Are SMSFs foreign social security?
It is not surprising that some tax practitioners have taken the position that a super should be treated as an exempt foreign social security plan, because legislative reforms to the superannuation laws effective July 1, 2017, provide a formal legislative intent for the superannuation regime to “provide to Australians retirement income that would substitute or supplement the Age Pension.” However, Australian legislative intent does not control U.S. tax classification of super funds. As previously discussed, a super fund is subject to the U.S. foreign tax classification rules for trusts, and an SMSF in particular would be likely treated as a foreign grantor trust in the United States. However, we must pause to consider whether the superannuation guarantee component, which would not fall under the foreign grantor trust treatment because it is contributed by an Australian employer (rather than the U.S. person), could be classified as foreign social security. To do so, one must understand first how Australia views the superannuation guarantee, and how the United States would likely treat it under its prevailing tax regime.
A. superannuation guarantee
Under Australia’s superannuation guarantee scheme, employers must provide to their employees the minimum prescribed level of superannuation support, subject to limited exceptions. Employers are now required to contribute a minimum amount of 9.5 percent of an employee’s ordinary time earnings (broadly, salary and wages) to the employee’s chosen super fund, which includes SMSFs. From July 1, 2021, the rate will increase to 10 percent and steadily increase to 12 percent from July 1, 2025, onward.
Employers must make these superannuation guarantee payments, which are tax-deductible, by the quarterly due dates. If an employer has not paid the minimum amount within these due dates, it will be liable to pay the superannuation guarantee charge to the ATO. The charge is nondeductible and comprises the unpaid superannuation contribution, an administrative component (AUD 20 per employee per quarter), and interest. Failure to pay the superannuation guarantee charge could give rise to penalties of up to 200 percent of the unpaid superannuation in some circumstances in which employers fail to provide information to the ATO, such as a quarterly superannuation guarantee statement, and it is not uncommon for these penalties to be imposed.
B. Australia-U.S. Agreements
Dixon claimed that his super funds were exclusively taxable in Australia under article 18, paragraph 2, of the Australia-U.S. tax treaty. The IRS challenged this position in its responsive pleadings filed with the Tax Court, on grounds that Dixon had neither identified nor substantiated any social security or other public pension payments that may be eligible for a benefit under the treaty.The IRS did not elaborate further on this aspect of the case, although it did file an amendment to its pleadings to assess additional deficiencies on Dixon’s amended U.S. tax returns for 2015 attributable to interests in SMSFs that generated taxable income and should have been subject to U.S. tax accordingly.
- Tax treaty article 18(1): Pensions and similar remuneration. Article 18 of the tax treaty concerns pensions, annuities, alimony, and child support. Under this article, pensions and annuities (other than government pensions referred to in article 19) are to be taxed only in the country of residence of the recipient. It is interesting that Dixon did not claim treaty benefits for his SMSFs under article 18(1), which provides that pensions and other similar remuneration paid to a resident of Australia in consideration for past employment shall be taxable only in Australia. The SMSFs would arguably fit within the definition of “pension and other similar remuneration,” which is defined under article 18(4) as periodic payments made by reason of retirement or death, in consideration for services rendered in connection with past employment. The Australian and U.S. governments did not address, through the negotiation process for the protocol, the issue regarding the double taxation of retirement saving plans of many individuals moving between the United States and Australia. Had the Australia-U.S. tax treaty been amended in more recent years, it would been able to address the taxation of cross-border retirement plans, as other newer treaties have done. Specifically, if the Australia-U.S. tax treaty were amended to incorporate article 18 of the 2006 and 2016 U.S. model income tax conventions, then neither the SMSF itself, employee or employer contributions, nor earnings accrued thereafter, would be subject to U.S. taxes.
- Tax treaty article 18(2): Social security payments and other public pensions. Dixon instead claimed treaty benefits under article 18(2) to exempt his super as privatized social security. Under paragraph (2), social security payments and other public pensions paid by one country to a resident of the other or to a citizen of the United States shall be taxable only in the country from which the payments are made. The IRS challenged this position, pointing out that Dixon has “neither identified nor substantiated any Social Security or other public pension payments that [he] received from Australia during tax year 2015. Accordingly, [Dixon] did not receive any payments that may be eligible for a benefit under Article 18 of the Treaty.” To some extent, a position could be taken that the superannuation guarantee portion of the Australian regime is equivalent to or should be taken in lieu of what the United States knows as Social Security. As previously noted, the superannuation guarantee is one of the three main pillars of Australia’s retirement system. Indeed, Australia’s intent to replace the age pension with the superannuation regime is reflected in the Social Security (International Agreements) Act of 1999 (SSIA),112 which was enacted in March 2000 shortly before the implementation of the superannuation scheme in the same year. The SSIA’s scope explicitly references Australia’s existing social security laws and the Superannuation Guarantee Administrative Act (SGAA) as the two primary regimes in Australia that would be subject to an international agreement on social security with another country (aka totalization agreement)113 that would override Australia’s domestic social security law.114
C. Totalization Agreement
The issue of what would constitute social security for purposes of article 18(2) was sought to be dealt with under a social security agreement between the two countries. In 2002 the Australia U.S. totalization agreement came into force on the heels of the 2001 protocol to the tax treaty. The totalization agreement referenced the SGAA as falling within the scope of the agreement (along with contributions made under the Old Age, Survivors, and Disability Insurance (OASDI) program of the United States and social security law of Australia), which could be interpreted as support for the position that the superannuation guarantee paid by employers as mandatory contributions to the super fund constitutes or is treated as equivalent to Social Security contributions in the United States.115 Moreover, the addition of the SGAA to the scope of Australia-U.S. totalization agreement falls squarely within the guidelines of the U.S. Social Security Act section 233, which allows additional provisions to be made to social security agreements that are consistent with Title II (that is, OASDI). Closer scrutiny of the superannuation guarantee contribution amounts payable by an Australian employer under the SGAA scheme shows substantial similarities between it and the U.S. Social Security taxes payable by an employer under FICA or self-employed individual the SelfEmployed Contributions Act (SECA). The similarity between the superannuation guarantee, FICA and SECA has been acknowledged and placed within the scope of coverage of the Australia-U.S. totalization agreement. Indeed, FICA and SECA explicitly do not apply during a period when employee wages are subject to the social security system of a foreign country under a totalization agreement between the United States and that other foreign country. In particular, FICA and SECA do not apply when a U.S. person is subject to Australia’s superannuation guarantee scheme. This means, by inference, that Australia’s superannuation guarantee is likely equivalent to the U.S. FICA and SECA taxes. If, based on the above authorities, the superannuation guarantee amounts paid to Dixon’s SMSF accounts as employer contributions, if any, were to be treated as equivalent to foreign social security, then those employer contributions would be excluded from Dixon’s taxable income and exempt from U.S. taxation under article 18(2) of the Australia-U.S. tax treaty. However, it appears that Dixon’s claim for tax treaty benefits fell short of providing adequate disclosure regarding specific amounts received or deemed received from his SMSF that were excluded from his U.S. taxable income as foreign social security. The IRS noted that Dixon failed to provide granular detail in the Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b),” submitted along with his tax returns to identify specific amounts received from the SMSF that would be treated as social security.
Since the Dixon Tax Court case has been placed on continuance pending resolution of IRS Appeals proceedings with Dixon, it remains to be seen whether the issue of Dixon’s SMSFs as foreign social security will ever get its proverbial day in court. Australians are passionate about their super funds, and if the DAG-Australia fallout is any indication, would likely be loathe to see any portion of their super funds subject to U.S. taxation. While Dixon and DAG-Australia’s reputation in Australia will probably never be redeemed in light of the misery it has bestowed on those who trusted their super fund monies to him, his firm, and his U.S. real estate fund, perhaps his remaining Tax Court case will garner some sympathy from dual citizens and residents of Australia and the United States who have suffered the punitive taxation of their Australian investments and retirement under the U.S. tax regime.