How do US Tax Rules Constrain the Investment Choices of US Taxpayers Living in Australia?

In the Facebook group last week, someone claimed that only the very wealthy are disadvantaged by the dual tax obligations imposed on US citizens and green card holders living in Australia. Certainly, for an Australian resident with only salary income, it is likely that foreign tax credits (FTC) or the Foreign Earned Income Exclusion (FEIE) will completely eliminate any US tax liability. However, for anyone who is considering investing for the future or running their own business, there are many pitfalls and traps in US tax law that need to be carefully considered. It seems like almost anything “foreign” is treated punitively by US tax law, and these xenophobic rules make it difficult for middle class US taxpayers to save effectively while living outside the US.

Over the next few weeks, I will be covering the following areas where US taxpayers living in Australia need to be particularly careful:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US
  8. Record keeping

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action.

1. Superannuation

As mentioned in an earlier post, there is disagreement among tax professionals as to how superannuation is to be treated under US tax law. The lack of clarity in the tax treaty coupled with the absence of authoritative rulings from the IRS leaves us in an unfortunate position where the conservative interpretations of tax compliance professionals end up creating precedent and expectations on the part of the IRS. The end result is a movement towards compliance that maximises US tax due.

The Australian government should use the mutual agreement mechanism in the treaty to pressure the IRS to make a determination as to whether any part of the superannuation system should be treated as equivalent to Social Security under the treaty. The US should have no right to tax the superannuation of Australian residents; to allow US taxation of super is to allow the US to drain capital from the Australian economy. However, as this area is still unclear, the remainder of this section will start from the premise that the US can tax super contributions, income, and distributions.

For readers who are not familiar with Australian superannuation, it works like this: employers are required to contribute 9.5% of employee salary to a superannuation fund. Tax is paid on this contribution by the super fund at a rate of 15%, the contribution is not taxable to the employee. In addition, employees can elect to make additional “salary-sacrifice” contributions, which are taxable to the super fund at the 15% contributions tax rate, but not to the employee. Self-employed individuals can also make tax deductible super contributions, which are also taxed at the 15% rate inside the super fund. All of these contributions collectively are called “concessional” contributions because they are taxed at 15% rather than the individual’s marginal tax rate. It is also possible to make “non-concessional” contributions, which are contributions from after-tax income. Non-concessional contributions are not subject to the 15% contributions tax at the fund level. There are limits on the amount of concessional and non-concessional contributions that an individual can make each financial year. Investment income generated inside a super fund is taxed at 15% on ordinary income and 10% on capital gains. Money must stay in a super account until retirement. While it is possible to withdraw the entire account in a lump sum upon retirement, it is more advantageous to leave the money in “pension mode” inside super where the tax rate drops to zero. For retirees over age 60, all super distributions are tax free. Of course, these are the Australian tax implications of super, the US tax implications can be very different.

Most tax professionals appear to be treating superannuation as an employees’ trust under Internal Revenue Code section 402(b). To oversimplify, this means that employer contributions are included as compensation income when computing US taxable income,[1] but as long as the only contributions in the account are employer contributions (essentially the 9.5% of salary), then the income inside the account is deferred for US tax until benefits are withdrawn.

However, if personal contributions (salary sacrifice contributions plus non-concessional contributions) exceed employer contributions, the classification of super under US tax law can change. Depending on several factors (that are beyond the scope of this post), excessive personal contributions can turn the super account into a foreign grantor trust. The consequence of classification as a grantor trust is that, for US tax reporting, the employee is treated as directly owning all investments inside the super fund, meaning that all income inside the fund is taxable currently to the individual. Foreign trust reporting is very complex and requires extra US tax compliance (more forms with huge penalties for non-filing). One major problem with this compliance nightmare is that super account holders rarely get all the information required on their regular account statements. If the super account is treated as a foreign grantor trust, then the Australian tax paid inside the super fund (both the 15% contribution tax and the 15% tax on fund earnings) should be available as FTC on the US return if it is separately stated on the super account statement. Because of the potential grantor trust treatment, a US taxpayer who wishes to make extra super contributions should consult a professional. It may be possible to make salary-sacrifice and/or non-concessional contributions to carefully utilise FTC and avoid foreign grantor trust status (possibly by segregating personal contributions from employer contributions).

US tax on superannuation will further constrain the choices of US taxpayers who wish to consolidate their superannuation accounts. Since super is not a qualified retirement plan for US tax purposes, rollovers may be a US-taxable event, so tread carefully here. For those who are self-employed, and those with a self-managed super fund (SMSF), the grantor trust rules will increase US tax and complicate compliance.

If superannuation is not equivalent to social security, then once distributions start, distributions will be US-taxable to the extent they have not been previously included in US taxable income. At the beginning of each year, you determine what fraction of the account represents previously included income, and that fraction of distributions is excluded from US taxable income. This income is not earned income, so it does not qualify for FEIE. To the extent that you have Australian taxable portfolio income, there may be some foreign tax credits available. Unused foreign tax credits carry over for 10 years, so for the early years of retirement, there may be plenty of FTC available to offset super distributions. However, given that pension distributions from super are not taxable in Australia after age 60, it is quite possible that FTC carryover will run out and US tax will be owed. Note that the income and assets tests for qualification for the Age Pension will not be adjusted due to US tax liability, so US taxpayers who qualify for the Age Pension while still drawing a super pension will have lower after-tax income than other Australians.

Allowing the US to tax superannuation in this manner means that this segment of the Australian population is unable to fully utilise the incentives given by the Australian government to increase retirement savings and reduce reliance on the Age Pension.

Well, the target for this post was about 750 words, and I’m already well and truly above 1000. If I missed anything you wanted to know about super, please ask in the comments. In a few days I’ll post the next installment of this series on the US tax complications of investing in real estate, either your own home or investment property.


[1] There are additional rules for highly compensated employees that further limit the advantages of investing in superannuation for US taxpayers.

6 thoughts on “How do US Tax Rules Constrain the Investment Choices of US Taxpayers Living in Australia?”

  1. The US should have no right to tax the INCOME OF ANY TYPE of Australian residents; to allow US taxation of INCOME OF ANY TYPE is to allow the US to drain capital from the Australian economy.

    It’s time for all nations to step up and tell the USA this is wrong and will not be tolerated. As the USA only listens to the sound of money, I would like to see a fee of 30% imposed on every American-bank transaction with any foreign country where the USA taxes its citizens and/or corporations. Maybe then the Land of the Fee will take notice to its wrongdoing.

    1. Thanks for the comment, John. Most countries tax on the basis of residence and source. I have no problem with the US taxing US-source income of Australian residents. The problem is that the US is taxing Australian-source income of Australian residents. As I mentioned in my series on the Saving Clause, one of the principles that Australia should take into the next treaty negotiation is that the Australian-source income of Australian residents is Australia’s tax base and should not be taxable by any other country, regardless of citizenship claims. As you say, the current system is draining capital from the Australian economy. When it comes to taxation of superannuation, the Australian government will eventually pay. The government Age Pension in Australia is means tested, so those who are unable to effectively save due to US tax rules will be drawing a larger Age Pension than they otherwise would have.

  2. Karen, great post.

    “In the Facebook group last week, someone claimed that only the very wealthy are disadvantaged by the dual tax obligations imposed on US citizens and green card holders living in Australia.”

    Yes, well the people who make these claims are part of the problem and NOT part of the solution. It’s as though there is a “class warfare” being carried out among Americans abroad. I see this nonsense frequently suggested in relation to the application of the U.S. Exit Tax as well usually stated as:

    “Well, the Exit Tax affects only the rich, and doesn’t affect me, so it is somehow okay for the U.S. to confiscate Australian assets.”

    To see how confiscatory the Internal Revenue Code S. 877A actually is (in relation to middle class Americans abroad) see:

    http://www.citizenshipsolutions.ca/2015/04/05/part-5-the-exit-tax-in-action-five-actual-scenarios-with-5-actual-completed-u-s-tax-returns/

    But that aside, I would like to comment specifically on:

    “1. Superannuation

    As mentioned in an earlier post, there is disagreement among tax professionals as to how superannuation is to be treated under US tax law. The lack of clarity in the tax treaty coupled with the absence of authoritative rulings from the IRS leaves us in an unfortunate position where the conservative interpretations of tax compliance professionals end up creating precedent and expectations on the part of the IRS. The end result is a movement towards compliance that maximises US tax due.”

    There is no doubt that:

    1. To allow the U.S. tax compliance to interpret the U.S. “taxability” of the Australian Superannuation (in its various permutations) is to to significantly increase the chances that the Super will be subject to punitive U.S. taxation.

    2. The problem is largely that the Australian Government has been unwilling (so far) to take the public position that the Super is “Social Security” within the intended meaning of the U.S. Australian Tax Treaty. I don’t see this as primarily an issue of IRS interpretation. It is ludicrous to allow the IRS by itself to determine whether the Australian Super is taxable by the USA. Both the United States and Australia have the right to interpret the treaty. Furthermore the treaty is to be interpreted in accordance with the expectations of both countries. See my commentary on the decision here:

    http://www.citizenshipsolutions.ca/2016/08/07/the-interpretation-of-us-tax-treaties-domestic-law-foreign-law-or-the-intent-of-the-treaty/

    Once again I suggest:

    It is inconceivable that Australia would have agreed to a treaty that would disallow any Australian citizen/resident from participating in the Australian Superannuation (an important cornerstone of Australian public policy).

    1. John,
      Thanks for your comment.

      Yes, the compliance industry is a major part of the problem. Due to the excessive complexity of the US tax system (especially for non-resident citizens), most expats must rely on expensive professional help for their US compliance. And, since many expats don’t really understand the US tax implications of their financial actions, they can’t judge whether the tax compliance services they are paying for are actually correct.

      As for your second point. I would agree that the Australian government has let down its dual Australian/US citizens and US citizen permanent residents by not resolving this issue. A letter I received last year from Treasurer Scott Morrison says:

      The Australian Government is aware that the United States Government, under its domestic law, taxes US citizens on their worldwide income and therefore income earned in Australia by US citizens, such as superannuation earnings, are subject to US taxation. In this regard, it is a matter for the United States Government to determine its own domestic tax laws.

      Clearly, we need to educate the Australian government on what they can do within the existing treaty to alleviate the problem of US taxation of superannuation.

      1. Karen, this is an outrageous comment from Treasurer Scott Morrison. He doesn’t seem to understand that Australia has both the right and the duty to interpret the tax treaty. That is, unless he thinks that the purpose of the tax treaty is to allow the U.S. to colonize Australia through U.S. “citizenship-based taxation”.

        Yup, you better invite these people to “Tax Treaty School”.

  3. This post and many others I have seen regarding the Australia-US Tax Treaty focus on the treatment of US Citizens resident in Australia. I fall into a different group, the Australian citizen who is a US resident. Are the issues of an Australian with property, stocks and superannuation accounts who migrates to the US the same as the US citizen living in Australia?
    Certainly the need for recognition by the IRS that Australian superannuation fund holdings should not be taxed in the US is similar.
    Are the experiences of other Australians in the US the same? If I become a US citizen, will I be in a worse situation?
    One thing I have learned is that there are very few resources to obtain reliable advice.

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