China Resident US Pension 401(k) Withholding Avoided by Tax Treaty

China-US Pension 401(k) Withholding Avoided by Tax Treaty

With the globalization of the world economy, it is not uncommon for taxpayers to have accrued pension benefits from several different countries across the globe. Take, for example, an individual who works in finance and they have been employed by four different companies across four different continents — each having its own foreign pension plan. For non-US persons who may have accrued pension benefits in the United States such as a 401(k), it could be very unfair from a tax perspective. That is because if the person is considered a non-resident alien, the United States is going to withhold 30% tax on the accrued income before distribution in accordance with FDAP rules (Fixed, Determinable, Annual, and Periodic). In order to avoid this unnecessarily harsh outcome, some non-residents who reside in a treaty country may be able to avoid withholding altogether. Let’s walk through the basics of how withholding tax on US pensions may be avoided by tax treaties.

US Pension NRA Withholding Rules

In general, the United States taxes non-resident aliens on FDAP 30% of the payment to the US government for tax. The purpose of this rule is that if the US government did not withhold any tax before remitting payment to the Taxpayer, there is a good possibility that the taxpayer living abroad may not pay US tax on the income. Oftentimes this has nothing to do with a fraudulent intention to seek to avoid tax — but rather the nonresident alien who has no other US-sourced income is simply not aware that they were required to pay tax.

What about the Saving Clause?

The saving clause would not prevent a non-US resident of China from taking advantage of tax treaty: 

As provided by the technical explanation of the treaty:

• • • Article 2 of the Protocol is a simplified version of the traditional “saving clause” which preserves the right of the United States to tax its citizens and residents under its domestic law.

    • The rule is drafted unilaterally, as China does not tax on the basis of citizenship and does not consider such a provision necessary to preserve its taxation of, and implement the Agreement with respect to, Chinese residents.

    • The reference to “citizens” of the United States is understood by the parties to include former citizens whose loss of citizenship had as one of its principal purposes the avoidance of U.S. tax. Such former citizens are taxable in accordance with section 877 of the Code. Certain benefits of the Agreement are available to U.S. residents, as defined in Article 4 of the Agreement.

China Resident 401K NRA Example

For example, a resident of China is neither a US citizen nor a lawful permanent resident. They amassed a significant 401K balance when they worked in the U.S. on an H-1B visa in their younger years.  To avoid withholding, they can take the opportunity to submit documents such as a W8-BEN in order to reduce and eliminate the withholding of taxes by the 401K pension administrator.  That is because a private pension such as 401K is typically only taxable in the country of residence and not the country of source.  Therefore, the United States (source country) would not have the opportunity to tax the income because according to the treaty it would only be taxable where the nonresident taxpayer resides, which is China.

China/US Tax Treaty, Article 17

As provided by the US-China Tax treaty:

(Pensions and Annuities)

• • • Subject to the provisions of paragraph 2 of Article 18, pensions and other similar remuneration paid to a resident of a Contracting State in consideration of past employment shall be taxable only in that Contracting State. 2. Notwithstanding the provisions of paragraph 1, pensions and other payments made by the government, a political subdivision or a local authority of a Contracting State under its social security system or public welfare plan shall be taxable only in that Contracting State.

Article 17 Treaty Explanation

As provided by the technical explanation of the treaty:

• • • This article deals with the taxation of private pensions and social security benefits. Pensions in consideration of government employment are covered under Article 18.

    • Paragraph 1 provides that pensions in respect of private employment derived by a resident of a Contracting State may be taxed only in that State.

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