In PLR 200828037 (April 14, 2008), the Internal Revenue Service for the first time ruled on the application of Code Section 72(w), enacted as part of the American Jobs Creation Act of 2004 and effective for distributions on or after October 22, 2004.

On the facts of the ruling, an employee made contributions to an apparently non-U.S. pension plan sponsored by his employer for eleven years while the employee was a nonresident alien for U.S. tax purposes. Those contributions were tax deferred under the laws of the governing country, and were not subject to the U.S. tax system. The employee then moved to the U.S., became a U.S. resident and continued to make contributions to that pension plan for another 19 years. These contributions were subject to the U.S. tax system and were included in the employee’s U.S. taxable income. In addition, employer contributions were made to the pension plan, none of which were taxable. Apparently, on termination of employment, the pension obligation was transferred from the pension plan to an unspecified entity for payment in the form of a joint and survivor annuity, originating as a fixed amount denominated in Euros and starting in 2007.

In general, Section 72 includes rules for computing the portion, if any, of taxable annuity or pension payments that constitutes a non-taxable return of the taxpayer’s aftertax “investment in the contract” (i.e., cost basis). For purposes of these computations, Section 72(w) provides that investment in the contract does not include employer or employee contributions:

  • Made with respect to compensation (i) for labor performed while a nonresident alien and (ii) treated as non-U.S. source; and
  • Not subject to either U.S. or any foreign income tax, and that would not have been subject to such income tax if paid as cash compensation when the services were rendered.

The Service ruled that the contributions made by the employee while a nonresident alien were described in Section 72(w) and thus were not includible in the employee’s investment in the contract. The employer contributions also were covered by Section 72(w), although the facts of the ruling are not clear in this respect. Employee contributions while a U.S. resident were investment in the contract.

Finally, because the amount payable annually in U.S. dollars would fluctuate with the Euro conversion rate, the Service used an “exclusion amount” (the approach that applies to variable annuities) rather than an “exclusion ratio” (the approach that applies to fixed annuities) to determine the taxable amount of the annuity payments. As a consequence, the same amount in U.S. dollars of each annuity payment was to be treated as a non-taxed return of investment in the contract, and the taxable amount of the payments in U.S. dollars would vary with the exchange rate.

Employers with internationally mobile employees, as well as annuity payors, may wish to consider whether this ruling has any implications for their operations.