The United States and Malta have entered into a Competent Authority Agreement (CAA)[1] on the meaning of a “pension fund” under the Malta-US income tax treaty. While that might seem like a matter of little consequence, the agreement is meant to quash what the IRS had identified in July as a 2021 “Dirty Dozen” scam that was being used to escape tax on the sale of appreciated property.[2]

The July 2021 IRS news release summarized the promoted program as follows:

Potentially abusive use of the US-Malta tax treaty

Some U.S. citizens and residents are relying on an interpretation of the U.S.-Malta Income Tax Treaty (Treaty) to take the position that they may contribute appreciated property tax free to certain Maltese pension plans and that there are also no tax consequences when the plan sells the assets and distributes proceeds to the U.S. taxpayer. Ordinarily gain would be recognized upon disposition of the plan's assets and distributions of the proceeds. The IRS is evaluating the issue to determine the validity of these arrangements and whether Treaty benefits should be available in such instances and may challenge the associated tax treatment.[3]

In August of 2021, the Wall Street Journal published an article describing the structure in more detail.[4]

The CAA provides additional details on the structures being used:

It has come to the attention of the competent authorities that U.S. citizens and residents are establishing personal retirement schemes in Malta under the Retirement Pensions Act of 2011 with no limitation based on earnings from employment or self-employment, and are making contributions to these schemes in forms other than cash (e.g., securities). Questions have arisen in the United States about whether these personal retirement schemes are “pension funds” for purposes of applying the Treaty.[5]

The CAA provides details on what the Treaty provisions cover (and exclude from tax) and what they do not:

The competent authorities confirm that a fund, scheme or arrangement established in a Contracting State that, except in the case of a qualified rollover from a pension fund established in the same Contracting State,

(a) is allowed to accept contributions from a participant in a form other than cash, or

(b) does not limit contributions by reference to earned income from personal services (including self-employment) of the participant or the participant’s spouse,

is not operated principally to administer or provide pension or retirement benefits within the meaning of paragraph 1(k) of Article 3 of the Treaty, and is therefore not a “pension fund”. The competent authorities therefore also confirm that distributions from this type of fund, scheme or arrangement are not “pensions or other similar remuneration” in consideration of past employment for purposes of paragraph 1(b) of Article 17 of the Treaty. This type of fund, scheme, or arrangement includes a personal retirement scheme established in Malta under the Retirement Pensions Act of 2011.[6]

The CAA goes on to clarify how this applies to U.S. citizens and residents:

Accordingly, U.S. citizens and residents may not claim benefits under paragraph 1(b) of Article 17 and Article 18 of the Treaty with respect to the type of fund, scheme or arrangement described in the paragraph immediately above, including a personal retirement scheme established in Malta under the Retirement Pensions Act of 2011. Additionally, these funds, schemes or arrangements may not apply paragraph 2(e) of Article 22 of the Treaty to be treated as a qualified resident and may not claim the benefits of paragraph 3 of Article 10 of the Treaty.

The competent authorities confirm that the interpretation in this Arrangement reflects the original intent of the Contracting States regarding the definition of “pension fund” for purposes of the Treaty.[7]

The IRS issued a news release at the same time as the CAA was released on the agreement.[8] The release reminds taxpayers that the IRS had already identified this sort of arrangement as problematical and advises taxpayers who entered into such arrangements to consult an independent tax adviser. Independent would mean in this context an adviser other than one who was a promoter of the arrangement.

The IRS put taxpayers on notice earlier this year that it was reviewing the use of Maltese personal retirement schemes. The IRS is actively examining taxpayers who have set up these arrangements and recognizes that other taxpayers may have filed tax returns claiming Treaty benefits as a result of their participation in these arrangements. These taxpayers should consult an independent tax advisor prior to filing their 2021 tax returns and take appropriate corrective actions on prior filings.[9]

The paragraph presumably is meant to suggest that taxpayers who push forward with such an arrangement will face penalties and other actions that those who voluntarily take actions to undo their participation and return any already claimed benefits will avoid.

The IRS adds a paragraph warning against similar attempts to exploit other treaty provisions:

The IRS also cautions taxpayers against entering into any substantially similar arrangements that would seek to misconstrue the provisions of a bilateral income tax treaty of the United States to avoid income tax.[10]

The release goes on to threaten both civil and criminal enforcement activities:

IRS enforcement, both the civil and criminal divisions, is committed to pursuing abuse and those who market and participate in abusive transactions.[11]

Clearly the IRS is expecting such threats to dissuade taxpayers from pursuing similar schemes, as well as getting any individual who participated in such programs to come forward voluntarily. Of course, this, at the moment, represents a threatened IRS position in civil and criminal proceedings, one that they may not pursue in some, many or most cases and that they may or may not be able to persuade a court is correct.

However, most clients are not keen to take positions that have a possibility of leading to significant civil penalties or where Treasury is making any claims of potential criminal charges (regardless of how likely they are to pursue them). Certainly any taxpayer who entered into such an arrangement without understanding the significant risk that the IRS would not agree with this treatment and might look to impose significant penalties if the position is not upheld by a court needs to seriously consider taking the IRS’s suggestion to seek independent advice—the fact that the party promoting this did not make the risk and potential consequences of challenges to the arrangement clear would be a good indication that a “second opinion” on this from an adviser not associated with or recommended by the promoter would be a reasonable step.

Ultimately, I’d expect at least some of these arrangements to end up in the courts, at which time we’ll see if the IRS can persuade the Courts that these are and always have been abusive tax schemes in violation of the law. But any taxpayer who does not want to finance and go through such a court proceeding, risking the possibility of loss (with resultant penalties, potentially both civil and criminal) for the hope of a (potentially very) large tax benefit needs to, in consultation with an independent tax professional[12], consider the most appropriate actions to take from this point forward.

[1] Competent Authority Agreement: United States and Malta, December 21, 2021, https://www.irs.gov/pub/irs-utl/malta-competent-authority-arrangement-pension-funds.pdf (retrieved December 22, 2021)

[2] “IRS wraps up its 2021 "Dirty Dozen" scams list with warning about promoted abusive arrangements,” IR-2021-144, July 1, 2021, https://www.irs.gov/newsroom/irs-wraps-up-its-2021-dirty-dozen-scams-list-with-warning-about-promoted-abusive-arrangements (retrieved December 22, 2021)

[3] “IRS wraps up its 2021 "Dirty Dozen" scams list with warning about promoted abusive arrangements,” IR-2021-144, July 1, 2021

[4] Laura Saunders, “Quirks in a U.S. Treaty With Malta Turn Into a Tax Play,” Wall Street Journal online, August 20, 2021, https://www.wsj.com/articles/taxes-malta-pension-plan-11629418826?mod=article_inline (retrieved December 22, 2021, subscription required)

[5] Competent Authority Agreement: United States and Malta, December 21, 2021

[6] Competent Authority Agreement: United States and Malta, December 21, 2021

[7] Competent Authority Agreement: United States and Malta, December 21, 2021

[8] “United States, Malta sign a competent authority arrangement (CAA) confirming pension fund meaning,” IR-2021-253, December 21, 2021, https://www.irs.gov/newsroom/united-states-malta-sign-a-competent-authority-arrangement-caa-confirming-pension-fund-meaning (retrieved December 22, 2021)

[9] “United States, Malta sign a competent authority arrangement (CAA) confirming pension fund meaning,” IR-2021-253, December 21, 2021

[10] “United States, Malta sign a competent authority arrangement (CAA) confirming pension fund meaning,” IR-2021-253, December 21, 2021

[11] “United States, Malta sign a competent authority arrangement (CAA) confirming pension fund meaning,” IR-2021-253, December 21, 2021

[12] Given the IRS implied a threat of criminal penalties, prudence suggests that this independent tax adviser first consulted be a licensed attorney since the tax preparer privilege open to CPAs and EAs under IRC §7525 does not apply in criminal matters. An attorney will evaluate the exposure to criminal liability given all facts and then may determine that the use of a CPA or EA is appropriate for any amended returns to be prepared.