Tax Blog/Blawg

Recently, the IRS has been devoting substantial resources to its investigation of Malta Pension Plans.  Just this month, the IRS Criminal Investigation division served summonses on multiple entities and persons who it believes were involved with such plans, and has proposed making the transaction a “listed” transaction.  Either action would be noteworthy, but that combined activity tells a story of deep IRS scrutiny.  This article discusses that activity, and provides some high-level options for affected taxpayers.

The Latest Listed Transaction: the Maltese Pension

On June 7, 2023 the Treasury Department issued Proposed Treasury Regulation 1.6011-12 to designate what the IRS calls the “Malta Personal Retirement Scheme” (the “Maltese Pension”) as a listed transaction (the “Proposed Regulation”).  The IRS solicited comments over the following 60 days, and will hold a public hearing on the Proposed Regulation on September 21.  The Proposed Regulation will not be effective until after the public has this opportunity to comment.  

The designation of the Maltese Pension as a listed transaction comes in reaction to U.S. taxpayers’ participation in Maltese retirement plans pursuant to a treaty between the United States and the Republic of Malta.  These plans purport to allow for an effective step-up in the basis of appreciated assets, deferral of income, and more favorable taxation of certain income.  Taxpayers who have participated in these plans, expecting benefits under a retirement plan made possible by a treaty between nations, are now scrambling for answers and a clear path forward.

The Treaty and Benefits

On August 8, 2008, the United States and Malta signed the “Convention Between the Government of the United States of America and the Government of Malta for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income” (the “Treaty”).  One purpose of this treaty is to alleviate double taxation.  As is relevant here, if Malta-based income is taxed in Malta, the U.S. generally will not tax that income a second time.[1]   

The treaty contains what is known as a “savings clause,” which allows the U.S. to tax its citizens on any income.[2]  As this savings clause would otherwise serve to undermine the “no double taxation” portion of the treaty, there are exceptions[3].

First, “pensions and other similar remuneration” arising in Malta are exempted to the extent that such pensions or remuneration would be exempt from tax under Maltese law if the beneficial owner were a resident of Malta.[4]

Second, income earned by a “pension fund” established in Malta is exempted until such income is distributed.[5]  These exemptions allow U.S. citizens the option of participating in Malta Pensions, which have different rules than U.S. retirement plans, such as I.R.A.’s.

Some have described the combined Treaty and the Maltese definition of “pension” as something like a “supercharged” Roth IRA.  Most notably, the Maltese Pension allows contributions of almost any asset, such as appreciated securities, business interests, or real estate.  Further, there is no limit on the amount of annual or total contributions.  There is no taxation on income earned within the Pension, and distributions are taxed under the more favorable Malta scheme, which allows certain lump sums to be distributed tax free.

Maltese pensions allow distributions to begin as early as age 50 (which continue to age 70), as opposed to 59 ½ for a U.S. based Roth I.R.A.  When a taxpayer does finally take that first distribution, he may receive up to 30% of the total fund on a tax-free basis.  From then on, the taxpayer receives minimum annual distributions – the “pension.”  These minimum distributions are taxed as ordinary income.  Three years after that first 30% distribution, the taxpayer may begin taking tax free distributions of 50% of the amount in excess of the corpus required to fund the minimum distributions. 

The IRS Response

In July of 2021, the IRS added the Malta Pension to its “Dirty Dozen” list.[6]  According to the IRS announcement:

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.

Notably, the IRS said the transaction was “potentially” abusive and that the IRS “is evaluating the issue”. It is clear that the IRS had not yet reached a conclusion as of the date of this statement, which could, at a minimum, constitute a strong rebuttal to any penalty that the IRS might propose.  Importantly, the IRS also advised US taxpayers who were considering such a transaction “to show caution” and advised those who had already participated “to consult independent counsel about coming into compliance.”  

A few months later, on December 27, 2021, the Competent Authorities of the United States and Malta executed a Competent Authority Arrangement (the “CAA”).[7]  The CAA explains that 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.”  The CAA answered that they are not.   The purported effect is to remove the Maltese Pension from any exception to the Treaty savings clause, subjecting U.S. citizens to U.S. tax on any income therefrom.

The IRS again included the transaction on the 2022 Dirty Dozen list in June of that year.  This time, however, the IRS warned the public that it had determined that the transaction was improper and that participating taxpayers were “misconstruing” the treaty:

Maltese (or Other Foreign) Pension Arrangements Misusing Treaty. In these transactions, U.S. citizens or U.S. residents attempt to avoid U.S. tax by making contributions to certain foreign individual retirement arrangements in Malta (or possibly other foreign countries). In these transactions, the individual typically lacks a local connection, and local law allows contributions in a form other than cash or does not limit the amount of contributions by reference to income earned from employment or self-employment activities. By improperly asserting the foreign arrangement is a "pension fund" for U.S. tax treaty purposes, the U.S. taxpayer misconstrues the relevant treaty to improperly claim an exemption from U.S. income tax on earnings in, and distributions from, the foreign arrangement.

One year later, on June 7, 2023, the IRS issued the Proposed Regulation, which provides that a transaction that is the same as, or substantially similar to, a Malta Pension[8] is a “listed transaction.”  According to the preamble, a listed transaction is a transaction that is the same as or substantially similar to a transaction that the IRS has identified as an abusive transaction and identified by notice, regulation or other form of published guidance as a listed transaction, which is a long way of saying that the IRS has determined the Malta Pension to be an abusive transaction.  Notably, however, the proposed regulations expressly limit their application to Malta pension plans, and not to similar plans in any other country (yet).

The Proposed Regulation also sets out some IRS arguments against the perceived tax benefits:

First, the Treaty benefits claimed with respect to personal retirement schemes established in Malta are not available because these schemes are not “pension funds,” and their distributions are not “pensions or other similar remuneration,” as explained in the CAA. Second, under Article 3(2) of the Treaty, the undefined terms “pension” and “retirement” are interpreted according to the tax law of the United States, which is the country that is applying the Treaty. Under U.S. law applicable to individual retirement arrangements, Malta personal retirement schemes are neither “pensions” nor do they provide “retirement benefits” for purposes of the Treaty. Maltese law does not condition the tax benefits it provides for these arrangements upon reasonably analogous requirements of U.S. law. Those requirements include that an individual's contributions to an individual retirement arrangement (other than qualified rollovers from a pension or retirement arrangement that is tax-favored under the same country's laws) must be made in cash and must be based on income earned from employment or self-employment activities. See sections 219, 408, and 408A. Third, in appropriate fact patterns, the transaction viewed as a whole may be disregarded under relevant judicial doctrines, including the step-transaction doctrine, the substance-over-form doctrine, and the assignment of income doctrine, in order to give effect to the general purpose of the Treaty to mitigate double taxation but not improperly create instances of non-taxation, especially in cases in which the person establishing the retirement arrangement has no other connection to the treaty jurisdiction.[9]

Assuming the Proposed Regulation is finalized, U.S. participants in Malta Pensions will have no choice but to disclose their participation to the IRS, unless the participant’s statute of limitations is closed, lest they risk significant escalated penalties.  The proposed regulations provide that anyone who filed a tax return reflecting a Malta Pension prior to the date of the final publication of the regulations must disclose that transaction for any tax return where the period of limitations has yet to expire prior to the final publication of the regulations.  

A taxpayer’s statute of limitations could be three years, six years, or forever, depending on whether the taxpayer filed all required forms, whether the IRS asserts fraud, and whether the taxpayer adequately disclosed the transaction on a return if the transaction caused the taxpayer to omit more than 25% of gross income.  Moreover, the structure of the transaction would likely affect multiple tax years, meaning that the statute of limitations could be closed in some years, but open in other years.

Regarding required forms, the preamble to the Proposed Regulation explains that U.S. taxpayers must annually report information regarding a U.S. person’s transfers of money or other property to, ownership of, and distributions from, foreign trusts.  The Treasury Department and IRS have, however, relieved most U.S. taxpayers from these reporting requirements in Revenue Procedure 2020-17.  In the preamble, though, the IRS explains that participants in Malta Pensions are not eligible for that relief, meaning that they should have been filing Forms 3520 every year to comply with the reporting requirement explained above.  The preamble makes this point in multiple places, which may indicate that at least some participants did not file Forms 3520.  If the IRS is correct that the Revenue Procedure does not apply and that taxpayers were required to file Forms 3520, then the statute of limitations has not even begun to run.  In any event, Taxpayers should endeavor to work with their tax advisors to assess whether their statute of limitations could be open and if it is when it will likely close for all relevant years. 

If a taxpayer’s statute of limitations for any period is open when the regulation is finalized, the taxpayer will have to report the transaction to the IRS and the IRS will have one year to assess any tax with respect to the transaction from that date (unless a material advisor provides the information to the IRS on an earlier date).

Potential Penalty Exposure Listing the Malta Pension may result in stiff penalties for some participants. Failure to disclose a transaction results in a penalty of 75 percent of the decrease in tax shown on the return as a result of the reportable transaction (with a minimum amount of $5,000 (natural person) / $10,000 (other case) and a maximum amount of $100,000 (natural person) / $200,000 (other case)).[10]

The Internal Revenue Code also imposes a 20 percent accuracy-related penalty on any understatement that is attributable to a listed transaction (the actually computation is complicated). However, if a taxpayer is required to but does not disclose a listed transaction, the penalty rate jumps to 30 percent of the understatement.[11]

And those are just the penalties that are specific to listed transactions.  The IRS can pursue other, more general penalties, such as negligence, substantial understatement, or civil fraud, which can be as much as 75 percent of the amount of any understatement (although the IRS cannot “stack” most penalties).

What’s a Taxpayer to Do?

First and foremost, taxpayers need to confirm that they are in compliance with all foreign reporting. Suffice it to say there may effectively be no limitations period for assessments due to a failure to file a foreign information reporting return.[12]  Said another way, if the taxpayer did not file the appropriate forms to report foreign holdings, the IRS could have forever to assess tax and penalties.

Aside from any reporting issues, the taxpayer needs to consider whether she wants to “get out” before the IRS really turns up the heat.  The IRS has not “listed” many transactions recently, but if past history is any guide it will audit all (or close to all) participants, resources permitting.  From the IRS’ perspective, that makes complete sense – if it knows (via a disclosure) that a taxpayer has engaged in a transaction that the IRS has determined is abusive, the IRS would almost certainly prioritize that transaction for audit. 

If the taxpayer is not yet under audit she may have the option of filing a qualified amended return.  If the taxpayer is eligible to file such a return, then the taxpayer can essentially “undo” the transaction and avoid most civil penalties.  Eligibility depends on various timing rules, so taxpayers who want to consider this option should speak with their tax advisors.

Criminal Investigations

On June 30, 2023, the IRS Criminal Investigation Division served summonses on multiple persons and entities who it believes were involved in Malta Pension plan transactions.  The summonses seek information from the recipients about U.S. investors.  

Although most taxpayers who participated in these plans should have no reason to fear criminal prosecution, sometimes witnesses misspeak or misremember, documents tell a story different from reality, and government agents and prosecutors simply get it wrong.  Consequently, even if a taxpayer has nothing to hide, it is still a dangerous game for them to approach a criminal investigation alone.  To that end, Taxpayers who are contacted by IRS criminal investigators should consider politely declining interviews unless and until they have spoken with an attorney experienced in sophisticated criminal tax matters.

Taxpayer Options

Taxpayers who are proactive are likely to have more options to help themselves avoid potentially adverse consequences than those who are not

Time is of the essence.  Even if they have yet to be contacted by IRS criminal investigators, taxpayers who claimed tax benefits from Malta pension plans would be well served to expeditiously seek out attorneys experienced in sensitive tax matters to assess their exposure.  There are a number of events that could occur during the course of the Malta Pension Plan criminal tax investigation that could restrict taxpayers’ ability to “undo” their plans and eliminate their penalty exposure by filing qualified amended returns.  For example, to the extent the IRS uses the information it learns to open a Section 6700 civil investigation into the advisers that promoted their particular plan, the initiation of said investigation would foreclose all future qualified amended returns with respect to that plan.  The IRS’s use of a special type of summons called a John Doe summons or a visit by IRS criminal investigators could similarly foreclose a taxpayer’s ability to proactively extinguish his or her penalty exposure.

Conclusion

The IRS has repeatedly warned taxpayers that have participated in a Malta Pension plan to consult a tax adviser.  Those that don’t may soon live to regret it.  By ensuring that their particular plan is expeditiously analyzed by an attorney with experience handling the types of issues referenced above and by taking appropriate action to either remediate or begin mounting a defense, taxpayers can favorably position themselves to survive the coming IRS scrutiny of these transactions.   

[1] Treaty, Art. 23, paragraph 1

[2] Treaty, Art. 1, paragraph 4

[3] Treaty, Art. 1, paragraph 5

[4] Id.; Treaty, Art. 17(1)(b)

[5] Treaty, Art. 1, paragraph 5; Art. 18

[6] “IRS Wraps Up Its 2021 Dirty Dozen Scams List With Warning About Promoted Abusive Arrangements,” IR-2021-144 (July 1, 2021).

[7] I.R.B. 2021-52, Ann. 2021-19

[8] Proposed §1.6011-12(b)(1) defines a Malta personal retirement scheme transaction as one where: a U.S. citizen or a U.S. resident alien directly or indirectly (1) transfers (within the meaning of §1.679-3 or §1.684-2) cash or other property to, or receives a distribution from, a personal retirement scheme established under Malta’s Retirement Pension Act of 2011 and (2) takes the position on a U.S. Federal income tax return that (a) income earned or gain realized by the Malta personal retirement scheme is not includible in income on a current basis for U.S. Federal income tax purposes by reason of the Treaty, or (b) a distribution from a Malta personal retirement scheme attributable to earnings or gains of the scheme that have not been included in income for U.S. Federal income tax purposes is exempt from U.S. taxation by reason of the Treaty. Indirect transfers include transfers to a Malta personal retirement scheme by any person (intermediary) to whom a U.S. person transfers property if such transfer is made pursuant to a plan one of the principal purposes of which is the avoidance of United States tax.

[9] Proposed Regulations, Preamble part V (footnote omitted).

[10] I.R.C. § 6707A(b)

[11] I.R.C. § 6662A(c)

[12] I.R.C. § 6501(e)(1)(A)(ii)

Tom Cullinan is a shareholder in Chamberlain Hrdlicka’s Atlanta office. He joined the firm from the IRS, where he served as the Counselor to the IRS Commissioner and then as the acting IRS Chief of Staff. While at IRS he either conceived or helped launch the Office of Fraud Enforcement, the Office of Promoter Investigations, and the Joint Strategic Emerging Issues Team.   Before he went to work for the IRS he spent twenty years at a different law firm representing clients in tax controversy matters. He can be reached at tom.cullinan@chamberlainlaw.com.

Kevin F. Sweeney is a former federal tax prosecutor. He is currently a Shareholder in the Philadelphia Office of Chamberlain Hrdlicka, where he focuses on IRS audits, civil and criminal tax litigation, white-collar criminal defense, and corporate investigations. He may be reached at (610) 772-2327 or by email at ksweeney@chamberlainlaw.com.

John Kirbo is a senior counsel in Chamberlain Hrdlicka’s tax controversy practice in Atlanta. John has a background in business transactions, as well as both civil litigation and criminal defense, primarily in Federal District Court. John is skilled at solving complex problems for clients through litigation or other more creative means. He can be reached at  john.kirbo@chamberlainlaw.com.