Introduction
Many individuals, after years of service in Japan, receive a substantial severance package and then relocate to the United States, or receive such payments while already residing in the US. It is widely known that under the US-Japan Tax Treaty (hereinafter, the “Tax Treaty”), Japanese severance pay can be exempt from US federal income tax (taxable only in Japan). However, assuming this “tax-exempt” status automatically extends to state taxes can lead to unexpected tax liabilities. Particularly in major states like California and New York, Japanese severance pay is often subject to state tax, differing from the federal treatment. This article provides a comprehensive and detailed analysis, from a professional perspective, of the complex mechanisms, risks, and specific strategies concerning US state taxation on Japanese severance pay.
Basics: Japanese Severance Pay, the US-Japan Tax Treaty, and US Tax System
What is Japanese Severance Pay (Taikushokin)?
Japanese “Taikushokin,” or severance pay, is typically a lump-sum payment provided to employees upon retirement, resignation, or termination. It serves as both a post-retirement financial security measure and a reward for long service. Under Japanese income tax law, severance pay is treated as “retirement income” and is taxed separately from other income, benefiting from preferential tax treatment, including specific deductions based on years of service.
Role of the US-Japan Tax Treaty and Federal Tax Treatment
The US-Japan Tax Treaty is an international agreement designed to prevent double taxation and tax evasion between the two countries. For severance pay, Article 17 (Pensions, Social Security Benefits, Alimony, and Child Support) or Article 21 (Other Income) of the Tax Treaty are particularly relevant. Many forms of Japanese severance pay, especially lump-sum distributions from retirement annuity plans or general severance payments based on years of service, may fall under these treaty provisions. This typically means that such payments are taxable only in Japan and are exempt from US federal income tax. For a US resident receiving Japanese severance pay, this offers a significant tax advantage: by filing Form 8833 (Treaty-Based Return Position Disclosure), they do not need to report this income for federal tax purposes.
Independence of US State Taxation
The US tax system operates under a “dual taxation structure,” where the federal government and individual state governments each possess independent taxing authority. While federal tax laws apply nationwide, each state enacts its own tax laws, establishing unique tax rates, deductions, and taxable income definitions. This independence is the primary reason for the complexity of state tax treatment of Japanese severance pay. Even if federal tax is exempted by a tax treaty, state tax laws do not necessarily conform to the treaty’s provisions.
Detailed Analysis: The Conflict Between the US-Japan Tax Treaty and State Tax Laws
Non-Conformity of Federal Tax Treaties and State Tax Laws
Under the US Constitution’s Supremacy Clause, international treaties generally supersede federal laws. However, the extent to which this principle applies to state taxes is often left to individual state interpretation. Many states, especially high-tax states like California and New York, do not automatically consider their state tax laws to be bound by the provisions of federal tax treaties. These states often take the position that unless their own tax laws explicitly incorporate or recognize the application of a tax treaty, they will disregard the treaty’s exemption provisions and tax Japanese severance pay as ordinary income. This stance is often driven by the states’ need to secure their own revenue, avoiding the extension of federal treaty benefits to state tax collections.
Specific State Examples: California and New York
California (California Franchise Tax Board: FTB)
California is known for its general non-conformity to federal tax treaty provisions for state income tax purposes. The California Franchise Tax Board (FTB) often eliminates the impact of federal income adjustments (such as income exclusions under a tax treaty) by requiring specific state adjustments to the Federal Adjusted Gross Income (Federal AGI), which serves as the starting point for state tax calculations. In the case of Japanese severance pay, even if you file Form 8833 with your federal return to exclude the severance pay from federal income, California typically requires you to include that severance pay as taxable income on your state return. This is based on the FTB’s clear position that tax treaties do not apply to state taxes.
New York (New York State Department of Taxation and Finance: DTF)
Similar to California, New York State does not automatically follow federal tax treaty provisions for state tax purposes. New York tax law stipulates that unless a federal tax treaty provision is explicitly incorporated into state law, the income exemption under the treaty will not apply for state tax purposes. Therefore, even if Japanese severance pay is exempt from federal tax, a New York resident is highly likely to have that severance pay treated as state taxable income. The Department of Taxation and Finance (DTF) may use the AGI resulting from federal tax treaty application as a starting point for state tax, but then apply state-specific additions or adjustments to effectively reverse the treaty-based exclusion and tax the income.
Treatment in Other States
Not all states disregard tax treaties to the same extent as California or New York. Some states may, to varying degrees, accept the federal tax treatment of income, including adjustments made under tax treaties, when calculating state income tax. However, these are often the minority. In most states, there is a significant risk that state tax laws will either take precedence over federal tax treaties or simply not provide explicit provisions for their application, making the income subject to state taxation. It is crucial to individually verify the tax laws of your state of residence.
Nature of Severance Pay and Tax Risk
The specific nature and form of Japanese severance pay can influence which article of the Tax Treaty applies, and consequently, its treatment for state tax purposes.
- Lump-sum distributions from retirement annuity plans: Payments from corporate pension plans or defined contribution plans are likely to be treated as “pensions” under Article 17 of the Tax Treaty. In this scenario, they are generally taxable in Japan and exempt from US federal tax. However, they remain subject to state tax in many states.
- Severance lump-sum as a gratuity or consolation payment: A lump-sum payment purely for meritorious service or as a consolation is likely to fall under Article 21, “Other Income,” which generally dictates that it is taxable only in the country of residence of the payer (Japan). Again, while exempt from federal tax, state tax treatment follows the patterns described above.
- Settlement payments for employment contract termination: If the payment, though called “severance,” is actually a settlement for damages or a termination of an employment contract, its nature differs. It might be interpreted as “employment income” or “other income” under the Tax Treaty, potentially incurring US tax obligations even at the federal level, depending on the circumstances.
Case Studies and Calculation Examples
Case Study 1: California Resident with a Green Card
Mr. A, a Green Card holder residing in California, worked for a Japanese company for 30 years and received 10,000,000 JPY (approximately $70,000 USD, assuming a 140 JPY/USD exchange rate) as severance pay.
- Federal Tax: Mr. A files Form 8833 and, based on Article 17 (or Article 21) of the US-Japan Tax Treaty, excludes this severance pay from his federal income tax. Therefore, his federal taxable income from this payment is $0.
- California State Tax: California does not apply the Tax Treaty. The state considers Mr. A’s $70,000 severance pay as taxable income. Depending on Mr. A’s other income and deductions, California’s state income tax rates (e.g., approximately 6-9%) would apply, potentially resulting in several thousand dollars of state tax.
Case Study 2: New York Resident, US Citizen
Ms. B, a US citizen residing in New York, previously worked in Japan and received a lump-sum severance payment of 5,000,000 JPY (approximately $35,000 USD) from a Japanese company while living in the US.
- Federal Tax: Ms. B files Form 8833 and excludes the severance pay from her federal income tax. Her federal taxable income from this payment is $0.
- New York State Tax: New York also does not apply the Tax Treaty. Ms. B’s $35,000 severance pay is considered taxable income for state purposes. Combined with her other income, New York’s state income tax rates (e.g., approximately 4-6%) would apply, leading to state tax liability.
Calculation Example: Impact of Federal Exemption, State Taxation
Example for a single California resident with $100,000 in annual gross income (e.g., salary) and $70,000 in Japanese severance pay.
- Federal Tax:
– Federal Adjusted Gross Income (Federal AGI): $100,000 (salary) + $0 (severance – treaty applied)
– Taxable Income: Federal tax rates apply to the amount after standard deductions, etc., from $100,000. - California State Tax:
– State Adjusted Gross Income (State AGI): $100,000 (salary) + $70,000 (severance – treaty not applied) = $170,000
– Taxable Income: California state tax rates apply to the amount after state-specific deductions, etc., from $170,000.
In this example, federal taxable income is calculated based on $100,000 (excluding severance), while state taxable income is calculated based on $170,000 (including severance). State tax will be imposed on this $70,000 difference.
Pros and Cons
Pros
- Federal Tax Exemption: Properly applying the US-Japan Tax Treaty can exempt Japanese severance pay from significant US federal income tax, providing a substantial tax benefit for US residents.
- Avoidance of Double Taxation (Federal Level): The treaty ensures that severance pay, once taxed in Japan, is not taxed again at the federal level in the US, thus avoiding federal double taxation.
- Potential for State Exemption in Some States: Not all states disregard tax treaties. In some states, the federal tax treatment may be followed, potentially leading to state tax exemption as well.
Cons
- Unexpected State Tax Burden: In many states, especially California and New York, federal tax treaty provisions are not applied, making Japanese severance pay subject to state tax. This can result in an unexpected and significant tax liability.
- Complex Filing Procedures: The differing treatment between federal and state taxes makes tax filing highly complex. It requires filing Form 8833 and making intricate adjustments on state tax returns, necessitating specialized knowledge.
- Professional Fees: To properly navigate these complex tax issues, engaging a US Certified Public Accountant (CPA) experienced in international tax is essential, incurring professional fees.
- Audit Risk: Incorrect reporting increases the risk of an audit by both federal (IRS) and state tax authorities.
Common Pitfalls and Important Considerations
Common Pitfalls
- Misconception of “Totally Tax-Exempt Due to Treaty”: The most common mistake is assuming that if federal tax is exempt, state tax will automatically be exempt as well.
- Failure to File Form 8833: To benefit from the Tax Treaty at the federal level, you must file Form 8833 to disclose your treaty-based return position to the IRS. Failure to do so can result in the income being subject to federal tax.
- Neglecting to Check State Tax Laws: Proceeding with tax filing without confirming how your state of residence treats tax treaties is risky.
- Misunderstanding the Nature of Severance Pay: Not all Japanese severance payments are treated equally. Their nature and form can affect which treaty article applies and thus the tax implications. Avoid making casual judgments.
Important Considerations and Specific Strategies
- Consult a Professional Tax Accountant (CPA): Consulting a US CPA specializing in US-Japan international taxation, particularly the complex interplay between tax treaties and state taxes, is paramount. Avoid self-assessment.
- Thoroughly Review Your State’s Tax Laws: Carefully check the website and published guidelines of your state’s tax authority (e.g., FTB for California, DTF for New York) or ask your CPA to do so.
- Always File Form 8833: Attach Form 8833 to your federal tax return to clearly disclose that your Japanese severance pay is exempt under the Tax Treaty.
- Consider Timing of Severance Receipt: If possible, receiving severance pay before becoming a US resident might help avoid US tax issues altogether. However, this varies significantly by individual circumstances and requires careful planning.
- Understand Potential for Double Taxation: If state tax is imposed, you might face de facto double taxation (taxed in Japan and by the US state). While foreign tax credits might be available at the federal level, many states do not allow foreign tax credits against state income tax, making this a crucial point to consider.
Frequently Asked Questions (FAQ)
Q1: I heard that the US-Japan Tax Treaty always exempts Japanese severance pay from federal tax. Is this true?
A1: No, it’s not always true. The applicable treaty article for Japanese severance pay depends on its nature (e.g., pension, other income). Furthermore, the treatment can vary based on your individual status, such as whether you are a US citizen, a Green Card holder, or a non-resident alien. To receive federal tax exemption under the treaty, you must also follow specific procedures, including properly filing Form 8833. It is crucial to understand the specific details of your severance pay and seek professional advice.
Q2: If state tax is imposed, can I claim the Japanese tax paid as a credit against my US state tax?
A2: Generally, US states do not allow for a foreign tax credit against state income tax. The foreign tax credit mechanism is primarily designed at the federal level to prevent double taxation. Most states do not have provisions for foreign tax credits in their own tax laws. Therefore, if your Japanese severance pay is subject to state tax, you typically cannot directly offset the tax paid in Japan against your state tax liability, which can effectively lead to double taxation.
Q3: I heard that if I receive Japanese severance pay before moving to the US, it won’t be taxed in the US. Is this true?
A3: Yes, this can be true. US tax law generally imposes worldwide income taxation on its “residents.” Therefore, if you receive severance pay before becoming a US resident (i.e., while you are a non-resident alien), that income is generally not subject to US taxation. However, the definition of “resident” is complex and determined by factors such as Green Card status or meeting the substantial presence test. Additionally, there might be exceptions where income received during a non-resident period is still taxable if, for example, it is connected to a US business activity. Do not make assumptions; meticulous tax planning before moving to the US is essential.
Conclusion
The US tax treatment of Japanese severance pay is a highly specialized area, intricately intertwined with the dual structure of federal and state taxation, the application of the US-Japan Tax Treaty, and the unique tax laws of each state. Particularly in major states like California and New York, it is crucial to recognize that the federal tax exemption under the US-Japan Tax Treaty often does not extend to state taxes, making Japanese severance pay highly susceptible to state taxation. To navigate this complex landscape, the expert knowledge and specific advice of a professional Certified Public Accountant (CPA) specializing in international tax are indispensable. If you are considering or have already received severance pay, always consult with a professional to ensure proper tax planning and filing, thereby avoiding unexpected tax risks and enjoying peace of mind in the United States.
#US-Japan Tax Treaty #Severance Pay #State Tax #Federal Tax #California Tax #New York Tax #Tax Planning #International Tax #Non-Resident Alien #Tax Exemption