Rev. Rul. 58-472

Advice has been requested concerning the taxability of pensions received under the United States Civil Service Retirement System by two United States citizens for services performed by each wholly or partly in a possession of the United States.

The two United States citizens were employed in the Panama Canal Zone by the Panama Canal Company during the years 1921 through 1948, inclusive. During such period they and their employment were covered by the United States Civil Service Retirement Act (hereinafter sometimes referred to only as the `Act'). As required by such Act, they, through withholding from their salaries by their employer, made contributions with respect to all of their Panama Canal Zone employment to the retirement and disability fund maintained under that Act. As of December 31, 1948, while still residing in the Canal Zone, the older of such employees, hereinafter referred to as `A,' having reached age 62, retired. Immediately thereafter she returned to the United States. On February 1, 1949, she commenced to receive an annuity of $1800 per year, or $150 per month, under the civil service retirement system. On the same date, the younger of the two employees, hereinafter referred to as `B,' resigned her employment and returned to the United States. Upon returning to the United States, B withdrew from the civil service retirement and disability fund the entire amount standing to her credit therein. Upon resuming employment within the United States in 1950 with the United States government, B redeposited in the civil service retirement and disability fund the entire amount withdrawn in 1949, plus interest for the period during which it had been withdrawn. On July 31, 1956, having reached age 55, B also retired and, on the first day of the second month following the date of retirement, commenced receiving an annuity under the civil service retirement system.

Under the provisions of sections 251(a) and 931(a), respectively, of the Internal Revenue Codes of 1939 and 1954, and under a corresponding section of each prior Revenue Act subsequent to and including the Revenue Act of 1921, 42 Stat. 227, effective as of January 1, 1921, a United States citizen may, under certain circumstances, exclude from gross income for Federal income tax purposes that income derived from sources within a possession of the United States. However, commencing with section 262 of the Revenue Act of 1921 and including section 931 of the 1954 Code, the section of law in question has always provided, in subsection (b) thereof, that, notwithstanding subsection (a), there shall be included in gross income all amounts received by such citizens within the United States, whether derived from sources within or without the United States. Effective with respect to taxable years beginning after December 31, 1950, section 251 of the 1939 Code was amended (see P.L. 82, July 23, 1951, 65 Stat. 124, C.B. 1951-2.350) by adding thereto a subsection (j), now subsection (i) of section 931 of the 1954 Code, reading as follows:

(j) EMPLOYEES OF UNITED STATES.-For purposes of this section, amounts paid for services performed by a citizen of the United States as an employee of the United States or any agency thereof shall be deemed to be derived from sources within the United States.

The Panama Canal Zone is a possession of the United States and the Panama Canal Company is an agency of the United States. Consequently, salaries received in the Panama Canal Zone by A and B for services performed therein on and prior to December 31, 1948, were excludable from their gross incomes for Federal income tax purposes since such salaries were paid and received prior to January 1951 for services performed in a United States possession and were received while the employees were nonresident of the United States.

Effective with and after the first day of the first pay period which began after June 30, 1957, section 4(a) of the Civil Service Retirement Act Amendments of 1956, 70 Stat. 743, has provided, with respect to each employee covered by that Act who has amounts withheld from his salary, pay or compensation and deposited in the retirement and disability fund, that `an equal sum shall also be contributed from the respective appropriation or fund which is used for payment of his salary, pay or compensation.' Prior to the effective date of such section 4(a), as so amended, it was not the policy or practice of the United States Government and its agencies to make contributions to the civil service retirement and disability fund on behalf of employees at the same time, and in like amounts, that the employees' contributions were deposited therein. Instead, it was deemed that the government's contribution on behalf of an employee was made, in its entirety, on the effective date of the employee's retirement, death or disability when he or his beneficiary first became entitled to a pension or annuity under the terms of the Act.

The civil service retirement and disability fund, first created by the United States Civil Service Retirement Act of May 22, 1920, 41 Stat. 614, and now administered under the Civil Service Retirement Act Amendments of 1956, supra , is a trust held to be qualified under section 401(a), and eligible for tax-exemption under section 501(a), of the 1954 Code. See I.T. 4102, C.B. 1952-2, 173. All amounts distributed or made available from such fund are taxable to the distributee, at the time distributed or made available, as provided in section 402(a) of the 1954 Code (formerly section 165(b) of the 1939 Code). With respect to amounts distributed as pensions or annuities, that section provides that such amounts shall be taxable under section 72 (relating to annuities) except that section 72(e)(3) shall not apply. Subsection (f) of section 72 reads as follows:

(f) SPECIAL RULES FOR COMPUTING EMPLOYEES' CONTRIBUTIONS.-In computing, for purposes of subsection (c)(1)(A), the aggregate amount of premiums or other consideration paid for the contract, for purposes of subsection (d)(1), the consideration for the contract contributed by the employee, and for purposes of subsection (e)(1)(B), the aggregate premiums or other consideration paid, amounts contributed by the employer shall be included, but only to the extent that-

(1) such amounts were includable in the gross income of the employee under this subtitle or prior income tax laws; or

(2) if such amounts had been paid directly to the employee at the time they were contributed, they would not have been includible in the gross income of the employee under the law applicable at the time of such contribution.

Where a part of the consideration paid for an employee's annuity is contributed by the annuitant's employer, as in the case of civil service annuities, section 72 of the 1954 Code, effective only for taxable years commencing after December 31, 1953, and ending after August 16, 1954, provides two methods of taxing such an annuity, i.e. , (1) the so-called `three-year recoverable' method under subsection (d) thereof and (2) the so-called `life-expectancy' method under subsection (b) thereof.

Under section 72(d) (or the `three-year recoverable' method), where part of the consideration for the annuity is contributed by the employer and the aggregate amount receivable under the contract by the annuitant, during the three-year period beginning on the date (whether or not before January 1, 1954) on which an amount is first received under the contract as an annuity, is equal to or greater than the consideration for the contract contributed by the employee, all amounts received as an annuity under the contract shall be excluded from gross income until there has been so excluded an amount equal to the consideration for the contract contributed by the employee. Thereafter, all amounts so received under the contract shall be included in the annuitant's gross income.

Under section 72(b), or the so-called `life-expectancy' method of taxing annuities, all payments received by an annuitant are each divided into a taxable portion includible in the annuitant's gross income and a nontaxable (excludable) portion which represents a return of the annuitant's investment in the contract. The nontaxable and excludable portion is, in general, the same proportion of each annuity payment which the employee's investment in the contract is of the annuitant's expected return under the contract. See section 1.72-4 of the Income Tax Regulations.

The rules stated above supersede the one contained in section 22(b)(2) of the 1939 Code for taxable years governed by the 1939 Code, as follows:

* * * Amounts received as an annuity under an annuity or endowment contract shall be included in gross income; except that there shall be excluded from gross income the excess of the amount received in the taxable year over an amount equal to 3 per centum of the aggregate premiums or consideration paid for such annuity (whether or not paid during such year), until the aggregate amount excluded from gross income under this chapter or prior income tax laws in respect of such annuity equals the aggregate premiums or consideration paid for such annuity. * * *

Amounts received as pensions or annuities in taxable years commencing prior to January 1, 1954, or ending prior to August 17, 1954, are taxable as provided in section 22(b)(2) of the 1939 Code. See section 165(b) of the Internal Revenue Code of 1939.

On the basis of the foregoing, A's annuity for the years 1949 to 1953, inclusive, was includible in and excludable from gross income as provided in section 22(b)(2) of the 1939 Code. The `aggregate premiums or consideration paid for such annuity,' within the meaning of such subsection, was limited to the sum of her own contributions to the civil service retirement and disability fund and, under the so-called three percent rule set forth in such section 22(b)(2), A completed a tax-free recovery of that consideration during 1950. Accordingly, for the years 1951 to 1953, inclusive, A had no unrecovered consideration for, or investment in, her annuity and the amount of each annuity payment received by her during those years was includible in her gross income. However, by reason of section 72(f)(2) of the 1954 Code and the provisions of section 251 of the 1939 Code as in effect on the retirement date of December 31, 1948, A became entitled, for taxable years beginning after December 31, 1953, to recover tax-free also the amount contributed to the civil service retirement and disability fund by the United States Government at the time of retirement with respect to the 27 years of employment in the Canal Zone. The total consideration paid by A was well in excess of the amount of the annual annuity of $1,800 for three years. Consequently, for 1954 and all subsequent years as long as A lives, A's annuity is includible in, and excludable from, gross income as provided in section 72(a) and (b) of the 1954 Code. The excludable portion of each monthly payment of $150 received after December 31, 1953, is determined by multiplying $150 by a fraction, the numerator of which is the amount deemed to have been contributed on December 31, 1948, to the civil service retirement fund on A's behalf by the Panama Canal Company and the denominator of which is $1,800 multiplied by 16.9 (the expected return multiple of a female at age 67 on January 1, 1954, for an ordinary single-life annuity; see Table I of section 1.72-9 of the Income Tax Regulations).

It is further held, however, as to employee B herein, that, where a United States citizen employed by the United States or any agency thereof retires after December 31, 1950, or retires prior to that date at a time when resident in the United States, on an annuity under the civil service retirement system based (either in whole or in part) on services rendered in a possession of the United States, such citizen's `aggregate premiums or consideration paid for such annuity,' within the meaning of section 22(b)(2) of the 1939 Code, or `investment in' or `consideration for' such annuity, within the meaning of section 72(b) or (d) of the 1954 Code, is limited to the aggregate of the amounts contributed by the retiring employee to the civil service retirement and disability fund. Such `aggregate' also includes any interest paid to the fund by the retiring employee, upon redeposit therein prior to retirement, of amounts, which had been previously withdrawn from the fund.