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We have discussed the UK in general before –
US Taxation of UK Pension Plans: The United States and the United Kingdom have entered into several international tax treaties.
Is a UK Pension Plan is taxable in the U.S under the US/UK tax treaty?
Unfortunately, the IRS guidance and previous rulings do not make the answer easy to decipher. Whether or not the UK pension is taxable in the US will depend on various factors. The primary source of law (and confusion) is the US UK income tax treaty (main treaty) — but there are treaties and agreements as well. Some of these other agreements, include:
- Totalization Agreement (Social Security)
- FATCA Agreement (Foreign Account Compliance)
- Estate Tax (Estates)
The main issues involving if UK Pension Taxable in the US:
- Is my 25% tax free UK pension withdrawal taxed?
- Are the contributions to my foreign retirement tax deductible?
- Personal Pension vs. Employment Pension.
- Is the growth within the pension fund taxable?
- FBAR & FATCA Reporting.
- Form 8833 Treaty Position.
- Article 17: Is a 25% UK Tax Free Withdrawal taxed in the U.S.?
- Chances are the IRS will tax the 25% UK tax free withdrawal.
Let’s go through the analysis:
Option A: The 25% Lump-Sum is not taxable in the U.S.
Treaty Language:
Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum payment derived from a pension scheme established in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the first-mentioned State. The argument is that the treaty does not specify that it must be a “complete distribution.” Rather, it used the phrase lump-sum. Therefore, why can’t a lump-sum be a partial payment?
In other words, a lump-sum payment can be a partial payment or else the treaty would specify that partial payments do not qualify for lump-sum treatment and/or the treaty would further qualify the term, lump-sum. For example: if you receive 25% worth of the pension value as a lump-sum, then it would meet the general definition of a lump-sum payment, and that lump-sum payment of 25% from the UK pension shall be taxable only in the UK.
Option B: U.S. Can Tax the 25% Lump Sum Pension Distribution
Let’s start with the language from the U.S./U.K. tax treaty:
a) Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that State.
b) Notwithstanding sub-paragraph a) of this paragraph, the amount of any such pension or remuneration paid from a pension scheme established in the other Contracting State that would be exempt from taxation in that other State if the beneficial owner were a resident thereof shall be exempt from taxation in the first-mentioned State.
Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum payment derived from a pension scheme established in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the first-mentioned State.
Opinion?
From a baseline perspective, a pension owned by a resident of contracting state (US) shall be taxable only in the U.S. This follows the concept of resident based tax. But, paragraph (b) clarifies (a), by limiting the the taxability in the resident state for a tax exempt pension. In other words, if the pension from the other contacting state (UK) would be exempt in the UK if the person was a resident in the UK, then it will also be exempt from tax in the US. If the UK deems the 25% distribution as tax-free, does that make the pension “exempt from tax in the UK,” and therefore is not taxable in the US?
Step 1 – Article 17 (1)(a)
“The US has the right to tax the pension of a person who is a resident of the US unless the pension is exempt in the other country.” Since the person resides in the U.S., the U.S. has the general right to tax the pension distributions.
Step 2 – The Pension is not tax exempt in the UK 17(1)(b)
If the pension is tax-exempt in the UK, it is not taxable in the U.S.
Does the 25% Tax-Free Lump Sum withdrawal equate to a tax exempt pension?
Even though the UK allows you to take a 25% tax-free distribution from an otherwise taxable pension, the entire pension is not tax exempt in the U.K. (aka Tax-Exempt Pension). Rather, the UK is carving out a 25% tax-free distribution from an otherwise taxable pension. Therefore, the pension itself would not qualify as tax-exempt. Presumably, this does not make the entire Pension tax-free in the UK, and does not make the full pension a “tax-exempt pension.”
Result: This is not a tax-exempt pension and therefore 17(1)(b) be does not apply.
Step 3 – UK 17(2) – 25% Lump Sum Payment
The 25% term “lump-sum” payment is not expressly defined in the Treaty.
While it can mean many things, ordinarily when a person refers to a “lump sum payment” they are usually referring to a total disposition. For example, if you were provided the option of an annuity or full-payment, the question would be posed as, “would you like to receive your pension payments in the form of an annuity, or do you prefer a lump-sum payment?
Stated Another Way: a lump some payment presumes you receive the full amount of your pension payment, in a “lump sum.”
Result: This is not a lump-sum payment in accordance with 17(2) and therefore, the US reserves the right to tax it.
Saving Clause
The US Tax of UK Pension Plans is further impacted by the Saving Clause. Exceptions to the Saving Clause do not include Section 17(2), so the Saving Clause applies to 17(2). Therefore, even if you can show that the 25% tax-free lump sum payment qualified as a lump sum payment under 17(2), the IRS can still tax you……and that seems to be the IRS’ general position.
While the US Taxation of UK Pension is not set in stone, the IRS tends to rely on its own prior memoranda.
IRS Ruling on the US Tax of UK Pension Plans
In 2008, the IRS issued a ruling on the US Taxation of UK Pension Plans involving lump sum distributions:
This letter responds to your request for information dated March 5, 2008. In your letter, you requested certain information about the tax treatment of a lump-sum distribution from a qualified U.K. pension scheme paid to a U.S. resident.
Under the Internal Revenue Code, the United States generally taxes its residents on their worldwide income, regardless of their citizenship or the source of their income. However, an income tax treaty to which the United States is a party could change the application of the law.
The United States has an income tax treaty with the United Kingdom (the Treaty).
Article 17(1) of the Treaty provides that:
a) Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that State.
b) Notwithstanding sub-paragraph a) of this paragraph, the amount of any such pension or remuneration paid from a pension scheme established in the other Contracting State that would be exempt from taxation in that other State if the beneficial owner were a resident thereof shall be exempt from taxation in the first-mentioned State.
Article 17(2) of the Treaty provides that: Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum payment derived from a pension scheme established in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the first-mentioned State. GENIN-111967-08 2
Although Article 17(2) provides that the Contracting State in which the pension scheme is established has the exclusive right to tax a lump-sum payment, Article 1(4) of the Treaty contains a “saving clause” that allows the United States to tax its residents and citizens as if the Treaty had not come into effect.
Article 1(4) of the Treaty provides that: Notwithstanding any provision of this Convention except paragraph 5 of this Article, a Contracting State may tax its residents (as determined under Article 4 (Residence), and by reason of citizenship may tax its citizens, as if this Convention had not come into effect.
Article 1(5) of the Treaty provides a number of exceptions to the saving clause, but there is no exception for Article 17(2).
Therefore, the saving clause overrides Article 17(2) and allows the United States to tax a lump-sum payment received by a U.S. resident from a U.K. pension plan.”
Article 18 (5) Contributions to Foreign Retirement Tax Deductible?
Generally, contributions to foreign pension plan are not deductible to the U.S. taxpayer on their U.S. tax return. But there is an exception under the U.S./U.K. tax treaty.
UK Tax Treaty Article 18 (5)
If you are a U.S. Citizen in the UK, earning a pension from your UK based employer, you should take notice of this analysis:
“(5) (a) Where a citizen of the United States who is a resident of the United Kingdom exercises an employment in the United Kingdom the income from which is taxable in the United Kingdom and is borne by an employer who is a resident of the United Kingdom or by a permanent establishment situated in the United Kingdom, and the individual is a member or beneficiary of, or participant in, a pension scheme established in the United Kingdom.”
Non-Technical Translation Article 18 (5)
When a U.S. citizen resides in the United Kingdom and works for a UK based UK employer, if the US citizen as part of a pension scheme which the employer participates in, then the US. Citizen may be entitled to certain benefits.
Important: “Borne By an Employer”
This is very important language for the US Tax of UK Pension Plans.
Why?
Because the fact that the pension must be borne by the employer is crucial. A personal, non-employment pension plan would not qualify, as they would not be borne from an employer, and would not be included in this exception to otherwise taxable income.
UK Tax Treaty Article 18 (5)(i)
“(i) contributions paid by or on behalf of that individual to the pension scheme during the period that he exercises the employment in the United Kingdom, and that are attributable to the employment, shall be deductible (or excludable) in computing his taxable income in the United States.”
Non-Technical Translation Article 18 (5)(i)
When a U.S. citizen receives employer contributions that meet the requirements of article 18 section 5, the U.S. citizen may be able to exclude or deduct the income as part of their taxable income.
UK Tax Treaty Article 18 (5)(ii)
“(ii) any benefits accrued under the pension scheme, or contributions made to the pension scheme by or on behalf of the individual’s employer, during that period, and that are attributable to the employment, shall not be treated as part of the employee’s taxable income in computing his taxable income in the United States.
This paragraph shall apply only to the extent that the contributions or benefits qualify for tax relief in the United Kingdom.”
Non-Technical Translation Article 18 (5)(ii)
For the US citizen that qualifies under article 18 subsection 5, any benefits that accrued under the pension scheme addition to contributions made pension scheme by (or on behalf of) the employer — and which are in relation to the US citizens employment for that employer — will not be taxed (currently).
UK Tax Treaty Article 18 (5)(b) Limitation
“(b) The reliefs available under this paragraph shall not exceed the reliefs that would be allowed by the United States to its residents for contributions to, or benefits accrued under, a generally corresponding pension scheme established in the United States.”
Non-Technical Translation Article 18 (5)(b)
In other words, you are not entitled to any greater benefit under UK law that you would be entitled to under US law freight comparable benefit.
Thus, if you’re receiving some type of equivalent 401K contribution on behalf of your UK employer, you would be entitled to the same benefit that you will receive had been a US employer for a US 401(k) — but no greater benefit.
UK Tax Treaty Article 18 (5)(c)
“(c) For purposes of determining an individual’s eligibility to participate in and receive tax benefits with respect to a pension scheme established in the United States, contributions made to, or benefits accrued under, a pension scheme established in the United Kingdom shall be treated as contributions or benefits under a generally corresponding pension scheme established in the United States to the extent reliefs are available to the individual under this paragraph.”
Non-Technical Translation Article 18 (5)(c)
This reiterates the eligibility requirements.
UK Tax Treaty Article 18 (5)(d)
“(d) This paragraph shall not apply unless the competent authority of the United States has agreed that the pension scheme generally corresponds to a pension scheme established in the United States.”
Non-Technical Translation Article 18 (5)(d)
This section is very important. It basically says that in order for the UK pension to qualify, it has to correspond to a pension scheme established in United States. This is to avoid personal pensions and other types of pensions which generally do not qualify under US law, to be included as part of the US citizens pension plan an attempt to avoid US tax on employer contributions.
Personal vs. Employment Pension
When analyses refer to the US Taxation of UK Pension Plans, they generally refer to “Employment Pension” and not “Personal Pension.”
A personal pension which is not sponsored by the employer is not an “employment pension” under U.S. tax law — it is an investment. And, oftentimes, it is a fund that results in PFIC treatment (which is not good).
Is the Growth within the Retirement Fund Taxed?
Generally, the growth of an employment fund is not taxed until distribution.
Article 18 (1)
“Where an individual who is a resident of a Contracting State is a member or beneficiary of, or participant in, a pension scheme established in the other Contracting State, income earned by the pension scheme may be taxed as income of that individual only when, and, subject to paragraphs 1 and 2 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support) of this Convention, to the extent that, it is paid to, or for the benefit of, that individual from the pension scheme (and not transferred to another pension scheme).”
FBAR & FATCA Reporting
Beyond the US Taxation of UK Pension, there is the other pesky issue of offshore reporting. UK pensions are generally reported on the FBAR and FATCA Form 8938:
FBAR
Most U.K. Pension Plans are reportable on the FBAR as a Foreign Bank and Financial Account. The value is exchanged into USD. If the plan is a defined benefit plan, with no surrender value other than the received distributions, the FBAR value is zero, until the filer begins to take distributions. Once distributions are taken, the value will change accordingly.
FATCA
In addition to FBAR Foreign Bank Account Reporting, U.K. Pension Plans are reportable on FATCA Form 8938 as an asset. Depending on the type of retirement will determine how it is reported on the 8938. Like the FBAR, the value is exchanged into USD. If the plan is a defined benefit plan, with no surrender value other than the received distributions, the FBAR value is zero, until the filer begins to take distributions. Once distributions are taken, the value will change accordingly.
Foreign pension plans in general
The most common classifications of foreign pension plans, for U.S. tax purposes, are as an employees’ trust (under Regs. Sec. 1.402(b)-1), a grantor trust (under Secs. 671-679), or a trust bifurcated between those two categories. The applicable classification depends on contributions and other factors.
Employees trust:
If a pension plan is more than 50% funded by the employer and the plan does not favor highly compensated employees, the foreign pension is considered a nonexempt employees’ trust and governed by Sec. 402(b).
In that case, employer contributions are generally taxable income to the employee, but growth inside those plans is tax-deferred until distribution. Upon distribution, the fund functions like an annuity under Sec. 72, and the taxpayer would be allowed to recover his or her basis (contributions) as a return of capital.
However, if one of the reasons a trust is nonexempt from income tax is a failure of the plan to meet the participation requirements of Sec. 401(a)(26) or the coverage requirements of Sec. 410(b), then a highly compensated employee shall, in lieu of the contribution amount to the plan under Sec. 402(b)(1) and distributions from the plan under Sec. 402(b)(2), include in gross income an amount equal to the vested accrued benefit as of the close of the tax year of the trust.
Thus, the highly compensated taxpayer will end up including in gross income the incremental increase in the value of the plan as of the end of each year. The meaning of “highly compensated” for these purposes is set forth in Sec. 414(q). This amount is adjusted for inflation each year and for 2020 equals $130,000.
Grantor trust:
If a retirement trust is funded entirely by the taxpayer rather than an employer, then the trust will be a grantor trust for U.S. income tax purposes. All items of income, deduction, and credit would appear on the taxpayer’s individual income tax return as if the taxpayer owned directly the assets of the retirement trust.
Bifurcated trust:
Generally, by definition, an employees’ trust is not a grantor trust as to the employee participant.
However, if more than 50% of the contributions are made by the employee, the trust is considered to be bifurcated for U.S. tax purposes: The amounts contributed by the employer constitute an employees’ trust, and the rest of the contributions made by the employee participant are classified as a foreign grantor trust.
In addition, depending on the type of underlying assets of the pension plan (e.g., foreign mutual funds), passive foreign investment company (PFIC) rules may apply.
While the United States generally taxes its residents on their worldwide income regardless of their citizenship or the source of the income, an income tax treaty to which the United States is a party could modify the usual rules and mitigate some of the disadvantages of participating in a foreign pension plan.
The tax treaty between the United States and the United Kingdom, which this item focuses on, is one of the most comprehensive when it comes to pensions. Pension provisions are set forth in Articles 17 and 18.
Taxation of retirement plan contributions
Generally, because a foreign pension plan is not a “qualified” plan under Sec. 401, the employee’s contributions to the plan are not deductible by the employee, and any employer contributions are taxable compensation to the employee.
However, the U.S.-U.K. tax treaty offers a rare exception to these rules. For example, if a U.S. national is living and working in the U.K. and is contributing to a qualified U.K. pension, he or she could receive a tax deduction in the United States for the contribution to the U.K. plan. This deduction would be available only for so long as the U.S. person resides in the U.K. and may not exceed the tax relief that would be allowed in the United States under Sec. 402(g) (U.S.-U.K. Income Tax Treaty, Art. 18, ¶5).
Alternatively, the U.S. national, while living and working in the U.K., can continue to contribute on a pretax basis to his or her U.S. 401(k) plan, provided that the individual was already enrolled in the U.S. plan prior to his or her departure (Art. 18, ¶¶2a and 3a). Furthermore, under the tax treaty, employer contributions to the employee’s pension do not constitute compensation and are considered a business expense in computing the employer’s profit and loss (Art. 18, ¶2b).
The treaty thus allows transferred employees to continue to contribute to their home country pension plans without having the employer portion of the contribution be considered taxable income in the host country. Additionally, both employer and employee contributions to the home country pension plan are tax-deductible in the host country (Art. 18, ¶¶2a and 2b).
Certain conditions apply:
The limits of the host country govern. For example, if a U.K. national works in the United States and continues to participate in a U.K. pension plan, he or she cannot deduct more than the limit prescribed in the United States (the host country) under Sec. 402(g).
The employee must have already been participating in the home country pension plan before moving to the host country.
The pension plan must be accepted as a generally corresponding pension scheme by the appropriate authorities in the host country (Art. 18, ¶2, 3).
Taxation of retirement earnings/growth
As noted above, earnings accumulating in a foreign pension plan that is deemed to be a foreign grantor trust ordinarily must be included in income. This would apply, for instance, to earnings inside a U.K. self-invested personal pension (SIPP), given that it is fully funded by the employee.
However, the U.S.-U.K. tax treaty alters this rule by clearly indicating that income earned by the pension scheme may be taxed as income of that individual only when distributed, meaning that earnings inside the plan are tax-deferred (Art. 18, ¶1).
What about rollovers?
A U.K. national is allowed rollovers from one approved pension plan to another U.K. plan. Similarly, a rollover from a U.S. 401(k) plan is allowed to another, say, 401(k) or traditional IRA. By contrast, an individual cannot make a rollover from a U.K. to a U.S. plan and vice versa (see Chief Counsel Advice Memorandum AM2008-009, advising that a transfer from a U.K.-registered pension outside of the original state (the U.K.) is not an “eligible rollover distribution” under Sec. 402(c)(4)).
Special attention should be given to U.K. pension rollovers to offshore plans, such as the qualifying recognized overseas pension scheme (QROPS) and the recognized overseas pension scheme (ROPS) plans, which are offshore plans that are sometimes set up in countries such as Malta, Gibraltar, and the Isle of Man. Even though these are permitted under U.K. law, once these rollovers occur, they are no longer governed by the provisions of the U.S.-U.K. tax treaty.
Taxation of retirement distributions
According to Article 17 of the U.S.-U.K. tax treaty, the country of residence at the time of distribution has the sole right to tax the distribution (Art. 17, ¶1a).
However, this provision must be read in tandem with the “saving clause” found in Article 1 (General Scope), under which the United States and the U.K. each reserve a broad right to tax their own citizens “as if this Convention had not come into effect” (Art. 1, ¶4). Due to the saving clause, a U.S. citizen who is a resident of the U.K. and receives a pension payment will be subject to U.S. tax, notwithstanding the language in Article 17.
Under a separate provision of the tax treaty that is expressly not subject to the saving clause, if an individual would have enjoyed tax-exempt status for all or a portion of the distributions in the home country, the host country will confer the same benefit (Art. 17, sub ¶1(b)).
Form 8833 Treaty Position
As long as a tax treaty position is not frivolous, the Taxpayer should not be in much danger. Some treaty positions are much riskier than others. And, if the IRS disagrees with the position, it may lead to audits, fines, and penalties down the line. Therefore before taking a treaty position on the US Taxation of UK Pension, Taxpayers must carefully review and evaluate the pros and cons of each approach.
