US Taxation of UK Pension Plans

US Taxation of UK Pension Plans

US Taxation of UK Pension Plans & the IRS

US Taxation of UK Pension Plans: A common question we receive about foreign pension plans and the UK is:

“Is a UK Pension Taxable in the U.S.?”

 The United States and the United Kingdom have several international tax treaties in place. Whether the UK pension is taxable in the USA 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)

In general, the US Tax of UK Pension Plans is one of the more complicated IRS tax analyses. This is because unlike many other bilateral tax treaties, the articles within the U.S.-U.K. tax treaty involving pension and tax rules are very robust. This further complicates the US taxation of UK pension, with many clients questioning, “How is UK Pension Taxable in the US?”

The main issues involving if UK Pension Taxable in the US:

  1. Is My 25% Tax Free SIPP withdrawal taxed in the U.S.?
  2. Are the Contributions to my Foreign Retirement Tax Deductible?
  3. Personal Pension vs. Employment Pension
  4. Is the Growth within the Fund Taxed?
  5. FBAR & FATCA Reporting
  6. Form 8833 Treaty Position

As you can imagine, the US Taxation of UK Pension Plan Income analyses of each treaty article are incredibly time-intensive.

We summarize each portion as succinctly as possible and answer the question of whether UK Pension Taxable in the US? 

Article 17:  25% Tax Free withdrawal taxed in the U.S.?

Chances are the IRS will tax the withdrawal. 

Option A: The 25% Lump-Sum is not taxable in the U.S.

The Treaty does not specify “complete distribution,” it says lump-sum. A lump-sum payment can be a partial payment or else it would say specifically that partial payments do not qualify.

Therefore, the argument is that the pension scheme was established in the contracting state (UK) and therefore a resident of the other contracting state (US) will only be taxed in the first mentions day (UK).

*Note: Even if this interpretation holds water, the IRS can still call in back-up (aka “Saving Clause”).

Option B: U.S. Can Tax the 25% Lump Sum Pension Distribution

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)

Let’s assume it is a pension that is taxable in the UK, but that the UK allows you to take a 25% tax-free distribution from an otherwise taxable pension.

The entire pension is not tax exempt. Instead, the UK is carving out a 25% tax-free distribution from an otherwise taxable pension. Therefore, the pension is taxable (save for that 25% distribution).

Stated Another Way: Only the Partial Payment distribution is tax-free in UK for 25% value, but that does not make the entire Pension tax-free in the UK .

Result: This is not a tax-exempt pension and therefore 17(1)(b) be does not apply.

Step 3

The 25% lump sum payment is not expressly stated or defined in the Treaty.

Generally, when a person refers to “lump sum payment” they are referring to a total disposition

Example: Would you like your payment as an annuity, or in a lump-sum payment?

Therefore, the 25% lump sum payment does not qualify as a lump sum payment under 17(2).

Stated Another Way: a lump some payment presumes you are receiving 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?

Pension contribution and pre-tax deductions on a United States tax return is a common considering for the US Taxation of UK Pension Plans. In many circumstances, the pension contributions by a foreign employer to a foreign employment pension are deductible.

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 .

See, in many foreign countries such as the UK, there are retirement accounts which are called personal retirement or personal pension such as Aviva/Friends Life –– which are more personal investment types of accounts as opposed to an employer retirement fund.

Presumably, these “personal pensions” are not 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 his 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 — we’ll 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’re 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 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, QROPS, in 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.”

While a U.S. person contributing to an employment pension within the U.K. may receive tax deferred treatment, the same cannot be said of a personal pension.

A person 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

Form 8833 Treaty Position

As long as a tax treaty position is not frivolous, the Taxpayer should not be in much danger.

But, 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.

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