US Taxation of UK Pension Plans

US Taxation of UK Pension Plans

US UK Tax Treaty Pension

US Taxation of UK Pension Plans: The U.S. Tax rules involving foreign pensions are complicated. Because the U.S and U.K. have entered into such a complex and detailed bilateral tax treaty on matters involving the tax treatment of pensions, there are many nuances, limitations and exceptions to the “general” tax rules involving tax treatment of pension plans in the U.S.

Unlike many other bilateral tax treaties that the U.S. has entered into, the tax treaty between the UK and US is very detailed involving the IRS and tax rules of UK pension plan income, retirement rules, and which country has the right to tax the income — and when it is taxable.

This is why the US Taxation of UK Pension rules are so complex.

The main components to the U.S. taxation of U.K. pension include IRS treatment of:

  • Plan Contributions
  • Plan Distributions, and
  • Plan Growth

Is a U.K. Pension Taxable in the U.S.?

It depends.

The outcome of the analysis is largely dependent on the U.S. status of the taxpayer, residence, and whether or not the the taxpayer may take a Form 8833 tax treaty position. 

There are also other very important issues involving UK Pension and rollovers, such as the 25% lump sum distribution.

In addition, taxpayers are at the mercy of the “saving” clause.

We have a separate article to assist you with IRS reporting of U.K. pension of FBAR and FATCA and the 25% lump sum distribution.

We also have separate articles on how the IRS taxes ISA — which are considered a supplement to UK traditional pensions.

How is a UK Pension Treated in US?

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

  1. Is my 25% tax free UK pension withdrawal taxed?
  2. Are the contributions to my foreign retirement tax deductible?
  3. Personal Pension vs. Employment Pension
  4. Is the growth within the pension fund taxable?
  5. FBAR & FATCA Reporting
  6. 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.

2. 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.

What does this Gibberish Mean?

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.”

ResultThis 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. 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.

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.

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