US UK Tax Treaty: Introduction to Taxation Rules

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US UK Tax Treaty

US UK Tax Treaty

Introduction to the US UK Tax Treaty 

US UK Tax Treaty: The United States and the UK have entered into several different International Tax Treaties. These treaties impact how the IRS enforces US Tax law — and vice versa. The two main treaties are the Double Tax Treaty and the Foreign Account Reporting Act. The focus of this article will be the US and UK Income Tax Treaty. The treaty impacts many different issues, including passive income, foreign pension, double taxation, and more. One important issue to keep in mind is that while the treaty is a good baseline for assessing tax issues between the respective countries, there are hidden issues (and roadblocks) to be aware of — the most common being the application of the Saving Clause. We represent many clients throughout the UK and the United States, who have UK assets and income — including dual-citizens and residents.

The United States and the U.K. have entered into several treaties, including:

The focus of this article will be on the International Tax Treaty between the U.S. and UK — and how the IRS enforces its key provisions. Under certain articles of the treaty, residents are taxed at a reduced rate — and sometimes have certain taxes exempted. The United Kingdom Tax Treaty with the United States impacts the taxation of real estate, retirement, pension, & business income for residents & non-residents. 

The focus of this article is on how the US and IRS apply treaty principles to U.S. taxpayers.

Important US UK Tax Issues

The treaty language touches upon a broad range of tax issues. Common questions include:

      • US UK Tax Treaty Introduction

      • What is a Tax Treaty?

      • Who is Covered?

      • What is Worldwide Taxation?

      • What is Residency?

      • What Taxes are Covered?

      • What is a Permanent Establishment?

      • How are Pensions and Retirement Taxed?

      • What is the Saving Clause?

We have a separate article detailing the tax treatment of pensions.

We have also summarized how ISAs are treated for U.S. Tax.

Here is the analysis for you to know how the IRS may treat your 25% lump sump tax-free withdrawal in the U.K.

If you are employed in the UK, your contributions to foreign retirement deductible may be deductible on your U.S. tax return.

What is a Tax Treaty?

To best understand what a Tax Treaty is meant to do, it is important to understand the purpose behind the Treaty.

The main purpose of the bilateral income tax treaty is to provide some relief and clarifications on tax issues involving the two specific countries that have entered into a “Tax Agreement.”

Who is Covered?

It is first important to determine whether the person trying to apply the treaty is a US person or not.

U.S. Worldwide Taxation 

The Treaty does not modify the general proposition that when a person is a U.S. Person, the U.S. has the right to tax them on their worldwide income. Likewise, the UK has the right to tax UK citizens/residents in accordance with HMRC rules.

Rather, the treaty is generally used to:

      • Limit or restrict taxation Rules for certain residents

      • Minimize certain FDAP income

      • Avoid certain business taxation unless a Permanent Establishment is met

      • Define who gets to tax retirement income

In other words, just because there is a tax treaty, does not mean the U.S. loses the right to tax U.S. persons. This is where a Form 8833 treaty position may help the taxpayer to be treated as a foreign resident — but watch out for the expatriation trip wire.

Article 4 (Residence)

This is very important and one of the key impacts of any tax treaty.

If for example, a person is from the UK and resides in the U.S. then portions of the tax treaty will impact certain taxes (such as retirement) but not others. This is is the same as if a person is a U.S. person, but resides in the UK.

What Taxes are Covered?

The Treaty applies to taxes as they relate to income and capital gains.

More specifically:

In the case of the United States:

          • The Federal income taxes imposed by the Internal Revenue Code (but excluding social security taxes); and

          • The Federal excise taxes imposed on insurance policies issued by foreign insurers and with respect to private foundations.

 In the case of the United Kingdom:

          • The income tax the capital gains tax the corporation tax the petroleum revenue tax.

More generally:

      • “This Convention shall apply also to any identical or substantially similar taxes that are imposed after the date of signature of this Convention in addition to, or in place of, the existing taxes.

      • The competent authorities of the Contracting States shall notify each other of any changes that have been made in their respective taxation or other laws that significantly affect their obligations under this Convention.”

Who is Considered a Resident?

Generally, a “Resident” is defined as:

      • “For the purposes of this Convention, any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.”

Non-Technical Summary & Example on “Residence”

If a person is a resident of one of the contracting states (example U.K.), and under U.K. Law, the person is liable for taxes based on residence or domicile in the U.K. — then he is considered a resident of the U.K.

IRS Technical Summary

Subsection (a): The technical explanation actually sums this up nicely: “As a general matter, a person who, under those laws, is a resident of one Contracting State and not of the other need look no further. For purposes of the Convention, that person is a resident of the State in which he is resident under internal law.

Article 6 (Income from Real Property)

      • “Income derived by a resident of a Contracting State from real property, including income from agriculture or forestry, situated in the other Contracting State may be taxed in that other State.

      • The provisions of paragraph 1 of this Article shall apply to income derived from the direct use, letting, or use in any other form of real property.

      • The provisions of paragraphs 1 and 2 of this Article shall also apply to the income from real property of an enterprise.”

Non-Technical Summary & Example (Real Property Income)

If a person is considered a resident of the U.S. for example and is receiving income from certain real property located in the U.K.– it may be taxed in the U.K.

*This does not mean a U.S. Person escapes tax on the rental income. He doesn’t, since the U.S. follows a worldwide income model — and the treaty does not say the other contracting state has “exclusive” tax rights.

Article 10 (Dividends)

      • “Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.

      • However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State, but if the dividends are beneficially owned by a resident of the other Contracting State, the tax so charged shall not exceed, except as otherwise provided,

      • a) 5 per cent. of the gross amount of the dividends if the beneficial owner is a company that owns shares representing directly or indirectly at least 10 per cent. of the voting power of the company paying the dividends;

      • b) 15 per cent. of the gross amount of the dividends in all other cases. This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.”

Non-Technical Summary & Example (Dividend Income)

Dividends paid by a company that is a resident in the U.K. to a resident of the U.S., may be taxed in the U.S.

Non-Technical Summary (Dividend Non-Exclusive Taxation)

Even if the beneficial owner (you) reside in the U.S. and are receiving dividends from a U.K. Company, the U.K. can still tax, but is limited to either 5% or 15%

*Exceptions and Exclusions apply

Article 11 (Interest)

Interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State.

Non-Technical Summary & Example (Interest Income)

Interest arising from the U.K. but paid to a resident of the U.S., may be taxed only in the U.S.

*Exceptions and Exclusions apply

Article 13 (Gains)

      • Gains derived by a resident of a Contracting State that are attributable to the alienation of real property situated in the other Contracting State may be taxed in that other State.

Non-Technical Summary & Example (Capital Gains)

Capital Gains generated from a resident of a contracting state (U.S.) stem from the sale of real property in the other state (UK), and may be taxed in the other state. (U.K.). It is important to note that Article 13 does not give exclusive rights to tax in the contracting state that the property is situated.

Article 14 (Income from Employment)

      • “Subject to the provisions of Articles 15 (Directors’ Fees), 17 (Pensions, Social Security, Annuities, Alimony, and Child Support) and 19 (Government Service) of this 18 Convention, salaries, wages, and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State.

      • If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State.

      • Notwithstanding the provisions of paragraph 1 of this Article, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if:

      • a) the recipient is present in the other State for a period or periods not exceeding in the aggregate 183 days in any twelve-month period commencing or ending in the taxable year or year of assessment concerned;

      • b) the remuneration is paid by, or on behalf of, an employer who is not a resident of the other State; and

      • c) the remuneration is not borne by a permanent establishment which the employer has in the other State. 3. Notwithstanding the preceding provisions of this Article, remuneration described in paragraph 1 of this Article that is derived by a resident of a Contracting State in respect of an employment as a member of the regular complement of a ship or aircraft operated in international traffic shall be taxable only in that State.”

Non-Technical Summary & Example (Income From Employment)

General Rule: If a UK person is a resident of the U.S. and earns salary or wages in the U.S., only the U.S. may tax the income (as rthe source of the income) — unless the individual works in the first state (UK) — and then the UK can tax the income

Non-Technical Summary & Example (Exception to the Rule on Income From Employment)

This sections limits the ability of the country in which the income is being earned (source of income) from taxing the income  in the 3 situations identified in paragraph 2.

Article 15 (Directors’ Fees)

      • Directors’ Fees Directors’ fees and other similar payments derived by a resident of a Contracting State for services rendered in the other Contracting State in his capacity as a member of the board of directors of a company that is a resident of the other Contracting State may be taxed in that other State.

Non-Technical Summary & Example (Directors’ Fees)

For example, Director’s Fees generated to a resident of the U.S. (Contracting State), as a result of being a Board Member of a company in the UK (Other Contracting State), may be taxed in the UK (e.g., the other state.)

Article 17 & 18 (Pension et al.)

This a very complex Article in the tax treaty. Please refer to our stand-alone US UK Treaty Article 17 summary.

Article 18, Paragraph 5 (Employer Foreign Pension Contributions)

If you are a U.S. person working in the U.K. and receiving pension contributions to a U.K. Pension (or vice versa), please refer to our stand-alone US UK Treaty, Article 18 summary.

Article 19 (Government Service)

      • “Notwithstanding the provisions of Articles 14 (Income from Employment), 15 (Directors’ Fees) and 16 (Entertainers and Sportsmen) of this Convention: a) salaries, wages and other similar remuneration, other than a pension, paid from the public funds of a Contracting State or a political subdivision or a local authority thereof to an individual in respect of services rendered to that State or subdivision or authority shall, subject to the provisions of sub-paragraph b) of this paragraph, be taxable only in that State

      • b) such salaries, wages and other similar remuneration, however, shall be taxable only in the other Contracting State if the services are rendered in that State and the individual is a resident of that State who:

      • (i) is a national of that State; or

      • (ii) did not become a resident of that State solely for the purpose of rendering the services.”

Non-Technical Summary (Income from Government Service)

(Subject to other articles in the treaty) Any income paid by the public funds of a contracting state (U.K. government) for services rendered to the U.K. shall be taxable only in the U.K. 

Several Exceptions and limitations apply.

Article 25 Relief from Double Taxation

      • In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income

Non-Technical Summary & Example (Relief From Double Taxation)

The U.S. will allow for a Foreign Tax Credit for citizens or residents of the U.S. on taxes due to the U.S., against any tax already paid to the U.K. and vice versa

*Exceptions and limitations apply.

Saving Clause

      • “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.

What is the Saving Clause?

The Saving Clause basically says the contracting states (U.K. and U.S.) can disregard the treaty, when applicable, and still tax the resident/citizen as if the treaty was not in place.

Saving Clause (Limitation)

      • “The provisions of paragraph 4 of this Article shall not affect: a) the benefits conferred by a Contracting State under paragraph 2 of Article 9 (Associated Enterprises), sub-paragraph b) of paragraph 1 and paragraphs 3 and 5 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support), paragraph 1 of Article 18 (Pension Schemes) and Articles 24 (Relief From Double Taxation), 25 (Non-discrimination), and 26 (Mutual Agreement Procedure) of this Convention; and

      • b) the benefits conferred by a Contracting State under paragraph 2 of Article 18 (Pension Schemes) and Articles 19 (Government Service), 20 (Students), and 28 (Diplomatic Agents and Consular Officers) of this Convention, upon individuals who are neither citizens of, nor have been admitted for permanent residence in, that State.”

What is a “Limitation” on the Saving Clause?

There are certain articles and paragraphs which cannot be overridden by the Savings clause.

Are You Out of IRS Compliance?

If you have unreported income, accounts, assets, or investments from the UK or multiple countries – we can help.

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