Our international tax practice gets a large number of questions from United Kingdom (UK) citizens that are also United States (US) citizens and residents regarding their UK pensions. There are a number of complex issues around both UK private and public pensions that need to be addressed and each question requires separate research and analysis. Further complicating matters are issues for dual citizens that are trying to navigate not only both US and UK tax laws but also the US/UK Income Tax Treaty. These are certainly difficult waters to navigate even for experienced tax professionals.
One very common and complex question is the US tax treatment on a 25% lump-sum distribution from a UK pension. As many know, the UK government will not tax the 25% lump-sum payment as a matter of UK law. The tricky question is how does the US treat it?
There is a lot of information out there on the internet and much of it is either wrong or misleading. Many “advisers” claim that the 25% lump-sum payment is tax free both in the US and the UK. These folks claim that in the UK it is tax exempt by statute/law and that it is also tax free in the US by virtue of the US/UK Tax Treaty. They advise that the Treaty will allow you to escape US tax on this payment. Treaty questions are usually rather complex and difficult to understand especially if you’re not used to the language they use meaning things like “savings clause”, etc. I’ll try to explain below both what we’ve seen and what the rule is on this issue.
One thing that seems to be clear is that all of a US citizen’s income from any source is subject to US tax under IRC §61. Further, a dual citizen of the US and UK is entitled to rely on the aforementioned tax Treaty between the two countries by virtue of Article 23(2)(A).
The basic position we’ve seen out there is as such:
- There is a “reciprocal pension exemption” in Article 17(1)(b) that requires the US to respect the UK exemption on the 25% lump-sum payment when paid to a US citizen and resident. This is False.
- There is something in many tax treaties, including this one, that is called a “savings clause”. Basically, what this says is that if income received by a resident of country #1 is not taxed by county #2, country #1 can tax it. It almost serves as a soak-up clause to make sure all income is taxed by someone. This is true and is contained in many income tax treaties.
- An exemption from a savings clause would mean that income received by a treaty country resident – like a dual citizen of the UK and the US residing in the US – is not taxed on that exempted income in either the UK or US. True if it applies.
- The position to avoid tax here relies on the Article 1(4) savings clause – citing Article 1(5)(A) – to say that Article 17(1)(B) is not covered by the savings clause meaning, if read in conjunction with the earlier point, that the 25% lump-sum payment is not taxed by the US under Article 17(1)(b) and is exempt from the Treaty’s savings clause. This is false as the savings clause does apply as enumerated below.
- Stated alternatively, these advisers are saying that the Treaty binds the US to recognize the UK exemption on the 25% payment and the savings clause does not operate to “soak it up” or otherwise tax it. Thus, you escape both US and UK tax on the 25% lump-sum distribution.
There are some big problems with this. The first is that, if you read the Treaty, this is not what it says. The second is that the IRS has publicly stated that this is not what the Treaty says. Please read the latter as the IRS explains its position on this very specific issue.
Please allow me to explain what the Treaty says on this issue:
- Article 17(1)(B) provides us with a reciprocal pension exemption but not at all in the way described above. Treaty Article 17(1)(B) says no such thing. Also, Article 17(1)(B) does not address lump-sum payments which are clearly addressed in Article 17(2).
- Article 17(2), covering lump-sum pension payments like this one, tells us that a lump-sum payment that is tax-free in one state shall also be tax-free when received by a resident of the other state. That’s a great answer if you stop there.
- The Treaty’s savings clause specifically cites Article 1(5)(A). A reading of that article shows that it exempts Articles 17(3) – dealing with periodic payments of a social security scheme – and 17(5) – dealing with divorce and support payments – from the savings clause. Article 17(2) – dealing with lump-sum payments – is not mentioned or exempted in any way from the Treaty’s savings clause.
- As such, the savings clause will require that the lump-sum payment be picked up in the taxpayer’s US tax as neither US tax law nor the US/UK Tax Treaty offers any exemption.
The IRS has specifically said what is clearly in the Treaty:
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.
That is sufficiently clear regarding the US tax authority’s position on the issue.
In summary, a UK 25% lump-sum pension distribution is fully taxable to a US citizen and resident and the US tax authorities have specifically stated that the Treaty language agrees. Any other position on this issue contradicts the IRS’s position and, quite frankly, has no basis either in US tax law or the Treaty itself. One taking an alternative position on this issue should be aware that it will likely require a substantive audit defense. Further, any practitioner taking this position should be mindful of IRS Circular 230’s requirements for tax return positions.
This is surely a complex subject as any Treaty based analysis usually is and any slight change in facts could derive a completely different answer. Each taxpayer situation is slightly different and that is why an experienced international tax practitioners should always weigh in on these questions. We do a considerable amount of work in this area and we hope that this note clears up a situation with considerable confusion around it.
Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at firstname.lastname@example.org or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.