What is high-taxed income subject to HTKO?

What is high-taxed income requiring HTKO? The instructions for Form 1116 say

 "Generally, passive income and taxes must be treated as general category income if the foreign taxes you paid on the income (after allocation of expenses) exceed the highest U.S. tax that can be imposed on the income."

The highest US tax rate is 39.6%. So if I have $1,000 of UK bank interest, do I figure that I paid tax at 40%, my UK marginal rate, and so this is high-taxed - or do I look at my overall UK tax bill and compute that my average rate is 32% and so bank interest is not high-taxed.

A UK tax bill (which is hugely simpler to compute than a US one) has specific rates for dividends (32.5% - 1/9 credit) and capital gains at (28%, above the tax free amount). All other items of income (wages, interest, etc) are taxed as one basket. So how do I figure out what UK tax I paid on my bank interest? Suppose my UK tax bill is £20,000. I can say that a certain amount of that went to paid tax on dividends and capital gains, say £4000. Should I then reckon that the remaining £16,000 of my UK tax bill is spread proportionally across all other items of income? In that case, UK bank interest stays in the passive basket, no?

This would seem to be what they are saying in the 1116 instructions:

If the foreign tax you paid or accrued relates to more than one category of income, apportion the tax among the categories. The apportionment is based on the ratio of net foreign taxable income in each category to the total net income subject to the foreign tax.

So if my income in the general and passive baskets are in the ratio 3:1, and the passive basket is only bank interest (not UK dividends or CG), then I would reckon to have paid £12,000 tax on wages in the general basket, and £4,000 tax on the bank interest in the passive basket. There is no need to do a HTKO of the bank interest.

Do you file a self assessment form in the UK?

If so, the tax man will have sent a response, your tax calculation for 2012/13. On page two of that reply will be a breakdown of 'How I have worked out your income tax'. The first section will read 'Pay, pensions, profit, etc.'. A second section (depending on what you may have taxed) will read ' Interest received from a bank or building society etc.'. It further breaks that down into the amounts taxed at 10% (no longer available?), 20%, and 40%. Since interest is passive, you now know the amount on which the UK tax was charged at 40% and what the passive amount is for US tax. The question is: is the UK way of taxing you the same as the way the US taxes you? US taxes are often broken down proportionally (the % of total tax paid to the % of tax on interest). Does that apply in this case?

I've been following your posts, and it seems you're set on working out the exact amounts for the calendar year 2013. If so, the amount on the reply above will cover 9 months of 2012 and 3 months for 2013. If you persist to have accurate (calendar) yearly amounts, the above is no help. What you do have to consider (if the UK tax man knows your situation) is that in addition to the 20% the bank/building society withholds for tax, the UK tax man will be withholding an estimated additional 20% through your Tax Code all during the year.

If it's your dividend income, then that opens up a new consideration on how (or if) it was taxed in the UK.

There's also the issue of NIIT for 2013. The rate for NIIT is 3.6% (?). [hat tip to nun]   Is the highest rate that investment income (passive interest income in this case) can be taxed really only 39.6%, or does the additional NIIT tax only apply if your AGI is above the NIIT threshold?

Fun, isn't it.

theOAP: You say "you're set on working out the exact amounts ..." and "If you persist to have accurate (calendar) yearly amounts ..."

Should I read into those phrases the implication that you think I am making things harder for myself than need be? I hope that is the case and you can tell me a simpler method. Someone said just use the dates you received income and dates you paid tax. But that has two problems. (1) How do I decide how a tax payment spreads out over general/passive/re-sourced baskets? (2) The report of tax paid on 1116 will seem all out of whack with the income received. I might be having 0 income received in the passive basket in 2013 but still paying tax on passive income in 2013 because that is an HMRC charge on income in 2012. Surely I don't want to have to be amending my 1040 returns every single year.

I am finding it impossible to figure out a plausible way to know when I have paid the UK tax on an item of income that I had in calendar year 2013 and which sits in a particular US basket. My UK tax for 2013-14 is partly paid PAYE, partly contemporaneously in the January 2013 charge, and also partly in retrospect in the July 2014 charge and January 2015 charge.

"Fun", as you say.

Should I read into those phrases the implication that you think I am making things harder for myself than need be? I hope that is the case and you can tell me a simpler method.

I think the way in which you have shown grim determination to tackle what most realise is a highly complicated and some times inexplicable set of rules, regulations, instructions, and forms, and not run away to hide under the bed (as many do) is admirable.

Many of those approaching the US Tax Code for the first time are surprised to learn that, in many instances, there is no 'one' correct method of calculating a tax return. In many instances there are multiple ways. None are the sole correct way. In addition, there are many situations in which there are only opinions or interpretations of 'a' correct way to handle a given set of circumstances. International tax advisors may hire a tax attorney for a fairly substantial sum simply to review a set of circumstances and give an interpretation on which that tax advisor feels comfortable following. At times, The Code is that difficult to comprehend.

Someone said just use the dates you received income and dates you paid tax.

If I remember the conversation correctly, that was Guya. Guya is a highly (internationally) respected tax advisor specialising in US/UK tax. Even though I am a pure know nothing average punter, I may at times disagree with him on some topics whilst fully understanding his stance; but I will always respect his opinion. You may be wise to do the same.

The US/UK tax situation is additionally complicated by the use of two different tax years. The US has 1 Jan. to 31 Dec., the UK 6 Apr. to 5 Apr. of the following year. You know this very well, and the resulting difficulties that can arise.

Form 1116 has two options: the accrual method and the cash method. If I remember correctly, the cash method may also be used as an accrual method (a happy coincidence for the US/UK situation). I may be wrong about that. Your situation, again if I remember correctly, has three income sources: pay, interest, and qualified dividends. Your struggle with the dividends reminded me why I only have bank/building society current and savings accounts and nothing else. It may seem unfair to rule ones self out of a number of investment opportunities, but that's the downside of being a US Person unless you have the funds for employing an advisor, or a rabid interest to fully research the US Tax Code (and there are some on this site).

Most average individuals utilise the cash method for form 1116. If you have a very complicated tax situation; or you are a HNWI with angles to play; or you are a large international company; or you have lived in a country like France as a US Person; you will use the accrual method.

I view your situation as being a fairly basic situation (pay and interest) with the additional problem of having qualified dividends. For the pay and interest, the simple solution IS to declare all income received in the US tax year, and declare all taxes paid ONLY in that same US tax year, regardless of the source of the income. There will be years in which you come out ahead, and years you come out behind, but over time it WILL even out. I do not envy you the handling of the qualified dividends, but I'm sure a professional would advise a fairly straight forward way of handling that.

Finally, I would make the following suggestion:
The IRS can not fault you for making every effort to complete your tax return correctly. One of the areas I may disagree with Guya on is this: make your best effort to be correct with your understanding of the rules; note why you chose to do as you've done in the completion of the form; and then submit the form. If the IRS disagrees with you, they will let you know. You may hear nothing more, or they may disagree and you may suffer additional taxes and an interest penalty on a late payment; BUT you will now know the correct way (or the way the IRS deems the correct way, which isn't always correct), and you will know how to prepare your return in the future. You've paid a price, but you've gained knowledge.

Again, all of this is only my 'lacking of knowledge' opinion. The important thing is for you to submit a tax return in which you feel the way you have prepared it is the correct way. That's all you can do. Don't over-stress. If it's wrong, you'll be given an opportunity to correct it. If you've made a sincere effort, you are not a tax evader nor a criminal and the black helicopters are not going to land on your roof; you're just the average tax payer with foreign sources of income.

Treas. Reg. § 1.904-4(c)(1) is the relevant Regulation.

I concur with RW. The effective UK tax rate cannot technically be determined merely by looking at the overall UK tax rates, as the effective foreign tax rate is affected by the foreign currency translation methods of  §§ 985-989 and by the allocation and the apportionment of deductions against passive basket income.

theOAP: Thank you for typing that helpful and sympathetic reply. It gives me comfort to hear that there is no one right way to complete a tax return. I sure what you say will be food for thought for other readers of this forum.

I lived in the UK since childhood and have been submitting 1040s, and other forms, from the UK for every year of my working life, for the past 36 years, and the IRS has never questioned my returns ---despite there being many things within them which I now realise to have been "mistakes". It has bugged me each year that I waste many hours of my life on this activity and still cannot get it "right". The cost in time, anxiety (and money, if I were to employ a professional) far exceeds the amount of tax this is in question one way or the other. As I near my retirement things become more complicated, and the cumulative effect of my past mistakes worries me. There does not seem to be any easy way to wipe the slate clean of my past errors and re-start on a better footing.

After many days of study in the IRS publications, and even reading the detailed regulations and UK-US tax treaty, I am further along the learning curve than ever before. I even now know enough to find errors in the working of both TurboTax and TaxACT.  Because of an unexpected large capital gains in the US this year, in excess of the UK tax-free amount, I will try the 1116 resourced by treaty for the first time. Maybe I will be told that is not the correct approach. But I guess I can give it a whirl.

I like what you are saying about not being frightened to receive a penalty from the IRS, because at least that dark cloud would have a silver lining in teaching me what's right. I have had half a dozen conversations with IRS people at the end of the phone helplines in London and Philadelphia the past few weeks. None them can give me a clear answer about how to take tax credit for US source income taxed in the UK. They seem to echo what you say. One person even said that I should ignore Forms 1116 -- 'just put down what you think is right and we'll let you know if it is wrong." I don't feel comfortable taking such a cavalier approach. Filling out the 1116s, as best as one is able, is a good way of getting in the right ball-park.

Obviously a company, or a HNWI, needs professional help. I wish that when I was young, starting out on my working life in the UK, someone had said to me "Get yourself a tax advisor. It may seem simple now, but complexity creeps up on you and someday you'll find you are lost and it will feel like it's impossible to get back on track." As example is tax credits. Because my UK tax usually seemed to be so overwhelming greater than my US liability I never bothered to keep a record of these or think I might need them as carryovers. Now I realise that a record of this 10 year history could be put to use and it is what I need to smooth out the desynchronized tax year problems and cope with a year that my UK tax has been atypically low this year but will be atypically higher next year.

I am grateful for others on this forum who have mentioned software. I have tried TaxACT and TurboTax this year -- much better than trying to do it with Excel spreadsheet as I have in the past. Although even these programs do not cater for all the things that a US person overseas needs. TurboTax gets line 3d of 1116 wrong (when one is adjusting lines 1a and 18 for qualified dividends and capital gains). TaxACT cannot prepare a HTKO column.

Of course no one lives in the UK to avoid tax. I estimate that I pay about 50% more income tax to HMRC than I would pay to the IRS on the same income if I were living in the US.  But despite the bill being greater, it is almost a joy to complete a UK self-assessment return. It is so easy. HMRC have a great web site, where you can check you account, pay what you owe, compute your tax, amend your return, view past returns, etc. There is a clear "view your calculation" (no complicated calculation worksheets and dozens of forms). It does upset me that US has invented a tax system that is so impossibly complicated for a USC abroad to navigate. It just feels wrong.

This baskets business is a real nightmare. Its designers must have in mind people with millions in income who might otherwise might be able to avoid much tax. One simplification that would certainly help the average Joe would be to say that if your income is less than $XXX,XXX then you may consider all your worldwide income as being in a single basket and take as a tax credit the entirety of your resident country tax paid, excepting perhaps items which the US, under treaty, may tax. Another simplification that would really help would be the possibility of electing to use the same tax year as your resident country. If I could pay my US tax on a "year to April 5" basis, the same as my UK tax, that would make no difference to the tax the US receives, but would so greatly simplify the task that many of us face.

p.s. I would like to say "thank you" to those such as guya, politicfool, and theOAP, for the input they make to this forum. If I were living in the US I would probably gain helpful ideas from water cooler conversations with others in my workplace and social circle. This forum provides a bit of replacement for that.

There's a lot of interesting discussion here, but I just wanted to dig into the following point:

There's also the issue of NIIT for 2013. The rate for NIIT is 3.6% (?). [hat tip to nun]   Is the highest rate that investment income (passive interest income in this case) can be taxed really only 39.6%, or does the additional NIIT tax only apply if your AGI is above the NIIT threshold?

HTKO applies if the foreign tax rate exceeds the highest US statutory income tax rate, meaning the highest tax rate authorised by US law, that can be imposed on the income in question. Since NIIT is an income tax, I would assume it should be taken into account. Note the NIIT rate is 3.8% not 3.6%. If I'm right, the highest US statutory tax rate on most items of ordinary income is (39.6% + 3.8%) = 43.4%, which would mean most folks in the 20% and 40% UK brackets need not worry about HTKO. I might be wrong about this so welcome other views.

Treas. Reg. § 1.904-4(c)(1) is the relevant Regulation.

I concur with RW. The effective UK tax rate cannot technically be determined merely by looking at the overall UK tax rates, as the effective foreign tax rate is affected by the foreign currency translation methods of  §§ 985-989 and by the allocation and the apportionment of deductions against passive basket income.

That makes sense. I take only the standard deduction and allocate it proportionally to gross income across everything. But the thought that UK tax might exceed the greatest US rate simply because the pound appreciates against the dollar between the time the UK income was received and the time the UK tax on it is paid. That sounds right, but is certainly mind-boggling.

By the way, while we are talking deductions, I have wondered if there are places where the calculation methods described in i1116 are inconsistent with US tax code, or are only making some sort of approximation.

Suppose you have 20,000 foreign source qualified dividends and adjust it to .3788 x 20000 = 7576, as required. The allocation of your deductions in line 3d-g is to be done in proportion to the unadjusted amount of 20000 (unless you have good reason to allocate to certain income). In theory, if you have large deductions, this could lead to the proportionate share of the deductions exceeding 7576 and you could end up with a negative number, or 0, on line 7. The way TurboTax does it (wrong) that cannot happen.

Another oddity is that adjusting by the factor of .3788 = .15/.396 means that qualified dividend income is re-figured to an amount which if taxed at 39.6% would create a 15% tax charge. However, many people are not paying at rate 39.6%. This means that when working out the share of your US tax bill (on line 20) associated with UK wages the limitation figured in 1116 line 21 is actually too great. If you were to do the same calculation on lines 19-21 for the dividends you would find the limitation to be too small (less than 15%) (but you are not actually trying to re-source the dividends, so you do not do this.)

This is how, after taking a tax credit for UK wages I can end up owing less US tax than 15% of US source dividends would create - a fact that continues to bother me.

This is how, after taking a tax credit for UK wages I can end up owing less US tax than 15% of US source dividends would create - a fact that continues to bother me.

I have now re-figured the allocation of my UK tax to the US general/passive baskets in a manner that treats UK wages and UK bank interest as taxed at the same rate (mimicking the way my UK tax bill treats them and as also suggested in i1116), TaxACT is now computing a US tax bill that is only $29 less than the value of 15% of US company dividend income, (which is that portion of my worldwide income over which the UK does not have exclusive taxing authority.) I believe this a *complete fluke*. But am finally feeling comfortable that I could defend this "solution" as a good effort if the IRS were to question. I have been back through all my US tax returns since 2003 and filled into TaxACT the carryovers that would have existed on my 1116s if I had bothered to note them down. In fact, I have not needed to use any of the excess credits, but I think it will be a good idea to maintain these records going forward.