The Department of Treasury would differ with you on that (from a recent press release)
“When taxpayers overseas avoid paying what they owe, other Americans have to bear a disproportionate share of the tax burden,” said Emily McMahon, the acting assistant Treasury secretary for tax policy.
Well said, Emily. I think it's outrageous that hard-working Americans like Mitt Romney pay outrageously high rates of tax at 13.9% while welfare queens in foreign lands pay nothing.
Most US expats make an honest effort to comply with tax law. In this case the OP was trying to do just that. But non-taxable UK benefits seem to be an area that have fallen through the cracks and US citizen recipients are dealt with in an unfair way compared to US recipients of other forms of foreign income and gains. In this particular case I'd argue that the benefits are the UK equivalent of US welfare payments which are not included in the income of people resident in the US. So if you are poor or disabled you get a tax penalty if you live outside the USA. Also the fact that the money comes from the UK tax payer is another interesting aspect as there is no reciprocal way for the UK to tax welfare payments made to UK citizens living in the US.
Re- Reading the tax Treaty Article 17 p3 again I now think that it does not actually provide for "exclusive residence-country taxation of social security benefits" as claimed in the Technical Explanation. Here is what it says
3. Notwithstanding the provisions of paragraph 1 of this Article, payments made by a
Contracting State under the provisions of the social security or similar legislation of that State to a resident of the other Contracting State shall be taxable only in that other State.
What if you are a UK/US dual citizen resident in the UK and receiving both US SS and UK state pension, a situation I will probably be in in a few years. Applying Article 17 p3 my US SS will be taxable only in the UK (remember the savings clause does not apply). Now what about my UK state pension. That is a payment made by the UK to a resident of the UK, not the the other contracting state, so it doesn't sound as if it is covered and as I'm a US/UK citizen resident in the UK the UK state pension will be taxable in both the UK and the US. Not a big deal if I can claim a US tax credit, and now I understand why theOAP does not/cannot exempt his UK state pension from US tax.....
IMHO the Notes to Article 17 p3 are incorrect and to actually achieve "exclusive residence-country taxation of social security benefits" it should read
3. Notwithstanding the provisions of paragraph 1 of this Article, payments made by a
Contracting State under the provisions of the social security or similar legislation of that State to a resident of the other a Contracting State shall be taxable only in that other the State in which the beneficial owner is resident.
