Employer contributions to pension

I want to include my UK employers contribution to my defined-benefit pension  so that I can build up my cost-basis in the pension.  To this end, I will not use the treaty and I will instead include my employers contribution to the pension in  my gross US taxable income (excess tax credits via 1116 will eat up with the increased tax liability). However, it is unclear if we can include employer contributions to the cost-basis. The IRS instructions are cryptic (at least to me..):

"Foreign employment contributions.   If you worked abroad, your cost may include contributions by your employer to the retirement plan, but only if those contributions would be excludible from your gross income had they been paid directly to you as compensation. The contributions that apply are:
...
Contributions after 1962 by your employer if the contributions would be excludible from your gross income (not including the foreign earned income exclusion) had they been paid directly to you..."

This seems to indicate that employer contributions to a UK pension could NEVER be included in the cost-basis of the pension even if you include them in your gross income because, if the contributions had been paid directly to you, you would would not have been able to exclude them from your gross income.  It seems like we are forced to use the treaty and exclude employer contributions. But then, what is the IRS talking about? When would contributions made directly to me by my employer be excludible from my gross income?  The impression I have is that accounting firms are advising people to including employer contributions in their gross income to build up the cost-basis (for US-tax purposes) in their UK pensions.  Is that true? If so, what am I getting wrong?

In certain narrow circumstances you are able to include in your basis amounts that were not included in your income.  Your quote above from Publication 575 is dealing with these narrow circumstances.

The following is a quote from the Joint Committee on Taxation (http://www.jct.gov/x-78-03.pdf), see page 23 of the PDF:

Distributions from retirement plans are includible in gross income under the rules relating to annuities (FN 35) and, thus, are generally includible in income, except to the extent the amount received represents investment in the contract (i.e., the participant's basis). The participant’s basis includes amounts contributed by the participant, together with certain amounts contributed by the employer, minus the aggregate amount (if any) previously distributed to the extent that such amount was excludable from gross income. Amounts contributed by the employer are included in the calculation of the participant’s basis to the extent that such amounts were includible in the gross income of the participant, or to the extent that such amounts would have been excludable from the participant’s gross income if they had been paid directly to the participant at the time they were contributed.  (Emphasis added)

FN 35 Sections 72 and 402.

Code §402(b)(1) provides:

Contributions to an employees' trust made by an employer during a taxable year of the employer which ends with or within a taxable year of the trust for which the trust is not exempt from tax under section 501(a) shall be included in the gross income of the employee in accordance with section 83 (relating to property transferred in connection with performance of services), except that the value of the employee's interest in the trust shall be substituted for the fair market value of the property for purposes of applying such section.

Under this rule, contributions to a foreign retirement plan by an employer are included in the gross income of the employee.  Without the treaty, you are required to include employer contributions in your U.S. taxable income.

Thank you very much discly for pointing out this memo.  The take-away message I get from this is that I can indeed include my employer's contribution to the defined benefit pension scheme in my gross taxable (US) income, "pay tax" on that now via 1116,  and then, when I retire back to the USA, I can include my employers contribution (that I included in my income in years past..) in my cost-basis. Great, I calculate that, by doing this, about 50% of my UK pension payments will be tax-free (line 16a vs 16b on 1040)!   I understand that I must use the "general rule" to work out the actual number.

However, the part you quote also seems to say something very interesting:

"Amounts contributed by the employer are included in the calculation of the participants basis to the extent that such amounts were includible in the gross income of the participant, or to the extent that such amounts would have been excludable from the participants gross income if  they had been paid directly to the participant at the time they were contributed."

I have several university colleagues who are US citizens working the the UK who are also members of the same pension scheme (the university USS scheme).  Rather than go the 1116 route, they have always used the foreign Earned income exclusion when filing their US taxes… I always thought that was a big mistake as it means that they would not have accumulated any cost-basis in their pension. However, in light of the highlighted quote from the memo above,  it seems to me that, when they retire to the US, they could still count the employer contributions to the pension in their cost-basis since those employer contributions would have been excludable if payed directly as wages (assuming everything falls below the FEIE limit).  Is this a correct interpretation?

Unfortunately, I do not agree with your interpretation. As you quoted above, you get basis "if the contributions would be excludible from your gross income (not including the foreign earned income exclusion)."  Since your colleagues are claiming the foreign earned income exclusion, this rule would not apply to them.

Further, the I.R.S. takes the position (probably correctly) that the employer contributions cannot be excluded under the foreign earned income exclusion. See Sec. 911(b)(1)(B)(iii).