FTC 1116 and the new UK "Personal Savings Allowance"

Starting this month the UK government has introduced the new Personal Savings Allowance which means all savings interest is accumulated in UK bank accounts completely tax-free.

If you exceed your Personal Savings Allowance, the HMRC will collect tax on the excess interest by changing your tax code, using the PAYE system.

My question is: How should USA citizens handle this when filing form 1116, in which general income tax and passive income tax are reported in two distinct bins and cannot be shared between each other?

If the HMRC is now collecting my savings interest tax via PAYE within my paycheck, then will there be an obvious way to distinguish between the tax paid on my interest vs. the tax paid on my wages, so that I can report them separately to the IRS?

Maybe I don't fully understand how PAYE works. Please help clarify this for me!

Thanks

US citizens will need to carve out the portion of their PAYE that is collected on their investment income.   So it will be a case of working out what the UK tax on investment income would be (probably the interest amount taxable at 20%/40%/45% as appropriate) and declaring this as Passive FTC, and report the remainder as General Limitation FTC.

We see this already sometimes with taxpayers that have overpaid through PAYE for various reasons, but the overpaid PAYE covers their higher rate UK tax liability on their investment income. It's just a case of making sure that you carve out the UK tax paid on investments from the UK tax paid on employment earnings. 

Thanks for your reply DorsalFinn,

So it sounds like my paycheck will not include separate line items for tax paid on passive income vs. tax paid on wages, and I will need to do the math myself to calculate how much tax has gone to my interest based on the total amount accrued and my tax bracket.

Yep, I reckon so.   It's just (yet) another manual calculation to undertake as part of the US return process.

If you are paying UK tax at a marginal rate of 40% or higher then according to US law you should not compute a FTC for UK tax on your interest using Form 1116 passive, but rather you should claim it on Form 1116 general, along with your wages income.

Classifying interest income as general not passive income implies using the high tax kickout rule. However, this does seem a bit odd since one can now earn up to £500 interest at the 40% marginal rate and not pay UK tax. So the actual marginal tax rate is 0% if you don't go over £500.

Now it would seem entirely reasonable to throw it all in the general income basket but is this really kosher? After all, one could employ a similar argument on dividends and capital gains in ISAs.

If you are paying UK tax at a marginal rate of 40% or higher then according to US law you should not compute a FTC for UK tax on your interest using Form 1116 passive, but rather you should claim it on Form 1116 general, along with your wages income.

This doesn't make sense to me. Reporting your tax on interest under the 1116 general category could increase your tax owed to the US because you'd have too many FTC's for general and too few FTC's for passive.

Could you point me at where in the tax law it says to do it this way?

There must now be a strong argument that for most UK resident taxpayers that interest credited after 5 April 2016 is no longer HTKO because the average UK rate on the interest is in most circumstances well below 39.6%.  The effect of this for a US person in the UK is likely to lead to larger amounts of passive basket income with insufficient foreign tax credits.

This doesn't make sense to me. Reporting your tax on interest under the 1116 general category could increase your tax owed to the US because you'd have too many FTC's for general and too few FTC's for passive.

Could you point me at where in the tax law it says to do it this way?

Here is the relevant sentence from the Form 1116 instructions, page 4: "High-taxed income.  In some cases, passive income and taxes must be treated as general category income and taxes. 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.  See Pub. 514 and Regulations section 1.904-4(c) for more information."

As guya remarks, it looks as though UK interest will no longer qualify as high taxed and will henceforth be reported on Form 1116 passive, with perhaps insufficient tax credits to eliminate US tax. I suppose it would remain high taxed for the UK additional rate taxpayer (whose can have interest taxed at 45%), or for the theoretical case of a higher rate taxpayer who manages over £50,000 of interest income, since 0.40*(50,000-500)/50,000=0.396.

I am dealing with a similar situation as the OP, and struggling to understand if and how the liability can be reduced in such a situation.

I'm fortunate to have an amount of earned income over and above the FEIE and housing exclusion, but my low level of passive income is tax free in the UK (thereby not creating any passive FTCs).

Does anyone have any ideas on how the liability (arising from the tax free passive income) can be reduced? An accountant seems to think that I should not have a liability, but would for obvious reasons not reveal how!

I don't think there is a good solution to this, unfortunately.   Basically, if you have income that falls in the passive basket, and on which no (or little) UK tax has been paid, and you don't have any passive FTC carried forward from earlier years, and you don't have itemised deductions/standard deductions to use against the income, then US tax will be due.

With the Personal Savings Allowance coming into play, I think we'll be seeing quite a few more cases where US taxpayers such as yourself will have a small US tax liability each year, related to their UK investment income. Looking on the brighter side, the tax would previously have been payable in the UK at 40% or 45%, but now the tax will be due in the US at a slightly lower rate!

Many thanks for the reply! Although it's what I feared I would hear...

With a high income but low capital you end up in a bit of a tax trap because if the passive income were higher (requiring more capital) to the point where UK tax actually gets paid, you would be eligible for the passive FTCs and can eliminate the US liability.

The standard deductions/personal exemptions dont seem to help as they get diluted by the excess income over the FEIE + housing. With just FTC the standard deduction/personal exemption can't be applied directly against the tax free passive income.

Does anyone have any ideas on generating passive FTCs in a cost effective way? Any instruments available which are heavily taxed but still generate an attractive after tax return? Savings account paying 10% interest but taxed at 80%?

Can the liability be reduced by making contributions to any US tax efficient investment accounts (haven't delved into this option in much detail)?

In this kind of situation (high earned income, low tax free passive income), would I be better off claiming all the FEIE and housing I can, thereby reducing the marginal rate on the passive income?

There must be a way around this!

Many thanks!

Does anyone have any ideas on generating passive FTCs in a cost effective way? Any instruments available which are heavily taxed but still generate an attractive after tax return? Savings account paying 10% interest but taxed at 80%?

Even if such instruments exist, the HTKO rule will prevent you from benefiting in this way. Any passive income that is taxed at a rate more than 39.6% must be reported and foreign tax credited within the general basket. (See 1116 instructions page 4, second column "High-taxed income".)

Oh, haven't come across that one before. Might just have to bite the bullet on this one.

Because of all the tax exempt investment opportunities available in the UK, the liability would only increase year on year in the absence of any changes to the treaty/tax policy.

Might have to start looking at how quickly an initial investment of $2,350 can be recouped.

Anyone know how Sharia law investments are treated by the IRS? These products are open to non-Muslims and might be a solution to this problem. Islam forbids the payment of interest so the return comes in a different form.