interest or dividend ?

As a US citizen resident in the UK I am thinking along the following lines, but I wonder what other views there might be ?

A US bond fund pays income as a dividend, and under the UK/US treaty it is a dividend because it retains its nature as defined by the law of the state of source according to the Explanation of Article 10 thereof, and Article 11 specifically excludes from interest anything defined as a dividend in Article 10.

In the UK such bond fund income is taxed as interest, though I suppose that for the purposes of claiming a credit for US tax against UK tax it has to be thought of as a dividend.  Or does this only apply if one specifically invokes the treaty in some way.

It seems to me that it is, in either case, passive income, but why does Form 1116 ask me to allocate it to columns k or m in PART II.  Is there some little surprise waiting for me in the small print that I have not yet discovered.

Has anyone ventured into the murky depths of Article 24 (6) ?  In that case it is, at least partially recharacterised as re-sourced income.  I wonder what UK tax rate (applicable to interest or dividends) one might use in that example calculation ?

PL.

I would like to make some observations on parklane’s questions on the taxation of distributions for a US bond fund.

parklane is a UK resident US citizen. Under the savings clause in the UK US double tax treaty, most of the treaty does not apply to US citizens. The exceptions to this are listed in Article 1(5). These exceptions do not include Articles 10 or 11 to which parklane has referred. Perhaps therefore there is no guidance on how each country is to treat the distributions.

It would appear therefore that the UK would tax the distributions under UK domestic rules. This would generally mean that they would be taxed as income. I cannot offer any comments on how the US would go about giving foreign tax credits other than to say the resourcing rules work out differently for US dividends and US interest. Perhaps others could offer insights on this.

There may be an another potential tax mismatch, on a sale of the holding. Does the US bond fund have reporting status under the UK Offshore Income Gain rules? If so, thes  gain would be taxed as income in the UK. One of the issues would then be whether the US would give credit for the income tax under its foreign tax rules.

Thanks Dunedin for your well considered response.

To be pedantic, the savings clause allows a 'Contracting State', not just the US, to ignore many of its provisions.  Both the US and UK are contracting states, but UK domestic law does not generally seek to tax its citizens resident abroad, while the US does.  As a UK resident, the Treaty does apply to me insofar as the UK does not ignore its provisions.  So, as you say, the UK taxes it under its domestic law, but gives a credit for US tax paid to the extent allowed in the treaty.  What I would like to know is what that extent is.

The UK does allow a credit for foreign tax paid, and as far as the UK is concerned, that credit would be calculated on a foreign dividend under the provisions of Article 10.  So it assumes that an amount of tax up to 15% has been paid on the dividend to the US and seeks to give a credit for that amount.  Exanple calculations can be seen in the Explanatory memo under Article 24(6).  Note that in Example 1, the US tax actually paid is 26%, not 15%, and with the 'Net post-credit U.K. tax' of 10%, the total tax is 36%, the same as the US rate ignoring the treaty.  So the treaty does not limit the amount of total tax payable (in this case 36% according to US tax rates), but merely ensures that the total of US and UK tax adds up to no more than the 36% the US would tax without the treaty intervention.

However, in the case of the Bond dividend, the UK taxes it as if it were interest, i.e., at the rate applicable to interest, and it has to be put in the interest income box.  But, does it still remain a dividend for tax credit purposes and subject to the procedure shown in Article 24(6) as a dividend?  The explanation to Article 11 says 'Notwithstanding the foregoing limitations on source country taxation of interest, the saving clause of paragraph 4 of Article 1 (General Scope) permits the United States to tax its residents and citizens, subject to the special foreign tax credit rules of paragraph 6 of Article 24 (Relief from Double Taxation), as if the Convention had not come into force.'  i am wondering how to apply these rules, i.e., in the worked example, would you use a witholding rate of 15% for dividends, or 0% for interest, and do i have to re-source this income and invoke the treaty on Form ?  In fact, the payer of the bond dividend has not witheld anything, in recognition of the fact that I am a W8-BEN weilding UK resident.

Sale of the Bond Fund is another matter for another year.  Sigh !

How the bond fund is taxed by the UK will depend on it's reporting status....so what is that?

I would like to comment further, but restrict my comments to the taxation of US dividends. Where US dividends are taxed on an arising basis by a UK resident US citizen, my understanding is that the correct approach can be summarised as follows-
•   The UK taxes the dividends. But in doing so the UK is obliged to give credit for the tax that would have been paid by a UK resident non-citizen. That is the 15% withholding tax.
•   Suppose that the individual generally pays UK tax at 45%. Then the rate for dividends would be 38.1%. The UK tax would then be 23.1%.
•   The US would then tax the dividends. It would give credit for the UK tax paid. However, in doing so the US tax will never fall below the 15% rate.
•   Under the resourcing rules, there would not be any carry forward of unutilised foreign tax credits.
•   Any NIIT would not be reduced by foreign tax credits.
•   Therefore, the minimum overall tax in this example is 38.1%, and a further 3.8% might be payable, to bring the overall total to 41.9%.
•   For an individual paying 40% tax in the UK, the total tax by my calculations can reach 36.925%.
Perhaps others would say if these calculations are in line with their experience.

Thanks dunedin,

For the moment, lets avoid nun's otherwise valid question by assuming it distributes all income.

I am not in the tax brackets you suppose, but I think you are on the right lines.  Having re-constructed the two examples from Article 24(6) on a spreadsheet I can plug in any combination of tax rates.  The general outcome I believe is that the overal tax - US plus UK expressed in a common currency will equal the maximum tax applicable in either jurisdiction.  At a UK tax rate of 38.1 and US rate of 20% for dividends, I think the tax paid would be 15% to the US and 23.1 to the UK., a total of 38.1  For a UK dividend rate of 32.5% and US rate of 36%, the amounts are 17.5 to the Uk and 18.5 to the US, a total of 36.

My query really relates to whether the UK would approach this calculationn using the 15% witholding rate for dividends, or the 0% rate for interest ? 



 

It seems to me that you just apply the local rules for categorizing the income. In the UK the bond income is going to be taxed as interest, so you pay that tax, but taking a 15% tax credit for the US treaty tax. Then you resource the income to the UK so you can get the FTC add it to the 15% US tax already paid to come up with the US tax due.....which is probably zero.

Dunedin said previously;  "parklane is a UK resident US citizen. Under the savings clause in the UK US double tax treaty, most of the treaty does not apply to US citizens. The exceptions to this are listed in Article 1(5). These exceptions do not include Articles 10 or 11 to which parklane has referred. Perhaps therefore there is no guidance on how each country is to treat the distributions."

I responded not quite correctly.  Here is the Treaty Article 24(1)

1. In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income
(a) the income tax paid or accrued to the United Kingdom by or on behalf of such citizen or resident;

Article 24 is one of those excepted from the savings clause under clause 4, so it does apply to a US citizen.  My understanding is that the UK will only allow a tax credit of 15% as that is all Article 10(2)(b) allows, even if the US tax at the taxpayer's normal US tax rate is more than this by invoking the savings clause which does apply to Article 10.  But to avoid double taxation, the sum of taxes in both jurisdictions cannot exceed the maximum tax that could be levied individually by either one of them.  The calculation in Article 24(6) seeks to allocate the tax to each jurisdiction accordingly.  Howeverm the arithmetic mechanism involved is pretty obscure !  Nun, you will have to study the examples in Article 24(6) to see that your simplistic procedure is probably not correct.

By the way, am I the only one who reads this board who finds the light grey font on a white background used in the reply box extremely irritating and hard to read ?  Can something be done about it ?

I did not go into the exact arithmetic, just indicted the general flow of the thought in the examples given in the Technical Explanation to Article 24. I think with those it's pretty easy to follow the logic and come up with the right answer. There's a bit of a contortion with the amount resourced so you can take the right UK tax credit, but other than that it's straightforward.

If this helps, my calculations of the overall tax payable on a US dividend of 100 which is liable to US tax at 20% are

UK tax payer-general rate   40%           45%
-   dividend rate                32.5%        38.1%
      
UK tax                    17.50%        23.10%
US tax                   15.625%      15.00%
      
Overall tax                  33.125%      38.10%