Is tax free lump sum payment from UK pension subject to US tax

How does that work then?

The UK State Pension gets taxed by reducing the personal allowance.  No scope for deducting credit from UK tax for foreign tax already paid.

You could perhaps re-source the UK State Pension as US-source, and claim credit from the US against US tax due, but isn’t that just going round the houses to accomplish the same end?  (i.e. the UK State Pension ends up getting taxed by the UK, and not by the US, as per the Technical Explanation).

Extremely confusing!

I'm afraid you've lost me, I don't understand your post. I'll consider it due to my lack of a clear explanation.

Back to basics:
A USC, resident in the UK, receives both a UK SP (State Pension) and the US SS.
According to the Treaty,
the UK SP is fully taxed in the UK,
the US SS is fully taxed in the UK,
the UK SP is fully taxed in the US,
the US SS is not taxed in the US (if a Treaty position is taken).

For the US return, the UK SP is included on the both the 1040 (as taxable income) as well as the appropriate 1116 including tax paid to the UK (for tax credits). The 1040 changes for 2018, so which line, which new schedule, and where, is not clear yet.

For the UK return (Self Assessment - foreign income US SS), the gross UK SP is included on the normal pages, the gross US SS amount is included on the foreign pages.

For the US return, it is impossible to determine a basis in the UK SP. During the contribution stage (previous years), you may have declared your gross UK income including the UK NIC contributions on a 1040, and calculated tax on that amount, but there is no way of determining what amount of your UK NIC contributions were for the UK SP, therefore, no basis (theoretically taxed twice by the US on your contributions).

I'm afraid you've lost me, I don't understand your post. I'll consider it due to my lack of a clear explanation.

My fault, I’m sure.  My apologies.  I’ll try to explain what I meant.

The UK taxes the State Pension when it’s being paid to a UK resident, regardless of whether the recipient is or isn’t a US citizen, and regardless of whether the recipient (if a US citizen) does or does not report the pension as taxable on a 1040.

If the US citizen does report the pension to the IRS as US-taxable, the US citizen can (if I understand correctly) claim credit for the UK tax already paid, thus no US tax is due.

If the US citizen does not report the pension to the IRS as US-taxable (as per 1040 instructions and the probable intention of the treaty), no US tax is due.

I don’t see what’s the difference except that reporting it to the IRS as US-taxable causes more work?

For the US return, it is impossible to determine a basis in the UK SP. During the contribution stage (previous years), you may have declared your gross UK income including the UK NIC contributions on a 1040, and calculated tax on that amount, but there is no way of determining what amount of your UK NIC contributions were for the UK SP, therefore, no basis (theoretically taxed twice by the US on your contributions).

This is the bit I may be misunderstanding.  If you get credit from the US for the tax paid to the UK, doesn’t that cancel out any US tax that might otherwise have been due?

The UK taxes the State Pension when it’s being paid to a UK resident, regardless of whether the recipient is or isn’t a US citizen, and regardless of whether the recipient (if a US citizen) does or does not report the pension as taxable on a 1040.

Correct.

If the US citizen does not report the pension to the IRS as US-taxable (as per 1040 instructions and the probable intention of the treaty), no US tax is due.

Where in the 1040 instructions does it say that a UK SP is not taxed by the US, or did you mean it is taxed by the US in the 1040 instructions?

.......If the US citizen does report the pension to the IRS as US-taxable, the US citizen can (if I understand correctly) claim credit for the UK tax already paid, thus no US tax is due........
I don’t see what’s the difference except that reporting it to the IRS as US-taxable causes more work?
.............This is the bit I may be misunderstanding.  If you get credit from the US for the tax paid to the UK, doesn’t that cancel out any US tax that might otherwise have been due?

As the wording in the Treaty stands, the UK SP is taxed in the US. Does the IRS really enforce this, or are they bothered for the reasons you have identified? Or, do they secretly feel the same on the intentions of the Technical Explanation and nothing may be said. The IRS may not really care - or during a random audit, it may become evident they really do care and want it declared. You complete an IRS return to the best of your understanding and interpretation. The IRS may, or may not, agree with your understanding. Welcome to the wonderful world of IRS reporting of foreign (un-American) income.

Everyone's situation is different. For those in the 40% UK tax band especially, as well as others, claiming the UK SP as taxable on a US IRS return may result in an increase in the excess foreign tax credits available from that tax year. As displayed above in the comment from Guya, excess foreign tax credits may be very useful in the future.

Of course - ALL in my opinion, and I may be wrong.

Where in the 1040 instructions does it say that a UK SP is not taxed by the US, or did you mean it is taxed by the US in the 1040 instructions?

No, I mean the bit where the instructions tell you to leave foreign income out if it’s exempt by treaty.

The IRS may not really care - or during a random audit, it may become evident they really do care and want it declared.

Yes, I see.  Though if you leave out the UK State Pension and report the treaty claim on - is it 8833? - on even one year’s return, would that not establish definitely whether the pension is accepted by the US as exempt by treaty when paid to a UK resident?  Then in future years, there would no longer be any doubt as to whether the pension should be reported.

For those in the 40% UK tax band especially, as well as others, claiming the UK SP as taxable on a US IRS return may result in an increase in the excess foreign tax credits available from that tax year.

Yes, I can see that in such circumstances, reporting the pension to accumulate tax credits could be advantageous.

Thanks for the explanation.   

... if you leave out the UK State Pension and report the treaty claim on - is it 8833? - on even one year’s return, would that not establish definitely whether the pension is accepted by the US as exempt by treaty when paid to a UK resident?  Then in future years, there would no longer be any doubt as to whether the pension should be reported.

Or request Competent Authority assistance under the tax treaty Mutual Assistance Procedures to clarify whether a UK State pension received by a UK-resident US citizen is taxable exclusively by the residence country as stated in the Technical Explanation.  A simple question, involving no hazard for the taxpayer who is requesting the assistance from the Competent Authority (HMRC).

https://www.gov.uk/government/publications/statement-of-practice-1-2018/statement-of-practice-1-2018

In any case, it seems that reporting this treaty-based return position (i.e., that the UK State Pension is exempt from US taxation) is waived by statute:

Positions for which reporting is waived include, but are not limited to, the following. See Regulations section 301.6114-1(c) for other waivers from reporting.
• That a treaty reduces or modifies the taxation of income derived by an individual from dependent personal services, pensions, annuities, social security, and other public pensions, as well as income derived by artists, athletes, students, trainees, or teachers;

https://www.irs.gov/pub/irs-pdf/f8833.pdf

So it seems you can either report it as taxable to get the tax credits, or exclude it as exempt by treaty. 

Which is logical, given that it’s being paid by the UK Government to a UK resident, and is fully taxed by the UK Government, and the US is therefore required to allow credit for the UK tax paid; to do otherwise would result in double taxation.

My interpretation only, of course: I may be mistaken.

Yes, I see.  Though if you leave out the UK State Pension and report the treaty claim on - is it 8833? - on even one year’s return, would that not establish definitely whether the pension is accepted by the US as exempt by treaty when paid to a UK resident?  Then in future years, there would no longer be any doubt as to whether the pension should be reported.

It's an interesting speculation, but personally, I don't think it would work like that (I could be wrong).

IMO, the Treaty, although poorly written, says the UK SP is taxed in the US for a USC resident in the UK (they are not resident in the US - the wording in 17.3 only applies when cross border) which would make such an 8833 claim invalid. The return may not be flagged up, and may not be for several years, but at any point the IRS may reject the claim. The question then is it worth IRS time and money to challenge if the taxpayer can simply file a corrected 1040X, declaring the UK SP but also claiming the then allowed foreign tax credits. It's up to the IRS to decide.

The major consideration is an otherwise correct return has been filed and important forms such as 8938 have been included. The IRS is interested in your assets. Pragmatically, is it worth chasing the incorrect portion of the return? It's likely no additional tax would ultimately be collected, and if there is no tax due, there would be no penalties.

The IRS would have to issue a Notice (or private letter) to override the treaty position. There is no other way for the rules to change, aside from a new Treaty. Filing a return and having it unchallenged does not establish an acceptable precedent for that and future years if the return is initially incorrect.

The real problem, as I believe you are aware, is if the taxpayer has only minimal foreign unearned income like pensions. The 2018 US standard deduction will be $12,000 (MFS), but someone with only £11,000 or £12,000 unearned foreign income will be above that amount (thus possibly owing US tax at current exchange rates) since the UK personal allowance will remove 90%+ of that income from UK tax leaving very few foreign tax credits available.

IMO, the straightforward and correct solution is to declare the UK SP and take the credits, but each individual makes their own choice.

Or request Competent Authority assistance under the tax treaty Mutual Assistance Procedures to clarify whether a UK State pension received by a UK-resident US citizen is taxable exclusively by the residence country as stated in the Technical Explanation.  A simple question, involving no hazard for the taxpayer who is requesting the assistance from the Competent Authority (HMRC).

Why would HMRC care? The UK has residence based taxation, and they are able to tax the US SS for UK residents.
Why would the IRS care what HMRC would think? HMRC do not establish US tax rules. With the saving clause, the US taxes as it wishes and the UK has agreed to that in the Treaty.

IMO, the Treaty, although poorly written, says the UK SP is taxed in the US for a USC resident in the UK

It isn’t, though.  The US can’t tax it because it’s already been fully taxed by the UK.

Why would HMRC care? The UK has residence based taxation, and they are able to tax the US SS for UK residents.
Why would the IRS care what HMRC would think? HMRC do not establish US tax rules. With the saving clause, the US taxes as it wishes and the UK has agreed to that in the Treaty.

As the Competent Authority, HMRC are obliged to consider questions submitted under the Mutual Agreement Procedures.

With the saving clause, the US taxes as it wishes and the UK has agreed to that in the Treaty.

17.3 is an exception to the Saving Clause.

The major consideration is an otherwise correct return has been filed and important forms such as 8938 have been included. The IRS is interested in your assets.

Only the ones that are US-taxable, I’ll wager.

The real problem, as I believe you are aware, is if the taxpayer has only minimal foreign unearned income like pensions. The 2018 US standard deduction will be $12,000 (MFS), but someone with only £11,000 or £12,000 unearned foreign income will be above that amount (thus possibly owing US tax at current exchange rates) since the UK personal allowance will remove 90%+ of that income from UK tax leaving very few foreign tax credits available.

This is not a problem that affects the UK State Pension, which is fully taxed by the UK.  The real problem arises for those who who don’t realise that it’s fully taxed by the UK and can’t be taxed further by the US.

With the saving clause, the US taxes as it wishes and the UK has agreed to that in the Treaty.

I don’t think that’s quite correct. The UK has agreed that the US can tax its citizens as if the treaty had never come into force - in other words, the same way US residents would be taxed.  But the UK State Pension is covered by 17.3, which is an exception to the Saving Clause; and that allows US citizens to pay tax on the UK State pension only to their country of residence.

It isn’t, though.  The US can’t tax it because it’s already been fully taxed by the UK.

Let's look at 17.3 for the UK SP adding the country names: (notwithstanding basically means 'ignore')

3. Notwithstanding the provisions of paragraph 1 of this Article, payments
made by a Contracting State [UK] under the provisions of the social security or similar
legislation of that State [UK] to a resident of the other Contracting State [US] shall be taxable
only in that other State [US].

As it stands, 17.3 (for UK SP) only concerns residents of the US - not residents of the UK, and is taxed only in the US when the individual is a resident of the US. (UK residents pay UK tax on the UK SP.) The resident wording is the key sticking point and results in the UK SP not even being discussed in the Treaty for a UK resident, regardless of nationality. [EDIT TO ADD: A USC is taxed by the US on worldwide income and since the Treaty does not mention UK residents of any nationality (when applied for UK SP purposes), there is nothing in the Treaty that would allow the UK SP to be exempt from US taxation for USCs resident in the UK (saving clause or no saving clause). There is an implication, as read by some, that alternatively, the Treaty could mean "payments made ........ to a non-resident of the other Contracting State [US] shall not be taxable in that other State [US]., but that's not what the Treaty states. Although, normally, treaty practice is to limit taxation from all social security sources to the country of residence and this gives credence to the alternative reading.]

When we look at 17.3 in terms of US Social Security, it reads:

3. Notwithstanding the provisions of paragraph 1 of this Article, payments
made by a Contracting State [US] under the provisions of the social security or similar
legislation of that State [US] to a resident of the other Contracting State [UK] shall be taxable
only in that other State [UK].

In this case it's clear US SS is only taxed in the UK when the individual is a resident of the UK, regardless of nationality(s).

As they say, I wish I had £1 for every time this has been discussed on both this site and other expat sites. A satisfactory conclusion is rarely agreed, and as I stated above, it is up to each individual to decide how they wish to proceed.

From your quote above - "The US can’t tax it because it’s already been fully taxed by the UK." I wish this applied to all my foreign (non-US) pensions!   



 

From your quote above - "The US can’t tax it because it’s already been fully taxed by the UK." I wish this applied to all my foreign (non-US) pensions!   

The US can’t tax the UK State Pension because it’s already been fully taxed by the UK.  If a US citizen reports it as taxable, and doesn’t claim credit for the UK tax that they’ve already paid, that’s an unfortunate mistake.

So it doesn’t really matter whether you think the wording of 17.3 is correct or the Technical Explanation is correct: the US can’t tax it, whether you report it as taxable and claim credit, or exclude it from taxation.

If you have UK pensions which are not fully taxed by the UK (and are subject to the Saving Clause) then of course you’ll only get credit for the tax actually paid (zero, if tax-free).

When we look at 17.3 in terms of US Social Security, it reads:

3. Notwithstanding the provisions of paragraph 1 of this Article, payments
made by a Contracting State [US] under the provisions of the social security or similar
legislation of that State [US] to a resident of the other Contracting State [UK] shall be taxable
only in that other State [UK].

In this case it's clear US SS is only taxed in the UK when the individual is a resident of the UK, regardless of nationality(s).

See, I suspect this is why 17.3 is written the way it is.  If I understand correctly, the US social security is not fully taxed by the US in some cases.  Hence the need for the treaty provision making it taxable only in the residence country.  The UK State Pension is always fully taxed, so it doesn’t really need treaty exemption - indeed, as you’ve pointed out, it can be advantageous for a taxpayer to report it as taxable and gain the credits.

Not sure about the rest of the argument, but yes, US  SS pensions are not necessarily always taxable. Low-incomes (usually SS only) may be exempt completely. If mine was to be taxed (which it won't as I'm in the UK) by the USA it would be only 75% of it taxed.  Someone with a higher income might have their whole SS payment taxed.

For interest, here’s HMRC’s take on the treatment of social security benefits under the UK-US DTT:

Article 17(3) now specifically provides for exclusive residence-country taxation of social security benefits. Like the old Agreement it provides that payments made by one of the Contracting States under the provisions of its social security or similar legislation to a resident of the other Contracting State will be taxable only in the other Contracting State. The result is precisely the same as in the old Agreement.

https://www.gov.uk/hmrc-internal-manuals/double-taxation-relief/dt19876

Not sure about the rest of the argument, but yes, US  SS pensions are not necessarily always taxable. Low-incomes (usually SS only) may be exempt completely. If mine was to be taxed (which it won't as I'm in the UK) by the USA it would be only 75% of it taxed.  Someone with a higher income might have their whole SS payment taxed.

Thanks.  I thought I’d read it somewhere.  So without 17.3 (or similar provision), some UK residents receiving US SS might need to claim UK tax relief for US tax withheld.