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

As I've mentioned previously in this thread, this is a common topic on this and other expat forums where strong arguments are made for all viewpoints, on both topics - US taxation of the UK State Pension for USCs resident in the UK as well as the debate on UK lump sums being taxable in the US.

I wonder why.  The taxation of social security exclusively in the residence country is after all one of the simplest and most straightforward principles of the treaty. 

I suppose the confusion may be partly due to the fact that the UK State Pension is paid gross so that the tax can be taken by PAYE.  This may lead some to think the pension is being untaxed by the UK, but is being taxed by the US.  When in fact, the exact opposite is happening: the pension (when paid to a UK resident)  is being fully taxed by the UK and is not taxed by the US.  If you exclude the pension as exempt by treaty, you don’t pay US tax; if you include the pension as US-taxable income and claim credit for UK tax paid, you get the credit and therefore don’t pay US tax.  The only problem arises when a US citizen reports the pension as US-taxable but fails to claim FTCs for the UK tax they’ve already paid.  Thus they pay tax twice. 

Fortunately, most probably do claim the credit.

The pension lump sum question is a different matter.  The lump sum really is tax-free in the UK, and if it’s not a UK government pension it’s subject to the Saving Clause when paid to a US citizen resident in the UK; so in those circumstances the lump sum can indeed be taxed by the US. (Unless it’s treated by the US as belonging in a category of income which is tax-free under US tax law.)

I wonder why.  The taxation of social security exclusively in the residence country is after all one of the simplest and most straightforward principles of the treaty. 

Taxes For Expats has been a contributor to this forum over the years and was at one time, I believe, a sponsor.

"5. Taxation of Social Security Benefits

U.S. Social Security Benefits

U.S. Social Security benefits received by US citizens and green card holders residing in the UK are exempt from tax in the United States and are taxable only in the UK.

UK State Pension

UK State Pension and other payments received under the National Insurance legislation by US citizens and green card holders residing in UK are taxable in both countries.

Foreign tax credit can be applied to eliminate double taxation."

https://www.taxesforexpats.com/uk/us-tax-preparation-in-uk.html

updated to 2018/19 UK tax year.
scroll about 3/4 of the way down the page

You can choose whether you agree

a) with Taxes for Expats, who say US SS pensions are taxable exclusively by the residence country but UK social security is taxable in both countries, or

b) with the Competent Authority, who say that under the UK-US tax treaty (17.3), social security is taxable exclusively in the residence country.

The result’s the same, for most taxpayers, since the pension’s already fully taxed by the UK: no tax is owed to the US.

For some, excluding the UK State Pension may bring taxable income below the threshold; they won’t need to file a US tax return.

While for some, apparently, as you’ve mentioned, reporting the pension to the IRS and claiming credit for the UK tax paid, may result in excess tax credits.

So take your pick, or take it up with the Competent Authority under the MAP.   

For some, excluding the UK State Pension may bring taxable income below the threshold; they won’t need to file a US tax return.

This could be an especially significant consideration for anyone contemplating renunciation.  If the citizen is below the threshold, they don’t have to file anything except Form 8854 following renunciation; and Form 8854 is not likely to be troublesome, for a former citizen with income below the threshold.

17(3) requires that the recipient be a resident of the "other State" for the exemption to apply. A US citizen who is UK resident is therefore exempt from US tax on US social security pensions.

It is rare for any US citizen who is UK resident to find it material to argue that the Technical Explanation assists where an individual is not a resident of the other State...although under the Vienna Convention this  could be a valid interpretation of the intentions of the negotiating parties. Because of the foreign tax credit, no need to rely on the Technical Explanation in 99% of cases.

It is rare for any US citizen who is UK resident to find it material to argue that the Technical Explanation assists where an individual is not a resident of the other State...although under the Vienna Convention this  could be a valid interpretation of the intentions of the negotiating parties. Because of the foreign tax credit, no need to rely on the Technical Explanation in 99% of cases.

No need to rely on the Technical Explanation, indeed.  There doesn’t seem to be any need to rely on anything, since it’s not going to cause trouble regardless of whether the taxpayer reports the UK State Pension as taxable, or excludes it.   

It’s easy enough to include the UK State Pension as taxable if that’s advantageous or doesn’t make any difference.  And also easy enough to exclude it as exempt, if you agree with HMRC’s statement (that under Article 17(3) social security benefits are taxable exclusively in the residence country).

Article 17(3) now specifically provides for exclusive residence-country taxation of social security benefits.

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

It seems to be a non-issue.   

No need to rely on the Technical Explanation, indeed.  There doesn’t seem to be any need to rely on anything, since it’s not going to cause trouble regardless of whether the taxpayer reports the UK State Pension as taxable, or excludes it.   

It’s easy enough to include the UK State Pension as taxable if that’s advantageous or doesn’t make any difference.  And also easy enough to exclude it as exempt, if you agree with HMRC’s statement (that under Article 17(3) social security benefits are taxable exclusively in the residence country).https://www.gov.uk/hmrc-internal-manuals/double-taxation-relief/dt19876

It seems to be a non-issue.   

HMRCs view has no legal standing in the United States.  It might just possibly assist if someone were constructing an argument using the Vienna Convention where the words of a Treaty are unclear; but they are not.  UK State pension received by a US person who is UK resident  is fully US taxable with a claim for foreign tax credits. Is there a legal opinion to the contrary lurking somewhere?

Why, is one needed?

It all seems to come down to a semantic quibble.  The US clearly isn’t trying to tax the UK State Pension when received by a UK resident, any more than HMRC is trying to tax US Social Security when received by a US resident.  It doesn’t really matter whether a UK pensioner in the UK reports his State Pension to the IRS as “taxable” or not, since it won’t, in fact, get taxed by the US. 

The UK doesn’t care, the US doesn’t care.  Report it, and get the tax credits, or exclude it and file a simpler return or (if below the threshold) no return. 

Or it can be taken up with the horses’ mouths, by writing to the Competent Authority.

HMRC’s view has no legal standing in the United States.

And the IRS’s view has no legal standing in the UK, where we happen to be and where the pension under discussion  gets paid. 

But the UK Government, and the US Government, have reached agreement as to who will tax and who will concede, in order to try to avoid double-taxation (as defined by the treaty); so the views of their respective tax agencies, in their rôle as Competent Authorities, do carry weight via the Mutual Agreement Procedures. 

Presumably, if it turned out that the IRS disagreed with HMRC’s expressed position (that social security is taxable exclusively in the residence country), discussion would ensue and a new common position would be agreed.  Mutual Agreement, as they say. 

(Though it seems to me rather more likely that the two countries have actually already agreed that social security is taxable exclusively in the country of residence, given that that’s what both countries do actually do.)   

The pension lump sum question is a different matter.  The lump sum really is tax-free in the UK, and if it’s not a UK government pension it’s subject to the Saving Clause when paid to a US citizen resident in the UK; so in those circumstances the lump sum can indeed be taxed by the US.

If it is a UK government pension, paid to a UK resident, it’s taxable exclusively by the UK, regardless of the taxpayer’s nationality; the tax-free lump sum is safe from US taxation.

Unfortunately, the OP’s pension doesn’t qualify as a government pension, being paid by USS.   (https://www.gov.uk/hmrc-internal-manuals/international-manual/intm343040)

In short (if I understand correctly), thanks to tax credits and the treaty, the US can only tax the UK-source income of a UK-resident citizen to the extent that it hasn’t already been taxed by the UK; and only then if it’s subject to the Saving Clause. 

Thus a retired dual US/UK citizen who has spent all or nearly all of their working life in the UK, and has only UK-source income, may well find that their US-taxable income is below the threshold and they are therefore not required to file a US tax return. 

They can peacefully decide whether they prefer

(a) to continue as US citizens, signing the W-9 for FATCA purposes; or

(b) to renounce US citizenship, in order to get the CLN and thus simplify banking, investing, will-making, etc; in which case they'll need to make an appointment at the Embassy; pay the $2350 and swear the oath of renunciation; and file Form 8854, the following year, in order to notify the IRS that they are now (in IRS jargon) a “non-[US]-resident alien,” and are no longer subject to US tax law.  (Or, of course, with no US-source income, they can just renounce, without filing any US tax forms, given that they cease to be a US citizen as soon as they swear the oath; they can ask the Embassy for a letter confirming that they’ve renounced, which they can show to FIs while waiting for the CLN; or just show the receipt.)

Apologies for multiple edits.  I’ll stop now. 

The pension lump sum question is a different matter.  The lump sum really is tax-free in the UK, and if it’s not a UK government pension it’s subject to the Saving Clause when paid to a US citizen resident in the UK; so in those circumstances the lump sum can indeed be taxed by the US. (Unless it’s treated by the US as belonging in a category of income which is tax-free under US tax law.)

However: the Technical Explanation seems to say that the OP’s “lump sum” might not be taxable by the US.

The Technical Explanation says:

The State of residence, under subparagraph (b), must exempt from tax any amount of such pensions or other similar remuneration that would be exempt from tax in the State in which the pension scheme is established if the recipient were a resident of that State.

and, under “Relation to other Articles:”

Subparagraph 1(a) is subject to the saving clause of paragraph 4 of Article 1 (General Scope) while subparagraph 1(b) is not, by reason of the exception in subparagraph 5(a) of Article 1. Thus, a U.S. citizen who is a resident of the United Kingdom and receives a pension will be subject to U.S. tax on the payment, notwithstanding the rules in those paragraphs that give the State of residence of the recipient the exclusive taxing right. However, a U.S. citizen who receives a distribution from a pension scheme established in the United Kingdom will be taxable on only the portion of the pension distribution that is taxable in the United Kingdom.

https://www.treasury.gov/resource-center/tax-policy/treaties/Documents/teus-uk.pdf

Considering that US tax on 25% of a uK university pension could be a fair chunk of cash, if I were in this situation I think I would suck it and see, by treating the 25% as exempt and reporting the position on 8833.  (Prudently keeping enough cash on hand to pay up should the IRS not accept the position.)

I agree with Underfall. Don't pay it.  Claim it as tax free on the 8893 or whatever it's called an and quote the treaty reference. I would bet it would be fine.

I take a series of equal payments and in each distribution I claim the 25% portion tax free. A nice twist is to allocate the remaining 75% to the basis I have in the pension - i.e. I don't waste the 25% - the 25% comes from the profits which are taxable (not part of the basis).

PM me if you want to contact a US tax attorney who will support this position.

A

I agree with Underfall. Don't pay it.  Claim it as tax free on the 8893 or whatever it's called an and quote the treaty reference. I would bet it would be fine.

If the IRS agrees that it falls under 17.1(b) rather than 17.2.  Logically, if one takes that position and the IRS disagrees, one should surely be prepared to pay up, including possible interest and penalties.

Or, if dual and no longer content to be taxed by the US forever on one’s non-US income, an alternative would be to renounce and file no more.

Citizenship-based taxation is a condition of keeping the citizenship - it’s not the law of the land.  When the disadvantages of US citizenship outweigh the advantages, it’s sensible and honourable and perfectly legal for a UK dual citizen to renounce the US citizenship, if that’s their choice.  The minute the oath of renunciation has been sworn, one is no longer a US citizen and need not file any further US tax forms. 

If one does want to keep the citizenship, however, in my book there’s no option but to adhere to the terms and conditions, which unfortunately do include the US tax code.   

There is:
(a) an obvious and potentially huge financial benefit to taking a UK tax-free lump sum of 25% from a UK private pension and
(b) this option is very commonly available in many private pensions in the UK.

I would have thought many UK-resident-US-citizens would have done this by now. So I am surprised to see that, at least as of 2-1/2 years ago (when this thread started), there is still so much debate about whether the US taxes that 25% lump sum!

Has this been concretely resolved since this thread began? 

I suppose I am asking whether:
(1) the IRS has issued a definitive and deterministic answer specifically about this question? or
(2) whether many people have issued tax returns specifically claiming it as exempted (for example as a treaty exemption under Form 8833) and seen no blowback from the IRS?