Navigating the taxation of pensions in the US/UK Double Tax Treaty

By Arvinder Matharu, Prager Metis

A new client recently engaged me to handle a HMRC investigation opened into his UK tax return which was prepared by his previous UK accountant. Specifically, HMRC has queried a claim for double tax relief where the US tax paid was being claimed as a credit against the UK tax liability. On review, the following facts were relevant:

The individual is a US citizen and a tax resident of the UK.

US pension income was being paid to the individual. It should be noted this was an ordinary annual pension payment and not a lump sum.

The US tax paid on the pension was being claimed as a credit against the UK tax due on the same income.

Armed with the above facts, my approach to dealing with the investigation was to answer the following three questions:

What are the UK tax rules with regard to the taxation of the US pension?
What are the US tax rules with regard to the taxation of the US pension?
What does the US/UK Double Tax Treaty say with regards to how the UK and US can tax the pension and the alleviation of the double tax?

Following you can find the answers to above questions:

What are the UK tax rules with regards to the taxation of the US pension?

As a UK resident and prima facie, the individual is subject to UK tax on his worldwide income and gains. This is known as the arising basis of taxation.

Whilst not relevant in this case, it is possible for a UK resident and non-UK domiciled individual to pay UK tax on the remittance basis of taxation. That is, they would only pay UK tax on non-UK income/gains to the extent these are remitted to the UK. If the non-UK income/ gains are kept outside the UK then no UK tax is due. In my case, however, my client was deemed UK domiciled so that the remittance basis of taxation was not available to him.

What are the US tax rules with regard to the taxation of the US pension?

As a US citizen, the individual is subject to US tax on his worldwide income and gains.

What does the US/UK Double Tax Treaty say with regards to how the UK and US can tax the pension and the alleviation of the double tax?

It will have been noted that both the UK and US can tax the US pension thus leading to double taxation. I turned to the double tax treaty to ascertain how the pension would be taxed and how any double tax charge would be alleviated.

Article 17(1) of the treaty awards primary taxing rights on the pension to the UK by virtue of the individual being resident in the UK. This would be the standard stance in virtually all of the OECD style double tax treaties. However, because the US taxes on the basis of citizenship or the individual being a US person (e.g. Green Card holder), the double tax treaty between the US and UK has been modified to take this into account.

Article 1(4) of the treaty (otherwise known as the “savings clause”) states that, irrespective of the various provisions in the treaty regarding taxing rights, the US can, in this case, tax the pension on the basis of my client’s US citizenship.

So, the treaty allows both the UK and US to tax the pension which gives rise to a few issues. The UK will not allow a foreign tax credit for the US taxes paid due to Article 17 of the treaty which awards primary taxing rights to the UK. In addition, Article 24(6)(b) of the treaty provides that the UK will not provide relief for the US tax imposed on its citizens resident in the UK if that tax is solely charged in accordance with the savings clause in Article 1(4) which, in this case, it was. In the absence of any other provision in the treaty allowing some sort of mechanism to alleviate the double tax, the US would refuse a foreign tax credit for the UK tax. This would be on the basis that the pension is US domestic source income and that, therefore, no foreign tax credit relief is available as it is not foreign source income for the purposes of the treaty.

Fortunately, Article 24(6)(c) (Relief from double taxation) comes to the rescue. The provisions in Article 24(6)(c) re- sources the US pension and treats it as UK source income so that, for US tax purposes, the US pension is treated as foreign source income under the treaty. This allows the UK tax paid on the pension to be treated as a foreign tax credit against the US tax due on the pension thus alleviating the double tax charge. However, there is a challenge with this as I have read commentary to suggest that the IRS may resist foreign tax credit claims based on re-sourcing.

Whilst the above provided me with the tax analysis, this unfortunately did not help my client as it meant having to agree with HMRC that no foreign tax credit relief would be allowed for the US tax paid against the UK tax charge on the pension. There was a further problem in that his US accountant has fully subjected the US pension to US tax with no credit for the UK tax paid. I am now having to persuade them of my above analysis so that they can re-file the US tax return with a claim for foreign tax credit relief.

In finishing, I would say that the US/UK Double Tax Treaty is a trap for the unwary as it is not a typical double tax treaty. This may affect the interpretation of how other items of income and gains are taxed and so it should be appreciated that it is not only pensions which are affected. Also, this article focused on the tax issues affecting annual pension payments and not lump sum payments which has a different tax treatment. This will be the subject of a future article.

Published: GGI Insider, No. 124, March 2023 l Photo: sezerozger - stock.adobe.com