We write this article because we frequently have clients come to us after having read another blog or after their own casual reading of an income tax treaty. They often believe their income should be excluded; and more often than not, it is incorrect.
The United States has tax treaties with a number of foreign countries (link). Under these treaties, residents of foreign countries are taxed at a reduced rate, or are exempt from U.S. taxes on certain items of income they receive from sources within the United States. Tax treaties are convoluted and need to be read carefully.
Example IRA distribution for U.S. expat in the U.K.
Bob is a U.S. citizen residing in the U.K. and has a traditional IRA in the U.S. He receives a distribution from the IRA while residing in the U.K. Is he subject to tax on it in the U.K. or the U.S., or both?
Step 1: Determine residency
After locating the applicable treaty (link), Bob would read Article 4 to see if he qualifies as a “resident” of either the U.S. or the U.K. (or both) under the U.S.-U.K. treaty.
Generally, an individual is a U.S. resident under U.S. domestic law and for treaty purposes if he is a 1.) U.S. citizen, 2.) U.S. green card holder, or 3.) meets the substantial presence test. Exceptions may apply (e.g., certain visa exceptions to SPT, first year elections).
To determine if Bob is also a resident of the U.K. it would be necessary to look to the domestic laws of the U.K. If Bob is a resident of both the U.S. and the U.K., treaty tie-breaker rules will apply to resolve competing claims to residency.
For purposes of this example, we’ll assume Bob is determined to be a resident of the U.K after applying treaty-tie breaker rules.
Step 2: Classify the income
After determining that he has a U.S. private pension, Bob would locate the applicable provision in the tax treaty – in this case Article 17 “Pensions, Social Security, Annuities, Alimony, and Child Support.”
Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that State.
Bob is a resident of the U.K.; therefore, “Contracting State” and “State” refer to the U.K. If this is not a lump-sum payment or annuity, Bob need not read any further of Article 17. The provision above allows the U.K. to tax the IRA distribution.
Step 3: Determine if the saving clause applies
It would be a mistake for Bob (and a very common one) to stop at Step 2 and claim a tax treaty position on the U.S. return to exclude the IRA distribution.
All tax treaties that the U.S. is a party to contain a provision that is referred to as a “saving clause.” This provision reserves the right of each contracting state to tax its residents and citizens, even if they are residents of the other contracting state.
Article 1 Paragraph 4 states that:
Notwithstanding any provision of this Convention except paragraph 5 of this Article, a Contracting State may tax its residents (as determined under Article 4 (Residence)), and by reason of citizenship may tax its citizens, as if this Convention had not come into effect.
In other words, despite what Article 17 says, the U.S. still has the right to tax its residents (as defined under U.S. law) on worldwide income.
Then what exactly is the point of even having a tax treaty? The tax treaty assigns primary taxing jurisdiction to one or the other country (sometimes partially both). In this case, the primary taxing jurisdiction with respect to the pension distribution is the U.K. The U.S. may also tax the income, but must provide foreign tax credits to offset taxes paid to the U.K.
Step 4: Determine if there is an exception to the savings clause
Because life’s not fun without an exception to an exception – Article 1 Paragraph 5 contains a number of exceptions to the savings clause. The one relating to Article 17 is:
The provisions of paragraph 4 of this Article shall not affect….sub-paragraph b) of paragraph 1 and paragraphs 3 and 5 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support).
Sub-paragraph b of Article 17, paragraph 1 would apply if the U.S. pension was non-taxable to a U.S. resident (or vice versa for the U.K). Paragraph 3 of Article 17 would apply to social security type distributions. And Paragraph 5 of Article 17 would apply to pension distributions made under alimony and child support agreements. None of these apply to this situation.
Step 5: Claim either a treaty-based return position or foreign tax credits
Applying Article 17 and the savings clause, Bob should report his pension distribution on his U.K. tax return. Then he should report the distribution on his U.S. return and claim a foreign tax credit for the U.K. taxes paid on the distribution. Note: the foreign credit in this case should be classified as “certain income resourced by treaty” instead of as passive category income.
If the situation were different and Bob was able to exclude the income on his U.S. return, he would make a treaty-based return position disclosure on Form 8833.
Tax treaties should be read thoroughly when applying for tax treaty benefits. For example, any one of these two situations could have drastically changed the above result: a Roth instead of traditional IRA or a lump-sum distribution.