Trans Atlantic Pensions

VANESSA KNOX examines the pension provisions of the new United States and United Kingdom double taxation convention.

Over the past few weeks, other contributors have commented on the proposed new tax treaty between the United States and the United Kingdom; however, this article is the first to look exclusively at its implications for United States/United Kingdom pensions. Apart from the existing Protocol with Canada, this will be the first United States treaty to allow (in particular circumstances) United States citizens resident in another country to deduct, for United States tax purposes, contributions made to a foreign pension plan. This and other pension provisions attempt to soften the harshness of current United States/United Kingdom practice, in recognition of the increasing frequency with which individuals move between the two countries during their careers.

Signed on 24 July by the United States Secretary of the Treasury and United Kingdom Chancellor of the Exchequer, the treaty has been in preparation for three years. It is now subject to ratification in accordance with the procedures of each country (i.e. consent to ratification by the Senate in the United States and by Order in Council laid before Parliament in the United Kingdom); it will then replace the existing treaty, in force since 1980.

In Article 3(1)(o), the term 'pension scheme' is defined as any plan, scheme, fund, trust or other arrangement established in either contracting state which is:

• generally exempt from income taxation in that state; and
• operated principally to administer or provide pension or retirement benefits or to earn income for the benefit of one or more such arrangements.

The exchange of notes confirms that the definition includes:

• under United Kingdom law: employment-related arrangements (other than a social security scheme) approved as retirement benefit schemes for the purposes of Chapter I of Part XIV of the Taxes Act 1988, and personal pension schemes approved under Chapter IV of Part XIV of that Act; and
• under United States law: qualified plans under section 401(a) of the Internal Revenue Code, individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies section 408(k), individual retirement accounts, individual retirement annuities, section 408(p) accounts, and Roth individual retirement accounts under section 408A), section 403(a) qualified annuity plans, and section 403(b) plans.

The term 'pension scheme', wherever used in this article, reflects the treaty definition.

The pension sections of the treaty are mainly to be found under Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support) and Article 18 (Pension Schemes) although there is interaction with Article 1 (General Scope) and Article 4 (Residence). For example, Article 1(4) is designed to prevent a United States (or United Kingdom) resident from securing a more favourable tax position than a United States (or United Kingdom) citizen resident in his own country; Article 1(5) then identifies specific exclusions from Article 1(4) although, in relation to pensions, these are restricted to Article 17(1)(b), Article 17(3), Article 18(1) and Article 18(2). Article 4 should also be read carefully for the exact definitions (and exclusions) of 'resident of a contracting state'.

The problems stated

The decision to join a United Kingdom pension arrangement has always been a difficult one for any United States citizen or green card holder (i.e. an alien admitted to the United States for permanent residence). The reasons for this are twofold. Firstly, United Kingdom pension schemes are treated as 'non-qualifying' under the Internal Revenue Code, and, as such, enjoy no special protection from United States taxes. Secondly, benefits conferred by funded United Kingdom pension schemes generally vest immediately in the member when the contribution is made.

Accordingly, vested United States members of United Kingdom pension schemes are required to report any employer pension contributions on their United States tax returns; such contributions are treated as compensation paid other than in cash, i.e. taxable remuneration, similar to a United Kingdom P11D benefit. In addition, highly compensated employees (section 414(q), Internal Revenue Code) must report their vested accrued benefit, i.e. capital gains, both realised and unrealised, plus investment income as current income of the reportable year.

Practical advice

United States taxpayers can improve this position. Instead of joining the United Kingdom employer's pension arrangements, they opt to receive an amount equivalent to the pension contributions as additional salary, taxable in the United Kingdom, which is then contributed to a personal pension on their own behalf. This allows the employee to:

• claim a United Kingdom tax deduction for the personal pension contribution (which renders the 'salary increase' United Kingdom tax neutral) and
• either exclude the 'salary increase' for United States tax purposes under the United States foreign earned income exclusion ($78,000 in 2001 – section 911, Internal Revenue Code) or, alternatively, use available excess foreign tax credits against the resulting liability. These credits occur in respect of the higher amount of tax actually paid in the United Kingdom than would have been levied in the United States on the same level of earned income. The credits are a 'use it or lose it' benefit under United States law which, if unused within five years of the tax year in which they are credited, become forfeit.

In either event, for United States tax purposes, the pension contribution amount then becomes the employee's investment in the contract, i.e. deemed to be his own personal tax-paid funds. If the employee is United States resident at the time benefits are received, consideration for the total amount of investment in the contract is made in the United States tax treatment of the pension annuity (similar to the United Kingdom tax treatment of purchased life annuities).

Benefits of the new treaty

Pensions-in-payment, including state pensions, will only be taxed in the country where the individual is resident when benefits are received (Article 17(1)(a) and 17(3). This follows Article 18 of the current treaty.

Under Article 18(2), the new treaty will provide a new and valuable protection for:

• United Kingdom nationals, employed or self-employed in the United States but with benefits in a United Kingdom pension scheme; and
• United States citizens, employed or self-employed in the United Kingdom but with benefits in a United States pension.

In either case, contributions paid by individuals (or on their behalf) to the home country scheme while resident in the host state will be tax-deductible (or excluded from chargeable income) in the host state. In addition, contributions paid to or benefits accrued under the home country scheme will not be taxed as the individual's income.

Quite logically, to ensure that expatriates do not receive preferential treatment over United States citizens or United Kingdom nationals resident in their own countries, each state will restrict reliefs to the amounts generally available to its residents. However, Article 18(3) states that the reliefs will only be available where participation in the home country scheme pre-exists expatriate status. Transfers of benefits to similar or substitute arrangements will be permitted.

Expatriates with home country benefits will no longer be taxed on the annual investment growth within their pension scheme on an arising basis (Article 18(1)). Tax will be deferred until benefits are taken.

Lump sum payments from a pension scheme established in one state will only be subject to the tax treatment applicable in that state, regardless of whether the benefit is received by a resident of the other state (Article 17(2)).

This means that a United Kingdom national, resident in the United States, will be able to claim his much beloved United Kingdom tax-free cash lump sum free of United States tax. This will be a significant improvement on the current position where the lump sum payment is treated as a cash withdrawal prior to the annuity starting date (generally, fully taxable). Interestingly, because of the overriding nature of Article 1(4), it does not appear that United States citizens will reap a similar benefit.

Article 17(1)(b) expands the position. It excludes from tax any pension or remuneration received from a pension scheme situated in one state by a resident of the other state, but only to the extent that it would have been tax free if the benefit had been claimed locally.

Article 18(5) addresses the case of a United States citizen employed in the United Kingdom by a United Kingdom resident employer (with earnings subject to United Kingdom tax) and a member of that employer's United Kingdom pension scheme.

In these precise circumstances, and only during the period of United Kingdom employment, where contributions are paid in respect of that employment to an approved/tax-exempt arrangement:

• Pension contributions paid by the United States citizen will be tax deductible in the United States as well as in the United Kingdom. If contributions are made by an employer, such payments will be excluded from the employee's United States tax computation.
• Employer contributions paid to, or benefits accrued under, the employer's United Kingdom pension scheme will not be taxed as the employee's income in the United States.

The paragraph is specific to these explicit circumstances; there is no cross reference to United Kingdom nationals, working for United States employers in the United States and participants in United States qualified plans.

The reliefs will be restricted to the amounts which qualify for tax relief in the United Kingdom, and are available to United States residents under generally corresponding schemes established in the United States. Furthermore, if the individual is also eligible to participate in a United States pension scheme, eligibility for United States benefits will be restricted by the contributions to and accrued benefits under the United Kingdom scheme (which, for purposes of the calculation, will be deemed to be a United States scheme).

A United Kingdom national, resident in the United Kingdom, but also a United States green card holder will no longer be deemed to be a resident of the United States unless he has a substantial presence, permanent home or habitual abode in the United States (Article 4(2)).

For pension purposes, this represents a considerable improvement in the current position, where green card holders are as potentially liable to United States tax on their United Kingdom pensions as United States citizens. However, it will not apply to benefits which have accumulated pre-treaty.

An individual can elect out of the treaty (Article 29(3)). It is not the purpose of any treaty to increase an individual's tax liability. Accordingly, where the current convention (or statute) provides a better tax position than the proposed treaty, the individual may so elect. The current treaty will then have effect in its entirety in respect of that person for a 12-month period.

The treaty provides a zero rate of withholding tax on dividends received by qualifying pension funds (Article 10(3)(b)).

Disadvantages of the new treaty

Although the 'aspiration date' for implementation is 1 January 2002, it should be noted that the current treaty took four years to ratify!

The treaty will not be retrospective (Article 29(3)). This means that the treaty cannot provide protection to any United States taxpayer (not necessarily a citizen) with benefits already accumulated up to the ratification date; such individuals will continue to be taxed under statute.

At the Inland Revenue treaty briefing at Somerset House on 26 July, it was stated that United States citizens who are self-employed in the United Kingdom are excluded from the provisions of Article 18(5) as a specific limitation by the Internal Revenue Service. This means that, for the self employed, including many highly paid partners in professional and other partnerships, the United States tax implications of United Kingdom pensions will remain as onerous as ever.

Even for United States citizen employees who fall squarely within the provisions of Article 18(5), the treaty offers no visible means of creating or recouping their investment in the contract in respect of employer contributions or plan earnings.

This represents a lost opportunity for the employee who intends to retire in the United States. If, instead, he elected out of the treaty, reported the employer contributions and used excess foreign tax credits as 'currency' with which to 'pay' or offset United States tax liability, then he would secure a United States investment in the contract which would never be taxable in the United States. This is an effective use of tax credits which can rarely be used elsewhere.

Grey areas

We are checking certain ambiguities with the United Kingdom and United States tax authorities. Among others, we have raised the following queries:

• Will treaty protection extend to Article 18(5) employees where there is no obvious link between the contributions, the accumulating benefits and the employer? (for example, those employees who are not offered (or choose not to join) the employer's pension scheme and, instead, contribute to a personal pension on their own behalf).
• Would a transfer of employer-provided benefits by an Article 18(5) employee to a personal plan (with no connection to the employer) cause loss of treaty protection?

At the Somerset House briefing, the Revenue indicated that this might be the case, but wished to consider the point in more detail.

Planning opportunities

The proposed treaty creates some new tax planning opportunities, removes others and leaves some unaffected. The following are limited examples.

Place of retirement

The most important question to ask any Article 18(5) employee will be 'where do you intend to retire?'.

If in the United Kingdom, the treaty will provide the best tax position; tax liability on employer contributions and plan earnings will be deferred until benefits are taken, then taxed only in the country of receipt. Conversely, if the employee intends to return to the United States, he will be better to elect out of the treaty, use excess foreign tax credits to offset United States tax on employer contributions and create investment in the contract to reduce United States tax when benefits are ultimately received.

Reduced pensions

United Kingdom nationals, taking their benefits in the United States, will for the first time be able to take the United Kingdom tax-free cash lump sum also free of United States tax. But what about the reduced pension?

• If the pension is to be taken as a conventional annuity, this could be paid in arrears (say, annually). It should therefore be possible to receive the cash lump sum free of tax under Article 17(2) and immediately elect out of the treaty; the first annuity payment will then be received in a different 12-month period. Furthermore, because a conventional annuity meets United States annuity requirements under section 72(f), Internal Revenue Code, any existing investment in the contract can be flowed out over the policyholder's mortality as a non-taxable component of the income received.
• If the pension is taken under 'income drawdown', generally the position is different. Income drawdown does not meet the conditions of section 72(f) due to the flexibility as to how much and when such income is provided. This means that United States tax treatment of the withdrawal is interest first, capital last; investment in the contract is not apportioned equally across pension instalments and becomes difficult to recoup. Also, policyholders who commence withdrawals before age 59½ will be subject to a ten per cent tax surcharge.

Nevertheless, there is one United Kingdom personal pension/income drawdown contract which meets section 72(f) requirements; this appears to provide the same tax result as a conventional annuity.

Pre-emigration planning

Over recent years it has become increasingly common for United Kingdom nationals to emigrate to the United States on retirement. In this situation, pre-emigration planning is imperative and carries very significant advantages.

Many advisers take the position that individuals who receive pensions for services performed outside the United States (when a non-resident alien) have an investment in the contract as at the day that they move to the United States (section 402(b), Internal Revenue Code); in addition to accrued investment earnings, the tax basis would include all previous employer/employee contributions (section 72(f)(2), Internal Revenue Code). However, while this is a constructive argument, the Internal Revenue Service has not ruled in this area.

If certainty is to be provided, it is necessary to roll over (i.e. transfer) accumulated benefits into a new contract as close as possible, but prior, to the date on which the individual will become United States resident. For United States tax purposes, this would be an income recognition event.

An income recognition event would require a United States taxpayer to recognise tax liability on any portion of the benefit which had not previously been taxed (generally, investment earnings) and would provide an uplift in tax basis. This means that the entire fund value (at date of transfer) becomes investment in the contract going forward. However, for a United Kingdom national with no current links to the United States, a rollover would provide the uplift in tax basis without United States tax liability.

Tax free cash can be taken before or after becoming United States resident; if after, the treaty will provide protection from United States tax liability on investment earnings accrued since the rollover. Pension income should be taken outside the treaty (as described above) in order to access investment in the contract throughout the income stream.

So far, so good

A general comment on the treaty would be: so far, so good, but not far enough. Depending on their retirement intentions, the position for United States citizen employees is more complicated than before; for the self employed and those with pre-treaty benefits, the position is unchanged. While the easements are welcomed, as in the past (but perhaps more so than ever) specialist advice will be essential.

Vanessa Knox is a director of Knox Financial Consulting Ltd and also a consultant to Chown Dewhurst, Limited Liability Partnership. She can be contacted on 020 7730 8336; e-mail: knoxfincon@aol.com.

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