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Double taxation or double exemption?
Our client, a UK resident and domiciled husband and wife have United States individual retirement accounts (IRAs), which arise from a period when they worked in the USA. The husband must opt for either total repayment or annual instalment payments.
According to form 1099-R, no tax is to be deducted in the USA.
Double taxation or double exemption?
Our client, a UK resident and domiciled husband and wife have United States individual retirement accounts (IRAs), which arise from a period when they worked in the USA. The husband must opt for either total repayment or annual instalment payments.
According to form 1099-R, no tax is to be deducted in the USA.
It would seem that these payments are exempt from UK tax under Article 17 of the double taxation treaty between the UK and the USA, up to the level of any US liability (see the Inland Revenue's 'special edition' Tax Bulletin, April 2003, page 11), but will US tax returns be required, especially if annual payments are taken rather than a lump sum?
Readers' advice would be very much appreciated here.
(Query T16,533) — Michael.
The US tax treatment is that the couple have investments held within individual retirement arrangements (IRAs). Growth in these investments is normally free of United States tax, where the taxable event is typically when distributions are made. An individual can indeed either choose to take the entire amount as a lump sum (and may well be able to elect to have no withholding tax should this occur) or, instead, take regular payments from an IRA.
Distributions from an IRA will be taxable in the UK when they are taxable for US tax purposes (as and when distributions are made) with the same cost basis that the IRA has for US tax purposes.
The Inland Revenue's view has changed as a result of the latest US/UK tax treaty, so that the Revenue now says that 'for example, a distribution from a US IRA to a UK resident will be exempt from tax in the UK to the same extent the distribution would be exempt from tax in the US' (Inland Revenue Special Tax Bulletin) under Article 17(1)(b). The point is covered in greater detail in the Double Taxation Relief Manual at para DT19876A.
There seem to be certain flaws in para DT19876A, in that it does not mention that some individuals may still be subject to either the remittance clause or the saving clause. So, for such individuals, relief under the new treaty may not be available in the manner that the Inland Revenue describes.
Although the individuals concerned are UK resident and domiciled, they may still hold green cards which either are valid for US immigration purposes or where notice of their termination has not been given to the Secretary of Homeland Security as required under section 877 of the Internal Revenue Code as amended by section 804 of the American Jobs Creation Act of 2004. If these individuals fall within these provisions, then they are subject for the most part to the saving clause, so they could only claim relief under Article 17(1)(b) as described in the Special Tax Bulletin if that clause is exempt from the saving clause. The first question to ask in such cases is whether Article 17(1)(b) is excluded from the savings clause. According to the Treasury Department Explanation, p.65, 'subpara 1(a) is subject to the saving clause of para 4 of Article 1 (General Scope) while subpara 1(b) is not, by reason of the exception in subpara 5(a) of Article 1'. Therefore, because Article 17(1)(b) is not subject to the saving clause, even if these individuals are treated as if they were US citizens for most purposes, they can now have the beneficial tax treatment of exemption from UK tax on distributions to the same extent as such distributions are exempt from US tax.
What they could not have, however, is complete exemption from US tax under Article 17(1)(a), because this is still subject to the saving clause. The questions that Article 17 leaves unanswered are therefore when and how growth or distributions for individuals subject to the saving clause are taxable in the UK. Are they still taxable as they were historically, as interest, dividends, offshore income gains, capital gains, etc., on an arising basis? The Revenue does not address this point at para DT19876A.
The Revenue does, however, state in para DT19876A that after 2003-04 'the new agreement takes precedence and this will mean that no liability will arise until it would have done so under US tax law'. However, this bland statement does not take account of individuals subject to the saving clause or remittance clause, so without knowing if these might apply, reading this sentence in isolation is insufficient. It appears therefore that the drafters of para DT19876A were probably taking into account not just Article 17 (which deals with pension payments), but also the consequences of Article 18(1) (relating to pension schemes).
The US Treasury Department Explanation in respect of Article 18, states that 'para 1 is not subject to the saving clause of para 4 of Article 1'. Individuals subject to the saving clause could, therefore, also have relief under Article 18(1), which states that as these individuals are residents of the UK and members of a US pension scheme, 'income earned by the pension scheme may be taxed as income of the individual only when … and to the extent that it is paid to … that individual'.
The UK should therefore treat the IRAs as pension schemes under Article 18(1). Any amounts distributed in excess of basis (i.e. the amounts contributed by the husband and wife) are then taxable only in the UK. The fact that the IRA may have owned such things as US mutual funds that historically would have given rise to offshore income gains can now therefore be ignored, because the UK should be treating this as pension income. Under Article 17(1)(b), therefore, some fraction of any distribution may thus be exempt from UK tax. In addition, the UK exempts 10% of the taxable amount under TA 1988, s 65(2). Thus, overall, some part of any regular distribution will not be taxable in the United Kingdom.
But what should happen if a lump-sum distribution is taken instead? Under Article 17(2), a lump sum is only taxable in the United States. Such income would typically be taxable at graduated US tax rates (even if no tax is withheld). While this lump sum would be exempt from UK tax, there will be US tax payable in the year that the lump sum is paid.
And so, should one recommend filing of United States income tax returns? These are required if a lump sum distribution is taken because tax will be payable. Should regular distributions be made, then because the income will be taxable only in the UK, there is no US tax payable and therefore there will be no requirement to file US tax returns each year.
