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US-UK Tax Treaty Liberalizes Cross-Border Pension Treatment

Margolis, Steven M.

(August 2004, Employer Update)

By Steven M. Margolis
A new tax treaty between the United States and the United Kingdom - effective in the UK on April 6, 2003 and in the US on January 1, 2004 - provides significant tax relief for employees who are citizens of one of these countries but are employed in the other country. In this era of increased employee mobility, this will allow employers to more freely transfer employees between the US and the UK for strategic business opportunities without fear that these moves will have adverse tax consequences on the employees’ pension and retirement benefits. The treaty is particularly significant because, among other things, it will allow US citizens resident in the UK to deduct, for US tax purposes, contributions made to certain UK pension plans. Similarly, employer and employee contributions made on behalf of US or UK expatriate employees will be treated as though such contributions were made in the country in which the pension plan is maintained. The Tax Treaty also addresses the exercise of stock options granted to an employee who remains employed by an employer but who resides in both the US and the UK during the period between the grant and exercise of such option.


The United States and Great Britain entered into this new tax treaty on July 24, 2001 and was amended by protocol in 2002 and has been modified by Technical Explanations of the US Department of the Treasury (collectively, the “Tax Treaty”). The Tax Treaty was formally ratified on March 31, 2003 and became effective in the UK on April 6, 2003 and in the US on January 1, 2004. This Tax Treaty replaces the prior treaty which had been in effect since 1975 and which had become outdated with respect to pensionrelated issues in this age of increased employee mobility.

Benefits Taxable in Country in Which Individual Resides

Article 17 of the Tax Treaty provides, as a general rule, that pension benefits paid to an individual will be taxable only in the country in which that individual then resides. However, the country in which the individual then resides must exempt from tax any amount of such pension benefit if such benefit would be exempt from taxation in the country in which the pension plan was established. For example, a distribution from a USbased Roth IRA to a UK resident would be tax exempt in the UK to the same extent it would be exempt from tax in the US if distributed to a US resident. In addition, a transfer by a UK resident of US pension funds between pension plans, e.g., a rollover, would continue to be exempt from tax, as it is not deemed distributed for US or UK purposes.

Lump Sum Exception. An exception to the above rule concerns lump sum distributions. Lumpsum payments to an individual - regardless of where the individual resides - will be taxable in the country where the pension plan is established. However, due to the Tax Treaty’s “savings clause,” the country where the individual resides is still able to tax the lump sum distribution. This exception was enacted to avoid the lump sum distribution being exempt from tax in both the US and the UK, because the UK does not tax lump sum pension distributions, and individuals who anticipated receiving a lump sum distribution from a US pension plan were previously able to avoid US withholding tax on such distribution by establishing residence in the UK for the year in which the distribution was to be received. The impact of the savings clause, though, allows the US to tax such distributions from a UK pension plan to a US resident.

Taxation of Pension Contributions

Article 18 of the Tax Treaty deals with cross-border pension contributions and is generally intended to remove barriers to the flow of personal services (i.e., employees) that could otherwise result from differences in the US and UK laws regarding the deductibility of pension contributions. This is the first US tax treaty to allow US citizens residing in another country to deduct, for US tax purposes, contributions made to a foreign pension plan.

US Citizens Residing in the UK and Participating in a UK Pension Plan. The Tax Treaty allows US citizens resident in the UK to deduct, for US tax purposes, contributions to a pension plan established in the U.K. This deduction is only available while the US citizen continues to reside in the UK. The US citizen’s deduction is limited to the lesser of (1) the amount deductible in the UK for contributions and benefits under a UK-established pension scheme and (2) the amount that would be deductible in the US for contributions and benefits to a generally “corresponding pension scheme” established in the US. In addition, US citizens will not be taxed by the US as the pension benefit accrues, provided the UK-established pension scheme is a generally “corresponding pension scheme” (as described below).

Corresponding Pension Schemes. The Notes to the Tax Treaty state that “corresponding pension schemes” include:

In the UK: (1) Approved employment-related retirement benefit schemes (for purposes of Chapter 1 of Part XIV of the Income and Corporation Taxes Act of 1988) and (2) Personal pension schemes approved under Chapter IV of Part XIV of such Act).

In the US: (1) Qualified plans under IRC § 401(a), e.g., 401(k) plans, (2) Individual Retirement Accounts (including traditional, SEP and Roth IRAs) and (3) Qualified plans under IRC § 403(a) and (b).

Employees Residing Abroad But Participating in Home Country Plans. For both US and UK citizens, the Tax Treaty provides that each may stay in their home country pension plans when working and residing in the host country without suffering the current potential for adverse tax consequences. The Tax Treaty allows employees transferring between the UK and the US (and vice versa) to remain in their respective home country pension plans without having employer contributions to these plans taxed as imputed income by their host countries. In addition, both employer and employee contributions to the home country pension plan will be tax-deductible in the host country. However, the above rules only apply if:

(1) The tax relief granted by the host country for employee contributions to home country plans is limited to the amount of relief that would have been available under a pension plan established in the host country, e.g., a UK resident who participates in a US 401(k) plan would not be able to deduct more than the 401(k) limit proscribed under IRC Section 402(g) (for 2004, $13,000).

(2) The employee must have already been a member of, and participating in, the home country pension plan before moving to the host country.
(3) If the employee is only taxed on the amount remitted or received in the host country, the available tax relief will be reduced proportionally.
(4) The pension plan must be accepted as a generally “corresponding pension scheme” (as described above) by appropriate authorities in the host country.

For example, this means that a US citizen temporarily working in the UK may continue to make contributions to a US-based 401(k) plan, and the individual may deduct or exclude from income in the UK such contributions to the 401(k) plan.

Plan Earnings Not Taxed Until Distributed. For both US and UK citizens, the Tax Treaty provides that earnings under the home country pension plan or scheme while the employee residing in the host country, will not be taxed until a distribution is made from the applicable pension plan or scheme. Thus, for example, a US citizen who contributed to a 401(k) plan will not be taxed by the UK on the earnings and build-up of the 401(k) account if he subsequently becomes a UK resident. Rather, such earnings and build-up will be taxed upon distribution in accordance with Article 17 of the Tax Treaty.

Taxation of Stock Options

The Notes to the Tax Treaty also include guidance on avoiding double taxation of income earned from the exercise of stock options granted to employees who worked both in the US and the UK. In particular, the Notes state that any benefits, income or gains enjoyed by employees under stock option plans fall within the scope of Article 14, as a form of “other similar remuneration.” This is applicable where an employee:

  • has been granted a share/stock option in the course of employment in either the US or the UK;
  • has been employed in both the US and the UK during the period between the grant and exercise of the option;
  • remains employed by the US or the UK employer at the time the option is exercised; and
  • under the US and the UK tax laws, would be taxed by both the US and the UK with respect to such option gain.

The Tax Treaty provides that the home country, i.e., in this case, the country in which the stock options were granted but in which the employee no longer resides, is to tax only the pro-rata portion of the income based upon the period of time from the grant of the stock options to the exercise of such options in which the employee was employed in the home country.

The Technical Explanation to the Tax Treaty, issued by the Department of the Treasury, illustrates the mechanics behind this pro-rata allocation. Specifically it states that the “portion attributable to a Contracting State will be determined by multiplying the gain by a fraction, the numerator of which is the number of days during which the employee exercised employment in that State and the denominator of which will be the total number of days between grant and exercise of the option.” For example, on January 1, 2004, Company X grants an employee an option to purchase 100 shares of stock at $5 per share. The employee is residing in the US at the time of the grant but moves to the UK on January 1, 2006 while continuing employment with Company X. On December 31, 2006, while still employed by the company in the UK, the employee exercises the option while the stock is valued at $20/share. Under the Tax Treaty, the two-thirds of the option gain would be subject to tax in the US (based on employment in the US from January 1, 2004 through December 31, 2005) and one-third of the option gain would be subject to tax in the UK (based on employment in the UK from January 1, 2006 through December 31, 2006).

It is not clear from the Tax Treaty or the Notes if this same treatment would be afforded to other types of equity-based compensation, such as restricted stock or stock appreciation rights.


Although the Tax Treaty leaves open areas for interpretation, the Tax Treaty does present planning opportunities for employers with US and UK operations and employees who will work in both countries. This will be beneficial to both employers and employees, as it should encourage these employees to willingly work among these countries without their pension benefits being adversely affected.
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