(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since 1975 and which had become outdated with respect to pensionrelated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
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
(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 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
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.