Today we updated our flowchart analyzing the U.K.-U.S. Income Tax Treaty (the “Treaty”) as it applies to the taxation of U.S. and U.K. pensions. There has been significant uncertainty regarding the definition of the term “lump-sum” in Article 17(2) of the Treaty. The prior version the flowchart did not discuss which definition or definitions of the term “lump-sum” should be used. We have updated the flowchart to include our view on which definitions should be used. Below we provide a brief explanation of why we believe that the U.K. definition of “lump-sum” should be used in one circumstance and the U.S. definition of “lump-sum” should be used in another circumstance.
The Treaty can apply to two distinct pension scenarios:
- Outbound Pensions: The first scenario is a U.K. resident that has a U.S. pension, due to having worked in the U.S. in the past. We refer to this scenario as an “outbound” pension (following the flow of cash outside of the U.S.).
- Inbound Pensions: The second scenario is a U.S. resident that has a U.K. pension, due to having worked in the U.K. in the past. Since cash will be flowing into the U.S. to a U.S. resident, we refer to this scenario as an “inbound” pension (note that this scenario would also apply to a U.S. citizen resident in the U.K. with a U.K. pension).
For outbound pensions, we conclude that the U.K. definition of “lump-sum” should be used. The Treaty provides a general rule that U.S. definitions should be applied to undefined terms when analyzing U.S. tax law. However, there is an exception to this general rule if the context requires otherwise. Using the U.K. definition prevents the abuse that was targeted by the addition of Article 17(2) in 2001. Use of the U.S. definition of “lump-sum” would allow the targeted abuse to continue. Thus, the context of Article 17(2) requires the use of the U.K. definition of “lump-sum” for outbound pensions. Application of the U.K. definition of “lump-sum” to an outbound pension allows the U.S. to tax the distribution and prevents the individual from receiving a windfall.
For inbound pensions, we conclude that the general rule of the Treaty should be applied and that the U.S. definition of “lump-sum” should be used. Moving from the U.K. to the U.S. and taking a partial distribution from a U.K. pension does not result in a windfall (i.e., an unanticipated benefit). If the partial distribution from the U.K. pension would not be subject to U.K. tax while the individual was a U.K. resident (because the partial distribution is considered a lump-sum distribution under U.K. tax law), then exempting the partial distribution from both U.K. and U.S. taxes for inbound pensions would not result in an unanticipated benefit to the individual. Consequently, the context of an inbound pension should not require the use of a definition of “lump-sum” other than the U.S. definition.
Under U.S. tax law, a lump-sum distribution generally means a distribution of the entire balance of the pension in a single year. If a U.K. pension makes a partial distribution to a U.S. person, the distribution would not be a lump-sum distribution under U.S. rules, and Article 17(2) would not apply. When Article 17(2) does not apply, Article 17(1)(b) can apply. Article 17(1)(b) provides that the U.S. must exempt from income amounts that would be exempt from U.K. taxation if the individual were a resident of the U.K. To the extent a partial distribution from a U.K. pension would be exempt from U.K. tax, we believe the distribution should also be exempt from U.S. tax.
As always, for advice specific to your circumstances, we recommend that you speak with a tax advisor.