Individuals that have lived in the U.K. but then move to the U.S. may have U.K. pensions. One question that arises at times is whether a lump-sum distribution from the U.K. pension is tax-free in the U.S. under the U.K.-U.S. Income Tax Treaty (the “Treaty”). Unfortunately, the distribution is not tax-free.
The issue is whether Article 17(1)(b) or Article 17(2) of the Treaty applies to the distribution.
If Article 17(1)(b) applies, then U.S. tax should be avoided. On the other hand, if Article 17(2) applies, U.S. tax would be imposed on the distribution.
Article 17(2) applies to “lump-sum” distributions. If the pension distribution is treated as a “lump-sum” distribution under the Treaty, then U.S. tax would be imposed.
This brings up the question: What is the definition of a “lump-sum” distribution? U.S. tax law has one definition and U.K. tax law has another 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 (such as a 25% distribution) to a U.S. resident, the distribution would not be a lump-sum distribution under U.S. rules. This sounds appealing because it would mean that Article 17(2) would not apply, and the individual could potentially avoid U.S. tax under Article 17(1)(b).
Treaties often define terms that they use. Unfortunately, the Treaty does not define the term “lump-sum.” Article 3(2) of the Treaty provides that in applying the Treaty, unless the context otherwise requires, any term used but not defined in the Treaty will have the meaning that it has under the law of the country whose tax is being applied. Since we are trying to determine if U.S. tax will be imposed, we would apply the U.S. definition of the term, unless the context otherwise requires.
We need to determine if the context of Article 17(2) (where the term “lump-sum” is used) requires use of the U.K. definition instead of the U.S. definition.
Article 17(2) was specifically added to the Treaty to prevent a perceived abuse of the Treaty. If one were to apply the U.S. definition of “lump-sum”, the perceived abuse could continue. Therefore, the context requires that the U.K. definition of lump-sum be used. This means that Article 17(2) applies.
Since the saving clause applies to Article 17(2), U.S. tax would be imposed on the entire “lump-sum” distribution.