The general rule is that U.S. tax residents are subject to tax on their worldwide income from any source, including U.K. pension. The good news, however, is that treaties can be utilized to change this general rule.

Whenever U.S. taxpayers are confronted with an international tax issue, they need to know that there are two separate and distinct bodies of law that could potentially apply to their issue. First, there is domestic U.S. tax law; Title 26 of the United States Code, which is known as the Internal Revenue Code. Second, there is international treaty law; the Convention Between the Government on the United States of America and the Government of Great Britain and Northern Ireland for the Avoidance of Double Taxation, which is more commonly known as the U.S.-U.K. Income Tax Treaty. Domestic U.S. tax law applies by default unless a taxpayer specifically elects to apply the treaty by filing IRS Form 8833. If a U.S. taxpayer applies the benefits of a treaty, it supersedes domestic law.

Under domestic U.S. tax law, income within and distributions from a U.K. pension are subject to U.S. taxation just like any other pension income.

Under the U.S.-U.K. Income Tax Treaty, however, there is an opportunity to lawfully avoid U.S. taxation on the 25% Pension Commencement Lump Sum (PCLS) portion under Article 17, Paragraph 1(b) of the U.S.-U.K. Income Tax Treaty. Furthermore, our firm can take the position that, pursuant to the treaty, there is no U.S. tax on the growth during the accumulation phase.

It is important to note that there are highly technical requirements to taking a legal position under an income tax treaty. First, it must absolutely be disclosed on IRS Form 8833 to avoid penalties. Second, it must be accompanied by a full and complete legal explanation of the position. Third, without the legal explanation, the IRS will likely challenge the position, assess tax on all of the historical gains in the pension, and impose a 20% tax penalty with interest thereon. By having our firm handle the return, you can rest assured there will be no inadvertent errors that could lead to a staggering tax bill and penalties.

Contact Castro & Co. today to schedule a free consultation. Our team of international tax attorneys and CPAs can handle the submission of the federal income tax return to ensure everything is properly reported in accordance with the treaty to lawfully avoid taxation on the tax-free lump-sum distribution.


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