United States Income Taxation Of United Kingdom-Based Pension Plans

Many United Kingdom citizens work for part or all of their careers in the United Kingdom, and retire in the United States.  Such individuals’ interests in United Kingdom-based pension plans raise complex issues of United States income taxation and reporting.

United Kingdom law accommodates defined benefit as well as defined contribution pension plans.  Defined benefit plans are generally funded entirely by the sponsoring employer, though they can allow employee contributions.

Income Taxation

An employer-sponsored defined contribution plan provides for employee contributions, and for employer matching contributions up to a specified maximum.  Total contributions to defined contribution plans with respect to a given participant are limited to £40,000 ($52,493) per year, and £1,073,000 ($1,408,436) over the lifetime of the participant.  Contributions in excess of these limits will subject the participant to additional taxes.

When a United Kingdom citizen living in the United States receives a distribution from a United Kingdom-based defined contribution plan, the distribution is not subject to United States income tax to the extent it represents earnings of the individual contributed to the defined contribution plan in a year before the individual moved to the United States or became a U.S. citizen.  This is because the individual is a cash basis taxpayer, and he earned the contribution in a prior year before he became a “U.S. person” for United States income tax purposes.  A “U.S. person” is either a citizen or a resident of the United States. 

An interest in a defined benefit pension plan is not an account but a contractual right to receive a monthly benefit pursuant to the plan governing document.  A benefit received from a defined benefit pension plan looks like current gross income, even if the participant’s interest in the plan was funded entirely with contributions made before the participant became a U.S. person.

Several provisions of the United States-United Kingdom Income Tax Treaty of 2001 (the “Treaty”) also affect United States income taxation of the retiree’s interest in the United Kingdom-based pension plan in our hypothetical.   Every tax treaty has a savings clause providing that, notwithstanding any other provision of the treaty, a party to the treaty may tax its citizens and residents as if the treaty had not come into effect.  The savings clause of the Treaty, Article 4, paragraph 1, would have prevented the British citizen in our hypothetical, who worked in the United Kingdom before retiring to the United States, from benefitting from the Treaty, but for the exceptions to the savings clause in Article 1, paragraph 5.   The exceptions to the Treaty savings clause include Article 17 (Pensions, Social Security, Annuities, and Child Support) and Article 18 (Pension Schemes).  

Article 17, paragraph 1 a) of the Treaty provides, “Pensions and other remuneration beneficially owned by a resident of a Contracting State (the United States and the United Kingdom are the two Contracting States to the Treaty) shall be taxable only in that State.”  So, the United Kingdom citizen in our hypothetical, who worked his career in the United Kingdom before retiring in the United States, is taxable if at all with respect to his United Kingdom-based defined contribution pension plan only by the United States.

Article 17, paragraph 1 b) of the Treaty provides:

“Notwithstanding sub-paragraph a) of this paragraph, the amount of any such pension or remuneration paid from a pension scheme established in the other Contracting State that would be exempt from taxation in that other State if the beneficial owner were a resident thereof shall be exempt from taxation in the first-mentioned State.”

A participant may begin receiving distributions from a U.K.-based defined contribution pension upon reaching age 55.  25 percent of the balance to the credit of the participant in the plan at that time may, under U.K. law, be received by the participant free of U.K. income tax.  By virtue of Treaty Article 17, paragraph 1 b), said 25 percent may also be received free of U.S. income tax.

Treaty Article 18, paragraph 1 provides:

“Where an individual who is a resident of a Contracting State is a member or beneficiary of, or participant in, a pension scheme established in the other Contracting State, income earned by the pension scheme may be taxed as income of that individual only when, and, subject to paragraphs 1 and 2 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support) of this Convention, to the extent that, it is paid to, or for the benefit of, that individual from the pension scheme (and not transferred to another pension scheme).”

Thus, the participant in our hypothetical is not subject to U.S. income tax on income accrued in his U.K.-based defined contribution pension plan until such income is distributed to him.  But, as noted above, the United States cannot tax income accrued in a defined contribution pension plan before the participant became a “U.S. person.” 

Information Reporting

Our United Kingdom citizen retired in the United States need not report his Treaty-based tax return position concerning his United Kingdom-based defined contribution pension plan on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).  The Internal Revenue Service waives the Form 8833 reporting requirement for a treaty position that reduces or modifies the taxation of income derived from pensions.  Treas. Reg. § 301.6114-1(c)(1)(iv); Instructions to Form 8833.

Where a U.S. person is treated as an owner of a foreign trust under the grantor trust rules of Internal Revenue Code (“IRC”) Sections 671 through 679, two reporting requirements arise.  First, he U.S. person is required to report the foreign trust on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.  Second, the foreign trust itself is required to report the foreign trust on Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner.  But if the foreign trust itself fails to file a Form 3520 reporting the foreign trust, then the U.S. owner must file a substitute Form 3520-A reporting the foreign trust. 

There are many exceptions to the Form 3520 and Form 3520-A reporting requirements.  First, the arrangement must be a trust.  Treasury Regulation § 301.7701-4 defines “trust” as “an arrangement  .  .  .  whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.”  Such an arrangement requires a trustee and one or more beneficiaries.  It excludes a personal pension plan or a self-invested personal pension created and entirely funded in the United Kingdom by a self-employed individual who retains the power to currently make withdrawals from the Trust, or terminate the Trust.

Where the arrangement is a trust, we move to the question of whether the U.S. person is treated as an owner of the foreign trust under the grantor trust rules.  For example, IRC Section 673 treats the grantor as owner of any portion of a trust in which he retains a reversionary interest in corpus or income.  IRC Section 674 treats the grantor as owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or income therefrom is subject to a power of disposition exercisable by the grantor.  IRC Section 676 treats the grantor as the owner of any portion of a trust the income of which may be held or accumulated for future to the grantor or the grantor’s spouse.  The “grantor” is the person who funds the trust. 

IRC Section 678(a)(1) provides that a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself.  Thus, where a trust is funded entirely by an individual’s employer, the individual is not treated as the owner of the trust under the grantor trust rules until the individual can begin making withdrawals from the trust.  The beneficiary of a personal pension plan or a self-invested personal pension established under United Kingdom law cannot begin making withdrawals from the pension until he or she reaches age 55.  Hence such beneficiary would not be treated as owner of the pension under the grantor trust rules until he or she reaches age 55.

Revenue Procedure 2020-17 exempts from the Form 3520 and Form 3520-A filing requirements a foreign pension meeting the following requirements:

(1)  The trust is generally exempt from income tax or is otherwise tax-favored under the laws of the trust’s jurisdiction. For purposes of this revenue procedure, a trust is tax-favored if it meets any one or more of the following conditions: (i) contributions to the trust that would otherwise be subject to tax are deductible or excluded from income, are taxed at a reduced rate, give rise to a tax credit, or are otherwise eligible for another tax benefit (such as a government subsidy or contribution); and (ii) taxation of investment income earned by the trust is deferred until distribution or the investment income is taxed at a reduced rate.

(2) Annual information reporting with respect to the trust (or of its participants or beneficiaries) is provided, or is otherwise available, to the relevant tax authorities in the trust’s jurisdiction.

(3) Only contributions with respect to income earned from the performance of personal services are permitted.

(4) Contributions to the trust are limited by a percentage of earned income of the participant, are subject to an annual limit of $50,000 or less to the trust, or are subject to a lifetime limit of $1,000,000 or less to the trust. These contribution limits are determined using the U.S. Treasury Bureau of Fiscal Service foreign currency conversion rate on the last day of the tax year.

(5) Withdrawals, distributions, or payments from the trust are conditioned upon reaching a specified retirement age, disability, or death, or penalties apply to withdrawals, distributions, or payments made before such conditions are met. A trust that otherwise meets the requirements of this section 5.03(5), but that allows withdrawals, distributions, or payments for in-service loans or for reasons such as hardship, educational purposes, or the purchase of a primary residence, will be treated as meeting the requirements of this section 5.03(5).

(6) In the case of an employer-maintained trust, (i) the trust is nondiscriminatory insofar as a wide range of employees, including rank and file employees, must be eligible to make or receive contributions or accrue benefits under the terms of the trust (alone or in combination with other comparable plans), (ii) the trust (alone or in combination with other comparable plans) actually provides significant benefits for a substantial majority of eligible employees, and (iii) the benefits actually provided under the trust to eligible employees are nondiscriminatory.

Although your client’s United Kingdom-based defined contribution pension plan may not need to be reported on Form 3520 or Form 3520-A, the client will need to report it on Form 8938, Statement of Specified Foreign Financial Assets, if the client meets the Form 8938 filing threshold. A foreign defined contribution pension plan is an “account,” as is a mutual fund held within the plan.

As noted above, an interest in a foreign defined benefit pension plan is not an “account”  but a contractual right to receive a periodic sum of money.  Therefore, an interest in a foreign defined benefit pension plan is not reportable on form 8938.

FBAR Reporting

As a U.S. person’s interest in a United-Kingdom-based defined contribution pension plan is an “account,” and the U.S. person has  “financial interest” in the account, the U.S. person must report he account on an annual FinCEN Form 114, Report of Foreign Bank and Financial Account, (“FBAR”), filed with U.S. Treasury.  “Financial interest” in an account for this purpose means legal title or beneficial ownership.

But an interest in a defined benefit pension plan is not an “account,” and therefore is not reportable on an FBAR.

Summary

The foregoing principles are important in avoiding unnecessary United States  income tax and tax penalties with respect to United Kingdom-based pension plans.