View From Groom: US Tax Issues for US Expats in UK Pension Schemes

If you are overseeing a pension fund or other benefit program such as a stock option plan or bonus program for local employees in a country outside the US, or perhaps provide a global pension arrangement such as an International Pension Plan (IPP) or Third Country National (TCN) Plan, simply administering the plan and complying with the local tax and other regulatory concerns may be daunting enough. But with the rise of tax information sharing among country tax authorities, it is increasingly important to be aware of cross-border tax issues that may arise at the member level. This is particularly true for plan members who may happen to be US taxpayers, because the US income tax system taxes US citizens and green card holders and residents (generally those spending more than 183 days a year in the US, subject to tax treaty) on their worldwide income. One may recall Boris Johnson’s unhappiness with having to pay capital gains on the sale of his UK home, for example.

The low tolerance of the US Internal Revenue Service (IRS) for US taxpayers concealing foreign accounts is fairly well known. What is somewhat less well appreciated is that being a member in a pension scheme, having options or other share rights, or even bonus arrangements, may be considered having a financial account for this purpose. For a US taxpayer to not properly treat or disclose such benefit for US tax purposes can lead to significant penalties, and for their employers, some reputational risk or embarrassment. Thus, even if, as a plan administrator or HR director, you are not immediately concerned with US tax consequences to your local employees, it can still be in your company’s interest to be aware of the issues and alert US expats to them. An aware US taxpayer may well also need to come to the scheme administrator for assistance in complying with their individual reporting requirements.

US taxation of foreign pensions, deferred compensation, equity-based compensation and the like is subject to a large number of complex rules, but in addition to those of general or default application, there is an overlay of tax treaty provisions which vary country-by-country. For that reason, any analysis of cross-border taxation must be done country-by-country. In this article, we will focus on US taxpayers performing services in the UK and participating in UK plans or IPPs or TCNs.

Tax Treatment by the US Taxpayer of Participation in a Typical UK Pension Scheme

The tax treaty between the US and the UK prescribes the tax treatment of taxpayers participating in each other country’s pension schemes. Dating from 2001, the treaty is a relatively modern version, addressing the tax consequences of pension contributions, earnings within the scheme, and distributions.

Generally, the US-UK tax treaty provides that where a citizen of the US who is resident in the UK (1) exercises an employment in the UK, the income from which is taxable in the UK and is borne by an employer who is a resident of the UK or a permanent establishment situated in the UK, and (2) is a member or beneficiary of, or participant in, a pension scheme established in the UK, then (A) contributions paid by or on behalf of that individual to the pension scheme during the period that he or she exercises the employment in the UK, and that are attributable to that employment, shall be deductible (or excludable) in computing his or her taxable income in the US; and (B) any benefits accrued under the pension scheme, or contributions made to the pension scheme by or on behalf of the individual’s employer during that period, and that are attributable to the employment, shall not be treated as part of the employee’s taxable income in computing his taxable income in the US.

However, there are certain requirements. First, those rules apply only to the extent that the contributions or benefits qualify for tax relief in the UK. But perhaps more importantly:

• The relief may not exceed the relief that would be allowed by the US to its residents for contributions to, or benefits accrued under, a generally corresponding pension scheme established in the US. (The UK limits must be observed under local law as well, of course.) This can introduce complexity because the US limits are different than the UK limits. Greatly oversimplified, the US limit for defined contribution plans is generally USD 54,000 (for 2017) for an annual contribution, or for defined benefit plans is generally the actuarial value of a single life annuity of USD 215,000 per year (for 2017) beginning at age 62.
• The relief only applies if the UK plan is determined to be a corresponding pension scheme. A “corresponding pension scheme” in the UK, according to the Exchange of Notes accompanying the treaty, is an employment-related arrangements (other than a social security scheme) approved as retirement benefit schemes for the purposes of Chapter I of Part XIV of the Income and Corporation Taxes Act 1988, and personal pension schemes approved under Chapter IV of Part XIV of that Act.

As a cautionary note, these corresponding plans will usually be exempt from US Internal Revenue Code (“IRC”) section 409A, which exempts plan benefits treated as nontaxable under applicable tax treaties. Broad-based, non-US retirement plans in general are exempt from 409A under a separate exception, but there are a number of technical requirements. Trusts taxable to US beneficiaries under US IRC section 402(b) are also exempt from section 409A, but that implies the participant is recognizing US taxable income while participating. Essentially, though, if the US expat in the UK is participating in a plan which is not one of these corresponding pension schemes, it will be worth reviewing to make certain that the plan is exempt from or complies with section 409A as to any US taxpayer participants (or exclude those participants), because the penalties for a 409A violation are draconian.

But Wait—Special US Tax Forms that Must Accompany the Expat’s US Tax Return Even if the Benefit is Not Yet Taxable

If the US taxpayer performing services in the UK and participating in a UK pension scheme meets all the requirements to not be currently taxable for US income tax purposes on contributions to or benefits accrued under the UK scheme, it is important to recognize that may not be the end of the US taxpayer’s obligations to the IRS. One reason for that is because, since the 2011 tax year, pursuant to the Foreign Account Tax Compliance Act (FATCA), any US taxpayer that is required to file a US income tax return must, as a part of it, file a disclosure form referred to as Form 8938 to report specified “foreign financial assets” valued at over certain threshold amounts. Pensions, other deferred compensation and stock options are generally included as types of foreign assets that may need to be reported. For a US citizen taxpayer whose tax home is in a foreign country and is either a bona fide resident of a foreign country or countries for an uninterrupted period that includes the entire tax year, or if the taxpayer is a U.S. citizen or resident who, during a period of 12 consecutive months ending in their tax year, is physically present in a foreign country or countries at least 330 days, the reporting thresholds are essentially crossed if the taxpayer has more than USD 200,000 in foreign financial assets as of the end of tax year or USD 300,000 at any time during the tax year if they do not file a joint return, and USD 400,000/USD 600,000 respectively if they file a joint return. The reporting thresholds are lower if the taxpayer lives in the US. Proper reporting can raise questions of valuation that may require the assistance of the plan administrator.

As the Form 8938 is tied to the reporting of foreign accounts, the penalties for failing to file it are steep. The penalty for failure to file is USD 10,000, and if the failure continues for more than 90 days after the day on which IRS notifies the individual of the failure, the individual can be subject to an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure continues after the expiration of the 90-day period, subject to a maximum penalty of USD 50,000.

A secondary, and separate, concern as to whether or not to file a Form 8938 is whether or not to file an annual Report of Foreign Bank and Financial Accounts, known as an “FBAR.” The reporting threshold is much less for FBAR, only USD 10,000, but also generally only applies to deferred compensation to the extent the individual has ”signature authority” over an account or if the US person can “directly access” the holdings in that account. Thus, the US taxpayer will need to consider whether, as a member of a UK pension scheme, he or she has “signature authority” over the retirement account or benefit, or whether they can “directly access” the non-US retirement benefit. For many broad-based pension schemes, those may not exist, but they may exist with individual arrangements such as Qualifying Recognised Overseas Pension Scheme (“QROPs”) or personal or stakeholder pensions. It is particularly important to pay attention to the FBARs, because the civil penalties can be up to the greater of USD 100,000, or 50 percent of the balance of the account at the time of the violation for each year of violation, and there can be criminal penalties and additional penalties for willful failures to file. The FBAR is filed electronically and is normally due April 15, subject to extensions.

Equity-Based Compensation

The US-UK tax treaty was one of the first to address equity-based compensation, which the accompanying Exchange of Notes to the treaty provides are regarded as “other similar remuneration” for purposes of the article on “Income from Employment.” Those Notes provide that where an employee:

• a) Has been granted a share/stock option in the course of an employment in one of the Contracting States;
• b) Has exercised that employment in both States during the period between grant and exercise of the option;
• c) Remains in that employment at the date of the exercise; and
• d) Under the domestic law of the Contracting States, would be taxable by both Contracting States in respect of the option gain,

then, in order to avoid double taxation, a Contracting State of which, at the time of the exercise of the option, the employee is not a resident will tax only that proportion of the option gain which relates to the period or periods between the grant and the exercise of the option during which the individual exercised the employment in that Contracting State.

In other words, the income that would be generated upon exercise of the option—if still an employee on the date of exercise—will be taxed in the state of residence at the time of exercise under its laws, but as to the other state, that state will only tax a proportion based on the proportion of service period within it compared to the overall service period between grant and exercise. However, this provision is still subject to the “savings clause” taxing US citizens on their worldwide income.

As a result, the state of residence will tax the exercise of the option under its usual rules for taxing options. If the taxpayer is a US citizen but resident in the UK, however, under the savings clause, notwithstanding the proportional taxation rule, that US citizen would generally be subject to US tax upon all of his or her income on exercise, though potentially also have a tax credit for UK taxes paid. With different tax rules and tax years between the two countries, though, availability of the tax credit for UK taxes in the US is not always assured. In addition, if any of the requirements for avoidance of double taxation are not met, then double taxation can occur in both countries. Ultimately, the income tax rules are sufficiently complex that the US taxpayer’s liability for taxes on stock options must be determined on the individual facts and circumstances, but awareness of the possible application of the tax treaty is important.

Also importantly, the US taxpayer holding UK stock options must not forget the Form 8938 when they file their US tax return even if they would not be taxable until exercise or later. This, again, is subject to the aggregate reporting thresholds noted above.

Bonus Programs

Another type of program that can result in unintended US tax consequences for US taxpayers is the traditional bonus program, where, if certain criteria are met, or if management so decides, the employee may receive a cash bonus. The principal concern here is, again, IRC section 409A. Generally, a concern under 409A might arise where there occurs a substantial lag between the declaration of the bonus and payment to the US taxpayer (for example, later than March 15 of the year after the year the bonus is determined and vests), if the amount would be taxable for US income tax purposes under the US-UK tax treaty. In short, reviewing any such plans for the possible application of 409A to any US taxpayer participants may be advisable.

IPPs and TCNs

International Pension Plans and Third Country National Plans, that is, “ex-pat”-type plans, located typically in one low-tax jurisdiction for employees who are citizens of a second country and working in a third, present a special set of concerns for US taxpayers that participate in them. Again, the principal concern is IRC section 409A, because, in this case, an exemption will often not apply; for example, they will not be corresponding plans exempted by treaty, or broad-based plans exempted by regulation. In short, these are often exactly the type of plan intended to be captured by the tax rules of 409A for US taxpayers and reported under FATCA, at least on a Form 8938.

Another concern is that, sometimes, these plans are “funded” for US tax purposes—which typically results in being included in the taxable income of any US taxpayers each year as the benefits accrue. This has sometimes been by design in order to avoid 409A under an exemption for trusts that are taxable trusts under IRC section 402(b). That is good so far as that goes, but also depends on the proper design of the funding, inclusion in income for US tax purposes, and, again, filing an appropriate Form 8938 or FBAR where required. Should that fail to be the case, and the US IRS receive FATCA account information sharing from the jurisdiction involved—Bermuda, say, under its Intergovernmental Agreement with the US Treasury—significant adverse tax consequences could result.

Summary

US tax issues can certainly arise when US taxpayers participate in UK pension and benefit schemes. With the growing globalization of the workforce, more expats every day, and increasing information sharing among tax authorities, it may be wise to pay more attention to these issues before they turn into actual problems for your workforce.