What are Tax Treaties?
The United States has entered into tax treaties with countries worldwide, the UK included. What does that mean? In part, it means that residents of these foreign countries can avoid double taxation by reducing their tax US bills or even eliminating them. The US UK Tax Treaty is no different.
Each tax treaty the US makes with a foreign country will consider the individual taxation laws of that respective country. A new treaty is written for each country to achieve this kind of specificity. There will be plenty of cross-over from one treaty to another, but the specifics of each treaty are addressed on a case-by-case basis.
Why Tax Treaties?
The United States of America is one of the few countries that doesn’t only tax its residents. It also taxes US citizens and Green Card holders who live outside the country. Since most countries require their residents to pay income tax, this can create a problem for Americans and those with Green Cards. They could find themselves paying taxes twice on the same income. Charged once by the US and once by their country of residence.
So, whose tax rules rule? Tax treaties aim to answer this exact question and offer clarity to the citizens of both countries.
US UK Tax Treaty Specifics
The US United Kingdom Income Tax Convention was first established in 1975. The entire convention goes on for 51 pages. It also includes post-ratification updates as late as the 1980s. Like many tax treaties, it outlines goals created to help citizens of both countries avoid double taxation, whether we’re talking about an American living in the UK or the reverse. The tax treaty benefits both American and UK expats.
Sometimes even using the Foreign Earned Income Exclusion (FEIE) or the FTC is still not enough. For example, the US and the UK both handle pensions slightly differently. Situations like this are precisely why a tax treaty is necessary. In addition to helping with pension taxation, the US UK tax treaty also addresses tax evasion, income taxes, and capital gains taxes between the two countries.
Watch for these Two Key US UK Tax Treaty Points
We won’t get into all the fine details of the US UK Tax Treaty here, but we want to address some key points. Two particular passages in the US UK Tax Treaty affect Americans the most. They are:
- The Savings Clause
- Article 17
The Savings Clause:
Having a savings clause is standard practice with Tax Treaties. They allow countries to tax their citizens regardless of the tax treaty itself. Thanks to this little clause, Americans living in the UK can still find themselves taxed in the US. The US still has to honor the treaty for UK citizens living in the US, but they have the freedom to choose if they want Americans to utilize it.
The technical explanation provided by the Treasury Department explains:
“The Contracting States reserve their rights, except as provided in paragraph 5, to tax their residents and citizens as provided in their internal laws, notwithstanding any provisions of the Convention to the contrary.”Source
As you can see, even a Tax Treaty doesn’t exempt US citizens from double taxation. Fortunately, there are tax benefits like the Foreign Tax Credit and the Foreign Earned Income Exclusion. By using one or both, Americans living in the UK still have opportunities to avoid owing US income taxes.
Article 17 – Taxation of UK Pensions by the US
If you live in the UK and work there, then chances are good you also have a pension there. Thanks to the US UK Tax Treaty, you can defer tax payments on your foreign pension. In the eyes of the IRS, your outside pension is the same as an American 401k or other retirement contribution.
Once you are ready to start receiving pension payments, the tax treaty can help you avoid being double-taxed as well. According to the agreement, your pension only faces taxation in the country you reside.
Using the Foreign Tax Credit to avoid Double Taxation
One way to solve the double taxation dilemma is through Tax Treaties. For example, the US UK tax treaty still allows Americans living in the UK to use the Foreign Tax Credit.
When you’ve already paid income tax to a country in the UK, you can inform the IRS and use the Foreign Tax Credit (FTC). Suppose you’ve paid income taxes to the UK (or any other applicable country). In that case, you’ll be eligible to receive credit for what you’ve already paid, thus potentially eliminating or reducing your income tax burden in the US.
Using the Foreign Earned Income Exclusion
A second option to avoid US taxation while living in the UK is to claim the Foreign Earned Income Exclusion or FEIE. Claiming this allows you to exclude a certain amount of the income you earn outside the US, which will be completely exclude it from US taxation.
The exact sum you can exclude changes each year. When filing in 2023 (for Tax Year 2022), you can exclude up to $112,000 in foreign earned income.
How to claim US UK Tax Treaty benefits
Let’s assume you’ve used the Foreign Tax Credit and claimed all of the taxes you’ve already paid this year to the UK, then you’ve excluded the maximum amount via the FEIE, and somehow you find you are STILL being double taxed. That’s the best time to look into the US UK Tax Treaty.
One reason you may fall into this category is if you lived in the UK, worked in the UK for a UK company, but then were sent abroad for a period of time. Since that income was earned while working in the US, it is not considered foreign income.
To avoid double taxation here, you will need to file Form 8833. Unlike the tax forms most Americans are traditionally used to, where they fill in numbers, names, and addresses, Form 8833 is slightly different. You will have to write a summary of why you are filing it, why you were earning income in the US, and which article of the US UK Tax treaty you are claiming.
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Once you start diving into having to justify your tax claims, it’s a good idea to get into contact with a tax professional. At MyExpatTaxes, you can work with a tax specialist who regularly deals with complicated expat tax filing. Start filing today and ask your questions directly in the chat or upgrade to Premium at any time and work step-by-step with a qualified Tax Counselor.