The US-UK Tax Treaty for US Expats
As an American living in the UK you’re required to file a US tax return and report your UK income to the IRS. The US taxes it’s citizens on their worldwide income, even if they live in the UK. However, if income can be excluded under the provisions of the US-UK tax treaty, it’s not taxable in the US.
What is the purpose of a tax treaty?
The purpose of a tax treaty is to address potential issues of double taxation or non-taxation. In other words, tax treaties are bilateral agreements that establish the rules for the taxation of taxpayers that have connections to multiple countries. For example, the US-UK tax treaty allocates the right to tax the income of an American living in the UK to either the US or the UK. The allocation is made for each specific type of income separately.
What’s the Saving Clause?
The Saving Clause is a standard provision in US tax treaties. It’s included in Article 1(4) of the US-UK tax treaty. The Saving Clause allows the IRS to tax US citizens as if the US-UK tax treaty does not apply. The Technical Explanation to the US-UK tax treaty includes the following example.
A UK resident with self-employment income from the US would, based on the provisions of Article 7 of the US-UK tax treaty, not be subject to US income taxation, assuming the income is not attributable to a US permanent establishment. However, based on the Saving Clause of Article 4(1), that same UK resident would still be required to report that income on his US tax return if he’s also a US citizen. In other words, he would be subject to US income taxation as if the US-UK tax treaty does not exist.
The Saving Clause does not apply to certain types of income
However, not all types of income are affected by the Saving Clause. Article 1(5) of the US-UK tax treaty specifically excludes certain pension distributions, social security payments and child support. In other words, these types of income may not be taxable in the US.
The Foreign Tax Credit: Claiming a Credit for UK Income Taxes on Your US Tax Return
The basic idea behind the Foreign Tax Credit is to allow US taxpayers to reduce their US tax liability by the amount of income tax paid to the UK. The Foreign Tax Credit is subject to certain limitations. For example, the amount you’re allowed as a credit cannot exceed the tax amount you would have owed the IRS without the credit.
To claim the Foreign Tax Credit, you would file Form 1116 as part of your US tax return. The form calculates the amount you can claim as a credit. This is determined based on the amount of UK income tax paid or accrued and the amount you would have owed the IRS without the credit. If the amount of UK income tax exceeds the amount of US income tax, you have an ‘excess foreign tax credit’. The excess foreign tax credit can be carried back and forward to future tax years.
The UK resident who’s also a US citizen mentioned above would report his self-employment income on his US tax return. He would file Form 1116 to claim a credit for the UK income tax on his self-employment income that’s taxable in the UK based on Article 7 of the tax treaty. Because of the relatively high UK tax rates, the amount that’s allowed as a credit, would generally be sufficient to fully offset the US income tax on that income.
The Foreign Earned Income Exclusion: Excluding your UK Earned Income from Your US Taxable Income
In addition to the Foreign Tax Credit, there is another important provision in the Internal Revenue Code that allows US expats to reduce their US tax liability. The Foreign Earned Income Exclusion allows you to exclude foreign earned income from your US taxable income.
Deciding whether to claim a Foreign Tax Credit or use the Foreign Earned Income Exclusion depends on your individual circumstances and the specifics of your income and tax situation.
Generally, the FEIE is more advantageous if you live in a country where the tax rates are lower than those in the US. However, the FEIE allows you to exclude ‘earned income’ only. Earned income includes wages and self-employment income. It does not include pensions, and passive income such as dividends, interest, etc. The maximum amount you’re allowed to exclude for tax year 2023 is $120,000. The amount is adjusted for inflation annually. To qualify for the FEIE you must either meet the ‘bona fide residence test’ or the ‘physical presence test’.
You can claim a credit for foreign taxes paid on passive income and other unearned income.
Filing Form 8833 when Taking a Return Position Based on the US-UK Tax Treaty
Form 8833 is used to disclose treaty-based positions on a US tax return. As Form 8833 is filed as part of your Form 1040, the due date is April 15th. However, US citizens living in the UK on the regular due date qualify for an automatic two-month extension.
On Form 8833, you’re required to provide information about the tax treaty. For example, the specific treaty article you are relying on. Also, you’re required to provide information about the nature and the amount of the income involved. Essentially, by filing this form, you’re providing the IRS the necessary information to support your claim for US-UK treaty benefits.
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