AVOIDING DOUBLE TAXATION USING DOMESTIC LAWS AND THE US UK TAX TREATY
Last Update: December 2021
US expats living abroad face a number of tax challenges, perhaps the most potent of which is the potential for “double taxation” – i.e., taxation of your income in both the United States and your country of residence.
In this blog, we explore the main tools that the US makes available for expats to avoid double taxation – both in the context of US domestic laws and US tax treaties. For this purpose, we focus in on the US UK Tax Treaty, the provisions of which generally mimic the typical US tax treaty.
US DOMESTIC LAWS PREVENT DOUBLE TAXATION
Domestic law provisions, such as the foreign earned income exclusion (“FEIE”), foreign housing exclusion (“FHE”), and foreign tax credit (“FTC”) are designed specifically for taxpayers living abroad.
Foreign Earned Income Exclusion
Provided an individual is able to establish that his tax home is outside the US (by satisfying either the “bona fide residence” test or the “physical presence” test), such individual can exclude from income a portion of their income earned overseas. The FEIE amount is adjusted annually for inflation. For tax year 2021, the maximum foreign earned income exclusion is $108,700 ($217,400 for a married expat couple).
In order to claim this exclusion, an individual must file a US federal income tax return (Form 1040). To claim the FEIE, an individual must file Form 2555 with their US federal income tax return.
Foreign Housing Exclusion/Deduction
In addition to the FEIE, US expats can also exclude or deduct from their gross income their housing cost amount in a foreign country provided they qualify under the bona fide residence or physical presence tests. The exclusion is applicable whenever an individual has wages. The deduction is applicable whenever the individual is self-employed. In order to claim the foreign house exclusion/deduction, an individual must file Form 2555.
However, the housing cost amount is subject to certain limitations that are adjusted based on geographical location.
Foreign Tax Credits
As an alternative to (and for higher income earners, in complement to) the FEIE and foreign housing exclusion/deduction, a US expat can claim a foreign tax credit (“FTC”) for foreign income taxes paid. The amount of foreign tax credits that may be taken is limited to the amount of foreign source taxable income and cannot be used to offset US source income.
Since the UK tax rate on an expat’s income will generally be higher than the US tax rate, it will often be the case that there is no residual income tax to pay in the US after claiming a foreign tax credit for the UK tax paid. However, a foreign tax credit cannot be used to reduce the U.S net investment income tax and, as such, residual US tax may result even if the foreign tax credit can otherwise be fully utilized. The foreign tax credit rules are particularly complex and, as such, require a thorough analysis by a tax expert.
Aside from specific situations, in order to claim a foreign tax credit, an individual must file Form 1116 with their US federal income tax return.
US UK TAX TREATY PROVISIONS PREVENTS DOUBLE TAXATION
Many countries have signed treaties and other international agreements with the US whereby certain benefits are available to US expats residing in a particular foreign country, for instance in order to protect them from double taxation, both in the US and in their country of residence. US-UK bilateral agreements include:
US UK Tax Treaty
This treaty is designed to mitigate the effects of double income taxation. Generally, under an income tax treaty with the US, US expats may be entitled to certain credits, deductions, exemptions and reductions in the rate of income taxes of the foreign country in which they reside.
The US UK Tax Treaty is one of the few US tax treaties that has two robust pension articles that offer beneficial treatment with respect to pension plan employer contributions, plan earnings, and pension distributions. Importantly, the treaty distinguishes between periodic pension payments and lump-sum payments in terms of its treatment.
The US UK Tax Treaty also offers beneficial rules with respect to the foreign tax credit (for example, so-called “income resourcing” provisions), in the case that the credit would otherwise not be claimable under U.S. domestic law due to the cross-border nature of payments made to U.S. citizens living abroad.
US UK Totalization Agreement
This agreement affects tax payments and benefits under the respective social security systems. It is designed to eliminate dual social security taxation, the situation that occurs when a worker from one country works in another country and is required to pay social security taxes to both countries on the same earnings. It also helps fill gaps in benefit protection for workers who have divided their careers between the United States and the United Kingdom.
In this blog, we offer 5 basic tips for US citizens working in the UK, which elaborate on the obligation to file annually with the IRS, as well as other key insights.
THE TAKEAWAY FOR US EXPATS
The good news for expats living in the UK is that both US domestic tax law and the US UK Tax Treaty contain a number of provisions that are designed to prevent taxation on the same income in both countries.
These provisions, in many cases, can reduce or even eliminate the US federal income tax that would otherwise be due by the expat taxpayer.
Keep in mind, however, that even if no US tax is owed, a US tax return still generally must be filed and the failure to do so can result in severe penalties.
