U.S. Income Taxation of U.K. SIPPs and ISAs
Note: This is the third of three articles on United States income taxation of British Self-Invested Pension Plans (“SIPPs”) and Individual Savings Accounts (“ISAs”). The first article reviewed SIPPs and ISAs under United Kingdom laws, and how they are reported for United States tax purposes. The second article considered U.S. income taxation of contributions to SIPPs and ISAs. This article examines U.S. taxation of income realized by SIPPs and ISAs.
Recently a man called who had worked all of his career in England before retiring to the U.S. to be near his grandchildren. His retirement assets are in U.K. self-invested personal pensions (“SIPPs”) and individual savings accounts (“ISAs”).
A United Kingdom citizen is a “U.S. person” subject to U.S. taxation by reason of (1) being a dual citizen of the U.S., (2) being a lawful permanent resident (“green card holder”) of the United States, or (3) satisfying the substantial presence test of 26 USC 7701(b). The man who called is a lawful permanent resident of the U.S.
A SIPP is a highly advantageous personal retirement saving scheme available under U.K. tax law. A taxpayer deducts from gross income in determining U.K. taxable income contributions to a SIPP up to the total of the taxpayer’s earned income for the tax year (6 April to 5 April); but if a taxpayer’s total contributions to SIPPs exceed £40,000 for a tax year, the taxpayer is subject to a tax charge of up to 45 percent of the excess.
SIPP income, whether interest, dividends, or net capital gain, is not currently subject to U.K. income tax. After the SIPP owner reaches age 55, 25 percent of each withdrawal from the SIPP is free of U.K. income tax. The balance of withdrawals from a SIPP are subject to U.K. income tax.
Article 17, paragraph 1 of the U.S.-U.K. Income Tax Treaty of 2001 (the “Treaty”) provides:
a) Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that State.
b) 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.
Article 18, paragraph 1 of the Treaty 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).
By virtue of Treaty Article 17, paragraph 1 b), income realized by a SIPP, whether interest, dividends, or net capital gains, not currently taxable by the United Kingdom, is also not currently taxable by the United States. Also by virtue of Treaty Article 17, paragraph 1 b), 25 percent of each distribution from a SIPP after the owner’s 55th birthday, not subject to U.K. income tax, is also not subject to U.S. income tax.
Under Treaty Article 18, paragraph 1, income distributed by a SIPP is subject to U.S. income tax. But where dividends, interest, or capital gains are allocated to the 25 percent of a withdrawal from a SIPP that is free of U.K. and U.S. income tax, the dividends, interest, or capital gains so allocated will forever escape income tax.
Mutual funds in the United States send their shareholders an annual Form 1099 informing them of the income credited to their shares—interest, dividends, and net capital gains—during the year, so they can report such income on their income tax return. The mutual funds send a copy of the Forms 1099 to the IRS, enabling it to verify that the shareholders reported the income on their U.S. income tax returns.
Non-U.S.-based mutual funds do not report to shareholders on income credited to their shares. In theory, the unreported income increases the shares’ value, which the shareholders realize upon selling the shares. Congress concluded that such mutual funds deferred recognition of taxable income with respect to such shares, and converted it from ordinary income to capital gain. As a result Congress enacted the personal foreign investment company (“PFIC”) regime. Under this regime, a U.S. person who sells shares in a foreign mutual fund (a “PFIC”) is subject to income tax on the resulting gain at the highest marginal U.S. income tax rate for ordinary income (currently, 39.6 percent), plus an interest charge. To avoid this result, a U.S. person can mark PFIC shares to market—recognizing the annual increase in the shares’ market value as ordinary income, and increasing the shares’ adjusted basis for it.
The PFIC regime provides for recognition of income with respect to PFIC shares upon sale of the shares, or annually upon marking them to market. The Treaty, however, allows recognition of income with respect to a SIPP only upon a distribution from the SIPP. The PFIC regime thus is invalid as to PFIC shares held in a SIPP.
Income not reported on a U.S. income tax return by virtue of the Treaty must be disclosed on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), filed with the tax return.
A U.S. person has a “financial interest” in a foreign financial account held in his SIPP. Therefore, such foreign financial account must be reported on the U.S. person’s FinCEN Form 114, Report of Foreign Bank and Financial Accounts (“FBAR”).
An ISA is an advantageous personal retirement saving scheme available under U.K. tax law. A U.K. taxpayer may contribute up to £15,240 to ISAs in 2016. ISA contributions are not tax-deductible. An ISA holder is not subject to U.K. income tax on interest, dividends, or net capital gains realized in the ISA. Distributions from an ISA are free of U.K. income tax.
If an ISA is a “pension,” then, under Article 18, paragraph 1 of the Treaty, income generated in an ISA is subject to income only as distributed from the ISA. Under Article 17, paragraph b) of the Treaty, distributions from an ISA are otherwise exempt from U.S. income tax.
The issue is whether ISAs are “pensions” for purposes of the Treaty. Article 3, paragraph 1 o) of the Treaty provides that, for purposes of the Treaty—
the term “pension scheme” means any plan, scheme, fund, trust or other arrangement established in a Contracting State which is:
- generally exempt from income taxation in that State; and
- operated principally to administer or provide pension or retirement benefits or to earn income for the benefit of one or more such arrangements.
ISAs are established in the U.K., and they are exempt from U.K. income tax. Moreover, ISAs are a means of promoting saving for retirement. The longer assets are held in an ISA, the greater the benefit of the exemption of the assets from income tax. While not free of doubt, ISAs do appear to qualify as “pension schemes” under the Treaty. To know for sure whether an ISA is a “pension scheme” for purposes of the Treaty, one would have to submit the question to the U.S. competent authority under Treaty Article 26.
Assuming that ISAs are “pension schemes” for purposes of the Treaty, income included in distributions from an ISA to a U.S. taxpayer is, under Treaty Article 18, paragraph 1, taxable to the distributee. However, the Treaty does not specify a means of allocating income accumulated in an ISA, or its character as interest, dividends, or capital gain, to distributions from the ISA. Do the dividends, interest, and capital gains accumulated in an ISA represent the first distributions from the ISA or the last distributions from the ISA?
The PFIC regime, which would provide for recognition of income with respect to PFIC shares held in an ISA upon sale of the shares, or annually upon marking them to market, conflicts with the Treaty, which allows taxation of income with respect to a ISA only upon a distribution from the ISA. The PFIC regime thus is invalid as to PFIC shales held in an ISA.
Income not reported on a U.S. income tax return by virtue of the Treaty must be disclosed on Form 8833 filed with the tax return.
A U.S. person has a “financial interest” in a foreign financial account held in his ISA. Therefore, such foreign financial account must be reported on the U.S. person’s FinCEN Form 114, Report of Foreign Bank and Financial Accounts (“FBAR”).