Treaty Treatment of the 25% Tax-Free Distribution from a U.K. SIPP

This is another in the ongoing series about the U.S. income taxation of U.S. taxpayers who are participants in ​U.K. SIPPs​.

The 25% tax-free distribution at age 55

A participant can take a distribution of up to 25% from a U.K. SIPP at age 55.

Yes, the age is going up to 57 in a couple of years, and yes, I have wildly hand-waved away the details of U.K. tax law. Just take it on faith that a participant can take a big blob of cash out of a SIPP completely free of U.K. income tax.

The question is whether that 25% tax-free big blob of cash distribution is also tax-free on a U.S. SIPP participant’s Form 1040.

Choose the treaty or choose the Code

A U.S. participant in a U.K. SIPP might:

• choose a treaty-based reporting position for the distribution; or
• report the distribution based on the Internal Revenue Code.

When we look at how the income tax treaty works, there is a gateway question that determines the result:

Charmingly, “lump-sum payment” is undefined in the treaty.

Assume the 25% tax-free distribution is a “lump-sum payment”

Make a heroic assumption: the 25% tax-free distribution is a lump-sum payment as that term is used in the U.K./U.S. income tax treaty.

In future episodes I will explore what HMRC and IRS think about that phrase. For now, just assume your distribution is a lump-sum payment for treaty purposes.

Article 17(2)

There are two paragraphs in the treaty that deal with pension payments: Article 17(2) deals lump-sum payments, and Article 17(1) deals with all other pension payments.

The treaty tells you which country has the right to tax that a lump-sum payment:

You know that Article 17(2) is the correct paragraph to apply because that phrase “notwithstanding the provision of paragraph 1 of this Article.”

How to demystify Article 17(2)

The way to make sense of treaties is to do word substitution. It’s like taking an algebra equation and putting numbers in place of variables. That’s how you solve the equation.

First, let’s eliminate words we don’t need: the phrase that told us we are in the right place for lump-sum payments.

Second, take it as an article of faith that a SIPP is a “pension scheme” as that phrase is defined in the U.K./U.S. income tax treaty. And of course a SIPP is established in the United Kingdom. Therefore, “a pension scheme established in a Contracting State” can be simplified to . . . “SIPP.”

Third, let’s put in the names of the countries. “Contracting State” is how the two countries that are parties to the treaty refer to themselves. Thus, that first reference to “a Contracting State” must mean, in our context, the United Kingdom. We infer that from identifying the country in which the pension scheme is created.

And the “other Contracting State” must mean the United States. There are only two countries that are parties to the treaty.

And, since the first country to be mentioned in Article 17(2) is the United Kingdom (because it’s the country where the SIPP is established), “the first-mentioned State” must be the United Kingdom.

Article 17(2) rewritten says:

When Article 17(2) applies to a U.S. citizen/resident

Now Article 17(2) is easy to understand. I will remove the strikethrough text so it is easy to read.

If three conditions exist . . .

• A lump-sum payment exists–the 25% tax-free distribution.
• It came from a SIPP.
• It was paid to a resident of the United States.

. . . then Article 17(2) says:

• The only country that can tax this payment is the United Kingdom.

Never. The answer is always never.

If Article 17(2) applies to a U.S. resident/citizen. Which it doesn’t and never will.

There only one time when Article 17(2) applies to U.S. citizens and residents to prevent the U.S. from imposing income tax on a SIPP distribution: ​Always Never​. The saving clause is why.

The saving clause says that the U.S. can tax its citizens and residents as if the treaty had never existed. Article 1(4) says:

There are exceptions to the saving clause. The exceptions are listed in Article 1(5). Article 17(2) is not listed there. Therefore, the saving clause prevents U.S. citizen/residents from claiming the benefits of Article 17(2).

Conclusion

The general conclusion then, is simple:

• If a U.S. citizen or resident receives a “lump-sum payment” from a U.K. pension scheme (such as a SIPP), both countries will have the right to tax that distribution–and the treaty will not alter that fact.

This includes the 25% SIPP distribution at age 55. If it is a “lump-sum payment” the U.K. will say the payment is tax-free (yay) and the United States will include the payment in gross income of the recipient.