According to a report published by the United Nations, Department of Economic and Social Affairs, the number of Americans living in the United Kingdom was estimated at 212,150 in 2015. This represents a sizable group of Americans living in just one foreign country.
For U.S. expats living in the U.K., there are a number of U.S. tax considerations to keep in mind. Below we list the 5 key tax considerations heading into the 2017 U.S. tax season.
Consideration #1 – Your U.S. Tax Obligations Endure
U.S. expats so often mistakenly believe that once they move abroad, their U.S. tax obligations cease to exist. In fact, as a basic rule, U.S. citizens, even those residing outside the United States, are considered to be U.S. residents for tax purposes and are therefore subject to U.S. tax reporting on their worldwide income.
Expats must annually report all of their income to the IRS, just as they did prior to moving abroad, whether the income is from U.S. sources, U.K. sources, or from any other country.
Consideration #2 – You’re Likely Subject To Special Reporting Obligations
U.S. expats who hold accounts or other assets overseas may be subject to a number of specific filing requirements in the form of informational forms, such as the FBAR and the FATCA Form 8938.
The failure to file any of these forms can result in severe civil penalties, including a $10,000 penalty per form per year. Additionally, in certain extreme cases, criminal penalties, including fines and incarceration, may apply if the reporting delinquency is shown to be willful.
Consideration #3 – Your U.K. Activities Have Important U.S. Tax Implications
With each item of income that an expat earns and with each foreign asset that is owned or acquired, special considerations need to be addressed. For example:
Real Estate Transactions
With respect to purchasing real estate, an individual that buys a primary residence overseas is generally entitled to the same U.S. tax benefits as a homeowner in the U.S. As such, you can deduct mortgage interest, property taxes, and certain other items on your personal income tax return.
With respect selling real estate, the “primary residence exclusion” rule may apply. Under this rule, an individual can exclude a gain of up to $250,000 realized from the sale of his or her home ($500,000 if married and filing jointly), provided they meet the “ownership” and “use” tests for 2 out of the 5 years leading up to the sale. This exclusion is not limited to homes in the U.S.
Since the UK may offer an exemption on the sale of your residence (thereby creating no foreign tax credits to utilize), home sellers may have a capital gain tax in the U.S., but only to the extent the gain exceeds the primary residence exclusion rule, if available.
U.K. Investment Products / ISAS
A number of U.K. investment products may be classified as passive foreign investment companies (“PFICs”) for U.S. federal tax purposes. Technically, a PFIC is a foreign corporation that has one of the following attributes: (i) At least 75% of its income is considered “passive” (e.g., interest, dividends, royalties), or (ii) At least 50% of its assets are passive-income producing assets.
Examples of common U.K. investment products that may trigger adverse PFIC implications include U.K. corporate bond funds as well as certain insurance products with significant investment components (e.g., Scottish Widows). Additionally, most foreign mutual funds fall within the definition of a PFIC. This can be the case even if such funds are held through a tax-deferred savings account, such as a U.K. individual savings account (“ISA”).
Careful planning is often needed to ensure that the CFC and PFIC regimes do not subject your income to highly punitive U.S. federal tax rates or unnecessary current inclusions of income at the shareholder level.
U.K. Pensions Plans
Another common activity in the U.K. with important U.S. tax implications is participation in a U.K. pension plan. In general, non-U.S. pension plans do not qualify for the beneficial tax-deferral treatment afforded to certain U.S. pension plans under Section 401 of the U.S. Internal Revenue Code (e.g., a 401(k) plan). As such, employer contributions and plan earnings may be subject to U.S. tax on a current basis and required to be reported on the individual’s U.S. income tax return, even though these items may not be currently subject to U.K. tax. In the case of a foreign pension plan that qualifies as an “employees’ trust” within the meaning of Section 402(b) of the Internal Revenue Code, employer contributions are taxed currently but plan earnings may be tax deferred until retirement assuming certain conditions are met.
Fortunately for U.S. expats living in the U.K., the U.S.-U.K. income tax treaty will often exempt U.K. pension plan contributions and earnings, assuming that the plan qualifies for beneficial treatment under the treaty. Examples of plans that generally qualify include occupational pensions and stakeholder pensions. With respect to pension distributions, benefits may vary under the treaty depending on whether the payments are periodic or paid as a lump sum.
Because of the U.S. tax complexities associated with foreign pension plans, it is essential that U.S. expats participating in a U.K. pension plan understand the full U.S. tax and reporting implications associated with plan participation.
Consideration #4 – Know Your U.S. Tax Benefits
The good news for expats living in the U.K. is that both U.S. domestic tax law and U.S.-U.K. bilateral agreements contain a number of provisions that are designed to prevent “double taxation,” or taxation on the same income in both countries.
These provisions, in many cases, can reduce or even eliminate the U.S. federal income tax that would otherwise be due by the expat taxpayer. Keep in mind, however, that even if no U.S. tax is owed, a U.S. tax return still generally must be filed and the failure to do so can result in severe penalties.
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.
U.S.-U.K. treaties can also benefit expats in the U.K., including the U.S.-U.K. Totalization Agreement, an agreement that affects tax payments and benefits under the respective social security systems. It is designed to eliminate dual social security taxation.
Consideration #5 – The FATCA Factor
FATCA stands for the “Foreign Account Tax Compliance Act.” FATCA is a relatively new law that was enacted in 2010 as part of the HIRE Act. The objective behind FATCA is to combat offshore tax evasion by requiring U.S. citizens to report their holdings in foreign financial accounts and their foreign assets on an annual basis to the IRS. As part of the implementation of FATCA, starting with the 2011 tax season, the IRS requires certain U.S. citizens to report (on Form 8938) the total value of their “foreign financial assets.”
In order to further enforce FATCA reporting, starting on January 1, 2014, foreign financial institutions (“FFIs”) (which include just about every foreign bank, investment house and even some foreign insurance companies) became required to report the balances in the accounts held by customers who are U.S. citizens. To date, we have seen several large foreign banks require that all U.S. citizens who maintain accounts with them provide a Form W-9 (declaring their status as U.S. citizens) and sign a waiver of confidentiality agreement whereby they allow the bank to provide information about their account to the IRS. In some cases, foreign banks have closed the accounts of U.S. expats who refuse to cooperate with these requests.
It is this renewed effort by the U.S. government to combat offshore tax evasion through FATCA that has led to a recent surge in tax compliance efforts by U.S. expats in the U.K. and elsewhere.