I've always said that the IRS is poorly managed and dreadfully underemployed. There's no way on earth that it's ever acceptable to be on hold for two-plus hours to talk to someone about the tax debt that is throwing your future into limbo. And, if you're one of the lucky ones who doesn't get the infamous "courtesy disconnect," don't expect that the person you'll speak with can really help you make sense of how you should proceed. So, being the disorganized and inadequately staffed entity that the IRS is, I suppose it would be silly of us to expect them to post the correct information on their own website. What better evidence that the US income tax is a wholly "unadministratable" mess than this: the IRS can't even upload the correct US-UK tax treaty. At this point, I don't think any of us can say that we're surprised.
One of our eagle-eye Enrolled Agents, Julia Zhai, pointed this out:
First, the IRS-posted US-UK tax treaty:
5. The provisions of paragraph 4 of this Article shall not affect:
a) the benefits conferred by a Contracting State under paragraph 2 of Article 9 (Associated Enterprises), sub-paragraph b) of paragraph 1 and paragraphs 3 and 5 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support), paragraph 1 of Article 18 (Pension Schemes) and Articles 24 (Relief From Double Taxation), 25 (Non-discrimination), and 26 (Mutual Agreement Procedure) of this Convention…"
Well, that's quite dense.
And now the correct treaty, as posted by our obvious betters across the pond, with two extra words (in bold), that have a huge impact:
5. The provisions of paragraph 4 of this Article shall not affect: a) the benefits conferred by a Contracting State under paragraph 2 of Article 9 (Associated Enterprises), sub-paragraph b) of paragraph 1 and paragraphs 3 and 5 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support), paragraphs 1 and 5 of Article 18 (Pension Schemes) and Articles 24 (Relief From Double Taxation), 25 (Nondiscrimination), and 26 (Mutual Agreement Procedure) of this Convention…"
Now here's the thing, does it make sense that people look to the IRS for accurate documents and procedures, yet the protocol listed on a government website itself affirms that paragraph 5 of Article 18 is affected?
Why the "and 5" language matters
Is this really that big of a deal? After all, the IRS/US Treasury posted US-UK tax treaty only missed two words, "and 5." Why should it matter all that much? Well, here's the fifth paragraph of article 18 that the US version fails to allude to:
5 (a) Where a citizen of the United States who is a resident of the United Kingdom exercises an employment in the United Kingdom the income from which is taxable in the United Kingdom and is borne by an employer who is a resident of the United Kingdom or by a permanent establishment situated in the United Kingdom, and the individual is a member or beneficiary of, or participant in, a pension scheme established in the United Kingdom,
(i) contributions paid by or on behalf of that individual to the pension scheme during the period that he exercises the employment in the United Kingdom, and that are attributable to the employment, shall be deductible (or excludable) in computing his taxable income in the United States; and
(ii) any benefits accrued under the pension scheme, or contributions made to the pension scheme by or on behalf of the individual’s employer, during that period, and that are attributable to the employment, shall not be treated as part of the employee’s taxable income in computing his taxable income in the United States. This paragraph shall apply only to the extent that the contributions or benefits qualify for tax relief in the United Kingdom.
(b) The reliefs available under this paragraph shall not exceed the reliefs that would be allowed by the United States to its residents for contributions to, or benefits accrued under, a generally corresponding pension scheme established in the United States.
(c) For purposes of determining an individual’s eligibility to participate in and receive tax benefits with respect to a pension scheme established in the United States, contributions made to, or benefits accrued under, a pension scheme established in the United Kingdom shall be treated as contributions or benefits under a generally corresponding pension scheme established in the United States to the extent reliefs are available to the individual under this paragraph.
(d) This paragraph shall not apply unless the competent authority of the United States has agreed that the pension scheme generally corresponds to a pension scheme established in the United States.
The US/UK put specific language for US citizens living in the UK who make contributions to UK pensions (so those contributions wont be taxed, just like your 401(k)). And then, the IRS goes and uploads the treaty draft that carves that important information out. If it was just a mistake, we could shake our head at the embarrassing oversight on the part of the IRS, but then they added insult to injury. The IRS, in their infinite effort to collect money at all costs, has the gall to not fix it!
Without this exemption, as listed on the UK version and the US protocol, one would have to add the UK pension contributions to the gross income for US income taxation. This means a larger tax owed. While in many cases this number is significant, there are cases where it can be heavily substantial. Suddenly those two words — "and 5" — hold a lot more weight, don't they?
This error on the part of the IRS has effects on the OVDP as well. From the information available, one could reasonably conclude that unreported UK pension contributions should be taxed, thus creating a need to amend returns or even be forced to enter into an onerous Offshore Voluntary Disclosure Program rather than an FBAR-only submission. The government had a slight oversight (that's giving them the benefit of the doubt), and the people being hurt are normal people saving for retirement. It's a shame, and what's even more frustrating is how easily this error could be fixed.
References:
UK tax treaty links:
https://www.gov.uk/government/publications/usa-tax-treaties-in-force
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/411900/usa-consolidated.pdf
US tax treaty link: http://www.treasury.gov/resource-center/tax-policy/treaties/Documents/uktreaty.pdf
On the IRS website, the treaty technical explanation actually contains the correct treaty language:
Paragraph 5
Some provisions are intended to provide benefits to citizens and residents even if such benefits do not exist under internal law. Paragraph 5 sets forth certain exceptions to the saving clause that preserve these benefits for citizens and residents of the Contracting States. Subparagraph (a) lists certain provisions of the Convention that are applicable to all citizens and residents of a Contracting State, despite the general saving clause rule of paragraph 4:
(3) Paragraph 1 of Article 18 (Pension Scheme) provides an exemption for certain investment income of pension schemes located in the other State, while paragraph 5 provides benefits for certain contributions by or on behalf of a U.S. citizen to certain pension schemes established in the United Kingdom. "
