For US expat retirees, determining the US income tax rules regarding foreign (non-US) social security benefits is a common concern. While your foreign country of residence may provide an income tax exemption for its social security benefits, US domestic law is clear that foreign social security payments are in fact fully subject to US income tax. However, the provisions of a relevant US tax treaty can alter this outcome.
In this blog, we review 4 approaches taken in US income tax treaties regarding the taxation of foreign social security paid to US citizens living abroad. Given that each approach can be significantly different, it’s important that US expat retirees understand the provisions of the particular treaty that is relevant to them.
Approach #1 – Source-Based Taxation
The most common approach in US income tax treaties is that social security benefits paid by one Contracting State to a resident of the other Contracting State may be taxed only by the source State, and not by the residence State.
However, in the case of a US citizen living abroad who receives foreign social security, the question becomes whether the so-called “saving clause” applies to the social security benefits article. The saving clause preserves or “saves” the right of the US to tax its citizens as if the tax treaty does not exist. Tax treaties designate which treaty provisions are and are not subject to the saving clause.
In the US tax treaties with the UK and Australia, for example, the saving clause does not apply to the social security benefits article, which states that only the source State can tax the payment. Therefore, the source state (e.g., the UK or Australia) has the right to tax, but the US does not.
Approach #2 – Residence-Based Taxation
A number of US income tax treaties take the opposite approach, giving the residence State the exclusive right to tax the payments.
However, in the case of a US citizen living abroad who receives foreign social security, the foreign country is presumably both the source State and the residence State. So, the question remains, ultimately, whether the saving clause applies to the social security benefits article.
As an example, the US tax treaty with Japan calls for residence-based taxation of social security benefits. However, the treaty applies the saving clause to the social security benefits article, resulting in a US citizen in Japan who receives social security benefits being taxable in both countries.
Approach #3 – Source-and-Residence-Based Taxation
A small number of tax treaties directly provide that both the source State and the residence State may tax social security benefits, with the residence State allowing relief under the Relief from Double Taxation article.
Countries with this approach include Portugal, Spain, Tunisia and Venezuela.
Approach #4 – Exemption from Taxation
Finally, the US tax treaties with Israel and Romania provide that social security benefits are exempt from tax in both countries. The saving clause does not apply to the social security benefits provision in either treaty.
We reiterate that the taxability of a US expat’s income depends not only on the particular facts and on the US domestic law, but also on the specific tax treaty provisions that are applicable to the particular item of income. The provisions of a US treaty should be carefully reviewed by a tax professional to determine the correct outcome.
