Everything you wanted to know about US expat taxes but were too afraid to ask
Last Update: January 2023
The United Kingdom is one of the most popular destinations for first-time expats. According to HSBC’s recent Expat Explorer Global Report, 58% of expats in the U.K. report being on their first adventure living abroad. Expats moving to the U.K. more often than not decide to stay in large part due to the welcoming atmosphere afforded to people regardless of their faith, race, gender or sexual orientation. According to HSBC’s report, the U.K. scored in the top 5 of all countries surveyed in this regard. Also according to the report, nearly three in five expats in the U.K. said they were confident it is a good place to progress their career and acquire new skills.
The U.K. income tax system is fundamentally similar to the U.S. federal income tax system although there are significant differences. For instance, similar to the U.S. system, the U.K. taxes its residents on their worldwide income (i.e., whether the income is earned within our without the United Kingdom). Non-resident individuals are generally only required to pay tax on U.K. source income, although there a number of exceptions (e.g., the sale of U.K. residential real estate property). Unlike the U.S., another factor that is relevant in determining income taxability in the U.K. is one’s “domicile” status. In general, individuals who are resident in the U.K. for tax purposes but are considered domiciled outside the U.K. can elect to pay tax on overseas investment income, capital gains, and certain offshore earnings only to the extent that these are remitted to the U.K. (e.g., transferred to a U.K. bank account). This is referred to as the remittance basis of taxation.
Like the U.S., the United Kingdom employs a marginal tax rate based on a progressive tax system, where tax rates for an individual increase as income rises. The ordinary income tax rate ranges from 20% to 45% (the top rate applies if the owner’s annual U.K. income exceeds £150,000). Unlike the U.S., income taxes in the U.K. are imposed at the federal but generally not at the state or local level.
A further significant difference between the U.K. and U.S. tax systems relates to tax reporting. In the U.S., nearly all working individuals file income tax returns, because in the U.S., if you earn a certain threshold income amount, you are required to file an income tax return annually. In contrast, many taxpayers in the U.K. do not have to complete a tax return, because the U.K. employs the Pay As You Earn (“PAYE”) system on your wages or salary, whereby the employer withholds, remits, and reports on your behalf. However, there are a number of circumstances under which a U.K. resident will be required to complete a tax return, including the earning of taxable income from sources outside the U.K.
Unlike the U.S., the U.K. tax year is not based on the calendar year ending December 31, but rather on a tax year end of April 5. If a tax return is due, then a paper return must be received by October 31 following the end of the U.K. tax year or, alternatively, an online tax return must be received by January 31 following the end of the tax year. Also unlike the U.S., a husband and wife in the U.K. cannot file a joint income tax return, but rather must file their returns separately.
Principle #1 - Your Obligation Endures
Your U.S. Tax Filing Obligation Endures Even After Moving Abroad
Our first principle is of particular importance because U.S. expats so often mistakenly believe that once they have moved abroad their U.S. tax obligations cease to exist.
In fact, as a basic expat tax 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 to abroad, whether the income is U.S. source or foreign source, and whether that foreign source is the United Kingdom (e.g., employment in the U.K.) or any other foreign country.
Principle #2 - New Filing Obligations
You’re Likely Subject to New Information Reporting Obligations
U.S. expats who hold accounts or other assets overseas are subject to a number of specific filing requirements in the form of informational forms. Some of these forms are submitted to the IRS as attachments to the personal income tax return (Form 1040), while others are submitted to other governmental departments. The failure to file any of these forms can result in severe civil penalties, such as 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.
Some of the more common forms include:
- Foreign Bank and Financial Account Report (FBAR)
The FBAR is not a tax form and it is not filed with the IRS. Instead, it is an informational form that is submitted with the U.S. Treasury Department. A U.S. account holder (person or entity) with a financial interest in or signature authority over one or more foreign financial accounts, with more than $10,000 in aggregate value in a calendar year, must file the FBAR annually with the Treasury Department.
- Form 8938, Statement of Specified Foreign Financial Assets (FATCA Reporting)
If you reside outside the U.S. and have a bank account or investment account in a foreign financial institution, you are generally required to include FATCA Form 8938 with your U.S. federal income tax return if you meet certain monetary thresholds.
Principle #3 - New US Tax Considerations
Your Activities in the U.K. 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. The following are examples of common activities in the U.K. and their potential U.S. tax implications.
U.K. Limited Companies
Many business in the U.K. are operated via limited companies.This entity structure can be a very efficient way to run a business from a U.K. tax perspective, because the corporate income tax rates in the U.K. are significantly lower than the individual rates. Company directors can opt to take their earnings as a combination of salary (up to the National Insurance Contributions threshold) and dividends, thus minimizing their personal tax liability.
While often tax efficient from a U.K. tax perspective, limited companies do raise issues from a U.S. tax perspective. For instance, these entities may be considered controlled foreign corporations (“CFCs”) for U.S. federal income tax purposes, a classification that can potentially have significant U.S. tax implications. For instance, a 10% or more U.S. shareholder of a CFC must include currently in his or her gross income the CFC’s so-called “subpart F income,” which generally includes passive-type income, such as interest, dividends and rental income (meaning, for tax purposes, a CFC’s subpart F income is considered to be earned directly by the shareholder prior to an actual distribution to the shareholder). Under the CFC regime, company loans to an expat owner can trigger a so-called “Section 956 inclusion,” i.e., current inclusion of the loan amount in a 10% or more U.S. shareholder’s gross income. Starting with the 2018 tax year, certain non-subpart F income will also be required to be included currently at the shareholder level under the new so-called “GILTI” rules.
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. Pension Plans
Another common activity in the U.K. with important U.S. tax implications is participation in a U.K. pension plan. According to the latest Family Resources Survey from the UK Department for Work and Pensions, 29% of all adults in the U.K. participates in a pension plan in one form or another. Of this group, 25% participate in employer-sponsored pensions, while 4% participate in personal pensions or stakeholder pensions.
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.
It is important to note, however, that in certain situations, the utilization of treaty benefits may not be as advantageous as utilizing foreign tax credits, discussed further below, to reduce or eliminate U.S. tax on income associated with a U.K. pension. In this regard, the best strategy will depend greatly on the specific circumstances of the taxpayer.
Aside from the substantive tax consequences associated with U.K. pension plans, plan participation can also have important tax reporting implications. In some instances, a self-funded plan, such as a self-invested personal pension (“SIPP”), may be viewed as a “foreign grantor trust” for U.S. tax purposes, which may trigger additional reporting obligations.
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.
U.S. Tax Reporting Considerations
It is important to keep in mind that in addition to the substantive U.S. tax implications associated with the above activities, additional tax reporting obligations may also arise as a result of such activities. Some of the common forms associated with investment or other financial activities abroad include:
- Form 5471: must be filed by certain shareholders of foreign corporations
- Form 8621: must be filed by certain shareholders of passive foreign investment companies (such as foreign mutual funds)
- Form 3520: must be filed to report transactions with foreign trusts (including foreign pension plans treated as foreign grantor trusts) and receipt of certain foreign gifts
- Form 8865: must be filed for each controlled foreign partnership in which the taxpayer is a 10% or more partner
Principle #4 - US Tax Benefits
U.S. Tax Benefits Are Available to You
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.
Foreign Earned Income Exclusion
Provided an individual is able to establish that his tax home is outside the U.S. (by satisfying either the “bona fide residence” test or the “physical presence” test), such individual can exclude from income a portion of their income earned overseas. The FEIE amount is adjusted annually for inflation. For tax year 2022, the maximum exclusion is $112,000 per person ($224,000 for a married expat couple).
In order to claim this exclusion, an individual must file a U.S. federal income tax return (Form 1040). To claim the FEIE, an individual must file Form 2555 with their U.S. federal income tax return.
Foreign Housing Exclusion/Deduction
In addition to the FEIE, U.S. expats can also exclude or deduct from their gross income their housing cost amount in a foreign country provided they qualify under the bona fide residence or physical presence tests. The exclusion is applicable whenever an individual has wages. The deduction is applicable whenever the individual is self-employed. In order to claim the foreign house exclusion/deduction, an individual must file Form 2555.
However, the housing cost amount is subject to certain limitations that are adjusted based on geographical location. Without any adjustments to the limitations, the maximum foreign housing exclusion for 2022 is $15,680. Adjustments vary from city to city and are based on the cost of living in each city. Such adjustments apply specifically to a number of cities in the United Kingdom.
Housing costs generally qualify regardless of whether an employee directly pays his or her costs or the employer directly pays (or reimburses the employee). Employees should bear this in mind when negotiating their employment agreements, so as to maximize the available exclusion, especially in high cost of living areas in the UK.
Foreign Tax Credits
As an alternative to (and for higher income earners, in complement to) the FEIE and foreign housing exclusion/deduction, a U.S. expat can claim a foreign tax credit (“FTC”) for foreign income taxes paid. The amount of foreign tax credits that may be taken is limited to the amount of foreign source taxable income and cannot be used to offset U.S. source income.
Since the U.K. tax rate on an expat’s income will generally be higher than the U.S. tax rate, it will often be the case that there is no residual income tax to pay in the U.S. after claiming a foreign tax credit for the U.K. tax paid. However, a foreign tax credit cannot be used to reduce the U.S net investment income tax and, as such, residual U.S. tax may result even if the foreign tax credit can otherwise be fully utilized against the earned income tax. The foreign tax credit rules are particularly complex and, as such, require a thorough analysis by a tax expert.
Aside from specific situations, in order to claim a foreign tax credit, an individual must file Form 1116 with their U.S. federal income tax return.
Many countries have signed treaties and other international agreements with the U.S. whereby certain benefits are available to U.S. expats residing in a particular foreign country, for instance in order to protect them from double taxation, both in the U.S. and in their country of residence. U.S.-U.K. bilateral agreements include:
- U.S.-U.K. Income Tax Treaty – This treaty is designed to mitigate the effects of double income taxation. Generally, under an income tax treaty with the U.S., U.S. expats may be entitled to certain credits, deductions, exemptions and reductions in the rate of income taxes of the foreign country in which they reside. The U.S.-U.K. Treaty is one of the few U.S. tax treaties that has two robust pension articles that offer beneficial treatment with respect to pension plan employer contributions, plan earnings, and pension distributions.
- U.S.-U.K. Totalization Agreement – This agreement affects tax payments and benefits under the respective social security systems. It is designed to eliminate dual social security taxation, the situation that occurs when a worker from one country works in another country and is required to pay social security taxes to both countries on the same earnings. It also helps fill gaps in benefit protection for workers who have divided their careers between the United States and the United Kingdom.
Principle #5 - Reach of US Government
Due to FATCA and its Supporting International Agreements, the U.S. Income Tax Reach Has Become Wider Than Ever Before!
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.
Recently, the IRS announced that the United States had signed a so-called competent authority arrangement (“CAA”) with the United Kingdom in furtherance of a previously signed intergovernmental agreement (“IGA”), an agreement which is designed to promote the implementation of the FATCA law requiring financial institutions (mainly banks and investment houses) outside the U.S. to report information on financial accounts held by their U.S. customers to the IRS.
The CAA with the U.K., along with a simultaneously signed CAA with the Australia, are the very first of their kind. These arrangements contain specific provisions regarding exchange of information protocols. For example, under the arrangements, financial institutions and host country tax authorities are required to utilize the International Data Exchange Service (IDES) to exchange FATCA data with the IRS.
These latest developments further signify that efforts by the U.S. to combat offshore tax evasion are being met with support and cooperation by the U.K. as well as other jurisdictions. In time, FATCA will make the world a significantly smaller place in the eyes of the IRS. We believe this will lead to a further surge in tax compliance efforts by U.S. expats.
If you are a U.S. expat living in the U.K., it is essential that you remain compliant with your continuing U.S. tax obligations. Our experts at Expat Tax Professionals are available to help you understand your U.S. tax filing requirements and to assist you with all of your U.S. tax compliance needs.