Significant Change in HMRC Stance on US Pension Lump Sum Distributions

On 12th March 2025, HMRC released updated guidance on the UK tax treatment of lump sum distributions from taxable US pension plans, a major shift that has significant implications for US citizens residing in the UK. The US-UK tax treaty has been in place for 22 years, yet only now has HMRC issued guidance clarifying its position on this issue. Previously, it was widely understood that lump sum distributions from US pension plans to a UK resident individual were fully exempt from UK taxation under the treaty. However, HMRC now asserts that these distributions will be subject to UK tax, with a foreign tax credit allowed for any US taxes paid.

What Has Changed?

Article 17(2) of the US-UK tax treaty was interpreted to provide full UK tax exemption for lump sum distributions from US pension schemes.

However, HMRC is now applying the treaty’s saving clause (Article 1(4)) to override this exemption, allowing the UK to tax these payments. The saving clause allows the US and UK to tax their own citizens and residents as if the treaty did not exist, except for certain specific provisions. Given that the saving clause has historically been seen as a US-centric mechanism, HMRC’s new stance could be controversial and may face challenges.

HMRC is also silent on whether the saving clause will be applied in other areas or whether it is specific to Article 17(2).

HMRC view as of 12 March 2025:

The UK/US DTA

It should be noted that the US regards the lump-sum provision in paragraph 2 of Article 17 of the UK/US DTA to be an anti-avoidance measure. For payments arising in the US, regard must therefore be had for US domestic law.

A particular feature of the UK/US DTA is that, although paragraph 2 of Article 17 gives exclusive taxation rights over lump sum payments to the State in which the payment arises, this is in effect overridden by paragraph 4 of Article 1. The effect of paragraph 4 of Article 1 is that the DTA will not prevent either State from taxing its own residents unless the provision is specifically listed in paragraph 5 of Article 1. This means that although the State in which the pension lump sum arises will be able to tax that payment under Article 17, the State in which the recipient is resident will also be able to tax the payment under Article 1. Relief from double taxation will be available under the treaty in the usual way.

There is a second limb to paragraph 4 of Article 1, which is that the treaty does not prevent a State from taxing its citizens “by reason of citizenship” except where specifically listed. Because the UK does not tax “by reason of citizenship” (it taxes by reason of source or by reason of residence), this limb currently only has effect for the US, which is why the elimination of double taxation article deals only with the US citizenship tax in respect of paragraph 4 of Article 1. This means that while paragraph 4 of Article 1 allows the US to tax some residents of the UK, because of the interaction with UK domestic law the UK would not tax a US resident under this provision even if they were a UK citizen.

Key Implications for US Citizens in the UK

• Increased Tax Exposure: US citizens would now face UK tax on lump sum distributions from taxable US pension plans, potentially leading to a higher overall tax burden. The maximum UK income tax rate is 45% (or 48% in Scotland) for additional rate taxpayers compared to 37% in the US. Often the US effective tax rate is lower, so the global tax impact is higher than these percentages for high-earners.
• Foreign Tax Credit Considerations: The UK will allow a foreign tax credit for US tax paid, but this is unlikely to fully offset the UK taxes due and US citizens who are tax-resident in the UK may now face an estimated 8% (or 11%) uplift in their global tax liability.
• HMRC’s Definition of Lump Sums: In more positive news, the updated guidance sheds light on how HMRC will define a “lump sum,” factoring in payment frequency and the proportion of the pension fund withdrawn.

We will continue monitoring developments and sharing updates as more clarity emerges, especially with regards to HMRC stance on retrospective or prospective application of their new interpretation.

In the meantime, if you have any questions or need advice please contact our team.