Converting UK tax into dollars on Form 1116

Which exchange rate applies to UK tax on Form 1116?

The rate depends on whether you credit foreign tax when paid or when accrued. On the paid method, the default for individuals, each amount of UK tax is converted at the rate on the day it was paid or withheld. On the accrual method, the starting point is the average rate for the US tax year to which the tax relates.

Publication 514 (opens the official IRS page in a new tab) sets these out as the rules for translating foreign taxes, and the instructions for Form 1116 repeat them line by line. Report every figure on the form in dollars and attach an explanation of how you worked out the rate. Our post on paid or accrued credits explains which US year each payment falls into.

The IRS has no official exchange rate. Its page on foreign currency and exchange rates (opens the official IRS page in a new tab) says to use the rate prevailing when an item is received, paid or accrued, and its page of yearly average exchange rates (opens the official IRS page in a new tab) says any posted rate is accepted if it is used consistently.

• Paid method: the spot rate on the date each payment was made or each deduction withheld
• Accrual method: generally the average rate for the US year the tax relates to
• Accrued tax outside the average-rate conditions: the rate on the date of payment
• Either method: the same source of rates, used consistently from year to year

How do you convert PAYE and Self Assessment payments when paid?

On the paid method each deduction or payment is a separate event with its own date. PAYE is withheld every payday, so a monthly employee has twelve conversion dates in a calendar year. A Self Assessment balancing payment or payment on account is converted at the rate on the day the money reached HMRC.

Publication 514 says tax withheld in foreign currency is translated at the rate on the date of withholding, and foreign estimated tax is translated at the rate on the date of payment. A payment on account is the UK equivalent of an estimated payment, so it takes the rate on the day you paid it. The GOV.UK deadlines page (opens the official GOV.UK page in a new tab) gives due dates, but conversion uses the date you actually paid.

In practice this means building a schedule from payslips and the HMRC statement of account, one line per payment, each with its own rate. A single P60 figure converted at one rate does not fit the paid method, because the P60 spans two US calendar years and many payment dates. Where we prepare the UK return through our UK Self Assessment service, the payment dates come from the same records.

When can accrued UK tax use the yearly average rate?

Accrued UK tax can use the average rate for the US year it relates to only if three conditions hold. It must not be paid more than two years after that year ends. It must not be paid in a year before the year it relates to. And the liability must not be in an inflationary currency, which sterling is not.

The second condition matters most for employees. UK income tax for a UK tax year accrues on 5 April, so it relates to the US year containing that date. PAYE deducted between April and December belongs to a UK tax year that ends the following April. On the accrual method that PAYE was therefore paid in a US year before the year to which it relates, and the Form 1116 instructions take it outside the average-rate rule. It is converted at the rate on each date of payment.

The other payments for a UK tax year usually pass the test. PAYE deducted from January to 5 April, the payments on account due by 31 January and 31 July within the same calendar year, and a balancing payment made the following 31 January all fall within the relevant year or the two years after it. Accrued tax paid later than that loses the credit until it is paid, and is then converted at the payment-date rate.

• PAYE from 6 April to 31 December: paid before the related US year, so the payment-date rate
• PAYE from 1 January to 5 April: within the related US year, so the average rate is available
• Payments on account in the same calendar year as 5 April: average rate available
• Balancing payment the following January: average rate available if paid within the two-year window

Can you elect the payment-date rate instead of the average?

Yes. A taxpayer on the accrual method can elect to convert accrued foreign tax at the rate on the date of payment rather than the yearly average. The election is made by attaching a statement to the return by its due date, including extensions, and applies to that year and every later year unless the IRS consents to revoking it.

The instructions limit the election to accrued taxes that would otherwise use the average rate and are denominated in a currency other than your functional currency, which for an individual is the dollar. Tax that is accrued but still unpaid when the election applies is converted at the rate on the last day of the US year to which it relates, and adjusted when it is paid.

The election can simplify a return where most of the UK tax is already converted at payment-date rates under the exceptions above, because every amount then follows one rule. It also adds a small adjustment each time unpaid tax is settled at a different rate, although the instructions excuse a full redetermination where the change comes only from currency movement and stays below a threshold they set. Whether it helps depends on the pattern of payments, and we model both as part of our treaty relief service.

Why can UK income and UK tax use different rates?

Income and tax are converted under different rules. Income is translated when it is received or accrued, using the rate prevailing then. The tax on that income follows the paid or accrual rules above. On one Form 1116 the salary in Part I and the PAYE in Part II can therefore sit at different rates, and that is expected.

Publication 514 tells a taxpayer whose functional currency is the dollar to translate each item of income into dollars immediately, using the most appropriate rate where several exist. For a salary received evenly through the year, a consistently used yearly average is a common practical approach, but the rule itself refers to the rate when the income is received.

The gap widens on the accrual method. Most of the income behind a UK tax year is earned in the earlier calendar year, while the tax is converted by reference to the later one. Our post on carrying excess UK tax credits covers what happens to the difference.

• Income: the rate when received or accrued, or a posted average used consistently
• Tax on the paid method: the rate on each payment or withholding date
• Tax on the accrual method: the yearly average for the related US year, subject to the exceptions
• Treasury reporting rates, published quarterly for federal agencies, are posted rates but not daily spot rates

Which rate applies when HMRC refunds UK tax?

A refund of UK tax that has been credited is a foreign tax redetermination. The credit is reduced by the refund converted at the rate used when the tax was paid, not the rate on the day the refund arrives.

Publication 514 asks for a statement showing both the rate used when the credit was first claimed and the rate on the date the refund was received. Where the redetermination increases US tax, you generally file an amended return on Form 1040-X with a revised Form 1116, and the publication sets the deadline as the due date, with extensions, of the original return for the year in which the redetermination occurs. A penalty that grows each month, up to a cap, can apply to a failure to notify without reasonable cause.

Common UK triggers are a PAYE repayment after HMRC's year-end reconciliation, a payment on account that exceeds the final bill and is repaid, and a reduced liability after an amended Self Assessment return. Where a redetermination does not change US tax for any year, the instructions allow Schedule C (Form 1116) to be attached to the original return instead of amending. If HMRC increases the bill, the further UK tax can be credited, with a longer period to claim it.

How does the conversion work for a UK employee?

Take a US citizen employed in Leeds, paid monthly through PAYE, who also lets a flat and pays the tax on the rent through Self Assessment. She credits UK tax on the accrual method. Her PAYE splits at the calendar line, and her Self Assessment payments each need checking against the two-year window.

Her US return credits the UK tax for the UK year that ended on 5 April of that calendar year. The PAYE deducted from the previous April to December was paid before that US year began, so each deduction is converted at the rate on its payday. The PAYE from January to 5 April, the payments on account made in the same calendar year, and the balancing payment the following January can all use the IRS yearly average for that US year, because each is paid within the permitted period.

Her salary in Part I is converted at the rates for when it was received, and her rent at the rates for when it arose, so neither matches the tax figure. If HMRC later repays part of the tax, the credit is reduced at the original rate. She files an SA100 return in the UK and keeps one schedule of dates and rates that both returns draw on, which our cross-border tax service prepares each year. The wider choices are in our guide to US-UK double taxation.