Paid or accrued: which US tax year takes the UK tax credit?

Why do the US and UK tax years not line up?

The US tax year for an individual is the calendar year. The UK tax year runs from 6 April to 5 April. Each US year therefore holds roughly the last three months of one UK year and the first nine of the next, and UK documents such as a P60 or a Self Assessment calculation describe a period that no US return uses.

The mismatch matters because the foreign tax credit (opens the official IRS page in a new tab) is limited year by year. In each category of income, the credit cannot exceed the US tax on that year's foreign-source income. UK tax that lands in a year without the matching income becomes an excess to carry. Income that lands in a year without its UK tax bears US tax in full. The year to which the tax is assigned can matter as much as the amount.

For an employee the gap is small, because tax is deducted as the salary is earned. For gains, rent and self-employment profit it is wide. The UK tax for a year is settled through Self Assessment, with the balance due by 31 January after the UK year ends, as the GOV.UK page on Self Assessment deadlines (opens the official GOV.UK page in a new tab) sets out. That can be more than a year after the income arose.

What counts as UK tax paid in a US calendar year?

On the paid method, UK tax counts in the US year in which it is actually paid or withheld, whichever UK tax year it relates to. PAYE counts when it is deducted from each payslip. Self Assessment payments count on the date they are made to HMRC. The UK year printed on the bill is irrelevant.

The amount that qualifies is the legal and actual liability, which Publication 514 (opens the official IRS page in a new tab) says is not necessarily the amount withheld. PAYE that is refunded after the UK year end, or a payment on account that exceeds the final bill and is repaid, is not creditable to that extent. Nor is tax that is reasonably certain to be refunded if a claim were made. National Insurance is left out altogether, because it is a social security contribution covered by the totalization agreement.

The records follow from this. A paid-method return needs payslips for the twelve calendar months and an HMRC statement of account showing the date of each Self Assessment payment. Where we prepare the UK return through our UK Self Assessment service, the same schedule of payments feeds the US credit.

• PAYE deducted from pay between 1 January and 31 December, taken from payslips and not from a single P60.
• A balancing payment for the UK tax year that ended the previous April, due by 31 January.
• Payments on account towards the current UK tax year, due by 31 January and 31 July.
• Capital gains tax paid when reporting a UK property sale (opens the official GOV.UK page in a new tab), due within 60 days of completion.

How does the Form 1116 accrual election work?

A taxpayer on the cash method can choose to credit foreign taxes in the year they accrue by ticking the accrued box in Part II of Form 1116 (opens the official IRS page in a new tab) on a timely filed original return. The choice cannot be made on an amended return, it covers all creditable foreign taxes, and it must be followed in every later year.

Publication 514 says foreign taxes generally accrue when all the events have taken place that fix the amount of the tax and the liability to pay it, which is usually the last day of the foreign tax year. For UK income tax and capital gains tax that is 5 April. The whole UK year's tax then belongs to the US year containing that date, although about three quarters of the income behind it was earned in the previous calendar year. It includes PAYE for the full UK year and Self Assessment tax not yet paid.

The first year of the election has a helpful transitional rule. Someone who credited taxes when paid in earlier years can, in the year of the change, credit both the earlier-year taxes paid in that year and the current-year taxes accrued, so nothing falls between the two methods. There are conditions afterwards. Accrued tax must be paid within two years after the end of the US year it relates to, or the credit is reduced, and the IRS can ask for a bond.

Which method suits employees, the self-employed and investors?

Employees taxed through PAYE with little other income usually do well on the paid method, because tax is withheld as the income is earned. Self-employed people and investors, whose UK tax is settled through Self Assessment long after the income arises, often do better on accrual. The answer depends on the pattern of income, not the label.

Timing explains the difference. On the paid method a tax payment made more than a year after the income can only be carried back one year, which may not reach the year that needs it. On accrual the tax for a UK year always falls in the US year in which that UK year ends, so it is never further than the one-year carryback from the income it covers. Anyone with regular UK bills outside PAYE should have both methods modelled as part of tax planning.

• PAYE employee. Deductions from January to December sit against the salary of the same months, so the paid method matches closely.
• Self-employed. Accrual ties the credit to one UK tax computation each year, where the paid method depends on three payment dates.
• Investor with a one-off gain. On the paid method the UK tax on an autumn gain is paid in the second calendar year after it, beyond the reach of the carryback.
• New arrival. Accrual leaves the first calendar year with UK income but no accrued UK tax, because the UK year covering it ends the following April.

What if the credit still lands in the wrong year?

Unused foreign tax in a category is carried back one year and forward ten years. The carryback reaches only the year immediately before, and it is claimed by amending that year with a revised Form 1116. Carryforwards are used when a later year's US tax on foreign income in the category exceeds that year's foreign tax.

The carryover is the safety valve for both methods, with limits. It stays within its own category, so excess credit on salary cannot relieve US tax on an investment gain. It cannot reach back two years. A carryback is made on Form 1040-X, and the general period for amending is three years from filing or two years from payment, whichever is later, although Publication 514 allows ten years for refund claims that rest on foreign taxes.

Carried credits are never refunded. Many Americans on UK salaries hold general-category balances they will not use unless they later have foreign earnings taxed at lower rates. The practical aim is therefore narrower than a large carryforward. It is to make sure that in each year with US tax on foreign income, enough UK tax falls in that year or the one after it.

Which exchange rate applies and what if the UK tax changes?

On the paid method, UK tax is generally converted at the rate on the date it was paid. On accrual it is generally converted at the average rate for the US tax year to which the tax relates, provided it is paid within two years after that year ends. If the UK tax is later refunded or increased, the credit has to be redetermined.

Publication 514 allows an accrual taxpayer to elect the payment-date rate for taxes denominated in a foreign currency, and it applies the payment-date rate in any case to accrued tax paid outside the two-year period. The IRS publishes yearly average exchange rates (opens the official IRS page in a new tab) that can be used for the average. Whichever rate applies, it should be the same source of rates each year, and the same one used for the income.

A foreign tax redetermination arises when paid tax is refunded in whole or part, when accrued tax turns out to differ from the amount claimed, or when accrued tax is not paid within the two-year period. A PAYE refund after the year-end reconciliation and a reduced Self Assessment bill after an amended UK return are common examples. Where the change increases US tax, the publication generally requires an amended return notifying the IRS, with a penalty for failing to do so. Where HMRC increases the UK tax, a further credit can be claimed.

How do the two methods compare for a self-employed American?

Take a US citizen working as a self-employed consultant in Bristol whose profits are rising. On the paid method her credits trail her income and US tax can arise in the early years. On accrual each US return carries one complete UK tax computation, and the lag is fixed and predictable.

On the paid method, in one calendar year she pays the balancing payment for the UK year that ended the previous April and the first payment on account for the current UK year, both by 31 January, then the second payment on account by 31 July. Those payments are based on profits of earlier periods. Her US return taxes this calendar year's higher profit, so the credit falls short, and the excess UK tax that follows can be carried back only one year.

On accrual, her US return for a year credits the UK tax for the UK year ending on 5 April of that year, paid or not. It still relates partly to the previous calendar year's profit, but it is one figure from one UK return, and in the year she elects she can also credit the earlier-year tax paid that year. We settle the method with clients before the first return in our cross-border tax service, since both returns draw on it. The other relief choices are in our US-UK double taxation guide.