Is my UK redundancy payment taxable on my US tax return if HMRC treated it as tax free?

Yes. The United States taxes citizens on worldwide income and has no equivalent of the UK section 403 exemption. IRS Publication 525 requires severance pay and payments for cancellation of an employment contract to be included in income. The first 30,000 pounds that HMRC leaves out of charge is fully taxable on Form 1040, and because no UK tax was paid on it, no foreign tax credit attaches to that slice.

What is post-employment notice pay and why does it matter for my US filing?

Post-employment notice pay is the statutory measure of unworked notice, calculated under section 402D ITEPA 2003. HMRC guidance confirms it is charged as general earnings and gets no share of the 30,000 pound threshold. For US purposes it is ordinary compensation like any other. It matters because it is the element that carries full UK tax, and therefore the element generating creditable foreign tax to offset the US charge on the whole package.

How do I source a UK termination payment between US and UK workdays?

The IRS time basis method multiplies the total payment by the fraction of days services were performed in the United States over total days of service. An alternative basis is permitted where you can demonstrate it more accurately reflects the source. HMRC sources the payment as the remuneration it replaces, typically looking back 12 months for contractual amounts. Keep a workday calendar covering the whole relevant service period.

Which Form 1116 basket do severance and the UK tax on it fall into?

General category income. Compensation for personal services is active income, not passive, so both the severance and the UK income tax paid on it sit in the general category basket. That matters because the section 904 limitation and the one-year carryback and ten-year carryforward all operate separately within each category. General category excess credits cannot shelter US tax on passive investment income.

Do I pay US social security tax on a UK severance package?

Generally not, where you are covered by the UK National Insurance system under the bilateral totalization agreement between the two countries. The IRS explains that these agreements exist to avoid double social security taxation, and a certificate of coverage evidences which system applies. Note that National Insurance is not an income tax, so it is not creditable on Form 1116 even though it reduces what you actually receive.

Can I still claim UK foreign service relief on my termination payment?

Only in limited cases. GOV.UK confirms the relief was removed where the employee is UK resident in the tax year the employment terminates, for payments received after 13 September 2017 relating to employments ending on or after 6 April 2018. Foreign seafaring service remains an exception. Where a reduction is still available, HMRC requires the claim in writing within four years of the end of the relevant tax year.

US Tax Return Preparation for Expats: UK Exit Pay

US tax return preparation for expats leaving a UK role turns on a single uncomfortable fact: the money HMRC lets you keep tax free is still fully taxable by the IRS. A US citizen exiting a City position under a settlement agreement is taxed twice over on two different maps. The UK carves the package into earnings and a qualifying termination award, exempts part of it, and applies National Insurance selectively. The United States taxes its citizens on worldwide income and recognises none of that carving. The result is a payment that is partly tax free in Britain and wholly taxable in America, with the tax-free slice arriving on Form 1040 carrying no creditable UK tax at all. That mismatch, not the headline number in the agreement, is what decides whether you write a cheque to the IRS.

Why US tax return preparation for expats gets harder the moment you are handed a settlement agreement

A termination package is not one payment. It is six or eight payments stapled together, each with its own legal character, and each character drives a different answer in each country. In the returns we prepare, the single most common failure is treating the gross figure on the settlement agreement as one line of foreign wages. It is not. Some of it is contractual earnings, some is compensation for loss of office, some is consideration for a promise not to compete, and some is deferred remuneration accelerated to the exit date. The UK tax code separates those. The US code separates them too, but along different lines and for different reasons.

The practical consequence is that you cannot prepare the US return from the P45 and the final payslip alone. You need the signed settlement agreement, the employer's PENP calculation, the payroll breakdown showing what went through PAYE and what did not, and a workday record for the relevant service period. Without those four documents the foreign tax credit computation is guesswork, and guesswork in this area is expensive.

What is actually inside a senior UK exit package?

Before any tax analysis, itemise the agreement. A typical package for a senior employee leaving a UK financial services role contains most of the following, and each needs to be identified by name in the agreement rather than rolled into a single compensation figure.

Contractual notice pay, or a payment in lieu of notice where the employer exercises a PILON clause and you leave immediately
Statutory redundancy pay, where the exit is a genuine redundancy
Enhanced or contractual redundancy pay above the statutory minimum
An ex gratia or compensation element, described in the agreement as compensation for loss of employment and offered in exchange for waiving claims
A separately stated payment for restrictive covenants, typically non-compete, non-solicit and confidentiality undertakings
Accrued but untaken holiday pay, and any unpaid salary to the termination date
Bonus, whether a pro-rated current-year award or deferred cash from prior years accelerated on exit
Unvested share awards that either vest on termination under good leaver provisions or lapse
Outplacement or career transition support paid for by the employer
The employer's contribution towards your legal fees, usually paid direct to your solicitor
Continued benefits such as private medical cover or life assurance for a defined period after the leaving date

How does HMRC tax a UK termination payment?

The UK rules split the package into two buckets. Anything that is simply earnings is taxed as earnings, in full, through PAYE and with National Insurance in the usual way. GOV.UK confirms at https://www.gov.uk/termination-payments-and-tax-when-you-leave-a-job/what-you-pay-tax-and-national-insurance-on that unpaid wages, holiday pay, bonuses, restrictive covenant payments and any payment received instead of working the notice period all fall into this earnings bucket.

What is left is a relevant termination award. Section 403(1) ITEPA 2003 provides that relevant payments and benefits count as employment income only to the extent that they exceed 30,000 pounds, as set out in HMRC's Employment Income Manual at https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim13505. GOV.UK states at https://www.gov.uk/redundancy-your-rights/tax-and-national-insurance that statutory redundancy pay under 30,000 pounds is not taxable, and that the threshold is applied to the combined total of statutory redundancy pay, additional severance or enhanced redundancy payments and non-cash benefits. Employee National Insurance does not bite on the qualifying award, but employer Class 1A National Insurance applies to the part above the threshold.

The rule that catches most senior leavers is post-employment notice pay. HMRC explains at https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim13874 that a relevant termination award is split into PENP, calculated under the statutory formula in section 402D ITEPA 2003, and the remaining balance. The employer must run that formula whether or not any contractual or non-contractual payment in lieu of notice is actually made. PENP is then chargeable to income tax as general earnings and, per https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim13876, does not benefit from the 30,000 pound threshold in section 403. In plain terms, the value of notice you did not work is taxed in full no matter how the agreement labels it, and only the genuine compensation element above and beyond notice gets the exemption.

Component by component: UK treatment, US treatment, and where it lands on the return

This is the mapping we build for every termination file, and it is the part almost no published guidance sets out side by side. Read each line as: what the agreement calls it, what HMRC does with it, what the IRS does with it, and where it goes on the US return.

Contractual PILON or post-employment notice pay. UK: taxed in full as general earnings with employee and employer Class 1 National Insurance, no share of the 30,000 pound threshold. US: ordinary compensation income. Reported as foreign wages on Form 1040 line 1h or line 1a depending on how the payment is evidenced, and sourced by workdays over the notice period it replaces.
Statutory redundancy pay. UK: counts towards the combined 30,000 pound exempt amount and is typically free of tax and National Insurance. US: severance income, fully taxable. IRS Publication 525 at https://www.irs.gov/publications/p525 requires you to include in income amounts received as severance pay and any payment for the cancellation of an employment contract. Foreign wages on Form 1040, general category on Form 1116.
Enhanced or ex gratia severance. UK: part of the relevant termination award, exempt up to the combined 30,000 pound threshold, taxable above it with employer Class 1A National Insurance on the excess. US: fully taxable severance from the first pound. Foreign wages, general category.
Restrictive covenant payment. UK: taxed as earnings in full, with National Insurance, and it never touches the 30,000 pound threshold. US: ordinary compensation for an undertaking to refrain from performing services. Foreign wages, general category, sourced by reference to where the restriction bites.
Accrued holiday and unpaid salary. UK: earnings, taxed and NIC'd in the normal way through the final payroll. US: ordinary wages. Foreign wages, general category. Note that HMRC treats taxing rights over unused holiday from past service as split by residence over the last 12 months of employment, per https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim13695.
Bonus and accelerated deferred cash. UK: earnings, taxed in the tax year of receipt. US: ordinary compensation, taxable in the calendar year received by a cash-basis individual, but sourced by reference to the performance period the bonus relates to rather than the year of payment. Foreign wages, general category.
Share awards that vest on exit. UK: employment income at vest, usually with PAYE and NIC operated on the market value. US: ordinary income on vesting for restricted stock units, sourced on a time basis over the grant-to-vest period as the IRS practice unit on multi-year compensation at https://www.irs.gov/pub/fatca/int_practice_units/sourcing-multi-year-compensation-arrangements.pdf explains. Foreign wages, general category, with a fresh capital gains clock starting at vest.
Share awards that lapse on exit. UK: no charge, nothing vested. US: no income event, but the lapse ends any expectation of future foreign source income and can strand carryover credits.
Employer-paid legal fees. UK: not taxed where paid direct to your solicitor under the agreement, per GOV.UK. US: generally includible in your income, with any offsetting deduction available only in narrow circumstances. This is a classic silent add-back that appears in no UK payroll record.
Outplacement and career transition support. UK: generally provided free of charge to the employee where the statutory conditions are met. US: a benefit provided by the employer that needs to be tested rather than assumed to be excludable. Ask for the invoiced value.
Continued private medical or life cover after leaving. UK: a non-cash benefit counted within the combined 30,000 pound threshold. US: taxable compensation measured by the cost of the cover, and it will not appear on any UK payslip.
Employer pension contribution into a registered scheme. UK: not taxed as part of the package where it is within the annual allowance. US: a separate and complex analysis outside the scope of the termination computation, and one to segregate on the file rather than sweep into the wage line.

Why is a UK tax-free payment still taxable on your US return?

Because the United States taxes citizens on worldwide income and grants no equivalent of the section 403 exemption. There is no US provision that mirrors a threshold for compensation for loss of office. IRS Publication 525 is unambiguous that severance pay and payments for the cancellation of an employment contract are income. The UK exemption is a domestic UK relief, and a domestic relief in one country does not transplant into the other.

Nor does the treaty rescue you here. The saving clause in the US-UK convention preserves the United States' right to tax its own citizens as if the treaty had not come into force, subject to specific exceptions. HMRC's own guidance on the agreement is at https://www.gov.uk/hmrc-internal-manuals/double-taxation-relief/dt19939d. The treaty allocates taxing rights, it does not create a US exemption for a payment that Parliament chose to exempt in Britain.

The foreign tax credit trap hiding in the exempt slice

Here is the mechanic that turns a well-negotiated UK package into a US tax bill. The foreign tax credit is a credit for foreign tax actually paid or accrued on foreign source income. The IRS confirms at https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit that generally only income, war profits and excess profits taxes qualify. If HMRC exempts a slice of your package, no UK tax is paid on that slice. That slice therefore arrives on your Form 1040 as fully taxable foreign source compensation carrying zero creditable tax.

Now look at what that does to the section 904 limitation. The Form 1116 instructions at https://www.irs.gov/instructions/i1116 require the credit to be computed separately for each category of income, and the limit in each category is broadly the US tax on your worldwide income multiplied by the fraction of foreign source taxable income in that category over total worldwide taxable income. Adding a large block of foreign source income with no attached foreign tax raises the numerator of that fraction. It therefore raises your limitation, which sounds helpful, but it simultaneously raises the US tax on foreign source income that your existing UK tax now has to cover. The effective foreign tax rate on the general category, taken as a whole, falls. If your blended rate on general category income drops below the US rate applied to it, you have residual US tax to pay on a package your client believed was already fully taxed.

In practice, whether that residual bill materialises depends on the rest of the year. A senior employee who worked most of the tax year on a full UK salary taxed at the higher and additional rates will usually have enough excess UK tax on the salary to absorb the untaxed exempt slice within the same general category basket. An employee who is made redundant early in the year, or whose package dwarfs the salary actually earned, often will not. That is the difference between a nil balance due and a five-figure payment, and it is knowable before the agreement is signed.

Excess credits are not lost outright. The Form 1116 instructions confirm unused foreign taxes carry back one year and forward ten years. But those carryovers move only within the same separate category, so a general category carryover from a prior year is the only carryover that can help here. We cover the mechanics of that at https://us-uktax.com/insights/news-and-updates/foreign-tax-credit-carryback-and-carryover-form-1116, and the carryback year is a live planning lever when the termination year is the low-tax year.

How is a termination payment sourced between US and UK workdays?

Sourcing decides how much of the payment counts as foreign source income, and foreign source income is the only income against which a foreign tax credit can be claimed. Get this wrong and the credit fails even where the UK tax was genuinely paid. The IRS sets out the time basis method at https://www.irs.gov/individuals/international-taxpayers/source-of-income-personal-service-income: US source income is the total pay multiplied by the fraction of days on which services were performed in the United States over total days of service. An alternative basis is available if the taxpayer can support that it more accurately determines the source.

The complication is that the two revenue authorities do not always measure the same period. HMRC's approach is to source a termination payment in the same way as the remuneration it is intended to replace. For contractual and statutory payments, that generally means looking back over the last 12 months of employment. For a discretionary ex gratia payment, HMRC has tended to look forward instead, which is precisely where a mismatch with a treaty partner can arise. A senior employee who spent, say, one year of a five-year tenure on secondment in New York and the rest in London can end up with HMRC and the IRS measuring different denominators over the same payment. Document your chosen basis, keep the workday calendar, and be consistent across both filings.

A worked scenario

The following figures are purely illustrative and are not a client case. Assume a US citizen, UK resident throughout, leaving a senior London role in October. The settlement agreement provides a contractual PILON of 75,000 pounds, statutory redundancy of 6,000 pounds, an enhanced ex gratia compensation payment of 150,000 pounds, a restrictive covenant payment of 10,000 pounds, accrued holiday of 12,000 pounds, and accelerated deferred cash bonus of 200,000 pounds. Assume purely for illustration an exchange rate of 1.30 US dollars to the pound; in a real filing you would translate using an appropriate published rate consistently applied.

On the UK side, the PILON, the restrictive covenant payment, the holiday pay and the deferred bonus are all earnings, taxed in full with National Insurance. Because a contractual PILON of 75,000 pounds has already been paid and taxed as earnings, the PENP formula produces nil, so the whole of the statutory redundancy and the ex gratia amount, 156,000 pounds combined, is a relevant termination award. The first 30,000 pounds is outside the charge under section 403, leaving 126,000 pounds taxable with employer Class 1A National Insurance on the excess.

On the US side, the whole 453,000 pounds is compensation income. Nothing is exempt. Of that, 30,000 pounds arrives with no UK tax attached whatsoever, roughly 39,000 US dollars of foreign source general category income sitting in the Form 1116 numerator with a zero in the tax column. The question the preparer must answer, before the client signs, is whether the UK tax on the other 423,000 pounds plus the salary earned January to October is enough to cover the US tax on the whole. Where the exit happens late in the calendar year, it usually is. Where it happens in February, it frequently is not.

What about the tax year straddle and the timing mismatch?

The UK tax year runs to 5 April and the US tax year is the calendar year. A package paid in, say, March is taxed by HMRC in one UK tax year and by the IRS in a calendar year that ends nine months later. If instalments straddle 5 April, the UK tax attaching to the payment is finalised across two UK returns while the US return needs the whole picture in one calendar year.

This drives the accrual election. A cash-basis taxpayer claims the credit for foreign taxes in the year paid, which can put the income in one US year and the creditable UK tax in the next, wasting credit in the first and stranding it in the second. Electing to claim the credit on the accrual basis matches the UK tax to the year the income arises, which is usually the better answer on a termination file. The election is binding for later years, so it is a decision to take deliberately rather than by default. Where PAYE has over-withheld and a UK repayment follows, remember that a refund of foreign tax requires the US credit to be redetermined.

One further timing rule catches people who leave the UK on exit. The IRS states at https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion that payments received after the end of the tax year following the year in which the services were performed do not qualify as foreign earned income. Deferred cash paid out slowly after departure can therefore fall outside the exclusion entirely, leaving the foreign tax credit as the only relief and making the sourcing analysis decisive.

National Insurance, US social security and the totalization agreement

Employee National Insurance does not apply to the qualifying termination award, but it does apply in full to the earnings elements, including PENP and PILON. Employer Class 1A National Insurance applies above the 30,000 pound threshold. None of that National Insurance is an income tax, so it is not creditable against US income tax on Form 1116.

There is no US social security or Medicare charge on the package where the individual is covered by the UK system under the bilateral totalization agreement. The IRS explains the framework at https://www.irs.gov/individuals/international-taxpayers/totalization-agreements, and a certificate of coverage is the evidence that the exemption applies. Keep it on file. Self-employment tax on any consultancy that follows the exit is a separate question, and the certificate is what stands between a departing banker and a self-employment tax charge on the next engagement.

Foreign service relief: a UK relief that quietly helps the US filer

Historically, an employee with a period of overseas service could reduce or eliminate the UK charge on a termination payment. That changed. The GOV.UK policy paper at https://www.gov.uk/government/publications/termination-payments-removal-of-foreign-service-relief/income-tax-and-national-insurance-contributions-termination-payments-removal-of-foreign-service-relief-for-uk-residents confirms the relief was removed for individuals who are UK resident in the tax year the employment ends, for payments received after 13 September 2017 where the employment terminated on or after 6 April 2018. Seafarers retain the exception. HMRC's guidance at https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim13700 sets out both the restriction and, where the reduction is still available, the mechanics: PENP is reduced by foreign service over total service, and the amount charged under section 403 is reduced on the same proportion after the 30,000 pound threshold has been taken off. Claims must be made in writing within four years of the end of the tax year.

Counterintuitively, losing that relief is often good news for the US return. More UK tax on the payment means more creditable foreign tax against the same US income. The client who had a genuinely valuable UK relief was the client most likely to face a large residual US charge.

What a preparer checks before the client signs

Whether every element is separately identified and quantified in the agreement rather than combined into a single compensation figure, because an unallocated lump sum invites the worst characterisation in both countries
The employer's PENP calculation, in writing, with the basic pay figure, the unworked notice period in calendar days, the last pay period and any contractual PILON already deducted
How much of the package will be exempt in the UK, and therefore how much foreign source income will arrive on the US return with no creditable tax against it
The estimated blended UK effective rate across all general category income for the whole calendar year, tested against the US rate on that income
Whether general category foreign tax credit carryovers exist from prior years, and whether a carryback to the preceding year would absorb the excess
Which calendar year each instalment falls into, and whether shifting payment timing across the year end improves or worsens the credit position
The workday record for the sourcing period, and whether any US workdays create US source income the UK tax cannot shelter
Whether employer-paid legal fees, outplacement and continued benefits have a measurable value that must be added to US income even though no UK payslip shows them
Whether an accrual basis election for the foreign tax credit is appropriate, and the fact that it binds future years
State filing exposure where the individual retains a domicile or filing footprint in a US state that does not follow the federal foreign tax credit

Reporting the payment on the US return

The compensation goes on Form 1040 as wages, translated into US dollars using a consistent and defensible rate. The UK income tax on the package supports a Form 1116 in the general category, filed alongside any other Form 1116 for passive income from investments. Where the foreign earned income exclusion is claimed, remember the IRS position that no credit is available for tax on income excluded from US gross income, so the UK tax must be apportioned and the excluded portion stripped out of the credit computation. Foreign accounts holding the proceeds bring their own reporting: an FBAR filed with FinCEN's BSA E-Filing System where the aggregate maximum balance test is met, and Form 8938 where the specified foreign financial asset thresholds are met.

This is compliance work, not a negotiation aid, and it is done properly by mapping the agreement before the money moves rather than reconstructing it eighteen months later from a P60 and a bank statement. Our US filing work is set out at https://us-uktax.com/us-tax-services and the UK side at https://us-uktax.com/uk-tax-services, with the full engagement range at https://us-uktax.com/services. If you are holding a draft settlement agreement and a US passport, the mapping exercise above is the first thing to do with it.