Article by Bill Dodwell, a Tax Partner at Andersen.
Published in October 2001 issue of Tax Adviser.Overview
The current UK/US tax treaty has been in force for over 20 years and has long ceased to reflect modern practice and substantial changes in both countries’ tax laws. Its replacement emerged on 24 July 2001.
Arguably this is the most significant treaty since the US/Netherlands one introduced in 1992. That was a landmark treaty, as it included for the first time a limitation of benefits (LOB) clause and a base erosion clause, to kill off finance branches. As a result, a substantial amount of intermediary business shifted from The Netherlands to other more favourable locations. Taking this lesson on board, the UK negotiators have held out for a more favourable LOB clause, whereby benefits are preserved for companies based in EU Member States.
The new US/UK treaty also has its landmark provisions. The zero per cent dividend withholding tax for 80 per cent owned subsidiaries will offer noticeable benefits to UK investors in the US, not only through reducing the tax burden on profits remitted to the UK, but also in facilitating some reorganisations treated as deemed dividends under US domestic law. The UK Government must be delighted that they have now an economic lever to persuade UK companies to bring their shareholdings ‘onshore’.
Some of the most innovative provisions deal with tax avoidance. The first thing caught is a US/UK preference share repurchase arrangement. This is essentially a financing plan, whereby a US parent company sells to an investor (and agrees to repurchase in a defined period) preferred shares issued by its US subsidiary company. The US group receives an interest deduction, since US domestic law views this is a secured financing arrangement. By contrast, with appropriate structuring, a UK investor could simply receive dividends with tax credits. The treaty provides that credits will no longer be given in this situation and so direct US/UK repos will undoubtedly become a thing of the past. The Inland Revenue clearly had this treaty in mind when they instigated Taxes Act 1988, s. 793A which provides that where a tax treaty contains specific limitations on double tax relief, unilateral relief will no longer be available as a fall-back.
The treaty also puts up an effective barrier to dual resident companies, by providing that the US and UK competent authorities will need to agree on a case-by-case basis which treaty benefits will be granted. Yet another measure deals with hybrid entities, essentially denying treaty relief unless the ultimate beneficiary is itself entitled to treaty relief.
For the first time in any US treaty, there is a complete exemption from withholding taxes on certain dividends. In general, the exemption applies to dividends paid to UK resident shareholders that have owned shares representing at least 80 per cent of the voting power of the payer for the 12-month period ending on the date on which the dividend is declared, and which satisfy one of the following criteria:
- the 80 per cent ownership test has been met (directly or indirectly) since before 1 October 1998; or
- certain conditions of the LOB clause are met.
The US Treasury view is that the 80 per cent ownership test is only met where the LOB conditions are also satisfied. Some UK commentators have disagreed and confirmation of the Revenue’s view is not yet forthcoming.
The exemption also applies to dividends paid to pension schemes as long as the dividends are not derived directly or indirectly from the carrying on of a business by the pension scheme. Five per cent withholding applies to dividends if the beneficial owner is a company that owns shares representing (directly or indirectly) at least ten per cent of the voting power of the payer. The withholding tax rate is otherwise 15 per cent.
Provisions relating to tax credits in respect of dividends paid from the UK to the US have been removed following the abolition of advance corporation tax in the UK.
Branch profits tax
The treaty introduces a branch profits tax of up to five per cent in certain circumstances. The tax will not apply if, broadly, the branch was operating prior to 1 October 1998 and tests similar to the limitation on benefits tests for dividends are met. On the question of attributing business profits more generally, the treaty follows recent OECD discussions and in particular the risk-weighted method for the attribution of capital.
The general exemption from withholding tax on interest is over-ridden by a new contingent interest provision which allows for a maximum 15 per cent withholding tax on interest payments that are determined by reference to:
- receipts, sales, income, profits or other cash flow of the debtor or a related person;
- any change in the value of any property of the debtor or a related person; or
- dividends, partnership distributions or similar payments made by the debtor to a related person.
The treaty also generally provides for exemption from withholding tax on royalties. The definition of royalties now makes clear that payments for the use of, or right to use, computer software and cinematographic films are included.
Limitation on benefits
A UK or US resident can qualify for all the benefits of the treaty if that person is a ‘qualified person’. In essence, this is defined as a publicly traded company or one that meets the ‘ownership/base erosion’ test. There are detailed provisions outlining the requisite share ownership percentages and recognised exchanges. Alternatively, a resident of a treaty jurisdiction can qualify for benefits with respect to discrete items of income if that person meets one of three other tests.
In addition to comprehensive LOB provisions, the new treaty contains a novel ‘conduit’ rule designed to prevent so-called ‘treaty shopping’ for income under specific articles. Arrangements caught by the conduit rule are not entitled to specified treaty benefits.
The rule applies to income paid as part of a transaction (or series) which:
- has as one of its main purposes obtaining increased benefits under the treaty; and
- is structured so that the treaty beneficiary recipient pays all or substantially all of that to a person who is not a beneficiary of the treaty and who would not be entitled to equivalent or better benefits under a treaty between that person’s jurisdiction and the jurisdiction in which the income arises.
Fiscally transparent entities
The new treaty provides that monies derived through a person that is fiscally transparent under the laws of either the UK or US shall be considered to be derived by a resident of one of the contracting countries. This is only to the extent that the item is treated for tax purposes under the laws of that country as the income, profit or gain of a resident. This provision will adversely affect US limited liability companies considered transparent for US, but not UK purposes, and possibly also some hybrid financing arrangements into the UK. Such structures will need to be carefully reviewed in light of the changes.
Dual resident companies (DRCs)
The lack of any conventional ‘tie-breaker’ clause will be unsatisfactory for affected companies. In the absence of any mutual agreement by the competent authorities, a DRC is only entitled to limited treaty benefits.
Tax credit denial
In general, the treaty provides the usual confirmation of the creditability in one country of taxes paid in the other. One key exception is that UK tax credits are denied with respect to dividends paid by US corporations in transactions in which:
- the UK views the dividend as beneficially owned by a UK resident;
- the US views the dividend as beneficially owned by a US resident; and
- the US has allowed a deduction to a US resident in respect of an amount determined by reference to the dividend.
This provision affects certain cross-border ‘repo’ financing structures, where shares are sold subject to a repurchase agreement which the UK views as a sale and the US views as a secured loan. In these circumstances, tax credits on dividends paid to the UK will be denied.
Capital gains other than on real property will be broadly taxable in the country of residence. One exception is that either country may continue to tax gains derived by a resident of the other country if the person was resident in the first country at any time during the six years immediately preceding the disposal. Prima facie this means that those away for less than five years may still suffer double taxation.
Under the existing treaty, it has been possible for individuals resident in one of the countries to claim exemption from tax in the other provided that they are present in the other country for no more than 183 days in the tax year. The 183-day test will in future be applied over any 12-month period commencing or ending in the relevant tax year. This is a much more stringent test and will restrict the number of treaty claims short-term assignees will be able to make.
The Exchange of Notes makes it clear that share option gains fall within the scope of employment income. This has long been the position of the UK Revenue and the matter is now put beyond doubt.
The new treaty broadly provides that directors’ fees may be taxed by the country in which the company is resident.
Included are provisions allowing at least a measure of relief in respect of contributions paid into a pension scheme established in one country during a period of employment or self-employment in the other where the duties are performed. Somewhat disappointingly, the reliefs available in the host location are restricted to what would be available to a resident of that country if the contributions were made to a pension plan established in that country. This restriction is unlikely to affect US nationals working in the UK, but may well affect at least a proportion of British nationals who remain a member of a UK approved occupational pension plan during a period of employment in the US. The problem will be particularly acute in the case of highly paid executives who are not subject to the earnings cap.
Pension benefits will, in general, continue to be liable to tax only in the country in which the individual is resident at the date of receipt. The main exception to this is that lump sum pension benefits will be taxable only in the country in which the pension scheme is established.
Exchange of information
There are some subtle, but significant extensions to the exchange of information article, namely that:
Entry into force
- it is not limited to information concerning criminal violations of the tax law;
- information is to be provided even if the requested country does not require the information for the purpose of enforcing its own tax laws; and
- the Exchange of Notes confirms that the authority shall extend to information held by financial institutions, nominees and fiduciaries.
The treaty has still to be ratified by both governments, but there has been nothing to suggest that this will not occur by the end of this year. It will apply to:
- withholding taxes from the first day of the second month following ratification;
- to other US taxes for taxable periods beginning on or after 1 January of the year following ratification;
- to UK corporation tax for financial years beginning on or after 1 April following ratification;
- to UK capital gains and income taxes for years of assessment beginning on or after 6 April following ratification.
Where beneficial, companies may elect for the current treaty to continue to apply for 12 months after the new treaty would otherwise have had effect. This is an all or nothing election; it is not possible to pick and choose between provisons in the old and new treaties.
This sort of tax treaty could probably only have been entered into by the UK and the US, reflecting the close working relationship between the two tax authorities, who meet frequently and exchange considerable amounts of information. This treaty will no doubt help the revenue authorities of both countries in reducing the number of one-sided tax deductions available. Tax planners are now firmly on notice that in some cases it is more effective to shut down tax planning though treaties, rather than through amendments to domestic law.
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October 2001 by