The
2003 United States - United Kingdom Income Tax Treaty- Kicking In
by
Sally
Ramage
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29 September 2006
With recent
news such as "Britain’s Serious Organised Crimes Agency has identified the
top 130 crime barons it wants to put out of business. The SOCA has narrowed
down an original list of more than 1000 names to pinpoint its targets",
and "US wins fast-track rights in fraud case- The United States government
won a High Court battle for the right to bring fast-track extradition proceedings
against a couple who are friends of Baroness Thatcher and were guests of the Reagans’ at the White House", and "New rules will
make intercepted emails and wiretaps admissible in court; move brings UK into
line with USA and many EU countries", it is time to look again at the
little-known US-UK Income Tax Treaty of 2003.
This
little-known income tax treaty between the United States and the United
Kingdom, and its related protocol has been in force since 2003. The tremendous
amount of trade between the United States and the United Kingdom, particularly
in the banking and insurance sector makes for enormous implications.
Highlights of the Treaty
* The elimination of the dividend withholding tax on amounts paid by
certain U.S. corporations to U.K shareholders.
Dividends
from U.S. corporations are generally subject to a 30 percent withholding tax.
The rate is reduced to 15 or 5 percent under the existing treaty. There is no
dividend withholding tax under U.K. law. The US-UK Tax Treaty 2003 allows dividends
paid by a U.S. corporation to its U.K. shareholders to be exempt from U.S.
taxation. In order to prevent forum shopping, the US-UK Tax Treaty 2003 imposes
an additional holding requirement on companies that qualify for benefits under
either the active conduct of a trade or business or under the ownership-base
erosion test. The zero rate would apply if the beneficial owner of the
dividends is a company that has owned shares for a 12-month period ending on
the date the dividend is declared representing 80 percent or more of the voting
power of the company paying the dividends and has owned (directly or
indirectly) such voting percentage prior to October 1, 1998. In keeping with
the changes in U.S. tax law regarding securities lending transactions, the term "dividends" includes any
item which, under the laws of the country of which the company paying the
dividend is resident, is treated as a dividend or a distribution of a company.
* The adoption of a limitation of benefits
(LOB) and provision that are similar to that which has been included in most
recent U.S. treaties.
Article 23
contains a limitation on benefits clause similar to that contained in many
other treaties. A person that is not a "qualified person" will not be
able to avail itself of the 2003 US-UK Tax Treaty. Although LOB clauses are
familiar concepts in the context of U.S. treaties, this is the first time a LOB
clause has been included in a U.K. treaty. A resident is a "qualified
person" for a "taxable" or "chargeable" period only if
such resident is either
- an individual;
- a qualified governmental entity;
- a company, if (i) the principal class of its
shares is listed or admitted to dealings on a recognized stock exchange
and is regularly traded on one or more recognized stock exchanges, or (ii)
shares representing at least 50 percent of the aggregate voting power and
value of the company are owned directly or indirectly by five or fewer
publicly traded companies, provided that, in the case of indirect
ownership, each intermediate owner is a resident of either the United
States or the United Kingdom;
- a person other than an individual or a
company, if (i) the principal class of units in that person is listed or
admitted to dealings on a recognized stock exchange and is regularly
traded on one or more recognized stock exchanges, or (ii) the direct or
indirect owners of at least 50 percent of the beneficial interests in that
person are publicly-traded companies or publicly-traded persons other than
companies;
- a pension scheme, plan or similar arrangement,
or an organization established exclusively for religious, charitable,
scientific, artistic, cultural, or educational purposes provided that in
the case of a pension scheme, plan or similar arrangement, more than 50
percent of the person’s beneficiaries, members or participants are
individuals who are residents of either the United States or the United
Kingdom;
- a person other than an individual, if (i) on
at least half the days of the taxable or chargeable period, persons who
are qualified persons by reason of being an individual, qualified
governmental entity, a publicly-traded company or entity or a person
described in paragraph (e) above, own, directly, or indirectly, shares or
other beneficial interests representing at least 50 percent of the aggregate
voting power and value of that person and (ii) less than 50 percent of the
person’s gross income for the taxable or chargeable period is paid or
accrued, directly or indirectly, to persons who are not residents of
either the United States or the United Kingdom in the form of payments
that are deductible in the country of which the person is a resident (but
not including arm's length payments in the ordinary course of business for
services or tangible property and payments in respect of financial obligations
to banks, provided that where such bank is not a resident of the United
States or the United Kingdom such payment is attributable to a permanent
establishment of that bank located in one of such countries); or
- a trust, if at least 50 percent of the
beneficial interests in the trust is held by persons who are either: (i)
qualified persons by reason of being an individual, qualified governmental
entity, a publicly-traded company or entity or a person described in
paragraph (e) above (ii) equivalent beneficiaries, provided that less than
50 percent of the gross income arising to such trust for the taxable or
chargeable period is paid or accrued, directly or indirectly to persons
who are not residents of either the United States or the United Kingdom in
the form of payments that are deductible in the country in which that
trust is a resident (but not including arm's length payments in the
ordinary course of business for services or tangible property and payments
in respect of financial obligations to banks, provided that where such
bank is not a resident of the United States or the United Kingdom, such
payment is attributable to a permanent establishment of that bank located
in one of such countries).
A person,
who is not a qualified person, may be entitled to benefits if at least 95
percent of the aggregate voting power and value of the shares of the company
are owned, directly or indirectly, by seven or fewer persons who are
"equivalent beneficiaries". A person will qualify as an "equivalent
beneficiary," if, in addition to the requirements set out below, such
person is a resident of a Member State of the European Community or of a
European Economic Area state or of a party to the North American Free Trade
Agreement ("NAFTA"), but only if one of two alternative tests are
satisfied. The European Community includes Austria, Belgium, Denmark, Finland,
France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal,
Spain, Sweden and the United Kingdom. Several Eastern European countries will be
admitted in 2004. The European Economic Area includes Iceland, Liechtenstein
and Norway. The signatories to NAFTA are Canada, Mexico and the United States.
In order to
qualify as an equivalent beneficiary, such person must be entitled to "all
the benefits" of a comprehensive convention between the Member State of
the European Community or a European Economic Area state or any party to NAFTA
and the country from which the benefits of the New Treaty are claimed. So, if a U.K. corporation is owned by an
German corporation, it must qualify for benefits under the Germany - U.S.
treaty. However, if such treaty does not contain a comprehensive LOB
provision, the person will be an equivalent beneficiary only if that person
would be a qualified person (and in the case of trusts, without applying the
ownership test for equivalent beneficiaries if such person were a resident of
the United Kingdom or the United States).
Even though
a person may not be a qualified resident, it will be entitled to the benefits
of the treaty with the respect to an item of income1, profit, or
gain, if such person is engaged in the active conduct of a "trade or
business" and the income is derived in connection, with, or is incident to
that trade or business and such person satisfies any other specified conditions
required to obtain such benefits. The managing of investments for the resident’s own account does not count for these purposes,
unless the activities are banking, insurance or securities activities, carried
on by a bank, insurance company or a registered securities dealer. This active
trade or business provision will only apply if the trade or business activities
in the country of residence are substantial in relationship to the trade or
business in the other country.
The term "trade or business" is not defined in the 2003 US-UK
Treaty. Undefined
terms have the meaning that they have under the law of the country that applies
the provision. The Technical Explanation states that the U.S. competent
authority will refer to the regulations issued under section 367(a) of the
Internal Revenue Code to define the term "trade or business." This,
therefore, is a unified group of
activities that constitute or could constitute an independent economic
enterprise carried on for profit. A corporation generally will be
considered to carry on a trade or business only if the officers and employees
of the corporation conduct substantial managerial and operational activities.
A resident
of either the United States or the United Kingdom may be granted tax treaty
benefits if the "competent authority" of the other country determines
that the establishment, acquisition or maintenance of such resident and the
conduct of its operations did not have as one of its principal purposes the
obtaining of benefits under the New Treaty. Prior to denying a person benefits
under this provision, the competent authority will consult with the other
competent authority. In the United States, the Assistant Commissioner
(International) serves as the competent authority.
Article
23(5) denies the benefits of the Treaty to the disproportionate part of the
income earned by certain companies. A company is subject to this provision if
it meets two tests. First, it must have outstanding a class of shares which is
subject to terms or other arrangements which entitle its holders to a larger
portion of the company’s income, profit, or gain in the other country than the
holders would be entitled in the absence of such terms or arrangement. The
disproportionate part of the income of the company is the excess portion of the
company’s income, profit, or gain from the other country to which the holders
are entitled, above that to which they would otherwise be entitled. The
Technical Explanation illustrates this with an example of a company resident in
the United Kingdom having tracking stock that pays dividends based upon a
formula that approximates the earnings and profits of a U.S. subsidiary. The example concludes that the U.K. company
is subject to Article 23(5), with respect to the dividends received from its
U.S. subsidiary.
A company
meets the second part of the test if 50 percent or more of the voting power and
value of the class of shares in question is owned by persons who are not
"equivalent beneficiaries".
* A special provision dealing with the application of the treaty benefits
to amounts which are received by hybrid entities, such as interest, and which
may bring uncertainty in the application of this US-UK Treaty.
The
Interest article generally precludes withholding at source. Interest is defined to include income from
debt claims of every kind, "whether or not carrying a right to participate
in the debtor’s profits. However, interest that is determined by
reference to receipts, sales, income, profits or other cash flows of the debtor
or a related person, to any change in the value of any profit of the debtor or
a related person or to any dividend, partnership distribution or similar
payment made by a debtor to a related person, may be taxed at a rate not
exceeding 15 percent. The exemption from source country taxation does not apply
if the beneficial owner of the interest carried on business through a permanent
establishment in the source country and the interest paid is attributable to
the permanent establishment. In that case, the interest is taxed as business
profits. Also, any amount of interest
paid in excess of the arm’s-length interest is taxable according to the other
provisions. For example, excess interest paid to parent corporation may
be treated as a dividend under local law, and thus, entitled to the benefits of
the dividends article. Interest in an ownership vehicle used for the
securitization of real estate mortgages or other assets may be subject to
withholding tax to the extent that the amount of interest paid exceeds the return
on comparable debt instruments as specified in the paying country’s domestic
law.
*The introduction of conduit provisions, which will deny treaty benefits
in certain back–to–back arrangements.
The 2003 US-UK Tax Treaty includes an anti-conduit rule that can operate
to deny the benefits of the dividends article (Article 10), the interest
article (Article 11), the royalties article (Article 12), the other income
article (Article 22), and the insurance excise tax provision of the business
profits article (Article 7(5).It is a significant innovation and will add to
the complexity involved in interpreting the various provisions. Article 3(1)(n)
defines the term "conduit arrangement" as a transaction or series of
transactions that meets both of the following criteria: (1) a resident of one
contracting state receives an item of income that generally would qualify for
treaty benefits, and then pays (directly or indirectly, at any time or in any
form) all or substantially all of that income to a resident of a third state
who would not be entitled to equivalent or greater treaty benefits if it had
received the same item of income directly; and (2) obtaining the increased
treaty benefits is the main purpose or one of the main purposes of the
transaction or series of transactions.
* The denial of double taxation relief for situations in which shares
have been sold pursuant to a "sale-repurchase" agreement and hybrid
entities.
The New Treaty includes excise taxes within the definition of covered
taxes. However, the Business Profits article precludes taxation of an
enterprise in the absence of a permanent establishment. Thus, payments made to
U.K. insurers or reinsurers that do not have a U.S. permanent establishment
would not be subject to tax. Further, under an explicit provision of the
Business Profits article, insurance and reinsurance transactions are not
subject to the excise tax even if the U.K. company has a U.S. permanent
establishment. However, under Article 7(5), if such policies are entered into
as part of a conduit arrangement, the United States may impose excise tax on
those policies unless the premiums in respect of those policies are, or are
part of, the income of a permanent establishment that the U.K. enterprise has
in the United States. The Joint Committee Explanation notes that insurance
excise does not apply to amounts that are subject to U.S. income tax in the
hands of a foreign insurer or reinsurer pursuant to an election to be taxed as
a domestic corporation under section 953(d) or pursuant to an election under
section 953(c) to treat related person insurance income as effectively
connected to the conduct of a U.S. trade or business. The Technical Explanation
states that the anti-conduit rule is intended to apply to cases where a
resident of a country receives an insurance premium, and then pays
substantially all of that premium to a resident in a third state who would not
be entitled to equivalent benefits if it received the insurance premium
directly. However, a transaction will not fall within the conduit rules, unless
the main purpose or one of the main purposes of the transactions was the
obtaining of increased benefits. The Technical Explanation states that the
United States will interpret the "main purpose" requirement in a
manner consistent with the anti-conduit rules of regulation Section 1.881-3, as
it may be amended from time to time, and other domestic anti-abuse rules that
look to the purposes of a transaction. However, the current conduit rules do
not apply to the insurance excise tax.
The introduction of the conduit rule to insurance transactions will
vastly complicate transactions to the extent the insurer reinsures some or all
of its risk to a resident of a third country, such as Bermuda. .
The 2003 US-UK Treaty contains provisions dealing with fiscally
transparent entities. Under Article 1(8), an item of income, profit or gain
derived through a person that is fiscally transparent under the laws of either
country shall be considered to be derived by a resident of a country to the
extent that the item is treated for the purposes of the taxation law of such
country as the income, profit or gain of a resident. In the withholding
context, the only country that is relevant is the country of the payee’s
residence, not the payor’s. The rule is broad and
contemplates that entities such as limited liability companies may be treated
as pass-throughs (for example, for U.S. tax purposes)
even though one country (for example, the United Kingdom) treats them as
entities. If a U.K. company pays interest to an entity that is treated as
fiscally transparent for U.S. tax purposes, the interest will be considered
derived by a resident of the U.S only to the extent that the taxation laws of
the United States treat one or more U.S. residents as deriving the interest for
U.S. tax purposes. The diplomatic notes applicable to Article 24 (Relief from
Double Taxation) recognize the right of the source country to tax an item of
income, profit or gain derived through another person (the entity) which is
fiscally transparent under the laws of either country, and permit the other
country to tax (a) the same person; (b) the entity; or (c) a third person with
respect to that item. In such case, the tax paid will be eligible for the
foreign tax credit. Accordingly, the diplomatic notes confirm that paragraph 8
does not prevent a country from taxing an entity that is treated as a resident
of that country under its tax law.
Pensions
The 2003 US-UK Treaty contains several favourable provisions applicable
to deferred compensation plans. It is intended to remove barriers to the flow
of personal services between the United States and United Kingdom that could
otherwise result from discontinuities in the law of the respective countries
regarding the deductibility of pension contributions. There is no comparable
set of rules in the OECD Model. First, neither country may tax residents on
pension income earned through a pension scheme in the other country until such
income is distributed. For example, if a U.S. citizen contributes to a U.S.
qualified plan while working in the United States and then establishes
residence in the United Kingdom, the United Kingdom cannot tax the plan’s
earnings and accretions with respect to that individual. Rollovers to other
pension plans are not treated as distributions. When a distribution is
received, it is taxable in the recipient’s country of residence. Second, an
individual who exercises employment or self-employment in either the United
States or the United Kingdom can deduct or exclude from income in that country
contributions made by or on behalf of the individual during the period of
employment or self-employment to a pension scheme established in the other
country. Thus, for example, if a participant in a U.S. qualified plan goes to
work in the United Kingdom, the participant may deduct or exclude from income
in the United Kingdom contributions to a U.S. qualified plan made while the
participant works in the United Kingdom. This only applies, however, to the
extent of the relief allowed by the host country (e.g., the United Kingdom, in
the example) for contributions to a pension scheme established in that state
similarly, payments made to the plan by or on behalf of the individual's
employer during such period are not treated as part of the individual's taxable
income and are allowed as a deduction in computing the business profits of the
employer in the other country. For example, if a participant in a U.S.
qualified plan goes to work in the United Kingdom, the participant's employer
may deduct from its business profits in the United Kingdom contributions made
to a U.S. qualified plan for the benefit of the employee while the employee
renders services in the United Kingdom. As in the case above, this rule applies
only to the extent of the relief allowed in the host country for contributions
to pension schemes established in that country. Therefore, when the United
States is the host state, the exclusion of employer contributions from the
employee's income under this rule is limited to elective contributions not in
excess of the amount specified in section 402(g), deductions of employer
contributions is subject to the section 415 and 404 limitations, and the
section 404 limitation is calculated as if the individual were the only
employee in the plan. There are two limitations on this provision. First, this
provision only applies, however, if contributions by or on behalf of the
individual or by or on behalf of the individual’s employer were made to the
pension before the individual began employment or self-employment in the
country where services are performed. Second, the competent authority of the
other country must agree that the plan generally corresponds to a pension plan
recognized for tax purposes by that country.
Branch Profits
The 2003 US-UK Tax Treaty prevents the United States from imposing a tax
on dividends paid by a U.K. company unless such dividends are paid to a
resident or are attributable to a permanent establishment in the United States.
This provision generally overrides the ability of the United States to impose a
second level withholding tax on the U.S. source portion of dividends paid by a
U.K. corporation.
The United States is allowed to impose the branch profits tax at a rate
of 5 percent where a U.K. corporation has a permanent establishment in the
United States or is subject to tax on a net basis on income from real property
or gains from the disposition of interests in real property. The tax will be
imposed on the dividend-equivalent amount as defined in the Internal Revenue
Code. The branch profits tax will not be imposed in cases where the zero rate
would have been available if the U.S. business had been conducted by a separate
U.S. subsidiary. In addition, the branch profits tax will not apply to a
company which is a qualified person by reason of the publicly-traded prong of
the LOB article (Article 23(2)(c)), or to a company entitled to benefits under
the derivative benefits article (Article 23(3)) or the competent authority
discretionary test of Article 23(6). Thus, a U.K. company that might otherwise
be subject to the branch profits tax may be exempted from such tax if the
branch was established in the United States before October 1, 1998 and certain
other conditions are met. In contrast, the branch profits tax will apply if a U.K.
corporation takes over, after October 1, 1998, the activities of a branch
belonging to a third party, unless the U.K. company is a qualified person under
Article 23(2)(c), relating to publicly-traded corporations or under Article
23(3), relating to derivative benefits, or under Article 23(6), relating to
eligibility for benefits by the competent authorities. The United Kingdom
currently does not impose a branch profits tax. If the United Kingdom were to
impose such a tax, the base of such a tax would be limited to an amount
analogous to the U.S. dividend equivalent.
Article 24
Article 24 provides relief from double taxation through a combination of
direct and indirect foreign tax credits. Indirect credits are generally
allowable when dividends are paid to a shareholder in another jurisdiction for
taxes paid by the jurisdiction of the paying corporation. Under the double
taxation article, an indirect credit is generally allowable where a U.S.
company owns 10 percent or more of the voting stock of a U.K. company. A
similar provision applies for dividends paid to U.K. shareholders by U.S.
companies. The double taxation provisions preclude application of double
taxation relief for a cross-border financing technique commonly used involving
a sale-repurchase transaction. Sale-repurchase transactions are an example of a
cross-border arbitrage technique that has gained favour in recent years. In the
transaction, the recipient takes the position that the transaction is the
purchase of shares. The seller takes the position that the transaction is a
financing. The U.S. tax position that the transaction is a financing is based
on an analysis of the benefits and burdens associated with ownership of the
shares. The 2003 US-UK Treaty provides that the United Kingdom need not allow a
U.K. shareholder foreign tax credit relief for the underlying tax paid by the
U.S. corporation where: (i) both the United States and the United Kingdom treat
one of their residents as the beneficial owner of the dividend and (ii) the
United States has allowed a deduction to a U.S. resident in respect of an
amount determined by reference to the dividend.
Footnotes
1. Income includes pension as per Article 17 (Pensions, Social Security,
Annuities, Alimony, and Child Support), paragraph 1 of Article 18 (Pension
Schemes) the benefits conferred by a Contracting State under paragraph 2 of
Article 18 (Pension Schemes) A former citizen or long-term resident whose loss
of citizenship or long-term resident status had as one of its principal
purposes the avoidance of tax (as defined under the laws of the Contracting
State of which the person was a citizen or long-term resident) shall be treated
for the purposes of paragraph 4 of this Article as a citizen of that
Contracting State but only for a period of 10 years following the loss of such
status. This paragraph shall apply only in respect of income from sources
within that Contracting State (including income deemed under the domestic law
of that State to arise from such sources).