Trans Atlantic Agreement

NICHOLAS YASSUKOVICH looks at the expatriate tax issues in the new United Kingdom/United States double taxation treaty.

On 24 July the United States Treasury Secretary, Paul O'Neill, and United Kingdom Chancellor, Gordon Brown, signed a new treaty between the United Kingdom and United States 'for the avoidance of double taxation and the prevention of fiscal evasion'. This was an important event in the Anglo Saxon business community and indeed some of our daily papers even devoted resources away from their in-depth coverage of 'Big Brother' to report on the occasion.

Much of the commentary focused on the implications for the taxation of profits derived from financial capital. However, the treaty also has enormous implications for the taxation of employment income earned by employees assigned by an employer in one country to manage its financial capital in another country.

From the expatriate tax adviser perspective, this update to the current treaty can be summarised as one which:

• restricts the reliefs previously provided to short term assignees;
• develops some significant new reliefs for long term assignees;
• places on a statutory footing some useful Inland Revenue practice;
• incorporates recent expatriate tax developments in the domestic legislation of both countries.

The purpose of this article is to analyse some of the provisions in the treaty in light of current tax planning for international assignments between the United Kingdom and the United States. All references are to the new treaty unless otherwise stated and the equivalent reference in the current treaty is put in parentheses.

Timing of the assignment

It will now be harder to avoid income tax in the host country on a short-term assignment. This exemption is currently provided by Article 15. The 183-day test in the new Article 14(2), which provides for an exemption from host country tax if the assignee spends not more than 183 days in the host country, is now applied in respect of any 12-month period beginning or ending in the tax year. Previously, it was applied in respect of each host country tax year, allowing assignments starting in the middle of a host country tax year to be tax free in that country for up to one year. Effectively host country tax-free assignments will now be restricted to six months and assignment timing for tax purposes will be relevant only in respect of domestic tax legislation.

Article 14(2) only provides for the exemption if certain conditions are met: firstly as to the residence of the employee in the home country, and secondly in respect of the employment and its costs. The new treaty further restricts the relief available under Article 14(2) for organisations which operate in the host country through branches or other permanent establishments. Article 15(2) of the current treaty denies relief where the costs of the employment are borne 'as such' by a permanent establishment which the employer has in the host country. These two seemingly innocuous words in theory allow organisations to transfer employment costs to a host country permanent establishment through the use of a general management recharge. But the words are absent from the new treaty and so any cost recharge to a permanent establishment at all will deny relief from host country income tax even if the assignment is for less than 184 days and the other conditions are met.

It must be said that the impact of this change will mostly be felt in respect of United Kingdom nationals assigned to the United States. For assignees coming to the United Kingdom, Article 15(2) relief in the current treaty is already difficult, given the Revenue's position on treating the host country organisation as the employer. Under Article 15(2)(b), the employer must not be a host country entity.

Another key condition is that the assignee must be resident for tax purposes in his home country. The Revenue has always taken the view that a United States citizen should only be classified as a resident in the United States under the treaty, if he satisfies the clearly defined substantial presence test found at section 7701(b) of the Internal Revenue Code. This uses a formula to identify a substantial presence in the United States over the current and preceding two years to determine United States residence for non-citizens. Under this formula, it has been difficult for United States nationals assigned to the United Kingdom to remain United States resident for treaty purposes even on a short-term assignment of a year, especially if it starts near the turn of the year. The new treaty, however, contains an explicit definition of a United States treaty resident for United States citizens. Under Article 4(2), such people may prove United States residence through 'a substantial presence, permanent home or habitual abode in the United States'. In theory, we should see more United States citizens remaining a treaty resident of the United States while on a United Kingdom assignment, although in the context of employment income the planning opportunities this opens up to them remain limited.

Finally, regarding timing, it is worth noting with disappointment that Article 25(2) (Article 24(6)) continues the tradition whereby United States nationals not resident in the United Kingdom are not entitled to a personal allowance. Most other treaties provide some form of relief in this area, but it is clear that the special relationship does not extend to overriding the provisions of section 278, Taxes Act 1988. It will remain true, therefore, that to maximise personal allowances in the United Kingdom, a United States national assigned to this country must either be assigned for two years (thereby affording him the benefits of Extra-Statutory Concession A11) or, at least, must start the assignment in the first half of the United Kingdom tax year.

Remunerating the assignee

Article 18 of the new treaty provides a much needed relief from the imputed income United Kingdom nationals assigned to the United States must report on their United States income tax returns if they are vested members of a United Kingdom pension plan. The relief works in the context of employees who work in one country (the host country), but are members of a pension scheme set up in the other country (the home country), and it is manifest by the following exemptions from host country income tax:

• the income of a pension scheme is only taxable to a beneficiary when it is paid to him or for his benefit (Article 18(1));
• any growth in the value of the beneficiary's pension rights by reason of seniority does not represent taxable income to the beneficiary (Article 18(2)(b));
• tax relief for employer and employee contributions to the scheme (Article 18(2)(a)).

The relief will mainly benefit United Kingdom nationals assigned to the United States and remaining in a United Kingdom pension scheme. Equivalent relief is provided in section 192(3), Taxes Act 1988 for any assignee to the United Kingdom whose employer is not resident in the United Kingdom or Ireland and who is not personally domiciled in the United Kingdom.

There are, however, a number of crucial points to note:

• relief for contributions is restricted to that available to residents of the host country participating in a generally corresponding host country scheme;
• relief for growth in value and contributions is not available for citizens or permanent residents of the host country (Article 1(5)(b));
• the treaty explicitly incorporates current Revenue practice in respect of section 192(3) where the assignee is taxed at least in part under the remittance basis for Schedule E. Article 18(4) United States pension contributions of United States nationals assigned to the United Kingdom and taxed at least in part on the remittance basis for Schedule E must be deducted from income before apportioning emoluments between Case I or II and Case III of Schedule E (Article 18(4));
• the host country tax authorities must approve the plan as one generally corresponding to pension schemes in that country;
• for relief from contributions and growth in value, contributions to the pension scheme must have commenced prior to the individual starting his or her employment in the host country (Article 18(3)(a));
• the pension scheme must be set up in one of the treaty countries.

Matters arising

While these restrictions are not totally unreasonable, they do highlight the following issues:

• Tax relief in the United States may well be restricted for United Kingdom nationals contributing to a United Kingdom pension plan as United States contribution limits are quite low even when compared to our salary cap régime. Those outside the cap will be particularly restricted.
• United States nationals who are not resident in the United Kingdom but liable to tax under Schedule E appear able to deduct their United States pension contributions in full as against those who are resident but not ordinarily resident, as the former are not taxed under the remittance system. It remains to be seen whether the Revenue will extend its current practice in this area.
• It is not known whether beneficiaries will need to seek forgiveness or permission to obtain this relief. The treaty clearly states that for relief for contributions and growth in value the competent authorities must accept that a pension scheme set-up in the other country generally corresponds to one in their country. The Exchange of Notes confirms that firstly a United States qualified retirement plan, an individual retirement account (of whatever colour), United Kingdom exempt approved plans and personal pension schemes will be considered pension plans, and secondly that they will all be mutually corresponding. But is it not whether or not someone will actually have to apply for the relief beforehand as with relief under section 193(2), Taxes Act 1988?

Impact on planning

Despite these issues, the relief is welcomed. There has been widespread planning around the United States imputed income charge for membership of United Kingdom pension schemes, much of which has relied on exploiting general principles of United States tax law and on distorting the normal beneficiary/trustee relationship. Expatriate employers will welcome planning opportunities which are more transparent and may choose only to use current planning techniques for higher earners.

In addition to Article 18, Article 17 (Article 18) also covers pension schemes by determining the country which is entitled to tax payments from pension, social security schemes and annuities. One part of the new article appears to end planning opportunities some employers have set up using annuities. The article extends the definition of an annuity by stating that it does not include payments for services rendered. Therefore, schemes which involve the payment of a lump sum to United Kingdom nationals after their return from a United States assignment may no longer realise tax savings. Currently it is argued that for United States tax purposes, the income is from an annuity and so taxable in the country of residence, i.e. the United Kingdom, and that it is employment income for United Kingdom tax purposes and so taxable where earned, i.e. in the United States.

Employee incentives

While there is no mention of the topic in the actual treaty, the Exchange of Notes accompanying the treaty makes specific provision for share option gains. The notes state that gains from employer granted options are within the scope of Article 14 on employment income. The notes go on to confirm what is broadly current practice, at least when considering the income tax charge on share option gains. They set out the scenario where an option is granted in respect of employment exercised in one country and is then exercised at a time when, between grant and exercise, the employee has worked in both countries.

In such circumstances, where the employee is not resident in one of the countries at exercise, that country may only tax that portion of the gain which accrued while the employment was exercised in that country. This is on the proviso that the gains are taxable under the domestic law of both countries and the original employment is still active. This is in line with the effect of current practice for assignments between the United Kingdom and United States. However, it is noted that the treaty insists upon taxation in the country of residence. It is my understanding that the Revenue does not insist upon this when providing a similar relief in respect of assignments to countries other than the United States.

Gains realised from the ultimate sale of shares acquired under option are not mentioned in the notes and so, as one might expect, must be treated in accordance with the provisions of Article 13 on gains generally. While this is an improvement on the current Article 13, it does not allocate taxing between the countries in every possible scenario, so that it is necessary to resort to Article 24 providing general relief from double taxation by foreign tax credit (Article 23) or relief under domestic legislation. Affected most will be those receiving incentive stock options in the United States and enterprise management incentive options in the United Kingdom.

Considering localisation

Two areas of the new treaty may be important to international assignees who are considering whether to localise to the host country, i.e. take employment in the host country with a local employer under the same terms and conditions as a local national.

For United States nationals localising to the United Kingdom, Article 18(5) affords tax relief in the United States for contributions to a United Kingdom pension scheme (in addition to any United Kingdom tax relief under Part XIV, Taxes Act 1988). This is a welcome relief but comes with some restrictions:

• The relief available is restricted to that available for payments to a corresponding United States scheme (e.g. in accordance with 401K rules for an employer pension scheme and individual retirement account rules for a personal pension plan).
• The United States national has to treat the participation in the scheme as participation in a corresponding United States retirement plan when considering eligibility for relief in respect of an actual United States retirement plan. For example, a United States national in a United Kingdom employer pension plan will not be able to make deductible contributions to an individual retirement account in the United States if his gross wages exceed the limitations imposed by section 219(g) of the Internal Revenue Code (about $40,000).

Whether to join a United Kingdom pension plan has always been a difficult decision for United States nationals. This relief adds to the options available.

Furthermore, United States nationals seeking to abandon United States citizenship (the ultimate in localisation) may be affected by some interesting comments in the Exchange of Notes. These state that the countries will, for the purpose of the treaty, continue to treat an individual who has abandoned citizenship as if he were a citizen of that state for ten years following abandonment. This rule can be avoided if the individual can prove that the abandonment was not for the purpose of tax avoidance. Someone becoming 'fully liable' to tax in the other country, which is either his birthplace or that of his spouse or parents, will be looked upon favourably if such an argument is made. 'Fully liable' means not avoiding income tax under the United Kingdom's remittance rules for non domiciliaries.

These rules are very similar to the domestic United States expatriation rules found at section 877 of the Internal Revenue Code. These render the ex-citizen liable to United States income tax at graduate rates on certain types of income for the ten years following abandonment of citizenship unless citizenship was not abandoned for the purpose of avoiding income tax. There is a clearance procedure for this rule, and one of the scenarios where clearance will be given is the same as the scenario explained above but without the reference to becoming 'fully' liable to income tax. This Exchange of Notes may be a pointer to Internal Revenue Service thinking in this area.

We do not yet know when the treaty will be ratified but can expect it to take effect in 2002. As ever, the ancient Greeks had a special way for signing treaties between city states. The politicians would gather on a ship, cast a large stone into the sea and solemnly vow that neither side would renege on the treaty until the stone was seen to leap back out of the water. Unfortunately, inter city-state politics were notoriously fickle and treaties were forever being ignored. However, I think we can expect this new one to remain in force for a while yet.

Nicholas Yassukovich is a tax manager in Andersen's human capital practice and can be contacted via nick.yassukovich@uk.andersen.com. The views he expresses are his own and not necessarily those of that firm. He is indebted to Lynne Rennie for her review of this article.

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