New Slant on Old Convention -- I

JULIAN HICKEY provides an overview of the proposed United Kingdom and United States double taxation convention with particular emphasis on the new anti-avoidance measures.

The new United Kingdom/United States double taxation convention contains a panoply of radical provisions relating to anti-avoidance. These new provisions mark a dramatic shift in United Kingdom convention practice, and are likely to be replicated in other conventions.

On 24 July 2001, the United Kingdom and the United States of America signed the convention, which will be described here as the proposed convention as it has yet to come into force. There was also an exchange of notes by the countries which clarify the application of it. Negotiations for the proposed convention had commenced on 1 October 1998. The first convention on double taxation between the two countries was signed on 16 April 1945; this was subsequently replaced by the current convention of 31 December 1975. It is anticipated that the proposed convention will be ratified by both countries and enter into force in 2002.

The purpose of a convention on double taxation is to eliminate double taxation in relation to profits, income and gains derived from sources in one country by a resident of another country. Such a convention will determine the extent to which profits, income or gains will either be taxed in the source country in which they arise, or in the country of residence of the recipient of such profits, income or gains.

This article examines the principal provisions of the proposed convention between the United Kingdom and United States.

Themes

The convention reflects the normal range of articles on double taxation which appear in the Model Tax Convention on Income and Capital issued by the Organisation for Economic Co-operation and Development. A number of themes in it distinguish it from the current convention.

First, the proposed convention contains new rules designed to protect the tax bases of the United Kingdom and United States by the introduction of general and targeted measures which deny the benefits of the convention. Second, the taxation of dividends is simplified and source taxation on such payments is excluded in certain circumstances. Third, individuals benefit from certainty of taxation in respect of new provisions relating to remuneration, such as pensions and share options. Finally, the convention identifies with greater certainty the rights of both taxpayer and tax authorities in the use of information obtained under the exchange of information article.

Differences in the conventions

The principal differences between the current and proposed convention are summarised below:

Anti-avoidance

• The benefits provided in relation to dividends, interest, royalties and other income are denied where 'conduit arrangements' exist.
• Individuals who cause loss of long-term citizenship to procure fiscal benefits are subject to anti-avoidance provisions.
• Access to the benefits of the proposed convention is subject to a limitation of benefits article.
• Credit for United States tax against United Kingdom tax on profits, income or gains are subject to new limitations.

Dividends

• Refunds of United Kingdom tax credit to United States shareholders are removed.
• Dividends are paid without deduction for withholding tax where paid between certain corporations.

Interest

• Definition of interest is clarified.
• Certain types of interest are carved out of the general exemption from withholding tax.

Royalties

• Definition is extended.

Capital gains

• There is a new article in respect of capital gains. Previously each country could tax gains by reference to domestic tax law.

Individuals

There are new provisions/amendments to articles relating to directors' fees, entertainers and sportsmen, pensions, pension schemes, government service and students.

Application of the double taxation convention

There are new provisions in respect of mutual agreement procedure, and exchange of information.

Denial of benefits

The proposed convention contains a number of improvements on the current convention in respect of mechanisms which are designed to protect the tax bases of both the United Kingdom and United States. It also contains both general and targeted measures to deny its benefits.

The general mechanisms are as follow.

Conduit arrangements

The benefits provided by the dividend, interest, royalty, business profits and other income articles are denied if any such payments are paid under, or as part of, a conduit arrangement. Article 3.1(n) of the proposed convention defines the term 'conduit arrangement' as meaning a transaction or series of transactions that fulfil the following conditions:

• the transaction or series of transactions are structured in such a way that a resident of a contracting state entitled to the benefits of the convention receives an item of income arising in the other contracting state (the 'recipient'); and
• the recipient pays, directly or indirectly, all or substantially all of that income (at any time or in any form) to another person who is not a resident of either contracting state (the 'third person'); and
• the third person who, if it received that item of income direct from the other contracting state, would not be entitled under a convention for the avoidance of double taxation between the state in which the third person is resident and the contracting state in which the income arises, or otherwise, to benefits with respect to that item of income which are equivalent to, or more favourable than, those available under the convention to a resident of a contracting state; and
• the transaction or series of transactions has as its main purpose, or one of its main purposes, obtaining such increased benefits as are available under the convention.

The proposed convention and the exchange of notes do not provide any further guidance on the application of this provision. Key areas of potential dispute will relate to what constitutes a 'series of transactions' and in identifying the 'main purpose' of such transactions. This form of anti-avoidance mechanism is new to the United Kingdom network. Typically, treaty benefits are denied in the context of royalties and interest, if the right giving rise to the payment was created or assigned mainly for the purposes of taking advantage of the benefits of the article, and not for bona fide commercial reasons.

Limitation on benefits

The benefits of the proposed convention will only be available in the following circumstances:

Qualifying status

The benefits of it shall be accorded to a resident of a contracting state if the person satisfies any of the following requirements.

The resident must be a 'qualified person'. A resident of a contracting state is a qualified person only if such resident is either:

A company owned by seven or fewer persons will be entitled to the benefits of the convention if it satisfies any other specified conditions for obtaining such benefits, and (A) shares representing at least 95 per cent of the total voting power and value of the company are owned directly or indirectly by seven or fewer persons who are equivalent beneficiaries; and (B) less than 50 per cent of the company's gross income for the taxable period in which the item of income, profit or gain arises is paid or accrued directly or indirectly to persons who are not equivalent beneficiaries in the form of payments that are deductible for the purposes of the taxes covered by the convention in the state in which the company is a resident (excluding arm's length payments in the ordinary course of business for services or tangible property and certain payments in respect of financial obligations to a bank). An 'equivalent beneficiary' 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. This is provided that the resident:

• would be entitled to all the benefits of a comprehensive convention on double taxation between any Member State of the European Community or European Economic Area state or any party to the North American Free Trade Agreement (other conditions must be satisfied); and with respect to dividends, interest or royalties would be entitled to pay a rate of tax comparable to that provided under the proposed convention; or
• is a company resident in a Member State of the European Community which is entitled under any European Community directive to receive that class of income free of withholding tax.

A resident of a contracting state is entitled to the benefits of the convention in relation to an item of income, profit or gain derived from the source state, provided that the resident is engaged in the active conduct of a trade or business in its country of residence (excluding the business of making or managing investments for the resident's own account, unless the activities are banking, insurance or securities carried on by a bank, insurance company or registered securities dealer) and the income, profit or gain derived from the country of source is derived in connection with (or is incidental to) that trade or business and the resident satisfies any other conditions specified for obtaining such benefits. Additionally, if a resident of a contracting state or any of its associated enterprises carries on a trade or business activity in the other contracting state which gives rise to an item of income, profit or gain then the foregoing provisions shall apply to such item only if the trade or business activity in the country of residence is substantial in relation to the trade or business activity in the other state.

Class of shares with entitlement to income, profit or gain

If a company that is a resident of a contracting state, or a company that controls such a company has outstanding a class of shares:

the benefits of the convention will apply only to that proportion of the income which those holders would have received in the absence of those terms or arrangements.

Benefits motive

A resident of a contracting state who would not otherwise qualify, will be granted the benefits of the proposed convention if the competent authority of the other contracting state 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 convention.

Targeted anti-treaty shopping mechanisms

The proposed convention nullifies three tax advantages that individuals were able to obtain.

First, for income purposes individuals were able to obtain tax advantages through cessation of citizenship or loss of long-term resident status. The convention nullifies the advantages of such loss of status where it had as one of its principal purposes the avoidance of tax. Where the anti-avoidance rule applies, the individual is deemed to remain a citizen of the relevant contracting state for a ten-year period following loss of the status.

Second, the benefits of the convention are restricted where an individual is taxed on a remittance basis. The benefit of the convention is restricted in the country of source in which income or gains arise to the amount of income or gains which are actually taxed in the country of residence of the recipient.

Third, the convention includes the United Kingdom anti-avoidance rule contained in section 10A, Taxation of Chargeable Gains Act 1992 which applies to capital gains derived by temporary non-residents. The United Kingdom rule is subject to any relief available under double taxation arrangements. However, Article 13.6 of the convention provides that the general provision that gains from the alienation of property (other than real property, ships, business property of a permanent establishment) shall be taxed only by the state of residence of the alienator, shall not affect the right of a contracting state to impose tax on gains from the alienation of any property derived by an individual who is a resident of the other contracting state and who has been a resident of the source state at any time during the six years immediately preceding the alienation of the property.

Where a dividend is paid by a United States company to a United Kingdom tax resident company which controls directly or indirectly at least ten per cent of the voting power of the paying company, the United Kingdom credit for United States tax will take into account the United States tax payable by the paying company in respect of the profits out of which the dividend is paid. However, no credit will be given to the extent that:

• the United Kingdom treats the dividend as beneficially owned by a resident of the United Kingdom; and
• the United States treats the dividend as beneficially owned by a resident of the United States; and
• the United States has allowed a deduction to a resident of the United States in respect of an amount determined by reference to that dividend.

Part II of this article to appear in next week's issue of Taxation will examine the treaty provisions for specific types of income and gains, and will in addition include a table summarising the principal differences between the current and the proposed treaty.

Julian JB Hickey is an associate with Cleary, Gottlieb, Steen & Hamilton.

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