New Slant on Old Convention -- II

03 October 2001 / Julian Hickey

Issue: 3827 / Categories:

JULIAN HICKEY concludes his overview of the proposed United Kingdom and United States double taxation convention.

JULIAN HICKEY concludes his overview of the proposed United Kingdom and United States double taxation convention.

In the first part of this article published in last week's issue of Taxation, Julian Hickey summarised the main changes in the forthcoming new double tax treaty with the United States of America and examined its application to certain individuals, trustees and companies. This concluding instalment explains how the treaty deals with different categories of income and gains and includes a Table setting out a summary of the main Articles in the new treaty.

Business profits

The general rule is that business profits of an enterprise of a contracting state shall only be taxable in that state. However, if business profits are derived from a permanent establishment in the other contracting state, then the state in which the permanent establishment is located may tax the profits of the permanent establishment. The proposed convention is amended so that business profits to be attributed to a permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by it. The exchange of notes provides that by analogy the Organisation for Economic Co-operation and Development Transfer Pricing Guidelines will apply for the purposes of determining the profits attributable to the permanent establishment. The notes state that in determining the amount of attributable profits, the permanent establishment shall be treated as having the same amount of capital that it would need to support its activities if it were a distinct and separate enterprise engaged in the same or similar activities.

Dividends

General provisions

The convention permits in specified circumstances the payment of dividends between corporations without any deduction in respect of withholding taxes. The general rule under it is that dividends may be taxed both in the country of residence of the company paying the dividend, and in the country of residence of the recipient.

Where shares of the paying company are beneficially owned by a resident of another contracting state, the country of residence of the paying company cannot impose tax on the dividends paid:

in excess of five per cent of the gross amount of the 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 paying company; and
in all other cases, 15 per cent of the gross amount of the dividends.

For the first time in the history of conventions between the United Kingdom and United States, no source taxation will be applied to dividends of the paying company if the beneficial owner of the dividends is a resident of the other contracting state and either:

is a company that has owned shares representing 80 per cent of the voting power of the payer for a 12-month period ending on the date the dividend is declared, and that owned shares representing directly or indirectly at least 80 per cent of the voting power of the company paying the dividends prior to 1 October 1998; or
is a qualified person as defined above; or
is entitled to benefits under paragraph 3 of Article 23 (company owned by seven or fewer persons) or paragraph 6 of Article 23 (benefits motive); or
is a pension scheme, provided that such dividends are not derived from the carrying on of a business.

Pooled investment vehicles

The benefits provided under Article 10 for corporate shareholders, namely, a cap of five per cent on withholding tax where ten per cent of the voting capital of the paying company is held and the payment of dividends on a gross basis between certain corporations, do not apply in the case of dividends paid by pooled investment vehicles. Instead only the cap of 15 per cent on withholding tax applies in the case of dividends paid by a pooled investment vehicle the assets of which consist wholly or mainly of shares, securities or currencies or derivative contracts relating to shares, securities or currencies. Dividends paid by any other type of pooled investment vehicle will only be subject to the 15 per cent withholding cap if:

the beneficial owner of the dividends is an individual holding an interest of not more than ten per cent in the pooled investment vehicle;
the dividends are paid with respect to a class of stock that is publicly traded and the beneficial owner of the dividends is a person holding an interest of not more than five per cent of any class of the stock of the pooled investment vehicle; or
the beneficial owner of the dividends is a person holding an interest of not more than ten per cent in the pooled investment vehicle, and that vehicle is diversified.

Interest

The proposed convention amends the definition of interest for the purposes of Article 11 as meaning income from 'debt-claims of every kind'.

Under the current convention, interest is defined as income from 'Government securities, bonds or debentures'.

The benefit provided by Article 11, which restricts the taxation of interest to the country of residence of the beneficial owner, does not apply under the proposed convention in respect of interest payments determined by reference to receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment made by the debtor to a related person. Where such interest is paid, it may also be taxed in the country of source. However, if the beneficial owner is a resident of the other contracting state, source taxation cannot exceed 15 per cent. The exclusion of this category of interest does not apply to any interest solely by reason of the fact that it is paid under an arrangement the terms of which provide:

that the amount of interest payable shall be reduced in the event of an improvement in the factors by reference to which the amount of interest payable is determined; or
that the amount of interest payable shall be increased in the event of a deterioration in the factors by reference to which the amount of interest payable is determined.

Royalties

The convention expands the definition of royalties to mean consideration for the use of, or the right to use computer software and cinematographic films and works reproduced on audio or video tapes, disks or any other means of image or sound reproduction.

Gains

The convention provides new benefits in relation to capital gains. The current convention permits both the country of source and residence to tax capital gains in accordance with domestic law. The new article provides that gains derived from the alienation of real property situated in another contracting state may be taxed in that other state. Gains from the alienation of property forming part of the business property of a permanent establishment may be taxed in the state in which the permanent establishment is located. Gains derived from the alienation of ships or aircraft operated in international traffic by an enterprise, or of containers used in international traffic shall only be taxable in the contracting state in which the enterprise is located. Gains from the alienation of any other type of property are taxable only in the contracting state of which the alienator is a resident.

Mutual agreement procedure

The convention provides in addition to the current convention that the competent authorities may agree:

to the same characterisation of particular items of income, including the same characterisation of income that is assimilated to income from shares by the taxation law of one of the contracting states and that is treated as a different class of income in the other contracting state;
to the same characterisation of persons;
the common meaning of a term;
that the conditions for the application of the anti-avoidance provisions in relation to conduit arrangements are met.

Exchange of information

Article 27.1 provides that in addition to information exchange as is necessary for the carrying out of the provisions of the convention, information exchange can also be made as is necessary for the purposes of carrying out the provisions of domestic laws of the contracting states concerning taxes covered by the convention. Any information received by a contracting state shall be treated as secret in the same manner as information obtained under the domestic laws of that state. The article additionally permits the information to be disclosed in public court proceedings or in judicial decisions.

Article 27.3 amplifies the limits of the exchange of information provision. It additionally provides that the exchange of information provisions shall not be construed so as to impose on a contracting state the obligation:

to carry out administrative measures at variance with the laws and administrative practice of that or of the other contracting state;
to supply information that is not obtainable under the laws or in the normal course of the administration of that or of the other contracting state; or
to supply information the disclosure of which would be contrary to public policy.

Individuals

The exchange of notes makes it clear that any benefits, income or gains enjoyed by employees under share/stock option plans are within Article 14. The 183-day rule which is contained in many double taxation conventions provides that employment income derived by a resident of a contracting state from employment exercised in the other contracting state is only taxable in the country of residence of the individual, if the individual is not present in the other contracting state for in excess of 183 days. The proposed convention amends the 183 day rule so that the individual must not be present in the other contracting state for a period exceeding 183 days in any 12-month period commencing or ending in the taxable year or year of assessment concerned. Currently, the 183-day period is computed over the tax year.

Pensions

In relation to pensions and similar remuneration, the general rule is that such amounts are only taxable in the contracting state in which the beneficial owner is resident. There are certain exceptions, such as in respect of a lump sum payment derived from a pension scheme established in a contracting state and beneficially owned by a resident of the other contacting state. In such a case, the lump sum payment shall only be taxable in the country in which the pension scheme is located.

Summary of the Proposed New United Kingdom/United States Tax Treaty

aor r= right/no right to tax income/capital
INCOME, GAINS, AND OTHER AMOUNTS
Provision	Income / Gains / Profits arising in Contracting State and derived by Resident of the other Contracting State: Source Taxation Permitted by Country of Source.	Taxing rights in Country of Residence of Taxpayer who derives income / gains / profits from Country of Source?	Other Points
Business Profits of a Permanent Establishment	a Only profits attributable to the permanent establishment. If permanent establishment has ceased to exist, income or profits attributable to it may nonetheless be taxed in the country of source.	a	Business profits attributed to permanent establishment that it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.
Dividends – paid by a company which is a resident of a Contracting State to a resident of the other Contracting State Article 10	a If the dividend is beneficially owned by a resident of the other Contracting State the source taxation cannot exceed: (a) 5% if the beneficial owner is a company that owns 10% (directly/indirectly) of the voting power of the payer; (b) 15% in any other case. No source taxation will be imposed where the beneficial owner of the dividends is a resident of the other Contracting State and either: (a) owns 80% of the paying company for a 12-month period ending on the date the dividend is declared, and that owned the shares prior to 1 Oct 1998, or is a qualified person/otherwise entitled to the benefits of the dividends article under the Limitation of Benefits Article; or (b) pension scheme provided that the dividends are not derived from the carrying on of a business by the pension scheme. Dividends paid by a pooled investment vehicle cannot be taxed in excess of 15%	a	If dividends attributable to a permanent establishment the Business Profits article shall apply; Benefit of dividends article denied if paid under, or as part of, a conduit arrangement.
Interest Article 11	r - the resident of the other Contracting State must be the beneficial owner of the interest. Benefit of Article does not apply in respect of interest payments determined by reference to receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment made by the debtor to a related person. Source taxation cannot exceed 15%. The exclusion of this category of interest does not apply to any interest solely by reason of the fact that it is paid under an arrangement the terms of which provide: that the amount of interest payable shall be reduced in the event of an improvement in the factors by reference to which the amount of interest payable is determined; or that the amount of interest payable shall be increased in the event of a deterioration in the factors by reference to which the amount of interest payable is determined.	a	If interest attributable to a permanent establishment the Business Profits article shall apply; If a special relationship exists between the payer and beneficial owner; and the amount of the interest exceeds what would have been paid in the absence of such a relationship the benefit of the article is restricted to the amount which would have been payable in the absence of a special relationship. Any excess will be taxable in accordance with the laws of each State. Benefit of interest article denied if paid under, or as part of, a conduit arrangement.
Royalties Article 12	r Royalties must be beneficially owned by resident of other Contracting State	a	If royalties attributable to a permanent establishment the Business Profits article shall apply; If a special relationship exists between the payer and beneficial owner; and the amount of the royalties exceeds what would have been paid in the absence of such a relationship the benefit of the article is restricted to the amount which would have been payable in the absence of a special relationship. Any excess will be taxable in accordance with the laws of each State. Benefit of royalties article denied if paid under, or as part of, a conduit arrangement.
Capital Gains Article 13	a - Gains derived from the alienation of real property. a - Gains from the alienation of property (other than real property) forming part of the business property of a permanent establishment. r - Gains from the alienation of ships or aircraft operated in international traffic/or of containers used in international traffic, or of property pertaining to the operation or use of such ships, aircraft or containers. r - Gains from alienation of any other type of property.	a a a a	Benefit of Article in respect of gains from the alienation of "any other type of property" denied where derived by an individual who is a resident of the other Contracting State but has been a resident of the first Contracting State at any time during the 6 years preceding the alienation of the property.
Income from Employment Article 14	a - Salaries, wages and other similar remuneration derived from employment exercised in Contracting State by resident of the other Contracting State. r - EXCEPT that such remuneration shall only be taxed in the Country of residence of the employee if: (a) the recipient is present in the source country for less than 183 days in any 12 month period in the taxable year; (b) the remuneration is paid by, or on behalf of, an employer who is not a resident of the Source State; and (c) the remuneration it not borne by a permanent establishment which the employer has in the Source State. r - remuneration in respect of employment as a regular complement of a ship/aircraft operated in international traffic.	a a a	-
Directors' Fees Article 15	a - Fees and other similar payments for services rendered by a resident of a Contracting State in the Country of Source in the Directors' capacity as a member of the board of directors of a company that is a resident of the Country of Source.	a	-
Entertainers and Sportsmen Article 16	a - Income derived by a resident of a Contracting State as an entertainer or as a sportsman from personal activities exercised in the Country of Source; except where the amount of gross receipts derived by the resident does not exceed $20,000 (or sterling equivalent). Source taxation also permitted where the income accrues to another person unless the entertainer/sportsman does not participate in the profits of that other person.	a	-
Pensions and other similar remuneration Article 17	r a - lump-sum payments derived from pension scheme established in source state. r - payments made by source state under provisions of social security or similar legislation of source state. r - annuity payments provided derived & beneficially owned by an individual who is a resident of the other Contracting State.	a - provided that beneficially owned by resident of a Contracting State r a a	Where an individual who is a resident of a Contracting State is a member or beneficiary of a pension scheme established in the other Contracting State income earned by the pension scheme may be taxed as income of that individual in accordance with Article 17 to the extent that it is paid to or for the benefit of the individual from the pension scheme (Article 18).
Other Income Article 22	r	a - Items of income beneficially owned by a resident of a Contracting State, wherever arising, and not otherwise dealt with under the Convention (other than income paid out of trusts or the estates of deceased persons in the course of administration).	If other income attributable to a permanent establishment the Business Profits article shall apply; If a special relationship exists between the resident and some other person; and the amount of the other income exceeds what would have been paid in the absence of such a relationship the benefit of the article is restricted to the amount which would have been payable in the absence of a special relationship. Any excess will be taxable in accordance with the laws of each State; Benefit of other income article denied if paid under, or as part of, a conduit arrangement.
Relief from Double Taxation	Profits, income or chargeable gains	Dividends
Credit for tax payable in a territory outside the UK against UK tax. Article 24	US tax payable on profits, income or chargeable gains from sources within the US (excluding in the case of a dividend, US tax in respect of the profits out of which the dividend is paid). Credit US tax allowed as a credit against any UK tax computed by reference to the same profits, income or chargeable gains by reference to which the US tax is computed.	A dividend paid by a US resident company to a company which is a resident of the UK, & which controls at least 10% (directly/indirectly) of the voting power in the payer. Credit US tax payable by the payer of the dividend in respect of the profits out of which the dividend is paid. US tax shall not be allowed as a credit if and to the extent that: (i) the UK treats the dividend as beneficially owned by a resident of the UK, and (ii) the US treats the dividend as beneficially owned by a resident of the US; and (iii) the US has allowed a deduction to a resident of the US in respect of an amount determined by reference to the dividend.
Anti Conduit / Treaty-Shopping
Provision	Scope
Article 1	Income, profit or gain derived through a fiscally transparent entity considered derived by a resident to the extent treated as the income, profit or gain of a resident.
Articles 10, 11, 12, 22 (Dividends, Interest, Royalties, Other Income)	Benefits of relevant article denied if payments made as part of a conduit arrangement.
Article 23	Limitation on benefits.

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

Issue: 3827 / Categories: