Transatlantic Investment

Transatlantic Investment

ALLAN CINNAMON, international tax consultant with BDO Stoy Hayward, assesses the impact of the new United Kingdom/United States tax treaty on United Kingdom corporate investment into the United States.

AFTER SEVERAL YEARS of negotiation, the United Kingdom signed an important new tax treaty with the United States in July 2001. The United States is the largest outward destination for the United Kingdom corporate business sector and an understanding of the new treaty and its impact on their United States activities is therefore of crucial importance to United Kingdom companies.

Quoted United Kingdom companies and pension funds will benefit from the new treaty, particularly the 0 per cent dividend withholding tax. But unquoted companies will face a more difficult situation. Their shareholder profile could disqualify them from the 0 per cent dividend withholding tax and, in some cases, all other treaty benefits, unless they can obtain a clearance under a 'competent authority procedure' and can meet certain 'base erosion' tests.

It will be seen from what follows that there are a number of interpretational uncertainties in the new treaty. In particular, there are various potential problems applicable to United Kingdom unquoted companies including those owned by trusts. It is understood that a Revenue Bulletin is to be issued when the treaty is ratified with the aim of clarifying various points at issue that have been raised by taxpayers and their advisers.

This article comments on how the treaty affects United Kingdom corporate investment into the United States. Unless otherwise stated, references are to the relevant articles of the new treaty.

Entry into force

The treaty requires ratification by both countries. It is believed that amendments are unlikely and the aim is for instruments of ratification to be exchanged, and the treaty to take effect, in 2002. Assuming exchange of instruments of ratification on either 31 March 2002, or 30 June 2002, the new treaty will take effect as follows:

31.03.02 30.06.02

US corporate income tax 01.01.03 01.01.03
US withholding tax 01.05.02 01.08.02
UK corporation tax 01.04.02 01.04.03
UK withholding tax 01.05.02 01.08.02
 

Where the existing treaty is more beneficial it can be elected under Article 29.3 to apply for a 12 month period after the new treaty takes effect. Since the new treaty is generally more advantageous to most United Kingdom companies, the only companies likely to elect are those that will not qualify under the new treaty. The election is not selective and must apply the existing treaty in its entirety.

Limitation on benefits

First, however, here is a word of warning about limitation on benefits.

In line with all recent United States treaties, Article 23 of the new treaty includes very complex limitation on benefits provisions designed to prevent so-called treaty shopping.

In general, most United Kingdom companies with United States interests are not involved in treaty shopping and so should fully qualify for the benefits of the new treaty. However, below are some examples of situations where a United Kingdom company would not be a so-called 'qualified person' even though it was owned by United Kingdom residents. In such a case, United States dividends, interest and royalties received could suffer a full 30 per cent United States withholding tax.

• An unquoted United Kingdom company (even one controlled by qualified persons) which pays 50 per cent or more of its income to persons resident in neither the United Kingdom nor the United States, in the form of royalties or interest other than to the United Kingdom or United States branch of a foreign (non-United States) bank (Article 23.2(f)(ii)). There is the so-called 'base erosion' test. It could easily trap perfectly innocent, even pre-treaty, borrowing or licensing arrangements. There is no bona fide commercial escape.


• A United Kingdom company controlled by any trust, whether United Kingdom or offshore (Article 23.2(f)(i)). This is a particularly surprising and worrying limitation.


• An unquoted United Kingdom company controlled by a foreign resident such as a foreign quoted company, a foreign individual or a foreign trust (Article 23.2). (There are exceptions where the foreign person is a resident of the European Union, European Economic Area or North American Free Trade Agreement.)

However, in these cases (and some others discussed below) it may be possible for the non-qualifying United Kingdom company to avoid the 30 per cent United States withholding tax by resorting to what could be a time-consuming 'competent authority procedure'.

Competent authority procedure

If a United Kingdom company which is a non-qualified person is to avoid the 30 per cent withholding tax, it will be necessary to demonstrate to the United States Internal Revenue Service that its acquisition of the United States source income did not have the obtaining of treaty benefits as one of its principal purposes (Article 23.6). Most domestically-owned United Kingdom companies will easily pass this test, but it could be a time-consuming process during which they will be out of pocket to the extent of the excess withholding tax suffered.

In other treaties containing limitation on benefits provisions, principally the United States/Netherlands treaty, this has been a lengthy process in which a number of cases are brought together to be considered at one time by a very small staff in the Internal Revenue Service. In view of the enormous number of situations in which it seems that unquoted companies will require competent authority procedure clearance, it must be hoped that the necessary arrangements will be made to ensure that such claims are dealt with on a very prompt basis that will avoid the necessity for a reclaim of withholding taxes unnecessarily suffered.

Conduit arrangements

The new treaty contains an additional anti-treaty shopping weapon in the form of conduit arrangements that divert United States source dividends, interest, royalties and 'other income' (Articles 10.9, 11.7, 12.5 and 22.4) from the United Kingdom company in any form, to non-United Kingdom residents who would not themselves be entitled to benefit from a similar treaty with the United States (Article 3.1(n)). So this diversion could include dividend payments to non-resident shareholders.

Under Article 3(i)(n)(ii) these provisions will not apply where obtaining the benefits of the new treaty is not one of the main purpose of the arrangements. But there is no clearance procedure and it remains to be seen how this test will be satisfied.

Since Article 3(i)(n)(ii) is concerned with obtaining benefits under the new treaty, pre-existing arrangements should not be subject to the conduit rules. There are a number of other issues.

• It appears that dividends paid to an offshore trust would disqualify the United States source income of the United Kingdom company from treaty benefits unless this was a pre-existing arrangement, or it could be demonstrated that the obtaining of treaty benefits was not one of the main purposes of the settlement. Dividends paid to a United Kingdom resident trust should be acceptable. Such a trust can be a qualified person entitled to treaty benefits provided stringent conditions are met; see Article 23.2(g).


• Article 3.1(n)(i) sets no time frame on the period within which the United Kingdom company might pay its United States source income to a non-resident. In practice it seems that this could therefore create considerable uncertainties.


• Suppose a United Kingdom company pays a dividend to resident of a country having a double tax treaty with the United States. Since no other country's treaty with the United States presently confers a 0 per cent rate of dividend withholding tax, this would therefore be considered a conduit arrangement under Article 3.1(n)(i) unless it could be demonstrated that it was not the main purpose to obtain increased benefits under the new treaty.

Except where otherwise stated this article continues on the assumption that the United Kingdom company is not subject to the conduit rules, and is a qualified person entitled to the benefits of the new treaty. It should also be noted that a United Kingdom company controlled by a foreign domiciled United Kingdom resident individual is a qualified person (Article 23.2(a)).

Dividends from United States subsidiaries

The United States imposes a 30 per cent withholding tax on outbound dividends paid by United States companies. Both the existing and the new treaty reduce the rate to five per cent where the United Kingdom company owns ten per cent or more of the United States company's shares (Article 10.2(a)). United States corporate tax rates are higher than in the United Kingdom, so the five per cent withholding tax constitutes an additional tax that cannot be offset against the United Kingdom parent company's corporation tax liability on the United States dividend it receives.

Article 10.3 of the new treaty eliminates the five per cent withholding tax in certain cases, and has therefore been widely welcomed by the business community. However, it appears that the five per cent withholding tax will still apply to United States dividends paid to an unquoted United Kingdom parent company although the competent authority procedure could reduce this to 0 per cent.

Planning: Where the United States subsidiary's dividend payments qualify for the 0 per cent withholding tax, it should therefore consider deferring dividend payments to its United Kingdom parent until the new treaty is in force. This could be as early as February 2002.

Holdings owned pre 1.10.98

Irrespective of the United Kingdom company's ownership profile, the new treaty can reduce the withholding tax to 0 per cent where the United Kingdom company owns 80 per cent or more of the United States company's voting shares and did so prior to 1 October 1998 (Article 10.3(a)(i)). The 80 per cent holding at 1 October 1998 can have been held indirectly, i.e. split over a number of United Kingdom subsidiaries.

A competent authority procedure clearance will be necessary where the United Kingdom company is controlled by non-qualified persons including any trust (Articles 23.1, 23.2(f) and 23.6).

Planning: So pre 1.10.98 holdings could be valuable in qualifying unquoted United Kingdom groups for the 0 per cent dividend withholding tax without the need for a competent authority procedure clearance. Therefore, great care should be exercised to ensure that the holdings are not depleted, for example, in a reorganisation.

Holdings owned post 30.9.98 - quoted groups

For 80 per cent or more holdings reached or acquired after 30.9.98, the 0 per cent rate applies if the United Kingdom company is a quoted company (Articles 10.3(a)(ii) and 23.2(c)(i)). A United Kingdom subsidiary of a quoted United Kingdom company must be owned by or through United Kingdom (or United States) companies (Article 23.2(c)(ii). Thus, ownership through a Dutch company would disqualify the 0 per cent rate.

Planning: The 0 per cent rate only applies to dividends paid at least 12 months after the 80 per cent holding is reached or acquired. Otherwise the rate will be five per cent.

Holdings post 30.9.98 - unquoted groups

In principle, the rate of withholding tax is five per cent (Article 10.2(a)). However, although the new treaty is not clear on the point, there seems to be an intention to reduce this to 0 per cent under the potentially time-consuming competent authority procedure (Articles 10.3(a)(iii) and 23.6).

EU, EEA or NAFTA owned UK company

Because of its non-United Kingdom ownership, the United Kingdom company is not a qualified person (Article 23.2). However, it can take advantage of the treaty if it is owned at least 95 per cent, directly or indirectly, by seven or fewer residents of the European Union, European Economic Area or North American Free Trade Agreement, and also satisfies a base erosion test covering payments of its income to persons outside those areas (Article 23.3 and 23.7(d)).

Article 23.7(d)(i) does not confer equivalent beneficiary Article 23.3 relief for United States dividends received by United Kingdom companies which are controlled by residents of European Union, European Economic Area or North American Free Trade Agreement countries, since none of their tax treaties includes a 0 per cent withholding tax on United States source dividends. However, article 23.7(d)(ii) appears to confer the 0 per cent withholding tax. A United Kingdom company controlled by an European Union resident company can qualify under this article without resort to the competent authority procedure, because the particular class of income (namely dividends) for which benefits are being claimed under the treaty would be free of withholding tax under the European Union Parent/Subsidiary Directive if paid by the United Kingdom company to its shareholder. There is no specification that the dividend need be from United States sources and indeed such dividends would be outside the ambit of the Parent/Subsidiary Directive.

Non-EU, EEA or NAFTA owned UK Co

Because of its non-United Kingdom ownership, the United Kingdom company is not a qualified person under Article 23.2. The United States withholding tax rate on dividends is therefore 30 per cent but is reducible to 0 per cent if the competent authority procedure test is passed.

United States branch profits

A United Kingdom company carrying on a branch business in the United States is liable to United States federal and state taxes on the profits it generates. The United Kingdom company will also be liable to United Kingdom corporation tax on the profits but will be entitled to a credit for the United States taxes paid; and the credit will normally eliminate the United Kingdom tax liability.

In addition the United States imposes a branch profits tax at the rate of 30 per cent on branch after-tax profits remitted to the foreign (United Kingdom) head office, or that are surplus to business requirements. The existing treaty reduces this tax to 0 per cent.

The new treaty deals with branch profits tax in exactly the same way as dividends where ownership of the United Kingdom company is as above, namely:

Branches in existence pre 1.10.98

0 per cent branch profits tax (competent authority procedure clearance required for non-qualified persons) (Article 10.7(a)).

Planning: If the United States branch were subsequently incorporated, the United Kingdom company would then receive dividends from its United States subsidiary. For unquoted companies this appears to require a competent authority procedure clearance and meanwhile a five per cent withholding tax would be suffered on the dividends.

Post 30.9.98 branches set up by quoted UK groups

0 per cent branch profits tax (Article 10.7(b)).

Post 30.9.98 branches set up by unquoted United Kingdom groups

Five per cent branch profit tax (Article 10.8 and 10.2(a)); but apparently reduced to 0 per cent if the competent authority procedure test is met (Articles 10.7(c) and 23.6).

European Union/European Economic Area/North American Free Trade Agreement - owned United Kingdom branches

• 0 per cent for European Union-owned branches (Article 23.3 and 23.7(d)(ii));


• 30 per cent for European Economic Area/North American Free Trade Agreement branches but could be reduced to 0 per cent if the United Kingdom company passes the competent authority procedure test (Article 23.6).

Non-European Union/European Economic Area/North American Free Trade Agreement - owned branches

30 per cent branch profits tax, but could be reduced to 0 per cent if the United Kingdom company passes the competent authority procedure test (Article 23.6).

United States real estate

The position is exactly the same as with United States branches. Article 10.7 covers United States real estate ownership as well as United States branches.

Limited liability companies

United Kingdom companies often use a limited liability company as a vehicle for doing business in the United States. Because of its hybrid nature (the United States taxes it as a branch whereas the United Kingdom regards it as a separate legal entity), it provides cross-border tax planning opportunities.

An additional advantage under the present treaty is that the limited liability company dividend payments qualify for a 0 per cent branch profits tax (since it is treated as a branch), rather than a five per cent withholding tax. This latter advantage will end when the new treaty comes into force since, in general, both dividends and branch distributions will be free of withholding tax and branch profits tax respectively if the competent authority procedure test is passed.

Because of its hybrid nature, the limited liability company will be denied treaty benefits, and so will remain liable to United States tax on any United States dividends, interest and royalties it may receive. In most cases, this should not matter since the limited liability company will be liable to United States tax on this income as part of its United States business profits.

United States source interest and royalties

A 30 per cent United States withholding tax applies to United States source interest and royalties paid to non-residents. However under the existing and the new treaty, this is generally reduced to 0 per cent, see Articles 11.1 and 12.1. It appears that United Kingdom companies that are not qualified persons, such as those controlled by trusts, will need to apply for competent authority procedure clearance (Article 23.6).

United States capital gains

Unlike the existing treaty, Article 13 of the new treaty specifically deals with capital gains. However, this does not change the treatment of a United Kingdom company's United States gains which continue to be taxed as follows:

Taxable in the US and the UK

The United Kingdom will allow a credit against corporation tax for the United States tax payable:

• Gains from the sale of a United States branch, or of its assets (Article 13.3).


• Gains from the sale of shares of a limited liability company (Article 13.3).


• Gains from the sale of United States real estate (Article 13.1).


• Gains from the sale of shares of a United States company, 50 per cent or more of whose assets comprise United States real estate (Article 13.2(b)).

Taxable only in the United Kingdom

• Gains on all other United States assets including shares in non real estate subsidiaries (Article 13.3). (A United Kingdom company's gains on realisation of ships, aircraft and container businesses operating in international traffic are specifically exempted from United States tax under Article 13.4).

Other than gains from ships and aircraft etc., most of the United States gain exemptions do not arise from the treaty. Therefore United Kingdom companies that are not qualified persons need not meet the competent authority procedure test.

US subsidiary's capital gains

In general these gains are taxable in the hands of United States 1 and are not taxed in the United Kingdom until repatriated. However in the case of a closely-owned United Kingdom company, United States 1's gains on sale of its non-business assets (typically investments) are taxed to its United Kingdom parent company on a flowthrough basis as they arise, under section 13, Taxation of Chargeable Gains Act 1992.

A credit for the United States tax payable will be allowed against the United Kingdom corporation tax liability but this may not always eliminate it, for example United States tax may not arise because of losses etc.

Most of the United Kingdom's tax treaties reserve the taxing rights to the state of residence and the Revenue accepts that this prevents the flowthrough of gains under section 13. However, it appears that despite Article 13.5, the United Kingdom retains taxing rights for either of the following reasons:

• under the 'savings' Article 1.4 (normally invoked by the United States) which allows a contracting state to tax its residents as if the treaty had not come into effect;


• under Article 1.8 dealing with hybrid entities. The United Kingdom resident shareholder of United States 1 would be treated as deriving the gain. Thus under Article 13.5 the United Kingdom would retain its taxing rights. (This would not prevent the United States from also taxing the gain, see the Exchange of Notes commentary on Article 1.8.)

Dual resident trading companies

Article 4.5 leaves the residence of the company to be decided between the United Kingdom and the United States Revenues for treaty purposes. In the absence of any agreement between them, the company will not be entitled to benefit from the treaty. This would result in a full 30 per cent withholding tax on United States source dividends, interest and royalties received by the United States company, but these will generally constitute part of the company's taxable United States profits and so will be liable to United States tax in any event.

The treaty should not impact on the facility to use the United States company's losses in a group relief claim.

Planning: Typically a loss-making United States subsidiary may be resident in the United Kingdom because it is managed and controlled here. Its losses will then be available for United Kingdom group relief.

Fiscally transparent entities

A typical fiscally transparent entity is a limited liability company. The United States 'check-the-box' facility also results in an entity which would be treated as transparent for United States tax purposes but non-transparent for United Kingdom purposes.

Planning: Hybrids are often used to facilitate United Kingdom/United States planning. The treaty does not adversely impact on these planning techniques.

Article 1.8 provides that, for treaty purposes, the entity's income is to be treated as derived by its shareholders partners or beneficiaries to the extent it is treated as theirs for tax purposes in their state of residence.

Conclusion

The new treaty is to be particularly welcomed from the viewpoint of avoiding withholding tax on dividends and thus stimulating a business activity between the United Kingdom and the United States. However, it will be seen that there are a number of areas of complexity that will require careful study.

Issue: 3842 / Categories: