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Tax authorities provide welcome post-Brexit clarification of US-UK Tax Treaty9 August 2021

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Competent authorities have provided welcome guidance regarding the application of the “Limitation on Benefits” clause of the US-UK income tax treaty.

"The Arrangement will come as a welcome development for UK companies owned by a mix of UK and EU shareholders, as well as US taxpayers dealing with such companies."

On July 26, 2021, the competent authorities of the United States and the United Kingdom entered into an arrangement (the “Arrangement”) interpreting the US-UK income tax treaty (officially, the “Convention between the United States of America and the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains” signed at London on July 24, 2001, as amended by the Protocol signed on July 19, 2002) (the “Treaty”). The Arrangement interprets the Treaty’s “Limitation on Benefits” clause sensibly to avoid a perverse result wherein, following Brexit, it could in certain circumstances be easier for a UK company owned 100% by non-UK EU shareholders to qualify for Treaty benefits than it would be for a UK company owned by a mix of UK and EU shareholders. The Arrangement will come as a welcome development for UK companies owned by a mix of UK and EU shareholders, as well as US taxpayers dealing with such companies.

Treaty: Limitation on Benefits

Many or most countries tax non-residents on income derived from such country. To avoid double-taxation and generally facilitate international trade, many countries enter into bilateral income tax treaties (also referred to as “double taxation treaties”) with other countries, eliminating or mitigating such double taxation, and otherwise containing several specialized tax provisions that override domestic law to taxpayers’ benefit. The Treaty is one such double taxation treaty and is thus of great importance for trade between the US and UK.

Only residents of the US or the UK can rely on the benefits of the Treaty. For this purpose, a “resident” generally includes any company or other entity that is liable to US or UK tax by virtue of being organized or managed in the US or UK. However, there has long been a concern that companies will be established in the US or UK solely to claim Treaty benefits, with the “true” taxpayer being tax resident in a non-treaty jurisdiction. Therefore, like many modern treaties, the Treaty contains a “Limitation on Benefits” clause designed to combat “treaty shopping” by residents of third countries attempting to obtain inappropriate treaty benefits.

The Treaty’s Limitation on Benefits provision is in Article 23. It generally provides that an otherwise eligible US or UK tax resident will be unable to qualify for benefits under the Treaty if it cannot satisfy the Limitation on Benefits requirements. A company generally can satisfy the Limitation on Benefits requirements if it is publicly traded (and meets certain specified trading requirements) or is a subsidiary of such a publicly traded company. It can also satisfy the Limitation on Benefits requirements if it is engaged in the active conduct of a trade or business in the US or the UK and meets certain other criteria, or if it can otherwise demonstrate its eligibility to the US or UK competent authorities.

In addition to the foregoing, a company can satisfy the Limitation on Benefits requirements if it meets one of two ownership and earnings stripping tests. Specifically, a company can qualify if it both satisfies an earnings stripping test (designed to ensure that its earnings are not channelled to another country by means of deductible payments), and either:

  • It is owned 50% or more (by vote and value) by US or UK tax residents who otherwise would satisfy specified Limitation on Benefits tests (the “50% ownership test”); or
  • It is owned 95% or more (by vote and value) by seven or fewer “equivalent beneficiaries” (the “95% ownership test”).

An equivalent beneficiary generally is defined as a tax resident of the European Union or European Economic Area, or the North American Free Trade Agreement (“NAFTA”), who otherwise satisfies the Limitation on Benefits article of the treaty between such resident’s jurisdiction and the US or UK, as applicable. (NAFTA has been superseded by the Agreement between the United States of America, the United Mexican States, and Canada, done at Buenos Aires on November 30, 2018, as amended. Additional guidance confirms that the reference to NAFTA continues to apply to the successor agreement).

"A UK company can satisfy the Limitation on Benefits requirements of the Treaty if it satisfies the earnings stripping test and it is owned either (a) 50% or more by any number of qualified UK tax residents, or (b) 95% or more by seven or fewer qualified EU/EEA tax residents."

To simplify, under the ownership test, a UK company can satisfy the Limitation on Benefits requirements of the Treaty if it satisfies the earnings stripping test and it is owned either (a) 50% or more by any number of qualified UK tax residents, or (b) 95% or more by seven or fewer qualified EU/EEA tax residents.

Post-Brexit Interpretation

Following Brexit, the UK is no longer a member state of the EU or EEA. Accordingly, applying the Treaty’s definitions strictly, a UK tax resident would no longer be an “equivalent beneficiary”. This generally would have no effect on a company that is owned 50% or more by qualified UK tax residents and therefore satisfies the 50% ownership test. However, it could matter for a company with mixed UK/EU ownership.

To illustrate, imagine a UK company that satisfies the earnings stripping test and is owned equally by three individual tax residents of, respectively, France, Germany and the Netherlands. Each of the three owners would be an “equivalent beneficiary”, and therefore the UK company generally could claim benefits under the Treaty under the 95% ownership test. Now imagine that a UK individual tax resident were admitted to the company ownership, with the four owners continuing to share ownership equally. If the UK tax resident were not an “equivalent beneficiary”, the company would be owned only 75% by equivalent beneficiaries, so it would fail the 95% ownership test. Furthermore, because the company would be owned only 25% by UK tax residents, it would also fail the 50% ownership test. But this result is perverse, since it would treat foreign-owned UK companies more favorably than domestically-owned UK companies.

Accordingly, the Arrangement provides that UK tax residents will continue to be treated as “equivalent beneficiaries” under the Treaty. The Arrangement was issued jointly by US and UK competent authority and is in effect for both US and UK purposes. Furthermore, the Arrangement is an interpretation rather than an amendment to the Treaty, so taxpayers can rely on the Arrangement with respect to prior tax periods.

Conclusion

The Arrangement reaches a sensible conclusion to the application of the Treaty post-Brexit. Nevertheless, questions regarding Treaty qualification remain complex. Taxpayers should carefully monitor further tax guidance in respect of the Treaty and raise any questions to tax counsel.

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