(Fall 2001, Tax Break)
By Kimberly S. Blanchard, New York
Representatives of the US and the UK signed a new income tax treaty on
July 24, 2001. The new treaty will become effective only after it
is ratified by both nations, which many expect to occur in time for a 2002
effective date. It is no overstatement to point out that the US-UK
tax treaty is one of the most, if not the most, commercially significant
tax treaties in the world. For that reason alone, it will be closely
examined as a possible model for other worldwide tax treaties, increasing
its significance even more.
The new treaty contains a large number of provisions not found in the existing
treaty signed in 1975. We summarize here what we believe to be some
of the most significant new additions and changes.
New Dividend Exemption
The new treaty is the first US tax
treaty to exempt certain cross-border dividends from withholding tax at
source. Similar relief is accorded from the US branch tax.
The new exemption is mainly significant to UK investors, since the
UK currently imposes no withholding tax on dividends and no branch tax
on US investors.
The exemption will be available where the
recipient is a corporation that has owned, for at least one year, 80% or
more of the payor’s shares by vote if any of the following are true: (1)
such shares were owned prior to October 1, 1998; (2) the recipient is a
publicly-traded corporation (or a corporation controlled by five or fewer
qualifying publicly-traded corporations); (3) to the extent the recipient
satisfies the derivative benefits test described in the next section; or
(4) is otherwise granted relief by the competent authorities.
The normal rate of dividend withholding continues to be 15%, reduced to
5% where the recipient is a corporation that owns at least 10% of the voting
shares of the payor (other than mutual funds and similar pooled investment
The new treaty retains the zero-rate withholding of source country tax
on interest. It adds, however, a rule that recharacterizes interest
as a dividend, subject to the 15% dividend withholding rate, where the
interest is determined by the payor’s profits or similar factors.
The new treaty will eliminate the tax credit
previously available to US shareholders of UK corporations in respect of
UK-source dividends. As a result of the UK’s 1999 repeal of its
ACT (see a related article on page 1), the tax credit had effectively become
a subsidy paid by the US treasury to US shareholders receiving UK dividends.
Limitations on Benefits; Arbitrage
All treaties limit benefits to persons
who are “resident” in at least one of the contracting states. Apart
from the residency requirement, the current US-UK treaty contains few limitations
upon the types of persons who can claim treaty benefits. The new
treaty contains a separate limitations on benefits article, by now a standard
feature of US tax treaties. To claim treaty benefits, a resident
of a contracting state must be a “qualified person,” meaning an individual,
a government-owned entity, a local pension or employee benefits fund, or
a local charity. Corporations will qualify only if they satisfy one
of several alternative tests, including a public trading test, an ownership-plus-base-erosion
test or an active business test. In deference to the UK’s membership
in the European Community and to the US’s membership in NAFTA, a “derivative
benefits” rule allows certain entities controlled by persons resident
in the EC or in a NAFTA country to qualify for treaty benefits.
One important limitation in the current
treaty, repeated in the new treaty, allows the US to deny treaty benefits
to a UK resident with respect to an item of income, to the extent the UK
resident is not taxed currently in the UK by reason of the latter’s “remittance”
system of taxation of nondomiciliaries. This concept of denying treaty
benefits where the source state does not fully and currently tax its own
residents is expanded in the new treaty. The new treaty incorporates
an “anti-hybrid” rule, obviously modeled on US regulations, that
would deny treaty benefits for income derived through an entity that one
state treats as transparent but the other does not. Thus, for example,
if a US-source dividend is paid to a UK-owned Cayman Islands entity that
the US treats as a partnership, but the UK treats as a corporation, treaty
benefits cannot be claimed by the entity’s UK owners. However, to
eliminate double taxation of hybrid entities and their owners, the new
treaty allows a person taxed as an owner in his or her country of residence
to claim a credit for tax imposed on the entity by the other country.
The treaty incorporates disallowance rules for amounts paid through “conduit
arrangements.” Similar to the US conduit regulations, treaty benefits
are denied if an item of income nominally paid to a qualified resident
of a country state is passed through to a third party in any form. Thus,
for example, a US entity cannot claim treaty benefits in the UK for interest
received under a back-to-back loan arrangement whereby the US entity on-lent
funds received from a third-country national to a UK person.
The new treaty contains an interesting rule pursuant to which the UK will
not recognize a US citizen or green-card holder as a US resident if such
US person does not actually reside in the United States, or if he or she
is treated as a resident of a third country with which the UK has a treaty.
Thus, for example, a US citizen who is treated as a resident of France
under the UK-French treaty cannot claim benefits with respect to an item
of UK-source income under the US-UK treaty (but presumably may claim benefits
under the UK’s treaty with France).
Finally, the new treaty denies an indirect
foreign tax credit in the UK for US tax on a dividend paid by a US corporation
where the US views the dividend as paid to a US person and allows a deduction
to another US resident for an amount equivalent to the dividend. This
new provision appears aimed at the “repo” structure in which a US person
transfers a dividend-paying share to a UK person in a transaction that
the US views as a secured loan, but the UK sees as a purchase of the share.
Treatment of Pensions
Under the new treaty, each country recognizes
the existence of tax-exempt pension trusts or pension schemes established
under the other’s laws. A UK pension fund will now generally be
eligible to receive US-source dividends exempt from US withholding tax.
If an individual is covered by a pension plan in his home country and then
goes to work in a second country, contributions made to the plan will generally
be deductible or excludible from the worker’s income in the country where
he is working, and will be deductible by the employer. Earnings on
pension investments accrue as tax free.
Amounts paid from pension plans to individual
participants are generally taxed only in the state of the participant’s
residence, and only when distributed. Moreover, if amounts paid in
the form of a pension to a resident of one country would be exempt if he
or she had received it in the source country, the residence country will
honor the exemption.
These rules do not apply to lump-sum payments, which instead are taxable
only by the state in which the pension plan is established. It is
unfortunate that neither the new treaty nor the diplomatic notes provide
any clarification as to what constitutes “a pension or other similar remuneration.”
Uncertainty therefore remains as to whether deferred compensation
for services, paid out under a nonqualified deferral compensation plan,
qualifies for taxation only in the residence state.
Taxation of Stock Options
In an exchange of diplomatic notes, thetwo countries agree that the provision of the new treaty applicable to
income from employment applies to the receipt of compensatory shares and
options. Recognizing that income from option plans can sometimes
be subject to double tax where the employee resides in one country but
works in both countries, the countries agreed that the non-resident country
cannot tax the employee on exercise of an option except to the extent he
or she performed services within that country during the period between
grant and exercise. Unfortunately, it is difficult to read this language
to achieve the same result with respect to shares of restricted stock,
although it might have been the countries’ interest to apply a similar
rule in such a case.