Weil, Gotshal & Manges LLP

New Tax Treaty Between US and UK

Blanchard, Kimberly S.

(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 vehicles).

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.  
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