New U.S.-U.K. Income Tax Treaty's Implications for U.S. Businesses

The U.S. and the U.K. signed an income tax treaty on July 24, 2001 that will replace the current treaty signed in 1975. The new treaty will probably come into force for withholding taxes sometime in 2002 and fully into force on Jan. 1, 2003 (subject to ratification). It will be economically significant for both countries.

Dividend-Withholding Taxes

This is the first U.S. income tax treaty that, in certain circumstances, eliminates the dividend-withholding tax. This relief will apply if the dividend recipient is either a pension scheme or a company that has owned at least 80% of the payor for 12 months and it:

• Has owned at least 80% of the corporate payor before Oct. 1, 1998;
• Is a public company (under Article 23, par. 2(c));
• Is entitled to benefits under the derivative-benefits provision (Article 23, par. 3); or
• Is entitled to benefits under the competent-authority determination (Article 23, par. 6).

In general, the large number of at-least-80%-owned U.S. subsidiaries with a U.K. parent that have either existed before Oct. 1, 1998 or the parent is a public company will now be able to pay gross dividends.

When the exemptions noted do not apply, the dividend-withholding rate will be 5% if the beneficial owner is a company that owns more than 10% of the payor's voting power. It will be 15% in all other circumstances.

Branch-Profits Tax

The new treaty allows the imposition of a 5% branch-profits tax by the U.S., unless the U.K. company:

• Had a U.S. permanent establishment before Oct. 1, 1998;
• Is a public company (under Article 23, par. 2(c)); or
• Is entitled to benefits under either the derivative-benefits provision (Article 23, par. 3) or the competent-authority determination (Article 23, par. 6).

The current treaty does not allow the branch-profits tax to be imposed (Regs. Sec. 1.884-1(g)(3)).

Persons detrimentally affected by the new treaty can elect to apply the current treaty for an additional 12 months after the new treaty comes into force (Article 29, par. 3).

Interest- and Royalty-Withholding Taxes

Generally, the current withholding tax exemptions are continued, but with some definitional changes. For example, the new royalty provisions cover films; previously, they did not.

Conduit Arrangements

The new treaty's withholding tax provisions for dividends, interest and royalties will not apply if conduit arrangements exist. Generally, conduit arrangements are defined (in Article 3, par. 1(n)) as arrangements entered into to obtain increased treaty benefits if the income received under the treaty is subsequently paid to someone who would not qualify for these benefits. A similar restriction applies to the general exemption for other income under Article 22 and the insurance excise-tax exemption.

Fiscally Transparent and Hybrid Entities

The new treaty extends the rules for fiscal transparency to cover, for example, limited liability companies (LLCs). This will allow the U.K. to continue its present practice of restricting treaty benefits by reference to LLC members' status. Generally, the new treaty should not affect planning in this area, as it allows each country to apply domestic rules as it deems appropriate.

Dual-Resident Companies

The new treaty provides that the competent authorities will determine the appropriate residence of any dual-resident companies. The current treaty provides no tiebreaker rule; so, this is a limited improvement.

LOB

The current treaty contains no limitation-on-benefits (LOB) article. The new treaty's Article 23 follows the U.S. Model Treaty and more recent treaty precedents. It provides, generally, that treaty benefits will only be available if a resident is:

• A qualified person;
• Entitled to derivative benefits;
• Engaged in an active trade or business; or
• Entitled to benefits after competent-authority determination.

Pensions

Under the new treaty, pensions and Social Security payments generally are taxable only in the country of residence. (This is the same treatment as under the current treaty.) The new treaty also provides that the country of residence will not tax pensions received from the source country that would be exempt from tax in that country if the recipient were a resident of such country. The new treaty provides that only the source country will tax lump-sum payments.

There are some helpful new rules on contributions. The new treaty provides, generally, that contributions will be deductible if paid by individuals and excluded from income if paid on their behalf. Any benefits accrued in a pension scheme will not be taxed until distributed; rollovers to other pension plans will not be treated as distributions.

Stock Options

The diplomatic notes to Article 14 of the new treaty clarify the treatment of stock options to avoid double taxation that could occur if stock options earned while resident in one country are exercised when resident in the other country. Currently, this issue is resolved by concession and practice in the two countries. These notes commit the countries to mutual-agreement procedures, to try to ensure that double taxation does not arise.

Ancillary Matters

The new treaty contains a generally conventional capital gain article drawn from the U.S. and Organization for Economic Cooperation and Development (OECD) model treaties. The current treaty contains a very unusual provision limited to shipping and air transportation.

In accordance with OECD recommendations, there is no equivalent in the new treaty to the current treaty's Article 14, dealing with income from independent personal services. This income is now covered by the new treaty's Article 7, Business Profits, pursuant to the definition of "business" in Article 3, par. 1(d).

The new treaty's Article 15 covers directors' fees. There is no equivalent in the current treaty.

There is no equivalent in the new treaty to the current treaty's Article 16 that limits treaty benefits for certain investment and holding companies. Presumably, this is because of the new treaty's LOB article.

From Tony J. Sheard, LL.B., FCA, ATII, Los Angeles, CA