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US-UK competent authority agreement resolves Brexit issue for some UK companies
August 2021
In brief
The IRS released two competent authority agreements on July 28 that the United States and the United Kingdom entered into (the ‘US-UK competent authority agreements’) to express their agreement on the application of certain aspects of the limitation on benefits (LOB) article of the US-UK income tax treaty (Article 23). The expressed agreement is in light of Brexit – the United Kingdom’s departure from the European Union (EU) – and the United States-Mexico-Canada Agreement (USMCA), which replaced the North American Free Trade Agreement (NAFTA). Under the new agreements, the two countries have agreed that neither Brexit nor NAFTA’s replacement by the USMCA should adversely impact the ability of US or UK tax residents to qualify as ‘equivalent beneficiaries’ under the US-UK income tax treaty.
Action item: The fact that the US-UK competent authority agreement on Brexit was issued as a clarification of, rather than a change in, the shared understanding of the United States and the United Kingdom that a ‘resident of a Member State of the European Community’ continues to include a UK resident for the purposes of the US-UK income tax treaty, means that taxpayers may wish to review their treatment of any affected payments since the effective date of Brexit (i.e., January 31, 2020).
Background
A resident of a country which is a party to a US income tax treaty that wishes to avail itself of the treaty benefits generally must, among other requirements, satisfy the anti-treaty shopping provisions in the treaty’s LOB article.
One way a company may seek to meet the requirements of the LOB article is under the ‘derivative benefits test.’ That test, which is contained in several US income tax treaties, includes an ownership prong and a base erosion prong. The ownership portion of the test is based on the company’s ultimate ownership by a person or persons (seven or fewer) that, in relevant part, qualify as an ‘equivalent beneficiary.’ The base erosion portion of the test considers whether certain deductible payments are made to persons that are not ‘equivalent beneficiaries.’
Several treaties, including the US-UK income tax treaty, define the term ‘equivalent beneficiary’ for this purpose by reference to the person being a resident of a country that is a member state of the European Community (currently, the EU) or a party to NAFTA. The departure of the United Kingdom from the EU (effective January 31, 2020) and the replacement of NAFTA with the USMCA (which entered into force on July 1, 2020) impact the ability of mainly UK, US, and Canadian-parented groups to rely on the derivative benefits test for treaty benefits with respect to certain US-source payments. See prior PwC Insights ‘Arrival of Brexit puts treaty claims at risk’ and ‘Imminent replacement of NAFTA by USMCA puts treaty claims at risk.’
Example: In a typical fact pattern (see illustration below) where the derivative benefits test may be relevant, UK PubCo, a UK tax resident publicly traded company, directly wholly owns three subsidiaries: (i) UK Principal; a UK tax resident; (ii) Lux HoldCo, a Luxembourg tax resident; and (iii) Lux FinCo, also a Luxembourg tax tax resident. Lux HoldCo owns UK HoldCo, a UK tax resident, which owns USCo, a US tax resident.
During its taxable year, USCo makes royalty payments to UK Principal, dividend payments to UK HoldCo, and interest payments to LuxFinCo. Assume that (1) UK PubCo satisfies the requirements of the publicly traded test of the LOB article under the US-UK income tax treaty, such that if these payments were made directly from USCo to UK PubCo, they would be exempt from US income tax and withholding under the US-UK income tax treaty (provided all the other requirements of the treaty were met); and (2) none of the entities in the example satisfies the active trade or business test of the LOB article of the applicable US income tax treaty.
Despite all of the subsidiaries having the same publicly traded UK parent company, treaty eligibility varies for each of the different income flows.
Royalty payments
Regarding the royalty payments made by USCo to UK Principal, UK Principal would be expected to qualify for treaty benefits with respect to such payments under the US-UK income tax treaty as a subsidiary of a publicly traded company (provided all the other requirements of the treaty were met), such that Brexit (and, therefore, the corresponding US-UK competent authority agreement) has no impact on UK Principal’s treaty qualification in the fact pattern above.
Dividend payments
The recent competent authority agreement on Brexit impacts the dividend payments made by USCo to UK HoldCo. The default rate of source state taxation under the treaty’s dividends article is 15%. That rate is reduced to 5% if the shareholder holds at least 10% of the voting power of the dividend-paying company. In certain limited circumstances, the tax may be eliminated if the shareholder satisfies a 12-month holding period requirement and an 80% voting stock ownership requirement with respect to the dividend-paying company. Outside of limited circumstances, only companies satisfying the publicly traded or subsidiary of a publicly traded company test, or the derivative benefits test of the LOB article, can obtain the exemption from US federal income tax on dividends.
UK HoldCo does not qualify for treaty benefits under the subsidiary of a publicly traded company test of the US-UK income tax treaty, as it is indirectly owned by UK PubCo through Lux HoldCo (i.e., a person that is not a resident of either the United Kingdom or the United States), which runs afoul of the intermediate entity rule in the US-UK income tax treaty’s subsidiary of a publicly traded company test. Accordingly, for UK HoldCo to meet the treaty’s derivative benefits test and, thus, satisfy the requirements for the exemption from US federal income tax with respect to the dividend income received from USCo, UK PubCo would need to be treated, among other requirements, as an ‘equivalent beneficiary’ for purposes of the US-UK income tax treaty.
For this purpose, the US-UK competent authority agreement on Brexit acknowledges that the withdrawal of the United Kingdom from the EU ‘has created uncertainty’ as to whether a UK resident may continue to be considered an ‘equivalent beneficiary’ for purposes of applying the derivative benefits test of the US-UK income tax treaty. Thus, to clarify that the shared understanding of the United States and the United Kingdom is that residents of either country should be eligible to qualify as ‘equivalent beneficiaries’ for the purpose of applying the derivative benefits test of the US-UK income tax treaty, the US-UK competent authority agreement on Brexit provides that, post-Brexit, a UK resident continues to be treated as ‘a resident of a Member State of the European Community’ for purposes of the definition of an ‘equivalent beneficiary’ under the US-UK income tax treaty.
Observation: For practical purposes, this means that the understanding expressed in the US-UK competent authority agreement has effect from the effective date of Brexit (i.e., January 31, 2020). Therefore, in the example above, UK HoldCo should be able to qualify for treaty benefits under the derivative benefits test with respect to the US-source dividend payments from USCo both before and after the effective date of Brexit, provided that the base erosion test and the other treaty requirements also are satisfied.
Interest payments
Regarding the interest payments made by USCo to LuxFinCo, since both of the US-UK competent authority agreements, as bilateral agreements, only apply for purposes of the US-UK income tax treaty – and, consequently, do not cover US tax treaties with other countries – the qualification of Lux FinCo in the example above under the US-Luxembourg treaty would not be affected by such agreements. As a result, absent a specific agreement between the United States and Luxembourg regarding Brexit’s impact on the definition of ‘equivalent beneficiary’ for the purposes of the US-Luxembourg income tax treaty, UK PubCo may not be treated as an ‘equivalent beneficiary’ for purposes of the derivative benefits test of the US-Luxembourg income tax treaty and; thus, the US-source interest payments by USCo to LuxFinCo potentially may be subject to 30% US income tax and withholding (if no other basis to claim treaty benefits applies).
Base erosion
The clarification provided by the US-UK competent authority agreement on Brexit also is relevant for purposes of the base erosion prong of the derivative benefits test. In the example above, if prior to this recent competent authority agreement, UK HoldCo had made certain deductible payments to UK PubCo in an amount equal to 50% of its gross income during the taxable year, it may not have satisfied the test’s base erosion prong. However, based on the US-UK competent authority agreement on Brexit, UK HoldCo, in the example above, should meet the base erosion prong of the derivative benefits test.
Closely held companies
The US-UK competent authority agreement on Brexit also can favorably impact the ability of certain closely held companies with seven or fewer UK resident individual owners to rely on the derivative benefits test for the purposes of qualifying for the exemption of US income tax and withholding on US-source dividends. As a simplified example, consider a case where a privately owned UK resident company is indirectly owned by seven or fewer UK tax resident individuals. If such UK tax resident individuals are not considered to meet the definition of an ‘equivalent beneficiary’ under the US-UK income tax treaty, the requirements of the ownership portion of the derivative benefits test would not be satisfied.
Observation: Since there are only limited ways a company can satisfy the requirements for the exemption from US federal income tax on dividends under the treaty, and one of those applies only to companies with a publicly traded parent, in many cases, the closely held UK company with UK tax resident individual owners may not be eligible for the exemption on US-source dividends unless its UK owners are considered ‘equivalent beneficiaries.’ As the US-UK competent authority agreement regarding Brexit indicates that a resident of the United Kingdom, such as a UK tax resident individual, continues to be a resident of a member state of the European Community for the purposes of the ‘equivalent beneficiary’ definition of the US-UK income tax treaty, a privately held UK company owned by seven or fewer UK tax resident individuals may be able to avail itself of the exemption from US federal income tax on US-source dividends based on this recent competent authority agreement, provided the company meets all other requirements for the exemption.
USMCA
The US-UK competent authority agreement regarding the USMCA provides that references to NAFTA for purposes of the definition of an ‘equivalent beneficiary’ under the US-UK income tax treaty shall be understood as references to the USMCA upon entry into force of the USMCA, which occurred July 1, 2020. This interpretation is consistent with how the IRS and the Treasury Department had unilaterally announced that they will interpret references to NAFTA in a US bilateral income tax treaty (see Announcement 2020-6 and prior PwC Insight ‘Treasury to interpret references to NAFTA as references to USMCA for certain tax treaty purposes’). This interpretation also is consistent with the June 2020 agreement between the United States and Switzerland that references to NAFTA in the US-Switzerland income tax treaty shall be understood as references to the USMCA upon entry into force of the USMCA.
Observation: Therefore, in the example above, if UK HoldCo, instead of being owned by a UK tax resident, were owned, for instance, by a Canadian tax resident qualifying under the publicly traded company test of the US-Canada tax treaty, the US-UK competent authority agreement regarding the USMCA would indicate that UK HoldCo could still meet the ownership portion of the derivative benefits test of the US-UK income tax treaty’s LOB article.
Other observations
The US-UK competent authority agreements – and, specifically the agreement on the inclusion of the United Kingdom as ‘a resident of a Member State of the European Community’ for purposes of the US-UK income tax treaty – can provide welcome relief for companies seeking benefits under the US-UK income tax treaty. Some may have been anticipating, or hoping for, a more comprehensive solution to address the impact of Brexit on treaty qualification. As indicated above, since the US-UK competent authority agreements only apply for purposes of the US-UK income tax treaty, taxpayers relying on satisfying the LOB requirements under the derivative benefits test of other US income tax treaties based on having a UK tax resident parent company no longer may qualify for treaty benefits as of Brexit’s effective date, absent some other basis for qualifying under the relevant LOB article, or obtaining a discretionary grant of treaty benefits from the IRS.
The US-UK competent authority agreements may have particular relevance in the case of UK or US subsidiaries that, although owned by a UK tax resident publicly traded company, may not meet the detailed requirements of the other LOB tests, such as the subsidiary of a publicly traded company test or the trade or business test. In such a case, provided all of the requirements are met (including the base erosion portion of the derivative benefits test), such UK or US subsidiary may be able to satisfy the LOB requirements based on the US-UK competent authority agreement on Brexit.
Although the US-UK competent authority agreement on Brexit states that it was reached in order to clarify that a UK resident can be an ‘equivalent beneficiary’ for the purposes of the derivative benefits test, the language of the agreement states that the parties “agree that, for the purposes of applying paragraph 7(d) of Article 23, a ‘resident of a Member State of the European Community’ continues to include a resident of the United Kingdom.” Given that paragraph 7(d) of Article 23 is also relevant for other purposes – namely, for the LOB qualification related to trusts (Article 23(2)(g)(ii)) and disproportionate income of certain companies (Article 23(5)) – the treatment of a UK resident as an ‘equivalent beneficiary’ may also apply for those other purposes.
The takeaway
The US-UK competent authority agreements offer a limited scope of relief for certain companies that were affected by Brexit. In particular, groups headed by a UK publicly traded parent with indirectly held US or UK subsidiaries relying on treaty benefits to reduce or eliminate US tax on certain US-source payments may have the needed clarity to continue relying on the derivative benefits test (provided all other requirements are met). Similarly, certain closely held companies with seven or fewer UK individual owners who previously had relied upon the exemption from dividends provided by the treaty (provided all relevant requirements are met) also may have the needed clarity to continue applying the exemption. However, the Brexit clarification applies only for purposes of the US-UK income tax treaty. Brexit treaty relief is not provided for UK-parented groups with non-UK subsidiaries that receive US- source income; whether such additional relief may be forthcoming remains to be seen.
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