New UK-US Tax Treaty Clarification Explained
In July 2021, the US and UK governments reached an important agreement on the interpretation of the US-UK double tax avoidance treaty. It will prevent certain taxpayers from being denied access to treaty tax benefits. The background to the problem and the new treaty interpretation agreement are summarised here.
Double Tax Avoidance Treaties – What Are They?
In short, double tax treaties are agreements between countries designed to prevent the same income from being taxed in two jurisdictions. As such, they provide important protections against double taxation for expats, individuals with sources of income in multiple countries, and businesses with international operations.
Further, tax treaties usually offer favourable withholding tax rates on payments between jurisdictions to encourage cross border trade, but they also include anti-avoidance provisions to prevent treaty benefits from being improperly claimed.
The US-UK Treaty
The US/UK tax treaty was signed in July 2001 and has been effective since 2003. It covers a wide range of taxes in both jurisdictions, including corporate tax, personal income tax and taxes withheld at source. It also provides reduced withholding tax rates on dividends and guarantees that interest and royalties derived in one state by a taxpayer located in the other state are taxable only in the other state.
Normally, tax treaty benefits can be claimed only by tax residents in jurisdictions party to a treaty.
Limitation on benefits (LOB) provisions, which form part of the UK-US treaty, seek to stop residents of third countries (i.e., a country not party to a tax treaty) from engaging in "treaty shopping" — that is, obtaining benefits under a treaty that were not intended for them.
LOB clauses are a series of tests that taxpayers must meet to be eligible for treaty benefits. Generally, to pass these tests, a company must be publicly traded, a subsidiary of a public company or actively trading in either of the jurisdictions party to the treaty.
However, the UK-US tax treaty includes rules allowing treaty benefits to be accessed even when a company’s owners are residents of other jurisdictions, subject to certain conditions, including that: at least 50% of the company’s owners are UK or US tax residents; or at least 95% of the company is owned by no more than seven “equivalent beneficiaries”. These are tax residents of the EU/EEA or the North American Free Trade Agreement (NAFTA) meeting the LOB tests.
Problematically, the UK’s withdrawal from the EU has created a situation whereby UK tax residents are no longer “equivalent beneficiaries”. Essentially, when applying the 95% test, this means that a company with 100% foreign ownership would gain access to treaty benefits, but another company with UK owners may fail the test – a scenario which obviously contradicts the intention of the US-UK treaty.
To fix this anomaly, under the newly agreed competent authority arrangement, the UK is still considered a member of the EU/EEA for the purposes of applying the provisions of the UK-US tax treaty. An additional competent authority agreement clarifies that references to NAFTA in the UK-US tax treaty will be understood to mean the US-Mexico-Canada trade agreement (USMCA) which has superseded NAFTA.
This important clarification has been welcomed by businesses facing considerable uncertainty over the post-Brexit interpretation of the UK-US tax treaty.