<DOC>
[Joint Comm. on Taxation]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:85199.wais]
[JOINT COMMITTEE PRINT]
EXPLANATION OF PROPOSED
INCOME TAX TREATY BETWEEN
THE UNITED STATES AND
THE UNITED KINGDOM
Scheduled for a Hearing
before the
COMMITTEE ON FOREIGN RELATIONS
UNITED STATES SENATE
ON MARCH 5, 2003
__________
Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
[GRAPHIC] [TIFF OMITTED] TONGRESS.#13
March 3, 2003
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U.S. GOVERNMENT PRINTING OFFICE
85-199 WASHINGTON : 2003 JCS-4-03
JOINT COMMITTEE ON TAXATION
108th Congress, 1st Session
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HOUSE SENATE
WILLIAM M. THOMAS, California, CHARLES E. GRASSLEY, Iowa,
Chairman Vice Chairman
PHILIP M. CRANE, Illinois ORRIN G. HATCH, Utah
E. CLAY SHAW, Jr., Florida DON NICKLES, Oklahoma
CHARLES B. RANGEL, New York MAX BAUCUS, Montana
FORTNEY PETE STARK, California JOHN D. ROCKEFELLER IV, West
Virginia
Mary M. Schmitt, Acting Chief of Staff
Bernard A. Schmitt, Deputy Chief of Staff
C O N T E N T S
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Page
Introduction..................................................... 1
I. Summary...........................................................2
II. Overview of U.S. Taxation of International Trade and Investment and
U.S. Tax Treaties.................................................4
A. U.S. Tax Rules........................................ 4
B. U.S. Tax Treaties..................................... 5
III.Explanation of Proposed Treaty....................................8
Article 1. General Scope................................ 8
Article 2. Taxes Covered................................ 13
Article 3. General Definitions.......................... 13
Article 4. Residence.................................... 16
Article 5. Permanent Establishment...................... 18
Article 6. Income from Real Property.................... 19
Article 7. Business Profits............................. 20
Article 8. Shipping and Air Transport................... 25
Article 9. Associated Enterprises....................... 26
Article 10. Dividends.................................... 27
Article 11. Interest..................................... 34
Article 12. Royalties.................................... 36
Article 13. Gains........................................ 38
Article 14. Income from Employment....................... 39
Article 15. Directors' Fees.............................. 40
Article 16. Entertainers and Sportsmen................... 41
Article 17. Pensions, Social Security, Annuities,
Alimony, and Child Support........................... 41
Article 18. Pension Schemes.............................. 43
Article 19. Government Service........................... 44
Article 20. Students..................................... 45
Article 20A. Teachers.................................... 45
Article 21. Offshore Exploration and Exploitation
Activities........................................... 46
Article 22. Other Income................................. 46
Article 23. Limitation on Benefits....................... 47
Article 24. Relief From Double Taxation.................. 56
Article 25. Non-Discrimination........................... 62
Article 26. Mutual Agreement Procedure................... 64
Article 27. Exchange of Information and Administrative
Assistance........................................... 66
Article 28. Diplomatic Agents and Consular Officers...... 68
Article 29. Entry into Force............................. 68
Article 30. Termination.................................. 69
IV. Issues...........................................................71
A. Zero Rate of Withholding Tax on Dividends from 80-
Percent-Owned Subsidiaries........................... 71
B. Anti-Conduit Rule..................................... 76
C. Insurance Excise Tax.................................. 78
D. Dividend Substitute Payments.......................... 79
E. Attribution of Business Profits....................... 82
F. Income from the Rental of Ships and Aircraft.......... 87
G. Creditability of U.K. Petroleum Revenue Tax........... 87
H. Teachers, Students, and Trainees...................... 91
INTRODUCTION
This pamphlet,\1\ prepared by the staff of the Joint
Committee on Taxation, describes the proposed income tax treaty
between the United States of America and the United Kingdom, as
supplemented by an exchange of diplomatic notes (the ``notes'')
and a protocol (the ``proposed protocol''). The proposed treaty
and notes were signed on July 24, 2001. The proposed protocol
was signed on July 22, 2002. Unless otherwise specified, the
proposed treaty, the notes, and the proposed protocol are
hereinafter referred to collectively as the ``proposed
treaty.'' The Senate Committee on Foreign Relations has
scheduled a public hearing on the proposed treaty for March 5,
2003.\2\
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\1\ This pamphlet may be cited as follows: Joint Committee on
Taxation, Explanation of Proposed Income Tax Treaty Between the United
States and the United Kingdom (JCS-4-03), March 3, 2003.
\2\ For a copy of the proposed treaty, see Senate Treaty Doc. 107-
19.
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Part I of the pamphlet provides a summary of the proposed
treaty. Part II provides a brief overview of U.S. tax laws
relating to international trade and investment and of U.S.
income tax treaties in general. Part III contains an article-
by-article explanation of the proposed treaty. Part IV contains
a discussion of issues relating to the proposed treaty.
I. SUMMARY
The principal purposes of the proposed treaty are to reduce
or eliminate double taxation of income earned by residents of
either country from sources within the other country and to
prevent avoidance or evasion of the taxes of the two countries.
The proposed treaty also is intended to promote close economic
cooperation between the two countries and to eliminate possible
barriers to trade and investment caused by overlapping taxing
jurisdictions of the two countries.
As in other U.S. tax treaties, these objectives principally
are achieved through each country's agreement to limit, in
certain specified situations, its right to tax income derived
from its territory by residents of the other country. For
example, the proposed treaty contains provisions under which
each country generally agrees not to tax business income
derived from sources within that country by residents of the
other country unless the business activities in the taxing
country are substantial enough to constitute a permanent
establishment (Article 7). Similarly, the proposed treaty
contains ``commercial visitor'' exemptions under which
residents of one country performing personal services in the
other country will not be required to pay tax in the other
country unless their contact with the other country exceeds
specified minimums (Articles 14 and 16). The proposed treaty
provides that dividends, interest, royalties, and certain
capital gains derived by a resident of either country from
sources within the other country generally may be taxed by both
countries (Articles 10, 11, 12, and 13); however, the rate of
tax that the source country may impose on a resident of the
other country on dividends, interest, and royalties may be
limited or eliminated by the proposed treaty (Articles 10, 11,
and 12). In the case of dividends, the proposed treaty contains
provisions that for the first time in a U.S. income tax treaty
would eliminate source-country tax on certain dividends in
which certain ownership thresholds and other requirements are
satisfied.
In situations in which the country of source retains the
right under the proposed treaty to tax income derived by
residents of the other country, the proposed treaty generally
provides for relief from the potential double taxation through
the allowance by the country of residence of a tax credit for
certain foreign taxes paid to the other country (Article 24).
The proposed treaty contains the standard provision (the
``saving clause'') included in U.S. tax treaties pursuant to
which each country retains the right to tax its residents and
citizens as if the treaty had not come into effect (Article 1).
In addition, the proposed treaty contains the standard
provision providing that the treaty may not be applied to deny
any taxpayer any benefits the taxpayer would be entitled under
the domestic law of a country or under any other agreement
between the two countries (Article 1).
The proposed treaty contains provisions which can operate
to deny the benefits of the dividends article (Article 10), the
interest article (Article 11), the royalties article (Article
12), the other income article (Article 22), and the insurance
excise tax provision of the business profits article (Article
7(5)) with respect to amounts paid under, or as part of, a
conduit arrangement. The proposed treaty also contains a
detailed limitation on benefits provision to prevent the
inappropriate use of the treaty by third-country residents
(Article 23).
The United States and the United Kingdom have an income tax
treaty currently in force (signed in 1975). The proposed treaty
is similar to other recent U.S. income tax treaties, the 1996
U.S. model income tax treaty (``U.S. model''), and the 1992
model income tax treaty of the Organization for Economic
Cooperation and Development, as updated (``OECD model'').
However, the proposed treaty contains certain substantive
deviations from these treaties and models.
II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE AND INVESTMENT AND
U.S. TAX TREATIES
This overview briefly describes certain U.S. tax rules
relating to foreign income and foreign persons that apply in
the absence of a U.S. tax treaty. This overview also discusses
the general objectives of U.S. tax treaties and describes some
of the modifications to U.S. tax rules made by treaties.
A. U.S. Tax Rules
The United States taxes U.S. citizens, residents, and
corporations on their worldwide income, whether derived in the
United States or abroad. The United States generally taxes
nonresident alien individuals and foreign corporations on all
their income that is effectively connected with the conduct of
a trade or business in the United States (sometimes referred to
as ``effectively connected income''). The United States also
taxes nonresident alien individuals and foreign corporations on
certain U.S.-source income that is not effectively connected
with a U.S. trade or business.
Income of a nonresident alien individual or foreign
corporation that is effectively connected with the conduct of a
trade or business in the United States generally is subject to
U.S. tax in the same manner and at the same rates as income of
a U.S. person. Deductions are allowed to the extent that they
are related to effectively connected income. A foreign
corporation also is subject to a flat 30-percent branch profits
tax on its ``dividend equivalent amount,'' which is a measure
of the effectively connected earnings and profits of the
corporation that are removed in any year from the conduct of
its U.S. trade or business. In addition, a foreign corporation
is subject to a flat 30-percent branch-level excess interest
tax on the excess of the amount of interest that is deducted by
the foreign corporation in computing its effectively connected
income over the amount of interest that is paid by its U.S.
trade or business.
U.S.-source fixed or determinable annual or periodical
income of a nonresident alien individual or foreign corporation
(including, for example, interest, dividends, rents, royalties,
salaries, and annuities) that is not effectively connected with
the conduct of a U.S. trade or business is subject to U.S. tax
at a rate of 30 percent of the gross amount paid. Certain
insurance premiums earned by a nonresident alien individual or
foreign corporation are subject to U.S. tax at a rate of 1 or 4
percent of the premiums. These taxes generally are collected by
means of withholding.
Specific statutory exemptions from the 30-percent
withholding tax are provided. For example, certain original
issue discount and certain interest on deposits with banks or
savings institutions are exempt from the 30-percent withholding
tax. An exemption also is provided for certain interest paid on
portfolio debt obligations. In addition, income of a foreign
government or international organization from investments in
U.S. securities is exempt from U.S. tax.
U.S.-source capital gains of a nonresident alien individual
or a foreign corporation that are not effectively connected
with a U.S. trade or business generally are exempt from U.S.
tax, with two exceptions: (1) gains realized by a nonresident
alien individual who is present in the United States for at
least 183 days during the taxable year, and (2) certain gains
from the disposition of interests in U.S. real property.
Rules are provided for the determination of the source of
income. For example, interest and dividends paid by a U.S.
citizen or resident or by a U.S. corporation generally are
considered U.S.-source income. Conversely, dividends and
interest paid by a foreign corporation generally are treated as
foreign-source income. Special rules apply to treat as foreign-
source income (in whole or in part) interest paid by certain
U.S. corporations with foreign businesses and to treat as U.S.-
source income (in whole or in part) dividends paid by certain
foreign corporations with U.S. businesses. Rents and royalties
paid for the use of property in the United States are
considered U.S.-source income.
Because the United States taxes U.S. citizens, residents,
and corporations on their worldwide income, double taxation of
income can arise when income earned abroad by a U.S. person is
taxed by the country in which the income is earned and also by
the United States. The United States seeks to mitigate this
double taxation generally by allowing U.S. persons to credit
foreign income taxes paid against the U.S. tax imposed on their
foreign-source income. A fundamental premise of the foreign tax
credit is that it may not offset the U.S. tax liability on
U.S.-source income. Therefore, the foreign tax credit
provisions contain a limitation that ensures that the foreign
tax credit offsets only the U.S. tax on foreign-source income.
The foreign tax credit limitation generally is computed on a
worldwide basis (as opposed to a ``per-country'' basis). The
limitation is applied separately for certain classifications of
income. In addition, a special limitation applies to the credit
for foreign taxes imposed on foreign oil and gas extraction
income.
For foreign tax credit purposes, a U.S. corporation that
owns 10 percent or more of the voting stock of a foreign
corporation and receives a dividend from the foreign
corporation (or is otherwise required to include in its income
earnings of the foreign corporation) is deemed to have paid a
portion of the foreign income taxes paid by the foreign
corporation on its accumulated earnings. The taxes deemed paid
by the U.S. corporation are included in its total foreign taxes
paid and its foreign tax credit limitation calculations for the
year in which the dividend is received.
B. U.S. Tax Treaties
The traditional objectives of U.S. tax treaties have been
the avoidance of international double taxation and the
prevention of tax avoidance and evasion. Another related
objective of U.S. tax treaties is the removal of the barriers
to trade, capital flows, and commercial travel that may be
caused by overlapping tax jurisdictions and by the burdens of
complying with the tax laws of a jurisdiction when a person's
contacts with, and income derived from, that jurisdiction are
minimal. To a large extent, the treaty provisions designed to
carry out these objectives supplement U.S. tax law provisions
having the same objectives; treaty provisions modify the
generally applicable statutory rules with provisions that take
into account the particular tax system of the treaty partner.
The objective of limiting double taxation generally is
accomplished in treaties through the agreement of each country
to limit, in specified situations, its right to tax income
earned from its territory by residents of the other country.
For the most part, the various rate reductions and exemptions
agreed to by the source country in treaties are premised on the
assumption that the country of residence will tax the income at
levels comparable to those imposed by the source country on its
residents. Treaties also provide for the elimination of double
taxation by requiring the residence country to allow a credit
for taxes that the source country retains the right to impose
under the treaty. In addition, in the case of certain types of
income, treaties may provide for exemption by the residence
country of income taxed by the source country.
Treaties define the term ``resident'' so that an individual
or corporation generally will not be subject to tax as a
resident by both the countries. Treaties generally provide that
neither country will tax business income derived by residents
of the other country unless the business activities in the
taxing jurisdiction are substantial enough to constitute a
permanent establishment or fixed base in that jurisdiction.
Treaties also contain commercial visitation exemptions under
which individual residents of one country performing personal
services in the other will not be required to pay tax in that
other country unless their contacts exceed certain specified
minimums (e.g., presence for a set number of days or earnings
in excess of a specified amount). Treaties address passive
income such as dividends, interest, and royalties from sources
within one country derived by residents of the other country
either by providing that such income is taxed only in the
recipient's country of residence or by reducing the rate of the
source country's withholding tax imposed on such income. In
this regard, the United States agrees in its tax treaties to
reduce its 30-percent withholding tax (or, in the case of some
income, to eliminate it entirely) in return for reciprocal
treatment by its treaty partner.
In its treaties, the United States, as a matter of policy,
generally retains the right to tax its citizens and residents
on their worldwide income as if the treaty had not come into
effect. The United States also provides in its treaties that it
will allow a credit against U.S. tax for income taxes paid to
the treaty partners, subject to the various limitations of U.S.
law.
The objective of preventing tax avoidance and evasion
generally is accomplished in treaties by the agreement of each
country to exchange tax-related information. Treaties generally
provide for the exchange of information between the tax
authorities of the two countries when such information is
necessary for carrying out provisions of the treaty or of their
domestic tax laws. The obligation to exchange information under
the treaties typically does not require either country to carry
out measures contrary to its laws or administrative practices
or to supply information that is not obtainable under its laws
or in the normal course of its administration or that would
reveal trade secrets or other information the disclosure of
which would be contrary to public policy. The Internal Revenue
Service (the ``IRS''), and the treaty partner's tax
authorities, also can request specific tax information from a
treaty partner. This can include information to be used in a
criminal investigation or prosecution.
Administrative cooperation between countries is enhanced
further under treaties by the inclusion of a ``competent
authority'' mechanism to resolve double taxation problems
arising in individual cases and, more generally, to facilitate
consultation between tax officials of the two governments.
Treaties generally provide that neither country may subject
nationals of the other country (or permanent establishments of
enterprises of the other country) to taxation more burdensome
than that it imposes on its own nationals (or on its own
enterprises). Similarly, in general, neither treaty country may
discriminate against enterprises owned by residents of the
other country.
At times, residents of countries that do not have income
tax treaties with the United States attempt to use a treaty
between the United States and another country to avoid U.S.
tax. To prevent third-country residents from obtaining treaty
benefits intended for treaty country residents only, treaties
generally contain an ``anti-treaty shopping'' provision that is
designed to limit treaty benefits to bona fide residents of the
two countries.
III.
EXPLANATION OF PROPOSED TREATY
Article 1. General Scope
Overview
The general scope article describes the persons who may
claim the benefits of the proposed treaty. It also includes a
``saving clause'' provision similar to provisions found in most
U.S. income tax treaties.
The proposed treaty generally applies to residents of the
United States and to residents of the United Kingdom, with
specific modifications to such scope provided in other articles
(e.g., Article 19 (Government Service), Article 25 (Non-
Discrimination), and Article 26 (Exchange of Information)).
This scope is consistent with the scope of other U.S. income
tax treaties, the U.S. model, and the OECD model. For purposes
of the proposed treaty, residence is determined under Article 4
(Resident).
The proposed treaty provides that it does not restrict in
any manner any benefit accorded by internal law or by any other
agreement between the United States and the United Kingdom.
Thus, the proposed treaty will not apply to increase the tax
burden of a resident of either the United States or the United
Kingdom. According to the Treasury Department's Technical
Explanation (hereinafter referred to as the ``Technical
Explanation''), the fact that the proposed treaty only applies
to a taxpayer's benefit does not mean that a taxpayer may
select inconsistently among treaty and internal law provisions
in order to minimize its overall tax burden. In this regard,
the Technical Explanation sets forth the following example.
Assume a resident of the United Kingdom has three separate
businesses in the United States. One business is profitable and
constitutes a U.S. permanent establishment. The other two
businesses generate effectively connected income as determined
under the Internal Revenue Code (the ``Code''), but do not
constitute permanent establishments as determined under the
proposed treaty; one business is profitable and the other
business generates a net loss. Under the Code, all three
businesses would be subject to U.S. income tax, in which case
the losses from the unprofitable business could offset the
taxable income from the other businesses. On the other hand,
only the income of the business which gives rise to a permanent
establishment is taxable by the United States under the
proposed treaty. The Technical Explanation makes clear that the
taxpayer may not invoke the proposed treaty to exclude the
profits of the profitable business that does not constitute a
permanent establishment and invoke U.S. internal law to claim
the loss of the unprofitable business that does not constitute
a permanent establishment to offset the taxable income of the
permanent establishment.\3\
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\3\ See Rev. Rul. 84-17, 1984-1 C.B. 308.
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The proposed treaty provides that the dispute resolution
procedures under its mutual agreement article (Article 26) take
precedence over the corresponding provisions of any other
agreement to which the United States and the United Kingdom are
parties in determining whether a taxation measure is within the
scope of the proposed treaty. The proposed treaty also provides
that the dispute resolution procedures set forth in Article II
and Article XVII of the General Agreement on Trade in Services
(``GATS'') shall not apply to any taxation measure unless the
competent authorities agree that the measure is not within the
scope of the non-discrimination provisions of Article 25 (Non-
Discrimination) of the proposed treaty. The Technical
Explanation clarifies that no national treatment or most-
favored nation obligations undertaken by the United States and
the United Kingdom pursuant to GATS will apply to a taxation
measure, unless the competent authorities otherwise
agree.<SUP>3A</SUP> For purposes of this provision, the term
``measure'' means a law, regulation, rule, procedure, decision,
administrative action, or any similar provision or action.
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\3A\ It is unclear whether this statement in the Technical
Explanation encompasses all interaction between GATS and the proposed
treaty.
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The Technical Explanation points out that, unlike the U.S.
model, the proposed treaty does not include an additional
limitation on the application of other agreements between the
United States and the United Kingdom that impose national
treatment or most-favored nation obligations.\4\ According to
the notes and the Technical Explanation, instead of generally
limiting the effect of other such agreements, the United States
and the United Kingdom analyzed existing agreements and believe
that the only such agreements in force between the countries
are: GATS; the General Agreement on Tariffs and Trade; the
Convention to Regulate the Commerce between the Territories of
the United States and of his Britannic Majesty, signed in
London on July 3, 1815; and the Treaty of Amity, Commerce, and
Navigation, between his Britannic Majesty and the United States
of America, signed at London, November 19, 1794. The Technical
Explanation states that these agreements (other than GATS, as
described in the preceding paragraph) are unlikely ever to
apply with respect to an income tax provision.
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\4\ The Technical Explanation does not explain the rationale for
this variation from the U.S. model.
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There are two ways in which the absence of the U.S. model
provision affects the implementation of this provision. The
first is the interaction of the proposed treaty with these
three \5\ agreements, should they apply with respect to an
income tax provision. According to the Technical Explanation:
(1) if one of the three agreements overlaps with Article 25
(Non-Discrimination) of the proposed treaty, remedies would be
available under both agreements; (2) if benefits are available
under one of the three agreements but not under Article 25, a
resident is entitled to the benefits under the applicable
agreement; and (3) if benefits are available under Article 25
but not under one of the three agreements, a resident is
entitled to the benefits under Article 25. These rules, as
articulated in the Technical Explanation, may be more
burdensome to apply than would be the case if the U.S. model
rule had been incorporated. In addition, if it were determined
that there is in fact overlap between the proposed treaty and
the General Agreement on Tariffs and Trade, the consequences
may be more severe than they would be with respect to the 1815
and 1794 agreements, because those two agreements are
bilateral, while the General Agreement on Tariffs and Trade is
multilateral.
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\5\ The four agreements listed in the notes and Technical
Explanation, except for GATS. The interaction of GATS with the proposed
treaty is described in the second preceding paragraph.
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The second is the interaction of the proposed treaty with
any other agreements in effect between the two treaty countries
that were not listed. It is uncertain that the agreements
enumerated in the notes and Technical Explanation constitute
the complete and exhaustive list.\6\ Accordingly, the Technical
Explanation states that the treaty countries will consult with
a view to ensuring the proper interaction of the proposed
treaty and any other relevant agreements in force that are
determined at the time of the signing of the proposed treaty to
include obligations with respect to taxation measures. The
Technical Explanation also states that such consultation may
result in an amendment to the proposed treaty if necessary but,
unless and until such an amendment is made, any other agreement
between the treaty countries would apply concurrently with the
proposed treaty. The Technical Explanation does not clarify how
to resolve the concurrent application of conflicting provisions
in the proposed treaty and the other agreement should both
provisions apply with respect to an income tax provision.
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\6\ The Technical Explanation states that ``the Contracting States
believe that the only agreements. . . .'' (emphasis added).
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It is unclear why the notes and Technical Explanation
include references to other agreements that the Technical
Explanation states are unlikely ever to apply with respect to
an income tax provision. In order to assure itself that this
provision is not utilized in unintended or unforeseen ways in
the future, the Committee may wish to instruct the Secretary of
the Treasury to report to the Committee regarding every
instance in which the Treasury or the IRS is aware that a
taxpayer claims any income tax benefit outside of the proposed
treaty but under any of these agreements or under any other
agreements not listed in the notes and Technical Explanation.
Saving clause
Like all U.S. income tax treaties and the U.S. Model, the
proposed treaty includes a ``saving clause.'' Under this
clause, with specific exceptions described below, the proposed
treaty does not affect the taxation by either treaty country of
its residents or its citizens. By reason of this saving clause,
unless otherwise specifically provided in the proposed treaty,
the United States may continue to tax its citizens who are
residents of the United Kingdom as if the treaty were not in
force. For purposes of the proposed treaty (and, thus, for
purposes of the saving clause), the term ``residents,'' which
is defined in Article 4 (Resident), includes corporations and
other entities as well as individuals.
The proposed treaty contains a provision under which the
saving clause (and therefore the U.S. jurisdiction to tax)
applies to a former U.S. citizen or long-term resident (whether
or not treated as such under Article 4 (Resident)), whose loss
of citizenship or resident status, respectively, had as one of
its principal purposes the avoidance of tax; such application
is limited to the ten-year period following the loss of
citizenship or resident status. The proposed treaty provides
that this provision does not apply to former citizens or
residents who relinquished such status at any time before
February 6, 1995. The Technical Explanation states that this
date is consistent with the effective date of amendments to
Section 877 of the Code that were made by the Health and
Insurance Accountability and Portability Act of 1996, section
511 (Public Law 104-191). As amended, Section 877 provides
special rules for the imposition of U.S. income tax on former
U.S. citizens and long-term residents for a period of ten years
following the loss of citizenship; these special tax rules
apply to a former citizen or long-term resident only if his or
her loss of U.S. citizenship or resident status had as one of
its principal purposes the avoidance of U.S. income, estate, or
gift taxes. For purposes of applying the special tax rules to
former citizens and long-term residents, individuals who meet a
specified income tax liability threshold or a specified net
worth threshold generally are considered to have lost
citizenship or resident status for a principal purpose of U.S.
tax avoidance.
For purposes of the proposed treaty, the United States and
the United Kingdom have agreed in the notes that an individual
is considered a ``long-term resident'' of a treaty country only
if the individual (other than a citizen of that country) was a
lawful permanent resident of that country in at least 8 of the
15 taxable years ending with the taxable year in which the
individual ceased to be a long-term resident. The Technical
Explanation states that this standard is consistent with U.S.
domestic law. The notes also provide several factors that shall
be considered favorably in determining whether or not one of
the principal purposes of an individual's loss of citizenship
of either treaty country was the avoidance of tax. These
factors generally are consistent with U.S. domestic law.
Exceptions to the saving clause are provided for the
following benefits conferred by a treaty country: the allowance
of correlative adjustments when the profits of an associated
enterprise are adjusted by the other country (Article 9,
paragraph 2); the exemption from source- and residence-country
tax for certain pension, social security, alimony, and child
support payments (Article 17, paragraphs 1(b), 3 and 5); the
exemption from source- and residence-country tax for certain
investment income of pension schemes established in the other
treaty country (Article 18, paragraphs 1 and 5); relief from
double taxation through the provision of a foreign tax credit
(Article 24); protection from discriminatory tax treatment with
respect to transactions with residents of the other country
(Article 25); and benefits under the mutual agreement
procedures (Article 26). These exceptions to the saving clause
permit residents or citizens of the United States or the United
Kingdom to obtain such benefits of the proposed treaty with
respect to their country of residence or citizenship.
In addition, the saving clause does not apply to certain
benefits conferred by one of the countries upon individuals who
neither are citizens of that country nor have been admitted for
permanent residence in that country. Under this set of
exceptions to the saving clause, the specified treaty benefits
are available to, for example, a citizen of the United Kingdom
who spends enough time in the United States to be taxed as a
U.S. resident but who has not acquired U.S. permanent residence
status (i.e., does not hold a ``green card''). The benefits
that are covered under this set of exceptions are the
beneficial host-country tax treatment of pension fund
contributions (paragraph 2 of Article 18), as well as the
exemptions from host country tax for certain compensation from
government service (Article 19), certain income received by
visiting students and trainees (Article 20), certain income
received by visiting teachers (Article 20A), and certain income
of diplomats and consular officials (Article 28).
Fiscally transparent entities
The proposed treaty contains special rules for fiscally
transparent entities. Under these rules, income derived through
an entity that is fiscally transparent under the laws of either
treaty country is considered to be the income of a resident of
one of the treaty countries only to the extent that the income
is subject to tax in that country as the income of a resident.
For example, if a U.K. company pays interest to an entity that
is treated as fiscally transparent for U.S. tax purposes, the
interest will be considered to be derived by a resident of the
United States only to the extent that U.S. tax laws treat one
or more U.S. residents (whose status as U.S. residents is
determined under U.S. tax laws) as deriving the interest income
for U.S. tax purposes.
The Technical Explanation states that these rules for
income derived through fiscally transparent entities apply
regardless of where the entity is organized (i.e., in the
United States, the United Kingdom, or a third country). The
Technical Explanation also states that these rules apply even
if the entity is viewed differently under the tax laws of the
other country. As an example, the Technical Explanation states
that income from U.S. sources received by an entity organized
under the laws of the United States, which is treated for U.K.
tax purposes as a corporation and is owned by a U.K.
shareholder who is a U.K. resident for U.K. tax purposes, is
not considered derived by the shareholder of that corporation
even if, under the tax laws of the United States, the entity is
treated as fiscally transparent. Rather, for purposes of the
proposed treaty, the income is treated as derived by the U.S.
entity.
The Technical Explanation also states that the treatment of
fiscally transparent entities is not an exception to the saving
clause. Therefore, such treatment does not preclude a treaty
country from taxing an entity that is treated as a resident of
that country under its tax laws. For example, if a U.S. limited
liability company (``LLC'') with U.K. members elects to be
taxed as a corporation for U.S. tax purposes, the United States
will tax that LLC on its worldwide income on a net basis,
without regard to whether the United Kingdom views the LLC as
fiscally transparent. The diplomatic notes provide rules under
Article 24 (Relief from Double Taxation) for determining which
treaty country has the primary right to tax income derived
through a fiscally transparent entity and which treaty country
must provide a credit for such taxes.
Article 2. Taxes Covered
The proposed treaty generally applies to the income and
capital gains taxes of the United States and the United
Kingdom. However, like the present treaty, Article 25 (Non-
Discrimination) of the proposed treaty is applicable to all
taxes imposed at all levels of government, including State and
local taxes.
In the case of the United States, the proposed treaty
applies to the Federal income taxes imposed by the Code, but
excludes social security taxes. In addition, the proposed
treaty applies to the U.S. excise taxes imposed on insurance
premiums paid to foreign insurers and with respect to private
foundations. Unlike the present treaty, but like the U.S.
model, the proposed treaty applies to the accumulated earnings
tax and the personal holding company tax.
The proposed treaty applies to the excise taxes on
insurance premiums paid to foreign insurers. Because the
insurance excise taxes are covered taxes under the proposed
treaty, U.K. insurers generally are not subject to the U.S.
excise taxes on insurance premiums for insuring U.S. risks. The
excise taxes continue to apply, however, when a U.K. insurer
reinsures a policy it has written on a U.S. risk with a foreign
insurer that is not entitled to a similar exemption under this
or a different tax treaty, in an arrangement with a main
purpose of obtaining the benefits of the proposed treaty.
The notes state that it is understood that, if a political
subdivision or local authority of the United States seeks to
impose tax on the profits of any enterprise of the United
Kingdom from the operation of ships or aircraft in
international traffic, in circumstances where the proposed
treaty would preclude the imposition of a Federal income tax on
such profits, the United States Government will use its best
endeavors to persuade the political subdivision or local
authority to refrain from imposing tax.
In the case of the United Kingdom, the proposed treaty
applies to the income tax; the capital gains tax; the
corporation tax; and the petroleum revenue tax (subject to the
limitations under paragraph 3 of Article 24 (Relief from Double
Taxation) on the amount of petroleum revenue tax allowable as a
credit against U.S. tax).
The proposed treaty also contains a rule generally found in
U.S. income tax treaties (including the present treaty) that
provides that the proposed treaty applies to any identical or
substantially similar taxes that may be imposed subsequently in
addition to or in place of the taxes covered. The proposed
treaty obligates the competent authority of each country to
notify the competent authority of the other country of any
changes in its internal tax laws that significantly affect
their obligations under the proposed treaty. The Technical
Explanation states that this requirement relates to changes
that are significant to the operation of the proposed treaty.
Article 3. General Definitions
The proposed treaty provides definitions of a number of
terms for purposes of the proposed treaty. Certain of the
standard definitions found in most U.S. income tax treaties are
included in the proposed treaty.
The term ``person'' includes an individual, an estate, a
trust, a partnership, a company, and any other body of persons.
A ``company'' under the proposed treaty is any body
corporate or any entity that is treated as a body corporate for
tax purposes.
The term ``enterprise'' includes any activity or activities
that constitute a trade or business, while the term
``business'' includes the performance of professional services
and other activities of an independent character. The
definitions of ``enterprise'' and ``business'' in the proposed
treaty are identical to the same definitions recently added to
the OECD Model in conjunction with the deletion of Article 14
(Independent Personal Services) from the OECD Model. The
Technical Explanation states that the inclusion of these
definitions is intended to clarify that the performance of
personal services or other activities of an independent
character are considered to constitute an enterprise, covered
by Article 7 (Business Profits). By contrast, the U.S. Model
does not provide definitions of the terms ``enterprise'' and
``business'' because, unlike the proposed treaty and the OECD
Model, the U.S. Model continues to include a separate article
concerning the treatment of independent personal services.
The terms ``enterprise of a Contracting State'' and
``enterprise of the other Contracting State'' mean,
respectively, an enterprise carried on by a resident of a
treaty country and an enterprise carried on by a resident of
the other treaty country.
The proposed treaty defines ``international traffic'' as
any transport by a ship or aircraft, except when the transport
is solely between places in the other treaty country.
Accordingly, with respect to a U.K. enterprise, purely domestic
transport within the United States does not constitute
``international traffic.''
The U.S. ``competent authority'' is the Secretary of the
Treasury or his delegate. The U.S. competent authority function
has been delegated to the Commissioner of Internal Revenue, who
has re-delegated the authority to the Assistant Commissioner
(International). On interpretative issues, the latter acts with
the concurrence of the Associate Chief Counsel (International)
of the IRS. The U.K. ``competent authority'' is the
Commissioners of Inland Revenue or their authorized
representative.
The term ``United States'' means the United States of
America (including the States thereof and the District of
Columbia), but does not include Puerto Rico, the Virgin
Islands, Guam, or any other U.S. possession or territory. The
term ``United States'' also includes the territorial sea of the
United States and any area beyond the territorial sea that is
designated as an area within which the United States, in
compliance with its legislation and in conformity with
international law, exercises sovereign rights in respect of the
exploration and exploitation of the natural resources of the
seabed, the subsoil, and the superjacent waters. The Technical
Explanation states that the extension of the term to such areas
applies only if the person, property, or activity to which the
proposed treaty is being applied is connected with such natural
resource exploration or exploitation.
The term ``United Kingdom'' means Great Britain and
Northern Ireland, and includes any area outside the territorial
sea of the United Kingdom which has been or may hereafter be so
designated, in accordance with international law and under the
laws of the United Kingdom concerning the Continental Shelf, as
an area within which the rights of the United Kingdom with
respect to the sea bed and sub-soil and their natural resources
may be exercised. The Technical Explanation states that the
proposed treaty does not apply to the Channel Islands or the
Isle of Man.
The term ``national'' means: (1) all individuals possessing
the citizenship of a treaty country; and (2) all legal persons,
partnerships, and associations deriving their status as such
from the laws in force in a treaty country.
The proposed treaty defines the term ``qualified
governmental entity'' as a treaty country, or a political
subdivision or local authority of a treaty country. Also
defined as a qualified governmental entity is a person that is
wholly owned (directly or indirectly) by a treaty country or a
political subdivision or local authority thereof, provided it
is organized under the laws of a treaty country, its earnings
are credited to its own account with no portion of its income
inuring to the benefit of any private person, and its assets
vest in the treaty country, political subdivision or local
authority upon dissolution. The definition described in the
previous sentence only applies if the entity does not carry on
commercial activities. These definitions are the same as those
in the U.S. model. However, unlike the U.S. model, the proposed
treaty excludes from the definition of the term ``qualified
governmental entity'' government pension funds. According to
the Technical Explanation, a number of the benefits that are
relevant only to government pension funds in the U.S. Model are
available to all qualified pension funds under the proposed
treaty.
The term ``Contracting State'' means the United States or
the United Kingdom, as the context requires.
The proposed treaty defines the term ``real property,''
consistent with the definition provided in Treas. Reg. Sec.
1.897-1(b), to include: land and the unsevered products of the
land (including property accessory to real property);
improvements; personal property associated with the use of real
property (such as livestock and equipment used in agriculture
and forestry); rights to which the provisions of general law
respecting landed property apply; usufructs of real property;
and rights to variable or fixed payments as consideration for
the working of, or the right to work, mineral deposits,
sources, and other natural resources. The term does not include
an interest in land solely as a creditor. The term also does
not include ships, boats, and aircraft.
The proposed treaty defines the term ``conduit
arrangement'' as a transaction or series of transactions that
meets both of the following criteria: (1) a resident of one
contracting state receives an item of income that generally
would qualify for treaty benefits, and then pays (directly or
indirectly, at any time or in any form) all or substantially
all of that income to a resident of a third state who would not
be entitled to equivalent or greater treaty benefits if it had
received the same item of income directly; and (2) obtaining
the increased treaty benefits is the main purpose or one of the
main purposes of the transaction or series of transactions.
The proposed treaty also contains the standard provision
that, unless the context otherwise requires or the competent
authorities agree upon a common meaning pursuant to Article 26
(Mutual Agreement Procedure), all terms not defined in the
proposed treaty have the meaning pursuant to the respective tax
laws of the country that is applying the treaty.
Article 4. Residence
The assignment of a country of residence is important
because the benefits of the proposed treaty generally are
available only to a resident of one of the treaty countries as
that term is defined in the proposed treaty. Furthermore,
issues arising because of dual residency, including situations
of double taxation, may be avoided by the assignment of one
treaty country as the country of residence when under the
internal laws of the treaty countries a person is a resident of
both countries.
Internal taxation rules
United States
Under U.S. law, the residence of an individual is important
because a resident alien, like a U.S. citizen, is taxed on his
or her worldwide income, while a nonresident alien is taxed
only on certain U.S.-source income and on income that is
effectively connected with a U.S. trade or business. An
individual who spends sufficient time in the United States in
any year or over a three-year period generally is treated as a
U.S. resident. A permanent resident for immigration purposes
(i.e., a ``green card'' holder) also is treated as a U.S.
resident.
Under U.S. law, a company is taxed on its worldwide income
if it is a ``domestic corporation.'' A domestic corporation is
one that is created or organized in the United States or under
the laws of the United States, a State, or the District of
Columbia.
United Kingdom
Under U.K. law, resident individuals are subject to tax on
their worldwide income, while nonresident individuals generally
are subject to tax only on income arising in the United
Kingdom. However, resident individuals who are not domiciled in
the United Kingdom generally are subject to U.K. tax on income
from sources outside the United Kingdom only to the extent that
the income is remitted to the United Kingdom. Individuals
generally are considered residents of the United Kingdom if
they are present for a sufficient time in any individual year
or over a four-year period. Even if not present for a
sufficient time, individuals may be treated as residents if
they own or lease accommodations in the United Kingdom.
Companies that are resident in the United Kingdom are
subject to tax on their worldwide income. A company is resident
in the United Kingdom if it is incorporated under U.K. law or
it is managed and controlled in the United Kingdom. Companies
that are not resident in the United Kingdom are subject to
corporate income tax on income derived from the United Kingdom.
Proposed treaty rules
The proposed treaty specifies rules to determine whether a
person is a resident of the United States or the United Kingdom
for purposes of the proposed treaty. The rules generally are
consistent with the rules of the U.S. model.
The proposed treaty generally defines ``resident of a
Contracting State'' to mean any person who, under the laws of
that country, is liable to tax in that country by reason of the
person's domicile, residence, place of management, place of
incorporation, or any other criterion of a similar nature. The
term ``resident of a Contracting State'' does not include any
person that is liable to tax in that country only on income
from sources in that country or on profits attributable to a
permanent establishment in that country. The proposed treaty
provides that the United Kingdom will treat an individual who
is a U.S. citizen or lawful permanent resident of the United
States (i.e., a ``green card'' holder) as a resident of the
United States only if he or she has a substantial presence,
permanent home, or habitual abode in the United States and is
not a resident of a third country for purposes of a tax treaty
between such country and the United Kingdom. The determination
of whether a citizen or national is considered a resident of
the United States or the United Kingdom is made based on the
principles of the treaty tie-breaker rules described below.
The proposed treaty treats as residents of a treaty country
certain organizations that generally are exempt from tax in
that country. Under these rules, a resident includes a legal
person that is organized under the laws of a treaty country and
is generally exempt from tax in the treaty country because it
is established and maintained: (1) to provide pensions or other
similar benefits to employees pursuant to a tax-exempt scheme
or plan; (2) exclusively for a religious, charitable,
scientific, artistic, cultural, or educational purposes; or (3)
as a qualified governmental entity that is, is a part of, or is
established in, that country.
The proposed treaty provides a set of ``tie-breaker'' rules
to determine residence in the case of an individual who, under
the basic residence definition, would be considered to be a
resident of both countries. Under these rules, an individual is
deemed to be a resident of the country in which he or she has a
permanent home available. If the individual has a permanent
home in both countries, the individual's residence is deemed to
be the country with which his or her personal and economic
relations are closer (i.e., his or her ``center of vital
interests''). If the country in which the individual has his or
her center of vital interests cannot be determined, or if he or
she does not have a permanent home available in either country,
he or she is deemed to be a resident of the country in which he
or she has an habitual abode. If the individual has an habitual
abode in both countries or in neither country, he or she is
deemed to be a resident of the country of which he or she is a
national. If the individual is a national of both countries or
neither country, the competent authorities of the countries
will settle the question of residence by mutual agreement.
In the case of any person other than an individual that
would be a resident of both countries, the proposed treaty
requires the competent authorities to endeavor to settle the
issue of residence by mutual agreement and to determine the
mode of application of the proposed treaty to such person.
Like the present treaty, the proposed treaty provides that,
for U.K. tax purposes, the domicile of a woman who is a U.S.
national and who was married before January 1, 1974 to a man
domiciled in the United Kingdom is determined as if such
marriage took place on January 1, 1974. Prior to January 1,
1974, the domicile of a woman was the same as the domicile of
her husband under U.K. law. Although this law was repealed, a
transitional rule provides that a woman who was married before
1974 is treated as retaining her husband's domicile unless and
until she changes her domicile by acquisition or revival of
another domicile after 1973. By providing a special tax rule
for women who were married before 1974, the proposed treaty
equalizes the treatment of male and female U.S. citizens who
are married to spouses domiciled in the U.K.
Article 5. Permanent Establishment
The proposed treaty contains a definition of the term
``permanent establishment'' that generally follows the pattern
of the present treaty, other recent U.S. income tax treaties,
the U.S. model, and the OECD model.
The permanent establishment concept is one of the basic
devices used in income tax treaties to limit the taxing
jurisdiction of the host country and thus to mitigate double
taxation. Generally, an enterprise that is a resident of one
country is not taxable by the other country on its business
profits unless those profits are attributable to a permanent
establishment of the resident in the other country. In
addition, the permanent establishment concept is used to
determine whether the reduced rates of, or exemptions from, tax
provided for dividends, interest, and royalties apply, or
whether those items of income will be taxed as business
profits.
In general, under the proposed treaty, a permanent
establishment is a fixed place of business in which the
business of an enterprise is wholly or partly carried on. A
permanent establishment includes a place of management, a
branch, an office, a factory, a workshop, a mine, a quarry, or
other place of extraction of natural resources. It also
includes a building site or construction or assembly project
that continues for more than twelve months. The Technical
Explanation states that the twelve-month test applies
separately to each individual site or project, with a series of
contracts or projects that are interdependent both commercially
and geographically treated as a single project. The Technical
Explanation further states that if the twelve-month threshold
is exceeded, the site or project constitutes a permanent
establishment as of the first day that work in the country
began. The proposed treaty differs from the U.S. Model in that
the general definition of a permanent establishment does not
apply to offshore drilling rigs, which are governed by the
special rules in Article 21 (Offshore Exploration and
Exploitation Activities) concerning exploration and
exploitation of natural resources.
Under the proposed treaty, as under the present treaty, the
following activities are deemed not to constitute a permanent
establishment: (1) the use of facilities solely for storing,
displaying, or delivering goods or merchandise belonging to the
enterprise; (2) the maintenance of a stock of goods or
merchandise belonging to the enterprise solely for storage,
display, or delivery or solely for processing by another
enterprise; and (3) the maintenance of a fixed place of
business solely for the purchase of goods or merchandise or for
the collection of information for the enterprise. The proposed
treaty also provides that the maintenance of a fixed place of
business solely for the purpose of carrying on, for the
enterprise, any other activity of a preparatory or auxiliary
character does not constitute a permanent establishment. The
proposed treaty provides that a combination of these activities
will not give rise to a permanent establishment, but only if
the combination results in an overall activity that is of a
preparatory or auxiliary character. This rule is derived from
the OECD model but differs from the U.S. model, which provides
that any combination of otherwise excepted activities is not
deemed to give rise to a permanent establishment, without the
additional requirement that the combination, as distinct from
each individual activity, be preparatory or auxiliary. The
Technical Explanation states that it is assumed that if
preparatory or auxiliary activities are combined, the
combination generally will also be of a preparatory or
auxiliary character, but that a permanent establishment may
result from a combination of such activities if this is not the
case.
Under the proposed treaty, as under the present treaty, if
a person, other than an independent agent, is acting in a
treaty country on behalf of an enterprise of the other country
and has, and habitually exercises in such first country, the
authority to conclude contracts that are binding on such
enterprise, the enterprise is deemed to have a permanent
establishment in the first country in respect of any activities
undertaken for that enterprise. This rule does not apply where
the activities are limited to the purchase of goods or
merchandise for the enterprise.
Under the proposed treaty, no permanent establishment is
deemed to arise if the agent is a broker, general commission
agent, or any other agent of independent status, provided that
the agent is acting in the ordinary course of its business. The
Technical Explanation states that whether an enterprise and an
agent are independent is a factual determination, relevant
factors of which include: (1) the extent to which the agent
operates on the basis of instructions from the principal; (2)
the extent to which the agent bears business risk; and (3)
whether the agent has an exclusive or nearly exclusive
relationship with the principal.
The proposed treaty provides that the fact that a company
that is a resident of one country controls or is controlled by
a company that is a resident of the other country or that
carries on business in the other country does not of itself
cause either company to be a permanent establishment of the
other.
Article 6. Income From Real Property
This article covers income from real property. The rules
covering gains from the sale of real property are included in
Article 13 (Gains).
Under the proposed treaty, income derived by a resident of
one country from real property situated in the other country
may be taxed in the country where the property is situated.
This rule is consistent with the rules in the U.S. and OECD
models. For this purpose, income from real property includes
income from agriculture or forestry. The term ``real property''
is defined in paragraph (1)(m) of Article 3.
The proposed treaty specifies that the country in which the
property is situated also may tax income derived from the
direct use, letting, or use in any other form of real property.
The rules of Article 6, permitting source-country taxation,
also apply to the income from real property of an enterprise.
Article 7. Business Profits
Internal taxation rules
United States
U.S. law distinguishes between the U.S. business income and
the other U.S. income of a nonresident alien or foreign
corporation. A nonresident alien or foreign corporation is
subject to a flat 30-percent rate (or lower treaty rate) of tax
on certain U.S.-source income if that income is not effectively
connected with the conduct of a trade or business within the
United States. The regular individual or corporate rates apply
to income (from any source) that is effectively connected with
the conduct of a trade or business within the United States.
The performance of personal services within the United States
may constitute a trade or business within the United States.
The treatment of income as effectively connected with a
U.S. trade or business depends upon whether the source of the
income is U.S. or foreign. In general, U.S.-source periodic
income (such as interest, dividends, rents, and wages) and
U.S.-source capital gains are effectively connected with the
conduct of a trade or business within the United States if the
asset generating the income is used in (or held for use in) the
conduct of the trade or business or if the activities of the
trade or business were a material factor in the realization of
the income. All other U.S.-source income of a person engaged in
a trade or business in the United States is treated as
effectively connected with the conduct of a trade or business
in the United States (under what is referred to as a ``force of
attraction'' rule).
The income of a nonresident alien individual from the
performance of personal services within the United States is
excluded from U.S.-source income, and therefore is not taxed by
the United States in the absence of a U.S. trade or business,
if the following criteria are met: (1) the individual is not in
the United States for over 90 days during the taxable year; (2)
the compensation does not exceed $3,000; and (3) the services
are performed as an employee of, or under a contract with, a
foreign person not engaged in a trade or business in the United
States, or are performed for a foreign office or place of
business of a U.S. person.
Foreign-source income generally is effectively connected
income only if the foreign person has an office or other fixed
place of business in the United States and the income is
attributable to that place of business. Only three types of
foreign-source income are considered to be effectively
connected income: rents and royalties for the use of certain
intangible property derived from the active conduct of a U.S.
business; certain dividends and interest either derived in the
active conduct of a banking, financing or similar business in
the United States or received by a corporation the principal
business of which is trading in stocks or securities for its
own account; and certain sales income attributable to a U.S.
sales office. Special rules apply for purposes of determining
the foreign-source income that is effectively connected with a
U.S. business of an insurance company.
Any income or gain of a foreign person for any taxable year
that is attributable to a transaction in another year is
treated as effectively connected with the conduct of a U.S.
trade or business if it would have been so treated had it been
taken into account in that other year (Code sec. 864(c)(6)). In
addition, if any property ceases to be used or held for use in
connection with the conduct of a trade or business within the
United States, the determination of whether any income or gain
attributable to a sale or exchange of that property occurring
within ten years after the cessation of business is effectively
connected with the conduct of a trade or business within the
United States is made as if the sale or exchange occurred
immediately before the cessation of business (Code sec.
864(c)(7)).
An excise tax is imposed on insurance premiums paid to a
foreign insurer or reinsurer with respect to U.S. risks. The
rate of tax is either 4 percent or 1 percent. The rate of the
excise tax is 4 percent of the premium on a policy of casualty
insurance or indemnity bond that is (1) paid by a U.S. person
on risks wholly or partly within the United States, or (2) paid
by a foreign person on risks wholly within the United States.
The rate of the excise tax is 1 percent of the premium paid on
a policy of life, sickness or accident insurance, or an annuity
contract. The rate of the excise tax is also 1 percent of any
premium for reinsurance of any of the foregoing types of
contracts.
Two exceptions to the application of the insurance excise
tax are provided. One exception is for amounts that are
effectively connected with the conduct of a U.S. trade or
business (provided no treaty provision exempts the amounts from
U.S. taxation). Thus, under this exception, the insurance
excise tax does not apply to amounts that are subject to U.S.
income tax in the hands of a foreign insurer or reinsurer
pursuant to its election to be taxed as a domestic corporation
under Code section 953(d), or pursuant to its election under
Code section 953(c) to treat related person insurance income as
effectively connected to the conduct of a U.S. trade or
business. The other exception applies to premiums on an
indemnity bond to secure certain pension and other payments by
the United States government.
United Kingdom
Foreign corporations and nonresident individuals generally
are subject to tax in the United Kingdom only on income arising
in the United Kingdom. Business income derived in the United
Kingdom by a foreign corporation or nonresident individual
generally is taxed in the same manner as the income of a
resident corporation or individual.
Proposed treaty limitations on internal law
Under the proposed treaty, business profits of an
enterprise of one of the countries are taxable in the other
country only to the extent that they are attributable to a
permanent establishment in the other country through which the
enterprise carries on business. This is one of the basic
limitations on a country's right to tax income of a resident of
the other country. The rule is similar to those contained in
the U.S. and OECD models.
Although the proposed treaty does not provide a definition
of the term ``business profits,'' the Technical Explanation
states that the term generally means income derived from any
trade or business. This definition includes income from
independent personal services, which, unlike the U.S. Model but
like the OECD Model, is not addressed in a separate article.
Although the proposed treaty does not include a separate
article for independent personal services, this Article limits
the right of a treaty country to tax income from the
performance of personal services by a resident of the other
treaty country in a manner similar to the limitations provided
in the separate article applicable to independent personal
services that is included in the U.S. Model and other U.S.
treaties.
Because the definition of ``business profits'' includes
independent personal services under the proposed treaty, the
Technical Explanation states that the term includes income
attributable to notional principal contracts and other
financial instruments to the extent that the income is
attributable to a trade or business of dealing in such
instruments or is otherwise related to a trade or business
(e.g., notional principal contracts entered into for the
purpose of hedging currency risk arising from an active trade
or business). Any other income derived from financial
instruments is addressed in Article 22 (Other Income), unless
specifically governed by another article.
The Technical Explanation states that business profits also
include income earned by an enterprise from the furnishing of
personal services. For example, a U.S. consulting firm whose
employees or partners perform services in the United Kingdom
through a permanent establishment may be taxed in the United
Kingdom on a net basis under this Article, rather than Article
14 (Income from Employment), consistent with the OECD Model.
However, salaries of employees of the consulting firm would
remain subject to Article 14 (Income from Employment). In
addition, the Technical Explanation states that business
profits include income derived by a partner of one treaty
country that is attributable to personal services performed in
the other treaty country through a partnership with a permanent
establishment in that other country. Thus, income that may be
taxed as business profits includes all income that is
attributable to the permanent establishment with respect to the
performance of personal services carried on by the partnership
(whether by the partner himself, other partners in the
partnership, or employees assisting the partners), as well as
any income from activities that are ancillary to the
performance of the services (e.g., charges for facsimile
services). For example, if a U.K. partnership has four partners
who are resident and perform personal services only in the U.K.
office and one partner who performs personal services in a U.S.
office that is a permanent establishment in the United States
(and the five partners agree to equally split profits), the
four U.K. resident partners may be taxed in the United States
with respect to their shares of the income that is attributable
to the U.S. office. The services that generate the income
attributable to the U.S. office would include the services
performed by the partner in the U.S. office, as well as any
income with respect to services performed on behalf of the U.K.
office by a U.K. partner who travels to the United States and
performs such services in the United States, regardless of
whether the U.K. partner actually visited or used the U.S.
office while performing the services in the United States.
The proposed treaty provides that there will be attributed
to a permanent establishment the business profits which it
might be expected to make if it were a distinct and separate
enterprise engaged in the same or similar activities under the
same or similar conditions and dealing wholly independently
with the enterprise of which it is a permanent establishment
and other associated enterprises. The Technical Explanation
states that this rule permits the use of methods other than
separate accounting to determine the arm's-length profits of a
permanent establishment where it is necessary to do so for
practical reasons, such as when the affairs of the permanent
establishment are so closely bound up with those of the head
office that it would be impossible to disentangle them on any
strict basis of accounts.
In computing taxable business profits of a permanent
establishment, the proposed treaty provides that deductions are
allowed for expenses, wherever incurred, which are attributable
to the activities of the permanent establishment. These
deductions include an allocation of executive and general
administrative expenses, as determined by applying the arm's-
length principle and regardless of which accounting unit of the
enterprise books the expenses, provided they are incurred for
the purposes of the permanent establishment. The notes state
that the OECD Transfer Pricing Guidelines apply by analogy in
determining the profits attributable to a permanent
establishment. Accordingly, any of the methods described in the
guidelines (including profits methods) may be used in
accordance with the guidelines to determine the income of a
permanent establishment.
For purposes of determining the amount of profits that are
attributable to a permanent establishment, the notes state that
the permanent establishment is treated as having the same
amount of capital that it would need to support its activities
if it were a distinct and separate enterprise engaged in the
same or similar activities. This means, for example, that a
permanent establishment cannot be funded entirely with debt. To
the extent that a permanent establishment does not have
sufficient capital to carry on its activities as if it were a
distinct and separate enterprise, a treaty country may
attribute such capital to the permanent establishment and deny
an interest deduction to the extent necessary to reflect that
capital attribution. The Technical Explanation states that the
amount of capital attributable to a permanent establishment
that is a financial institution (other than an insurance
company) is determined by allocating the institution's total
equity among its various offices on the basis of the proportion
of the institution's risk-weighted assets attributable to each
of them.
Unlike the U.S. model and the OECD model, the proposed
treaty does not include a rule providing that business profits
are not attributed to a permanent establishment merely by
reason of the purchase of goods or merchandise by the permanent
establishment for the enterprise. This rule is only relevant to
an office that performs functions in addition to purchasing
because such activity does not, by itself, give rise to a
permanent establishment under Article 5 (Permanent
Establishment) to which income can be attributed. When it
applies, the rule provides that business profits may be
attributable to a permanent establishment with respect to its
non-purchasing activities (e.g., sales activities), but not
with respect to its purchasing activities. The Technical
Explanation states that the rule was not included in the
proposed treaty because such a result is inconsistent with the
arm's-length principle, which would view a separate and
distinct enterprise as receiving some compensation to perform
purchasing services.
The proposed treaty requires the determination of business
profits of a permanent establishment to be made in accordance
with the same method year by year unless a good and sufficient
reason to the contrary exists.
The proposed treaty generally waives the application of the
U.S. insurance excise tax on premiums on policies issued by
foreign insurers and reinsurers, in the case of a U.K.
enterprise carrying on an insurance business.
The waiver of the insurance excise tax generally does not
apply, however, if the policies are entered into as part of a
conduit arrangement. A conduit arrangement is defined in
paragraph (1)(n) of Article 3 of the proposed treaty as a
transaction (or series of transactions) in which a resident of
the United States or the United Kingdom (that is entitled to
the benefits of the proposed treaty) receives income arising in
the other country, then pays it to a resident of a third
country who is not entitled to equivalent or more favorable
treaty benefits. The arrangement is treated as a conduit
arrangement only if has as its main purpose, or one of its main
purposes, obtaining the increased benefits available under the
proposed treaty.
The Technical Explanation notes that U.S. domestic law
provides specific anti-conduit rules as well as domestic anti-
abuse principles, and states that the United States intends to
interpret the conduit arrangement provisions of the proposed
treaty in accordance with U.S. domestic law, as it may evolve
over time. The Technical Explanation further states that the
United States will interpret the provision of the proposed
treaty by analogy to the anti-conduit rules of Treas. Reg. sec.
1.881-3. The Technical Explanation notes that the application
of the anti-conduit rules to the insurance excise tax is
somewhat narrower than the exception in other U.S. tax treaties
that cover the insurance excise tax, because it includes the
intent test found in the anti-conduit test applicable to
withholding taxes.
The U.S. insurance excise tax does not apply to amounts
that are effectively connected to a U.S. trade or business,
including income from a U.S. permanent establishment. The
proposed treaty provides for the same result as U.S. domestic
law, by providing that the anti-conduit exception to the waiver
of the insurance excise tax does not apply in the case of
premiums attributable to a U.K. enterprise's permanent
establishment in the United States. Thus, the provision of U.S.
domestic law would prevent the application of the insurance
excise tax in this situation, although the U.S. income tax
would apply under U.S. domestic law. As discussed above,
another provision of Article 7 provides that the business
profits of a U.K. enterprise that are attributable to a
permanent establishment in the United States may be taxed in
the United States.
Where business profits include items of income that are
dealt with separately in other articles of the proposed treaty,
those other articles, and not the business profits article,
govern the treatment of those items of income. Thus, for
example, dividends are taxed under the provisions of Article 10
(Dividends), and not as business profits, except as
specifically provided in Article 10.
The proposed treaty provides that, for purposes of the
taxation of business profits, income may be attributable to a
permanent establishment (and therefore may be taxable in the
source country) even if the payment of such income is deferred
until after the permanent establishment or fixed base has
ceased to exist. This rule incorporates into the proposed
treaty the rule of Code section 864(c)(6) described above. This
rule applies with respect to business profits (Article 7,
paragraphs 1 and 2), dividends (Article 10, paragraph 5),
interest (Article 11, paragraph 3), royalties (Article 12,
paragraph 3), and other income (Article 22, paragraph 2). A
similar rule is included in paragraph 3 of Article 13 (Gains).
The Technical Explanation notes that this article is
subject to the savings clause of paragraph 4 of Article 1
(General Scope), as well as Article 23 (Limitation on
Benefits). Thus, in the case of the savings clause, if a U.S.
citizen who is a resident of the United Kingdom derives
business profits from the United States that are not
attributable to a permanent establishment in the United States,
the United States may, subject to the special foreign tax
credit rules of paragraph 6 of Article 24 (Relief from Double
Taxation), tax those profits, notwithstanding that paragraph 1
of this Article would exempt the income from U.S. Tax.
Article 8. Shipping and Air Transport
Article 8 of the proposed treaty covers income from the
operation of ships and aircraft in international traffic. The
rules governing income from the disposition of ships, aircraft,
and containers are in Article 13 (Capital Gains).
The United States generally taxes the U.S.-source income of
a foreign person from the operation of ships or aircraft to or
from the United States. An exemption from U.S. tax is provided
if the income is earned by a corporation that is organized in,
or an alien individual who is resident in, a foreign country
that grants an equivalent exemption to U.S. corporations and
residents. The United States has entered into agreements with a
number of countries providing such reciprocal exemptions.
Like the present treaty, the proposed treaty provides that
profits that are derived by an enterprise of one country from
the operation in international traffic of ships or aircraft are
taxable only in that country, regardless of the existence of a
permanent establishment in the other country. ``International
traffic'' is defined in Article 3(1)(f) (General Definitions)
as any transport by a ship or aircraft, except when the
transport is solely between places in the other treaty country.
The proposed treaty provides that profits from the
operation of ships or aircraft in international traffic include
profits derived from the rental of ships or aircraft on a full
(time or voyage) basis (i.e., with crew). Like the present
treaty, it also includes profits from the rental of ships or
aircraft on a bareboat basis (i.e., without crew) if such
rental activities are incidental to the activities from the
operation of ships or aircraft in international traffic. The
Technical Explanation notes that this provision is narrower
than the U.S. Model, which also covers rentals from bareboat
leasing that are not incidental to the operation of ships and
aircraft in international traffic by the lessor. Under the
proposed treaty, income from such rentals is covered by Article
7 (Business Profits).
The proposed treaty provides that profits derived by an
enterprise from the inland transport of property or passengers
within either treaty country are treated as profits from the
operation of ships or aircraft in international traffic (and,
thus, governed by this Article) if such transport is undertaken
as part of international traffic by the enterprise. For
example, if a U.K. enterprise contracts to carry property from
the United States to the United Kingdom and, as part of the
contract, it transports (or contracts to transport) the
property by truck from its point of origin to an airport in the
United States, the income earned by the U.K. enterprise from
the overland leg of the journey would be taxable only in the
United Kingdom. Similarly, the diplomatic notes state that this
Article would also apply to income from lighterage undertaken
as part of the international transport of goods.
The proposed treaty provides that profits of an enterprise
of a country from the use, maintenance, or rental of containers
(including trailers, barges, and related equipment for the
transport of containers) used for the transport of goods or
merchandise in international traffic is taxable only in that
country. The Technical Explanation states that, unlike the OECD
Model, this rule applies without regard to whether the
recipient of the income is engaged in the operation of ships or
aircraft in international traffic or whether the enterprise has
a permanent establishment in the other country.
As under the U.S. model, the shipping and air transport
provisions of the proposed treaty apply to profits derived from
participation in a pool, joint business, or international
operating agency. This refers to various arrangements for
international cooperation by carriers in shipping and air
transport.
The Technical Explanation notes that this article is
subject to the savings clause of paragraph 4 of Article 1
(General Scope), as well as Article 23 (Limitation on
Benefits).
Article 9. Associated Enterprises
The proposed treaty, like most other U.S. tax treaties,
contains an arm's-length pricing provision. The proposed treaty
recognizes the right of each country to make an allocation of
profits to an enterprise of that country in the case of
transactions between related enterprises, if conditions are
made or imposed between the two enterprises in their commercial
or financial relations which differ from those which would be
made between independent enterprises. In such a case, a country
may allocate to such an enterprise the profits which it would
have accrued but for the conditions so imposed. This treatment
is consistent with the U.S. model.
For purposes of the proposed treaty, an enterprise of one
country is related to an enterprise of the other country if one
of the enterprises participates directly or indirectly in the
management, control, or capital of the other enterprise.
Enterprises are also related if the same persons participate
directly or indirectly in their management, control, or
capital.
Under the proposed treaty, when a redetermination of tax
liability has been made by one country under the provisions of
this article, the other country will make an appropriate
adjustment to the amount of tax paid in that country on the
redetermined income. In making such adjustment, due regard is
to be given to other provisions of the proposed treaty and
proposed protocol. Any such adjustment is to be made only in
accordance with the mutual agreement procedures of the proposed
treaty. The proposed treaty's saving clause retaining full
taxing jurisdiction in the country of residence or citizenship
does not apply in the case of such adjustments. Accordingly,
internal statute of limitations provisions do not prevent the
allowance of appropriate correlative adjustments. However, the
Technical Explanation states that statutory or procedural
limitations cannot be overridden to impose additional tax
because paragraph 2 of Article 1 (General Scope) provides that
the proposed treaty cannot restrict any statutory benefit.
The diplomatic notes state that, if the amount of interest
or royalties paid exceeds the amount that would have been paid
in the absence of a special relationship under paragraph 4 of
Article 11 (Interest) or paragraph 4 of Article 12 (Royalties),
a treaty country generally will adjust the amount of deductible
interest or royalties paid under the authority of this Article
and make any other appropriate adjustments. The diplomatic
notes further state that the treaty country making the
adjustments will not also impose its domestic rate of
withholding tax with respect to such excess amount.
The Technical Explanation also states that the proposed
treaty does not limit any provisions of either country's
internal law that permit the distribution, apportionment, or
allocation of income, deductions, credits, or allowances
between related parties, including adjustments in cases
involving the evasion of taxes or fraud. Any such adjustments
are permitted even if they are different from, or go beyond,
those specifically authorized by this Article, as long as they
are in accord with general arm's length principles.
Article 10. Dividends
Internal taxation rules
United States
The United States generally imposes a 30-percent tax on the
gross amount of U.S.-source dividends paid to nonresident alien
individuals and foreign corporations. The 30-percent tax does
not apply if the foreign recipient is engaged in a trade or
business in the United States and the dividends are effectively
connected with that trade or business. In such a case, the
foreign recipient is subject to U.S. tax on such dividends on a
net basis at graduated rates in the same manner that a U.S.
person would be taxed.
Under U.S. law, the term dividend generally means any
distribution of property made by a corporation to its
shareholders, either from accumulated earnings and profits or
current earnings and profits. However, liquidating
distributions generally are treated as payments in exchange for
stock and, thus, are not subject to the 30-percent withholding
tax described above (see discussion of capital gains in
connection with Article 13 below).
Dividends paid by a U.S. corporation generally are U.S.-
source income. Also treated as U.S.-source dividends for this
purpose are portions of certain dividends paid by a foreign
corporation that conducts a U.S. trade or business. The U.S.
30-percent withholding tax imposed on the U.S.-source portion
of the dividends paid by a foreign corporation is referred to
as the ``second-level'' withholding tax. This second-level
withholding tax is imposed only if a treaty prevents
application of the statutory branch profits tax.
In general, corporations are not entitled under U.S. law to
a deduction for dividends paid. Thus, the withholding tax on
dividends theoretically represents imposition of a second level
of tax on corporate taxable income. Treaty reductions of this
tax reflect the view that where the United States already
imposes corporate-level tax on the earnings of a U.S.
corporation, a 30-percent withholding rate may represent an
excessive level of source-country taxation. Moreover, the
reduced rate of tax often applied by treaty to dividends paid
to direct investors reflects the view that the source-country
tax on payments of profits to a substantial foreign corporate
shareholder may properly be reduced further to avoid double
corporate-level taxation and to facilitate international
investment.
A real estate investment trust (``REIT'') is a corporation,
trust, or association that is subject to the regular corporate
income tax, but that receives a deduction for dividends paid to
its shareholders if certain conditions are met. In order to
qualify for the deduction for dividends paid, a REIT must
distribute most of its income. Thus, a REIT is treated, in
essence, as a conduit for federal income tax purposes. Because
a REIT is taxable as a U.S. corporation, a distribution of its
earnings is treated as a dividend rather than income of the
same type as the underlying earnings. Such distributions are
subject to the U.S. 30-percent withholding tax when paid to
foreign owners.
A REIT is organized to allow persons to diversify ownership
in primarily passive real estate investments. As such, the
principal income of a REIT often is rentals from real estate
holdings. Like dividends, U.S.-source rental income of foreign
persons generally is subject to the 30-percent withholding tax
(unless the recipient makes an election to have such rental
income taxed in the United States on a net basis at the regular
graduated rates). Unlike the withholding tax on dividends,
however, the withholding tax on rental income generally is not
reduced in U.S. income tax treaties.
U.S. internal law also generally treats a regulated
investment company (``RIC'') as both a corporation and a
conduit for income tax purposes. The purpose of a RIC is to
allow investors to hold a diversified portfolio of securities.
Thus, the holder of stock in a RIC may be characterized as a
portfolio investor in the stock held by the RIC, regardless of
the proportion of the RIC's stock owned by the dividend
recipient.
United Kingdom
The United Kingdom does not currently impose a withholding
tax on dividend payments to nonresidents. The United Kingdom
also currently does not impose a branch profits tax.
Proposed treaty limitations on internal law
In general
Under the proposed treaty, dividends paid by a company that
is a resident of a treaty country to a resident of the other
country may be taxed in such other country. Such dividends also
may be taxed by the country in which the payor company is
resident, but the rate of such tax is limited. Under the
proposed treaty, source-country taxation of dividends (i.e.,
taxation by the country in which the dividend-paying company is
resident) generally is limited to 15 percent of the gross
amount of the dividends paid to residents of the other treaty
country. A lower rate of 5 percent applies if the beneficial
owner of the dividend is a company that owns at least 10
percent of the voting stock of the dividend-paying company.
The term ``beneficial owner'' is not defined in the present
treaty or proposed protocol and, thus, is defined under the
internal law of the source country. The Technical Explanation
states that the beneficial owner of a dividend for purposes of
this article is the person to which the dividend income is
attributable for tax purposes under the laws of the source
country. Further, companies holding shares through fiscally
transparent entities such as partnerships are considered to
hold their proportionate interest in the shares.
In addition, the proposed protocol provides a zero rate of
withholding tax with respect to certain intercompany dividends
in cases in which there is a sufficiently high (80-percent)
level of ownership (often referred to as ``direct dividends'').
The zero rate also would apply with respect to dividends
received by a tax-exempt pension fund, provided that such
dividends are not derived from the carrying on of a business,
directly or indirectly, by such fund.
Zero rate for direct dividends
Under the proposed treaty, the withholding tax rate is
reduced to zero on dividends beneficially owned by a company
that has owned at least 80 percent of the voting power of the
company paying the dividend for the 12-month period ending on
the date the dividend is declared (subparagraph 3(a) of Article
10 (Dividends)).\7\ Under the present treaty, these dividends
may be taxed at a 5-percent rate (although, as noted above, the
United Kingdom currently does not exercise this right as a
matter of domestic law, whereas the United States does).
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\7\ The Technical Explanation indicates that only direct ownership
will count for this purpose. The text of the proposed treaty is less
precise but is consistent with this view.
---------------------------------------------------------------------------
In certain circumstances, eligibility for the zero rate
under the proposed treaty is subject to an additional
restriction designed to prevent companies from reorganizing for
the purpose of obtaining the benefits of the provision.
Specifically, in cases in which a company satisfies the
Limitation on Benefits article only under the ``active trade or
business'' and/or ``ownership/base-erosion'' tests (paragraph 4
and subparagraph 2(f), respectively, of Article 23 (Limitation
on Benefits)), the zero rate will apply only if the dividend-
receiving company owned (directly or indirectly) at least 80
percent of the voting power of the dividend-paying company
prior to October 1, 1998.\8\ In other cases, the Limitation on
Benefits article itself is considered sufficient to prevent
treaty shopping. Thus, companies that qualify for treaty
benefits under the ``public trading,'' ``derivative benefits,''
or discretionary tests (subparagraph 2(c) and paragraphs 3 and
6, respectively, of Article 23 (Limitation on Benefits)) will
not need to meet the October 1, 1998 holding requirement in
order to claim the zero rate.
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\8\ October 1, 1998 is the date on which the parties announced that
they were negotiating the proposed treaty.
---------------------------------------------------------------------------
Prior to amendment by the proposed protocol, the language
of the proposed treaty left open a fundamental interpretive
issue regarding the scope of the zero-rate provision. Under the
``derivative benefits'' test of Article 23, a company may
qualify for treaty benefits (including, potentially, the zero
rate) if at least 95 percent of the vote and value of the
company is owned (directly or indirectly) by seven or fewer
``equivalent beneficiaries,'' and less than 50 percent of its
gross income for the year is paid or accrued in deductible form
to persons who are not ``equivalent beneficiaries'' (paragraph
3 of Article 23 (Limitation on Benefits)). Under the proposed
treaty as originally signed, one type of ``equivalent
beneficiary'' was a company resident in a European Community
member state that would have been entitled under a European
Community Directive ``to receive the particular class of income
for which benefits are being claimed under [the proposed
treaty] free of withholding tax'' (subparagraph 7(d) of Article
23 (Limitation on Benefits), prior to amendment by the proposed
protocol). Under the European Community ``Parent-Subsidiary
Directive,'' dividends paid by a subsidiary resident in one
member state to a parent company resident in another member
state are exempt from withholding tax. Interpreting the
originally proposed treaty language in light of the Parent-
Subsidiary Directive, it could have been argued that any
company resident in a European Community member state would
have qualified as an ``equivalent beneficiary'' for purposes of
the zero-rate provision, since it would have been entitled ``to
receive the particular class of income for which benefits are
being claimed''--i.e., a subsidiary-parent dividend, according
to this view--free of withholding tax. If this view were
correct, then the United States effectively would have agreed
to extend the benefits of the zero-rate provision to European
companies generally, rather than just to U.K. companies. The
European companies simply would have had to place the stock of
their U.S. subsidiaries into U.K. holding companies in order to
enjoy the zero rate.
If, on the other hand, ``the particular class of income''
described in the ``equivalent beneficiary'' definition were
construed as referring not to subsidiary-parent dividends
generally, but rather to dividends from U.S. subsidiaries, then
European companies would not have been eligible for the zero
rate by way of the ``derivative benefits'' test and the Parent-
Subsidiary Directive, since such companies would not have been
entitled to receive dividends directly from U.S. subsidiaries
free of withholding tax. This latter interpretation of the
originally proposed treaty language is the one consistent with
the intent of the United States. In negotiating the proposed
treaty, the United States never intended to extend the benefits
of the zero-rate provision to non-U.K. European parent
companies as a class.
Since the language of the originally proposed treaty was
ambiguous in this regard, and did arguably admit the former,
unintended interpretation, the parties amended the proposed
treaty's ``equivalent beneficiaries'' definition in order to
clarify that non-U.K. European parent companies will not be
entitled to the benefits of the zero-rate provision through the
expedient of establishing a U.K. holding company (paragraph
7(d) of Article 23 (Limitation on Benefits), as amended by
article 4 of the proposed protocol). Under the amended
definition, a non-U.K. European company can qualify as an
equivalent beneficiary for purposes of the zero-rate provision
only if such company: (1) would be entitled to all the benefits
of a comprehensive income tax treaty between a European
Community member state and the treaty country from which
benefits under the proposed treaty are being claimed (i.e., the
United States); and (2) would be entitled to a zero rate of tax
on the relevant dividends under such other treaty (i.e., a
treaty between another European Community member state and the
United States). Thus, unless and until the United States adopts
a zero-rate provision in a treaty with a given European
Community member state, companies resident in such state will
not be treated as equivalent beneficiaries for purposes of
claiming the zero rate under the proposed treaty.\9\
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\9\ See Part III, Article 23, infra, for a more detailed
description of the ``equivalent beneficiary'' definition and the anti-
treaty-shopping provision in general.
---------------------------------------------------------------------------
Dividends paid by RICs and REITs
The proposed treaty generally denies the 5-percent and zero
rates of withholding tax to dividends paid by ``pooled
investment vehicles'' (e.g., RICs and REITs).
The 15 percent rate of withholding is generally allowed for
dividends paid by a RIC. The 15 percent rate of withholding is
allowed for dividends paid by a REIT only if one of three
additional conditions is met. First, the dividend may qualify
for the 15 percent rate if the person beneficially entitled to
the dividend is an individual holding an interest of not more
than 10 percent in the REIT. Second, the dividend may qualify
for the 15 percent rate if it is paid with respect to a class
of stock that is publicly traded and the person beneficially
entitled to the dividend is a person holding an interest of not
more than 5 percent of any class of the REIT's stock. Third,
the dividend may qualify for the 15 percent rate if the person
beneficially entitled to the dividend holds an interest in the
REIT of not more than 10 percent and the REIT is
``diversified'' (i.e., the gross value of no single interest in
real property held by the REIT exceeds 10 percent of the gross
value of the REIT's total interest in real property).
Dividends received by tax-exempt pension funds from RICs
and REITs generally are eligible for the zero rate. In the case
of REIT dividends, this eligibility is also subject to the
requirement of meeting one of the three conditions described
above in connection with the general 15-percent rate.
The Technical Explanation indicates that the restrictions
on availability of the lower rates are intended to prevent the
use of RICs and REITs to gain unjustifiable source-country
benefits for certain shareholders resident in the United
Kingdom. For example, a company resident in the United Kingdom
could directly own a diversified portfolio of U.S. corporate
shares and pay a U.S. withholding tax of 15 percent on
dividends on those shares. There is a concern that such a
company could purchase 10 percent or more of the interests in a
RIC, which could even be established as a mere conduit, and
thus obtain a lower withholding rate by holding a similar
portfolio through the RIC (transforming portfolio dividends
generally taxable at 15 percent into direct investment
dividends taxable under the treaty at zero or 5 percent).
Similarly, the Technical Explanation gives an example of a
resident of the United Kingdom directly holding real property
and required to pay U.S. tax either at a 30 percent rate on
gross income or at graduated rates on the net income. By
placing the property in a REIT, the investor could transform
real estate income into dividend income, taxable at the lower
rates provided in the proposed treaty. The limitations on REIT
dividend benefits are intended to protect against this result.
Special rules and limitations
The proposed treaty's reduced rates of tax on dividends do
not apply if the dividend recipient carries on business through
a permanent establishment in the source country, or performs in
the source country independent personal services from a fixed
base located in that country, and the holding in respect of
which the dividends are paid is effectively connected with such
permanent establishment or fixed base. In such cases, the
dividends effectively connected to the permanent establishment
or the fixed base are taxed as business profits (Article 7).
The proposed treaty prevents the United States from
imposing a tax on dividends paid by a U.K. company unless such
dividends are paid to a resident of the United States or are
attributable to a permanent establishment in the United States.
Thus, this provision generally overrides the ability of the
United States to impose a ``second-level'' withholding tax on
the U.S.-source portion of dividends paid by a U.K.
corporation. The proposed treaty also restricts the United
States from imposing corporate level taxes on undistributed
profits, other than a branch profits tax.
The United States is allowed under the proposed protocol to
impose the branch profits tax (at a rate of 5 percent) on a
U.K. corporation that either has a permanent establishment in
the United States, or is subject to tax on a net basis in the
United States on income from real property or gains from the
disposition of interests in real property. The tax is imposed
on the ``dividend equivalent amount,'' as defined in the Code
(generally, the dividend amount a U.S. branch office would have
paid up to its parent for the year if it had been operated as a
separate U.S. subsidiary). In cases in which a U.K. corporation
conducts a trade or business in the United States but not
through a permanent establishment, the proposed treaty
completely eliminates the branch profits tax that the Code
would otherwise impose on such corporation (unless the
corporation earned income from real property as described
above). The United Kingdom currently does not impose a branch
profits tax. If the United Kingdom were to impose such tax, the
base of such a tax would be limited to an amount analogous to
the U.S. ``dividend equivalent amount.''
The branch profits tax will not be imposed by the United
States in cases in which a zero-rate would apply if the U.S.
branch business had been conducted by the U.K. company through
a separate U.S. subsidiary. In addition, the tax will not apply
to a U.K. company that is considered a qualified person by
reason of being a publicly-traded company, or that is entitled
to benefits with respect to the dividend equivalent amount
under the derivative benefits or competent-authority discretion
rules under Article 23 (Limitation on Benefits).
The proposed treaty provides an anti-conduit provision
under which the provisions with respect to dividends will not
apply to any dividend paid under, or as part of, a conduit
arrangement (as defined in Article 3 (General
Definitions)).\10\
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\10\ See Part III, Article 3, supra, for a description of the
proposed treaty's conduit arrangement provisions, and Part IV.B, infra,
for a discussion of the issues raised by these provisions.
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The proposed treaty generally defines ``dividends'' as
income from shares (or other corporate participation rights
that are not treated as debt under the law of the source
country), as well as other amounts that are subjected to the
same tax treatment as income from shares by the source country
(e.g., constructive dividends).
Relation to other Articles
The technical explanation notes that the savings clause of
paragraph 4 of Article 1 (General Scope) permits the United
States to tax dividends received by its residents and citizens,
subject to the special foreign tax credit rules of paragraph 6
of Article 24 (Relief from Double Taxation), as if the proposed
treaty had not come into effect.
The benefits of the dividends article are also subject to
the provisions of Article 23 (Limitation on Benefits). Thus, if
a resident of the United Kingdom is the beneficial owner of
dividends paid by a U.S. company, the shareholder must qualify
for treaty benefits under at least one of the tests of Article
23 in order to receive the benefits of Article 10.
Article 11. Interest
Internal taxation rules
United States
Subject to several exceptions (such as those for portfolio
interest, bank deposit interest, and short-term original issue
discount), the United States imposes a 30-percent withholding
tax on U.S.-source interest paid to foreign persons under the
same rules that apply to dividends. U.S.-source interest, for
purposes of the 30-percent tax, generally is interest on the
debt obligations of a U.S. person, other than a U.S. person
that meets specified foreign business requirements. Also
subject to the 30-percent tax is interest paid by the U.S.
trade or business of a foreign corporation. A foreign
corporation is subject to a branch-level excess interest tax
with respect to certain ``excess interest'' of a U.S. trade or
business of such corporation; under this rule, an amount equal
to the excess of the interest deduction allowed with respect to
the U.S. business over the interest paid by such business is
treated as if paid by a U.S. corporation to a foreign parent
and, therefore, is subject to the 30-percent withholding tax.
Portfolio interest generally is defined as any U.S.-source
interest that is not effectively connected with the conduct of
a trade or business if such interest (1) is paid on an
obligation that satisfies certain registration requirements or
specified exceptions thereto and (2) is not received by a 10-
percent owner of the issuer of the obligation, taking into
account shares owned by attribution. However, the portfolio
interest exemption does not apply to certain contingent
interest income.
If an investor holds an interest in a fixed pool of real
estate mortgages that is a real estate mortgage interest
conduit (``REMIC''), the REMIC generally is treated for U.S.
tax purposes as a pass-through entity and the investor is
subject to U.S. tax on a portion of the REMIC's income (which,
generally is interest income). If the investor holds a so-
called ``residual interest'' in the REMIC, the Code provides
that a portion of the net income of the REMIC that is taxed in
the hands of the investor--referred to as the investor's
``excess inclusion''--may not be offset by any net operating
losses of the investor, must be treated as unrelated business
income if the investor is an organization subject to the
unrelated business income tax, and is not eligible for any
reduction in the 30-percent rate of withholding tax (by treaty
or otherwise) that would apply if the investor were otherwise
eligible for such a rate reduction.
United Kingdom
U.K.-source interest payments to nonresidents generally are
subject to withholding tax at a rate of 20 percent. However,
tax is generally not required to be withheld on payments to
nonresidents for interest from banks or building societies,
interest on short-term loans (less than one year), or interest
on government securities.
Proposed treaty limitations on internal law
The proposed treaty generally exempts interest arising in
one country (the source country) and beneficially owned by a
resident of the other country from tax in the source country.
This exemption from source country tax is similar to that
provided in the U.S. model and the present treaty. The present
treaty generally exempts from U.S. tax interest derived and
beneficially owned by a U.K. resident, and generally exempts
from U.K. tax interest derived and beneficially owned by a U.S.
resident.
The proposed treaty defines interest as income from debt
claims of every kind, whether or not secured by mortgage and
whether or not carrying a right to participate in the debtor's
profits. In particular, it includes income from government
securities and from bonds and debentures, including premiums or
prizes attaching to such securities, bonds, or debentures. The
term ``interest'' also includes all other income that is
treated as income from money lent under the tax law of the
country in which the income arises. Interest does not include
income covered in Article 10 (Dividends). Penalty charges for
late payment also are not treated as interest.
This exemption from source country tax does not apply if
the beneficial owner of the interest carries on business
through a permanent establishment in the source country and the
interest paid is attributable to the permanent establishment.
In that event, the interest is taxed as business profits
(Article 7). According to the Technical Explanation, interest
attributable to a permanent establishment but received after
the permanent establishment is no longer in existence is
taxable in the country where the permanent establishment
existed.
The proposed treaty addresses the issue of non-arm's-length
interest charges between related parties (or parties having an
otherwise special relationship) by stating that this article
applies only to the amount of arm's-length interest. Any amount
of interest paid in excess of the arm's-length interest is
taxable according to other provisions of the proposed treaty.
For example, excess interest paid to a parent corporation may
be treated as a dividend under local law and, thus, entitled to
the benefits of Article 10 (Dividends). The Notes provide that
if the amount of interest paid exceeds the amount that would
have been paid in the absence of the special relationship, a
country generally will adjust the amount of deductible interest
paid under the authority of Article 9 (Associated Enterprises)
and make such other adjustments as are appropriate. The Notes
further provide that if adjustments are made, the country
making such adjustment will not also impose its domestic
withholding tax with respect to such excess amount.
The proposed treaty provides two anti-abuse exceptions to
the general source-country exemption from tax discussed above.
The first exception relates to ``contingent interest''
payments. If interest is paid by a source-country resident and
is determined with reference to (1) receipts, sales, income,
profits, or other cash flow of the debtor or a related person,
(2) to any change in the value of any property of the debtor or
a related person, or (3) to any dividend, partnership
distribution, or similar payment made by the debtor to a
related person, such interest may be taxed in the source
country in accordance with its laws. However, if the beneficial
owner is a resident of the other country, such interest may not
be taxed as a rate exceeding 15 percent (i.e., the rate
prescribed in paragraph 2(b) of Article 10 (Dividends)). The
proposed treaty provides that this anti-abuse rule will not
apply to any interest solely because it is paid under an
arrangement providing that the amount of interest payable will
be reduced (or increased) in the event of improvements (or
deteriorations) in the factors by reference to which the amount
of interest payable. The Technical Explanation states that
interest will not, for example, become contingent interest
solely by virtue of a provision in an agreement that calls for
an increase in the rate charged upon the deterioration of the
credit position of the borrower.
The second anti-abuse exception provides that exemptions
from source country tax do not apply to interest paid with
respect to ownership interests in a vehicle used for the
securitization of real estate mortgages or other assets, to the
extent that the amount of interest paid exceeds the return on
comparable debt instruments as specified by the domestic law of
that country. The Technical Explanation states that this
provision denies source country exemptions with respect to
excess inclusions with respect to a residual interest in a
REMIC. This provision is analogous to the U.S. model, but is
drafted reciprocally presumably to apply to similar U.K.
securitization vehicles. Such income may be taxed in accordance
with each country's internal law.
The proposed treaty provides an anti-conduit provision
similar to that for dividends (Article 10) under which the
provisions with respect to interest will not apply in respect
of any interest paid under, or as part of, a conduit
arrangement (as defined in Article 3 (General
Definitions)).\11\
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\11\ See Part III, Article 3, supra, for a description of the
proposed treaty's conduit arrangement provisions, and Part IV.B, infra,
for a discussion of the issues raised by these provisions.
---------------------------------------------------------------------------
Article 12. Royalties
Internal taxation rules
United States
Under the same system that applies to dividends and
interest, the United States imposes a 30-percent withholding
tax on U.S.-source royalties paid to foreign persons. U.S.-
source royalties include royalties for the use of or right to
use intangible property in the United States.
United Kingdom
Royalties paid to nonresidents are generally subject to a
22 percent withholding rate.
Proposed treaty limitations on internal law
The proposed treaty provides that royalties arising in a
country (the source country) and beneficially owned by a
resident of the other country is exempt from tax in the source
country. This exemption from source country tax is similar to
that provided in the U.S. model and the present treaty. The
present treaty generally exempts from U.S. tax royalties
derived and beneficially owned by a U.K. resident, and
generally exempts from U.K. tax royalties derived and
beneficially owned by a U.S. resident.
The term ``royalties'' means any consideration for the use
of, or the right to use, any copyright of literary, artistic,
scientific, or other work (including computer software and
cinematographic films), including works reproduced on audio or
video tapes or disks or any other means of image or sound
production. The term also includes consideration for the use
of, or the right to use, any patent, trademark, design or
model, plan, secret formula or process, or other like right or
property, or for information concerning industrial, commercial,
or scientific experience. The term also includes gain from the
alienation of any right or property described in the preceding
two sentences, to the extent that the amount of such gain is
contingent on the productivity, use, or disposition of the
right or property. The Technical Explanation states that the
term royalties does not include income from leasing personal
property. The Technical Explanation further states that it is
understood that a typical retail sale of ``shrink wrap''
computer software will not be considered as royalty income
(even though for copyright law purposes it may be characterized
as a license).
The exemption from source country tax does not apply if the
beneficial owner of the royalties carries on a business through
a permanent establishment in the source country, and the
royalties are attributable to the permanent establishment. In
that event, the royalties are taxed as business profits
(Article 7). According to the Technical Explanation, royalties
attributable to a permanent establishment but received after
the permanent establishment is no longer in existence is
taxable in the country where the permanent establishment
existed.
The proposed treaty addresses the issue of non-arm's-length
royalties between related parties (or parties otherwise having
a special relationship) by providing that this article applies
only to the amount of arm's-length royalties. Any amount of
royalties paid in excess of the arm's-length interest is
taxable according to other provisions of the proposed treaty.
For example, excess royalties paid by a subsidiary corporation
to its parent corporation may be treated as a dividend under
local law and, thus, entitled to the benefits of Article 10
(Dividends). The Notes provide that if the amount of royalties
paid exceeds the amount that would have been paid in the
absence of the special relationship, a country generally will
adjust the amount of deductible royalties paid under the
authority of Article 9 (Associated Enterprises) and make such
other adjustments as are appropriate. The Notes further provide
that if adjustments are made, the country making such
adjustment will not also impose its domestic withholding tax
with respect to such excess amount.
As in the case of dividends (Article 10) and interest
(Article 11), the proposed treaty includes an anti-conduit rule
under which the provisions of this article will not apply in
respect of any royalty paid under, or as part of, a conduit
arrangement (as defined in Article 3 (General
Definitions)).\12\
---------------------------------------------------------------------------
\12\ See Part III, Article 3, supra, for a description of the
proposed treaty's conduit arrangement provisions, and Part IV.B, infra,
for a discussion of the issues raised by these provisions.
---------------------------------------------------------------------------
Article 13. Gains
Internal taxation rules
United States
Generally, gain realized by a nonresident who is a
noncitizen or a foreign corporation from the sale of a capital
asset is not subject to U.S. tax unless the gain is effectively
connected with the conduct of a U.S. trade or business or, in
the case of a nonresident who is a noncitizen, he or she is
physically present in the United States for at least 183 days
in the taxable year. A nonresident noncitizen or foreign
corporation is subject to U.S. tax on gain from the sale of a
U.S. real property interest as if the gain were effectively
connected with a trade or business conducted in the United
States. ``U.S. real property interests'' include interests in
certain corporations if at least 50 percent of the assets of
the corporation consist of U.S. real property.
United Kingdom
Capital gains are subject to tax at the normal corporate
tax rate. Nonresidents carrying on a business in the United
Kingdom through a U.K. branch or agency are charged tax on
gains with respect to assets used in the branch or agency.
Other nonresidents are generally not charged capital gains tax
on the disposal of U.K. assets. A former resident who
reestablishes residence in the United Kingdom within five years
will remain subject to tax in the United Kingdom with respect
to gains realized through the period of nonresidence.
Proposed treaty limitations on internal law
The proposed treaty specifies rules governing when a
country may tax gains from the alienation of property by a
resident of the other country. The rules are generally
consistent with those contained in the U.S. model. The present
treaty generally provides that each country may tax capital
gains in accordance with its own internal laws.
Under the proposed treaty, gains derived by a resident of
one treaty country from the alienation of real property
situated in the other country may be taxed in the country in
which the property is situated. For the purposes of this
article, real property situated in the other country includes
rights to assets to be produced by the exploration or
exploitation of the sea and sub soil of the other country and
their natural resources, including rights to interests in or
the benefit of such assets. In the case of the United States,
the term includes a U.S. real property interest. In the case of
the United Kingdom, the term includes (1) shares, including
rights to acquire shares, (other than shares in which there is
regular trading on a stock exchange) deriving their value or
the greater part of their value directly or indirectly from
real property situated in the United Kingdom, and (2) a
partnership or trust interest to the extent that the assets of
the partnership or trust consist of real property situated in
the United Kingdom, or of shares referred to in (1) above.
The proposed treaty contains a standard provision which
permits a country to tax gains from the alienation of property
(other than real property) that forms a part of the business
property of a permanent establishment located in that country.
This rule also applies to gains from the alienation of such a
permanent establishment (alone or with the enterprise as a
whole). This rule also applies whether or not the permanent
establishment exists at the time of alienation.
The proposed treaty provides that gains derived by an
enterprise of one of the treaty countries from the alienation
of ships or aircraft operated in international traffic by the
enterprise are taxable only in such country. This rule also
applies to gains derived from the sale of containers used in
international traffic, or of property (other than real
property) pertaining to the operation or use of such ships,
aircraft, or containers.
Gains from the alienation of any property other than that
discussed above is taxable under the proposed treaty only in
the country where the person alienating the property is
resident. The proposed treaty provides that this rule does not
affect the right of a country tax levy according to its law a
tax on gains from the alienation of any property derived by an
individual who is a resident of the other country and has been
a resident of the first country at any time during the six
years immediately preceding the alienation of the property. The
Technical Explanation states that this special rule was
included in the proposed treaty in order to allow the United
Kingdom to apply its domestic law regarding such sales.
According to the Technical Explanation, under U.K. law, a
former U.K. resident who re-establishes U.K. residency within
five years remains subject to U.K. tax on gains realized during
the intermediate period of nonresidency.\13\ Under the proposed
treaty, if such gains are derived while the individual was a
U.S. resident and such gains are taxed by the United States in
accordance with the proposed treaty and by the United Kingdom
pursuant to this provision, then such gains will be treated as
U.S.-source income. Thus, pursuant to paragraph 2(b) of Article
24 (Relief from Double Taxation), discussed below, the United
Kingdom will be required to grant a credit for U.S. taxes
imposed on such gains.
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\13\ The Technical Explanation further states that the analogous
U.S. rules under Code section 877 (dealing with the taxation of certain
U.S.-source income of former U.S. citizens and long-term residents) is
separately preserved in the treaty under paragraph 6 of Article 1
(General Scope).
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Article 14. Income From Employment
Under the proposed treaty, salaries, wages, and other
similar remuneration derived from services performed as an
employee in one treaty country (the source country) by a
resident of the other treaty country are taxable only by the
country of residence if three requirements are met: (1) the
individual is present in the source country for not more than
183 days in any twelve-month period commencing or ending in the
taxable year or year of assessment concerned; (2) the
individual is paid by, or on behalf of, an employer who is not
a resident of the source country; and (3) the remuneration is
not borne by a permanent establishment of the employer in the
source country. These limitations on source country taxation
are similar to the rules of the U.S. model and OECD model.
The proposed treaty contains a special rule that permits
remuneration derived by a resident of one treaty country with
respect to employment as a regular member of the crew of a ship
or aircraft operated in international traffic by an enterprise
of the other treaty country to be taxed only in the first
treaty country. A similar rule is included in the OECD model.
U.S. internal law does not impose tax on such income of a
person who is neither a citizen nor a resident of the United
States, even if the person is employed by a U.S. entity.
The diplomatic notes provide special rules concerning the
treatment of employee share or stock option plans under this
article. The diplomatic notes state that any benefits, income
or gains received by employees under such plans constitute
``other similar remuneration'' and are subject to the
application of this article. The notes require the allocation
of taxing jurisdiction between the treaty countries over such
plans if an employee: (1) has been granted a share or stock
option in the course of employment in one of the treaty
countries; (2) has exercised that employment in both treaty
countries during the period between grant and exercise of the
option; (3) remains in that employment on the date of the
exercise; and (4) under the respective domestic laws of the
treaty countries, would be taxable by both countries with
respect to the gain on the option. Under this special
allocation rule, each treaty country may tax, as the source
country, only the portion of the gain on an option that relates
to the period or periods between the grant and the exercise of
the option during which the employee has exercised employment
in that treaty country. The Technical Explanation states that
the portion attributable to a treaty country under this rule
will be determined by multiplying the gain by a fraction, the
numerator of which is the number of days during which the
employee exercised employment in that country and the
denominator of which is the total number of days between the
grant and the exercise of the option. To prevent the special
allocation rule from resulting in double taxation, the
diplomatic notes state that the competent authorities of the
treaty countries will endeavor to resolve by mutual agreement
any difficulties or doubts arising from the interpretation or
application of this article and Article 24 (Relief from Double
Taxation) in relation to employee share or stock option plans.
This article is subject to the provisions of the separate
articles covering directors' fees (Article 15), pensions,
social security, annuities, alimony, and child support payments
(Article 17), and government service income (Article 19).
Article 15. Directors' Fees
Under the proposed treaty, director's fees and other
similar payments derived by a resident of one country for
services rendered in the other country in his or her capacity
as a member of the board of directors of a company that is a
resident of that other country is taxable in that other
country. Under the proposed treaty, as under the U.S. model,
the country of the company's residence may tax the remuneration
of nonresident directors, but only with respect to remuneration
for services performed in that country.
Article 16. Entertainers and Sportsmen
Like the U.S. and OECD models, the proposed treaty contains
a separate set of rules that apply to the taxation of income
earned by entertainers (such as theater, motion picture, radio,
or television artistes or musicians) and athletes. These rules
apply notwithstanding the other provisions dealing with the
taxation of income from personal services (Articles 7 and 14)
and are intended, in part, to prevent entertainers and athletes
from using the treaty to avoid paying any tax on their income
earned in one of the countries.
Under the proposed treaty, income derived by an entertainer
or athlete who is a resident of one country from his or her
personal activities as such in the other country may be taxed
in the other country if the amount of the gross receipts
derived by him or her from such activities exceeds $20,000 or
its equivalent in pounds sterling. The $20,000 threshold
includes expenses that are reimbursed to the entertainer or
athlete or borne on his or her behalf. Under this rule, if a
U.K. entertainer or athlete maintains no fixed base in the
United States and performs (as an independent contractor) in
the United States for total compensation of $10,000 during a
taxable year, the United States would not tax that income. If,
however, that entertainer's or athlete's total compensation
were $30,000, the full amount would be subject to U.S. tax.
The proposed treaty provides that where income in respect
of activities performed by an entertainer or athlete in his or
her capacity as such accrues not to the entertainer or athlete
but to another person, that income is taxable by the country in
which the activities are performed unless it is established
that neither the entertainer or athlete nor persons related to
him or her participated directly or indirectly in the profits
of that other person in any manner, including the receipt of
deferred remuneration, bonuses, fees, dividends, partnership
distributions, or other distributions. This provision applies
notwithstanding the business profits and income from employment
articles (Articles 7 and 14). This provision prevents highly-
paid entertainers and athletes from avoiding tax in the country
in which they perform by, for example, routing the compensation
for their services through a third entity such as a personal
holding company or a trust located in a country that would not
tax the income.
Article 17. Pensions, Social Security, Annuities, Alimony, and Child
Support
This article deals with the taxation of private pensions
and annuities, social security benefits, alimony and child
support payments. This article does not cover government
pensions.
Pensions
Under the proposed treaty, pensions and other similar
remuneration derived and beneficially owned by a resident of
either country is taxable only in the recipient's country of
residence. The proposed treaty also requires each country not
to tax the portion of pension income received from pension
schemes in the other country to the extent such income would
have been exempt if the beneficiary were a resident of the
other country.
The term ``pension scheme'' is defined in Article 3
(General Definitions). Unlike many U.S. income tax treaties and
the U.S. model, the term ``pensions and other similar
remuneration'' does not include lump sum payments.
The proposed treaty provides specific rules to deal with
lump sum payments. Notwithstanding the general rule preventing
source country taxation of pension schemes, any lump sum
payment derived by a resident of one country from a pension
scheme established in the other country is subject to tax in
the other country. Thus, a U.S. person who receives a lump sum
payment from a U.S. pension scheme (related to U.S. employment)
would be subject to withholding tax if resident in the United
Kingdom at the time of distribution. The Technical Explanation
provides that the special rules related to lump sum payments
are intended to address cases of double non-taxation that arise
under the present treaty because the United Kingdom does not
tax lump-sum distributions from pension funds.
Social Security benefits
The proposed treaty, like the present treaty, provides for
exclusive residence-country taxation of social security
benefits. This treatment differs from the U.S. model, which
allows source country taxation of social security benefits. The
provision under the proposed treaty applies to both private
sector and government employees. The Technical Explanation
provides that the term ``similar legislation'' is in reference
to United States Tier 1 Railroad Retirement benefits.
Annuities
The proposed treaty also provides that annuities (other
than those covered under the pension rule described above)
derived and beneficially owned by a resident of either country
are taxable only in the recipient's country of residence. This
is consistent with the corresponding rule in the U.S. model,
which provides that annuities are taxable only in the
individual recipient's country of residence. The term
``annuity'' is defined for purposes of this provision as a
stated sum paid periodically at stated time during the life of
the annuitant, or during a specified or ascertainable period of
time, under an obligation to make the payments in return for
adequate and full consideration (other than in return for
services rendered). The Technical Explanation states that an
annuity received in consideration for services rendered would
be treated as deferred compensation and generally taxable in
accordance with Article 7 (Business Profits) or Article 14
(Income form Employment).
Alimony and Child Support
The proposed treaty allows residence country taxation of
deductible alimony payments made by a resident of one country
to a resident of the other country. The proposed treaty
provides that child support payments are exempt from tax in
both countries as long as such payments are not deductible to
the payer. The treatment of both child support and alimony
payments is consistent with corresponding provisions under the
U.S. model.
Article 18. Pension Schemes
This article deals with cross-border pension contributions.
It is intended to remove barriers to the flow of personal
services between the two countries that could otherwise result
from discontinuities under the laws of each country regarding
the deductibility of pension contributions.
The proposed treaty provides that neither country may tax
residents on pension income earned through a pension scheme in
the other country until such income is distributed. For
purposes of this provision, roll-overs to other pension plans
are not treated as distributions. When a resident receives a
distribution from a pension plan, such distribution is
generally subject to residency country taxation in accordance
with Article 17 (Pensions, Social Security, Annuities, Alimony,
and Child Support).
Under the proposed treaty, if an individual who is a member
of a pension plan established and recognized under the law of
one country performs personal services in the other country,
contributions made by the individual to the plan during the
period he or she performs such personal services are deductible
in computing his or her taxable income in the other country
within the limits that would apply if the contributions were
made to a pension plan established and recognized under the
laws of the other country. Similarly, payments made to the plan
by or on behalf of his or her employer during such period are
not treated as part of his or her taxable income and are
allowed as a deduction in computing the employer's profits in
the other country.
These rules apply only if: (1) contributions were made by
or on behalf of the individual, or by or on behalf of the
individual's employer to the plan (or to a similar plan for
which this plan is substituted) before he or she began to
exercise employment or self-employment in the other country;
and (2) the competent authority of the other country has agreed
that the plan generally corresponds to a pension plan
recognized for tax purposes by that country. Moreover, the
benefits provided under these rules will not exceed the
benefits that would be allowed by the other country to its
residents for contributions to a pension plan recognized for
tax purposes by that country.
It is understood that for purposes of this provision, in
accordance with the notes of the proposed treaty, U.S. pension
schemes eligible for such benefits include qualified plans
under section 401(a), individual retirement plans, individual
retirement accounts, individual retirement annuities, section
408(p) accounts and Roth IRAs, section 403(a) qualified annuity
plans, and section 403(b) plans.
The proposed treaty further provides that where
contributions to a foreign pension plan are deductible in
computing an individual's taxable income in a country and the
individual is subject to tax in that country only in respect of
income or gains remitted or received in such country, then the
deduction otherwise allowed for such contributions is reduced
to an amount that bears the same proportion to such deduction
as the amount remitted bears to the full amount of the
individual's income or gains that would be taxable in the
country if the individual had not been subject to tax on
remitted amounts only. This rule is necessary because of the
United Kingdom's remittance system of taxation for individuals
who are U.K. residents not domiciled in the United Kingdom.
The proposed treaty also provides a U.S. citizen resident
in the United Kingdom may exclude or deduct for U.S. tax
purposes certain contributions to a pension scheme established
in the United Kingdom that would not have been taxable in the
United States in computing the employee's taxable income,
provided such contributions are made during the period the U.S.
citizen exercises employment in the United Kingdom and expenses
related to such employment are borne by a U.K. employer or U.K.
permanent establishment. Similarly, employer contributions to
and benefits accrued in the U.K. pension scheme are not treated
as taxable income in the United States.
Article 19. Government Service
Under the proposed treaty, remuneration, other than a
pension, paid by a treaty country (or a political subdivision
or local authority thereof) to an individual for services
rendered to that country (or subdivision or authority)
generally is taxable only by that country. However, such
remuneration is taxable only by the other country if the
services are rendered in that other country by an individual
who is a resident of that country and who: (1) is also a
national of that country; or (2) did not become a resident of
that country solely for the purpose of rendering the services.
This treatment is similar to the OECD model, but differs from
the U.S. model in that these rules only apply to government
employees and not to independent contractors engaged by
governments to perform services for them.
The proposed treaty provides that any pension paid by a
treaty country (or a political subdivision or local authority
thereof) to an individual for services rendered to that country
(or subdivision or authority) generally is taxable only by that
country. However, such a pension is taxable only by the other
country if the individual is a national and resident of that
other country. Social security benefits with respect to
government service are subject to paragraph 2 of Article 17
(Pensions, Social Security, Annuities, Alimony, and Child
Support) and not this article.
The provisions of this article are exceptions to the
proposed treaty's savings clause for individuals who are
neither citizens nor permanent residents of the country where
the services are performed. Thus, for example, payments by the
government of the United Kingdom to its employees in the United
States are exempt from U.S. tax if the employees are not U.S.
citizens or green card holders and were not residents of the
United States at the time they became employed by the United
Kingdom government.
The proposed treaty provides that if a treaty country (or a
political subdivision or local authority thereof) is carrying
on a business (as opposed to functions of a governmental
nature), the provisions of Articles 14 (Income from
Employment), 15 (Directors' Fees), 16 (Entertainers and
Sportsmen), and 17 (Pensions, Social Security, Annuities,
Alimony, and Child Support) will apply to remuneration and
pensions for services rendered in connection with that
business.
Article 20. Students
The treatment provided to students and business apprentices
under the proposed treaty generally corresponds to the
treatment provided under the present treaty, with certain
modifications. The provision in the proposed treaty corresponds
to the provision in the U.S. model.
Under the proposed treaty, a student or business apprentice
who visits a country (the host country) for the purpose of his
or her full-time education at a university, college, or other
recognized educational institution of a similar nature, or for
his or her full-time training, and who immediately before that
visit is, or was a resident of the other treaty country,
generally is exempt from host country tax on payments he or she
receives for the purpose of such maintenance, education, or
training; provided, however, that such payments arise outside
the host country. The Technical Explanation states that for
purposes of this article, the phrase ``university, college, or
other recognized educational institution of a similar nature''
clarifies that a qualifying education institution is one that
offers a diversified curriculum for full-time students. Whether
a student is to be considered full-time will be determined by
the rules of the educational institution where he or she is
studying. The Technical Explanation also states that an
educational institution is understood to be an institution that
normally maintains a regular faculty and normally has a regular
body of students in attendance at the place where the education
activities are carried on. An educational institution is
considered to be recognized if it is accredited by an authority
that generally is responsible for the accreditation of
institutions in the particular field of study. The Technical
Explanation states that a payment generally is considered to
arise outside the host country if the payer is located outside
the host country.
Under the proposed treaty, the exemption from host country
tax will apply to a business apprentice only for a period of
not more than one year from the date he or she first arrives in
the host country for the purpose of training. This limitation
is not contained in the present treaty.
This article of the proposed treaty is an exception from
the saving clause in the case of persons who are neither
citizens nor lawful permanent residents of the host country.
Article 20A. Teachers
The treatment provided to professors and teachers under the
proposed treaty corresponds to the treatment provided under the
present treaty, with certain modifications. Such a provision is
not part of the U.S. model. Such a provision is not part of the
OECD model. Prior to amendment by the proposed protocol, the
proposed treaty would have conformed to the U.S. model and OECD
model.
Under the proposed treaty, a professor or teacher who
visits a country (the host country) for the purpose of teaching
or engaging in research at a university, college, or other
recognized educational institution of a similar nature, and who
immediately before that visit is, or was a resident of the
other treaty country, generally is exempt from host country tax
on any remuneration received for teaching or research. This
exemption applies for not more than the two-year period
beginning on the date of the professor's or teacher's arrival
in the host country. If the professor or teacher remains in the
host country for more than two years, the exemption does not
apply for the first two years.
This article of the proposed treaty is an exception from
the saving clause in the case of persons who are neither
citizens nor lawful permanent residents of the host country.
Article 21. Offshore Exploration and Exploitation Activities
The treatment provided under the proposed treaty for
offshore exploration and exploitation activities is similar to
that provided under the present treaty, with certain
modifications. The U.S. and OECD models address the taxation of
these activities under the standard rules found in other
articles (such as the Business Profits article).
Under the proposed treaty, an enterprise of a country which
carries on exploration activities or exploitation activities in
the other country will be deemed to be carrying on business in
that other country through a permanent establishment situated
therein. This provision applies notwithstanding any other
provisions of the proposed treaty where activities are carried
on offshore in a country in connection with exploration or
exploitation of the sea bed and sub-soil and their natural
resources situated in that country. This provision applies to
all exploitation activities. It also applies to exploration
activities carried on by an enterprise of a country (and
certain associated persons) in the other country for a period
or periods aggregating more than 30 days in any 12-month
period. For this purpose, if an enterprise carrying on
exploration activities in the other country is associated with
another enterprise carrying on substantially similar activities
there, the former enterprise will be deemed to carrying on all
of the activities of the latter enterprise, except to the
extent that those activities are carried on at the same time as
its own activities. Enterprises are associated if one
participates directly or indirectly in the management, control,
or capital of the other, or if the same persons participate
directly or indirectly in the management, control, or capital
of both enterprises.
Under the proposed treaty, salaries, wages, and similar
remuneration derived by a resident of one country from
employment in respect of exploration activities or exploitation
activities carried on in the other country, to the extent
performed offshore in the other country, may be taxed in the
other country. However, such remuneration is taxable only in
the first country (i.e., the employee's country of residence)
if the employment is performed in the other country for a
period or periods not exceeding in the aggregate 30 days in any
12-month period.
Article 22. Other Income
This article is a catch-all provision intended to cover
items of income not specifically covered in other articles, and
to assign the right to tax income from third countries to
either the United States or the United Kingdom. As a general
rule, items of income not otherwise dealt with in the proposed
treaty (other than income paid out of trusts or the estates of
deceased persons in the course of administration) which are
beneficially owned by residents of one of the countries are
taxable only in the country of residence. This rule is similar
to the rules in the U.S. and OECD models.
This rule, for example, gives the United States the sole
right under the proposed treaty to tax income derived from
sources in a third country and paid to a U.S. resident. This
article is subject to the saving clause, so U.S. citizens who
are residents of the United Kingdom will continue to be taxable
by the United States on their third-country income.
The general rule just stated does not apply to income
(other than income from real property as defined in Article 6)
if the beneficial owner of the income is a resident of one
country and carries on business in the other country through a
permanent establishment situated therein, and the income is
attributable to such permanent establishment. In such a case,
the provisions of Article 7 (Business Profits) will apply. Such
exception also applies where the income is received after the
permanent establishment or fixed base is no longer in
existence, but the income is attributable to the former
permanent establishment or fixed base.
The Technical Explanation states that under U.S. tax law,
trust income and distributions have the character of the
associated distributable net income and, thus, generally are
covered under other articles of the proposed treaty. The notes
confirm that income paid out of trusts or the estates of
deceased persons in the course of administration is
characterized for purposes of the proposed treaty according to
the character of the underlying income.
The proposed treaty addresses the issue of non-arm's-length
income amounts between related parties (or parties otherwise
having a special relationship) by providing that the amount of
income for purposes of applying this article is the amount that
would have been agreed upon by the payer and the beneficial
owner in the absence of the special relationship. Any amount of
income paid in excess of such amount is taxable according to
the laws of each country, taking into account the other
provisions of the proposed treaty. This provision is not
contained in the U.S. or OECD models (but is suggested in
Commentary to the OECD model).
The proposed treaty provides that this article (Article 22)
will not apply to any income paid under, or as part of, a
conduit arrangement. This rule is similar to that provided with
respect to the dividends, interest, and royalties articles
(Articles 10, 11 and 12).\14\
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\14\ See Part III, Article 3, supra, for a description of the
proposed treaty's conduit arrangement provisions, and Part IV.B. infra,
for a discussion of the issues raised by these provisions.
---------------------------------------------------------------------------
Article 23. Limitation on Benefits
In general
The proposed treaty contains a provision generally intended
to limit the indirect use of the proposed treaty by persons who
are not entitled to its benefits by reason of residence in the
United States or the United Kingdom, or in some cases, in
another member country of the European Union (``EU'') or the
North American Free Trade Agreement (``NAFTA''). The current
U.S.-U.K. income tax treaty does not include such a provision.
The proposed treaty is intended to limit double taxation
caused by the interaction of the tax systems of the United
States and the United Kingdom as they apply to residents of the
two countries. At times, however, residents of third countries
attempt to use a treaty. This use is known as ``treaty
shopping,'' which refers to the situation where a person who is
not a resident of either treaty country seeks certain benefits
under the income tax treaty between the two countries. Under
certain circumstances, and without appropriate safeguards, the
third-country resident may be able to secure these benefits
indirectly by establishing a corporation or other entity in one
of the treaty countries, which entity, as a resident of that
country, is entitled to the benefits of the treaty.
Additionally, it may be possible for the third-country resident
to reduce the income base of the treaty country resident by
having the latter pay out interest, royalties, or other amounts
under favorable conditions either through relaxed tax
provisions in the distributing country or by passing the funds
through other treaty countries until the funds can be
repatriated under favorable terms.
The proposed anti-treaty shopping article provides that a
treaty country resident is entitled to all treaty benefits only
if it is in one of several specified categories. Generally, a
resident of either country qualifies for the benefits accorded
by the proposed treaty if such resident is within one of the
following categories of ``qualified persons'' (and satisfies
any other specified conditions for obtaining benefits):
(1) An individual;
(2) A qualified governmental entity;
(3) A company that satisfies a public company test
and certain subsidiaries of such companies;
(4) An entity, other than a company, that satisfies a
public ownership test and certain entities owned by
such entities;
(5) A tax-exempt pension scheme or employee benefit
arrangement that meets an ownership test, or an
organization operated exclusively for religious,
charitable, scientific, artistic, cultural, or
educational purposes;
(6) An entity that satisfies an ownership test and a
base erosion test; and
(7) A trust that satisfies an ownership test and a
base erosion test.
Alternatively, a resident that does not fit into any of the
above categories may claim treaty benefits with respect to
certain items of income under a derivative benefits test. In
addition, a resident that does not fit into any of the above
categories may claim treaty benefits with respect to certain
items of income under an active business test. Finally, a
person that does not satisfy any of the above requirements may
be entitled to the benefits of the proposed treaty if the
source country's competent authority so determines.
Individuals
Under the proposed treaty, individual residents of one of
the countries are entitled to all treaty benefits.
Qualified governmental entities
Under the proposed treaty, a qualified governmental entity
is entitled to all treaty benefits. Under Article 3 (General
Definitions), qualified governmental entities include the two
countries, their political subdivisions, or their local
authorities. Qualified governmental entities also include
certain government-owned corporations and other entities.
Public company tests
A company that is a resident of the United Kingdom or the
United States is entitled to treaty benefits if the principal
class of its shares is listed on a recognized U.S. or U.K.
stock exchange and is regularly traded on one or more
recognized stock exchanges. Thus, such a company is entitled to
the benefits of the treaty regardless of where its actual
owners reside.
In addition, a company that is a resident of the United
Kingdom or the United States is entitled to treaty benefits if
at least 50 percent of the aggregate vote and value of the
company's shares is owned (directly or indirectly) by five or
fewer companies that satisfy the test described above, provided
that each intermediate owner used to satisfy the control
requirement is a resident of the United Kingdom or the United
States.
The term ``recognized stock exchange'' means the NASDAQ
System owned by the National Association of Securities Dealers;
any stock exchange registered with the U.S. Securities and
Exchange Commission as a national securities exchange under the
U.S. Securities Exchange Act of 1934; the London Stock Exchange
and any other recognized investment exchange within the meaning
of the Financial Services Act of 1986 or the Financial Services
and Markets Act of 2000; the Irish Stock Exchange; the Swiss
Stock Exchange; the stock exchanges of Amsterdam, Brussels,
Frankfurt, Hamburg, Johannesburg, Madrid, Milan, Paris,
Stockholm, Sydney, Tokyo, Toronto, and Vienna; and any other
stock exchange agreed upon by the competent authorities of the
two countries.
The term ``principal class of shares'' means the ordinary
or common shares of the company representing the majority of
the aggregate voting power and value of the company. If the
company does not have a single class of ordinary or common
shares representing the majority of the aggregate voting power
and value, then the ``principal class of shares'' means that
class or any combination of classes of shares that represents,
in the aggregate, a majority of the aggregate voting power and
value of the company. For these purposes, the term ``shares''
includes depository receipts for shares or trust certificates
for shares.
Shares are considered to be ``regularly traded'' in a
taxable period on one or more recognized stock exchanges if the
aggregate number of shares of that class traded during the 12
months ending on the day before the beginning of that taxable
period is at least six percent of the average number of shares
outstanding in that class during that 12-month period. The
notes provide that if a class of shares was not listed on a
recognized stock exchange during this 12-month period, the
class of shares will be treated as regularly traded only if
that class meets the aggregate trading requirements for the
taxable period in which the income arises. The Technical
Explanation states that this requirement can be met by
aggregating trading on one or more of the recognized stock
exchanges.
Public entity tests
Under the proposed treaty, a person other than an
individual or company that is a resident of the United Kingdom
or the United States is entitled to treaty benefits if the
principal class of units in that entity is listed or admitted
to dealings on a recognized U.S. or U.K. stock exchange and is
regularly traded on one or more recognized stock exchanges.
Alternatively, the entity is entitled to treaty benefits if the
direct or indirect owners of at least 50 percent of the
beneficial interests in the entity are public entities under
the preceding sentence or public companies described below.
The Technical Explanation states that this provision
applies generally to trusts the shares of ownership in which
are publicly traded and to trusts that are owned by publicly
traded entities. The Technical Explanation further states that
for U.S. tax purposes, this provision relating to publicly
traded trusts is redundant because the United States generally
would consider such entities to be companies covered by the
public company tests described above.
The term ``units'' includes shares and any other
instrument, not being a debt claim, granting an entitlement to
share in the assets or income of, or to receive a distribution
from, the entity. The term ``principal class of units'' means
the class of units that represent the majority of the value of
the entity. If no single class of units represent the majority
of the value of the person, the ``principal class of units'' is
any combination of classes that in the aggregate represent the
majority of the value of the entity.
The term ``regularly traded'' is defined as above for
public companies. The Technical Explanation states that trading
on one or more recognized stock exchanges may be aggregated for
purposes of this requirement.
Tax-exempt and charitable organizations
Under the proposed treaty, an entity is entitled to treaty
benefits if it is a (1) pension scheme (defined in Article 3
(General Definitions) as a plan, scheme, fund, trust, or other
arrangement that is operated principally to administer or
provide pension or retirement benefits or to earn income for
the benefit of such arrangements and that is generally exempt
from income tax in that country), (2) a plan, scheme, fund,
trust, company, or other arrangement established in a country
that is operated exclusively to administer or provide employee
benefits and that is generally exempt from income tax in that
country, or (3) an organization that is established exclusively
for religious, charitable, scientific, cultural, or educational
purposes (notwithstanding that all or part of its income is
tax-exempt); provided, however, that in the case of entities
described in (1) or (2) above, more than 50 percent of the
entity's beneficiaries, members, or participants must be
individual residents of either country.
Ownership and base erosion tests--entities
Under the proposed treaty, an entity that is a resident of
one of the countries is entitled to treaty benefits if it
satisfies an ownership test and a base erosion test. Under the
ownership test, on at least half the days of the taxable
period, shares or other beneficial interests representing at
least 50 percent of the entity's aggregate voting power and
value must be owned (directly or indirectly) by certain
qualified persons described above (i.e., individuals, qualified
governmental entities, companies that meet the public company
test described above, entities that meet the public entity test
described above, or entities that meet the tests described
above for a tax-exempt pension scheme or employee benefit
arrangement, or an organization operated exclusively for
religious, charitable, scientific, artistic, cultural, or
educational purposes).
The base erosion test is satisfied only if less than 50
percent of the person's gross income for the taxable period is
paid or accrued, directly or indirectly, in the form of
deductible payments, to persons who are not residents of either
treaty country. The notes provide that for this purpose, the
term ``gross income'' means the total revenues derived by a
resident of a country from its principal operations, less the
direct costs of obtaining such revenues. The Technical
Explanation states that in the case of the United States, the
term ``gross income'' has the same meaning as under domestic
law (i.e., section 61 of the Code and the regulations
thereunder). In addition, for purposes of this test, deductible
payments do not include arm's-length payments in the ordinary
course of business for services or tangible property and
payments in respect of financial obligations to a bank;
provided that, if the bank is not a resident of one of the
countries, such payment is attributable to a permanent
establishment of that bank located in one of the countries.
The Technical Explanation states that trusts may be
entitled to the benefits of this provision if they are treated
as residents of one of the countries and they otherwise satisfy
the requirements of the provision. An additional way for trusts
to qualify for treaty benefits is described below.
Ownership and base erosion tests--trusts
Under the proposed treaty, a trust or trustee of a trust
(in their capacity as such) that is a resident of one of the
countries is entitled to treaty benefits if it satisfies an
ownership test and a base erosion test. Under the ownership
test, at least 50 percent of the beneficial interests in the
trust must be held by (1) individuals, qualified governmental
entities, companies that meet the public company test described
above, entities that meet the public entity test described
above, or entities that meet the tests described above for a
tax-exempt pension scheme or employee benefit arrangement, or
an organization operated exclusively for religious, charitable,
scientific, artistic, cultural, or educational purposes, or (2)
equivalent beneficiaries (as described below, in connection
with the ``derivative benefits'' provision).
The base erosion test is satisfied only if less than 50
percent of the person's gross income arising to the trust or
trustee (in their capacity as such) for the taxable period is
paid or accrued, directly or indirectly, to persons who are not
residents of either treaty country in the form of deductible
payments for tax purposes in the trust or trustee's country of
residence. The notes provide that for this purpose, the term
``gross income'' means the total revenues derived by a resident
of a country from its principal operations, less the direct
costs of obtaining such revenues. The Technical Explanation
states that in the case of the United States, the term ``gross
income'' has the same meaning as under domestic law (i.e.,
section 61 of the Code and the regulations thereunder). In
addition, for purposes of this test, deductible payments do not
include arm's-length payments in the ordinary course of
business for services or tangible property and payments in
respect of financial obligations to a bank; provided that, if
the bank is not a resident of one of the countries such payment
is attributable to a permanent establishment of that bank
located in one of the countries.
Derivative benefits rule
The proposed treaty contains a reciprocal derivative
benefits rule. This rule effectively allows a U.K. company, for
example, to receive ``derivative benefits'' in the sense that
it derives its entitlement to U.S. tax reductions in part from
the U.S. treaty benefits to which its owners would be entitled
if they earned the income directly. If the requirements of this
rule are satisfied, a company that is resident in one of the
treaty countries will be entitled to the benefits of the
proposed treaty.
A company resident in one of the countries satisfies this
rule if both ownership and base-erosion requirements are met.
Under the ownership requirement, shares representing at least
95 percent of the aggregate voting power and value of the
company must be owned, directly or indirectly, by seven or
fewer persons who are ``equivalent beneficiaries.''
For this purpose, an equivalent beneficiary is a resident
of a member state of the European Community or of a European
Economic Area state or a party to the North American Free Trade
Agreement, but only if one of two alternative conditions are
satisfied. Under the first alternative condition, that resident
must be entitled to all the benefits of a comprehensive tax
treaty between its residence country and the country from which
the benefits of the proposed treaty are being claimed. However,
if such treaty does not contain a comprehensive limitation on
benefits provision, the person must be a person that would be a
qualified person under the tests described above (and in the
case of trusts, without applying the ownership test for
equivalent beneficiaries), if such person were a resident of
the United Kingdom or the United States under the proposed
treaty. With respect to dividends, interest, and royalties, the
resident must be entitled under such treaty to a rate of tax
that is at least as low as the rate applicable to such income
under the proposed treaty. Under the second alternative
condition for qualifying as an equivalent beneficiary, the
person must be a resident of either the United States or the
United Kingdom and be treated as a qualified person under the
tests described above.\15\
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\15\ See Part III, Article 10, supra, for a discussion of an
interpretive issue that arose in connection with the zero-rate
provision under the equivalent beneficiary definition in the proposed
treaty as originally signed, prior to amendment by the proposed
protocol.
---------------------------------------------------------------------------
Under the second requirement to satisfy the derivative
benefits rule, the company must satisfy the base erosion test
similar to that described above, with certain modifications.
The base erosion test is satisfied only if less than 50 percent
of the person's gross income for the taxable period is paid or
accrued, directly or indirectly, to persons who are not
equivalent beneficiaries (as defined above) in the form of
deductible payments for tax purposes in the company's country
of residence. The notes provide that for this purpose, the term
``gross income'' means the total revenues derived by a resident
of a country from its principal operations, less the direct
costs of obtaining such revenues. The Technical Explanation
states that in the case of the United States, the term ``gross
income'' has the same meaning as under domestic law (i.e.,
section 61 of the Code and the regulations thereunder). In
addition, for purposes of this test, deductible payments do not
include arm's-length payments in the ordinary course of
business for services or tangible property and payments in
respect of financial obligations to a bank; provided that, if
the bank is not a resident of one of the countries such payment
is attributable to a permanent establishment of that bank
located in one of the countries.
Active business test
Under the active business test, residents of one of the
countries are entitled to treaty benefits with respect to
income, profit, or gain derived from the other country if (1)
the resident is engaged in the active conduct of a trade or
business in its residence country, (2) the income is derived in
connection with, or is incidental to, that trade or business,
and (3) the trade or business is substantial in relation to the
trade or business activity in the other country. The proposed
treaty provides that the business of making or managing
investments for the resident's own account does not constitute
an active trade or business unless these activities are
banking, insurance, or securities activities carried on by a
bank, insurance company, or registered securities dealer. For
this purpose, the proposed treaty defines the term ``insurance
company'' as an incorporated or unincorporated entity if its
gross income consists primarily of insurance or reinsurance
premiums and investment income attributable to such premiums.
The notes provide that income is considered to be derived
``in connection'' with an active trade or business if the
activity generating the item of income in the other country is
a line of business that forms a part of, or is complementary
to, the trade or business. The Technical Explanation states
that a business activity generally is considered to form a part
of a business activity conducted in the other country if the
two activities involve the design, manufacture, or sale of the
same products or type of products, or the provision of similar
services. The notes clarify that the line of business in the
country of residence may be, in relation to the activity in the
country of source, upstream (e.g., providing inputs to a
manufacturing process that occurs in the other country),
downstream (e.g., selling the output of a manufacturer that is
a resident of the other country), or parallel (e.g., selling in
one country the same sorts of products that are being sold by
the trade or business carried on in the other country). The
Technical Explanation further states that in order for two
activities to be considered ``complimentary,'' the activities
need not relate to the same types of products or services, but
they should be part of the same overall industry and be related
in the sense that the success or failure of one activity will
tend to result in success or failure of the other.
The notes provide that income is considered ``incidental''
to a trade or business if the item is not produced by a line of
business that forms a part of, or is complimentary to, the
trade or business, but the production of such item facilitates
the conduct of the trade or business in the other country. The
notes state that an example of such ``incidental'' income is
interest income earned from the short-term investment of
working capital of a resident of a country in securities issued
by persons in the other country.
The proposed treaty provides that whether a trade or
business is substantial is determined on the basis of all the
facts and circumstances. The Technical Explanation states that
this takes into account the comparative sizes of the trades or
businesses in each country (measured by reference to asset
values, income and payroll expenses), the nature of the
activities performed in each country, and the relative
contributions made to that trade or business in each country.
The Technical Explanation further states that in making each
determination or comparison, due regard will be given to the
relative sizes of the U.S. and U.K. economies.
The proposed treaty provides that in determining whether a
person is engaged in the active conduct of a trade or business,
activities conducted by a partnership in which that person is a
partner and activities conducted by persons connected to such
person will be deemed to be conducted by such person. For this
purpose, a person is connected to another person if (1) one
person owns at least 50 percent of the beneficial interest in
the other person (or, in the case of a company, owns shares
representing at least 50 percent of the aggregate voting power
and value of the company or the beneficial interest in the
company), or (2) another person owns, directly or indirectly,
at least 50 percent of the beneficial interest in each person
(or, in the case of a company, owns shares representing at
least 50 percent of the aggregate voting power and value of the
company or the beneficial interest in the company). The
proposed treaty provides that in any case, persons are
considered to be connected if on the basis of all the facts and
circumstances, one has control of the other or both are under
the control of the same person or persons.
The term ``trade or business'' is not defined in the
proposed treaty. However, as provided in Article 3 (General
Definitions), undefined terms are to have the meaning which
they have under the laws of the country applying the proposed
treaty. In this regard, the Technical Explanation states that
the U.S. competent authority will refer to the regulations
issued under Code section 367(a) to define the term ``trade or
business.''
Disproportionate interests
The proposed treaty denies benefits to the disproportionate
part of income earned by certain companies. Under the proposed
treaty, a company that is a resident of one of the countries or
a company that controls such a company has outstanding a class
of shares: (1) that is subject to terms or other arrangements
that entitle its holders to a portion of the income, profit, or
gain of the company derived from the other country that is
larger than the portion such holders would receive in the
absence of such terms and arrangements, and (2) in which 50
percent or more of the voting power and value is owned by
persons who are not equivalent beneficiaries (as defined
above), then the benefits of the proposed treaty will apply
only to that proportion of the income which those holders would
have received in the absence of those terms or arrangements.
Grant of treaty benefits by the competent authority
The proposed treaty provides a ``safety-valve'' for a
person that has not established that it meets one of the other
more objective tests, but for which the allowance of treaty
benefits would not give rise to abuse or otherwise be contrary
to the purposes of the treaty. Under this provision, such a
person may be granted treaty benefits if the competent
authority of the source country determines that the
establishment, acquisition, or maintenance of such resident and
the conduct of its operations did not have as one of its
principal purposes the obtaining of benefits under the proposed
treaty. The notes provide that in applying this provision, the
competent authorities will consider the respective obligations
of the United Kingdom by virtue of its membership in the
European Community and by it being a party to the European
Economic Area, and the respective obligations of the United
States by virtue of it being a party to the North American Free
Trade Agreement. The notes specify that in particular, the
competent authorities will consider any legal requirements for
the facilitation of the free movement of capital and persons,
the differing internal tax systems, tax incentive regimes and
existing treaty policies among member states of the European
Community or the European Economic Area states, or parties to
the North American Free Trade Agreement.
The notes further provide that where certain changes in
circumstances might cause a person to cease to qualify as a
qualified person (as defined above), such changes need not
result in the denial of benefits under the treaty. The
Technical Explanation states that this rule recognizes the
legal requirements for the free flow of goods and services
within the European Communities and within the North American
Free Trade Agreement. The changes in circumstances contemplated
by the notes include, all under ordinary business conditions,:
(1) a change in the country of residence of a major participant
in the company, (2) the sale of part of the ownership interests
in a company to a resident of a qualifying country; (3) or an
expansion of a company's activities in another qualifying
country. The notes provide that if the competent authority is
satisfied that these changed circumstances are not attributable
to tax avoidance motives, then this will be a factor weighing
in favor of granting benefits in accordance with this
provision.
The proposed treaty provides that the competent authority
of the source country must consult with the competent authority
of the residence country before refusing to grant benefits
under this provision.
Article 24. Relief From Double Taxation
Internal taxation rules
United States
The United States taxes the worldwide income of its
citizens and residents. It attempts unilaterally to mitigate
double taxation generally by allowing taxpayers to credit the
foreign income taxes that they pay against U.S. tax imposed on
their foreign-source income. An indirect or ``deemed-paid''
credit is also provided. Under this rule, a U.S. corporation
that owns 10 percent or more of the voting stock of a foreign
corporation and that receives a dividend from the foreign
corporation (or an inclusion of the foreign corporation's
income) is deemed to have paid a portion of the foreign income
taxes paid (or deemed paid) by the foreign corporation on its
earnings. The taxes deemed paid by the U.S. corporation are
included in its total foreign taxes paid for the year the
dividend is received.
A fundamental premise of the foreign tax credit is that it
may not offset the U.S. tax on U.S.-source income. Therefore,
the foreign tax credit provisions contain a limitation that
ensures that the foreign tax credit only offsets U.S. tax on
foreign-source income. The foreign tax credit limitation
generally is computed on a worldwide consolidated basis. Hence,
all income taxes paid to all foreign countries are combined to
offset U.S. taxes on all foreign income. The limitation is
computed separately for certain classifications of income
(e.g., passive income and financial services income) in order
to prevent the crediting of foreign taxes on certain high-taxed
foreign-source income against the U.S. tax on certain types of
traditionally low-taxed foreign-source income. Other
limitations may apply in determining the amount of foreign
taxes that may be credited against the U.S. tax liability of a
U.S. taxpayer.
United Kingdom
U.K. double tax relief is allowed through a foreign tax
credit. U.K. foreign tax credits are limited to the lesser of
the foreign tax paid or the U.K. tax that relates to such
amount of income. If the foreign tax credit is not claimed, a
taxpayer may deduct from foreign gross income any foreign tax
paid. Surplus foreign taxes may be carried forward
indefinitely, or carried back for up to three years, to offset
U.K. tax on income from the same source. U.K. law also provides
for limited onshore pooling of dividend income.
Proposed treaty limitations on internal law
Overview
One of the principal purposes for entering into an income
tax treaty is to limit double taxation of income earned by a
resident of one of the countries that may be taxed by the other
country. Unilateral efforts to limit double taxation are
imperfect. Because of differences in rules as to when a person
may be taxed on business income, a business may be taxed by two
countries as if it were engaged in business in both countries.
Also, a corporation or individual may be treated as a resident
of more than one country and be taxed on a worldwide basis by
both.
Part of the double tax problem is dealt with in other
articles of the proposed treaty that limit the right of a
source country to tax income. This article provides further
relief where both the United Kingdom and the United States
otherwise still tax the same item of income. This article is
not subject to the saving clause, so that the country of
citizenship or residence will waive its overriding taxing
jurisdiction to the extent that this article applies.
The present treaty provides separate rules for relief from
double taxation for the United States and the United Kingdom.
The present treaty generally provides for relief from double
taxation of U.S. residents and citizens by requiring the United
States to permit a credit against its tax for taxes paid to the
United Kingdom. The determination of this credit is made in
accordance with U.S. law. The present treaty treats the U.K.
petroleum revenue tax as a creditable tax, subject to certain
limitations provided in the treaty. In the case of the United
Kingdom, the present treaty generally provides relief from
double taxation by requiring the United Kingdom to permit a
credit against its tax for taxes paid to the United States,
subject to U.K. law provisions allowing a foreign tax credit.
Treaty restrictions on U.S. internal law
The proposed treaty generally provides that the United
States will allow a U.S. citizen or resident a foreign tax
credit for the income taxes imposed by the United Kingdom. The
proposed treaty also requires the United States to allow a
deemed-paid credit, with respect to U.K. income tax, to any
U.S. company that receives dividends from a U.K. company if the
U.S. company owns 10 percent or more of the voting stock of
such U.K. company. The credit generally is to be computed in
accordance with the provisions and subject to the limitations
of U.S. law (as such law may be amended from time to time
without changing the general principles of the proposed treaty
provisions). This provision is similar to those found in the
U.S. model and many U.S. treaties.
The proposed treaty provides that the taxes referred to in
paragraphs 3(b) and 4 of Article 2 (Taxes Covered) will be
considered creditable income taxes for purposes of the proposed
treaty. This includes the U.K. income tax, capital gains tax,
corporation tax, and the petroleum revenue tax (subject to the
provisions and limitations of Article 23 (Relief from Double
Taxation)).
The proposed treaty contains a resourcing rule for these
purposes. Under the proposed treaty, an item of gross income
(as defined under U.S. law) that is derived by a U.S. resident
and that is taxed by the United Kingdom under the proposed
treaty will be deemed to be U.K.-source income for U.S. foreign
tax credit purposes. The Technical Explanation states that this
resourcing rule is intended to ensure that a U.S. resident can
obtain a U.S. foreign tax credit for U.K. taxes paid when the
proposed treaty assigns primary taxing jurisdiction to the
United Kingdom. The Technical Explanation further states that
in the case of a U.S.-owned foreign corporation, the resourcing
rules under Code section 904(g)(10) may apply for purposes of
determining the amount of the U.S. foreign tax credit with
respect to such income (including rules applying separate
foreign tax credit limitations to such resourced income). The
U.S. model does not contain a resourcing rule. However, a
similar resourcing rule is contained in the present treaty.
According to the notes, if a U.S. resident receives a dividend
from a U.K. company that is eligible for the deemed-paid
credit, such dividend will be deemed to constitute U.K.-source
income, even if the dividend may be taxed only in the United
States because the zero rate of withholding applies (pursuant
to paragraph 3(a) of Article 10 (Dividends)).
The general resourcing rule described above does not apply
in the case of certain gains. Under the proposed treaty, gains
derived by an individual while he or she was a U.S. resident
and that are taxed by the United States under the proposed
treaty, but that also may be taxed by the United Kingdom under
paragraph 6 of Article 13 (Gains), will be deemed to be U.S.-
source gain. Paragraph 6 of Article 13 (Gains) provides that
each country may tax gains derived by certain non-residents who
used to be residents of that country, and it allows the United
Kingdom to tax gains from the alienation of property derived by
a individual who is a U.S. resident and who had been a U.K.
resident during the six years immediately preceding the
alienation. Thus, for example, if a U.K. resident gives up his
or her U.K. resident and becomes a U.S. resident, sells
property, and then re-establishes residence in the United
Kingdom within five years, such gains are considered to be
U.S.-source income.
The proposed treaty provides special rules and limits to
determine the amount of creditable U.K. petroleum revenue
taxes. The credit is limited to the amount attributable to
U.K.-source taxable income. The proposed treaty provides
further limitations on crediting such taxes that are similar to
the present treaty, with certain modifications. Under the
proposed treaty, the amount of U.K. petroleum revenue tax on
income from the extraction of minerals from oil or gas wells in
the United Kingdom to be allowed as a credit may not exceed the
amount, if any, by which the product of the maximum U.S.
statutory rate applicable to a corporation (currently 35
percent) for such taxable year and the amount of such income
exceeds the amount of other U.K. tax on such income. The
Technical Explanation states that the limitations provided
under the proposed treaty apply before applying other foreign
tax credit limitations contained under the Code (e.g., section
907 of the Code relating to foreign oil and gas extraction
income and foreign oil related income).
The Technical Explanation describes a four-step process for
computing the creditable U.K. petroleum revenue taxes. Under
the first step, the amount of the corporation's taxable income
(computed under U.S. standards) from the extraction of oil or
gas wells in the U.K. is multiplied by 35 percent (the maximum
U.S. statutory corporate rate). Under the second step, the
amount of other U.K. tax imposed on the taxpayer's income from
the extraction of minerals from oil or gas wells in the United
Kingdom is subtracted from the product arrived at under the
first step. The Technical Explanation states that because other
U.K. taxes on such income may be calculated on a base which
includes non-extraction activities, it may be necessary to
allocate other U.K. tax to the extraction income, and that
principles similar to Code section 907(c)(5) are to apply for
this purpose. The difference between the amounts computed under
these first two steps is the limitation with respect to the
petroleum revenue tax on extraction income.
Under the third step, the total U.K. petroleum revenue tax
paid or accrued must be allocated to income from extraction and
to income from initial transportation, initial treatment, and
initial storage. The Technical Explanation states that under
the U.K. Oil Taxation Act of 1975, as amended March 15, 1979,
which is the legislation that imposes the U.K. petroleum
revenue tax, it is possible for the tax to be levied on income
from non-extraction activities. Specifically, the base on which
the petroleum revenue tax is computed is determined by
reference to the value of oil or gas after initial
transportation to the U.K., and after initial treatment and
initial storage. The Technical Explanation states that the U.K.
petroleum revenue tax allocated to income from extraction is
determined by multiplying the total petroleum revenue tax by a
fraction, the numerator of which is taxable income from
extraction determined under U.S. standards (i.e., the amount
determined under the first step) and the denominator of which
is taxable income from extraction, initial transportation,
initial treatment, and initial storage.
Under the fourth step, the lesser of the petroleum revenue
tax paid or accrued with respect to extraction income under the
third step or the limit determined under the second step is
treated as income taxes paid or accrued for the taxable year
under section 901 of the code.
The proposed treaty provides for a carryback or
carryforward of the amount of petroleum revenue tax disallowed
under the steps described above. Under the proposed treaty,
where the amount of petroleum revenue tax allocable to
extraction income (determined under the third step above)
exceeds the credit limit (determined under the second step),
the excess is treated as income taxes paid or accrued in the
two preceding or five succeeding taxable years (in that order)
and to the extent not deemed paid or accrued in a prior taxable
year. The proposed treaty provides that such amounts are
allowable as a credit in the year deemed paid or accrued
subject to the limitations described above for claiming a
credit for petroleum revenue taxes. The present treaty provides
for a carryover of petroleum revenue taxes based on the lesser
of the excess credit or 2 percent of extraction income for the
taxable year. The Technical Explanation states that the
proposed treaty does not contain this additional restriction on
the carryover of credits to account for the intervening repeal
of the 2-percent ceiling.
The proposed treaty applies similar limitations and
carryover provisions for U.K. petroleum revenue taxes with
respect to income from initial transportation, initial
treatment, and initial storage of minerals from oil or gas
wells in the United Kingdom. Under the proposed treaty, these
items of income are combined for this purpose and the amount of
creditable taxes is computed by applying, mutatis mutandis, the
first, second, and fourth steps described above to such taxes.
Credits disallowed are carried over in a similar manner to that
discussed above.
The proposed treaty generally provides that the United
Kingdom will allow its citizens and residents a credit against
U.K. tax for U.S. taxes. For this purpose, the U.S. taxes
referred to in paragraph 3(a)(i) and 4 of Article 2 (Taxes
Covered) are considered U.S. taxes. The credit is subject to
the provisions of U.K. law regarding the allowance of credits
against U.K. tax for taxes payable in a territory outside the
United Kingdom (which may not affect the general principles of
the proposed treaty provisions).
Under the proposed treaty, the amount of U.S. tax payable
under U.S. laws and in accordance with the proposed treaty,
whether directly or by deduction, on profits, income or
chargeable gain from U.S. sources (excluding in the case of a
dividend, U.S. tax in respect of the profits out of which the
dividend is paid) is allowed as a credit against U.K. tax
computed by reference to the same profits, income, or
chargeable gains to which the U.S. tax is computed. In
addition, in the case of a dividend paid by a U.S. company to a
U.K. company which controls directly or indirectly at least 10
percent of the voting power of the payor company, the proposed
treaty provides that the credit allowed must take into account
(in addition to any U.S. tax allowed directly as described
above) the U.S. tax payable by the company in respect of the
profits out of which such dividend is paid.
The proposed treaty denies the U.K. credit described above
with respect to dividends received by U.K. companies from U.S.
companies in certain circumstances. Under the proposed treaty,
the indirect credit may not be claimed if and to the extent
that (1) the United Kingdom treats the dividend as beneficially
owned by a U.K. resident, (2) the United States treats the same
dividend as beneficially owned by a U.S. resident, and (3) the
United States allows the U.S. resident a deduction in respect
of the amount determined by reference to that dividend. The
Technical Explanation states that this rule is intended to
apply to a particular type of financing transaction that has
been used widely by U.K. resident companies to finance their
U.S. operations. The Technical Explanation provides an example
of this transaction in which a U.S. holding company sells stock
in another U.S. company to a U.K. company. Simultaneously, the
U.S. holding company enters into a repurchase agreement with
the U.K. company that allows the U.S. holding company to buy
back the stock at a predetermined price. The sale and the
repurchase agreement are structured in such a way that the
transactions are treated together as a loan for U.S. tax
purposes (with the dividends paid to the U.K. company treated
as payments of interest on a loan from the U.K. company to the
U.S. company). Because U.K. domestic law provides no mechanism
for similarly treating the sale and repurchase in accordance
with its economic substance, the United Kingdom would be
required to respect the form of the transaction as a sale and
grant an indirect credit with respect to dividends from the
U.S. company, resulting in double non-taxation of income.
However, U.K. domestic law does permit the United Kingdom to
disallow U.K. foreign tax credits through its treaties.
The Technical Explanation states that the United Kingdom
had seen several of these transactions and was concerned about
the loss of U.K. tax revenues arising from the ability of a
U.K. company to receive a U.K. foreign tax credit for a payment
that economically is interest. Accordingly, the Technical
Explanation states that the United Kingdom requested this
exception to the general rule described above relating to U.K.
foreign tax credits for dividends. In order to facilitate the
elimination of the U.K. foreign tax credit under this
provision, the proposed treaty provides that paragraph 2 of
Article 1 (General Scope) does not apply for this purpose,
which otherwise would not permit the proposed treaty to
restrict a benefit provided under (in this case) U.K. domestic
law.
The proposed treaty provides a resourcing rule for purposes
of allowing credits for U.S. taxes against U.K. taxes. The
Technical Explanation states that this provision is intended to
ensure that a U.K. resident can obtain a U.K. foreign tax
credit for U.S. taxes paid when the proposed treaty assigns
primary taxing jurisdiction to the United States. Under the
proposed treaty, income of a U.K. resident that is taxed by the
United States in accordance with the proposed treaty will be
deemed to be U.S.-source income.
The proposed treaty contains special rules designed to
provide relief from double taxation for U.S. citizens who are
U.K. residents. Unlike the U.S. model, the rules also apply to
former U.S. citizens or long-term residents who are U.K.
residents. Under the proposed treaty, the United Kingdom is not
required to provide a credit to such U.K. residents for U.S.
tax on profits, income, or chargeable gains from sources
outside the United States (as determined under U.K. laws). This
provision is similar to a provision in the present treaty.
In addition, under the proposed treaty, the United Kingdom
will allow a foreign tax credit to a U.S. citizen, former U.S.
citizen, or former U.S. resident who is a U.K. resident by
taking into account only the amount of U.S. taxes, if any, that
may be imposed pursuant to the proposed treaty on a U.K.
resident who is not a U.S. citizen. The Technical Explanation
states that these rules apply to items of U.S.-source income
that would either be exempt from U.S. tax or subject to reduced
rates of U.S. tax under the proposed treaty if they had been
received by a U.K. resident who is not a U.S. citizen. The
Technical Explanation further states that the U.K. tax credit
allowed with respect to such items need not exceed the U.S. tax
that may be imposed under the proposed treaty, other than taxes
imposed solely by reason of the U.S. citizenship of the
taxpayer under saving clause of paragraph 4 of Article 1
(General Scope). The United States will then credit the income
tax and capital gains tax actually paid to the United Kingdom,
determined after application of the preceding rule. The
proposed treaty recharacterizes the income that is subject to
U.K. taxation as foreign-source income for purposes of this
computation, but only to the extent necessary to avoid double
taxation of such income.
The notes contain special rules for the application of
Article 24 to fiscally transparent entities. The notes state
that under paragraph 4 or 8 of Article 1 (General Scope), the
proposed treaty may permit a country of which a person is
resident (or, in the case of the United States, a citizen) to
tax an item of income derived through another person (the
``entity'') that is fiscally transparent under the laws of
either country, and may also permit the other country to tax
the same person, the entity, or another person on that same
item of income. The notes provide that in such circumstances,
taxes paid or accrued by the entity will be treated as if it
were paid or accrued by the first-mentioned person for purposes
of determining relief from double taxation to be allowed by
that resident's home country (or, in the case of the United
States, a citizen). Thus, according to the Technical
Explanation, if a U.K. company pays interest to a U.K.
unlimited liability company (``ULC'') with U.S. resident
partners and the ULC is treated for U.S. tax purposes as a
partnership such that the partners are subject to U.S. tax on
that income, but the United Kingdom taxes the ULC on such
income as a U.K. resident, under the proposed treat the United
States will treat the U.K. tax paid by the ULC as having been
paid by the partners for purposes of providing a foreign tax
credit with respect to such interest income. The notes provide
an exception from this rule for fiscally transparent entities
in the case of items of income from real property to which
paragraph 1 of Article 6 (Income from Real Property) applies,
or gain from the alienation of real property to which paragraph
1 of Article 13 (Gains) applies. The notes provide that for
such income and gains, the tax paid or accrued by the person
who is a resident of the country in which the real property is
situated will be treated as if it were paid by the person who
is a resident of the other country.
The notes also provide special rules for the application of
Article 24 where the same item of income, profit, or gain
derived through a trust is treated by each country as derived
by different persons resident in either country, and the person
taxed by one country is the settlor or grantor of a trust, and
the person taxed by the other country is a beneficiary of that
trust. In such cases, the notes provide that the tax paid or
accrued by the beneficiary will be treated as paid or accrued
by the settlor or grantor for purposes of determining the
relief from double taxation to be allowed by the country in
which the settlor or grantor is resident (or, in the case of
the United States, a citizen). Thus, according to the Technical
Explanation, if a trust is a grantor trust for U.S. tax
purposes and the income of the trust is included in the income
of the grantor, but for U.K. tax purposes the beneficiaries
must also pay tax on the same income, under the proposed treaty
the United States would be required to provide a credit to the
U.S. grantor for the U.K. tax imposed on the U.K. beneficiaries
of the trust. The notes provide an exception from this rule in
the case of items of income from real property to which
paragraph 1 of Article 6 (Income from Real Property) applies,
or gain from the alienation of real property to which paragraph
1 of Article 13 (Gains) applies. The notes provide that for
such income and gains, the tax paid or accrued by the person
who is a resident of the country in which the real property is
situated will be treated as if it were paid by the person who
is a resident of the other country.
The notes further provide that the resourcing rules in
paragraphs 2 and 5 of this article (described above) will apply
to such items of income through fiscally transparent entities
to the extent necessary to provide relief from double taxation.
This article is not subject to the saving clause, so that
the country of citizenship or residence will waive its
overriding taxing jurisdiction to the extent that this article
applies.
Article 25. Non-Discrimination
The proposed treaty contains a comprehensive non-
discrimination article relating to all taxes of every kind
imposed at the national, state, or local level. It is similar
to the non-discrimination article in the U.S. model, the
present treaty, and to provisions that have been included in
other recent U.S. income tax treaties.
In general, under the proposed treaty, one country cannot
discriminate by imposing more burdensome taxes (or requirements
connected with taxes) on nationals of the other country than it
would impose on its own nationals in the same circumstances,
particularly with respect to taxation on worldwide income. The
Technical Explanation states that if one person is taxable in a
country on worldwide income and another is not, distinctions in
such treatment would not be discriminatory. Like the U.S.
model, non-discrimination protection is provided with respect
to all taxes imposed by a country or its political subdivisions
or local authorities, and not just to taxes covered by the
proposed treaty under Article 2 (Taxes Covered). Unlike the
U.S. model,\16\ the proposed treaty does not contain the
provision extending the application of the non-discrimination
rules to persons who are not residents of one or both of the
States. The Technical Explanation states that this rule was not
included in the proposed treaty at the request of the United
Kingdom. Consistent with the U.K.'s position with respect to
the proposed treaty, the United Kingdom has also stated that it
reserves its position \17\ with respect to the parallel
provision in the OECD model.\18\
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\16\ U.S. model, Article 24, paragraph 1, last sentence.
\17\ OECD model, Commentary on Article 24, paragraph 67.
\18\ OECD model, Article 24, paragraph 1, last sentence.
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Under the proposed treaty, neither country may tax a
permanent establishment of an enterprise of the other country
less favorably than it taxes its own enterprises carrying on
the same activities. Similar to the U.S. and OECD models,
however, a country is not obligated to grant residents of the
other country any personal allowances, reliefs, or reductions
for tax purposes that are granted to its own residents or
nationals.
Each country is required (subject to the arm's-length
pricing rules of paragraph 1 of Article 9 (Associated
Enterprises), paragraph 4 of Article 11 (Interest), paragraph 4
of Article 12 (Royalties), or paragraph 3 of Article 22 (Other
Income), and subject to the conduit arrangement rules of the
second sentence of paragraph 5 of Article 7 (Business Profits),
paragraph 9 of Article 10 (Dividends), paragraph 7 of Article
11 (Interest), paragraph 5 of Article 12 (Royalties), or
paragraph 4 of Article 22 (Other Income)) to allow its
residents to deduct interest, royalties, and other
disbursements paid by them to residents of the other country
under the same conditions that it allows deductions for such
amounts paid to residents of the same country as the payor. The
Technical Explanation states that the term ``other
disbursements'' is understood to include a reasonable
allocation of executive and general administrative expenses,
research and development expenses, and other expenses incurred
for the benefit of a group of related persons that includes the
person incurring the expense. The Technical Explanation further
states that the exception with respect to paragraph 4 of
Article 11 (Interest) would include the denial or deferral of
certain interest deductions under section 163(j) of the Code.
The non-discrimination rules also apply to enterprises of
one country that are owned in whole or in part by residents of
the other country. Enterprises resident in one country, the
capital of which is wholly or partly owned or controlled,
directly or indirectly, by one or more residents of the other
country, will not be subjected in the first country to any
taxation (or any connected requirement) that is more burdensome
than the taxation (or connected requirements) that the first
country imposes or may impose on its similar enterprises. The
Technical Explanation includes examples of Code provisions that
are understood by the two countries not to violate this
provision of the proposed treaty. Those examples include the
rules that impose a withholding tax on non-U.S. partners of a
partnership and the rules that prevent foreign persons from
owning stock in Subchapter S corporations.
The proposed treaty provides that nothing in the non-
discrimination article is to be construed as preventing either
of the countries from imposing a branch profits tax as
described in paragraph 7 of Article 10 (Dividends). In
addition, notwithstanding the definition of taxes covered in
Article 2 (Taxes Covered), this article applies to taxes of
every kind and description imposed by either country, or a
political subdivision or local authority thereof.
The saving clause (which allows the country of residence or
citizenship to impose tax notwithstanding certain treaty
provisions) does not apply to the non-discrimination article.
Thus, a U.S. citizen resident in the United Kingdom may claim
benefits with respect to the United States under this article.
Article 26. Mutual Agreement Procedure
The proposed treaty contains the standard mutual agreement
provision, with some variation, that authorizes the competent
authorities of the two countries to consult together to attempt
to alleviate individual cases of double taxation not in
accordance with the proposed treaty. The saving clause of the
proposed treaty does not apply to this article, so that the
application of this article might result in a waiver (otherwise
mandated by the proposed treaty) of taxing jurisdiction by the
country of citizenship or residence.
Under this article, a resident of one country who considers
that the action of one or both of the countries cause him or
her to be subject to tax which is not in accordance with the
provisions of the proposed treaty may (irrespective of internal
law remedies) present his or her case to the competent
authority of the country in which he or she is a resident or a
national. Similar to the OECD model, and unlike the U.S. model,
the proposed treaty provides that the case must be presented
within three years from the first notification of the action
resulting in taxation not in accordance with the provisions of
the treaty (or, if later, within six years from the end of the
taxable year or chargeable period with respect to which that
tax is imposed or proposed).
The proposed treaty provides that if the objection appears
to be justified and that competent authority is not itself able
to arrive at a satisfactory solution, that competent authority
must endeavor to resolve the case by mutual agreement with the
competent authority of the other country, with a view to the
avoidance of taxation which is not in accordance with the
proposed treaty. The proposed treaty provides that any
agreement reached will be implemented notwithstanding any time
limits or other procedural limitations under the domestic laws
of either country (e.g., a country's applicable statute of
limitations). The notes provide an exception from this rule for
such limitations as apply for purposes of giving effect to such
agreements (e.g., a domestic law requirement that the taxpayer
file a return reflecting the agreement within a designated time
period).
The notes provide that where the competent authorities are
seeking to resolve a case pursuant to this article, neither
country may seek to collect the tax that is in dispute until
the mutual agreement procedure has been completed. However, the
notes further provide that any tax that is payable following
the completion of the mutual agreement procedure will be
subject to applicable interest charges, surcharges, or
penalties for so long as the tax remains unpaid.
The competent authorities of the countries are to endeavor
to resolve by mutual agreement any difficulties or doubts
arising as to the interpretation or application of the proposed
treaty. In particular, the competent authorities may agree to:
(1) the same attribution of income, deductions, credits, or
allowances of an enterprise of one treaty country to the
enterprise's permanent establishment situated in the other
country; (2) the same allocation of income, deductions,
credits, or allowances between persons; (3) the same
characterization of particular items of income, including the
same characterization of income that is assimilated to income
from shares by the tax laws of one country and that is treated
as a different class of income in the other country; (4) the
same characterization of persons; (5) the same application of
source rules with respect to particular items of income; (6) a
common meaning of a term; (7) that the conditions for the
application of the conduit arrangement tests under the second
sentence of paragraph 5 of Article 7 (Business Profits),
paragraph 9 of Article 10 (Dividends), paragraph 7 of Article
11 (Interest), paragraph 5 of Article 12 (Royalties), or
paragraph 4 of Article 22 (Other Income) have been met; and (8)
the application of the provisions of each country's domestic
law regarding penalties, fines, and interest in a manner
consistent with the purposes of the proposed treaty. The
Technical Explanation clarifies that this list is a non-
exhaustive list of examples of the kinds of matters about which
the competent authorities may reach agreement. With respect to
item (7) above, the Technical Explanation states that if the
competent authorities become aware of a type of tax avoidance
transaction entered into by several taxpayers, it is
anticipated that each competent authority will respond to that
transaction by means of domestic laws and procedures, rather
than through the issuance of a general agreement, in order to
deny benefits in appropriate cases.
The proposed treaty provides that the competent authorities
may consult together for the elimination of double taxation
regarding cases not provided for in the proposed treaty. In
addition, the notes provide that it is understood that any
principle of general application established by an agreement
between the competent authorities will be published by both
competent authorities. This will increase transparency in the
administration of the treaty by providing taxpayers with
notification of principles of general applicability upon which
both competent authorities have agreed.
The proposed treaty authorizes the competent authorities to
communicate with each other directly for purposes of reaching
an agreement in the sense of this mutual agreement article. The
Technical Explanation states that this provision makes clear
that it is not necessary to go through diplomatic channels in
order to discuss problems arising in the application of the
proposed treaty.
The notes provide that the provisions of Article 26 (Mutual
Agreement Procedure) of the proposed treaty will have effect
from the date of entry into force of the proposed treaty,
without regard to the taxable or chargeable period to which the
matter relates.
Article 27. Exchange of Information and Administrative Assistance
The proposed treaty provides that the two competent
authorities will exchange such information as is necessary \19\
to carry out the provisions of the proposed treaty, or the
domestic laws of the two countries concerning taxes covered by
the proposed treaty insofar as the taxation thereunder is not
contrary to the proposed treaty, including for purposes of
preventing fraud and facilitating the administration of
statutory provisions against legal avoidance. This exchange of
information is not restricted by Article 1 (General Scope).
Therefore, information with respect to third-country residents
is covered by these procedures. The two competent authorities
may exchange information on a routine basis, on request in
relation to a specific case, or spontaneously. The Technical
Explanation states that it is contemplated that all of these
types of exchange will be utilized, as appropriate.
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\19\ The U.S. model uses ``relevant'' instead of ``necessary.'' The
Technical Explanation states that ``necessary'' has been consistently
interpreted as being equivalent to ``relevant,'' and does not
necessitate a demonstration that a State would be disabled from
enforcing its tax laws absent the information.
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Unlike the U.S. model, the proposed treaty is limited to
taxes that are identified in Article 2 (Taxes Covered). The
Technical Explanation states that U.K. legislation for
implementing tax treaties does not provide authority to
exchange information with respect to other types of taxes.
Any information exchanged under the proposed treaty is
treated as secret in the same manner as information obtained
under the domestic laws of the country receiving the
information. The exchanged information may be disclosed only to
persons or authorities (including courts and administrative
bodies) involved in the assessment, collection, or
administration of, the enforcement or prosecution in respect
of, or the determination of appeals in relation to, the taxes
to which the proposed treaty applies, or to persons or
authorities engaged in the oversight of the above (e.g., the
tax-writing committees of Congress and the General Accounting
Office). Such persons or authorities must use the information
for such purposes only. Information received by these bodies
must be for use in the performance of their role in overseeing
the administration of U.S. tax laws. Exchanged information may
be disclosed in public court proceedings or in judicial
decisions.
If information is requested by a country in accordance with
this article, the proposed treaty provides that the other
country will obtain that information in the same manner and to
the same extent as if the tax of the requesting country were
the tax of the other country and were being imposed by that
country, notwithstanding that such other country may not need
such information at that time. The Technical Explanation states
that a recent change in U.K. domestic law allows the United
Kingdom to agree to this provision of the proposed treaty, and
to obtain and exchange information in which it does not have a
direct tax interest.
As is true under the U.S. model and the OECD model, under
the proposed treaty, a country is not required to carry out
administrative measures at variance with the laws and
administrative practice of either country, to supply
information that is not obtainable under the laws or in the
normal course of the administration of either country, or to
supply information that would disclose any trade, business,
industrial, commercial, or professional secret or trade process
or information, the disclosure of which would be contrary to
public policy.
The notes provide that the powers of each country's
competent authority to obtain information include the ability
to obtain information held by financial institutions, nominees,
or persons acting in an agency or fiduciary capacity. This does
not include the ability to obtain information that would reveal
confidential communications between a client and an attorney,
solicitor, or other legal representative, where the client
seeks legal advice. The Technical Explanation states that, in
the case of the United States, the scope of the privilege for
such confidential communications is coextensive with the
attorney-client privilege under U.S. law. The notes also
provide that the competent authorities may obtain information
relating to the ownership of legal persons. The notes confirm
that each country's competent authority is able to exchange
such information in accordance with this article.
The proposed treaty provides that if specifically requested
by the competent authority of a country, the competent
authority of the other country must provide information under
this article in the form of authenticated copies of unedited
original documents (including books, papers, statements,
records, accounts, and writings), to the same extent such
documents can be obtained under the laws and administrative
practices of the requested country with respect to its own
taxes. Unlike the U.S. model, the proposed treaty does not
authorize the use of depositions of witnesses to obtain
information under this article. The Technical Explanation
states that under current U.K. law and practice, the U.K.
Inland Revenue does not have the authority to take such
depositions.
Under the proposed treaty, a country may collect on behalf
of the other country such amounts as may be necessary to ensure
that relief granted under the treaty by the other country does
not inure to the benefit of persons not entitled thereto.
However, neither country is obligated to carry out
administrative measures that would be contrary to its
sovereignty, security, or public policy.
Under the proposed treaty, the competent authority of a
country intending to send its officials to the other country to
interview individuals and examine books and records with the
consent of the person subject to examination must notify the
competent authority of the other country of such intention.
Like the present treaty, the proposed treaty provides that
the competent authorities will consult with each other for
purposes of cooperating and advising in respect of any action
to be taken in implementing this article.
The notes provide that the provisions of Article 27
(Exchange of Information and Administrative Assistance) of the
proposed treaty will have effect from the date of entry into
force of the proposed treaty, without regard to the taxable or
chargeable period to which the matter relates.
Article 28. Diplomatic Agents and Consular Officers
The proposed treaty contains the rule found in the U.S.
model, the present treaty, and other U.S. tax treaties that its
provisions do not affect the fiscal privileges of diplomatic
agents or consular officers under the general rules of
international law or under the provisions of special
agreements. Accordingly, the proposed treaty will not defeat
the exemption from tax which a host country may grant to the
salary of diplomatic officials of the other country. The saving
clause does not apply in the application of this article to
host country residents who are neither citizens nor lawful
permanent residents of that country. Thus, for example, U.S.
diplomats who are considered U.K. residents may be protected
from U.K. tax.
Article 29. Entry Into Force
The proposed treaty provides that the treaty is subject to
ratification in accordance with the applicable procedures of
each country, and that instruments of ratification will be
exchanged as soon as possible. The proposed treaty will enter
into force upon the exchange of instruments of ratification.
With respect to the United States, the proposed treaty will
be effective with respect to taxes withheld at source for
amounts paid or credited on or after the first day of the
second month following the date on which the proposed treaty
enters into force. With respect to other taxes, the proposed
treaty will be effective for taxable periods beginning on or
after the first day of January next following the date on which
the proposed treaty enters into force.
With respect to the United Kingdom, the proposed treaty
will be effective with respect to taxes withheld at source for
amounts paid or credited on or after the first day of the
second month following the date on which the proposed treaty
enters into force. With respect to income taxes not described
in the preceding sentence and with respect to capital gains
taxes, the proposed treaty will be effective for any year of
assessment beginning on or after the sixth day of April next
following the date on which the proposed treaty enters into
force. With respect to the corporation tax, the proposed treaty
will be effective for any financial year beginning on or after
the first day of April next following the date on which the
proposed treaty enters into force.\20\ With respect to
petroleum revenue taxes, the proposed treaty will be effective
for chargeable periods beginning on or after the first day of
January next following the date on which the proposed treaty
enters into force.
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\20\ Thus, with respect to these taxes, the proposed treaty would
take effect almost immediately if instruments of ratification were
exchanged in March 2003; otherwise, the earliest it could take effect
with respect to these taxes would be for financial years or years of
assessment beginning in April 2004.
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The present treaty generally will cease to have effect in
relation to any tax from the date on which the proposed treaty
takes effect in relation to that tax. Taxpayers may elect
temporarily to continue to claim benefits under the present
treaty with respect to a period after the proposed treaty takes
effect. For such a taxpayer, the present treaty would continue
to have effect in its entirety for a twelve-month period from
the date on which the provisions of the proposed treaty would
otherwise take effect. The present treaty will terminate on the
last date on which it has effect in relation to any tax in
accordance with the provisions of this article.
Notwithstanding the entry into force of the proposed
treaty, an individual who is entitled to the benefits of
Article 21 (Students and Trainees) of the present treaty at the
time the proposed treaty enters into force will continue to be
entitled to such benefits as if the present treaty remained in
force. The Technical Explanation states that the treatment of
trainees under the present treaty may be more generous than
under the proposed treaty (which generally limits benefits for
such individuals for up to one year). The Technical Explanation
states that the special rule in the proposed treaty was
included so that the rules do not change with respect to
certain trainees that have based their decisions to come to a
host country on the assumption that the benefits of the present
treaty would apply to them.
The notes provide that the provisions of Article 26 (Mutual
Agreement Procedure) and Article 27 (Exchange of Information
and Administrative Assistance) of the proposed treaty will have
effect from the date of entry into force of the proposed
treaty, without regard to the taxable or chargeable period to
which the matter relates.
Article 30. Termination
The proposed treaty will remain in force until terminated
by either country. Either country may terminate the proposed
treaty by giving notice of termination to the other country
through diplomatic channels. In such case, with respect to the
United States, a termination is effective with respect to taxes
withheld at source for amounts paid or credited after six
months following notice of termination. With respect to other
taxes, a termination is effective for taxable periods beginning
on or after the date that is six months following notice of
termination.
With respect to the United Kingdom, a termination is
effective with respect to taxes withheld at source for amounts
paid or credited after six months following notice of
termination. With respect to income taxes not described in the
preceding sentence and with respect to capital gains taxes, a
termination is effective for any year of assessment beginning
on or after the date that is six months following the notice of
termination. With respect to the corporation tax, a termination
is effective for any financial year beginning on or after the
date that is six months following notice of termination. With
respect to the petroleum revenue tax, a termination is
effective for chargeable periods beginning on or after the date
that is six months following notice of termination.
Other Matters
The notes provide that the two countries will consult
together at regular intervals regarding the terms, operation,
and application of the proposed treaty to ensure that it
continues to serve the purpose of avoiding double taxation and
preventing fiscal evasion, and where appropriate, conclude
protocols to amend the proposed treaty. The notes provide that
the first consultation will take place no later than December
31 of the fifth year following the date on which the proposed
treaty enters into force. The notes further provide that
subsequent consultations will take place in intervals of no
more than five years.
Notwithstanding the above, the notes provide that either
country may at any time request consultations with the other
country with respect to matters relating to the terms,
operation, and application of the proposed treaty that it
considers require urgent resolution.
IV. ISSUES
A. Zero Rate of Withholding Tax on Dividends From 80-Percent-Owned
Subsidiaries
In general
The proposed treaty would eliminate withholding tax on
dividends paid by one corporation to another corporation that
owns at least 80 percent of the stock of the dividend-paying
corporation (often referred to as ``direct dividends''),
provided that certain conditions are met (subparagraph 3(a) of
Article 10 (Dividends)). The elimination of withholding tax
under these circumstances is intended to reduce further the tax
barriers to direct investment between the two countries.
Unlike the United States, the United Kingdom currently does
not impose withholding tax on dividends paid to foreign
shareholders as a matter of domestic law. Thus, the principal
immediate effect of this provision would be to exempt dividends
that U.S. subsidiaries pay to U.K. parent companies from U.S.
withholding tax. With respect to dividends paid by U.K.
subsidiaries to U.S. parent companies, the effect of this
provision would be to lock in the currently applicable zero
rate of U.K. withholding tax, regardless of how U.K. domestic
law might change in this regard.
Currently, no U.S. treaty provides for a complete exemption
from withholding tax under these circumstances, nor do the U.S.
or OECD models. However, many bilateral tax treaties to which
the United States is not a party eliminate withholding taxes
under similar circumstances, and the same result has been
achieved within the European Union under its ``Parent-
Subsidiary Directive.'' In addition, subsequent to the signing
of the proposed treaty, the United States signed proposed
protocols with Australia and Mexico that include zero-rate
provisions similar to the one in the proposed treaty.
Description of provision
Under the proposed treaty, the withholding tax rate is
reduced to zero on dividends beneficially owned by a company
that has owned at least 80 percent of the voting power of the
company paying the dividend for the 12-month period ending on
the date the dividend is declared (subparagraph 3(a) of Article
10 (Dividends)). Under the current U.S.-U.K. treaty, these
dividends may be taxed at a 5-percent rate (although, as noted
above, the United Kingdom currently does not exercise this
right as a matter of domestic law, whereas the United States
does).
In certain circumstances, eligibility for the zero rate
under the proposed treaty is subject to an additional
restriction designed to prevent companies from reorganizing for
the purpose of obtaining the benefits of the provision.
Specifically, in cases in which a company satisfies the
Limitation on Benefits article only under the ``active trade or
business'' and/or ``ownership/base-erosion'' tests (paragraph 4
and subparagraph 2(f), respectively, of Article 23 (Limitation
on Benefits)), the zero rate will apply only if the dividend-
receiving company owned (directly or indirectly) at least 80
percent of the voting power of the dividend-paying company
prior to October 1, 1998.\21\ In other cases, the Limitation on
Benefits article itself is considered sufficient to prevent
treaty shopping. Thus, companies that qualify for treaty
benefits under the ``public trading,'' ``derivative benefits,''
or discretionary tests (subparagraph 2(c) and paragraphs 3 and
6, respectively, of Article 23 (Limitation on Benefits)) will
not need to meet the October 1, 1998 holding requirement in
order to claim the zero rate.\22\
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\21\ October 1, 1998 is the date on which the parties announced
that they were negotiating the proposed treaty.
\22\ See Part III, Article 10, supra, for a discussion of an
interpretive issue that arose regarding the scope of the zero-rate
provision under the language of the proposed treaty as originally
signed, prior to amendment by the proposed protocol.
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Issues
In general
Given that the United States has never before agreed
bilaterally to a zero rate of withholding tax on direct
dividends, the Committee may wish to devote particular
attention to the benefits and costs of taking this step. The
Committee also may want to determine whether the inclusion of
the zero-rate provision in the proposed treaty (as well as in
the proposed protocols with Australia and Mexico) signals a
broader shift in U.S. treaty policy, and under what
circumstances the United States may seek to include similar
provisions in other treaties. Finally, the Committee may wish
to note the ramifications of including this provision in the
U.S.-U.K. treaty in view of a ``most favored nation'' provision
relating to this subject in the current U.S.-Mexico treaty.
Benefits and costs of adopting a zero rate with the United
Kingdom
Tax treaties mitigate double taxation by resolving the
potentially conflicting claims of a residence country and a
source country to tax the same item of income. In the case of
dividends, standard international practice is for the source
country to yield mostly or entirely to the residence country.
Thus, the residence country preserves its right to tax the
dividend income of its residents, and the source country agrees
either to limit its withholding tax to a relatively low rate
(e.g., 5 percent) or to forgo it entirely.
Treaties that permit a positive rate of dividend
withholding tax allow some degree of double taxation to
persist. To the extent that the residence country allows a
foreign tax credit for the withholding tax, this remaining
double taxation may be mitigated or eliminated, but then the
priority of the residence country's claim to tax the dividend
income of its residents is not fully respected. Moreover, if a
residence country imposes limitations on its foreign tax
credit,\23\ withholding taxes may not be fully creditable as a
practical matter, thus leaving some double taxation in place.
For these reasons, dividend withholding taxes are commonly
viewed as barriers to cross-border investment. The principal
argument in favor of eliminating withholding taxes on certain
direct dividends in the proposed treaty is that it would remove
one such barrier.
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\23\ See, e.g., Code sec. 904.
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Direct dividends arguably present a particularly
appropriate case in which to remove the barrier of a
withholding tax, in view of the close economic relationship
between the payor and the payee. Whether in the United States
or in the United Kingdom, the dividend-paying corporation
generally faces full net-basis income taxation in the source
country, and the dividend-receiving corporation generally is
taxed in the residence country on the receipt of the dividend
(subject to allowable foreign tax credits). If the dividend-
paying corporation is at least 80-percent owned by the
dividend-receiving corporation, it is arguably appropriate to
regard the dividend-receiving corporation as a direct investor
(and taxpayer) in the source country in this respect, rather
than regarding the dividend-receiving corporation as having a
more remote investor-type interest warranting the imposition of
a second-level source-country tax.
Since the United Kingdom does not impose a withholding tax
on these dividends under its internal law, the zero-rate
provision would principally benefit direct investment in the
United States by U.K. companies, as opposed to direct
investment in the United Kingdom by U.S. companies. In other
words, the potential benefits of the provision would accrue
mainly in situations in which the United States is importing
capital, as opposed to exporting it.\24\
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\24\ In contrast, including a similar provision in a treaty with a
country that does impose withholding tax on some or all direct
dividends under its internal law (e.g., Australia) would provide more
immediate and direct benefits to the United States as both an importer
and an exporter of capital.
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In this regard, the Committee may wish to note that
adopting a zero-rate provision in the U.S.-U.K. treaty would
have uncertain revenue effects for the United States. The
United States would forgo the 5-percent tax that it currently
collects on qualifying dividends paid by U.S. subsidiaries to
U.K. parent companies, but since the United Kingdom currently
does not impose any tax on comparable dividends paid by U.K.
subsidiaries to U.S. parent companies, there would be no
offsetting revenue gain to the United States in the form of
decreased foreign tax credit claims with respect to withholding
taxes.\25\ However, in order to account for the recent repeal
of the U.K. advance corporation tax and related developments,
the proposed treaty also eliminates a provision of the present
treaty requiring the United States to provide a foreign tax
credit with respect to certain dividends received from U.K.
companies. On balance, these two effects are likely to increase
revenues for the U.S. fisc. Over the longer term, if capital
investment in the United States by U.K. persons is made more
attractive, total investment in the United States may increase,
ultimately creating a larger domestic tax base. However, if
increased investment in the United States by U.K. persons
displaced other foreign or U.S. investments in the United
States, there would be no increase in the domestic tax base.
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\25\ The overall revenue impact of including a similar provision in
a treaty with a country that does impose withholding tax on direct
dividends would be more favorable for the United States, as the direct
revenue loss to the United States as a source country would be offset
in whole or in part by a revenue gain as a residence country from
reduced foreign tax credit claims with respect to withholding taxes.
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Revenue considerations aside, the removal of an impediment
to the import of capital from the United Kingdom into the
United States is a not-inconsiderable economic benefit.
Further, it should be noted that, although U.K. internal law
currently does not impose a withholding tax on dividends paid
to foreign persons, there is no guarantee that this will always
be the case. Thus, the inclusion of a zero-rate provision in
the treaty would give U.S.-based enterprises somewhat greater
certainty as to the applicability of a zero rate in the United
Kingdom, which arguably would facilitate long-range business
planning for U.S. companies in their capacities as capital
exporters. Along the same lines, the provision would protect
the U.S. fisc against increased foreign tax credit claims in
the event that the U.K. were to change its internal law in this
regard.
Although the United States has never agreed bilaterally to
a zero rate of withholding tax on direct dividends, many other
countries have done so in one or more of their bilateral tax
treaties. These countries include OECD members Austria,
Denmark, France, Finland, Germany, Iceland, Ireland, Japan,
Luxembourg, Mexico, the Netherlands, Norway, Sweden,
Switzerland, and the United Kingdom, as well as non-OECD-
members Belarus, Brazil, Cyprus, Egypt, Estonia, Israel,
Latvia, Lithuania, Mauritius, Namibia, Pakistan, Singapore,
South Africa, Ukraine, and the United Arab Emirates. In
addition, a zero rate on direct dividends has been achieved
within the European Union under its ``Parent-Subsidiary
Directive.'' Finally, many countries have eliminated
withholding taxes on dividends as a matter of internal law
(e.g., the United Kingdom and Mexico). Thus, although the zero-
rate provision in the proposed treaty is unprecedented in U.S.
treaty history, there is substantial precedent for it in the
experience of other countries. It may be argued that this
experience constitutes an international trend toward
eliminating withholding taxes on direct dividends, and that the
United States would benefit by joining many of its treaty
partners in this trend and further reducing the tax barriers to
cross-border direct investment.
General direction of U.S. tax treaty policy
Looking beyond the U.S.-U.K. treaty relationship, the
Committee may wish to determine whether the inclusion of the
zero-rate provision in the proposed treaty (as well as in
later-signed proposed protocols with Australia and Mexico)
signals a broader shift in U.S. tax treaty policy.
Specifically, the Committee may want to know whether the
Treasury Department: (1) intends to pursue similar provisions
in other proposed treaties in the future; (2) proposes any
particular criteria for determining the circumstances under
which a zero-rate provision may be appropriate or
inappropriate; (3) expects to seek terms and conditions similar
to those of the proposed treaty in connection with any zero-
rate provisions that it may negotiate in the future; and (4)
intends to amend the U.S. model to reflect these
developments.\26\ In light of the fact that the United States
would stand to benefit more comprehensively from zero-rate
provisions in treaties with countries that currently impose
withholding taxes on the relevant dividends, the general
implications of this first zero-rate provision are likely to be
of greater interest in the United States than the particular
implications with respect to the United Kingdom.
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\26\ More broadly, since the U.S. Model has not been updated since
1996, the Committee may wish to ask whether the Treasury Department
intends to update the model to reflect all relevant developments that
have occurred in the intervening years. A thoroughly updated model
would provide a more meaningful and useful guide to current U.S. tax
treaty policy and would thereby increase transparency and facilitate
Congressional oversight in this important area. See Joint Committee on
Taxation, Study of the Overall State of the Federal Tax System and
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of
the Internal Revenue Code of 1986 (JCS-3-01), April 2001, Vol. II, at
445-47 (recommending that the Treasury Department revise U.S. model tax
treaties once per Congress).
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``Most favored nation'' agreement with Mexico
The adoption of a zero-rate provision in the U.S.-U.K.
treaty relationship may have particular ramifications for the
U.S.-Mexico treaty relationship. Under the current U.S.-Mexico
income tax treaty, dividends beneficially owned by a company
that owns at least 10 percent of the voting stock of the
dividend-paying company are subject to a maximum withholding
rate of 5 percent (paragraph 2(a) of Article 10 of the U.S.-
Mexico treaty), which is the lowest rate of withholding tax on
dividends currently available under U.S. treaties. Under
Protocol 1 to that treaty, as modified by a formal
understanding subject to which the treaty and protocol were
ratified, the United States and Mexico have agreed, if the
United States adopts a rate on dividends lower than 5 percent
in a treaty with another country, ``to promptly amend [the
U.S.-Mexico treaty] to incorporate that lower rate.'' \27\
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\27\ This formal understanding was a response to an objection
raised by the Committee to the original language of the treaty
protocol, under which the ``most-favored nation'' provision would have
been self-executing--i.e., immediately upon U.S. agreement to a lower
rate with another treaty partner, the United States and Mexico would
have begun applying that lower rate in their treaty.
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Adopting the zero-rate provision in the proposed treaty
would trigger this obligation to amend the current treaty with
Mexico. The recently signed proposed protocol with Mexico would
amend that treaty to incorporate a zero-rate provision
substantially identical to that of the proposed treaty with the
United Kingdom, and thus would seem to fulfill the U.S.
obligation under the ``most favored nation'' agreement. Thus,
if the Senate were to ratify both the proposed treaty with the
United Kingdom and the proposed protocol with Mexico, no issues
of interaction between the two treaty relationships would need
to be confronted.
If, on the other hand, the Senate were to ratify the
proposed treaty with the United Kingdom, but not the proposed
protocol with Mexico, then the possibility would arise that the
United States eventually could be regarded as falling out of
compliance with its obligations under the U.S.-Mexico treaty.
This would raise difficult questions as to the exact nature of
this obligation and whether and how the United States would
come into compliance with it.
B. Anti-Conduit Rule
In general
The proposed treaty includes an anti-conduit rule that can
operate to deny the benefits of the dividends article (Article
10), the interest article (Article 11), the royalties article
(Article 12), the other income article (Article 22), and the
insurance excise tax provision of the business profits article
(Article 7(5)).\28\ This rule is not found in any other U.S.
treaty, and it is not included in the U.S. or OECD models. The
rule is similar to, but significantly narrower and more precise
than, the ``main purpose'' rules that the Senate rejected in
1999 in connection with its consideration of the U.S.-Italy and
U.S.-Slovenia treaties.\29\
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\28\ The issues raised by the proposed anti-conduit rule in the
context of the insurance excise tax differ from those raised in
connection with the other articles. Issues relating to the insurance
excise tax are discussed separately in Part IV.C of this pamphlet. The
present discussion of the rule is limited to the issues raised in the
context of the dividends, interest, royalties, and other income
articles.
\29\ See Senate Committee on Foreign Relations, Report, Tax
Convention with Italy, Exec. Rpt. 106-8, Nov. 3, 1999; Senate Committee
on Foreign Relations, Report, Tax Convention with Slovenia, Exec. Rpt.
106-7, Nov. 3, 1999; see also Joint Committee on Taxation, Explanation
of Proposed Income Tax Treaty and Proposed Protocol between the United
States and the Italian Republic (JCS-9-99), October 8, 1999; Joint
Committee on Taxation, Explanation of Proposed Income Tax Treaty
between the United States and the Republic of Slovenia (JCS-11-99),
October 8, 1999.
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The rule was included at the request of the United Kingdom,
which has similar provisions in many of its tax treaties. The
purpose of the rule, from the U.K. perspective, is to prevent
residents of third countries from improperly obtaining the
reduced rates of U.K. tax provided under the treaty by
channeling payments to a third-country resident through a U.S.
resident (acting as a ``conduit'').
From the U.S. perspective, the rule is unnecessary, because
U.S. domestic law provides detailed rules governing
arrangements to reduce U.S. tax through the use of
conduits.\30\ Thus, apart from accommodating the request of a
treaty partner, no apparent U.S. interest is served by adding a
general anti-conduit rule to the treaty.
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\30\ See Code sec. 7701(l); Treas. Reg. sec. 1.881-3.
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Description of provision
Under the proposed anti-conduit rule, the benefits of the
dividends, interest, royalties, and other income articles are
denied in connection with any payment made under, or as part
of, a ``conduit arrangement'' (Articles 10(9), 11(7), 12(5),
and 22(4), respectively). Article 3(1)(n) defines the term
``conduit arrangement'' as a transaction or series of
transactions that meets both of the following criteria: (1) a
resident of one contracting state receives an item of income
that generally would qualify for treaty benefits, and then pays
(directly or indirectly, at any time or in any form) all or
substantially all of that income to a resident of a third state
who would not be entitled to equivalent or greater treaty
benefits if it had received the same item of income directly;
and (2) obtaining the increased treaty benefits is the main
purpose or one of the main purposes of the transaction or
series of transactions.
The inclusion of the first criterion above limits the scope
of the rule to situations involving objectively defined conduit
payments. Thus, the rule is less vague and more narrowly
targeted than the similar rules that the Senate rejected in the
proposed U.S.-Italy and U.S.-Slovenia treaties, which would
have applied to any transaction that met a ``main purpose''
test similar to the second criterion described above.
Issues
Although the proposed anti-conduit rule is considerably
narrower and more objective than the similar rules rejected by
the Senate in 1999, the rule is also without precedent in
existing U.S. tax treaties, and thus the Committee may wish to
give it particular attention.
The rule may create confusion, because it applies not only
to conduit arrangements in which a reduction in U.K. tax is
claimed, but also to conduit arrangements in which a reduction
in U.S. tax is claimed, despite the fact that there is no
apparent reason for the rule to apply in the latter
circumstance, in view of the existence of anti-conduit
provisions under U.S. domestic law. To the extent that the
proposed treaty's anti-conduit rule and the U.S. domestic-law
anti-conduit rules are not consistent in every particular,
taxpayers may be confused as to which set of rules the United
States will apply in certain situations.\31\
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\31\ For example, the anti-conduit rules of U.S. domestic law
currently do not apply to transactions involving dividend payments on
common stock, but the anti-conduit rule in the proposed treaty could
apply to such transactions. (The Treasury Department has the authority
under Code section 7701(l) to apply anti-conduit principles to these
transactions, but it has not exercised this authority.)
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In order to mitigate this potential confusion, as well as
to provide guidance as to how the United Kingdom will apply the
anti-conduit rule in situations in which a reduction in U.K.
tax is claimed, the parties executed an exchange of letters in
July 2002, in which they described in some detail how they
intend to apply the anti-conduit rule.\32\
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\32\ See Letter from Barbara M. Angus, International Tax Counsel,
Department of the Treasury, to Gabriel Makhlouf, Director, Inland
Revenue, International Division, July 19, 2002 (the ``U.S. letter'');
Letter from Gabriel Makhlouf, Director, Inland Revenue, International
Division, to Barbara M. Angus, International Tax Counsel, Department of
the Treasury, July 19, 2002 (the ``U.K. letter''). These letters are
appended to the Technical Explanation.
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The U.S. letter suggests that the United States simply will
continue to apply its domestic law, without regard to the
treaty rule:
With respect to the United States, we intend to
interpret the conduit arrangement provisions of the
Convention in accordance with U.S. domestic law as it
may evolve over time. The relevant law currently
includes in particular the rules of regulation section
1.881-3 and other regulations adopted under the
authority of section 7701(l) of the Internal Revenue
Code. Therefore, the inclusion of the conduit
arrangement rules in the Convention does not constitute
an expansion (or contraction) of U.S. domestic anti-
abuse principles (except with respect to the
application of anti-conduit principles to the insurance
excise tax).\33\
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\33\ U.S. letter, at 1. Similar language appears in the Technical
Explanation to article 3(1).
An annex to the U.S. letter provides six examples illustrating
how the United States intends to apply the rule in a manner
consistent with current U.S. domestic law.\34\
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\34\ For example, the letter indicates that the United States will
not apply anti-conduit principles to a transaction involving dividends
on common stock, because the transaction is not covered by the current
U.S. domestic anti-conduit rules. Annex to the U.S. letter, Example 2.
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This statement of intent from the U.S. perspective should
substantially mitigate the potential uncertainty regarding how
the United States will treat conduit arrangements.
Nevertheless, some may find it difficult to understand why,
given this intent, the rule in the proposed treaty was drafted
to apply to situations addressed by U.S. domestic law in the
first place.
The U.K. letter includes an annex that evaluates examples
analogous to those set forth in the annex to the U.S. letter,
reaching results consistent with those of the U.S. letter. The
U.K. letter thus provides helpful guidance as to how the anti-
conduit rules of the proposed treaty will be applied in cases
in which a reduction in U.K. tax is claimed.
The Committee may wish to satisfy itself that these
measures adequately address the potential confusion and
uncertainty that could arise from including an anti-conduit
rule in the proposed treaty. The Committee also may wish to
satisfy itself that that the Treasury Department has agreed to
this provision solely as an accommodation to the United Kingdom
and does not intend to include similar provisions in future
treaties.
C. Insurance Excise Tax
The proposed treaty, like the present treaty, waives the
application of the U.S. insurance excise tax on foreign
insurers and reinsurers. Thus, for example, a U.K. insurer or
reinsurer generally may receive premiums on policies with
respect to U.S. risks free of this tax. As further discussed
below, waiver of this tax may raise concerns if a substantial
tax is not imposed by the United Kingdom or a third country on
the foreign insurer or reinsurer.
Unlike the present treaty, the proposed treaty incorporates
an anti-conduit rule to prevent persons not entitled to
equivalent or more favorable treaty benefits from obtaining the
benefit of the insurance excise tax waiver under the proposed
treaty. The addition of an anti-conduit rule in the proposed
treaty makes the proposed treaty more comparable than the
present treaty to other U.S. treaties that provide waivers of
the application of the insurance excise tax (with anti-conduit
rules). Thus, the rule of the proposed treaty may be viewed as
an improvement over the rule of the present treaty, which
provides a waiver of the insurance excise tax without any anti-
conduit rule.
The anti-conduit rule in the proposed treaty differs from
insurance excise tax anti-conduit rules in other U.S. tax
treaties; in particular, the rule in the proposed treaty
incorporates a ``main purpose'' test. That is, the anti-conduit
rule in the proposed treaty applies only if the conduit
arrangement has as its main purpose, or one of its main
purposes, obtaining such increased benefits as are available
under the proposed treaty. The main purpose test apparently is
modeled after similar ``main purpose'' provisions found in
treaties of other countries, such as many of the modern
treaties of the United Kingdom. The ``main purpose'' aspect of
the proposed treaty's anti-conduit rule presents some issues.
Specifically, the test is subjective and lacks conformity with
the relevant provisions of most other U.S. tax treaties.
The Technical Explanation to the proposed treaty, however,
states that the United States intends to interpret the conduit
arrangement provisions of the proposed treaty in accordance
with U.S. domestic law, as it may evolve over time, and further
states in the context of the waiver of the insurance excise tax
that the United States will interpret the provision of the
proposed treaty by analogy to the anti-conduit rules of
regulation section 1.881-3. The interpretation of the anti-
conduit rule as applied to the insurance excise tax waiver in
the proposed treaty in a manner consistent with U.S. law may be
different from the interpretation and application of insurance
excise tax anti-conduit rules in other U.S. treaties.
Waivers of the insurance excise tax in other treaties have
raised serious congressional concerns. For example, concern has
been expressed over the possibility that such waivers may place
U.S. insurers at a competitive disadvantage with respect to
foreign competitors in U.S. markets if a substantial tax is not
otherwise imposed (e.g., by the treaty partner country) on the
insurance income of the foreign insurer or reinsurer.\35\
Moreover, in such a case, a waiver of the tax does not serve
the primary purpose of treaties to prevent double taxation, but
instead has the undesirable effect of eliminating all tax on
such income.
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\35\ See, e.g., U.S. Treasury Department, Report to Congress on the
Effect on U.S. Reinsurance Corporations of the Waiver by Treaty of the
Excise Tax on Certain Reinsurance Premiums, 90 TNT 71-31 (March 1990).
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The U.S.-Barbados and U.S.-Bermuda tax treaties each
contained such a waiver as originally signed. In its report on
the Bermuda treaty, the Committee expressed the view that those
waivers should not have been included. The Committee stated
that waivers should not be given by Treasury in its future
treaty negotiations without prior consultations with the
appropriate committees of Congress. Congress subsequently
enacted legislation to ensure the sunset of the waivers in the
two treaties.
The Committee may wish to satisfy itself that the U.K. tax
imposed on U.K. insurers and reinsurers on premium income
results in a burden that is substantial in relation to the U.S.
tax on U.S. insurers and reinsurers, and that the anti-conduit
rule in the proposed treaty is sufficient to prevent persons
not entitled to equivalent or more favorable treaty benefits
from obtaining the benefit of the insurance excise tax waiver.
D. Dividend Substitute Payments
The proposed treaty provides that, in the case of a
dividend paid by a U.S. company to a U.K. company that directly
or indirectly controls at least 10 percent of the voting power
of the U.S. company, the U.K. company generally is eligible for
a credit against U.K. tax for U.S. taxes that are payable by
the U.S. company in respect of the profits out of which such
dividend is paid.
However, the proposed treaty also provides an anti-abuse
rule that eliminates the U.K. indirect credit in certain
circumstances if the U.K. company receives an amount from a
U.S. resident that is equivalent to a dividend from the U.S.
company but is not an actual dividend from the U.S. company
(i.e., a dividend substitute payment). Specifically, the
proposed treaty provides that a U.K. company is not eligible
for a credit against U.K. tax for U.S. taxes paid if and to the
extent that (1) the United Kingdom treats the dividend from the
U.S. company as beneficially owned by a U.K. resident, (2) the
United States treats the same dividend as beneficially owned by
a U.S. resident, and (3) the United States allows a deduction
to a resident of the United States in respect of an amount
determined by reference to the dividend. This anti-abuse
provision is not found in any other U.S. treaty, and is not
included in the U.S. model or the OECD model.
The Technical Explanation provides the following example to
illustrate the operation of the exception for certain dividend
substitute payments: A U.S. holding company sells stock in
another U.S. company to a U.K. company. Simultaneously, the
U.S. holding company enters into a repurchase agreement with
the U.K. company that allows the U.S. holding company to buy
back the stock at a predetermined price. The sale and the
repurchase agreement are structured in such a way that the
transactions are treated together as a loan for U.S. tax
purposes (with the dividends paid to the U.K. company treated
as payments of interest on a loan from the U.K. company to the
U.S. company). Because U.K. domestic law provides no mechanism
for similarly treating the sale and repurchase in accordance
with its economic substance, the United Kingdom would be
required to respect the form of the transaction as a sale and
grant an indirect credit with respect to dividends from the
U.S. company, resulting in double non-taxation of income.
In general, there are several types of cross-border
transactions (often referred to as ``hybrid'' transactions)
that take advantage of the interaction between (or among) the
tax laws of two (or more) jurisdictions, which can
independently give rise to different tax consequences under
each country's laws with respect to the same transaction.\36\
Some commentators argue that the interaction between U.S.
domestic tax laws and foreign tax laws can lead to unwarranted
tax arbitrage opportunities for taxpayers, particularly when
the foreign laws and the U.S. tax rules yield inconsistent tax
results for the same transaction.\37\ However, others contend
that the potential for tax arbitrage in cross-border
transactions is an unavoidable and acceptable consequence of
different laws and complex tax systems in the U.S. and other
countries that reflect the individual policy decisions of each
jurisdiction. In any case, many commentators argue that efforts
to combat cross-border tax arbitrage should be addressed in
general provisions of domestic law rather than specific tax
treaty provisions of limited jurisdictional and transactional
scope.\38\
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\36\ For a more detailed discussion of the cross-border tax issues
concerning the interaction of U.S. Federal tax laws with the laws of
foreign countries and tax treaties, see Joint Committee on Taxation,
Study of the Overall State of the Federal Tax System and
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of
the Internal Revenue Code of 1986 (JCS-3-01), April 2001 (vol. 1, pages
93-100).
\37\ For further discussion and analysis of the issues raised by
cross-border hybrid transactions, see Joint Committee on Taxation,
Description of Revenue Provisions Contained in the Fiscal Year 1999
Budget Proposal (JCS-4-98), February 24, 1998, at 193-196.
\38\ For example, although most recent U.S. tax treaties address
structural cross-border tax arbitrage (among other things) with
provisions concerning fiscally transparent entities, Congress enacted
894(c) in 1997 (Pub. L. No. 105-34) to deny certain treaty benefits to
foreign persons with regard to items of income derived through U.S.
entities that are treated as partnerships (or are otherwise treated as
fiscally transparent) for U.S. tax purposes. In addition, section
894(c) authorizes the Secretary of the Treasury to prescribe
regulations to determine, in situations other than the situation
specifically described in the statutory provision, the extent to which
a taxpayer shall not be entitled to benefits under an income tax treaty
of the United States with respect to any payment received by, or income
attributable to activities of, an entity that is treated as a
partnership for U.S. Federal income tax purposes (or is otherwise
treated as fiscally transparent for such purposes) but is treated as
fiscally non-transparent for purposes of the tax laws of the
jurisdiction of residence of the taxpayer.
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The issue raised by the dividend substitute payment
provision in the proposed treaty concerns the extent to which
treaties should depart from the U.S. model to address
transactional tax arbitrage and, specifically, whether the
proposed treaty should address cross-border transactions in a
manner that is categorically limited to a specific type of
transaction and, by definition, is limited to transactions
involving the United States and the United Kingdom.\39\ The
provision could be characterized as being simultaneously too
narrow and too broad. The provision might be too narrow in the
sense that it may be readily avoided through transactions that
are economically equivalent to the transactions covered by the
provision but, for example, involve payments other than
dividend substitute payments. On the other hand, the provision
might be too broad in that it applies to all transactions that
meet the specified conditions, without regard to whether the
transaction was entered into for tax-motivated purposes or for
legitimate business reasons.\40\ In this respect, the provision
is broader than the conduit arrangement provision in the
proposed treaty, which only applies if a main purpose of the
transaction is to obtain increased benefits under the proposed
treaty. In addition, whereas the conduit arrangement provision
can preclude either U.S. or U.K. tax benefits under the
proposed treaty, the provision concerning dividend substitute
payments only provides for the loss of U.K. tax benefits (i.e.,
U.K. indirect foreign tax credits) rather than U.S. tax
benefits (e.g., dividend substitute payment deductions),
although the very application of the provision is contingent
upon the deductibility of the payments under U.S. domestic tax
law.
---------------------------------------------------------------------------
\39\ Because the provision is limited on a transactional basis to
dividend substitute payments, it does not apply to several other types
of cross-border tax arbitrage transactions. For example, the provision
does not apply to multiple depreciation deductions that can be obtained
through certain cross-border leasing transactions in which a taxpayer
retains legal title to leased property in a country that provides
depreciation deductions based upon legal (rather than economic)
ownership of property, and transfers economic ownership of property to
another party in a different country in which depreciation deductions
are based upon economic (rather than legal) ownership. The provision is
also limited on a jurisdictional basis to dividend substitute payments
that are made to the U.K. By contrast, although Congress enacted
section 894(c) in response specifically to the use of fiscally
transparent U.S. subsidiaries by Canadian corporations to obtain
multiple tax benefits, section 894(c) is not limited to transactions
involving Canada.
\40\ The Technical Explanation suggests that the provision is
targeted appropriately because it will only apply with respect to
transactions involving persons who own more than 10 percent of the U.S.
company paying the dividends. The Technical Explanation states further
that the repurchase price with respect to most sale-repurchase
agreements reflects the current cost of funds, and is not determined by
reference to the dividends paid on the stock. Consequently, the
Technical Explanation concludes that the provision should not (and is
not intended to) affect most sale-repurchase agreements and similar
transactions that take place in the public markets.
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The Committee might wish to consider the advisability of a
treaty anti-abuse provision that is limited to denying U.K.
indirect foreign tax credits for specific types of cross-border
transactions, particularly if the provision in the proposed
treaty can be avoided through transactions that are
economically equivalent to the transactions covered by the
provision. In addition, because the provision is unique to the
proposed treaty and the application of the provision is not
conditioned upon the presence of a tax-motivated purpose, the
Committee might wish to consider whether the provision could
have the unintended effect of discouraging certain legitimate
non-tax motivated cross-border securities repurchase and
securities lending arrangements between taxpayers in the United
States and the United Kingdom, particularly in relation to such
transactions between taxpayers in the United States and another
country. The Committee also might wish to consider under which
circumstances rules against transactional tax arbitrage are
more appropriately implemented in generally applicable U.S.
domestic tax laws rather than narrow provisions in tax treaties
with certain countries.
E. Attribution of Business Profits
Background
Present treaty
The present treaty provides that business profits are
attributed to a permanent establishment based upon an arm's-
length pricing approach in which the permanent establishment is
allocated an amount of profits that it might be expected to
earn if it were a distinct and separate enterprise that is
engaged in the same or similar activities under the same or
similar conditions and deals wholly independently with the
enterprise of which it is a permanent establishment (often
referred to as the ``separate enterprise'' principle). In
determining the amount of business profits attributable to a
permanent establishment, the present treaty provides for the
deduction of expenses incurred for the purposes of the
permanent establishment, including a reasonable allocation of
executive and general administrative expenses, research and
development expenses, interest, and other expenses incurred for
the purposes of the enterprise as a whole (or the part of the
enterprise that includes the permanent establishment), whether
incurred in the treaty country in which the permanent
establishment is situated or elsewhere.
In general, the present treaty follows the OECD model in
its approach to attributing business profits to a permanent
establishment. Nevertheless, the rules under the present treaty
for the attribution of business profits to a permanent
establishment have been the subject of considerable commentary
and debate, particularly in relation to U.S. domestic tax rules
for determining the amount of interest expense that a foreign
corporation may deduct against the U.S. taxable income of the
foreign corporation.
U.S. domestic tax law
Under the general authority of section 482, U.S. domestic
tax law provides the Secretary of the Treasury the power to
make reallocations wherever necessary in order to prevent
evasion of taxes or to clearly reflect the income of related
enterprises. Under regulations, the Treasury Department
implements this authority using an arm's-length standard, and
has indicated its belief that the standard it applies under
section 482 is fully consistent with the arm's-length standard
provided in most U.S. tax treaties, including the present and
proposed treaties with the United Kingdom.\41\
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\41\ The current OECD report on transfer pricing generally approves
the methods that are incorporated in the current Treasury regulations
under section 482 as consistent with the arm's-length principles upon
which Article 9 (Associated Enterprises) of the present and proposed
treaties, and Article 7 (Business Profits) of the proposed treaty, are
based. See OECD Committee on Fiscal Affairs, ``Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrators''
(1995).
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For purposes of determining the amount of interest expense
that a foreign corporation engaged in a U.S. trade or business
is permitted to deduct against U.S. taxable income, U.S.
domestic tax law requires the use of an allocation formula that
generally involves measuring the total assets and liabilities
of a U.S. trade or business with a ``constructed'' (rather than
actual) balance sheet for the U.S. trade or business, and then
apportioning the interest expense (using a mathematical
formula) among the tax jurisdictions that claim primary taxing
rights over the portions of the whole enterprise of which the
U.S. trade or business is a part.\42\ In contrast to this
method, allocations using an arm's-length standard generally
are based upon the actual business records and accounts of the
enterprise, including the records of branches on the basis of
treating them as distinct and separate enterprises, with any
adjustments that may be necessary to impute adequate capital to
the branches and to ensure that any interbranch transactions
taken into account have economic substance and market pricing.
---------------------------------------------------------------------------
\42\ See Treas. Reg. sec. 1.882-5.
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In applying an allocation formula to determine U.S.
interest expense, the U.S. domestic tax laws require the
foreign corporation to completely disregard interbranch
transactions, such as loans between a U.S. branch of the
foreign corporation and its head office. Thus, whereas
allocations using an arm's-length standard permit adjustments
to interbranch transactions only to the extent necessary to
reflect economic substance and market pricing, the allocation
formula under U.S. domestic tax laws wholly disregards such
transactions without any inquiry into their substance or
pricing. Although the allocation formula of U.S. domestic tax
law clearly applies to foreign corporations from countries that
do not have a tax treaty with the United States, the rules also
provide that they apply to foreign corporations from countries
that do have a tax treaty with the United States.
In published rulings, the Treasury Department has taken the
position that the allocation formula under U.S. domestic tax
law (including the disregard of interbranch transactions) is
consistent with treaty provisions that govern the attribution
of business profits to a U.S. permanent establishment of a
foreign corporation that is resident in the other treaty
country.\43\ The Treasury Department has expressed the same
view in the technical explanations of several recently
negotiated treaties,\44\ as well as the technical explanation
of the U.S. model treaty. However, the position of the Treasury
Department has been controversial and, in the case of the
present treaty with the United Kingdom, recently has been
rejected by the U.S. Court of Federal Claims, which concluded
that the arm's-length standard mandated by the present treaty
fundamentally conflicts with formula-based allocation and, in
particular, the U.S. domestic tax laws that mandate an
allocation formula and disregard any interbranch
transactions.\45\
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\43\ See Rev. Rul. 85-7, 1985-1 C.B. 188 (income tax treaty between
the United States and Japan); Rev. Rul. 89-115, 1989-2 C.B. 130
(present treaty between the United States and the United Kingdom).
\44\ See, e.g., Technical Explanations of Tax Conventions with: The
Republic of Austria, Treaty Doc. 104-31; The French Republic, Treaty
Doc. 103-32; The Federal Republic of Germany, Treaty Doc. 101-10;
Ireland, Treaty Doc. 105-31; The United Mexican States, Treaty Doc.
103-7; The Kingdom of The Netherlands, Treaty Doc. 103-6; The
Portuguese Republic, Treaty Doc. 103-34; The Swiss Confederation,
Treaty Doc. 105-8; The Kingdom of Thailand, Treaty Doc. 105-2; and The
Republic of Turkey, Treaty Doc. 104-31.
\45\ National Westminster Bank, PLC v. United States, 44 Fed. Cl.
120 (1999); see also North West Life Assurance Co. of Canada v.
Commissioner, 107 T.C. 363 (1996).
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Proposed treaty
Like the present treaty, the proposed treaty includes
provisions that attribute the business profits of an enterprise
to a permanent establishment on the basis of treating the
permanent establishment as if it were independent from the
enterprise of which it is a permanent establishment. The
provisions in the proposed treaty concerning attribution of
business profits to a permanent establishment generally are
similar to provisions in the U.S. model and OECD model, except
for additional language in the proposed treaty that further
limits the attribution of business profits to a permanent
establishment on the basis of risks assumed (as well as assets
used and activities performed) by the permanent establishment.
The proposed treaty also does not include a provision from the
U.S. model and OECD model that would preclude the attribution
of business profits to a permanent establishment that solely
purchases goods or merchandise for the enterprise, apparently
because this provision is inconsistent with the arm's-length
standard.
The diplomatic notes state that the OECD Transfer Pricing
Guidelines apply by analogy in determining the profits
attributable to a permanent establishment. With respect to
financial institutions (other than insurance companies), the
diplomatic notes state that a treaty country may determine the
amount of capital to be attributed to a permanent establishment
by allocating the institution's total equity between (or among)
its various offices on the basis of the proportion of the
financial institution's risk-weighted assets attributable to
each office.
Issues
Attribution of business profits generally
The provisions in the proposed treaty that attribute
business profits to a permanent establishment present several
issues. One issue concerns the continuing viability of U.S.
domestic tax laws that require a formula-based allocation
method for purposes of attributing business profits to a
permanent establishment. The proposed treaty continues to apply
the arm's-length standard on the basis of language that is
substantially similar to the present treaty. In addition, the
proposed treaty actually enhances the application of the arm's-
length standard, for purposes of attributing business profits
to a permanent establishment, by extending the OECD Transfer
Pricing Guidelines and eliminating language that diverges from
the arm's-length standard. However, the Technical Explanation
does not indicate expressly whether the Treasury Department
maintains its view that the interest expense allocation formula
under U.S. domestic tax law is consistent with the arm's-length
standard under the proposed treaty. Instead, the Technical
Explanation appears to indicate that, to the extent the tax
consequences of applying the allocation formula under U.S.
domestic law diverges from the consequences of applying the
arm's-length standard under the proposed treaty in determining
the interest expense of a U.S. permanent establishment, U.K.
residents with U.S. permanent establishments may effectively
elect to apply either approach.
The Committee may wish to satisfy itself that it
understands the current state of the Treasury Department
position concerning the continuing viability of the interest
expense allocation formula under U.S. domestic tax law within
the context of the proposed treaty, as well as existing and
future treaties.
Interbranch transactions
Another issue related to the interest expense allocation
formula under U.S. domestic tax law concerns the treatment of
interbranch transactions under the proposed treaty. As
described above, U.S. domestic tax law provides that
interbranch loans and other interbranch transactions are
completely disregarded in determining the amount of interest
expense deductions that are allowable against the U.S. taxable
income of a foreign corporation. By contrast, the Technical
Explanation indicates that interbranch transactions generally
may be respected under the proposed treaty.
The OECD commentary for the OECD model provision upon which
the proposed treaty is based provides that interbranch
transactions generally are recognized in attributing business
profits to a permanent establishment under arm's-length
standards, except for ``purely artificial arrangements''. The
OECD commentary does provide that interbranch transactions
should be disregarded unless they constitute the types of
transactions that the permanent establishment would have
otherwise conducted with unrelated third parties in the normal
course of their business. In this regard, the OECD commentary
states that interbranch lending transactions and interest
generally should be disregarded, although ``special
considerations'' are to be given to recognizing interbranch
lending transactions of financial institutions. As with
formula-based allocations in general, the Treasury Department
position that disregarding interbranch transactions altogether
under U.S. domestic tax law is consistent with the arm's-length
standard has been rejected in court with respect to interbranch
lending transactions involving financial institutions.
The Committee may wish to satisfy itself that it
understands the current state of the Treasury Department
position concerning the continuing viability of disregarding
interbranch transactions for purposes of the interest expense
allocation formula under U.S. domestic tax law within the
context of the proposed treaty, as well as existing and future
treaties.
OECD interpretation of business profits attribution
Another issue concerns the currently evolving OECD
interpretation of the provisions in the OECD model that provide
for attributing business profits to a permanent establishment,
which are substantially similar to the provisions in the
proposed treaty for business profits attribution. In February
2001, the OECD published a discussion draft in which the OECD
considered how to further integrate the arm's length standards
of the 1995 OECD Transfer Pricing Guidelines into the business
profits attribution provisions in the OECD model.\46\ The OECD
discussion draft is significant for purposes of the proposed
treaty because the diplomatic notes state that the OECD
Transfer Pricing Guidelines are to apply by analogy for
purposes of determining the business profits that are
attributable to a permanent establishment under the proposed
treaty.
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\46\ See OECD Committee on Fiscal Affairs, ``Discussion Draft on
the Attribution of Profits to Permanent Establishment'' (2001). The
OECD has indicated that it expects to release on March 4, 2003 a
revised version of the discussion draft as it pertains to permanent
establishments of banks. The OECD also has indicated that it expects to
release in March 2003 a revised version of the discussion draft as it
pertains to global trading of financial instruments.
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The OECD discussion draft generally attempts to outline a
comprehensive approach that would apply the arm's-length
standard under the OECD Transfer Pricing Guidelines to a
permanent establishment in a manner similar to the current
treatment of affiliated entities under the provisions of the
OECD model concerning associated enterprises. However, it is
clear from the OECD discussion draft that extending the OECD
Transfer Pricing Guidelines to permanent establishments is
problematic in several respects, and the OECD discussion draft
expresses concern with respect to the lack of consensus among
OECD members regarding the manner in which the arm's-length
standard in the OECD Transfer Pricing Guidelines can
accommodate the basic operational differences that exist
between permanent establishments and affiliated entities. For
example, the lack of documentation relating to interbranch
transactions tends to be more prevalent than with respect to
transactions between affiliated entities.
The OECD discussion draft devotes considerable attention to
the application of the OECD Transfer Pricing Guidelines to bank
branches and, in particular, the manner in which the arm's-
length standard should take into account the financial risks
assumed by a bank branch for purposes of allocating capital to
the branch. For bank branches, the OECD discussion draft
proposes a risk-based attribution of business profits using the
1988 capital measurement and capital adequacy standards set
forth by the Basel Committee on Bank Supervision. The proposed
treaty contemplates a similar risk-based approach by limiting
the attribution of business profits to a permanent
establishment on the basis of risks assumed (as well as assets
used and activities performed) by the permanent establishment.
However, attributing business profits to bank branches on the
basis of non-tax regulatory standards is problematic for
several reasons, including regulatory competition and arbitrage
among regulatory jurisdictions.
Because the diplomatic notes adopt the OECD Transfer
Pricing Guidelines with regard to attributing business profits
to a permanent establishment, the proposed treaty is
effectively committed to the outcome of the currently evolving
and somewhat controversial interpretation of the arm's-length
standard that was proposed in the OECD discussion draft. The
Committee may wish to consider the potential implications of
the eventual OECD interpretation on the future application of
the proposed treaty with regard to the attribution of business
profits to a permanent establishment.
F. Income From the Rental of Ships and Aircraft
The proposed treaty includes a provision found in the U.S.
model and many U.S. income tax treaties under which profits
from an enterprise's operation of ships or aircraft in
international traffic are taxable only in the enterprise's
country of residence. This provision includes income from the
rental of ships and aircraft on a full basis (i.e., with crew)
when such ships and aircraft are used in international traffic.
However, in the case of profits derived from the rental of
ships and aircraft on a bareboat basis (i.e., without crew),
the rule limiting the right to tax to the country of residence
applies to such rental profits only if the rental income is
incidental to other income of the lessor from the operation of
ships and aircraft in international traffic. If the lease is
not merely incidental to the international operation of ships
and aircraft by the lessor, then profits from rentals on a
bareboat basis generally would be taxable by the source country
as business profits (if such profits are attributable to a
permanent establishment).
In contrast, the U.S. model and many other treaties provide
that profits from the rental of ships and aircraft operated in
international traffic on a bareboat basis are taxable only in
the country of residence, without requiring that the rental
income be incidental to other profits of the lessor from the
international operation of ships and aircraft. Thus, unlike the
U.S. model, the proposed treaty provides that an enterprise
that engages only in the rental of ships and aircraft on a
bareboat basis, but does not engage in the operation of ships
and aircraft, would not be eligible for the rule limiting the
right to tax income from operations in international traffic to
the enterprise's country of residence. It should be noted that,
under the proposed treaty, profits from the use, maintenance,
or rental of containers used in international traffic are
taxable only in the country of residence, regardless of whether
the recipient of such income is engaged in the operation of
ships or aircraft in international traffic. The Committee may
wish to consider whether the proposed treaty's rules treating
profits from certain rentals of ships and aircraft on a
bareboat basis less favorably than profits from the operation
of ships and aircraft (or from the rental of ships and aircraft
with crew) are appropriate.
G. Creditability of U.K. Petroleum Revenue Tax
Treatment under the proposed treaty
The proposed treaty extends coverage to the U.K. Petroleum
Revenue Tax (paragraph 3(b)(iv) of Article 2 (Taxes Covered)).
Article 24 of the proposed treaty (Relief from Double Taxation)
further provides, among other things, that the U.K. Petroleum
Revenue Tax is to be considered an income tax that is
creditable against U.S. tax on income, subject to the
provisions and limitations of that provision of the proposed
treaty.
Specifically, the proposed treaty provides that the amount
that the United States will allow as a credit against U.S. tax
on income for U.K. Petroleum Revenue Taxes imposed on income
from the extraction of minerals from oil or gas wells is
limited to the amount attributable to U.K.-source taxable
income. The proposed treaty further limits the creditable
amount, however, to: (1) the product of the maximum statutory
U.S. rate applicable to a corporation (i.e., 35 percent) and
the amount of such extraction income; less (2) the amount of
other U.K. taxes imposed on such extraction income. The
proposed treaty provides that U.K. Petroleum Revenue Taxes from
the extraction of minerals from oil or gas wells in excess of
the above limitation may be used as a credit in the two
preceding or five succeeding taxable years in accordance with
the limitation described above. The proposed treaty further
provides that its special rules on creditability apply
separately and in the same way to the amount of U.K. Petroleum
Revenue Tax imposed on income from the initial transportation,
initial treatment, and initial storage of minerals from oil or
gas wells in the United Kingdom.
To the extent that a taxpayer would obtain a more favorable
result with respect to the creditability of the U.K. Petroleum
Revenue Tax under the Code than under the proposed treaty, the
taxpayer could choose not to rely on the proposed treaty.\47\
The Technical Explanation to Article 24 of the proposed treaty
states that if a person chooses in any year not to rely on the
proposed treaty to claim a credit for U.K. Petroleum Revenue
Taxes, then the special limitations under the proposed treaty
would not apply for that year. Instead, the current overall
foreign tax credit limitations of the Code would apply, and
U.K. Petroleum Revenue Taxes creditable under the Code could be
used, subject to the Code's limitations, to offset U.S. tax on
other income from U.K. and other foreign sources.
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\47\ See paragraph 2 of Article 1 of the proposed treaty (General
Scope), and accompanying description in the Technical Explanation.
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Thus, the proposed treaty operates to create a separate
``per country'' limitation with respect to each U.S. category
of extraction income, and initial transportation, treatment,
and storage income on which U.K. Petroleum Revenue Tax is
assessed. Accordingly, U.K. Petroleum Revenue Tax paid with
respect to extraction income cannot be used as a credit to
offset U.S. tax on: (1) oil and gas extraction income arising
in another country; (2) U.K.-source transportation, treatment,
or storage income on which U.K. Petroleum Revenue Tax is
assessed; or (3) other U.K.-source non-oil related income.
U.K. internal law
The U.K. Petroleum Revenue Tax, introduced in 1975, is
currently imposed at a rate of 50 percent on assessable profits
from oil and gas extraction and certain other activities in the
United Kingdom (including the North Sea) on a field-by-field
basis. Under a separate Ring Fence Tax, oil and gas companies
are required to segregate their income and expenses
attributable to oil and gas related activities, and pay a
separate corporate income tax for taxable income from unrelated
activities. The U.K. Petroleum Revenue Tax is imposed in
addition to, and separate from, this Ring Fence Tax. The amount
of U.K. Petroleum Revenue Tax paid is allowed as a deduction
for purposes of computing the Ring Fence Tax. The U.K.
Petroleum Revenue Tax applies to fields approved for
development on or before March 15, 1993. Revenues from fields
approved after March 15, 1993, are only subject to regular U.K.
corporate income tax.
The U.K. Petroleum Revenue Tax is imposed on income
relating to the extraction of oil and gas in the United Kingdom
including such areas as the North Sea, income earned by
taxpayers providing transportation, treatment, and other
services relating to oil and gas resources in such areas, and
income relating to the sale of such oil and gas related assets.
With the exception of interest expense, most significant costs
and expenses are currently deductible in determining taxable
income. Operating losses may be carried back or forward without
limit to income associated with a particular field.
Various other deductions and allowances are available
against income assessed for these purposes, including: a
supplemental uplift charge equal to 35 percent of most capital
expenditures relating to a field; an oil allowance or exemption
from the U.K. Petroleum Revenue Tax for each field up to a
certain amount of metric tons of oil; a tariff receipts
allowance for transportation receipts up to a certain amount,
and certain non-field specific expenses such as research.
Issues
The proposed treaty treats the U.K. Petroleum Revenue Tax,
and any substantially similar tax, as a creditable tax for U.S.
foreign tax credit purposes. The United States Tax Court has
recently addressed the creditability under the Code and the
regulations under Code section 901 of the U.K. Petroleum
Revenue Tax in the case of Exxon v. Commissioner.\48\
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\48\ 113 T.C. 338 (1999).
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In Exxon v. Commissioner, the United Kingdom granted
licenses to Exxon for the exploitation of petroleum resources
in the U.K.'s segment of the North Sea. Under those licenses,
Exxon paid royalties, upfront fees, and annual fees. After the
grant of the licenses, the U.K. enacted a modified version of
the U.K. corporate income tax (the Ring Fence Tax) and the U.K.
Petroleum Revenue Tax for oil production activities. The Tax
Court considered whether the U.K. Petroleum Revenue Tax
satisfied the net income requirement under the section 901
regulations and whether the U.K. Petroleum Revenue Tax was paid
in exchange for a specific economic benefit (e.g., a royalty
and not a tax). With respect to the net income issue, the court
held that, notwithstanding the nondeductibility of interest
expense in computing taxable income, the various allowances
against the U.K. Petroleum Revenue Tax (particularly the 35
percent uplift charge which based on the Court's findings
significantly exceeded interest expense) resulted in the
predominant character of the tax being in the nature of an
income or profits tax in the U.S. sense. With respect to the
specific economic benefit issue, the court held that the U.K.
Petroleum Revenue Tax paid for the years in question (1983-
1988) constituted taxes and not payments for specific economic
benefits. In so holding, the court relied on the fact that
Exxon acquired its licenses to extract oil from the North Sea
before the U.K. Petroleum Revenue Tax was enacted and that it
received no new or additional benefits as a result of paying
the U.K. Petroleum Revenue Tax.\49\ The court thus found the
U.K. Petroleum Revenue Tax paid by Exxon to be creditable under
U.S. law.
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\49\ The Court further based its holding that Exxon did not pay the
U.K Petroleum Revenue Tax in exchange for specific economic benefits
based on the following: (1) the royalties and other fees paid by Exxon
represented substantial and reasonable compensation, (2) the U.K.'s
purposes in enacting the U.K. Petroleum Revenue Tax was to take
advantage of increases in oil prices and to assure itself of a share of
those excess profits, and (3) the U.K. Petroleum Revenue Tax had all of
the characteristics of a tax and was intended to be a tax.
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The Internal Revenue Service acquiesced in the Exxon
decision, but only as to its results.\50\ The Internal Revenue
Service indicated in its acquiescence that it will only follow
the opinion in disposing of cases involving the U.K. Petroleum
Revenue Tax where the facts are substantially similar to those
in the Exxon case. Since such determinations are inherently
factual, the determination of the creditability of the U.K.
Petroleum Revenue Tax under U.S. law as a general matter is
unclear.
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\50\ 2001-31 I.R.B. 98 (August 20, 2001).
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If the U.K. Petroleum Revenue Tax would generally be
considered creditable under the Code, then there may be a
question as to the need for the additional limitations provided
under the proposed treaty for determining the amount of
creditable U.K. Petroleum Revenue Tax. Taxpayers are likely to
rely on the proposed treaty only to the extent that it provides
them with a more favorable foreign tax credit result than would
otherwise result from the application of the Code. In addition,
since the U.K. Petroleum Revenue Tax has been eliminated with
respect to fields approved after March 15, 1993, it is unclear
to what extent these creditability issues will remain important
in future years.
On the other hand, to the extent that it is unclear whether
the U.K. Petroleum Revenue Tax is generally considered to be
creditable under U.S. law, the primary issue is the extent to
which treaties should be used to provide a credit for taxes
that may not otherwise be fully creditable and, in cases where
a treaty does provide creditability, to what extent the treaty
should impose limitations not contained in the Code. A related
issue is whether a controversial matter in U.S. tax policy such
as the tax credits to be allowed U.S. oil companies on their
foreign extraction operations should be resolved through the
treaty process rather than through the normal legislative
process.
Similar provisions making Denmark's Hydrocarbon Tax,
Norway's Submarine Petroleum Resource Tax, and the
Netherlands's Profit Share creditable are contained in the
U.S.-Denmark income tax treaty, the protocol to the U.S.-Norway
income tax treaty, and the U.S.-Netherlands income tax treaty,
respectively. Also at issue, therefore, is whether the United
Kingdom should be denied a special treaty credit for taxes on
oil and gas extraction income when Denmark, Norway, and the
Netherlands, its North Sea competitors, now receive a similar
treaty credit under the U.S. income tax treaties with those
countries currently in force. On the one hand, it would appear
fair to treat the United Kingdom like Denmark, Norway, and the
Netherlands. On the other hand, the United States should not
view any particular treaty concession to one country as
requiring identical or similar concessions to other countries.
The present treaty contains a similar provision providing
for the creditability of the U.K. Petroleum Revenue Tax. During
Senate consideration of the third protocol to the present
treaty, a reservation was proposed to apply similar per-country
limitations to prevent U.S. oil companies from using the U.K.
Petroleum Revenue Tax as a credit against their U.S. tax
liability on extraction income from other countries.\51\ The
reservation was withdrawn and the per-country limitations were
included in that protocol to the present treaty.
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\51\ The text of the proposed reservation is reprinted at 124 Cong.
Rec. S9559 (daily ed., June 27, 1978).
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The Committee may wish to satisfy itself as to whether, to
the extent that the creditability of the U.K. Petroleum Revenue
Tax is unclear under U.S. law, the proposed treaty is an
appropriate vehicle for granting such creditability.
H. Teachers, Students, and Trainees
Treatment under proposed treaty
General rule
The proposed treaty generally would not change the
application of income taxes to certain individuals who visit
the United States or United Kingdom as students, teachers,
academic researchers, or so-called ``business apprentices''
engaged in full-time training. The present treaty (Article 20)
provides that a professor or teacher who visits the United
States from the United Kingdom or the United Kingdom from the
United States for a period of two years or less to engage in
teaching or research at a university or college is exempt from
tax by the host country on any remuneration received for such
teaching or research. In addition, the present treaty (Article
21) provides that certain payments that a student or business
apprentice who visits the United States from the United Kingdom
or the United Kingdom from the United States to pursue full-
time education at a university or college or to engage in full-
time training are exempt from taxation by the host country. The
exempt payments are limited to those payments the individual
may receive for his or her maintenance, education or training
as long as such payments are from sources outside the host
country.
Under Article 20 of the proposed treaty, U.S. taxpayers who
are visiting the United Kingdom and individuals who immediately
prior to visiting the United States was resident in the United
Kingdom will be exempt from income tax in the host country on
certain payments received if the purpose of their visit is to
engage in full-time education at a university or college or to
engage in full-time training. The exempt payments are limited
to those payments the individual may receive for his or her
maintenance, education or training as long as such payments are
from sources outside the host country. In the case of
individuals engaged in full-time training, the exemption from
income tax in the host country applies only for a period of one
year or less.
Under Article 20A of the proposed treaty, U.S. taxpayers
who are visiting the United Kingdom and individuals who
immediately prior to visiting the United States was resident in
the United Kingdom will be exempt from income tax in the host
country on remuneration they receive for teaching or research
at a university, college, or other recognized educational
institution. The exemption is limited to visiting periods of
two years or less.
Transition rule
Under the entry in force provisions of the proposed treaty
(Article 29), taxpayers may elect temporarily to continue to
claim benefits under the present treaty with respect to a
period after the proposed treaty takes effect. For an
individual engaged in full-time training, Article 21 of the
present treaty would continue to have effect in its entirety
until such time as the individual had completed his or her
training. For some individuals this special rule may provide
benefits under the present treaty that exceed those available
under the general transition rule. The general transition rule
would provide that an individual would have the benefits of the
present treaty for twelve months from the date on which the
proposed treaty comes into force.
Issues
General rule
Teachers and professors.--Unlike the U.S. model, but like
the present treaty, the proposed treaty would provide an
exemption from the host country income tax for income an
individual receives from teaching or research in the host
country. Prior to amendment by the protocol, the proposed
treaty would have followed the U.S. model and no such exemption
would have been provided. Article 20 of the present treaty and
Article 20A of the proposed treaty provide that a teacher who
visits a country for the purpose of teaching or engaging in
research at a recognized educational institution generally is
exempt from tax in that country for a period not exceeding two
years. Under the proposed treaty, a U.S. person who is a
teacher or professor may receive effectively an exemption from
any income tax for income earned related to visiting the United
Kingdom for the purpose of engaging in teaching or research for
a period of two years or less. Under the terms of the treaty,
the United Kingdom would exempt any such income of a U.S.
person from U.K. income tax. Under Code sec. 911, $80,000 would
be exempt from U.S. income tax in 2003 through 2007,\52\ and in
addition certain living expenses would be deductible from
income. To the extent the U.S. teacher's or professor's
remuneration related to his or her visit to the United Kingdom
was less that $80,000, the income would be tax free. Likewise,
under the proposed treaty, a U.K. person who is a teacher or
professor may receive effectively an exemption from any income
tax for income earned related to visiting the United States for
the purpose of engaging in teaching or research for a period of
two years or less. Under the terms of the treaty, the United
States would exempt any such income from U.S. income tax. Under
the terms of U.K. tax law, such income generally would not be
taxable by the U.K. as the individual would not be resident in
the United Kingdom.
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\52\ For years after 2007, the $80,000 amount is indexed for
inflation after 2006 (Code sec. 911(b)(2)(D)).
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The effect of the proposed treaty is to make such cross-
border visits more attractive financially. Ignoring relocation
expenses, a U.S. citizen or permanent resident may receive more
net, after-tax remuneration from teaching or research from
visiting the United Kingdom as a teacher or researcher than if
he or she had remained in the United States. Likewise a U.K.
resident may receive more net, after-tax remuneration from
teaching or research from visiting the United States as a
teacher or researcher than if he or she had remained in the
United Kingdom. Increasing the financial reward may serve to
encourage cross-border visits by academics. Such cross-border
visits by academics for teaching and research may foster the
advancement of knowledge and redound to the benefit of
residents of both countries.
On the other hand, complete exemption from income tax in
both the United States and the United Kingdom may be seen as
unfair when compared to persons engaged in other occupations
whose occupation or employment may cause them to relocate
temporarily abroad. For a U.S. citizen or permanent resident
who is not a teacher or professor, but who temporarily takes up
residence and employment in the United Kingdom, his or her
income is subject to income tax in the United Kingdom and may
be subject income tax in the United States. Likewise, for a
U.K. resident who is not a teacher or professor, but who
temporarily takes up residence and employment in the United
States, his or her income is subject to income tax in the
United States. In other words, the proposed treaty could be
said to violate the principle of horizontal equity by treating
otherwise similarly economically situated taxpayers
differently.
The proposed treaty reverses the position of the originally
proposed treaty with respect to visiting teachers and
professors. Prior to amendment by the protocol, the proposed
treaty would have followed the U.S. model and no such exemption
would have been provided. While this is the position of the
U.S. model, an exemption for visiting teachers and professors
has been included in many bilateral tax treaties. Of the more
than 50 bilateral income tax treaties in force, 30 include
provisions exempting from host country taxation the income of a
visiting individual engaged in teaching or research at an
educational institution, and an additional 10 treaties provide
a more limited exemption from taxation in the host county for a
visiting individual engaged in research. Although the proposed
protocols with Australia and Mexico would not include similar
provisions, three of the most recently ratified income tax
treaties did contain such a provision.\53\
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\53\ The treaties with Italy, Slovenia, and Venezuela, each
considered in 1999, contain provisions exempting the remuneration of
visiting teachers and professors from host country income taxation. The
treaties with Denmark, Estonia, Latvia, and Lithuania, also considered
in 1999, did not contain such an exemption, but did contain a more
limited exemption for visiting researchers.
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The Committee may wish to satisfy itself that the inclusion
of such an exemption for a limited class of individuals is
appropriate. Looking beyond the U.S.-U.K. treaty relationship,
the Committee may wish to determine whether the inclusion of
the exemption from host country taxation for visiting teachers
and professors signals a broader shift in U.S. tax treaty
policy. Specifically, the Committee may want to know whether
the Treasury Department intends to pursue similar provisions in
other proposed treaties in the future and intends to amend the
U.S. model to reflect such a development.\54\
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\54\ More broadly, since the U.S. model has not been updated since
1996, the Committee may wish to ask whether the Treasury Department
intends to update the model to reflect all relevant developments that
have occurred in the intervening years. A thoroughly updated model
would provide a more meaningful and useful guide to current U.S. tax
treaty policy and would thereby increase transparency and facilitate
congressional oversight in this important area. See, Recommendations
for Simplification, Pursuant to Section 8002(3)(B) of the Internal
Revenue Code of 1986 (JCS-3-01), April 2001, Vol. II, at 445-47
(recommending that the Treasury Department revise U.S. model tax
treaties once per congress).
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Full-time students and persons engaged in full-time
training.--The present treaty has no limitation on the duration
of such training. As was the case for teachers and professors,
described above, the proposed treaty generally has the effect
of exempting payments received for the maintenance, education,
and training of full-time students and persons engaged in full-
time training as a visitor from the United States to the United
Kingdom or as a visitor from the United Kingdom to the United
States from the income tax of both the United States and the
United Kingdom. This conforms to the U.S. model and OECD model
provisions with respect to students and trainees.
This provision generally would have the effect of reducing
the cost of such education and training received by visitors.
The proposed treaty would narrow the exemption provided under
the current treaty to persons who are engaged in full-time
training by limiting the exemption in the case of a business
apprentice to payments made relating to training received
during a period of one year or less. (The exemption for full-
time students remains unchanged from the current treaty.) By
potentially subjecting such payments to host country income
tax, the cost for cross-border visitors of engaging in such
longer duration training programs would be increased. This may
discourage visitors to such programs in both the United States
and the United Kingdom. It could be argued that the training of
a business apprentice relates primarily to specific job skills
of value to the individual or the individual's employer rather
than enhancing general knowledge and cross-border
understanding, as may be the case in the university or college
education of a full-time student. This could provide a
rationale for providing more open-ended treaty benefits in the
case of students as opposed to business apprentices. However,
if this provides the underlying rationale, a question might
arise as to why training requiring one year or less is
preferred to training that requires a longer visit to the host
country. As such, the proposed treaty would favor certain types
of training arrangements over others.
Transition rule
The primary issue is the extent to which a special
transition rule should be included in U.S. tax treaties. It is
the staff's understanding that there is not a similar precedent
for such a special transition rule in other U.S. tax treaties.
The proposed treaty contains a general grandfather provision
that would allow taxpayers, including trainees, to continue to
apply the provisions of the present treaty for one year. It
could be argued that the general grandfather provision
sufficiently addresses the transition of all taxpayers into the
proposed treaty. It also could be argued that the special
transition rule for trainees results in disparate treatment for
other taxpayers that do not get the benefit of similar
transition rules for other provisions of the proposed treaty.
It further could be argued that this rule may be viewed as a
precedent to provide similar or possibly even broader
transition relief with respect to future revisions of existing
treaties for benefits that may not be viewed as appropriate or
consistent with current U.S. treaty policy or are otherwise
viewed as inconsistent with the purposes of an income tax
treaty.
On the other hand, the special transition rule presumably
was included to provide relief for trainees who may have based
their decisions to begin training upon the assumption that the
relevant provisions of the present treaty would apply to them.
The general one-year grandfather provision may not provide
complete relief for such individuals. There also may be a
general expectation among taxpayers that subsequently
renegotiated tax treaties generally do not restrict benefits
contained in existing treaties, but instead often provide
further benefits. It could be argued that these special
transition rules apply to a limited class of taxpayers and only
for a limited period of time beyond the general grandfather
period.
The Committee may wish to satisfy itself as to the
appropriateness of including a special transition rule such as
that described above in U.S. tax treaties.
<greek-d>