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A Deep Dive Into the United States-United Kingdom Income, Gift, and Estate Tax Treaties

A Deep Dive Into the United States-United Kingdom Income, Gift, and Estate Tax Treaties

By Anthony Diosdi


The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States -United Kingdom Income Tax Treaty.

There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the U.S. is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- United Kingdom Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States-United Kingdom Income Tax Treaty and the implications to individuals attempting to make use of the treaty.

Definition of Resident

The tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Income derived by a partnership or other pass-through entity is treated as derived by a resident of a treaty country to the extent that, under the domestic laws of that country, the income is treated as taxable to a person that qualifies as a resident of that treaty country. Under Article 4 of the U.S.-United Kingdom Income Tax Treaty, a resident is any person who, under a country’s internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation, or other criterion of a similar nature. Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. Whether a person is a resident of the United States or the United Kingdom for treaty purposes is determined by reference to the internal laws of each country.

Because the United States and United Kingdom have their own unique definition of residency, a person may qualify as a resident of both countries. For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of the United Kingdom under its definition of resident. To resolve this issue, the United States has included tie-breaker provisions in many of its income tax treaties. Tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. Article 4 of the United States-United Kingdom Income Tax Treaty provides the following tie-breaker for individuals:

a) The individual shall be deemed to be a resident of the Contracting State in which he
has a permanent home available to him in both States or in neither State, he shall be deemed to be a resident of the Contracting State with which his personal and economic relations are closer (centre of vital interests);

b) If the Contracting State in which he has his central of vital interests cannot be determined, he shall be deemed to be a resident of the Contracting State in which he has an habitual abode;

c) If he has an habitual abode in both States or in neither State, he shall be deemed to be a resident of the Contracting State of which he is a citizen; and

d) if he is a citizen of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

Below, please see Illustration 1 which provides an example how a treaty-tie breaker can be analyzed and resolved.

Illustration 1.

Jason Staham is a citizen and resident of Canada. Staham owns Action Films, a company incorporated in the United Kingdom that is in the process of expanding to the much more lucrative U.S. market by opening a branch office in the United States. Staham is divorced and maintains an apartment in London, where he spends every other weekend visiting his children. Staham’s first wife, who kept their house in their divorce, has never left the United Kingdom. Staham becomes a U.S. resident alien under the substantial presence test as he operates Action Film’s U.S. branch. In the United States Staham owns a luxury condominium in Manhattan where he lives with his second wife.

Because Staham is considered a resident of both the United States and United Kingdom, the treaty tie-breaker procedures must be analyzed to determine which country has primary taxing jurisdiction. With an apartment in London and a condominium in the United States, Staham has a permanent home available in both countries. With Staham’s children and his home office in the United Kingdom as opposed to the lucrative portion of his business and his new wife in the United States, Jason Staham does not have a center of vital interests in either country. Furthermore, because Staham regularly spends time in both countries, he arguably has a habitual abode in both. As a result, under the treaty tie-breaker, Jason Staham may be considered a resident of the United Kingdom because he is a citizen of the United Kingdom.

There is an exception to the principle that residence determines the availability of treaty benefits. Under the so-called savings clause provisions, a treaty country saves the right to tax its own citizens as though the treaty did not exist. For example, under Article 11(1) of the income tax treaty between the United States and the United Kingdom, interest received by U.K. residents is exempt from U.S. taxation. However, under Article 1(3) of the treaty, the United States reserves the right to tax the payee if a U.K. resident also is a U.S. citizen. As a consequence, the treaty does not impede the right of the United States to tax the worldwide income of U.S. citizens.

Estate and Gift Tax Treaty

The United States and United Kingdom have negotiated a separate estate and gift tax treaty. Article 8(5) of the United States-United Kingdom Estate and Gift Tax Treaty provides:

“Where property may be taxed in the United States on the death of a United Kingdom national who was neither domiciled in nor a national of the United States and a claim is made under this paragraph, the tax imposed in the United States shall be limited to the amount of tax which would have been imposed had the decedent become domiciled in the United States immediately before his death, on the property which would in that event have been taxable.”

The related U.S. Treasury Technical Explanation for this provision provides as follows:

“[Article 8] Paragraph (5) provides that U.S. tax imposed on the estate of a national of the United Kingdom, who was neither domiciled in nor a national of the United States, will not be greater than the tax which would have been imposed if the decedent had been domiciled in the United States and taxed by the United States on his worldwide property. Paragraph (5) does not require a formal election; the appreciation information need only be included in an estate tax return, which is filed or amended within the applicable time period.”

Article 8(5) could be beneficial to the estates of many nonresident citizens of the United Kingdom. This clause in the United States-United Kingdom Estate and Gift Tax Treaty likely exempts all U.S. situs assets owned by the estate from U.S. estate tax as long as the worldwide estate value does not exceed the U.S. applicable exclusion amount ($11.7 million for 2021).

Permanent Establishment

A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.

Article 5 of the United States-United Kingdom Income Tax Treaty defines a permanent establishment as: a) a branch; b) an office; c) a factory; d) a workshop; e) a mine, oil or gas well, quarry, or other place of extraction of natural resources; and f) a building or construction or installation project which exists for more than 12 months. The term “permanent establish” shall be deemed not a fixed place of business used for one or more of the following activities: a) the storage, display, or delivery of goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the enterprise for the purpose of storage, display or delivery; c) the maintenance of stock of goods or merchandise belonging to the enterprise for the purpose of processing by another person; e) the maintenance of a fixed place of business for the purpose of advertising, for the supply of information, for scientific research, or for similar activities which have a preparatory or auxiliary character, for the enterprise; or f) a building or construction or installation project which does not exist for more than 12 months.

A person acting in a Contracting State on behalf of an enterprise of the other Contracting State – other than an agent of an independent status shall be deemed to be a permanent establishment of the enterprise in the first-mentioned State if such person has, and habitually exercises in that State, an authority to conclude contracts in the name of the enterprise.

Thus, under Article 5 of the United States-United Kingdom Income Tax Treaty, a resident of a Contracting State shall not be deemed to have a permanent establishment in the other Contracting State merely because such resident carries on business in that other State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

Marketing products in either the United States or the United Kingdom solely through independent brokers or distributors does not create a permanent establishment, regardless of whether these independent agents conclude sales contracts in the exporter’s name. In addition, the mere presence within the importing country does not create a permanent establishment. Please see Illustration 2 and Illustration 3.

Illustration 2.

USAco, a domestic corporation, markets its products through the internet to United Kingdom customers. Under the United States-United States Income Tax Treaty, the mere solicitation of orders through the internet does not constitute a permanent establishment. Therefore, USAco’s export profits are not subject to United Kingdom income tax.

Illustration 3.

USAco decided to expand its United Kingdom marketing activities by leasing retail store space in London, United Kingdom in order to display its goods and keep an inventory from which to fill foreign orders. Under the United States-United Kingdom Income Tax Treaty, USAco’s business profits would still not be subject to United Kingdom income taxation as long as USAco does not conclude any sales through its foreign office. However, if USAco’s employees start concluding sales at the London office, USAco may have a permanent establishment in the United Kingdom,

Independent Personal Services

Article 14 of the United States-United Kingdom Income Tax Treaty provides that income derived by an individual who is a resident of one of the Contracting States from the performance of personal services in an independent capacity may be taxed in that State. Such income may also be taxed in the other Contracting State if: a) the individual is present in that other State for a period or periods exceeding in the aggregate 183 days in the tax year concerned, but only so much thereof as is attributable to services in that State, or b) the individual has a fixed base regularly available to him in that other State for the purpose of performing his activities, but only so much thereof as is attributable to services performed in that State.

Dividends, Interest, and Royalties

Like the United States, most foreign countries impose flat rate withholding taxes on dividends, interest, and royalty income derived by offshore investors from sources within the country’s borders. Tax treaties usually reduce these withholding taxes. Tax treaties usually reduce the withholding tax rate on dividends to 15 percent or less.

Under Article 10(2) of the United States-United Kingdom Income Tax Treaty, in the case of dividends the withholding rate is zero percent. The term “dividends” for United Kingdom tax purposes includes any item which under the laws of the United Kingdom is treated as a distribution and for the United States tax purposes includes any item which under the law of the United States is treated as a distribution out of earnings and profits. Where a corporation which is a resident of a Contracting State derives profits or income from the other Contracting State, that other State may not impose any tax on the dividends paid by the corporation, except insofar as such dividends are paid to a resident of that other State or insofar as the holding in respect of which dividends are paid is effectively connected with a permanent establishment or fixed base situated in that other State.

Eligibility for the zero rate of withholding tax is subject to an active trade or business or ownership-base erosion test and ownership test (these tests are discussed in more detail below).

For example, assume that ThirdCo is a company resident in a third country, a member of the European Union. ThirdCo owns 100 percent of the issued and outstanding voting stock of USCo, a U.S. company, and of UKco, a U.K. company. UKCo is a substantial company that manufactures widgets; USACo distributes those widgets in the United States. If ThirdCo contributes to UKCo all the stock of USCo, dividends paid by USCo to UKCo would qualify for treaty benefits under the active trade or business test of Paragraph 4 of Article 23 of the treaty. However, allowing ThirdCo to qualify for the zero rate of withholding tax, which is not available to it under the third state’s treaty with the United States (if any), would encourage treaty-shopping.

In order to prevent this type of treaty-shopping, the United States-United Kingdom Income Tax Treaty imposes an additional holding requirement on companies that qualify for benefits only under the “active conduct of a trade or business” test (paragraph 4 of Article 23) or under the “ownership-base erosion” test (paragraph 2(f) of article 23). For those companies, the zero rate of withholding is available only with respect to dividends received from companies that the recipient company owned, directly or indirectly, prior to October 1, 1998. Accordingly, in the example above, UKCo will not qualify for the zero rate of withholding tax on dividends unless it owned USCo before October 1, 1998.

The result would be different under the “ownership-base erosion” test. For example, assume UKCo is a passive holding company owned by UK individuals, which was established in 1996 to hold shares of USCo. UKCo qualifies for benefits only under the ownership-base erosion test. If the UK individuals sold their stock in UKCo to FWCo, UKCo would lose all the benefits accorded to residents of the UK under the treaty.

Under Article 10(3)(a)(iii) of the United States-United Kingdom Income Tax Treaty, a company that is a resident of a Contracting State may also qualify for the zero rate of withholding tax on dividends if it satisfies the derivative benefits test of paragraph 3 of Article 23. Qualification for zero rate of withholding tax through the application of the derivative benefits test currently is limited because of the definition of “equivalent beneficiary.” The definition of “equivalent beneficiary” is intended to ensure that certain joint ventures, not just wholly-owned subsidiaries, can qualify for benefits. For example, assume that the United States has entered into a treaty with Country X, a member of the European Union, that includes a provision identical to Article 10(3)(a) of the United States-United Kingdom Income Tax Treaty. USCo is 100 percent owned by UKCo, which in turn is owned 49 percent by a UK publicly-traded company and 51 percent by XCo, a publicly-traded company that is a resident in Country X. The definition of “equivalent beneficiary” includes a rule of application that is intended to ensure that such joint ventures qualify for benefits. Under that rule, each of the shareholders is treated as owning the shares held by UKCo for purposes of determining whether it would be entitled to an equivalent rate of withholding tax.

The United States-United Kingdom Income Tax Treaty provides favorable dividend rates for “pooled investment vehicles.” According to the technical definition of “pooled investment vehicles” under the tax, a pooled investment vehicle is a person with three attributes. First, its assets must consist wholly or mainly of real property, or of shares, securities or currencies, or of derivative contracts relating to shares, securities or currencies or real property. Second, its gross income must consist wholly or mainly of dividends, interest, gains from the alienation of assets and rents and other income and gains from the holding and alienation of real property. Third, it must be exempt from tax in respect to its income, profits or gains in the State for which it is a resident; or subject to tax at a special rate in that State; or entitled to a deduction for dividends paid to its shareholders in computing the amount of its income, profits or gains. This definition encompasses a U.S. regulated investment company (“RIC”) or a U.S. real estate investment trust (“REIT”). Paragraph 4 of the treaty provides that withholdings between 0 to 15 percent shall apply to pooled investment vehicles.

The United States-United Kingdom Income Tax Treaty permits either the United States or the United Kingdom to impose on a company resident a branch profits tax. Either the United States or United Kingdom may impose a branch profits tax on a corporation if the corporation has income attributable to a permanent establishment in that State derives from gains. The tax is limiteds to items of income that are in the “dividend equivalent amount.” The “dividend equivalent amount” approximates the dividend that a U.S. branch office would have paid during the year if the branch had been operated as a separate U.S. subsidiary company. The United States may not impose its branch profits tax on the business profits of a corporation resident in the United Kingdom that are effectively connected with a U.S. trade or business but that are not attributable to a permanent establishment and are not otherwise subject to U.S. taxation. The United Kingdom currently does not impose a branch profits tax. The branch profits tax may not be imposed, however, if certain requirements are met. The branch profits tax may not be imposed in the case of a company which, before October 1, 1998, was engaged in activities constituting a permanent establishment.

Article 11 and Article 12 of the United States-United Kingdom Income Tax Treaty provides that interest and royalties generally may be subject to a withholding tax of 0 percent, although a complete exemption applies in certain circumstances. The term “interest” as used in the treaty means income from Government securities, bonds or debentures, whether or not secured by mortgage and whether or not carrying a right to participate in profits, and other debt claims as well as all other income assimilated to income from money. However, penalty charges for late payment are not regarded as interest for purposes of the treaty. The term “royalties” as used in the United States-United Kingdom Income Tax Treaty (a) means payment of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work (but not including cinematographic films or films or tapes used for radio or television broadcasting); any patent, trade mark, design or model plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial or scientific experience; and (b) shall include gains derived from the alienation of any right or property which are contingent on the productivity, use, or disposition thereof; including the supply of assistance of an ancillary and subsidiary nature furnished as a means of enabling the application or enjoyment of any such right or property. These provisions do not apply if the person deriving the royalties is a resident of a Contracting State, carries on business in the other Contracting State in which the royalties arise, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the right or property in respect of which the royalties are paid is effectively connected with such permanent establishment

Gains from the Disposition of Property

Under Article 13 of the United States- United Kingdom Income Tax Treaty assigns either primary or exclusive taxing jurisdiction over gains from the alienation of property to the state of residence or the State of source. Article 13 preserves the non-exclusive right of the State of source to tax gains attributable to the alienation of real property situated in that State. The treaty therefore permits the United States to apply Internal Revenue Code Section 897 to tax gains derived by a resident of the United Kingdom that are attributable to the alienation of real property situated in the United States.

Article 13 of the United States-United Kingdom Income Tax Treaty also permits the taxation of gains from the alienation of property other than real property. Such gains may be taxed in the State in which the permanent establishment is located. Thus, a resident of the United Kingdom that is a partner in a partnership doing business in the United States generally will have a permanent establishment as a result of the activities of the partnership, assuming that the activities of the partnership rise to the level of a permanent establishment. See Rev. Rul. 91-32, 1991-1 C.B. 107. Further, under the treaty, the United States generally may tax a partnership’s distributive share of income realized by a partnership on the disposition of personal (movable) property forming part of the business property of the partnership in the United States.

Income from Employment

Article 14 of the United States- United Kingdom Income Tax Treaty apportions taxing jurisdiction over remuneration derived by a resident of a Contracting State as an employee between the States of source and residence. According to Article 14 of the treaty, remuneration derived by a resident of a Contracting State as an employee may be taxed by the State of residence, and the remuneration also may be taxed by the other Contracting State to the extent derived from employment exercised in that other Contracting State. The treaty refers to “salaries, wages, and other similar remuneration.” Consistent with Internal Revenue Code Section 864(c)(6), Article 14 of the United States- United Kingdom Income Tax Treaty applies regardless of the timing of actual payment of services. Thus, a bonus paid to a resident of a Contracting State with respect to services performed in the other Contracting State with respect to a particular taxable year would be subject to Article 14 of the treaty for that year even if it was paid after the close of the year.

Article 14 of the United States- United Kingdom Income Tax Treaty defines stock-option plans as “other similar remuneration.” Specific allocation must be made for the taxation of stock-option plans. Typically, stock-option plans are allocated between both Contracting states. The portion attributable to a Contracting State will be determined by multiplying the gain by a fraction, the numerator of which is the number of days which the employee exercised his employment in that State and the denominator of which will be the total number of days between the grant and exercise of the option.

Article 14(2) of the United States- United Kingdom Income Tax Treaty sets forth an exception to the general rule that employment income may be taxed in the State where the employment is exercised. Under Article 14(2), the State where the employment is exercised may not tax the income from the employment if three conditions are satisfied: 1) the individual is present in the other Contracting State for a period or periods not exceeding 183 days in any 12-month period that begins or ends during the relevant (i.e., the year in which the services are performed) calendar year; 2) the remuneration is paid by, or on behalf of, an employer who is not a resident of that other Contracting State; and 3) the remuneration is not borne by a permanent establishment that the employer has in that other State. In order for the remuneration to be exempt from tax in the source State, all three conditions must be satisfied.

Dependent Personal Services

Article 15 of the United States-United Kingdom Income Tax Treaty salaries, wages and other remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in the State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State. Remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if: a) the recipient is present in that other State for a period not exceeding in the aggregate 183 days in the tax year concerned; b) the remuneration is paid by, or on behalf of, an employer who is not a resident of that other State; and c) the remuneration is not borne as such by a permanent establishment or a fixed base which the employer has in that other State.

Pensions, Social Security, Annuities, Alimony, and Child Support

The United States-United Kingdom Income Tax Treaty provides as a general rule that the State of residence of the beneficial owner has the exclusive right to tax pensions and other similar remuneration. However, the State of residence must exempt from tax any amount of such pensions or other similar remuneration that would be exempt from tax in the State in which the pension scheme is established if the recipient were a resident of that State. Thus, for example, a distribution from a U.S. “Roth IRA” to a UK resident would be exempt from tax in the United Kingdom to the same extent the distribution would be exempt from tax in the United States if it were distributed to a U.S. resident. The same is true with respect to distributions from a traditional IRA to the extent that the distribution represents a return of non-deductible contributions. Similarly, if the distribution were not subject to tax when it was “rolled over” into another U.S. IRA (but not, for example, to a UK pension scheme), then the distribution would be exempt from tax in the United Kingdom.

The United States-United Kingdom Income Tax Treaty also provides for exclusive residence-country taxation of social security benefits. Under the treaty, payments made by one of the Contracting States under the provisions of its social security or similar legislation to a resident of the other Contracting State will be taxable only in the other Contracting State. In regards to annuities, any annuity that is derived and beneficially owned by an annuitant who is a resident of a Contracting State is taxable only in that State. The term “annuity” means a stated sum paid periodically at stated times during the life of the annuitant, or during a specified or ascertainable period of time, under an obligation to make the payment in return for adequate and full consideration. Finally, the United States-United Kingdom Income Tax Treaty covers periodic payments made pursuant to a written separation agreement or a decree of divorce, separate maintenance, or compulsory support. The treaty exempts from tax in both Contracting States such payments made by a resident of one of the Contracting States to a resident of the other Contracting State, unless the payments are deductible in the payer’s State of residence. Thus, child support payments from a resident of a Contracting State to a resident of the other Contracting State are taxable in neither Contracting State, assuming that the payments are not deductible to the payer. By contrast, alimony payments made by a resident of a Contracting State to a resident of the other Contracting State are taxable, exclusively, in the recipient’s State of Residence. 

Pension Schemes

Article 18 of the United States -United Kingdom Income Tax Tax Treaty deals with cross-border pension contributions. Article 18(1) of the United States – United Kingdom Income Tax Treaty provides that if a resident of a Contracting States participates in a pension scheme established in the other Contracting State, the State of residence will not tax the income of the pension scheme with respect to that resident until a distribution is made from the pension scheme. Thus, for example, if a U.S. citizen contributes to a U.S. qualified plan while working in the United States and then establishes residence in the United Kingdom, paragraph 1 prevents the United Kingdom from currently taxing the plan’s earnings and accretions with respect to that individual.

Article 18(2) of the United States- United Kingdom Income Tax Treaty provides certain benefits with respect to cross-border contributions to a pension scheme. Article 18(2)(a) allows an individual who exercises employment or self-employment in a Contracting State to deduct or exclude from income in that Contracting State contributions made by or on behalf of the individual during the period of employment or self-employment to a pension scheme established in the other Contracting State. Thus, for example, if a participant in a U.S. qualified plan goes to work in the United Kingdom, the participant may deduct or exclude from income in the United Kingdom contributions to the U.S. qualified plan made while the participant works in the United Kingdom. 

Article 18(4) of the United States – United Kingdom Income Tax Treaty limits the availability of benefits under Article 18(2) of the treaty. Article 18(4) of the United States – United Kingdom Income Tax Treaty provides a special rule in cases where income dealt with by the treaty is taxable to a resident of a Contracting State only if and to the extent it is remitted to or received by that person. In such a case, Article 18(4) of the United States- United Kingdom Income Tax Treaty reduces proportionately the deduction or exclusion of contributions to a pension scheme subject to tax in the State of residence. Although this rule is written in bilateral fashion, it presently applies to residents of the United Kingdom only, because the United States does not tax on a remittance basis. Article 18(4) of the United States – United Kingdom Income Tax Treaty would apply, for example, if a U.S. citizen resident in the United Kingdom earns income in the United States that is not subject to tax in the United Kingdom because the income in the United States that is not subject to tax in the United Kingdom because the income is not remitted to the United Kingdom. In this case, Article 18(4) would reduce proportionately the amount of any deduction or exclusion allowed in the United Kingdom to the U.S. citizen by Article 18(2) for contributions to a U.S. pension scheme.

Article 18(5) of the United States – United Kingdom Income Tax Treaty generally provides U.S. tax treatment for certain contributions by or on behalf of U.S. citizens resident in the United Kingdom to pension schemes established in the United Kingdom that are comparable to the treatment that would be provided for contributions to U.S. schemes. Under Article 18(5)(a) of the United States – United Kingdom Income Tax Treaty, 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. Qualifying contributions generally include contributions made during the period the U.S. citizen exercises an employment in the United Kingdom if expenses of the employment are borne by a UK employer or UK permanent establishment. Similarly, with respect to the U.S. citizen’s participation in the UK pension scheme, accrued benefits and contributions during that period generally are not treated as taxable income in the United States.

Anti-treaty Shopping Provision (Limitation on Benefits)

Because the United States- United Kingdom Income Tax Treaty often provides zero withholding tax rates on dividend, interest, and royalty income, a multinational corporation may be able to reduce its foreign withholding taxes by owning its subsidiaries through strategically located holding companies. This practice is known as “treaty shopping”.” The United States- United Kingdom Income Tax Treaty provides a number of mechanisms to prevent treaty shopping. Article 23 of the United States – United Kingdom Income Tax Treaty sets forth a series of objective tests to determine a taxpayer’s motives in establishing an entity in a particular country.

Article 23 of the United States -United Kingdom Income Tax Treaty follows the form used in other recent U.S. income tax treaties. Article 23(1) of the United States – United Kingdom Income Tax Treaty states the general rule that a resident of a Contracting State, any one of which suffices to make such resident a so-called “derivative benefits” test under which certain categories of income may qualify for benefits. Article 23(4) of the treaty sets forth the active trade or business test, under which a person not entitled to benefits under paragraph Article 23(2) may nonetheless be granted benefits with regard to certain types of income. Article 23(5) of the treaty limits the benefits available under the other provisions of the treaty involving the issuance of “tracking stock” and similar instruments.

Article 23(2)(a) of the United States- United Kingdom Income Tax Treaty provides that individual residents of a Contracting State will be entitled to all treaty benefits. If such an individual receives income as a nominee on behalf of a third country resident, benefits may be denied under the respective articles of the treaty by the requirement that the beneficial owner of the income be a resident of a Contracting State.

Article 23(c)(2) of the United States – United Kingdom Income Tax Treaty applies to two categories of companies: publicly traded companies and subsidiaries of publicly traded companies. Article 23(c)(i) generally provides that a company will be a qualified person (for purposes of the United States-United Kingdom Income Tax Treaty) if the principal class of its shares is listed on a recognized U.S. or UK stock exchange and is regularly traded on one or more recognized stock exchanges.

The term “recognized stock exchange” is defined as the NASDAQ System owned by the National Association of Securities Dealers and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purpose of the Securities Exchange Act of 1934; (2) the London Stock Exchange and any other recognized investment exchange within the meaning of the Financial Services Act 1986 or the Financial Services and Markets Act 2000; 3) the Irish Stock Exchange, the Swiss Stock Exchange, and the stock exchanges of Amsterdam, Brussels, Frankfurt, Mamburg, Johannesburg, Madred, Milan, Paris, Stockholm, Sydney, Toronto, and Vienna.

The term “principal class of shares” is defined to mean 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 class of ordinary or common shares representing the majority of the aggregate, a majority of the voting power and value of the company.

A company resident in a Contracting State is entitled to the benefits of the United States- United Kingdom Income Tax Treaty if five or fewer direct and indirect owners of at least 50 percent of the aggregate vote and value of the company’s shares are publicly traded companies. Thus, for example, a UK company, all the shares of which are owned by another UK company, would qualify for benefits under the treaty if the princi[pal class of shares of the UK parent company were listed on the London Stock Exchange and regularly traded on the Irish stock exchange. However, the UK company would not qualify for benefits if the publicly traded company were a resident of Ireland, not of the United States or the United Kingdom.Furthermore, if the UK parent indirectly owned the UK company through a chain of subsidiaries, each subsidiary in the chain, as an intermediate owner, must be a resident of the United States or the United Kingdom for the UK company.

Article 23(3) of the United States- United Kingdom Income Tax Treaty sets forth a derivative benefits test that applies to all treaty benefits. In general, a derivative test entitles the resident of a Contracting State to treaty benefits if the owner of the resident would have entitled to the same benefit had the income in question flowed directly to that owner. Article 23(3) of the United States- United Kingdom Income Tax Treaty provides a derivative benefits test under which a company that is a resident of a Contracting State may be entitled to the benefits of the treaty with respect to certain items of income. To qualify under this paragraph, the company must meet an ownership test and a base erosion test.

Under the ownership test, seven or fewer equivalent beneficiaries must own shares representing at least 95 percent of the aggregate voting power and value of the company. Ownership may be direct or indirect. The term “equivalent beneficiary” may be satisfied in two alternative ways. The first requirement (despite NAFTA and Brexit), the person must be a resident or a Member State of the European Community, a European Economic Area state, or a party to the North American Free Trade Agreement (collectively, “qualifying States”).

The second requirement of the definition of “equivalent beneficiary” is that the person must be entitled to equivalent benefits under an applicable treaty. To satisfy the second requirement, the person must be entitled to all the benefits of a comprehensive treaty between the Contracting State from which benefits of the treaty are claimed under a qualifying State. For this purpose, however, if the treaty in question does not have a comprehensive limitation on benefits article, this requirement only is met if the person would be a “qualified person” test discussed in Article 23(2) of the treaty.

In order to satisfy the additional requirement necessary to qualify as an “equivalent beneficiary” with respect to dividends, interest, or royalties, the person must be entitled to a rate of withholding tax that is at least as low as the withholding rate that would apply under the United States- United Kingdom Income Tax Treaty. For example, USCo is a wholly owned subsidiary of UKCo, a company resident in the United Kingdom. UKCo is wholly owned by FCo, a corporation resident in France. Assuming UKCo satisfies the requirements of Article 10 (Dividends), UKCo would be eligible for a zero rate of withholding tax. The dividend withholding rate in the treaty between the United States and France is 5 percent. Thus, if FCo received the dividend directly from SSCO, FCo would have been subject to a 5 percent rate of withholding tax on the dividend. Because FCo would not be entitled to a rate of withholding tax that is at least as low as the rate that would apply under the treaty to such income (i.e., zero), FCo is not an equivalent beneficiary.

The requirement that a person be entitled to “all the benefits” of a comprehensive treaty eliminates those persons that qualify for benefits with respect to only certain types of income. Accordingly, the fact that a French parent of a UK company is engaged in the active conduct of a trade or business in France and therefore would be entitled to the benefits of the United states- France Income Tax Treaty if it received dividends directly is not sufficient. Further, the French company cannot be an equivalent beneficiary if it qualifies for benefits only with respect to certain income as a result of the “derivative benefits” provision in the United States- France Income Tax Treaty. However, it would be possible to look through the French company to its parent company to determine whether the parent company is an equivalent beneficiary.

The following example illustrates the “all the benefits” requirement. A UK resident company, Y, owns all the shares in a U.S. resident company, Z. Y is wholly owned by X, a Gern resident company that would not qualify for all of the benefits of the United States- Germany Income Tax Treaty but may qualify for benefits with respect to certain items of income under the “active trade or business” test of the United States- Germany Income Tax Treaty. X, in turn, is wholly owned by W, a French resident company that is substantially and regularly traded on the Paris Stock Exchange. Z pays a dividend to Y. Y qualifies for benefits under Article 23(3) of the United States- United Kingdom Income Tax Treaty, Y is directly owned by X, which is not an equivalent beneficiary within Article 23(7)(d)(i) of the treaty (X does not qualify for all the benefits of the United States- Germany Income Tax Treaty). However, Y is also indirectly owned by W and W may be an equivalent beneficiary. Y would not be entitled to the zero rate of withholding tax on dividends available under the United States- United Kingdom Income Tax Treaty because W is not an equivalent beneficiary with respect to the zero rate of withholding tax since W is not eligible for such rate under the United States- France Income Tax Treaty. W qualifies as an equivalent beneficiary with respect to the 5 maximum rate of withholding tax because (a) it is a French resident company whose shares are substantially and regularly traded on a recognized stock exchange, within the meaning of the Limitation on Benefits of the United States- France Income Tax Treaty and 2) the dividend withholding rate in the treaty between the United States and France is 5 percent. Accordingly, U.S. withholding tax on the dividend from Z to Y will be imposed at a rate of 5 percent.

The second alternative for satisfying the “equivalent beneficiary” test is available only to residents of one of the two Contracting States. A UK individual will be an equivalent beneficiary without regard to whether the individual would have been entitled to receive the same benefits if it received the income directly. Thus, if 90 percent of a UK company is owned by five companies that are resident in member of the European Union who satisfy the requirements of clause (i), and 10 percent of the UK company is owned by a U.S. or U.K. individual, then the UK company still satisfy the requirements of the treaty.
A company meets this base erosion test if less than 50 percent of its gross income for the taxable period is paid or accrued, directly, or indirectly, to a person or persons who are not equivalent beneficiaries in the form of payments deductible for tax purposes who are equivalent beneficiaries in the form of payments deductible for tax purposes in company’s State of residence.

For example, UKCo is a UK holding company, all the issued and outstanding stock of which is owned 50 percent by a privately-held Danish company, DCo, and 50 percent by a privately-held French company, FCo. UKCo, in turn, owns 75 percent of the issued and outstanding stock of USCo, a U.S. company engaged in the manufacture of wallpaper and jet fuel. UKCo pays less than 50 percent of its gross income to other persons in the form of payments deductible under UK law. DCo and FCo are approached by a Thai company, TCo, engaged in the business of wallpaper manufacturers in Southeast Asia. DCo, FCo, and TCo arrange for UKCo to issue a class of preferred stock to TCo, in exchange for a capital contribution. Payments with respect to this class of preferred stock will be set at a fixed rate increased by the excess of the internal rate of return on USCo’s wallpaper business over the yield on 30-year U.S. Treasury Bonds. UKCo would be entitled to a 5 percent withholding rate with respect to distributions from USCo because DCo and FCo would have been entitled to the same withholding rate on a direct payment from USCo. However, UKCo will not be entitled to a 5 percent withholding rate on a portion of the dividends paid by USCo because of the preferred shares issued to TCo. TCo is not an equivalent beneficiary within the meaning of Article 23 of the United States- United Kingdom Income Tax Treaty.

Finally, Article 23(a) sets forth the general rule that a resident of a Contracting State engaged in the active conduct of a trade or business in that State may obtain the benefits of the United States-United Kingdom Income Tax Treaty with respect to an item of income, profit, or gain derived in that other Contracting State. The item of income, profit, or gain, however, must be derived in connection with or incident of that trade or business.

The term “trade or business” is not defined in the treaty. Accordingly, the Internal Revenue Service (“IRS”) will refer to the regulations under Internal Revenue Code Section 367(a) for the definition of the term “trade or business.” In general, therefore, a trade or business will be considered to be a specific unified group of activities that constitute or could constitute an independent economy and an independent economic enterprise carried on for profit. Furthermore, a corporation generally will be considered to carry on a trade or business only if the officers and employees of the corporation conduct substantial managerial and operational activities. A business activity generally will be considered to form a business activity conducted in the State of source if the two activities involve the design, manufacture or sale of same products or types of products, or provisions of similar services. The following examples illustrate this rule.

Example 1.

USCo is a corporation resident in the United States. USCo is engaged in an active manufacturing business in the United States. USCo owns 100 percent of the shares of UKCo, a company resident in the United Kingdom. UKCo distributes USCo products in the United Kingdom. Because the business activities conducted by the two corporations involve the same product, UKCo’s distribution business is considered to form a part of USCo’s manufacturing business.

Example 2.

The facts are the same as in Example 1, except that USCo does not manufacture. Rather, USCo operates a large research and development facility in the United States that licenses intellectual property to affiliates worldwide, including UKCo. UKCo and other USCo affiliates then manufacture and market the USCo-designed products in their respective markets. Because the activities conducted by UKCo and USCo involve the same respective markets. Because the activities conducted by UKCo and USCo involve the same product line, these activities are considered to form a part of the same trade or business.

Example 3.

Americair is a corporation resident in the United States that operates an international airline. UKSub is a wholly-owned subsidiary of Americanair resident in the United Kingdom. UKSub operates a chain of hotels in the United Kingdom that are located near airports served by Americair Flights. Americair frequently sells tour packages that include air travel to the United Kingdom and lodging at UKSub hotels. Although both companies are engaged in the active conduct of a trade or business. Therefore UKSub’s business does not form a part of Americair’s business. However, UKSub’s business is considered to be complementary to Americair’s business because they are part of the same overall industry (travel), and the links between their operation tend to make them interdependent.

Example 4.

The facts are the same as in Example 3, except that EKSub owns an office building in the United Kingdom instead of a hotel chain. No part of Americair’s business is conducted through the office building. UKSub’s business is not considered to form a part of or to be complementary to Americair’s business. They are engaged in distinct trades or businesses in separate industries, and there is no economic dependence between the two operations.

Disclosure of Treaty-Based Return Positions

Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.

The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:

1. The name and employer identification number of both the recipient and payor of the income at issue;

2. The type of treaty benefited item and its amount;

3. The facts and an explanation supporting the return position taken;

4. The specific treaty provisions on which the taxpayer bases its claims;

5. The Internal Revenue Code provision exempted or reduced; and

6. An explanation of any applicable limitations on benefits provisions.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com


This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

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