U.K., U.S. Reach Competent Authority Agreement on "Equivalent Beneficiary" Status
Does It Solve Post-Brexit Treaty Planning Issues?
- The United Kingdom and the U.S. Competent Authorities have entered into a Competent Authority Agreement (the Agreement) under the bilateral U.K.-U.S. Income Tax Treaty (the U.K. Treaty) dealing with the uncertainty post-Brexit as to whether a person resident in the United Kingdom may continue to be considered as an "equivalent beneficiary" – a resident of a Member State of the European Community – for purposes of applying the so-called "derivative benefits" test of the Limitation on Benefits (LOB) test contained in Article 23.3 of the U.K. Treaty.
- The Agreement provides that the competent authorities agree that a resident of a Member State of the European Community continues to include a resident of the U.K. The stated rationale for this interpretation "reflects the shared understanding of the competent authorities that residents of either contracting state should be eligible to qualify as equivalent beneficiaries for purposes of applying the derivative benefits test."
- Prior to Brexit, international tax planners had expressed concern that the withdrawal of the U.K. from the EU adversely could impact certain cross-border organization structures, particularly because U.K. residents no longer would be "equivalent beneficiaries" under the "derivative benefits" test contained not only in the U.K. Treaty but also in the 13 other bilateral income tax treaties that utilize an EU "equivalent beneficiary" test, and urged that the U.S. Department of the Treasury find a solution to extend "equivalent beneficiary" status to U.K. residents after Brexit.
- The Agreement provides relief, but limited to the U.K. Treaty. While the relief provided is welcome, it remains to be seen whether unilateral or bilateral relief with respect to this uncertainty will be forthcoming in any of the other U.S. treaties that contain the EU "equivalent beneficiary" terminology in the LOB article.
The United Kingdom and the U.S. Competent Authorities published on July 28, 2021, a Competent Authority Agreement (the Agreement) under the bilateral U.K.-U.S. Income Tax Treaty (the U.K. Treaty).1 It provides for purposes of applying the "equivalent beneficiary" ownership prong of the so-called "derivative benefits" test of the limitation on benefits article of the U.K. Treaty (Article 23.3) that a resident of a Member State of the European Community2 continues to include a resident of the United Kingdom. This interpretation was reached notwithstanding that the U.K. withdrew from the European Union (EU) on Jan. 31, 2020 (Brexit).
The rationale contained in the Agreement for this interpretation "reflects the shared understanding of the competent authorities that residents of either contracting state should be eligible to qualify as equivalent beneficiaries for purposes of applying the derivative benefits test" contained in the limitation on benefits article of the U.K. Treaty.
A bilateral income tax treaty is intended to be a reciprocal agreement between two contracting countries to facilitate cross-border trade and investment by eliminating cross-border tax impediments to cross-border flows, providing mechanisms to relieve double taxation, preventing treaty abuse and providing for dispute resolution procedures.
The limitation on benefits (LOB) article of a bilateral income tax treaty, as its name implies, is intended to ensure that only persons that have the requisite nexus with a treaty jurisdiction benefit from the treaty. In other words, the purpose of the LOB article is to prevent residents of third countries from obtaining benefits under a treaty (a reciprocal agreement between two contracting countries) that were not intended for them.
The United States has been the leading proponent for the inclusion of an LOB article in its treaties. With the advent of the Organization for Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting (BEPS) initiatives, other countries are catching on. The sophistication of U.S. LOB articles has evolved and increased over time.
The modern version of the LOB article contained in U.S. bilateral income tax treaties contains a two-part test for a treaty claimant to obtain treaty benefits.3 First, the treaty claimant must satisfy any specified conditions in the treaty (and domestic law) for obtaining treaty benefits.4 Second, and only if it does so, the treaty claimant then has to satisfy one of the objective tests of the LOB article to be treated as eligible to obtain treaty benefits.5
The LOB article does not rely on a determination of subjective intent or purposes, Rather, it relies on objective criteria contained in a series of tests that, if satisfied, entitle the treaty resident to benefit from the treaty. In effect, the LOB article serves as the last barrier in a treaty to counter treaty abuse.
The Impact of Brexit on Treaty Planning
Brexit (a portmanteau of "British exit" denoting the withdrawal of the U.K. from the EU) has had a direct impact on cross-border planning that utilized bilateral income tax treaties. After Brexit (and prior to the issuance of the Agreement), a plain reading of the EU "equivalent beneficiary" definition could lead to the conclusion that a U.K. resident no longer is a resident of an EU Member State – and hence not an "equivalent beneficiary" for purposes of the application of the "derivative benefits" test.6
The Derivative Benefits Test
The LOB article derivative benefits test entitles the residents of a contracting state to treaty benefits if the owner of the resident would have been entitled to the same benefit had the income in question flowed directly to that owner. To qualify under this test under the UK Treaty, the resident company must meet an ownership test7 and a base erosion test.8 Note, other bilateral income tax treaties that have the "derivative benefits" test may contain other requirements. So, care must be taken to carefully identify the requirements for "equivalent beneficiary" status under a particular treaty.
The "derivative benefits" test has been commonly used by treaty investors to structure investments into the United States. Prior to Brexit, some 14 U.S. bilateral income tax treaties9 contained an EU "equivalent beneficiary" definition in their respective "derivative benefits" tests. As a result, a wide array of investors interposed treaty structures to invest in the United States. Interposing a treaty-based holding company to make the U.S. investment may be advantageous compared to a direct investment for a number of reasons.10 After Brexit that type of planning generally was thought no longer possible for U.K. residents, at least prior to the release of the Agreement.
Let's take a simple example to highlight the issue: U.K. Holding Co. owns all the shares of U.S. OPCO. U.K. Holding, in turn, is owned 48 percent by Dutchco, 44 percent by Germanco and 8 percent by UKco, all qualifying owners pre-Brexit, as each entity is a resident member of the EU. US OPCO pays U.K. Holding a $1 million license fee.11 Issue: Can it be paid free of U.S. withholding tax under the U.K. Treaty or is it ineligible for treaty benefits and subject to a $300,000 U.S. withholding tax? Pre-Brexit, the ownership test would have been met as all owners are residents of the EU. Post-Brexit, the U.K. 8 percent member is not an EU resident and thus only 92 percent (but not the requisite 95 percent) of the owners are EU residents, so U.K. Holding would not meet eligibility status under the U.K. Treaty and a $300,000 U.S. tax payment would have been incurred. With the issuance of the Agreement treating the U.K. owner of U.K. Holding as an EU resident, no U.S. tax would be due.
U.K./U.S. CA Agreement
The Agreement is less than a page and simple.
First, it states: It has come to the attention of the competent authorities that the withdrawal of the United Kingdom from the European Union has created uncertainty as to whether a person resident in the United Kingdom may continue to be considered a "resident of a Member State of the European Community" for the purposes of applying the so-called "derivative benefits test" in paragraph 3 of Article 23 (Limitation on benefits) of the Treaty, including the term "equivalent beneficiary," as defined in subparagraph (d) of paragraph 7 of Article 23. (Emphasis added.)
Second, it provides: The competent authorities agree that, for the purposes of applying paragraph 7(d) of Article 23, a "resident of a Member State of the European Community" continues to include a resident of the United Kingdom. (Emphasis added.)
Third, the rational is as follows: This interpretation reflects the shared understanding of the competent authorities that residents of either Contracting State should be eligible to qualify as equivalent beneficiaries for purposes of applying the derivative benefits test in paragraph 3 of Article 23. (Emphasis added.)
- Prior to Brexit, tax commentators had identified potential detrimental tax consequences that could result post-Brexit if a U.K. resident no longer was considered a resident of a Member State of the EU and suggested various governmental solutions to remedy that problem.12 The most straightforward of these was for the Treasury Department and the Internal Revenue Service (IRS) to issue a notice confirming that a U.K. resident would continue to be a resident of a Member State of the EU for purposes of the 14 treaties that contain the EU "equivalent beneficiary" reference. While the Agreement provides welcome relief, as a competent authority agreement, it is limited in application solely to the U.K. Treaty.13
- For purposes of the qualification of U.K. residents as EU resident "equivalent beneficiaries" under the other 13 treaties, time will tell whether the Competent Authorities of the 13 countries may reach some form of resolution of this issue. In the interim, impacted taxpayers perhaps should consider filing a Competent Authority request to prompt the United States to negotiate with the counterpart contracting state. Alternatively, impacted taxpayers should consider the potential viability of filing a request for discretionary competent authority relief.14
- Interestingly, on the same day the U.K. and U.S. Competent Authorities issued the Agreement, they also issued another competent authority agreement regarding the interpretation of the term North American Free Trade Agreement (NAFTA), also referred to in the "equivalent beneficiary" provision of the U.K. Treaty (Article 23.7.d), and concluded that the reference to NAFTA shall be understood as references to the United States-Mexico-Canada Agreement (USMCA) in the U.K. Treaty. The basis for that interpretation by the competent authorities is that the USMCA modernizes NAFTA, is entered into by the same parties, and governs the standards for trade and investment among the parties going forward.15
1 The authority to enter into the Agreement is found in Article 26.3.f. of the U.K. Treaty, i.e., "The competent authorities of the Contracting States shall endeavour to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of this Convention. In particular, the competent authorities of the Contracting States may agree: … to a common meaning of a term."
2 The European Community was the predecessor of the European Union.
3 See, e.g., U.K. Treaty, Art. 23.1
4 This means that prior to the application of the LOB article, the treaty claimant has to satisfy all of the applicable substantive specific treaty article requirements, such as those relating to residence, entitlement to treaty benefit sought to be claimed (e.g., beneficial ownership and all of the other technical elements of the dividend, interest or royalties article) and U.S. domestic law anti-abuse provisions (e.g., business purposes, substance-over –form, step transactions and/or conduit principles).
5 These tests encompass individuals resident in one of the contracting states, qualified governmental entities, public companies and their subsidiaries, tax exempt entities and pension plans, entities that satisfy an ownership and base erosion test, persons that satisfy a derivative benefits test, persons that satisfy an active business test, and persons that receive a favorable competent authority ruling. Certain treaties may include other tests, such as a headquarters company (HQ) test.
6 The term "equivalent beneficiary" is defined in Article 23.7.d of the U.K. Treaty and contains a series of detailed requirements apart from membership in the European Community, European Economic Area or North American Free Trade Agreement (NAFTA). For informative background discussions of these issues, see Lee A. Sheppard, "Brexit and Tax Planning," Tax Notes International (Feb 24, 2020) (Sheppard Article), and Daniel W. Rubin, "EB or Not EB? That is the Question Treasury Must Answer after Brexit," Bloomberg Tax Management International Journal (Vol. 49, No. 2, Feb. 14, 2020) (Rubin Article). In both of these articles with respect to treaty interpretation, the authors refer to the ambulatory rather than static interpretation of treaties, as well as the reference to the Vienna Convention on the Law of Treaties, which the United States has signed but not ratified, for the conclusion that after Brexit, the U.K. no longer would be an EU "equivalent beneficiary" for purposes of the "derivative benefits" test.
7 Under this 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 met in two alternative ways,
8 The base erosion test is met if less than 50 percent of the applicable person's gross income for the taxable period is paid or accrued to a person or persons who are not equivalent beneficiaries in the form of tax deductible payments in the company's state of residence.
9 The treaty countries are: Belgium, Denmark, Finland, France, Germany, Iceland, Ireland, Luxembourg, Malta, Netherlands, Spain, Sweden, Switzerland and the United Kingdom. See Rubin Article at pp. 2-3. Spain was added through a protocol after the Rubin Article was published. Note: The Canadian Treaty, the Jamaican treaty as well as the 2016 Model Income Tax Treaty, do not use geography or membership in an international organization as a qualifier for equivalent beneficiary status. Also, the Mexican Treaty, although not applying to the EU, applies to NAFTA.
10 See generally Jeffrey L Rubinger, "Qualifying for Treaty Benefits Under the 'Derivative Benefits' Article," The Florida Bar Journal (Sept.-Oct. 2014). The author also suggests that certain treaties actually may enable investors to achieve a lower rate of withholding by investing through an interposed corporation in another jurisdiction compared to a direct investment in the investor's home country.. A specific illustration of the aforementioned planning opportunity can be found in an example contained in the U.S. Treasury Department's Technical Explanation to the U.K. Treaty, at p. 87.
11 The focus of this example is the 95 percent ownership test requirement. Treaty benefits could separately fail if U.K. Holding made a deductible payment outside the EU group of 50 percent or more of its gross income under the base erosion requirement discussed above. The Agreement would also provide eligibility for such payment under the base erosion requirement should such payment be made to a U.K. resident.
12 See articles cited in note 6.
13 Note, "equivalent beneficiary" status under Article 23.7.d. (apart from its application for purposes of the "derivative benefits" test) also is referred to in other portions of the LOB article in the U.K. Treaty, and should be applicable in those circumstances.
14 See Rev. Proc. 2015.40, Section 3.06(2) Discretionary LOB Requests.
15 Prior to Brexit, commentators had suggested that the reference to NAFTA should be understood as a reference to USMCA by analogy and could be used to support an interpretation that a U.K. resident should continue to be treated as an EU resident post-Brexit. That analogy, however, is inapposite to that of the EU situation, pre- and post-Brexit, because with respect to the NAFTA/USMCA reference, NAFTA is entered into by the same parties, and governs the standards for trade and investment among the parties going forward. Note further, prior to the U.K./U.S. competent authority agreement, the Treasury Department and IRS in Announcement 2020-6 (May 19, 2020) stated that upon the entry into force of the USMCA, references in U.S. income tax treaties to NAFTA would be interpreted as a reference to the USMCA. The Treasury and IRS in that announcement noted that they would reach out to countries that have an applicable tax treaty containing references to the NAFTA to confirm that those countries would similarly interpret references to the NAFTA as references to the USMCA. In that regard, Switzerland and the United States entered into a competent authority agreement in June 2020.
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