Author: PEG O’CONNOR, MIN YU, MARIA MARTINEZ, JOSE MURILLO, AND CRAIG HILLIER
The authors are members of Ernst & Young LLP’s International Tax Services group based in London and Washington DC. The views expressed in this column are solely the authors’ and do not necessarily reflect those of Ernst & Young LLP.
On 6/24/16, the United Kingdom (U.K.) held a referendum to decide whether to leave or remain in the European Union (EU). With a voter turnout of 71.8%, leave won by 52% to 48%. The results of the referendum mark a significant change for the U.K., the EU, and their trading partners.
Following the referendum, David Cameron resigned as Prime Minster, and Theresa May was elected as the new Prime Minister, effective on 7/13/16. Theresa May has indicated that she plans to execute the results of the referendum and guide the U.K. through the EU exit process (colloquially referred to as “Brexit”). To leave the EU, the U.K. must invoke Article 50 of the Treaty of Lisbon, 1 which has not been tested or used since the treaty entered into force. The exit process is expected to take at least two years, until then the U.K. will remain an EU member. However, as the U.K. negotiates a withdrawal agreement and the terms of its new relationship with the remaining EU members, it will not participate in any EU decision processes.
Apart from political and regulatory implications, Brexit will have other consequences that will impact global business in areas such as trade, financial markets, and international tax. For example, the U.K. acts as a holding company and EU headquarters location for many multinational groups. While the U.K. remains an EU member, these multinationals are able to avail themselves of several EU directives that provide benefits for headquarters and holding company functions. However, once the U.K. leaves the EU, U.K. companies may no longer be able to benefit from directives such as the EU parent and subsidiary directive, which eliminates withholding tax on dividends between associated EU entities, or the EU interest and royalties directive, which eliminates withholding tax on interest and royalty payments between EU resident entities. In addition, the U.K. may no longer be covered by the EU merger directive, which permits certain cross-border reorganizations.
Furthermore, an entity’s ability to claim treaty benefits may be effected by the U.K.’s non-EU member status. In this respect, from a U.S. federal tax perspective, one important issue to be considered is the “derivative benefits test” included in the “limitation on benefits test” article. This test grants treaty benefits on the basis of direct or indirect ownership by specified persons (the ownership test) if the entity seeking treaty benefits does not make deductible payments made to certain disqualified persons (the base erosion test) in excess of a threshold amount. The derivative benefits tests contained in U.S. tax treaties are not identical. Some variations include additional or fewer requirements, but in all cases, to meet the ownership test the ultimate owners of the company seeking treaty benefits must be residents of certain specified countries (referred to in many treaties as equivalent beneficiaries), either of a country that is a party to the North American Free Trade Agreement (a NAFTA country), a member of the EU (an EU member state), or, in certain treaties, a party to the agreement for the European Economic Area (EEA member state). For example, the U.S.-Luxembourg tax treaty requires, among other conditions, that, to constitute a qualifying owner, a person must be a resident in a NAFTA country or an EU member state. 2 By contrast, the U.S.-Dutch tax treaty permits the equivalent beneficiary to also be a resident in an EEA member state (in additional to a NAFTA country or EU member state). 3
Currently, a publicly traded U.K. company entitled to benefits under the U.S.-U.K. tax treaty can constitute an equivalent beneficiary under a U.S. tax treaty that requires the equivalent beneficiary to be a member of the EU or EEA. Thus, currently a company resident in such a treaty country that is wholly owned, directly or indirectly, by that U.K. company may possibly qualify for treaty benefits, assuming all other conditions are met, under the derivative benefits test of the relevant U.S. tax treaty. However, once the U.K. exits the EU, that same company may no longer qualify for treaty benefits under the derivative benefits test. So what can be done? One option would be to update the existing treaties to reflect Brexit, if and when the U.S. and the other country renegotiate an existing tax treaty. Prior to an updated tax treaty entering into force following Brexit, entities that relied on derivative ownership by a U.K. equivalent beneficiary may no longer qualify for benefits under the U.S.-U.K. treaty .
The starting point for renegotiation of the derivative benefits test could be the version of the test included in the 2016 U.S. Model Treaty . 4 Notably, the 2016 U.S. Model Treaty expands the definition of an “equivalent beneficiary” for purposes of the derivative benefits test by eliminating the geographic restriction included in existing U.S. tax treaties and requiring instead that the equivalent beneficiary: (a) be a resident of a country that has a tax treaty with the source country, (b) qualify for all the benefits of such treaty under the relevant limitation provision (e.g., an individual, government, pension, tax-exempt, publicly traded company or, in some circumstances, a headquarters company), and (c) qualify under that treaty for benefits or rates that are at least as favorable as those being sought by the company seeking benefits by reason of the derivative ownership.
The 2016 U.S. Model Treaty , however, includes other proposed changes that would likely also be considered during the negotiation of the new treaty, some of which would restrict treaty benefits. It is likely these more restrictive conditions would be part of any renegotiated treaty. For example, the ownership test would require that any intermediate entities between the equivalent beneficiary and the person seeking to claim treaty benefits on the basis of derivative ownership be: (a) a resident of a country that has a tax treaty with the source country that includes provisions on special tax regimes and notional interest deductions similar to the ones in the 2016 U.S. Model Treaty , or (b) a resident of the same country as the entity seeking treaty benefits by reason of the derivative ownership. The 2016 Model Treaty provides a detailed definition of what constitutes a “special tax regime” but, generally speaking, it is a regime that grants preferential taxation for certain types of income.
Moreover, the base erosion test of the derivative benefits test included in the 2016 U.S. Model Treaty is more restrictive than the base erosion test of the derivative benefits test included in existing U.S. tax treaties. For example, the 2016 U.S. Model Treaty ‘s base erosion test would require, among other conditions, that less than 50% of the company’s gross income be paid or accrued, directly or directly, in payments that are deductible for purposes of taxes covered by the treaty in the company’s country of residence to related equivalent beneficiaries that benefit from a special tax regime with respect to the deductible payment.
It is uncertain at this stage what status the U.K. will have with its EU trading partners. It could join the EEA like Norway, or it could be outside of the common market and rely on World Trade Organization rules. Companies should consider, and potentially plan for, the effect of the U.K.’s eventual departure from the EU on the ability to continue claiming benefits under a U.S. tax treaty on the basis of the U.K. company constituting an equivalent beneficiary. However, until the U.K. leaves the EU, all EU directives and regulations that apply to the U.K. and the U.K.’s status in the EU will remain the same.
1 The Treaty of Lisbon was signed on 12/13/07, and entered into force on 12/1/09.
2 See Article 24(4) of the Convention between the Government of the United States of America and the Government of the Grand Duchy of Luxembourg for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and Capital, 4/3/96.
3 Article 26(3) of the Convention between the Government of the United States of America and the Kingdom of The Netherlands for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, 12/31/93.
4 United States Model Income Tax Treaty, Article 22(4), 2/17/16.
The post Certain U.S. Tax Treaty Implications of Brexit appeared first on Thomson Reuters Tax & Accounting.
