Limitation on Brexit: the UK, the EU, and US treaty benefits

23 August 2021

A recent agreement between the UK and US competent authorities seeks to address the impact of Brexit on the UK/US double tax treaty, which has historically relied on referencing the EU when limiting access to its beneficial provisions.

The agreement brings a welcome end to a period of uncertainty on the availability of treaty benefits for certain UK companies, but the bilateral approach fails to solve a broader problem impacting many multi-jurisdictional arrangements.

Accessing treaty benefits

The UK/US treaty, like many other US double tax treaties, contains a “limitation on benefits” (LOB) article. This restricts the availability of benefits, such as reduced dividend withholding tax rates, provided for by the treaty. LOB provisions are intended to prevent so-called “treaty shopping” arrangements, where artificial structures are used to gain access to favourable tax treaties that would not otherwise be available.

The LOB article in the UK/US treaty restricts benefits in the first instance to a list of “qualified persons”, which includes individuals and listed companies. There are then provisions permitting other persons to claim treaty benefits, for example the “derivative benefits” test. This aims to grant benefits to companies whose ultimate shareholders would be entitled to the same benefits if the payment in question were made to them directly. Broadly, a company qualifies if it is 95% owned (directly or indirectly) by seven or fewer “equivalent beneficiaries”, provided its profits are not artificially eroded through deductible payments to non-equivalent beneficiary persons.

The Brexit issue

Equivalent beneficiaries for these purposes are residents of member states of the EU (and in some cases the EEA) or of parties to the North American Free Trade Agreement (NAFTA), provided roughly the same benefits would be available under the applicable treaty if the relevant payment were made to such residents (i.e. the ultimate shareholders) rather than to the company in question.

The impact of Brexit thus becomes apparent – now the UK has left the EU, UK resident companies do not appear to fall within the definition of equivalent beneficiary. In a situation where, for example, a UK company is 90% owned by a German resident and 10% owned by a UK resident, the 95% test would no longer be satisfied.

Problem solved?

This issue is addressed by the new UK/US competent authority agreement, which states that references to the EU in this context should be interpreted as including the UK. So far, so good – but this only deals with part of the problem.

A more common circumstance in which the derivative benefits test is relied upon is in the context of non-UK treaties with the US. Multinational groups often contain UK intermediary and/or ultimate parent companies, with payment flows in various forms elsewhere in the structure between the US and (current) EU countries. A simple example of this might be a Luxembourg company that has a UK parent and provides debt funding to a US sister company, in respect of which it receives payments of interest.

Prior to Brexit, such groups could often meet the derivative benefits test by virtue of the UK parent company being an equivalent beneficiary. The recent competent authority agreement, though, deals only with the reference to the EU in the UK/US treaty. Similar references in LOB articles of treaties between the US and the remaining EU countries have not yet been clarified, such that UK-parent groups may be unable to claim treaty benefits in this context. In the Luxembourg example above, this could result in 30% interest withholding tax instead of 0% under the treaty. This issue applies all the way back to 31 January 2020, as the provisions of the transition period do not cover relationships with third countries (in this case the US).

The way forward

The post-Brexit interpretation of US LOB provisions has been on the radar of tax advisers for some time – see for example The Long Arm of Brexit, published in 2017. Although the UK/US agreement is a step in the right direction, clearly there remains significant uncertainty for particular groups with a European presence. The US authorities appear willing to enter into such agreements to ensure continuity post-Brexit, but on such a sensitive political issue it remains to be seen whether or not the remaining EU countries feel the same.

Another UK/US competent authority agreement published recently confirmed that references to the NAFTA in the UK/US treaty will be understood as references to its successor agreement, the Agreement between the United States of America, the United Mexican States, and Canada (USMCA). This is in addition to a previous unilateral statement by US authorities to that effect, which suggested that they would also seek confirmation on the point from treaty partners.

In the absence of an equivalent unilateral statement on the Brexit issue, the bilateral approach appears to be the more likely option. If the US authorities intend to replicate the NAFTA/USMCA competent authority agreement across the EU, perhaps they will use the opportunity to propose the same for the Brexit issue as well. One hopes that their treaty partners would oblige.