Treaty relief for UK residents investing into the US

Article 01 September 2021 Experience: Tax

The US and UK tax administrations recently issued a “Competent Authority Arrangement“ (“CAA”) relating to a tax treaty issue arising out of the United Kingdom’s departure from the European Union (“Brexit”). The CAA is welcome news for UK-resident individuals who make investments in US funds or US portfolio securities through EU-based holding company structures.

By way of background, a company is generally precluded from claiming lower treaty-based US tax withholding rates on US-source income unless it meets at least one of the “Limitation on Benefits (“LOB”) tests set forth in the relevant tax treaty. The LOB clause is an anti-“treaty shopping” measure the purpose of which is to inhibit a non-US investor or business from establishing a company in a particular jurisdiction for the sole purpose of claiming treaty benefits vis-à-vis the United States. A passive investment holding company is generally able to satisfy the LOB test only by, among other requirements, demonstrating that a threshold proportion of its equity is beneficially owned by either (i) individuals residing in the same jurisdiction as the company, or (ii) under the “derivative benefits” test, so-called “equivalent beneficiaries.” In most bilateral US-European tax treaties, an “equivalent beneficiary” is very generally defined to mean any person who resides in a country that has a tax treaty in effect with the United States, provided that (i) the applicable provisions of that beneficial owner’s tax treaty are at least as generous as the treaty that applies to the company itself, and (ii) the beneficial owner’s country of residence is a member state of the European Union (or, depending upon the particular treaty, the broader European Economic Area and/or Switzerland).

Until recently, a UK-resident individual investor could invest in US portfolio securities through a European holding company structure—for example, a holding company organized in Luxembourg or the Netherlands—and take the position that the holding company qualified for reduced treaty withholding rates on US-source portfolio income. Specifically, in the pre-Brexit era, the UK investor would have been an equivalent beneficiary under the US-Netherlands or US-Luxembourg tax treaties on the basis that (i) the US-UK treaty generally provided for reduced withholding rates which were at least as low as the rates provided in those two treaties, and (ii) the UK was an EU member state. When the UK ceased being an EU member state in January 2020, this immediately called into question whether these holding company structures were still entitled to claim treaty-based withholding rates on US-source dividends and interest.

Before the CAA was issued, practitioners had debated whether the IRS or the US Treasury Department might be willing to deem the UK to be an EU member state for derivative benefits clause purposes. But neither the IRS nor Treasury had taken any public position on this issue before promulgating the CAA. As a consequence, UK investors owning equity in EU holding company structures faced an unappealing choice between paying higher levels of US withholding tax on their underlying US investment positions or making a potentially risky treaty claim.

The CAA goes some way to resolving this dilemma by confirming that, contrary to the plain meaning of the text, Treasury and the IRS will continue to treat the UK as a “Member State of the European Community” going forward for purposes of the US-UK treaty’s derivative benefits clause. The CAA technically only applies to UK holding companies claiming benefits under the US-UK tax treaty. This situation might arise if, for example, a UK holding company were owned beneficially by a combination of UK and European individuals and thus needed to invoke the derivative benefits clause in order to ensure eligibility under the US-UK treaty. On its face, the CAA is silent as to the other treaties for which the same interpretive issue arises—for instance, treaties with Luxembourg or the Netherlands. We nevertheless believe that the CAA is a credible indication as to Treasury’s and the IRS’s thinking on this issue more generally. We think the CAA bolsters the view that the UK should be treated as an EU member state for purposes of all derivative benefits clauses in European-US tax treaties.

While the CAA does not offer complete comfort on this issue, it considerably strengthens the view that Brexit did not hurt the treaty eligibility of EU holding company structures owned by UK-resident individuals.

We would be happy to discuss how to leverage the guidance contained in the CAA to establish tax-efficient holding company structures.