UK/US Treaty: Equivalent Beneficiary – Competent Authority Agreement

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Posted: 25th November 2021 by
Miles Dean
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A Competent Authority Agreement (CAA) between the UK and US was published on 28 July. The CAA confirms that despite the UK no longer being a member state of the EU, it will be treated as such for the purposes of applying paragraph 7(d) of Article 23 of the UK/US double taxation agreement (DTA).

The CAA apparently “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.”

Before the CAA was agreed, concerns had been raised that, after Brexit, UK residents would no longer be “equivalent beneficiaries” under the “derivative benefits” test in the DTA. This position could adversely impact certain important cross-border structures. While the CAA is a welcome development, it is important to note that it only covers the UK/US DTA. We will have to await the conclusion of similar CAAs between the US and the Competent Authorities of the other 13 countries where this lacuna presents an issue although this CAA is a hopeful sign as to how the IRS will approach any others.

US-inspired Limitation on Benefits (LOB) article

As many readers will know, the UK/US treaty contains a now-standard US-inspired Limitation on Benefits (LOB) article. The aim of this article is to limit the class of persons that can benefit from the treaty to those with sufficient nexus with either contracting state. In very simple terms, a company incorporated in England might be resident in the UK for tax purposes by virtue of being incorporated here, but that does not entitle it to automatically benefit from the UK/US DTA. 

The derivatives benefits test essentially waters down the LOB by allowing, for example, an English company to avail of treaty benefits if the ultimate owners thereof would have been entitled to the same benefit, had the income in question flowed directly to them. Under the LOB, a resident company must meet an ownership test which requires that 95% of the ultimate beneficial owners must be EU residents. It also requires that a base erosion test be met, which requires that no more than 50% of gross income is paid or accrued to a person or persons who are not equivalent beneficiaries in the form of tax deductible payments.

For example, imagine that an English holding company had been incorporated by UK, Luxembourg, Spanish and Irish investors, with shares of 25% each, in order to make a US acquisition. Two years after the acquisition was concluded, the US subsidiary then wants to pay a dividend to its UK holding company. This would mean that the US company has to work out what rate of US withholding tax is due on the dividend. The UK/US DTA gives a rate of 5% or 0% if the UK company qualifies for the benefits of the DTA because it is owned by equivalent beneficiaries.

Impact of Brexit

Under the terms of the UK/US DTA, as it stood prior to the CAA agreement but following Brexit, Luxembourg, Spanish and Irish investors were all potential equivalent beneficiaries, as they were residents of a country within the EU. However, if the UK investor was a UK company, it would not qualify as an equivalent beneficiary since it is no longer resident in an EU country. The effect of this would be that the UK holding company used to make the acquisition may not qualify for the UK/US DTA. As a result, the US withholding tax would fall due at 30% on the dividend. This is both a highly inequitable and undesirable consequence of the residence of a single shareholder falling outside the EU. It is notable that, in the scenario described, the three EU shareholders would also suffer the loss caused by the imposition of the US withholding tax of 30%. Such outcomes are obviously not in the interest of the EU, or the UK. It is therefore very welcome news that this initial CAA has been agreed upon.

As a result of the CAA, the UK investor in this scenario qualifies as an equivalent beneficiary. The net effect of the CAA is that, for these purposes, it is as if Brexit never happened, and the US subsidiary may be able to pay the dividend with a reduced rate of withholding tax.

In the scenario described above, there are many ifs and maybes. The reason for such caveats is that the question of whether a person is an equivalent beneficiary depends on more than simply being resident in the EU. In a real-world scenario, there would be several important additional considerations and requirements to be taken into account. However, the above scenario is simplified in order to illustrate the impact of the CAA in terms of the issue of residency. Of course, in a real-world scenario, the dividend may qualify for treaty relief in another way. However, to cover all of the possibilities would require one if not more newsletters all of their own.

The scenario addressed by the CAA demonstrates that there are still many loose ends to be tied up in the wake of Brexit. Those advising on corporate structures and acquisitions with an international dimension need to be wary of such risk. 

About the author: Miles Dean is the Head of International Tax at Andersen in the United Kingdom. 

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