Tax News Update    Email this document    Print this document  

Two arrangements signed recently by the US and UK competent authorities clarify certain terms as used in the current tax treaty between the two countries.

Executive Summary

On July 26, 2021, the US and UK competent authorities signed two arrangements regarding the interpretation of the terms "North American Free Trade Agreement (NAFTA)" and "resident of a Member State of the European Community" in the Limitation on Benefits (LOB) provision of the Convention between the United States of America and the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, signed on July 24, 2001, as amended by the Protocol signed on July 19, 2002 (the US-UK Treaty). The first arrangement clarifies that the references to the NAFTA in the LOB provision of the US-UK Treaty will be understood as references to the Protocol Replacing the North American Free Trade Agreement with the Agreement between the United States of America, the United Mexican States, and Canada (USMCA). The second arrangement clarifies that a "resident of a Member State of the European Community" for purposes of the LOB provision of the US-UK Treaty continues to include a resident of the UK.

Detailed Discussion

First Competent Authority Arrangement

On November 30, 2018, the governments of the United States, Mexico and Canada signed the USMCA. Upon entry into force on July 1, 2020, the USMCA supersedes the NAFTA. The NAFTA had governed trade relations between the United States, Mexico and Canada since January 1, 1994, and many US tax treaties in force today contain explicit references to the NAFTA (e.g., the derivative benefits test within the LOB article), but do not mention agreements that might supersede it. As a result, questions have arisen regarding the application of treaty provisions referencing the NAFTA after the USMCA entered into force.

In Announcement 2020-6, published in May 2020, the US Treasury Department (Treasury) and the Internal Revenue Service (IRS) indicated that, once the USMCA enters into force, they would interpret references in US income tax treaties to the NAFTA as references to the USMCA. The IRS and Treasury also noted that they would reach out to countries with applicable tax treaties that contain references to the NAFTA to confirm that those countries will similarly interpret references to the NAFTA as references to the USMCA. (See Tax Alert 2020-1356.)

In the first arrangement (Competent Authority Arrangement Regarding USMCA), the US and UK competent authorities agreed that the references to the NAFTA in paragraph 7(d) of Article 23 of the US-UK Treaty, which defines the term "equivalent beneficiary" for purposes of the LOB article of the US-UK Treaty, shall be understood as references to the USMCA upon entry into force of the USMCA.

Second Competent Authority Arrangement

The UK's withdrawal from the European Union (EU) has created uncertainty as to whether a person resident in the UK may continue to be considered a "resident of a Member State of the European Community" for the purposes of applying the "derivative benefits test" in paragraph 3 of Article 23 of the US-UK Treaty.

In general, the derivative benefits test of the US-UK Treaty provides treaty benefits to a company that is a resident of a treaty country if (a) at least 95 percent of the aggregate voting power and value of its shares is owned, directly or indirectly, by seven or fewer persons that are "equivalent beneficiaries," and (b) less than 50 percent of the company's gross income for the tax year or chargeable period is paid or accrued, directly or indirectly, to persons who are not equivalent beneficiaries, in the form of certain payments that are deductible in the residence country. (The term "equivalent beneficiary" for these purposes is defined in paragraph 7(d) of Article 23 as a resident of a "Member State of the European Community or of a European Economic Area state or of a party to the North American Free Trade Agreement," but only if certain requirements are met.

In the second arrangement (Competent Authority Arrangement Regarding the UK Withdrawal from the European Union), the US and UK competent authorities agreed that, for the purposes of applying paragraph 7(d) of Article 23 of the US-UK Treaty, a "resident of a Member State of the European Community" continues to include a resident of the UK because residents of either treaty country should be eligible to qualify as equivalent beneficiaries for purposes of applying the derivative benefits test in paragraph 3 of Article 23.

Implications

The two competent authority arrangements provide helpful guidance for interpreting the US-UK Treaty. Although the IRS and Treasury had previously announced that, once the USMCA enters into force, they will interpret references in US income tax treaties to the NAFTA as reference to the USMCA, the first arrangement confirms that the UK competent authority will similarly interpret references to the NAFTA as references to the USMCA. Likewise, the second arrangement puts an end to any uncertainty that may have existed with respect to defined terms in the US-UK Treaty as a result of the UK's withdrawal from the EU.

The US-UK competent authority arrangement regarding the USMCA is not the first arrangement clarifying references to the NAFTA in US tax treaties with other countries. In June 2020, the competent authorities of Switzerland and the United States entered into a similar arrangement, agreeing that references to the NAFTA in the US-Switzerland Treaty shall be understood as references to the USMCA. The competent authority arrangements with the UK and Switzerland deliver on the promise by the IRS and Treasury to reach out to countries that have applicable tax treaties containing references to the NAFTA to confirm that those countries will similarly interpret such references as references to the USMCA. The Competent Authority Arrangement Regarding the UK Withdrawal from the European Union applies only to the US-UK Treaty. It remains to be seen whether the IRS and Treasury would enter into similar arrangements to treat the UK as an EU member for purposes of the derivative benefits test (or other relevant provisions) in other treaties.

———————————————