Posted on:Brexit, Europe, Features, Insights, International, Legal Developments, M&A / Cross-Border, U.K. Tax, What’s New on the Blog?
The withdrawal of the United Kingdom (“U.K.”) from the European Union (“E.U.”) may impact certain cross-border organizational structures. We have previously considered some of those U.K. tax impacts in our post “Brexit and Tax: An Uncertain Future”. The points considered in that previous post continue to be relevant to cross-border structures involving the U.K. and some, including, for instance, the benefits of E.U. directives to mitigate withholding tax on cross-border payments, may have a greater impact from January 1, 2021 when the Brexit transition period is scheduled to end.
However, the subject of this blog post is the ability of U.K. investors who invest in the United States (“U.S.”) through a third-country investment vehicle or holding company to rely on income tax treaties between the U.S. and the third country. This is a topic that we are seeing increasingly in practice. Therefore, such U.K. investors should ensure that their current investment structures will not result in tax leakage once the Brexit transition period is scheduled to end on January 1, 2021.
Generally, non-U.S. investors who receive certain passive-type income sourced in the U.S. are subject to a 30% U.S. tax enforced by withholding. The income subject to such a withholding tax includes dividends, interest, royalties and other “fixed or determinable annual or periodical gains, profits and income,” colloquially known as “FDAP.” However, such withholdings taxes may be reduced or eliminated under an applicable U.S. income tax treaty. In general, income tax treaties reduce or eliminate withholding taxes otherwise imposed by the source jurisdiction on passive income, albeit such a reduction or elimination is typically subject to various anti-abuse rules, including the “limitation on benefits” article (“LOB”).
LOB & Derivative Benefits
The LOB is designed to prevent investors from accessing treaty benefits provided by an income tax treaty between the source jurisdiction and a third-country by, for example, establishing a holding company in such a third-country, when such benefits would not be available if the investor invested directly (so-called “treaty shopping”). Because not all structures that involve three or more jurisdictions are abusive, the LOB ordinarily includes various safe harbors, such as for third-country holding companies that are publicly traded or are subsidiaries of a publicly traded company resident in the same country or that are engaged in the active conduct of a trade or business in the third-country. One such commonly utilized safe harbor is the so-called “derivative benefits” test, under which a third-country investor may derive treaty benefits even though no other LOB safe harbor applies if the investor could have obtained the same benefits (for example, source-based withholding taxes on passive income reduced to the same or lower percentage) by investing directly and not through a third-country holding company. Some income tax treaties refer to such investors as “equivalent beneficiaries”. The treaties that contain the derivative benefits test include the U.S. treaties with typical holding company jurisdictions such as Luxembourg, the Netherlands, and Ireland. Most income tax treaties that include the derivative benefits test, including those listed above, contain an array of limitations, such as that the third-country investor must be a tax resident of a jurisdiction that is a member state of the E.U. or the European Economic Area, a party to the North American Free Trade Agreement (“NAFTA”), or that is specifically enumerated.
The question that arises in connection with Brexit is apparent: Once the U.K. ceases to be treated as a member state of the E.U., will U.K. investors who invest in the U.S. through a holding jurisdiction be able to rely on reduced rates of withholding on passive income derived from the U.S., or will they fail to meet the LOB and incur tax leakage? Unfortunately, the U.S. Department of the Treasury has indicated in the technical explanation of the U.S.-Netherlands income tax treaty that references in the derivative benefits test are ambulatory, and that if a country departed from the European Communities (as they were then, prior to the introduction of the E.U. in 1993), it would no longer be considered a member state of the European Communities for purposes of the treaty. This interpretation is also arguably in line with the interpretative principles of the Vienna Convention on the Law of Treaties, which the U.S. signed but not ratified, and which principally look to the ordinary meaning of the terms of the treaty. Finally, the U.S. Internal Revenue Service (“IRS”) addressed a similar issue, which arose in connection with the renegotiation of the NAFTA, by issuing Announcement 2020-6, under which references to the NAFTA in income tax treaties should be interpreted as references to the new U.S.-Mexico-Canada Agreement. The IRS has not issued a similar announcement in connection with Brexit and has not otherwise indicated what position it expects to take.
In light of this significant uncertainty, U.K. investors should reevaluate their U.S. inbound investment structures to make sure they will not run afoul of the LOB starting from January 1, 2021. Unfortunately, the only transaction cost-free resolution of the issue is on the governmental level. Unless the IRS issues a notice or the treaty jurisdictions enter into protocols or renegotiate treaties, U.K. investors may need to reorganize their holding structures. Aside from going back to the drawing boards, U.K. investors may consider requesting a competent authority determination from the IRS (so-called “discretionary LOB relief”), which is a mechanism built into most LOB provisions and subject to specific procedural guidelines in Revenue Procedure 2015-40.