Competent authority agreements between the UK and the US have recently been published addressing the interpretation of certain provisions in the US/UK double tax treaty (DTT). These agreements do not solve the main “Brexit US LOB” problem (explained below), but they provide a helpful indication that the US authorities are minded to resolve things and how they might be planning to do that.
What is the “US LOB”?
US DTTs often include “limitation on benefits” or “LOB” provisions which are intended to prevent “treaty shopping” (e.g. establishing a shell holding company in a particular jurisdiction with the sole aim of seeking treaty benefits). The LOB provisions in US DTTs generally operate to only allow certain "qualified persons" to access the benefits available under a DTT.
If a resident company does not fall within any of the categories of qualified persons there are alternative grounds for qualifying under the LOB rules. One of these is the “derivative benefits” test. This is a type of look-through test where the aim is to grant treaty benefits to a company resident in a treaty state (the Resident) where the Resident’s ultimate shareholders (often a parent company) would be granted the same treaty benefits if the particular payment (e.g. typically an interest payment or dividend) was made directly to the ultimate shareholders.
This test is satisfied where a certain proportion (usually 95%) of the Resident’s shares are held by residents of member states of the EU (and in some cases also the EEA) or of parties to the North American Free Trade Agreement (NAFTA) with which the other state has a comprehensive DTT under which broadly the same treaty benefits would be available as between the other state and the state of the Resident’s ultimate shareholders - these are often referred to as "equivalent beneficiaries".
For example, an Irish subsidiary that invests in the US may seek benefits under the US/Ireland DTT which includes a LOB provision. However, that Irish subsidiary may not itself satisfy any of the categories of qualified person or other alternative grounds for qualifying under the LOB provision. In such case, the Irish company may be able to rely on having an EU parent company that satisfies the derivative benefits test in order to access the benefits under the US/Ireland DTT. On a payment of interest from a US entity to the Irish subsidiary, this could be the difference between US withholding tax of up to 30% being applicable or not.
What is the Brexit US LOB problem?
Before Brexit, a number of groups had been relying on being UK headed to satisfy the derivative benefits test to qualify under the US LOB provision. Such groups had cause for quite significant concern as a result of Brexit because on a plain reading of the US LOB provisions a UK parent company now fails at the first hurdle of the "equivalent beneficiary" definition requirements because it is no longer a resident of an EU member state. Meaning that treaty relief that had previously been available for non-UK subsidiaries within the group (the Irish company in the example above) would no longer be available unless, in the absence of any other alternative grounds for qualifying under the LOB rules being applicable, it is agreed that references to EU member states in the US DTT LOB provisions can continue to be read to include the UK. This is generally viewed as the main Brexit US LOB problem.
A similar, but less common, concern arises for UK companies seeking to rely on the derivative benefits test in the US/UK DTT where the UK company’s shares are held, say, 80% by an EU27 resident and 20% by a UK resident. In that case, post Brexit the UK company is no longer 95% owned by residents of EU member states and again the equivalent beneficiaries definition is no longer satisfied.
These concerns have been in point going back to exit day, that is 31 January 2020. The transition period ending 31 December 2020 only related to the UK-EU relationship, so for agreements with third party jurisdictions such as the US the operative exit date is 31 January 2020.
Possible solutions to the Brexit US LOB problem
The Brexit US LOB problem was highlighted to HMRC (the UK tax authority) early on in the Brexit process and it is understood that HMRC initially proposed the problem could be addressed by the US authorities issuing a statement providing that for the purposes of US DTTs that define equivalent beneficiary status by reference to EU membership, UK residents will continue to be treated as equivalent beneficiaries post Brexit.
There is precedent for the US taking this approach in relation to interpreting the equivalent beneficiaries test in DTTs. As mentioned above, the equivalent beneficiaries definition usually applies to residents of an EU member state, or parties to NAFTA. The NAFTA was superseded from July 2020 by the US–Mexico–Canada Agreement (USMCA) and in May last year the US Treasury and IRS issued a statement confirming they would interpret references in US DTTs to the NAFTA as references to the USMCA and would contact their treaty partners to confirm they agreed with that interpretation.
However, DTTs are heavily negotiated bilateral agreements between two states. The relevant treaty partners of the US may not be entirely happy with the US authorities unilaterally deciding on the interpretation of a definition included in that heavily negotiated agreement. The position is likely to be somewhat more sensitive for US treaty partners that are also remaining EU member states that may not be particularly supportive of helping the UK plug DTT gaps created as a result of the UK leaving the EU.
An alternative to the US authorities issuing a blanket unilateral statement is for the US to enter into competent authority agreements with each of its relevant treaty partners to clarify the interpretation of the equivalent beneficiaries test. This is the approach that has been taken in relation to the US/UK DTT and the recently published competent authority agreements confirm that in the definition of equivalent beneficiary in the US/UK LOB provision: (i) the UK will continue to be regarded as an EU member state (see here); and (ii) references to NAFTA should be understood as references to USCMA (see here). The major downside with this approach is that it will take more time to agree the position with each treaty state and the problem will be resolved in a more piecemeal way, that is on a treaty partner by treaty partner basis as new competent authority agreements are agreed and published.
Do the recent UK/US competent authority agreements fix the Brexit US LOB problem?
The clarification of the interpretation of the derivative benefits test in the recent UK/US competent authority agreements only relates to the US/UK DTT. This assists with the less common issue where UK companies seek to rely on the derivative benefits test in the US/UK DTT and, as per the example above, the UK company’s shares are split 80:20 between EU27 resident and UK resident shareholders. The clarification in the US/UK competent authority agreement confirms that the UK company is still regarded as being 95% owned by residents of EU member states in these circumstances.
However, this does not address the main Brexit US LOB problem described above. In the example of a UK headed group investing into the US indirectly via a subsidiary in Ireland, it is the interpretation of the derivative benefits test in the US/Ireland DTT that is key rather than the US/UK DTT. Equivalent competent authority agreements for these DTTs have not so far been published.
In the interim, even where the derivative benefits test is not met, the relevant LOB requirements may still be satisfied via the “active business” test which is a further alternative grounds for qualifying that does not consider the status of the Resident’s shareholders. Using the example above, where the Irish subsidiary earns US source income for which it wishes to claim relief from US tax under the US/Ireland DTT, if the US source income is derived in the course of an active business carried on in Ireland, this test will be satisfied.
If that is not a viable alternative, groups still concerned with the main Brexit US LOB problem may consider the recent US/UK agreements to be helpful as they provide a steer that the US is of the view that UK residents should continue to be eligible for equivalent beneficiary status under the relevant DTTs. It can also be seen as an indication of the approach that the US authorities will use to resolve this issue, although this remains subject to official confirmation from the US authorities.
It is hoped the US authorities will now move to finally address the remaining main Brexit US LOB problem sooner rather than later by agreeing and publishing equivalent competent authority agreements with its relevant treaty partners.