Provisions of the US-UK Tax Treaty of Interest to Companies Doing Business in the US
Both the US and the UK tax their residents on their worldwide income, including income sourced to other countries. In addition, both countries tax non-residents on income sourced within their borders. Consequently, when companies resident in one country do business in the other, there is the potential for income to be taxed twice – once by the country of residence and again by the source country.
The US-UK Tax Treaty (formally known as the “Convention between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital Gains”) is a bilateral tax treaty primarily designed to solve this problem. Through this treaty, the US and the UK have agreed among themselves as to how each will tax certain types of income (and at what rate) that otherwise could be subject to double taxation. For UK companies doing business in the US, there are four key provisions of interest:
- Taxation of Business Profits. Under US tax law, when a foreign person engages in a trade or business in the US, all income from sources within the United States connected with the conduct of that trade or business (called “effectively connected income” or “ECI”) is subject to US taxation. The US-UK tax treaty changes this default rule by establishing a higher threshold for US taxation of US-sourced business profits earned by UK traders or corporations. Specifically, UK residents will generally not be taxed on business profits arising out of the US unless the UK resident has established a “permanent establishment” in the US, and then only to the extent that the profits are attributable to that permanent establishment. A permanent establishment is a “fixed place of business through which the business of an enterprise is wholly or partly carried on” and generally includes a place of management, branch, office, or factory. The mere use of a broker, general commission agent, or other independent agent generally does not result in a permanent establishment. Furthermore, operating in the US through a subsidiary will not result in the creation of a permanent establishment for the UK parent. However, if a dependent agent (including an employee) of the UK company “habitually exercises” in the US the authority to conclude contracts that are binding on the UK company, this will generally be deemed to result in a permanent establishment that subjects the UK company to taxation on its US profits.
- Dividends. The default rule under US tax law is that a US corporation which pays dividends to a foreign person must withhold and pay over to the US Treasury 30% of the gross amount of the payment. The US-UK tax treaty changes this default rule by lowering – and in some cases eliminating – the withholding requirement. Firstly, where the treaty benefits apply, the US withholding tax will in no case be greater than 15%. Secondly, if the dividends are paid to a UK company owning (directly or indirectly) 10% or more of the US company, the withholding tax will be no greater than 5% of the gross amount of the payment. Finally, if the dividends are paid to a qualifying UK company that during the twelve months preceding the payment has owned (directly or indirectly) 80% or more of the US company, there will be no withholding tax. To be a qualifying company eligible to receive dividends without US withholding the company must meet certain tests that are designed to ensure that the UK company is not a mere conduit established to take advantage of the treaty’s benefits. As a general matter, this will include UK companies that are owned 50% or more by UK residents and that make deductible payments (other than arm-length payments incurred in the ordinary course of business) to non-UK residents amounting to less than 50% of the UK company’s gross income.
- Royalties. In many instances, a UK entity will license to a US company – either its own subsidiary or an independent entity such as a franchisee or distributor – the right to use certain intellectual property, including its trademarks, patents, or copyrights. As with dividends, the default rule in the US is that royalty payments made by a US resident are subject to a withholding tax of 30% of the gross amount of the payment. However, under the US-UK tax treaty, this withholding obligation is eliminated. Thus, provided the royalty payment reflects the amount that would be paid in an arms-length transaction between unrelated parties, any royalty paid by a US company (including a US subsidiary or affiliate) will only be subject to tax in the UK.
- Interest. It is common for a UK entity to loan funds to its US subsidiary or affiliate, particularly in the startup phase of US operations. When this occurs, the US entity must pay interest to the UK entity. Generally, interest paid by a US person to a non-US person is subject to a US withholding tax of 30% of the gross amount of the payment. Under the US-UK tax treaty, this withholding obligation is eliminated, if (and to the extent that) interest is paid at a rate that would exist had the transaction been an arms-length transaction between unrelated entities. It is noteworthy that, if the “interest” payable varies based on the payor’s gross receipts, profit, or other similar factors, the payment may be recharacterized as a dividend, subject to the treaty’s provisions relating to dividends.