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Brexit impact on US tax treaty relief

07 December 2018

Groups with international structures are likely to have started reviewing their group structure in the EU to assess whether it will be optimal for a post-Brexit environment. Clearly, this should encompass the customs and VAT implications and consideration of which group companies import or export and from where. However, it is also vital to review the funds flow around the group in terms of dividends, interest and royalties. 

Where there are significant intra-group payments across borders, groups should pay close attention to the way withholding tax is currently mitigated and whether there is reliance on EU directives or UK membership of the EU to claim tax reliefs.

After 29 March 2019

As things stand, the UK will leaving the EU on 29 March 2019. If the UK Parliament approves the proposed withdrawal agreement, a transition agreement will be in place from 29 March at 11pm. This agreement between the UK and the EU27 will mean that EU countries will treat the UK as remaining part of the EU during the transition period (up to 31 December 2020 – or later by extension). Therefore, the Parent-Subsidiary Directive and Interest and Royalties Directive should continue in relation to UK companies during the transition period. 

However, from an international law perspective, irrespective of whether a transition agreement is in place the UK will have left the EU on 29 March 2019 and there is no reason why a third country would be bound by any transition agreement and continue to treat the UK as an EU member state. Clearly, a ‘no-deal’ Brexit would also mean that the UK is no longer an EU member state.

US double tax treaties

US double tax treaties under certain conditions, allow companies that invest in the US to qualify for reduced withholding tax rates on payments from US-based subsidiaries (e.g. interest on intra-group loans, or US source royalties). 

This benefit can be restricted under the limitation on benefits (LOB) clause in US tax treaties. This clause essentially tests the commercial substance of an arrangement or holding structure to assess whether the granting of treaty benefits is within the intended purposes of the treaty. In the case of groups that are listed outside of the US or the UK, are privately held by individuals who are resident outside the US or the UK or who invest into the US via non-US/UK based structures, they may seek to satisfy the criteria of the LOB clause through reliance on the “derivative benefits provision” in the LOBs that allows treaty benefits to a company resident in the other state (i.e. Luxembourg in the example below) if the two conditions below are met. 

The first condition includes a test that at least a certain proportion of the shares (for example, for example, 95% in the case of the Luxembourg/US treaty) of the company claiming the benefits are ultimately owned by seven or fewer persons that are residents of a different EU/EEA member state, or party to the North American Free Trade Agreement with which the other state (i.e. Luxembourg) has a comprehensive double tax treaty. Therefore, in the example below, the Luxembourg company (although it’s a shell company) currently may meet this test if it is ultimately owned by seven or fewer persons that are residents in the UK, and the UK has a comprehensive double tax treaty with the US.

The second condition is that less than half of the company’s gross income is paid (or accrued) to persons who are not "equivalent beneficiaries" as tax-deductible payments. For most group companies this is unlikely to be a difficult test to meet.

Under the withdrawal agreement or a ‘no-deal’ Brexit, UK groups will cease to be resident in the EU or EEA. Therefore, if a UK group invests into the US through, for example a Luxembourg shell company structure as below, it may no longer get the benefits under the current US-Luxembourg double tax treaty. This may mean that withholding tax or a higher rate of withholding tax would then apply to intra-group payments made from the US subsidiary to the group company in Luxembourg. 

The US double tax treaties with other EU member states (including Ireland) will have a similar impact where group transactions are routed through those member states. Therefore, any groups that have US subsidiaries and an EU-based financing or investment structure should review their arrangements to examine their future exposure to withholding tax. 

Even if political considerations result in a delay in the UK leaving the EU, perhaps to give more time for Brexit negotiations, this withholding tax issue could still arise when Brexit day does eventually come. 

For help and advice on international tax issues please contact Ross Robertson, Tim Ferris or Leon Luftig

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