United States-United Kingdom Tax Treaty
The United Kingdom’s International Tax Compliance Rules
UK US Tax Treaty Quick Summary. In the United Kingdom, Her Majesty’s Revenue and Customs (HMRC) is responsible for administering and collecting taxes in the UK. For 2019, HMRC collected $841.19 billion in tax revenue. But it took over 300 years of taxation in the United Kingdom to get to this level.
The UK was not officially formed until 1707, but even prior to its formation, taxes were commonplace in England and the surrounding geographical area. For example, records demonstrate that King John placed export taxes on wool from England as early as the year 1203. Eventually, a national tax was adopted in England in 1601—with taxes still being levied by the monarchy. But in 1628, English Parliament passed a law prohibiting the crown from levying new taxes without the consent of Parliament.
England (Great Britain at the time) first initiated a formal income tax in 1798 under William Pitt the Younger to help fund England’s participation in the Napoleonic Wars. This tax was actually a progressive tax based on the amount of income a citizen received—similar to the current United States income tax system, albeit far less complicated. But this income tax was later abolished in 1802. The income tax was then instituted once again in 1803, but abolished for a second time in 1816 after the Battle of Waterloo.
Throughout the second half of the 19th century, British politicians battled over tax laws, with numerous tax provisions being instated and repealed, but the income tax ultimately survived. At the turn of the century, during the First World War, Great Britain funded its war efforts mainly through borrowing and levy of new taxes, and the public generally accepted the taxes levied as citizens, as they knew it would help fuel the war effort. But as a result of the war, national debt soared by nearly 1,200%.
In 1940, during the Second World War, Great Britain levied a “purchase tax,” where the rate of tax on the purchase of a good depended on its “luxioursness.” But unlike a typical VAT tax, this was applied on the manufacturing and distribution stages, not at final sale. This lasted until 1973, when a true VAT was adopted.
U.S.-UK Tax Treaty
The UK still has an income tax, and the taxation depends on certain “schedules” as identified in law passed by Parliament, tax treaties, regulations, and case law.
The United States and the UK government have entered into a number of tax treaties including the Bilateral Tax Treaty, entered into in 2001, (“US-UK Treaty”), Totalization Agreement (Social Security), FATCA (Foreign Account Tax Compliance Act), and Estate Tax Treaty. The main focus of this article will be on the US-UK Treaty.
- 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 signed at London on December 31, 1975, and an exchange of notes signed at London on April 13, 1976, modifying certain provisions of the Convention
- TECHNICAL EXPLANATION OF 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 CAPITAL GAINS SIGNED AT LONDON, ON DECEMBER 31, 1975, AS AMENDED BY THE NOTES EXCHANGED AT LONDON ON APRIL 13, 1976, THE PROTOCOL SIGNED AT LONDON ON AUGUST 26, 1976, AND THE SECOND PROTOCOL SIGNED AT LONDON ON MARCH 31, 1977
- 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
- Technical Explanation of the Convention between the United States and the United Kingdom of Great Britain and Northern Ireland, signed on July 24, 2001
- PROTOCOL AMENDING 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, SIGNED AT LONDON ON 24th JULY 2001
- United States response to United Kingdom note setting forth additional agreements regarding the U.S.-U.K. Double Taxation Convention, signed July 24, 2001, London
Under the UK’s system of laws, HMRC administers the following central taxes:
- Income tax
- Corporation tax
- Capital gains tax
- Inheritance tax
- Insurance premium tax
- Stamp, land, and petroleum revenue taxes
- Environmental taxes
- Climate change and aggregates levy and landfill tax
- Value-Added Tax (VAT), including import VAT
- Customs duty;
- Excise duties.
But devolved governments (such as Scotland) and local governments may also levy their own taxes. Thus, careful attention may be required in analyzing any treaty benefits under the US-UK Treaty. Some of the US-UK Treaty benefits and provisions are discussed below.
Application to Taxes: The US-UK Treaty specifically applies to taxes on income and on capital gains imposed on behalf of the US or UK irrespective of the manner in which they are levied. But with respect to current taxes, the US-UK Treaty applies to US federal income taxes (excluding social security), federal excise taxes on insurance policies issued by foreign insurers with respect to private foundations, UK income tax, UK capital gains tax, UK corporation tax, and UK petroleum revenue tax.
Residence: This is important for determining application of the US-UK Treaty because certain sections of the treaty may apply or not apply depending on whether the individual is a resident of the UK or the US. Generally, a resident is “any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.” But the rules can be quite a bit more complex in reality.
Income from Real Property: Generally, under the US-UK Treaty, income from real property, including income from agriculture or forestry, may be taxed in the country where that property is located. However, this rule does not apply to direct use, letting, or use in any other form of real property. And both rules apply to income from real property of an enterprise.
Business Profits: Business profits are typically only taxable in the country where the business is located, unless the business operates in the other country to the treaty through a permanent establishment in said country. The business profits can then be taxed in that other country, but only to the extent the profits are attributable to the permanent establishment. And deductions can be taken for expenses incurred for the purpose of the permanent establishment.
Dividends: If dividends arise in one country and are paid to a resident of the other country, the dividend payments are generally subject to a reduced tax rate of 5% if the beneficial owner is a company that owns shares representing directly or indirectly at least 10% of the voting power of the company paying the dividends. Otherwise, the dividend tax rate is limited to 15%. However, certain types of dividends are excluded from the reduced tax rate, among other complex provisions.
Interest: Interest income arising in one country that is beneficially owned by a resident of the other contracting country is only taxable in that other country. And the term “interest” here is quite broad, including “income from debt-claims of every kind.” However, there are exceptions to this rule. For example, if the beneficial owner of one contracting state carries on business in the other state where the interest income arises through a permanent establishment and is attributable to such permanent establishment, then business profits rule under Article 7 will apply.
Royalties: If royalties arising in one state are beneficially owned by a resident of the other state, the royalties are only taxable in the other state. And the term “royalties” includes “any consideration for the use of, or the right to use, any copyright of literary, artistic, scientific or other work” and any gain derived from the alienation of any such royalty. There are similar limitations based on carrying on business in a certain state as with the US-UK Treaty provision on interest.
Capital Gains: Any gain derived by a resident of one state that are attributed to the transfer of real property in the other state may be taxed in the other state. And the term “real property” includes mineral rights and typical real property rights. But with respect to the UK, this term actually includes sales of shares of stock or similar securities that derive a portion of their value directly or indirectly from real property located in the UK. It also includes transfer of an interest in a partnership or trust in the UK to the extent the assets of the partnership or trust consist of real property situated in the UK. With respect to gains on the transfer of non-real property forming part of the business property of a permanent establishment in a state may be taxed in the other state, regardless of if the permanent establishment existed at the time of transfer. Otherwise, any other gains of property not specifically discussed in the US-UK Treaty are taxed only in the state where the transferor is a resident.
Income from Employment: Salaries, wages, etc. of a resident of one state is taxed only in that state unless employment is exercised in the other state. For example, if a a UK person is a US resident and earns wages in the US, only the US may tax those wages, but if that person instead works in the UK, then the UK may tax such wages. Certain residency tests (183 days) are applied.
Pensions, Social Security, Etc.: Articles 17 and 18 in the treaty are arguably some of the most complex provisions of any bilateral treaty that the US has entered into. To be frank, this topic deserves its own article. Knowing that, the general rule is that pensions and similar remunerations beneficially owned by a resident of one state are taxable only in that state. However, there are countless exceptions and limitations to this rule. For example, subparagraph b provides that the amount of any such pension or remuneration paid from a pension scheme established in the other state that would be exempt from taxation in that other state if the beneficial owner were a resident thereof shall be exempt from taxation in the first-mentioned State, even though that person is a resident of the first aforementioned state. A practical example helps explain this confusing language; if a pension is owned by a US resident, then it is taxable in the US under the general rule. However, if the pension from the UK would be exempt in the UK, assuming the person was a resident of the UK, then it will also be exempt from tax in the US even though the individual is not actually a resident of the UK. Social security, annuities, and other periodic payments also carry their own rules.
Government Service: Salaries, wages, etc., except for pensions, paid from public funds of a state, politicial subdivision, or local government for services rendered to such entity are only taxable in that state. However, they may be taxable in the other state if the services are rendered in that state and the individual is a resident of that state who is a national of that state or did not become a resident of that state solely for the provision of the services. Other limitations and exceptions may apply to pensions etc. paid from public funds for services rendered to the public entity.
Relief from Double Taxation: The US will allow a citizen or resident of the US a credit against tax on income for income tax paid or accrued to the UK, and in the the case of a US company owning at least 10% of the voting stock of a company that is a resident of the UK and from which the US company receives dividends, the income tax paid or accrued to the UK by or on behalf of the payer with respect to the profits out of which the dividends are paid. This Article then further articulates exactly which taxes fall under the definition of “income tax” for this purpose. A credit against UK tax for US tax payable is allowed. However, with respect to certain US taxes, a US citizen, former US citizen, or long-term resident of the US, that is now a UK resident, is not entitled to receive a credit against tax in the UK for US tax paid that is based on income from outside the US.
Savings Clause: The US-UK Treaty contains what is commonly known as a “Savings Clause.” Found in section 4 of Article 1, this clause provides that the contracting states (U.K. and U.S.) can essentially disregard the treaty, when applicable, and still tax the the resident or citizen as if the treaty did not exist.
United Kingdom Currency: The official currency of the UK is the British Pound. It is a free-floating currency.
Common Legal Entities: UK law permits various forms of business organization. These include sole proprietorships, general partnerships, limited liability partnerships, private limited companies, public limited companies, unlimited companies, community interest companies, charitable incorporated companies, and trusts.
Careful attention is required when formally organizing a business in the UK, particularly in light of requirements that may apply at the federal and local levels. For example, the federal government and has enacted legislation providing for the formation and regulation of companies, including registering such companies.
US-UK double Tax Treaty
United Kingdom Tax Treaties: The UK has double tax treaties with over 130 countries, making it one of largest networks of tax treaties in the world. This includes the OECD MLI.
Corporate Income Tax Rate: Generally, the UK federal corporate net tax rate is 19% for years starting April 1, 2017 through 2019. For tax year starting April 1, 2020, the rate was decreased to 18%. Prior to 2015, the tax rate depended on the profits of the corporation. However, marginal relief is available for companies if its taxable profits before 1 April 2015 are betweenm£300,000 and £1.5 million.
Individual Tax Rate: Similar to the United States, the UK’s federal government imposes graduated tax rates on the taxable income of individuals. For 2020, these graduated rates range from 0% to 45%.
Local governments also impose “council taxes” which is essentially a property tax on residences.
Capital Gains Tax Rate: In the UK, the capital gains rate depends on the type of property and the income tax rate of the taxpayer. Generally, an individual does not pay capital gains on the sale of their home, but certain taxpayers (“higher or additional rate taxpayers”) pay 28% capital gains on sale of residential property and 20% on other assets. For “basic” rate taxpayers, the capital gains rate depends on the size of the gain, the taxpayer’s income, and whether the gain is from residential property or other property. However, the UK does have a tax free allowance that may be used for capital gains.
Withholding Tax: UK does not impose a withholding tax on dividends paid by UK companies. However, a 20% withholding tax generally applies to distributions paid a REIT from its tax-exempt rental profits. Interest paid to a nonresidentis subject to a 20% withholding tax unless the rate is reduced under a tax treaty or the interest is exempt under the EU interest and royalties directive. A reduction of the withholding tax rate under a tax treaty is not automatic; advance clearance must be granted by the UK tax authorities. And royalties paid to nonresidents are subject to a 20% withholding tax unless the rate is reduced under a tax treaty or the royalties are exempt under the EU interest and royalties directive. Advance clearance is not required to apply a reduced treaty rate.
Branch Profits Tax: Foreign branches of UK companies are subject to corporation tax unless an election is made for exemption.
Transfer Pricing: UK legislation allows only for a transfer pricing adjustment to increase taxable profits or reduce a tax loss. It is not possible to decrease profits or increase a tax loss. The UK’s transfer pricing legislation also applies to transactions between any connected UK entities. The ‘arm’s length principle’ applies to transactions between connected parties. For tax purposes such transactions are treated by reference to the profit that would have arisen if the transactions had been carried out under comparable conditions by independent parties.
CFC Rules: If UK profits are diverted to a CFC, those profits are apportioned and charged on a UK corporate interest-holder that holds at least a 25% interest in the CFC. The regime operates by applying a series of charge gateways to different types of profits to identify any profits diverted from the UK that will then be apportioned and charged on the relevant UK corporate interest-holders. There are also a number of entity level exemptions to reflect the fact that it’s considered that the majority of CFCs are set up for genuine commercial reasons and to reduce the compliance burden in applying the rules.
Thin Capitalization: The UK transfer pricing and thin capitalisation rules prescribe an arm’s-length test for calculating an acceptable amount of debt. A UK company may be said to be thinly capitalised when it has excessive debt in relation to its arm’s-length borrowing capacity, leading to the possibility of excessive interest deductions that are disallowed.
United Kingdom Inheritance/Estate Tax: The UK generally charges a 40% inheritance tax, with some downward variances for certain situations. However, no inheritance tax is charged on estates valued at less than £325,000, or if everything above the £325,000 threshold is left to the deceased individual’s spouse, civil partner, a charity, or a community amateur sports club. The threshold increases to £500,000 if the deceased individual’s home is given to children or grandchildren. And for married individuals, any unused threshold can actually be added to the partner’s threshold when he or she dies.
Overview of the UK’s Income Tax System: The UK imposes a federal income tax on the income of individuals and companies, based on residency. Non-residents are generally subject to tax on income from UK sources and on gains from the disposal of taxable UK property. The UK corporate tax system attempts to alleviate the double taxation of income by exempting dividends from tax for most companies.
Individuals: UK resident individuals are subject to income tax on their worldwide income. Each individual must separately compute his or her tax liability, and family members may not file joint income tax returns. Income tax is usually deducted automatically from wages, pensions, etc., but people and businesses with other income must file a Self Assessment Tax Return. Gross income is divided among several categories, including employment income, self-employment income, property income, and capital gains.
Individual taxpayers are entitled to allowances and relief for items such as pension contributions, charitable donations, and business expenses.
Dividends, interest, and royalties are subject to tax, and the expenses incurred to produce investment income generally are deductible. Individuals are afforded a £2,000 dividend allowance (£5,000 in some previous years). An individual’s effective tax rate on dividends over their allowance depends on the taxpayer’s income tax rate.
Corporations: UK resident corporations are taxable on their worldwide profits from doing business. This includes “trading profits,” investment income, and capital gains. Even foreign companies with a UK branch or office must pay corporate tax, but only pay tax on profits from UK activities.
Expenses are generally deductible to the extent they are reasonable and incurred for the purpose of gaining or producing income and, if related to capital structure (i.e., an amount deducted with respect to an outlay, loss, or replacement of capital). Anything that provides some sort of personal benefit is not deductible, and may actually be taxable.
The UK levies taxes at both the individual and the corporate, although the double taxation is partially eliminated through exempting dividends paid to shareholders.
Corporate groups are not permitted to file consolidated tax returns, but the UK does provide for “group relief.” Where a company has losses arising in an accounting period (other than capital losses, or certain other losses) in excess of its other taxable profits for the period, it may surrender these losses to another group member with sufficient taxable profits in the same accounting period. The receiving company may use those losses to offset its own taxable profits. But some exceptions do exist.
Partnerships. Similar to United States tax law, UK tax law does not recognize a partnership as a separate taxpayer. Accordingly, each partner of a UK partnership is subject to tax on such partner’s share of partnership income each year, regardless of whether distributions are made from the partnership to the partner.
Indirect Taxes. The UK imposes a value added tax (VAT). The tax generally applies to all domestic transactions, and even some goods and services imported from outside the European Union. The VAT is charged at each stage of the economic chain, and venders are able to claim refunds based on the difference between VAT paid and VAT charged.
All businesses that provide “taxable” goods and services and whose taxable turnover exceeds the threshold must register for VAT, but the UK has one of the highest VAT thresholds in the world. And only businesses registered for VAT may charge VAT. There are currently three VAT rates: 20%, 5%, and 0%.
A separate scheme, called The Flat Rate Scheme is also run by HMRC. This scheme allows a VAT registered business with a turnover of less than £150,000 per annum to pay a fixed percentage of its turnover to HMRC every 3 months. The scheme is designed to reduce red tape for small business and allow new companies to keep some of the VAT they charge to their customers.
Tax Treaty Network – United Kingdom International Tax Attorneys
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