U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

1

85–199 2003 JCS–4–03

[JOINT COMMITTEE PRINT]

EXPLANATION OF PROPOSED 

INCOME TAX TREATY BETWEEN 

THE UNITED STATES AND 

THE UNITED KINGDOM

SCHEDULED FOR A HEARING

BEFORE THE

COMMITTEE ON FOREIGN RELATIONS 

UNITED STATES SENATE

ON MARCH 5, 2003

PREPARED BY THE STAFF

OF THE

JOINT COMMITTEE ON TAXATION

March 3, 2003 


E:\Seals\Congress.#13
(II)

JOINT COMMITTEE ON TAXATION 

108TH CONGRESS, 1ST SESSION

HOUSE SENATE 

WILLIAM M. THOMAS, California, 

Chairman 

PHILIP M. CRANE, Illinois 

E. CLAY SHAW, JR., Florida 

CHARLES B. RANGEL, New York 

FORTNEY PETE STARK, California 

CHARLES E. GRASSLEY, Iowa, 

Vice Chairman 

ORRIN G. HATCH, Utah 

DON NICKLES, Oklahoma 

MAX BAUCUS, Montana 

JOHN D. ROCKEFELLER IV, West Virginia 

MARY M. SCHMITT, Acting Chief of Staff 

BERNARD A. SCHMITT, Deputy Chief of Staff 

(III)

C O N T E N T S 

Page 

INTRODUCTION .............................................................................. 1

I. SUMMARY .............................................................................. 2

II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE

AND INVESTMENT AND U.S. TAX TREATIES ...................... 4

A. U.S. Tax Rules ......................................................... 4

B. U.S. Tax Treaties .................................................... 5

III. EXPLANATION OF PROPOSED TREATY ................................... 8

Article 1. General Scope ............................................ 8

Article 2. Taxes Covered ............................................ 13

Article 3. General Definitions ................................... 13

Article 4. Residence ................................................... 16

Article 5. Permanent Establishment ........................ 18

Article 6. Income from Real Property ....................... 19

Article 7. Business Profits ......................................... 20

Article 8. Shipping and Air Transport ..................... 25

Article 9. Associated Enterprises .............................. 26

Article 10. Dividends ................................................... 27

Article 11. Interest ....................................................... 34

Article 12. Royalties ..................................................... 36

Article 13. Gains .......................................................... 38

Article 14. Income from Employment ......................... 39

Article 15. Directors’ Fees ........................................... 40

Article 16. Entertainers and Sportsmen .................... 41

Article 17. Pensions, Social Security, Annuities, Alimony, and Child Support ...................................... 41

Article 18. Pension Schemes ....................................... 43

Article 19. Government Service .................................. 44

Article 20. Students ..................................................... 45

Article 20A. Teachers .................................................. 45

Article 21. Offshore Exploration and Exploitation 

Activities ................................................................. 46

Article 22. Other Income ............................................. 46

Article 23. Limitation on Benefits .............................. 47

Article 24. Relief From Double Taxation ................... 56

Article 25. Non-Discrimination ................................... 62

Article 26. Mutual Agreement Procedure .................. 64

Article 27. Exchange of Information and Administrative Assistance .................................................. 66

Article 28. Diplomatic Agents and Consular Officers .......................................................................... 68

Article 29. Entry into Force ........................................ 68

Article 30. Termination ............................................... 69

IV. ISSUES ................................................................................... 71

Page

IV

A. Zero Rate of Withholding Tax on Dividends from 

80–Percent-Owned Subsidiaries ........................... 71

B. Anti-Conduit Rule ................................................... 76

C. Insurance Excise Tax .............................................. 78

D. Dividend Substitute Payments .............................. 79

E. Attribution of Business Profits .............................. 82

F. Income from the Rental of Ships and Aircraft ...... 87

G. Creditability of U.K. Petroleum Revenue Tax ...... 87

H. Teachers, Students, and Trainees ......................... 91

(1)

1This pamphlet may be cited as follows: Joint Committee on Taxation, Explanation of Proposed Income Tax Treaty Between the United States and the United Kingdom (JCS–4–03), March 

3, 2003. 2For a copy of the proposed treaty, see Senate Treaty Doc. 107–19. 

INTRODUCTION 

This pamphlet,1 prepared by the staff of the Joint Committee on 

Taxation, describes the proposed income tax treaty between the 

United States of America and the United Kingdom, as supplemented by an exchange of diplomatic notes (the ‘‘notes’’) and a protocol (the ‘‘proposed protocol’’). The proposed treaty and notes were 

signed on July 24, 2001. The proposed protocol was signed on July 

22, 2002. Unless otherwise specified, the proposed treaty, the notes, 

and the proposed protocol are hereinafter referred to collectively as 

the ‘‘proposed treaty.’’ The Senate Committee on Foreign Relations 

has scheduled a public hearing on the proposed treaty for March 

5, 2003.2

Part I of the pamphlet provides a summary of the proposed treaty. Part II provides a brief overview of U.S. tax laws relating to 

international trade and investment and of U.S. income tax treaties 

in general. Part III contains an article-by-article explanation of the 

proposed treaty. Part IV contains a discussion of issues relating to 

the proposed treaty. 

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I. SUMMARY 

The principal purposes of the proposed treaty are to reduce or 

eliminate double taxation of income earned by residents of either 

country from sources within the other country and to prevent 

avoidance or evasion of the taxes of the two countries. The proposed treaty also is intended to promote close economic cooperation 

between the two countries and to eliminate possible barriers to 

trade and investment caused by overlapping taxing jurisdictions of 

the two countries. 

As in other U.S. tax treaties, these objectives principally are 

achieved through each country’s agreement to limit, in certain 

specified situations, its right to tax income derived from its territory by residents of the other country. For example, the proposed 

treaty contains provisions under which each country generally 

agrees not to tax business income derived from sources within that 

country by residents of the other country unless the business activities in the taxing country are substantial enough to constitute 

a permanent establishment (Article 7). Similarly, the proposed 

treaty contains ‘‘commercial visitor’’ exemptions under which residents of one country performing personal services in the other 

country will not be required to pay tax in the other country unless 

their contact with the other country exceeds specified minimums 

(Articles 14 and 16). The proposed treaty provides that dividends, 

interest, royalties, and certain capital gains derived by a resident 

of either country from sources within the other country generally 

may be taxed by both countries (Articles 10, 11, 12, and 13); however, the rate of tax that the source country may impose on a resident of the other country on dividends, interest, and royalties may 

be limited or eliminated by the proposed treaty (Articles 10, 11, 

and 12). In the case of dividends, the proposed treaty contains provisions that for the first time in a U.S. income tax treaty would 

eliminate source-country tax on certain dividends in which certain 

ownership thresholds and other requirements are satisfied. 

In situations in which the country of source retains the right 

under the proposed treaty to tax income derived by residents of the 

other country, the proposed treaty generally provides for relief from 

the potential double taxation through the allowance by the country 

of residence of a tax credit for certain foreign taxes paid to the 

other country (Article 24). 

The proposed treaty contains the standard provision (the ‘‘saving 

clause’’) included in U.S. tax treaties pursuant to which each country retains the right to tax its residents and citizens as if the treaty 

had not come into effect (Article 1). In addition, the proposed treaty 

contains the standard provision providing that the treaty may not 

be applied to deny any taxpayer any benefits the taxpayer would 

be entitled under the domestic law of a country or under any other 

agreement between the two countries (Article 1). 

3

The proposed treaty contains provisions which can operate to 

deny the benefits of the dividends article (Article 10), the interest 

article (Article 11), the royalties article (Article 12), the other income article (Article 22), and the insurance excise tax provision of 

the business profits article (Article 7(5)) with respect to amounts 

paid under, or as part of, a conduit arrangement. The proposed 

treaty also contains a detailed limitation on benefits provision to 

prevent the inappropriate use of the treaty by third-country residents (Article 23). 

The United States and the United Kingdom have an income tax 

treaty currently in force (signed in 1975). The proposed treaty is 

similar to other recent U.S. income tax treaties, the 1996 U.S. 

model income tax treaty (‘‘U.S. model’’), and the 1992 model income 

tax treaty of the Organization for Economic Cooperation and Development, as updated (‘‘OECD model’’). However, the proposed treaty 

contains certain substantive deviations from these treaties and 

models. 

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II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL 

TRADE AND INVESTMENT AND U.S. TAX TREATIES 

This overview briefly describes certain U.S. tax rules relating to 

foreign income and foreign persons that apply in the absence of a 

U.S. tax treaty. This overview also discusses the general objectives 

of U.S. tax treaties and describes some of the modifications to U.S. 

tax rules made by treaties. 

A. U.S. Tax Rules 

The United States taxes U.S. citizens, residents, and corporations on their worldwide income, whether derived in the United 

States or abroad. The United States generally taxes nonresident 

alien individuals and foreign corporations on all their income that 

is effectively connected with the conduct of a trade or business in 

the United States (sometimes referred to as ‘‘effectively connected 

income’’). The United States also taxes nonresident alien individuals and foreign corporations on certain U.S.-source income that is 

not effectively connected with a U.S. trade or business. 

Income of a nonresident alien individual or foreign corporation 

that is effectively connected with the conduct of a trade or business 

in the United States generally is subject to U.S. tax in the same 

manner and at the same rates as income of a U.S. person. Deductions are allowed to the extent that they are related to effectively 

connected income. A foreign corporation also is subject to a flat 30–

percent branch profits tax on its ‘‘dividend equivalent amount,’’ 

which is a measure of the effectively connected earnings and profits 

of the corporation that are removed in any year from the conduct 

of its U.S. trade or business. In addition, a foreign corporation is 

subject to a flat 30–percent branch-level excess interest tax on the 

excess of the amount of interest that is deducted by the foreign corporation in computing its effectively connected income over the 

amount of interest that is paid by its U.S. trade or business. 

U.S.-source fixed or determinable annual or periodical income of 

a nonresident alien individual or foreign corporation (including, for 

example, interest, dividends, rents, royalties, salaries, and annuities) that is not effectively connected with the conduct of a U.S. 

trade or business is subject to U.S. tax at a rate of 30 percent of 

the gross amount paid. Certain insurance premiums earned by a 

nonresident alien individual or foreign corporation are subject to 

U.S. tax at a rate of 1 or 4 percent of the premiums. These taxes 

generally are collected by means of withholding. 

Specific statutory exemptions from the 30–percent withholding 

tax are provided. For example, certain original issue discount and 

certain interest on deposits with banks or savings institutions are 

exempt from the 30–percent withholding tax. An exemption also is 

provided for certain interest paid on portfolio debt obligations. In 

5

addition, income of a foreign government or international organization from investments in U.S. securities is exempt from U.S. tax. 

U.S.-source capital gains of a nonresident alien individual or a 

foreign corporation that are not effectively connected with a U.S. 

trade or business generally are exempt from U.S. tax, with two exceptions: (1) gains realized by a nonresident alien individual who 

is present in the United States for at least 183 days during the taxable year, and (2) certain gains from the disposition of interests in 

U.S. real property. 

Rules are provided for the determination of the source of income. 

For example, interest and dividends paid by a U.S. citizen or resident or by a U.S. corporation generally are considered U.S.-source 

income. Conversely, dividends and interest paid by a foreign corporation generally are treated as foreign-source income. Special 

rules apply to treat as foreign-source income (in whole or in part) 

interest paid by certain U.S. corporations with foreign businesses 

and to treat as U.S.-source income (in whole or in part) dividends 

paid by certain foreign corporations with U.S. businesses. Rents 

and royalties paid for the use of property in the United States are 

considered U.S.-source income. 

Because the United States taxes U.S. citizens, residents, and corporations on their worldwide income, double taxation of income can 

arise when income earned abroad by a U.S. person is taxed by the 

country in which the income is earned and also by the United 

States. The United States seeks to mitigate this double taxation 

generally by allowing U.S. persons to credit foreign income taxes 

paid against the U.S. tax imposed on their foreign-source income. 

A fundamental premise of the foreign tax credit is that it may not 

offset the U.S. tax liability on U.S.-source income. Therefore, the 

foreign tax credit provisions contain a limitation that ensures that 

the foreign tax credit offsets only the U.S. tax on foreign-source income. The foreign tax credit limitation generally is computed on a 

worldwide basis (as opposed to a ‘‘per-country’’ basis). The limitation is applied separately for certain classifications of income. In 

addition, a special limitation applies to the credit for foreign taxes 

imposed on foreign oil and gas extraction income. 

For foreign tax credit purposes, a U.S. corporation that owns 10 

percent or more of the voting stock of a foreign corporation and receives a dividend from the foreign corporation (or is otherwise required to include in its income earnings of the foreign corporation) 

is deemed to have paid a portion of the foreign income taxes paid 

by the foreign corporation on its accumulated earnings. The taxes 

deemed paid by the U.S. corporation are included in its total foreign taxes paid and its foreign tax credit limitation calculations for 

the year in which the dividend is received.

B. U.S. Tax Treaties 

The traditional objectives of U.S. tax treaties have been the 

avoidance of international double taxation and the prevention of 

tax avoidance and evasion. Another related objective of U.S. tax 

treaties is the removal of the barriers to trade, capital flows, and 

commercial travel that may be caused by overlapping tax jurisdictions and by the burdens of complying with the tax laws of a jurisdiction when a person’s contacts with, and income derived from, 

6

that jurisdiction are minimal. To a large extent, the treaty provisions designed to carry out these objectives supplement U.S. tax 

law provisions having the same objectives; treaty provisions modify 

the generally applicable statutory rules with provisions that take 

into account the particular tax system of the treaty partner. 

The objective of limiting double taxation generally is accomplished in treaties through the agreement of each country to limit, 

in specified situations, its right to tax income earned from its territory by residents of the other country. For the most part, the various rate reductions and exemptions agreed to by the source country in treaties are premised on the assumption that the country of 

residence will tax the income at levels comparable to those imposed 

by the source country on its residents. Treaties also provide for the 

elimination of double taxation by requiring the residence country 

to allow a credit for taxes that the source country retains the right 

to impose under the treaty. In addition, in the case of certain types 

of income, treaties may provide for exemption by the residence 

country of income taxed by the source country. 

Treaties define the term ‘‘resident’’ so that an individual or corporation generally will not be subject to tax as a resident by both 

the countries. Treaties generally provide that neither country will 

tax business income derived by residents of the other country unless the business activities in the taxing jurisdiction are substantial 

enough to constitute a permanent establishment or fixed base in 

that jurisdiction. Treaties also contain commercial visitation exemptions under which individual residents of one country performing personal services in the other will not be required to pay 

tax in that other country unless their contacts exceed certain specified minimums (e.g., presence for a set number of days or earnings 

in excess of a specified amount). Treaties address passive income 

such as dividends, interest, and royalties from sources within one 

country derived by residents of the other country either by providing that such income is taxed only in the recipient’s country of 

residence or by reducing the rate of the source country’s withholding tax imposed on such income. In this regard, the United 

States agrees in its tax treaties to reduce its 30–percent withholding tax (or, in the case of some income, to eliminate it entirely) 

in return for reciprocal treatment by its treaty partner. 

In its treaties, the United States, as a matter of policy, generally 

retains the right to tax its citizens and residents on their worldwide income as if the treaty had not come into effect. The United 

States also provides in its treaties that it will allow a credit against 

U.S. tax for income taxes paid to the treaty partners, subject to the 

various limitations of U.S. law. 

The objective of preventing tax avoidance and evasion generally 

is accomplished in treaties by the agreement of each country to exchange tax-related information. Treaties generally provide for the 

exchange of information between the tax authorities of the two 

countries when such information is necessary for carrying out provisions of the treaty or of their domestic tax laws. The obligation 

to exchange information under the treaties typically does not require either country to carry out measures contrary to its laws or 

administrative practices or to supply information that is not obtainable under its laws or in the normal course of its administration 

7

or that would reveal trade secrets or other information the disclosure of which would be contrary to public policy. The Internal Revenue Service (the ‘‘IRS’’), and the treaty partner’s tax authorities, 

also can request specific tax information from a treaty partner. 

This can include information to be used in a criminal investigation 

or prosecution. 

Administrative cooperation between countries is enhanced further under treaties by the inclusion of a ‘‘competent authority’’ 

mechanism to resolve double taxation problems arising in individual cases and, more generally, to facilitate consultation between 

tax officials of the two governments. 

Treaties generally provide that neither country may subject nationals of the other country (or permanent establishments of enterprises of the other country) to taxation more burdensome than that 

it imposes on its own nationals (or on its own enterprises). Similarly, in general, neither treaty country may discriminate against 

enterprises owned by residents of the other country. 

At times, residents of countries that do not have income tax treaties with the United States attempt to use a treaty between the 

United States and another country to avoid U.S. tax. To prevent 

third-country residents from obtaining treaty benefits intended for 

treaty country residents only, treaties generally contain an ‘‘antitreaty shopping’’ provision that is designed to limit treaty benefits 

to bona fide residents of the two countries. 

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III. 

EXPLANATION OF PROPOSED TREATY 

Article 1. General Scope 

Overview 

The general scope article describes the persons who may claim 

the benefits of the proposed treaty. It also includes a ‘‘saving 

clause’’ provision similar to provisions found in most U.S. income 

tax treaties. 

The proposed treaty generally applies to residents of the United 

States and to residents of the United Kingdom, with specific modifications to such scope provided in other articles (e.g., Article 19 

(Government Service), Article 25 (Non-Discrimination), and Article 

26 (Exchange of Information)). This scope is consistent with the 

scope of other U.S. income tax treaties, the U.S. model, and the 

OECD model. For purposes of the proposed treaty, residence is determined under Article 4 (Resident). 

The proposed treaty provides that it does not restrict in any 

manner any benefit accorded by internal law or by any other agreement between the United States and the United Kingdom. Thus, 

the proposed treaty will not apply to increase the tax burden of a 

resident of either the United States or the United Kingdom. According to the Treasury Department’s Technical Explanation (hereinafter referred to as the ‘‘Technical Explanation’’), the fact that 

the proposed treaty only applies to a taxpayer’s benefit does not 

mean that a taxpayer may select inconsistently among treaty and 

internal law provisions in order to minimize its overall tax burden. 

In this regard, the Technical Explanation sets forth the following 

example. Assume a resident of the United Kingdom has three separate businesses in the United States. One business is profitable 

and constitutes a U.S. permanent establishment. The other two 

businesses generate effectively connected income as determined 

under the Internal Revenue Code (the ‘‘Code’’), but do not constitute permanent establishments as determined under the proposed treaty; one business is profitable and the other business generates a net loss. Under the Code, all three businesses would be 

subject to U.S. income tax, in which case the losses from the unprofitable business could offset the taxable income from the other 

businesses. On the other hand, only the income of the business 

which gives rise to a permanent establishment is taxable by the 

United States under the proposed treaty. The Technical Explanation makes clear that the taxpayer may not invoke the proposed 

treaty to exclude the profits of the profitable business that does not 

constitute a permanent establishment and invoke U.S. internal law 

to claim the loss of the unprofitable business that does not conVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00012 Fmt 6604 Sfmt 6604 E:\HR\OC\A199.XXX A199
9

3See Rev. Rul. 84–17, 1984–1 C.B. 308. 3A It is unclear whether this statement in the Technical Explanation encompasses all interaction between GATS and the proposed treaty. 4The Technical Explanation does not explain the rationale for this variation from the U.S. 

model. 5The four agreements listed in the notes and Technical Explanation, except for GATS. The 

interaction of GATS with the proposed treaty is described in the second preceding paragraph. 

stitute a permanent establishment to offset the taxable income of 

the permanent establishment.3

The proposed treaty provides that the dispute resolution procedures under its mutual agreement article (Article 26) take precedence over the corresponding provisions of any other agreement to 

which the United States and the United Kingdom are parties in determining whether a taxation measure is within the scope of the 

proposed treaty. The proposed treaty also provides that the dispute 

resolution procedures set forth in Article II and Article XVII of the 

General Agreement on Trade in Services (‘‘GATS’’) shall not apply 

to any taxation measure unless the competent authorities agree 

that the measure is not within the scope of the non-discrimination 

provisions of Article 25 (Non-Discrimination) of the proposed treaty. The Technical Explanation clarifies that no national treatment 

or most-favored nation obligations undertaken by the United States 

and the United Kingdom pursuant to GATS will apply to a taxation 

measure, unless the competent authorities otherwise agree.3A For 

purposes of this provision, the term ‘‘measure’’ means a law, regulation, rule, procedure, decision, administrative action, or any similar provision or action. 

The Technical Explanation points out that, unlike the U.S. 

model, the proposed treaty does not include an additional limitation on the application of other agreements between the United 

States and the United Kingdom that impose national treatment or 

most-favored nation obligations.4 According to the notes and the 

Technical Explanation, instead of generally limiting the effect of 

other such agreements, the United States and the United Kingdom 

analyzed existing agreements and believe that the only such agreements in force between the countries are: GATS; the General 

Agreement on Tariffs and Trade; the Convention to Regulate the 

Commerce between the Territories of the United States and of his 

Britannic Majesty, signed in London on July 3, 1815; and the Treaty of Amity, Commerce, and Navigation, between his Britannic 

Majesty and the United States of America, signed at London, November 19, 1794. The Technical Explanation states that these 

agreements (other than GATS, as described in the preceding paragraph) are unlikely ever to apply with respect to an income tax provision. 

There are two ways in which the absence of the U.S. model provision affects the implementation of this provision. The first is the 

interaction of the proposed treaty with these three 5 agreements, 

should they apply with respect to an income tax provision. According to the Technical Explanation: (1) if one of the three agreements 

overlaps with Article 25 (Non-Discrimination) of the proposed treaty, remedies would be available under both agreements; (2) if benefits are available under one of the three agreements but not under 

Article 25, a resident is entitled to the benefits under the applicable agreement; and (3) if benefits are available under Article 25 but 

10

6The Technical Explanation states that ‘‘the Contracting States believe that the only agreements. . . .’’ (emphasis added). 

not under one of the three agreements, a resident is entitled to the 

benefits under Article 25. These rules, as articulated in the Technical Explanation, may be more burdensome to apply than would 

be the case if the U.S. model rule had been incorporated. In addition, if it were determined that there is in fact overlap between the 

proposed treaty and the General Agreement on Tariffs and Trade, 

the consequences may be more severe than they would be with respect to the 1815 and 1794 agreements, because those two agreements are bilateral, while the General Agreement on Tariffs and 

Trade is multilateral. 

The second is the interaction of the proposed treaty with any 

other agreements in effect between the two treaty countries that 

were not listed. It is uncertain that the agreements enumerated in 

the notes and Technical Explanation constitute the complete and 

exhaustive list.6 Accordingly, the Technical Explanation states that 

the treaty countries will consult with a view to ensuring the proper 

interaction of the proposed treaty and any other relevant agreements in force that are determined at the time of the signing of the 

proposed treaty to include obligations with respect to taxation 

measures. The Technical Explanation also states that such consultation may result in an amendment to the proposed treaty if 

necessary but, unless and until such an amendment is made, any 

other agreement between the treaty countries would apply concurrently with the proposed treaty. The Technical Explanation does 

not clarify how to resolve the concurrent application of conflicting 

provisions in the proposed treaty and the other agreement should 

both provisions apply with respect to an income tax provision. 

It is unclear why the notes and Technical Explanation include 

references to other agreements that the Technical Explanation 

states are unlikely ever to apply with respect to an income tax provision. In order to assure itself that this provision is not utilized 

in unintended or unforeseen ways in the future, the Committee 

may wish to instruct the Secretary of the Treasury to report to the 

Committee regarding every instance in which the Treasury or the 

IRS is aware that a taxpayer claims any income tax benefit outside 

of the proposed treaty but under any of these agreements or under 

any other agreements not listed in the notes and Technical Explanation. 

Saving clause 

Like all U.S. income tax treaties and the U.S. Model, the proposed treaty includes a ‘‘saving clause.’’ Under this clause, with 

specific exceptions described below, the proposed treaty does not affect the taxation by either treaty country of its residents or its citizens. By reason of this saving clause, unless otherwise specifically 

provided in the proposed treaty, the United States may continue to 

tax its citizens who are residents of the United Kingdom as if the 

treaty were not in force. For purposes of the proposed treaty (and, 

thus, for purposes of the saving clause), the term ‘‘residents,’’ which 

is defined in Article 4 (Resident), includes corporations and other 

entities as well as individuals. 

11

The proposed treaty contains a provision under which the saving 

clause (and therefore the U.S. jurisdiction to tax) applies to a 

former U.S. citizen or long-term resident (whether or not treated 

as such under Article 4 (Resident)), whose loss of citizenship or 

resident status, respectively, had as one of its principal purposes 

the avoidance of tax; such application is limited to the ten-year period following the loss of citizenship or resident status. The proposed treaty provides that this provision does not apply to former 

citizens or residents who relinquished such status at any time before February 6, 1995. The Technical Explanation states that this 

date is consistent with the effective date of amendments to Section 

877 of the Code that were made by the Health and Insurance Accountability and Portability Act of 1996, section 511 (Public Law 

104–191). As amended, Section 877 provides special rules for the 

imposition of U.S. income tax on former U.S. citizens and long-term 

residents for a period of ten years following the loss of citizenship; 

these special tax rules apply to a former citizen or long-term resident only if his or her loss of U.S. citizenship or resident status had 

as one of its principal purposes the avoidance of U.S. income, estate, or gift taxes. For purposes of applying the special tax rules 

to former citizens and long-term residents, individuals who meet a 

specified income tax liability threshold or a specified net worth 

threshold generally are considered to have lost citizenship or resident status for a principal purpose of U.S. tax avoidance. 

For purposes of the proposed treaty, the United States and the 

United Kingdom have agreed in the notes that an individual is considered a ‘‘long-term resident’’ of a treaty country only if the individual (other than a citizen of that country) was a lawful permanent resident of that country in at least 8 of the 15 taxable years 

ending with the taxable year in which the individual ceased to be 

a long-term resident. The Technical Explanation states that this 

standard is consistent with U.S. domestic law. The notes also provide several factors that shall be considered favorably in determining whether or not one of the principal purposes of an individual’s loss of citizenship of either treaty country was the avoidance 

of tax. These factors generally are consistent with U.S. domestic 

law. 

Exceptions to the saving clause are provided for the following 

benefits conferred by a treaty country: the allowance of correlative 

adjustments when the profits of an associated enterprise are adjusted by the other country (Article 9, paragraph 2); the exemption 

from source- and residence-country tax for certain pension, social 

security, alimony, and child support payments (Article 17, paragraphs 1(b), 3 and 5); the exemption from source- and residencecountry tax for certain investment income of pension schemes established in the other treaty country (Article 18, paragraphs 1 and 

5); relief from double taxation through the provision of a foreign 

tax credit (Article 24); protection from discriminatory tax treatment 

with respect to transactions with residents of the other country 

(Article 25); and benefits under the mutual agreement procedures 

(Article 26). These exceptions to the saving clause permit residents 

or citizens of the United States or the United Kingdom to obtain 

such benefits of the proposed treaty with respect to their country 

of residence or citizenship. 

12

In addition, the saving clause does not apply to certain benefits 

conferred by one of the countries upon individuals who neither are 

citizens of that country nor have been admitted for permanent residence in that country. Under this set of exceptions to the saving 

clause, the specified treaty benefits are available to, for example, 

a citizen of the United Kingdom who spends enough time in the 

United States to be taxed as a U.S. resident but who has not acquired U.S. permanent residence status (i.e., does not hold a ‘‘green 

card’’). The benefits that are covered under this set of exceptions 

are the beneficial host-country tax treatment of pension fund contributions (paragraph 2 of Article 18), as well as the exemptions 

from host country tax for certain compensation from government 

service (Article 19), certain income received by visiting students 

and trainees (Article 20), certain income received by visiting teachers (Article 20A), and certain income of diplomats and consular officials (Article 28). 

Fiscally transparent entities 

The proposed treaty contains special rules for fiscally transparent entities. Under these rules, income derived through an entity that is fiscally transparent under the laws of either treaty country is considered to be the income of a resident of one of the treaty 

countries only to the extent that the income is subject to tax in 

that country as the income of a resident. For example, if a U.K. 

company pays interest to an entity that is treated as fiscally transparent for U.S. tax purposes, the interest will be considered to be 

derived by a resident of the United States only to the extent that 

U.S. tax laws treat one or more U.S. residents (whose status as 

U.S. residents is determined under U.S. tax laws) as deriving the 

interest income for U.S. tax purposes. 

The Technical Explanation states that these rules for income derived through fiscally transparent entities apply regardless of 

where the entity is organized (i.e., in the United States, the United 

Kingdom, or a third country). The Technical Explanation also 

states that these rules apply even if the entity is viewed differently 

under the tax laws of the other country. As an example, the Technical Explanation states that income from U.S. sources received by 

an entity organized under the laws of the United States, which is 

treated for U.K. tax purposes as a corporation and is owned by a 

U.K. shareholder who is a U.K. resident for U.K. tax purposes, is 

not considered derived by the shareholder of that corporation even 

if, under the tax laws of the United States, the entity is treated as 

fiscally transparent. Rather, for purposes of the proposed treaty, 

the income is treated as derived by the U.S. entity. 

The Technical Explanation also states that the treatment of fiscally transparent entities is not an exception to the saving clause. 

Therefore, such treatment does not preclude a treaty country from 

taxing an entity that is treated as a resident of that country under 

its tax laws. For example, if a U.S. limited liability company 

(‘‘LLC’’) with U.K. members elects to be taxed as a corporation for 

U.S. tax purposes, the United States will tax that LLC on its 

worldwide income on a net basis, without regard to whether the 

United Kingdom views the LLC as fiscally transparent. The diplomatic notes provide rules under Article 24 (Relief from Double TaxVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00016 Fmt 6604 Sfmt 6604 E:\HR\OC\A199.XXX A199
13

ation) for determining which treaty country has the primary right 

to tax income derived through a fiscally transparent entity and 

which treaty country must provide a credit for such taxes. 

Article 2. Taxes Covered 

The proposed treaty generally applies to the income and capital 

gains taxes of the United States and the United Kingdom. However, like the present treaty, Article 25 (Non-Discrimination) of the 

proposed treaty is applicable to all taxes imposed at all levels of 

government, including State and local taxes. 

In the case of the United States, the proposed treaty applies to 

the Federal income taxes imposed by the Code, but excludes social 

security taxes. In addition, the proposed treaty applies to the U.S. 

excise taxes imposed on insurance premiums paid to foreign insurers and with respect to private foundations. Unlike the present 

treaty, but like the U.S. model, the proposed treaty applies to the 

accumulated earnings tax and the personal holding company tax. 

The proposed treaty applies to the excise taxes on insurance premiums paid to foreign insurers. Because the insurance excise taxes 

are covered taxes under the proposed treaty, U.K. insurers generally are not subject to the U.S. excise taxes on insurance premiums for insuring U.S. risks. The excise taxes continue to apply, 

however, when a U.K. insurer reinsures a policy it has written on 

a U.S. risk with a foreign insurer that is not entitled to a similar 

exemption under this or a different tax treaty, in an arrangement 

with a main purpose of obtaining the benefits of the proposed treaty. 

The notes state that it is understood that, if a political subdivision or local authority of the United States seeks to impose tax on 

the profits of any enterprise of the United Kingdom from the operation of ships or aircraft in international traffic, in circumstances 

where the proposed treaty would preclude the imposition of a Federal income tax on such profits, the United States Government will 

use its best endeavors to persuade the political subdivision or local 

authority to refrain from imposing tax. 

In the case of the United Kingdom, the proposed treaty applies 

to the income tax; the capital gains tax; the corporation tax; and 

the petroleum revenue tax (subject to the limitations under paragraph 3 of Article 24 (Relief from Double Taxation) on the amount 

of petroleum revenue tax allowable as a credit against U.S. tax). 

The proposed treaty also contains a rule generally found in U.S. 

income tax treaties (including the present treaty) that provides 

that the proposed treaty applies to any identical or substantially 

similar taxes that may be imposed subsequently in addition to or 

in place of the taxes covered. The proposed treaty obligates the 

competent authority of each country to notify the competent authority of the other country of any changes in its internal tax laws 

that significantly affect their obligations under the proposed treaty. 

The Technical Explanation states that this requirement relates to 

changes that are significant to the operation of the proposed treaty. 

Article 3. General Definitions 

The proposed treaty provides definitions of a number of terms for 

purposes of the proposed treaty. Certain of the standard definitions 

14

found in most U.S. income tax treaties are included in the proposed 

treaty. 

The term ‘‘person’’ includes an individual, an estate, a trust, a 

partnership, a company, and any other body of persons. 

A ‘‘company’’ under the proposed treaty is any body corporate or 

any entity that is treated as a body corporate for tax purposes. 

The term ‘‘enterprise’’ includes any activity or activities that constitute a trade or business, while the term ‘‘business’’ includes the 

performance of professional services and other activities of an independent character. The definitions of ‘‘enterprise’’ and ‘‘business’’ in 

the proposed treaty are identical to the same definitions recently 

added to the OECD Model in conjunction with the deletion of Article 14 (Independent Personal Services) from the OECD Model. The 

Technical Explanation states that the inclusion of these definitions 

is intended to clarify that the performance of personal services or 

other activities of an independent character are considered to constitute an enterprise, covered by Article 7 (Business Profits). By 

contrast, the U.S. Model does not provide definitions of the terms 

‘‘enterprise’’ and ‘‘business’’ because, unlike the proposed treaty and 

the OECD Model, the U.S. Model continues to include a separate 

article concerning the treatment of independent personal services. 

The terms ‘‘enterprise of a Contracting State’’ and ‘‘enterprise of 

the other Contracting State’’ mean, respectively, an enterprise carried on by a resident of a treaty country and an enterprise carried 

on by a resident of the other treaty country. 

The proposed treaty defines ‘‘international traffic’’ as any transport by a ship or aircraft, except when the transport is solely between places in the other treaty country. Accordingly, with respect 

to a U.K. enterprise, purely domestic transport within the United 

States does not constitute ‘‘international traffic.’’ 

The U.S. ‘‘competent authority’’ is the Secretary of the Treasury 

or his delegate. The U.S. competent authority function has been 

delegated to the Commissioner of Internal Revenue, who has redelegated the authority to the Assistant Commissioner (International). On interpretative issues, the latter acts with the concurrence of the Associate Chief Counsel (International) of the IRS. The 

U.K. ‘‘competent authority’’ is the Commissioners of Inland Revenue or their authorized representative. 

The term ‘‘United States’’ means the United States of America 

(including the States thereof and the District of Columbia), but 

does not include Puerto Rico, the Virgin Islands, Guam, or any 

other U.S. possession or territory. The term ‘‘United States’’ also 

includes the territorial sea of the United States and any area beyond the territorial sea that is designated as an area within which 

the United States, in compliance with its legislation and in conformity with international law, exercises sovereign rights in respect 

of the exploration and exploitation of the natural resources of the 

seabed, the subsoil, and the superjacent waters. The Technical Explanation states that the extension of the term to such areas applies only if the person, property, or activity to which the proposed 

treaty is being applied is connected with such natural resource exploration or exploitation. 

The term ‘‘United Kingdom’’ means Great Britain and Northern 

Ireland, and includes any area outside the territorial sea of the 

15

United Kingdom which has been or may hereafter be so designated, 

in accordance with international law and under the laws of the 

United Kingdom concerning the Continental Shelf, as an area within which the rights of the United Kingdom with respect to the sea 

bed and sub-soil and their natural resources may be exercised. The 

Technical Explanation states that the proposed treaty does not 

apply to the Channel Islands or the Isle of Man. 

The term ‘‘national’’ means: (1) all individuals possessing the citizenship of a treaty country; and (2) all legal persons, partnerships, 

and associations deriving their status as such from the laws in 

force in a treaty country. 

The proposed treaty defines the term ‘‘qualified governmental entity’’ as a treaty country, or a political subdivision or local authority 

of a treaty country. Also defined as a qualified governmental entity 

is a person that is wholly owned (directly or indirectly) by a treaty 

country or a political subdivision or local authority thereof, provided it is organized under the laws of a treaty country, its earnings are credited to its own account with no portion of its income 

inuring to the benefit of any private person, and its assets vest in 

the treaty country, political subdivision or local authority upon dissolution. The definition described in the previous sentence only applies if the entity does not carry on commercial activities. These 

definitions are the same as those in the U.S. model. However, unlike the U.S. model, the proposed treaty excludes from the definition of the term ‘‘qualified governmental entity’’ government pension funds. According to the Technical Explanation, a number of 

the benefits that are relevant only to government pension funds in 

the U.S. Model are available to all qualified pension funds under 

the proposed treaty. 

The term ‘‘Contracting State’’ means the United States or the 

United Kingdom, as the context requires. 

The proposed treaty defines the term ‘‘real property,’’ consistent 

with the definition provided in Treas. Reg. Sec. 1.897–1(b), to include: land and the unsevered products of the land (including property accessory to real property); improvements; personal property 

associated with the use of real property (such as livestock and 

equipment used in agriculture and forestry); rights to which the 

provisions of general law respecting landed property apply; usufructs of real property; and rights to variable or fixed payments as 

consideration for the working of, or the right to work, mineral deposits, sources, and other natural resources. The term does not include an interest in land solely as a creditor. The term also does 

not include ships, boats, and aircraft. 

The proposed treaty defines the term ‘‘conduit arrangement’’ as 

a transaction or series of transactions that meets both of the following criteria: (1) a resident of one contracting state receives an 

item of income that generally would qualify for treaty benefits, and 

then pays (directly or indirectly, at any time or in any form) all or 

substantially all of that income to a resident of a third state who 

would not be entitled to equivalent or greater treaty benefits if it 

had received the same item of income directly; and (2) obtaining 

the increased treaty benefits is the main purpose or one of the 

main purposes of the transaction or series of transactions. 

16

The proposed treaty also contains the standard provision that, 

unless the context otherwise requires or the competent authorities 

agree upon a common meaning pursuant to Article 26 (Mutual 

Agreement Procedure), all terms not defined in the proposed treaty 

have the meaning pursuant to the respective tax laws of the country that is applying the treaty. 

Article 4. Residence 

The assignment of a country of residence is important because 

the benefits of the proposed treaty generally are available only to 

a resident of one of the treaty countries as that term is defined in 

the proposed treaty. Furthermore, issues arising because of dual 

residency, including situations of double taxation, may be avoided 

by the assignment of one treaty country as the country of residence 

when under the internal laws of the treaty countries a person is 

a resident of both countries. 

Internal taxation rules 

United States 

Under U.S. law, the residence of an individual is important because a resident alien, like a U.S. citizen, is taxed on his or her 

worldwide income, while a nonresident alien is taxed only on certain U.S.-source income and on income that is effectively connected 

with a U.S. trade or business. An individual who spends sufficient 

time in the United States in any year or over a three-year period 

generally is treated as a U.S. resident. A permanent resident for 

immigration purposes (i.e., a ‘‘green card’’ holder) also is treated as 

a U.S. resident. 

Under U.S. law, a company is taxed on its worldwide income if 

it is a ‘‘domestic corporation.’’ A domestic corporation is one that 

is created or organized in the United States or under the laws of 

the United States, a State, or the District of Columbia. 

United Kingdom 

Under U.K. law, resident individuals are subject to tax on their 

worldwide income, while nonresident individuals generally are subject to tax only on income arising in the United Kingdom. However, 

resident individuals who are not domiciled in the United Kingdom 

generally are subject to U.K. tax on income from sources outside 

the United Kingdom only to the extent that the income is remitted 

to the United Kingdom. Individuals generally are considered residents of the United Kingdom if they are present for a sufficient 

time in any individual year or over a four-year period. Even if not 

present for a sufficient time, individuals may be treated as residents if they own or lease accommodations in the United Kingdom. 

Companies that are resident in the United Kingdom are subject 

to tax on their worldwide income. A company is resident in the 

United Kingdom if it is incorporated under U.K. law or it is managed and controlled in the United Kingdom. Companies that are 

not resident in the United Kingdom are subject to corporate income 

tax on income derived from the United Kingdom. 

17

Proposed treaty rules 

The proposed treaty specifies rules to determine whether a person is a resident of the United States or the United Kingdom for 

purposes of the proposed treaty. The rules generally are consistent 

with the rules of the U.S. model. 

The proposed treaty generally defines ‘‘resident of a Contracting 

State’’ to mean any person who, under the laws of that country, is 

liable to tax in that country by reason of the person’s domicile, residence, place of management, place of incorporation, or any other 

criterion of a similar nature. The term ‘‘resident of a Contracting 

State’’ does not include any person that is liable to tax in that 

country only on income from sources in that country or on profits 

attributable to a permanent establishment in that country. The 

proposed treaty provides that the United Kingdom will treat an individual who is a U.S. citizen or lawful permanent resident of the 

United States (i.e., a ‘‘green card’’ holder) as a resident of the 

United States only if he or she has a substantial presence, permanent home, or habitual abode in the United States and is not a 

resident of a third country for purposes of a tax treaty between 

such country and the United Kingdom. The determination of 

whether a citizen or national is considered a resident of the United 

States or the United Kingdom is made based on the principles of 

the treaty tie-breaker rules described below. 

The proposed treaty treats as residents of a treaty country certain organizations that generally are exempt from tax in that country. Under these rules, a resident includes a legal person that is 

organized under the laws of a treaty country and is generally exempt from tax in the treaty country because it is established and 

maintained: (1) to provide pensions or other similar benefits to employees pursuant to a tax-exempt scheme or plan; (2) exclusively 

for a religious, charitable, scientific, artistic, cultural, or educational purposes; or (3) as a qualified governmental entity that is, 

is a part of, or is established in, that country. 

The proposed treaty provides a set of ‘‘tie-breaker’’ rules to determine residence in the case of an individual who, under the basic 

residence definition, would be considered to be a resident of both 

countries. Under these rules, an individual is deemed to be a resident of the country in which he or she has a permanent home 

available. If the individual has a permanent home in both countries, the individual’s residence is deemed to be the country with 

which his or her personal and economic relations are closer (i.e., his 

or her ‘‘center of vital interests’’). If the country in which the individual has his or her center of vital interests cannot be determined, 

or if he or she does not have a permanent home available in either 

country, he or she is deemed to be a resident of the country in 

which he or she has an habitual abode. If the individual has an habitual abode in both countries or in neither country, he or she is 

deemed to be a resident of the country of which he or she is a national. If the individual is a national of both countries or neither 

country, the competent authorities of the countries will settle the 

question of residence by mutual agreement. 

In the case of any person other than an individual that would be 

a resident of both countries, the proposed treaty requires the competent authorities to endeavor to settle the issue of residence by 

18

mutual agreement and to determine the mode of application of the 

proposed treaty to such person. 

Like the present treaty, the proposed treaty provides that, for 

U.K. tax purposes, the domicile of a woman who is a U.S. national 

and who was married before January 1, 1974 to a man domiciled 

in the United Kingdom is determined as if such marriage took 

place on January 1, 1974. Prior to January 1, 1974, the domicile 

of a woman was the same as the domicile of her husband under 

U.K. law. Although this law was repealed, a transitional rule provides that a woman who was married before 1974 is treated as retaining her husband’s domicile unless and until she changes her 

domicile by acquisition or revival of another domicile after 1973. By 

providing a special tax rule for women who were married before 

1974, the proposed treaty equalizes the treatment of male and female U.S. citizens who are married to spouses domiciled in the 

U.K. 

Article 5. Permanent Establishment 

The proposed treaty contains a definition of the term ‘‘permanent 

establishment’’ that generally follows the pattern of the present 

treaty, other recent U.S. income tax treaties, the U.S. model, and 

the OECD model. 

The permanent establishment concept is one of the basic devices 

used in income tax treaties to limit the taxing jurisdiction of the 

host country and thus to mitigate double taxation. Generally, an 

enterprise that is a resident of one country is not taxable by the 

other country on its business profits unless those profits are attributable to a permanent establishment of the resident in the other 

country. In addition, the permanent establishment concept is used 

to determine whether the reduced rates of, or exemptions from, tax 

provided for dividends, interest, and royalties apply, or whether 

those items of income will be taxed as business profits. 

In general, under the proposed treaty, a permanent establishment is a fixed place of business in which the business of an enterprise is wholly or partly carried on. A permanent establishment includes a place of management, a branch, an office, a factory, a 

workshop, a mine, a quarry, or other place of extraction of natural 

resources. It also includes a building site or construction or assembly project that continues for more than twelve months. The Technical Explanation states that the twelve-month test applies separately to each individual site or project, with a series of contracts 

or projects that are interdependent both commercially and geographically treated as a single project. The Technical Explanation 

further states that if the twelve-month threshold is exceeded, the 

site or project constitutes a permanent establishment as of the first 

day that work in the country began. The proposed treaty differs 

from the U.S. Model in that the general definition of a permanent 

establishment does not apply to offshore drilling rigs, which are 

governed by the special rules in Article 21 (Offshore Exploration 

and Exploitation Activities) concerning exploration and exploitation 

of natural resources. 

Under the proposed treaty, as under the present treaty, the following activities are deemed not to constitute a permanent establishment: (1) the use of facilities solely for storing, displaying, or 

19

delivering goods or merchandise belonging to the enterprise; (2) the 

maintenance of a stock of goods or merchandise belonging to the 

enterprise solely for storage, display, or delivery or solely for processing by another enterprise; and (3) the maintenance of a fixed 

place of business solely for the purchase of goods or merchandise 

or for the collection of information for the enterprise. The proposed 

treaty also provides that the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any 

other activity of a preparatory or auxiliary character does not constitute a permanent establishment. The proposed treaty provides 

that a combination of these activities will not give rise to a permanent establishment, but only if the combination results in an overall activity that is of a preparatory or auxiliary character. This rule 

is derived from the OECD model but differs from the U.S. model, 

which provides that any combination of otherwise excepted activities is not deemed to give rise to a permanent establishment, without the additional requirement that the combination, as distinct 

from each individual activity, be preparatory or auxiliary. The 

Technical Explanation states that it is assumed that if preparatory 

or auxiliary activities are combined, the combination generally will 

also be of a preparatory or auxiliary character, but that a permanent establishment may result from a combination of such activities if this is not the case. 

Under the proposed treaty, as under the present treaty, if a person, other than an independent agent, is acting in a treaty country 

on behalf of an enterprise of the other country and has, and habitually exercises in such first country, the authority to conclude contracts that are binding on such enterprise, the enterprise is deemed 

to have a permanent establishment in the first country in respect 

of any activities undertaken for that enterprise. This rule does not 

apply where the activities are limited to the purchase of goods or 

merchandise for the enterprise. 

Under the proposed treaty, no permanent establishment is 

deemed to arise if the agent is a broker, general commission agent, 

or any other agent of independent status, provided that the agent 

is acting in the ordinary course of its business. The Technical Explanation states that whether an enterprise and an agent are independent is a factual determination, relevant factors of which include: (1) the extent to which the agent operates on the basis of instructions from the principal; (2) the extent to which the agent 

bears business risk; and (3) whether the agent has an exclusive or 

nearly exclusive relationship with the principal. 

The proposed treaty provides that the fact that a company that 

is a resident of one country controls or is controlled by a company 

that is a resident of the other country or that carries on business 

in the other country does not of itself cause either company to be 

a permanent establishment of the other. 

Article 6. Income From Real Property 

This article covers income from real property. The rules covering 

gains from the sale of real property are included in Article 13 

(Gains). 

Under the proposed treaty, income derived by a resident of one 

country from real property situated in the other country may be 

20

taxed in the country where the property is situated. This rule is 

consistent with the rules in the U.S. and OECD models. For this 

purpose, income from real property includes income from agriculture or forestry. The term ‘‘real property’’ is defined in paragraph (1)(m) of Article 3. 

The proposed treaty specifies that the country in which the property is situated also may tax income derived from the direct use, 

letting, or use in any other form of real property. The rules of Article 6, permitting source-country taxation, also apply to the income 

from real property of an enterprise. 

Article 7. Business Profits 

Internal taxation rules 

United States 

U.S. law distinguishes between the U.S. business income and the 

other U.S. income of a nonresident alien or foreign corporation. A 

nonresident alien or foreign corporation is subject to a flat 30–percent rate (or lower treaty rate) of tax on certain U.S.-source income 

if that income is not effectively connected with the conduct of a 

trade or business within the United States. The regular individual 

or corporate rates apply to income (from any source) that is effectively connected with the conduct of a trade or business within the 

United States. The performance of personal services within the 

United States may constitute a trade or business within the United 

States. 

The treatment of income as effectively connected with a U.S. 

trade or business depends upon whether the source of the income 

is U.S. or foreign. In general, U.S.-source periodic income (such as 

interest, dividends, rents, and wages) and U.S.-source capital gains 

are effectively connected with the conduct of a trade or business 

within the United States if the asset generating the income is used 

in (or held for use in) the conduct of the trade or business or if the 

activities of the trade or business were a material factor in the realization of the income. All other U.S.-source income of a person 

engaged in a trade or business in the United States is treated as 

effectively connected with the conduct of a trade or business in the 

United States (under what is referred to as a ‘‘force of attraction’’ 

rule). 

The income of a nonresident alien individual from the performance of personal services within the United States is excluded from 

U.S.-source income, and therefore is not taxed by the United States 

in the absence of a U.S. trade or business, if the following criteria 

are met: (1) the individual is not in the United States for over 90 

days during the taxable year; (2) the compensation does not exceed 

$3,000; and (3) the services are performed as an employee of, or 

under a contract with, a foreign person not engaged in a trade or 

business in the United States, or are performed for a foreign office 

or place of business of a U.S. person.

Foreign-source income generally is effectively connected income 

only if the foreign person has an office or other fixed place of business in the United States and the income is attributable to that 

place of business. Only three types of foreign-source income are 

considered to be effectively connected income: rents and royalties 

21

for the use of certain intangible property derived from the active 

conduct of a U.S. business; certain dividends and interest either derived in the active conduct of a banking, financing or similar business in the United States or received by a corporation the principal 

business of which is trading in stocks or securities for its own account; and certain sales income attributable to a U.S. sales office. 

Special rules apply for purposes of determining the foreign-source 

income that is effectively connected with a U.S. business of an insurance company. 

Any income or gain of a foreign person for any taxable year that 

is attributable to a transaction in another year is treated as effectively connected with the conduct of a U.S. trade or business if it 

would have been so treated had it been taken into account in that 

other year (Code sec. 864(c)(6)). In addition, if any property ceases 

to be used or held for use in connection with the conduct of a trade 

or business within the United States, the determination of whether 

any income or gain attributable to a sale or exchange of that property occurring within ten years after the cessation of business is effectively connected with the conduct of a trade or business within 

the United States is made as if the sale or exchange occurred immediately before the cessation of business (Code sec. 864(c)(7)). 

An excise tax is imposed on insurance premiums paid to a foreign insurer or reinsurer with respect to U.S. risks. The rate of tax 

is either 4 percent or 1 percent. The rate of the excise tax is 4 percent of the premium on a policy of casualty insurance or indemnity 

bond that is (1) paid by a U.S. person on risks wholly or partly 

within the United States, or (2) paid by a foreign person on risks 

wholly within the United States. The rate of the excise tax is 1 percent of the premium paid on a policy of life, sickness or accident 

insurance, or an annuity contract. The rate of the excise tax is also 

1 percent of any premium for reinsurance of any of the foregoing 

types of contracts. 

Two exceptions to the application of the insurance excise tax are 

provided. One exception is for amounts that are effectively connected with the conduct of a U.S. trade or business (provided no 

treaty provision exempts the amounts from U.S. taxation). Thus, 

under this exception, the insurance excise tax does not apply to 

amounts that are subject to U.S. income tax in the hands of a foreign insurer or reinsurer pursuant to its election to be taxed as a 

domestic corporation under Code section 953(d), or pursuant to its 

election under Code section 953(c) to treat related person insurance 

income as effectively connected to the conduct of a U.S. trade or 

business. The other exception applies to premiums on an indemnity 

bond to secure certain pension and other payments by the United 

States government. 

United Kingdom 

Foreign corporations and nonresident individuals generally are 

subject to tax in the United Kingdom only on income arising in the 

United Kingdom. Business income derived in the United Kingdom 

by a foreign corporation or nonresident individual generally is 

taxed in the same manner as the income of a resident corporation 

or individual. 

22

Proposed treaty limitations on internal law 

Under the proposed treaty, business profits of an enterprise of 

one of the countries are taxable in the other country only to the 

extent that they are attributable to a permanent establishment in 

the other country through which the enterprise carries on business. 

This is one of the basic limitations on a country’s right to tax income of a resident of the other country. The rule is similar to those 

contained in the U.S. and OECD models. 

Although the proposed treaty does not provide a definition of the 

term ‘‘business profits,’’ the Technical Explanation states that the 

term generally means income derived from any trade or business. 

This definition includes income from independent personal services, 

which, unlike the U.S. Model but like the OECD Model, is not addressed in a separate article. Although the proposed treaty does not 

include a separate article for independent personal services, this 

Article limits the right of a treaty country to tax income from the 

performance of personal services by a resident of the other treaty 

country in a manner similar to the limitations provided in the separate article applicable to independent personal services that is included in the U.S. Model and other U.S. treaties. 

Because the definition of ‘‘business profits’’ includes independent 

personal services under the proposed treaty, the Technical Explanation states that the term includes income attributable to notional 

principal contracts and other financial instruments to the extent 

that the income is attributable to a trade or business of dealing in 

such instruments or is otherwise related to a trade or business 

(e.g., notional principal contracts entered into for the purpose of 

hedging currency risk arising from an active trade or business). 

Any other income derived from financial instruments is addressed 

in Article 22 (Other Income), unless specifically governed by another article. 

The Technical Explanation states that business profits also include income earned by an enterprise from the furnishing of personal services. For example, a U.S. consulting firm whose employees or partners perform services in the United Kingdom through a 

permanent establishment may be taxed in the United Kingdom on 

a net basis under this Article, rather than Article 14 (Income from 

Employment), consistent with the OECD Model. However, salaries 

of employees of the consulting firm would remain subject to Article 

14 (Income from Employment). In addition, the Technical Explanation states that business profits include income derived by a 

partner of one treaty country that is attributable to personal services performed in the other treaty country through a partnership 

with a permanent establishment in that other country. Thus, income that may be taxed as business profits includes all income that 

is attributable to the permanent establishment with respect to the 

performance of personal services carried on by the partnership 

(whether by the partner himself, other partners in the partnership, 

or employees assisting the partners), as well as any income from 

activities that are ancillary to the performance of the services (e.g., 

charges for facsimile services). For example, if a U.K. partnership 

has four partners who are resident and perform personal services 

only in the U.K. office and one partner who performs personal services in a U.S. office that is a permanent establishment in the 

23

United States (and the five partners agree to equally split profits), 

the four U.K. resident partners may be taxed in the United States 

with respect to their shares of the income that is attributable to 

the U.S. office. The services that generate the income attributable 

to the U.S. office would include the services performed by the partner in the U.S. office, as well as any income with respect to services performed on behalf of the U.K. office by a U.K. partner who 

travels to the United States and performs such services in the 

United States, regardless of whether the U.K. partner actually visited or used the U.S. office while performing the services in the 

United States. 

The proposed treaty provides that there will be attributed to a 

permanent establishment the business profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar 

conditions and dealing wholly independently with the enterprise of 

which it is a permanent establishment and other associated enterprises. The Technical Explanation states that this rule permits the 

use of methods other than separate accounting to determine the 

arm’s-length profits of a permanent establishment where it is necessary to do so for practical reasons, such as when the affairs of 

the permanent establishment are so closely bound up with those of 

the head office that it would be impossible to disentangle them on 

any strict basis of accounts. 

In computing taxable business profits of a permanent establishment, the proposed treaty provides that deductions are allowed for 

expenses, wherever incurred, which are attributable to the activities of the permanent establishment. These deductions include an 

allocation of executive and general administrative expenses, as determined by applying the arm’s-length principle and regardless of 

which accounting unit of the enterprise books the expenses, provided they are incurred for the purposes of the permanent establishment. The notes state that the OECD Transfer Pricing Guidelines apply by analogy in determining the profits attributable to a 

permanent establishment. Accordingly, any of the methods described in the guidelines (including profits methods) may be used 

in accordance with the guidelines to determine the income of a permanent establishment. 

For purposes of determining the amount of profits that are attributable to a permanent establishment, the notes state that the 

permanent establishment is treated as having the same amount of 

capital that it would need to support its activities if it were a distinct and separate enterprise engaged in the same or similar activities. This means, for example, that a permanent establishment cannot be funded entirely with debt. To the extent that a permanent 

establishment does not have sufficient capital to carry on its activities as if it were a distinct and separate enterprise, a treaty country may attribute such capital to the permanent establishment and 

deny an interest deduction to the extent necessary to reflect that 

capital attribution. The Technical Explanation states that the 

amount of capital attributable to a permanent establishment that 

is a financial institution (other than an insurance company) is determined by allocating the institution’s total equity among its varVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00027 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
24

ious offices on the basis of the proportion of the institution’s riskweighted assets attributable to each of them. 

Unlike the U.S. model and the OECD model, the proposed treaty 

does not include a rule providing that business profits are not attributed to a permanent establishment merely by reason of the purchase of goods or merchandise by the permanent establishment for 

the enterprise. This rule is only relevant to an office that performs 

functions in addition to purchasing because such activity does not, 

by itself, give rise to a permanent establishment under Article 5 

(Permanent Establishment) to which income can be attributed. 

When it applies, the rule provides that business profits may be attributable to a permanent establishment with respect to its nonpurchasing activities (e.g., sales activities), but not with respect to 

its purchasing activities. The Technical Explanation states that the 

rule was not included in the proposed treaty because such a result 

is inconsistent with the arm’s-length principle, which would view 

a separate and distinct enterprise as receiving some compensation 

to perform purchasing services. 

The proposed treaty requires the determination of business profits of a permanent establishment to be made in accordance with 

the same method year by year unless a good and sufficient reason 

to the contrary exists. 

The proposed treaty generally waives the application of the U.S. 

insurance excise tax on premiums on policies issued by foreign insurers and reinsurers, in the case of a U.K. enterprise carrying on 

an insurance business. 

The waiver of the insurance excise tax generally does not apply, 

however, if the policies are entered into as part of a conduit arrangement. A conduit arrangement is defined in paragraph (1)(n) 

of Article 3 of the proposed treaty as a transaction (or series of 

transactions) in which a resident of the United States or the 

United Kingdom (that is entitled to the benefits of the proposed 

treaty) receives income arising in the other country, then pays it 

to a resident of a third country who is not entitled to equivalent 

or more favorable treaty benefits. The arrangement is treated as a 

conduit arrangement only if has as its main purpose, or one of its 

main purposes, obtaining the increased benefits available under 

the proposed treaty. 

The Technical Explanation notes that U.S. domestic law provides 

specific anti-conduit rules as well as domestic anti-abuse principles, 

and states that the United States intends to interpret the conduit 

arrangement provisions of the proposed treaty in accordance with 

U.S. domestic law, as it may evolve over time. The Technical Explanation further states that the United States will interpret the 

provision of the proposed treaty by analogy to the anti-conduit 

rules of Treas. Reg. sec. 1.881–3. The Technical Explanation notes 

that the application of the anti-conduit rules to the insurance excise tax is somewhat narrower than the exception in other U.S. tax 

treaties that cover the insurance excise tax, because it includes the 

intent test found in the anti-conduit test applicable to withholding 

taxes. 

The U.S. insurance excise tax does not apply to amounts that are 

effectively connected to a U.S. trade or business, including income 

from a U.S. permanent establishment. The proposed treaty proVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00028 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
25

vides for the same result as U.S. domestic law, by providing that 

the anti-conduit exception to the waiver of the insurance excise tax 

does not apply in the case of premiums attributable to a U.K. enterprise’s permanent establishment in the United States. Thus, the 

provision of U.S. domestic law would prevent the application of the 

insurance excise tax in this situation, although the U.S. income tax 

would apply under U.S. domestic law. As discussed above, another 

provision of Article 7 provides that the business profits of a U.K. 

enterprise that are attributable to a permanent establishment in 

the United States may be taxed in the United States. 

Where business profits include items of income that are dealt 

with separately in other articles of the proposed treaty, those other 

articles, and not the business profits article, govern the treatment 

of those items of income. Thus, for example, dividends are taxed 

under the provisions of Article 10 (Dividends), and not as business 

profits, except as specifically provided in Article 10. 

The proposed treaty provides that, for purposes of the taxation 

of business profits, income may be attributable to a permanent establishment (and therefore may be taxable in the source country) 

even if the payment of such income is deferred until after the permanent establishment or fixed base has ceased to exist. This rule 

incorporates into the proposed treaty the rule of Code section 

864(c)(6) described above. This rule applies with respect to business 

profits (Article 7, paragraphs 1 and 2), dividends (Article 10, paragraph 5), interest (Article 11, paragraph 3), royalties (Article 12, 

paragraph 3), and other income (Article 22, paragraph 2). A similar 

rule is included in paragraph 3 of Article 13 (Gains). 

The Technical Explanation notes that this article is subject to the 

savings clause of paragraph 4 of Article 1 (General Scope), as well 

as Article 23 (Limitation on Benefits). Thus, in the case of the savings clause, if a U.S. citizen who is a resident of the United Kingdom derives business profits from the United States that are not 

attributable to a permanent establishment in the United States, 

the United States may, subject to the special foreign tax credit 

rules of paragraph 6 of Article 24 (Relief from Double Taxation), 

tax those profits, notwithstanding that paragraph 1 of this Article 

would exempt the income from U.S. Tax. 

Article 8. Shipping and Air Transport 

Article 8 of the proposed treaty covers income from the operation 

of ships and aircraft in international traffic. The rules governing 

income from the disposition of ships, aircraft, and containers are in 

Article 13 (Capital Gains). 

The United States generally taxes the U.S.-source income of a 

foreign person from the operation of ships or aircraft to or from the 

United States. An exemption from U.S. tax is provided if the income is earned by a corporation that is organized in, or an alien 

individual who is resident in, a foreign country that grants an 

equivalent exemption to U.S. corporations and residents. The 

United States has entered into agreements with a number of countries providing such reciprocal exemptions. 

Like the present treaty, the proposed treaty provides that profits 

that are derived by an enterprise of one country from the operation 

in international traffic of ships or aircraft are taxable only in that 

26

country, regardless of the existence of a permanent establishment 

in the other country. ‘‘International traffic’’ is defined in Article 

3(1)(f) (General Definitions) as any transport by a ship or aircraft, 

except when the transport is solely between places in the other 

treaty country. 

The proposed treaty provides that profits from the operation of 

ships or aircraft in international traffic include profits derived from 

the rental of ships or aircraft on a full (time or voyage) basis (i.e., 

with crew). Like the present treaty, it also includes profits from the 

rental of ships or aircraft on a bareboat basis (i.e., without crew) 

if such rental activities are incidental to the activities from the operation of ships or aircraft in international traffic. The Technical 

Explanation notes that this provision is narrower than the U.S. 

Model, which also covers rentals from bareboat leasing that are not 

incidental to the operation of ships and aircraft in international 

traffic by the lessor. Under the proposed treaty, income from such 

rentals is covered by Article 7 (Business Profits). 

The proposed treaty provides that profits derived by an enterprise from the inland transport of property or passengers within either treaty country are treated as profits from the operation of 

ships or aircraft in international traffic (and, thus, governed by this 

Article) if such transport is undertaken as part of international 

traffic by the enterprise. For example, if a U.K. enterprise contracts to carry property from the United States to the United Kingdom and, as part of the contract, it transports (or contracts to 

transport) the property by truck from its point of origin to an airport in the United States, the income earned by the U.K. enterprise 

from the overland leg of the journey would be taxable only in the 

United Kingdom. Similarly, the diplomatic notes state that this Article would also apply to income from lighterage undertaken as 

part of the international transport of goods. 

The proposed treaty provides that profits of an enterprise of a 

country from the use, maintenance, or rental of containers (including trailers, barges, and related equipment for the transport of containers) used for the transport of goods or merchandise in international traffic is taxable only in that country. The Technical Explanation states that, unlike the OECD Model, this rule applies 

without regard to whether the recipient of the income is engaged 

in the operation of ships or aircraft in international traffic or 

whether the enterprise has a permanent establishment in the other 

country. 

As under the U.S. model, the shipping and air transport provisions of the proposed treaty apply to profits derived from participation in a pool, joint business, or international operating agency. 

This refers to various arrangements for international cooperation 

by carriers in shipping and air transport. 

The Technical Explanation notes that this article is subject to the 

savings clause of paragraph 4 of Article 1 (General Scope), as well 

as Article 23 (Limitation on Benefits). 

Article 9. Associated Enterprises 

The proposed treaty, like most other U.S. tax treaties, contains 

an arm’s-length pricing provision. The proposed treaty recognizes 

the right of each country to make an allocation of profits to an enVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00030 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
27

terprise of that country in the case of transactions between related 

enterprises, if conditions are made or imposed between the two enterprises in their commercial or financial relations which differ 

from those which would be made between independent enterprises. 

In such a case, a country may allocate to such an enterprise the 

profits which it would have accrued but for the conditions so imposed. This treatment is consistent with the U.S. model. 

For purposes of the proposed treaty, an enterprise of one country 

is related to an enterprise of the other country if one of the enterprises participates directly or indirectly in the management, control, or capital of the other enterprise. Enterprises are also related 

if the same persons participate directly or indirectly in their management, control, or capital. 

Under the proposed treaty, when a redetermination of tax liability has been made by one country under the provisions of this article, the other country will make an appropriate adjustment to the 

amount of tax paid in that country on the redetermined income. In 

making such adjustment, due regard is to be given to other provisions of the proposed treaty and proposed protocol. Any such adjustment is to be made only in accordance with the mutual agreement procedures of the proposed treaty. The proposed treaty’s saving clause retaining full taxing jurisdiction in the country of residence or citizenship does not apply in the case of such adjustments. 

Accordingly, internal statute of limitations provisions do not prevent the allowance of appropriate correlative adjustments. However, the Technical Explanation states that statutory or procedural 

limitations cannot be overridden to impose additional tax because 

paragraph 2 of Article 1 (General Scope) provides that the proposed 

treaty cannot restrict any statutory benefit. 

The diplomatic notes state that, if the amount of interest or royalties paid exceeds the amount that would have been paid in the 

absence of a special relationship under paragraph 4 of Article 11 

(Interest) or paragraph 4 of Article 12 (Royalties), a treaty country 

generally will adjust the amount of deductible interest or royalties 

paid under the authority of this Article and make any other appropriate adjustments. The diplomatic notes further state that the 

treaty country making the adjustments will not also impose its domestic rate of withholding tax with respect to such excess amount. 

The Technical Explanation also states that the proposed treaty 

does not limit any provisions of either country’s internal law that 

permit the distribution, apportionment, or allocation of income, deductions, credits, or allowances between related parties, including 

adjustments in cases involving the evasion of taxes or fraud. Any 

such adjustments are permitted even if they are different from, or 

go beyond, those specifically authorized by this Article, as long as 

they are in accord with general arm’s length principles. 

Article 10. Dividends 

Internal taxation rules 

United States 

The United States generally imposes a 30–percent tax on the 

gross amount of U.S.-source dividends paid to nonresident alien individuals and foreign corporations. The 30–percent tax does not 

28

apply if the foreign recipient is engaged in a trade or business in 

the United States and the dividends are effectively connected with 

that trade or business. In such a case, the foreign recipient is subject to U.S. tax on such dividends on a net basis at graduated rates 

in the same manner that a U.S. person would be taxed. 

Under U.S. law, the term dividend generally means any distribution of property made by a corporation to its shareholders, either 

from accumulated earnings and profits or current earnings and 

profits. However, liquidating distributions generally are treated as 

payments in exchange for stock and, thus, are not subject to the 

30–percent withholding tax described above (see discussion of capital gains in connection with Article 13 below). 

Dividends paid by a U.S. corporation generally are U.S.-source 

income. Also treated as U.S.-source dividends for this purpose are 

portions of certain dividends paid by a foreign corporation that conducts a U.S. trade or business. The U.S. 30–percent withholding 

tax imposed on the U.S.-source portion of the dividends paid by a 

foreign corporation is referred to as the ‘‘second-level’’ withholding 

tax. This second-level withholding tax is imposed only if a treaty 

prevents application of the statutory branch profits tax. 

In general, corporations are not entitled under U.S. law to a deduction for dividends paid. Thus, the withholding tax on dividends 

theoretically represents imposition of a second level of tax on corporate taxable income. Treaty reductions of this tax reflect the view 

that where the United States already imposes corporate-level tax 

on the earnings of a U.S. corporation, a 30–percent withholding 

rate may represent an excessive level of source-country taxation. 

Moreover, the reduced rate of tax often applied by treaty to dividends paid to direct investors reflects the view that the sourcecountry tax on payments of profits to a substantial foreign corporate shareholder may properly be reduced further to avoid double 

corporate-level taxation and to facilitate international investment. 

A real estate investment trust (‘‘REIT’’) is a corporation, trust, or 

association that is subject to the regular corporate income tax, but 

that receives a deduction for dividends paid to its shareholders if 

certain conditions are met. In order to qualify for the deduction for 

dividends paid, a REIT must distribute most of its income. Thus, 

a REIT is treated, in essence, as a conduit for federal income tax 

purposes. Because a REIT is taxable as a U.S. corporation, a distribution of its earnings is treated as a dividend rather than income of the same type as the underlying earnings. Such distributions are subject to the U.S. 30–percent withholding tax when paid 

to foreign owners. 

A REIT is organized to allow persons to diversify ownership in 

primarily passive real estate investments. As such, the principal 

income of a REIT often is rentals from real estate holdings. Like 

dividends, U.S.-source rental income of foreign persons generally is 

subject to the 30–percent withholding tax (unless the recipient 

makes an election to have such rental income taxed in the United 

States on a net basis at the regular graduated rates). Unlike the 

withholding tax on dividends, however, the withholding tax on 

rental income generally is not reduced in U.S. income tax treaties. 

U.S. internal law also generally treats a regulated investment 

company (‘‘RIC’’) as both a corporation and a conduit for income tax 

29

7The Technical Explanation indicates that only direct ownership will count for this purpose. 

The text of the proposed treaty is less precise but is consistent with this view. 

purposes. The purpose of a RIC is to allow investors to hold a diversified portfolio of securities. Thus, the holder of stock in a RIC 

may be characterized as a portfolio investor in the stock held by 

the RIC, regardless of the proportion of the RIC’s stock owned by 

the dividend recipient. 

United Kingdom 

The United Kingdom does not currently impose a withholding 

tax on dividend payments to nonresidents. The United Kingdom 

also currently does not impose a branch profits tax. 

Proposed treaty limitations on internal law 

In general 

Under the proposed treaty, dividends paid by a company that is 

a resident of a treaty country to a resident of the other country 

may be taxed in such other country. Such dividends also may be 

taxed by the country in which the payor company is resident, but 

the rate of such tax is limited. Under the proposed treaty, sourcecountry taxation of dividends (i.e., taxation by the country in which 

the dividend-paying company is resident) generally is limited to 15 

percent of the gross amount of the dividends paid to residents of 

the other treaty country. A lower rate of 5 percent applies if the 

beneficial owner of the dividend is a company that owns at least 

10 percent of the voting stock of the dividend-paying company. 

The term ‘‘beneficial owner’’ is not defined in the present treaty 

or proposed protocol and, thus, is defined under the internal law 

of the source country. The Technical Explanation states that the 

beneficial owner of a dividend for purposes of this article is the person to which the dividend income is attributable for tax purposes 

under the laws of the source country. Further, companies holding 

shares through fiscally transparent entities such as partnerships 

are considered to hold their proportionate interest in the shares. 

In addition, the proposed protocol provides a zero rate of withholding tax with respect to certain intercompany dividends in cases 

in which there is a sufficiently high (80–percent) level of ownership 

(often referred to as ‘‘direct dividends’’). The zero rate also would 

apply with respect to dividends received by a tax-exempt pension 

fund, provided that such dividends are not derived from the carrying on of a business, directly or indirectly, by such fund. 

Zero rate for direct dividends 

Under the proposed treaty, the withholding tax rate is reduced 

to zero on dividends beneficially owned by a company that has 

owned at least 80 percent of the voting power of the company paying the dividend for the 12–month period ending on the date the 

dividend is declared (subparagraph 3(a) of Article 10 (Dividends)).7

Under the present treaty, these dividends may be taxed at a 5–percent rate (although, as noted above, the United Kingdom currently 

does not exercise this right as a matter of domestic law, whereas 

the United States does). 

30

8October 1, 1998 is the date on which the parties announced that they were negotiating the 

proposed treaty. 

In certain circumstances, eligibility for the zero rate under the 

proposed treaty is subject to an additional restriction designed to 

prevent companies from reorganizing for the purpose of obtaining 

the benefits of the provision. Specifically, in cases in which a company satisfies the Limitation on Benefits article only under the ‘‘active trade or business’’ and/or ‘‘ownership/base-erosion’’ tests (paragraph 4 and subparagraph 2(f), respectively, of Article 23 (Limitation on Benefits)), the zero rate will apply only if the dividend-receiving company owned (directly or indirectly) at least 80 percent 

of the voting power of the dividend-paying company prior to October 1, 1998.8 In other cases, the Limitation on Benefits article itself 

is considered sufficient to prevent treaty shopping. Thus, companies that qualify for treaty benefits under the ‘‘public trading,’’ ‘‘derivative benefits,’’ or discretionary tests (subparagraph 2(c) and 

paragraphs 3 and 6, respectively, of Article 23 (Limitation on Benefits)) will not need to meet the October 1, 1998 holding requirement 

in order to claim the zero rate. 

Prior to amendment by the proposed protocol, the language of the 

proposed treaty left open a fundamental interpretive issue regarding the scope of the zero-rate provision. Under the ‘‘derivative benefits’’ test of Article 23, a company may qualify for treaty benefits 

(including, potentially, the zero rate) if at least 95 percent of the 

vote and value of the company is owned (directly or indirectly) by 

seven or fewer ‘‘equivalent beneficiaries,’’ and less than 50 percent 

of its gross income for the year is paid or accrued in deductible 

form to persons who are not ‘‘equivalent beneficiaries’’ (paragraph 

3 of Article 23 (Limitation on Benefits)). Under the proposed treaty 

as originally signed, one type of ‘‘equivalent beneficiary’’ was a 

company resident in a European Community member state that 

would have been entitled under a European Community Directive 

‘‘to receive the particular class of income for which benefits are 

being claimed under [the proposed treaty] free of withholding tax’’ 

(subparagraph 7(d) of Article 23 (Limitation on Benefits), prior to 

amendment by the proposed protocol). Under the European Community ‘‘Parent-Subsidiary Directive,’’ dividends paid by a subsidiary resident in one member state to a parent company resident 

in another member state are exempt from withholding tax. Interpreting the originally proposed treaty language in light of the Parent-Subsidiary Directive, it could have been argued that any company resident in a European Community member state would have 

qualified as an ‘‘equivalent beneficiary’’ for purposes of the zerorate provision, since it would have been entitled ‘‘to receive the particular class of income for which benefits are being claimed’’—i.e., 

a subsidiary-parent dividend, according to this view—free of withholding tax. If this view were correct, then the United States effectively would have agreed to extend the benefits of the zero-rate 

provision to European companies generally, rather than just to 

U.K. companies. The European companies simply would have had 

to place the stock of their U.S. subsidiaries into U.K. holding companies in order to enjoy the zero rate. 

31

9See Part III, Article 23, infra, for a more detailed description of the ‘‘equivalent beneficiary’’ 

definition and the anti-treaty-shopping provision in general. 

If, on the other hand, ‘‘the particular class of income’’ described 

in the ‘‘equivalent beneficiary’’ definition were construed as referring not to subsidiary-parent dividends generally, but rather to 

dividends from U.S. subsidiaries, then European companies would 

not have been eligible for the zero rate by way of the ‘‘derivative 

benefits’’ test and the Parent-Subsidiary Directive, since such companies would not have been entitled to receive dividends directly 

from U.S. subsidiaries free of withholding tax. This latter interpretation of the originally proposed treaty language is the one consistent with the intent of the United States. In negotiating the proposed treaty, the United States never intended to extend the benefits of the zero-rate provision to non-U.K. European parent companies as a class. 

Since the language of the originally proposed treaty was ambiguous in this regard, and did arguably admit the former, unintended 

interpretation, the parties amended the proposed treaty’s ‘‘equivalent beneficiaries’’ definition in order to clarify that non-U.K. European parent companies will not be entitled to the benefits of the 

zero-rate provision through the expedient of establishing a U.K. 

holding company (paragraph 7(d) of Article 23 (Limitation on Benefits), as amended by article 4 of the proposed protocol). Under the 

amended definition, a non-U.K. European company can qualify as 

an equivalent beneficiary for purposes of the zero-rate provision 

only if such company: (1) would be entitled to all the benefits of a 

comprehensive income tax treaty between a European Community 

member state and the treaty country from which benefits under the 

proposed treaty are being claimed (i.e., the United States); and (2) 

would be entitled to a zero rate of tax on the relevant dividends 

under such other treaty (i.e., a treaty between another European 

Community member state and the United States). Thus, unless 

and until the United States adopts a zero-rate provision in a treaty 

with a given European Community member state, companies resident in such state will not be treated as equivalent beneficiaries for 

purposes of claiming the zero rate under the proposed treaty.9

Dividends paid by RICs and REITs 

The proposed treaty generally denies the 5–percent and zero 

rates of withholding tax to dividends paid by ‘‘pooled investment 

vehicles’’ (e.g., RICs and REITs). 

The 15 percent rate of withholding is generally allowed for dividends paid by a RIC. The 15 percent rate of withholding is allowed 

for dividends paid by a REIT only if one of three additional conditions is met. First, the dividend may qualify for the 15 percent rate 

if the person beneficially entitled to the dividend is an individual 

holding an interest of not more than 10 percent in the REIT. Second, the dividend may qualify for the 15 percent rate if it is paid 

with respect to a class of stock that is publicly traded and the person beneficially entitled to the dividend is a person holding an interest of not more than 5 percent of any class of the REIT’s stock. 

Third, the dividend may qualify for the 15 percent rate if the person beneficially entitled to the dividend holds an interest in the 

32

REIT of not more than 10 percent and the REIT is ‘‘diversified’’ 

(i.e., the gross value of no single interest in real property held by 

the REIT exceeds 10 percent of the gross value of the REIT’s total 

interest in real property). 

Dividends received by tax-exempt pension funds from RICs and 

REITs generally are eligible for the zero rate. In the case of REIT 

dividends, this eligibility is also subject to the requirement of meeting one of the three conditions described above in connection with 

the general 15–percent rate. 

The Technical Explanation indicates that the restrictions on 

availability of the lower rates are intended to prevent the use of 

RICs and REITs to gain unjustifiable source-country benefits for 

certain shareholders resident in the United Kingdom. For example, 

a company resident in the United Kingdom could directly own a diversified portfolio of U.S. corporate shares and pay a U.S. withholding tax of 15 percent on dividends on those shares. There is a 

concern that such a company could purchase 10 percent or more of 

the interests in a RIC, which could even be established as a mere 

conduit, and thus obtain a lower withholding rate by holding a 

similar portfolio through the RIC (transforming portfolio dividends 

generally taxable at 15 percent into direct investment dividends 

taxable under the treaty at zero or 5 percent). 

Similarly, the Technical Explanation gives an example of a resident of the United Kingdom directly holding real property and required to pay U.S. tax either at a 30 percent rate on gross income 

or at graduated rates on the net income. By placing the property 

in a REIT, the investor could transform real estate income into dividend income, taxable at the lower rates provided in the proposed 

treaty. The limitations on REIT dividend benefits are intended to 

protect against this result. 

Special rules and limitations 

The proposed treaty’s reduced rates of tax on dividends do not 

apply if the dividend recipient carries on business through a permanent establishment in the source country, or performs in the 

source country independent personal services from a fixed base located in that country, and the holding in respect of which the dividends are paid is effectively connected with such permanent establishment or fixed base. In such cases, the dividends effectively connected to the permanent establishment or the fixed base are taxed 

as business profits (Article 7). 

The proposed treaty prevents the United States from imposing a 

tax on dividends paid by a U.K. company unless such dividends are 

paid to a resident of the United States or are attributable to a permanent establishment in the United States. Thus, this provision 

generally overrides the ability of the United States to impose a 

‘‘second-level’’ withholding tax on the U.S.-source portion of dividends paid by a U.K. corporation. The proposed treaty also restricts 

the United States from imposing corporate level taxes on undistributed profits, other than a branch profits tax. 

The United States is allowed under the proposed protocol to impose the branch profits tax (at a rate of 5 percent) on a U.K. corporation that either has a permanent establishment in the United 

States, or is subject to tax on a net basis in the United States on 

33

10See Part III, Article 3, supra, for a description of the proposed treaty’s conduit arrangement 

provisions, and Part IV.B, infra, for a discussion of the issues raised by these provisions. 

income from real property or gains from the disposition of interests 

in real property. The tax is imposed on the ‘‘dividend equivalent 

amount,’’ as defined in the Code (generally, the dividend amount 

a U.S. branch office would have paid up to its parent for the year 

if it had been operated as a separate U.S. subsidiary). In cases in 

which a U.K. corporation conducts a trade or business in the 

United States but not through a permanent establishment, the proposed treaty completely eliminates the branch profits tax that the 

Code would otherwise impose on such corporation (unless the corporation earned income from real property as described above). The 

United Kingdom currently does not impose a branch profits tax. If 

the United Kingdom were to impose such tax, the base of such a 

tax would be limited to an amount analogous to the U.S. ‘‘dividend 

equivalent amount.’’ 

The branch profits tax will not be imposed by the United States 

in cases in which a zero-rate would apply if the U.S. branch business had been conducted by the U.K. company through a separate 

U.S. subsidiary. In addition, the tax will not apply to a U.K. company that is considered a qualified person by reason of being a publicly-traded company, or that is entitled to benefits with respect to 

the dividend equivalent amount under the derivative benefits or 

competent-authority discretion rules under Article 23 (Limitation 

on Benefits). 

The proposed treaty provides an anti-conduit provision under 

which the provisions with respect to dividends will not apply to any 

dividend paid under, or as part of, a conduit arrangement (as defined in Article 3 (General Definitions)).10

The proposed treaty generally defines ‘‘dividends’’ as income from 

shares (or other corporate participation rights that are not treated 

as debt under the law of the source country), as well as other 

amounts that are subjected to the same tax treatment as income 

from shares by the source country (e.g., constructive dividends). 

Relation to other Articles 

The technical explanation notes that the savings clause of paragraph 4 of Article 1 (General Scope) permits the United States to 

tax dividends received by its residents and citizens, subject to the 

special foreign tax credit rules of paragraph 6 of Article 24 (Relief 

from Double Taxation), as if the proposed treaty had not come into 

effect. 

The benefits of the dividends article are also subject to the provisions of Article 23 (Limitation on Benefits). Thus, if a resident of 

the United Kingdom is the beneficial owner of dividends paid by 

a U.S. company, the shareholder must qualify for treaty benefits 

under at least one of the tests of Article 23 in order to receive the 

benefits of Article 10. 

34

Article 11. Interest 

Internal taxation rules 

United States 

Subject to several exceptions (such as those for portfolio interest, 

bank deposit interest, and short-term original issue discount), the 

United States imposes a 30–percent withholding tax on U.S.-source 

interest paid to foreign persons under the same rules that apply to 

dividends. U.S.-source interest, for purposes of the 30–percent tax, 

generally is interest on the debt obligations of a U.S. person, other 

than a U.S. person that meets specified foreign business requirements. Also subject to the 30–percent tax is interest paid by the 

U.S. trade or business of a foreign corporation. A foreign corporation is subject to a branch-level excess interest tax with respect to 

certain ‘‘excess interest’’ of a U.S. trade or business of such corporation; under this rule, an amount equal to the excess of the interest 

deduction allowed with respect to the U.S. business over the interest paid by such business is treated as if paid by a U.S. corporation 

to a foreign parent and, therefore, is subject to the 30–percent 

withholding tax. 

Portfolio interest generally is defined as any U.S.-source interest 

that is not effectively connected with the conduct of a trade or business if such interest (1) is paid on an obligation that satisfies certain registration requirements or specified exceptions thereto and 

(2) is not received by a 10–percent owner of the issuer of the obligation, taking into account shares owned by attribution. However, the 

portfolio interest exemption does not apply to certain contingent interest income. 

If an investor holds an interest in a fixed pool of real estate 

mortgages that is a real estate mortgage interest conduit 

(‘‘REMIC’’), the REMIC generally is treated for U.S. tax purposes 

as a pass-through entity and the investor is subject to U.S. tax on 

a portion of the REMIC’s income (which, generally is interest income). If the investor holds a so-called ‘‘residual interest’’ in the 

REMIC, the Code provides that a portion of the net income of the 

REMIC that is taxed in the hands of the investor—referred to as 

the investor’s ‘‘excess inclusion’’—may not be offset by any net operating losses of the investor, must be treated as unrelated business income if the investor is an organization subject to the unrelated business income tax, and is not eligible for any reduction in 

the 30–percent rate of withholding tax (by treaty or otherwise) that 

would apply if the investor were otherwise eligible for such a rate 

reduction. 

United Kingdom 

U.K.-source interest payments to nonresidents generally are subject to withholding tax at a rate of 20 percent. However, tax is generally not required to be withheld on payments to nonresidents for 

interest from banks or building societies, interest on short-term 

loans (less than one year), or interest on government securities. 

35

Proposed treaty limitations on internal law 

The proposed treaty generally exempts interest arising in one 

country (the source country) and beneficially owned by a resident 

of the other country from tax in the source country. This exemption 

from source country tax is similar to that provided in the U.S. 

model and the present treaty. The present treaty generally exempts 

from U.S. tax interest derived and beneficially owned by a U.K. 

resident, and generally exempts from U.K. tax interest derived and 

beneficially owned by a U.S. resident. 

The proposed treaty defines interest as income from debt claims 

of every kind, whether or not secured by mortgage and whether or 

not carrying a right to participate in the debtor’s profits. In particular, it includes income from government securities and from 

bonds and debentures, including premiums or prizes attaching to 

such securities, bonds, or debentures. The term ‘‘interest’’ also includes all other income that is treated as income from money lent 

under the tax law of the country in which the income arises. Interest does not include income covered in Article 10 (Dividends). Penalty charges for late payment also are not treated as interest. 

This exemption from source country tax does not apply if the 

beneficial owner of the interest carries on business through a permanent establishment in the source country and the interest paid 

is attributable to the permanent establishment. In that event, the 

interest is taxed as business profits (Article 7). According to the 

Technical Explanation, interest attributable to a permanent establishment but received after the permanent establishment is no 

longer in existence is taxable in the country where the permanent 

establishment existed. 

The proposed treaty addresses the issue of non-arm’s-length interest charges between related parties (or parties having an otherwise special relationship) by stating that this article applies only 

to the amount of arm’s-length interest. Any amount of interest paid 

in excess of the arm’s-length interest is taxable according to other 

provisions of the proposed treaty. For example, excess interest paid 

to a parent corporation may be treated as a dividend under local 

law and, thus, entitled to the benefits of Article 10 (Dividends). The 

Notes provide that if the amount of interest paid exceeds the 

amount that would have been paid in the absence of the special relationship, a country generally will adjust the amount of deductible 

interest paid under the authority of Article 9 (Associated Enterprises) and make such other adjustments as are appropriate. The 

Notes further provide that if adjustments are made, the country 

making such adjustment will not also impose its domestic withholding tax with respect to such excess amount. 

The proposed treaty provides two anti-abuse exceptions to the 

general source-country exemption from tax discussed above. The 

first exception relates to ‘‘contingent interest’’ payments. If interest 

is paid by a source-country resident and is determined with reference to (1) receipts, sales, income, profits, or other cash flow of 

the debtor or a related person, (2) to any change in the value of 

any property of the debtor or a related person, or (3) to any dividend, partnership distribution, or similar payment made by the 

debtor to a related person, such interest may be taxed in the source 

country in accordance with its laws. However, if the beneficial 

36

11See Part III, Article 3, supra, for a description of the proposed treaty’s conduit arrangement 

provisions, and Part IV.B, infra, for a discussion of the issues raised by these provisions. 

owner is a resident of the other country, such interest may not be 

taxed as a rate exceeding 15 percent (i.e., the rate prescribed in 

paragraph 2(b) of Article 10 (Dividends)). The proposed treaty provides that this anti-abuse rule will not apply to any interest solely 

because it is paid under an arrangement providing that the amount 

of interest payable will be reduced (or increased) in the event of improvements (or deteriorations) in the factors by reference to which 

the amount of interest payable. The Technical Explanation states 

that interest will not, for example, become contingent interest solely by virtue of a provision in an agreement that calls for an increase in the rate charged upon the deterioration of the credit position of the borrower. 

The second anti-abuse exception provides that exemptions from 

source country tax do not apply to interest paid with respect to 

ownership interests in a vehicle used for the securitization of real 

estate mortgages or other assets, to the extent that the amount of 

interest paid exceeds the return on comparable debt instruments as 

specified by the domestic law of that country. The Technical Explanation states that this provision denies source country exemptions 

with respect to excess inclusions with respect to a residual interest 

in a REMIC. This provision is analogous to the U.S. model, but is 

drafted reciprocally presumably to apply to similar U.K. 

securitization vehicles. Such income may be taxed in accordance 

with each country’s internal law. 

The proposed treaty provides an anti-conduit provision similar to 

that for dividends (Article 10) under which the provisions with respect to interest will not apply in respect of any interest paid 

under, or as part of, a conduit arrangement (as defined in Article 

3 (General Definitions)).11

Article 12. Royalties 

Internal taxation rules 

United States 

Under the same system that applies to dividends and interest, 

the United States imposes a 30–percent withholding tax on U.S.-

source royalties paid to foreign persons. U.S.-source royalties include royalties for the use of or right to use intangible property in 

the United States. 

United Kingdom 

Royalties paid to nonresidents are generally subject to a 22 percent withholding rate. 

Proposed treaty limitations on internal law 

The proposed treaty provides that royalties arising in a country 

(the source country) and beneficially owned by a resident of the 

other country is exempt from tax in the source country. This exemption from source country tax is similar to that provided in the 

U.S. model and the present treaty. The present treaty generally exempts from U.S. tax royalties derived and beneficially owned by a 

37

12See Part III, Article 3, supra, for a description of the proposed treaty’s conduit arrangement 

provisions, and Part IV.B, infra, for a discussion of the issues raised by these provisions. 

U.K. resident, and generally exempts from U.K. tax royalties derived and beneficially owned by a U.S. resident. 

The term ‘‘royalties’’ means any consideration for the use of, or 

the right to use, any copyright of literary, artistic, scientific, or 

other work (including computer software and cinematographic 

films), including works reproduced on audio or video tapes or disks 

or any other means of image or sound production. The term also 

includes consideration for the use of, or the right to use, any patent, trademark, design or model, plan, secret formula or process, or 

other like right or property, or for information concerning industrial, commercial, or scientific experience. The term also includes 

gain from the alienation of any right or property described in the 

preceding two sentences, to the extent that the amount of such 

gain is contingent on the productivity, use, or disposition of the 

right or property. The Technical Explanation states that the term 

royalties does not include income from leasing personal property. 

The Technical Explanation further states that it is understood that 

a typical retail sale of ‘‘shrink wrap’’ computer software will not be 

considered as royalty income (even though for copyright law purposes it may be characterized as a license). 

The exemption from source country tax does not apply if the beneficial owner of the royalties carries on a business through a permanent establishment in the source country, and the royalties are 

attributable to the permanent establishment. In that event, the 

royalties are taxed as business profits (Article 7). According to the 

Technical Explanation, royalties attributable to a permanent establishment but received after the permanent establishment is no 

longer in existence is taxable in the country where the permanent 

establishment existed. 

The proposed treaty addresses the issue of non-arm’s-length royalties between related parties (or parties otherwise having a special 

relationship) by providing that this article applies only to the 

amount of arm’s-length royalties. Any amount of royalties paid in 

excess of the arm’s-length interest is taxable according to other provisions of the proposed treaty. For example, excess royalties paid 

by a subsidiary corporation to its parent corporation may be treated as a dividend under local law and, thus, entitled to the benefits 

of Article 10 (Dividends). The Notes provide that if the amount of 

royalties paid exceeds the amount that would have been paid in the 

absence of the special relationship, a country generally will adjust 

the amount of deductible royalties paid under the authority of Article 9 (Associated Enterprises) and make such other adjustments as 

are appropriate. The Notes further provide that if adjustments are 

made, the country making such adjustment will not also impose its 

domestic withholding tax with respect to such excess amount. 

As in the case of dividends (Article 10) and interest (Article 11), 

the proposed treaty includes an anti-conduit rule under which the 

provisions of this article will not apply in respect of any royalty 

paid under, or as part of, a conduit arrangement (as defined in Article 3 (General Definitions)).12

38

Article 13. Gains 

Internal taxation rules 

United States 

Generally, gain realized by a nonresident who is a noncitizen or 

a foreign corporation from the sale of a capital asset is not subject 

to U.S. tax unless the gain is effectively connected with the conduct 

of a U.S. trade or business or, in the case of a nonresident who is 

a noncitizen, he or she is physically present in the United States 

for at least 183 days in the taxable year. A nonresident noncitizen 

or foreign corporation is subject to U.S. tax on gain from the sale 

of a U.S. real property interest as if the gain were effectively connected with a trade or business conducted in the United States. 

‘‘U.S. real property interests’’ include interests in certain corporations if at least 50 percent of the assets of the corporation consist 

of U.S. real property. 

United Kingdom 

Capital gains are subject to tax at the normal corporate tax rate. 

Nonresidents carrying on a business in the United Kingdom 

through a U.K. branch or agency are charged tax on gains with respect to assets used in the branch or agency. Other nonresidents 

are generally not charged capital gains tax on the disposal of U.K. 

assets. A former resident who reestablishes residence in the United 

Kingdom within five years will remain subject to tax in the United 

Kingdom with respect to gains realized through the period of nonresidence. 

Proposed treaty limitations on internal law 

The proposed treaty specifies rules governing when a country 

may tax gains from the alienation of property by a resident of the 

other country. The rules are generally consistent with those contained in the U.S. model. The present treaty generally provides 

that each country may tax capital gains in accordance with its own 

internal laws. 

Under the proposed treaty, gains derived by a resident of one 

treaty country from the alienation of real property situated in the 

other country may be taxed in the country in which the property 

is situated. For the purposes of this article, real property situated 

in the other country includes rights to assets to be produced by the 

exploration or exploitation of the sea and sub soil of the other country and their natural resources, including rights to interests in or 

the benefit of such assets. In the case of the United States, the 

term includes a U.S. real property interest. In the case of the 

United Kingdom, the term includes (1) shares, including rights to 

acquire shares, (other than shares in which there is regular trading 

on a stock exchange) deriving their value or the greater part of 

their value directly or indirectly from real property situated in the 

United Kingdom, and (2) a partnership or trust interest to the extent that the assets of the partnership or trust consist of real property situated in the United Kingdom, or of shares referred to in (1) 

above. 

39

13The Technical Explanation further states that the analogous U.S. rules under Code section 

877 (dealing with the taxation of certain U.S.-source income of former U.S. citizens and longterm residents) is separately preserved in the treaty under paragraph 6 of Article 1 (General 

Scope). 

The proposed treaty contains a standard provision which permits 

a country to tax gains from the alienation of property (other than 

real property) that forms a part of the business property of a permanent establishment located in that country. This rule also applies to gains from the alienation of such a permanent establishment (alone or with the enterprise as a whole). This rule also applies whether or not the permanent establishment exists at the 

time of alienation. 

The proposed treaty provides that gains derived by an enterprise 

of one of the treaty countries from the alienation of ships or aircraft operated in international traffic by the enterprise are taxable 

only in such country. This rule also applies to gains derived from 

the sale of containers used in international traffic, or of property 

(other than real property) pertaining to the operation or use of such 

ships, aircraft, or containers. 

Gains from the alienation of any property other than that discussed above is taxable under the proposed treaty only in the country where the person alienating the property is resident. The proposed treaty provides that this rule does not affect the right of a 

country tax levy according to its law a tax on gains from the alienation of any property derived by an individual who is a resident of 

the other country and has been a resident of the first country at 

any time during the six years immediately preceding the alienation 

of the property. The Technical Explanation states that this special 

rule was included in the proposed treaty in order to allow the 

United Kingdom to apply its domestic law regarding such sales. According to the Technical Explanation, under U.K. law, a former 

U.K. resident who re-establishes U.K. residency within five years 

remains subject to U.K. tax on gains realized during the intermediate period of nonresidency.13 Under the proposed treaty, if 

such gains are derived while the individual was a U.S. resident 

and such gains are taxed by the United States in accordance with 

the proposed treaty and by the United Kingdom pursuant to this 

provision, then such gains will be treated as U.S.-source income. 

Thus, pursuant to paragraph 2(b) of Article 24 (Relief from Double 

Taxation), discussed below, the United Kingdom will be required to 

grant a credit for U.S. taxes imposed on such gains. 

Article 14. Income From Employment 

Under the proposed treaty, salaries, wages, and other similar remuneration derived from services performed as an employee in one 

treaty country (the source country) by a resident of the other treaty 

country are taxable only by the country of residence if three requirements are met: (1) the individual is present in the source 

country for not more than 183 days in any twelve-month period 

commencing or ending in the taxable year or year of assessment 

concerned; (2) the individual is paid by, or on behalf of, an employer who is not a resident of the source country; and (3) the remuneration is not borne by a permanent establishment of the employer in the source country. These limitations on source country 

40

taxation are similar to the rules of the U.S. model and OECD 

model. 

The proposed treaty contains a special rule that permits remuneration derived by a resident of one treaty country with respect 

to employment as a regular member of the crew of a ship or aircraft operated in international traffic by an enterprise of the other 

treaty country to be taxed only in the first treaty country. A similar 

rule is included in the OECD model. U.S. internal law does not impose tax on such income of a person who is neither a citizen nor 

a resident of the United States, even if the person is employed by 

a U.S. entity. 

The diplomatic notes provide special rules concerning the treatment of employee share or stock option plans under this article. 

The diplomatic notes state that any benefits, income or gains received by employees under such plans constitute ‘‘other similar remuneration’’ and are subject to the application of this article. The 

notes require the allocation of taxing jurisdiction between the treaty countries over such plans if an employee: (1) has been granted 

a share or stock option in the course of employment in one of the 

treaty countries; (2) has exercised that employment in both treaty 

countries during the period between grant and exercise of the option; (3) remains in that employment on the date of the exercise; 

and (4) under the respective domestic laws of the treaty countries, 

would be taxable by both countries with respect to the gain on the 

option. Under this special allocation rule, each treaty country may 

tax, as the source country, only the portion of the gain on an option 

that relates to the period or periods between the grant and the exercise of the option during which the employee has exercised employment in that treaty country. The Technical Explanation states 

that the portion attributable to a treaty country under this rule 

will be determined by multiplying the gain by a fraction, the numerator of which is the number of days during which the employee 

exercised employment in that country and the denominator of 

which is the total number of days between the grant and the exercise of the option. To prevent the special allocation rule from resulting in double taxation, the diplomatic notes state that the competent authorities of the treaty countries will endeavor to resolve 

by mutual agreement any difficulties or doubts arising from the interpretation or application of this article and Article 24 (Relief from 

Double Taxation) in relation to employee share or stock option 

plans. 

This article is subject to the provisions of the separate articles 

covering directors’ fees (Article 15), pensions, social security, annuities, alimony, and child support payments (Article 17), and government service income (Article 19). 

Article 15. Directors’ Fees 

Under the proposed treaty, director’s fees and other similar payments derived by a resident of one country for services rendered in 

the other country in his or her capacity as a member of the board 

of directors of a company that is a resident of that other country 

is taxable in that other country. Under the proposed treaty, as 

under the U.S. model, the country of the company’s residence may 

41

tax the remuneration of nonresident directors, but only with respect to remuneration for services performed in that country. 

Article 16. Entertainers and Sportsmen 

Like the U.S. and OECD models, the proposed treaty contains a 

separate set of rules that apply to the taxation of income earned 

by entertainers (such as theater, motion picture, radio, or television 

artistes or musicians) and athletes. These rules apply notwithstanding the other provisions dealing with the taxation of income 

from personal services (Articles 7 and 14) and are intended, in 

part, to prevent entertainers and athletes from using the treaty to 

avoid paying any tax on their income earned in one of the countries. 

Under the proposed treaty, income derived by an entertainer or 

athlete who is a resident of one country from his or her personal 

activities as such in the other country may be taxed in the other 

country if the amount of the gross receipts derived by him or her 

from such activities exceeds $20,000 or its equivalent in pounds 

sterling. The $20,000 threshold includes expenses that are reimbursed to the entertainer or athlete or borne on his or her behalf. 

Under this rule, if a U.K. entertainer or athlete maintains no fixed 

base in the United States and performs (as an independent contractor) in the United States for total compensation of $10,000 during a taxable year, the United States would not tax that income. 

If, however, that entertainer’s or athlete’s total compensation were 

$30,000, the full amount would be subject to U.S. tax. 

The proposed treaty provides that where income in respect of activities performed by an entertainer or athlete in his or her capacity as such accrues not to the entertainer or athlete but to another 

person, that income is taxable by the country in which the activities are performed unless it is established that neither the entertainer or athlete nor persons related to him or her participated directly or indirectly in the profits of that other person in any manner, including the receipt of deferred remuneration, bonuses, fees, 

dividends, partnership distributions, or other distributions. This 

provision applies notwithstanding the business profits and income 

from employment articles (Articles 7 and 14). This provision prevents highly-paid entertainers and athletes from avoiding tax in 

the country in which they perform by, for example, routing the 

compensation for their services through a third entity such as a 

personal holding company or a trust located in a country that 

would not tax the income. 

Article 17. Pensions, Social Security, Annuities, Alimony, and 

Child Support 

This article deals with the taxation of private pensions and annuities, social security benefits, alimony and child support payments. This article does not cover government pensions. 

Pensions 

Under the proposed treaty, pensions and other similar remuneration derived and beneficially owned by a resident of either country 

is taxable only in the recipient’s country of residence. The proposed 

treaty also requires each country not to tax the portion of pension 

42

income received from pension schemes in the other country to the 

extent such income would have been exempt if the beneficiary were 

a resident of the other country. 

The term ‘‘pension scheme’’ is defined in Article 3 (General Definitions). Unlike many U.S. income tax treaties and the U.S. model, 

the term ‘‘pensions and other similar remuneration’’ does not include lump sum payments. 

The proposed treaty provides specific rules to deal with lump 

sum payments. Notwithstanding the general rule preventing source 

country taxation of pension schemes, any lump sum payment derived by a resident of one country from a pension scheme established in the other country is subject to tax in the other country. 

Thus, a U.S. person who receives a lump sum payment from a U.S. 

pension scheme (related to U.S. employment) would be subject to 

withholding tax if resident in the United Kingdom at the time of 

distribution. The Technical Explanation provides that the special 

rules related to lump sum payments are intended to address cases 

of double non-taxation that arise under the present treaty because 

the United Kingdom does not tax lump-sum distributions from pension funds. 

Social Security benefits 

The proposed treaty, like the present treaty, provides for exclusive residence-country taxation of social security benefits. This 

treatment differs from the U.S. model, which allows source country 

taxation of social security benefits. The provision under the proposed treaty applies to both private sector and government employees. The Technical Explanation provides that the term ‘‘similar legislation’’ is in reference to United States Tier 1 Railroad Retirement benefits. 

Annuities 

The proposed treaty also provides that annuities (other than 

those covered under the pension rule described above) derived and 

beneficially owned by a resident of either country are taxable only 

in the recipient’s country of residence. This is consistent with the 

corresponding rule in the U.S. model, which provides that annuities are taxable only in the individual recipient’s country of residence. The term ‘‘annuity’’ is defined for purposes of this provision 

as a stated sum paid periodically at stated time during the life of 

the annuitant, or during a specified or ascertainable period of time, 

under an obligation to make the payments in return for adequate 

and full consideration (other than in return for services rendered). 

The Technical Explanation states that an annuity received in consideration for services rendered would be treated as deferred compensation and generally taxable in accordance with Article 7 (Business Profits) or Article 14 (Income form Employment). 

Alimony and Child Support 

The proposed treaty allows residence country taxation of deductible alimony payments made by a resident of one country to a resident of the other country. The proposed treaty provides that child 

support payments are exempt from tax in both countries as long as 

such payments are not deductible to the payer. The treatment of 

43

both child support and alimony payments is consistent with corresponding provisions under the U.S. model. 

Article 18. Pension Schemes 

This article deals with cross-border pension contributions. It is 

intended to remove barriers to the flow of personal services between the two countries that could otherwise result from discontinuities under the laws of each country regarding the deductibility of pension contributions.

The proposed treaty provides that neither country may tax residents on pension income earned through a pension scheme in the 

other country until such income is distributed. For purposes of this 

provision, roll-overs to other pension plans are not treated as distributions. When a resident receives a distribution from a pension 

plan, such distribution is generally subject to residency country 

taxation in accordance with Article 17 (Pensions, Social Security, 

Annuities, Alimony, and Child Support). 

Under the proposed treaty, if an individual who is a member of 

a pension plan established and recognized under the law of one 

country performs personal services in the other country, contributions made by the individual to the plan during the period he or 

she performs such personal services are deductible in computing 

his or her taxable income in the other country within the limits 

that would apply if the contributions were made to a pension plan 

established and recognized under the laws of the other country. 

Similarly, payments made to the plan by or on behalf of his or her 

employer during such period are not treated as part of his or her 

taxable income and are allowed as a deduction in computing the 

employer’s profits in the other country. 

These rules apply only if: (1) contributions were made by or on 

behalf of the individual, or by or on behalf of the individual’s employer to the plan (or to a similar plan for which this plan is substituted) before he or she began to exercise employment or self-employment in the other country; and (2) the competent authority of 

the other country has agreed that the plan generally corresponds 

to a pension plan recognized for tax purposes by that country. 

Moreover, the benefits provided under these rules will not exceed 

the benefits that would be allowed by the other country to its residents for contributions to a pension plan recognized for tax purposes by that country. 

It is understood that for purposes of this provision, in accordance 

with the notes of the proposed treaty, U.S. pension schemes eligible 

for such benefits include qualified plans under section 401(a), individual retirement plans, individual retirement accounts, individual 

retirement annuities, section 408(p) accounts and Roth IRAs, section 403(a) qualified annuity plans, and section 403(b) plans. 

The proposed treaty further provides that where contributions to 

a foreign pension plan are deductible in computing an individual’s 

taxable income in a country and the individual is subject to tax in 

that country only in respect of income or gains remitted or received 

in such country, then the deduction otherwise allowed for such contributions is reduced to an amount that bears the same proportion 

to such deduction as the amount remitted bears to the full amount 

of the individual’s income or gains that would be taxable in the 

44

country if the individual had not been subject to tax on remitted 

amounts only. This rule is necessary because of the United Kingdom’s remittance system of taxation for individuals who are U.K. 

residents not domiciled in the United Kingdom. 

The proposed treaty also provides a U.S. citizen resident in the 

United Kingdom may exclude or deduct for U.S. tax purposes certain contributions to a pension scheme established in the United 

Kingdom that would not have been taxable in the United States in 

computing the employee’s taxable income, provided such contributions are made during the period the U.S. citizen exercises employment in the United Kingdom and expenses related to such employment are borne by a U.K. employer or U.K. permanent establishment. Similarly, employer contributions to and benefits accrued in 

the U.K. pension scheme are not treated as taxable income in the 

United States. 

Article 19. Government Service 

Under the proposed treaty, remuneration, other than a pension, 

paid by a treaty country (or a political subdivision or local authority thereof) to an individual for services rendered to that country 

(or subdivision or authority) generally is taxable only by that country. However, such remuneration is taxable only by the other country if the services are rendered in that other country by an individual who is a resident of that country and who: (1) is also a national of that country; or (2) did not become a resident of that country solely for the purpose of rendering the services. This treatment 

is similar to the OECD model, but differs from the U.S. model in 

that these rules only apply to government employees and not to 

independent contractors engaged by governments to perform services for them. 

The proposed treaty provides that any pension paid by a treaty 

country (or a political subdivision or local authority thereof) to an 

individual for services rendered to that country (or subdivision or 

authority) generally is taxable only by that country. However, such 

a pension is taxable only by the other country if the individual is 

a national and resident of that other country. Social security benefits with respect to government service are subject to paragraph 2 

of Article 17 (Pensions, Social Security, Annuities, Alimony, and 

Child Support) and not this article. 

The provisions of this article are exceptions to the proposed treaty’s savings clause for individuals who are neither citizens nor permanent residents of the country where the services are performed. 

Thus, for example, payments by the government of the United 

Kingdom to its employees in the United States are exempt from 

U.S. tax if the employees are not U.S. citizens or green card holders and were not residents of the United States at the time they 

became employed by the United Kingdom government. 

The proposed treaty provides that if a treaty country (or a political subdivision or local authority thereof) is carrying on a business 

(as opposed to functions of a governmental nature), the provisions 

of Articles 14 (Income from Employment), 15 (Directors’ Fees), 16 

(Entertainers and Sportsmen), and 17 (Pensions, Social Security, 

Annuities, Alimony, and Child Support) will apply to remuneration 

45

and pensions for services rendered in connection with that business. 

Article 20. Students 

The treatment provided to students and business apprentices 

under the proposed treaty generally corresponds to the treatment 

provided under the present treaty, with certain modifications. The 

provision in the proposed treaty corresponds to the provision in the 

U.S. model. 

Under the proposed treaty, a student or business apprentice who 

visits a country (the host country) for the purpose of his or her fulltime education at a university, college, or other recognized educational institution of a similar nature, or for his or her full-time 

training, and who immediately before that visit is, or was a resident of the other treaty country, generally is exempt from host 

country tax on payments he or she receives for the purpose of such 

maintenance, education, or training; provided, however, that such 

payments arise outside the host country. The Technical Explanation states that for purposes of this article, the phrase ‘‘university, college, or other recognized educational institution of a similar 

nature’’ clarifies that a qualifying education institution is one that 

offers a diversified curriculum for full-time students. Whether a 

student is to be considered full-time will be determined by the 

rules of the educational institution where he or she is studying. 

The Technical Explanation also states that an educational institution is understood to be an institution that normally maintains a 

regular faculty and normally has a regular body of students in attendance at the place where the education activities are carried on. 

An educational institution is considered to be recognized if it is accredited by an authority that generally is responsible for the accreditation of institutions in the particular field of study. The Technical Explanation states that a payment generally is considered to 

arise outside the host country if the payer is located outside the 

host country. 

Under the proposed treaty, the exemption from host country tax 

will apply to a business apprentice only for a period of not more 

than one year from the date he or she first arrives in the host 

country for the purpose of training. This limitation is not contained 

in the present treaty. 

This article of the proposed treaty is an exception from the saving clause in the case of persons who are neither citizens nor lawful permanent residents of the host country. 

Article 20A. Teachers 

The treatment provided to professors and teachers under the proposed treaty corresponds to the treatment provided under the 

present treaty, with certain modifications. Such a provision is not 

part of the U.S. model. Such a provision is not part of the OECD 

model. Prior to amendment by the proposed protocol, the proposed 

treaty would have conformed to the U.S. model and OECD model. 

Under the proposed treaty, a professor or teacher who visits a 

country (the host country) for the purpose of teaching or engaging 

in research at a university, college, or other recognized educational 

institution of a similar nature, and who immediately before that 

46

visit is, or was a resident of the other treaty country, generally is 

exempt from host country tax on any remuneration received for 

teaching or research. This exemption applies for not more than the 

two-year period beginning on the date of the professor’s or teacher’s 

arrival in the host country. If the professor or teacher remains in 

the host country for more than two years, the exemption does not 

apply for the first two years. 

This article of the proposed treaty is an exception from the saving clause in the case of persons who are neither citizens nor lawful permanent residents of the host country. 

Article 21. Offshore Exploration and Exploitation Activities 

The treatment provided under the proposed treaty for offshore 

exploration and exploitation activities is similar to that provided 

under the present treaty, with certain modifications. The U.S. and 

OECD models address the taxation of these activities under the 

standard rules found in other articles (such as the Business Profits 

article). 

Under the proposed treaty, an enterprise of a country which carries on exploration activities or exploitation activities in the other 

country will be deemed to be carrying on business in that other 

country through a permanent establishment situated therein. This 

provision applies notwithstanding any other provisions of the proposed treaty where activities are carried on offshore in a country 

in connection with exploration or exploitation of the sea bed and 

sub-soil and their natural resources situated in that country. This 

provision applies to all exploitation activities. It also applies to exploration activities carried on by an enterprise of a country (and 

certain associated persons) in the other country for a period or periods aggregating more than 30 days in any 12-month period. For 

this purpose, if an enterprise carrying on exploration activities in 

the other country is associated with another enterprise carrying on 

substantially similar activities there, the former enterprise will be 

deemed to carrying on all of the activities of the latter enterprise, 

except to the extent that those activities are carried on at the same 

time as its own activities. Enterprises are associated if one participates directly or indirectly in the management, control, or capital 

of the other, or if the same persons participate directly or indirectly 

in the management, control, or capital of both enterprises. 

Under the proposed treaty, salaries, wages, and similar remuneration derived by a resident of one country from employment in 

respect of exploration activities or exploitation activities carried on 

in the other country, to the extent performed offshore in the other 

country, may be taxed in the other country. However, such remuneration is taxable only in the first country (i.e., the employee’s 

country of residence) if the employment is performed in the other 

country for a period or periods not exceeding in the aggregate 30 

days in any 12-month period. 

Article 22. Other Income 

This article is a catch-all provision intended to cover items of income not specifically covered in other articles, and to assign the 

right to tax income from third countries to either the United States 

or the United Kingdom. As a general rule, items of income not othVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00050 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
47

14See Part III, Article 3, supra, for a description of the proposed treaty’s conduit arrangement 

provisions, and Part IV.B. infra, for a discussion of the issues raised by these provisions. 

erwise dealt with in the proposed treaty (other than income paid 

out of trusts or the estates of deceased persons in the course of administration) which are beneficially owned by residents of one of 

the countries are taxable only in the country of residence. This rule 

is similar to the rules in the U.S. and OECD models. 

This rule, for example, gives the United States the sole right 

under the proposed treaty to tax income derived from sources in a 

third country and paid to a U.S. resident. This article is subject to 

the saving clause, so U.S. citizens who are residents of the United 

Kingdom will continue to be taxable by the United States on their 

third-country income. 

The general rule just stated does not apply to income (other than 

income from real property as defined in Article 6) if the beneficial 

owner of the income is a resident of one country and carries on 

business in the other country through a permanent establishment 

situated therein, and the income is attributable to such permanent 

establishment. In such a case, the provisions of Article 7 (Business 

Profits) will apply. Such exception also applies where the income 

is received after the permanent establishment or fixed base is no 

longer in existence, but the income is attributable to the former 

permanent establishment or fixed base. 

The Technical Explanation states that under U.S. tax law, trust 

income and distributions have the character of the associated distributable net income and, thus, generally are covered under other 

articles of the proposed treaty. The notes confirm that income paid 

out of trusts or the estates of deceased persons in the course of administration is characterized for purposes of the proposed treaty 

according to the character of the underlying income. 

The proposed treaty addresses the issue of non-arm’s-length income amounts between related parties (or parties otherwise having 

a special relationship) by providing that the amount of income for 

purposes of applying this article is the amount that would have 

been agreed upon by the payer and the beneficial owner in the absence of the special relationship. Any amount of income paid in excess of such amount is taxable according to the laws of each country, taking into account the other provisions of the proposed treaty. 

This provision is not contained in the U.S. or OECD models (but 

is suggested in Commentary to the OECD model). 

The proposed treaty provides that this article (Article 22) will not 

apply to any income paid under, or as part of, a conduit arrangement. This rule is similar to that provided with respect to the dividends, interest, and royalties articles (Articles 10, 11 and 12).14

Article 23. Limitation on Benefits 

In general 

The proposed treaty contains a provision generally intended to 

limit the indirect use of the proposed treaty by persons who are not 

entitled to its benefits by reason of residence in the United States 

or the United Kingdom, or in some cases, in another member country of the European Union (‘‘EU’’) or the North American Free 

48

Trade Agreement (‘‘NAFTA’’). The current U.S.-U.K. income tax 

treaty does not include such a provision. 

The proposed treaty is intended to limit double taxation caused 

by the interaction of the tax systems of the United States and the 

United Kingdom as they apply to residents of the two countries. At 

times, however, residents of third countries attempt to use a treaty. 

This use is known as ‘‘treaty shopping,’’ which refers to the situation where a person who is not a resident of either treaty country 

seeks certain benefits under the income tax treaty between the two 

countries. Under certain circumstances, and without appropriate 

safeguards, the third-country resident may be able to secure these 

benefits indirectly by establishing a corporation or other entity in 

one of the treaty countries, which entity, as a resident of that country, is entitled to the benefits of the treaty. Additionally, it may be 

possible for the third-country resident to reduce the income base of 

the treaty country resident by having the latter pay out interest, 

royalties, or other amounts under favorable conditions either 

through relaxed tax provisions in the distributing country or by 

passing the funds through other treaty countries until the funds 

can be repatriated under favorable terms. 

The proposed anti-treaty shopping article provides that a treaty 

country resident is entitled to all treaty benefits only if it is in one 

of several specified categories. Generally, a resident of either country qualifies for the benefits accorded by the proposed treaty if such 

resident is within one of the following categories of ‘‘qualified persons’’ (and satisfies any other specified conditions for obtaining 

benefits): 

(1) An individual; 

(2) A qualified governmental entity; 

(3) A company that satisfies a public company test and certain subsidiaries of such companies; 

(4) An entity, other than a company, that satisfies a public 

ownership test and certain entities owned by such entities; 

(5) A tax-exempt pension scheme or employee benefit arrangement that meets an ownership test, or an organization 

operated exclusively for religious, charitable, scientific, artistic, 

cultural, or educational purposes; 

(6) An entity that satisfies an ownership test and a base erosion test; and 

(7) A trust that satisfies an ownership test and a base erosion test. 

Alternatively, a resident that does not fit into any of the above 

categories may claim treaty benefits with respect to certain items 

of income under a derivative benefits test. In addition, a resident 

that does not fit into any of the above categories may claim treaty 

benefits with respect to certain items of income under an active 

business test. Finally, a person that does not satisfy any of the 

above requirements may be entitled to the benefits of the proposed 

treaty if the source country’s competent authority so determines. 

Individuals 

Under the proposed treaty, individual residents of one of the 

countries are entitled to all treaty benefits. 

49

Qualified governmental entities 

Under the proposed treaty, a qualified governmental entity is entitled to all treaty benefits. Under Article 3 (General Definitions), 

qualified governmental entities include the two countries, their political subdivisions, or their local authorities. Qualified governmental entities also include certain government-owned corporations 

and other entities. 

Public company tests 

A company that is a resident of the United Kingdom or the 

United States is entitled to treaty benefits if the principal class of 

its shares is listed on a recognized U.S. or U.K. stock exchange and 

is regularly traded on one or more recognized stock exchanges. 

Thus, such a company is entitled to the benefits of the treaty regardless of where its actual owners reside. 

In addition, a company that is a resident of the United Kingdom 

or the United States is entitled to treaty benefits if at least 50 percent of the aggregate vote and value of the company’s shares is 

owned (directly or indirectly) by five or fewer companies that satisfy the test described above, provided that each intermediate 

owner used to satisfy the control requirement is a resident of the 

United Kingdom or the United States. 

The term ‘‘recognized stock exchange’’ means the NASDAQ System owned by the National Association of Securities Dealers; any 

stock exchange registered with the U.S. Securities and Exchange 

Commission as a national securities exchange under the U.S. Securities Exchange Act of 1934; the London Stock Exchange and any 

other recognized investment exchange within the meaning of the 

Financial Services Act of 1986 or the Financial Services and Markets Act of 2000; the Irish Stock Exchange; the Swiss Stock Exchange; the stock exchanges of Amsterdam, Brussels, Frankfurt, 

Hamburg, Johannesburg, Madrid, Milan, Paris, Stockholm, Sydney, 

Tokyo, Toronto, and Vienna; and any other stock exchange agreed 

upon by the competent authorities of the two countries. 

The term ‘‘principal class of shares’’ means the ordinary or common shares of the company representing the majority of the aggregate voting power and value of the company. If the company does 

not have a single class of ordinary or common shares representing 

the majority of the aggregate voting power and value, then the 

‘‘principal class of shares’’ means that class or any combination of 

classes of shares that represents, in the aggregate, a majority of 

the aggregate voting power and value of the company. For these 

purposes, the term ‘‘shares’’ includes depository receipts for shares 

or trust certificates for shares. 

Shares are considered to be ‘‘regularly traded’’ in a taxable period 

on one or more recognized stock exchanges if the aggregate number 

of shares of that class traded during the 12 months ending on the 

day before the beginning of that taxable period is at least six percent of the average number of shares outstanding in that class during that 12–month period. The notes provide that if a class of 

shares was not listed on a recognized stock exchange during this 

12–month period, the class of shares will be treated as regularly 

traded only if that class meets the aggregate trading requirements 

for the taxable period in which the income arises. The Technical 

50

Explanation states that this requirement can be met by aggregating trading on one or more of the recognized stock exchanges. 

Public entity tests 

Under the proposed treaty, a person other than an individual or 

company that is a resident of the United Kingdom or the United 

States is entitled to treaty benefits if the principal class of units 

in that entity is listed or admitted to dealings on a recognized U.S. 

or U.K. stock exchange and is regularly traded on one or more recognized stock exchanges. Alternatively, the entity is entitled to 

treaty benefits if the direct or indirect owners of at least 50 percent 

of the beneficial interests in the entity are public entities under the 

preceding sentence or public companies described below. 

The Technical Explanation states that this provision applies generally to trusts the shares of ownership in which are publicly traded and to trusts that are owned by publicly traded entities. The 

Technical Explanation further states that for U.S. tax purposes, 

this provision relating to publicly traded trusts is redundant because the United States generally would consider such entities to 

be companies covered by the public company tests described above. 

The term ‘‘units’’ includes shares and any other instrument, not 

being a debt claim, granting an entitlement to share in the assets 

or income of, or to receive a distribution from, the entity. The term 

‘‘principal class of units’’ means the class of units that represent 

the majority of the value of the entity. If no single class of units 

represent the majority of the value of the person, the ‘‘principal 

class of units’’ is any combination of classes that in the aggregate 

represent the majority of the value of the entity. 

The term ‘‘regularly traded’’ is defined as above for public companies. The Technical Explanation states that trading on one or more 

recognized stock exchanges may be aggregated for purposes of this 

requirement. 

Tax-exempt and charitable organizations 

Under the proposed treaty, an entity is entitled to treaty benefits 

if it is a (1) pension scheme (defined in Article 3 (General Definitions) as a plan, scheme, fund, trust, or other arrangement that is 

operated principally to administer or provide pension or retirement 

benefits or to earn income for the benefit of such arrangements and 

that is generally exempt from income tax in that country), (2) a 

plan, scheme, fund, trust, company, or other arrangement established in a country that is operated exclusively to administer or 

provide employee benefits and that is generally exempt from income tax in that country, or (3) an organization that is established 

exclusively for religious, charitable, scientific, cultural, or educational purposes (notwithstanding that all or part of its income is 

tax-exempt); provided, however, that in the case of entities described in (1) or (2) above, more than 50 percent of the entity’s 

beneficiaries, members, or participants must be individual residents of either country. 

Ownership and base erosion tests—entities 

Under the proposed treaty, an entity that is a resident of one of 

the countries is entitled to treaty benefits if it satisfies an ownerVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00054 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
51

ship test and a base erosion test. Under the ownership test, on at 

least half the days of the taxable period, shares or other beneficial 

interests representing at least 50 percent of the entity’s aggregate 

voting power and value must be owned (directly or indirectly) by 

certain qualified persons described above (i.e., individuals, qualified 

governmental entities, companies that meet the public company 

test described above, entities that meet the public entity test described above, or entities that meet the tests described above for 

a tax-exempt pension scheme or employee benefit arrangement, or 

an organization operated exclusively for religious, charitable, scientific, artistic, cultural, or educational purposes). 

The base erosion test is satisfied only if less than 50 percent of 

the person’s gross income for the taxable period is paid or accrued, 

directly or indirectly, in the form of deductible payments, to persons who are not residents of either treaty country. The notes provide that for this purpose, the term ‘‘gross income’’ means the total 

revenues derived by a resident of a country from its principal operations, less the direct costs of obtaining such revenues. The Technical Explanation states that in the case of the United States, the 

term ‘‘gross income’’ has the same meaning as under domestic law 

(i.e., section 61 of the Code and the regulations thereunder). In addition, for purposes of this test, deductible payments do not include 

arm’s-length payments in the ordinary course of business for services or tangible property and payments in respect of financial obligations to a bank; provided that, if the bank is not a resident of 

one of the countries, such payment is attributable to a permanent 

establishment of that bank located in one of the countries. 

The Technical Explanation states that trusts may be entitled to 

the benefits of this provision if they are treated as residents of one 

of the countries and they otherwise satisfy the requirements of the 

provision. An additional way for trusts to qualify for treaty benefits 

is described below. 

Ownership and base erosion tests—trusts 

Under the proposed treaty, a trust or trustee of a trust (in their 

capacity as such) that is a resident of one of the countries is entitled to treaty benefits if it satisfies an ownership test and a base 

erosion test. Under the ownership test, at least 50 percent of the 

beneficial interests in the trust must be held by (1) individuals, 

qualified governmental entities, companies that meet the public 

company test described above, entities that meet the public entity 

test described above, or entities that meet the tests described above 

for a tax-exempt pension scheme or employee benefit arrangement, 

or an organization operated exclusively for religious, charitable, scientific, artistic, cultural, or educational purposes, or (2) equivalent 

beneficiaries (as described below, in connection with the ‘‘derivative 

benefits’’ provision). 

The base erosion test is satisfied only if less than 50 percent of 

the person’s gross income arising to the trust or trustee (in their 

capacity as such) for the taxable period is paid or accrued, directly 

or indirectly, to persons who are not residents of either treaty country in the form of deductible payments for tax purposes in the trust 

or trustee’s country of residence. The notes provide that for this 

purpose, the term ‘‘gross income’’ means the total revenues derived 

52

15See Part III, Article 10, supra, for a discussion of an interpretive issue that arose in connection with the zero-rate provision under the equivalent beneficiary definition in the proposed 

treaty as originally signed, prior to amendment by the proposed protocol. 

by a resident of a country from its principal operations, less the direct costs of obtaining such revenues. The Technical Explanation 

states that in the case of the United States, the term ‘‘gross income’’ has the same meaning as under domestic law (i.e., section 

61 of the Code and the regulations thereunder). In addition, for 

purposes of this test, deductible payments do not include arm’slength payments in the ordinary course of business for services or 

tangible property and payments in respect of financial obligations 

to a bank; provided that, if the bank is not a resident of one of the 

countries such payment is attributable to a permanent establishment of that bank located in one of the countries. 

Derivative benefits rule 

The proposed treaty contains a reciprocal derivative benefits 

rule. This rule effectively allows a U.K. company, for example, to 

receive ‘‘derivative benefits’’ in the sense that it derives its entitlement to U.S. tax reductions in part from the U.S. treaty benefits 

to which its owners would be entitled if they earned the income directly. If the requirements of this rule are satisfied, a company that 

is resident in one of the treaty countries will be entitled to the benefits of the proposed treaty. 

A company resident in one of the countries satisfies this rule if 

both ownership and base-erosion requirements are met. Under the 

ownership requirement, shares representing at least 95 percent of 

the aggregate voting power and value of the company must be 

owned, directly or indirectly, by seven or fewer persons who are 

‘‘equivalent beneficiaries.’’ 

For this purpose, an equivalent beneficiary is a resident of a 

member state of the European Community or of a European Economic Area state or a party to the North American Free Trade 

Agreement, but only if one of two alternative conditions are satisfied. Under the first alternative condition, that resident must be 

entitled to all the benefits of a comprehensive tax treaty between 

its residence country and the country from which the benefits of 

the proposed treaty are being claimed. However, if such treaty does 

not contain a comprehensive limitation on benefits provision, the 

person must be a person that would be a qualified person under 

the tests described above (and in the case of trusts, without applying the ownership test for equivalent beneficiaries), if such person 

were a resident of the United Kingdom or the United States under 

the proposed treaty. With respect to dividends, interest, and royalties, the resident must be entitled under such treaty to a rate of 

tax that is at least as low as the rate applicable to such income 

under the proposed treaty. Under the second alternative condition 

for qualifying as an equivalent beneficiary, the person must be a 

resident of either the United States or the United Kingdom and be 

treated as a qualified person under the tests described above.15

Under the second requirement to satisfy the derivative benefits 

rule, the company must satisfy the base erosion test similar to that 

described above, with certain modifications. The base erosion test 

is satisfied only if less than 50 percent of the person’s gross income 

53

for the taxable period is paid or accrued, directly or indirectly, to 

persons who are not equivalent beneficiaries (as defined above) in 

the form of deductible payments for tax purposes in the company’s 

country of residence. The notes provide that for this purpose, the 

term ‘‘gross income’’ means the total revenues derived by a resident 

of a country from its principal operations, less the direct costs of 

obtaining such revenues. The Technical Explanation states that in 

the case of the United States, the term ‘‘gross income’’ has the 

same meaning as under domestic law (i.e., section 61 of the Code 

and the regulations thereunder). In addition, for purposes of this 

test, deductible payments do not include arm’s-length payments in 

the ordinary course of business for services or tangible property 

and payments in respect of financial obligations to a bank; provided 

that, if the bank is not a resident of one of the countries such payment is attributable to a permanent establishment of that bank located in one of the countries. 

Active business test 

Under the active business test, residents of one of the countries 

are entitled to treaty benefits with respect to income, profit, or gain 

derived from the other country if (1) the resident is engaged in the 

active conduct of a trade or business in its residence country, (2) 

the income is derived in connection with, or is incidental to, that 

trade or business, and (3) the trade or business is substantial in 

relation to the trade or business activity in the other country. The 

proposed treaty provides that the business of making or managing 

investments for the resident’s own account does not constitute an 

active trade or business unless these activities are banking, insurance, or securities activities carried on by a bank, insurance company, or registered securities dealer. For this purpose, the proposed 

treaty defines the term ‘‘insurance company’’ as an incorporated or 

unincorporated entity if its gross income consists primarily of insurance or reinsurance premiums and investment income attributable to such premiums. 

The notes provide that income is considered to be derived ‘‘in 

connection’’ with an active trade or business if the activity generating the item of income in the other country is a line of business 

that forms a part of, or is complementary to, the trade or business. 

The Technical Explanation states that a business activity generally 

is considered to form a part of a business activity conducted in the 

other country if the two activities involve the design, manufacture, 

or sale of the same products or type of products, or the provision 

of similar services. The notes clarify that the line of business in the 

country of residence may be, in relation to the activity in the country of source, upstream (e.g., providing inputs to a manufacturing 

process that occurs in the other country), downstream (e.g., selling 

the output of a manufacturer that is a resident of the other country), or parallel (e.g., selling in one country the same sorts of products that are being sold by the trade or business carried on in the 

other country). The Technical Explanation further states that in 

order for two activities to be considered ‘‘complimentary,’’ the activities need not relate to the same types of products or services, 

but they should be part of the same overall industry and be related 

54

in the sense that the success or failure of one activity will tend to 

result in success or failure of the other. 

The notes provide that income is considered ‘‘incidental’’ to a 

trade or business if the item is not produced by a line of business 

that forms a part of, or is complimentary to, the trade or business, 

but the production of such item facilitates the conduct of the trade 

or business in the other country. The notes state that an example 

of such ‘‘incidental’’ income is interest income earned from the 

short-term investment of working capital of a resident of a country 

in securities issued by persons in the other country. 

The proposed treaty provides that whether a trade or business is 

substantial is determined on the basis of all the facts and circumstances. The Technical Explanation states that this takes into 

account the comparative sizes of the trades or businesses in each 

country (measured by reference to asset values, income and payroll 

expenses), the nature of the activities performed in each country, 

and the relative contributions made to that trade or business in 

each country. The Technical Explanation further states that in 

making each determination or comparison, due regard will be given 

to the relative sizes of the U.S. and U.K. economies. 

The proposed treaty provides that in determining whether a person is engaged in the active conduct of a trade or business, activities conducted by a partnership in which that person is a partner 

and activities conducted by persons connected to such person will 

be deemed to be conducted by such person. For this purpose, a person is connected to another person if (1) one person owns at least 

50 percent of the beneficial interest in the other person (or, in the 

case of a company, owns shares representing at least 50 percent of 

the aggregate voting power and value of the company or the beneficial interest in the company), or (2) another person owns, directly 

or indirectly, at least 50 percent of the beneficial interest in each 

person (or, in the case of a company, owns shares representing at 

least 50 percent of the aggregate voting power and value of the 

company or the beneficial interest in the company). The proposed 

treaty provides that in any case, persons are considered to be connected if on the basis of all the facts and circumstances, one has 

control of the other or both are under the control of the same person or persons. 

The term ‘‘trade or business’’ is not defined in the proposed treaty. However, as provided in Article 3 (General Definitions), undefined terms are to have the meaning which they have under the 

laws of the country applying the proposed treaty. In this regard, 

the Technical Explanation states that the U.S. competent authority 

will refer to the regulations issued under Code section 367(a) to define the term ‘‘trade or business.’’ 

Disproportionate interests 

The proposed treaty denies benefits to the disproportionate part 

of income earned by certain companies. Under the proposed treaty, 

a company that is a resident of one of the countries or a company 

that controls such a company has outstanding a class of shares: (1) 

that is subject to terms or other arrangements that entitle its holders to a portion of the income, profit, or gain of the company derived from the other country that is larger than the portion such 

55

holders would receive in the absence of such terms and arrangements, and (2) in which 50 percent or more of the voting power and 

value is owned by persons who are not equivalent beneficiaries (as 

defined above), then the benefits of the proposed treaty will apply 

only to that proportion of the income which those holders would 

have received in the absence of those terms or arrangements. 

Grant of treaty benefits by the competent authority 

The proposed treaty provides a ‘‘safety-valve’’ for a person that 

has not established that it meets one of the other more objective 

tests, but for which the allowance of treaty benefits would not give 

rise to abuse or otherwise be contrary to the purposes of the treaty. 

Under this provision, such a person may be granted treaty benefits 

if the competent authority of the source country determines that 

the establishment, acquisition, or maintenance of such resident and 

the conduct of its operations did not have as one of its principal 

purposes the obtaining of benefits under the proposed treaty. The 

notes provide that in applying this provision, the competent authorities will consider the respective obligations of the United Kingdom by virtue of its membership in the European Community and 

by it being a party to the European Economic Area, and the respective obligations of the United States by virtue of it being a party 

to the North American Free Trade Agreement. The notes specify 

that in particular, the competent authorities will consider any legal 

requirements for the facilitation of the free movement of capital 

and persons, the differing internal tax systems, tax incentive regimes and existing treaty policies among member states of the European Community or the European Economic Area states, or parties to the North American Free Trade Agreement. 

The notes further provide that where certain changes in circumstances might cause a person to cease to qualify as a qualified 

person (as defined above), such changes need not result in the denial of benefits under the treaty. The Technical Explanation states 

that this rule recognizes the legal requirements for the free flow of 

goods and services within the European Communities and within 

the North American Free Trade Agreement. The changes in circumstances contemplated by the notes include, all under ordinary 

business conditions,: (1) a change in the country of residence of a 

major participant in the company, (2) the sale of part of the ownership interests in a company to a resident of a qualifying country; 

(3) or an expansion of a company’s activities in another qualifying 

country. The notes provide that if the competent authority is satisfied that these changed circumstances are not attributable to tax 

avoidance motives, then this will be a factor weighing in favor of 

granting benefits in accordance with this provision. 

The proposed treaty provides that the competent authority of the 

source country must consult with the competent authority of the 

residence country before refusing to grant benefits under this provision. 

56

Article 24. Relief From Double Taxation 

Internal taxation rules 

United States 

The United States taxes the worldwide income of its citizens and 

residents. It attempts unilaterally to mitigate double taxation generally by allowing taxpayers to credit the foreign income taxes that 

they pay against U.S. tax imposed on their foreign-source income. 

An indirect or ‘‘deemed-paid’’ credit is also provided. Under this 

rule, a U.S. corporation that owns 10 percent or more of the voting 

stock of a foreign corporation and that receives a dividend from the 

foreign corporation (or an inclusion of the foreign corporation’s income) is deemed to have paid a portion of the foreign income taxes 

paid (or deemed paid) by the foreign corporation on its earnings. 

The taxes deemed paid by the U.S. corporation are included in its 

total foreign taxes paid for the year the dividend is received. 

A fundamental premise of the foreign tax credit is that it may 

not offset the U.S. tax on U.S.-source income. Therefore, the foreign 

tax credit provisions contain a limitation that ensures that the foreign tax credit only offsets U.S. tax on foreign-source income. The 

foreign tax credit limitation generally is computed on a worldwide 

consolidated basis. Hence, all income taxes paid to all foreign countries are combined to offset U.S. taxes on all foreign income. The 

limitation is computed separately for certain classifications of income (e.g., passive income and financial services income) in order 

to prevent the crediting of foreign taxes on certain high-taxed foreign-source income against the U.S. tax on certain types of traditionally low-taxed foreign-source income. Other limitations may 

apply in determining the amount of foreign taxes that may be credited against the U.S. tax liability of a U.S. taxpayer. 

United Kingdom 

U.K. double tax relief is allowed through a foreign tax credit. 

U.K. foreign tax credits are limited to the lesser of the foreign tax 

paid or the U.K. tax that relates to such amount of income. If the 

foreign tax credit is not claimed, a taxpayer may deduct from foreign gross income any foreign tax paid. Surplus foreign taxes may 

be carried forward indefinitely, or carried back for up to three 

years, to offset U.K. tax on income from the same source. U.K. law 

also provides for limited onshore pooling of dividend income. 

Proposed treaty limitations on internal law 

Overview 

One of the principal purposes for entering into an income tax 

treaty is to limit double taxation of income earned by a resident of 

one of the countries that may be taxed by the other country. Unilateral efforts to limit double taxation are imperfect. Because of differences in rules as to when a person may be taxed on business income, a business may be taxed by two countries as if it were engaged in business in both countries. Also, a corporation or individual may be treated as a resident of more than one country and 

be taxed on a worldwide basis by both. 

57

Part of the double tax problem is dealt with in other articles of 

the proposed treaty that limit the right of a source country to tax 

income. This article provides further relief where both the United 

Kingdom and the United States otherwise still tax the same item 

of income. This article is not subject to the saving clause, so that 

the country of citizenship or residence will waive its overriding taxing jurisdiction to the extent that this article applies. 

The present treaty provides separate rules for relief from double 

taxation for the United States and the United Kingdom. The 

present treaty generally provides for relief from double taxation of 

U.S. residents and citizens by requiring the United States to permit a credit against its tax for taxes paid to the United Kingdom. 

The determination of this credit is made in accordance with U.S. 

law. The present treaty treats the U.K. petroleum revenue tax as 

a creditable tax, subject to certain limitations provided in the treaty. In the case of the United Kingdom, the present treaty generally 

provides relief from double taxation by requiring the United Kingdom to permit a credit against its tax for taxes paid to the United 

States, subject to U.K. law provisions allowing a foreign tax credit. 

Treaty restrictions on U.S. internal law 

The proposed treaty generally provides that the United States 

will allow a U.S. citizen or resident a foreign tax credit for the income taxes imposed by the United Kingdom. The proposed treaty 

also requires the United States to allow a deemed-paid credit, with 

respect to U.K. income tax, to any U.S. company that receives dividends from a U.K. company if the U.S. company owns 10 percent 

or more of the voting stock of such U.K. company. The credit generally is to be computed in accordance with the provisions and subject to the limitations of U.S. law (as such law may be amended 

from time to time without changing the general principles of the 

proposed treaty provisions). This provision is similar to those found 

in the U.S. model and many U.S. treaties. 

The proposed treaty provides that the taxes referred to in paragraphs 3(b) and 4 of Article 2 (Taxes Covered) will be considered 

creditable income taxes for purposes of the proposed treaty. This 

includes the U.K. income tax, capital gains tax, corporation tax, 

and the petroleum revenue tax (subject to the provisions and limitations of Article 23 (Relief from Double Taxation)). 

The proposed treaty contains a resourcing rule for these purposes. Under the proposed treaty, an item of gross income (as defined under U.S. law) that is derived by a U.S. resident and that 

is taxed by the United Kingdom under the proposed treaty will be 

deemed to be U.K.-source income for U.S. foreign tax credit purposes. The Technical Explanation states that this resourcing rule 

is intended to ensure that a U.S. resident can obtain a U.S. foreign 

tax credit for U.K. taxes paid when the proposed treaty assigns primary taxing jurisdiction to the United Kingdom. The Technical Explanation further states that in the case of a U.S.-owned foreign 

corporation, the resourcing rules under Code section 904(g)(10) may 

apply for purposes of determining the amount of the U.S. foreign 

tax credit with respect to such income (including rules applying 

separate foreign tax credit limitations to such resourced income). 

The U.S. model does not contain a resourcing rule. However, a 

58

similar resourcing rule is contained in the present treaty. According to the notes, if a U.S. resident receives a dividend from a U.K. 

company that is eligible for the deemed-paid credit, such dividend 

will be deemed to constitute U.K.-source income, even if the dividend may be taxed only in the United States because the zero rate 

of withholding applies (pursuant to paragraph 3(a) of Article 10 

(Dividends)). 

The general resourcing rule described above does not apply in 

the case of certain gains. Under the proposed treaty, gains derived 

by an individual while he or she was a U.S. resident and that are 

taxed by the United States under the proposed treaty, but that also 

may be taxed by the United Kingdom under paragraph 6 of Article 

13 (Gains), will be deemed to be U.S.-source gain. Paragraph 6 of 

Article 13 (Gains) provides that each country may tax gains derived by certain non-residents who used to be residents of that 

country, and it allows the United Kingdom to tax gains from the 

alienation of property derived by a individual who is a U.S. resident and who had been a U.K. resident during the six years immediately preceding the alienation. Thus, for example, if a U.K. resident gives up his or her U.K. resident and becomes a U.S. resident, 

sells property, and then re-establishes residence in the United 

Kingdom within five years, such gains are considered to be U.S.-

source income. 

The proposed treaty provides special rules and limits to determine the amount of creditable U.K. petroleum revenue taxes. The 

credit is limited to the amount attributable to U.K.-source taxable 

income. The proposed treaty provides further limitations on crediting such taxes that are similar to the present treaty, with certain 

modifications. Under the proposed treaty, the amount of U.K. petroleum revenue tax on income from the extraction of minerals 

from oil or gas wells in the United Kingdom to be allowed as a 

credit may not exceed the amount, if any, by which the product of 

the maximum U.S. statutory rate applicable to a corporation (currently 35 percent) for such taxable year and the amount of such income exceeds the amount of other U.K. tax on such income. The 

Technical Explanation states that the limitations provided under 

the proposed treaty apply before applying other foreign tax credit 

limitations contained under the Code (e.g., section 907 of the Code 

relating to foreign oil and gas extraction income and foreign oil related income). 

The Technical Explanation describes a four-step process for computing the creditable U.K. petroleum revenue taxes. Under the first 

step, the amount of the corporation’s taxable income (computed 

under U.S. standards) from the extraction of oil or gas wells in the 

U.K. is multiplied by 35 percent (the maximum U.S. statutory corporate rate). Under the second step, the amount of other U.K. tax 

imposed on the taxpayer’s income from the extraction of minerals 

from oil or gas wells in the United Kingdom is subtracted from the 

product arrived at under the first step. The Technical Explanation 

states that because other U.K. taxes on such income may be calculated on a base which includes non-extraction activities, it may 

be necessary to allocate other U.K. tax to the extraction income, 

and that principles similar to Code section 907(c)(5) are to apply 

for this purpose. The difference between the amounts computed 

59

under these first two steps is the limitation with respect to the petroleum revenue tax on extraction income. 

Under the third step, the total U.K. petroleum revenue tax paid 

or accrued must be allocated to income from extraction and to income from initial transportation, initial treatment, and initial storage. The Technical Explanation states that under the U.K. Oil Taxation Act of 1975, as amended March 15, 1979, which is the legislation that imposes the U.K. petroleum revenue tax, it is possible for 

the tax to be levied on income from non-extraction activities. Specifically, the base on which the petroleum revenue tax is computed 

is determined by reference to the value of oil or gas after initial 

transportation to the U.K., and after initial treatment and initial 

storage. The Technical Explanation states that the U.K. petroleum 

revenue tax allocated to income from extraction is determined by 

multiplying the total petroleum revenue tax by a fraction, the numerator of which is taxable income from extraction determined 

under U.S. standards (i.e., the amount determined under the first 

step) and the denominator of which is taxable income from extraction, initial transportation, initial treatment, and initial storage. 

Under the fourth step, the lesser of the petroleum revenue tax 

paid or accrued with respect to extraction income under the third 

step or the limit determined under the second step is treated as income taxes paid or accrued for the taxable year under section 901 

of the code. 

The proposed treaty provides for a carryback or carryforward of 

the amount of petroleum revenue tax disallowed under the steps 

described above. Under the proposed treaty, where the amount of 

petroleum revenue tax allocable to extraction income (determined 

under the third step above) exceeds the credit limit (determined 

under the second step), the excess is treated as income taxes paid 

or accrued in the two preceding or five succeeding taxable years (in 

that order) and to the extent not deemed paid or accrued in a prior 

taxable year. The proposed treaty provides that such amounts are 

allowable as a credit in the year deemed paid or accrued subject 

to the limitations described above for claiming a credit for petroleum revenue taxes. The present treaty provides for a carryover of 

petroleum revenue taxes based on the lesser of the excess credit or 

2 percent of extraction income for the taxable year. The Technical 

Explanation states that the proposed treaty does not contain this 

additional restriction on the carryover of credits to account for the 

intervening repeal of the 2–percent ceiling. 

The proposed treaty applies similar limitations and carryover 

provisions for U.K. petroleum revenue taxes with respect to income 

from initial transportation, initial treatment, and initial storage of 

minerals from oil or gas wells in the United Kingdom. Under the 

proposed treaty, these items of income are combined for this purpose and the amount of creditable taxes is computed by applying, 

mutatis mutandis, the first, second, and fourth steps described 

above to such taxes. Credits disallowed are carried over in a similar manner to that discussed above. 

The proposed treaty generally provides that the United Kingdom 

will allow its citizens and residents a credit against U.K. tax for 

U.S. taxes. For this purpose, the U.S. taxes referred to in paragraph 3(a)(i) and 4 of Article 2 (Taxes Covered) are considered U.S. 

60

taxes. The credit is subject to the provisions of U.K. law regarding 

the allowance of credits against U.K. tax for taxes payable in a territory outside the United Kingdom (which may not affect the general principles of the proposed treaty provisions). 

Under the proposed treaty, the amount of U.S. tax payable under 

U.S. laws and in accordance with the proposed treaty, whether directly or by deduction, on profits, income or chargeable gain from 

U.S. sources (excluding in the case of a dividend, U.S. tax in respect of the profits out of which the dividend is paid) is allowed as 

a credit against U.K. tax computed by reference to the same profits, income, or chargeable gains to which the U.S. tax is computed. 

In addition, in the case of a dividend paid by a U.S. company to 

a U.K. company which controls directly or indirectly at least 10 

percent of the voting power of the payor company, the proposed 

treaty provides that the credit allowed must take into account (in 

addition to any U.S. tax allowed directly as described above) the 

U.S. tax payable by the company in respect of the profits out of 

which such dividend is paid. 

The proposed treaty denies the U.K. credit described above with 

respect to dividends received by U.K. companies from U.S. companies in certain circumstances. Under the proposed treaty, the indirect credit may not be claimed if and to the extent that (1) the 

United Kingdom treats the dividend as beneficially owned by a 

U.K. resident, (2) the United States treats the same dividend as 

beneficially owned by a U.S. resident, and (3) the United States allows the U.S. resident a deduction in respect of the amount determined by reference to that dividend. The Technical Explanation 

states that this rule is intended to apply to a particular type of financing transaction that has been used widely by U.K. resident 

companies to finance their U.S. operations. The Technical Explanation provides an example of this transaction in which a U.S. 

holding company sells stock in another U.S. company to a U.K. 

company. Simultaneously, the U.S. holding company enters into a 

repurchase agreement with the U.K. company that allows the U.S. 

holding company to buy back the stock at a predetermined price. 

The sale and the repurchase agreement are structured in such a 

way that the transactions are treated together as a loan for U.S. 

tax purposes (with the dividends paid to the U.K. company treated 

as payments of interest on a loan from the U.K. company to the 

U.S. company). Because U.K. domestic law provides no mechanism 

for similarly treating the sale and repurchase in accordance with 

its economic substance, the United Kingdom would be required to 

respect the form of the transaction as a sale and grant an indirect 

credit with respect to dividends from the U.S. company, resulting 

in double non-taxation of income. However, U.K. domestic law does 

permit the United Kingdom to disallow U.K. foreign tax credits 

through its treaties. 

The Technical Explanation states that the United Kingdom had 

seen several of these transactions and was concerned about the loss 

of U.K. tax revenues arising from the ability of a U.K. company to 

receive a U.K. foreign tax credit for a payment that economically 

is interest. Accordingly, the Technical Explanation states that the 

United Kingdom requested this exception to the general rule described above relating to U.K. foreign tax credits for dividends. In 

61

order to facilitate the elimination of the U.K. foreign tax credit 

under this provision, the proposed treaty provides that paragraph 

2 of Article 1 (General Scope) does not apply for this purpose, 

which otherwise would not permit the proposed treaty to restrict 

a benefit provided under (in this case) U.K. domestic law. 

The proposed treaty provides a resourcing rule for purposes of allowing credits for U.S. taxes against U.K. taxes. The Technical Explanation states that this provision is intended to ensure that a 

U.K. resident can obtain a U.K. foreign tax credit for U.S. taxes 

paid when the proposed treaty assigns primary taxing jurisdiction 

to the United States. Under the proposed treaty, income of a U.K. 

resident that is taxed by the United States in accordance with the 

proposed treaty will be deemed to be U.S.-source income. 

The proposed treaty contains special rules designed to provide relief from double taxation for U.S. citizens who are U.K. residents. 

Unlike the U.S. model, the rules also apply to former U.S. citizens 

or long-term residents who are U.K. residents. Under the proposed 

treaty, the United Kingdom is not required to provide a credit to 

such U.K. residents for U.S. tax on profits, income, or chargeable 

gains from sources outside the United States (as determined under 

U.K. laws). This provision is similar to a provision in the present 

treaty. 

In addition, under the proposed treaty, the United Kingdom will 

allow a foreign tax credit to a U.S. citizen, former U.S. citizen, or 

former U.S. resident who is a U.K. resident by taking into account 

only the amount of U.S. taxes, if any, that may be imposed pursuant to the proposed treaty on a U.K. resident who is not a U.S. citizen. The Technical Explanation states that these rules apply to 

items of U.S.-source income that would either be exempt from U.S. 

tax or subject to reduced rates of U.S. tax under the proposed treaty if they had been received by a U.K. resident who is not a U.S. 

citizen. The Technical Explanation further states that the U.K. tax 

credit allowed with respect to such items need not exceed the U.S. 

tax that may be imposed under the proposed treaty, other than 

taxes imposed solely by reason of the U.S. citizenship of the taxpayer under saving clause of paragraph 4 of Article 1 (General 

Scope). The United States will then credit the income tax and capital gains tax actually paid to the United Kingdom, determined 

after application of the preceding rule. The proposed treaty recharacterizes the income that is subject to U.K. taxation as foreignsource income for purposes of this computation, but only to the extent necessary to avoid double taxation of such income. 

The notes contain special rules for the application of Article 24 

to fiscally transparent entities. The notes state that under paragraph 4 or 8 of Article 1 (General Scope), the proposed treaty may 

permit a country of which a person is resident (or, in the case of 

the United States, a citizen) to tax an item of income derived 

through another person (the ‘‘entity’’) that is fiscally transparent 

under the laws of either country, and may also permit the other 

country to tax the same person, the entity, or another person on 

that same item of income. The notes provide that in such circumstances, taxes paid or accrued by the entity will be treated as 

if it were paid or accrued by the first-mentioned person for purposes of determining relief from double taxation to be allowed by 

62

that resident’s home country (or, in the case of the United States, 

a citizen). Thus, according to the Technical Explanation, if a U.K. 

company pays interest to a U.K. unlimited liability company 

(‘‘ULC’’) with U.S. resident partners and the ULC is treated for 

U.S. tax purposes as a partnership such that the partners are subject to U.S. tax on that income, but the United Kingdom taxes the 

ULC on such income as a U.K. resident, under the proposed treat 

the United States will treat the U.K. tax paid by the ULC as having been paid by the partners for purposes of providing a foreign 

tax credit with respect to such interest income. The notes provide 

an exception from this rule for fiscally transparent entities in the 

case of items of income from real property to which paragraph 1 

of Article 6 (Income from Real Property) applies, or gain from the 

alienation of real property to which paragraph 1 of Article 13 

(Gains) applies. The notes provide that for such income and gains, 

the tax paid or accrued by the person who is a resident of the country in which the real property is situated will be treated as if it 

were paid by the person who is a resident of the other country. 

The notes also provide special rules for the application of Article 

24 where the same item of income, profit, or gain derived through 

a trust is treated by each country as derived by different persons 

resident in either country, and the person taxed by one country is 

the settlor or grantor of a trust, and the person taxed by the other 

country is a beneficiary of that trust. In such cases, the notes provide that the tax paid or accrued by the beneficiary will be treated 

as paid or accrued by the settlor or grantor for purposes of determining the relief from double taxation to be allowed by the country 

in which the settlor or grantor is resident (or, in the case of the 

United States, a citizen). Thus, according to the Technical Explanation, if a trust is a grantor trust for U.S. tax purposes and the 

income of the trust is included in the income of the grantor, but 

for U.K. tax purposes the beneficiaries must also pay tax on the 

same income, under the proposed treaty the United States would 

be required to provide a credit to the U.S. grantor for the U.K. tax 

imposed on the U.K. beneficiaries of the trust. The notes provide 

an exception from this rule in the case of items of income from real 

property to which paragraph 1 of Article 6 (Income from Real Property) applies, or gain from the alienation of real property to which 

paragraph 1 of Article 13 (Gains) applies. The notes provide that 

for such income and gains, the tax paid or accrued by the person 

who is a resident of the country in which the real property is situated will be treated as if it were paid by the person who is a resident of the other country. 

The notes further provide that the resourcing rules in paragraphs 2 and 5 of this article (described above) will apply to such 

items of income through fiscally transparent entities to the extent 

necessary to provide relief from double taxation. 

This article is not subject to the saving clause, so that the country of citizenship or residence will waive its overriding taxing jurisdiction to the extent that this article applies. 

Article 25. Non-Discrimination 

The proposed treaty contains a comprehensive non-discrimination article relating to all taxes of every kind imposed at the naVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00066 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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16 U.S. model, Article 24, paragraph 1, last sentence. 17OECD model, Commentary on Article 24, paragraph 67. 18OECD model, Article 24, paragraph 1, last sentence. 

tional, state, or local level. It is similar to the non-discrimination 

article in the U.S. model, the present treaty, and to provisions that 

have been included in other recent U.S. income tax treaties. 

In general, under the proposed treaty, one country cannot discriminate by imposing more burdensome taxes (or requirements 

connected with taxes) on nationals of the other country than it 

would impose on its own nationals in the same circumstances, particularly with respect to taxation on worldwide income. The Technical Explanation states that if one person is taxable in a country 

on worldwide income and another is not, distinctions in such treatment would not be discriminatory. Like the U.S. model, non-discrimination protection is provided with respect to all taxes imposed 

by a country or its political subdivisions or local authorities, and 

not just to taxes covered by the proposed treaty under Article 2 

(Taxes Covered). Unlike the U.S. model,16 the proposed treaty does 

not contain the provision extending the application of the non-discrimination rules to persons who are not residents of one or both 

of the States. The Technical Explanation states that this rule was 

not included in the proposed treaty at the request of the United 

Kingdom. Consistent with the U.K.’s position with respect to the 

proposed treaty, the United Kingdom has also stated that it reserves its position 17 with respect to the parallel provision in the 

OECD model.18

Under the proposed treaty, neither country may tax a permanent 

establishment of an enterprise of the other country less favorably 

than it taxes its own enterprises carrying on the same activities. 

Similar to the U.S. and OECD models, however, a country is not 

obligated to grant residents of the other country any personal allowances, reliefs, or reductions for tax purposes that are granted to 

its own residents or nationals. 

Each country is required (subject to the arm’s-length pricing 

rules of paragraph 1 of Article 9 (Associated Enterprises), paragraph 4 of Article 11 (Interest), paragraph 4 of Article 12 (Royalties), or paragraph 3 of Article 22 (Other Income), and subject to 

the conduit arrangement rules of the second sentence of paragraph 

5 of Article 7 (Business Profits), paragraph 9 of Article 10 (Dividends), paragraph 7 of Article 11 (Interest), paragraph 5 of Article 

12 (Royalties), or paragraph 4 of Article 22 (Other Income)) to 

allow its residents to deduct interest, royalties, and other disbursements paid by them to residents of the other country under the 

same conditions that it allows deductions for such amounts paid to 

residents of the same country as the payor. The Technical Explanation states that the term ‘‘other disbursements’’ is understood to 

include a reasonable allocation of executive and general administrative expenses, research and development expenses, and other expenses incurred for the benefit of a group of related persons that 

includes the person incurring the expense. The Technical Explanation further states that the exception with respect to paragraph 

4 of Article 11 (Interest) would include the denial or deferral of certain interest deductions under section 163(j) of the Code. 

64

The non-discrimination rules also apply to enterprises of one 

country that are owned in whole or in part by residents of the 

other country. Enterprises resident in one country, the capital of 

which is wholly or partly owned or controlled, directly or indirectly, 

by one or more residents of the other country, will not be subjected 

in the first country to any taxation (or any connected requirement) 

that is more burdensome than the taxation (or connected requirements) that the first country imposes or may impose on its similar 

enterprises. The Technical Explanation includes examples of Code 

provisions that are understood by the two countries not to violate 

this provision of the proposed treaty. Those examples include the 

rules that impose a withholding tax on non-U.S. partners of a partnership and the rules that prevent foreign persons from owning 

stock in Subchapter S corporations. 

The proposed treaty provides that nothing in the non-discrimination article is to be construed as preventing either of the countries 

from imposing a branch profits tax as described in paragraph 7 of 

Article 10 (Dividends). In addition, notwithstanding the definition 

of taxes covered in Article 2 (Taxes Covered), this article applies 

to taxes of every kind and description imposed by either country, 

or a political subdivision or local authority thereof.

The saving clause (which allows the country of residence or citizenship to impose tax notwithstanding certain treaty provisions) 

does not apply to the non-discrimination article. Thus, a U.S. citizen resident in the United Kingdom may claim benefits with respect to the United States under this article. 

Article 26. Mutual Agreement Procedure 

The proposed treaty contains the standard mutual agreement 

provision, with some variation, that authorizes the competent authorities of the two countries to consult together to attempt to alleviate individual cases of double taxation not in accordance with 

the proposed treaty. The saving clause of the proposed treaty does 

not apply to this article, so that the application of this article might 

result in a waiver (otherwise mandated by the proposed treaty) of 

taxing jurisdiction by the country of citizenship or residence. 

Under this article, a resident of one country who considers that 

the action of one or both of the countries cause him or her to be 

subject to tax which is not in accordance with the provisions of the 

proposed treaty may (irrespective of internal law remedies) present 

his or her case to the competent authority of the country in which 

he or she is a resident or a national. Similar to the OECD model, 

and unlike the U.S. model, the proposed treaty provides that the 

case must be presented within three years from the first notification of the action resulting in taxation not in accordance with the 

provisions of the treaty (or, if later, within six years from the end 

of the taxable year or chargeable period with respect to which that 

tax is imposed or proposed). 

The proposed treaty provides that if the objection appears to be 

justified and that competent authority is not itself able to arrive at 

a satisfactory solution, that competent authority must endeavor to 

resolve the case by mutual agreement with the competent authority of the other country, with a view to the avoidance of taxation 

which is not in accordance with the proposed treaty. The proposed 

65

treaty provides that any agreement reached will be implemented 

notwithstanding any time limits or other procedural limitations 

under the domestic laws of either country (e.g., a country’s applicable statute of limitations). The notes provide an exception from this 

rule for such limitations as apply for purposes of giving effect to 

such agreements (e.g., a domestic law requirement that the taxpayer file a return reflecting the agreement within a designated 

time period). 

The notes provide that where the competent authorities are seeking to resolve a case pursuant to this article, neither country may 

seek to collect the tax that is in dispute until the mutual agreement procedure has been completed. However, the notes further 

provide that any tax that is payable following the completion of the 

mutual agreement procedure will be subject to applicable interest 

charges, surcharges, or penalties for so long as the tax remains unpaid. 

The competent authorities of the countries are to endeavor to resolve by mutual agreement any difficulties or doubts arising as to 

the interpretation or application of the proposed treaty. In particular, the competent authorities may agree to: (1) the same attribution of income, deductions, credits, or allowances of an enterprise 

of one treaty country to the enterprise’s permanent establishment 

situated in the other country; (2) the same allocation of income, deductions, credits, or allowances between persons; (3) the same characterization of particular items of income, including the same characterization of income that is assimilated to income from shares by 

the tax laws of one country and that is treated as a different class 

of income in the other country; (4) the same characterization of persons; (5) the same application of source rules with respect to particular items of income; (6) a common meaning of a term; (7) that 

the conditions for the application of the conduit arrangement tests 

under the second sentence of paragraph 5 of Article 7 (Business 

Profits), paragraph 9 of Article 10 (Dividends), paragraph 7 of Article 11 (Interest), paragraph 5 of Article 12 (Royalties), or paragraph 4 of Article 22 (Other Income) have been met; and (8) the 

application of the provisions of each country’s domestic law regarding penalties, fines, and interest in a manner consistent with the 

purposes of the proposed treaty. The Technical Explanation clarifies that this list is a non-exhaustive list of examples of the kinds 

of matters about which the competent authorities may reach agreement. With respect to item (7) above, the Technical Explanation 

states that if the competent authorities become aware of a type of 

tax avoidance transaction entered into by several taxpayers, it is 

anticipated that each competent authority will respond to that 

transaction by means of domestic laws and procedures, rather than 

through the issuance of a general agreement, in order to deny benefits in appropriate cases. 

The proposed treaty provides that the competent authorities may 

consult together for the elimination of double taxation regarding 

cases not provided for in the proposed treaty. In addition, the notes 

provide that it is understood that any principle of general application established by an agreement between the competent authorities will be published by both competent authorities. This will increase transparency in the administration of the treaty by proVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00069 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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19The U.S. model uses ‘‘relevant’’ instead of ‘‘necessary.’’ The Technical Explanation states 

that ‘‘necessary’’ has been consistently interpreted as being equivalent to ‘‘relevant,’’ and does 

not necessitate a demonstration that a State would be disabled from enforcing its tax laws absent the information. 

viding taxpayers with notification of principles of general applicability upon which both competent authorities have agreed. 

The proposed treaty authorizes the competent authorities to communicate with each other directly for purposes of reaching an 

agreement in the sense of this mutual agreement article. The Technical Explanation states that this provision makes clear that it is 

not necessary to go through diplomatic channels in order to discuss 

problems arising in the application of the proposed treaty. 

The notes provide that the provisions of Article 26 (Mutual 

Agreement Procedure) of the proposed treaty will have effect from 

the date of entry into force of the proposed treaty, without regard 

to the taxable or chargeable period to which the matter relates. 

Article 27. Exchange of Information and Administrative Assistance 

The proposed treaty provides that the two competent authorities 

will exchange such information as is necessary 19 to carry out the 

provisions of the proposed treaty, or the domestic laws of the two 

countries concerning taxes covered by the proposed treaty insofar 

as the taxation thereunder is not contrary to the proposed treaty, 

including for purposes of preventing fraud and facilitating the administration of statutory provisions against legal avoidance. This 

exchange of information is not restricted by Article 1 (General 

Scope). Therefore, information with respect to third-country residents is covered by these procedures. The two competent authorities may exchange information on a routine basis, on request in relation to a specific case, or spontaneously. The Technical Explanation states that it is contemplated that all of these types of exchange will be utilized, as appropriate. 

Unlike the U.S. model, the proposed treaty is limited to taxes 

that are identified in Article 2 (Taxes Covered). The Technical Explanation states that U.K. legislation for implementing tax treaties 

does not provide authority to exchange information with respect to 

other types of taxes. 

Any information exchanged under the proposed treaty is treated 

as secret in the same manner as information obtained under the 

domestic laws of the country receiving the information. The exchanged information may be disclosed only to persons or authorities (including courts and administrative bodies) involved in the assessment, collection, or administration of, the enforcement or prosecution in respect of, or the determination of appeals in relation to, 

the taxes to which the proposed treaty applies, or to persons or authorities engaged in the oversight of the above (e.g., the tax-writing 

committees of Congress and the General Accounting Office). Such 

persons or authorities must use the information for such purposes 

only. Information received by these bodies must be for use in the 

performance of their role in overseeing the administration of U.S. 

tax laws. Exchanged information may be disclosed in public court 

proceedings or in judicial decisions. 

67

If information is requested by a country in accordance with this 

article, the proposed treaty provides that the other country will obtain that information in the same manner and to the same extent 

as if the tax of the requesting country were the tax of the other 

country and were being imposed by that country, notwithstanding 

that such other country may not need such information at that 

time. The Technical Explanation states that a recent change in 

U.K. domestic law allows the United Kingdom to agree to this provision of the proposed treaty, and to obtain and exchange information in which it does not have a direct tax interest. 

As is true under the U.S. model and the OECD model, under the 

proposed treaty, a country is not required to carry out administrative measures at variance with the laws and administrative practice of either country, to supply information that is not obtainable 

under the laws or in the normal course of the administration of either country, or to supply information that would disclose any 

trade, business, industrial, commercial, or professional secret or 

trade process or information, the disclosure of which would be contrary to public policy. 

The notes provide that the powers of each country’s competent 

authority to obtain information include the ability to obtain information held by financial institutions, nominees, or persons acting 

in an agency or fiduciary capacity. This does not include the ability 

to obtain information that would reveal confidential communications between a client and an attorney, solicitor, or other legal representative, where the client seeks legal advice. The Technical Explanation states that, in the case of the United States, the scope 

of the privilege for such confidential communications is coextensive 

with the attorney-client privilege under U.S. law. The notes also 

provide that the competent authorities may obtain information relating to the ownership of legal persons. The notes confirm that 

each country’s competent authority is able to exchange such information in accordance with this article. 

The proposed treaty provides that if specifically requested by the 

competent authority of a country, the competent authority of the 

other country must provide information under this article in the 

form of authenticated copies of unedited original documents (including books, papers, statements, records, accounts, and writings), 

to the same extent such documents can be obtained under the laws 

and administrative practices of the requested country with respect 

to its own taxes. Unlike the U.S. model, the proposed treaty does 

not authorize the use of depositions of witnesses to obtain information under this article. The Technical Explanation states that 

under current U.K. law and practice, the U.K. Inland Revenue does 

not have the authority to take such depositions. 

Under the proposed treaty, a country may collect on behalf of the 

other country such amounts as may be necessary to ensure that relief granted under the treaty by the other country does not inure 

to the benefit of persons not entitled thereto. However, neither 

country is obligated to carry out administrative measures that 

would be contrary to its sovereignty, security, or public policy. 

Under the proposed treaty, the competent authority of a country 

intending to send its officials to the other country to interview individuals and examine books and records with the consent of the perVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00071 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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20Thus, with respect to these taxes, the proposed treaty would take effect almost immediately 

if instruments of ratification were exchanged in March 2003; otherwise, the earliest it could take 

effect with respect to these taxes would be for financial years or years of assessment beginning 

in April 2004. 

son subject to examination must notify the competent authority of 

the other country of such intention. 

Like the present treaty, the proposed treaty provides that the 

competent authorities will consult with each other for purposes of 

cooperating and advising in respect of any action to be taken in implementing this article. 

The notes provide that the provisions of Article 27 (Exchange of 

Information and Administrative Assistance) of the proposed treaty 

will have effect from the date of entry into force of the proposed 

treaty, without regard to the taxable or chargeable period to which 

the matter relates. 

Article 28. Diplomatic Agents and Consular Officers 

The proposed treaty contains the rule found in the U.S. model, 

the present treaty, and other U.S. tax treaties that its provisions 

do not affect the fiscal privileges of diplomatic agents or consular 

officers under the general rules of international law or under the 

provisions of special agreements. Accordingly, the proposed treaty 

will not defeat the exemption from tax which a host country may 

grant to the salary of diplomatic officials of the other country. The 

saving clause does not apply in the application of this article to 

host country residents who are neither citizens nor lawful permanent residents of that country. Thus, for example, U.S. diplomats 

who are considered U.K. residents may be protected from U.K. tax. 

Article 29. Entry Into Force 

The proposed treaty provides that the treaty is subject to ratification in accordance with the applicable procedures of each country, 

and that instruments of ratification will be exchanged as soon as 

possible. The proposed treaty will enter into force upon the exchange of instruments of ratification. 

With respect to the United States, the proposed treaty will be effective with respect to taxes withheld at source for amounts paid 

or credited on or after the first day of the second month following 

the date on which the proposed treaty enters into force. With respect to other taxes, the proposed treaty will be effective for taxable periods beginning on or after the first day of January next following the date on which the proposed treaty enters into force. 

With respect to the United Kingdom, the proposed treaty will be 

effective with respect to taxes withheld at source for amounts paid 

or credited on or after the first day of the second month following 

the date on which the proposed treaty enters into force. With respect to income taxes not described in the preceding sentence and 

with respect to capital gains taxes, the proposed treaty will be effective for any year of assessment beginning on or after the sixth 

day of April next following the date on which the proposed treaty 

enters into force. With respect to the corporation tax, the proposed 

treaty will be effective for any financial year beginning on or after 

the first day of April next following the date on which the proposed 

treaty enters into force.20 With respect to petroleum revenue taxes, 

69

the proposed treaty will be effective for chargeable periods beginning on or after the first day of January next following the date 

on which the proposed treaty enters into force. 

The present treaty generally will cease to have effect in relation 

to any tax from the date on which the proposed treaty takes effect 

in relation to that tax. Taxpayers may elect temporarily to continue 

to claim benefits under the present treaty with respect to a period 

after the proposed treaty takes effect. For such a taxpayer, the 

present treaty would continue to have effect in its entirety for a 

twelve-month period from the date on which the provisions of the 

proposed treaty would otherwise take effect. The present treaty will 

terminate on the last date on which it has effect in relation to any 

tax in accordance with the provisions of this article. 

Notwithstanding the entry into force of the proposed treaty, an 

individual who is entitled to the benefits of Article 21 (Students 

and Trainees) of the present treaty at the time the proposed treaty 

enters into force will continue to be entitled to such benefits as if 

the present treaty remained in force. The Technical Explanation 

states that the treatment of trainees under the present treaty may 

be more generous than under the proposed treaty (which generally 

limits benefits for such individuals for up to one year). The Technical Explanation states that the special rule in the proposed treaty was included so that the rules do not change with respect to certain trainees that have based their decisions to come to a host 

country on the assumption that the benefits of the present treaty 

would apply to them. 

The notes provide that the provisions of Article 26 (Mutual 

Agreement Procedure) and Article 27 (Exchange of Information and 

Administrative Assistance) of the proposed treaty will have effect 

from the date of entry into force of the proposed treaty, without regard to the taxable or chargeable period to which the matter relates. 

Article 30. Termination 

The proposed treaty will remain in force until terminated by either country. Either country may terminate the proposed treaty by 

giving notice of termination to the other country through diplomatic channels. In such case, with respect to the United States, a 

termination is effective with respect to taxes withheld at source for 

amounts paid or credited after six months following notice of termination. With respect to other taxes, a termination is effective for 

taxable periods beginning on or after the date that is six months 

following notice of termination. 

With respect to the United Kingdom, a termination is effective 

with respect to taxes withheld at source for amounts paid or credited after six months following notice of termination. With respect 

to income taxes not described in the preceding sentence and with 

respect to capital gains taxes, a termination is effective for any 

year of assessment beginning on or after the date that is six 

months following the notice of termination. With respect to the corporation tax, a termination is effective for any financial year beginning on or after the date that is six months following notice of termination. With respect to the petroleum revenue tax, a termination 

70

is effective for chargeable periods beginning on or after the date 

that is six months following notice of termination. 

Other Matters 

The notes provide that the two countries will consult together at 

regular intervals regarding the terms, operation, and application of 

the proposed treaty to ensure that it continues to serve the purpose 

of avoiding double taxation and preventing fiscal evasion, and 

where appropriate, conclude protocols to amend the proposed treaty. The notes provide that the first consultation will take place no 

later than December 31 of the fifth year following the date on 

which the proposed treaty enters into force. The notes further provide that subsequent consultations will take place in intervals of no 

more than five years. 

Notwithstanding the above, the notes provide that either country 

may at any time request consultations with the other country with 

respect to matters relating to the terms, operation, and application 

of the proposed treaty that it considers require urgent resolution. 

(71)

IV. ISSUES 

A. Zero Rate of Withholding Tax on Dividends From 80–

Percent-Owned Subsidiaries 

In general 

The proposed treaty would eliminate withholding tax on dividends paid by one corporation to another corporation that owns at 

least 80 percent of the stock of the dividend-paying corporation 

(often referred to as ‘‘direct dividends’’), provided that certain conditions are met (subparagraph 3(a) of Article 10 (Dividends)). The 

elimination of withholding tax under these circumstances is intended to reduce further the tax barriers to direct investment between the two countries. 

Unlike the United States, the United Kingdom currently does not 

impose withholding tax on dividends paid to foreign shareholders 

as a matter of domestic law. Thus, the principal immediate effect 

of this provision would be to exempt dividends that U.S. subsidiaries pay to U.K. parent companies from U.S. withholding tax. 

With respect to dividends paid by U.K. subsidiaries to U.S. parent 

companies, the effect of this provision would be to lock in the currently applicable zero rate of U.K. withholding tax, regardless of 

how U.K. domestic law might change in this regard. 

Currently, no U.S. treaty provides for a complete exemption from 

withholding tax under these circumstances, nor do the U.S. or 

OECD models. However, many bilateral tax treaties to which the 

United States is not a party eliminate withholding taxes under 

similar circumstances, and the same result has been achieved within the European Union under its ‘‘Parent-Subsidiary Directive.’’ In 

addition, subsequent to the signing of the proposed treaty, the 

United States signed proposed protocols with Australia and Mexico 

that include zero-rate provisions similar to the one in the proposed 

treaty. 

Description of provision 

Under the proposed treaty, the withholding tax rate is reduced 

to zero on dividends beneficially owned by a company that has 

owned at least 80 percent of the voting power of the company paying the dividend for the 12–month period ending on the date the 

dividend is declared (subparagraph 3(a) of Article 10 (Dividends)). 

Under the current U.S.-U.K. treaty, these dividends may be taxed 

at a 5–percent rate (although, as noted above, the United Kingdom 

currently does not exercise this right as a matter of domestic law, 

whereas the United States does). 

In certain circumstances, eligibility for the zero rate under the 

proposed treaty is subject to an additional restriction designed to 

prevent companies from reorganizing for the purpose of obtaining 

the benefits of the provision. Specifically, in cases in which a comVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00075 Fmt 6604 Sfmt 6604 E:\HR\OC\A199.XXX A199
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21October 1, 1998 is the date on which the parties announced that they were negotiating the 

proposed treaty. 22See Part III, Article 10, supra, for a discussion of an interpretive issue that arose regarding 

the scope of the zero-rate provision under the language of the proposed treaty as originally 

signed, prior to amendment by the proposed protocol. 23See, e.g., Code sec. 904.

pany satisfies the Limitation on Benefits article only under the ‘‘active trade or business’’ and/or ‘‘ownership/base-erosion’’ tests (paragraph 4 and subparagraph 2(f), respectively, of Article 23 (Limitation on Benefits)), the zero rate will apply only if the dividend-receiving company owned (directly or indirectly) at least 80 percent 

of the voting power of the dividend-paying company prior to October 1, 1998.21 In other cases, the Limitation on Benefits article 

itself is considered sufficient to prevent treaty shopping. Thus, 

companies that qualify for treaty benefits under the ‘‘public trading,’’ ‘‘derivative benefits,’’ or discretionary tests (subparagraph 2(c) 

and paragraphs 3 and 6, respectively, of Article 23 (Limitation on 

Benefits)) will not need to meet the October 1, 1998 holding requirement in order to claim the zero rate.22

Issues 

In general 

Given that the United States has never before agreed bilaterally 

to a zero rate of withholding tax on direct dividends, the Committee may wish to devote particular attention to the benefits and 

costs of taking this step. The Committee also may want to determine whether the inclusion of the zero-rate provision in the proposed treaty (as well as in the proposed protocols with Australia 

and Mexico) signals a broader shift in U.S. treaty policy, and under 

what circumstances the United States may seek to include similar 

provisions in other treaties. Finally, the Committee may wish to 

note the ramifications of including this provision in the U.S.-U.K. 

treaty in view of a ‘‘most favored nation’’ provision relating to this 

subject in the current U.S.-Mexico treaty. 

Benefits and costs of adopting a zero rate with the United 

Kingdom 

Tax treaties mitigate double taxation by resolving the potentially 

conflicting claims of a residence country and a source country to 

tax the same item of income. In the case of dividends, standard 

international practice is for the source country to yield mostly or 

entirely to the residence country. Thus, the residence country preserves its right to tax the dividend income of its residents, and the 

source country agrees either to limit its withholding tax to a relatively low rate (e.g., 5 percent) or to forgo it entirely. 

Treaties that permit a positive rate of dividend withholding tax 

allow some degree of double taxation to persist. To the extent that 

the residence country allows a foreign tax credit for the withholding tax, this remaining double taxation may be mitigated or 

eliminated, but then the priority of the residence country’s claim to 

tax the dividend income of its residents is not fully respected. 

Moreover, if a residence country imposes limitations on its foreign 

tax credit,23 withholding taxes may not be fully creditable as a 

practical matter, thus leaving some double taxation in place. For 

73

24 In contrast, including a similar provision in a treaty with a country that does impose withholding tax on some or all direct dividends under its internal law (e.g., Australia) would provide 

more immediate and direct benefits to the United States as both an importer and an exporter 

of capital. 25The overall revenue impact of including a similar provision in a treaty with a country that 

does impose withholding tax on direct dividends would be more favorable for the United States, 

as the direct revenue loss to the United States as a source country would be offset in whole 

or in part by a revenue gain as a residence country from reduced foreign tax credit claims with 

respect to withholding taxes. 

these reasons, dividend withholding taxes are commonly viewed as 

barriers to cross-border investment. The principal argument in 

favor of eliminating withholding taxes on certain direct dividends 

in the proposed treaty is that it would remove one such barrier. 

Direct dividends arguably present a particularly appropriate case 

in which to remove the barrier of a withholding tax, in view of the 

close economic relationship between the payor and the payee. 

Whether in the United States or in the United Kingdom, the dividend-paying corporation generally faces full net-basis income taxation in the source country, and the dividend-receiving corporation 

generally is taxed in the residence country on the receipt of the dividend (subject to allowable foreign tax credits). If the dividend-paying corporation is at least 80–percent owned by the dividend-receiving corporation, it is arguably appropriate to regard the dividendreceiving corporation as a direct investor (and taxpayer) in the 

source country in this respect, rather than regarding the dividendreceiving corporation as having a more remote investor-type interest warranting the imposition of a second-level source-country tax. 

Since the United Kingdom does not impose a withholding tax on 

these dividends under its internal law, the zero-rate provision 

would principally benefit direct investment in the United States by 

U.K. companies, as opposed to direct investment in the United 

Kingdom by U.S. companies. In other words, the potential benefits 

of the provision would accrue mainly in situations in which the 

United States is importing capital, as opposed to exporting it.24

In this regard, the Committee may wish to note that adopting a 

zero-rate provision in the U.S.-U.K. treaty would have uncertain 

revenue effects for the United States. The United States would 

forgo the 5–percent tax that it currently collects on qualifying dividends paid by U.S. subsidiaries to U.K. parent companies, but 

since the United Kingdom currently does not impose any tax on 

comparable dividends paid by U.K. subsidiaries to U.S. parent companies, there would be no offsetting revenue gain to the United 

States in the form of decreased foreign tax credit claims with respect to withholding taxes.25 However, in order to account for the 

recent repeal of the U.K. advance corporation tax and related developments, the proposed treaty also eliminates a provision of the 

present treaty requiring the United States to provide a foreign tax 

credit with respect to certain dividends received from U.K. companies. On balance, these two effects are likely to increase revenues 

for the U.S. fisc. Over the longer term, if capital investment in the 

United States by U.K. persons is made more attractive, total investment in the United States may increase, ultimately creating a 

larger domestic tax base. However, if increased investment in the 

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74

26More broadly, since the U.S. Model has not been updated since 1996, the Committee may 

wish to ask whether the Treasury Department intends to update the model to reflect all relevant developments that have occurred in the intervening years. A thoroughly updated model 

vestments in the United States, there would be no increase in the 

domestic tax base. 

Revenue considerations aside, the removal of an impediment to 

the import of capital from the United Kingdom into the United 

States is a not-inconsiderable economic benefit. Further, it should 

be noted that, although U.K. internal law currently does not impose a withholding tax on dividends paid to foreign persons, there 

is no guarantee that this will always be the case. Thus, the inclusion of a zero-rate provision in the treaty would give U.S.-based enterprises somewhat greater certainty as to the applicability of a 

zero rate in the United Kingdom, which arguably would facilitate 

long-range business planning for U.S. companies in their capacities 

as capital exporters. Along the same lines, the provision would protect the U.S. fisc against increased foreign tax credit claims in the 

event that the U.K. were to change its internal law in this regard. 

Although the United States has never agreed bilaterally to a zero 

rate of withholding tax on direct dividends, many other countries 

have done so in one or more of their bilateral tax treaties. These 

countries include OECD members Austria, Denmark, France, Finland, Germany, Iceland, Ireland, Japan, Luxembourg, Mexico, the 

Netherlands, Norway, Sweden, Switzerland, and the United Kingdom, as well as non-OECD-members Belarus, Brazil, Cyprus, 

Egypt, Estonia, Israel, Latvia, Lithuania, Mauritius, Namibia, 

Pakistan, Singapore, South Africa, Ukraine, and the United Arab 

Emirates. In addition, a zero rate on direct dividends has been 

achieved within the European Union under its ‘‘Parent-Subsidiary 

Directive.’’ Finally, many countries have eliminated withholding 

taxes on dividends as a matter of internal law (e.g., the United 

Kingdom and Mexico). Thus, although the zero-rate provision in 

the proposed treaty is unprecedented in U.S. treaty history, there 

is substantial precedent for it in the experience of other countries. 

It may be argued that this experience constitutes an international 

trend toward eliminating withholding taxes on direct dividends, 

and that the United States would benefit by joining many of its 

treaty partners in this trend and further reducing the tax barriers 

to cross-border direct investment. 

General direction of U.S. tax treaty policy 

Looking beyond the U.S.-U.K. treaty relationship, the Committee 

may wish to determine whether the inclusion of the zero-rate provision in the proposed treaty (as well as in later-signed proposed protocols with Australia and Mexico) signals a broader shift in U.S. 

tax treaty policy. Specifically, the Committee may want to know 

whether the Treasury Department: (1) intends to pursue similar 

provisions in other proposed treaties in the future; (2) proposes any 

particular criteria for determining the circumstances under which 

a zero-rate provision may be appropriate or inappropriate; (3) expects to seek terms and conditions similar to those of the proposed 

treaty in connection with any zero-rate provisions that it may negotiate in the future; and (4) intends to amend the U.S. model to reflect these developments.26 In light of the fact that the United 

75

would provide a more meaningful and useful guide to current U.S. tax treaty policy and would 

thereby increase transparency and facilitate Congressional oversight in this important area. See

Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code 

of 1986 (JCS–3–01), April 2001, Vol. II, at 445–47 (recommending that the Treasury Department revise U.S. model tax treaties once per Congress). 27This formal understanding was a response to an objection raised by the Committee to the 

original language of the treaty protocol, under which the ‘‘most-favored nation’’ provision would 

have been self-executing—i.e., immediately upon U.S. agreement to a lower rate with another 

treaty partner, the United States and Mexico would have begun applying that lower rate in 

their treaty. 

States would stand to benefit more comprehensively from zero-rate 

provisions in treaties with countries that currently impose withholding taxes on the relevant dividends, the general implications of 

this first zero-rate provision are likely to be of greater interest in 

the United States than the particular implications with respect to 

the United Kingdom. 

‘‘Most favored nation’’ agreement with Mexico 

The adoption of a zero-rate provision in the U.S.-U.K. treaty relationship may have particular ramifications for the U.S.-Mexico 

treaty relationship. Under the current U.S.-Mexico income tax treaty, dividends beneficially owned by a company that owns at least 

10 percent of the voting stock of the dividend-paying company are 

subject to a maximum withholding rate of 5 percent (paragraph 

2(a) of Article 10 of the U.S.-Mexico treaty), which is the lowest 

rate of withholding tax on dividends currently available under U.S. 

treaties. Under Protocol 1 to that treaty, as modified by a formal 

understanding subject to which the treaty and protocol were ratified, the United States and Mexico have agreed, if the United 

States adopts a rate on dividends lower than 5 percent in a treaty 

with another country, ‘‘to promptly amend [the U.S.-Mexico treaty] 

to incorporate that lower rate.’’ 27

Adopting the zero-rate provision in the proposed treaty would 

trigger this obligation to amend the current treaty with Mexico. 

The recently signed proposed protocol with Mexico would amend 

that treaty to incorporate a zero-rate provision substantially identical to that of the proposed treaty with the United Kingdom, and 

thus would seem to fulfill the U.S. obligation under the ‘‘most favored nation’’ agreement. Thus, if the Senate were to ratify both 

the proposed treaty with the United Kingdom and the proposed 

protocol with Mexico, no issues of interaction between the two treaty relationships would need to be confronted. 

If, on the other hand, the Senate were to ratify the proposed 

treaty with the United Kingdom, but not the proposed protocol 

with Mexico, then the possibility would arise that the United 

States eventually could be regarded as falling out of compliance 

with its obligations under the U.S.-Mexico treaty. This would raise 

difficult questions as to the exact nature of this obligation and 

whether and how the United States would come into compliance 

with it. 

76

28The issues raised by the proposed anti-conduit rule in the context of the insurance excise 

tax differ from those raised in connection with the other articles. Issues relating to the insurance excise tax are discussed separately in Part IV.C of this pamphlet. The present discussion 

of the rule is limited to the issues raised in the context of the dividends, interest, royalties, and 

other income articles. 29See Senate Committee on Foreign Relations, Report, Tax Convention with Italy, Exec. Rpt. 

106–8, Nov. 3, 1999; Senate Committee on Foreign Relations, Report, Tax Convention with Slovenia, Exec. Rpt. 106–7, Nov. 3, 1999; see also Joint Committee on Taxation, Explanation of Proposed Income Tax Treaty and Proposed Protocol between the United States and the Italian Republic (JCS–9–99), October 8, 1999; Joint Committee on Taxation, Explanation of Proposed Income Tax Treaty between the United States and the Republic of Slovenia (JCS–11–99), October 

8, 1999. 30See Code sec. 7701(l); Treas. Reg. sec. 1.881–3. 

B. Anti-Conduit Rule 

In general 

The proposed treaty includes an anti-conduit rule that can operate to deny the benefits of the dividends article (Article 10), the interest article (Article 11), the royalties article (Article 12), the other 

income article (Article 22), and the insurance excise tax provision 

of the business profits article (Article 7(5)).28 This rule is not found 

in any other U.S. treaty, and it is not included in the U.S. or 

OECD models. The rule is similar to, but significantly narrower 

and more precise than, the ‘‘main purpose’’ rules that the Senate 

rejected in 1999 in connection with its consideration of the U.S.-

Italy and U.S.-Slovenia treaties.29

The rule was included at the request of the United Kingdom, 

which has similar provisions in many of its tax treaties. The purpose of the rule, from the U.K. perspective, is to prevent residents 

of third countries from improperly obtaining the reduced rates of 

U.K. tax provided under the treaty by channeling payments to a 

third-country resident through a U.S. resident (acting as a ‘‘conduit’’). 

From the U.S. perspective, the rule is unnecessary, because U.S. 

domestic law provides detailed rules governing arrangements to reduce U.S. tax through the use of conduits.30 Thus, apart from accommodating the request of a treaty partner, no apparent U.S. interest is served by adding a general anti-conduit rule to the treaty. 

Description of provision 

Under the proposed anti-conduit rule, the benefits of the dividends, interest, royalties, and other income articles are denied in 

connection with any payment made under, or as part of, a ‘‘conduit 

arrangement’’ (Articles 10(9), 11(7), 12(5), and 22(4), respectively). 

Article 3(1)(n) defines the term ‘‘conduit arrangement’’ as a transaction or series of transactions that meets both of the following criteria: (1) a resident of one contracting state receives an item of income that generally would qualify for treaty benefits, and then 

pays (directly or indirectly, at any time or in any form) all or substantially all of that income to a resident of a third state who 

would not be entitled to equivalent or greater treaty benefits if it 

had received the same item of income directly; and (2) obtaining 

the increased treaty benefits is the main purpose or one of the 

main purposes of the transaction or series of transactions. 

The inclusion of the first criterion above limits the scope of the 

rule to situations involving objectively defined conduit payments. 

Thus, the rule is less vague and more narrowly targeted than the 

77

31For example, the anti-conduit rules of U.S. domestic law currently do not apply to transactions involving dividend payments on common stock, but the anti-conduit rule in the proposed 

treaty could apply to such transactions. (The Treasury Department has the authority under 

Code section 7701(l) to apply anti-conduit principles to these transactions, but it has not exercised this authority.) 32See Letter from Barbara M. Angus, International Tax Counsel, Department of the Treasury, 

to Gabriel Makhlouf, Director, Inland Revenue, International Division, July 19, 2002 (the ‘‘U.S. 

letter’’); Letter from Gabriel Makhlouf, Director, Inland Revenue, International Division, to Barbara M. Angus, International Tax Counsel, Department of the Treasury, July 19, 2002 (the 

‘‘U.K. letter’’). These letters are appended to the Technical Explanation. 33 U.S. letter, at 1. Similar language appears in the Technical Explanation to article 3(1).

similar rules that the Senate rejected in the proposed U.S.-Italy 

and U.S.-Slovenia treaties, which would have applied to any transaction that met a ‘‘main purpose’’ test similar to the second criterion described above. 

Issues 

Although the proposed anti-conduit rule is considerably narrower 

and more objective than the similar rules rejected by the Senate in 

1999, the rule is also without precedent in existing U.S. tax treaties, and thus the Committee may wish to give it particular attention. 

The rule may create confusion, because it applies not only to conduit arrangements in which a reduction in U.K. tax is claimed, but 

also to conduit arrangements in which a reduction in U.S. tax is 

claimed, despite the fact that there is no apparent reason for the 

rule to apply in the latter circumstance, in view of the existence 

of anti-conduit provisions under U.S. domestic law. To the extent 

that the proposed treaty’s anti-conduit rule and the U.S. domesticlaw anti-conduit rules are not consistent in every particular, taxpayers may be confused as to which set of rules the United States 

will apply in certain situations.31

In order to mitigate this potential confusion, as well as to provide 

guidance as to how the United Kingdom will apply the anti-conduit 

rule in situations in which a reduction in U.K. tax is claimed, the 

parties executed an exchange of letters in July 2002, in which they 

described in some detail how they intend to apply the anti-conduit 

rule.32

The U.S. letter suggests that the United States simply will continue to apply its domestic law, without regard to the treaty rule:

With respect to the United States, we intend to interpret 

the conduit arrangement provisions of the Convention in 

accordance with U.S. domestic law as it may evolve over 

time. The relevant law currently includes in particular the 

rules of regulation section 1.881–3 and other regulations 

adopted under the authority of section 7701(l) of the Internal Revenue Code. Therefore, the inclusion of the conduit 

arrangement rules in the Convention does not constitute 

an expansion (or contraction) of U.S. domestic anti-abuse 

principles (except with respect to the application of anticonduit principles to the insurance excise tax).33

78

34For example, the letter indicates that the United States will not apply anti-conduit principles to a transaction involving dividends on common stock, because the transaction is not covered by the current U.S. domestic anti-conduit rules. Annex to the U.S. letter, Example 2. 

An annex to the U.S. letter provides six examples illustrating how 

the United States intends to apply the rule in a manner consistent 

with current U.S. domestic law.34

This statement of intent from the U.S. perspective should substantially mitigate the potential uncertainty regarding how the 

United States will treat conduit arrangements. Nevertheless, some 

may find it difficult to understand why, given this intent, the rule 

in the proposed treaty was drafted to apply to situations addressed 

by U.S. domestic law in the first place. 

The U.K. letter includes an annex that evaluates examples analogous to those set forth in the annex to the U.S. letter, reaching 

results consistent with those of the U.S. letter. The U.K. letter thus 

provides helpful guidance as to how the anti-conduit rules of the 

proposed treaty will be applied in cases in which a reduction in 

U.K. tax is claimed. 

The Committee may wish to satisfy itself that these measures 

adequately address the potential confusion and uncertainty that 

could arise from including an anti-conduit rule in the proposed 

treaty. The Committee also may wish to satisfy itself that that the 

Treasury Department has agreed to this provision solely as an accommodation to the United Kingdom and does not intend to include 

similar provisions in future treaties.

C. Insurance Excise Tax 

The proposed treaty, like the present treaty, waives the application of the U.S. insurance excise tax on foreign insurers and reinsurers. Thus, for example, a U.K. insurer or reinsurer generally 

may receive premiums on policies with respect to U.S. risks free of 

this tax. As further discussed below, waiver of this tax may raise 

concerns if a substantial tax is not imposed by the United Kingdom 

or a third country on the foreign insurer or reinsurer. 

Unlike the present treaty, the proposed treaty incorporates an 

anti-conduit rule to prevent persons not entitled to equivalent or 

more favorable treaty benefits from obtaining the benefit of the insurance excise tax waiver under the proposed treaty. The addition 

of an anti-conduit rule in the proposed treaty makes the proposed 

treaty more comparable than the present treaty to other U.S. treaties that provide waivers of the application of the insurance excise 

tax (with anti-conduit rules). Thus, the rule of the proposed treaty 

may be viewed as an improvement over the rule of the present 

treaty, which provides a waiver of the insurance excise tax without 

any anti-conduit rule. 

The anti-conduit rule in the proposed treaty differs from insurance excise tax anti-conduit rules in other U.S. tax treaties; in particular, the rule in the proposed treaty incorporates a ‘‘main purpose’’ test. That is, the anti-conduit rule in the proposed treaty applies only if the conduit arrangement has as its main purpose, or 

one of its main purposes, obtaining such increased benefits as are 

available under the proposed treaty. The main purpose test apparently is modeled after similar ‘‘main purpose’’ provisions found in 

79

35See, e.g., U.S. Treasury Department, Report to Congress on the Effect on U.S. Reinsurance 

Corporations of the Waiver by Treaty of the Excise Tax on Certain Reinsurance Premiums, 90 

TNT 71–31 (March 1990). 

treaties of other countries, such as many of the modern treaties of 

the United Kingdom. The ‘‘main purpose’’ aspect of the proposed 

treaty’s anti-conduit rule presents some issues. Specifically, the 

test is subjective and lacks conformity with the relevant provisions 

of most other U.S. tax treaties. 

The Technical Explanation to the proposed treaty, however, 

states that the United States intends to interpret the conduit arrangement provisions of the proposed treaty in accordance with 

U.S. domestic law, as it may evolve over time, and further states 

in the context of the waiver of the insurance excise tax that the 

United States will interpret the provision of the proposed treaty by 

analogy to the anti-conduit rules of regulation section 1.881–3. The 

interpretation of the anti-conduit rule as applied to the insurance 

excise tax waiver in the proposed treaty in a manner consistent 

with U.S. law may be different from the interpretation and application of insurance excise tax anti-conduit rules in other U.S. treaties. 

Waivers of the insurance excise tax in other treaties have raised 

serious congressional concerns. For example, concern has been expressed over the possibility that such waivers may place U.S. insurers at a competitive disadvantage with respect to foreign competitors in U.S. markets if a substantial tax is not otherwise imposed (e.g., by the treaty partner country) on the insurance income 

of the foreign insurer or reinsurer.35 Moreover, in such a case, a 

waiver of the tax does not serve the primary purpose of treaties to 

prevent double taxation, but instead has the undesirable effect of 

eliminating all tax on such income. 

The U.S.-Barbados and U.S.-Bermuda tax treaties each contained such a waiver as originally signed. In its report on the Bermuda treaty, the Committee expressed the view that those waivers 

should not have been included. The Committee stated that waivers 

should not be given by Treasury in its future treaty negotiations 

without prior consultations with the appropriate committees of 

Congress. Congress subsequently enacted legislation to ensure the 

sunset of the waivers in the two treaties. 

The Committee may wish to satisfy itself that the U.K. tax imposed on U.K. insurers and reinsurers on premium income results 

in a burden that is substantial in relation to the U.S. tax on U.S. 

insurers and reinsurers, and that the anti-conduit rule in the proposed treaty is sufficient to prevent persons not entitled to equivalent or more favorable treaty benefits from obtaining the benefit of 

the insurance excise tax waiver. 

D. Dividend Substitute Payments 

The proposed treaty provides that, in the case of a dividend paid 

by a U.S. company to a U.K. company that directly or indirectly 

controls at least 10 percent of the voting power of the U.S. company, the U.K. company generally is eligible for a credit against 

U.K. tax for U.S. taxes that are payable by the U.S. company in 

respect of the profits out of which such dividend is paid. 

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36For a more detailed discussion of the cross-border tax issues concerning the interaction of 

U.S. Federal tax laws with the laws of foreign countries and tax treaties, see Joint Committee 

on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for 

Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS–3–01), 

April 2001 (vol. 1, pages 93–100). 37For further discussion and analysis of the issues raised by cross-border hybrid transactions, 

see Joint Committee on Taxation, Description of Revenue Provisions Contained in the Fiscal Year 

1999 Budget Proposal (JCS–4–98), February 24, 1998, at 193–196. 

However, the proposed treaty also provides an anti-abuse rule 

that eliminates the U.K. indirect credit in certain circumstances if 

the U.K. company receives an amount from a U.S. resident that is 

equivalent to a dividend from the U.S. company but is not an actual dividend from the U.S. company (i.e., a dividend substitute 

payment). Specifically, the proposed treaty provides that a U.K. 

company is not eligible for a credit against U.K. tax for U.S. taxes 

paid if and to the extent that (1) the United Kingdom treats the 

dividend from the U.S. company as beneficially owned by a U.K. 

resident, (2) the United States treats the same dividend as beneficially owned by a U.S. resident, and (3) the United States allows 

a deduction to a resident of the United States in respect of an 

amount determined by reference to the dividend. This anti-abuse 

provision is not found in any other U.S. treaty, and is not included 

in the U.S. model or the OECD model. 

The Technical Explanation provides the following example to illustrate the operation of the exception for certain dividend substitute payments: A U.S. holding company sells stock in another 

U.S. company to a U.K. company. Simultaneously, the U.S. holding 

company enters into a repurchase agreement with the U.K. company that allows the U.S. holding company to buy back the stock 

at a predetermined price. The sale and the repurchase agreement 

are structured in such a way that the transactions are treated together as a loan for U.S. tax purposes (with the dividends paid to 

the U.K. company treated as payments of interest on a loan from 

the U.K. company to the U.S. company). Because U.K. domestic 

law provides no mechanism for similarly treating the sale and repurchase in accordance with its economic substance, the United 

Kingdom would be required to respect the form of the transaction 

as a sale and grant an indirect credit with respect to dividends 

from the U.S. company, resulting in double non-taxation of income. 

In general, there are several types of cross-border transactions 

(often referred to as ‘‘hybrid’’ transactions) that take advantage of 

the interaction between (or among) the tax laws of two (or more) 

jurisdictions, which can independently give rise to different tax 

consequences under each country’s laws with respect to the same 

transaction.36 Some commentators argue that the interaction between U.S. domestic tax laws and foreign tax laws can lead to unwarranted tax arbitrage opportunities for taxpayers, particularly 

when the foreign laws and the U.S. tax rules yield inconsistent tax 

results for the same transaction.37 However, others contend that 

the potential for tax arbitrage in cross-border transactions is an 

unavoidable and acceptable consequence of different laws and complex tax systems in the U.S. and other countries that reflect the 

individual policy decisions of each jurisdiction. In any case, many 

commentators argue that efforts to combat cross-border tax arbitrage should be addressed in general provisions of domestic law 

81

38For example, although most recent U.S. tax treaties address structural cross-border tax arbitrage (among other things) with provisions concerning fiscally transparent entities, Congress 

enacted 894(c) in 1997 (Pub. L. No. 105–34) to deny certain treaty benefits to foreign persons 

with regard to items of income derived through U.S. entities that are treated as partnerships 

(or are otherwise treated as fiscally transparent) for U.S. tax purposes. In addition, section 

894(c) authorizes the Secretary of the Treasury to prescribe regulations to determine, in situations other than the situation specifically described in the statutory provision, the extent to 

which a taxpayer shall not be entitled to benefits under an income tax treaty of the United 

States with respect to any payment received by, or income attributable to activities of, an entity 

that is treated as a partnership for U.S. Federal income tax purposes (or is otherwise treated 

as fiscally transparent for such purposes) but is treated as fiscally non-transparent for purposes 

of the tax laws of the jurisdiction of residence of the taxpayer. 39 Because the provision is limited on a transactional basis to dividend substitute payments, 

it does not apply to several other types of cross-border tax arbitrage transactions. For example, 

the provision does not apply to multiple depreciation deductions that can be obtained through 

certain cross-border leasing transactions in which a taxpayer retains legal title to leased property in a country that provides depreciation deductions based upon legal (rather than economic) 

ownership of property, and transfers economic ownership of property to another party in a different country in which depreciation deductions are based upon economic (rather than legal) 

ownership. The provision is also limited on a jurisdictional basis to dividend substitute payments that are made to the U.K. By contrast, although Congress enacted section 894(c) in response specifically to the use of fiscally transparent U.S. subsidiaries by Canadian corporations 

to obtain multiple tax benefits, section 894(c) is not limited to transactions involving Canada. 40The Technical Explanation suggests that the provision is targeted appropriately because it 

will only apply with respect to transactions involving persons who own more than 10 percent 

of the U.S. company paying the dividends. The Technical Explanation states further that the 

repurchase price with respect to most sale-repurchase agreements reflects the current cost of 

funds, and is not determined by reference to the dividends paid on the stock. Consequently, the 

Technical Explanation concludes that the provision should not (and is not intended to) affect 

most sale-repurchase agreements and similar transactions that take place in the public markets. 

rather than specific tax treaty provisions of limited jurisdictional 

and transactional scope.38

The issue raised by the dividend substitute payment provision in 

the proposed treaty concerns the extent to which treaties should 

depart from the U.S. model to address transactional tax arbitrage 

and, specifically, whether the proposed treaty should address crossborder transactions in a manner that is categorically limited to a 

specific type of transaction and, by definition, is limited to transactions involving the United States and the United Kingdom.39 The 

provision could be characterized as being simultaneously too narrow and too broad. The provision might be too narrow in the sense 

that it may be readily avoided through transactions that are economically equivalent to the transactions covered by the provision 

but, for example, involve payments other than dividend substitute 

payments. On the other hand, the provision might be too broad in 

that it applies to all transactions that meet the specified conditions, 

without regard to whether the transaction was entered into for taxmotivated purposes or for legitimate business reasons.40 In this respect, the provision is broader than the conduit arrangement provision in the proposed treaty, which only applies if a main purpose 

of the transaction is to obtain increased benefits under the proposed treaty. In addition, whereas the conduit arrangement provision can preclude either U.S. or U.K. tax benefits under the proposed treaty, the provision concerning dividend substitute payments only provides for the loss of U.K. tax benefits (i.e., U.K. indirect foreign tax credits) rather than U.S. tax benefits (e.g., dividend 

substitute payment deductions), although the very application of 

the provision is contingent upon the deductibility of the payments 

under U.S. domestic tax law. 

The Committee might wish to consider the advisability of a treaty anti-abuse provision that is limited to denying U.K. indirect foreign tax credits for specific types of cross-border transactions, parVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00085 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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ticularly if the provision in the proposed treaty can be avoided 

through transactions that are economically equivalent to the transactions covered by the provision. In addition, because the provision 

is unique to the proposed treaty and the application of the provision is not conditioned upon the presence of a tax-motivated purpose, the Committee might wish to consider whether the provision 

could have the unintended effect of discouraging certain legitimate 

non-tax motivated cross-border securities repurchase and securities 

lending arrangements between taxpayers in the United States and 

the United Kingdom, particularly in relation to such transactions 

between taxpayers in the United States and another country. The 

Committee also might wish to consider under which circumstances 

rules against transactional tax arbitrage are more appropriately 

implemented in generally applicable U.S. domestic tax laws rather 

than narrow provisions in tax treaties with certain countries. 

E. Attribution of Business Profits 

Background 

Present treaty 

The present treaty provides that business profits are attributed 

to a permanent establishment based upon an arm’s-length pricing 

approach in which the permanent establishment is allocated an 

amount of profits that it might be expected to earn if it were a distinct and separate enterprise that is engaged in the same or similar activities under the same or similar conditions and deals wholly 

independently with the enterprise of which it is a permanent establishment (often referred to as the ‘‘separate enterprise’’ principle). 

In determining the amount of business profits attributable to a permanent establishment, the present treaty provides for the deduction of expenses incurred for the purposes of the permanent establishment, including a reasonable allocation of executive and general 

administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part of the enterprise that includes the permanent establishment), whether incurred in the treaty country in 

which the permanent establishment is situated or elsewhere. 

In general, the present treaty follows the OECD model in its approach to attributing business profits to a permanent establishment. Nevertheless, the rules under the present treaty for the attribution of business profits to a permanent establishment have 

been the subject of considerable commentary and debate, particularly in relation to U.S. domestic tax rules for determining the 

amount of interest expense that a foreign corporation may deduct 

against the U.S. taxable income of the foreign corporation. 

U.S. domestic tax law 

Under the general authority of section 482, U.S. domestic tax law 

provides the Secretary of the Treasury the power to make reallocations wherever necessary in order to prevent evasion of taxes or to 

clearly reflect the income of related enterprises. Under regulations, 

the Treasury Department implements this authority using an 

arm’s-length standard, and has indicated its belief that the standard it applies under section 482 is fully consistent with the arm’sVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00086 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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41The current OECD report on transfer pricing generally approves the methods that are incorporated in the current Treasury regulations under section 482 as consistent with the arm’slength principles upon which Article 9 (Associated Enterprises) of the present and proposed 

treaties, and Article 7 (Business Profits) of the proposed treaty, are based. See OECD Committee 

on Fiscal Affairs, ‘‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators’’ (1995). 42See Treas. Reg. sec. 1.882–5. 43See Rev. Rul. 85–7, 1985–1 C.B. 188 (income tax treaty between the United States and 

Japan); Rev. Rul. 89–115, 1989–2 C.B. 130 (present treaty between the United States and the 

United Kingdom). 44See, e.g., Technical Explanations of Tax Conventions with: The Republic of Austria, Treaty 

Doc. 104–31; The French Republic, Treaty Doc. 103–32; The Federal Republic of Germany, Treaty Doc. 101–10; Ireland, Treaty Doc. 105–31; The United Mexican States, Treaty Doc. 103–7; 

The Kingdom of The Netherlands, Treaty Doc. 103–6; The Portuguese Republic, Treaty Doc. 

103–34; The Swiss Confederation, Treaty Doc. 105–8; The Kingdom of Thailand, Treaty Doc. 

105–2; and The Republic of Turkey, Treaty Doc. 104–31. 

length standard provided in most U.S. tax treaties, including the 

present and proposed treaties with the United Kingdom.41

For purposes of determining the amount of interest expense that 

a foreign corporation engaged in a U.S. trade or business is permitted to deduct against U.S. taxable income, U.S. domestic tax 

law requires the use of an allocation formula that generally involves measuring the total assets and liabilities of a U.S. trade or 

business with a ‘‘constructed’’ (rather than actual) balance sheet for 

the U.S. trade or business, and then apportioning the interest expense (using a mathematical formula) among the tax jurisdictions 

that claim primary taxing rights over the portions of the whole enterprise of which the U.S. trade or business is a part.42 In contrast 

to this method, allocations using an arm’s-length standard generally are based upon the actual business records and accounts of 

the enterprise, including the records of branches on the basis of 

treating them as distinct and separate enterprises, with any adjustments that may be necessary to impute adequate capital to the 

branches and to ensure that any interbranch transactions taken 

into account have economic substance and market pricing. 

In applying an allocation formula to determine U.S. interest expense, the U.S. domestic tax laws require the foreign corporation 

to completely disregard interbranch transactions, such as loans between a U.S. branch of the foreign corporation and its head office. 

Thus, whereas allocations using an arm’s-length standard permit 

adjustments to interbranch transactions only to the extent necessary to reflect economic substance and market pricing, the allocation formula under U.S. domestic tax laws wholly disregards such 

transactions without any inquiry into their substance or pricing. 

Although the allocation formula of U.S. domestic tax law clearly 

applies to foreign corporations from countries that do not have a 

tax treaty with the United States, the rules also provide that they 

apply to foreign corporations from countries that do have a tax 

treaty with the United States. 

In published rulings, the Treasury Department has taken the position that the allocation formula under U.S. domestic tax law (including the disregard of interbranch transactions) is consistent 

with treaty provisions that govern the attribution of business profits to a U.S. permanent establishment of a foreign corporation that 

is resident in the other treaty country.43 The Treasury Department 

has expressed the same view in the technical explanations of several recently negotiated treaties,44 as well as the technical explaVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00087 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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45 National Westminster Bank, PLC v. United States, 44 Fed. Cl. 120 (1999); see also North 

West Life Assurance Co. of Canada v. Commissioner, 107 T.C. 363 (1996). 

nation of the U.S. model treaty. However, the position of the Treasury Department has been controversial and, in the case of the 

present treaty with the United Kingdom, recently has been rejected 

by the U.S. Court of Federal Claims, which concluded that the 

arm’s-length standard mandated by the present treaty fundamentally conflicts with formula-based allocation and, in particular, the 

U.S. domestic tax laws that mandate an allocation formula and disregard any interbranch transactions.45

Proposed treaty 

Like the present treaty, the proposed treaty includes provisions 

that attribute the business profits of an enterprise to a permanent 

establishment on the basis of treating the permanent establishment as if it were independent from the enterprise of which it is 

a permanent establishment. The provisions in the proposed treaty 

concerning attribution of business profits to a permanent establishment generally are similar to provisions in the U.S. model and 

OECD model, except for additional language in the proposed treaty 

that further limits the attribution of business profits to a permanent establishment on the basis of risks assumed (as well as assets 

used and activities performed) by the permanent establishment. 

The proposed treaty also does not include a provision from the U.S. 

model and OECD model that would preclude the attribution of 

business profits to a permanent establishment that solely purchases goods or merchandise for the enterprise, apparently because 

this provision is inconsistent with the arm’s-length standard. 

The diplomatic notes state that the OECD Transfer Pricing 

Guidelines apply by analogy in determining the profits attributable 

to a permanent establishment. With respect to financial institutions (other than insurance companies), the diplomatic notes state 

that a treaty country may determine the amount of capital to be 

attributed to a permanent establishment by allocating the institution’s total equity between (or among) its various offices on the 

basis of the proportion of the financial institution’s risk-weighted 

assets attributable to each office. 

Issues 

Attribution of business profits generally 

The provisions in the proposed treaty that attribute business 

profits to a permanent establishment present several issues. One 

issue concerns the continuing viability of U.S. domestic tax laws 

that require a formula-based allocation method for purposes of attributing business profits to a permanent establishment. The proposed treaty continues to apply the arm’s-length standard on the 

basis of language that is substantially similar to the present treaty. 

In addition, the proposed treaty actually enhances the application 

of the arm’s-length standard, for purposes of attributing business 

profits to a permanent establishment, by extending the OECD 

Transfer Pricing Guidelines and eliminating language that diverges 

from the arm’s-length standard. However, the Technical Explanation does not indicate expressly whether the Treasury DepartVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00088 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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ment maintains its view that the interest expense allocation formula under U.S. domestic tax law is consistent with the arm’slength standard under the proposed treaty. Instead, the Technical 

Explanation appears to indicate that, to the extent the tax consequences of applying the allocation formula under U.S. domestic 

law diverges from the consequences of applying the arm’s-length 

standard under the proposed treaty in determining the interest expense of a U.S. permanent establishment, U.K. residents with U.S. 

permanent establishments may effectively elect to apply either approach. 

The Committee may wish to satisfy itself that it understands the 

current state of the Treasury Department position concerning the 

continuing viability of the interest expense allocation formula 

under U.S. domestic tax law within the context of the proposed 

treaty, as well as existing and future treaties. 

Interbranch transactions 

Another issue related to the interest expense allocation formula 

under U.S. domestic tax law concerns the treatment of interbranch 

transactions under the proposed treaty. As described above, U.S. 

domestic tax law provides that interbranch loans and other interbranch transactions are completely disregarded in determining the 

amount of interest expense deductions that are allowable against 

the U.S. taxable income of a foreign corporation. By contrast, the 

Technical Explanation indicates that interbranch transactions generally may be respected under the proposed treaty. 

The OECD commentary for the OECD model provision upon 

which the proposed treaty is based provides that interbranch transactions generally are recognized in attributing business profits to 

a permanent establishment under arm’s-length standards, except 

for ‘‘purely artificial arrangements’’. The OECD commentary does 

provide that interbranch transactions should be disregarded unless 

they constitute the types of transactions that the permanent establishment would have otherwise conducted with unrelated third parties in the normal course of their business. In this regard, the 

OECD commentary states that interbranch lending transactions 

and interest generally should be disregarded, although ‘‘special considerations’’ are to be given to recognizing interbranch lending 

transactions of financial institutions. As with formula-based allocations in general, the Treasury Department position that disregarding interbranch transactions altogether under U.S. domestic 

tax law is consistent with the arm’s-length standard has been rejected in court with respect to interbranch lending transactions involving financial institutions. 

The Committee may wish to satisfy itself that it understands the 

current state of the Treasury Department position concerning the 

continuing viability of disregarding interbranch transactions for 

purposes of the interest expense allocation formula under U.S. domestic tax law within the context of the proposed treaty, as well 

as existing and future treaties. 

OECD interpretation of business profits attribution 

Another issue concerns the currently evolving OECD interpretation of the provisions in the OECD model that provide for attribVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00089 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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46See OECD Committee on Fiscal Affairs, ‘‘Discussion Draft on the Attribution of Profits to 

Permanent Establishment’’ (2001). The OECD has indicated that it expects to release on March 

4, 2003 a revised version of the discussion draft as it pertains to permanent establishments of 

banks. The OECD also has indicated that it expects to release in March 2003 a revised version 

of the discussion draft as it pertains to global trading of financial instruments. 

uting business profits to a permanent establishment, which are 

substantially similar to the provisions in the proposed treaty for 

business profits attribution. In February 2001, the OECD published a discussion draft in which the OECD considered how to further integrate the arm’s length standards of the 1995 OECD Transfer Pricing Guidelines into the business profits attribution provisions in the OECD model.46 The OECD discussion draft is significant for purposes of the proposed treaty because the diplomatic 

notes state that the OECD Transfer Pricing Guidelines are to apply 

by analogy for purposes of determining the business profits that 

are attributable to a permanent establishment under the proposed 

treaty. 

The OECD discussion draft generally attempts to outline a comprehensive approach that would apply the arm’s-length standard 

under the OECD Transfer Pricing Guidelines to a permanent establishment in a manner similar to the current treatment of affiliated entities under the provisions of the OECD model concerning 

associated enterprises. However, it is clear from the OECD discussion draft that extending the OECD Transfer Pricing Guidelines to 

permanent establishments is problematic in several respects, and 

the OECD discussion draft expresses concern with respect to the 

lack of consensus among OECD members regarding the manner in 

which the arm’s-length standard in the OECD Transfer Pricing 

Guidelines can accommodate the basic operational differences that 

exist between permanent establishments and affiliated entities. For 

example, the lack of documentation relating to interbranch transactions tends to be more prevalent than with respect to transactions between affiliated entities. 

The OECD discussion draft devotes considerable attention to the 

application of the OECD Transfer Pricing Guidelines to bank 

branches and, in particular, the manner in which the arm’s-length 

standard should take into account the financial risks assumed by 

a bank branch for purposes of allocating capital to the branch. For 

bank branches, the OECD discussion draft proposes a risk-based 

attribution of business profits using the 1988 capital measurement 

and capital adequacy standards set forth by the Basel Committee 

on Bank Supervision. The proposed treaty contemplates a similar 

risk-based approach by limiting the attribution of business profits 

to a permanent establishment on the basis of risks assumed (as 

well as assets used and activities performed) by the permanent establishment. However, attributing business profits to bank 

branches on the basis of non-tax regulatory standards is problematic for several reasons, including regulatory competition and arbitrage among regulatory jurisdictions. 

Because the diplomatic notes adopt the OECD Transfer Pricing 

Guidelines with regard to attributing business profits to a permanent establishment, the proposed treaty is effectively committed to 

the outcome of the currently evolving and somewhat controversial 

interpretation of the arm’s-length standard that was proposed in 

87

the OECD discussion draft. The Committee may wish to consider 

the potential implications of the eventual OECD interpretation on 

the future application of the proposed treaty with regard to the attribution of business profits to a permanent establishment. 

F. Income From the Rental of Ships and Aircraft 

The proposed treaty includes a provision found in the U.S. model 

and many U.S. income tax treaties under which profits from an enterprise’s operation of ships or aircraft in international traffic are 

taxable only in the enterprise’s country of residence. This provision 

includes income from the rental of ships and aircraft on a full basis 

(i.e., with crew) when such ships and aircraft are used in international traffic. However, in the case of profits derived from the 

rental of ships and aircraft on a bareboat basis (i.e., without crew), 

the rule limiting the right to tax to the country of residence applies 

to such rental profits only if the rental income is incidental to other 

income of the lessor from the operation of ships and aircraft in 

international traffic. If the lease is not merely incidental to the 

international operation of ships and aircraft by the lessor, then 

profits from rentals on a bareboat basis generally would be taxable 

by the source country as business profits (if such profits are attributable to a permanent establishment). 

In contrast, the U.S. model and many other treaties provide that 

profits from the rental of ships and aircraft operated in international traffic on a bareboat basis are taxable only in the country 

of residence, without requiring that the rental income be incidental 

to other profits of the lessor from the international operation of 

ships and aircraft. Thus, unlike the U.S. model, the proposed treaty 

provides that an enterprise that engages only in the rental of ships 

and aircraft on a bareboat basis, but does not engage in the operation of ships and aircraft, would not be eligible for the rule limiting the right to tax income from operations in international traffic 

to the enterprise’s country of residence. It should be noted that, 

under the proposed treaty, profits from the use, maintenance, or 

rental of containers used in international traffic are taxable only in 

the country of residence, regardless of whether the recipient of 

such income is engaged in the operation of ships or aircraft in 

international traffic. The Committee may wish to consider whether 

the proposed treaty’s rules treating profits from certain rentals of 

ships and aircraft on a bareboat basis less favorably than profits 

from the operation of ships and aircraft (or from the rental of ships 

and aircraft with crew) are appropriate. 

G. Creditability of U.K. Petroleum Revenue Tax 

Treatment under the proposed treaty 

The proposed treaty extends coverage to the U.K. Petroleum Revenue Tax (paragraph 3(b)(iv) of Article 2 (Taxes Covered)). Article 

24 of the proposed treaty (Relief from Double Taxation) further provides, among other things, that the U.K. Petroleum Revenue Tax 

is to be considered an income tax that is creditable against U.S. tax 

on income, subject to the provisions and limitations of that provision of the proposed treaty. 

88

47See paragraph 2 of Article 1 of the proposed treaty (General Scope), and accompanying description in the Technical Explanation. 

Specifically, the proposed treaty provides that the amount that 

the United States will allow as a credit against U.S. tax on income 

for U.K. Petroleum Revenue Taxes imposed on income from the extraction of minerals from oil or gas wells is limited to the amount 

attributable to U.K.-source taxable income. The proposed treaty 

further limits the creditable amount, however, to: (1) the product 

of the maximum statutory U.S. rate applicable to a corporation 

(i.e., 35 percent) and the amount of such extraction income; less (2) 

the amount of other U.K. taxes imposed on such extraction income. 

The proposed treaty provides that U.K. Petroleum Revenue Taxes 

from the extraction of minerals from oil or gas wells in excess of 

the above limitation may be used as a credit in the two preceding 

or five succeeding taxable years in accordance with the limitation 

described above. The proposed treaty further provides that its special rules on creditability apply separately and in the same way to 

the amount of U.K. Petroleum Revenue Tax imposed on income 

from the initial transportation, initial treatment, and initial storage of minerals from oil or gas wells in the United Kingdom. 

To the extent that a taxpayer would obtain a more favorable result with respect to the creditability of the U.K. Petroleum Revenue 

Tax under the Code than under the proposed treaty, the taxpayer 

could choose not to rely on the proposed treaty.47 The Technical 

Explanation to Article 24 of the proposed treaty states that if a 

person chooses in any year not to rely on the proposed treaty to 

claim a credit for U.K. Petroleum Revenue Taxes, then the special 

limitations under the proposed treaty would not apply for that 

year. Instead, the current overall foreign tax credit limitations of 

the Code would apply, and U.K. Petroleum Revenue Taxes creditable under the Code could be used, subject to the Code’s limitations, to offset U.S. tax on other income from U.K. and other foreign sources. 

Thus, the proposed treaty operates to create a separate ‘‘per 

country’’ limitation with respect to each U.S. category of extraction 

income, and initial transportation, treatment, and storage income 

on which U.K. Petroleum Revenue Tax is assessed. Accordingly, 

U.K. Petroleum Revenue Tax paid with respect to extraction income cannot be used as a credit to offset U.S. tax on: (1) oil and 

gas extraction income arising in another country; (2) U.K.-source 

transportation, treatment, or storage income on which U.K. Petroleum Revenue Tax is assessed; or (3) other U.K.-source non-oil related income. 

U.K. internal law 

The U.K. Petroleum Revenue Tax, introduced in 1975, is currently imposed at a rate of 50 percent on assessable profits from 

oil and gas extraction and certain other activities in the United 

Kingdom (including the North Sea) on a field-by-field basis. Under 

a separate Ring Fence Tax, oil and gas companies are required to 

segregate their income and expenses attributable to oil and gas related activities, and pay a separate corporate income tax for taxable income from unrelated activities. The U.K. Petroleum Revenue 

89

48 113 T.C. 338 (1999). 

Tax is imposed in addition to, and separate from, this Ring Fence 

Tax. The amount of U.K. Petroleum Revenue Tax paid is allowed 

as a deduction for purposes of computing the Ring Fence Tax. The 

U.K. Petroleum Revenue Tax applies to fields approved for development on or before March 15, 1993. Revenues from fields approved 

after March 15, 1993, are only subject to regular U.K. corporate income tax. 

The U.K. Petroleum Revenue Tax is imposed on income relating 

to the extraction of oil and gas in the United Kingdom including 

such areas as the North Sea, income earned by taxpayers providing 

transportation, treatment, and other services relating to oil and gas 

resources in such areas, and income relating to the sale of such oil 

and gas related assets. With the exception of interest expense, most 

significant costs and expenses are currently deductible in determining taxable income. Operating losses may be carried back or 

forward without limit to income associated with a particular field. 

Various other deductions and allowances are available against 

income assessed for these purposes, including: a supplemental uplift charge equal to 35 percent of most capital expenditures relating 

to a field; an oil allowance or exemption from the U.K. Petroleum 

Revenue Tax for each field up to a certain amount of metric tons 

of oil; a tariff receipts allowance for transportation receipts up to 

a certain amount, and certain non-field specific expenses such as 

research. 

Issues 

The proposed treaty treats the U.K. Petroleum Revenue Tax, and 

any substantially similar tax, as a creditable tax for U.S. foreign 

tax credit purposes. The United States Tax Court has recently addressed the creditability under the Code and the regulations under 

Code section 901 of the U.K. Petroleum Revenue Tax in the case 

of Exxon v. Commissioner.48

In Exxon v. Commissioner, the United Kingdom granted licenses 

to Exxon for the exploitation of petroleum resources in the U.K.’s 

segment of the North Sea. Under those licenses, Exxon paid royalties, upfront fees, and annual fees. After the grant of the licenses, 

the U.K. enacted a modified version of the U.K. corporate income 

tax (the Ring Fence Tax) and the U.K. Petroleum Revenue Tax for 

oil production activities. The Tax Court considered whether the 

U.K. Petroleum Revenue Tax satisfied the net income requirement 

under the section 901 regulations and whether the U.K. Petroleum 

Revenue Tax was paid in exchange for a specific economic benefit 

(e.g., a royalty and not a tax). With respect to the net income issue, 

the court held that, notwithstanding the nondeductibility of interest expense in computing taxable income, the various allowances 

against the U.K. Petroleum Revenue Tax (particularly the 35 percent uplift charge which based on the Court’s findings significantly 

exceeded interest expense) resulted in the predominant character of 

the tax being in the nature of an income or profits tax in the U.S. 

sense. With respect to the specific economic benefit issue, the court 

held that the U.K. Petroleum Revenue Tax paid for the years in 

question (1983–1988) constituted taxes and not payments for speVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00093 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
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49The Court further based its holding that Exxon did not pay the U.K Petroleum Revenue 

Tax in exchange for specific economic benefits based on the following: (1) the royalties and other 

fees paid by Exxon represented substantial and reasonable compensation, (2) the U.K.’s purposes in enacting the U.K. Petroleum Revenue Tax was to take advantage of increases in oil 

prices and to assure itself of a share of those excess profits, and (3) the U.K. Petroleum Revenue 

Tax had all of the characteristics of a tax and was intended to be a tax. 50 2001–31 I.R.B. 98 (August 20, 2001). 

cific economic benefits. In so holding, the court relied on the fact 

that Exxon acquired its licenses to extract oil from the North Sea 

before the U.K. Petroleum Revenue Tax was enacted and that it received no new or additional benefits as a result of paying the U.K. 

Petroleum Revenue Tax.49 The court thus found the U.K. Petroleum Revenue Tax paid by Exxon to be creditable under U.S. law. 

The Internal Revenue Service acquiesced in the Exxon decision, 

but only as to its results.50 The Internal Revenue Service indicated 

in its acquiescence that it will only follow the opinion in disposing 

of cases involving the U.K. Petroleum Revenue Tax where the facts 

are substantially similar to those in the Exxon case. Since such determinations are inherently factual, the determination of the creditability of the U.K. Petroleum Revenue Tax under U.S. law as a 

general matter is unclear. 

If the U.K. Petroleum Revenue Tax would generally be considered creditable under the Code, then there may be a question as 

to the need for the additional limitations provided under the proposed treaty for determining the amount of creditable U.K. Petroleum Revenue Tax. Taxpayers are likely to rely on the proposed 

treaty only to the extent that it provides them with a more favorable foreign tax credit result than would otherwise result from the 

application of the Code. In addition, since the U.K. Petroleum Revenue Tax has been eliminated with respect to fields approved after 

March 15, 1993, it is unclear to what extent these creditability 

issues will remain important in future years. 

On the other hand, to the extent that it is unclear whether the 

U.K. Petroleum Revenue Tax is generally considered to be creditable under U.S. law, the primary issue is the extent to which 

treaties should be used to provide a credit for taxes that may not 

otherwise be fully creditable and, in cases where a treaty does provide creditability, to what extent the treaty should impose limitations not contained in the Code. A related issue is whether a controversial matter in U.S. tax policy such as the tax credits to be 

allowed U.S. oil companies on their foreign extraction operations 

should be resolved through the treaty process rather than through 

the normal legislative process. 

Similar provisions making Denmark’s Hydrocarbon Tax, Norway’s Submarine Petroleum Resource Tax, and the Netherlands’s 

Profit Share creditable are contained in the U.S.-Denmark income 

tax treaty, the protocol to the U.S.-Norway income tax treaty, and 

the U.S.-Netherlands income tax treaty, respectively. Also at issue, 

therefore, is whether the United Kingdom should be denied a special treaty credit for taxes on oil and gas extraction income when 

Denmark, Norway, and the Netherlands, its North Sea competitors, 

now receive a similar treaty credit under the U.S. income tax treaties with those countries currently in force. On the one hand, it 

would appear fair to treat the United Kingdom like Denmark, Norway, and the Netherlands. On the other hand, the United States 

91

51The text of the proposed reservation is reprinted at 124 Cong. Rec. S9559 (daily ed., June 

27, 1978). 

should not view any particular treaty concession to one country as 

requiring identical or similar concessions to other countries. 

The present treaty contains a similar provision providing for the 

creditability of the U.K. Petroleum Revenue Tax. During Senate 

consideration of the third protocol to the present treaty, a reservation was proposed to apply similar per-country limitations to prevent U.S. oil companies from using the U.K. Petroleum Revenue 

Tax as a credit against their U.S. tax liability on extraction income 

from other countries.51 The reservation was withdrawn and the 

per-country limitations were included in that protocol to the 

present treaty. 

The Committee may wish to satisfy itself as to whether, to the 

extent that the creditability of the U.K. Petroleum Revenue Tax is 

unclear under U.S. law, the proposed treaty is an appropriate vehicle for granting such creditability. 

H. Teachers, Students, and Trainees 

Treatment under proposed treaty 

General rule 

The proposed treaty generally would not change the application 

of income taxes to certain individuals who visit the United States 

or United Kingdom as students, teachers, academic researchers, or 

so-called ‘‘business apprentices’’ engaged in full-time training. The 

present treaty (Article 20) provides that a professor or teacher who 

visits the United States from the United Kingdom or the United 

Kingdom from the United States for a period of two years or less 

to engage in teaching or research at a university or college is exempt from tax by the host country on any remuneration received 

for such teaching or research. In addition, the present treaty (Article 21) provides that certain payments that a student or business 

apprentice who visits the United States from the United Kingdom 

or the United Kingdom from the United States to pursue full-time 

education at a university or college or to engage in full-time training are exempt from taxation by the host country. The exempt payments are limited to those payments the individual may receive for 

his or her maintenance, education or training as long as such payments are from sources outside the host country. 

Under Article 20 of the proposed treaty, U.S. taxpayers who are 

visiting the United Kingdom and individuals who immediately 

prior to visiting the United States was resident in the United Kingdom will be exempt from income tax in the host country on certain 

payments received if the purpose of their visit is to engage in fulltime education at a university or college or to engage in full-time 

training. The exempt payments are limited to those payments the 

individual may receive for his or her maintenance, education or 

training as long as such payments are from sources outside the 

host country. In the case of individuals engaged in full-time training, the exemption from income tax in the host country applies only 

for a period of one year or less. 

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52For years after 2007, the $80,000 amount is indexed for inflation after 2006 (Code sec. 

911(b)(2)(D)). 

Under Article 20A of the proposed treaty, U.S. taxpayers who are 

visiting the United Kingdom and individuals who immediately 

prior to visiting the United States was resident in the United Kingdom will be exempt from income tax in the host country on remuneration they receive for teaching or research at a university, college, or other recognized educational institution. The exemption is 

limited to visiting periods of two years or less. 

Transition rule 

Under the entry in force provisions of the proposed treaty (Article 29), taxpayers may elect temporarily to continue to claim benefits under the present treaty with respect to a period after the proposed treaty takes effect. For an individual engaged in full-time 

training, Article 21 of the present treaty would continue to have effect in its entirety until such time as the individual had completed 

his or her training. For some individuals this special rule may provide benefits under the present treaty that exceed those available 

under the general transition rule. The general transition rule 

would provide that an individual would have the benefits of the 

present treaty for twelve months from the date on which the proposed treaty comes into force. 

Issues 

General rule 

Teachers and professors.—Unlike the U.S. model, but like the 

present treaty, the proposed treaty would provide an exemption 

from the host country income tax for income an individual receives 

from teaching or research in the host country. Prior to amendment 

by the protocol, the proposed treaty would have followed the U.S. 

model and no such exemption would have been provided. Article 20 

of the present treaty and Article 20A of the proposed treaty provide 

that a teacher who visits a country for the purpose of teaching or 

engaging in research at a recognized educational institution generally is exempt from tax in that country for a period not exceeding 

two years. Under the proposed treaty, a U.S. person who is a teacher or professor may receive effectively an exemption from any income tax for income earned related to visiting the United Kingdom 

for the purpose of engaging in teaching or research for a period of 

two years or less. Under the terms of the treaty, the United Kingdom would exempt any such income of a U.S. person from U.K. income tax. Under Code sec. 911, $80,000 would be exempt from U.S. 

income tax in 2003 through 2007,52 and in addition certain living 

expenses would be deductible from income. To the extent the U.S. 

teacher’s or professor’s remuneration related to his or her visit to 

the United Kingdom was less that $80,000, the income would be 

tax free. Likewise, under the proposed treaty, a U.K. person who 

is a teacher or professor may receive effectively an exemption from 

any income tax for income earned related to visiting the United 

States for the purpose of engaging in teaching or research for a period of two years or less. Under the terms of the treaty, the United 

States would exempt any such income from U.S. income tax. Under 

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53The treaties with Italy, Slovenia, and Venezuela, each considered in 1999, contain provisions exempting the remuneration of visiting teachers and professors from host country income 

taxation. The treaties with Denmark, Estonia, Latvia, and Lithuania, also considered in 1999, 

did not contain such an exemption, but did contain a more limited exemption for visiting researchers. 

the terms of U.K. tax law, such income generally would not be taxable by the U.K. as the individual would not be resident in the 

United Kingdom. 

The effect of the proposed treaty is to make such cross-border 

visits more attractive financially. Ignoring relocation expenses, a 

U.S. citizen or permanent resident may receive more net, after-tax 

remuneration from teaching or research from visiting the United 

Kingdom as a teacher or researcher than if he or she had remained 

in the United States. Likewise a U.K. resident may receive more 

net, after-tax remuneration from teaching or research from visiting 

the United States as a teacher or researcher than if he or she had 

remained in the United Kingdom. Increasing the financial reward 

may serve to encourage cross-border visits by academics. Such 

cross-border visits by academics for teaching and research may foster the advancement of knowledge and redound to the benefit of 

residents of both countries. 

On the other hand, complete exemption from income tax in both 

the United States and the United Kingdom may be seen as unfair 

when compared to persons engaged in other occupations whose occupation or employment may cause them to relocate temporarily 

abroad. For a U.S. citizen or permanent resident who is not a 

teacher or professor, but who temporarily takes up residence and 

employment in the United Kingdom, his or her income is subject 

to income tax in the United Kingdom and may be subject income 

tax in the United States. Likewise, for a U.K. resident who is not 

a teacher or professor, but who temporarily takes up residence and 

employment in the United States, his or her income is subject to 

income tax in the United States. In other words, the proposed treaty could be said to violate the principle of horizontal equity by 

treating otherwise similarly economically situated taxpayers differently. 

The proposed treaty reverses the position of the originally proposed treaty with respect to visiting teachers and professors. Prior 

to amendment by the protocol, the proposed treaty would have followed the U.S. model and no such exemption would have been provided. While this is the position of the U.S. model, an exemption 

for visiting teachers and professors has been included in many bilateral tax treaties. Of the more than 50 bilateral income tax treaties in force, 30 include provisions exempting from host country 

taxation the income of a visiting individual engaged in teaching or 

research at an educational institution, and an additional 10 treaties provide a more limited exemption from taxation in the host 

county for a visiting individual engaged in research. Although the 

proposed protocols with Australia and Mexico would not include 

similar provisions, three of the most recently ratified income tax 

treaties did contain such a provision.53

The Committee may wish to satisfy itself that the inclusion of 

such an exemption for a limited class of individuals is appropriate. 

Looking beyond the U.S.-U.K. treaty relationship, the Committee 

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54More broadly, since the U.S. model has not been updated since 1996, the Committee may 

wish to ask whether the Treasury Department intends to update the model to reflect all relevant developments that have occurred in the intervening years. A thoroughly updated model 

would provide a more meaningful and useful guide to current U.S. tax treaty policy and would 

thereby increase transparency and facilitate congressional oversight in this important area. See, 

Recommendations for Simplification, Pursuant to Section 8002(3)(B) of the Internal Revenue 

Code of 1986 (JCS–3–01), April 2001, Vol. II, at 445–47 (recommending that the Treasury Department revise U.S. model tax treaties once per congress). 

may wish to determine whether the inclusion of the exemption 

from host country taxation for visiting teachers and professors signals a broader shift in U.S. tax treaty policy. Specifically, the Committee may want to know whether the Treasury Department intends to pursue similar provisions in other proposed treaties in the 

future and intends to amend the U.S. model to reflect such a development.54

Full-time students and persons engaged in full-time training.— The present treaty has no limitation on the duration of such training. As was the case for teachers and professors, described above, 

the proposed treaty generally has the effect of exempting payments 

received for the maintenance, education, and training of full-time 

students and persons engaged in full-time training as a visitor 

from the United States to the United Kingdom or as a visitor from 

the United Kingdom to the United States from the income tax of 

both the United States and the United Kingdom. This conforms to 

the U.S. model and OECD model provisions with respect to students and trainees. 

This provision generally would have the effect of reducing the 

cost of such education and training received by visitors. The proposed treaty would narrow the exemption provided under the current treaty to persons who are engaged in full-time training by limiting the exemption in the case of a business apprentice to payments made relating to training received during a period of one 

year or less. (The exemption for full-time students remains unchanged from the current treaty.) By potentially subjecting such 

payments to host country income tax, the cost for cross-border visitors of engaging in such longer duration training programs would 

be increased. This may discourage visitors to such programs in 

both the United States and the United Kingdom. It could be argued 

that the training of a business apprentice relates primarily to specific job skills of value to the individual or the individual’s employer rather than enhancing general knowledge and cross-border 

understanding, as may be the case in the university or college education of a full-time student. This could provide a rationale for providing more open-ended treaty benefits in the case of students as 

opposed to business apprentices. However, if this provides the underlying rationale, a question might arise as to why training requiring one year or less is preferred to training that requires a 

longer visit to the host country. As such, the proposed treaty would 

favor certain types of training arrangements over others. 

Transition rule 

The primary issue is the extent to which a special transition rule 

should be included in U.S. tax treaties. It is the staff’s understanding that there is not a similar precedent for such a special 

transition rule in other U.S. tax treaties. The proposed treaty conVerDate Jan 31 2003 21:20 Feb 28, 2003 Jkt 085199 PO 00000 Frm 00098 Fmt 6604 Sfmt 6602 E:\HR\OC\A199.XXX A199
95

tains a general grandfather provision that would allow taxpayers, 

including trainees, to continue to apply the provisions of the 

present treaty for one year. It could be argued that the general 

grandfather provision sufficiently addresses the transition of all 

taxpayers into the proposed treaty. It also could be argued that the 

special transition rule for trainees results in disparate treatment 

for other taxpayers that do not get the benefit of similar transition 

rules for other provisions of the proposed treaty. It further could 

be argued that this rule may be viewed as a precedent to provide 

similar or possibly even broader transition relief with respect to future revisions of existing treaties for benefits that may not be 

viewed as appropriate or consistent with current U.S. treaty policy 

or are otherwise viewed as inconsistent with the purposes of an income tax treaty. 

On the other hand, the special transition rule presumably was 

included to provide relief for trainees who may have based their decisions to begin training upon the assumption that the relevant 

provisions of the present treaty would apply to them. The general 

one-year grandfather provision may not provide complete relief for 

such individuals. There also may be a general expectation among 

taxpayers that subsequently renegotiated tax treaties generally do 

not restrict benefits contained in existing treaties, but instead often 

provide further benefits. It could be argued that these special transition rules apply to a limited class of taxpayers and only for a limited period of time beyond the general grandfather period. 

The Committee may wish to satisfy itself as to the appropriateness of including a special transition rule such as that described 

above in U.S. tax treaties.

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