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[Senate Executive Report 108-2]
[From the U.S. Government Publishing Office]

108th Congress                                               Exec. Rpt.
                                 SENATE
 1st Session                                                      108-2

======================================================================

 
                 TAX CONVENTION WITH THE UNITED KINGDOM

                                _______
                                

                 March 13, 2003.--Ordered to be printed

                                _______
                                

           Mr. Lugar from the Committee on Foreign Relations,
                        submitted the following

                              R E P O R T

                   [To accompany Treaty Doc. 107-19]

    The Committee on Foreign Relations, to which was referred 
the Convention between the Government of the United States of 
America and the Government of the United Kingdom of Great 
Britain and Northern Ireland for the Avoidance of Double 
Taxation and the Prevention of Fiscal Evasion with Respect to 
Taxes on Income and on Capital Gains, signed at London on July 
24, 2001, together with an Exchange of Notes, as amended by the 
Protocol signed at Washington on July 19, 2002, having 
considered the same, reports favorably thereon and recommends 
that the Senate give its advice and consent to ratification 
thereof, as set forth in this report and the accompanying 
resolution of ratification.

                                CONTENTS

                                                                   Page
  I. Purpose..........................................................1
 II. Background.......................................................2
III. Summary..........................................................2
 IV. Entry Into Force and Termination.................................3
  V. Committee Action.................................................4
 VI. Committee Comments...............................................5
VII. Budget Impact...................................................16
VIII.Explanation of Proposed Treaty..................................17

 IX. Text of Resolution of Ratification..............................17

                               I. Purpose

    The principal purposes of the proposed income tax treaty 
between the United States and the United Kingdom 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 continue 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.

                             II. Background

    The proposed treaty was signed on July 24, 2001. The United 
States and the United Kingdom exchanged notes on the same day 
to provide clarification with respect to the application of the 
proposed treaty. The proposed protocol was signed on July 19, 
2002. The proposed treaty, together with the proposed protocol 
and the exchange of notes, would replace the existing income 
tax treaty between the United States and the United Kingdom 
that was signed in 1975.
    The proposed treaty, together with the proposed protocol 
and the exchange of notes, was transmitted to the Senate for 
advice and consent to its ratification on November 14, 2002 
(see Treaty Doc. 107-19). The Committee on Foreign Relations 
held a public hearing on the proposed treaty on March 5, 2003.

                              III. Summary

    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.
    As in other U.S. tax treaties, the purposes of the treaty 
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).
    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).

                  IV. Entry Into Force and Termination

                          A. ENTRY INTO FORCE

    The proposed treaty will enter into force upon the exchange 
of instruments of ratification. The effective dates of the 
treaty's provisions, however, vary.
    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. With respect to petroleum 
revenue taxes, 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 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.

                             B. 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 is 
effective for chargeable periods beginning on or after the date 
that is six months following notice of termination.

                          V. Committee Action

    The Committee on Foreign Relations held a public hearing on 
the proposed treaty with the United Kingdom (Treaty Doc. 107-
19) on March 5, 2003. The hearing was chaired by Senator 
Hagel.\1\ The Committee considered the proposed treaty on March 
12, 2003, and ordered the proposed treaty with the United 
Kingdom favorably reported by a vote of 19 in favor and 0 
against, with the recommendation that the Senate give its 
advice and consent to ratification of the proposed treaty.
---------------------------------------------------------------------------
    \1\ The transcript of this hearing will be forthcoming as a 
separate Committee print.
---------------------------------------------------------------------------

                         VI. Committee Comments

    On balance, the Committee on Foreign Relations believes 
that the proposed treaty with the United Kingdom is in the 
interest of the United States and urges that the Senate act 
promptly to give advice and consent to ratification. The 
Committee has taken note of certain issues raised by the 
proposed treaty and believes that the following comments may be 
useful to the Treasury Department officials in providing 
guidance on these matters should they arise in the course of 
future treaty negotiations.

  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 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. 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.

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, withholding taxes may not be fully creditable as a 
practical matter, thus leaving some double taxation in place. 
For 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 dividend-receiving corporation as a direct investor 
(and taxpayer) in the source country in this respect, rather 
than regarding the dividend-receiving 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.
    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. 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 United States by U.K. persons 
displaced other foreign or U.S. investments 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.

Committee conclusions

    The Committee believes that every tax treaty must strike 
the appropriate balance of benefits in the allocation of taxing 
rights. The agreed level of dividend withholding for 
intercompany dividends is one of the elements that make up that 
balance, when considered in light of the benefits inuring to 
the United States from other concessions the treaty partner may 
make, the benefits of facilitating stable cross-border 
investment between the treaty partners, and each partner's 
domestic law with respect to dividend withholding tax.
    In the case of this treaty, considered as a whole, the 
Committee believes that the elimination of withholding tax on 
intercompany dividends appropriately addresses a barrier to 
cross-border investment. The Committee believes, however, that 
the Treasury Department should only incorporate similar 
provisions into future treaty or protocol negotiations on a 
case-by-case basis, and it notes with approval Treasury's 
statement that ``[i]n light of the range of facts that should 
be considered, the Treasury Department does not view 
[elimination of withholding tax on intercompany dividends] as a 
blanket change in the United States' tax treaty practice.''
    The Committee encourages the Treasury Department to develop 
criteria for determining the circumstances under which the 
elimination of withholding tax on intercompany dividends would 
be appropriate in future negotiations with other countries. The 
Committee expects the Treasury Department to consult with the 
Committee with regard to these criteria and to the 
consideration of elimination of the withholding tax on 
intercompany dividends in future treaties.

                          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)). 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.\2\
---------------------------------------------------------------------------
    \2\ See 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.
---------------------------------------------------------------------------
    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 outside 
the context of the insurance excise tax, because U.S. domestic 
law provides detailed rules governing arrangements to reduce 
U.S. tax through the use of conduits. \3\ 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.
---------------------------------------------------------------------------
    \3\ See Code sec. 7701(l); Treas. Reg. sec. 1.881-3.
---------------------------------------------------------------------------

Description of provision

    Under the proposed general 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 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

    The proposed general anti-conduit 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. domestic-law 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.
    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.
    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 anti-conduit principles to the insurance 
        excise tax).\4\
---------------------------------------------------------------------------
    \4\ See Letter from Barbara M. Angus, International Tax Counsel, 
Department of the Treasury, to Gabriel Makhlouf, Director, Inland 
Revenue, International Division, July 19, 2002.

    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. This 
statement of intent from the U.S. perspective should 
substantially mitigate the potential uncertainty regarding how 
the United States will treat conduit arrangements.
    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.
    On balance, the Committee believes that the exchange of 
letters along with the attached examples provide adequate 
guidance as to the application of these anti-conduit rules that 
were included in the proposed treaty at the request of the 
United Kingdom.

             C. 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.
    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. 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 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.
    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.\5\
---------------------------------------------------------------------------
    \5\ 113 T.C. 338 (1999).
---------------------------------------------------------------------------
    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 specific 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.\6\ The court thus found the 
U.K. Petroleum Revenue Tax paid by Exxon to be creditable under 
U.S. law.
---------------------------------------------------------------------------
    \6\ The 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.
---------------------------------------------------------------------------
    The Internal Revenue Service acquiesced in the Exxon 
decision, but only as to its results.\7\ 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.
---------------------------------------------------------------------------
    \7\ 2001-31 I.R.B. 98 (August 20, 2001).
---------------------------------------------------------------------------
    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 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. 
\8\ The reservation was withdrawn and the per-country 
limitations were included in that protocol to the present 
treaty.
---------------------------------------------------------------------------
    \8\ The text of the proposed reservation is reprinted at 124 Cong. 
Rec. S9559 (daily ed., June 27, 1978).
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                  D. TEACHERS, STUDENTS, AND TRAINEES

Treatment under proposed treaty

    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 were 
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 full-time 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.
    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 were 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

    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,\9\ 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 than $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 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.
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    \9\ For years after 2007, the $80,000 amount is indexed for 
inflation after 2006 (Code sec. 911(b)(2)(D)).
---------------------------------------------------------------------------
    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.\10\
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    \10\ The 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.
---------------------------------------------------------------------------

Committee conclusions

    The Committee notes that while the provision regarding the 
taxation of visiting teachers and professors is inconsistent 
with the U.S. Model, over half of the bilateral income tax 
treaties in force contain a similar provision. The provision in 
the U.K. treaty was included in three of the seven income tax 
treaties reported by the Committee in 1999. However, the 
provision was not included in the proposed protocols with 
Mexico and Australia under consideration by the Committee. The 
Committee encourages the Treasury Department to develop 
criteria for determining under what circumstances this 
provision is appropriate.

                           VII. Budget Impact

    The Committee has been informed by the staff of the Joint 
Committee on Taxation that the proposed treaty is estimated to 
cause a negligible change in Federal budget receipts during the 
fiscal year 2003-2012 period.

                  VIII. Explanation of Proposed Treaty

    A detailed, article-by-article explanation of the proposed 
income tax treaty between the United States and the United 
Kingdom can be found in the pamphlet of the Joint Committee on 
Taxation entitled Explanation of Proposed Income Tax Treaty 
Between the United States and the United Kingdom (JCS-4-03), 
March 3, 2003.

                 IX. Text of Resolution of Ratification

    Resolved (two-thirds of the Senators present concurring 
therein), That the Senate advise and consent to the 
ratification of the Convention between the Government of the 
United States of America and the Government of the United 
Kingdom of Great Britain and Northern Ireland for the Avoidance 
of Double Taxation and the Prevention of Fiscal Evasion with 
Respect to Taxes on Income and on Capital Gains, signed at 
London on July 24, 2001, together with an Exchange of Notes, as 
amended by the Protocol signed at Washington on July 19, 2002 
(Treaty Doc. 107-19).

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