The pending income tax treaty with the United Kingdom was approved by the Senate on March 13, 2003. For U.S. purposes, the new Treaty is likely to become generally effective for taxable years beginning on or after January 1, 2004. (The provisions concerning U.S. withholding tax obligations will actually come into effect as of the first day of the second month after the exchange of instruments of ratification.)
The new U.K. Treaty has many unique features. One such feature is the inclusion of a "conduit arrangement" test that could restrict treaty benefits otherwise available for dividends, interest, royalties, other income, and insurance premiums paid with respect to U.S. risks. The "conduit arrangement" provision is a modified version of the "main purpose" provision included in the Slovenia and Italy treaties but rejected by the Senate for vagueness. The provision is designed to respond to that criticism by containing both an objective test and a subjective "main purpose" test. From a U.S. standpoint, the greatest impact of the "conduit arrangement" provision may well be on U.K. reinsurance business with companies based in jurisdictions such as Bermuda and Barbados.
Section 4371 imposes an excise tax of 1% to 4% on premiums paid to a foreign insurer or reinsurer with respect to coverage of U.S. risks. Article 7(6A) of the current U.S.-U.K. Treaty contains a blanket exemption from the excise tax for premiums paid to a U.K. insurance company. In contrast to the situation under the U.S. treaties with countries such as Germany, Switzerland and Ireland, the exemption currently is not lost if the U.K. company reinsures its risks with another company that would not enjoy equivalent treaty benefits.
Article 7(5) of the new U.K. Treaty preserves the excise tax exemption, but with a new exception for premiums paid to a U.K. company for insurance or reinsurance policies entered into as part of a "conduit arrangement." Under Article 3(1)(n) of the new Treaty, the term "conduit arrangement" is defined, so far as here pertinent, as a transaction or series of transactions structured in such a way that a U.K. insurance company entitled to Treaty benefits pays (at any time or in any form) all or substantially all of the premiums it receives in the transaction to another person residing in a third country who is not entitled under a different treaty with the U.S. to equivalent (or more favorable) benefits than those available under the U.K. Treaty, and the main purpose, or one of the main purposes, of the transaction is to obtain the benefits available under the U.K. Treaty. Bermuda and Barbados are examples of jurisdictions where the excise tax exemption is not available because of the 1988 Congressional override of the exemption provision in their respective treaties with the United States.
The objective test under the new Treaty looks to whether a U.K. company receiving a presumptively exempt premium subsequently pays "all or substantially all" of that premium to "another person" in a third country who would not be entitled to equivalent treaty benefits on its own. If so, and if the subjective "main purpose" test is also satisfied, the premium paid to the U.K. company will lose its exemption.
The recently released Technical Explanation to the new U.K. Treaty provides that the "conduit arrangement" rules will be applied in a manner consistent with the "conduit" regulations under Regs. §1.881-3, dealing with multi-party financing arrangements. The Technical Explanation further explains that the terms "main purpose" and "principal purpose" are synonymous and that the United States will interpret the main purpose requirement of the Treaty consistent with Regs. §1.881-3 and other U.S. anti-abuse rules (such as the business purpose doctrine) that look to the purposes of a transaction.
The Treasury Technical Explanation provides two examples illustrating when the new rules would apply. In the first example, UKCo owns USCo. Both entities are involved in the insurance business with USCo insuring U.S. risks. A third insurance company, XCo, located in a non-treaty country, wishes to reinsure 25% of the U.S. risks of USCo, without incurring the U.S. insurance excise tax. Accordingly, a transaction is entered into in which USCo pays a premium to UKCo for the reinsurance of 25% of USCo's U.S. risks, followed by a payment by UKCo to XCo of substantially all of that premium as consideration for the reinsurance of those same risks by XCo. The example concludes that because both the objective test and the main purpose test are satisfied, UKCo will be subject to the excise tax on the reinsurance premium it received from USCo. In the second example, the premiums paid to UKCo are attributable to its U.S. permanent establishment and are therefore subject to regular U.S. income tax. As a result, the insurance excise tax does not apply. See §4373(1).
If the conduit arrangement rules are applied literally, they will be triggered only if substantially all of the premium received by the U.K. company is paid to one company,i.e., "to another person." One potential avenue for avoiding the new rules that suggests itself would involve having the U.K. company divide among two or more reinsurance companies the U.S. risks it seeks to reinsure. In such a case, the U.K. company presumably would pay to each such company less than "substantially all" of the premium it received for taking on the risks in the first instance. As a result, the objective test would not be satisfied and the new rules would not come into play.
The Treaty does not provide a definition of the term "substantially all." Consequently, under Article 3(2) of the Treaty, for U.S. tax purposes, the term presumably will be defined by reference to U.S. tax law. The Internal Revenue Code also does not provide a definition of the term, but certainly less than 50% cannot be "substantially all" for this purpose.
It is also possible that the new rules would not apply whenever the reinsurance arrangement involves an unrelated reinsurer that has no knowledge or reason to know that it is participating in a conduit arrangement. Under Regs. §1.881-3(a)(3)(ii)(E), a financing entity that is unrelated to both the intermediate entity and the financed entity is relieved of any tax liability under the financing arrangement. Moreover, there is a presumption that an unrelated financing entity does not know or have reason to know that the arrangement is a conduit arrangement under certain circumstances.
The Treaty Technical Explanation example described above appears to involve an unrelated reinsurer, XCo. In the example, the subjective test was met because XCo proposed the arrangement and thus both XCo and UKCo (and perhaps even USCo) had knowledge that the transaction had as a main purpose the securing of the excise tax benefit for XCo.
The very nature of the subjective test raises a number of questions about its application. For example, will the Closing Agreement procedure that is available to insurance companies facing loss of the excise tax exemption if they reinsure U.S. risks with a company not entitled to equivalent treaty benefits without regard to subjective intent (see Rev. Proc. 92-39, 1992-1 C.B. 860) also be available to U.K. companies in light of the subjective intent test in the new U.K. Treaty? If so, securing the requisite Closing Agreement should relieve U.S. companies of any exposure to the excise tax in the event of a subsequent transaction that might trigger loss of the exemption under the new Treaty. See §4374.
If the Closing Agreement procedure does not become available to U.K. companies, query whether the subjective test should be ever satisfied in those cases where XCo is an unrelated company that simply engages in a reinsurance transaction with UKCo in the ordinary course of its business. In other words, should a "pure" XCo automatically preclude application of the new rules?
Also, absent the ability of a U.S. company to rely on a Closing Agreement, should a duty of inquiry be placed on every U.S. company seeking to engage in a reinsurance transaction with a U.K. company? Would the purposive collaboration of UKCo and XCo be sufficient to satisfy the subjective test, thereby exposing USCo to liability for the excise tax even though USCo may be completely ignorant of the other companies' activity, let alone their intent? If so, U.S. companies may need to consider whether they can secure contractual protection against the possibility of such an adverse result. If there is no duty of inquiry, we could readily see the adoption of a "don't ask, don't tell" policy by all U.S. companies seeking to insure or reinsure with a U.K. company. See generally Berner and May, "The New U.K.-U.S. Income Tax Treaty," 30 Tax Mgmt. Int'l J. 499, 506 (11/9/01).
The inclusion in the new U.K. Treaty of the "conduit arrangement" provisions certainly could impact the transatlantic insurance and reinsurance business in ways that may not be fully appreciated at this time.
This commentary also will appear in the May 9, 2003, issue of the Tax Management International Journal. In the Tax Management Portfolios, a summary of key changes to be introduced by the new U.S.-U.K. Treaty is contained in 989 T.M., Business Operations in the United Kingdom.
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