SECTION 2. BACKGROUND

.01 Prior U.K. Law . Under prior U.K. law, ACT was levied on a corporation resident in the United Kingdom (U.K. corporation) in respect of a dividend paid, or other qualifying distribution made, by the corporation to its shareholders. The rate of ACT varied over time, but equaled one-fourth of the amount of the dividend immediately prior to the repeal of ACT. At the corporate level, ACT was creditable against the general corporation tax liability of either the distributing corporation or a corporation related to the distributing corporation. At the shareholder level, a shareholder resident in the United Kingdom was generally entitled to a tax credit against the shareholder’s income tax liability in respect of the distribution. The tax credit was calculated by reference to the ACT rate and could be paid in cash to the extent that the credit exceeded the shareholder’s tax liability. Because the amount of the tax credit was calculated by reference to the ACT rate, the shareholder tax credit was commonly referred to in the United States as an “ACT refund.”

The tax credit was an integral part of a system of taxation under U.K. law that partially integrated the United Kingdom’s corporate and shareholder level income taxes. The shareholder tax credit was designed to eliminate or reduce a second level of tax on corporate profits at the shareholder level. In the absence of a specific tax treaty provision, tax credits were not generally available to shareholders not resident in the United Kingdom. Under its domestic law, the United Kingdom does not impose a withholding tax on dividends paid to nonresidents.

.02 Relevant Provisions of the Conven- tion . Paragraph (2) of Article 10 (Dividends) of the Convention provides that, as long as an individual resident in the United Kingdom is entitled under U.K. law to a tax credit in respect of dividends paid by a U.K. corporation, U.S. residents who are the beneficial owners of dividends paid by a U.K. corporation will be entitled to receive a payment from the United Kingdom of a tax credit, subject to a deduction withheld from the payment. In the case of U.S. corporations owning, directly or indirectly, 10 percent or more of the voting stock of a distributing U.K. corporation (“direct investors”), paragraph (2)(a)(i) of Article 10 provides that the amount payable by the United Kingdom is equal to one-half of the tax credit to which an individual shareholder resident in the United Kingdom would have been entitled, reduced by 5 percent of the sum of the dividend and the amount of the tax credit. In the case of all other U.S. investors (“portfolio investors”), paragraph (2)(a)(ii) of Article 10 provides that the amount payable by the United Kingdom is equal to the full amount of the tax credit to which an individual shareholder resident in the United Kingdom would have been entitled, reduced by 15 percent of the sum of the dividend and the amount of the tax credit. Under paragraph (2)(a)(iii) of Article 10, the gross amount of the tax credit (unreduced by the 5 or 15 percent withheld) is treated as an additional dividend paid by the U.K. corporation for U.S. tax credit purposes.

Paragraph (1) of Article 23 (Elimination of Double Taxation) of the Convention generally provides that the United States shall allow to its citizens and resi

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come tax imposed on the U.K. corporation paying the dividend. This paragraph made clear that the one-half of the ACT paid by the U.K. corporation that was not paid out to the U.S. investor was to be treated as an income tax imposed on the U.K. corporation for which the U.S. investor could claim an indirect credit under paragraph 1 of Article 23 (and pursuant to sections 902 and 960 of the Code). See S. Exec. Rep. No. 18, 95 ^th Cong., 2d Sess. (1980), reprinted in 1980–1 C.B. 411, 428. However, because paragraph (1) of Article 23 and section 901 of the Code specifically limit the allowable indirect credit to the appropriate amount of creditable U.K. income taxes actually paid by the U.K. corporation, the one-half of the ACT not paid out to the U.S. investor was creditable only to the extent it was actually paid by the U.K. corporation.

Under current U.K. law, a U.K. corporation is liable for corporation tax on the corporation’s profits, but is not liable for ACT or any other creditable income tax in respect of its profits. Under Article 23, and in accordance with section 902 or 960 of the Code, a direct investor is eligible to claim an indirect foreign tax credit for the U.K. corporation tax paid by the corporation. Because no additional U.K. income tax is paid by the U.K. corporation under current law, no portion of the shareholder tax credit is treated as additional tax paid by the U.K. corporation for which the investor may claim an indirect foreign tax credit under Article 23 and in accordance with section 902 or 960 of the Code.

.05 Effect of Tax Credit Paid Under the Convention on U.K. Corporation’s Earn- ings and Profits and Foreign Income Taxes. Under paragraph (2)(a)(iii) of Article 10, the gross amount of the tax credit (unreduced by amounts withheld) due from the United Kingdom under paragraphs (2)(a)(i) and (ii) of Article 10 is characterized as a dividend from the distributing U.K. corporation for U.S. tax credit purposes. The characterization of this amount as a dividend means that the U.K. corporation must be treated as receiving from the United Kingdom an equivalent amount out of which it pays the dividend. Prior to the repeal of ACT, the distributing U.K. corporation was treated as receiving from the United Kingdom a refund of the ACT paid (or one-half of the ACT paid in the case of a

in respect of dividends paid by a U.K. corporation. Because of the reduction in the amount of the U.K. shareholder tax credit, however, the amount of the payment due to U.S. investors will be reduced. For portfolio investors, the amount permitted to be withheld on the sum of the dividend and the tax credit pursuant to paragraph (2)(a)(ii) of Article 10 will completely eliminate the amount payable. As a result, no additional cash will be payable to the investor under the Convention. For direct investors, only a nominal amount of additional cash will be payable, because the 5-percent amount withheld on the sum of the dividend and the tax credit pursuant to paragraph (2)(a)(i) of Article 10 will almost entirely eliminate the payment.