Monday, October 12, 2020

Meaning of “engaged in the same or similar activities under the same or similar conditions” [Article 8(2) of the 1976 UK-Ireland Double Taxation Avoidance Convention] ― Irish Bank Resolution Corp Ltd v HMRC [2020] EWCA Civ 1128

        In Irish Bank Resolution Corp Ltd v HMRC [2020] EWCA Civ 1128, the UK Court of Appeal handed down on 28th August, 2020, a decision which could have a far-reaching effect on the determination of the profits of permanent establishments, at least in the UK.


2.     The taxpayers, being UK non-resident banks registered in the Republic of Ireland, carried on business in the UK through branches, which branches constituted UK Permanent Establishments (“PEs” or “PE”) of the taxpayer banks.

3.       In assessments made on the banks in respect of the profits of the PEs, HMRC,
in exercise of the powers conferred upon it by Sec 11AA of the Income and Corporation Taxes Act 1988 (“TA 1988”), disallowed a part of the interest which the banks claimed to deduct as expenses of the borrowings made by the branches in order to finance their lending businesses. Sec 11AA was couched in the following terms :

(1)      This section provides for determining for the purposes of corporation tax the amount of the profits attributable to a permanent establishment in the United Kingdom of a company that is not resident in the United Kingdom (“the non-resident company”).

(2)      There shall be attributed to the permanent establishment the profits it would have made if it were a distinct and separate enterprise, engaged in the same or similar activities under the same or similar conditions, dealing wholly independently with the non-resident company.

(3)      In applying subsection (2) ―

(a)      it shall be assumed that the permanent establishment has the same credit rating as the non-resident company, and

(b)      it shall also be assumed that the permanent establishment has such equity and loan capital as it could reasonably be expected to have in the circumstances specified in that subsection.

No deduction may be made in respect of costs in excess of those that would have been incurred on those assumptions

4.       In making the disallowance, HMRC applied a Capital Attribution Tax Adjustment (“CATA”) which included attributing to the PEs, notional additional free capital in cases where it was said that a PE operating as a distinct and separate enterprise in the manner contemplated by Sec 11AA(2) would have had a higher amount of free capital and therefore a correspondingly lower amount of borrowed capital. The effect of the Adjustment was to attribute a lower interest cost to the PEs, resulting in a disallowance of part of the interest actually incurred by them.

5.       The Court of Appeal acknowledged that the taxpayers’ appeals were “primarily concerned with s.11AA(3)(b).” (emphases supplied).


Rival Contentions

6.       The essence of the taxpayers’ argument (represented by Mr Philip Baker, QC), however, was that the reference in Article 8(2) of the 1976 UK-Ireland Double Taxation Avoidance Convention (“DTAC”) to the PE being treated as a distinct and separate enterprise “engaged in the same or similar activities under the same or similar conditions” required an assumption to be made, ―

(i)      not only that the PEs were engaged in the same or similar type of business to the one actually carried on by them,

(ii)     but also that the PEs should be taken to have traded with the same ratio of free to borrowed capital as they actually employed during the relevant accounting period.

On this basis, it was contended by Mr Baker that, having regard to the mandate of Sec 788(3) of TA 1988 [to the effect that the arrangements contained in a DTAC, once confirmed by Order in Council, have effect in relation to income tax and corporation tax “notwithstanding anything in any enactment”], Sec 11AA(3)(b) could not be given effect to, inasmuch as its application would have the effect of disallowing part of the interest expended by the PEs, which effect would be contrary to Art 8(2) of the UK-Ireland DTAC and, consequently, Sec 788(3). Mr Baker’s further submission was that Sec 11AA(3)(b) could have been available to the Revenue if the UK and Ireland had effected a substantive amendment of Art 8 by incorporating therein the amendments carried out by the OECD in Art 7 of its 2010 Model Tax Convention. HMRC’s counter to this submission was that the amended 2008 OECD Commentary on the Model Tax Convention was confirmation that the approach based on an attribution of capital had long been used by Member States to implement the provisions of Art 7, and was recognised by the OECD as permissible under the terms of Art 7 of the Model Tax Convention in its unamended form.


Decision  of  the  Court  of  Appeal


Whether the Practice of One Treaty Party Constitutes an Aid to Construction of the Treaty

7.       The Court rejected HMRC’s contention that it having for long years applied one or the other form of adjustment to determine the appropriate amount of free capital attributable to PEs of non-resident banks, such a practice constituted material evidencing the construction of the relevant provisions of the concerned DTACs conformably with the manner of their implementation by HMRC. The Court endorsed the conclusion of the Upper Tribunal that the unilateral practice of a contracting party ― even if that practice showed a careful attempt by that party to abide by a treaty ― could not affect the meaning of that treaty or constitute material going to its construction.

Meaning of “engaged in the same or similar activities under the same or similar conditions” [Art 8(2) of the UK-Ireland DTAC]

8.       The Court also upheld, for the following reasons, the Upper Tribunal’s rejection of the taxpayers’ construction of Art 8(2) of the UK-Ireland DTAC to the effect that that the PEs should be taken to have traded with the same ratio of free to borrowed capital as they actually employed during the relevant accounting period  :

(a)     The expression “same or similar provisions” must obviously refer to the business activities actually carried on by or through the PE and the market conditions which prevailed at the relevant time.

(b)      In order to operate the hypothesis of a distinct and separate enterprise dealing at arm’s length including with the overseas company of which it is part, it seems necessary to compare the way in which the PE financed and accounted for its business with what it would have done had the PE operated as a separate enterprise. Otherwise the comparator provisions of Article 8(2) cannot work. To construe the phrase “same or similar conditions” as requiring the PE’s actual ratio of free to borrowed capital to be applied would be self-defeating. It would rob Article 8(2) of any real ability to depart from the accounting treatment of the PE which the overseas company might choose to adopt and it would make the application of a uniform test of attribution impossible.

(c)      The taxpayers’ construction of Art 8(2) was not compelled by the ordinary meaning of the words used when read in their context, for which reason also it was liable to be rejected.

(d)      The provisions of Art 7 of the Model Tax Convention going back to 1963 have never been intended to lay down precise or exhaustive sets of rules and have always given contacting states a measure of flexibility in deciding how to implement them. They are umbrella provisions. It would be inconsistent with this approach to interpret “same or similar conditions” in the way in which the taxpayers have suggested.

3 Foreign Cases Cited on behalf of Taxpayers

9.       Although the Court was inclined to dismiss the taxpayers’ appeals for the foregoing reasons, it nonetheless felt compelled, for the sake of completeness and out of deference to the foreign courts concerned, to deal with them. The Court’s rulings on the applicability of the rationes of each of those cases were as set out below :

(1)           National Westminster Bank plc v The United States

The United States Court of Federal Claims upheld the taxpayer’s claim that the formula used in the concerned Treasury Regulation to calculate deductible interest in the hands of the US branch of a UK bank was inconsistent with Article 7 of the 1975 US-UK Tax Treaty, for, inter alia, the reason that the Regulation treated the branch as a unit of the bank rather than as a separate entity and applied the formula without regard to the actual assets and liabilities shown on the books of the branch.

Court of Appeals’s Ruling

[Refer to the ruling against the case at Sr No 2 below]

(1-A)     Nat West 2

The US Federal Court of Claims in this case upheld the taxpayer’s contention that the requirement of Art 7 of the 1975 US-UK Tax Treaty of treating the US Branch of NatWest
(a non-resident bank registered in the UK) as a “separate and distinct enterprise” did not mean that the branch should be treated as if it were "separately-incorporated,"; instead, "separate and distinct," meant separate and distinct from the rest of the bank of which it was a part. There was nothing in the plain words of the Treaty that allowed the government to adjust the books and records of the branch to reflect "hypothetical" infusions of capital based upon banking and market requirements that did not apply to the branch.

This decision was upheld by the US Federal Court of Appeals, which held as follows.
The US Branch was not required to maintain any minimal amount of capital. Therefore, because the corporate yardstick would essentially recharacterize loans that bear an interest expense as equity capital infusions based on regulatory and domestic market requirements that did not apply to the US Branch, the corporate yardstick ignored the real facts of the US Branch's situation and violated the 1975 Treaty as informed by the 1963 Draft Convention.

Court of Appeals’s Ruling

[For both, this case, as well as the one at Sr No 1 above]

The US Court of Appeal’s consideration of whether capital could be notionally attributed to the branch really turned on the argument of the IRS that the branch should be regarded as a US bank. The Court did not therefore have to consider a more nuanced approach to this question such as that embodied in s.11AA(3)(b) of TA 1988 and its denial of the IRS motion for reconsideration meant that one does not know what its reaction would have been to some other form of CATA. There was nothing in the decision to the effect that any form of capital attribution was precluded by the phrase “same or similar conditions” which was the argument the Court of Appeal had to consider. Nor, of course, did the US Court of Appeals have the benefit of the later OECD publications which have illuminated much of the thinking behind the provisions of Art 7 of the Model Tax Convention.

(2)           Re Bayerische Hypo and Verinbank AG                                                                                                              
                [18 ITLR 1 ]

In this case, the French Conseil d'État was considering the taxation of the French branches of foreign banks. The branches obtained loans from their parent banks at very high rates of interest and sought to deduct the interest as an expense. This was disallowed up to the level of capital that the branches would have required had they been subsidiary banks registered in France. The Conseil d'État held that this tax treatment contravened Article 4 of the France-Germany Double Taxation Convention which was in similar terms to Article 8(2) of the 1976 UK-Ireland Convention. It held that it was not appropriate, in interpreting the provisions of Art 4(2) of the Convention, to refer to the Commentaries of the OECD on Art 7 of the Model Tax Convention, since those Commentaries were subsequent to the adoption of the provisions at issue.

Court of Appeals’s Ruling

As in the NatWest case, the argument centred on whether the branches should be treated as if they were French registered banks. The Conseil d'État did not seem to have based its decision on the “same or similar conditions” wording and perhaps, most important of all, refused to have regard to later OECD publications such as the 2008 Commentary regardless of whether they were merely confirmatory of the existing effect of the provisions of the Model Tax Convention. The decision was therefore of limited assistance in the present case.

                    (3)        ING DIRECT v Central Court for Economic and Administrative Matters                                                                                                 [18 ITLR 680 ]

In this matter, the Spanish Audencia Nacional was concerned with the taxation of the Spanish branch of a Dutch bank. The Spanish tax authorities attributed free capital to the PE in proportion to the transactions it carried out and made an adjustment to its tax return, which they said complied with the 1971 Spain-Netherlands Double Taxation Treaty. As in the other foreign cases, they did so on the basis of treating the branch as an independent company. Art 7 of the 1971 Treaty was in the same form as Art 7 of the Model Tax Conventions up to 2010. The Spanish court held that it could not construe Art 7 with the assistance of what was said in the 2008 Commentary because in their view, that and indeed, some of the earlier commentaries, in articulating the development of the principles of attribution, had made substantive changes to the framework of the model conventions which could not be applied retrospectively.

Court of Appeals’s Ruling

The Court of Appeal disagreed with this decision. It held that the structure of Art 7 of the Model Tax Convention leaves a wide degree of flexibility as to how the test it lays down should be implemented and the 2008 Commentary is an articulation of various methods of attributing capital that have long been in operation by states which have adopted the wording of the Model Tax Convention.

In sum, the Court held each of the 3 decisions to be inapplicable to the instant case.


Singh LJ’s Separate but Concurring Judgment

10.     In a separate but concurring judgment, Singh LJ has made some telling points about the interplay between treaty provisions and domestic statute. He makes the point that, despite Parliament having itself enacted Sec 788(3) of TA 1988, a UK court would, nonetheless, be obliged to give effect to Sec 11AA of TA 1988, since the latter provision was brought onto the Statute Book later in time, in view of which Sec 788(3) would be deemed impliedly to have been repealed. While any student of the law would salivate at the opportunity of being instructed on this point, one wonders why Patten LJ did not reject the taxpayers’ case on the short ground that Sec 11AA(3)(b) prevailed over Sec 788(3) in view of the latter’s implied repeal.