On October 9 2019, the UK Upper Tribunal dismissed the taxpayers' appeals in Irish Bank Resolution Corporation Limited and Irish Nationwide Building Society v HMRC [2019] UKUT 0277 (TCC). The case concerned the deductibility of expenses in respect of "interest" paid in 2003-7 by UK permanent establishments (PEs) of these two Irish financial institutions on the provision of intra-entity "loans" from the companies' head offices.
The inverted commas are used here because of course a legal entity cannot transact with itself: there was no actual debt financing provided by the Irish head offices to the PEs, nor interest paid by the PEs to the head office. Nonetheless, the PEs drew up their accounting records on the basis that the PEs were separate entities with a certain amount of borrowing and consequential interest expense.
While the notional separate enterprise hypothesis was appropriate, HMRC asserted that interest deductibility should be restricted by UK tax law, then section 11AA of the Income and Corporation Taxes Act 1988 (introduced in 2003), now rewritten as section 21(2)(b) of the Corporation Tax Act 2009. Prior to 2003 there was no UK domestic tax law requirement to attribute capital to a UK PE.
More specifically, HMRC invoked the rule in section 11AA(3)(b) that prescribed an assumption that the PE "has such equity and loan capital as it could reasonably be expected to have" as a distinct and separate enterprise, carrying on the same or similar activities under the same or similar conditions, dealing wholly independently with the non-UK resident company of which it formed a part.
The taxpayers, however, pointed to Article 8 of the 1976 UK-Ireland tax treaty. Article 8(2) itself applied the "distinct and separate enterprise" principle found in Article 7(2) of the 1963 OECD Model Tax Convention, which indeed provided essentially the language used in section 11AA(2). Yet nothing was said in the treaty about assumed levels of equity and debt funding for the PE. The taxpayer accordingly claimed that section 11AA(3)(b) went beyond what the treaty permitted.
In 2017, the First-tier Tribunal found in favour of the revenue authority, approving an interest disallowance based on section 11AA(3)(b). Even though a notional capital attribution was not expressly contemplated by the treaty, it was held to be consistent with the treaty. The First-tier Tribunal considered relevant the historic UK practice, dating back to the 1950s, of ascribing to a PE an amount of "free" (i.e. interest-free) capital, and was also prepared to take into account the OECD model and commentaries in their 2010 and 2008 versions respectively as "clarification".
The Upper Tribunal has now dismissed the taxpayers' appeals. Again, the taxpayers had objected to the notional attribution by HMRC of free capital to their UK branches beyond what they regarded as the actual free capital represented by retained reserves. On the other hand, HMRC promoted a capital attribution tax adjustment (CATA).
The Upper Tribunal's decision included a helpful review of the UK courts' approach to the construction of tax treaties, including principles drawn from the Vienna Convention on the Law of Treaties and case law dating back to the 1970s. Prior HMRC practice was not, however, regarded as admissible, including its acceptance of a 1978 opinion by Michael Nolan QC, who later served as a judge in the House of Lords, that interest deductibility should be dictated by the "actual conditions" of a UK branch. For the Upper Tribunal the "unilateral practice" of a taxing authority was not relevant to the construction of the UK-Irish treaty.
Naturally enough, OECD materials pre-dating the 1976 treaty were to be taken into account; but, "ex hypothesi" (according to the theory), material post-dating the treaty could not have been in the minds of the contracting states, and so could not amount to admissible "traveaux préparatoires" (work preparatory to the treaty). The subsequent OECD materials were "at most" to be regarded as equivalent to "textbooks and articles" on the treaty. Thus, the 1963 OECD commentary, and a comparison of the 1976 UK-Ireland treaty with that model, could be considered, whereas the OECD's 1984 report on Transfer Pricing and Multinational Enterprises and the 2008 OECD model and commentary could not.
The Upper Tribunal noted the specific discussion in the 2008 commentary (drawing on the 2008 report Attribution of Profit to Permanent Establishments) of attributing "an arm's-length amount of interest to the permanent establishment after attributing an appropriate amount of 'free' capital in order to support the functions, assets and risks of the PE".
The revision to Article 7 of the OECD Model Tax Convention in 2010, which introduced references to a PE's "dealings with other parts of the enterprise… taking into account the functions, assets and risks assumed by the enterprise through the permanent establishment", was rehearsed – but could not be relevant to the interpretation of the 1976 treaty.
Turning back then to applying the particular terms of the UK-Irish treaty, the Upper Tribunal was clear that no single specific way of constructing the notional profits of the notional "distinct and separate enterprise" was prescribed. When a permanent establishment keeps its own books, the Upper Tribunal considered that those might well be the correct starting point – and would generally recognise the "true or actual revenues and expenses" of the PE. Those accounts might also show notional intra-entity interest expense, not just actual items.
Nevertheless, according to the Upper Tribunal, the books of account could "fail to reflect the hypothesis that Article 8(2) obliges [the UK] to make" as to the PE being a distinct and separate enterprise dealing at arm's length with the enterprise of which it is a PE. Then the books would have to be adjusted.
An adjustment to an arm's-length capital position was seen as consistent with the indication in paragraph 11 of the 1963 OECD commentary that an adjustment should be made if goods were invoiced between parts of an enterprise at prices such that "profits have thus been diverted from the permanent establishment to the head office or vice versa".
Thus section 11AA(3)(b) catered for "such possible distortions" via an adjustment – the CATA – if a PE's books failed to reflect the equity and loan capital the PE ought to have as a separate enterprise dealing independently with the non-resident company. The CATA was therefore "entirely consistent with, and permitted by" the treaty. Fundamentally, section 11AA(3)(b) was not precluded by the treaty, and this was enough to dismiss the taxpayers' appeals.
The Upper Tribunal was prepared to look at relevant foreign case law in arriving at its conclusion. Of particular note is their analysis of the well-known National Westminster Bank (NatWest) case in the US, where the taxpayer bank defeated the Internal Revenue Service's attempt to impute capital to its US branch by reference to a formulary method prescribed by Treasury regulation, rather than by reference to the bank's actual circumstances, adjusted if necessary to reflect imputation of "adequate" capital.
However, NatWest was not to be regarded as a rejection of all methods of capital attribution. The case, and cases in France and Spain, respectively, concerning Bayerische Hypo und Vereinbank and ING, were regarded by the Upper Tribunal as consistent with its approach to the Irish taxpayers' cases.
Murray Clayson is a tax partner at Freshfields Bruckhaus Deringer. Clayson has served as president of the International Fiscal Association (IFA) since 2017.
