This case concerned deductibility of notional interest paid in 2003-7 by two permanent establishments in the UK to their Irish HQs. The loans – and thus interest expenses – had been allocated to the PEs as if they were separate entities. The UK tax authorities held that interest deductibility was restricted by UK tax law, which prescribed that PE’s has such equity and loan capital as it could reasonably be expected to have as a separate entity. The UK taxpayers, refered to  Article 8 of the UK-Ireland tax treaty. Article 8 applied the “distinct and separate enterprise” principle found in Article 7 of the 1963 OECD Model Tax Convention, which used 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. In 2017, the First-tier Tribunal found in favour of the tax authority, and in October 2019 the Upper Tribunal also dismissed the taxpayers’ appeals. Judgement of the UK Court of Appeal The Court of Appeal upheld the decision of the Upper Tribunal and dismissed the appeal of Irish Bank Resolution Corporation and and Irish Nationwide Building Society. Click here for other translation ...

Bayerische Hypo und Vereinsbank AG (HVB-AG), a banking institution under German law, set up a French branch under the name “HVB-AG Paris” and contributed ten million Deutschmarks to this structure. The French branch also took out loans from the company’s head office or from third-party companies Following an audit of the branch’s accounts, the tax authorities, after considering that these loans revealed an insufficiency of the contribution made by the head office, particularly in relation to the equity capital that the branch should have had if it had had legal personality, refused to allow the interest corresponding to the fraction of the loans deemed excessive to be deducted from the results taxable in France in respect of the branch’s activity and demanded that the company pay additional corporation tax for the financial year ending in 1994, together with increases In order to justify this reassessment, the tax authorities first argued, during the contradictory reassessment procedure, that the disputed interest characterized a transfer of profits to the German head office within the meaning of Article 57 of the General Tax Code, and then by way of substitution of a legal basis that the interest was not borne by an autonomous company carrying on the same or similar activities as the branch under the same or similar conditions and dealing with the company’s head office as an independent company within the meaning of the provisions of Article 209(I) of the General Tax Code in conjunction with the stipulations of Article 4 of the Franco-German tax treaty of 21 July 1959; In 2008, the Paris administrative court discharged the disputed tax assessment. This decision was then appealed by the tax authorities to the Supreme Administrative Court. Judgement of the Supreme Administrative Court The Supreme Administrative Court upheld the decision of the administrative court and dismissed the appeal of the tax authorities. Excerpts “Considering, on the other hand, that there is no need, in order to interpret the stipulations of Article 4(2) cited above, to refer to the comments formulated by the Tax Committee of the Organisation for Economic Co-operation and Development (OECD) on Article 7 of the model convention drawn up by this organisation, since these comments were made after the adoption of the stipulations in question; that, in the wording applicable to the facts of the case, these provisions must be understood as authorising the State of the branch to attribute to the branch the profits that the interested party would have made if, instead of dealing with the rest of the company, it had dealt with separate companies under ordinary market conditions and prices; that, on the other hand, these stipulations do not have the object or, consequently, the effect of allowing that State to attribute to the branch the profits which would have resulted from the contribution to the interested party of own funds of an amount different from that which, entered in the accounting records produced by the taxpayer, faithfully retraces the withdrawals and contributions made between the various entities of the company; that, in particular, the tax authorities cannot substitute for this latter amount the equity capital with which the branch should have been endowed, by virtue of the applicable regulations or with regard, in particular, to the outstanding risks to which it is exposed, if it had enjoyed legal personality; 7. Considering that it follows from this that the terms of Article 209(I) of the General Tax Code subjecting to corporation tax “profits the taxation of which is attributed to France by an international convention on double taxation” could not, any more than the terms and rules mentioned in point 3, have the effect of attributing to the French tax authorities the taxation of profits established in accordance with the disputed reassessments; 8. Considering that it follows from all the above that, without needing to rule on the objection raised by HVB-AG, the Paris Administrative Court of Appeal, which was not required to respond to all the arguments raised before it, sufficiently reasoned its decision and did not commit an error of law, nor did it distort the documents in the file submitted to it by ruling, after having dismissed the domestic law grounds on which the tax authorities intended to base the contested taxes, that the stipulations of Article 4 of the Franco-German tax treaty could not be usefully invoked for the same purpose; that, consequently, the Minister responsible for the budget is not entitled to request the annulment of the judgment he is challenging;” Click here for English translation Click here for other translation ...

NatWest is a United Kingdom corporation engaged in international banking activities. For the tax years 1981-1987, NatWest conducted wholesale banking operations in the United States through six permanently established branch locations (collectively “the U.S. Branch”). On its United States federal income tax returns for the years at issue, NatWest claimed deductions for accrued interest expenses as recorded on the books of the U.S. Branch. On audit, the Internal Revenue Service (“IRS”) recomputed the interest expense deduction according to the formula set forth in Treasury Regulation § 1.882-5. The formula excludes consideration of interbranch transactions for the determination of assets, liabilities, and interest expenses. Treas. Reg. § 1.882-5(a)(5) (1981).2 The formula also imputes or estimates the amount of capital held by the U.S. Branch based on either a fixed ratio or the ratio of NatWest’s average total worldwide liabilities to average total worldwide assets. Id. § 1.882-5(b)(2). Pursuant to the IRS’s recalculation of the interest expense deduction, NatWest’s taxable income was increased by approximately $155 million for the years at issue. NatWest concluded that the increased income would result in an additional tax liability of at least $37 million in the United States for which a foreign tax credit would not be available in the United Kingdom. NatWest thus requested, under Article 24 of the 1975 Treaty, that the United Kingdom enter competent authority proceedings with the United States to resolve the double taxation issue. Pursuant to the competent authority proceedings, the United Kingdom presented NatWest with a settlement offer, which NatWest concluded did not sufficiently address its double taxation concerns. NatWest rejected the settlement offer, paid the additional taxes, and filed suit in 1995, claiming that the IRS’s application of § 1.882-5 to an international bank such as NatWest violated the terms of the 1975 Treaty. The 1975 US/UK Double Taxation Treaty contained an Article 7 in similar terms to Article 8 of the 1976 Convention. In the first of three cases, NatWest claimed that the formula used in the Treasury Regulation to calculate deductible interest was inconsistent with Article 7 of the Treaty. The United States Court of Federal Claims upheld the claim. In relation to Article 7 of the US/UK Treaty it said: “The foregoing examination of Article 7 of the Treaty, pre-ratification reports of the Treasury Department and the Senate, and Commentaries intended to assist in interpretation leads to the conclusion that the Treaty contemplates that a foreign banking corporation in the position of plaintiff will be subjected to U.S. taxation only on the profits of its U.S. branch and that such profits should be based on the books of account of such branch maintained as if the branch were a distinct and separate enterprise dealing wholly independently with the remainder of the foreign corporation, provided that the financial records of the branch, especially those reflecting intra-corporate lending transactions, are subject to adjustment as may be necessary for imputation of adequate capital to the branch and to insure use of market rates in computing interest expenses. In addition to normal deductible expenses reflected on the books of the branch, as adjusted, there shall be allowed in the determination of the profits of the U.S. Branch a reasonable allocation of general and administrative expenses incurred for the purposes of the foreign enterprise as a whole.” The Treasury Regulation was held to operate contrary to Article 7 for a number of reasons. It 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. Judgement of the Court The court allowed the appeal of National Westminster. According to the court there is nothing in the language of Article 7 to suggest that the government is allowed to impose capital requirements on a branch that are the same as those imposed on separately-incorporated banks in order to give meaning to the phrase “separate and distinct.” The phrase “separate and distinct” does not mean the branch should be treated as if it were “separately-incorporated,” but instead “separate and distinct,” means separate and distinct from the rest of the bank of which it is a part. Thus, Article 7 of the Treaty simply allows the taxing authorities to adjust the books and records of the branch to ensure that transactions between the branch and other portions of the foreign bank are properly identified and characterized for tax purposes. There is nothing in the plain words of the Treaty that allows the government to adjust the books and records of the branch to reflect “hypothetical” infusions of capital based upon banking and market requirements that do not apply to the branch. In short, the government’s reading of Article 7 goes too far ...