28 September 2020

Irish Bank Resolution Corporation Ltd (In Special Liquidation), Irish Nationwide Building Society v The Commissioners for Her Majesty's Revenue and Customs [2020] EWCA Civ 1128 has provided, though probably at considerably cost in the resolution process, clarification of a number of principles relating to the taxation of branches, and of the interaction of domestic legislation and double tax treaties more generally. 

Before turning to the detail, the starting point is that branches and permanent establishments ('PEs') present problems in terms of funding attribution which are not there with subsidiaries. Where a subsidiary is set up by an inbound group, it may be debt funded, equity funded or a mix. In the UK, unless the small or medium sized enterprise tests are met and certain other conditions are satisfied (for example, that the transaction is with an entity resident in a jurisdiction with a full non-discrimination clause in its treaty), transfer pricing rules will apply and may require deemed arm’s length adjustments for tax purposes both for related entity financing and certain third party funding arrangements (for example where these depend on related party arrangements, such as a guarantee). But because, broadly, the UK transfer pricing regime only operates to eliminate UK tax advantages, there is generally a clear starting point, which is the actual arrangement made between the parties. Normally this will be governed by some kind of legal agreement or memorandum – though poorly documented or undocumented intra group arrangements can complicate the picture.

However, with a PE or branch, there is no such starting point. The PE and the entity of which it is a PE are a single legal entity, which cannot contract with itself. So while for accounting purposes there may be an allocation of assets or funds between the entity and the PE, this has no legal force. With multi branch entities – quite common in certain sectors – there are particular complications. In order to split the entity’s profits (or sometimes losses) between the “home” location and PE location (or several PE locations) an allocation exercise has to take place if arm’s length principles are to be followed, and this includes an allocation of different types of funding. 

In sectors where there are minimum regulatory capital requirements, particularly banking and insurance, there is an overlap between regulatory capital requirements and transfer pricing principles. This means that taxable profits calculations have been affected by shifts in regulatory capital requirements, and the requirements for banks will no doubt change further as a result of Capital Requirements Directive V on which the PRA is currently consulting. The principle here is that if, for example, Ruritania would require a bank subsidiary with a mix of business equivalent to that of the PE to have a certain minimum of equity capital, a Ruritanian PE must be assumed to have that amount of equity also. However, HMRC’s view over time has been that in reality regulated financial institutions do not operate with the absolute minimum of regulatory capital, so that this amount provides a floor and not an 'arm’s length' measure when assessing the branch profits under transfer pricing principles. Additionally, in practice certain other types of regulatory capital in addition to equity may affect the overall allocation of finance cost.

This case related to UK PEs of two Irish banks which became insolvent in the financial crash. HMRC had disallowed an amount of interest expense in the years 2002 – 2007 that appeared in the accounts of each PE, arguing that an arm’s length attribution of equity was required, which increased the profits attributable to each PE. In challenging this, the taxpayers have now lost at three levels of appeal on a series of arguments which, had they been successful, could have opened up multiple tax reclaims for inbound entities under a range of older form treaties. The banks’ case centred on the argument that the wording of the 1976 UK/Ireland double tax treaty ('Treaty') should be construed as allowing the PEs to be treated for tax purposes as having the ratio of equity to debt that they actually held, rather than this being determined under UK legislation requiring their tax liabilities to be computed by reference to an adjusted amount of capital.

HMRC argued, broadly, that the PEs were subject to s11AA Income and Corporation Taxes Act 1988 ('ICTA') (in force during the relevant period), which required the banks to compute their PE taxable profits assuming:

  • the PE had the same amount of equity and loan capital as a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions
  • the PE has the same credit rating as the non-resident entity
  • the PE is a distinct and separate enterprise dealing at 'arm’s length' with the non-UK resident company of which it is part.

This meant that what is generally known as a capital attribution tax adjustment ('CATA') calculation had to be done. On the facts here this attributed to the PEs a higher proportion of free capital (ie equity, with no finance cost deduction) than the branch accounts drawn up by the entities. The resulting denial of interest deductions created higher UK taxable profits. The banks argued that the UK domestic law provisions could not result in treatment which was incompatible with the UK’s treaty obligations by reason of s788 ICTA, and that Article 8 Business Profits of the 1976 Treaty did not require such an attribution. The construction of Article 8 was crucial to the banks’ argument, which was broadly that the key OECD commentary discussion of capital attribution principles was not published until 2008, the OECD model double tax convention wording which expressly provides for an attribution of free (equity) capital to a PE was not published until 2010, the Treaty had not been updated to incorporate this wording, and that Article 8 did not require adjustment to the hypothetical branch capital, and that it should not be read in the light of these later developments.

The Court of Appeal confirmed the decision of the Upper Tier Tribunal and unanimously found for HMRC. It held that s11AA ICTA was not inconsistent with Article 8 of the Treaty, Article 8 could be implemented in a number of ways and a CATA was a method not precluded by the Treaty. What is of broader interest is the basis on which the Court reached its decision.

Key points emerging from the decision include the following:

  • The court accepted that in principle the UK was bound by its treaty obligations, appropriately implemented, and that these were capable in principle of overriding domestic law provisions.
  • It was not, however, prepared to give any weight to prior HMRC practice in interpreting the Treaty. While summarising some elements of the rather complex history of HMRC’s approach to capital allocation calculations in practice, it agreed with the Upper Tier Tribunal that, based on Article 31 of the Vienna Convention, a bilateral practice of the parties to the treaty could constitute evidence in support of the construction of the treaty provisions, but a unilateral practice of one party (here, HMRC) could not. Both Patten LJ and Singh LJ emphasised the absence of bilateral evidence. What is perhaps surprising here is that it is very hard to see how there could be bilateral evidence as to the interpretation of a treaty provision depending on arm’s length principles, when during the relevant period Ireland had no transfer pricing regime. The difficulty of producing bilateral evidence in this context was not addressed at all in the judgments.
  • The court cited at length OECD commentaries and addressed the changes in the 2008 commentary, which for the first time, explicitly considered at some length the issues arising in relation to the attribution of free capital. However, it rejected the argument for the taxpayers that the revised commentary could not be 'read backwards' into the wording of the 1976 Treaty. It admitted that the wording of the 2010 model treaty, agreed following the 2008 commentary, was more specific than the wording of the 1976 Treaty. However, in essence it held that the more specific requirement in the 2010 model treaty to take into account the 'functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise' did not result in a real change in the method of attributing profits to the PE. Instead, it was held merely to reflect a desire from the OECD for more consistency between jurisdictions. Patten LJ did not, however, explain why, if there was no change of substance, there were problems with consistency between jurisdictions at all.
  • Patten LJ explained the contrary conclusion of the US Courts in the Westminster Bank case and the Counseil d’Etat in the Bayerische Hypo und Vereinsbank case as distinguishable, on the basis that they were dealing with arguments by the tax authority that the branches should be treated as if they were banks. The decision of the Spanish Audencia National in ING Direct had to be admitted to be inconsistent with the court’s conclusion here and Patten LJ simply said that he disagreed with it.

The desire of the courts to avoid a conclusion which could have led to significant tax leakage in relation to inbound PEs through a reopening of positions which had long been accepted is perhaps understandable. However, insistence on bilateral evidence to support treaty interpretation may be an unhelpful precedent in other contexts, where one jurisdiction may have little or no interest in a point of Treaty interpretation which is highly relevant in the other – including, for example, entity status. The Court appears simply to have brushed past Philip Baker QC’s submissions, which seems uncontentious as a matter of historical fact, as to the evolution and purpose of the OECD model treaties and the associated commentary. Decisions of other jurisdictions to the effect that the older treaty wording had a different meaning from the 2010 model treaty wording appear to have been treated as something of an inconvenient truth. So, in other cases where there is a dispute as to the consistency of the UK’s treaty obligations with its domestic tax legislation, it will be harder to judge the weight to be attached to international precedents.

For those dealing with branch capital attribution questions day-to-day, unfortunately a range of difficult practical questions about the functioning and components of a CATA calculation and the grey areas to which this gives rise have been left unresolved. So questions about what happens when the best attempt at standalone calculations for a series of branches amounts to more than the entity capital, or where the nature of activities in the branch seems to justify a different capital allocation from that in the entity as a whole, or where tax authorities take incompatible views, will no doubt remain contentious. The anti-hybrid rules give this an added edge, since they can prevent double deduction of expenditure in computing branch profits unless it is against profits which are double taxed. In that context, it is particularly unhelpful to have uncertainty about what is deductible/taxable in each jurisdiction.

The Appellant banks have applied for permission to appeal to the Supreme Court.

For any issues about the tax treatment of UK permanent establishments please contact Ian Carnochan.

Key contact

Ian Carnochan

Ian Carnochan Partner

  • Tax
  • Corporate Tax
  • Real Estate Tax

Subscribe to news and insight

Burges Salmon careers

We work hard to make sure Burges Salmon is a great place to work.
Find out more