Attribution of notional capital to PE compatible with UK/Ireland DTT

The Court of Appeal has held that it was not contrary to the provisions of the UK/Ireland DTT to attribute notional capital to the UK permanent establishments (PEs) of Irish banks so as to limit deductions for notional interest payments: Irish Bank Resolution Corporation Ltd v HMRC [2020] EWCA Civ 1128. The provisions of UK tax law require an assumption to be made in determining the profits of a PE that it is a "distinct and independent enterprise". HMRC's approach to the application of this principle to the branches of overseas banks in requiring a notional element of capital to be attributed to them was therefore not contrary to the treaty.

Background

The case concerned two Irish banks with UK PEs. In both cases, the PEs sought to deduct from the UK profits subject to corporation tax notional interest deductions on book entry loans from the Irish entity. HMRC rejected these tax deductions, pointing to the provisions of ICTA 1988 s.11AA(3)(b) which requires an assumption to be made in determining the profits of a PE that the PE has "such equity and loan capital as it could reasonably be expected to have in the circumstances". Applying this provision to the facts, HMRC considered that the Irish banks had understated the amount of equity capital each PE was deemed to have and so had overstated the amount of loan capital and interest.

The Irish banks, however, contended that the application of s.11AA was contrary to the terms of the 1976 UK/Ireland double tax treaty. In particular, they argued that the business profits provision in the treaty (Article 8) did not allow the deeming of notional capital to the PEs. Article 8 required a PE to be treated as a "distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing at arm's length with the enterprise of which it is a permanent establishment." Whilst this provision replicated the "distinct and separate enterprise concept" of s.11AA, the Irish banks argued that the additional wording required an assumption to be made not only that the PE is engaged in the same or similar type of business to the one it actually carried on but also that it should be taken to have traded with the same ratio of free to borrowed capital as it actually employed during the relevant accounting period. On this basis, the banks argued that the UK was precluded by ICTA s.788(3) (giving effect to international double tax treaties) from relying on s.11AA(3)(b) in so far as that would lead to an adjustment in the amount of free capital it was taken to have employed in that period and a consequent disallowance of some of the interest charges on borrowed capital which it actually incurred.

The Upper Tribunal rejected the banks' arguments concluding that there was nothing in the treaty to preclude the approach adopted by HMRC and that HMRC's approach was one that was permissible under s.11AA. The Tribunal relied in part on the 2008 OECD commentary in their reasons, considering that the guidance in the 2008 OECD commentary was properly to be treated as no more than confirmatory of the scope of Article 7 in the 1963 Model Treaty (which was contemporaneous with the 1976 UK/Irish treaty).

Decision of the Court of Appeal

The Court of Appeal has now unanimously upheld the decision of the Upper Tribunal.

The UK/Irish treaty was closely based on the provisions of the 1963 OECD Model Treaty. As such, the 1963 Model and guidance notes could be considered to be relevant to the construction of the UK/Irish treaty. The same was not true of the later versions of the Model treaty and later OECD guidance, as these could not have been taken into account by the UK and Ireland when entering into the treaty.

The banks argued that the terms of the treaty precluded the application of the approach in the 2008 OECD Commentary which involved notionally capitalising the PE at the level at which it could reasonably be expected to have operated had it conducted its business as an independent enterprise. The banks contended that this approach required a substantive change to the terms of what was then Article 7 of the model convention and that this was achieved by the 2010 re-draft. HMRC, however, argued that the amended OECD commentary on the model convention published in 2008 merely confirmed that the approach based on an attribution of capital had long been used by Member States to implement the provisions of Article 7 and was recognised by the OECD as permissible under the terms of the earlier version of Article 7 of the model convention.

The Court of Appeal has agreed with HMRC on this point. The changes to the OECD commentary introduced in 2008 (providing commentary on an unchanged underlying Article 7 of the model convention) did not introduce any real change in the methodology for determining the profits attributable to a PE. The Commentary was rather affirmation that Article 7 always permitted a considerable degree of flexibility in the methods for attributing profits to a PE including various forms of capital contribution. Moreover, as the FTT found as a fact, some form of capital attribution had been UK Revenue practice since the 1950s. The purpose of the 2008 Commentary was to attempt to bring a degree of conformity to this approach rather then to allow capital attribution for the first time.

Equally, turning to the terms of the UK/Irish treaty, the Court noted that it too required an assumption that the PE be treated as a separate entity and did not prescribe how this exercise is to be carried out. If the books of account failed to properly reflect that assumption, then it was clear that an adjustment was permitted. Although this view was consistent with the 2008 Commentary it was not dependent on it. Accordingly, there was nothing inconsistent in the requirement in s.11AA(3)(b) to assume a notional amount of capital with the terms of Article 8 of the treaty. That was not necessarily the only way in which the terms of the treaty could be implemented, but it was not a method that was precluded by the treaty.

Accordingly, the Court held that Article 8(2) of the UK/Irish Treaty did not preclude the requirement in s.11AA(3)(b) to assign a notional amount of capital to the UK PE.

Comment

It is important to note that the taxpayer needed to overcome the burden of showing that the treaty precluded the treatment set out in s.11AA in order to succeed. This was a heavy burden and the general assumption in Article 8(2) along similar lines to the premise in s.11AA as a whole was sufficient to enable HMRC to show that attributing capital to a PE was within the general nature of the assumptions required in treating a PE as a separate and distinct entity.

The decision also includes a useful commentary on aspects of constitutional and international law when approaching the construction of treaties. Singh LJ, in particular, expressed concern that "some confusion has crept into this area of law because insufficient attention has been paid to the important distinction between different parts of the state".

As an enactment of primary law, the interpretation of s.11AA could not be affected by the practices of HMRC. It was the interpretation of the primary legislation that was important (not the interpretation of HMRC - though that might be relevant to a case based on legitimate expectation). A Court would normally be bound to give effect to s.11AA as an enactment of primary legislation irrespective of whatever might be said in an international treaty (even if that were incorporated into UK law by secondary legislation - as secondary legislation must give way to primary legislation). And it would normally be immaterial that s.788(3) provides that a provision in a double tax treaty is to override a contrary provision in primary legislation, where the particular contrary primary provision is subsequent to the enactment of s.788(3) (due to the doctrine of implied repeal). However, the Court agreed that "in the context of double taxation treaties, the doctrine of implied repeal does not operate. The legal position can be compared to the position as it has been until recently (before the UK's withdrawal from the European Union) under section 2 of the European Communities Act 1972, which applied to Acts of Parliament which came after that Act just as much as it did to earlier Acts. It is now well established that in the constitution of the UK there can be "constitutional" statutes, which are not "ordinary" statutes".