Court of Appeals Affirms NatWest Decisions United States Court of Appeals Affirms Decisions Holding Treas. Regs. 1.882-5 To Be Inconsistent with the 1975 U.S.-U.K. Tax Treaty SUMMARY In National Westminster Bank, PLC. v. United States ( NatWest ), decided on January 15, 2008, the Court of Appeals for the Federal Circuit affirmed decisions of the Federal Claims Court which had held that requiring the U.S. branch of a U.K. bank to determine its deductible interest expense under the threestep formula in Treas. Regs. 1.882-5 was inconsistent with Article 7 (Business Profits) of the 1975 U.S.- U.K. income tax treaty (the 1975 Treaty ), and it allowed the U.S. branch to determine its deductible interest expense for 1981-87 under Article 7 on the basis of the equity capital and liabilities (including inter-branch liabilities) shown on the books of the branch. Although no longer relevant to the determination of the deductible interest expense of a foreign bank, the decision in NatWest may be relevant to the interpretation in other contexts of the business profits articles of many U.S. income tax treaties. IMPLICATIONS Because of changes to the U.S.-U.K. income tax treaty and to Treas. Regs. 1.882-5 subsequent to the years involved in NatWest, the Court of Appeals decision is not relevant to the determination of the interest expense of a foreign bank under current law the current regulations specifically provide that deductible interest expense of the U.S. branch or other permanent establishment of a foreign corporation New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
is determined under the formula set out in the regulations, except where a different rule is expressly provided by a tax treaty. 1 The Court of Appeals reliance on the plain language of Article 7 of the 1975 Treaty may, however, be relevant in other applications of the business profits articles of U.S. income tax treaties. Specifically, while more recent U.S. tax treaties, consistent with the Court of Appeals interpretation of Article 7 of the 1975 Treaty and the 2006 U.S. Model Income Tax Convention, interpret the business profits articles as treating a U.S. branch or permanent establishment as substantively a separate entity (and thus, for example, recognizing inter-branch swap and other transactions) 2, it is the view of the U.S. Treasury that this approach the so-called authorised OECD approach (or AOA ) does not apply under most existing U.S. tax treaties. 3 The Court of Appeals emphasis on the plain language of the 1975 Treaty, particularly the reference to a permanent establishment as a distinct and separate enterprise, may support a broader application of the separate entity approach than contemplated by the Treasury. BACKGROUND NatWest involved claims for refunds by a U.K. bank for the years 1981-1987. On its returns, NatWest determined the deductible interest expense of its U.S. branch on the basis of the equity capital and 1 2 3 A new treaty came into effect between the United States and the United Kingdom in 2003. See Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, U.S.-U.K., July 24, 2001, S. Treaty Doc. No. 107-19 ( New Treaty ). Notes to that treaty allow a U.K. bank to use Treas. Regs. Section 1.882-5 or to determine the capital of a U.S. branch on the basis of risk-weighted assets. The regulations were also subsequently amended, in part to conform the regulations with treaties, such as the New Treaty, that provide for risk-weighting. The amended regulations make it clear that, absent a specific treaty provision, Treas. Reg. 1.882-5 provides exclusive guidance on the calculation of deductible interest. See Treas. Reg. 1.882-5T(a)(2) ( Except as expressly provided by or pursuant to a U.S. income tax treaty or accompanying documents (such as an exchange of notes), the provisions of this section provide the exclusive rules for determining the interest expense attributable to the business profits of a permanent establishment under a U.S. income tax treaty. ). See, e.g., Article 7(2) of the New Treaty ( Subject to the provisions of paragraph 3 of this Article, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the business profits that it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. For this purpose, the business profits to be attributed to the permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment. ) (emphasis added to show difference from the 1975 Treaty language). See Treasury Releases Statement on PE Attribution of Profits, 2007 TNT 112-53 ( While we fully support the Authorised OECD Approach (AOA) for attributing profits to a permanent establishment (PE), it will not apply to most existing U.S. tax treaties. We generally provide in Article 7(3) for a reasonable allocation of certain expenses, which is not consistent with the arm s-length approach of the AOA. ). -2-
liabilities (including inter-branch liabilities) shown on the books of the branch. On audit, the I.R.S. recalculated the interest expense deduction of the branch by using the formula set forth in Treas. Regs. 1.882-5, 4 which resulted in additional taxable income. Following a failed competent authority proceeding, NatWest paid the additional tax and filed suit for refunds on the basis that Treas. Regs. 1.882-5 was inconsistent with the terms of the 1975 Treaty. 5 In 1999, the Federal Claims Court sided with NatWest ( NatWest I ) 6 and held that Treas. Regs. 1.882-5 was inconsistent with the 1975 Treaty and that, under Article 7 (Business Profits) of the 1975 Treaty, NatWest had correctly deducted interest expense recorded on the books of its U.S. branch. 7 The Court of Appeals also stated that the books of the U.S. branch 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 expense. 8 In a later decision ( NatWest II ), 9 the Federal Claims Court determined that the separate enterprise principle did not allow 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. 10 Only capital allotted to the U.S. branch was relevant to the determination of its taxable income and only amounts not properly recorded in the books of the U.S. branch can be added to such capital. 4 5 6 7 8 9 10 Under Treas. Regs. 1.882-5, deductible interest expense of a foreign bank with a U.S. branch is calculated by a three-step formula. In the first step, U.S. assets are determined for the taxable year. In the second step, liabilities are attributed to those assets, based on either the actual worldwide ratio of the bank s liabilities to assets or a fixed ratio. In the third step, interest expense is attributed to the liabilities determined in step two. Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, U.S.-U.K., Dec. 31, 1975, 31 U.S.T. 5668 (the 1975 Treaty ). Article 7(2) of the 1975 Treaty states as follows (emphasis added): Subject to the provisions of paragraph (3), where an enterprise carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. Nat l Westminster Bank, PLC v. United States, 44 Fed. Cl. 120 (1999). See our Memorandum dated July 12, 1999, describing NatWest I and its implications in more detail. Nat l Westminster Bank, 44 Fed. Cl. at 128. See Nat l Westminster Bank, PLC v. United States, 58 Fed. Cl. 491 (2003). -3-
The Government appealed both decisions (as well as two further decisions of the Federal Claims Court), 11 and the Court of Appeals for the Federal Circuit affirmed the decisions of the Federal Claims Court. THE COURT OF APPEALS FOR THE FEDERAL CIRCUIT S OPINION The Court of Appeals for the Federal Circuit upheld the two Federal Claims Court decisions described above. 12 It affirmed the Federal Claims Court s holding that Treas. Regs. 1.882-5 was inconsistent with the 1975 Treaty on three grounds. First, the Court of Appeals found that the language of the 1975 Treaty itself, through the separate entity principle articulated in Article 7 of the 1975 Treaty, mandates that expenses incurred for the benefit of the U.S. Branch be deductible, including interest expenses paid to foreign branches of NatWest. 13 Second, the Court of Appeals analyzed the Commentaries on the Articles of the Organization for Economic Cooperation and Development s ( OECD ) 1963 Draft Double Taxation Convention on Income and Capital (the 1963 Commentaries ), and concluded that those supported the Court of Appeals reading of Article 7 of the 1975 Treaty. The Court of Appeals accorded the most weight to these first two points. It said that, [w]hen construing a treaty, the clear import of the treaty language controls unless application of the words of the treaty according to their obvious meaning effects a result inconsistent with the intent or expectations of its signatories. 14 Following this rule, the Court of Appeals interpreted the words distinct and separate enterprise in Article 7 to mean that permanent establishments of foreign enterprises in the U.S. should be treated as dealing with all other entities of the same enterprise at an arm s-length basis. Finally, the Court of Appeals found evidence that the United Kingdom s contemporaneous understanding of Article 7 of the 1975 Treaty was similarly consistent with this view. While the United States may have interpreted Article 7 differently, especially after 1984 (when the OECD acknowledged that the United States interpreted Article 7 in a way that allowed for the application of Treas. Regs. 1.882-5 to international financial institutions), the Court of Appeals held that such interpretation should not be given much deference in light of the fact that it was inconsistent with the language of the 1975 Treaty, the history of the negotiation of that treaty, and the expectations of the United Kingdom. 15 The Court of Appeals also noted that there was no evidence or indication before the 1984 OECD report of the 11 12 13 14 15 Nat l Westminster Bank, PLC v. United States, 69 Fed. Cl. 128 (2005); Nat l Westminster Bank, PLC v. United States, No. 95-785T (Fed. Cl. Jan. 18, 2005) (order denying reconsideration of allocation of capital to the U.S. branch). See Nat l Westminster Bank, PLC v. United States F.3d, 2008 WL 124227 (Fed. Cir. 2008). at 10. at 5 (quoting Sumitomo Shoji America, Inc. v. Avagliano, 457 U.S. 176, 180 (1982)). -4-
Treasury s belief that Treas. Regs. 1.882-5 was consistent with the 1975 Treaty. 16 Furthermore, even if the Treasury s belief could be established as of 1984, the United Kingdom s opposite interpretation could also be established as of that date. 17 Having concluded that Treas. Regs. 1.882-5 was inconsistent with the 1975 Treaty, the Court of Appeals considered whether the separate enterprise principle was intended by the parties to require a permanent establishment to be taxed as a separately incorporated institution or to be taxed according to the reality of its situation and accounts as adjusted to reflect market pricing in its dealings with the home office. 18 The Court of Appeals held that Government s method of taxing the U.S. branch as if it were subject to the same requirements as a separately incorporated U.S. subsidiary would also violate the 1975 Treaty. The Government, in reaching its position, relied on the language in Article 7(2) of the 1975 Treaty that states (with emphases added): there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. The Court of Appeals held that the same or similar conditions language supports the argument that the U.S. Branch should be taxed in a manner consistent with the actual conditions of its operation a branch with operations that are funded with little or no interest-free capital. 19 As noted, because of subsequent changes to Treas. Regs. 1.882.5 and to the U.S.-U.K. tax treaty, the Court of Appeals opinion is not relevant to the determination of the deductible interest expense of a U.S. branch of a foreign bank under current law. The opinion may, however, be important in the interpretation in other contexts of the business profits articles of U.S. tax treaties. Many of these use the same language in the business profits article that was before the Court of Appeals in NatWest, and the Court of Appeals interpretation of this language would, for example, support the recognition of arm s-length interbranch swaps and other transactions. * * * Copyright Sullivan & Cromwell LLP 2008 16 17 18 19 at 9. at 11. -5-
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