NatWest Case

By Willard B. Taylor, Esq. Sullivan & Cromwell LLP, New York, N.Y.

In National Westminster Bank, PLC v. U.S.¹ (hereafter, “NatWest”), decided on January 15, 2008, the Court of Appeals for the Federal Circuit, seemingly ending years of litigation, affirmed decisions of the Claims Court which had held that it would be inconsistent with Article 7 (Business Profits) of the 1975 U.S.-U.K. Income Tax Treaty to require the U.S. branch of a U.K. bank to determine its deductible interest expense under the three-step formula set out in Regs. §1.882-5.² The Court thus allowed the U.S. branch to determine its deductible interest expense under Article 7 on the basis of the equity capital and liabilities, including inter-branch liabilities, shown on the books of the branch.

NatWest involved claims for refunds for the years 1981-1987. Because a new treaty subsequently came into effect and because of subsequent changes to Regs. §1.882-5, NatWest is no longer relevant to the determination of a foreign bank’s deductible interest expense. Under the current regulations, the deductible interest expense of a U.S. branch is determined under the three-step formula set out in the regulations, except where a different rule is expressly provided by a tax treaty.³ The new treaty with the United Kingdom, which was signed July 24, 2001, and came into effect in 2003, allows a U.K. financial institution to use the method in the regulations or to risk-weight its assets in determining deductible interest expense.

What may be relevant in the NatWest decision, however, is the application in other contexts and under other tax treaties of the Court of Appeals’ view of the “plain language” of Article 7(2) of the 1975 treaty. The Court of Appeals interpreted the words “distinct and separate enterprise” in Article 7(2) to mean that a U.S. permanent establishment of a U.K. enterprise should be treated as dealing with all other branches of the same enterprise as if they were unrelated entities. 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. permanent establishment as substantively a separate entity (and thus, for example, as recognizing inter-branch swap and other transactions),⁴ it is the view of the U.S. Treasury that this approach–the so-called “authorized OECD approach”–does not apply under “most existing” U.S. tax treaties.⁵ The Court of Appeals’ interpretation of “plain” language of the business profits article–in particular 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. The Treasury’s rationale for its position–that the reference in Article 7(3) of most U.S. tax treaties to a “reasonable allocation” of expenses trumps the arm’s-length approach–was rejected by the Court of Appeals in NatWest.

This commentary also will appear in the April 11, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz and Plambeck, 908 T.M., U.S. Income Taxation of Foreign Corporations, and Cole, Venuti, Gordon and Croker, 940 T.M., Income Tax Treaties — Administrative and Competent Authority Aspects, and in Tax Practice Series, see ¶7120, Foreign Persons’ U.S. Activities, and ¶7140, U.S. Income Tax Treaties.

¹ 2008 WL 124227 (Fed. Cir. 2008).

² NatWest had calculated its deductible interest expense on the basis of the books of the U.S. branch. The IRS recalculated the deduction under Regs. §1.882-5, which resulted in additional taxable income. Following a failed Competent Authority proceeding, NatWest paid the additional tax and filed suit for refunds on the ground that the regulations were inconsistent with the 1975 treaty. In 1999, the Claims Court sided with NatWest and held that Regs. §1.882-5 was inconsistent with the 1975 treaty and that, under Article 7 (Business Profits), NatWest had correctly deducted interest expense recorded on the books of its U.S. branch. (The Claims Court also said 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.”) In a later decision, the Claims Court determined that the separate enterprise principle did not allow the IRS “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.” 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. The IRS appealed both decisions (as well as a further decision of the Claims Court with respect to the IRS’ motion to reopen discovery and the Claims Court’s final summary judgment in favor of NatWest).

³ See Regs. §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.”).

⁴ Article 7(2) of the new U.S.-U.K. treaty differs from Article 7(2) of the 1975 treaty only in that it adds, at the end, “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.”

⁵ See Treasury Releases, Statement on PE Attribution of Profits, 2007 TNT 112-53 (“While we fully support the Authorized 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”).