Treaty Bars Attribution of Capital to U.K. Banks U.S. Branch 

The Court of Federal Claims, in National Westminster Bank, PLC, 11/14/03, found that the U.S.-U.K. treatys plain language forbids the attribution of capital to a U.K. banks U.S. branch based on the capital requirements of banks incorporated in the U.S. The court held that separate and distinct in that treaty means that the branch should be treated not as if it were separately incorporated, but simply as separate and distinct from the rest of the bank. Article 7 of the U.S.-U.K. treaty (Business Profits) allows the taxing authorities to adjust a branchs books and records only to ensure that transactions between the branch and other parts of the foreign bank are properly identified and characterized for tax purposes, and that they reflect arms-length principles.

Facts

National Westminster (NatWest) is a U.K. corporation engaged in banking. During the years at issue (19811987), it conducted business in the U.S. through branches (U.S. Branch) and subsidiaries. U.S. Branch was supported by NatWests worldwide capital.

U.S. Branch obtained funds to conduct operations by borrowing from (among others) NatWests headquarters office and other branches, and paid interest on the borrowed funds. This interest, as reflected on U.S. Branchs books, was deducted for Federal income tax purposes.

NatWests U.S. subsidiaries were required by local banking laws to maintain minimum capital accounts separate from that of NatWest, but U.S. Branch was not.

Procedural History

The IRS disallowed a deduction for part of the interest U.S. Branch paid to NatWests headquarters after calculating the interest allocable to U.S. Branch under Regs. Sec. 1.882-5. That provision apportions interest using a formula that compares branch assets to worldwide assets. NatWest paid the additional tax and sued for a refund; see National Westminster Bank PLC, 40 Fed. Cl. 120 (1999).

NatWest argued that Article 7 of the U.S.-U.K. Income Tax Treaty bars use of the formulary method, because it requires a branch to be treated as a separate and distinct entity. The court agreed with the taxpayer, holding that the treaty contemplates that the profits of a U.K. companys U.S. branch that are subject to tax in the U.S. would be based on the books maintained by the branch as though the branch were a distinct and separate operation dealing wholly independently with the remainder of the foreign corporation.

After this holding and discovery, the parties moved for summary judgment on whether, in calculating U.S. Branchs interest deduction, some of the loaned funds could be treated as capital, because a separate and distinct entity would require such capital.

Law and Analysis

Article 7 of the treaty provides that an entitys business profits are subject to tax only in its state of residence, unless attributable to a permanent establishment in the other state. The profits attributable to the permanent establishment are those 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 government asserted that, to give meaning to the phrase separate and distinct, U.S. Branch should be treated as if it were a separately incorporated bank, and should be deemed to hold the capital that such a bank would be required to hold. Once the branchs appropriate deemed capital was determined, a corresponding portion of the debt owed to the headquarters would be recharacterized as equity; interest deductions on that portion would be denied.

NatWest argued that the treaty, as supported by its legislative history, required that the branchs books be used to determine the taxable profits attributable to the branch as if it were separate and distinct from its parent. NatWest further asserted that Article 7 does not allow the attribution of capital to a branch beyond an amount reflecting the branchs actual circumstances.

The court held that the treaty requires the use of U.S. Branchs books in determining each element affecting its profits. Additional capital can be attributed to U.S. Branch only if capital actually attributed to it was not properly recorded on its books as capital. 

From Raymond P. Lincourt, Jr., J.D., LL.M., and Thomas D. Fuller, J.D., Washington, DC