Irish Bank Resolution Corp – England and Wales Court of Appeal effectively finds that the Treaty PE Article has an embedded thin cap rule
HMRC increased the UK branch profits of the Irish taxpayers’ branch banking, or home mortgages, businesses by attributing to their UK permanent establishments notional additional free capital on the basis that if they had operated as distinct and separate enterprises, they would have had a higher amount of free capital and therefore a correspondingly lower amount of borrowed capital – with the result that HMRC disallowed interest which was actually paid to third parties.
The taxpayers unsuccessfully argued that this was contrary to the “comparator provisions” of the PE Article in the UK-Ireland Treaty, which required that there be attributed to a UK 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 at arm's length with the enterprise of which it is a permanent establishment.” They submitted that this rule “requires 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.”
In rejecting this argument (and dismissing the taxpayers’ appeals) Patten LJ stated:
In order to operate the hypothesis of a distinct and separate enterprise dealing at arm's length including with the overseas company of which it is part, it seems to me that it is necessary to compare the way in which the PE financed and accounted for its business with what it would have done had the PE operated as a separate enterprise. Otherwise the comparator provisions … cannot work. To construe the phrase "same or similar conditions" as requiring the PE's actual ratio of free to borrowed capital to be applied would be self-defeating.
He was fortified in his conclusions by passages in the 2008 OECD Commentaries notwithstanding that he was dealing with a 1976 Treaty, stating that the 2008 Commentary would “only be inadmissible if the new material made substantive changes which are inconsistent with the commentaries in existence at the time of the 1976 Convention.”