Irish Bank Resolution Corporation Ltd v Revenue and Customs, [2020] EWCA Civ 1128

The Irish taxpayers, which carried on a UK branch banking business or a business of financing UK house purchases, were required to determine their profits under UK taxing legislation which, in this regard, was generally similar to the “comparator provisions” of Art. 8(2) of the 1976 Ireland-UK Treaty (which required that there be attributed to a UK permanent establishment (“PE”) “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”) except that the UK legislation went on to provide that, in applying this test, “it shall also be assumed that the permanent establishment has such equity and loan capital as it could reasonably be expected to have in the circumstances specified” above.

In applying the domestic provision, HMRC attributed to the PEs 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 (as summarized at para. 11) that:

[T]he reference in Article 8(2) to the PE being treated as a distinct and separate enterprise "engaged in the same or similar activities under the same or similar conditions" 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 this regard, Patten LJ noted that the previous more favourable practice of HMRC was not relevant, noting (at para. 23) that the taxpayers were “unable to identify any established principle of international law which recognises the unilateral practice of a contracting state as an aid to the construction of a treaty.” After also noting (at para. 29) that the 2008 OECD commentary stated that “authorised OECD approach does not limit the methods by which domestic tax regimes may seek to implement the provisions of Article 7 and that the attribution of capital is a well-recognised and justifiable method of attributing profits to a branch of an overseas bank,” he stated (at para. 39):

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 of Article 8(2) 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.

Accordingly the appeals were dismissed.

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. Patten LJ was fortified in his conclusion that these adjustments accorded with the “comparator provisions” of the permanent establishment Article in the UK-Ireland Treaty (Art. 8(2), which was similar to Art. 7(2) of the OECD Model) by passages in the 2008 OECD Commentaries, notwithstanding that he was dealing with a 1976 Treaty. He stated (at para. 31):

Although [43]-[47] of the 2008 Commentary are new, it is clear from [7] of the Commentary that they were considered appropriate for inclusion by the OECD because they were not in conflict with earlier versions of the Commentary. … On that basis, the 2008 Commentary, although new, would be admissible as an aid to the construction of Article 8(2) of the 1976 Convention which, as I have explained, adopted the wording of Article 7(2). It 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.