The branch will often be allocated some level of capital backing with which it can offer banking services (i.e. deposit taking or lending). Regulated banks are required to keep around 10-15% of 'regulatory capital' in relation to their loan portfolio, meaning that for every £100 they lend, they must have £10-15 of assets in reserve.
Bank branches might be fully funded via loans from their head office, or they might be funded with 10-15% of equity - it will depend on the local regulations and the bank's operations policy.
Where a branch is funded with 100% debt, as opposed to 85% debt and 15% equity - its interest payments to head office will be proportionately higher than interest payments of comparable branches which are funded with 10-15% of equity. Where interest payments are higher, tax deductions are higher for the branch and therefore its taxable income would be lower. While it's true that the taxable income of the head office will be higher and therefore there is no net advantage governments generally want their share of the branch's taxable income.
The law
Section 21 of CTA 2009 addresses this issue, providing that:
"(1)The profits...attributable to the permanent establishment are those that the establishment would have made if it were a distinct and separate enterprise which–
...
...
(b) dealt wholly independently with the non-UK resident company."
and
(2) In applying subsection (1) assume that–
...
(b)the permanent establishment has such equity and loan capital as it could reasonably be expected to have in the circumstances specified in that subsection."
Subsection 2(b) clearly requires PEs to calculate their interest payments as if they held a normal level of equity. The issue in this case is whether or not that provision is consistent with Article 8 of the UK-Ireland double tax convention ('DTC'). DTCs take precedence over legislation where there is any disagreement between the two.
Article 8(2) of the DTC states:
"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 profits which
it might be expected to make if it were a distinct and separate enterprise [dealing at arm's length]"
Argument
Irish Bank Resolution Corporation Limited ('IBRC') was located in Ireland, and had a UK PE in the 90s and 00s. This case relates to its PE interest deductions between 2003 and 2007 (given the law was enacted in 2003).
IBRC contended that section 21 of CTA 2009¹ was inconsistent with the words of the DTC, and therefore the law was invalid. The case hinged upon whether the wording of Article 8(2) of the DTC precluded a law which allowed the UK or Irish government(s) to imagine PEs have hypothetical capital in order to reduce their allowable interest tax deductions.
IBRC also pointed out that Her Majesty's Revenue and Customs ('HMRCs') view on this topic varied from time to time. In fact, in the 90s the common view was that Inland Revenue had no authority to impute hypothetical capital, and at the time HMRC generally agreed with this. ²
Findings
The judge disagreed with IBRC and found in favor of HMRC. The judge generally agreed with expert evidence given by Mr Black - a former UK representative to OECD tax conferences.
"[Mr Black's] evidence was that capital is critical to the operation of a bank, and that, since banks normally trade through branches rather than subsidiaries, it is important to ensure that the amount of capital attributable to a PE in a country other than that of the parent is fairly determined in order that profits are taxed, or losses relieved, in the country in which they are generated or suffered, and that banks which perform a proper attribution or trade in only one jurisdiction are not put at a disadvantage by comparison with banks which are able, by adopting an artificial means of attribution, to shift profits to minimise their tax burden. The aim was to ensure that banks, and other similar organisations, operated on a level playing field." ³
The judge concluded:
"The underlying aim, equally clearly and uncontroversially, is to avoid double taxation or an escape from taxation. As I see it, art 8(2) achieves that aim by eliminating distortion, whether that distortion is deliberate or merely the accidental consequence of the entity’s structure or manner of operation. I do not understand how the distortion can be eliminated if the PE, though it is to be treated, as art 8(2) puts it, as a “distinct and separate enterprise”, “dealing at arm’s length with the enterprise of which it is a permanent establishment”, is nevertheless to be shielded from the adjustments or attribution which it is necessary to make if those requirements are to be met."⁴
Notes
1. Section 11 of ICTA 88 was later written into CTA 2009.
2. p22
3. p28
4. p63
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