Canada: U.S. Court Rejects Formula Apportionment in Computing Business Profits of a Foreign Bank Branch

In December 2005, the U.S. Court of Federal Claims held that National Westminster Bank, PLC, a U.K.-based multinational bank (NatWest), was not required to apply the formula-based apportionment of interest expense required under domestic U.S. tax law and ruled instead that it was entitled to rely on the properly maintained books and records of its U.S. branch in computing its business profits. In its third decision in the continuing tax dispute, the court provided some valuable guidance on the practical application of the "business profits" article in most tax treaties.

NatWest conducted its banking operations in the U.S. through several offices at various U.S. locations. NatWest treated all of these offices as a single U.S. branch operation, which it funded through intra-company advances. The U.S. branch reported the bulk of these advances on its books and records as loans and claimed interest expense with respect to these loans in computing its profits for U.S. tax purposes. NatWest’s U.S. branch was highly leveraged, operating with a far lower capital-to-total-assets ratio (as low as 0.76%) than would have a separately-incorporated bank subsidiary subject to U.S. minimum capital requirements. Since the interest "charged" by the U.K. parent on amounts reported as debt on the U.S. branch’s books and records reduced the branch’s income for U.S. tax purposes, what was at stake in the NatWest litigation was the proper determination of the share of NatWest’s worldwide profits taxable by the U.S.

While some aspects of the NatWest rulings (which dealt with the 1981-1987 tax years) may prove to be of principally historic interest to foreign banks with U.S. branches, the court’s approach contains helpful insights that may be applicable to many situations in which tax treaty rules overlay domestic rules for determining branch expenses.

The U.S. Internal Revenue Service (IRS) denied the deduction for the intra-company loan interest expense claimed by NatWest’s U.S. branch and applied a U.S. Treasury Regulation that apportions interest expense deductions in computing income that is "effectively connected" with a U.S. trade or business. The Regulation disregards intra-company advances (such as those recorded by NatWest’s U.S. branch as loans) and uses instead a formula-based determination of a foreign taxpayer’s U.S. branch interest expense. The formula treats a foreign corporation’s U.S. branch as having "U.S.-connected liabilities" in proportion to the actual ratio of worldwide liabilities to worldwide assets or to an elective fixed ratio (currently 93%). The U.S.-connected liabilities derived under that formula are then used as the basis for computing U.S. branch interest expense under the Regulation. NatWest’s U.S. branch had recorded an amount of the advances received from its headquarters as being debt (rather than equity) in excess of the level of debt that would be imputed to the branch under the Regulation’s formula. Consequently, the IRS sought to deny what it regarded as the excess interest expense claimed by NatWest.

The IRS had long maintained that these U.S. domestic tax rules are also the exclusive method for determining the business profits of a U.S. permanent establishment under U.S. tax treaties. However, in a series of three rulings on motions for summary judgment, the U.S. Court of Federal Claims upheld NatWest’s method of allocating interest expense deductions for U.S. tax purposes based on the properly maintained books and records of its U.S. branch. Contrary to the U.S. Regulation, the court’s rulings recognize as relevant, for computing branch business profits under a tax treaty, transactions of the branch with the head office.

In decisions delivered in 1999 and 2003, the Court of Federal Claims established important principles pertaining to the interaction of tax treaties and a jurisdiction’s internal legal rules in apportioning interest expense to local branches.

In the first case of the NatWest trilogy in 1999, the court ruled that the U.S. Treasury Regulation that used a formula to disallow some of the interest expense reflected in the financial records of the U.S. branch was inconsistent with the former U.K.–U.S. tax treaty’s business profits article, which required attribution to a permanent establishment of those profits it would make if it were a "distinct and separate enterprise." Thus, the court held that the treaty required that branch profits should be based on the books and records of the branch maintained as if the branch were a distinct and separate enterprise dealing independently with the remainder of the foreign corporation. In particular, the court recognized that intra-company dealings set forth in those books and records are relevant in determining the profits to be attributed to a permanent establishment. It further held that those books and records could only be adjusted, if necessary, to ensure the use of market rates in computing branch interest expense and to impute adequate capital to the branch.

In the second case in 2003, the dispute turned on whether NatWest’s U.S. branch was in fact adequately capitalized (see our Osler Update). The U.S. government interpreted the "distinct and separate enterprise" requirement in the U.K.–U.S. treaty to mean that the profits of NatWest’s U.S. branch should be determined as if the branch were a separately incorporated subsidiary. A U.S. incorporated bank is subject to minimum capital requirements, whereas a branch of a foreign bank is not. Thus, for example, for the tax years at issue NatWest’s various branch offices operated with capital ratios (capital/total assets) ranging from 0.76% to 1.75%, while a separately-incorporated U.S. subsidiary of NatWest had capital ratios that varied from 6.03% to 7.19%. Under the U.S. government’s position, based on a comparison to the capital of a U.S. incorporated bank, an amount of capital should be imputed to the branch and be treated as equity capital of the U.S. branch, thereby reducing the branch’s debt funding and, consequently, its interest expense.

The court in 2003 held that the text of the U.K.–U.S. treaty provided no support for hypothetical infusions of capital into the U.S. branch based upon capital requirements that applied to U.S. incorporated banks and not to branches. In addition, relevant OECD commentary rejected hypothetical equity capital imputations and only supported adjusting branch interest expense in limited circumstances, namely, where capital advances from a head office had been improperly reported as loans to a branch. To the extent that 2001 and 2003 OECD commentary took a different view, this was of no relevance to the proper interpretation of a treaty that had been negotiated in 1975. The court agreed with NatWest that its U.S. branch was entitled to base its deductible interest expense on its properly maintained books and records, provided that the transactions between the branch and other parts of NatWest were properly characterized in those books and records and met certain other requirements. In this connection, the court noted that NatWest’s position was consistent with the historic position of the U.K., as set forth in the Inland Revenue Banking Manual (the U.K. Manual).

In the December 2005 decision the issues decided by the court were framed, to a remarkable extent, by reference to the U.K. Manual. In the 2003 ruling, the court had found, based on principles stated in the U.K. Manual, that the properly maintained books for the U.S. branch could be adjusted if an interest expense was deducted on amounts designated as debt that had in fact been allotted to it for capital purposes, or if interest paid or received on inter-branch loan transactions was not at arm’s-length rates. In the 2005 ruling, the IRS argued that the books and records of the U.S. branch were not adequately maintained. However, the taxpayer’s evidence showed that the preparation of the U.S. branch’s books and records was subject to both regulatory and head office controls, as well as internal branch control procedures (which the Bank of England had found to be exemplary). The court concluded that the U.S. branch had properly maintained its books and records. The court repeatedly deferred to NatWest’s books and records as having presumptive validity in the determination of branch interest expense.

The next question before the court was whether NatWest was entitled to aggregate all of its U.S. offices and to treat them as a single taxable unit (or permanent establishment) for U.S. tax purposes. Because some of NatWest’s U.S. offices had sustained losses, the U.S. government had argued that more capital should be allocated to those offices and, in turn, that the interest expense allocable to those offices should be reduced. However, if the various offices were aggregated, there was no such need for additional capital. The court held that it was a question of law whether there was a single permanent establishment as maintained by NatWest. There was no precedent for treating each of NatWest’s branch offices as a separate permanent establishment, and the IRS had always accepted NatWest’s income tax returns filed on the basis that there was only one permanent establishment in the United States. The fact that NatWest’s six offices maintained separate books and records for internal accounting purposes did not mean that the offices were six separate permanent establishments. Accordingly, the court held that NatWest was entitled to account for its capital and claim an interest deduction on the basis that all of its U.S. offices were a single taxable unit (or permanent establishment).

The next question was whether the U.S. branch, in its books and records, had treated as debt financing what the IRS alleged should have been treated as capital advances (in which case, the U.K Manual would permit an adjustment to the interest expense reported on the branch books and records). The government argued that the U.S. branch had claimed interest expense on advances provided to it to finance fixed assets or other capital expenses of the U.S. branch which should have been treated as capital advances. The court disagreed. NatWest had voluntarily reversed any previously claimed U.S. interest deductions in respect of such capital advances. The government counter-argued that, even if that were so, in calculating its profits, NatWest had failed to account for "economic capital", i.e., an amount the branch would hypothetically need to support the economic risks of its banking operations. The court rejected the government’s position that the U.K.–U.S. tax treaty then in force required the U.S. branch to account for "economic capital". NatWest was entitled to compute its U.S. branch’s interest expense, consistently with the treaty and the U.K. Manual, based on the amount of capital which in reality had been advanced to the branch, not on a hypothetical economic capital amount.

The remaining issue was whether NatWest paid and received arm’s length interest rates on both (a) money market transactions and (b) clearing account transactions. Based on the court’s view of the facts, NatWest was successful on the first, but failed to obtain summary judgment on the second issue.

The NatWest trilogy of cases is required reading for anyone involved in international tax affairs of a multinational group. The specific context in which the rulings were made should be kept in mind. The cases involved the former U.K.–U.S. tax treaty, which was signed before the United States issued its formula-based Regulation, and the same conclusion would not be reached under the current treaty, which (like the Japan–U.S. treaty) was negotiated explicitly on the basis of permitting allocation of interest expense based on a type of formulary apportionment (risk weighting of worldwide assets). The NatWest court reached its conclusions in part because of the lack of evidence that the former treaty countenanced a formula-based method of allocating expenses. The tax years at issue in NatWest also predated the 1996 insertion in the language of the Regulation that it is generally meant to apply for purposes of determining U.S. branch business profits under tax treaties. Thus, it should not be assumed that a court interpreting a different OECD-based treaty than the 1975 U.K.–U.S. tax treaty, or later tax years, will reach the same conclusions as did the Court of Federal Claims. Nonetheless, the decisions offer some important insights and guidance:

• By rejecting domestic formula-based income and expense allocation and imputation methods and relying on the branch’s properly maintained books and records in the determination of a branch’s business profits, the NatWest trilogy raises questions about the validity in certain cases of domestic formulaic rules that apply to branches of certain foreign taxpayers – for example, banks and insurance companies – in the face of applicable tax treaty provisions (indeed, an analogous challenge of a domestic formulary rule succeeded in respect of a Canadian insurer’s determination of its U.S. business profits under the Canada–U.S. tax treaty in a 1996 U.S. Tax Court decision). Accordingly non-residents carrying on business through branches reporting expense and/or business profits based on such domestic rules may consider reviewing the provisions of applicable treaties – as well as their "legislative history" – to evaluate the basis on which the branch is, or should be, taxed in the host country. If, based on such a review, it seems that a treaty may provide a different basis for taxation than that provided by the host country’s rules, such taxpayers should aim to meet (or exceed) the standards set by NatWest in maintaining the books and records of their foreign branches, given the primacy of the branch books and records in the analysis applied in the NatWest rulings.

• The court’s analysis in the 2003 and 2005 decisions calls into question certain OECD interpretations of that organization’s own model tax treaty. The 2003 decision finds that certain interpretations of the business profits article advanced in two OECD reports (see the OECD’s 2001 "Discussion Draft on Attribution of Profits to Permanent Establishments" and its 2003 "Discussion Draft on the Attribution of Profits to Permanent Establishments: Part II (Banks)", advocating an approach akin to the "economic capital" imputation that was rejected by the court) lack support in the plain wording of the OECD model treaty-inspired U.K.–U.S. treaty. The 2005 decision rejected the U.S. government’s imputation of "economic capital" based on economic risk – an approach advocated in the OECD’s 2003 report on business profits of bank permanent establishments.

• The finding in the 2005 NatWest decision that all of the U.S. offices were a single permanent establishment is a helpful development for foreign taxpayers with multiple host country branch offices because it allows the consolidation of the profits and losses of such offices in computing the overall business profits attributable to the permanent establishment in the host country. Taxpayers that have no offices or other fixed places of business in a treaty jurisdiction but have some level of activity in the jurisdiction may find this aspect of the ruling less comforting if it is interpreted as permitting the aggregation of disparate activities into a permanent establishment.

Authors credit: Richard Tremblay is a tax partner in the Toronto office of Osler, Hoskin & Harcourt LLP with an international tax practice. Hemant Tilak is a partner in the firm's Tax Department and is based in the Toronto office, where he provides tax and related advisory services to insurance companies and other insurance organizations. Matias Milet is an associate in the Tax Department of Osler's Toronto office.

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