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January 31, 2008 Court of Appeals Affirms NatWest Decisions United States Court of Appeals Affirms Decisions Holding Treas. Regs. §1.882-5 To Be Inconsistent with the 1975 U.S.-U.K. Tax Treaty SUMMARY In National Westminster Bank, PLC. v. United States (“NatWest”), decided on January 15, 2008, the Court of Appeals for the Federal Circuit affirmed decisions of the Federal Claims Court which had held that requiring the U.S. branch of a U.K. bank to determine its deductible interest expense under the three- step formula in Treas. Regs. §1.882-5 was inconsistent with Article 7 (Business Profits) of the 1975 U.S.- U.K. income tax treaty (the “1975 Treaty”), and it allowed the U.S. branch to determine its deductible interest expense for 1981-87 under Article 7 on the basis of the equity capital and liabilities (including inter-branch liabilities) shown on the books of the branch. Although no longer relevant to the determination of the deductible interest expense of a foreign bank, the decision in NatWest may be relevant to the interpretation in other contexts of the business profits articles of many U.S. income tax treaties. IMPLICATIONS Because of changes to the U.S.-U.K. income tax treaty and to Treas. Regs. §1.882-5 subsequent to the years involved in NatWest, the Court of Appeals’ decision is not relevant to the determination of the interest expense of a foreign bank under current law – the current regulations specifically provide that deductible interest expense of the U.S. branch or other permanent establishment of a foreign corporation New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com is determined under the formula set out in the regulations, except where a different rule is expressly provided by a tax treaty.1 The Court of Appeals’ reliance on the “plain language” of Article 7 of the 1975 Treaty may, however, be relevant in other applications of the business profits articles of U.S. income tax treaties. Specifically, while more recent U.S. tax treaties, consistent with the Court of Appeals’ interpretation of Article 7 of the 1975 Treaty and the 2006 U.S. Model Income Tax Convention, interpret the business profits articles as treating a U.S. branch or permanent establishment as substantively a separate entity (and thus, for example, recognizing inter-branch swap and other transactions)2, it is the view of the U.S. Treasury that this approach – the so-called “authorised OECD approach” (or “AOA”) – does not apply under most existing U.S. tax treaties.3 The Court of Appeals’ emphasis on the plain language of the 1975 Treaty, particularly the reference to a permanent establishment as a “distinct and separate enterprise,” may support a broader application of the separate entity approach than contemplated by the Treasury. BACKGROUND NatWest involved claims for refunds by a U.K. bank for the years 1981-1987. On its returns, NatWest determined the deductible interest expense of its U.S. branch on the basis of the equity capital and 1 A new treaty came into effect between the United States and the United Kingdom in 2003. See Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, U.S.-U.K., July 24, 2001, S. Treaty Doc. No. 107-19 (“New Treaty”). Notes to that treaty allow a U.K. bank to use Treas. Regs. Section 1.882-5 or to determine the capital of a U.S. branch on the basis of risk-weighted assets. The regulations were also subsequently amended, in part to conform the regulations with treaties, such as the New Treaty, that provide for risk-weighting. The amended regulations make it clear that, absent a specific treaty provision, Treas. Reg. §1.882-5 provides “exclusive” guidance on the calculation of deductible interest. See Treas. Reg. § 1.882-5T(a)(2) (“Except as expressly provided by or pursuant to a U.S. income tax treaty or accompanying documents (such as an exchange of notes), the provisions of this section provide the exclusive rules for determining the interest expense attributable to the business profits of a permanent establishment under a U.S. income tax treaty.”). 2 See, e.g., Article 7(2) of the New Treaty (“Subject to the provisions of paragraph 3 of this Article, 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 business profits that 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. For this purpose, the business profits to be attributed to the permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment.”) (emphasis added to show difference from the 1975 Treaty language). 3 See Treasury Releases Statement on PE Attribution of Profits, 2007 TNT 112-53 (“While we fully support the Authorised OECD Approach (AOA) for attributing profits to a permanent establishment (PE), it will not apply to most existing U.S. tax treaties. We generally provide in Article 7(3) for a “reasonable allocation” of certain expenses, which is not consistent with the arm’s-length approach of the AOA.”). -2- Court of Appeals Affirms NatWest Decisions January 31, 2008 liabilities (including inter-branch liabilities) shown on the books of the branch. On audit, the I.R.S. recalculated the interest expense deduction of the branch by using the formula set forth in Treas. Regs. §1.882-5,4 which resulted in additional taxable income. Following a failed competent authority proceeding, NatWest paid the additional tax and filed suit for refunds on the basis that Treas. Regs. §1.882-5 was inconsistent with the terms of the 1975 Treaty.5 In 1999, the Federal Claims Court sided with NatWest (“NatWest I”)6 and held that Treas. Regs. §1.882-5 was inconsistent with the 1975 Treaty and that, under Article 7 (Business Profits) of the 1975 Treaty, NatWest had correctly deducted interest expense recorded on the books of its U.S. branch.7 The Court of Appeals also stated that the books of the U.S. branch “are subject to adjustment as may be necessary for imputation of adequate capital to the branch and to insure use of market rates in computing interest expense.”8 In a later decision (“NatWest II”),9 the Federal Claims Court determined that the separate enterprise principle did not allow the Government “to adjust the books and records of the branch to reflect ‘hypothetical’ infusions of capital based upon banking and market requirements that do not apply to the branch.”10 Only capital allotted to the U.S. branch was relevant to the determination of its taxable income and only amounts not properly recorded in the books of the U.S. branch can be added to such capital. 4 Under Treas. Regs. § 1.882-5, deductible interest expense of a foreign bank with a U.S. branch is calculated by a three-step formula. In the first step, U.S. assets are determined for the taxable year. In the second step, liabilities are attributed to those assets, based on either the actual worldwide ratio of the bank’s liabilities to assets or a fixed ratio. In the third step, interest expense is attributed to the liabilities determined in step two. 5 Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, U.S.-U.K., Dec. 31, 1975, 31 U.S.T. 5668 (the “1975 Treaty”). Article 7(2) of the 1975 Treaty states as follows (emphasis added): “Subject to the provisions of paragraph (3), where an enterprise 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 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. “ 6 Nat’l Westminster Bank, PLC v. United States, 44 Fed. Cl. 120 (1999). 7 See our Memorandum dated July 12, 1999, describing NatWest I and its implications in more detail. 8 Nat’l Westminster Bank, 44 Fed. Cl. at 128. 9 See Nat’l Westminster Bank, PLC v. United States, 58 Fed. Cl. 491 (2003). 10 Id. -3- Court of Appeals Affirms NatWest Decisions January 31, 2008 The Government appealed both decisions (as well as two further decisions of the Federal Claims Court),11 and the Court of Appeals for the Federal Circuit affirmed the decisions of the Federal Claims Court. THE COURT OF APPEALS FOR THE FEDERAL CIRCUIT’S OPINION The Court of Appeals for the Federal Circuit upheld the two Federal Claims Court decisions described above.12 It affirmed the Federal Claims Court’s holding that Treas. Regs. §1.882-5 was inconsistent with the 1975 Treaty on three grounds. First, the Court of Appeals found that the language of the 1975 Treaty itself, through the separate entity principle articulated in Article 7 of the 1975 Treaty, “mandates that expenses incurred for the benefit of the U.S.

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