IRS Can’t Shake Yardstick at Tax Treaty

The Court of Appeals for the Federal Circuit ruled a U.K. bank was entitled to a $65 million refund because the IRS applied a regulation that increased the institution’s income by $155 million in violation of the U.S.-U.K. tax treaty of 1975.

In the tax years 1981–1987, National Westminster Bank PLC (NatWest), a U.K. corporation engaged in international banking activities, conducted wholesale banking operations in the U.S. through six permanently established branch locations (the “U.S. Branch”). On its U.S. federal income tax returns for the years at issue, NatWest claimed deductions for accrued interest expenses as recorded on the books of the U.S. Branch.

The IRS used the formula of Treas. Reg. § 1.882-5 to recompute the U.S. Branch’s interest expense deduction. The formula excludes consideration of interbranch transactions for the determination of assets, liabilities and interest expenses under section 1.882-5(a)(5). The formula also imputed or estimated the amount of capital held by the U.S. Branch based on either a fixed ratio or the ratio of NatWest’s average total worldwide liabilities to average total worldwide assets under section 1.882-5(b)(2).

At the trial court level, the Court of Federal Claims granted summary judgment for NatWest, ruling that the application of section 1.882-5 violated the 1975 U.S.-U.K. tax treaty, Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains. The Federal Circuit upheld the ruling that NatWest was entitled to the refund of $65,723,053 plus interest.

The IRS argued that it was permitted to attribute capital to the U.S. Branch based on regulatory and marketplace capital requirements that apply to U.S. bank corporations, called the “corporate yardstick.” NatWest said the 1975 treaty did not allow the imputation of capital to the U.S. Branch based on capital requirements to which it was not subject. The appeals court agreed with NatWest that the “separate enterprise” principle of Article 7, paragraph 2 of the treaty barred the IRS from disregarding interbranch transactions when computing the interest expense properly deductible by a permanent establishment and from imputing capital on a basis other than an as-necessary adjustment of the U.S. Branch’s books to reflect actually allotted capital.

The appeals court also noted that this interpretation was in accord with a U.K. ruling that caused the U.K. to abandon a formula imposed by its tax authorities because it violated the treaty’s separate-enterprise principle.

n National Westminster Bank v. U.S., 101 AFTR2d 2008-490

Prepared by JofA staff member Jeffrey Gilman, Esq.