Tuesday, January 31, 2006

The NatWest Saga continues - NatWest III

For the ones that follow international tax case-law, the Natwest cases in the US have been a must (although difficult) read. National Westminster Bank (NatWest), which is a publicly-held U.K. corporation engaged in a world-wide banking business, conducted business in the United States in both branch and subsidiary form. The cases (three until now) concern the amount of profits that should be attributed to the U.S. branch operations of NatWest under Art. 7 of the U.S.-U.K. Treaty, and whether NatWest overpaid its U.S. federal income taxes on those profits.

In 1999, the US Court of Federal Claims held in NatWest I that the U.S.-U.K. Treaty was inconsistent with Treasury Regulation Sec. 1.882-5, which provides for interest deduction allocations of foreign corporations engaged in a trade or business in the United States. In that groundbreaking case, NatWest claimed that the IRS had incorrectly denied the plaintiff’s interest deduction for interest paid on funds the branch had received from NatWest headquarters and other non-US NatWest branches. The court ruled that the regulation was inconsistent with the separate entity provision of Art. 7(2) of the Treaty. The Court focused on OECD Model and found that the interest apportionment formula in Treas. Reg. Sec. 1.882-5 was incompatible with Art. 7. The court further held that the profits of a U.S. branch of a U.K. bank should be determined on the basis of the branch’s books and records, “maintained as if the branch were a distinct and separate enterprise, dealing wholly independently with the remainder of the foreign corporation” subject to adjustments as necessary to attribute “adequate capital to the branch” and “to insure use of market rates” in computing interest, also referred to as the “arm’s-length” issue.

In 2003, the Court of Federal Claims in NatWest II ruled on the question of capital imputation and found that the Treaty does not permit attribution of regulatory or marketplace capital requirements of a separately incorporated subsidiary to a branch operation. The court held that the government could not require NatWest to recharacterize loans from other branches to establish a 6%-7% capital base, which was approximately equal to the amount that would have been required if the branch were a domestic subsidiary. Instead, the court agreed with NatWest that under the Treaty the court was bound to look at the business records of the entity and make adjustments only to the extent that the branch’s capital was not properly identified in the branch’s books and records.

In NatWest III issued on December 2005, the Bank was entitled to partial summary judgment on its tax refund claim. Based on the parties’ arguments, the court was required to decide: (1) whether the books and records of NatWest’s branch offices were “properly maintained”; (2) what number of “PEs” NatWest maintained in the United States for tax purposes; (3) whether NatWest paid interest (which it then deducted from its profits) on allotted capital or amounts to be treated as allotted capital; and (4) whether NatWest paid and received arm’s-length interest rates on both (a) money market transactions and (b) clearing account transactions.

The judgment is long and quite complex to follow (just as the preceding ones). Nevertheless, for international tax experts the issue of whether NatWest (which had six different branch offices) maintained in the United States one, three or six PE’s for tax purposes is an interesting one.

Basically, the dispute was whether these six branch offices can be treated as a single PE for purposes of calculating NatWest’s tax liability or whether each must be treated separately for purposes of calculating NatWest’s tax liability.

NatWest asserted that it had a single PE in the United States and therefore the books and records of the six branch offices could be aggregated into a single unit for tax purposes. In that regard it argued that under the Treaty the right of a host country to tax a foreign business in the United States turns on whether the foreign corporation operates a “PE” in the host country. NatWest contended that there is not a single reference in a case or the OECD Commentary to suggest that a bank operating several offices in a single host country is deemed to be operating more than one PE.

On the contrary, the IRS submited that NatWest should separately account for “capital” at each branch and that it is not allowed to aggregate the balance sheets of the six branches into a single PE. The IRS considers that NatWest must account for profits and losses on a segregated basis. Since NatWest maintained six separate PE’s in the United States, each must be accounted for separately for tax purposes.

The Court considered that the fact that NatWest operated separate banking operations in different jurisdictions within the US territory does not mean that it operated several PEs. In addition, the Court held that the fact that the six offices maintained separate books and records for internal accounting purposes does not mean that the offices are not part of a single PE for tax purposes under the Treaty. In fact, the Court identified that there was no precedent for treating the branches as separate establishments either in the U.S. or in the U.K.

In conclusion, the Court of Federal Claims (on the issue of how many PE’s) agreed with the plaintiff that as a matter of law NatWest operated a single PE in the United States and thus NatWest may account for capital and interest paid on capital contributions on an aggregated basis.

For the remaining issues please see the decision.

Selected bibliography
- Connors, P.J., NatWest decision prevents IRS adjustments of US branch's interest deductions : impact on capital allocation, Derivatives and financial instruments, Vol. 7 (2005), no. 4 ; p. 173-175
- Leeds, M.H., What does the taxpayer victory in NatWest II mean for foreign bank branches?, Journal of international taxation. - New York. - Vol. 15 (2004), no. 7 ; p. 44-50
- Jie, W.A., The NatWest Saga: the beginning of an end? , Tax notes international, Vol. 34 (2004), no. 7 ; p. 765-780
- Katz, J.L., Treaties and interest expense allocation: moving in a NatWesterly direction, Tax notes international, Vol. 86 (2000), no. 3 ; p. 403-424


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