National Westminster Bank, PLC v. United States
2008 U.S. App. LEXIS 811, 512 F.3d 1347, 80 Fed. Cl. 1347 (2008)
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Rule of Law:
A tax treaty requiring a foreign corporation's permanent establishment (e.g., a local branch) to be treated as a "distinct and separate enterprise" prohibits a domestic tax authority from using a formulaic regulation that disregards the branch's actual interbranch transactions and imputes hypothetical capital. The treaty mandates that the branch's taxable profits be determined from its own books and records, subject only to adjustments to ensure transactions reflect arm's-length terms.
Facts:
- National Westminster Bank PLC (NatWest), a United Kingdom corporation, conducted banking operations in the United States through a permanent branch ("U.S. Branch") during the tax years 1981-1987.
- The 1975 U.S.-U.K. Tax Treaty governed the taxation of NatWest's U.S. business profits, requiring under its "separate enterprise principle" that the U.S. Branch be treated as a distinct entity dealing independently with the rest of NatWest.
- On its federal income tax returns, NatWest claimed interest expense deductions based on the actual transactions recorded on the books of its U.S. Branch, including interest paid on loans from other NatWest branches.
- Upon audit, the Internal Revenue Service (IRS) disregarded the interest expenses as recorded on the U.S. Branch's books.
- The IRS instead applied Treasury Regulation § 1.882-5, a formula that ignores all interbranch transactions and imputes a hypothetical amount of capital to the branch to calculate its deductible interest.
- The IRS's recalculation under this regulation increased NatWest's taxable income by approximately $155 million, resulting in a significantly higher tax liability.
Procedural Posture:
- NatWest paid the additional taxes assessed by the IRS and filed for a refund.
- After its refund claim was not resolved, NatWest filed suit against the United States in the U.S. Court of Federal Claims in 1995.
- The trial court, on cross-motions for partial summary judgment, ruled in a series of opinions that Treasury Regulation § 1.882-5 violated the 1975 Treaty.
- The trial court specifically held that the regulation's disregard for interbranch transactions and its formulaic approach to capital allocation were inconsistent with the treaty's separate enterprise principle.
- The trial court entered a final judgment in favor of NatWest, ordering a refund of $65,723,053 plus interest.
- The United States Government (appellant) appealed the trial court's judgment to the U.S. Court of Appeals for the Federal Circuit, with NatWest as the appellee.
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Issue:
Does Treasury Regulation § 1.882-5, which uses a formulaic approach to calculate a foreign bank's U.S. branch interest deduction by disregarding interbranch transactions and imputing capital, violate the "separate enterprise principle" of Article 7 of the 1975 U.S.-U.K. Tax Treaty?
Opinions:
Majority - Gajarsa, Circuit Judge.
Yes, Treasury Regulation § 1.882-5 violates the 'separate enterprise principle' of the 1975 U.S.-U.K. Tax Treaty as applied to NatWest's U.S. Branch. The plain language of the treaty requires treating the branch as a distinct entity, which means its intracorporate transactions must be recognized and adjusted to arm's-length terms, not disregarded entirely. The court reasoned that the treaty's mandate to treat the branch as a 'distinct and separate enterprise... dealing wholly independently' prohibits a formulaic approach that ignores the real facts of the branch's operations as reflected in its books. The court found this interpretation was strongly supported by the official Commentaries to the 1963 OECD Model Convention, upon which the treaty was based, which explicitly state that interbranch interest payments for banks are deductible. Furthermore, the court gave little deference to the U.S. Treasury's interpretation because the United Kingdom, the other treaty signatory, held a contrary view. The court also affirmed the rejection of the government's alternative 'corporate yardstick' method for imputing capital, finding it also violated the treaty by imposing hypothetical conditions instead of assessing the 'real facts' of the branch's operation.
Analysis:
This decision significantly reinforces the principle that specific obligations within an international tax treaty will override a conflicting domestic administrative regulation. It limits the IRS's authority to use formulaic apportionment methods to determine the profits of a foreign branch when a treaty mandates adherence to the 'separate enterprise' or arm's-length standard. The case establishes that this standard requires tax authorities to begin their analysis with the branch's actual books and records, treating it as a functionally separate entity. This holding provides greater certainty for multinational corporations, particularly in the financial sector, that their internal, arm's-length dealings will be respected for tax purposes in jurisdictions with similar treaty provisions.
