Irish Bank – HMRC entitled to disallow interest deductions claimed by UK permanent establishments

In Irish Bank Resolution Corporation Ltd (in special liquidation) and another v HMRC [2020] EWCA Civ 1128, the Court of Appeal upheld the decisions of the First-tier Tribunal (FTT) and the Upper Tribunal (UT) and confirmed that HMRC was entitled to disallow interest deductions claimed by the UK permanent establishments (PEs) of two Irish companies.

Background 

The appellants are registered in the Republic of Ireland but carried on business through a branch in the United Kingdom during the relevant period. Irish Bank Resolution Corporation Ltd (IBRC) (which was formerly Anglo Irish Bank Corporation plc) opened an office in the UK in 1988 and in 1991 was granted branch status by the Bank of England, which enabled it to undertake regulated financial services including the taking of deposits. Irish Nationwide Building Society (INBS) opened a retail branch in Belfast in 1994 and provided loans for the purchase of domestic property. 

The appellants became insolvent following the financial crisis in 2007. INBS is now a shell company and IBRC is in liquidation. During the relevant period, the appellants operated profitable businesses through their UK branches (the branches were PEs, for the purposes of section148(1)(a), Finance Act 2003) which rendered them liable to UK corporation tax. 

The appellants claimed deductions in relation to interest paid by the PEs to the appellants but these claims were denied by HMRC. HMRC considered that section 11AA(3)(b), Income and Corporation Taxes Act 1988, precluded such deductions as the returns submitted by the appellants understated the amount of equity capital each PE was deemed to hold and so overstated the amount of loan capital and the associated interest charges. The appellants disagreed, arguing that the disallowance was contrary to the UK-Ireland double tax treaty (DTT) and that the PEs should be treated as having the ratio of free to borrowed capital that they actually held, rather than being deemed to have a notional amount of free capital. 

This argument hinged on the fact that the DTT dated from 1976 and was based on the 1963 version of the Organisation for Economic Cooperation and Development (OECD) Model Tax Convention. It was only in 2010 that the updated Model expressly contemplated the attribution of notional free capital. The appellants argued that such an attribution would only be permissible if the DTT had been amended to reflect the wording of the 2010 OECD Model. No such amendment had been made and therefore no such attribution was allowed.

The appellants' appeals to the FTT and the UT were dismissed. The appellants appealed to the Court of Appeal.

Court of Appeal judgment  

The appeals were dismissed. 

The Court of Appeal rejected the appellants' arguments. In the view of the Court, it was not obvious that the 2010 changes to the OECD Model introduced a requirement to attribute a notional level of capital to a PE. The new wording emphasised the requirement to treat the PE as an independent entity but did not address the issue of capital attribution. The OECD commentaries had stressed that the OECD Model had not laid down precise or exhaustive rules. The Court considered the business profits article of the DTT. In its view, the separate enterprise principle, as set out in that article, required a comparison of how the PE financed and accounted for its business with what it would have done had it operated as a separate enterprise. In the view of the Court, to construe it as requiring the PE’s actual ratio of free to borrowed capital to be applied would be self-defeating. The Court therefore rejected the appellants' construction of the DTT, concluding that there was nothing in it to prevent the UK from attributing notional free capital to a PE.

Comment 

This decision will be of interest to any non-UK companies who conduct business through UK PEs, especially those in a jurisdiction whose double tax treaty with the UK pre-dates 2010. The appellants have applied for permission to appeal to the Supreme Court and it will be interesting to see what view that Court takes should permission be granted.

The judgment can be viewed here.