On July 7 1999 the US Court of Claims handed down a decision which could constitute a major setback to the IRS in the international tax area if it prompts other taxpayers, US and foreign, to challenge IRS rules under relevant tax treaties.
During the 1980s, National Westminster Bank conducted its operations in the US through a number of branch offices. These branches obtained funds to conduct their activities by borrowing from NatWest's headquarters office or from other branches outside the US. The lending headquarters or branch would charge interest on its loans to the US branches. The books of account of the US branches reflected the interest expense paid pursuant to such interbank transactions just as if they were separate legal entities in the US.
The US branches took a deduction for US income tax purposes for the amount of interest expense shown on their books. These deductions had the effect of reducing taxable income of the US branches. On audit, the US Internal Revenue Service (IRS) disallowed a portion of the interest expense reflected on the books of the US branches on the grounds that the allowable interest deduction had to be calculated pursuant to a formula contained in regulations issued by the IRS. Applying the IRS formula resulted in lower interest deductions and higher tax liability for NatWest with respect to its US operations. NatWest argued that it was entitled to a deduction for the interest expense shown on its books pursuant to the provisions of the US-UK Income Tax Treaty. Nevertheless, it paid the tax and sued for a refund in the US Court of Claims.
In deciding this case, the Court of Claims had to determine whether the IRS regulations are consistent with the provisions of the US – UK Tax Treaty in respect of the calculation of the business profits of a UK firm doing business in the US. If the regulations are not consistent with the Treaty, they would be invalid in the case of UK firms subject to taxation in the US.
The court found that the IRS regulations are inconsistent with the Treaty because the regulations apportion interest expense on the basis of worldwide assets and liabilities of the entire foreign enterprise, while "the Treaty contemplates that a foreign banking corporation in the position of [NatWest] will be subjected to US taxation only on the profits of its US branch and that such profits should be based on the book of account of such branch maintained as if the branch were a distinct and separate enterprise dealing wholly independently with the remainder of the foreign corporation".
The only caveat was that the deduction for interest could be subject to adjustment to "insure use of market rates in computing interest expense". In other words, if the US branches of NatWest were paying an excessive rate of interest in order to shift income away from the US, the IRS could disallow a portion of the deduction in excess of a market rate. However, this issue was not before the court.
Accordingly, the court held that the formulaic approach contained in the IRS regulations is indeed inconsistent with the Treaty and, therefore, the IRS had no legal basis for disallowing a portion of NatWest's interest expense deductions on its US tax returns. As a result, NatWest will be entitled to a refund which indicate could be as high as $180 million plus interest.
While significant, foreign companies doing business should not exaggerate the importance of this case. To challenge the IRS regulations on allocating interest expense, there first must be an income tax treaty in place similar to the OECD model treaty on which the US – UK Tax Treaty is based. Second, the foreign taxpayer must be a bank or other financial institution; non-financial companies may still be subject to the IRS regulations. Nevertheless, the Court of Claims decision is a significant victory for both tax simplicity and foreign taxpayers seeking to challenge the IRS on the basis of an applicable tax treaty.
Robert S Rendell
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