| ||Tax Treaty Interpretation |
John A. Townsend
Partner, Townsend and Jones, L.L.P., Houston, Texas; A.B., University of South Carolina, 1964; LL.B., University of Virginia (1967); and LL.M., New York University (1969). An earlier version of this article was presented to the Houston Tax Roundtable, and the author is indebted to the members for their helpful comments.
In National Westminster Bank, PLC v. United States (" NatWest"), the Court of Federal Claims handed the Internal Revenue Service a stunning defeat based on the court's interpretation of the United States-United Kingdom treaty. The treaty requires that a resident of one treaty state ("residence state") doing business in the other ("host state") through a permanent establishment (PE) must compute its host state tax using "the Separate Enterprise Construct." The question in NatWest was whether, under the Separate Enterprise Construct, the taxpayer could treat intracompany advances from the home office and non-U.S. branches to its U.S. branch (a PE) as loans and deduct the "interest" against the PE's U.S. tax. The advances had been booked by the PE as loans to it on a separate profit center accounting basis. The court held that the Separate Enterprise Construct of the treaty required the Service to honor the loans, and thus the taxpayer could deduct the interest in computing its U.S. tax. In so holding, the court held that the treaty trumped the U.S. law, as interpreted in regulations, which would have limited the taxpayer's opportunity to distort its U.S. PE's debt relative to its worldwide debt.
The Service views the treatment required by the regulations as important to curb artificial reductions in the U.S. tax base. Very large amounts of tax are at issue. Although the NatWest court limited its holding to financial institutions, other British financial firms doing business in the United States through a PE will qualify for this relief if the decision stands. Moreover, financial firms resident in other treaty partner states and doing business in the United States through a PE may qualify for relief, for the Separate Enterprise Construct is common in U.S. treaties. Fiscally, therefore, the decision is important.
The focus of this article is not the importance of or even correctness of the issue resolved in NatWest. Rather, this article uses NatWest as an entre into broader issues of tax treaty interpretation.