Judicial developments in recent treaty cases
In a number of recent cases concerning the application of double tax treaties the tribunals and courts have resisted HMRC's expansionist approach to construction, with a more natural interpretation being preferred.
This blog is based on an article which was first published in Tax Journal on 30 August 2023. A link to the article can be found here.
A double taxation treaty (DTT) is an agreement made between (usually) two jurisdictions, which allocates taxing rights in relation to various items of income or gains between them. A DTT is designed to reduce juridical double taxation, typically by eliminating or limiting taxation in the country in which the income or gain arises (source state taxation) or by requiring the country in which the person subject to taxation is resident to grant relief for source state taxation through a credit or exemption mechanism. A DTT commonly applies to residents of one or both of the contracting states and deals with specified taxes.
There have been a number of recent cases concerning the application of DTTs: Royal Bank of Canada v HMRC  EWCA Civ 695; GE Financial Investments v HMRC  UKUT 146 (TCC); Hargreaves Property Holdings Ltd v HMRC  UKUT 120 (TCC); Aozora GMAC Investment  UKUT 258 (TCC); Burlington Loan Management v HMRC  UKFTT 290 (TC); and Oppenheimer v HMRC  UKFTT 112 (TC). For the most part, the (at present) ultimate determination of these cases reveals a positive trend in the development of the jurisprudence in this area. What might best be described as 'common sense' outcomes have been reached, with the tribunals and courts routinely declining to follow an expansionist approach to interpretation advocated by HMRC.
The most recent decision on a dispute concerning the allocation of taxing rights under a DTT was given by the Court of Appeal (CA) in Royal Bank of Canada. The Royal Bank of Canada (RBC) lent money from its Canadian operations to a Canadian company, Sulpetro, to fund exploration in the UK continental shelf. Following Sulpetro’s insolvency, its rights to receive ‘royalty’ payments in respect of oil extracted from an oil field in the UK sector of the continental shelf were assigned to RBC by the receiver. RBC wrote off its original loan to Sulpetro in its Canadian banking business accounts and treated the payments as recoveries of that bad debt. HMRC considered that the payments were taxable in the UK as profits of a deemed separate ‘ring-fence’ trade applicable to oil-related activities under Article 6(2) of the UK/Canada DTT. HMRC succeeded in both the First-tier Tribunal (FTT) and Upper Tribunal (UT).
The key issue before the CA was whether the terms of the DTT permitted the UK to exercise taxing rights over the payments to Sulpetro in the first place. The FTT and UT had agreed with HMRC that the payments fell within the definition of income from immovable property in Article 6(2) - specifically, within what was referred to as the ‘fifth limb’ of the extended definition of ‘immovable property’, namely, "rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources and other natural resources". This, the tribunals agreed, gave the UK, as the contracting state where the ‘immovable property’ was located, the right to tax them.
The CA preferred a narrower construction of Article 6(2). It held that it was wrong to apply the fifth limb to a purely contractual right to receive payments, where that right to payment was held by a person with no interest in the underlying land in question. The CA found that the definition of immovable property was confined to rights to payments held by a person who has some form of continuing interest in the land to which the rights can be attributed, albeit that the ability to tax would not fall away simply because the obligation to make payments passed to someone other than the original grantee of extraction rights (see paragraph ). Contrary to a very peculiar argument that was accepted by the tribunals below, that more restrictive interpretation was supported by the French text in the treaty which, because it had equally authoritative status to the English version, was relevant. It was also supported by OECD commentary and other provisions of the treaty with which Article 6 had to be considered (see: Fowler v HMRC  UKSC 22).
The CA also drew support from Vogel on Double Taxation Conventions, which questioned the scope of the fifth limb, particularly in the context of debt claims with “no more than a historical relation to the immovable property”, noting that even debt claims secured by a mortgage are accepted as generally falling within Article 11 (the interest article) rather than Article 6. The CA observed (at paragraph ) that, if HMRC was right, the tax treatment of rights relating to mineral and other natural resources would differ markedly from that in respect of other rights with some economic connection to the value of land. That did not sit well when read in conjunction with Articles 13 and 27A, which dealt explicitly with capital gains and offshore activities, respectively. The CA noted that the UK and Canada agreed to include these specific, and carefully drafted, provisions in respect of offshore activity and disposals of assets related to hydrocarbon exploration and exploitation, which provide a coherent, and explicit, structure for the allocation of taxing rights.
GE Financial Investments
This case concerned a UK company, GE Financial Investments (GEFI) and its place of residence for UK/US DTT purposes. GEFI was UK tax resident under UK law but was indirectly US owned and stapled to a US corporation, with which GEFI established a Delaware limited partnership (DLP). The stapling and US ownership rendered GEFI a deemed US resident under US law. DLP made intra-group loans, on which interest was paid, and GEFI claimed UK credits for US tax on DLP's interest income. HMRC objected, viewing GEFI as not US resident for treaty purposes and so not benefiting from treaty relief. The FTT agreed, but the UT allowed GEFI's appeal.
As the UT recognised, the DTT residence test included US non-OECD model concepts. The UT considered that the model's residence test identified connection criteria commonly used to impose "full" (ie worldwide) taxation. It was widely drawn, with considerable latitude for domestic law (in this instance, US law, where the place of incorporation is clearly the defining feature in the way in which the staple tax rule operates) to determine situations attracting full taxation. The model's commentary showed that this included domestic deemed residence, including residence through incorporation, which was not expressly mentioned in the model - accepting only substantive territorial links would generally exclude this. There was, accordingly, no basis for the additional requirement used by the FTT for there to be a legal connection between the corporation and the US. A corporation is undoubtedly resident in the US by reference to its incorporation in the US even if it carries on no activity whatsoever in the US.
The UT commented that US law could have achieved the same result through the concept of 'deemed incorporation' rather than deemed residence, and that formal differences should not impact substantive outcomes under the DTT. Having chosen the route that it did, the UT held that it was no surprise that the US authorities made sure that US treaties referred to the actual criteria used in their domestic law, hence the inclusion of the place of incorporation. It also considered it inexplicable if a US incorporated entity without US economic ties was US resident for treaty purposes but a non-US incorporated entity with such ties (like GEFI) was not. The UT's reasoning accorded with relevant Canadian case law, which similarly rejected taking an "overly literal view" of a treaty provision.
In Aozora, the taxpayer, Azora GMAC Investment (Aozora), received interest payments, net of withholding tax, from its US subsidiary. The US tax authority denied Aozora’s application to access the benefit of the UK/US DTT on the grounds that Aozora was not a 'qualified person' within the meaning of Article 23 on the limitation on benefits. The US tax authority also declined to use its discretion, under Article 23(6), to allow Aozora to benefit from the DTT relief. Aozora claimed unilateral relief (for the US withholding tax) by way of credit against the UK tax due on the interest it received. HMRC refused the claim, arguing that section 793A(3), ICTA 1988 (now section 11(3), TIOPA 2010) prevented unilateral relief in these circumstances.
The UT, like the FTT, decided that section 793A(3) did not deny Aozora’s claim to unilateral relief. The UT based its decision on a "straightforward interpretation" of the provision. To deny unilateral relief, section 793A(3) required a DTT to "contain express provision to the effect that relief by way of credit shall not be given under the [DTT] in cases or circumstances specified or described in the [DTT]".
In the view of the UT, HMRC's interpretation of section 793A(3) put disproportionate weight on the word "effect", and the entire subsection had instead to be construed in its wider context, with the result that section 793A(3) applied only where a DTT states, in terms, that credit relief shall not be given. HMRC's argument relied on a subtle distinction between non-residents not falling within the scope of the DTT in the first place (and thereby not being caught by section 793A(3)) and non-qualified persons who were residents who, HMRC argued, were within the scope of the DTT but were taken out by Article 23. The proper interpretation of Article 23 was that, to the extent that the DTT conferred benefits on residents, it was confined to qualified persons and other persons who satisfied the conditions set out in Article 23(3) or (4), or in respect of whom discretion was exercised under Article 23(6). Others were simply not within the scope of those provisions. As Article 1(2) indicated, neither it, nor other DTT provisions, were intended to preclude credit being given under domestic law.
The dispute in Burlington turned on whether the taxpayer, Burlington Loan Management (Burlington) could recover tax under the UK/Ireland (ROI) DTT, which (under Article 12(1)) provides Irish tax resident recipients with full relief from UK withholding tax on interest. This was subject to an anti-avoidance provision in Article 12(5), which (as it then stood) required that no person concerned with the assignment of the debt claim had a main purpose of taking advantage of the DTT exemption by means of that assignment. HMRC refused Burlington's repayment claim, arguing that the anti-avoidance provision applied.
In concluding that Burlington did not have a main purpose of taking advantage of the UK withholding tax exemption, the FTT distinguished between Burlington's purpose for purchasing the debt (to realise a profit by reference to the difference between its purchase price and the cash flows that it received as a result of its acquisition of the relevant claim) and Burlington's implicit understanding of the consequences of that purchase (that UK withholding tax was not a permanent cost because of its Irish tax residence).
Inevitably, Burlington’s ability to receive UK source interest without UK withholding tax, pursuant to Article 12(1), was one tax attribute which it took into account when considering the price which it was prepared to pay for the UK-source debts that it acquired. It was an inevitable consequence of being resident in the ROI and therefore entitled to the benefit of Article 12(1). In that respect, Burlington's exemption from UK withholding tax under Article 12(1) was no different from the tax benefits which it enjoyed in the ROI by virtue of its status as a “designated activity company” under the laws of the ROI. In other words, like those tax benefits, the UK withholding tax exemption which Burlington enjoyed was merely part of the scenery, the “setting”, in which Burlington made its offer. Taking this attribute into account when considering the price of the debt did not mean that obtaining that benefit was one of Burlington's main purposes in acquiring the debt, any more than it was when Burlington acquired any other debt from other creditors.
The FTT recognised the substantive difference between a case where a person disposes outright of a debt claim bearing the right to interest for a market price which happens to reflect the fact that its purchaser, along with many others, enjoys tax attributes which it does not have – such as an exemption from UK withholding tax under UK domestic law or under an applicable DTT – and the cases at which Article 12(5), and its equivalent in other DTTs, are aimed, such as transactions involving conduits or “treaty-shopping”. A feature of the latter type of case is that the resident of the non-treaty jurisdiction typically retains an indirect economic interest in the debt claim generating the flow of income which passes through the person claiming the benefit of the DTT. In that way, the resident of the non-treaty jurisdiction can be said to be “acting through” the person located in the treaty jurisdiction and thereby “takes advantage” of the benefit of the DTT by accessing the benefit of the DTT indirectly.
Importing domestic concepts
As the CA summarised in RBC, DTT's should be interpreted: (a) in line with the Vienna Convention on the Law of Treaties, of which Article 31(1) states that a “treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose.”; and (b) in a way that is “international, not exclusively English” and in a manner that is “unconstrained by technical rules of English law, or by English legal precedent, but on broad principles of general acceptation” (see also: HMRC v Anson  UKSC 44).
In essence, although the conclusions reached in both cases seem to be correct, the approach taken to the interpretation of, for example, Article 12(5) in Burlington, and the concept of 'beneficial ownership' in Hargreaves, presents some difficulties. In either context, the international fiscal meaning of the provision can be something quite different to the UK domestic meaning.
There is insufficient space in this blog to go into detail on why, in the authors' view, the outcomes in Burlington and Hargreaves were probably right, notwithstanding any inconsistencies in the approach to interpretation. It is likely that the issue identified will be dealt with by the CA and/or the Supreme Court, at some point in the future.
The tax tribunals and courts in these cases have taken a flexible approach to interpretation to achieve what in most cases is, as the UT put it in GE at paragraph , "obviously" the right result:
- The CA in RBC preferred a 'narrower' construction of Article 6 to achieve the overall purpose of the DTT, whereas in GE, the UT eschewed a literal interpretation of Article 4(1), so that the taxpayer's place of incorporation did not relieve the taxpayer of US taxation in circumstances where the contrary outcome was clearly envisaged by the treaty.
- In GE, the UT similarly rejected an approach that would have given rise to two classes of domestic residents, only one of which is treaty resident. There was no credible basis for an additional requirement for the criteria to be of a direct nature in the form of a legal connection between the corporation and the US.
- In Aozora, the UT was extremely hesitant to accept HMRC's interpretation of section 793A(3), as it would have given rise to "undesirable uncertainty", which it is unlikely that the “reasonable legislature” (referred to by Lord Hodge in R (PRCBC) v Home Secretary)  2 WLR 343), would have intended (see paragraph ). It preferred a "straightforward" interpretation of the provision.
- In Burlington, as the FTT noted, if the facts were sufficient to trigger Article 12(5), there would be significant upheaval to the secondary debt market and, taking HMRC’s argument to its logical conclusion, whenever a person took into account their counterparty’s tax position in pricing a transaction, they would thereby potentially have a main purpose of taking advantage of a tax exemption and so fall foul of any applicable principal purpose test. Given that is a key feature of so many commercial transactions, the ramifications could be enormous.
There is some concern amongst tax practitioners that, with the advent of Pillar 2 and all of its complexities, it may become difficult to litigate cases concerning international taxation and the proper allocation of taxing rights. Others have fairly commented on practical issues arising from certain cases in recent times. But for the most part, the tax tribunals and courts have the broader picture in mind, in particular, the overall purpose of the provisions and the intentions of the contracting states, when determining these cases. That approach, which appears to be drawn from the judges' practical knowledge and understanding of the commercial realities, is to be welcomed, and may provide hope in an otherwise uncertain future on the international tax landscape.