Treaty bars attribution of capital to U.K. bank's U.S. branch.

• Author: Fuller, Thomas D.

The Court of Federal Claims, in National Westminster Bank, PLC, 11/14/03, found that the U.S.-U.K, treaty's plain language forbids the attribution of capital to a U.K. bank's U.S. branch based on the capital requirements of banks incorporated in the U.S. The court held that "separate and distinct" in that treaty means that the branch should be treated not as if it were separately incorporated, but simply as separate and distinct from the rest of the bank. Article 7 of the U.S.-U.K. treaty (Business Profits) allows the taxing authorities to adjust a branch's books and records only to ensure that transactions between the branch and other parts of the foreign bank are properly identified and characterized for tax purposes, and that they reflect arm's-length principles.

Facts

National Westminster (NatWest) is a U.K. corporation engaged in banking. During the years at issue (1981-1987), it conducted business in the U.S. through branches (U.S. Branch) and subsidiaries. U.S. Branch was supported by NatWest's worldwide capital.

U.S. Branch obtained funds to conduct operations by borrowing front (among others) NatWest's headquarters office and other branches, and paid interest on the borrowed funds, This interest, as reflected on U.S. Branch's books, was deducted for Federal income tax purposes.

NatWest's U.S. subsidiaries were required by local banking laws to maintain minimum capital accounts separate from that of NatWest, but U.S. Branch was not.

Procedural History

The IRS disallowed a deduction for part of the interest U.S. Branch paid to NatWest's headquarters after calculating the interest allocable to U.S. Branch under Kegs. Sec. 1.882-5. That provision apportions interest using a formula that compares branch assets to worldwide assets. NatWest paid the additional tax and sued for a refund; see National Westminster Bank PLC, 40 Fed. Cl. 120 (1999).

NatWest argued that Article 7 of the U.S.-U.K. Income Tax Treaty bars use of the formulary method, because it requires a branch to be treated as a "separate and distinct entity." The court agreed with the taxpayer, holding that the treaty contemplates that the profits of a U.K. company's U.S. branch that are subject to tax in the U.S. would be based on the books maintained by the branch as though the branch were a distinct and separate operation dealing wholly independently with the remainder of the foreign corporation.

After this...