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	United Kingdom Special Commissioners of Income Tax Decisions
You are here: BAILII >> Databases >> United Kingdom Special Commissioners of Income Tax Decisions >> Bayfine UK Products Bayfine UK v Revenue & Customs [2008] UKSPC SPC00719 (19 November 2008) URL: http://www.bailii.org/uk/cases/UKSPC/2008/SPC00719.html Cite as: [2009] STC (SCD) 43, 11 ITL Rep 440, [2008] UKSPC SPC00719, [2008] UKSPC SPC719, [2008] STI 2735

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Spc00719

DEBT CONTRACTS – whether self-cancelling contracts can be looked at together – yes but s 165 FA 1994 still not applicable – in the light of Tower MCashback can the Revenue raise s 167 FA 1994 having made their amendment to the self-assessment under s 165 – yes – whether s 167 applies – no

DOUBLE TAXATION RELIEF – US ignoring UK subsidiary with unlimited liability for US tax purposes and taxing the parent on the subsidiary's profit – whether unilateral relief for US tax paid by the parent – no – whether treaty relief under US-UK tax treaty (1975) – no – whether, had relief been available, certain steps would be reasonable to take to reduce US tax – no – appeal dismissed

THE SPECIAL COMMISSIONERS

BAYFINE UK PRODUCTS

BAYFINE UK Appellants

- and -

THE COMMISSIONERS FOR HER MAJESTY'S

REVENUE AND CUSTOMS Respondents

Special Commissioners: DR JOHN F. AVERY JONES CBE

EDWARD SADLER

Sitting in public in London on 13 to 15 October 2008

Jonathan Peacock QC and Francis Fitzpatrick, counsel, instructed by Slaughter and May for the Appellants

David Ewart QC and Richard Vallatt, counsel, instructed by the General Counsel and Solicitor to HM Revenue and Customs for the Respondents

© CROWN COPYRIGHT 2008


 


DECISION
1. These are appeals by Bayfine UK Products ("BUKP"), an unlimited company incorporated in England in the Morgan Stanley Dean Witter & Co Inc ("Morgan Stanley") group, against the conclusion of the Respondents' ("the Revenue") enquiries set out in a letter of 12 September 2006 and the Revenue's amendment to its self assessment refusing the loss claimed of £118,662,873 and the consequent surrender of part of that loss by way of group relief; and by Bayfine UK ("BUK"), another unlimited company incorporated in England in the Morgan Stanley group, against the Revenue's amendment to its self assessment that a profit of £119,846,305 was not to be taken into account for corporation tax purposes, and that no credit for US tax on that profit was available. Mr Jonathan Peacock QC and Mr Francis Fitzpatrick appeared for the Appellants, and Mr David Ewart QC and Mr Richard Vallatt for the Revenue.
2. In broad outline, BUKP entered into a forward contract with Irving Park Inc (a US company in the Bank of America, N.A. group), and BUK entered into a forward contract with Mecklenberg Park Inc (another US company in the Bank of America, N.A. group), the result of which was that, depending on whether 3-month US$ LIBOR was greater, or equal to or less than, a certain figure, BUKP could gain (or lose) and Irving Park Inc lose (or gain), and BUK lose (or gain) and Mecklenberg Park Inc gain (or lose) an equal amount. In other words, taken together BUK and BUKP would break even, with one gaining and the other losing an equal amount, with the corresponding opposite result for the respective Bank of America counterparty companies, but at the time of entering into the contracts it was uncertain which companies would gain and lose. In the result, BUKP made a loss of about £119.8m, of which about £96m was surrendered by way of group relief to other companies in the Morgan Stanley group, and BUK made a profit of the same amount which in principle was taxable in the UK, but against such tax it claimed double taxation relief for US tax on the same profit paid by its immediate parent Bayfine DE Inc ("BDE") (a US corporation) thus eliminating its UK tax liability. The taxation in the US of the profit in the hands of BDE arises because for US federal income tax purposes BUK is classified as a "disregarded entity" on account of its having a single shareholder and unlimited liability, so that for US tax purposes the profits in question are treated as profits of BDE.
3. The following issues arise: (1) whether s 165 of the Finance Act 1994 permits the Revenue to cancel the profit in BUK and the loss of BUKP; (2) whether under the principle in Tower MCashback LLP1 v HMRC the Revenue are entitled to take an alternative point under s 167 of the Finance Act 1994; if they are, (3) whether s 167 of the Finance Act 1994 leads to the same result; if the Appellant succeeds on the foregoing, (4) whether BUK is entitled to claim unilateral relief for the US tax paid by BDE against BUK's UK corporation tax liability on the profit in question, (5) whether it is entitled to claim relief under the Double Taxation Relief (Taxes on Income (The United States of America) Order 1980 (SI 1980/568) ("the Treaty") for the US tax; and (6) if it is entitled to claim either relief, whether this is reduced by s 795A of the Taxes Act 1988.
4. There was an agreed statement of facts as follows:

Introduction

(1) This Statement of Agreed Facts is in relation to appeals against the Revenue's amendments dated 13 October 2006, in respect of a Corporation Tax Self-Assessment of BUK, and 17 October 2006, in respect of a Corporation Tax Self-Assessment of BUKP, each for their accounting periods ending on 30 November 2000 ("the Amendments").

The transaction under Appeal

(2) At all material times:

(a) the First Appellant, BUKP, a private unlimited company, was the UK resident and incorporated wholly-owned direct subsidiary of Baycliff DE Inc., a US resident and incorporated wholly-owned indirect subsidiary of (as it then was) Morgan Stanley Dean Witter & Co. Inc. (now Morgan Stanley), the US resident parent of the Morgan Stanley group of companies ("Morgan Stanley"); and

(b) the Second Appellant, BUK, a private unlimited company, was the UK resident and incorporated wholly-owned direct subsidiary of BDE, a US resident and incorporated wholly-owned indirect subsidiary of Morgan Stanley.

(3) On 20 July 2000, the following agreements were entered into:

(a) an agreement ("the First Debt Contract") whereby BUKP agreed to pay Irving Park, Inc., a US resident and incorporated wholly-owned indirect subsidiary of Bank of America, N.A., on 15th August 2000 ("the Settlement Date"), an amount equal to the market value of US Treasuries with an aggregate principal amount of US$ 170,000,000 as of 10 a.m. on 10 August 2000 ("the Trigger Date"), in return for a portfolio of US Treasuries (to be delivered by Irving Park, Inc. to BUKP on the Settlement Date) with an aggregate principal amount having a market value equal to either:

(a) US$ 339,000,000, if 3-month US$ LIBOR-BBA on the Trigger Date was greater than 6.77942%; or

(b) US$ 1,000,000, if US$ LIBOR-BBA on the Trigger Date was less than or equal to 6.77942%; and

(b) an agreement ("the Second Debt Contract" and, together with the First Debt Contract, "the Debt Contracts") whereby BUK agreed to pay Mecklenberg Park, Inc., a US resident and incorporated wholly-owned indirect subsidiary of Bank of America, N.A., on the Settlement Date, an amount equal to either:

(a) US$ 339,000,000, if 3-month LIBOR-BBA was greater than 6.77942% at 10 a.m. on the Trigger Date; or

(b) US$ 1,000,000, if 3-month LIBOR-BBA was less than or equal to 6.77942% on the Trigger Date,

in return for a portfolio of US Treasuries (to be delivered by Mecklenberg Park, Inc. to BUK on the Settlement Date) with an aggregate principal amount of US$ 170,000,000.

(4) Under each of the Debt Contracts, cash settlement was provided for and could be elected for on or before the Trigger Date by either party to the relevant Debt Contract. If either party so elected, the amount owed (or value required to be delivered) by each party under the relevant Debt Contract would be set off against the amount owed (or value required to be delivered) by the other party under such Debt Contract.

(5) Each of Irving Park, Inc. and Mecklenberg Park, Inc. elected for cash settlement on 7 August 2000. On the Settlement Date, as 3-month US$ LIBOR-BBA on the Trigger Date was less than 6.77942%:

(a) the First Debt Contract was cash-settled by the payment by BUKP to Irving Park, Inc. of an amount equal to US$ 170,792,969; and

(b) the Second Debt Contract was cash-settled by the payment by Mecklenberg Park, Inc., to BUK of an amount equal to US$ 170,792,969.

The Appellants' Returns and the Amendments

(6) The Appellants filed corporation tax returns for the accounting period ending 30 November 2000 on the following bases:

(a) BUKP recognised a loss in respect of the First Debt Contract equal to £119,846,305, being the equivalent in pounds sterling on the Settlement Date of US$ 170,792,969 (the "BUKP Loss");

(b) the BUKP Loss formed part of an overall non-trading deficit of £118,662,873 which was available for surrender to any member of the Morgan Stanley UK group under the group relief provisions in sections 402 et seq. of the Taxes Act 1988;

(c) accordingly, BUKP surrendered £96,427,563 of that overall non-trading deficit as follows:

(a) £44,643,181 to Morgan Stanley & Co. Limited, a UK resident and incorporated indirect subsidiary of Morgan Stanley;

(b) £20,421,155 to Morgan Stanley Dean Witter Management Limited (now Morgan Stanley Investment Management Limited), a UK resident and incorporated indirect subsidiary of Morgan Stanley; and

(c) £31,363,227 to Morgan Stanley & Co. International Limited (now Morgan Stanley & Co. International plc), a UK resident and incorporated indirect subsidiary of Morgan Stanley,

with the remainder of the overall non-trading deficit, in the amount of £22,235,310, being carried forward in accordance with s 83(2)(d) of the Finance Act 1996;

(d) BUK recognised a profit in respect of the Second Debt Contract equal to £119,846,305, being the equivalent in pounds sterling on the Settlement Date of US$170,792,969 (the "BUK Profit"); and

(e) the BUK Profit formed part of an overall non-trading profit of £125,862,659 in respect of which BUK was liable to UK corporation tax. In relation to that liability BUK claimed double taxation relief of £35,888,482 under article 23 of the Treaty for the US federal income tax paid by BDE in respect of the BUK Profit, so that no further tax was payable in the UK in respect of the BUK Profit.

(7) The Revenue has contested the basis on which the Appellants filed their tax returns. In summary, the Revenue contends that:

(a) the BUKP Loss (incurred by BUKP under the First Debt Contract) should be reduced to nil by the operation of s 165 of the Finance Act 1994, such that BUKP should have no losses available for surrender as group relief or capable of being carried forward in its accounting period ending on 30 November 2000;

(b) BUKP should instead be treated as having made a profit of £1,183,432 in that accounting period resulting, therefore, in corporation tax payable of approximately £355,030;

(c) through the operation of s 166 of the Finance Act 1994, the BUK Profit (realised by BUK under the Second Debt Contract) should not be taken into account for the purposes of computing BUK's profits chargeable to corporation tax;

(d) BUK's profits chargeable to corporation tax should therefore be amended to £6,016,354, resulting in corporation tax payable of approximately £1,804,906; and

(e) in any event, even if s 165 of the Finance Act 1994 does not apply to BUKP in respect of the First Debt Contract (with the result that no adjustment falls to be made to the taxable profit realised by BUK in respect of the Second Debt Contract), BUK's claim for double taxation relief for the US federal income tax paid by BDE in respect of the profits of BUK should be rejected under the terms of the Treaty and, in the alternative, under s 795A of the Taxes Act 1988.

5. The following further facts were agreed:

(1) The First and Second Debt Contracts reflected market rates at the time they were entered into, so no diminution in the net assets of BUKP occurred immediately after entering into the First Debt Contract.

(2) The Second Debt Contract was executed in the US, was partly negotiated in the US, with the US resident counterparty acting out of its US office, related to assets situated in the US, and was governed by New York law.

6. We find the following additional facts:

(1) The relationship between various companies referred to in this decision is as shown in the chart in the Annex.

(2) BUK and BUKP are associated companies within s 416 of the Taxes Act 1988, which definition is incorporated into s 165 of the Finance Act 1994; and Irving Park Inc and Mecklenberg Park Inc are associated third parties of BUK and BUKP for the purpose of s 165.

(3) Under the debt contract regime in the Finance Act 1994 if the profit of BUK is not reduced as contended for by the Revenue it is taxable under Case III of Schedule D as a non-trading profit.

(4) For US federal income tax purposes (but not for other legal purposes) Treasury Regulation §301.7701-3 ("the Check the Box Regulation") classifies domestic and foreign eligible entities. Under the Check the Box Regulation a foreign eligible entity is "disregarded as an entity separate from its owner if it has a single owner that does not have limited liability." This is applicable to BUK and BUKP as unlimited companies with a single member. However an eligible entity can elect to be treated differently and such an election may be made with effect from a date 75 days before it is filed. BUKP elected to be treated as a corporation with effect from 8 June 2000 and therefore was not a disregarded entity for US federal income tax purposes. BUK made no such election, and therefore was at all material times a disregarded entity for US federal income tax purposes. Pursuant to the Check the Box Regulation Bayview Holdings Limited, a Cayman company, elected to be treated as a disregarded entity for US federal income tax purposes. All other companies shown in the Appendix are treated as corporations for US federal income tax purposes.

(5) Federal income tax was paid in the US by BDE on the profit on the Second Debt Contract.

(6) The shares in BUKP were distributed by BDE and Baycliff Cayman Limited to Bayview Holdings Limited which sold them to an unrelated purchaser, thus realising a loss for US federal income tax purposes corresponding to the loss made by BUKP on the First Debt Contract.

7. We had two experts' reports on US tax by Mr Stuart Leblang of Akin Gump Strauss Hauer & Field LLP, New York, for the Appellants, and by Mr Michael J Miller of Roberts & Holland LLP, New York, for the Revenue. They also made a joint report dated 10 October 2008 for which we are most grateful. We treat the contents of the joint report as a finding of fact, whether or not we refer to it in our decision, but we do not annex this to our decision.

Section 165

8. Section 165 of the Finance Act 1994 provides:

165 Transfers of value by qualifying companies

(1) Subsection (2) below applies where, as a result of—

 (a) a qualifying company entering into a relevant transaction on or after its commencement day, or

 (b) the expiry on or after a qualifying company's commencement day of an option held by the company which, until its expiry, was a qualifying contract,

there is a transfer of value by the qualifying company to an associated company or an associated third party.

(2) For the accounting period of the qualifying company in which the transaction was entered into or the option expired, there shall be deducted from amount B or, as the case may require, added to amount A an amount equal to the value transferred by that company.

(3) For the purposes of subsection (1) above there is a transfer of value by the qualifying company to an associated company or an associated third party if, immediately after the transaction or expiry—

(a) the value of the qualifying company's net assets is less, and

(b) the value of the associated company's or associated third party's net assets is more,

than it would have been but for the transaction or expiry; and the amount by which the value mentioned in paragraph (a) above is less is the value transferred by the qualifying company for the purposes of subsection (2) above.

(4) Any reference in subsection (3) above to the value of a person's net assets being less or more than it would have been but for the transaction or expiry includes a reference to the value of that person's net liabilities being more or, as the case may be, less than it would have been but for the transaction or expiry.

(5) In applying subsection (3) above, no account shall be taken of any such payment as is mentioned in section 151(2)(a) or (b) above.

(6) A third party, that is to say, a person who is not an associated company, is an associated third party for the purposes of this section at the time when the relevant transaction is entered or the option expires if, at that time, each of the two conditions mentioned below is fulfilled.

(7) The first condition is that the relevant transaction is entered into or the option is allowed to expire in pursuance of arrangements made with the third party.

(8) The second condition is that, in pursuance of those arrangements, a transfer of value has been or will be made to an associated company (directly or indirectly) by the third party or by a company which was at the time when the arrangements were made an associated company of that party.

(9) Where it appears to the inspector that there is a transfer of value by the qualifying company to a third party, he may by notice in writing require the company, within such time (which shall not be less than 30 days) as may be specified in the notice, to furnish to the inspector such information—

(a) as is in its possession or power, and

(b) as the inspector reasonably requires for the purpose of determining whether the third party is an associated third party for the purposes of this section.

(10) Subsection (3) above shall (with the necessary modifications) apply for the purposes of subsections (7) to (9) above as it applies for the purposes of subsection (1) above.

(11) In this section—

 "associated company" shall be construed in accordance with section 416 of the Taxes Act 1988;

"relevant transaction" means a transaction as a result of which—

(a) a qualifying company becomes party to a qualifying contract, or

(b) the terms of a qualifying contract to which a qualifying company is party are varied;

 and any reference to an associated company is, unless the contrary intention appears, a reference to an associated company of the qualifying company.

We do not set out s 166 as it is common ground that if s 165 operates to eliminate the loss s 166 operates in the same way to eliminate the gain.

9. Mr Peacock QC and Mr Fitzpatrick contend in outline:

(1) The Finance Act 1994 code is a detailed code applying separately to each Debt Contract.

(2) IRC v Scottish Provident Institution [2005] STC 15 is authority for saying that a composite transaction can be looked at as one transaction to determine entitlement in s 150A of the Finance Act 1994. It does not mean that throughout that code composite transactions can be looked at as one since the code is specific in dealing with each contract separately. Even though it may be more likely that a composite view is taken in applying anti-avoidance legislation, it is still necessary to ask whether the particular legislation permitted it. The draftsman deals specifically with cases where other transactions can be taken into account, for example s 167(9)(c) (see below).

(3) There were commercial risks to the transactions, for example if one of the parties had gone into liquidation before the performance was completed. Although one is more conscious of bank risk today, that risk existed in 2000. Further, there were commercial consequences arising from the transactions in that BUK's profit was invested by that company in the Morgan Stanley UK group, and the profit would not have been in that company had the transactions not taken place.

(4) Even if the Debt Contracts are taken together this does not assist the Revenue since there is no reduction in the value of one company's net assets and no corresponding increase in the associated company's net assets immediately after the relevant transaction, which is the entering into the Debt Contracts, (the relevant transaction being defined as the transaction "as a result of which" the company becomes a party to a qualifying contract). Here, immediately after the two companies entered into the Debt Contracts (even if they are taken together) there is no such reduction – there is, it is admitted, the certainty that, by the Trigger Date, one company will make a profit and the other a loss, so that by that date value can be regarded as transferred from one to the other, depending on the movement of the relevant interest rate, but immediately after the Debt Contracts were entered into, since they were entered into on market terms, no value was transferred in either direction.

10. Mr Ewart QC and Mr Vallatt contend in outline:

(1) This is a tax avoidance scheme in which all the steps are set out in a document entitled "Morgan Stanley Dean Witter Internal Funding Opportunity," all the companies concerned were set up as part of the scheme, the two Debt Contracts were entered into at the same time with each party knowing about the other contract since two of the directors of the two Morgan Stanley companies were the same, and the board meetings of both Morgan Stanley companies were held at the same place and at the same time. The scheme had no commercial purpose or effect apart from Bank of America's fees and there was no indication that the fees were commensurate with the risk undertaken by each company of some $171m for each transaction. The transactions had no net effect on the Appellant companies. No commercial reason was given by either company for entering into the Debt Contracts, which were no more than a 50/50 bet which, taking the companies individually, could not be justified as a prudent commercial transaction. The profit may have been invested in the Morgan Stanley UK group but it merely represented the capital that had been put by the group into the two companies which ended in BUK. The two Debt Contracts should be looked at together.

(2) The Scottish Provident Institution case concerned the same statutory code and demonstrates that composite transactions can be looked at as a single transaction in applying that code. Which of the Appellants would make a profit was an uncertainty introduced to avoid the consequences of s 165. It was a commercially irrelevant contingency that should be ignored in accordance with Scottish Provident Institution.

(3) Section 165 is one of a group of sections headed Anti-avoidance and related provisions which should be given a wide meaning taking into account that it dealt with both direct and indirect artificial losses between associated companies.

(4) The composite transaction was the combined operation of the two Debt Contracts including their performance and end consequences. Accordingly, and contrary to the position where there was a single contract, s 165 applies to test whether there has been a reduction and corresponding increase in the associated companies' net assets immediately after the combined transaction i.e. performance of the contracts.

(5) There was certain to be a transfer of value between the two Appellants although the direction of the transfer was unclear.

(6) There was no commercial risk: all the contracting companies were guaranteed by their respective parent banks, and the idea that one of the banks might have gone into liquidation was not in contemplation in 2000. Further, the ISDA standard form master agreement under which the Debt Contracts were written had offset protection provisions which would have come into play in the event of guarantor default.

11. On the issue of whether the contracts can be looked at together for the purpose of this legislation, Lord Hoffmann giving the judgment of the Privy Council in Carreras Group Ltd v Stamp Commissioner [20004] STC 1377, said:

[8] Whether the statute is concerned with a single step or a broader view of the acts of the parties depends upon the construction of the language in its context. Sometimes the conclusion that the statute is concerned with the character of a particular act is inescapable: see MacNiven (Inspector of Taxes) v Westmoreland Investments Ltd [2001] UKHL 6, [2001] STC 237, [2003] 1 AC 311. But ever since W T Ramsay Ltd v IRC [1981] STC 174, [1982] AC 300 the courts have tended to assume that revenue statutes in particular are concerned with the characterisation of the entirety of transactions which have a commercial unity rather than the individual steps into which such transactions may be divided. This approach does not deny the existence or legality of the individual steps but may deprive them of significance for the purposes of the characterisation required by the statute. This has been said so often that citation of authority since Ramsay's case is unnecessary.

12. On the approach to be adopted to statutory interpretation, in Barclays Mercantile Business Finance Ltd v Mawson [2005] STC 1 Lord Nicholls giving the speech to which all members had contributed said:

[32] The essence of the new approach was to give the statutory provision a purposive construction in order to determine the nature of the transaction to which it was intended to apply and then to decide whether the actual transaction (which might involve considering the overall effect of a number of elements intended to operate together) answered to the statutory description. Of course this does not mean that the courts have to put their reasoning into the straitjacket of first construing the statute in the abstract and then looking at the facts. It might be more convenient to analyse the facts and then ask whether they satisfy the requirements of the statute. But however one approaches the matter, the question is always whether the relevant provision of statute, upon its true construction, applies to the facts as found. As Lord Nicholls of Birkenhead said in MacNiven (Inspector of Taxes) v Westmoreland Investments Ltd [2001] UKHL 6 at [8], [2001] STC 237 at [8], [2003] 1 AC 311:

'The paramount question always is one of interpretation of the particular statutory provision and its application to the facts of the case.'

[33] The simplicity of this question, however difficult it might be to answer on the facts of a particular case, shows that the Ramsay case did not introduce a new doctrine operating within the special field of revenue statutes. On the contrary, as Lord Steyn observed in McGuckian [1997] STC 908 at 915, [1997] 1 WLR 991 at 999 it rescued tax law from being 'some island of literal interpretation' and brought it within generally applicable principles.

[34] Unfortunately, the novelty for tax lawyers of this exposure to ordinary principles of statutory construction produced a tendency to regard Ramsay as establishing a new jurisprudence governed by special rules of its own. This tendency has been encouraged by two features characteristic of tax law, although by no means exclusively so. The first is that tax is generally imposed by reference to economic activities or transactions which exist, as Lord Wilberforce said, 'in the real world'. The second is that a good deal of intellectual effort is devoted to structuring transactions in a form which will have the same or nearly the same economic effect as a taxable transaction but which it is hoped will fall outside the terms of the taxing statute. It is characteristic of these composite transactions that they will include elements which have been inserted without any business or commercial purpose but are intended to have the effect of removing the transaction from the scope of the charge.

[35] There have been a number of cases, such as IRC v Burmah Oil Co Ltd [1982] STC 30, 1982 SC (HL) 114, Furniss (Inspector of Taxes) v Dawson [1984] STC 153, [1984] AC 474 and Carreras Group Ltd v Stamp Comr [2004] UKPC 16, [2004] STC 1377 in which it has been decided that elements which have been inserted into a transaction without any business or commercial purpose did not, as the case might be, prevent the composite transaction from falling within a charge to tax or bring it within an exemption from tax. Thus in the Burmah case, a series of circular payments which left the taxpayer company in exactly the same financial position as before was not regarded as giving rise to a 'loss' within the meaning of the legislation. In Furniss, the transfer of shares to a subsidiary as part of a planned scheme immediately to transfer them to an outside purchaser was regarded as a taxable disposition to the outside purchaser rather than an exempt transfer to a group company. In Carreras the transfer of shares in exchange for a debenture with a view to its redemption a fortnight later was not regarded as an exempt transfer in exchange for the debenture but rather as an exchange for money. In each case the court looked at the overall effect of the composite transactions by which the taxpayer company in Burmah suffered no loss, the shares in Furniss passed into the hands of the outside purchaser and the vendors in Carreras received cash. On the true construction of the relevant provisions of the statute, the elements inserted into the transactions without any commercial purpose were treated as having no significance.

[36] Cases such as these gave rise to a view that, in the application of any taxing statute, transactions or elements of transactions which had no commercial purpose were to be disregarded. But that is going too far. It elides the two steps which are necessary in the application of any statutory provision: first, to decide, on a purposive construction, exactly what transaction will answer to the statutory description and secondly, to decide whether the transaction in question does so. As Ribeiro PJ said in Collector of Stamp Revenue v Arrowtown Assets Ltd [2003] HKCFA 46 at [35], (2004) 6 ITLR 454 at [35]:

'[T]he driving principle in the Ramsay line of cases continues to involve a general rule of statutory construction and an unblinkered approach to the analysis of the facts. The ultimate question is whether the relevant statutory provisions, construed purposively, were intended to apply to the transaction, viewed realistically.'

13. Since Scottish Provident Institution relates to the statutory code relevant to the transactions we are concerned with we start by looking at what it decided. The facts were that by transaction A the taxpayer granted a call option to Citibank of £100m of certain gilts at a strike price of 70, and Citibank granted the taxpayer a call option in respect of the same amount of the same gilts at a strike price of 90. The prices were set so that there was, as was found as a fact, a practical likelihood of one option being exercised and the other not exercised. The House of Lords disregarded the remote uncertainty that the options would not follow this course on the ground that it was a commercially irrelevant contingency inserted in order to prevent its being said that the transaction was a composite one. On that basis, one applied the concept of entitlement to becoming party to a loan relationship (the gilts) in s 150A of the Finance Act 1994 on the basis that the two options cancelled out leaving the taxpayer with no such entitlement. This shows that while the code is a detailed one dealing with individual debt contracts the taxation of which is based on a formula, a concept such as entitlement can be read so as to treat separate contracts together. The issue for us is whether the same approach can be applied to s 165 and, if so, with what result.
14. We infer from the agreed primary facts that both Debt Contracts should be taken together. They were planned together, entered into at the same time, with some at least of the company directors common to both BUK and BUKP. If either of those companies had proposed to enter into one contract separately with a Bank of America company we infer that the Bank of America company would have refused as it put them in a position of possibly losing about £198.8m in return for a fee of $162,500, and similarly if the same had been proposed to BUK or BUKP they would also have refused for similar reasons. But the composite transaction was bound to result in one Bank of America company gaining the same amount as the other lost while (together) retaining a total fee of $325,000, and the two Morgan Stanley companies taken together breaking even while hopefully obtaining group relief for the loss and no UK tax on the profit after credit for US tax, for which they were willing to pay the fee. (For completeness we should mention that, by reason of the sale of BUKP following the distribution of the shares in BUKP to Bayview Holding Limited, losses arose which provided a US tax relief broadly equivalent to the US tax paid on the profit earned by BUK).
15. Taking the two Debt Contracts together and reading in the definition of relevant transaction and transfer of value, s 165(1) provides:

(1) Subsection (2) below applies where, as a result of—

  a qualifying company entering into [a transaction as a result of which—

(a) a qualifying company becomes party to a qualifying contract on or after its commencement day,…]

[immediately after the transaction…—

 (a) the value of the qualifying company's net assets is less, and

 (b) the value of the associated company's or associated third party's net assets is more,

than it would have been but for the transaction…]

16. This requires that the result of the transaction is the entering into the qualifying contract (or taken together, contracts) and that immediately after entering into them the value of one company's net assets was less, and the associated company's net assets more, than they would have been but for the entering into of the contracts. We infer that immediately after entering into the two contracts it cannot be said that either Morgan Stanley company was more likely to gain than to lose compared to their existing position. Therefore although we agree with Mr Ewart that the section should, in the circumstances of this case, be read as applying to both Debt Contracts taken together, doing so does not result in the section operating. The wording is quite specific in looking at the loss immediately after the (combined) transaction meaning the entering into the qualifying contracts. We cannot read the section in the way proposed by Mr Ewart that the "relevant transaction" is the whole of the two Debt Contracts and their operation or performance, when the transaction (here, transactions) must, by definition, be that as a result of which the company in question enters into the qualifying contract(s), and the position must be tested at a particular time immediately after entering into them. Accordingly on this point we prefer Mr Peacock's interpretation and decide that ss 165 and 166 do not operate to eliminate the loss and gain respectively.

The Tower MCashback issue

17. Mr Peacock contends that since the Revenue's conclusion to their enquiry and amendment to the self-assessment was based solely on ss 165 and 166 they cannot now seek to invoke s 167 on the basis of Tower MCashback LLP1 v HMRC ([2008] EWHC 2387 (Ch), 13 October 2008 (decided while we were sitting, and not yet reported). In particular, this is because the question whether, if the parties had been dealing at arm's length the transaction would not have been entered into, was a necessary additional fact to the facts concerning s 165.
18. Mr Ewart contends that the facts on which the conclusion and amendment was based comprised the two Debt Contracts and therefore he can contend any point of law relating to them. Whether parties dealing at arm's length would have entered into the transaction is a conclusion from the primary facts.
19. In Tower MCashback Henderson J said:

"114. A further important principle can in my judgment be deduced from the wording of section 50(6) and (7). Because one of the matters that the Commissioners [the learned judge is here referring to the Special Commissioners and the General Commissioners] have to consider is whether the taxpayer is undercharged to tax by an assessment or self-assessment, or whether any amounts contained in a partnership statement are insufficient, it would seem to follow that the Commissioners are not confined to an examination of the reasons advanced by HMRC in support of the conclusions set out in a closure notice, and that they are not compelled to treat an amendment to a return under section 28A or 28B as fixing the maximum amount of tax which is recoverable. Provided that they act fairly, and on the basis of evidence that is properly before them, the Commissioners may take the initiative and apply the law to the facts in the manner that appears to them to be correct, regardless of the arguments advanced by either side.

There is nothing surprising in this conclusion, because the wording of section 50(6) and (7), which applies alike to appeals relating to self-assessments and appeals against assessments made by an officer of HMRC, reflects similar wording of very long standing which goes back long before the introduction of self-assessment. There is a venerable principle of tax law to the general effect that there is a public interest in taxpayers paying the correct amount of tax, and it is one of the duties of the Commissioners in exercise of their statutory functions to have regard to that public interest. This principle finds expression in cases such as R v Income Tax Special Commissioners, ex parte Elmhirst [1936] 1KB 487 (CA), and in the need for special legislation (now contained in section 54 of TMA 1970) to enable tax appeals to be settled by agreement between the parties without the need for a hearing. The precise nature and scope of this principle in the 21st century is a controversial topic, having regard in particular to changes which have taken place over the years in the functions of the General and Special Commissioners, and to the introduction in 1994 of procedural rules regulating appeals to both tribunals. Furthermore, the whole question may become academic when appeals to the Commissioners are replaced next year by appeals to the new Tax Tribunal. For present purposes, however, it is enough to say that the principle still has at least some residual vitality in the context of section 50, and if the Commissioners are to fulfil their statutory duty under that section they must in my judgment be free in principle to entertain legal arguments which played no part in reaching the conclusions set out in the closure notice. Subject always to the requirements of fairness and proper case management, such fresh arguments may be advanced by either side, or may be introduced by the Commissioners on their own initiative.

That is not to say, however, that an appeal against a closure notice opens the door to a general roving enquiry into the relevant tax return. The scope and subject matter of the appeal will be defined by the conclusions stated in the closure notice and by the amendments (if any) made to the return. The legislation does not say this in so many words, but it follows from the fact that the taxpayer's right of appeal under section 31(1)(b) is confined to an appeal against any conclusions stated or amendments made by a closure notice. That is the only appeal which the Commissioners have jurisdiction to entertain.

Again, there is in my judgment nothing surprising about this conclusion. The introduction of self-assessment placed new and considerable burdens on taxpayers, including in many cases the obligation to calculate the amount of tax payable. For a helpful introduction to the subject, see the judgment of Park J in Langham v Veltema [2002] EWHC 2698 (Ch), (2004) 76 TC 259 at 274-6. As Park J said, "[t]he new burdens were balanced by new protections for taxpayers who conscientiously complied with the system". The protections which were considered by Park J and the Court of Appeal in Langham v Veltema (and, more recently, by myself in HMRC v Household Estate Agents Ltd [2007] EWHC 1684 (Ch), (2007) 78 TC 705), were the new and tighter time limits on the power of HMRC to make further tax assessments under section 29 of TMA 1970. In the present case, the more relevant protections are the strict time-limits within which an enquiry may be opened into a return (normally up to 12 months from the filing date for the return), and the provisions relating to closure notices in sections 28A and 28B. During the course of an enquiry into a return, HMRC have extensive information-gathering powers available to them, and any question arising in connection with the subject matter of the enquiry may be referred to the Special Commissioners for their determination (see section 28ZA). Furthermore, the officer conducting the enquiry cannot be compelled to issue a closure notice until he has completed his investigations and is ready to do so, subject only to the procedure set out in section 28A(4)-(6) and 28B(5)-(7) whereby the taxpayer may apply to the Commissioners for a direction requiring a closure notice to be issued within a specified period, and the Commissioners are required to give the direction applied for "unless they are satisfied that there are reasonable grounds for not issuing a closure notice within a specified period".

Against this background, it is I think clearly implicit in the statutory scheme that an appeal under section 31(1)(b) may not stray beyond the subject matter of the conclusions and amendments (if any) stated in the closure notice."

20. There, the conclusion stated was that the claim for relief under s 45 of the Capital Allowances Act 2001 was excessive and the Revenue's letter explained that the scheme "fails on the s 45(4) CAA 2001 point alone." Since s 45(4) operates by excluding certain expenditure which would otherwise qualify for relief, it presupposes that the other conditions for relief were otherwise satisfied. Accordingly the Revenue could not argue in the appeal that the other conditions were not satisfied. This was contrasted with the Special Commissioner's decision in D'Arcy v HMRC [2006] STC 543 at 547-554 (the case was appealed, but not on this aspect), the reasoning in which the learned judge approved, where the Revenue had concluded their enquiry by denying the deduction claimed on Ramsay grounds and in the appeal contended instead that the deduction was cancelled by a statutory provision deeming an equivalent amount to be income. This was permitted on the ground that the factual scope of the closure on which the Ramsay contention was based related to the disposal, acquisition and repo over certain gilts, and the new legal argument was based on the same facts. D'Arcy was distinguished in Tower MCashback for the following reason:

Finally, the decision in D'Arcy is in my judgment clearly distinguishable, because the factual compass of the conclusion stated in the Closure Notice embraced all the steps in the scheme, and all that HMRC wished to do was to advance fresh legal arguments arising out of those facts. In the present case, by contrast, the limitation of the stated conclusion to the provisions of section 45(4) meant that the factual compass of the appeal was confined to those facts which are relevant for the purposes of section 45(4).

21. In our view this case is well on the D'Arcy side of the line. The factual scope of the closure to the effect that s 165 applies is the two Debt Contracts. Section 167 is an alternative legal argument based on the same facts. The fact that s 167 requires a further inference of fact does not alter this.

Section 167

22. Section 167 of the Finance Act 1994 provides as follows:

"167 Transactions not at arm's length

(1) A transaction entered into on or after a qualifying company's commencement day is a relevant transaction for the purposes of this section if as a result of the transaction—

(a) the qualifying company becomes party to a qualifying contract, or

(b) the terms of a qualifying contract to which the qualifying company is party are varied.

(2) Subsections (3) to (5) below apply where—

(a) if the parties to a relevant transaction had been dealing at arm's length, the transaction—

 (i) would not have been entered into at all, or

 (ii) would have been entered into on different terms, ...

(b) ...

but subject, in a case falling within paragraph (a)(ii) above, to the modifications made by subsection (7) below.

(3) For each relevant accounting period for the whole of which the other party is a qualifying company, the following deductions shall be made—

 (a) from amount B, a deduction of such amount as may be necessary to reduce amount B to nil, and

  (b) from amount A, a deduction of such amount as may be necessary to reduce amount A to nil…."

…

(8) In applying subsections (2) and (7) above—

(a) no account shall be taken of any transfer of value in respect of which an adjustment is made under section 165 or 166 above, but

(b) subject to that, all factors shall be taken into account.

(9) The factors which may be so taken into account include—

(a) in a case where the qualifying contract is an interest rate contract or option, any notional principal amounts and rates of interest that would have been involved;

(b) in a case where the qualifying contract is a currency contract or option, any currencies and amounts that would have been involved;

(ba) in a case where the qualifying contract is a debt contract or option, the amount of the debt by reference to which any loan relationship that would have been involved would have subsisted, and any terms as to repayment, redemption or interest that, in the case of that debt or any asset representing it, would have been involved; and

(c) in any such case, any transactions which are related to the relevant transaction.

23. Mr Peacock contends in outline that the Morgan Stanley companies were at arm's length with the Bank of America companies. The draftsman demonstrated that contracts had to be looked at in isolation by including specific provision in subs (9)(c) entitling related transactions to be taken into account.
24. Mr Ewart contends in outline:

(1) The combined contracts were not commercial; they were part of a scheme. The Bank of America companies were taking a fee for entering into transactions in which they took no risk. The companies on each side were in effect making a 50/50 bet, which is not a commercial transaction, seen in relation to legislation dealing with debt contracts. Looked at together the two Appellants must break even. While the Appellants may have been at arm's length from the Bank of America companies, they were not dealing at arm's length in entering into the pre-planned scheme. The effect would have been the same if the two Morgan Stanley companies had bet each other without any involvement of Bank of America companies.

(2) The subs (9)(c) point made by Mr Peacock demonstrated that the contracts could be looked at together.

(3) Even if the Debt Contracts were not looked at together each one was an irrational and uncommercial gamble and not a contract such as one would expect between parties dealing at arm's length.

25. For the reasons given in relation to s 165 we consider that the two Debt Contracts are required to be considered together. As stated above, the combined transaction was bound to result in one Bank of America company gaining the same amount as the other lost while the Bank of America group received a total fee of $325,000, and the two Morgan Stanley companies taken together breaking even while hopefully obtaining group relief for the loss and no UK tax on the profit after credit for US tax, for which they were willing to pay the fee. The question is whether if the parties to the relevant transactions taken together had been dealing at arm's length, the transaction would not have been entered into at all. This is a transaction in which the Bank of America parties had opposite interests to the Morgan Stanley parties and a substantial fee was payable to the Bank of America parties in order to secure a tax benefit that the Morgan Stanley parties hoped to achieve (and which at the time the legislation did not say should not be taken into account; the unallowable purpose provision in s 168A being introduced in 2002). The two sides were not only at arm's length, but we find that they were dealing at arm's length, and in that relationship they entered into the combined transaction. The fact that the result for the two companies on each side would cancel out does not, in our view, deprive the transaction of this status, since regard should be had to the fees paid and the tax benefit anticipated. Accordingly, we prefer Mr Peacock's interpretation on this issue.

Unilateral relief

26. Section 790 of the Taxes Act 1988 provides:

"790 Unilateral relief

(1) To the extent appearing from the following provisions of this section, relief from income tax and corporation tax in respect of income and chargeable gains shall be given in respect of tax payable under the law of any territory outside the United Kingdom by allowing that tax as a credit against income tax or corporation tax, notwithstanding that there are not for the time being in force any arrangements under section 788 providing for such relief.

(2) Relief under subsection (1) above is referred to in this Part as "unilateral relief".

(3) Unilateral relief shall be such relief as would fall to be given under Chapter II of this Part if arrangements with the government of the territory in question containing the provisions specified in subsections (4) to [(10C)]¹ below were in force by virtue of section 788, but subject to any particular provision made with respect to unilateral relief in that Chapter; and any expression in that Chapter which imports a reference to relief under arrangements for the time being having effect by virtue of that section shall be deemed to import also a reference to unilateral relief.

(4) Credit for tax paid under the law of the territory outside the United Kingdom and computed by reference to income arising or any chargeable gain accruing in that territory shall be allowed against any United Kingdom income tax or corporation tax computed by reference to that income or gain (profits from, or remuneration for, personal or professional services performed in that territory being deemed for this purpose to be income arising in that territory).

(5) Subsection (4) above shall have effect subject to the following modifications, that is to say—

(a) …

(b) where arrangements with the government of the territory are for the time being in force by virtue of section 788 [i.e. double tax treaties], credit for tax paid under the law of the territory shall not be allowed by virtue of subsection (4) above in the case of any income or gains if any credit for that tax is allowable under those arrangements in respect of that income or those gains; and…"

27. In addition to s 790(5)(b), s 793A contains provisions relevant to the interaction of unilateral and treaty relief:

"(2) Where, under arrangements having effect by virtue of section 788 [i.e. double tax treaties], credit may be allowed in respect of an amount of tax, credit by way of unilateral relief may not be allowed in respect of that tax.

(3) Where a double tax treaty contains express provision to the effect that relief by way of credit shall not be given under the treaty in cases or circumstances specified or described in the treaty, then neither shall credit by way of unilateral relief be allowed in those cases or circumstances.

Subsection (3) applies only to treaties made after 20 March 2000.

28. Mr Peacock contends that the source of income is in the US as it is agreed that the Second Debt Contract was executed in the US, was partly negotiated there, the counterparty was a US corporation acting out of its US office, it related to assets situated in the US, and was governed by New York law. As in National Bank of Greece v Westminster Bank Executor and Trustee Co (Channel Islands) Ltd [1971] AC 945 all the factors point one way to its having a non-UK source. For claiming relief it is necessary to identify the income taxed in both countries, as in George Wimpey International Ltd v Rolfe [1989] STC 609.
29. Mr Ewart contends that the source of the income is not the Debt Contract but what is taxable under the Finance Act 1994 code, which is the difference between two amounts. That is taxed under Case III as a non-trading profit as provided in s 82(4) the Finance Act 1996 and is therefore determined to be UK source. It is therefore unnecessary to consider authorities like National Bank of Greece.
30. Sections 790(5)(b) and 793A(2) and (3) are inapplicable and accordingly there is nothing in principle to prevent a claim for unilateral relief on the basis of our conclusion below that relief is not available under the Treaty. Unilateral relief is given for tax on income "arising in" the territory in which it is taxed, the only reference to which is that "profits from, or remuneration for, personal or professional services performed in that territory [are] deemed for this purpose to be income arising in that territory," which does not apply. Where the income arises must therefore be determined in accordance with UK tax law.
31. We have summarised the rival contentions above. Mr Peacock concentrates on the source of the Debt Contract, while Mr Ewart looks to the source identified by taxation as Case III income under the Finance Act 1994 code. We do not consider that the UK schedule or case under which income is taxed is conclusive. For example, it would be contrary to the approach in George Wimpey International Limited to argue that profits of a foreign branch do not arise in the territory in which it is situated, but those profits would be taxable under Case I of Schedule D (although if there were a treaty the point would be covered by the deemed source rule considered below). There the fact that a company is taxable on total profits did not mean that one could identify the income taxed abroad with any UK income. One had to look at Case I separately. The taxpayer had a Case I overall loss and so there was no UK tax against which to credit the tax on the foreign branches. It cannot be argued that had there been a Case I profit this arose entirely in the UK because it is UK source income. Yates v GCA International Limited [1991] STC 157 (which was not cited to us) is an example of a taxpayer whose income was taxed under Case I being entitled to unilateral relief for tax in respect of work performed in Venezuela without its having a branch there. The point may not have been argued specifically but the fact that it was not argued shows that the parties considered it obvious that taxation under Case I was not conclusive. We therefore consider that one should take a common sense view about where income arises. The reason why the income is taxed in the other territory must be significant, and in accordance with GCA International should correspond to what we would say was where the income in substance arose. If the facts relating to the US had been in the UK we would not have had a basis for bringing the profit of the non-resident into the UK tax charge. The Finance Act 1994 code has no territorial provisions and so must depend on chargeability of the company on general principles. A non-resident company without a permanent establishment would not have been taxed regardless of the fact that a contract had been executed and partly negotiated with a UK resident. We would say that the profits in substance arose where the company was resident. This is not a case where one can apportion the profit between the two territories.
32. Applying this approach to the facts of this case, the reason for the US tax has nothing to do with the income arising in the US because of the situs of the Second Debt Contract; it arises solely because the US disregards BUK for federal income tax purposes. On common sense principles we conclude that BUK's profit arises in substance in the UK regardless of the situs of the Second Debt Contract or the fact that the charge is under Case III. Accordingly, the terms of s 790(4) are not satisfied, and unilateral relief is not available to BUK for the US tax paid (by BDE) on the profit resulting from the Second Debt Contract. Although we have decided this issue on a basis that was not argued we do not consider that it is necessary to give the parties the opportunity of commenting as this is a point of law that can be argued on appeal.
33. We should add, although the point was not taken, that the Tower MCashback issue might arise here as well since the Revenue in their letter of 12 September 2006 giving their conclusions to their enquiries declined credit relief under the Treaty and under s 795A. If it does arise, our conclusion is the same, that the factual scope of the appeal includes the facts relevant to unilateral relief and there is nothing to prevent the Revenue from raising this additional legal argument.

The Treaty

Interpretation of the Treaty in general

34. Before looking at the terms of the Treaty we deal with the correct approach to interpretation of a tax treaty. Both parties relied on the following passage in the decision of the Special Commissioners in Smallwood v HMRC [2008] STC (SCD) 629 (we have omitted the part relating to the use of the OECD Commentary, which is not relevant here):

The approach to interpreting a treaty

"94. In IRC v Commerzbank [1990] STC 285, 297-8, in a passage approved by the Court of Appeal in Memec v IRC [1998] STC 754, 766g, Mummery J summarised the approach to treaty interpretation laid down by the House of Lords in Fothergill v Monarch Airlines Ltd [1981] AC 251 in the following way:

'(1) It is necessary to look first for a clear meaning of the words used in the relevant article of the convention, bearing in mind that 'consideration of the purpose of an enactment is always a legitimate part of the process of interpretation': per Lord Wilberforce (at 272) and Lord Scarman (at 294). A strictly literal approach to interpretation is not appropriate in construing legislation which gives effect to or incorporates an international treaty: per Lord Fraser (at 285) and Lord Scarman (at 290). A literal interpretation may be obviously inconsistent with the purposes of the particular article or of the treaty as a whole. If the provisions of a particular article are ambiguous, it may be possible to resolve that ambiguity by giving a purposive construction to the convention looking at it as a whole by reference to its language as set out in the relevant United Kingdom legislative instrument: per Lord Diplock (at 279)

(2) The process of interpretation should take account of the fact that—

'The language of an international convention has not been chosen by an English parliamentary draftsman. It is neither couched in the conventional English legislative idiom nor designed to be construed exclusively by English judges. It is addressed to a much wider and more varied judicial audience than is an Act of Parliament which deals with purely domestic law. It should be interpreted, as Lord Wilberforce put it in James Buchanan & Co. Ltd v. Babco Forwarding & Shipping (UK) Limited, [1987] AC 141 at 152, "unconstrained by technical rules of English law, or by English legal precedent, but on broad principles of general acceptation': per Lord Diplock (at 281–282) and Lord Scarman (at 293).".

(3) Among those principles is the general principle of international law, now embodied in article 31(1) of the Vienna Convention on the Law of Treaties, that 'a treaty should be interpreted in good faith and 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'. A similar principle is expressed in slightly different terms in McNair's The Law of Treaties (1961) p 365, where it is stated that the task of applying or construing or interpreting a treaty is 'the duty of giving effect to the expressed intention of the parties, that is, their intention as expressed in the words used by them in the light of the surrounding circumstances'. It is also stated in that work (p 366) that references to the primary necessity of giving effect to 'the plain terms' of a treaty or construing words according to their 'general and ordinary meaning' or their 'natural signification' are to be a starting point or prima facie guide and 'cannot be allowed to obstruct the essential quest in the application of treaties, namely the search for the real intention of the contracting parties in using the language employed by them'.

(4) If the adoption of this approach to the article leaves the meaning of the relevant provision unclear or ambiguous or leads to a result which is manifestly absurd or unreasonable recourse may be had to 'supplementary means of interpretation' including travaux préparatoires: per Lord Diplock (at 282) referring to article 32 of the Vienna Convention, which came into force after the conclusion of this double taxation convention, but codified an already existing principle of public international law. See also Lord Fraser (at 287) and Lord Scarman (at 294).

(5) Subsequent commentaries on a convention or treaty have persuasive value only, depending on the cogency of their reasoning. Similarly, decisions of foreign courts on the interpretation of a convention or treaty text depend for their authority on the reputation and status of the court in question: per Lord Diplock (at 283–284) and per Lord Scarman (at 295).

(6) Aids to the interpretation of a treaty such as travaux préparatoires, international case law and the writings of jurists are not a substitute for study of the terms of the convention. Their use is discretionary, not mandatory, depending, for example, on the relevance of such material and the weight to be attached to it: per Lord Scarman (at 294).'

Article 31 of the Vienna Convention on the Law of Treaties referred to in this quotation provides as follows:

"1. 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.

The context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes:

(a) any agreement relating to the treaty which was made between all the parties in connection with the conclusion of the treaty;

(b) any instrument which was made by one or more parties in connection with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty.

There shall be taken into account together with the context:

(a) any subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions;

(b) any subsequent practice in the application of the treaty which establishes the agreement of the parties regarding its interpretation;

(c) any relevant rules of international law applicable in the relations between the parties.

A special meaning shall be given to a term if it is established that the parties so intended."

Mr Brennan also contended that we should apply a commonsense approach to tax treaties following Lord Walker in Pirelli Cable Holding NV v IRC [2006] STC 548 at [150] where he said:

"[105] In his printed case Mr Aaronson QC (for the respondent Pirelli companies) acknowledged (para 38) that if commonsense or plain justice required it, the Revenue might be able to justify what he has called a selective reading of ss 231 and 247. The requirements of justice are not easy to discern in the world of cross-border taxation of multinationals, but I think that commonsense does point in favour of the Revenue's appeal. The evident purpose of s 788(3)(d) and of article 10 of the DTAs is to give a tax credit (of a certain sort) to a non-resident shareholder who receives a dividend from a United Kingdom company. It is central to the concept of the United Kingdom granting a tax credit to the shareholder in respect of a dividend that some United Kingdom tax should have been paid (or at least payable) in respect of that dividend. It would be an abuse of language, and contrary to commonsense, to speak of granting a tax credit when no such tax has been paid."

While it is no doubt never wrong to apply commonsense we believe that Lord Walker was dealing here more with domestic law, which was Mr Aaronson's point, than tax treaties, although in that particular case the two were closely linked. But even if we were to apply common sense we do not consider that it would favour Mr Brennan's interpretation."

Relevant Treaty provisions

35. The Statutory Instrument to which the Treaty is scheduled declares that the arrangements:

"…have been made with the Government of the United States of America with a view to affording relief from double taxation…"

The preamble sets out the purpose of the Treaty as a whole as being:

"…for the avoidance of double taxation and the prevention of fiscal evasion…"

The following provisions of the Treaty are particularly relevant:

"Article 1 Personal scope

…

(3)     Notwithstanding any provision of this Convention except paragraph (4) of this Article, a Contracting State may tax its residents (as determined under Article 4 (Fiscal residence)) and its nationals as if this Convention had not come into effect.

(4)     Nothing in paragraph (3) of this Article shall affect the application by a Contracting State of—

(a)     [paragraph (4) of Article 4 (Fiscal residence),] [paragraph (2) of Article 8 (Shipping and air transport), and] Articles 9 (Associated enterprises), 23 (Elimination of double taxation), 24 (Non-discrimination) and 25 (Mutual agreement procedure); and

 (b)     Articles 19 (Government service), 20 (Teachers), 21 (Students and trainees) and 27 (Effect on diplomatic and consular officials and domestic laws), with respect to individuals who are neither nationals of, nor have immigrant status in, that State.

Article 23 Elimination of double taxation

(1)     In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a resident or national of the United States as a credit against the United States tax the appropriate amount of tax paid to the United Kingdom; [… relates to underlying tax credit, or indirect credit in US parlance]. Such appropriate amount shall be based upon the amount of tax paid to the United Kingdom, but the credit shall not exceed the limitations (for the purpose of limiting the credit to the United States tax on income from sources outside of the United States) provided by United States law for the taxable year. For the purposes of applying the United States credit in relation to tax paid to the United Kingdom—

 (a)     the taxes referred to in paragraphs (2)(b) and (3) of Article 2 (Taxes covered) shall be considered to be income taxes;

 (b), (c) [relate to dividend tax credits]    

(2)     Subject to the provisions of the law of the United Kingdom regarding the allowance as a credit against United Kingdom tax of tax payable in a territory outside the United Kingdom (as it may be amended from time to time without changing the general principle hereof)—

(a)     United States tax payable under the laws of the United States and in accordance with the present Convention, whether directly or by deduction, on profits or income from sources within the United States (excluding in the case of a dividend, tax payable in respect of the profits out of which the dividend is paid) shall be allowed as a credit against any United Kingdom tax computed by reference to the same profits or income by reference to which the United States tax is computed;

(b)     [relates to credit for underlying tax]

(3)     For the purposes of the preceding paragraphs of this Article, income or profits derived by a resident of a Contracting State which may be taxed in the other Contracting State in accordance with this Convention shall be deemed to arise from sources within that other Contracting State, except that where the United States taxes on the basis of citizenship, the United Kingdom shall not be bound to give credit to a United States national who is resident in the United Kingdom on income from sources outside the United States as determined under the laws of the United Kingdom and the United States shall not be bound to give credit for United Kingdom tax on income received by such national from sources outside the United Kingdom, as determined under the laws of the United States…."

Contentions of the parties

36. Mr Peacock contends in outline:

(1) The Revenue's contention that the US tax is not paid in accordance with the Treaty ignores that art 1(3) is part of the Treaty.

(2) The Revenue's contention gives the odd result that the US have to give credit for UK tax on what the US regards as US source income of a US company (BDE). From the UK point of view the income (although the income of a UK company (BUK)) is US source income (see the Appellants' arguments above in relation to unilateral relief) and art 23(3) merely confirms this.

(3) The purpose of art 23(3) is to deal with third state source income so as to enable a credit to be given. Alternatively it operates as a tie-breaker rule where each State sources the income in the other.

(4) Here the income is not "derived by" BDE from the UK point of view and so art 23(3) does not apply to give credit in the US. The profits were, from the UK point of view, derived by BUK and as they were taxed in the US the UK gives credit.

(5) If the answer is that both States have to give credit the appeal should be allowed and the matter left to the mutual agreement procedure in art 25. The experts are agreed that the US will give credit for UK tax; but if the UK gives credit for the US tax there will be no net UK tax to credit in the US. One cannot assume that because tax is payable in the UK (before any credit) the income is sourced in the US in accordance with art 23(3) and therefore the US gives credit, when the issue is whether the UK gives credit. The Revenue's argument is circular.

(6) In reply to Mr Ewart's contention that the Treaty contains a minimum tax rule, there is nothing in he Treaty to support this and it would make s 795A unnecessary.

37. Mr Ewart contends in outline:

(1) The purpose of the Treaty, as set out in the heading includes "the avoidance of double taxation and the prevention of fiscal evasion."

(2) Art 1(3) construed purposively cannot allow the US to tax the income of a UK resident simply by deeming it to be the income of a US resident.

(3) As Klaus Vogel on Double Taxation Conventions 3^rd ed at art 1 mn 46 onwards points out art 1(3) of the US Model, which is the same as the Treaty, only operates when the other State is given exclusive taxing rights.

(4) Art 1(4) says that "nothing in paragraph (3) of this Article shall affect the application by a Contracting State of…Article 23" so that when applying art 23 one must assume that art 1(3) does not exist. In that case the US tax is not "in accordance with the present (or, in art 23(3) this) Convention" and there is therefore no credit to be given in the UK.

(5) The restriction of credit for tax paid "under the laws of the US and in accordance with the present Convention" in art 23(2) involves an implicit minimum tax rule, that the UK is only obliged to give credit for the minimum amount of tax that would have been paid had the taxpayer taken advantage of relevant rights under the Treaty. BUK could have claimed credit in the US for the UK tax and so reduced its US tax bill.

(6) On Mr Peacock's argument that the Revenue's argument is circular, his argument is equally circular as it depended on tax being paid in the US first.

Reasons for our decision

38. The problem of interpreting the Treaty arises because the UK considers the resident taxpayer to be BUK while the US treats BDE as the resident taxpayer because it disregards BUK. If the same taxpayer is a resident of both States the dual residence provisions of the Treaty will resolve residence in favour of one of them for the purpose of applying the Treaty. But the Treaty is silent about what to do when they are different persons.

Taxing rights under the Treaty

39. The UK reads the Treaty as saying that since BUK is a UK resident (both for domestic law and the Treaty) only the UK can tax the profit under art 7 (or, if art 7 does not apply, art 22). Article 7(1) provides:

"(1) the business profits of an enterprise of a Contracting State [defined as an industrial or commercial undertaking carried on by a resident of a Contracting State] shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein [which it is common ground it does not].

Article 22(1) provides:

"Items of income of a resident of a Contracting State, wherever arising, not dealt with in the foregoing Articles of this Convention shall be taxable only in that State."

It is not necessary to decide which applies since the result is the same but we incline towards art 7 on the basis that these are business profits, business being wider than trade.

40. From the US point of view, according to the joint report of the two experts in US taxation, BUK, as an unlimited company with one shareholder, is a "disregarded entity" for US federal income tax purposes in accordance with the Check the Box Regulation. We find that this disregarding is restricted to tax purposes; there is no suggestion that the US would disregard BUK for other purposes, so that if, for example, a US company has to list its subsidiaries in its accounts, BUK would appear on the list. The result is that what the UK regards as the income of BUK is regarded for US tax purposes as income of its parent company, BDE.
41. Article 1(3) (the "saving clause" or, as the experts say, savings clause, but we prefer the singular) is also relevant:

"Notwithstanding any provision of this Convention except paragraph (4) of this Article, a Contracting State may tax its residents (as determined under Article 4 (Fiscal residence)) and its nationals as if this Convention had not come into effect."

The saving clause is not found in the OECD Model Tax Convention, but is in the US Model Income Tax Convention (the current version of which is dated 15 November 2006). Its operation is that one first reads the rest of the Treaty and, if the effect is that the Treaty would otherwise prevent the US from taxing, then the US may still tax by virtue of the saving clause as if the Treaty had not come into effect. Its purpose is primarily to preserve the right of the US to continue to tax its citizens (who are liable to tax on their worldwide income regardless of residence) when the UK is given exclusive right to tax them under the Treaty as UK residents, but it applies also to US residents (after determining dual residence in accordance with the Treaty). While drafted reciprocally it has no effect in the UK in this case.

42. So far as the US is concerned, the experts are agreed that the saving clause is applicable to override art 7 (or 22):

"The taxable income of [BDE] would have included the BUK Contract Income. In this regard, the Experts also agree that the 'savings clause' of Article 1(3) would override any provision of the Treaty (including specifically, Art 7 or 22) that might otherwise prevent the US from imposing FIT [Federal Income tax] on the BUK Contract Income, although that tax liability would be subject to the potential availability of FTCs [foreign tax credits] under Article 23"

43. Whereas the UK looks solely to BUK in relation to the taxation of the profits in question, the US is not contending that the only relevant enterprise is BDE (and art 7 (or 22) gives the US exclusive taxing rights in relation to BDE's profits in any event). It is clear from the above quotation that the US recognises that if it disregards a UK resident entity it will have to accept the UK's right to tax that entity. The experts are therefore viewing the matter from the UK point of view, saying that, while the UK may read art 7 (or 22) as saying the US may not tax, this is overridden by the saving clause.
44. This results in there being two residence States for the purpose of the Treaty. Dual residence of a single person is solved by the Treaty dual residence provision the result of which is to give a single residence for the purposes of the Treaty. But that does not apply here because each regards a different entity as its resident. So both States tax and we have the issue of who gives credit for the other State's tax.

Credit from the US point of view

45. The Treaty credit to be given by the US in art 23(1) does not refer to the UK tax being in accordance with the Treaty (as does the UK's equivalent provision in art 23(2)) but merely that:

"In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a resident or national of the United States as a credit against the United States tax the appropriate amount of tax paid to the United Kingdom…."

Nationals are defined for the US to be its citizens, so that, unlike the OECD Model Tax Convention, a national refers only to individuals, and the same applies in the UK.

46. The saving clause is subject to art 1(4):

"(4) Nothing in paragraph (3) of this Article shall affect the application by a Contracting State of—

(a)     paragraph (4) of Article 4 (Fiscal residence), paragraph (2) of Article 8 (Shipping and air transport), and Articles 9 (Associated enterprises), 23 (Elimination of double taxation), 24 (Non-discrimination) and 25 (Mutual agreement procedure);…"

We consider that the purpose of art 1(4) is that, while a State may tax under the saving clause as if the Treaty had not come into effect, the taxpayer can still claim some Treaty benefits. These include not to be taxed in a discriminating manner by the other State, to be able to invoke the mutual agreement procedure to deal with differences arising between the two States, and, what is important here, the benefit of the elimination of double taxation article. Since Treaty relief is given by reference to each State's domestic law, this does not confer any right to relief as such, but it does give the taxpayer the right to apply the Treaty source rule in art 23(3) ("the deemed source rule") instead of the domestic source rule:

"For the purposes of the preceding paragraphs of this Article [ie the credit provisions applying to the US and UK respectively], income or profits derived by a resident of a Contracting State which may be taxed in the other Contracting State in accordance with this Convention shall be deemed to arise from sources within that other Contracting State…"

47. Mr Peacock puts forward some suggestions for the purpose of the deemed source rule. First, he said, it deals with third State source income. We do not agree because no problem arises in respect of third State source income because art 22 of the Treaty would in any case prevent the State other than the residence State from taxing it. Also the State other than the residence State can have no interest in whether third State source income is credited in the residence State. Secondly, he said that the deemed source rule operates as a tie-breaker when each State sources the income in the other. Nor do we agree with this suggestion because, at least in the normal case contemplated by the Treaty of there being one source State and one residence State, only the residence State will be giving relief and so the deemed source rule will be read by only one State (any dual residence conflict will have previously been resolved by art 4). Thirdly, Mr Peacock contends that the profits are not "derived by" BDE as they were actually derived by BUK. But this interpretation would give a result in the US that is contrary to the joint experts' view that the deemed source rule does source the income in the UK thus enabling the US to give credit, which must imply that they consider that the income is derived by a US resident.
48. It seems to us that the purpose of the deemed source rule is merely to marry up the Treaty taxing rights with domestic law credit rules which are incorporated into the Treaty in paras (1) and (2) by reference. Domestic law source rules may not match the Treaty taxing rights. With the deemed source rule one can be sure that there will in principle be credit for everything the other State is entitled to tax under the Treaty even though domestic credit rules would not source the income in the other State, a good example of which is given by the quotation below from the joint experts' report.
49. Although source is not mentioned in art 23(1) one assumes that US domestic law on credit refers to source because the experts agreed that the source rule under the Code was overridden by the deemed source rule. Accordingly the deemed source rule is applicable to move to the UK the source of income that the UK may tax in accordance with the Treaty. The experts agree that the US will apply the deemed source rule:

"Under the Transaction, no FTC would have been available (if at all) unless UK taxes were paid with respect to the BUK Contract Income (such taxes hereinafter referred to as "BUK Taxes")

The Experts are in agreement that under the rules of the [Internal Revenue] Code, the BUK Contract Income would likely have a US source. The Experts are also in agreement that if the BUK Contract Income may be taxed in the UK under the Treaty and is, in fact, so taxed (i.e. no double tax relief is granted in the UK), then this rule of the Code would be overridden by paragraph 3 of Article 23 of the treaty, with the result that the BUK Contract Income would have been treated as foreign source income for FTC [foreign tax credit] purposes and that therefore an FTC would have been available…."

We deduce that the US applies art 23, including the change of source effected by the deemed source rule, because of art 1(4), that "Nothing in [the saving clause] shall affect the application by a Contracting State [in this case, the US] of… article 23…". We understand this to mean that if the US taxes under the saving clause the taxpayer can take the benefit of the deemed source rule instead of the domestic source rule in determining whether credit for any UK tax is due in accordance with domestic law. Without art 1(4) the saving clause would provide that the US could tax its residents and nationals as if the Treaty had not come into effect. The effect of art 1(4) is to give the US resident (not it seems a national because of the words "derived by a resident") taxed by the saving clause the benefit of the Treaty source rule, in the same way as for a US resident taxed in the normal way without the saving clause.

50. The implication of art 1(4) is that if the US taxes under the saving clause as if the Treaty had not come into effect, the specific exception for art 23, and the consequent change in the source of the income by the deemed source rule, means that the giving of credit by the State invoking the saving clause is in contemplation of the Treaty. The State invoking the saving clause on account of residence will be a second residence State and its taxing rights are subsidiary to the residence State applying the Treaty without the saving clause. Because of the incorporation by reference of domestic law credit provisions by art 23(1) of the Treaty, whether or not the US gives relief is a mater of domestic law rather than interpretation of the Treaty.

Credit from the UK point of view

51. Article 23(2) provides:

"(2)     Subject to the provisions of the law of the United Kingdom regarding the allowance as a credit against United Kingdom tax of tax payable in a territory outside the United Kingdom (as it may be amended from time to time without changing the general principle hereof)—

(a)     United States tax payable under the laws of the United States and in accordance with the present Convention, whether directly or by deduction, on profits or income from sources within the United States (excluding in the case of a dividend, tax payable in respect of the profits out of which the dividend is paid) shall be allowed as a credit against any United Kingdom tax computed by reference to the same profits or income by reference to which the United States tax is computed;…"

52. As for the US, the UK domestic law on credit is incorporated by reference. In applying the Treaty in the UK to give relief for US tax, the person who is taxed in the US is irrelevant; all that is required is that both States' taxes are computed by reference to the same profits. We have decided above that the UK would not give credit under domestic unilateral relief because the source of the income was in the UK. Does the deemed source rule in art 23(3) change this? If it does, the UK will have to give credit for the US tax on the same income because this now has a source in the US for the Treaty. The result is that each State says that it accepts that the other can tax in accordance with the Treaty, so that the source of the income is in the other State, and both States must give credit for the other's tax.
53. The order in which tax is paid and credited is important. If tax is properly paid first in the UK without any credit for the US tax, the experts are agreed that it may be credited in the US. But if tax is properly paid first in the US (which has in fact occurred) and the UK has to give credit for the US tax, then there will be no net UK tax available for credit in the US. The fact that the Treaty does not say anything about who gives credit first leaves some doubt about whether this is the correct reading.
54. Two linguistic arguments to counter this result were canvassed. First, that a possible reading of art 1(4) from the UK point of view that, in a case where the US taxes under the saving clause, "Nothing in [the saving clause] shall affect the application by a Contracting State [here the UK] of… Article 23." If it can be read in this way, it says that where the US charges tax under the saving clause this does not require the UK to apply the deemed source rule in art 23(3) to change the source of the income. It is hard to say whether such a reading was intended by the Contracting State parties.
55. Secondly, that the reference to income that may be taxed "in accordance with this Convention" in art 23(3) did not include taxation pursuant to the saving clause, since the saving clause applies "Notwithstanding any provision of this Convention." On the other hand, having included the saving clause in the Treaty it has become part of the Treaty and so logically taxation in accordance with the saving clause is "in accordance with this Convention." Support for this view is obtained from the fact that the second part of art 23(3) deals with the case "where the United States taxes on the basis of citizenship," which can only be because of the saving clause. The second part of art 23(3) therefore itself recognises a situation where taxation is by the saving clause; it is not likely that art 23(2) and the first part of art 23(3) (or art 23(1)) regards such taxation as not "in accordance with this [or the present] Convention."
56. Solely from the point of the meaning of language, the literal result of both States giving credit seems unexpected and we turn to the other factors to be considered in accordance with the Vienna Convention on the Law of Treaties.

Context

57. We consider the context of the relevant provisions within the form of the Treaty (excluding for the moment the saving clause), which in broad outline corresponds to the OECD Model Tax Convention. There are two main categories of income: (1) in some cases (art 7 business profits in the absence of a permanent establishment, art 8 shipping and air transport profits, art 11 interest, art 12 royalties, art 18 pensions, art 19 Government service, art 20 teachers, art 21 students and trainees, art 22 other income) income is taxable in one State only; and (2) in other cases (art 6 income from immovable property, art 7 business profits where there is a permanent establishment in the other State, art.10 dividends, art 14 independent personal services, art 15 dependent personal circumstances, art 17 artistes and athletes) income can be taxed in both States, in the case of dividends with a reduction in the source State's taxation, but the residence State has to give relief for the source State tax.
58. The saving clause modifies category (1) by providing that if the State with exclusive taxing rights is the UK, the US may tax its residents (having applied the dual residence provisions if necessary) and nationals as if the Treaty had not come into force but in giving relief to its residents it must treat income that the Treaty provides that the UK may tax as having a UK source. The form of the Treaty including the saving clause is that the source State taxes first, the residence State taxes second, giving relief for the source State tax, and the State invoking the saving clause taxes third, giving credit for the source State tax subject to its domestic law (as modified by the deemed source rule).
59. The effect of the saving clause may therefore be that both States may tax worldwide income in accordance with the Treaty. The first circumstance in which this may arise is envisaged by the end of art 23(3) containing an exception to the deemed source rule:

…except that where the United States taxes on the basis of citizenship, the United Kingdom shall not be bound to give credit to a United States national who is resident in the United Kingdom on income from sources outside the United States as determined under the laws of the United Kingdom and the United States shall not be bound to give credit for United Kingdom tax on income received by such national from sources outside the United Kingdom, as determined under the laws of the United States…."

The situation might therefore exist that each State considered the source of income under its domestic law to be in the other State in which case they might (depending on whether credit was otherwise available under domestic law) both give credit. If such exception exists it arises from the way the second part of art 23(3) deals with a special situation of conflicting domestic source rules. We do not think we can read any general principle into this, probably unusual, set of circumstances

60. The second circumstance is where controlled foreign companies legislation applies, which is factually similar to our case because there are different companies resident in each State, but the State of the parent company is effectively disregarding the existence of the subsidiary and taxing its profits. It might be argued (as it was argued in Bricom Holdings Limited v IRC [1997] STC 1179) that the Treaty prevents the State of the parent company from taxing the subsidiary's income because the income was business profits of the subsidiary that are taxable only in the subsidiary's State in the absence of a permanent establishment in the parent company's State (or in Bricom the interest article gave the same result), but in that case the saving clause will apply to enable the parent company's State to tax. The experts considered this aspect in relation to BUK checking the box to be treated as a corporation for US tax purposes. They agreed that the US would tax BDE on the income of BUK under its Subpart F rules (which broadly correspond to, or might be more accurately described as the inspiration for, the UK CFC legislation), in which case the US would source the income in the UK under domestic law and credit would apply in the US under domestic law. They said that the question whether the deemed source rule would change the source was not relevant. They did not actually say that the saving clause operates to permit the US to tax under Subpart F but we consider that it is inherent in what they say and we find that it does. In such a case nobody would contemplate a second round of credit by the UK on the basis of a literal reading of the deemed source rule moving the source back to the US.
61. The third circumstance (which we should make clear was not used in argument by either party) is if the UK treated a partnership as opaque and taxed it while the US treated it as transparent and taxed the partners on the same income. This is also similar to our facts. We turn to the OECD Report "The Application of the OECD Model Tax Convention to Partnerships," 1999, to see if there is any international consensus about the result. Example 17, into which we substitute the US and UK on the above basis, reads: "P is a partnership established in [the UK]. A and B are P's partners who reside in [the US]. [The UK] treats P as a taxable entity while [the US] treats it as a transparent entity. P derives royalty income from [the UK] that is not attributable to a permanent establishment in [the UK]." The majority view in the Report was that the UK would not be limited in its taxing rights by a treaty in the form of the OECD Model eliminating the source State's taxing right on the royalties: "…the situation involves a purely domestic matter from the perspective of [the UK]; it is simply taxing the domestic source income of a resident taxpayer and nothing in the Convention can limit that right." It cross-refers to another section of the Report for the relief position, which we understand to mean that the US would give relief for the UK tax; further relief by the UK does not seem to have been considered. On the other hand, the Report records that a minority of delegates consider that the UK should relieve the source tax on the royalties taking into account that the treaty allocates the right to tax the royalty income to the US (which has no application to our case).
62. We should also mention Example 16, which reads, again substituting the US and the UK on the same basis: "P is a partnership established in [the UK]. Partner B is a resident of [the US] while partner A is a resident of [the UK]. [The UK] treats the partnership as a taxable entity while [the US] treats it as a transparent entity. P derives royalty income from [the US] that is not attributable to a permanent establishment in [the US]. P has an office in [the UK] and may therefore be considered to have a permanent establishment in [the UK]." The Report states that the treaty clearly prevents the US from taxing the royalty which is taxable in the hands of P, a UK resident. On the issue of whether the US can tax its partner B, a minority of delegates considered that the treaty provided for exclusive taxation of the royalty in the UK and so the US could not tax. The possibility of this result being overridden by the saving clause was expressly mentioned. The majority of delegates disagreed with this view and considered that the royalty article affected taxation based on source, not residence, so that the US could tax its partner (impliedly this assumes that there is no saving clause in the treaty). If so it would have to give relief for the UK tax. This example has similarities with Padmore v IRC [1989] STC 493, for which if the States had been reversed the UK could operate the saving clause to tax the UK resident partner.
63. We do not derive much assistance from these partnership examples because the existence of majority and minority views show a lack of international consensus. Our case is also more complex because each State considers that the income is domestic source income from its point of view. But we do derive some assistance from the separation of source and residence considerations. This is clearly seen in Example 16. First the US, as source State of the royalties applies the treaty and exempts them. Secondly, the UK as residence State of the partnership, taxes them (and if there had been taxation of royalties at source under the Model, would give relief for the source State tax). Thirdly, the US, as residence State of one of the partners, taxes the partner (either on the majority view, or by virtue of the saving clause), giving relief for the UK tax on the partnership. Nobody would contemplate a fourth round of credit by the UK on the basis of a literal reading of the deemed source rule moving the source of the partner's income back to the US.

Conclusion

64. We consider that the way out of the circle in which both States tax on a residence basis and on a literal reading of the Treaty both give credit, is to consider who has the stronger taxing right. Undoubtedly this is the UK. We are taxing a UK resident on (as we have found in relation to unilateral relief) UK source income, that is to say taxing on a residence plus source basis. The US is disregarding the UK taxpayer, but impliedly acknowledging that the UK has the better right to tax by saying that its taxation is by virtue of the saving clause. (If the experts had said that the US taxed because the US was taxing a US corporation (defined to be a resident under the Treaty) on US domestic source income and art 7 (or 22) prevented the UK from taxing, so that we were dealing with a case of two equally competing claims to tax both on a source plus residence basis, the result might be different, and we say nothing about it.) Accordingly, the first taxing right is with the UK. There is no credit to be given because at that stage there is no US tax because the saving clause only comes into operation if the Treaty (excluding the saving clause) prevents the US from taxing.
65. The fact that art 1(4) provides that art 23 is applicable even though the saving clause allows taxation as if the Treaty had not come into effect, demonstrates the secondary nature of taxation by virtue of the saving clause either as a secondary residence State, or, if it taxation on the basis of citizenship, that is secondary to taxation on the basis of residence. For the purpose of credit by the US the deemed source rule moves the source to the UK. For this limited purpose the UK has become the source State, although strictly it is the source plus residence State, and the US is now the residence, but not the source, State. The US should therefore give credit for the UK tax, as the experts agree it will once the tax has been paid in the UK. Since art 1(4) refers expressly to art 23 the order of credit must be that if the US taxes by virtue of the saving clause it gives credit for the UK tax. It cannot be said that now that the US has taxed under the saving clause one can go back to the beginning and argue that the UK should give credit first.
66. Since the US tax rate was higher there will be some net US tax after the US has given credit for the UK tax. In our view the process stops there. One cannot say from the UK point of view, as primary residence State, that the US, as secondary residence State, is a quasi source State, giving rise to a second round of relief by the UK. The whole form of the Treaty is for the source State to have the primary taxing right and for the residence State to tax and give relief. The saving clause operates to give a tertiary taxing right as a secondary residence State, after giving relief for the first residence State's tax, but that is all. One sees this operating in relation to CFC legislation. The State of the subsidiary as source plus residence State clearly has the stronger taxing right and the State of the parent taxing by virtue of the saving clause gives relief. Nobody would even consider that a literal reading of the deemed source rule in the Treaty required the State of the subsidiary to give a further round of relief if the rates of tax were such that there was a balance of tax.
67. The partnership examples are similar showing first tax on the source, then on the partnership as a resident, then on the partner as a resident of the State other than the partnership (by virtue of the saving clause, and on the majority view in all cases) with relief given at the second and third stages. There is no suggestion in the Partnership Report that there is a fourth stage.
68. Our case is essentially the same as the CFC example. There is no separate source taxation, but had the income of BUK been, for example, a US dividend, the US would have a right to tax it at source. The UK would then tax BUK, giving relief for the US tax on the dividend. The US would then tax the income under the CFC rules, having the right to do so by virtue of the saving clause, giving relief for the UK tax on the basis that the source of the dividend had been moved to the UK by the deemed source rule. At that stage any double taxation has been relieved, which is the purpose of the Treaty. A further round of relief by the UK, having moved the source of the dividend back to the US by a second operation of the deemed source rule, is not within the contemplation of the Treaty. That would be double relief of double taxation.
69. We apply this approach to the wording of art 23(2):

"(2)     Subject to the provisions of the law of the United Kingdom regarding the allowance as a credit against United Kingdom tax of tax payable in a territory outside the United Kingdom (as it may be amended from time to time without changing the general principle hereof)—

(a)     United States tax payable under the laws of the United States and in accordance with the present Convention, whether directly or by deduction, on profits or income from sources within the United States (excluding in the case of a dividend, tax payable in respect of the profits out of which the dividend is paid) shall be allowed as a credit against any United Kingdom tax computed by reference to the same profits or income by reference to which the United States tax is computed;…"

The UK taxation of BUK was on the basis of source (as we decided in relation to unilateral relief) plus residence and no question of the operation of art 23(2) arises at that stage because there was no taxation in the US on the basis of source. The US then taxes by virtue of the saving clause on a secondary residence basis and gives relief for the UK tax by art 23(1) combined with the deemed source rule moving the source to the UK. That exhausts the Treaty credits. One cannot apply the deemed source rule a second time to create another round of credit on the basis that:

"…income or profits derived by a resident of a Contracting State [the UK] which may be taxed in the other Contracting State [the US] in accordance with this Convention shall be deemed to arise from sources within that other Contracting State…"

The taxation in the US is in accordance with the Treaty being by virtue of the saving clause. But one never reaches the deemed source rule from the UK point of view. The US tax treatment under the Treaty (as opposed to domestic law) was on the basis of residence but not source; the source was moved to the UK for the purpose of the US giving relief. As we have said, one cannot go on and say from the UK point of view that the US, as secondary residence State, is a quasi source State. It would be contrary to the whole form of the Treaty to categorise the US tax as tax on "income from sources within the United States" because the deemed source rule had moved the source for a second time to the US. The form of the Treaty contemplates at most one movement of the source, as in our example of the source being a US dividend. If more than one movement of source was contemplated the Treaty would surely have told one how to compute relief by both States simultaneously. The possible alternative reading of art 1(4) by the UK as set out in paragraph 54 above is support for the conclusion we have reached on the basis of looking at the Treaty as a whole.

70. On this aspect our decision is that we prefer Mr Ewart's contentions. The taxing rights should be that the UK taxes first, the US then taxes by virtue of the saving clause, giving relief for the UK tax by applying the deemed source rule, and there is no further round of relief by the UK.

795A of the Taxes Act 1988

71. On the basis of our decision that no credit is available for the US tax against the UK tax, the final issue does not arise but we deal with it in case our decision is wrong on any of the previous issues. Section 795A provides:

"Limits on credit: minimisation of the foreign tax

(1) The amount of credit for foreign tax which, under any arrangements, is to be allowed against tax in respect of any income or chargeable gain shall not exceed the credit which would be allowed had all reasonable steps been taken—

(a) under the law of the territory concerned, and

(b) under any arrangements made with the government of that territory,

to minimise the amount of tax payable in that territory.

(2) The steps mentioned in subsection (1) above include—

(a) claiming, or otherwise securing the benefit of, reliefs, deductions, reductions or allowances; and

(b) making elections for tax purposes.

(3) For the purposes of subsection (1) above, any question as to the steps which it would have been reasonable for a person to take shall be determined on the basis of what the person might reasonably be expected to have done in the absence of relief under this Part against tax in the United Kingdom."

72. Mr Peacock contends in outline:

(1) The comparison required by the section must start with the situation where there in no credit available in the UK. If Parliament did not intend this it would have need to say so. In such circumstances the experts are agreed that there would be no US tax, and so no steps that might be taken would reduce the US tax. The hypothetical steps which the Revenue have suggested might be reasonable steps in fact give the same result and so there is no reduction in the amount of credit available.

(2) What are reasonable steps may depend on the nature and circumstances of the taxpayer but one still has to ask whether the steps are reasonable for it to take. It was not reasonable to expect BUK to have undertaken research into restructuring the transaction.

(3) The Revenue's International Manual INTM 164140 repeats the examples given in Parliament (20 June 2000, Standing Committee H, cols 839-40) indicating that the steps to be taken are those which the taxpayer claiming the credit is in a position to take. The examples include that a parent company is not in a position to influence the amount of tax paid by its subsidiary in relation to credit for underlying tax. Here the Revenue are contending that the subsidiary should influence it parent and even companies further removed to take steps to reduce their tax. Later legislation introduced by the Finance Act 2005 as s 804ZA and Sch 28AB to the Taxes Act 1988 permits consideration to be given to what other parties to a transaction could have done.

(4) A step that changes the legal character of the person is not within the section as such a step is different in nature from the examples in subs (2)(a) and (b). The steps must relate to the actual transaction and not the creation of some alternative transaction.

73. Mr Ewart contends in outline:

(1) The comparison to be made is between the actual situation and the result if there had been no UK credit. But the hypothesis of there being no UK credit should not feed through to affect the US tax analysis.

(2) The steps cannot be limited to those to be taken by the particular taxpayer claiming credit. For example, some elections have to be joint elections. The guidance in the manual is aimed at normal commercial transactions and cannot be applied in a case where the whole transaction was designed to achieve a tax purpose. The Morgan Stanley group is a sophisticated taxpayer with advice available on tax mitigation.

(3) The simplest step would be for BUK to pay the UK tax, which it has not done, and then reduce the US tax by claiming the credit in accordance with the Treaty (steps taken under the Treaty being specifically referred to in subs (1)(b)), as the experts are agree they can do.

74. Dealing first with whether the hypothesis of no credit in the UK in s 795A(3) should affect the US tax analysis, we prefer Mr Ewart's interpretation. The statutory purpose of that subsection is to determine what steps are reasonable to take. If the UK gives credit for the full amount of foreign tax claimed, if subs (3) had not existed it could be argued that the person was not reasonably required to take steps which will make no difference to his tax position. The purpose is clearly that the UK will not give credit for foreign tax that the person could by taking reasonable steps have reduced. In order to determine what is reasonable subs (3) imposes the hypothesis that no credit is available and so any reduction in foreign tax benefits the person concerned (as opposed to the UK exchequer in the absence of the hypothesis), so that the issue becomes what steps are reasonable for the person to take in order to obtain the benefit to him of the saving of foreign tax.
75. The experts were asked to make the assumption that no credit is available in the UK and they jointly concluded that in such circumstances:

"the most plausible reason for (and the only material benefit that might reasonably be expected to arise from) undertaking [the transaction] would have been an attempt to reduce aggregate US tax liabilities. The Experts further assume that so undertaking the Transaction (or any alternative of it) would indeed have reduced aggregate US tax liabilities if an FTC for the BUK taxes were indeed permitted in the US. In light of this, the Experts believe that a number of common-law anti-abuse doctrines (including specifically, the economic substance doctrine) would likely have applied to the Transaction (or any alternative of it) with the likely result that the Transaction (or any alternative to it) would have been disregarded for FIT purposes (ie treated as if it hadn't ever been entered into)."

We do not consider that the hypothesis should be taken this far. We have stated the purpose of subs (3) which is to test whether steps to reduce foreign tax are reasonable to take. It is no part of the purpose to enquire what the effect of the hypothesis would be in relation to foreign tax, particularly where, as here, the only reason for the transaction was to save UK tax and so the experts have to deduce an otherwise non-existent US reason for it. The hypothesis is required to test the reasonableness of the steps. That can be done on the basis that the other State is not concerned about the hypothesis. On that basis we propose to ignore the experts' conclusions on the basis of the hypothesis being applied in the US. It follows that we prefer Mr Ewart's contention that in applying s 795A one starts with the actual situation and not the hypothetical situation in which there is no credit in the UK and no tax in the US because of the application of common-law anti-abuse doctrines.

76. Mr Ewart's simplest proposed step was the payment of tax in the UK and the claiming of credit for it in the US. We bear in mind the parties' contentions summarised in relation to the Treaty when each said that the other's was circular. On the assumption on which this issue depends that credit is available in the UK, it makes a difference which State collects the tax first. Mr Peacock contends that one starts with payment of tax in the US, followed by credit in the UK, after which there will be no net UK tax after credit to credit in the US because the US tax is at a higher rate than the UK tax. Mr Ewart contends that one starts with payment of tax in the UK, followed by credit in the US leaving some residual net US tax after credit available for credit in the UK. Our problem is that we do not agree with the assumption that credit is available in the UK and so we do not know how double credit would operate. Mr Peacock would have us ignore the US position and concentrate on credit in the UK for which he would start with the actual situation of payment of tax in the US. We do not consider that this is the right approach because the starting point affects the amount of the reduction in US tax which is the point in issue. We suspect that if double credit were available the matter would have to be determined by the mutual agreement procedure under art 25 of the Treaty. Accordingly, we cannot decide which State should collect tax first and therefore we do not accept Mr Ewart's contention.
77. Mr Ewart also put forward a number of other suggestions about what steps might be taken to reduce US tax on which the experts had given their opinion of the effect on US federal income tax. References to being characterised as a corporation or as a disregarded entity are to the election under the Check the Box Regulation (see para 6(4) above). The alternatives are as follows:

(1) BUK electing to be characterised as a corporation for US federal income tax purposes. The experts are agreed that the amount of federal income tax would be unchanged compared to the existing situation. (The reason is that the income would be taxed in the hands of BDE as Subpart F income and credit for any UK tax would have been available under US domestic law without regard to the Treaty.)

(2) BDE and Baycliff DE Inc (the parent of BUKP) being organised as limited liability companies (and not electing to be treated as corporations), and Bayview Holdings Limited (the common grandparent of BDE and Baycliff DE Inc) being characterised as a corporation for US federal income tax purposes, and all other entities being characterised as disregarded entities for US federal income tax purposes. The experts are agreed that the income of BUK and the loss of BUKP would have been treated as that of Bayview Holdings Limited.

(3) Bayfine Cayman Limited (BDE's parent) (as well as Bayview Holdings Limited, and BUK, but not BUKP or Baycliff Cayman Limited (the parent of Baycliff DE Inc)) being characterised as disregarded entities for US federal income tax purposes. The experts are agreed that the income of BUK and the loss made by Bayview Holdings Limited on the sale of the shares in BUKP would have been included in the Morgan Stanley consolidated group.

(4) Baycliff Cayman Limited and Bayfine Cayman Limited (as well as Bayview Holdings Limited and BUK, but not BUKP) being characterised as disregarded entities for US federal income tax purposes. The experts are agreed that the result is the same as in (3) above.

(5) Baycliff Cayman, Bayfine Cayman and BUKP (as well as Bayview Holding Limited and BUK) being characterised as disregarded entities for US federal income tax purposes. The experts are agreed that the result is the same as in (3) above except that as a result of the US dual consolidated loss rules the BUKP loss would have been available only if it had not been surrendered by way of UK group relief.

In summary, para (1) does not reduce the US tax and can be ignored. Taking paras (2) to (5) above together, the US tax relating to the BUK profit available for credit in the UK (making the assumption that credit were available in the UK) would clearly be reduced to nil in paras (2) to (4) and by the amount of the BUKP loss not surrendered by way of group relief in (5). Accordingly, they would minimise the US tax.

78. The issue for us is whether these are steps which it is reasonable to take. The first question is who is expected to take steps. By implication from s 795A(3) this must be the person claiming credit, here BUK. In para 77(1) above the only action is that of BUK, but the experts are agreed that this action will not reduce the US tax. In all the others, steps have to be taken by other members of the group over which BUK has no control, BUK being at the bottom of the chain of companies and merely sharing a common great-grandparent with BUKP. The Revenue's manual says that they interpret s 795A as being restricted to steps that the taxpayer claiming credit is in a position to take. Mr Ewart contends that in a tax avoidance scheme in which all the companies concerned are set up as part of the scheme one should not be bound by guidance in the manual intended to apply to normal commercial situations. He also pointed out that some elections had to be made by companies jointly. Our view is that the manual states the law correctly and it must be implied that the steps must be confined to those which the taxpayer claiming credit is in a position to take. There cannot be a different interpretation applying to tax avoidance schemes. Accordingly we disregard all the above steps in applying s 795A.
79. We should add that we should in any event ignore the steps in para 77(2) above that BDE and Baycliff DE Inc "had been organised" (in the words of Mr Miller) as limited liability companies. This seems to be a step that would have to be taken before the event giving rise to credit whereas the section implies that the steps are those to be taken afterwards (in contrast to checking the box, which can be done up to 75 days retrospectively), which is a common feature of the proposed steps in para 77 above. Even if we are wrong about this, there is no evidence about how one converts US corporations into LLCs and whether this has adverse tax or other consequences, and so we are not in a position to say whether the step would be reasonable. The evidential burden would be on the Revenue to produce such evidence.
80. Accordingly, our decision on this issue is that, on the assumption that credit for US tax is available in the UK, none of the steps proposed are within s 795A and so credit would not be restricted.

Conclusion

81. Our decision on each of the issues is:

(1) Section 165 of the Finance Act 1994 has no effect;

(2) The Revenue are entitled to raise s 167 of the Finance Act 1994 as an issue in this appeal;

(3) However, s 167 of the Finance Act 1994 has no effect;

(4) Unilateral relief is not available to BUK;

(5) The Treaty does not entitle BUK to claim relief for any US tax paid on its profit from the Debt Contract it entered into; the UK tax should be paid first and credit for it claimed in the US;

(6) If credit had been available to BUK for the US tax paid on its profit from the Debt Contract, s 795A would not have operated to reduce it;

and accordingly we dismiss the appeal.

JOHN F. AVERY JONES
EDWARD SADLER SPECIAL COMMISSIONERS RELEASE DATE: 19 November 2008

SC 3097-8/07

Authorities referred to in skeletons and not referred to in the decision:

R v National Asylum Support Service [2002] 1 WLR 2956

Attorney General's Reference (No 5 of 2002) [2004] 3 WLR 957

ANNEX