England and Wales High Court (Chancery Division) Decisions

IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION

		Royal Courts of Justice Strand, London, WC2A 2LL
		23/03/2010

Peter Smith J :

INTRODUCTION

1. This is the appeal of Bayfine UK ("BUK") against the dismissal by the Special Commissioners ("the Commissioners") of its claims in a decision ("the Decision") of 19th November 2008. By the Decision the Commissioners dismissed BUK's appeal against the Respondents'("HMRC") amendment dated 17th October 2006 to BUK's corporation tax self assessment for its accounting period ending 30th November 2000.
2. This appeal relates to financial transactions entered into by BUK with a US counterparty, which transaction gave rise to questions as to the credit in the UK against UK tax on the profit made by BUK on the transaction for tax suffered on the same income in the US. BUK argues that the profit on the transaction has been taxed in the US and that should give rise to credit against UK tax and not (as HMRC contends) further tax for the UK.
3. The parties agreed a Statement of Agreed Facts adopted by the Commissioners. The parties agreed further facts and the Commissioners found additional facts. Each party adduced expert evidence of US law and the experts produced a Joint Report treated by the Commissioners as a finding of fact.

ISSUES ARISING ON THE APPEAL

4. Three issues arose on the appeal. BUK contended that the Commissioners erred in law in deciding that BUK had no entitlement to:-

1) Unilateral relief pursuant to section 790 Income and Corporation Taxes Act 1988 ("ICTA 1988") in respect of the US Federal Income Tax paid by Bayfine DE Inc ("BDE") in respect of the BUK Profit ("Issue 1").

2) Relief under the Double Taxation Relief (Taxes on Income) (the United States of America) Order 1980 ("the Treaty") in respect of the US Federal Income Tax paid by BDE in respect of the BUK profit ("Issue 2").

The third issue was that BUK sought:

3) Affirmation that the Commissioners' Decision under section 795A ICTA 1988 in favour of BUK should be upheld on additional grounds. The Commissioners sought to uphold the Special Commissioners decision on the additional ground that the section 795A issue should be determined in their favour ("Issue 3").

5. In addition HMRC initially sought to appeal the Commissioners' decision to allow BUKP to appeal. HMRC did not proceed with that at the hearing before me.

BACKGROUND

6. The appeals related to two contracts both dated 20th July 2000. In the first one Bayfine UK Products ("BUKP") entered into a contract with Irving Park Inc a US resident and incorporated wholly owned indirect subsidiary of Bank of America NA ("BoA"). In the second BUK entered into a contract with Mecklenberg Park Inc again a US resident and incorporated wholly owned indirect subsidiary of BoA.
7. To understand those agreements it is necessary to examine the structure of the group of companies of which BUKP and BUK were part. I attach as an annex to this judgment the same structural diagram which was attached to the Decision of the Commissioners.
8. BUKP is a private and limited company. It was a UK resident and incorporated wholly owned direct subsidiary of Baycliff DE ("Baycliff DE"). Baycliff DE is 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. It will be seen that that latter company ("MSDW") is at the top of the pyramid of companies set out in the annex. BUK the Appellant before me and one of the Appellants before the Commissioners is also a private and limited company UK resident and incorporated wholly owned direct subsidiary of BDE.

THE TWO AGREEMENTS

9. By the first agreement ("the First Debt Contract") BUKP agreed to pay Irving Park on 15th August 2000 ("the Settlement Date") an amount equal to the market value of US treasuries with an aggregate principle amount of $170,000,000 as of 10am on 10th August 2000 ("the Trigger Date") in return for a portfolio of US treasuries (to be delivered by Irving Park to BUKP on the Settlement Date) with an aggregate principle amount having a market value equal to either:-

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

b. $1,000,000 if the USD LIBOR-BBA on the Trigger Date was less than or equal to 6.77942%

10. By the second agreement ("the Second Debt Contract") BUK agreed to pay to Mecklenberg Park either:-

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

b. $1,000,000 if 3 month USD LIBOR-BBA was less than or equal to 6.77942% in return for a portfolio of US treasuries to be delivered by Mecklenberg Park as above to BUK on the Settlement Date with an aggregate principal amount of $170,000,000.

11. Each of Irving Park and Mecklenberg Park exercised rights to elect for cash settlement on 7th August 2000. On the Settlement Date the USD LIBOR-BBA was less than 6.77942%. As a result under the First Debt Contract BUKP paid $170,792,969 and under the Second Debt Contract Mecklenberg Park paid to BUK an amount equal to $170,792,969.
12. Thus the two contracts were back to back. A loss on one was matched by an equal profit on the other.
13. The payments under the two contracts (i.e. which way the payments went) depended on the rise or fall of the USD LIBOR-BBA. However the two transactions were entirely neutral because they would cancel each other out. It would not be known until the Trigger Date however which of the two companies made the loss and which one made the profit. Overall MSDW of course makes no profit or loss on a group basis. Furthermore it never would do any better or worse than break even on the 2 contracts.
14. BUKP undertook to pay Irving Park Inc a fee of $161,500 and BUK undertook to pay Mecklenberg Park Inc a fee of $161,500. Thus the BoA subsidiaries were formed solely for the purpose of these transactions and were paid fees to enter into the contracts. BoA was never exposed (unless the MSDW companies failed to make a payment on the two contracts) either. It would receive on the one hand and pay out on the other through the mediums of the two subsidiaries.
15. The transactions were entered into as a result of an internal document called the Morgan Stanley Dean Witter Internal Funding Opportunity. I was provided with a copy of this document after the hearing. There is no discernable commercial basis for the two transactions set out in this document. I asked Mr Peacock QC who appeared for BUK on the appeal before me what the purpose of the two transactions was. Beyond identifying the fact that losses would be created by the transactions he was unable to identify any other commercial reason why these two transactions would be entered into. The purpose appears solely to create losses for utilization against other profits in the Group.

TREATMENT OF TRANSACTIONS IN RETURNS

16. BUKP recognised a loss in respect of the First Debt Contract equal to £119,846,300 being the equivalent in pounds sterling on the Settlement Date of $170,792,969 (the "BUKP loss"). That loss formed part of an overall non trading deficit which was available to surrender to any member of the Morgan Stanley UK Group under the group relief provisions in sections 402 et seq of the ICTA 1988. BUKP accordingly surrendered £96,427,563 to various other UK subsidiaries of MSDW. The remainder of the non trading deficit (£22,235,310) was carried forward.
17. 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 $170,792,969 ("the BUK profit"). That 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.
18. HMRC challenged the BUK loss by virtue of section 165 FA 1994. HMRC rejected the claim for double taxation relief under the Treaty or alternatively under section 795A ICTA 1988.
19. The taxation rate in the US at that time was 35% and 30% in the UK.
20. Finally the shares in BUKP which had made the loss were distributed up by its parent Baycliff BDE to Baycliff Cayman (as set out in the annex to this judgment) and distributed on by Baycliff Cayman to Bayview Holdings Ltd. It then sold those shares to a third party at a loss. The shares were sold at a loss because of the large loss BUKP had made. That loss thereby sustained by Bayview Holdings Ltd is available against other gains that have been made in the Morgan Stanley US Group (i.e. capital gains not income profit).
21. Thus to put it in a simple way, the effect of the completion of these two transactions is that a capital loss accrued to the US companies to offset against other profits. BUKP generated losses which it sought to offset against other Morgan Stanley UK company profits. BDE paid US tax on the BUK profits but it seeks a credit for the US tax thereby paid against the profit it made on the Second Debt Contract.
22. The arrangement therefore appears to be to generate losses to offset against other profits within the Morgan Stanley Group either on a capital basis in the US or on an income basis in the UK. No other purpose for these transactions has been put forward before me. The figures are very large. The transactions as I have said are entirely bereft of any commercial purpose beyond generating these losses to apply against other profits as set out above. BoA was paid the fees set out above simply to provide subsidiary counterparties to these transactions it was never at risk (save the risk of the Morgan Stanley Group failing to honour its obligations) (at that time presumably a minimal risk).

DETERMINATION BY COMMISSIONERS

23. As I have said above HMRC challenged both sides of the arrangements. By that I mean it challenged BUKP's attempt to offset a loss and BUK's attempt to claim relief for the Federal US tax paid by BDE.
24. HMRC's contentions (see paragraph 24 of the Decision) were that the combined contracts were not commercial; they were part of a scheme. The BoA 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. Alternatively if the two Debt Contracts were not looked at together each one was an irrational and commercial gamble and not a contract such as which one would expect between the parties dealing at arm's length.
25. BUK's submissions were (paragraph 9 of the Decision) that there were commercial risks to the transaction because one of the parties might go into liquidation. That was a risk which existed even in 2000 and that there were commercial consequences arising from the transaction that BUK's profit was invested by that company in the Morgan Stanley US Group and the profit would not have been in that company had the transactions not taken place. Further it was also contended (paragraph 9(4) of the Decision) that even if the Debt Contracts were taken together this did not assist HMRC because there was no reduction in 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 of the Debt Contracts. The contention is that at that time there was no reduction although admittedly by the Trigger Date one company would make a profit and the other a loss so that by that date value can be regarded as transfer 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 in market terms no value was transferred in either direction.
26. The Commissioners (paragraph 14) inferred from the agreed primary facts that both the Debt Contracts should be taken together because 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 the companies had proposed to enter into one contract separately with a BoA company they inferred the BoA company would have refused as it put it in the position of possibly losing £198,800,000 in return for a fee of $161,500. Similarly if the same had been proposed to BUK or BUKP they would have also refused for the identical reasons. The result of the composite transactions would lead to one BoA company gaining the same amount as the other lost whilst taking together a total fee of $325,000. The two Morgan Stanley companies taken together were breaking even while obtaining group relief for losses and no UK tax on the profit after credit for the US tax for which they were willing to pay the fee.
27. They accepted Mr Peacock QC's submission as to the time when the anti avoidance section (see below section 165 and 166) applied. They determined that the relevant question was to be looked at immediately after the two Debt Contracts were entered into. Accordingly on that point they accepted BUKP and BUK's submissions that the anti avoidance provisions on loss (section 165) and profit (section 166) did not operate to eliminate the loss and gain respectively. They accepted the transactions were arms length and regard should be had to the fees paid and the tax benefits anticipated (paragraph 28).
28. Although HMRC in a Respondent's Notice challenged the Decision by the Commissioners on the BUKP loss in its Respondent's Notice it did not proceed with it at the hearing before me. Therefore the BUKP part of the transactions remain unchallenged. Thus the losses are capable of being set off as set out above. HMRC seek to maintain the determination as regards BUK. If the Decision stands in the light of HMRC's stance looking at it globally the two sets of losses sustained by the MSDW group (i.e. the capital loss by Bayview Holdings and the income losses by BUKP) will be matched by paying two sets of tax (US Federal and UK Tax) on the single profit of BUK. The effect that stance by HMRC if successful will mean that no global tax savings will have been effected within the MSDW group by the two Debt Contracts.
29. The Commissioners accepted HMRC's submission that the two Debt Contracts were required to be put together. They further accepted the combined transactions were bound to result in one BoA company gaining the same amount the other lost while the BoA Group received a total of $325,000. They also accepted that the two Morgan Stanley companies taken together would break even whilst hopefully obtaining group relief for the loss and no UK tax on the profit after credit for the US tax for which they were willing to pay the fee.
30. As I have said they determined that the BoA parties had opposite interests to the Morgan Stanley parties and a substantial fee was payable to those parties in order to secure a tax benefit that the Morgan Stanley parties hoped to achieve. They pointed out that the purpose at that time was not unallowable but was later corrected by section 168A which was introduced in 2002. They determined that the two parties were not only at arm's length but dealing at arm's length and in that relationship they entered into the combined transaction. The fact that the results of the two companies each side would cancel out did not in their view deprive the transaction of this status since regard should be had to the fees paid and the tax benefit anticipated.
31. In coming to that conclusion the Commissioners rejected HMRC's contention that the transactions in question were part of a scheme which had no commercial purpose or effect apart from Bank of America's fees and that those fees were not commensurate with the risk undertaken by each company of some $171,000,000 on each transaction. Further HMRC submitted there was no net effect on the Appellant companies and no commercial reason had been given for either company entering into the Debt Contracts.
32. Various well known authorities were cited to the Commissioners concerning how the court should construe the taxing acts. They are well known and were set out in the Decision (paragraphs 11-13). The line of authorities in effect starts with WT Ramsay Ltd v IRC [1982] AC 300 culminating in the decision in Barclays Mercantile Business Finance Ltd v Mawson [2005] STC 1 and IRC v Scottish Provident Institution [2004] UK HL 52 (given on the same day). These well known authorities were extensively reviewed in the Court of Appeal in Astall & Edwards v HMRC [2009] EWCA Civ 1010.
33. In applying those authorities the Commissioners as I have said rejected HMRC's arguments on section 165 and 166. There is no appeal against that decision.
34. The appeal therefore relates to the statutory provisions and Treaty provisions set out in the issues above as applicable to the desire of BUK to obtain double taxation relief against the tax due on its UK profits for the Federal Income Tax paid by BDE.
35. The latter paid that sum the Federal Income Tax payable by BDE because of the application of Treasury Regulation 301.7701-3 ("the Check the Box Regulation") which 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 and does not have limited liability.
36. This is applicable both to BUKP and BUK as unlimited companies with a single member. However an eligible entity can in effect be treated differently and such 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 8th 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 Ltd a Cayman company elected to be treated as a disregarded entity for US Federal Income Tax purposes. All other companies shown in the annex were treated as corporations for the US Federal Income Tax purposes. As a result Federal Income Tax was paid in the US by BDE on the profit BUK made on the Second Debt Contract.

DECISION ON OUTSTANDING ISSUES

37. I have set out above the outstanding issues before me.

ISSUE 1 UNILATERAL RELIEF

38. This is described as unilateral relief and it arises under section 790 of the Taxes Act 1988 which provides as follows:-

"790.— Unilateral relief.

(1) 1To 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) 2Unilateral relief shall be such relief as would fall to be given under Chapter II of this Part if arrangements [in relation to]3 the territory in question containing the provisions specified in [subsections (4) to (10C)]4 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) 5Credit 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) where the territory is the Isle of Man or any of the Channel Islands, the limitation to income or gains arising in the territory shall not apply;

(b) where arrangements [in relation to]3 the territory are for the time being in force by virtue of section 788, 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

(c) credit shall not be allowed by virtue of subsection (4) above for overseas tax on a dividend paid by a company resident in the territory unless—

(i) the overseas tax is directly charged on the dividend, whether by charge to tax, deduction of tax at source or otherwise, and the whole of it represents tax which neither the company nor the recipient would have borne if the dividend had not been paid; or

(ii) the dividend is paid to a company within subsection (6) below; or

(iii) the dividend is paid to a company to which section 802(1) applies and is a dividend of the kind described in that subsection."

39. As Mr Peacock QC observed in his submissions the Commissioners dealt with this issue first in the Decision. That is illogical to a certain extent because relief under this section arises only if there is no relief under the Treaty. Nevertheless it is convenient to deal with the issues in this judgment in the same way in which the Commissioners dealt with them in their Decision.
40. It will be seen from subsection (1) the purpose of the section is to give relief from income tax and corporation tax in respect of income and chargeable gains in respect of tax payable under the law of any territory outside the UK by allowing that tax as a credit against income tax or corporation tax not withstanding there are no arrangements in force providing for such relief.
41. The relief is identified in subsection (3) as being such relief as would fall to be given if arrangements as set out in subsections 4-10C were in force but subject to any particular provision made in respect of unilateral relief. Effect is given by subsection (4) by giving a credit for tax paid under the law of the territory outside the UK and "computed by reference to income arising or any chargeable gain accruing in that territory…….." It provides that it should be allowed against any UK income tax or corporation tax "computed by reference to that income or gain….."
42. BUK submitted before the Commissioners that the source of the income was 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. All the factors it was contended pointed one way to it having a non UK source.
43. HMRC's counter submission was that the source of the income was not the Debt Contract but what is taxable under the Finance Act 1994 code which is the difference between the two amounts. That was taxed under Case (III) as a non trading profit as provided in section 82 (4) and was therefore deemed to be UK source.
44. The Commissioners (paragraph 31) after reviewing a number of authorities and having summarised the counter submissions concluded that they should take "a common sense" approach about where the income arose. Applying that common sense approach they came to the conclusion that the reason for the US tax had nothing to do with the income arising in the US because of the situs of the Second Debt Contract; it arose solely because the US disregarded BUK for Federal Income Tax purposes. On that basis they concluded that BUK's profit arose in substance in the UK regardless of the situs of the Second Debt Contract or the fact that the charge was under case (III) therefore they concluded the requirements of section 790 (4) were not satisfied and unilateral relief was not available to BUK for the US tax paid by BDE.
45. This was not a basis that was argued before them.
46. Their conclusion was that the tax did not arise under the lex situs of the Second Debt Contract. On this "common sense basis" the BUK profit, they determined, arose in substance in the UK irrespective of the situs of the Second Debt Contract.
47. Unsurprisingly Mr Peacock QC made a strong challenge to this determination.
48. Mr Peacock QC submitted that had the Commissioners paid proper regard to guidance and case law summarised in his Skeleton Argument they would have asked themselves where did the operations take place from which the income in substance arose and would have taken a number of considerations into account:-

a. The counter party and, as it turned out, the debtor, was a US resident operating out of its US office

b. The Second Debt Contract was governed by US law and it fell to be enforced in the US

c. The Second Debt Contract was executed in the US

d. The Second Debt Contract related to US situs assets being US Treasuries (and contained provision for settlement in US currency)

49. These he submitted lead inexorably to a conclusion and the only conclusion that the BUK profit arose in the US.
50. By way of contrast the only UK factor was the residence of BUK. As he rightly said the residence of the person entitled to the income cannot be determinative as to where the income arose. I agree with his observation in his Skeleton Argument (paragraph 26) as it would be nonsensical. If the residence was a determinative factor there would never be any possibility of obtaining section 790 relief as any applicant presumably is going to be a UK resident seeking relief against taxes that are assessable in the UK.
51. Thus he submitted that the only proper conclusion that the Commissioners could have made without committing any error in law was that the BUK profit arose in the US. In the consequence absent entitlement to double tax and relief under the Treaty BUK was entitled to Unilateral Relief under section 790 ICTA 1988. He submitted that the Commissioners were wrong to conclude otherwise.
52. With respect to the Commissioners I do not see that there is any principle that enables them to take what they call a common sense view about where the income arises. Even if there were with respect to the Commissioners I do not see how given the facts set out above a "common sense" view could lead to any conclusion other than that contended for by Mr Peacock QC. All the pointers are one way in my view. This in my view is a classic case of a profit arising abroad on the part of a company which was resident in the UK. I do not see that the Commissioners with respect to them have properly considered the clear factors applicable to the Second Debt Contract summarised above.
53. It follows therefore that with great deference to the experienced Commissioners I disagree with their conclusion under section 790. I therefore conclude that the appeal ought to be allowed and that the conclusion ought to have been that Bayfine is entitled to Unilateral Relief under section 790 ICTA 1988 if that is reached.
54. That is on the way in which the Commissioners dealt with the issues in succession enough to determine this Appeal given that they rejected the claim for relief under the Treaty and held that section 795A did not apply. However as this case will probably almost inevitably proceed its way through the higher courts I will express my views on the other issues before me.

ISSUE 2

55. The relevant paragraphs of the Treaty are as follows:-
ARTICLE 1 Personal scope

"(1) Except as specifically provided herein, this Convention is applicable to persons who are residents of one or both of the Contracting States.

(2) A corporation which is both a resident of the United Kingdom within the meaning of paragraph (1)(a)(ii) of Article 4 (Fiscal residence), and a resident of the United States within the meaning of paragraph (1)(b)(ii) of Article 4 shall not be entitled to claim any relief or exemption from tax provided by this Convention except that such corporation may claim the benefits of Article 23 (Elimination of double taxation) with respect to the petroleum revenue tax referred to in paragraph (2)(b) of Article 2 (Taxes covered), of Article 24 (Non-discrimination) and of Article 28 (Entry into force).

(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) 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 3 General definitions

(1) In this Convention, unless the context otherwise requires:

(a) the term "corporation" means a United States corporation, a United Kingdom corporation, or any body corporate or other entity of a third State which is treated as a body corporate for tax purposes by both Contracting State;

(b)

(i) the term "United States corporation" means a corporation (or any unincorporated entity treated as a corporation for United States tax purposes) which is created or organised under the laws of the United States or any State thereof or the District of Columbia; and

(ii) the term "United Kingdom corporation" means any body corporate or unincorporated association created or organised under the laws of the United Kingdom, but does not include a partnership, a local authority, or a local authority association;

(c) the term "person" includes an individual, a corporation, a partnership, an estate, a trust and any other body of persons;

(d) the term "enterprise of a Contracting State" means an industrial or commercial undertaking carried on by a resident of a Contracting State;

(e) the term "international traffic" means any transport by a ship or aircraft operated by an enterprise of a Contracting State, except when the ship or aircraft is operated solely between places in the other Contracting State;

(f) the term "competent authority" means :

(i) in the case of the United States, the Secretary of the Treasury or his delegate, and

(ii) in the case of the United Kingdom, the Commissioners of Inland Revenue or their authorised representative;

(g)

(i) the term "United States" means the United States of America; and

(ii) when used in a geographical sense, the States thereof and the District of Columbia.

Such term also includes:

(aa) the territorial sea thereof, and

(bb) the seabed and subsoil of the submarine areas adjacent to the coast thereof, but beyond the territorial sea, over which the United States exercises sovereign rights, in accordance with international law, for the purpose of exploration for and exploitation of the natural resources of such areas, but only to the extent that the person, property, or activity to which the Convention is being applied is connected with such exploration or exploitation;

(h)

(i) the term "United Kingdom" means Great Britain and Northern Ireland, including any area outside the territorial sea of the United Kingdom which in accordance with international law has been or may hereafter be designated, under the laws of the United Kingdom concerning the Continental Shelf, as an area within which the rights of the United Kingdom with respect to the seabed and subsoil and their natural resources may be exercised;

(i) the term "Contracting State" means the United States or the United Kingdom, as the context requires;

(j) the term "third State" means any State or territory other than the United States or the United Kingdom and the term "enterprise of a third State" shall be construed accordingly;

(k) the term "nationals" means :

(i) in relation to the United Kingdom, all citizens of the United Kingdom and Colonies, British subjects under sections 2, 13(1) or 16 of the British Nationality Act 1948, and British subjects by virtue of section 1 of the British Nationality Act 1965, provided they are partial within the meaning of the Immigration Act 1971, so far as these provisions are in force on the date of entry into force of this Convention or have been modified only in minor respects so as not to affect their general character;

(ii) in relation to the United States, United States citizens.

(2) As regards the application of this Convention by a Contracting State any term not otherwise defined shall, unless the context otherwise requires and subject to the provisions of Article 25 (Mutual agreement procedure), have the meaning which it has under the laws of that Contracting State relating to the taxes which are the subject of this Convention.

"ARTICLE 22 Other income

(1) 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.

(2) The provisions of paragraph (1) shall not apply if the person deriving the income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the right or property in respect of which the income is paid is effectively connected with such permanent establishment or fixed base. In such a case the provisions of Articles 7 (Business profits), 14 (Independent personal services), or 17 (Artistes and athletes), as the case may be, shall apply.

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; and, in the case of a United States corporation owning at least 10 per cent of the voting stock of a corporation which is a resident of the United Kingdom from which it receives dividends in any taxable year, the United States shall allow credit for the appropriate amount of tax paid to the United Kingdom by that corporation with respect to the profits out of which such dividends are paid. 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) the amount of 5 or 15 per cent, as the case may be, withheld under paragraph (2) (a) (i) or (ii) of Article 10 (Dividends) from the tax credit paid by the United Kingdom shall be treated as an income tax imposed on the recipient of the dividend; and

(c) that amount of tax credit referred to in paragraph (2) (a) (i) of Article 10 (Dividends) which is not paid to the United States corporation but to which an individual resident in the United Kingdom would have been entitled had he received the dividend shall be treated as an income tax imposed on the United Kingdom corporation paying the dividend.

(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) in the case of a dividend paid by a United States corporation to a corporation which is resident in the United Kingdom and which controls directly or indirectly at least 10 per cent of the voting power in the United States corporation, the credit shall take into account (in addition to any United States tax creditable under (a)) the United States tax payable by the corporation in respect of the profits out of which such dividend is paid.

(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.

(4) The provisions of this Article shall not affect the taxation by the United States of foreign oil and gas extraction income and foreign oil related income as provided in the Tax Reduction Act of 1975.

56. The facts in this case are out of the norm. Normally under the Treaty one would expect the tax to be paid and payable by the same entity or person in both jurisdictions. However as I have said the Federal US tax has been paid by BDE and the credit is sought to be claimed by BUK.
57. The facts of this case give rise to a difficulty. Both the US and UK tax the same profit albeit in the hands of different entities and both levy tax. The question then is which state must give credit. The fact that each state tax a different entity gives rise to the possibility that either state must give credit as long as tax is paid in the other state.

CONCLUSION OF THE COMMISSIONERS

58. The Commissioners (paragraph 38) appreciated the problem of different taxed entities in the UK and the US. They observe rightly that the Treaty was silent about what to do when they were different persons.
59. After considering various provisions set out in the Treaty their conclusion (paragraph 64) was as follows:-

"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 (who we 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 tax payer but impliedly acknowledging that the UK has the better right to tax by saying that its taxation is by virtue of the saving clause. …… 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 in to operation if the Treaty (excluding the saving clause) prevents the US from taxing".

60. It appears that there were 2 key factors in their conclusion. First they believed that the UK has a stronger taxing right. It is difficult to see what is meant by a stronger taxing right. It is a concept unknown to English law, to the Treaty and the OECD commentary on the OECD model double tax convention on which the Treaty is based. Second having decided as a preliminary the basis of source under section 790 they also considered that they were taxing a UK resident.
61. It is true that article 7 of the Treaty prima facie confers on the UK an exclusive right to tax the BUK profit (as the BUK profit is a business profit of an enterprise in the UK i.e. BUK). Nevertheless article 1 (3) (the saving clause) preserves the US right to tax the BUK profit in the hands of BDE which it has done.
62. The main relevant provision is article 23 which I have set out above. The fundamental purpose of the Double Taxation Treaty is to ensure that persons or organisations that fall within it are not taxed twice in different countries. The converse is also of course to ensure that reliefs are not given twice either. Article 23 (2) (a) provides US tax payable in the United States in accordance with the convention whether directly or by deduction on profits or income from sources within the US shall be allowed as a credit against any UK tax computed by reference to the same profits or income by reference to US tax is computed.
63. Sub section (3) provides that for the purposes of the preceding paragraphs of the article income or profits derived by a resident or 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 tax on the basis of citizenship the United Kingdom shall not be bound to give credit to a US national who is resident in the UK on income from sources outside the US as determined under the laws of the UK. I can disregard that latter point it has no application.
64. The provisions seem to me to be clear. If a UK resident pays US tax under US law it is entitled to credit against the taxation of those profits in the UK. Sub section (3) provides that the income is deemed to be income to arise from sources within the other contracting state i.e. the US. The exceptions are of no concern.
65. As I have said above in relation to Unilateral Relief the profits in this case were clearly made in the US for all the reasons I have set out above. It is true that they were taxed on a different entity but that seems to me to make no difference at all. That arises out of the application of US tax laws; it is still the same profit which is being sought to be taxed in both countries. This with respect to the Commissioners shows the consequence of their fundamental error in approach. They were wrong to conclude under Unilateral Relief (as set out above) that the source was a UK source. They have repeated that error in respect of the Treaty. I can see no argument for sustaining that part of their decision.
66. Article 7 gives the prima facie right on the UK exclusively to tax the BUK profit (as the BUK profit is the business profit of an enterprise of the UK). Article 1 (3) (the saving clause) preserves the US's right to tax the BUK profit in the hands of BDE.
67. Accordingly BDE is assessed as a US resident in respect of the BUK profit. As set out in paragraph 43 of the Commissioners Decision relying on the joint expert report the taxable income of BDE would have included the BUK profit. However the experts also agree that the savings clause of Article 1 (3) would override any provision of the Treaty that might otherwise prevent the US from imposing Federal Income Tax on the BUK profit although that tax liability would be subject to potential availability of foreign tax credits under Article 23. BDE has already paid the Federal tax and it follows on that analysis that if BUK is taxed in the UK BDE would be able presumably to seek a foreign tax credit against the tax that it has already paid. It does not matter which entity actually pays the tax; all that is required is that both states' taxes are computed by reference to the same profits. As the Commissioners said in paragraph 52 of their Decision they stated that the UK ought not give credit under Unilateral Relief because the source of the income was in the UK. As I have said above I disagree with that decision. They then went on to consider "does the deemed source rule in Article 23 (3) change that?" They accepted that if that deemed source rule changes it the UK would have to give credit for the US tax on the same income because this now has a source in the US for the Treaty. Given as I have said I believe their decision on the source was erroneous the consequence of paragraph 52 of the Decision is to acknowledge that if the tax is paid in the US as being from sources within the US credit must be given for it in the UK. That on its own in my view is enough to displace their decision.
68. In paragraph 53 they then went on to observe that the order in which tax is paid and credited is important. If the 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. If the tax is properly paid first in the US (which has in fact occurred) the UK has to give credit for the US tax. On the facts there will be no net UK tax available for credit in the US. The tax rates in the US were higher than in the UK at the time.
69. The Treaty does not say anything about who gives credit first.
70. It seems to me to be straightforward. I accept Mr Peacock QC's submissions. Where more than one state taxes the question as to which state must give credit needs to be resolved in the ordinary way namely that the state of the source has the primary taxing right and the state of residence charges tax on its residents but must give credit for the source taxation. In this case therefore the source as I have determined is the US. It therefore has the primary right to tax and credit must be given for that tax in the UK under Article 23. If for some reason the tax was first paid in the UK then when it came to be taxed in the US the US would have to acknowledge a credit for the tax paid in the UK.
71. The question is simply to be decided on the basis of which state taxes first. If the US tax first then credit must be given in the UK. If it is the other way round then the converse applies. To do otherwise seems to me to be a distortion of the clear and obvious words of Article 23 and Article 1 (3). It might also lead to double relief or (if this appeal is not allowed) double taxation. I do not accept there is any stronger taxing right. Nor do I accept the Commissioners were correct to determine on that basis that BUK is a UK resident taxed on what the Commissioners decided is UK source income. I accept Mr Peacock QC's submission that this is a key flaw in their reasoning as the source of the BUK profit is undoubtedly the US and not the UK. It is clear to me that the application of the Treaty will simply be determined by the order in which the taxes are paid. This is not based on any priority but on a question of fact. If as the experts have determined the taxation and credit will flow either way depending on where the tax is paid. Thus in the present case the tax was first paid in the US and levied on BDE. Thus to give effect to the Treaty BUK is entitled to a credit in the UK. Had the tax been first paid in the UK then as the experts have determined the US would be required to give credit for the tax paid in the UK.
72. Accordingly I determine that the Commissioners were wrong to disallow double taxation relief under the Treaty when they determined that in the second issue.

ISSUE 3 : SECTION 795A OF THE TAXES ACT 1988

73. This section provides as follows :-

"795A.— 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 [in relation to]2 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".

74. As the Commissioners had decided no credit was available for the US tax against the UK tax the final issue did not arise before them but they dealt with it in case their decision was wrong on any of the previous issues. As I have determined above I am of the view that their decision was wrong on issue 1 and issue 2.
75. The purpose of the section is to require a tax payer seeking credit for US tax to take all steps as defined in the section that can be taken in order to minimise the amount of exposure of the UK to the claim for the credit.
76. For HMRC it was contended that there were 3 steps that could have been taken that were reasonable steps under section 795A (1). First it is submitted that the transaction should not have been done at all. Second it is submitted that the Appellant could have claimed a tax credit in the US for the UK tax paid i.e. that it should litigate in the US to seek a credit for tax which has been admitted in the UK. The third possibility advanced by HMRC was to make various elections in various other companies in the group identified in the Commissioners Decision in paragraph 77. Only items 3 (3) – (5) are now pursued by HMRC.
77. The Commissioners decided this issue in favour of the Appellants. HMRC seeks to challenge that decision. The Appellants seek the decision of the Commissioners to be upheld on the grounds set out in the Decision and further seek to introduce 2 further reasons. The first of those is based on sub section (3) which requires any question as to whether or not the steps are reasonably taken to be determined on the basis of what might reasonably have been expected to have been done in the absence of relief in the UK. The joint experts agreed that if there was no UK tax credit then that itself would have had an impact on the UK tax position and in such a case the absence of a UK tax credit would have meant that the transaction was entirely disregarded in the US. It is submitted that the requirement to disregard the availability of the tax credit in the UK is not limited territorially. Thus any tax position in the US should also be considered on the basis that there is no UK credit available. As I have said above on that basis the experts are agreed the transaction will be disregarded for US Federal Income Tax purposes. The consequence of disregarding it will be that there will be a nil US tax bill. There are thus no steps it is contended therefore that can be taken to reduce a nil bill.
78. The Commissioners (unsurprisingly in my view) rejected this argument in paragraph 74 and 75 of the Decision.
79. The second additional ground is that steps contemplated by section 795A cannot include a step which has the effect of changing the legal character of a person. The step it is contended must relate to the actual transaction undertaken and not steps which result in the creation of an alternative transaction.

DISCUSSION

80. Taxation statutes and regulations are often Byzantine in their meaning and structure. Often there are therefore elaborate arguments put forward by parties in an attempt to sever the Gordian knot in respect of statutes and regulations that appear at first sight difficult to understand.
81. In my view both the parties have developed over elaborate arguments which do not do justice to what in my view is a relatively straightforward provision. I prefer an approach of "Artless Chancery Simplicity" (Ross v Caunters [1980] 1 Ch 297 at 306b).
82. The purpose of the provision in my view is clear. Any person who seeks relief from UK tax based on tax paid in another state already must take all reasonable steps that it can do to reduce the amount of tax that was paid in the other state arising out of the transaction which gave rise to the tax liability in the other state as it is. The purpose is to reduce to the minimum reasonable amount the burden of giving the credit in the UK.
83. It seems to me that in approaching it from that point of view the following is clear:-

a. The idea that a person can be required to mitigate by not doing the transaction is simply untenable. No one would ever obtain any relief.

b. The idea that the disregard of the existence of the UK tax relief means that (in this case) the impact of that is considered in the other state's law and thus (in this case) would lead to a disregard of the transaction in its entirety is equally untenable.

c. The purpose of the disregard is simply to require the transaction that gives rise to the tax liability to be considered on the basis of the transaction taking place in the other state. The tax payer then must take all reasonable steps to reduce that foreign tax liability. By requiring the availability of the relief in the UK to be disregarded it means that one simply looks at the transaction by the tax payer in respect of the relevant foreign jurisdiction and the tax laws applicable thereto. The removal of the presence of the credit is to ensure that a tax payer pursues all steps that are necessary to mitigate the foreign tax and cannot fail to do things because it is aware it can recoup the tax payable overseas by applying it against its tax bill in the UK. An example will suffice. Suppose a tax payer received a higher assessment for tax that was appealably wrong. As part of the mitigation exercise it would be required to expend money to challenge the decision. It cannot simply choose not to appeal because it can recoup its losses by not appealing against the credit available in the UK.

d. It is equally clear that one looks at the taxpayer and looks at all steps that that taxpayer can reasonably take. That in my view will extend to any third parties that a taxpayer can reasonably compel to take steps in order to reduce the tax liability which otherwise it would incur in the foreign state. Another example will suffice. Suppose hypothetically a tax liability could be reduced by a subsidiary of the taxpayer serving a notice or doing some other act within its power. It seems to me plain that the taxpayer which controls the subsidiary would be in a position to compel it to do something and must do so, so as to reduce its tax liability.

e. The amount of tax payable in the foreign state is calculated by reference to the transaction as it is. Absent an anti-avoidance challenge or a challenge to the genuineness of the transaction (and there is none in this case) it is not open to HMRC in my view to say that other parties which are not compellable by the taxpayer could serve notices or do other things which would reduce the foreign based tax bill. I do not see how it can be reasonable to take into account something which is beyond the control of the taxpayer in question. If the taxpayer has officers which are identical to officers in other companies in respect to the transaction there may be a possibility of arguing that the taxpayer is in a position reasonably to mitigate its loss. However as I have said that does not extend in my view to altering the transaction. One looks at the tax which arises as a result of the transaction and sees what steps can be reasonably required of the taxpayer in order to reduce that bill.

84. It follows from that for the reasons that I have already given earlier in this judgment it cannot be regarded as reasonable mitigation to require the taxpayer to pay the tax in the UK and then seek to claim a credit for that tax paid against tax already paid in the US. One looks at the position that appertains when the taxpayer comes to claim the tax credit. By that time it has already paid the tax in the US and is seeking the credit for that. To reverse that and require it to pay the UK tax and seek repayment of tax already paid is another example of absurdity. If that is the case no one would ever be able to make a successful claim for the tax paid in the foreign state. HMRC would simply say "pay your tax in this jurisdiction and then recover your tax back in the foreign state". Thus no one would ever be in a position ever to make a claim.
85. Drawing all of that together it seems to me that I should reject all of HMRC's 3 arguments on mitigation as set out above. Equally I reject the first extra point raised by the Appellants. I accept the second point in that it is part and parcel of my determination above that one does not require the taxpayer as mitigation to change the transaction, change its status and do anything other than submit its claim for tax in the foreign state and require it to take all reasonable steps it can take to ensure that tax liability is reduced as much as possible.
86. There is nothing therefore in my view to suggest that the Appellant has not mitigated the tax liability in this case.

CONCLUSION

87. I would therefore allow the Appellants' appeal on issues 1 and 2 and dismiss HMRC's contentions on Issue 3 not only on the grounds put forward by the Commissioners but also on the additional ground 2 rejected by them.
88. I am grateful to the parties' lawyers for their detailed written submissions which assisted me greatly in untangling the thickets of the complex arguments. In this case I was additionally greatly helped by the process of oral arguments which threw even more light on these issues.