The U.S. Court of Appeals for the Federal Circuit recently upheld lower court judgments involving how to allocate the interest expense of a United Kingdom bank to its U.S. permanent establishment under the prior U.S.-UK Income Tax Treaty (see National Westminster Bank PLC v. United States, No. 2007-5028 (Fed. Cl. Jan. 15, 2008)). The court reiterated the rationale of prior decisions, that in determining the interest expense and profits of the U.S. permanent establishment of National Westminster Bank, the Internal Revenue Service (IRS) is obliged under the Treaty to start with the “real facts” of the taxpayer’s situation as they appear from the business records. The IRS is not authorized by the Treaty to “hypothesize” what the facts might have been in different circumstances. Although the relevant UK treaty language has changed, the issue is still important for some other tax treaties and circumstances. The decision also has favorable implications for Internal Revenue Code section 482 on the question whether the IRS must, in examining the transfer pricing between related parties, test the transfer pricing under the taxpayer’s own structure and contractual arrangements as they stand, or if it instead can consider alternative structures or arrangements not chosen by the taxpayer.
The court stated that the IRS interest allocation regulations in Treas. Reg. §1.882-5 conflicted with, and were invalidated by, the UK tax treaty. The opinion may also affect future cases challenging IRS regulations under section 482 that purport to “hypothesize” or consider alternative structures in examining the taxpayer’s transfer pricing under that statutory provision.