Relying on a tax treaty is not an abuse of law: lessons from the Lehman litigation

HMRC v Burlington Loan Management is an important Court of Appeal decision on the interpretation of double tax treaty anti-abuse articles in the context of the international secondary debt market, which came out of the Lehman Brothers administration.

The case provides reassurance that genuine cross-border sales of debt to taxpayers entitled to interest free from withholding are not engaged in improper withholding tax arbitrage, even if the deal pricing takes that treaty benefit into account.

What happened?

The facts of the case were straightforward. Burlington Loan Management (Burlington), an Irish tax resident investment company, took an assignment of a debt claim from a Cayman Islands company (SICL) which was in liquidation, during the administration of Lehman Brothers. As a result of the assignment, Burlington became entitled to receive payments of UK source interest.  UK domestic law required the UK payee to withhold income tax from these interest payments, subject to the provisions of any applicable double tax treaty. While there was no protection from withholding tax in the UK-Caymans treaty, Article 12(1) of UK-Ireland treaty provided that interest beneficially owned by an Irish resident could only be taxed in Ireland. Once the debt was assigned to Burlington, the UK had taxing rights only if it could be shown that the anti-abuse provision in Article 12(5) applied. To do this, HMRC needed to prove that either the liquidators of SICL or Burlington had a main purpose of taking advantage of Article 12(1).

The parties were unable to agree on whether Article 12(5) applied and the matter eventually came before the Court of Appeal. HMRC’s arguments focussed solely on Burlington’s purposes in entering into the assignment. Burlington countered that Article 12(5) only applied to transactions involving artificial steps or arrangements. HMRC discontinued its claim against the liquidators of SICL. It had by then been established that the liquidators’ aim was simply to realise the highest possible price for the debt claim. The liquidators knew that there were people in the market who could pay a higher price for the debt because UK withholding tax would not be a permanent cost. But when commercial terms for the assignment with Burlington were agreed via a third-party broker, the liquidators did not know, or care about, the identity of the purchaser.

HMRC and Burlington agreed that the expression “main purpose or one of the main purposes” was an undefined term in the treaty, and - as the relevant tax was imposed by the UK - this meant the Court should have regard to UK domestic law cases on the meaning of this expression. The Court was critical of this agreement and unconvinced that the UK and Ireland intended their treaty to mean that domestic law should apply without taking account of wider principles of international treaty interpretation. The Court once again affirmed that these wider international principles, most recently articulated in Royal Bank of Canada, meant that the Court must take into account that what is being interpreted is an international treaty, not a UK statute. Words should be given their ordinary meaning in the light of the treaty’s context, object and purpose. That meaning could be confirmed by supplementary means, which in the case of double tax treaties included OECD commentary on the Model Convention.

Taking this approach, the Court rejected Burlington’s argument that Article 12(5) should be limited to transactions involving artificial steps or arrangements. The express words and history of Article 12(5) meant it was capable of applying where the parties had genuine commercial reasons for entering into an assignment. This was because they might seek to construct that transaction in a way that enabled one, or both of them, to obtain benefits contrary to the objects and purposes of the treaty. There was nothing in OECD commentary to indicate that the improper use of a double tax treaty should be limited to arrangements involving some level of artificiality. Whether there were any artificial aspects to the transactions in this case and whether Burlington had genuine commercial reasons for entering into the assignment were highly relevant questions for determining whether Burlington had a main purpose of taking advantage of the UK-Ireland treaty within the meaning of Article 12(5).

Assuming Burlington had a main purpose of obtaining the benefit of the UK treaty, the question was whether this amounted to taking advantage of the treaty so that UK withholding tax was due. This point was considered in a recent decision, Vietjet Aviation JSC v FW Aviation (Holdings) Ltd, a case that had not been available to the lower courts in Burlington. In Vietjet, aircraft financing agreements required any assignee to be an entity that could benefit from a double tax treaty so no withholding tax would be levied on interest payments. The relevant treaty was the UK-Japan double tax treaty, which had materially identical wording to Article 12(5) of the UK-Ireland treaty. The judge in Vietjet held that the treaty wording and OECD commentary on the Model Convention made it clear that the article in the UK-Japan treaty was an anti-abuse provision and that taking advantage of the treaty was not synonymous with obtaining the benefit of the treaty.

Applying that reasoning to Burlington, the Court of Appeal held that, without more, it could not be an abuse for an Irish resident taxpayer to acquire a debt-claim in the expectation that it would enjoy the benefit of a tax exemption expressly provided by the treaty. In common with double tax treaties generally, one of the UK-Ireland treaty’s principal objectives was to promote the movement of capital between the contracting states by eliminating double taxation. Burlington was an independent entity that acquired debt claims on arm’s-length terms. Its expectation that it could, in this case, bid a higher price to acquire the debt because it would only be taxed on the interest income in Ireland, and not in the UK, was entirely in line with the objects and purposes of the UK-Ireland double tax treaty. Importantly, maximising UK tax revenue was not part of the treaty’s objects and purposes. Article 12(5) did not apply simply because less tax would be paid to HMRC than if the assignment did not take place.

What does this mean?

The presence of what HMRC claimed was UK withholding tax arbitrage did not, of itself, mean that an anti-abuse provision in a double tax treaty applied. The fact that Burlington only paid the price it did because it expected to receive interest payments free from withholding did not mean that there was a main purpose of taking advantage of the UK-Ireland treaty.

That treaty has since been modified by the Multilateral Convention to prevent base erosion and profit shifting. Article 12(5) has been replaced with principal purpose test wording which does not contain the “take advantage” wording. Nevertheless, the importance of interpreting double tax treaties as international conventions in the light of their object and purpose has once again been asserted by the UK Courts. That purpose is to allocate taxing rights between contracting states in accordance with the relevant treaty’s detailed provisions. Maximising revenue for one contracting state is not part of an anti-abuse article’s object and purpose.