Bayfine UK v HMRC

For unilateral and treaty double-tax relief, the source of income is determined by the operations from which the profit substantially arises. The residence of the taxpayer is not determinative. Where the same profits are taxed in two states, the source state has the primary taxing right and the residence state must give credit, subject to the applicable instrument. Credit is not denied merely because the foreign tax was paid by a different entity under the foreign state’s tax rules. Under section 795A of the Income and Corporation Taxes Act 1988, reasonable mitigation concerns reducing the foreign tax arising from the transaction as it stands. It does not require the taxpayer to avoid the transaction, change its legal character, or pay tax in the residence state first.

Bayfine UK appealed against the Special Commissioners’ dismissal of its challenge to an amendment to its corporation tax self-assessment for the year ending 30 November 2000. Back-to-back financial contracts produced a profit in Bayfine UK and a corresponding loss in a related UK company. The United States treated Bayfine UK as disregarded for federal tax purposes, so the related United States entity paid United States tax on the profit.

The appeal concerned entitlement to unilateral relief under section 790 of the Income and Corporation Taxes Act 1988, relief under article 23 of the Double Taxation Relief (Taxes on Income) (the United States of America) Order 1980, and the limits on credit under section 795A of the 1988 Act.

The appeal was allowed on Issues 1 and 2. HMRC’s arguments on Issue 3 were rejected.

1. Unilateral relief. The Commissioners had erred in adopting a general “common sense” approach to the source of the profit. The relevant factors pointed to the profit arising in the United States: the counterparty was a United States corporation, the contract was executed and enforceable there, it was governed by United States law, and it concerned United States Treasury assets. Bayfine UK’s residence was not determinative. The profit therefore arose abroad and qualified for relief under section 790 of the Income and Corporation Taxes Act 1988.
2. Treaty relief. Article 23 required credit for United States tax computed by reference to the same profits as the United Kingdom tax. It made no material difference that the United States tax was paid by Bayfine DE rather than Bayfine UK, because that resulted from United States tax law. The saving clause in article 1(3) preserved the United States’ power to tax, while article 23 required relief against the United Kingdom tax.
3. Where two states tax the same profits, the source state has the primary taxing right and the residence state gives credit. In this case the source was the United States and the United States tax had been paid first. Bayfine UK was therefore entitled to credit under article 23. The Commissioners’ concept of a “stronger taxing right” had no basis in English law, the Treaty or the OECD commentary.
4. Section 795A. The provision requires reasonable steps to minimise the foreign tax arising from the transaction as it exists. It does not require the taxpayer not to enter into the transaction, or to alter the transaction or the legal status of any person. The United Kingdom credit is disregarded only so that the taxpayer cannot decline reasonable foreign-law mitigation on the basis that the foreign tax will ultimately be recovered in the United Kingdom.
5. The taxpayer must take reasonable steps within its control, including steps it can reasonably compel a controlled subsidiary to take. Section 795A does not require action by parties whom the taxpayer cannot compel, nor does it require payment of United Kingdom tax first followed by an attempt to recover credit in the United States.

The Commissioners’ decision was accordingly reversed on the unilateral-relief and treaty-relief issues, and their decision on section 795A was upheld on the additional ground concerning alteration of the transaction.

Special Commissioners: On 19 November 2008, dismissed Bayfine UK’s appeal against HMRC’s amendment to its corporation tax self-assessment, while allowing the related loss position to stand.

High Court (Chancery Division): Allowed Bayfine UK’s appeal on unilateral relief and treaty relief, and rejected HMRC’s challenge concerning section 795A.