Be fair to foreign banks in India

DIRECT TAX

A recent Court of Appeals decision in the US has trammelled upon a familiar question of international law that has baffled tax courts in India. The question revolves around the treatment of a branch "" whether, for tax purposes, it should be considered as an entity separate and independent from its head office or whether it would constitute the same legal entity and hence incapable of transacting with its own self.

The question has been answered in the recent US Court of Appeals decision, in the case of National Westminster Bank (NatWest). NatWest, a UK banking corporation, conducted wholesale banking operations in the US through six permanently established branch locations.

While filing its tax return in the US, NatWest claimed deduction for interest expenses as recorded in the books of its US branches. During audit, Internal Revenue Service (IRS) re-computed the interest deduction based on domestic law provisions which had the effect of increasing NatWest's taxable income by $ 155 million.

In its ruling, the US Court of Appeals held that the domestic law provisions limiting deductibility of interest were inconsistent with Article 7 of the US-UK tax treaty. Accordingly, the treaty provisions were to prevail and intra-bank interest payments were fully deductible.

In other words, the Court of Appeals has given full effect to the 'separate entity principle' enshrined in tax treaties and a widely accepted basis for attributing profits to branch offices. The principle postulates that, for determining the income of the branch, it should be hypothesised as an entity which is separate and distinct from its head office.

Accordingly, while interest payments made by the branch to the head office should be recognised as deductible expenses, interest received from head office should be considered as taxable income.

While the US Court of Appeals has clarified the law on deductibility of intra-bank interest payments, echoing the current international thinking, it continues to be a contentious issue between different benches of Tax Tribunals in India. This is exemplified by the conflicting judgments of the Calcutta and the Mumbai benches in the case of ABN Amro and Dresdner bank, respectively.

In the ABN Amro Bank case, the Calcutta Tribunal disallowed interest payments made by the branch to the overseas head office based on the doctrine 'no profit from self'. The Tribunal drew support from several judicial decisions, wherein the same doctrine had been applied, and it was held that neither income from self could be assessed nor expenditure for payment to self could be allowed as a deduction.

A contrary view was taken in the Dresdner Bank case, wherein the Tribunal concluded that any interest received from the overseas head office was taxable as income of the branch. Invoking the doctrine of 'no profit from self', the bank contended that interest received from its overseas headquarters was a result of an intra-organisation transaction and hence a revenue neutral activity.

However, rejecting this argument the Tribunal held that neutrality of revenue could be considered only when the operations of the enterprise were examined as a whole. On the other hand, where the profits of the branch alone were to be computed, the 'separate entity principle' was applicable.

Clearly, there is a conflict in the principles laid down by the two Tribunal decisions insofar as, while in one, the 'no profit from self' doctrine has been applied, in the other the same has been unequivocally rejected in favour of 'separate entity principle'.

A literal application of the two decisions is rather harsh, besides defiant of the basic principles of international tax and matching principle for accounting purposes. Essentially, multinational banks are taxed on interest receipts from the head office and intra-bank interest payments are not considered as deductible expenditure.

Currently, an appeal against the ABN Amro decision is up for adjudication with the Calcutta High Court. In the meantime, there is confusion among banks and tax administrators alike, over tax implications of intra-bank transactions. In such a scenario of uncertainty, to mitigate hardship to the taxpayer while safeguarding the interests of Revenue, principles articulated in NatWest case are useful.

In the background of the US Court of Appeals decision, one can only hope that the controversy is resolved in an informed manner with due regard to internationally accepted principles of taxation, and domestic transfer pricing regulations that expressly incorporate the 'separate entity principle', limiting the application of 'no profit from self' doctrine primarily to domestic transactions.

While further aligning Indian tax laws with international law, such a step would provide the requisite relief to banks which, under the current state of affairs, run the risk of 'double jeopardy'.

Finally, we shouldn't forget that Indian banks could be meted with similar treatment in foreign jurisdictions under the respective tax treaties.

The author is a partner, BMR & Associates. Views expressed here are his own.