UK interpretation of tax treaties clarified by Supreme Court

Jake Landman of Pinsent Masons was commenting after the UK Supreme Court dismissed an appeal by HM Revenue and Customs (HMRC) in a case in which the Court of Appeal in England and Wales had ruled that payments a Canadian bank received in connection with the extraction of oil from the UK continental shelf were not subject to UK tax. At the heart of the case was how the double tax treaty agreed between the UK and Canada should be applied.

Royal Bank of Canada (RBC) lent money from its Canadian operations to another Canadian company, Sulpetro. Later, after Sulpetro got into financial difficulties, its receiver assigned Sulpetro’s rights to receive payments in respect of oil extracted from a UK continental shelf oil field – the Buchan Field – to RBC.

RBC wrote off the original loan to Sulpetro as a bad debt and treated the payments received from the Buchan Field as recoveries of that bad debt, which were treated as taxable income in Canada.

HMRC argued, however, that the payments were taxable in the UK as profits of a deemed separate ring-fence trade applicable to oil-related activities. The UK tax authority was successful with those arguments before both the First-tier and Upper tax tribunals, but RBC successfully appealed to the Court of Appeal. The Supreme Court has now upheld the Court of Appeal’s judgment.

In considering HMRC’s appeal, the Supreme Court assessed how the UK-Canada double tax treaty should be interpreted in the context of the circumstances of the case. A double tax treaty is a bilateral agreement between countries to allocate the rights to tax certain types of income and gains arising to persons connected with both jurisdictions. There are also typically other provisions relating to double taxation relief and cooperation.

Under the UK-Canada double tax treaty, article 6 deals with income deriving from immovable property and specifically incorporates payments received “as consideration for the working of, or the right to work, …natural resources”. If this article applied, the UK would have the right to tax the payments to RBC.

Sulpetro, a Canadian entity, had historically incorporated a UK subsidiary (Sulpetro UK) which obtained a license to exploit the Buchan Field. Sulpetro entered into an agreement with Sulpetro UK, commonly referred to as an illustrative agreement, whereby Sulpetro provided all the funds and expertise for Supeltro UK, the license holder, to extract from the Buchan Field. Sulpetro Canada then received all of the oil and sold it.

The Supreme Court considered that this illustrative agreement did not give Sulpetro a “right to work” the Buchan Field.

BP acquired Sulpetro UK and the rights that Sulpetro had under the illustrative agreement. BP agreed to make payments to Sulpetro calculated by reference to the volume of oil BP acquired once the price at which that oil could be sold by BP rose above a certain level. The payments eventually received by RBC were the contractual payments made by BP, which had originally been paid to Sulpetro before the right to receive them was assigned to RBC.

The Supreme Court decided that BP had not acquired the right to work the Buchan Field because Sulpetro did not have the right to work. In this context the ‘right to work’ had to be distinguished from the right to direct another person to work the field. The court considered that where those rights are split between two separate legal entities, the treaty does not look through that, nor is there any requirement to consider the “economic reality” rather than the separate legal personalities and contractual rights.

That determination was sufficient to settle the dispute in RBC’s favour, however the Supreme Court went on to give its view on other remaining questions arising from the case.

On the question of whether RBC’s right to payments constituted ‘consideration for’ the rights to work, if they had been rights to work, the Supreme Court highlighted that the application of article 6(2) of the UK-Canada double tax treaty is highly fact specific. It also accepted that the dividing lines in this context would be very fine, leading to some very similar payments falling within scope and some without. Ultimately, the court agreed with the Court of Appeal and RBC that the payments made to RBC were too remote from the immoveable property to constitute consideration for the rights to work it.

The Supreme Court also considered whether, if it had determined that the treaty had allocated the taxing rights to the UK, the income RBC received would have been caught by the UK’s tax regime – specifically section 1313 of the Corporation Tax Act (CTA) 2009. The court found that it would.

Under section 1313 of the CTA, profits arising to a non-UK resident company from exploration or exploitation rights are taxed as if they were carried on through a permanent establishment in the UK and are therefore subject to UK tax. ‘Exploration or exploitation rights’ are defined in that section as meaning rights to assets to be produced by exploration or exploitation activities or to interests in or to the benefit of such assets.

The debate before the Supreme Court centred on the meaning of ‘the benefit of’ the oil. In that regard, the Supreme Court found that the payments to RBC were more closely related to the extraction of oil than a price that was simply determined by reference to oil prices and therefore would have been taxed in the UK had RBC lost on the first two points, which it did not.

Landman said the ruling is relevant to all businesses engaging in cross border activity that deal with double tax treaties. He said they would be interested in the Supreme Court’s reluctance to look beyond separate legal personalities and contractual rights in applying the treaty in this case.

“Many businesses will rely on double tax treaties to ensure that their income, profits and gains are taxed in the right place and double taxation is avoided,” Landman said. “One interesting comment from the Supreme Court was to confirm that there is no underlying presumption of where the boundary should fall when considering the allocation of taxing rights. The key is to construe the treaty itself properly.”