## Facts

- National Westminster Bank PLC (NatWest), a United Kingdom banking company, operated in the United States through one or more branch operations that constituted a U.S. permanent establishment.
- NatWest’s U.S. branch obtained funding from NatWest’s U.K. head office and other non-U.S. branches through internal (interbranch) loans recorded on NatWest’s books.
- Those interbranch loans produced interest entries—interest income to NatWest and corresponding interest expense allocations associated with the U.S. branch’s funding.
- For tax years 1981–1987, NatWest filed U.S. federal income tax returns treating its U.S. branch as a separate unit for computing U.S. taxable business profits, taking account of the interbranch interest amounts on the branch’s books.
- After audit, the IRS disallowed NatWest’s claimed U.S. interest-expense deductions to the extent they were computed by reference to the interbranch transactions.
- The IRS instead applied Treasury Regulation § 1.882-5 (as in effect for the years at issue), which determined the U.S. branch’s deductible interest expense using an allocation method focused on NatWest’s worldwide assets and liabilities and not the interbranch borrowings shown on the branch’s books.
- NatWest paid the additional assessed tax and filed a refund suit in the United States Court of Federal Claims.
- NatWest and the United States filed cross-motions for summary judgment on whether the regulation-based approach could be used consistently with Article 7 (Business Profits) of the 1975 U.S.–U.K. income tax treaty.

## Issues

1. Whether Article 7 of the 1975 U.S.–U.K. income tax treaty requires profits attributable to NatWest’s U.S. permanent establishment to be determined as if the branch were a distinct and separate enterprise, using the branch’s properly maintained books and recognizing interbranch lending (subject to appropriate adjustments).
2. Whether Treas. Reg. § 1.882-5’s worldwide, formula-based interest-allocation method—disregarding the interbranch transactions reflected on the U.S. branch’s books—is consistent with Article 7 when applied to a treaty-protected U.K. bank’s U.S. branch.
3. If Article 7 and Treas. Reg. § 1.882-5 conflict for the years at issue, whether the treaty controls the computation of NatWest’s U.S. branch interest deduction and resulting U.S. taxable profits.

## Decision

- The Court of Federal Claims ruled for NatWest on summary judgment on the central treaty-versus-regulation question.
- The court interpreted Article 7 to require attribution of U.S. branch profits as if the branch were a distinct and separate enterprise dealing at arm’s length with the rest of the bank.
- Consistent with that treaty standard, the court held that the U.S. branch’s properly maintained books, including interbranch lending and related interest entries, must be taken into account in computing branch profits, with room for adjustments (such as capital attribution and arm’s-length pricing) where warranted.
- The court held that Treas. Reg. § 1.882-5, as applied to compute NatWest’s U.S. branch interest deduction by reference to worldwide assets and liabilities while disregarding interbranch borrowing shown on the branch’s books, was inconsistent with Article 7 for the tax years at issue.
- Because the treaty and the regulation could not be reconciled on this point, the court concluded the treaty standard governed the branch-profit computation for NatWest, and the case proceeded toward determining the refund under a treaty-consistent method.

## Legal Principles

- Under Article 7 of the 1975 U.S.–U.K. income tax treaty, profits attributable to a U.S. permanent establishment must be determined as those the establishment would earn if it were a distinct and separate enterprise dealing independently and at arm’s length with the rest of the enterprise.
- In applying Article 7 to a bank branch, properly maintained branch books are a starting point for measuring the elements of profit, including funding costs reflected through interbranch lending, subject to adjustments needed to reflect arm’s-length terms and appropriate capital allocation to the branch.
- A Treasury regulation governing the computation of a foreign corporation’s U.S. interest deductions cannot be applied to a treaty-protected taxpayer in a way that conflicts with the treaty’s profit-attribution rule, absent a clear overriding act of Congress.
- An interest-allocation method that computes a branch’s deductible interest by reference to worldwide assets and liabilities while ignoring internal funding transactions recorded on the branch’s books is inconsistent with a treaty rule requiring separate-enterprise profit attribution.

## Conclusion

National Westminster Bank PLC v. United States held that Article 7 of the 1975 U.S.–U.K. treaty required NatWest’s U.S. branch profits to be computed on a distinct-and-separate-enterprise basis that takes account of interbranch lending reflected on the branch’s properly maintained books (subject to limited adjustments), and that Treas. Reg. § 1.882-5’s worldwide interest-allocation method could not be used to deny or limit NatWest’s interest deductions in a manner inconsistent with that treaty standard for the years at issue.


National Westminster Bank PLC v. United States, 44 Fed. Cl. 120 (1999)