The Spanish National High Court (AN - Audiencia Nacional in Spanish) issued a decision, recently published (case number 281/2012), where it upholds that the authorized Organisation for Economic Co-operation and Development (OECD) approach which was included in the Commentaries to article 7 of the OECD Model tax Convention in 2008 cannot be used to determine the profits and free capital to be attributed to Spanish permanent establishments (PEs) of non-Spanish resident banks when the applicable tax treaty was signed prior to 2008.
The resolution is of special interest in relation to the rules governing the interpretation of Tax Conventions to Avoid the Double Taxation on Income and on Capital (the tax treaty/ies) in light of the OECD Commentaries to the Model Tax Convention (the Commentaries) and the OECD Transfer Pricing Guidelines.
Background
The Spanish branch of a Dutch Bank NV operated in Spain with a single financial license obtained by the Dutch Central Bank.
The Spanish tax audit re-assessed the tax returns filed by the Spanish branch for fiscal years 2002 and 2003 and disallowed the deduction of a portion of interest expense recorded by the branch (with the head office and with a related party), on the grounds that said portion should be allocated to the free capital of the branch.
The Spanish tax authorities determined the amount of free capital based on the solvency ratio required for financial entities as provided for in Directive 2000/12/EC1 and in the Bank of Spain Circular 5/1993,2 which implements the Directive and accepted that the Spanish branch complied with the mercantile/financial conditions under the above-mentioned dispositions, since these ratios were complied with by the Dutch head office. However, they took the view that the Spanish branch's financial statements did not reflect an appropriate level of own funds (free capital) for tax purposes. Therefore, the Spanish tax authorities determined the amount of free capital required for the PE for tax purposes based on article 7.2. of the Spain-Netherlands tax treaty (1971) and disallowed part of the deduction of the interest expense.
The decision
The main question dealt with in the AN's decision is whether the authorized OECD approach which was included in the Commentaries to article 7 of the OECD Model in 2008, and which was used as the grounds for the reclassification by the tax authorities, may be retroactively applied to years 2002 and 2003.
The AN ruled in favor of the taxpayer based on the following summarized arguments:
- The AN sets forth that tax treaties prevail over domestic law and that the OECD Commentaries are merely interpretative tools in respect of the same; the AN takes the view that such soft law cannot apply when it introduces material changes to international tax and that, when this is the case, a static interpretation of the Treaty in light of the Commentaries that were in force when the Treaty was signed must be made (assuming that the Treaty clauses follow the OECD Model Tax Convention). The AN highlights that a dynamic interpretation of tax treaties or of the Model Tax Convention should only be allowed when there are no substantial or material changes.
- In the instant case, the AN considers that the 2008 Model Tax Convention and the 2006 Report on the Attribution of Profits to PEs introduced far-reaching changes in respect of the attribution of free capital to PEs. In essence, in the Court's view, it may not be considered that the change from an attribution of profits following a separate entity approach to one following the authorized approach, based on a functional analysis (considering functions, assets and risks), is a mere clarification of the wording of the Model Tax Convention. Therefore, the AN rejects such dynamic interpretation to calculate the amount of free capital as such dynamic interpretation would constitute an infringement of the principles of non-retroactivity of the Law, legitimate expectations and good faith.
- Finally, the AN takes the view that, since the Spanish tax authorities did not produce evidence that revealed that the attribution of profit made by the taxpayer was not arm's length and did not evidence how other financial entities in similar conditions (EU financial companies acting in Spain by means of a branch) operated, the tax assessments which had been filed should be allowed.
Impact
The AN's decision addresses the attribution of free capital to banking branches and, perhaps more importantly, sets forth that soft law may not replace the functions of the legislative power or introduce differences in the substance of the meaning, terms and scope of domestic legislation or bilateral treaties therefore laying grounds for the restriction to the dynamic interpretation of tax treaties.
Whether the attribution of free capital to Spanish PEs is duly supported from a Spanish transfer pricing perspective should, in any case, be reviewed. A case-by-case analysis should be made considering the facts and circumstances of each PE and the tax treaties applicable to each fact pattern. Also Spanish multinational companies should reconsider whether the attribution of free capital to PEs abroad is duly supported.
Bron: EY
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