Double taxation treaties and 'deeming': UK Supreme Court takes narrow approach

"Deeming provisions" in domestic legislation can be a difficult area in the application of double taxation treaties. One of the potential problems is that, if a party to a treaty deems a particular state of affairs to be something else, that country can in effect (inadvertently or not) distort the agreed allocation of taxing rights between the two countries. (See, for example, the wary approach to deeming in the OECD commentary on the Model Tax Convention).

The problem has been illustrated by the recent judgment in the UK Supreme Court in Fowler v HMRC that has ruled in HMRC's favour on a point of interpretation of the UK-South Africa double taxation treaty (DTT). In Fowler, the Supreme Court was keen to limit the scope of a domestic deeming provision, which would otherwise have seen employment earnings treated as trading profits under the DTT (with the result, in that case, that neither the UK nor South Africa would tax the income). The UK courts and HMRC are likely to take a similarly careful approach to domestic deeming provisions in other situations where these affect double taxation agreements.

The facts in Fowler

The taxpayer, Mr Fowler, was a qualified diver who was resident in South Africa. He undertook diving engagements in the waters of the UK Continental Shelf. The assumption made for the purposes of the preliminary issue addressed by the Supreme Court was that under general principles Mr Fowler undertook those engagements as an employee, rather than as a self-employed contractor.

HMRC argued that on that basis the income, which Mr Fowler earned from those diving engagements, should be taxed in the UK. Whether the UK could do so depended on how the DTT applied to a person in his position. The treaty provides for employment income to be taxed in the place where it is earned (that is, in the UK), but for the earnings of self-employed persons to be taxed only where they are resident (South Africa in this case).

Given the assumption that Mr Fowler was an employee, then, ordinarily, he should be taxable only in the UK on the relevant income. However:

• Certain employed divers in UK waters (including Mr Fowler) are, under UK tax law, to be treated as if they were self-employed for income tax purposes: section 15 Income Tax (Trading and Other Income) Act 2005 (ITTOIA); and
• Terms used in the DTT, if not defined in the treaty itself, are to be given the meaning that they have in the tax law, or the general law, of the state seeking to recover tax (here the UK).

The taxpayer therefore argued that the effect of the UK tax law’s requirement under Section 15 ITTOIA to treat certain divers as if they were self-employed should govern the meaning of relevant terms in the DTT, with the result that he was to be treated as self-employed under the treaty and therefore not taxable in the UK as HMRC accepted that he had no UK permanent establishment.

The Supreme Court's decision

The Supreme Court rejected the taxpayer's argument. Expressions in the DTT such as “salaries, wages and other remuneration”, “employment”, and “enterprise” should be given their ordinary meaning unless domestic legislation alters the meaning that they would otherwise have. Section 15 of ITTOIA provides that a person who would otherwise be taxed as an employee is “instead treated” as self-employed for the purposes of domestic income tax. While section 15 uses the expressions "income, "employment" and "trade", it does not change their meaning but rather takes their ordinary meaning as a starting point and taxes the earnings as though they were derived from a trade.

As this case demonstrates, the courts and HMRC will tread very carefully when construing deeming provisions. In particular, any interpretation that produced anomalous results, such as double non-taxation, is likely to be resisted as far as possible.