Which article of the U.K.–South Africa tax treaty—Article 7, on business profits, or Article 14, on income from employment—applies for the purpose of allocating taxing rights in respect of remuneration for services provided by a diver in the U.K. under a contract of employment?
This was the moot issue that the U.K. Supreme Court recently decided upon in the case of Fowler v. Commissioners for Her Majesty’s Revenue & Customs (Fowler). The unanimous decision by a five-judge Bench in Fowler was handed down on May 20, 2020, and is the second tax treaty-related case heard and decided by the U.K. Supreme Court.
The basic facts in Fowler are relatively simple and straightforward. Mr Fowler is a qualified diver and a tax resident of South Africa. In the tax years 2011–2012 and 2012–2013, he undertook diving engagements in the waters of the U.K. continental shelf. The dispute concerned whether the U.K. or South Africa is entitled to levy tax on Mr Fowler’s income derived from his diving activities during those two tax years.
It was common ground that, if Mr Fowler was self-employed, the answer to the question is South Africa. This is in view of Article 7 of the tax treaty, which grants the right to tax profits arising from a trade only to the country of the taxpayer’s residence in the absence of a “permanent establishment” in the source country. However, it was in dispute whether Mr Fowler was in fact self-employed. The case proceeded on the factual assumption that Mr Fowler was indeed an employee in those years.
The complicated nature of the dispute left U.K. courts divided: Judge Brannan in the First-tier Tribunal answered the question in Mr Fowler’s favor, but Judge Marcus Smith, in the Upper Tribunal, reversed that decision. The Court of Appeal, by a majority of 2:1, allowed the appeal by Mr Fowler. And finally, on May 20, a five-judge Bench of the Supreme Court unanimously decided in favor of HM Revenue & Customs (HMRC).
The Tax Treaty and the Deeming Fiction in U.K. Tax Law
The tax treaty between the U.K. and South Africa came into force in the U.K. by means of the Double Taxation Relief (Taxes on Income) (South Africa) Order, 2002 (SI 2002/3138). The Preamble to the tax treaty states that the treaty has been agreed for the purpose of promoting and strengthening the economic relations between the two countries, avoiding double taxation, and preventing fiscal evasion. Importantly, as the U.K. Supreme Court correctly notes in its decision, there is no general provision in the tax treaty to deal with double non-taxation of income.
The dispute between the parties arose because Article 3 of the tax treaty, which defines the words “business” and “enterprise,” does not define the word “employment”: it was Mr Fowler’s position that since the tax treaty did not define the word “employment,” it was necessary to look into the domestic tax law meaning of the word to ascertain if his earnings were indeed taxable under, and in accordance with, the U.K. tax law. Clause 2 permits this.
Article 3(2) of the tax treaty provides that any term not defined in the treaty shall, unless the context otherwise requires, have the meaning that it has under the domestic tax law at the time of implementing the treaty. In similar vein, Article 3, paragraph 4, of the Vienna Convention on the Law of Treaties (VCLT) notes that “a special meaning shall be given to a term if it is established that the parties so intended.”
To ascertain the domestic tax law meaning of the word “employment,” the court had to inevitably examine a few provisions from the U.K. domestic tax law. Section 4 of the Income Tax (Earnings and Pensions) Act, 2003 (ITEPA) defines “employment” to, inter alia, include “any employment under a contract of service.”
Section 6 of the ITEPA provides for the nature of charge to tax on employment income and clause (5) states that employment income is not charged to tax under this Part if it is within the charge to tax as trading income by virtue of Section 15 of the Income Tax (Trading and Other Income) Act, 2005 (ITTOIA).
Section 15 of the ITTOIA states that it applies if a person performs the duties of employment as a diver or diving supervisor in the U.K., the duties consist wholly or mainly of seabed diving activities (as stipulated in clause 3), and any employment income from the employment would otherwise be chargeable to tax under the ITEPA. Clause 2—which was at the center of discussion—notes that “the performance of the duties of employment is instead treated for income tax purposes as the carrying on of a trade in the U.K.”
To sum up, the taxpayer’s contention was that in the absence of a definition of the word “employment” in the tax treaty, Article 3(2) requires the court to delve into the meaning of the term stipulated in the U.K.’s domestic tax law. In view of the deeming fiction contained in Section 15(2), the taxpayer contented that the diving activities carried on by the taxpayer in the U.K. continental shelf be instead treated as the carrying on of a trade in the U.K. for income tax purposes, including for tax treaty purposes.
Because earnings from diving activities are deemed as trade and taxed as such under the U.K.’s domestic tax law, the taxpayer argued that the relevant Article under the tax treaty to govern his income was Article 7 (on business profits), and not Article 14 (on income from employment). And because the taxpayer did not have a permanent establishment in the U.K., his earnings would only be taxable in South Africa, if at all, in view of Article 7.
Decision of the U.K. Supreme Court
The taxpayer’s arguments did not find the favor of the U.K. Supreme Court. The Court’s decision begins with an observation that “nothing in the tax treaty requires articles 7 and 14 to be applied to the fictional, deemed world which may be created by the UK income tax legislation.” The Court added: “the meaning of ‘employment’ is laid down in section 4 of the ITEPA, and his remuneration plainly constitutes employment income. UK tax law would not regard him as making profits from a trade, or his business as being that of as establishment.”
The Court then went on to briefly examine the purpose for which the deeming fiction under Section 15(2) of the ITTOIA was created in the first place. The Court noted that the fiction was created “not for the purpose of deciding whether qualifying employed divers are to be taxed in the UK upon their employment income, but for the purpose of adjusting how that income was to be taxed, specifically by allowing a more generous regime for the deduction of expenses.”
The Court observed that “to apply the deeming provision in section 15(2) of the ITTOIA so as to alter the meaning of terms in the tax treaty with the result of rendering a qualifying diver immune from UK tax would be contrary to its purpose and would produce an ‘anomalous result.’”
Finally, the Court observed that Article 3(2) of the tax treaty should not be construed to bring a qualifying diver within Article 7, and not Article 14, of the tax treaty. That construction, the Court noted, would be “contrary to the purposes of the treaty.” In this regard, the Court referred to Article 2(1) of the tax treaty, which states that the treaty is not concerned with the way a tax falling within the scope of the treaty is levied.
Interpreting the Role of Interpretation
In December 2009, noted American jurist Ronald Dworkin, while speaking at the U.S. Library of Congress as the inaugural lecturer in the Frederic R. and Molly S. Kellogg Lecture Series in Jurisprudence, sparked a thought-provoking debate on whether there is truth to be had in interpretation. Dworkin suggested that the legal instruments are interpreted best when the role of interpretation itself is interpreted correctly.
In questions of true interpretation, the right answer depends upon how one looks at the legal principles involved in a given case and if that answer is inspired by, and grounded in, solid legal reasoning. The Supreme Court’s reading of the tax treaty in Fowler, unfortunately, does not best serve the responsibility of the purpose of interpretation as Dworkin would see it.
The U.K.–South Africa tax treaty was signed on July 4, 2002 and entered into force on December 17, 2002. As noted above, the Preamble to the U.K.–South Africa tax treaty does not include prevention of double non-taxation as one of its purposes. In any event, the Court itself noted that the fact that South Africa exempted foreign employment income from the purview of its domestic tax rules, resulting in double non-taxation of Mr Fowler’s income (given that the income would also not be taxed in the U.K. in view of Article 7), would not have a bearing on the merits of the dispute. Besides, the exemption of foreign employment income from tax in South Africa flows from the government’s exercise of sovereign power and such unilateral domestic tax measures should not guide or inform the interpretation of treaty provisions.
A true reading of the word “shall” used in Article 3(2) of the tax treaty would mean that courts have no option but to look at the domestic meaning of an undefined term. The only exceptions are cases in which the context of the tax treaty otherwise requires. However, the court did not spend much time and effort in trying to examine the context of the tax treaty and what that context requires.
Besides, the rules of interpretation set out in Articles 31 and 32 of the VCLT are rules of customary international law and are binding on both contracting states, i.e. both the U.K. and South Africa. The importance of the principles of interpretation set out in the VCLT cannot be stressed enough: they exist to ensure uniformity in the application of the principles across jurisdictions and prevent national courts from imposing their views on how international instruments should or ought to be interpreted and applied. Article 32(4) of the VCLT provides that a special meaning shall be given to a term if it is established that the parties so intended. It is difficult to subscribe to the Court’s view that Section 15(2) of the ITTOIA did not provide a special meaning to the term “employment,” because it clearly did.
In the author’s view, there is no clear conflict between Article 14 of the tax treaty and Section 15(2) of the ITTOIA: the deeming fiction in Section 15(2) applies to treat diving activities instead as the carrying on of a trade, whereas the treaty is silent on the issue in that it nowhere states that employment should not or cannot be considered as the carrying on of trade. This is particularly important to note given that the Court’s reasoning surrounding the purpose behind the introduction of the deeming fiction in Section 15(2) of the ITTOIA seems to flow from the fact that Section 15(2) does not expressly state that the deeming fiction was meant to adjudicate “between the UK and South Africa as the potential recipient on tax.”
Pertinently, the words employed in Section 15(2) of the ITTOIA are “for income tax purposes,” which are wide enough to cover tax treaties, which are given effect to in the U.K. domestic law by virtue of Section 6 of the Taxation (International and Other Provisions) Act, 2010. Lord Asquith in East End Dwelling Co Ltd v. Finsbury Borough Council (1952) famously said: “The statute says that you must imagine a certain state of affairs; it does not say that having done so, you must cause or permit your imagination to boggle when it comes to the inevitable corollaries of that state of affairs.”
The effect of the deeming fiction in Section 15(2) is that Mr Fowler’s diving activities are treated as carrying on of a trade, giving rise to trading income and charged to U.K. tax as such. This, in turn, entirely displaces the charge to tax on employment income, which would have been applied but for the deeming fiction. Once that happens, and Mr Fowler’s diving activities are treated as the carrying on of a trade, and not employment duties, the remuneration derived from the diving activities cannot be said to be derived from employment.
In Fowler, the U.K. Supreme Court had a rare opportunity to add to the existing jurisprudence on the true role that Article 3(2) of the tax treaty as well as Articles 31 and 32 of the VCLT assume in the context of deeming fictions created by domestic tax laws. Not only was that opportunity lost, the Court’s decision raises more questions than it embarked upon to answer.
Ashish Goel is an international tax lawyer with Comtax AB, Sweden.
The author may be contacted at email@example.com
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.