In the First-tier Tribunal, Judge Brannan described the case of Fowler v HMRC, which concerns the taxation of the taxpayer’s income as a diver, as raising a short but difficult point of interpretation. This turned out to be something of an understatement. The decision at each level of the judicial system was reversed on appeal. The final decision was delivered recently by the Supreme Court ([2020] UKSC 22). Apparently, this is the first Supreme Court case to be heard remotely.
The facts
In the tax years in question, 2011/12 and 2012/13, Mr Fowler was resident in South Africa. He was engaged as a qualified diver and performed the duties of his engagement in the UK Continental Shelf sector of the North Sea. There was a dispute between Mr Fowler and HMRC as to whether the nature of this engagement was that of an employment or a self-employed trade.
The law and the dispute between the parties
Mr Fowler contended that, even if his diving activities amounted to an employment, rather than a trade, his income from those activities was, by virtue of ITTOIA 2005 s 15, to be treated as the profits of a trade. Furthermore, as he did not carry on that trade in the UK through a UK permanent establishment, those profits were only chargeable to income tax in South Africa (article 7 of the 2002 UK/South Africa double tax treaty (‘the treaty’)).
ITTOIA 2005 s 15 provides that, where:
the performance of the duties of employment is instead treated for income tax purposes as the carrying on of a trade in the UK. ITEPA 2003 s 6(5) provides that employment income is not to be charged to tax under Part 2 of ITEPA 2003 if it is chargeable to tax as trading profits by virtue of s 15.
HMRC took the view that, even though s 15 might treat Mr Fowler’s income as trading profits under domestic tax law, that income still fell within article 14 (income from employment) of the treaty and, accordingly, Mr Fowler’s earnings from his diving activities in UK waters were not entitled to the exemption under article 7 for profits earned in the UK otherwise than through a UK permanent establishment. The role of articles 7 and 14 was to allocate taxing rights between the UK and South Africa according to the legal character of the activity, not any character deemed to apply for domestic tax law purposes. The fact that an employee cannot have a permanent establishment strongly indicated that article 7 could not be the applicable article. HMRC issued a closure notice to Mr Fowler on that basis and he appealed against the notice.
It was decided to defer the question of Mr Fowler’s status as either an employee or a self-employed contractor and to determine the effect of s 15 on the applicable article of the treaty as a preliminary issue. Accordingly, the FTT proceeded on the assumption that Mr Fowler satisfied the requirements of s 15, in particular that he was an employee at the relevant time and that his income derived from that employment would otherwise be chargeable to employment income tax. The question was how the treaty applied on the basis of that assumption.
The treaty and treaty interpretation
The relevant provisions of the treaty are those dealing with treaty interpretation, trading profits and employment income. The main provisions are as follows:
The treaty fell to be interpreted in accordance with articles 31 and 32 of the Vienna Convention on the Law of Treaties 1969. These articles provide that a treaty is to be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. Accordingly, international treaties are to be construed purposively, not literally. Those articles also specify the supplementary material to which recourse can be had to assist in treaty interpretation. As the treaty is based on the OECD Model Convention, recourse could be had to the OECD Commentary on points of interpretation.
When the treaty was concluded, the OECD Commentary said that, under article 3(2), ‘business’ in the business profits article should generally have its domestic law meaning but was silent on the application of article 3(2) to the word ‘employment’ in the employment income article. The Commentary now provides that, in accordance with article 3(2), whether duties performed in the source state amount to an employment is generally a matter for the domestic tax law of that state.
The decisions of the tribunals and the Court of Appeal
Although the FTT surmised that the purpose of s 15 may have been limited to giving divers engaged on the UK continental shelf the more generous rules for the deductibility of expenses that apply to the self-employed, it held that the effect of that section was not confined to requiring Mr Fowler’s income from his UK diving activities to be computed according to the UK’s domestic law rules applicable to trading profits. It extended, by virtue of article 3(2), to bringing that income within article 7, rather than article 14, of the treaty, because it treated that income as trading profits and did not intend that treatment to be confined to domestic law.
The UT reversed the FTT’s decision. It held that the term that defined the scope of article 14 was the term ‘employment’. That term was undefined and, accordingly, its meaning was to be supplied by domestic law by virtue of article 3(2). The term ‘salaries, wages and other similar remuneration’ had its own inherent treaty meaning and, accordingly, resort to article 3(2) was not permitted. Section 15 was not relevant to the definition of ‘employment’, because it relates, not to that definition, but to the definition of ‘employment income’. Likewise, the term that defined the scope of article 7 was the term ‘enterprise’, not ‘profits of an enterprise’. Again, therefore, a distinction was drawn between the taxpayer’s status (to which s 15 was not relevant) and the fruits of the status. Only the former delineated the scope of article 7.
The Court of Appeal restored the decision of the FTT. It started from the principle underlying deeming provisions that it is normally necessary to treat as real the consequences and incidents inevitably flowing from the deemed state of affairs (Marshall v Kerr [1993] STC 360). It then pointed out that ITTOIA 2005 s 15 treated the duties of Mr Fowler’s actual employment as a diver, for income tax purposes, as the carrying on of a trade in the UK. Section 15 did not just determine how Mr Fowler’s employment income was to be taxed. Rather, it substituted one (notional) source of taxable income for another (actual, but disregarded) source. Furthermore, the words ‘for income tax purposes’ in s 15 were clearly wide enough to embrace the purposes of double tax treaties.
Lewison LJ, dissenting, drew a distinction between what is taxed and how it is taxed. Section 15 had no bearing on what was taxed, namely employment income. The purpose of s 15 was merely to describe how Mr Fowler’s employment income was to be taxed, namely as trading profits. The treaty was concerned with the allocation of taxing rights over what was taxed to one contracting state or the other, not with how that state taxed it.
The decision of the Supreme Court
The Supreme Court found for HMRC, essentially agreeing with Lewison LJ. Its decision draws heavily on the nature and effect of deeming provisions. The court held that nothing in the treaty required articles 7 and 14 to be applied to any fictional world created by UK domestic law. Rather, they were to be applied to the real world, unless the effect of article 3(2) was that a deeming provision altered the meaning which relevant terms of the treaty would otherwise have. That is not normally what a deeming provision does and s 15 was no exception. It uses ‘employment’, ‘employment income’ and ‘trade’ in their conventional sense and does not alter the meaning of those terms in the treaty. It taxes income from employment but provides for it to be taxed as if, contrary to the fact, it was profits of a trade and, thereby, allows a more generous regime for the deduction of expenses.
Accordingly, the purpose of the fiction created by s 15 was not to allocate taxing rights between the UK and (in this case) South Africa but simply to adjust the basis on which the employment income of qualifying divers was taxed.
The ramifications of the Supreme Court’s decision
As deeming provisions are scattered throughout the UK’s tax code, the ramifications of Fowler could be very far-reaching. We will consider the potential implications for two kinds of deeming provision as they apply to employment taxes.
Provisions that treat income as employment income
As a result of Fowler, provisions that treat as employment income payments to employees that are not remuneration for services should not bring such payments within a conventional employment income article based on article 15 of the OECD Model Convention, unless (i) the term ‘salaries, wages and other similar remuneration’ is an undefined term (so article 3(2) potentially applies), and (ii) the purpose of the deeming provision includes altering the meaning of that treaty term so as to determine the allocation of taxing rights between the UK and the other contracting state.
The question whether the term ‘salaries, wages and other similar remuneration’ is an undefined term is unclear. There are cases at first instance (for example, Resolute Management Services Ltd v HMRC [2008] STC (SCD) 1202) that have applied domestic law by virtue of article 3(2). However, the UT in Fowler held that the term had its own inherent treaty meaning and, accordingly, resort to article 3(2) was not permitted.
Examples of income treated as employment income to which these principles may be relevant include:
Provisions that treat an activity or status as an employment
As a result of Fowler, provisions that treat as an employment an activity or status that belongs to some other category should not bring income derived from the deemed employment within an employment income article based on article 15, unless the purpose of the deeming provision includes altering the treaty meaning of ‘employment’ or ‘employer’, by virtue of article 3(2), so as to determine the allocation of taxing rights between the UK and the other contracting state.
There is a brief obiter discussion at the end of the decision of the UT in Fowler as to the effect that article 3(2) would have on the applicable article of the treaty (article 7 or 14) in relation to business income from a contract for services that was treated by a deeming provision of domestic tax law as a contract of employment. The UT thought that, depending on the nature and drafting of the deeming provision, article 14 might be the applicable article on the basis that, by virtue of article 3(2), the deeming provision supplied an extended treaty meaning of ‘employment’. An example of a deeming provision to which this question is relevant is the salaried members legislation. This treats a distribution out of the business income of a body corporate (an LLP) to a member (otherwise deemed to be a profit share) as his or her earnings under a deemed contract of employment.
The off-payroll working regime that applies to clients in the public sector (to be extended to the private sector next year) treats, in prescribed circumstances, an amount based on the fees paid by a client to an intermediary for the provision of a worker’s services as earnings derived from an employment between the worker and the client. Suppose (i) the intermediary and the worker are non-UK resident, (ii) the worker works for the client in the UK, and (iii) article 7 of the applicable treaty gives the other contracting state the exclusive right to tax the intermediary’s fees. The other contracting state’s exclusive right to tax the intermediary’s fees may not preclude the application of the off-payroll working regime (see Bricom Holdings Ltd v IRC [1997] STC 1179), which could lead to double taxation. The question for the worker would be whether he or she could resist the application of the off-payroll working regime on the grounds that the deemed earnings do not fall within article 15 (but are, perhaps, some form of ‘other income’). Following Fowler, that would depend on whether the off-payroll working regime is intended, by virtue of article 3(2), to alter the treaty meaning of ‘employment’ in article 15.
Finally, the decision in Fowler is relevant to HMRC’s ‘economic employer’ argument. The lack of a legitimate basis for that argument has been explained in this journal (‘Extending short term business visitors relief to overseas branches’ (Rhiannon Kinghall Were & Nigel Doran), Tax Journal, 1 June 2018), but in essence it denies the exemption in article 15(2) for the UK earnings of an employee of a non-UK resident employer who is seconded on a short-term basis to work for a UK resident company (generally a company in the same group as the employer), where the employee is economically integrated into the UK company’s business. This is on the basis that the term ‘employer’ in article 15(2)(b) should be interpreted, under article 3(2), according to domestic UK tax law. However, apart from the off-payroll working rules in the public sector, there is no provision of UK tax law or employment law that deems the UK company to be the employee’s employer. The economic employer argument is, therefore, simply inconsistent with the decision in Fowler.
Where does this leave us?
The Supreme Court has set a high bar for deeming provisions to alter the meaning of terms in double tax treaties. It could not see anything in the treaty to require a departure from the real world to a fictional world created by UK domestic law. Its decision is also a timely reminder of the importance of construing deeming provisions according to their language and purpose when seeking to determine the scope and extent of the fictional world to which the relevant tax is intended to be applied. The questions of statutory construction to which deeming provisions give rise are rarely straightforward but are of the utmost importance given their prevalence in UK tax law.
In the First-tier Tribunal, Judge Brannan described the case of Fowler v HMRC, which concerns the taxation of the taxpayer’s income as a diver, as raising a short but difficult point of interpretation. This turned out to be something of an understatement. The decision at each level of the judicial system was reversed on appeal. The final decision was delivered recently by the Supreme Court ([2020] UKSC 22). Apparently, this is the first Supreme Court case to be heard remotely.
The facts
In the tax years in question, 2011/12 and 2012/13, Mr Fowler was resident in South Africa. He was engaged as a qualified diver and performed the duties of his engagement in the UK Continental Shelf sector of the North Sea. There was a dispute between Mr Fowler and HMRC as to whether the nature of this engagement was that of an employment or a self-employed trade.
The law and the dispute between the parties
Mr Fowler contended that, even if his diving activities amounted to an employment, rather than a trade, his income from those activities was, by virtue of ITTOIA 2005 s 15, to be treated as the profits of a trade. Furthermore, as he did not carry on that trade in the UK through a UK permanent establishment, those profits were only chargeable to income tax in South Africa (article 7 of the 2002 UK/South Africa double tax treaty (‘the treaty’)).
ITTOIA 2005 s 15 provides that, where:
the performance of the duties of employment is instead treated for income tax purposes as the carrying on of a trade in the UK. ITEPA 2003 s 6(5) provides that employment income is not to be charged to tax under Part 2 of ITEPA 2003 if it is chargeable to tax as trading profits by virtue of s 15.
HMRC took the view that, even though s 15 might treat Mr Fowler’s income as trading profits under domestic tax law, that income still fell within article 14 (income from employment) of the treaty and, accordingly, Mr Fowler’s earnings from his diving activities in UK waters were not entitled to the exemption under article 7 for profits earned in the UK otherwise than through a UK permanent establishment. The role of articles 7 and 14 was to allocate taxing rights between the UK and South Africa according to the legal character of the activity, not any character deemed to apply for domestic tax law purposes. The fact that an employee cannot have a permanent establishment strongly indicated that article 7 could not be the applicable article. HMRC issued a closure notice to Mr Fowler on that basis and he appealed against the notice.
It was decided to defer the question of Mr Fowler’s status as either an employee or a self-employed contractor and to determine the effect of s 15 on the applicable article of the treaty as a preliminary issue. Accordingly, the FTT proceeded on the assumption that Mr Fowler satisfied the requirements of s 15, in particular that he was an employee at the relevant time and that his income derived from that employment would otherwise be chargeable to employment income tax. The question was how the treaty applied on the basis of that assumption.
The treaty and treaty interpretation
The relevant provisions of the treaty are those dealing with treaty interpretation, trading profits and employment income. The main provisions are as follows:
The treaty fell to be interpreted in accordance with articles 31 and 32 of the Vienna Convention on the Law of Treaties 1969. These articles provide that a treaty is to be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. Accordingly, international treaties are to be construed purposively, not literally. Those articles also specify the supplementary material to which recourse can be had to assist in treaty interpretation. As the treaty is based on the OECD Model Convention, recourse could be had to the OECD Commentary on points of interpretation.
When the treaty was concluded, the OECD Commentary said that, under article 3(2), ‘business’ in the business profits article should generally have its domestic law meaning but was silent on the application of article 3(2) to the word ‘employment’ in the employment income article. The Commentary now provides that, in accordance with article 3(2), whether duties performed in the source state amount to an employment is generally a matter for the domestic tax law of that state.
The decisions of the tribunals and the Court of Appeal
Although the FTT surmised that the purpose of s 15 may have been limited to giving divers engaged on the UK continental shelf the more generous rules for the deductibility of expenses that apply to the self-employed, it held that the effect of that section was not confined to requiring Mr Fowler’s income from his UK diving activities to be computed according to the UK’s domestic law rules applicable to trading profits. It extended, by virtue of article 3(2), to bringing that income within article 7, rather than article 14, of the treaty, because it treated that income as trading profits and did not intend that treatment to be confined to domestic law.
The UT reversed the FTT’s decision. It held that the term that defined the scope of article 14 was the term ‘employment’. That term was undefined and, accordingly, its meaning was to be supplied by domestic law by virtue of article 3(2). The term ‘salaries, wages and other similar remuneration’ had its own inherent treaty meaning and, accordingly, resort to article 3(2) was not permitted. Section 15 was not relevant to the definition of ‘employment’, because it relates, not to that definition, but to the definition of ‘employment income’. Likewise, the term that defined the scope of article 7 was the term ‘enterprise’, not ‘profits of an enterprise’. Again, therefore, a distinction was drawn between the taxpayer’s status (to which s 15 was not relevant) and the fruits of the status. Only the former delineated the scope of article 7.
The Court of Appeal restored the decision of the FTT. It started from the principle underlying deeming provisions that it is normally necessary to treat as real the consequences and incidents inevitably flowing from the deemed state of affairs (Marshall v Kerr [1993] STC 360). It then pointed out that ITTOIA 2005 s 15 treated the duties of Mr Fowler’s actual employment as a diver, for income tax purposes, as the carrying on of a trade in the UK. Section 15 did not just determine how Mr Fowler’s employment income was to be taxed. Rather, it substituted one (notional) source of taxable income for another (actual, but disregarded) source. Furthermore, the words ‘for income tax purposes’ in s 15 were clearly wide enough to embrace the purposes of double tax treaties.
Lewison LJ, dissenting, drew a distinction between what is taxed and how it is taxed. Section 15 had no bearing on what was taxed, namely employment income. The purpose of s 15 was merely to describe how Mr Fowler’s employment income was to be taxed, namely as trading profits. The treaty was concerned with the allocation of taxing rights over what was taxed to one contracting state or the other, not with how that state taxed it.
The decision of the Supreme Court
The Supreme Court found for HMRC, essentially agreeing with Lewison LJ. Its decision draws heavily on the nature and effect of deeming provisions. The court held that nothing in the treaty required articles 7 and 14 to be applied to any fictional world created by UK domestic law. Rather, they were to be applied to the real world, unless the effect of article 3(2) was that a deeming provision altered the meaning which relevant terms of the treaty would otherwise have. That is not normally what a deeming provision does and s 15 was no exception. It uses ‘employment’, ‘employment income’ and ‘trade’ in their conventional sense and does not alter the meaning of those terms in the treaty. It taxes income from employment but provides for it to be taxed as if, contrary to the fact, it was profits of a trade and, thereby, allows a more generous regime for the deduction of expenses.
Accordingly, the purpose of the fiction created by s 15 was not to allocate taxing rights between the UK and (in this case) South Africa but simply to adjust the basis on which the employment income of qualifying divers was taxed.
The ramifications of the Supreme Court’s decision
As deeming provisions are scattered throughout the UK’s tax code, the ramifications of Fowler could be very far-reaching. We will consider the potential implications for two kinds of deeming provision as they apply to employment taxes.
Provisions that treat income as employment income
As a result of Fowler, provisions that treat as employment income payments to employees that are not remuneration for services should not bring such payments within a conventional employment income article based on article 15 of the OECD Model Convention, unless (i) the term ‘salaries, wages and other similar remuneration’ is an undefined term (so article 3(2) potentially applies), and (ii) the purpose of the deeming provision includes altering the meaning of that treaty term so as to determine the allocation of taxing rights between the UK and the other contracting state.
The question whether the term ‘salaries, wages and other similar remuneration’ is an undefined term is unclear. There are cases at first instance (for example, Resolute Management Services Ltd v HMRC [2008] STC (SCD) 1202) that have applied domestic law by virtue of article 3(2). However, the UT in Fowler held that the term had its own inherent treaty meaning and, accordingly, resort to article 3(2) was not permitted.
Examples of income treated as employment income to which these principles may be relevant include:
Provisions that treat an activity or status as an employment
As a result of Fowler, provisions that treat as an employment an activity or status that belongs to some other category should not bring income derived from the deemed employment within an employment income article based on article 15, unless the purpose of the deeming provision includes altering the treaty meaning of ‘employment’ or ‘employer’, by virtue of article 3(2), so as to determine the allocation of taxing rights between the UK and the other contracting state.
There is a brief obiter discussion at the end of the decision of the UT in Fowler as to the effect that article 3(2) would have on the applicable article of the treaty (article 7 or 14) in relation to business income from a contract for services that was treated by a deeming provision of domestic tax law as a contract of employment. The UT thought that, depending on the nature and drafting of the deeming provision, article 14 might be the applicable article on the basis that, by virtue of article 3(2), the deeming provision supplied an extended treaty meaning of ‘employment’. An example of a deeming provision to which this question is relevant is the salaried members legislation. This treats a distribution out of the business income of a body corporate (an LLP) to a member (otherwise deemed to be a profit share) as his or her earnings under a deemed contract of employment.
The off-payroll working regime that applies to clients in the public sector (to be extended to the private sector next year) treats, in prescribed circumstances, an amount based on the fees paid by a client to an intermediary for the provision of a worker’s services as earnings derived from an employment between the worker and the client. Suppose (i) the intermediary and the worker are non-UK resident, (ii) the worker works for the client in the UK, and (iii) article 7 of the applicable treaty gives the other contracting state the exclusive right to tax the intermediary’s fees. The other contracting state’s exclusive right to tax the intermediary’s fees may not preclude the application of the off-payroll working regime (see Bricom Holdings Ltd v IRC [1997] STC 1179), which could lead to double taxation. The question for the worker would be whether he or she could resist the application of the off-payroll working regime on the grounds that the deemed earnings do not fall within article 15 (but are, perhaps, some form of ‘other income’). Following Fowler, that would depend on whether the off-payroll working regime is intended, by virtue of article 3(2), to alter the treaty meaning of ‘employment’ in article 15.
Finally, the decision in Fowler is relevant to HMRC’s ‘economic employer’ argument. The lack of a legitimate basis for that argument has been explained in this journal (‘Extending short term business visitors relief to overseas branches’ (Rhiannon Kinghall Were & Nigel Doran), Tax Journal, 1 June 2018), but in essence it denies the exemption in article 15(2) for the UK earnings of an employee of a non-UK resident employer who is seconded on a short-term basis to work for a UK resident company (generally a company in the same group as the employer), where the employee is economically integrated into the UK company’s business. This is on the basis that the term ‘employer’ in article 15(2)(b) should be interpreted, under article 3(2), according to domestic UK tax law. However, apart from the off-payroll working rules in the public sector, there is no provision of UK tax law or employment law that deems the UK company to be the employee’s employer. The economic employer argument is, therefore, simply inconsistent with the decision in Fowler.
Where does this leave us?
The Supreme Court has set a high bar for deeming provisions to alter the meaning of terms in double tax treaties. It could not see anything in the treaty to require a departure from the real world to a fictional world created by UK domestic law. Its decision is also a timely reminder of the importance of construing deeming provisions according to their language and purpose when seeking to determine the scope and extent of the fictional world to which the relevant tax is intended to be applied. The questions of statutory construction to which deeming provisions give rise are rarely straightforward but are of the utmost importance given their prevalence in UK tax law.
