I. Case Overview
Mr. F, a South African tax resident, worked as a diver on the UK continental shelf in the North Sea. Under UK tax law, “divers and diving supervisors employed on the UK continental shelf are deemed to be engaged in a trade or business for tax purposes,” meaning the income they earn is taxed as business income in the UK. Based on this rule, Mr. F argued that if his activities are considered a “trade or business,” he should be able to apply the “business profits” clause under the UK-South Africa Double Taxation Agreement (the “Treaty”). Since he did not have a permanent establishment in the UK, he believed he should only be taxed in South Africa. However, UK HM Revenue and Customs (HMRC) disagreed, stating that the “employment income” clause in the tax treaty should apply based on the nature of the employment, meaning Mr. F’s income should be taxed in the UK. Mr. F appealed this decision. Both the First-Tier Tribunal and the Upper Tribunal dismissed his appeal, but the Court of Appeal ruled in his favor. Ultimately, the Supreme Court decided that Mr. F’s diving income should be treated as “employment income” under the tax treaty and therefore be taxed in the UK.
II. Key Point of Dispute
The main issue was whether the UK’s domestic law, which treats diving income as “business income,” could override the actual employment relationship described in the tax treaty. Essentially, could the UK’s domestic classification of diving income as “business income” prevail over the fact that Mr. F was employed, and thus subject the income to the “business profits” clause instead of the “employment income” clause in the tax treaty?
The First-Tier Tribunal found that the UK’s rule treating diving income as “business income” was intended to provide divers with more favorable expense deductions than those typically available to employees. Mr. F’s claim was contrary to this intent, and the rule only determined how tax should be calculated, not where it should be paid. Therefore, according to UK law, the income should still be considered “employment income.”
The Upper Tribunal stated that the first step in interpreting the relevant provisions of a tax treaty is to see if there is a clear definition in the treaty itself. If not, domestic law should be considered, and if necessary, the Vienna Convention on the Law of Treaties should be used for a “good faith interpretation in accordance with the ordinary meaning.” The key to interpreting the “employment income” clause in the tax treaty is the state of being “employed,” rather than the nature of the income received. The UK’s rules for diving income merely clarify that it remains “employment income” and do not redefine the legal status of “employment.” Thus, the deemed tax treatment as “business income” does not affect the recognition of “employment status.” Therefore, the Upper Tribunal also believed the income should be taxed as “employment income” in the UK.
The Court of Appeal took a different view, citing a principle from the Marshall v Kerr case: “If a person is required to treat a certain deemed situation as reality, then they must also treat the necessary consequences or situations that accompany this deemed situation as reality, unless explicitly prohibited.” Hence, the Court of Appeal believed that the UK’s domestic rule deeming diving income as “business income” should also apply to the relevant clauses of the tax treaty, allowing the income to fall under the “business profits” clause.
III.Final Ruling
The Supreme Court ruled that, despite the UK’s domestic rule treating diving income as “business income” for tax purposes, this does not override the fact that Mr. F earned his income as an employee. When interpreting tax rules, one must consider both the domestic law and the starting point of the tax treaty. The purpose of a tax treaty is not to alter how countries determine taxable income or dictate how each country should tax specific types of income but rather to resolve issues of double taxation. In this case, there was a mismatch between the domestic law and the tax treaty. The Supreme Court concluded that Mr. F’s diving income should be taxed under the “employment income” clause of the tax treaty, meaning it should be taxed in the UK.
IV. Insights for International Businesses
Understand the Host Country’s Domestic Tax Laws: The Supreme Court highlighted that tax treaties do not change how countries apply their domestic tax laws. Different countries may follow various doctrines—such as “international law supremacy,” “domestic law supremacy,” or “dualism,” where international law and domestic law operate in parallel. However, the significant role of domestic law in practical application cannot be ignored. It is crucial to understand both the local tax laws and the rationale behind specific tax rules to conduct business effectively in the host country.
Clarify the Relationship Between Domestic Law and Tax Treaties: The Supreme Court ruled that the fact of “employment” takes precedence over the tax treatment of “business income.” Additionally, UK law, through principles like “piercing the corporate veil,” allows courts to disregard a company’s corporate structure in cases of misconduct, such as fraud, holding shareholders and directors personally liable. Although this principle is applied narrowly, UK law emphasizes the factual substance over the literal wording of legal provisions. Therefore, international businesses should evaluate the actual substance of their transactions and structures to avoid misinterpretation and non-compliance risks.
Familiarize with Legal Procedures for Resolving Tax Disputes: In this case, Mr. F’s challenge to the tax authority’s decision went through several stages, including the First-Tier Tribunal, the Upper Tribunal, the Court of Appeal, and finally, the Supreme Court. International businesses should understand the judicial system in the host country to better protect their interests in similar disputes.
