What can an aircraft leasing case tell us about the interpretation of tax treaties? Quite a bit, as it turns out. In VietJet Aviation, the UK Court of Appeal dismissed the borrower’s arguments that an assignment of debt was invalid because the assignee was ineligible for treaty benefits and therefore not a “qualifying lender”. So, in confirming the High Court’s judgment in favour of VietJet’s creditors, the Court of Appeal has given us valuable guidance on the construction and application of the interest and anti-abuse articles in the double tax treaty between the UK and Japan (which largely mirror OECD model provisions). 

What was the case about?

As a result of Covid, VietJet, a Vietnamese airline, fell behind with payments under certain Japanese financing arrangements for some of its aircraft. FitzWalter Capital group, which operates funds investing in distressed credit assets, took over from the original lenders and started proceedings in the High Court to enforce the debt and take possession of the aircraft. VietJet resisted these proceedings, including on the basis that the assignment of rights from the original lenders to a certain FitzWalter entity (FWC) was invalid. 

Under the relevant loan agreement, the consent of the borrower was required for an assignment unless the assignee was a “Qualifying Lender” within the meaning of that loan agreement. VietJet’s consent had not been obtained, and VietJet argued that the assignment was therefore invalid because FWC was not a “Qualifying Lender”. 

The relevant aspect of the definition of “Qualifying Lender” required the assignee to be a lender which “benefits from a double tax treaty with Japan so that no withholding tax will be levied in relation to payments of interest […] being qualified as an entity that can receive such interest free of withholding tax under [that double tax treaty] and the relevant regulations”. Here, the relevant “double tax treaty with Japan” was that between the UK and Japan as signed on 2 February 2006 and amended by a Protocol signed on 17 December 2013 (the Treaty).

So, for the assignment to be valid, FWC had to be entitled to benefit from the exemption from interest withholding tax under Article 11(1) of the Treaty. VietJet argued that this was not the case because:

• FWC was either not an “exempt resident” as defined in Article 22(5) (this was Ground 3 before the Court of Appeal), or 
• FWC was disqualified from benefits under Article 11(1) because it failed the purpose test in Article 11(7) (Ground 4 before the Court of Appeal).

Ground 3: “exempt resident” as defined in Article 22(5)

To be an “exempt resident” under Article 22(5) of the Treaty, FWC had to be “carrying on business in the [UK] (other than the business of making or managing investments for the resident’s own account…)” (emphasis added). VietJet argued that, in taking the assignment, FWC was carrying out the “business of making or managing investments” for its own account, such that it could not be an “exempt resident”.

The Court of Appeal disagreed. The purpose of Article 22(5) was to prevent a taxpayer from claiming Treaty benefits in respect of investment income by reference to its place of residence if it did not undertake economic business activity there to earn that income. The Court of Appeal accepted FitzWalter’s argument that, if a person carried on a trade (rather than an investment business) for UK tax purposes, they were not engaged in a “business of making or managing investments” for the purposes of Article 22(5). Here, FWC’s business was in the nature of a trade: namely, buying loans in order to enforce the security and realise its value. 

Ground 4: purpose test in Article 11(7)

Article 11(7) of the Treaty provided that “no relief shall be available under [Article 11] if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the debt-claim in respect of which the interest is paid to take advantage of this Article by means of that creation or assignment”. VietJet argued that the FitzWalter group had chosen to incorporate FWC in England in order to take advantage of the Treaty. 

The Court of Appeal disagreed. It interpreted the phrase “taking advantage” as meaning more than simply taking the benefit of Article 11; instead, Article 11(7) should be read as an anti-abuse provision preventing a taxpayer from taking the benefit of Article 11 in a way which was “contrary to the object and purpose of the treaty”. On the facts, by the time FWC had taken the assignment, the loan had already been accelerated and it could not have received any interest payments anyway. Therefore, it could not have had a main purpose of taking advantage of the tax treatment of interest income available under Article 11. Furthermore, if any interest had been paid, FWC would have been subject to income tax in the UK, in accordance with the object and purpose of the Treaty as interpreted by the court. 

More broadly, the court had little sympathy with VietJet’s focus on the incorporation of FWC in England rather than anywhere else. Article 11(7) operated to prevent taxpayers from achieving favourable tax positions from an assignment of a loan, rather than from achieving contractual status (such as through incorporation in a particular jurisdiction) which entitled them to take such an assignment. 

What’s next for treaty purpose tests?

The equivalent purpose test in the UK-Ireland treaty is key to HMRC’s appeal of the Upper Tribunal’s decision in Burlington Loan Management which the Court of Appeal is scheduled to hear in December. Burlington concerns an Irish-resident company’s claim for treaty relief from UK withholding tax in respect of interest paid on a receivable assigned to it by a Cayman company (which would have suffered the withholding in full) where the price paid for the receivable reflected the assignee’s expectation to be able to benefit from the treaty. I wouldn’t be surprised if the hearing and eventual decision featured a consideration of VietJet Aviation.