Substance, Tax Treaties and the UK Supreme Court in Royal Bank of Canada

Last week’s Supreme Court judgment in Royal Bank of Canada v. HMRC [2025] UKSC 2 casts a spotlight on – among a wide range of other things – the UK’s approach to tax substance which will be of interest to the worlds of private capital and financial institutions.

UK tax law and practice have generally shied away from employing an overarching economic substance doctrine to police entitlement to tax treaty benefits. This can make the UK appear an island of (relative) certainty in contrast to some continental European jurisdictions, where the prospect of a unifying approach to substance held out by the proposed ATAD III directive is now apparently receding fast. 

Asset managers structuring investments into Europe therefore continue to grapple with the need to satisfy shifting, and sometimes conflicting, source state requirements in respect of investing entities such as holding company platforms and SPVs. In contrast, reliance on a tax treaty to achieve an expected UK tax treatment is typically not contingent on meeting and managing substance-based criteria such as company premises, staff and payroll, own-name bank accounts, or a diversified asset base and sources of income.

The judgment in Royal Bank of Canada may concern an unusual and historic fact pattern, which is highly specific to the natural resources sector, but it also reasserts this orthodox UK approach to tax treaties in a way that is generally likely to reassure inbound investors into the UK.

RBC financed a Canadian company, Sulpetro Ltd (Sulpetro), with a sizeable loan which Sulpetro used to fund offshore oil exploration and exploitation under a UK Government-granted license which was required to be held by a UK subsidiary (Sulpetro (UK)). Sulpetro (UK) had an obligation, under the license and an accompanying Illustrative Agreement, to pay a royalty to the Government and to land the oil (which Sulpetro owned and then sold on) on the UK mainland but otherwise had no asset base and no material activities. 

Sulpetro subsequently transferred this business, including Sulpetro (UK), to BP, formerly the operator of the oil field, for cash consideration plus a quarterly contingent payment payable to the extent the price per barrel extracted from the field exceeded $20 (the Payments). Sulpetro subsequently entered insolvency proceedings in Canada as a result of which the receiver assigned Sulpetro’s right to the Payment to RBC who wrote off the outstanding loan and paid Canadian tax on the Payment but no UK tax (whether through RBC’s UK branch or otherwise).

The question before the Supreme Court concerned whether, and on what basis, the UK enjoyed taxing rights over the Payments. As a Canadian resident receiving business profits other than through a UK permanent establishment, RBC might have expected to enjoy protection from UK taxation under the UK-Canada double taxation treaty through the exclusive allocation of the right to tax the Payments to the residence state. 

The immovable property article, however, gives the source state another bite of the cherry: “rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources and other natural resources” are deemed for the purposes of the treaty to be themselves immovable property and may be taxed in the non-residence state – and the UK does duly exercise, for profits of this nature, those taxing rights under the corporation tax regime for oil-related and UK continental shelf activities (ss 1313 CTA 2009 and 279A CTA 2010). 

Were the Payments, which arose under the transfer agreement with BP for Sulpetro’s UK oil business, consideration for the working of / right to work the oil field, and so taxable in the UK (at the then-applicable rate of 62%) by virtue of the treaty’s deeming provision? 

If they were anything else, they would be generic business profits and so have the non-UK taxable treatment that RBC would undoubtedly have expected when, as a result of Sulpetro’s receivership, its loan was replaced by a contingent payment right in the form of the Payments. Precisely how to classify the Payments, which had earn-out qualities but were inconsistently referred to as royalties (the actual royalty on the license was payable by Sulpetro (UK) to the Government), for tax purposes seems to have eluded the various courts or (ultimately) not to have mattered.

The approach taken by Lady Rose’s leading judgment, following that of Falk LJ in the Court of Appeal, was to focus on the strict legal reality of the arrangements. Sulpetro (UK), and not its parent company, had the UK Government-granted right to explore and exploit of the oil field, the obligation to pay the (actual) royalty in respect of oil extracted, and was answerable to the Secretary of State for the discharge of its obligations under the license in respect of its exploration and exploitation activities. 

As a limited company with legal personality, Sulpetro (UK) contracts under English law in its own right irrespective of considerations of its economic substance. The (Government-approved) agreement between the parties required Sulpetro to bear the costs of the exploration, in exchange for owning and receiving all the actual oil extracted, but did not change the fact that only Sulpetro (UK) had the actual license and the legal entitlement to the oil. As a result, the right to work the natural resources was Sulpetro (UK)’s only and the consideration payable to Sulpetro was (whatever else it was) not consideration for that right and so didn’t fall to be treated as UK immovable property.

In taking this approach to construing the treaty, Lady Rose said of the deeming provision in the treaty that:

Any definition which extends the meaning of a term such as “immovable property” beyond what would normally be included in it creates its own penumbra of uncertainty in a different place from the penumbra that exists around the ordinary meaning of the term. There must be a dividing line somewhere between what is caught and what is not caught and that has the inevitable consequence that some cases will fall on one side of the line and others on the other side even though they appear similar in economic terms.

This approach of seeking certainty and clarity of tax treatment where reasonably available based on a transaction’s legal reality may resonate with anyone grappling with recent and evolving European approaches to substance and beneficial ownership. Securities financing transactions present a good example of the latter, with the courts and tax authorities of various jurisdictions taking the approach of ignoring the legal reality of the transactions (under a stock loan, say, the disposal of securities by the lender who therefore does not receive the income arising during the term of the loan) on the basis of a supposed economic reality (i.e., that manufactured payments received by the lender may be equated with the income). 

The uncertainty that this can open up is considerable. Just as there are important legal differences between owning securities and having contractual rights based on them, or between making an investment outright and making it through an SPV, so in Royal Bank of Canada the majority judgment held that “[t]here is a legal difference between someone having a right to work natural resources and someone having a right to require another person to work those natural resources”. Sulpetro had the latter but not the former and as a result the Payments were protected under the treaty.

Dissenting judgments in tax cases in the UK’s highest courts are (increasingly) rarities and so attract attention when they do appear. In “lonely disagreement” with the majority, Lord Briggs’s tightly-reasoned dissent uses principles of statutory (and UK treaty) construction to argue that the required realistic view of the facts at hand does necessitate an economic analysis which in turn justifies the conclusion that Sulpetro had the right to work the oil field and the Payments were consideration for the disposal of that right:

Although Sulpetro (UK) remained the holder of the relevant government licenses, its role in the working of the hydrocarbons to which the licences related became nothing more than that of a not for profit (or loss) risk-free puppet, with all its relevant strings being pulled by Sulpetro, which thereby enjoyed the whole of the economic benefits and risks of the working of that share.

It is notable that the brief dissent uses the term “substance” repeatedly in reaching the conclusion that the right held legally by Sulpetro (UK), as a “wholly-owned subsidiary, acting as [the parent’s] puppet and at no charge”, should be imputed to its parent Sulpetro for the purposes of the treaty. This use of an overarching economic override of a transaction’s legal reality would represent a novel approach to UK treaty construction in a non-tax avoidance case. 

The scope for that override to create its own penumbra of uncertainty may be illustrated by a counterfactual in which the license-owning UK SPV was owned not by a sole parent company but by a consortium of three 1/3 joint venture partners or coinvestors, perhaps with contract outsourcing of operational services. Where would ownership for treaty purposes lie in that case – fragmented across the three owners, or perhaps with the operator, or would it return to the level of the UK SPV – and how would you start to apply the treaty? Sometimes sticking to legal reality has much to recommend it.

Ultimately the fact that avoidance and artificiality were not at issue in Royal Bank of Canada – unlike in the SPV business rates case of Hurstwood Properties v. Rossendale Borough Council [2021] UKSC 16, decided by the Supreme Court on statutory interpretation grounds and with a leading judgment by Lord Briggs – was determinative in the judgment of the majority (para. 90). The treaty purpose case of Burlington Loan Management v. HMRC, recently heard in the Court of Appeal, may also throw further light on the UK’s approach to this area in the context of a transaction which involved entities of substance (BLM had $6.9bn of assets) but was classed by HMRC as a form of engineered arbitrage. 

The approach taken by the Tribunals in Burlington, of unpicking the parties’ respective percentage economic returns from the transaction, has parallels with prominent jurisprudence in the Swiss Federal Supreme Court and may be effective in isolated cases but could prove to be a blunt tool in more sophisticated scenarios (e.g., broker-dealers and other market participants who may trade at high volumes on small margins and thereby provide market liquidity).

The fact that the majority in Royal Bank of Canada upheld the conventional approach taken by the Court of Appeal, and declined to follow the substance-based approach taken by Lord Briggs and the lower Tribunals, is to be welcomed and will appear to many to ensure an appropriate outcome on these facts. Whether the UK’s general aversion to the fiscal doctrine of economic substance continues in the long run, however, remains to be seen and investors and their advisers will be watching this space keenly.

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