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Introduction: The Ardmore Construction Ltd v HMRC [2018] EWCA Civ 1438 case marks a significant examination of the “source” principle in UK tax law, a cornerstone concept dictating that income tax is only levied on income originating within the UK. This principle is integral to understanding territorial taxation and its implications on international tax practices. Ardmore specifically delves into the nuances of identifying the source of income—distinguishing between active and passive income—and the application of this principle in determining tax liabilities. The case provides a critical analysis of how the source of income, particularly interest income, is determined, factoring in the origin of economic activities and the roles played by the involved parties. This exploration is pivotal for tax practitioners, policymakers, and corporate entities, offering insights into the complexities of source-based taxation and its impact on cross-border financial arrangements.

Ardmore deals with the correct application of the “source” principle, which is the principle that tax is territorial and income tax is only payable on income from a source in the UK. Source-based taxation is a territoriality principle in international taxation. Tax at source means where the income or capital located in a state. (Shwarz)

Its general definition is subject to the application and cases like Overseas define the source as ‘origin’ of income rather than where it is located. Following CIR we know that the location of a source is determined when an ‘originating cause’ of the income is identifiable.

To do that we must first check what is the source from which we receive it and then we must locate the source. The location of a source is relevant to its nature i.e.; whether the income is passive or active(Shwarz). Active income mainly encapsulates some form of activity and passive income arises due to the use of an asset that generates an economic return. In this particular context, following Ardmore, we will look at the source of interest. Interest is accrued overexploitation of capital thus we may classify it as passive income. CIR is an important authority for locating the source of interest. In CIR the courts looked at the creditor, contracts, services and obligations performed by the South African source in order to determine whether there was a source of interest for withholding tax (WHT) purposes.

Ardmore primarily concerns two complex arrangements to lend capital to the borrowers residing in the UK without giving rise to the UK source. The taxpayer in the case argued for a single test approach but the Upper Tribunal held that the ‘correct test’ of the source of interest was multi-factorial.

While there is no universal test, so the court adopts a ‘practical approach’. While the multifactorial test did not help in selecting the determining factors and a ‘practical sense’ was applied (Rhodesia). The courts also concluded that Westminster Bank and National were applicable so the source to pay interest was pertinent and was established with regard to necessary factors.

A practical person would regard the source belonging to one administration by virtue of the facts and the courts must ‘examine’ all the relevant facts ‘singly and cumulatively’.

This raises concern as to how a practical person might find a source as a practical hard matter of fact. In the facts of the case if the collateral was held by Gibraltor to secure the source then a completely different scenario might have occurred. Determining source through the multifactorial test is at best ‘contentious’.

The courts aim to reduce the difficulty by removing the content but fail to consider the problems that may arise from factors being examined, in the absence of a guidance, the taxpayer would continue to contemplate on making a payment. One may even argue that courts in Ardmore tend to disregard legal outlook and look at the economic reality to determine the source. However, a Tax system is practical only if we include a legal reality. Income is an artificial construct, but legal systems need legal distinctions to function (Judith Freedman). Following the facts of Ardmore, it can be argued that the court may have achieved some form of clarification with regards to a test for source, but they do not purport to be aiming at certainty. Bringing certainty may give further rise to tax avoidance schemes and is undesirable, it is clarity of constitutional source and authority and the application of principles. (Freedman)

An opportunity to simplify the rules in this area had arisen but the outcome of a ‘practical person’ identifying a ‘practical hard matter of fact may complicate it even further. However, one may argue in favour of the courts that normal debt arrangement facts in a case are more complex than Ardmore and one for all approach adopted by the courts hold the status quo. There are two alternatives to the current outcome.

Statutory reform would be an approach that could provide greater clarity to the source of interest on WHT as we would be able to adopt a statutory definition of source drawing upon OECD principles. On the other hand, we may seek guidance from the courts as Hailsham’s judgment in the National suggested to take guidance from Income Tax Act in order to find a source relating to the obligation to pay interest on bond (foreign document).

However, it is only possible when a territorial assumption is invoked. This focus on the source of obligation appears to have been, at least implicitly, accepted by the Court of Appeal in Ardmore. Thirdly, private international law has itself matured. (Gerald), following the current rules dealing with conflicts of jurisdiction between the member states as set out in 12125/2012/EU on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters. This regulation provides a ‘domicile’ as the main ground for jurisdiction and Dicey suggests it is appropriate to interpret the test of residence, as applied in determining situs of debts, so as to take account of any developments in the law on choice of jurisdiction. Finally, the modern approach taken by Private international Law to ascertain residence is dictated by substantive considerations and looks at factors which are not apt to be distorted for the purposes of contrived abuse and thereby “go with the flow” of tax law in recent years(Angel Schnidel).

Conclusion: The Ardmore Construction Ltd v HMRC case presents a detailed dissection of the “source” principle within the framework of UK taxation law, contributing substantially to the discourse on territorial taxation. Through its examination of complex financial arrangements and the multifactorial test for determining the source of interest income, the court has underscored the necessity for clear, practical guidelines in identifying the origin of income for tax purposes. This ruling not only clarifies the legal landscape for taxpayers and practitioners but also signals towards the potential for legislative refinement to address the challenges inherent in source-based taxation. By emphasizing the importance of the economic reality over strict legal formalism, Ardmore enriches the understanding of tax law, encouraging a more nuanced application of principles that balance legal requirements with the practicalities of global finance. The case thus serves as a critical reference point for future discussions on the evolution of tax law, particularly in the context of international taxation and the ongoing efforts to harmonize tax practices in an increasingly interconnected economic environment.

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