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IN THE UNITED STATES COURT OF FEDERAL CLAIMS ____________ No. 95-758T (Judge Nancy B. Firestone) NATIONAL WESTMINSTER BANK PLC, Plaintiff v. THE UNITED STATES, Defendant. _____________
EXPERT REPORT OF A. LAWRENCE KOLBE ON THE CAPITAL ISSUE
Prepared for the U.S. Department of Justice
The Brattle Group 44 Brattle Street Cambridge, MA 02138-3736 617.864.7900 voice 617.864.1576 fax March 4, 2005
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Table of Contents INTRODUCTION AND SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Purpose of Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Disclosure Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Summary of Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Organization of Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 NATURE OF THE ASSIGNMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 The Inland Revenue Banking Manual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Economic Concepts Highlighted by Inland Revenue Banking Manual . . . . . . . . . . . . . . 7 Functions of Bank Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Investments Made with Bank Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 ANALYSIS OF PLAINTIFF'S APPROACHES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Original Tax Return Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Revised Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 ATTEMPT TO DEVELOP AN ECONOMICALLY REASONABLE APPROACH . . . . . . . . . . . . . . . . . . . . 23 Inadequate Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Facts and Principles that Must Be Ignored . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Appendix A: QUALIFICATIONS OF A. LAWRENCE KOLBE . . . . . . . . . . . . . . . . . . . . . A-1 Appendix B: MATERIALS CONSIDERED BY A. LAWRENCE KOLBE . . . . . . . . . . . . . . B-1 Appendix C: EXAMPLES OF FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . C-1
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I.
INTRODUCTION AND SUMMARY
My name is A. Lawrence Kolbe. My business address is The Brattle Group, 44 Brattle Street, Cambridge, Massachusetts, 02138. I am a Principal and a Director of The Brattle Group, Inc. ("Brattle"), an economic, environmental and management consulting firm with offices in Cambridge, Washington, London and San Francisco. Among other duties, I lead the firm's financial economics practice. My work concentrates on financial and regulatory economics. I hold a B.S. in International Affairs (Economics) from the U.S. Air Force Academy (1968) and a Ph.D. in Economics from the Massachusetts Institute of Technology (1979). I left active duty in the Air Force in 1977. Before co-founding Brattle in 1990, I was a Director of Putnam, Hayes and Bartlett, and before that, a Vice President of Charles River Associates. I am co-author of three books and author or co-author of a number of articles. The principal topics of these publications involve investment issues such as the cost of capital, risk, and valuation. My latest book is entitled Capital Investment and Valuation. It is one of a two-volume set that lists "The Brattle Group" as third author with Professors Richard A. Brealey and Stewart C. Myers. The set adapts their leading textbook, Principles of Corporate Finance, now in its seventh edition, for business professionals, rather than graduate students.1 Clients for my work have included federal, state and local government agencies, industry organizations, and numerous private firms, in a variety of industries. I have testified on financial and regulatory issues in many forums. These include international arbitrations in The Hague, London and Melbourne, Australia; lawsuits in U.S. courts; U.S. arbitrations; and regulatory proceedings before U.S. and Canadian federal, state and provincial regulatory bodies. Appendix A provides more detail on my professional qualifications. A. Purpose of Report
I have been asked by counsel for the U.S. Department of Justice ("DOJ") to evaluate the capital of the U.S. branches of National Westminster Bank, PLC ("NatWest"), during tax years 1981 to 1987, in accordance with the opinions and orders of Judge Turner2 and Judge Firestone3 that have interpreted Article 7(2) of the U.S.-U.K. Tax Treaty. As expressed in the Court's 2003 Opinion, I have been asked to consider "amounts designated as capital" on the branches' books and amounts
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The companion volume, Financing and Risk Management, was adapted by Mr. James A. Read, Jr., another Brattle Principal. All of these volumes are published by McGraw-Hill. 44 Fed. Cl. 120 (1999). 58 Fed. Cl. 491 (2003) ("Court's 2003 Opinion"); Transcript, August 18, 2004 (capital issue includes historic expenditures for premises and fixed assets) ("Court's 2004 Transcript"); January 18, 2005, Order Denying Reconsideration (capital issue does not include capital on books of NatWest PLC) ("Court's 2005 Order").
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"in fact allotted" to the branches "for capital purposes."4 I have been instructed to be guided in this regard by the U.K.'s Inland Revenue Banking Manual,5 which the Court has ruled provides an "adequate basis" to resolve the capital issue.6 Specific enquiries are to include: · The manner in which NatWest has determined branch capital and calculated interest expense. Whether the Plaintiff's approach7 is the only approach under the Inland Revenue Banking Manual. Whether the Plaintiff's approach fully implements the language of the Inland Revenue Banking Manual. Whether plaintiff's approach yields the goal of a "reasonable result" as expressed in the Inland Revenue Banking Manual and an economically sound and reasonable result regarding the profits a branch "might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment" as provided in Treaty Article 7(2). If plaintiff's approach does not yield an economically reasonable result, whether it is possible from information in the record to identify another approach that might be applied in accordance with the Court's opinions and would yield a more economically sound result under the Treaty. If such an alternative approach is possible, the amount of capital allotted to the U.S. branches under such an alternative approach and the necessary adjustments to interest expense, if any, for NatWest's U.S. branches for the years in question.
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My examination of the evidence concerning these matters is from the standpoint of a financial economist. I do not address questions concerning purely legal, accounting or operational issues. This report reflects my analyses and findings to date. However, my work is ongoing, and I expect
4
Court's 2003 Opinion at 505. Inland Revenue Banking Manual, Appendix 9A (1994) ("Inland Revenue Banking Manual"). Court's 2003 Opinion at 506. Actually, as discussed in the body of my report, Plaintiff has taken at least three approaches to attribution of branch capital over the period of this dispute; I analyze all of Plaintiff's approaches, to the extent I can given limits on available information that I identify below.
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to supplement this report in accord with the Court's schedule for such supplements, currently scheduled to be filed on May 2, 2005.8 B. Disclosure Compliance
Appendix A includes my publications for the last ten years and lists the trials, depositions and regulatory hearings at which I have testified during the last four years. The materials I considered in preparing my report are listed in Appendix B. Brattle has been compensated for my time in this case at a rate of $425 per hour. C. Summary of Findings
Briefly, my finding are: · NatWest has determined the amounts treated as allotted capital for its various branches in at least three different ways. The methods it originally used varied across different branches in the same year and across different years for the same branch. Its revised method appears to use a consistent methodology, but that methodology is one of those Plaintiff used originally, long before the Inland Revenue Banking Manual was written. Upon review, I find it is not grounded in the language of the Inland Revenue Banking Manual, and in some ways it appears to be inconsistent with that language. The Inland Revenue Banking Manual envisions a flexible approach, so no methodology could lay fair claim to being the only possible interpretation of the Inland Revenue Banking Manual. The Plaintiff's approach certainly can make no such claim. The Plaintiff's revised approach does not in general reach a reasonable result. For example, in some years for some branches, it produces negative amounts treated as allotted capital, yet the basic economics of the banking business mean that a bank must have positive capital. The same principles mean that a bank branch that is to be judged as "if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment" must have positive capital also, if the quoted phrase means in law what it says in English.9 Paragraph 2.1 of the Inland Revenue Banking Manual recognizes the economic reality that a bank or a branch of a bank may use some of its Free Working Capital (the quantity the Inland Revenue Banking Manual attempts to determine) to buy general income-producing assets. Such purchased assets may well be indistinguishable from other assets on the bank's
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·
·
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Court's 2005 Order. That is, this statement assumes that the legal meaning of the quoted phrase is not in opposition to the plain English meaning of the words. I am not an attorney, and I am not qualified to opine on the legal meaning of the words. This statement should not be read as an attempt to do so.
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or a branch's balance sheet, and if backed on the liability-and-equity side of a branch balance sheet by amounts not explicitly allotted as capital, there will be no simple way for an outsider to identify the funds in question as branch capital. Such issues instead will have to be addressed during the course of the negotiation envisioned by the Inland Revenue Banking Manual. · The data currently available in this case are such that, while adhering to the legal test described in the Court's 2003 Opinion, the Court's 2004 Transcript, and the Court's 2005 Order, I am unable to identify an economically reasonable approach to determine the amounts to be treated as allotted capital for NatWest's U.S. branches. The reasons for this involve (1) the fact that the data from the available books and records are incomplete, insufficient for the task in the present litigation, and in some cases anomalous, and (2) the fact that important considerations that might enable us to overcome these data problems, which we know to be true as a matter of institutional practice and/or economic principle, must be ignored as a matter of law, as I understand the Court's instructions on how to implement the Treaty. On its face, the Inland Revenue Banking Manual was written with the setting of a negotiation rather than a lawsuit in mind. In that setting, it appears that the Inland Revenue Banking Manual can in fact be successfully used to reach a reasonable result.10 But the present setting is not informal discussion and negotiation, it is litigation. This particular lawsuit has not elicited the requisite information to reach a reasonable result. So while I find that the Plaintiff's method to calculate amounts treated as allotted capital demonstrably produces answers that are far below a reasonable level for at least some branches in some years, I lack the data to apply the Inland Revenue Banking Manual to identify a reasonable level in general, without drawing on facts or economic principles that I am forbidden by the Court's rulings to use or implement. Given this, however effective the Inland Revenue Banking Manual might be in the U.K. as a guide to negotiations, I presently do not see how an economically reasonable outcome can be obtained under the circumstances in this lawsuit. However, my work is continuing, and if new information or new analysis suggests a way to reach a reasonable outcome in the present circumstances, I will describe it in my supplemental report. D. Organization of Report
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The remainder of this report contains four major sections. Section II discusses the nature of my assignment, including reviews of the relevant language from the Inland Revenue Banking Manual and of certain economic concepts that the Inland Revenue Banking Manual's language highlights. Section III contains my analysis of the Plaintiff's various approaches to attribution of capital to NatWest's U.S. branches. Section IV describes the reasons that (to date) I have not been able to
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See in particular the last sentence of paragraph 14.1 of the Inland Revenue Banking Manual.
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develop an economically reasonable approach that could work in the present circumstances. Section V concludes.
II.
NATURE OF THE ASSIGNMENT
Based on the above-cited judicial rulings, my report conducts its analyses under guidance from the Inland Revenue Banking Manual, as interpreted by the Court rulings. In addition to the plain language of the manual, I am guided in my understanding of its intent and operation by the Joint Further Opinion of Messrs. Michael Flesch and Philip Baker in this case, dated November 8, 2002 ("Barristers' Opinion"). Here I first review the relevant parts of the Inland Revenue Banking Manual and then discuss some relevant underlying economic concepts. A. The Inland Revenue Banking Manual
The stated goal under the Inland Revenue Banking Manual is to assist in the identification of the branch's "Free Working Capital." Paragraphs 2.1 and 2.2 of the Inland Revenue Banking Manual explain the concept of Free Working Capital as follows:11 2.1 As banks make their profits from lending money, the sources of such funds are important. When the bank borrows for on-lending its gross return is limited to a small margin, but where it has sources of "free capital" (such as share capital and retained profits) which have no associated interest costs, the gross return will be the whole interest on lending. Therefore the amount of free capital available will significantly affect profitability. While the free capital available to a bank overall will be apparent, in the UK there is no regulatory requirement that the UK branch of an overseas bank must be given capital. The branch may well be borrowing from Head Office and deducting interest on these funds either in its accounts or in its taxation computations. The question is therefore, how do we determine the amount of free capital which has in reality been granted to the UK and on which no interest will be due?
2.2
11
As discussed in the Barristers' Opinion, the content of the 1994 and 2000 versions of the Inland Revenue Banking Manual with respect to the Free Working Capital provisions is essentially the same, although the paragraph numbers differ. I cite the 1994 version because it is the first version available, and the dispute period predates it. Also, although I read the Barristers' Opinion to state (for example, at paragraphs 11 and 25) that the actual practice of the U.K. tax authorities during the 1981-87 dispute period did not follow the process described in the Inland Revenue Banking Manual in all respects, I take the Court's 2003 Opinion and the Court's 2005 Order to require me nonetheless to attempt to do so.
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In answering this question, the Inland Revenue Banking Manual identifies two concepts, "allotted capital" and "amounts treated as allotted capital."12 Allotted capital is described as "an identifiable sum ... perceived and properly termed capital by Head Office."13 In the present dispute, there is no "allotted capital" on the books and records of NatWest's U.S. branches -- their balance sheets show assets and liabilities, but no allotted capital.14 Therefore, the Inland Revenue Banking Manual recognizes that "[t]here is authority ... for treating part of a branch's funds as allotted capital...",15 which is the basis of my present assignment. The Inland Revenue Banking Manual also makes clear that Free Working Capital may exceed16 the assets held by the branch as owner, such as premises ..., because [such an excess] forms part of the capital infra-structure of the branch in much the same way that shares would be part of the capital structure of a company. The Inland Revenue Banking Manual describes "factors to be considered" in deciding on amounts treated as allotted capital. It states that "[t]he following list is not exhaustive, but may give a flavour of what is involved."17 The items on this list are: · · · · · Premises and Fixed Assets; Initial Working Capital; Retained Profits; Depreciation, and Other reserves.
Additionally, paragraph 11.1 of the Inland Revenue Banking Manual suggests the need for extra attention in cases in which a branch incurs losses, a relevant consideration in the present case, but I do not find clear guidance on how to proceed in such cases. This, however, is only a specific example of a more general proposition: the discussion of Free Working Capital concludes at paragraph 14.1, which says in its entirety,18
12
Inland Revenue Banking Manual, paragraphs 5 and 6. Inland Revenue Banking Manual, paragraph 5.1. Appendix C to this report contains samples of the financial records available in this case. Inland Revenue Banking Manual, paragraph 6.1, emphasis in the original. Inland Revenue Banking Manual, paragraph 7.1. The context of this paragraph is to explain why no interest may be deductible on allotted capital in excess of amounts treated as allotted capital, but the logical point described in the quoted text is true even when no allotted capital is on the books. Inland Revenue Banking Manual, paragraphs 10 and 10.1, emphasis added. Emphases added. Note that the entire paragraph, including in particular the final sentence, is repeated (continued...)
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To sum up, this is substantially a grey area where each case will depend on its particular facts. Negotiation will be very much the order of the day, and if the District feels that the level of free working capital is approximately correct then a reasonable result will have been achieved. To date, all cases have been successfully concluded by way of negotiation and hopefully this will continue to be the case. I therefore conclude that the plain language of the Inland Revenue Banking Manual does in fact mean that the Plaintiff's interpretation of the Inland Revenue Banking Manual cannot be the only possible interpretation. I regard that part of my assignment as settled by the language of the document on which the Court's rulings direct me to rely.19 B. Economic Concepts Highlighted by Inland Revenue Banking Manual
The next parts of my assignment are (1) to analyze the method used by the Plaintiff to calculate the amounts treated as allotted capital for NatWest's U.S. branches, and to assess (2) whether Plaintiff's approach implements the language of the Inland Revenue Banking Manual and (3) whether plaintiff's approach yields the goal of a "reasonable result" as expressed in the Inland Revenue Banking Manual and an economically sound and reasonable result regarding the profits a branch "might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment" as provided in Treaty Article 7(2). These tasks are the topic of the next section of my report. However, to perform those tasks it is useful first to highlight two economic concepts that emerge from the above-quoted language from the Inland Revenue Banking Manual. 1. Functions of Bank Capital
The first such concept emerges from the quotation from paragraph 7.1 that Free Working Capital may exceed "the assets held by the branch as owner, such as premises ..., because [such an excess] forms part of the capital infra-structure of the branch in much the same way that shares would be part of the capital structure of a company." This quotation accurately reflects the fact that bank capital serves purposes in addition to the purchase of premises and fixed assets. Three such purposes of bank capital are important for the assignments I have been given:
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(...continued) in the 2000 version of the Inland Revenue Banking Manual at its paragraph A9.135. I am not an attorney, but in this regard I would note that the Barristers' Opinion echos the interpretation that the just-quoted paragraph that the Inland Revenue Banking Manual is not intended to be applied in any particular formulaic or mechanical way (at the Barristers' Opinion's paragraphs 22 and 29), and it supplies additional support for this view from texts on the topic at its paragraphs 23-28. I take this to mean that there is no subtle legal meaning to the above-quoted words that would give them an interpretation opposite to that of their plain English.
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· · ·
Purchase of various physical assets; Risk-bearing, and Provision of security to other suppliers of bank funds.
The purchase of the various physical assets that enable the bank to operate is not the most important of these purposes for a bank. Unlike, for example, an automobile manufacturer, physical assets are a relatively small part of a bank's assets, and they ordinarily are not a direct source of its profits. Money is the vital raw material for a bank, not physical assets. At the most basic level, banks make money by "buying low and selling high," but the basic commodity bought and sold is access to money.20 Banks hope to borrow at lower levels than they lend, in part in exchange for services that they provide. While risk management is an important function within a bank, banks nonetheless take risks to earn profits. Another function of bank capital thus is to bear the consequences of the risks the bank does take. As in any corporation, equity capital has (in most circumstances) the residual claim on the bank's net operating revenues. If bank operations go unexpectedly well or badly, capital ordinarily enjoys the benefits or suffers the costs. If things go badly enough, however, the consequences can spill over to affect the suppliers of other sources of funds. Capital markets demand higher expected rates of return when greater risk is borne, so third-party suppliers of these funds (e.g., depositors) will provide them to a bank only if the expected rate of return on the funds is adequate for the risk borne. A bank in financial difficulty either will have to promise higher rates of return to its other suppliers of funds or watch those funds dry up, either one of which is likely to worsen the financial difficulty. A bank that wants to remain profitable, therefore, must have enough capital to compete successfully for other funds at reasonable costs. 2. Investments Made with Bank Capital
The second of the economic concepts that arise from the above quotations concerns how a bank's capital is actually used, i.e., what parts of the "asset" side of the bank's balance sheet correspond to the capital part of the "liability and equity" side. As just noted, premises and fixed assets are ordinarily a relatively minor part of a bank's assets, and the Inland Revenue Banking Manual explicitly recognizes the existence of capital in excess of premises and fixed assets as part of the bank's "capital infra-structure." But the Inland Revenue Banking Manual speaks to this issue even more directly. Most of a bank's assets are in various income-producing investments. Those assets are purchased not just with funds supplied by third parties, but also with bank capital. The Inland Revenue Banking Manual recognizes this explicitly in the above quotation from paragraph 2.1, which for convenience I reproduce here:
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For the record, modern banking is an extremely complicated business, and this discussion is intended only to provide a basic intuition of the economic functions of bank capital.
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As banks make their profits from lending money, the sources of such funds are important. When the bank borrows for on-lending its gross return is limited to a small margin, but where it has sources of "free capital" (such as share capital and retained profits) which have no associated interest costs, the gross return will be the whole interest on lending. Therefore the amount of free capital available will significantly affect profitability. If the amount of a bank's free capital were limited to premises and fixed assets, it would be "used up" by the purchase of those assets. There would be none left over to purchase additional incomeproducing assets in the bank's ongoing business. But if the Inland Revenue Banking Manual believed that to be an appropriate way to measure Free Working Capital, how could it imagine that the bank's free capital could produce any "interest on lending", let alone the "whole interest on lending"? There would be no free capital left to lend, after buying the fixed assets.21 Thus, in my analysis of whether the Plaintiff's approach is reasonable, I take the Inland Revenue Banking Manual to recognize explicitly the economic facts (1) that the amount of free working capital necessary to a bank's operations will (in ordinary conditions) exceed the amount of the bank's premises and fixed assets,22 and (2) that the excess amount will join funds from other sources as investments in income-producing assets. I would also note that this fact has very important implications for an analysis of amounts treated as allotted capital under the Inland Revenue Banking Manual. Paragraph 2.1 of the Inland Revenue Banking Manual recognizes the economic reality that a bank or a branch may use Free Working Capital to buy general income-producing assets. Those assets may well be indistinguishable from other assets on the branch's balance sheet, and if backed on the liability-and-equity side of the balance sheet by amounts not explicitly allotted as capital, there will be no simple way for an outsider to identify the funds in question as branch capital. Such issues instead will have to be addressed during the course of the negotiation envisioned by the Inland Revenue Banking Manual.
21
For completeness, I will note that the Inland Revenue Banking Manual cannot have had in mind a case in which the branch borrowed to buy its premises and fixed assets and then invested its free capital. In that case, some or all of the income on its invested free capital would have to go to pay the interest on the borrowed funds used to purchase premises and fixed assets, and so the "whole interest on lending" would not go to the branch. In fact, in ordinary conditions a bank's capital will materially exceed the amount of premises and fixed assets, so that the capital can perform the other two functions just discussed.
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III.
ANALYSIS OF PLAINTIFF'S APPROACHES
To the best of my knowledge, the Plaintiff's contemporaneous books and records for its six U.S. branches do not designate any amount of capital, since the branch balance sheets show only assets and liabilities. Nor am I aware of an analysis by Plaintiff, on the basis of the Court's 2003 Opinion and the Inland Revenue Manual, of the items and amounts that should, and should not, be treated as allotted capital for each branch. However, with the exception of items that even Plaintiff's consultant, PricewaterhouseCoopers LLP ("PWC"), cannot explain, it is possible to infer the methods Plaintiff has used to calculate the amounts treated as branch capital. Here I analyze all of Plaintiff's implied approaches to calculation of amounts treated as branch capital, i.e., those used to produce the original claim on Plaintiff's tax returns and that which underlies its revised claim in this litigation, subject to uncertainties specifically identified below.23 A. Original Tax Return Approaches
An examination of the PWC Report reveals that Plaintiff's original tax returns implicitly employed at least three different methods for calculation of the amounts treated as branch capital. The 1990 Memorandum states at pp. 2-3 that24 NatWest's U.S. branches had interest-free funds equal to the lesser of (i) the sum of U.S. branches' fixed asset loans from head office, capital loans from head office, and net retained earnings or (ii) the U.S. branches' total investment in fixed assets.25 To illustrate this method, assume that the only potential sources of a branch's capital were its fixed assets or the three liabilities, i.e., loans for fixed assets from head office, capital loans from head office, and net retained earnings. Under this assumption, Figure 1 imagines a case in which fixed assets are $90 and the sum of the three liabilities (i.e., loans for fixed assets from head office, capital
23
The primary sources of the below analyses are (1) the books and records of the various branches for the various years; (2) the November 1, 1990 Memorandum from Shaw, Pittman, Potts & Trowbridge, "Re: National Westminster Bank PLC: Recognition of Branch Capital for U.S. Tax Purposes Under the Separate Entity Method" ("1990 Memorandum"); (3) the Plaintiff's Report on the Capital Issue, dated October 29, 2004 ("2004 Plaintiff Report"), and (4) the accompanying Expert Report of Kevin D. Bandoian of PWC dated October 29, 2004, as corrected November 2, 2004 ("PWC Report"). At p. 3, the 1990 Memorandum also identified reserves for loan losses as interest-free capital. At pp. 3-4 it also identifies interest-free inter-branch clearing accounts as "effectively" additional capital. The Plaintiff does not include these latter accounts as capital in its response to Interrogatory 8.14, so I ignore them in this report. Note that Plaintiff used the net book value of premises and fixed assets, i.e., original cost less accumulated depreciation. Plaintiff also used retained earnings whether they were positive or negative (i.e., were accrued losses). Accrued losses reduce the sum of the three liabilities.
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loans from head office, and net retained earnings) are $70. In this case, the 1990 Memorandum would set branch capital at the level of the sum of the three liabilities, $70.
1990 Memorandum Method, Outcome 1: If Sum of Three Liabilities Is Less Than Fixed Assets, Branch Capital = Sum of Three Liabilities
$120
$100
$80
$60
$40
$20
$0
Fixed Assets
Three Liabilities
Branch Capital
Figure 1 Figure 2 imagines an alternative case, in which fixed assets are still $90, but the sum of the three liabilities is $110. In this case, the approach described in the 1990 Memorandum would set branch capital at the level of fixed assets, $90.
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1990 Memorandum Method, Outcome 2: If Sum of Three Liabilities Is Greater Than Fixed Assets, Branch Capital = Fixed Assets
$120
$100
$80
$60
$40
$20
$0
Fixed Assets
Three Liabilities
Branch Capital
Figure 2 However, the PWC Report performed calculations to see whether the 1990 Memorandum's description of what the Plaintiff had actually done fit the facts, and found that it did not.26 The actual methods for treating these items varied across different branches in the same year and across different years for the same branch: · · Some branches in some years did follow the 1990 Memorandum's approach. Some branches in some years simply used the sum of the three liabilities regardless of whether it was greater than or less than the amount of premises and fixed assets. One branch in one year used the amount of fixed assets even though that amount exceeded the sum of the three liabilities.27
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26
The 1990 Memorandum addressed the years 1981-1985. The PWC Report adds 1986 and 1987. This was New York/IBF (really two branches, New York and IBF) in 1987. As explained in the PWC Report and in the Notes to my Table 1, there is an "Unexplained Adjustment" to the New York/IBF 1987 calculation that makes the original amount they actually used greater than the amount of their premises (continued...)
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Table 1 summarizes the actual policies used by branch and by year, using the definition "Sum of 3 Liabilities" as the sum of the three liabilities, i.e., loans for fixed assets from head office plus capital loans from head office plus net retained earnings. Table 1 Plaintiff's Original Approaches to Treatment of Sum of Fixed Asset Loans from Head Office plus Capital Loans from Head Office plus Net Retained Earnings ("Sum of 3 Liabilities") versus Total Investment in Fixed Assets ("Fixed Assets") Branch Chicago 1981-1985 Sum of 3 Liabilities 1986 Lesser of Sum of 3 Liabilities and Fixed Assets Lesser of Sum of 3 Liabilities and Fixed Assets Lesser of Sum of 3 Liabilities and Fixed Assets Lesser of Sum of 3 Liabilities and Fixed Assets Lesser of Sum of 3 Liabilities and Fixed Assets 1987 Lesser of Sum of 3 Liabilities and Fixed Assets Lesser of Sum of 3 Liabilities and Fixed Assets Lesser of Sum of 3 Liabilities and Fixed Assets Fixed Assets (See Notes below)
Grand Cayman
N/A
Nassau
Sum of 3 Liabilities
New York/IBF
Lesser of Sum of 3 Liabilities and Fixed Assets (See Notes below) Sum of 3 Liabilities
San Francisco
Lesser of Sum of 3 Liabilities and Fixed Assets
Sources: Notes:
1990 Memorandum, PWC Report. (1) For 1983 and 1987, the PWC Report describes what it calls "Unexplained Adjustments" for the New York/IBF branches that have the effect of increasing reported taxable income beyond the amount that corresponds directly to these measures of branch capital. (2) In 1987, the capital measure that underlies the "Capital Loan Charge," defined below, is negative in the New York/IBF calculation, a result that needs to be zeroed-out for the implied branch capital to be "the lesser of" the Sum of 3 Liabilities and Fixed Assets. Instead, the PWC report indicates that the Plaintiff originally subtracted a negative Capital Loan Charge, which has the effect of making the implied branch capital measure equal to Fixed Assets. (3) Because of the Unexplained Adjustment for New York/IBF in 1987, Plaintiff's original implied branch capital measure for these components would seem actually to exceed Fixed Assets by the amount of the Unexplained Adjustment.
27
(...continued) and fixed assets.
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B.
Revised Approach
The mechanism by which the Plaintiff's original approaches (sometimes) implemented the "lesser of" part of the 1990 Memorandum's approach was called the "Capital Loan Charge." The Capital Loan Charge was based on the difference between the sum of the three liabilities and fixed assets. When this difference was positive (i.e., if the sum of the three liabilities exceeded fixed assets, as in Figure 2), interest expense was to be claimed on the difference, through an adjustment to reduce interest income. This had the effect of setting the allocation to capital at the level of fixed assets. When the difference was negative (i.e., if fixed assets exceeded the sum of the three liabilities, as in Figure 1), no adjustment to interest income was made.28 This had the effect of setting the allocation to branch capital at the level of the sum of the three liabilities, which in this case is less than the branch's fixed assets. I understand that the Plaintiff now states that it is no longer claiming deductions for the Capital Loan Charge amounts originally included in its tax returns.29,30 This has the effect of treating the sum of the three liabilities as allotted capital for all branches in all years, whether this sum is greater or less than the branch's fixed assets. While simpler, however, this change leads to anomalous results, as discussed below. First, however, consider how the Plaintiff's current method to identify amounts treated as allotted capital stacks up against the Inland Revenue Banking Manual. In this regard, note that Plaintiff's revised method actually just adopts one of the methods it originally used, long before the Inland Revenue Banking Manual was published. Therefore, there is no particular reason to expect that it will stack up well against the Inland Revenue Banking Manual criteria, and in fact, it does not.
28
An exception occurred for New York/IBF in 1987, as explained in the Notes to Table 1. See the 2004 Plaintiff Report and the PWC Report, for example. There is one potential anomaly in Plaintiff's revised claim, however. According to the 2004 Plaintiff Report, p. 9, and the PWC Report, Exhibit 3, the actual "concession" for 1986 exceeds the amount that would flow solely from the dropping of the Capital Loan Charge. I am presently unaware of the basis of this so-called "over-concession," which amounts to $267,323. Except in this footnote, I address solely the effects of dropping the Capital Loan Charge. However, I would also note that the PWC Report amount for the Capital Loan Charge for Nassau for 1986, $1,815,277, appears to be materially below the number in the manually generated profit and loss reports, which I understand are intended to correct problems in the computer-generated reports. (See Deposition of Harrylall Samaroo, (January 23, 2002, pages 23, 38, and 73.) The amount on the manually generated report (Bates no. PwC-NWB 0000320, also available as INT504-00280) is $3,996,578. If the number in the manually generated report is in fact correct, the PWC Report appears to understate the Capital Loan Charge for the Nassau branch for 1986 by $2,181,301. If this conclusion is correct, Plaintiff's so-called "over-concession" is actually an "underconcession" in the amount of $1,913,978 (i.e., $2,181,301 minus $267,323).
29
30
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In particular, recall the five factors that the Inland Revenue Banking Manual identifies as examples to consider in calculation of amounts treated as allotted capital. Here is how the Plaintiff's revised method relate to those factors:31 Banking Manual Factor Premises and Fixed Assets Initial Working Capital Retained Profits Depreciation Other reserves Treatment under Plaintiff's Revised Measure Ignored Ignored Included, but accrued losses reduce branch capital Ignored Included, but limited to provisions for bad and doubtful debt Loans due head office re fixed assets Loans due head office re capital loan
[Not mentioned]
The two items that Plaintiff includes that are not mentioned in the Inland Revenue Banking Manual list do not correspond directly to any of the factors that are in the list. For example, the amount of loans due head office re fixed assets, when present, has no particular relationship to, and on average is much lower than, the amount of premises and fixed assets on the branches' books for the branches that have premises and fixed assets (i.e., New York, Chicago, and San Francisco). This can be seen in Table 2, on the next page, which also reports the balances due to the head office re capital loans for these branches. (Note that under the Plaintiff's practices, the calculations for a given tax year depend on the balance sheet as of the end of the previous tax year. Table 2 therefore reports end-ofyear -- "EOY" -- data for 1980 to 1986.)
31
This definition of the Plaintiff's revised approach is confirmed by Plaintiff's response to Interrogatory 8.14.
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Table 2 NatWest Premises & Fixed Assets and Balances Due to Home Office New York, Chicago and San Francisco Branches (figures in dollars) Premises & Fixed Assets, Balance Due to HO re Balance Due to HO Net Book Value Fixed Assets re Capital Loan [1] [2] [3] New York EOY 1980 EOY 1981 EOY 1982 EOY 1983 EOY 1984 EOY 1985 EOY 1986 Chicago EOY 1980 EOY 1981 EOY 1982 EOY 1983 EOY 1984 EOY 1985 EOY 1986 San Francisco EOY 1980 EOY 1981 EOY 1982 EOY 1983 EOY 1984 EOY 1985 EOY 1986 7,552,958 9,939,171 12,887,463 12,584,062 21,808,920 23,322,332 26,977,616 1,219,904 1,666,298 2,355,172 2,824,398 2,818,071 395,106 364,230 619,968 1,222,563 1,349,925 6,723,537 7,552,958 7,552,958 7,552,958 7,552,958 7,552,958 909,193 1,085,000 1,085,000 1,085,000 1,085,000 712,086 395,106 364,230 619,968 1,222,563 1,265,000 2,494,463 175,807 1,085,000 552,914 869,894 900,770 645,032 42,437 -
Sources: Data gathered from year-end manual balance sheets, except for San Francisco in EOY 1980, which comes from the B126 report.
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To make clear just how odd these amounts are, Figures 3 to 5 graph the amounts of the premises and fixed assets and the balances due head office for fixed assets for New York, Chicago and San Francisco, respectively.
New York Branch, Premises and Fixed Assets versus Balance Due Head Office re Fixed Assets ($000s)
30,000 25,000 20,000 15,000 10,000 5,000 1980 1981 1982 1983 1984 1985 1986 1987 End of Year Data (used for the following tax year, e.g., "1980" amounts affect 1981 taxes) Premises and Fixed Assets Bal Due HO re Fixed Assets
Figure 3 In the case of New York, Figure 3 indicates that the amounts are almost the same for the first tax year, 1981 (which relies on end-of-year 1980 data). However, the lines soon diverge, and New York obviously adds a considerable amount of premises and fixed assets over the tax period while not increasing the balance due to NatWest for fixed assets. In fact, in the last tax year New York has no balance due to NatWest regarding fixed assets, despite having almost $27 million of fixed assets on its books. Even more odd, the New York branch is accumulating very material losses on its balance sheet during the latter part of this period, so these new premises and fixed assets cannot have been funded out of profits from the New York branch. Note also that since the Plaintiff's original calculation for New York/IBF attributed the amount of premises and fixed assets to branch capital (see Table 1 above) and Plaintiff's revised method does not, the Plaintiff's "concession" has the effect of materially reducing the capital treated as allocated to New York/IBF in 1987.
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Chicago Branch, Premises and Fixed Assets versus Balance Due Head Office re Fixed Assets ($000s)
3,000 2,500 2,000 1,500 1,000 500 1980 1981 1982 1983 1984 1985 1986 1987 End of Year Data (used for the following tax year, e.g., "1980" amounts affect 1981 taxes) Premises and Fixed Assets Bal Due HO re Fixed Assets
Figure 4 Figure 4 shows that Chicago looks even stranger than New York. It starts with a balance due to NatWest for fixed assets that is less than its premises and fixed assets, but the balance rapidly falls behind the growth in Chicago's premises and fixed assets. Then Chicago's fixed assets (and the balance due NatWest) fall to zero at the end of 1985, and Chicago reports no premises and fixed assets for tax years 1986 and 1987. However, it is, at the very least, hard to imagine that Chicago actually operated without access to premises and fixed assets, no matter what Plaintiff's books and records say.
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San Francisco Branch, Premises and Fixed Assets versus Balance Due Head Office re Fixed Assets ($000s)
1,600 1,400 1,200 1,000 800 600 400 200 1980 1981 1982 1983 1984 1985 1986 1987 End of Year Data (used for the following tax year, e.g., "1980" amounts affect 1981 taxes) Premises and Fixed Assets Bal Due HO re Fixed Assets
Figure 5 Figure 5 shows that San Francisco is the only one of these three branches to have balances due to NatWest in some years that equal or exceed the amount of its premises and fixed assets, but its data are no less odd. San Francisco, too, ends up with no premises and fixed assets for tax years 1986 and 1987, even though it shows a positive balance for the amounts owed to NatWest for fixed assets at the end of 1986 (which affects tax year 1987). As noted, to my knowledge the Plaintiff has yet to analyze the amounts to be treated as allocated to branch capital for the various branches for the various years. The 1990 Memorandum suggests the Plaintiff might add provisions for bad debt to the sum of the three liabilities in such a definition, for example, and Plaintiff's response to Interrogatory 8.14 confirms this addition. However, Plaintiff's response to this interrogatory does not distinguish between reserves for specified and non-specified bad debt. Such an addition would be economically logical with respect to reserves for non-specified bad debt, but not for reserves against specified bad and doubtful debt.32 Therefore, the inclusion of
32
The Inland Revenue Banking Manual does not address a specific bad debt reserve, but there is a clear factual distinction between a specific and a non-specific bad debt reserve. One identifies a general contingency, while the other is a concession that certain identified assets do not really have the value attributed to them on the asset side of the balance sheet. In effect, those specific assets require their own (continued...)
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specified bad debt reserves, if they were material, could give a quite misleading picture of the actual amount of Free Working Capital available to the branch under a particular way of measuring branch capital. As will be seen below, this does in fact prove to be a problem under the Plaintiff's revised approach. First, however, I note that even with both types of provision for bad debts included in branch capital, the Plaintiff's revised method produces seven branch-years that have negative branch capital.33 The same branch-years produce measures of branch capital that are below premises and fixed assets, yet (as discussed in the previous section), both economic principle and paragraph 2.1 of the Inland Revenue Banking Manual imply bank capital should exceed premises and fixed assets. To help make these problems more tangible, Figures 6A, 6B and 7 plot the branch capital amounts that result from Plaintiff's revised approach (i.e., the sum of the three liabilities plus reserves for bad debt) as a percent of branch assets. Figures 6A and 6B examine Chicago, Grand Cayman, Nassau, and San Francisco in two different ways, with and without specified bad debt reserves treated as branch capital. Figure 7 examines New York, IBF, and the combination of the two under the Plaintiff's revised approach, i.e., with both types of bad debt reserves included.
32
(...continued) source of bank capital, at a capital ratio far above that needed for general bank purposes. The specified bad debt reserves are no longer available to serve the general purposes of bank capital, and a potential depositor who was unaware of the distinction could believe a bank with high specified bad debt reserves that were rolled in as part of the bank's general capital offered far more security than it actually did. This view is consistent with that identified in the September 1980 Bank of England document cited in Exhibit B of the November 19, 2004 Report of Richard Henry Farrant in this matter ("Farrant Report"), "The Measurement of Capital," which states in paragraphs 20 and 21 that The Bank has ... concluded that amounts set aside to cover possible or probable losses that have already been identified provide no protection against future unidentified losses and they should therefore be excluded from the capital base. ... The Bank has concluded that, where it is satisfied that a general provision is freely available to absorb future losses, it is appropriate to include it within the Bank's definition of the capital base.
33
Two of these negative capital amounts are for Chicago, one for Grand Cayman, and four for the New York branch.
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Capital Under Revised Plaintiff Approach as Percent of Branch Assets (Chicago, Nassau, San Francisco and Grand Cayman)
6% 5% 4% 3% 2% 1% 0% -1% -2% -3% 1980
1981
1982
1983
1984
1985
1986
1987
End of Year Data (used for the following tax year, e.g., "1980" amounts affect 1981 taxes) Chicago Nassau San Francisco Grand Cayman
Figure 6A Figure 6A is calculated using total bad debt reserves, which I understand to be the Plaintiff's revised approach. It shows that Chicago's ratio is very unstable and is negative as of the end of 1981 and 1982. Grand Cayman has negative capital in one year and almost none in the other, and the amounts for San Francisco and Nassau, while more stable, are very different from each other and from Chicago and Grand Cayman in most years. The Plaintiff's revised approach thus produces anomalous results with no consistency among branches. Figure 6B (below) reproduces Figure 6A, but without including specified bad debt reserves in branch capital, since those reserves are already allocated to specific assets and not available to serve the general purposes of bank capital. The difference is startling. Chicago's capital-to-assets ratio as of the end of 1980 declines by over 1.5 percentage points in going from Figure 6A to Figure 6B, to create a third negative value. Chicago's capital-to-assets ratios grow much more negative for end-of-year 1981 and 1982, by 1.9 percentage points and 1.5 percentage points, respectively. Additionally, the peak in Chicago's ratio as of the end of 1983 completely disappears, as the end-of-year 1983 ratio declines by a full 3.5 percentage points, from over 5 percent to under 2 percent. Chicago has much less uncommitted capital than it seemed to have under the Plaintiff's method in Figure 6A. Additionally, San Francisco loses some of its apparent stability, as its capital-to-assets ratio drops as of the end of 1982. 21
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Thus, the use of specified bad debt reserves to calculate branch capital makes a huge difference for Chicago, and a material difference for San Francisco. The actual amount of capital that is still uncommitted at these branches under Plaintiff's general approach to determination of amounts treated as allotted capital is much less than it first seems to be. The determination of whether the amount of branch capital that results from the Plaintiff's general approach is reasonable needs to take this difference into account.
Capital Under Revised Plaintiff Approach Without Specified Bad Debt Reserves as Percent of Branch Assets (Chicago, Nassau, San Francisco and Grand Cayman)
6% 5% 4% 3% 2% 1% 0% -1% -2% -3% 1980
1981
1982
1983
1984
1985
1986
1987
End of Year Data (used for the following tax year, e.g., "1980" amounts affect 1981 taxes) Chicago Nassau San Francisco Grand Cayman
Figure 6B Figure 7 (below) looks at New York. Under Plaintiff's revised approach, the capital of the New York branch itself becomes quite negative in later years, while that of IBF is very positive. The combination of the two is relatively stable, but that combination corresponds to no actual NatWest branch.34
34
I do not include a version of Figure 7 without specified provisions for bad debt because those values are proportionately much smaller for New York and IBF than for Chicago and San Francisco. The same kind of startling difference does not appear for these two branches, although all the capital-to-assets ratios in Figure 7 do decline somewhat.
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Capital Under Revised Plaintiff Approach as Percent of Branch Assets (New York Alone, IBF Alone, and New York/IBF Combined)
8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% 1980 1981 1982 1983 1984 1985 1986 1987
End of Year Data (used for the following tax year, e.g., "1980" amounts affect 1981 taxes) New York IBF NewYork/IBF
Figure 7
Based on these considerations, I conclude that the Plaintiff's revised measure of capital produces branch capital amounts that are unstable and unsupported by either economic principle or the Inland Revenue Banking Manual. As a result, Plaintiff's interest expense deduction in the disputed years is unsupported, and it is demonstrably far too high in at least some branch-years.
IV.
ATTEMPT TO DEVELOP AN ECONOMICALLY REASONABLE APPROACH
The data currently available in this case are such that, while adhering to the legal test described in the Court's 2003 Opinion, the Court's 2004 Transcript, and the Court's 2005 Order, I am unable to identify an economically reasonable approach to determine the amounts to be treated as allotted capital for NatWest's U.S. branches. The reasons for this involve (1) the fact that the available books and record data are incomplete, insufficient for the task in the present litigation, and in some cases anomalous, and (2) the fact that important considerations that might enable us to overcome these data problems, which we know to be true as a matter of institutional practice and/or economic principle, must be ignored as a matter of law, as I understand the Court's instructions on how to implement the Treaty. This section explains these difficulties in turn, then summarizes their implications. 23
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A.
Inadequate Data
Table 4, which runs over the next four pages, describes the balance sheet entries with respect to allotted capital and amounts treated as allotted capital for the six U.S. branches at issue in this proceeding, New York, New York IBF, Nassau, Grand Cayman, Chicago, and San Francisco. The relevant years for the dispute are 1981 to 1987. As noted earlier, the data for each of those years are based on the end-of-year data for the previous year. For example, the capital amounts considered for 1981 are based on data as of the end of 1980. The elements in the table are those identified in the Inland Revenue Banking Manual, as discussed above. Panel A of Table 4 identifies the amount of "allotted capital" on the books of the branches. This is identified in the Inland Revenue Banking Manual as "a sum perceived and properly termed capital by Head Office" (Paragraph 5.1). Panel B of the table describes the balance sheet entries for each of the six branches for the Inland Revenue Banking Manual's five examples of factors to be considered in determination of "Amounts Treated as Allotted Capital." The categories are obtained from paragraph 10.1 of the Inland Revenue Banking Manual. As noted above, the items identified in this section are: · · · · · Premises and Fixed Assets Initial Working Capital Retained Profits Depreciation Other reserves
Discussion of the contents of the table follows the table itself.
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Table 4 DATA AVAILABLE ON ITEMS OF ALLOTTED CAPITAL PER INLAND REVENUE BANKING MANUAL
PANEL A: ALLOTTED CAPITAL New York EOY 1980-EOY 1986 None IBF None Nassau None Grand Cayman None Chicago None San Francisco None
PANEL B: AMOUNTS TREATED AS ALLOTTED CAPITAL 1. Premises and Fixed Assets ("Present" indicates a positive value was found on balance sheet for that period. "N/A" is not applicable, and a "0" indicates a value of zero was found on the balance sheet. Information is for net premises and fixed assets.) New York EOY 1980 EOY 1981 EOY 1982 EOY 1983 EOY 1984 EOY 1985 EOY 1986 Present Present Present Present Present Present Present IBF N/A N/A N/A 0 0 0 0 Nassau 0 0 0 0 0 0 0 Grand Cayman N/A N/A N/A N/A N/A 0 0 Chicago Present Present Present Present Present 0 0 San Francisco Present Present Present Present Present 0 0
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Table 4 (cont.)
2. Initial Working Capital Initial working capital does not appear on any balance sheets for any of the branches and years in question. Additional information follows. New York Branch Opened1 1/2/1970 IBF 12/3/81 (Based on first available microfiche) First balance sheet, with ID number provided by Plaintiff, June 1982 (B126) May be available on microfiche, not provided in compilation of balance sheets provided by Plaintiff. Nassau 2/2/1974 Grand Cayman June 1985 Chicago 2/2/1974 San Francisco 7/3/1972
First balance sheet 2/21/1979
First balance sheet 1/17/1979
First balance sheet 12/31/1985
First balance sheet 1/17/1979
First balance sheet 12/17/1975 (pounds), 12/31/1976 ($)
Was Balance Sheet Available as of When Branch Started?
No
No
First manually prepared balance sheet available approximately six months after branch opened.
No
No
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Table 4 (cont.)
3. Retained Profits ("Present" indicates branch showed positive retained profits in that year; "Losses" indicates the branch showed negative retained profits in that year.) New York EOY 1980 Q1 1981, Present; Q2-Q4 1981, Retained Profits = 0 due to repatriation of all retained profits. Present Present Losses Losses Losses Losses IBF N/A Nassau Present Grand Cayman N/A Chicago Losses San Francisco Present
EOY 1981 EOY 1982 EOY 1983 EOY 1984 EOY 1985 EOY 1986
N/A N/A Present Present Present Present
Present Present Present Present Present Present
N/A N/A N/A N/A Losses Present
Losses Losses Present Present Present Present
Present Present Present Present Present Present
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Table 4 (cont.)
4. Depreciation Accumulated depreciation not reported on manually prepared balance sheets. It is available on B126 reports. For branches with premises and fixed assets as discussed in panel B.1, gross book value can be obtained from B126 reports. Other Reserves ("Present" indicates a positive value was found on the balance sheet for bad debt reserves during that period. Bad debt reserves include total bad and doubtful debt, both specific and non-specific.) New York EOY 1980 EOY 1981 EOY 1982 EOY 1983 EOY 1984 EOY 1985 EOY 1986
1
5.
IBF N/A N/A N/A 0 Present Present Present
Nassau 0 0 0 0 0 0 0
Grand Cayman N/A N/A N/A N/A N/A 0 0
Chicago Present Present Present Present Present Present Present
San Francisco Present Present Present Present Present Present Present
Present Present Present Present Present Present Present
For New York, Chicago, Nassau and San Francisco, see Plaintiff's response to Interrogatory 8.12. For Grand Cayman, see October 29, 2004 PWC Report, p. 1981-1. For IBF, 12/3/81 date based on first available Microfiche according to Microfiche Account Statements provided by Plaintiff. Source: Information from EOY manually prepared balance sheets for each branch. When not available, B126 computer generated reports were relied on.
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Panel A of Table 4 records the fact that there are no entries for allotted capital for any of the branches for any of the years. This by itself eliminates the single easiest way for an outsider to determine if the amount of designated capital is sufficient to buy the income-producing assets envisioned in the Inland Revenue Banking Manual's paragraph 2.1. That in turn makes the task of deciding on amounts treated as allotted capital much harder, since there may be no (and in the present case, there is no) ready way to identify the amount of a branch's income-producing assets that actually are backed by branch capital. Panel B looks at the five specific factors identified in the Inland Revenue Banking Manual regarding amounts treated as allotted capital, one by one. Part 1 of Panel B reports on premises and fixed assets, indicating whether there is a positive asset recorded as premises and fixed assets (indicated by "present") or no such asset (indicated by "0").35 The Inland Revenue Banking Manual states in paragraph 10.1 about premises and fixed assets, This is the item most commonly found in the calculation of free working capital. If premises are acquired when the branch is set up they are capital assets and prima facie where the funds came from Head Office it will be treated as allotted capital. The assumption that premises will be funded from capital is based primarily on examination of normal banking practice. Yet, when we look for premises and fixed assets amounts on the books and records of NatWest's U.S. branches, there are as many zeros as there are positive values! That is, there are as many branch-year combinations that report no premises and fixed assets (17) as there are branch-years that report positive amounts (also 17). Nor is the problem restricted to the branches located in New York. As noted earlier, Chicago and San Francisco both report no premises and fixed assets for tax years 1986 and 1987.36 Part 2 of Panel B addresses initial working capital. No data on initial working capital are available. Part 3 turns to retained profits. Eight branch-years report accumulated losses rather than retained profits, including three years for Chicago. The Plaintiff's approach simply treats these accumulated losses as negative branch capital, but it is not clear that this is in accord with the Inland Revenue Banking Manual. Paragraph 11.1 of the Inland Revenue Banking Manual states, The position where a branch makes losses is not clear-cut. It has been suggested that where such losses exist they must per se be met out of the bank's capital and that therefore an allotment of capital takes place automatically when losses are made. While this has the apparent merit of simplicity, the current view is that this is an argument which cannot be sustained in law, domestically or under treaty.
35
An entry of "N/A" indicates the issue is not applicable for that branch in that year.
36
Again, the balance sheet relevant for each tax year in the Plaintiff's computations is the end-ofyear, or "EOY," balance sheet for the year before. 29
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That is, this paragraph 11.1 actually raises the possibility that accumulated losses should be added to branch capital. While it appears to dismiss this possibility as a matter of law, the mere fact that it is raised suggests that treating losses as subtractions from capital, as the Plaintiff does, may be inconsistent with the Inland Revenue Banking Manual. Perhaps they should simply be left out of the calculation, under the Inland Revenue Banking Manual's guidelines. Additional light on this issue may be shed by a paragraph 10.1 statement about initial working capital: It is not unusual for a newly established branch to have a projected business plan covering the first 1 to 3 years of activity. If such a plan exists it may merit detailed examination. The plan may show initial losses, caused by administrative expenditure incurred prior to the business generating profits or positive cash flow, and there is a reasonable case for saying that initial working capital should be sufficient to meet these excess expenses. Chicago, in particular, shows a growing amount of accumulated losses for the first three years of this dispute. I lack data on how far back these losses go, b