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HMRC internal manual

International Manual

Controlled Foreign Companies: The CFC Charge Gateway Chapter 6 - Trading Finance Profits: The Basic Rule

The basic rule is applied to the CFC’s accounting period via a three step process. Steps 1 and 2 (in conjunction with TIOPA/S371FB and S371FC) consider the level of capitalisation of the CFC and step 3 calculates the trading finance profits, if any, passing through the CFC charge gateway at Chapter 6. Overall, the process determines the extent to which the CFCs assumed total profits for the accounting period arise from overcapitalisation and then, to the extent that the overcapitalisation arises from UK connected capital contributions, quantifies the amount of Chapter 6 profits.

INTM207600 and INTM207700 to this guidance set out some of the commercial drivers behind the capitalisation of banks and insurance companies. These factors will be helpful in firstly understanding the capitalisation position of the CFC being examined and secondly assessing the extent to which its capitalisation position is comparable to that of a company not controlled by any other company. Thus enabling consideration of whether it is “reasonable to suppose” the relevant CFC has excess free capital or assets.

The basic rule is applied as part of the self-assessment process. It includes no safe harbours, so determining the Chapter 6 profits will depend on the facts and circumstances of each individual case.

Step 1

(a) This considers whether, during its accounting period, a CFC’s ‘free capital’ is greater than what it is reasonable to suppose it would be were the CFC not a 51% subsidiary of any other company carrying on the same business. Where it can be shown the ‘free capital’ is above that hypothetical comparable, then the CFC has “excess free capital”.

(b) ‘The Step 1 amount’ is the lesser of the excess free capital amount and the free capital derived (directly or indirectly) from UK connected capital contributions. In quantifying UK connected capital contributions the total free capital of the CFC (and not just the excess free capital) is considered.

Example {#IDALKSQB} 1

UK resident company A subscribes for share capital of £60m in its non-UK resident intermediate holding company B. Company B in turn subscribes for share capital of £100m in CFC C which carries on banking business (£40m being sourced from Co. B’s own reserves, the retained profits of which have no previous UK connection). CFC C’s total free capital is now £100m. On review, the facts of the case show that if CFC C was not a 51% subsidiary of any other company it would have free capital of £20m. CFC C therefore has excess free capital (Step 1(a) of TIOPA10/S371FA(1) amount) of £80m. However, as only £60m is provided from the UK Step 1(b) reduces the excess free capital (‘the Step 1 amount’) to £60m.

Use this link to see example 1 diagram

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Step 2 (Insurance CFCs)

Step 2 applies only to a CFC’s insurance business if it has one. In this case it is necessary to determine if and how much the CFC’s free assets exceeds what it would be reasonable to suppose its free assets would be if it were not a 51% subsidiary of another company.

Step 1 will have limited application to most insurers as they typically hold little equity finance. Step 2 applies specifically to insurance CFCs (of both insurance and non-insurance groups).

Insurance business is defined at TIOPA10/S371VA and means the business of effecting or carrying out of ‘contracts of insurance’, including the investment of premiums received (See INTM248100)

Insurance companies are financed by a mixture of equity, subordinated debt and premiums. Profits from these premiums are invested and retained as free assets, of varying forms, against the risk of insurance claims and losses i.e. the free assets are held to support the company’s insurance risk exposure. Broadly the risks will include, but not be limited to:

  • underwriting risks - those arising from the underwriting activities of the insurer;
  • operational risks - those arising from its internal operations i.e. processing errors.
  • strategic risks - those arising from its management errors
  • credit risks- those arising from a default by an insurance counterparty
  • market risks - those arising from fluctuations in its investments.

In contrast to step 1, step 2 therefore focuses on the free assets of an insurance CFC and the extent to which they are excessive.

However, in common with step 1, if the step 2 excess free assets amount exceeds the free assets derived directly or indirectly from UK connected capital contributions, then ‘the step 2 amount’ is limited to those UK connected capital contributions (section 371FA(1) step 2 (b)).

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Exclusion of Guarantees from free assets

An insurance CFC may use its own free assets to provide guarantees against the insurance liabilities of other connected insurance companies. TIOPA10/S371FA(5) and TIOPA10/371FA(6) provide an exclusion of these amounts where those guarantees require an insurance CFC to hold free assets in excess of the assets that it would otherwise hold.

The exclusion deducts the value of these assets from the free assets considered within step 2.

To qualify the assets must:

  • arise from the CFC, acting outside its own insurance business, giving a guarantee against the insurance losses of a connected company’s insurance business;
  • the guarantee provided is necessary for the purpose of that connected company meeting its own insurance business’s regulatory requirements;
  • as a result of giving the guarantee the CFC is required to hold more assets, than it would otherwise be required to hold to meet the regulatory requirements for its own insurance business; and
  • during the accounting period the CFC holds those assets solely for the purpose of meeting that additional requirement i.e. holding them does not have an additional purpose.

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CFC A carries on insurance business (no step 1 amount arises) and has free assets of £900m. £200m of these are held to support guarantees it has provided to connected insurance company B. CFC A also has UK connected capital contributions of £150m.

On review, the facts of the case show that if CFC A was not a 51% subsidiary of any other company it would hold free assets of £550m. The same review also shows that only £150m of the £200m guarantees is necessary to support the regulatory requirements of B’s insurance business. It is this £150m of the guarantee that is necessary to support the regulatory requirements that is excluded when calculating the excess free assets.

The CFC A’s excess free assets are £200m (being £900m - £150m - £550m). However, as the UK connected capital contributions are lower than £200m then the step 2 amount is reduced to £150m.

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When and over what time period should excess free capital or free assets be measured for the purposes of Step 1 and Step 2?

Step 1 and Step 2 apply to assess the extent to which a CFC is overcapitalised at any time within its accounting period. As they apply at any time an assessment of excess free capital or free assets can be done at any period of time, however short, within that accounting period.

However, in applying either step the capitalisation levels of the company throughout the accounting period must be factored in to put the periods of high levels of capital within a wider context. Care must be taken to ensure that each step is not applied in a manner which means peaks and spikes in capital levels that arise as a normal part of the CFC’s financial trading are automatically considered as indicative of overcapitalisation.

The capital levels of a financial trading CFC will fluctuate during an accounting period. The steps should therefore be applied in a manner which distinguishes between peaks in capitalisation levels that:

  • arise as a normal part of the CFC’s business,
  • are outside of the control of the CFC (or its connected parties),
  • are short-term in duration or isolated in nature,


  • from those that are indicative of overcapitalisation.

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Step 3

Where no excess amounts arise within either step 1 or step 2, then no Chapter 6 profits arise.

Where step 1 and/or step 2 amount(s) do arise, then the profits falling within Chapter 6 are the trading finance profits of the CFC so far as it is reasonable to suppose those profits arise from the investment or other use of either of the identified step 1 and/or step 2 amounts. It is important to note that step 3 is not seeking to merely apportion a share of the CFC’s trading finance profits. It is instead seeking to identify the profits (which fall within the definition of trading finance profits), that are shown to be attributable to the excess.

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A CFC carrying on banking activity has excess free capital of £250m, but UK connected capital contributions of £150m. The step 1 amount is therefore limited to £150m. There is no step 2 amount.

In addition to a capital contribution from its UK parent of £150m equity, the CFC also borrows £150m from a connected UK company, at an interest rate of 5%.

The trading finance profits of the CFC are £30m.

Step 3 states that the Chapter 6 profits of the CFC are so much of its trading finance profits as it is reasonable to assume arise from the investment or other use of the step 1 and/or step 2 amounts.

In this case, a comparable is that the £150m loan from a UK connected company gives rise to income of £7.5m per annum (the income level comparison is the equivalent of profit, as a feature of free capital is that it should have negligible or no costs attached to it). It is reasonable to assume that the £150m equity - the step 1 amount - would give rise to a similar level of income. The step 3 amount, and therefore the Chapter 6 profit, is £7.5m.

Where a CFC is over-capitalised and the extent of the over-capitalisation varies throughout the accounting period, the step 3 amount should reflect the investment profits arising from the excess amounts determined at step 1 or step 2 as it varies from time to time throughout the period. For example, if there is a £100m excess for 8 months and no excess for 4 months, the step 3 amount is the investment return attributable to £100m for that 8 month period. This provides protection against any manipulation of capitalisation levels which could arise had step 1 or step 2 provided a specific application date or dates.