Controlled Foreign Companies: The CFC Charge Gateway Chapter 6 -Trading Finance Profits: Banking Safe Harbour Regulations
The Banking “safe harbour” Regulations - SI 3041/2012 contain detailed conditions which enable banking CFCs to apply a mechanical capitalisation test. If a CFC meets the conditions set out in the Regulations, no Chapter 6 charge will arise in respect of the profits arising from the banking business of the CFC.
TIOPA10/S371FD confers the necessary powers for these regulations. The purpose of these regulations is to provide an alternative to the main Chapter 6 conditions for a CFC carrying on banking business. That alternative is a mechanical calculation which compares the tier one capital ratio of the CFC with the tier one capital ratio of the group as a whole.
Such a comparison may well form part of the process of assessing whether a banking CFC has excess free capital. However, these regulations are intended to offer an alternative, mechanical “safe harbour”. Unlike the capital interest test in the previous CFC regime, this banking safe harbour is based on UK regulatory capital ratio requirements. The aim here was to provide a safe harbour which was relatively simple to apply, and aligned with existing regulatory requirements.
The Regulations themselves are relatively short and straightforward. They are structured as follows.
- Regulation 2: Interpretation. This defines the terms used in the Regulations. These are covered in more detail below.
- Regulation 3: Disapplication of the primary legislation. Provided that the conditions within Regulation 4 are met, step 3 of Section 371FA(1) will not apply to the trading finance profits which arise from the banking business of the CFC.
- Regulation 4: Sets out the capital requirements test, the details of which are set out below.
- Regulation 5: Supplementary provisions which provide the necessary definitions and formulae to apply the capital requirements test in Regulation 4.
Definitions used in Regulations
The Regulations are based on the requirements of the Financial Services Authority (FSA) Handbook, and in particular on the requirements set out in BIPRU 11 and GENPRU 2 Annex 2 of the FSA Handbook.
These FSA rules set out requirements for banking groups to make regulatory returns which set out the consolidated capital position of the group. In particular, these regulatory returns set out details of the risk weighted assets and the total tier one capital of the group.
Regulation 2 simply uses the terms employed by the FSA Handbook as the basis for terms used in the safe harbour regulations. In particular, the regulations are based on the requirement that there is a group for which a return of consolidated information is required under BIPRU 11 - for the purposes of the regulations, this group is called a “UK Banking Group”.
Regulatory Capital Requirements Test
The actual capital “safe harbour” test is set out in regulation 4. It comprises three conditions. All three conditions need to be met in order for the Chapter 6 charging mechanism to be turned off by Regulation 3.
- Regulation 4(1) The first condition is that the CFC must be a member of a UK banking group throughout its accounting period.
- Regulation 4(2) The second condition is that the tier one capital ratio of the CFC at the end of its accounting period does not exceed the capital ratio limit of the group.
- Regulation 4(3) The third condition is that it must be reasonable to suppose that the average tier one capital ratio of the CFC throughout the accounting period does not exceed the capital ratio limit.
This third condition is an anti-avoidance measure, which is designed to prevent manipulation of capital levels. For example, in the absence of this condition, it would be possible for a group to hold a large amount of capital within a CFC for 11 months, and then to move that capital out of the CFC before the end of the accounting period. Whilst the level of capital at the end of the period may well be within the capital ratio limit, it is likely that for much of the accounting period the CFC had an excess of free capital.
The third condition would not be met in such circumstances, because the average tier one capital ratio throughout the accounting period would exceed the capital ratio limit.
Regulation 5: Capital Ratio Definitions
Regulation 5 provides the necessary definitions for the three conditions of the capital requirements test.
The capital ratio limit is defined as 125% of the group tier 1 capital ratio for the last regulatory return period which ends before the beginning of the CFC’s accounting period (the relevant accounting period).
So, for example, if the CFC’s accounting period is the period 1 January 2015- 31 December 2015 then the last regulatory return period which ends before 1 January 2015 would be the period ended 31 December 2014.
The safe harbour regulations allow groups to monitor the level of capital in the CFC during the accounting period by reference to a fixed limit which is determined by the group position at the end of the previous period.
The group tier one capital ratio is calculated as 100% x A/B, where:
- A is the total tier one capital of the group for the regulatory return period as shown either in the FSA regulatory return or, if different, in the group consolidated accounts, so long as they have been calculated on the same UK regulatory basis. This option is included to account for the possibility that the finalised figures in the group accounts may have been updated from the initial regulatory return - for example by including the profits of the final quarter.
- B is the total risk weighted assets of the group for the regulatory return period or, again, if different the amount shown in the group consolidated accounts (calculated on the same UK regulatory basis).
The capital requirements test makes a comparison between the capital ratio limit (set by reference to the group tier one capital ratio) and the tier one capital ratio of the CFC.
The tier one capital ratio of the CFC is calculated using the formula 100% x C/D, where:
- C is the net total tier one capital of the CFC at the time and
- D is the aggregate of the risk weighted exposure amounts of the CFC at that time.
This formula is to be applied on the assumption that BIPRU 11 applies to the CFC, and that the CFC was required to make a regulatory return other than as part of a group return.
The reason for the different terms used in the two ratios is simply that whilst the consolidated regulatory returns of banking groups actually use the terms total risk weighted assets and total tier one capital, the FSA Handbook refers to risk weighted exposure amounts and net total tier one capital. As Regulation 5(3) only deems that a CFC makes a UK regulatory return, it is necessary to use precise terms within the FSA Handbook, rather than the terms in common usage in the actual regulatory returns made to the UK. In practical terms, there is not intended to be any difference between the way the tier one capital ratios of the group and the CFC are calculated.
The regulations are not intended to be applied in such a way that a group has to carry out entirely separate capital ratio calculation for the CFC. Whilst in strictness it may be the case that a different method of risk weighting might be appropriate for a standalone entity such as a single CFC, this does not mean that groups will be required to use a different basis of calculation for the CFC.
The regulations are intended to allow a direct comparison between the level of capital in the CFC and the level of capital in the group as a whole. In order to allow such a comparison, the expectation is that the same basis of risk weighting would be used for both the group and the CFC.
Although the mechanics of the regulations require two separate calculations - one for the group and one for the CFC - another way of looking at the regulations is that they are asking whether the balance of capital and assets in the CFC is in proportion to the balance in the group as a whole.
An alternative approach would have been for the regulations to seek to identify the extent to which the CFC contributed tier one capital and risk weighted assets to the group regulatory return. However, this approach would have required various adjustments to take account of intra-group balances and transactions which would have been cancelled out on consolidation.
The capital ratio limit set by reference to the UK group regulatory return for the last period before the start of the CFC’s accounting period was 14%. This was calculated as 100% x total tier one capital of the group for the period/total risk weighted assets of the group for the regulatory return period.
- Total tier one capital 112.
- Total Risk Weighted Assets 1000.
- Group Tier One Capital Ratio 112/1000 = 11.2%
- Capital Ratio Limit is 125% of group tier one capital ratio: 11.2% x 125% = 14%
The CFC’s tier one capital ratio at the end of its accounting period was 12%. This was calculated as 100% x net total tier one capital/total risk weighted exposure amounts
- CFC total tier 1 capital 12
- CFC total risk weighted exposure amounts 100
- CFC tier 1 capital ratio 12/100 = 12%
However, for the first 9 months of the accounting period of CFC, additional tier 1 capital of 20 had been provided to the CFC from its UK parent. The tier one capital of the CFC at the start of the accounting period was 12. The risk weighted exposure amounts of the CFC had remained relatively static throughout the accounting period.
This amount of additional tier 1 capital through the application of Regulation 4(3) - Condition 3 - to the CFC could cause it to exceed its capital ratio limit. This regulation asks whether it is reasonable to suppose that the average tier one capital ratio of the CFC throughout the accounting period did not exceed the capital ratio limit.
On the basis that the risk weighted exposure amounts during the accounting period remained at 100, the tier one capital ratio of the CFC for the first 9 months of the accounting period would have been as follows:
- Total tier 1 capital 12 + 20 = 30
- Total risk weighted exposure amounts 100
- Average CFC Tier 1 capital ratio for first 9 months of accounting period = 30%
Although the average CFC Tier 1 capital ratio for the last quarter would have been 12%, the average CFC Tier 1 capital ratio for the accounting period exceeds the capital ratio limit of 14%. On a time-apportioned basis, the average CFC tier 1 capital ratio for the accounting period would have been 25.5%
It follows that in this example, Condition 3 in Regulation 4(3) is not met: it is not reasonable to suppose that the average tier one capital ratio of the CFC did not exceed the capital ratio limit.