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International Manual

HM Revenue & Customs
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Controlled Foreign Companies: The CFC Charge Gateway Chapter 6 - Trading Finance Profits: Capital requirements in the banking sector.

There are a number of regulatory requirements which govern the level of capital required for banks, building societies, and similar institutions. Within the UK these requirements are set by the Financial Services Authority (FSA) and are linked to:

  • the international requirements which arise out of the Basel accords (Basel I, II and III) and
  • the capital requirements set by the European Commission (the most recent of which is Capital Requirement Directive IV, published in July 2011).

Following on from the 2007 financial crisis, all regulators have moved towards a requirement for a greater amount of capital to be held by banks and similar financial institutions. So, for example, the European Commission CRD IV package, published on 20 July 2011, consists of a Capital Requirements Directive (CRD) and a Capital Requirements Regulation (CRR). These in turn reflect the Basel III capital proposals.

The stated aim of CRD IV is to increase both the quality and quantity of bank capital, including an emphasis on Tier 1, strengthening capital requirements for counterparty credit risk and introducing a leverage ratio, new capital conservation and countercyclical capital buffers. In addition, CRD IV includes proposals for a Single European rulebook, which is intended to replace the separate rules within each Member State with a harmonised approach across the UK.

The UK Government set up an Independent Commission on Banking (ICB) which reported in September 2011. The ICB recommendations, which have been adopted by the UK Government, included higher capital requirements, and mandatory minimum leverage ratios.

All of the regulatory requirements are based on minimum capital requirements, with associated buffers or margins above those minimums. In practice, banks ensure that they hold capital in excess of the minimum requirements set by the regulators. However, from a CFC perspective, the risk is in relation to banks holding too much capital or equity, rather than too little especially where the CFC is resident in a territory with a beneficial tax regime.

So although regulatory requirements may be a sensible starting point when reviewing a CFC’s capital requirements, a test that only required a bank to meet the regulatory capital requirements of the territory in which it was resident would not have any real impact as this identifies the minimum capital required to be held and does not identify the reason behind capitalisation in excess of the regulatory limit. The issue instead is the extent to which the equity-like capital held by a bank exceeds any regulatory requirement, and, if there is any excess, identifying whether there is a commercial (non-tax) rationale for retaining that level of capital.

As set out above, the TIOPA10/S371FA step 1 calculation approaches this by asking whether the free capital of the CFC exceeds that which it is reasonable to suppose would be held by the CFC if it was not a 51% subsidiary of any other company). This is subject to a further limitation which is that if the total UK capital contributions are less than the excess free capital, then the step 1 amount is limited to the total UK connected capital contributions.

In ascertaining the CFC’s free capital the facts and circumstances in each case may differ and consequently there will be a range of possible outcomes that reflect an appropriate commercial level of free capital, rather than a precise, fixed amount of free capital for each CFC.

In assessing whether the free capital of a bank exceeds that which would be held if the CFC was not a 51% subsidiary of any other company, there will be a number of factors which need to be taken into consideration. The following list is illustrative of the type of factors that can be taken into consideration with regard to this condition.

i) Local regulatory requirements.

Evidence that the local regulator has stipulated that the CFC hold a specified minimum level of capital (plus an appropriate buffer to ensure that that regulatory minimum is not breached) will in most cases be a suitable measure of a CFC’s free capital especially where the CFC is resident in a high tax territory.

In some circumstances, it will be necessary to understand the regulator’s approach to local capital requirements - for example, where a CFC’s local regulatory capital requirements appear higher than would be expected in that territory. In such cases it will be necessary to review and understand the basis for the regulator’s decision. This is likely to be the case where the local regulatory capital requirement for that CFC does not reflect similar local capital requirements for other companies (within the group or externally) in that territory.

Another example where further assurances may be needed is when the local regulatory requirements are significantly greater than would be the case if the CFC were subject to UK regulatory requirements.

ii) Group regulatory requirements.

To the extent that the lead regulator for a banking group sets regulatory requirements for the whole group, the expectation will be that those requirements will be reflected in the level of capital held by the CFC.

iii) Group capitalisation and distribution policy.

This will include evidence of consistency across the group covering both low and high tax jurisdictions. Evidence that the level of capital within a CFC in a low tax territory is similar to the level of capital in high tax territories will support the view that the CFC under consideration is not over-capitalised. This may require more detailed consideration than the simple application of a group capital average, as that average may be affected by certain holdings in certain jurisdictions. However, evidence that the group follows a consistent capitalisation policy which is independent of territorial tax considerations will support the view that a CFC is not over-capitalised. Similarly, a consistent group dividend policy would tend to support the view that a CFC is appropriately capitalised. Any exceptions to such a policy may warrant further consideration.

iv) Commercial Considerations.

Evidence of particular market-led or commercial considerations which required a particular level of capital being held by a CFC. These considerations may be linked to local regulatory requirements, but commercial judgement about market conditions, or concerns about particular transactions with independent counter-parties can also be taken into consideration.

Unusual or exceptional commercial circumstances will typically be short term in nature and not part of the structural financing structure of the CFC. Groups will need to be able to demonstrate that the additional free capital was required to be held directly by the CFC, rather than it being a group capital requirement. These commercial factors will be need to be considered alongside other factors such as regulatory capital requirements in the CFC’s territory of residence and that of the group, and whether obtaining a tax advantage was a consideration in fixing capital levels.

v) UK Tax Considerations.

Evidence to whether there is a link between the level of capital held and UK tax considerations. The most obvious case would be a CFC holding capital which is then used to fund loans back to UK connected parties. If such arrangements are in place, it will be harder for the CFC to demonstrate that there is a commercial reason for the level of capital held.

Annual Review Required

Although the CFC capitalisation position will need to be assessed on an annual basis, it is anticipated that groups will discuss the application of Chapter 6 with their CRM - with appropriate support from the Foreign Profits team within CTIS where necessary. Given the general terms adopted by the Chapter 6 legislation, it is expected that once the capitalisation of a CFC has been reviewed and agreed, the ongoing Chapter 6 position will be subject to a risk assessment approach for both sides.

Fluctuations in level of capital

The basic rule at TIOPA10/S371FA requires a determination of whether, at any time during the accounting period, the CFC has excess free capital (or, if less, free capital derived from UK connected capital contributions).

Applying this condition during the accounting period means that whilst it is not sufficient to test the position at the accounting date, nor is it necessary for the position to be tested on a daily basis. Although in strictness, any spike in the level of free capital could cause this condition to be triggered, the practical application of such an approach would be problematical.

Clearly, if it was determined that the CFC had excess free capital for, say, one week during an accounting period, then this would produce a “step 1 amount.” However, the application of step 3, which asks how much of the trading finance profits it is reasonable to suppose arose from the investment or other use of that excess free capital, would have to consider not just the step 1 amount, but also the length of time for which that step 1 amount was available. (See INTM207300 for the basic rule in determining the Trading Finance Profits.)

Subsidiaries of CFCs carrying on banking business

As a matter of practicality, it is expected that Chapter 6 will be applied to the direct banking subsidiaries of UK banking groups in the first instance. If it is determined that CFC A, which is a direct subsidiary of a UK bank, does not have any excess free capital, and therefore no charge arises under Chapter 6, does it follow that no Chapter 6 charge will arise in respect of all subsidiaries of CFC A ? The legislation applies to all CFCs on an individual entity basis, so it is not possible to exempt a sub-group from consideration under Chapter 6 on the basis that no Chapter 6 charge arises for the holding company of the banking sub-group.

However, it is expected that a group’s risk assessment, will cover the capitalisation position for a banking sub-group. If, as a matter of fact, the members of a sub-group have a similar business profile and a similar capitalisation profile, it will be reasonable for the relevant CFCs to be considered together. Conversely, if the business activities and the capitalisation profile of different CFCs within a banking sub-group are markedly different, then those differences will require further consideration.