Non-residents trading in the UK: profits of the PE: Allocation of expenses in the attribution exercise
Method of allocation
The domestic legal provisions for deduction of expenses in arriving at the amount of the non-resident’s UK chargeable profits follow the same general principle as do the provisions on attribution of profits generally. The rules for allocation of expenses in CT cases are specifically stated at CTA09/SS21-32 (formerly ICTA88/S11AA and Schedule A1) since the FA03 provisions introduced the ‘separate entity principle’ (INTM267040) and for IT cases the general ICTA provisions apply. (If the Business Profits article of a treaty applies and it is based on Article 7 of the OECD model the same separate enterprise approach is adopted- see below.) In either case the result is that expenses are only attributable to the PE or UK operations where the expense was incurred for the purposes of the PE or UK operations regardless of whether the PE reimburses sums initially paid away by another part of the entity. This applies whether or not the expenses are incurred by the UK PE itself or by another part of the non-resident company in another territory but the expenses must actually have been incurred as a real cost by the non-resident company. For example, no deduction could be allowed to the PE for rent hypothetically charged to it by the rest of the entity of which the UK PE was a part. Rent could only be allowed as a deduction in calculating the PE profits if the entity as a whole paid rent to another party for premises that were used in the PE operations, i.e. a real cost had been incurred and it was attributable to the PE.
Where expenditure is incurred for other purposes apart from those of the UK permanent establishment alone then a reasonable apportionment should be made to calculate the expense attributable to the UK PE. For example, if the Swiss head office of a non-resident entity paid a marketing consultant a monthly fee for services provided to several PEs in various European countries including the UK - the monthly fee should be apportioned on any reasonable basis. Depending on the facts in any case, this may be by reference to a proportionate part of the expense based on relative turnover being attributed to each part of the entity whose operations received marketing services.
It may be appropriate for the expenses attributable to the UK operations to include a proportionate part of general administrative costs of the entity as a whole. Any reasonable method of apportionment can be adopted, e.g. relative turnovers or gross profits of the different parts of the enterprise. The chosen method should be applied consistently from year to year. Care should be taken to eliminate expenditure that would not be allowable under UK domestic law, e.g. capital costs or business entertaining.
Royalties, license fees or other payments for the use of intangible assets
CTA09/S31 specifically prohibits a deduction to a PE for ‘intra-entity’ payments for the use of intangible assets, e.g. trade or brand names or any other intellectual property. This means that where such a payment is purported to be made by the PE to any other part of the non-resident company of which it is a PE the amount cannot be allowed in calculating the profits attributable to the PE. The only circumstances when payments for the use of intangible assets can be allowed to the PE are where the entity as a whole has incurred such a payment to an external party and the payment was wholly or partly in respect of the PE business. For example, the non-resident company pays royalties under a licence agreement to use particular software that is employed in the business carried out through the UK PE. As with any other expenses incurred, where the expenses are less than entirely in respect of the PE’s business the expense may be apportioned on a reasonable basis.
Interest or other financing costs
CTA09/S32 specifically prohibits a deduction to a PE for ‘intra-entity’ payments of interest or other financing costs. This means that where such a payment is purported to be made by the PE to any other part of the non-resident company of which it is a PE the amount cannot be allowed in calculating the profits attributable to the PE. (This prohibition does not apply to regulated banks or other financial businesses as defined at CTA09/S32(3)) and there are special rules for that sector. If you are concerned with a financial business case you can find guidance on attribution at INTM267130 onwards and in Parts II-IV of the OECD Report on the Attribution of Profits to PEs. The only circumstances when payments of interest or other financing costs can be considered for deduction in calculating the PE profits are where the entity as a whole has incurred such a payment to an external party and the payment was wholly or partly in respect of the PE business. For example, the non-resident company pays interest under a loan agreement in respect of funds used to purchase plant and machinery that is employed in the business carried out through the UK PE. As with any other expenses incurred, where the interest is less than entirely in respect of the PE’s business the expense may be apportioned on a reasonable basis.
For foreign companies, for accounting periods beginning on or after 1 January 2003, interest is only deductible in calculating the chargeable profits of a UK PE where the interest does not exceed the amount that would have been payable under the ‘separate entity principle’ (INTM267040). Therefore, before allowing the deduction of interest to a PE of a non-resident company you should consider whether the UK operations would be thinly capitalised if they had been carried out through a UK subsidiary entity. The guidance on carrying out a PE capital attribution exercise is at INTM267150.
Treaty provisions on attribution of expenses to a PE
Where a double tax treaty with permanent establishment and business profits articles applies there should be no tension between the treaty (taken together with the treaty commentary) and domestic law provisions for attribution of expenses and profits to the PE. This is because, when considering the OECD model which most of the UK treaties follow, the treaty rules will generally amount to the same result as do the domestic rules. Specifically the model treaty requires:
At Article 7(2) -
…an attribution of profits to the PE which it might have been 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 PE.
And at Article 7(3) -
In determining the profits of the PE, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the PE is situated or elsewhere.