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HMRC internal manual

International Manual

HM Revenue & Customs
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Non-residents trading in the UK: profits of the PE: Attribution of capital to the permanent establishment - companies only: practical 4 step approach

It is worth stating at the outset that the adjustment required is purely a computational one for tax purposes and has no effect on the way in which the permanent establishment conducts or funds its actual business.

It may be helpful to consider the approach in terms of four steps:


Step 1 - Attributing the assets

The amount of capital required by a permanent establishment will depend on the size and nature of its activities. The assets attributable to the PE are those from which it derives profits including both tangible and intangible assets. These may not correspond to the assets shown on any existing balance sheet that the permanent establishment has. For example, where the permanent establishment is responsible for business where assets are held off balance sheet, those assets must be attributed to the permanent establishment. Conversely, some assets that are on the balance sheet at market value may not have required an equivalent amount of funding because their actual cost, either through in-house creation or by purchase which was lower than current value. Revaluations above or below cost should be disregarded.

Step 2 - The capital requirement calculation

The capital requirement calculation is essentially a hypothesised balance sheet for the PE prepared purely for the purposes of the attribution of capital exercise. Assets would be the amount determined under step 1. Liabilities would consist of a balancing figure representing a mixture of loan and equity capital. This part of the exercise is concerned with determining how much of that capital would be made up of interest-free equity and how much by interest-bearing loan capital if the PE operations were carried out by a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions. Thin capitalisation principles using an independent banker approach are used to determine that apportionment of the capital between debt and equity. Further guidance on the principles of thin capitalisation can be found at INTM540000.

HMRC does not accept that a permanent establishment would have the most tax efficient mix of capital that is theoretically possible, i.e. comprising the minimum amount of equity capital and the maximum amount of loan capital, because such capital structures are not in fact seen at arm’s length. So for capital attribution to permanent establishments, in addition to considering how much an independent banker might have loaned to a similar business operation with similar assets, there are a number of factors that may have a bearing on how much interest-bearing debt would have been carried by the permanent establishment operations if they had been carried out by a separate entity. Those factors could include:

  • The capital structure of the non-resident company as a whole;
  • The capital structure of other companies of the same size, trading in the UK;
  • The capital structure of other companies undertaking the same type of activities in the UK;
  • The capital structure of other companies, trading in the UK, that are comparable, in both size and in terms of its activities, to the permanent establishment operations.
  • Interest-free facilities - Where any part of the existing debt capital is on interest-free terms it can be treated as meeting part, or all, of the equity capital requirement.

Treatment of retained profits and losses

It is accepted that post tax profits can be counted as equity capital to the extent that these funds have been kept in the UK and not remitted to head office (the remainder of the entity). To the extent that profits have not been remitted to head office they can be taken into account as they accrue. Profit and loss accounts and balance sheets would need to be provided to demonstrate the measure of retained profits where these had not been provided in detail before. The same principle applies to losses. Where a non-resident company has losses these should also be taken into account and they will effectively increase the amount of capital that needs to be attributed to the permanent establishment. There should be consistent treatment for both profits and losses with the same basis being applied to both.

Step 3 - Determine the notional costs of the PE capital requirement

Step 3 is a calculation of the notional funding costs on the combined amount representing the equity and loan capital determined under step 2. So far as the equity capital is concerned this will be nil.

The notional interest and other borrowing costs applicable to the PE loan capital requirement should be derived chiefly from the actual terms, including interest rates and other charges, of actual loans borrowed by the non-resident company and permanent establishment. Other factors may then require adjustment such as where the actual loan currency differs from the functional currency of the permanent establishment.

Where the non-resident company and permanent establishment have various loan facilities with different rates of interest and charges, an appropriate mix of interest bearing funds held by the permanent establishment will then have to be determined and the actual interest and other costs of those borrowed funds identified.

There is an inevitable tension between the hypothesis of a permanent establishment being a distinct and separate enterprise and the fact that it is in practice part of a larger entity. The legislative requirement that the attribution should be based on the hypothesis that the permanent establishment is a distinct and separate enterprise, engaged in the same or similar activities under the same or similar conditions goes some way to resolving this tension. It recognises the need to look at the economic reality of the permanent establishment’s activities. In line with this, and making it clear that the legislation is not simply seeking to treat the permanent establishment for tax purposes as if it were a free standing subsidiary of similar size, CTA09/S21(2)(a) states (for the avoidance of doubt) that among the same or similar conditions are included the fact that the permanent establishment has the same credit rating as the non-resident company of which it is a PE. That reflects the economic and legal reality that the PE is able to obtain funds at a cost below that of an independent entity of the same size. Consequently there should be no hypothesised additional borrowing cost paid from the PE to the rest of the entity on the assumption that the rest of the entity guaranteed the PE’s assumed borrowings.

Incidental costs of borrowing could also be restricted. The legislation in CTA09/S30 specifies that no deduction may be made for any costs in excess of those that would have been incurred if the permanent establishment had the equity and loan capital assumed by CTA09/S21(2). The term “cost” is intentionally not limited in the legislation, except by its context, to give it a broader meaning than simply interest. Its context will restrict it to funding, funding related costs and costs incidental to funding. It will certainly include fees and incidental costs associated with loans, such as those described in ITTOIA05/S58. It is also broad enough and intended to catch non-interest funding and funding related costs such as swap payments and premiums, whether related to hedging or used as the primary method of funding by, for example, embedded loans in swap arrangements. It will also include foreign exchange losses determined in accordance with normal rules, though it must be stressed that all these costs are limited to that part of the costs that relate to that part of the funding that has been displaced from the permanent establishment by the assumptions on equity and loan capital.

Step 4 - Determine the capital attribution tax adjustment to be made

This is the simple calculation of the difference between the permanent establishment’s claimed funding costs and the notional costs of the PE capital requirement calculated in step 3. The capital attribution tax adjustment should be carried to the PE tax computation.