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HMRC internal manual

International Manual

Non-residents trading in the UK: profits of the PE: Attribution of capital to the permanent establishment - companies only: practical example - non-financial business

A Swiss company manufactures widgets through a PE factory in the UK. The widgets are sold by the Swiss company to a third party distributor. The Swiss company has other manufacturing operations carried out through subsidiaries in various territories. In the year of enquiry the Swiss company pays interest of 6m to a bank on a new loan of 100m that was obtained to purchase the UK factory and plant and machinery at a cost of 100m. Also an initial 3% arrangement fee of 3m was paid. The loan is secured in part by the UK premises and in part by a guarantee from the Swiss company relating to its other world-wide assets. All of the costs of interest (6m) and arrangement fee (3m) are claimed in the tax computations of the UK PE.

The UK PE has no assets other than the factory and plant and machinery. These had been purchased quite recently at arms length so there is no suggestion that their value is significantly more or less than 100m. Clearly a borrower would not be able to obtain a loan from an independent party if the balance sheet was thinly capitalised in this way. A lender would seek to minimise its own risk by insisting on equity shareholders putting up equity to absorb some of the risk themselves should the business plan fail to repay the loan and interest throughout the term of the loan.

Step 1: Determine the assets attributable to the permanent establishment
 
Step 2: Make the capital requirement calculation
Step 3: Determine the notional costs of the PE capital requirement
Step 4: Determine the capital attribution tax adjustment to be made

Step 1: Determine the assets attributable to the permanent establishment

The permanent establishment assets in this simple case are clearly 100m. In the recent purchase the premises were valued at 90m and the plant and machinery at 10m.

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Step 2: Make the capital requirement calculation

The security that a lender would take from taking a charge over the premises could be quite a high percentage of its value, e.g. between 75% to 95% of the recent purchase price, i.e. between 67.5m and 85.5m less anticipated costs of potential foreclosure. In this case because the PE income is low compared to the costs of servicing the debt (interest and principle repayments) the banker might prefer to minimise risk by offering only the lower amount.

There are no factors to be taken into account in respect of the company’s capital structure and the banker’s approach is not out of step with that that would be taken towards similar operations in the UK carried out by separate entities.

So, the capital requirement of 100m would be comprised of equity of 32.5m and debt of 67.5m.

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

The notional costs of the 32.5m equity would be nil as equity is interest-free capital. The costs of 67.5m of the debt are simply 67.5% of the interest and arrangement costs:

Interest allowable 6m @ 67.5% = 4.050m
         
Other costs 3m @ 67.5% = 2.025m

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

The borrowing costs claimed for the accounting period were 9m so the amount disallowed is 2.925m

Because the costs of borrowing are known to be a settled 6m for each of the subsequent 4 years it should not be necessary to review the case again unless significant losses were to arise, in which case the losses would require further capital attribution.