Foreign banks trading in the UK through permanent establishments: Tax deduction for interest paid in the ‘ordinary course of business’
The legislation at CTA09/S32 prohibits the deduction of interest, or of other financing costs, where they are paid by a Permanent Establishment (PE) to another part of the same company. However, there is a general exception to this where the PE pays interest (or other financing costs) to another part of the company in the ordinary course of a financial business carried on by it. The meaning of financial business is defined at CTA09/S32(3).
Thus, interest paid by a UK banking PE to another part of the bank will be allowed as a deduction if that interest is payable in the ordinary course of its financial business. To the extent that any interest is not payable in the ordinary course of business then the deduction will be restricted. This restriction, and the domestic law provisions referred to above, are based on the text at paragraphs 18-20 of the Organisation for Economic Co-operation and Development (OECD) Commentary on Article 7 of the Model Tax Convention.
The meaning of the ordinary course of business is not set out in the legislation or in the OECD Model Commentary, but whether or not a particular PE has acted in a manner that is inconsistent with the ordinary course of its business will clearly depend on the facts of the case.
One situation where a PE may not be acting in a manner that is consistent with the ordinary course of its financial business is where it makes loans to thinly capitalised associated companies. To the extent that the PE can be regarded as funding such loans from money borrowed from another part of the foreign bank then the interest deduction obtained by the PE may need to be restricted.
- A UK PE obtains all of its funding from its head office at, say, 4%.
- It borrows £100m to make a loan of the same amount to a thinly capitalised associate.
- It is established that normally (i.e. if it were acting in the ordinary course of its business) it would only have loaned £75m, in which case it would only have borrowed £75m from its head office.
There is no reason why the full amount of interest receivable by the PE should be disregarded as there is nothing to prevent this from being chargeable to tax. However, the provisions of CTA09/S32 restrict the interest payable by the PE to the amount that would have been payable in the ordinary course of its business. The interest deduction would therefore be restricted to £75m x 4%.
This will not be the only situation in which CTA09/S32 will operate to restrict interest payable to another part of the bank, and of course any deduction for interest will be subject to the overall restriction contained in CTA10/S968. That is, CTA09/S30 may restrict the amount of interest that the PE can deduct even though that interest is incurred whilst carrying out normal banking business if the interest exceeds the amount that the PE would have paid if it had an arm’s length amount of equity and loan capital. In addition to this, a further interest restriction may apply under CTA09/S32.