The attribution of capital to foreign banking permanent establishment in the UK: Free working capital
Banks aim to maximise their profits by conducting the maximum amount of lending and dealing business that is possible without infringing the capital adequacy requirement (see INTM267701) they have been set. This means that they cannot borrow every pound they use in their business; they must have a certain amount of regulatory capital. Part of that amount, which will be at least equal to and normally in excess of the minimum amount of equity capital required by the regulator, is ‘free’ to the bank, since the bank is not paying interest to borrow it. The bank’s profit on this proportion of its capital will be much higher than its usual margin between the return on lending and its costs of borrowing. Therefore, the amount of the bank’s regulatory capital, particularly equity capital, has a direct effect on the profits it makes.
The position for a UK permanent establishment (PE) of a foreign bank until 31 December 2002 was, however, very different from that described above. While a foreign bank with a PE in the UK will itself be regulated in its home country, there is no FSA requirement for the PE to be regulated in the same way as an UK bank. This means that, if it chooses to do so, a PE in the UK, unlike a bank in the UK, is free to borrow the whole of the funds used in its business, without restriction. Thus, the absence of any regulatory requirement for free capital can result in higher funding costs overall and in lower profitability for a PE. It is quite possible for a foreign bank that is profitable overall to make a substantial loss in its UK PE, even if the terms on which the bank as a whole and the PE do business are broadly the same.
Prior to 1 January 2003 the only tax requirement for capital for UK PE’s was that described as ‘free working capital’. Free working capital adjustments made by HMRC, which in many cases would be based on the costs of fixed assets and the amount of capital required to cover other items such as losses, bear no resemblance to the regulatory capital that a PE would require if it were a separate entity regulated in the UK. In very broad terms these adjustments relate to the difference between capital formally allotted to a PE by the company of which it is part, and the amount the PE would need to fund identifiable capital expenses, such as buying premises or losses arising from start-up costs.
The free working capital adjustment process is by its nature very arbitrary. For example, if a bank allocates £50 million interest free to an UK PE by way of capital, then the commercial and tax profits will reflect the additional amounts earned on that free capital. If the bank does not allot any such capital and the PE has few physical assets in the UK, then the free working capital may be close to nil and the interest payable by the PE on the whole of the funds used in its UK business will be allowable for UK tax purposes, reducing the commercial profits and the UK tax payable.