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HMRC internal manual

International Manual

The attribution of capital to foreign banking permanent establishments in the UK: The approach in determining an adjustment to funding costs - STEP 3: Determining the equity capital: the treatment of retained profits and losses

The Financial Services Authority (FSA) allows current year profits, net of any tax, anticipated dividends and other appropriations, to be included in the Tier 1 capital of a bank where the amount of those profits has been verified by the bank’s external auditors. Current year losses are to be recognised without an audit. This applies to companies carrying on a banking business in the UK and not to a permanent establishment (PE) of a foreign bank.

There are clearly difficulties in replicating the audit requirement in the PE scenario when considering the application of CTA09/Part 2/Chapter 4. It is therefore accepted by HMRC 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.

To the extent that profits have not been remitted to head office they can be taken into account as they accrue over the year on an averaged basis, consistent with the basis and frequency with which the risk-weighted assets are calculated. The same principle applies to losses. Where a bank has losses these should also be taken into account (the regulator requires losses to be deducted from a bank’s Tier 1 capital) and they will effectively increase the amount of capital that needs to be attributed to the PE.

There should be consistent treatment for both profits and losses with the same basis being applied to both.

The simple example set out below shows how retained profits, or losses, can affect the capital ratios of a PE independently of any movement in the risk-weighted assets (WRA). There are obviously other factors which can affect the capital ratios, such as changes in the levels of provisions.


A PE starts with assets of £1000m, all risk weighted at 100%.

It is agreed that:

  • at arm’s length the PE would have a total capital ratio of 12% of which 8% will be equity capital (for convenience, loan capital is not covered in this example),
  • in reaching the capital attribution tax adjustment, regard will be had to the average capital ratios based on the figures shown at the beginning and end of the year (unless there is a dramatic change in the assets levels, and profit/loss accruing over the year).

It is assumed that profits or losses have accrued evenly over the year (although this is unlikely to happen in reality).

Year 1

Non-interest-bearing capital, or ‘equity’ capital, of £80M is allotted to the PE at the beginning of the year. By the end of the year the WRA are still £1000M but losses for the year are £10M. The equity type capital is therefore reduced by these losses and is now £70m, with the equity capital ratio becoming 7% of the WRA.

If the loss of £10m accrues evenly over the year then the average loss will be £5m and the average figure of ‘equity’ capital is therefore £75m. The capital attribution tax adjustment should therefore reflect an interest disallowance in respect of £5m ’equity’ which the PE would have been required to find if it were a separate entity.

The same principles will apply equally in an attribution case since losses will increase the amount of capital that the PE would require at arm’s length.

Year 2

WRA remain £1000m but the PE has profits of £5m, which accrued evenly over the year and which have been retained at the year end.

At the end of the previous year the PE effectively had allotted capital of £70m (£80m less the £10m loss of the previous year). At the end of year 2 it has retained the profits of £5m so has allotted capital of £75m. The average ‘equity’ over the year is £72.5m and the average capital ratio will be 7.25%.

Again there will be a restriction of the interest deduction to reflect the fact that the PE would have required a further £7.5m ‘equity’ type capital at arm’s length.

In some cases a PE may have losses brought forward from a period before the commencement of CTA09/Part 2/Chapter 4. These losses will not affect the amount of capital to be attributed to the branch or the way in which the capital attribution tax adjustment is calculated. That is, ultimately a comparison will still need to be made between the amount of equity and loan capital that the PE would have at arm’s length and the amount that it actually has.

However, losses brought forward will have an effect where capital has previously been allotted to the PE for the purpose of making good those losses. If the PE were a separate entity then losses would erode the capital base as they arise. Similarly, where capital has been allotted to a PE to cover losses, then that capital must have been absorbed and therefore it cannot be regarded as still available when considering the amount of capital that the PE actually has.