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HMRC internal manual

International Manual

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HM Revenue & Customs
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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: permanent establishments funded entirely by borrowing in local markets

Under the legislation at CTA09/Part 2/Chapter 4 a UK permanent establishment (PE) is treated as having the equity capital that it would have if it were a separate enterprise engaged in the same or similar activities under the same or similar circumstances. This applies equally whether funding for the PE is obtained directly from third parties or from head office.

Where all of the funding for the PE is from external sources, then any equity capital that would be required by the PE at arm’s length will be treated as displacing an equal amount of third-party debt. The surplus third-party funds will then be regarded as money raised by the PE for other parts of the company. This can be illustrated by a simple example:

Example

Assume that:

  • a UK PE has loans to customers of £100m, fully funded by monies that it raises in the London market,
  • it receives interest income on the loans at 6% , and
  • it pays interest to third parties at 5%
  • all of the loans are risk weighted at 100%, giving risk-weighted assets of £100m
  • the PE would, under CTA09/Part 2/Chapter 4, require 11% capital to support those assets, 8% equity and 3% loan capital, giving its equity capital as £8M.

Before the attribution of capital to the PE it has the following profit and loss account:

Interest income £100M @ 6% £6.0M  
     
Interest expense £100M @ 5% £5.0M  
Pre-tax profit £1.0M  

The £8m equity will effectively displace £8m of the funds that the PE has raised in the market, along with the associated interest cost. This displaced £8m of third-party loans will be regarded as raised by the PE for other parts of the same company and the profit and loss account will be as follows:

Interest income £100m @ 6% £6.0M  
     
Interest expense £92m @ 5% £4.6M  
Profit before tax £1.4M  

The displacement of third-party funds will lead to a disallowance of interest costs. In this situation HMRC will not expect an attribution of income to the PE on the £8m in addition to the interest disallowance.