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HMRC internal manual

International Manual

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 4: Determining the loan capital: Tier 2 subordinated debt

When considering a mix of capital, it is possible that a hypothesised permanent establishment (‘PE’) would have a mix of equity and loan capital that would include a proportion of Tier 2 subordinated debt.

HMRC does not accept that the PE will have the most tax efficient mix of capital that is theoretically possible i.e. the maximum amount of subordinated debt possible under the Financial Service Authority’s (‘FSA’) capital adequacy directive rules. This is because it is highly unlikely that a separate standalone entity would have such high levels of costly subordinated debt. Research into the published accounts for banks trading in the UK and internationally has shown that they do not carry high levels of subordinated debt. A number of UK and major international banks have Tier 2 capital that is less than maximum they could hold and that Tier 2 capital often contains significant levels of general provisions and reserves, rather than substantial amounts of subordinated debt.

As with innovative or hybrid Tier 1 debt (see INTM267773), it may be difficult to find companies that are true comparables. A practical starting point will therefore be the capital structure of the bank as a whole. Consider, for example a bank with the following capital structure:

  • Tier 1 capital ratio of, say, 7% with 1% being innovative or hybrid Tier 1.
  • Tier 2 capital of, say, 4%, of which 2% is subordinated debt.
  • The balance is provisions and reserves.

In such circumstances, it may be appropriate to hypothesise that the PE would have a similar capital structure. These ratios could then be applied to the PE’s risk-weighted assets (‘WRA’), taking into account the actual reserves and provisions of that PE. Assuming for simplicity that the PE does have the same level of reserves and provisions as the company as a whole, this would effectively mean that the PE would have equity capital of 6% in Tier 1 with a further 2% of capital, in the form of reserves and provisions, in Tier 2. It would also have loan capital of 3% (1% in Tier 1 and 2 in Tier 2). If the PE has different figures of reserves and provisions then the mix of capital included in Tier 2 may be different to that held by the company as a whole.

There may be instances where such an approach would not produce an attribution of capital to the PE that would fall within an arm’s length range. For example, the company as a whole may have been building up a ‘war chest’ to make further acquisitions, so it may not be reasonable to simply use the capital structure of the company as a whole as a blueprint for the capital structure of the PE. Additionally, the activities of the PE may be sufficiently different from the activities of the company as a whole that the PE would have had a somewhat different capital structure at arm’s length as an independent entity. However, even in these two situations it is envisaged that the capital structure of the company could still be used as a starting point and adjustments could then be made where these could be justified.

Generally, where the capital structure and ratios of the company as a whole are applied to the WRA of the PE, adjustments would not be required unless the resulting ratios clearly gave rise to a figure of capital that fell outside an arm’s length range. That is, where the results would be inconsistent with the range generally seen for companies carrying on a banking business in the UK, or would be below or out of line with the requirements of the FSA Capital Adequacy Directive.