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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 4: determining the loan capital: additional Tier 1 capital

Under Basel III banks must hold capital equal to at least 6% of Risk Weighted Assets. Of that 6%, 4.5% must be Common Equity Tier 1 (CET1) capital and 1.5% can be Additional Tier 1 (AT1) capital. AT1 capital is comprised of capital instruments which have certain characteristics of both equity and debt. EU regulation No 575/2013 on prudential requirements for credit institutions and investment firms (CRR) applies Basel III principles. The taxation of AT1 in the UK is applied under The Taxation of Regulatory Capital Securities Regulations 2013 SI 2013/3209 (“The Regulations”)

Under the regulations AT1 Regulatory Capital Securities (RCS) are treated as loan relationships and the coupons on them are deductible under the loan relationship rules and are treated as interest for income tax purposes.

S21 CTA 2009 provides that a UK permanent establishment (PE) of a foreign bank shall be assumed to have such equity and loan capital as it could reasonably be expected to have if it were a distinct and separate enterprise, engaged in the same or similar activities under the same or similar conditions. This means looking not just at the amount of equity capital that the PE would have at arm’s length, but also looking at the mix of CET1 and AT1 that it would have if it were a separate enterprise trading in the UK in the same or similar conditions.

Where it is accepted that a PE can be hypothesised as having AT1 capital then the amount of any ATI capital cannot exceed the amount that the company would be able to issue if it were a separate enterprise trading in the UK.

The regulations also provide that if there is any write down of the principal amount of the security, or conversion of the security to CET 1 capital, or any write up of the principal following a temporary write down, in accordance with any regulatory requirements or the provisions of that security, no credit or debit is to be brought into account under part 5 of CTA 2009. In accordance with the separate enterprise principle no credit or debit on such write downs, conversions or write ups should be brought into account in respect of the UK PEs of non-UK resident banks where AT1 capital is attributed to the PE.

The position where the company has issued AT1 capital

If the company itself has issued AT1 capital, then an appropriate proportion of this may be attributed to the PE if the PE would meet the regulatory requirements for such an issue if it were a separate enterprise. Thus the company must hold CET1 capital at least equal to 4.5 % of RWAs.

Provided that the conditions mentioned above are met, HMRC would be prepared to accept that an appropriate proportion of the AT1 capital issued by the company should be hypothesised as attributable to the PE, even if the branch was not itself of a size (in terms of assets etc.) to make such an issue likely.

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The position where the company has not issued AT1

There may be cases where the home state does not allow the issue of AT1 capital so there is none in the company, but the UK PE being treated as a standalone company in the UK would both satisfy the regulatory requirements for an issue of AT1 and would be of a sufficient size to make such an AT1 issue. If this is the case, HMRC will accept, in principle, that the UK PE may include an appropriate proportion of AT1 in its loan capital structure.

However, where there is no AT1 capital in the company as a whole and the home state regulator does allow such issues, it is extremely unlikely that HMRC would accept that a PE would have such AT1 capital, even if the PE were of a size etc. to make such an issue. That is, the fact that the company as a whole has chosen not to issue AT1 capital would be taken as a strong indication that the PE would similarly have chosen not to issue such instruments if it were a separate enterprise.

In considering whether an issue qualifies to be treated as AT1 capital for the above purposes, HMRC will have regard to how closely the terms and conditions of the issued instrument approximate to those of an RCS which would meet the requirement of CRR. In particular HMRC will take into consideration whether the issuer of the RCS is resident in a state which applies the terms of Basel III and whether the RCS would be regarded as AT1capital by the regulatory authorities in that state.

Regulation 8 contains an anti-avoidance provision. Where a bank issues an RCS and there are arrangements the main purpose, or one of the main purposes, of which is to obtain a tax advantage for any person, regulations 3 to 7 of the Regulations do not apply so the securities will not receive the treatment prescribed by the Regulations. Similarly, if a PE is attributed AT1 capital and there are such arrangements, then payments in respect of that capital will not be receive treatment similar to that prescribed by the Regulations and the RCS will not be treated as a loan relationship.