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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 - STEP 5: Determining the capital attribution tax adjustment:

Disallowance of interest and other costs on funding equivalent to attributed equity - overview

Having established the equity and loan capital, which a permanent establishment (PE) would require under CTA09/Part 2/Chapter 4, see INTM267761 to INTM267775, it is necessary to arrive at the hypothetical cost of such capital for the purposes of the capital attribution tax adjustment.

As far as the equity capital is concerned this will be nil. To the extent that there is deductible Tier 1 capital to be taken into consideration this will form part of the loan capital. The rate of interest to be applied to the total amount of loan capital will depend on a number of factors including the functional currency of the PE, the likely hypothetical mix of loan capital and to some extent the actual nature of, and rate of interest on, loan capital held by the PE and the bank of which it is part.

It is important to be clear that the mix of, and cost of, loan capital actually held by the PE will not necessarily determine the hypothetical cost of loan capital. Neither will that cost be based on the most tax effective capital cost, i.e., the maximum possible amount of tax deductible Tier 1 and Tier 2 subordinated debt. The aim is to arrive at an amount, which reflects the requirements of the legislation.

The hypothetical funding cost reached as described above must then be compared with the actual funding costs of an equivalent amount of funding in the PE. Clearly, any interest-free funds provided by the company will be deducted from this total figure first. An appropriate mix of interest-bearing funds held by the PE will then have to be determined and the actual interest costs of those funds identified.

The difference between the hypothetical funding costs for the appropriate mix of equity and loan capital and the actual funding costs of an equivalent amount of funding is the capital attribution tax adjustment required by CTA09/Part 2/Chapter 4. This will be carried to the PE’s tax computation. An example of how this might look is given in INTM267782.

The legislation specifies that no deduction may be made for any costs in excess of those that would have been incurred if the PE had the equity and loan capital assumed by CTA09/Part 2/Chapter 4. The term ‘cost’ is intentionally not limited in the legislation, except by its context, to give it a broader meaning than simply interest. Its context will restrict it to funding, funding related costs and costs incidental to funding. It will certainly include fees and incidental costs associated with loans, such as those described inITTOIA05/S58(2) to (4). It is also broad enough and intended to catch non-interest funding and funding related costs such as swap payments and premiums, whether related to hedging or used as the primary method of funding by, for example, embedded loans in swap arrangements. It will also include foreign exchange losses determined in accordance with normal rules, though it must be stressed that all these costs are limited to those part of the costs that relate to funding that is displaced from the PE by the assumptions on equity and loan capital.

For example, consider a PE of which the functional currency is sterling having:

  • assets of CHF1000M which are 100% funded by a loan from head office of CHF1000M at an interest rate of 4%,
  • been charged set up fees of CHF15M as an arm’s length arrangement fee,
  • on translating for tax purposes, a currency loss against sterling of CHF10m has been incurred on those costs.

If the analysis determined that the PE should be holding equity capital of CHF100M*, then no deduction may be made for the following:

Interest CHF40M x 10% = CHF4M
Arrangement fee CHF15M x 10% = CHF1.5M
Foreign exchange loss CHF10M x 10% = CHF1M
Costs to be disallowed     CHF6.5M

*NB this equates to 10% of the funding requirement and is used purely for arithmetic simplicity, it is not indicative of the level of capital likely to be held. Although the legislation does not require equity capital to be physically held by a PE, in practice the majority of PE’s are likely to have some equity capital already providing interest free funds. For example, they may have retained profits, provisions or their head office may have actually made physical allotments of capital to the PE. In such cases the costs for which no deduction may be made should be limited to those that relate to funding that is displaced by the additional amounts of equity capital assumed by CTA09/S21(2)(b).

Thus in the above example, if the PE already had CHF50M equity capital allotted to it, the position would be that the PE is:

  • 5% funded by its allotted (equity) capital,
  • 95% funded by a loan from head office of CHF950M at an interest rate of 4%,
  • charged set up fees of CHF14.25M as an arm’s length arrangement fee (assuming the fees are directly related to the amount of the loan),
  • on translating for tax purposes, a currency loss against sterling of CHF 9.5m has been incurred

If the analysis determined that the PE should be holding equity capital of CHF100M then no deduction may be made for the following (NB: 5.26% = 50 / 950):

Interest CHF38M x 5.26% = CHF2M
Arrangement fee CHF14.25M x 5.26% = CHF750,000
Foreign exchange loss CHF 9.5m x 5.2%6 = CHF500,000
Costs to be disallowed     CHF3.250M

In some cases, PE’s in the UK may have made adjustments in their tax computations to disallow interest in respect of free working capital adjustments agreed previously with HMRC. Such adjustments should be discontinued for accounting periods beginning on or after 1 January 2003 and replaced by capital attribution tax adjustments on the lines described above.