INTM267790 - The attribution of capital to foreign banking permanent establishments in the UK: The approach in determining an adjustment to funding costs - STEP 5: Determining the capital attribution tax adjustment: Allotment of capital
In addition to the issue of “excess” equity addressed at INTM267785 there are other issues that could arise where capital is actually allotted to a permanent establishment (PE). To illustrate these, a simple example is set out below.
A PE estimates that it will have risk-weighted assets (WRA) of £1000M at the year end.
Its capital requirement is agreed to be 11%, split 8% Tier 1 and 3% Tier 2. For simplicity only it is assumed that Tier 1 is all ‘equity’ and that Tier 2 is subordinated debt.
The PE is therefore allotted non-interest bearing capital of £80M at the start of the year.
At the end of the year the WRA are still £1000m.
The accounts for the branch do not include interest at subordinated debt rates.
If the hypothetical arm’s length funding costs of the PE are compared to the actual funding costs then the only adjustment to be made in the computations for the year will be a negative one to reflect the interest rate that would be payable on an arm’s length amount of subordinated debt, in this case interest on £30M.
Overall there is of course a positive adjustment as the PE will have ‘equity’ capital that it did not previously have.
There is a fall in WRA to £900M.
The PE still has allotted capital of £80M.
8% of £900M is £72M. Whilst there may appear to be ’excess’ equity it is likely that the £80M is still within the arm’s length range and at arm’s length a bank is unlikely to repay equity in the short term simply as a result of a small step up in its Tier 1 ratio.
But what about the subordinated debt? Should it be assumed that the PE still carries an amount of £30M or should it be assumed that in view of the “excess” equity the PE would have reduced the level of subordinated debt?
At arm’s length a bank is unlikely to maintain exactly the same capital ratio year on year and so either of the above could be realistic assumptions. One solution could be to have regard to what has happened at the entity level: how have the ratios changed, and has subordinated debt been repaid? However a more practical solution may be to reach agreements which build in ‘tolerances’ within which the capital ratios can move.
In this example it has been assumed that at arm’s length the PE would have equity capital of 8% and loan capital of 3%. This could be regarded as the ‘minimum’ that the PE would require at arm’s length (this is not a reference to the regulatory minimum). Thus where say the amount of equity capital dropped below this level an adjustment would be required in the computations to take account of the difference between the amount of equity capital that the PE would have at arm’s length and the amount that it actually has.
If 8% and 3% are regarded as ‘minimums’ then some kind of upward movement or tolerance could be agreed and this could be based on the movements that occur in the whole entity’s capital ratios over a period of time.
Where equity appears to be ‘excess’ then consideration will need to be given to whether or not the amount of equity capital has in fact moved outside an arm’s length range and this is dealt with at INTM267785 above.