INTM267769 - 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: the arm’s length amount

The legislation at CTA09/S21(2)(b) assumes that a UK permanent establishment (’PE’) has the equity capital that 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 circumstances. The question therefore arises as to what this amount of equity capital should be.

If the PE were a separate enterprise trading in the UK then it would be set a minimum level of regulatory capital by the PRA. Whilst this minimum would not be less than 8% of the total risk- weighted assets, capital levels set by the Prudential Regulation Authority (PRA) may range from between 9% to 15%, with some exceptional cases where the ratio is much higher. In addition, most banks actually operate with levels of capital in excess of the level set by the PRA and the amount of this excess varies depending on the needs, activities and the attitude of that particular bank. Thus, as a starting point, the amount of capital that the PE would have at arm’s length would be over and above the regulatory minimum, but the questions still arise as to what that regulatory minimum would be and how much more capital the PE would actually have. In forming a view on this there are a number of factors that could be taken into account:

• the level of capital that the bank has as a whole,
• the level of capital held by other banks of the same size, trading in the UK,
• the level of capital held by banks undertaking the same type of activities in the UK,
• the level of capital held by a bank, trading in the UK that is comparable, in both size and in terms of its activities, to the PE.

In practice it may be difficult to find companies that are true comparables in both terms of size and level or type of activities, so as a practical starting point consideration may be given to the capital levels of the company of which the PE is a part. Thus, if the bank as a whole has a capital ratio of say 11%, then as a starting point it might be assumed that the PE would have a similar capital ratio.

There may be instances where such an approach would not produce a level of capital that would be in an arm’s length range, for instance where the bank itself is based in a country where banks’ capital falls very close to the regulatory minimum (where the figure might be too low for a PE in a country where banks were generally much more generously capitalised). In such a case, using the capital ratio figure of the bank as a whole might produce a figure that would be less than the minimum level of capital that would be required by the PRA. More critically, it might give a figure which is significantly out of line with the known level of capital for companies carrying out a banking business in the UK.

It may also be the case that the activities of the PE are not a microcosm of the activities of the bank as a whole, with the PE undertaking activities which are either more, or less, risky than those undertaken by other parts of the same company. However, in this situation it is envisaged that, if necessary, adjustments could be made, so if PE carries on a relatively greater proportion of more risky activities than the bank as a whole, it might be reasonable to assume that as a stand alone it would have a slightly higher capital ratio, and vice versa.