INTM267776 - 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. Prior to 1 January 2019, the taxation of AT1 in the UK is applied under The Taxation of Regulatory Capital Securities Regulations 2013 SI 2013/3209. As of 1 January 2019, The Taxation of Regulatory Capital Securities Regulations 2013 have been revoked and ‘new’ Hybrid Capital Instrument (HCI) rules introduced at s475C CTA 2009 (“HCI rules”).
Most, if not all, AT1 instruments are expected to meet the definition of HCI in s475C CTA 2009 which means the coupons on them will normally be deductible. The special securities rules will apply where the interest paid is more than the commercial rate.
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 AT1 capital cannot exceed the amount that the company would be able to issue if it were a separate enterprise trading in the UK.
Unlike the Regulatory Capital Securities Regulations, the HCI rules do not include specific detail in respect of write downs or conversion of securities. Taxpayers should look to s322 CTA 2009 to ascertain whether credits are required to be brought in to account.
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.
HMRC would also be prepared to accept an issuance from a non-EEA company if it can be confirmed that the coupon on the instruments are deductible because they would, on the assumption that they had been issued by a UK bank, fall within the definition of HCI.
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 take into consideration whether the issuer of the instrument is resident in a state which applies the terms of Basel III and whether the instrument would be regarded as AT1 capital by the regulatory authorities in that state.
Section 475C(9) CTA 2009 contains an anti-avoidance provision. Where a bank makes an election to include an AT1 instrument in the HCI rules and there are arrangements the main purpose, or one of the main purposes, of which is to obtain a tax advantage for the bank or any other person, the AT1 instrument will not be a HCI and the coupon may not be deductible. Similarly, if a PE is attributed AT1 capital and there are such arrangements, then payments in respect of that capital may not be deductible.