INTM267784 - 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:
Allowance for potential additional interest costs and other costs on loan capital attributed to a UK permanent establishment
The legislation specifies that no deduction may be made for costs in excess of those that would have been incurred if a UK permanent establishment (‘PE’) had the equity and loan capital assumed by CTA09/S21(2)(b). This requires a composite adjustment to be made to interest and other funding costs in the tax computation (the capital attribution tax adjustment).
One of the assumptions in CTA09/S21(2)(b) is that the PE has loan capital, determined as described in INTM267771 to INTM267775. It is possible that attributed loan capital, which could be subordinated debt or innovative Tier 1 capital, may carry a higher interest rate (a premium to the lender for accepting the subordinated terms of the loan) than the actual funding of the PE if, for example, the PE were funded entirely at lower short-term interest rates. Therefore, it is possible that additional interest costs may need to be taken into account when considering the interest element. The following extension of the first example in INTM267782 illustrates this point.
A permanent establishment is:
- 100% funded by a loan from head office of CHF1000M at an interest rate of 4%,
- charged set up fees of CHF15M as an arm’s length arrangement fee,
- on translating for tax purposes, subject to a currency loss against sterling of CHF10M.
If the analysis determined that the PE should be holding equity capital of CHF100M and loan capital of CHF40M as subordinated debt at 6% then:
Additional interest to be allowed on the subordinated debt will be:
| Interest on the subordinated debt | CHF40M x 6% | = | CHF2,400,000 |
| Less interest on existing funding of same amount | CHF40M x 4% | = | CHF1,600,000 |
| Additional interest to be allowed | - | - | CHF800,000 |
Therefore, the costs for which no deduction may be made become:
| Interest | CHF 40m x 10% | = | CHF4,000,000 |
| Arrangement fee | CHF 15m x 10% | = | CHF1,500,000 |
| Foreign exchange loss | CHF 10m x 10% | = | CHF1,000,000 |
| Less Additional interest on subordinated debt | - | = | (CHF800,000) |
| Costs to be disallowed | - | - | CHF5,700,000 |
The question arises as to what the additional interest rate and other terms should be for the attributed loan capital. The obvious comparable is the actual rate on the bank’s loan capital, but this will not always be the case. If the bank has not issued loan capital to third parties then comparables may still be available from market data for issues of subordinated and other types of debt for banks across the range of credit ratings.
Another circumstance in which the bank’s own loan capital may not be a suitable comparable would be if it was issued before the PE was brought into existence. The terms prevailing at the time the subordinated debt was issued may not be arm’s length at the time the PE was created. Here it will be necessary to fall back on third-party comparables. It should be stressed that the legislation is not treating PE’ as created on 1 January 2003, so this should be a comparatively rare occurrence.
It will be necessary to review the interest rates and the premiums used on loan capital from time to time as they will change for new issues with changes in the market. It would not be an arm’s length assumption that loan capital once issued is permanent. Even perpetual debt issued as innovative Tier 1 is commonly created to be repayable after a period of time (usually around 5-10 years) through, for example, the use of interest payment step-ups that make it uneconomic to continue the loan after they apply.
The above would be a very simple situation. Complexities likely to be encountered are that the PE may be funded on a composite rate that already takes account of the additional interest and other funding related costs of issuing subordinated debt or innovative Tier 1, or the PE is funded (whether from head office, associates or third parties) by various loans of different duration, carrying a variety of interest rates, in different currencies, etc.
Where a simple weighted average of the company’s funding costs is used as the rate on head office loans then, if the capital structure agreed is broadly equivalent to that of the company as a whole, an adjustment for the attributed loan capital is unlikely to be necessary as the additional costs on the attributed loan capital will already have been taken into account. Where the capital structure agreed for the PE is different from that of the whole bank and the amounts are likely to be significant, an adjustment may need to be calculated. This could be positive or negative depending on whether the PE was assumed by CTA09/Part 2/Chapter 4 to hold proportionately less or more loan capital than the bank.
Where the PE is funded by loans at different rates of interest and on different terms, or where an adjustment must be made on a composite rate, there is no automatic presumption that the loan capital assumed byCTA09/S21(2)(b) should displace, or be replaced with, cheaper overnight funding. The loan capital should be treated as displacing or being replaced by longer term funding which is fulfilling a similar role in the funding structure of the PE. However, there may exceptionally be circumstances where the PE can show that a different answer is appropriate. For example, it may be that a particular issue of long terms bonds may be specifically linked to an identified structured transaction with a third party and, as such, it may not be appropriate to treat it as being displaced by attributed loan capital. Instead the loan capital should be treated as displacing other debt funding.
If subordinated debt or innovative Tier 1 has been issued through and used to fund the PE, then the interest rate on that debt should be used to calculate the costs of the PE’s loan capital. However, to the extent that the amount of such loan capital issued exceeds the amount assumed by CTA09/S21(2)(b) then a disallowance will still arise. The disallowance to be taken into account in the capital attribution tax adjustment will not be the whole of the interest on the excess loan capital, only the additional costs associated with the form of the loan capital compared to ordinary funding. In the same way that, when attributing additional loan capital, there should not be an automatic presumption that the additional loan capital displaces the cheapest funding, neither should it be presumed that excess loan capital should be replaced by the cheapest overnight funding. A similar principle to the above applies, namely that the replacement debt will most likely be longer term funding which is fulfilling a similar role in the funding structure of the PE, albeit not subordinated.
How this might work in practice is illustrated by the following example.
A permanent establishment is:
- 100% funded by a loan from head office of CHF 900M at an interest rate of 4% and a subordinated loan of CHF 100M from an associate at an interest rate of 6%,
- charged set up fees of CHF 15M as an arm’s length arrangement fee,
- on translating for tax purposes, subject to a currency loss against sterling of CHF10M
If the analysis determined that the PE should be holding equity capital of CHF100M and CHF40M of loan capital as subordinated debt at 6%, then no deduction may be made for the following:
There will be no additional interest to be allowed on the subordinated debt as it is assumed by CTA09/S21(2) that this will be reduced to CHF40M from the CHF100M actually held. However, a further disallowance will arise in respect of the premium on the CHF60M excess loan capital:
| Interest on the existing subordinated debt | CHF60M x 6% | = | CHF 3,600,000 |
| Interest on attributed funding of same amount | CHF60M x 4% | = | CHF 2,400,000 |
| Additional interest to be disallowed | - | - | CHF 1,200,000 |
Therefore, the costs for which no deduction may be made become:
| Interest | CHF40M x 10% | = | CHF 4,000,000 |
| Arrangement fee | CHF15M x 10% | = | CHF 1,500,000 |
| Foreign exchange loss | CHF10M x 10% | = | CHF 1,000,000 |
| Plus: additional interest on excess subordinated debt | - | = | CHF 1,200,000 |
| Costs to be disallowed | - | - | CHF 7,700,000 |