Benchmarking the Capital Attribution Tax Adjustment for UK branches of foreign banks
Non-UK resident companies trading in the UK through a permanent establishment (PE) must determine their 'attributable profits’ by applying the ‘separate enterprise principle’. This article shows how the capital attribution tax adjustment (CATA) for bank branches can be benchmarked to market rates and to capital ratios of comparable banks to produce a more accurate result.
The separate enterprise principle assumes the PE to be a distinct and separate enterprise, conducting the same or similar activities as the PE under the same or similar conditions, and dealing wholly and independently with the company of which it is part. It also assumes that the PE:
- Has the same credit rating as the non-UK resident company.
- Has such equity and loan capital as it could reasonably be expected to have in the hypothetical circumstances envisaged.
HMRC’s International Tax Manual explains that PEs can estimate what levels of equity and loan capital they might have under the principle. The manual aims to evaluate whether a PE’s accounting profit should be adjusted to arrive at the taxable profit that would arise if its proportions and costs of equity and loan capital were as they would be under the assumptions of the separate enterprise principle. For banks, HMRC recommends a 5-step CATA process. Whereas for non-banks, HMRC recommends a 4-step CATA process.
Details of the CATA calculation for bank branches were addressed in our previous article (Interest deductions for foreign banks operating in the UK).
Opportunities to benchmark key elements of the CATA
HMRC’s 5-step methodology for banks is non-statutory and non-binding. Many banks compute their CATA on the assumption that the UK branch’s capital ratios should mirror those of their head office. Although banks are seldom penalised for making this assumption, HMRC guidance confirms that this approach is just a starting point. The capital ratios adopted from the parent company are merely proxies for the amounts which a true separate enterprise might have. HMRC guidance points out that the UK branch may consider whether the head office capital ratios are truly representative of the equity and loan capital which a separate, independent bank would have.
HMRC acknowledges alternative approaches to arrive at the CATA, through benchmarking against banks of similar size and activities. Benchmarking relies on identifying similar UK entities to establish arm’s length capital ratios and costs of capital. Benchmarking is also seen as more accurately reflecting the operating environment of the bank branch in the UK. Failure to adequately benchmark the capital ratio may lead to inaccuracies in the bank branch’s tax computation.
The key areas where benchmarking may improve the accuracy of the tax computation are:
- Equity and loan capital ratios of the PE.
- Composition of loan capital.
- Spreads on Additional Tier 1 (AT1) and Tier 2 (T2) capital.
Hypothetical AT1 Capital
A UK branch of a foreign bank may compare its equity composition with that of a UK bank having similar business activities to those of the UK branch. Banks in the UK often issue AT1 capital (i.e. debt with certain equity features) to meet the minimum regulatory capital requirement under Prudential Regulation Authority (PRA) and Basel III rules.
HMRC allows branches to include AT1 capital in their CATA calculations, based on the fact that the branch could issue AT1 capital if it operated independently. Account would be taken of the home company regulatory regime with respect to AT1 capital and other commercial factors, in assessing whether this is reasonable. In appropriate cases, the arm’s length interest costs associated with AT1 capital are tax-deductible in the UK.
However, there are several factors which HMRC would consider when reviewing whether the claimed amount of AT1 capital exceeded the amount that the company would be able to issue if it were a separate UK bank. Where the branch relies on replicating its head office AT1 capital proportion, it is relevant to consider whether the bank is resident in a state which applies Basel III, as this may affect the comparability of the ratios.
Benchmarking example
XYZ Bank is a non-UK resident bank with a UK branch. The UK branch has a different business mix from the bank as a whole. The bank’s UK branch has conducted the benchmarking study and has identified benchmarked capital ratios and cost of capital as shown in the ‘Approach 2’ column below.
XYZ Bank, UK Branch – Calculation of Capital Attribution Tax Adjustment
Item | Approach 1: Mirroring parent company capital ratios | Approach 2: | Impact of Approach 2 £’000 | Comment |
|---|---|---|---|---|
| UK Branch's Risk-weighted assets (£’000) | 5,000,000 | 5,000,000 |
| The RWAs are unchanged. |
| Allotted equity capital (£’000) | 725,000 | 725,000 |
| Allotted capital is unchanged. |
| Capital ratios: | ||||
| - Common Equity Tier 1 (“CET1”) capital | 14.20% | 13.90% | (900) | Lower benchmarked CET1 can imply greater T2 interest. |
| - AT1 capital | 1.80% | 2.20% | (300) | Higher cost of AT1 gives greater deduction. |
| - T2 capital | 3.60% | 3.00% | 450 | Lower cost of T2 gives smaller deduction. |
| Cost of capital: | ||||
| - AT1 spread | 1.50% | 2.00% | (550) | Higher AT1 spread gives greater deduction. |
| - T2 spread | 2.20% | 3.30% | 0 | Market funding rate is ultimately neutral. |
| Change in CATA adjustment: Disallowed / (Allowed) | (1,150) |
| ||
Illustration: CATA computation comparing 2 approaches, including the hypothetical equity composition of AT1 capital instrument.
Results of benchmarking example
Examining the impact of benchmarked capital against head office capital ratios shows varied impacts on XYZ Bank’s CATA adjustment. The above example shows that the benchmarked AT1 capital exceeds that based on head office ratios, producing a benefit of £300,000. Conversely, the benchmarked T2 capital is less than before resulting in a disbenefit of £450,000. The benchmarked AT1 spread is 50 bps (0.5%) higher than previously, producing a £550,000 benefit. On the other hand, the benchmarked T2 spread is 10 bps (0.1%) less than had been thought, producing a £150,000 disbenefit.
The greatest contributor to the overall favourable variance of £1,150,000 derives from benchmarking of the CET1 ratio. By identifying that a comparable independent bank would have lower CET1 capital than the head office capital ratios suggests that the branch may contend the lower figure conforms to the separate enterprise principle. If the benchmarked CET1 capital amount were less than the CET1 capital actually allotted to the branch, the branch should be ready to demonstrate to HMRC that the benchmarked CET1 figure is the more commercial amount. In the example, this shows a £900,000 benefit, deriving from the additional interest deductions associated with lower CET1 capital.
To obtain any of the benefits described, the branch would need to demonstrate that its benchmarking or its costs of capital and of its capital proportions, particularly of its attributed CET1 capital, genuinely produced a better depiction of the hypothetical separate enterprise than was the case in its previous approach.
Conclusion
Foreign banks operating in the UK must compute their UK taxable profits according to the separate enterprise principle. Generally, HMRC may well accept attribution of loan and equity capital based on head office ratios. However, banks can improve their CATA calculations by benchmarking rates and ratios.
Forvis Mazars can assist banks to review and refine their CATA approaches, benchmarking to market rates and to capital ratios of comparable UK banks to apply the separate enterprise principle more effectively. To speak with one of our experts, get in touch today.
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