Interest deductions for foreign banks operating in the UK

The Finance Act 2021 clarified that deductions taken by banks in relation to their Capital Attribution Tax Adjustment calculations are not disallowed due to the hybrid mismatch rules. This offers an opportunity for bank branches to revisit their methodology for determining tax-deductible interest.

Background of the CATA

CATA stands for “Capital Attribution Tax Adjustment”. It is a methodology for calculating how much of the interest expense of a foreign bank’s UK branch is deductible. The calculation takes place in the context of the “separate enterprise principle” of attribution of profit to the UK permanent establishment (“PE”). This principle applies to all UK PEs of foreign companies. However, the CATA is particular to banks.

The separate enterprise principle of branch profit attribution goes back at least to the League of Nations’ draft tax convention of 1933. The CATA, relating to foreign banks’ interest deductions, has a history going back to 1950s, when an adjustment known as the “PW formula” was adopted by the Inland Revenue to determine how much interest expense a foreign bank’s UK permanent establishment could deduct when calculating taxable profits. The history of the CATA was addressed by the Court of Appeal in 2020 in Irish Bank Resolution Corporation v HMRC, although the decision in the case turned on treaty interpretation rather than on the CATA itself.

The aim of the CATA is to attempt to answer the question: how much interest expense would the bank’s UK branch bear if it were a “distinct and separate enterprise” engaged in the same activities as it currently does, but dealing wholly independently with the foreign bank? The separate enterprise principle envisages an independent bank, operating in the UK, with the same credit rating as the bank of which it is part, having “such equity and loan capital as it could reasonably be expected to have”.

The CATA methodology – a five-step process

Although the separate enterprise principle is set out in corporation tax law, the CATA is not. It is a non-statutory methodology recommended by HMRC.

HMRC’s CATA methodology is a 5-step process.

Step 1 - Attributing the assets to the UK branch: Loan attribution to the UK branch and financial asset transfers out of the UK branch are governed by statutory tax rules. HMRC guidance advises that where the UK PE is responsible for the creation of a financial asset, then the asset and the related income should be attributed to that PE.

Step 2 - Risk weighting the UK branch assets: HMRC accept that the fine detail of the Prudential Regulation Authority (“PRA”) regime is not always appropriate. Where the home state’s regulatory regime does not differ materially from the PRA’s, the UK branch may ‘risk weight’ their assets in line with the home state’s rules, adjusting only for material differences.

Step 3 - Determining the equity capital: The hypothetical separate enterprise needs equity capital appropriate to the risk-weighted asset of the branch. HMRC knows the search for companies that are comparable in size and activity is difficult, so the recommended starting point is to use the regulatory capital ratios of the whole bank entity as a guide for the proportion of equity and loan capital.

The whole bank regulatory capital ratios are not necessarily the end of the story. HMRC guidance suggests the UK branch may consider whether these ratios are truly representative in attributing the branch’s equity capital. The whole bank capital ratios are only proxies for the amounts which a true separate enterprise might have.

According to HMRC’s guidance, “there is no right answer when arriving at the equity and loan capital amounts” required by the legislation. The answer is likely to be “within a range of figures”. The CATA is therefore just a methodology - it is not to be regarded as a hard and fast set of rules.

Step 4 - Determining the loan capital: Loan capital in this context is the amount of interest-bearing capital within Tiers 1 and 2 of the bank’s regulatory capital. This includes Additional Tier 1 and Innovative Tier 1 capital which is interest-bearing debt. Preference shares, which are equity, are excluded. Tier 2 regulatory capital ratios of the whole bank may be representative of the loan capital attributable to the UK branch. However, other indicative factors include the capital structures of banks of similar size undertaking similar activities in the UK.

Step 5 - Determining the CATA adjustment: In this final step, the CATA is calculated by comparing the attributed equity and loan capital figures identified in the previous steps, according to the separate enterprise principle, with the actual allotted amounts. The market funding rate and the Tier 2 spread are used to cost shortfalls and excesses of equity and loan capital, so as to arrive at an adjustment (the CATA) which brings the deduction for interest expense to the amount attributable to the UK branch under the separate enterprise principle.

Why does the attributed equity capital matter?

If the hypothetical independent bank would have more “attributed” Tier 1 equity than has actually been “allotted” to the real branch, the branch has an “equity shortfall” for CATA purposes. The CATA then generates a disallowance of interest expense to adjust for the shortfall.

The interest adjustments are normally done at the branch’s “market funding rate”.

Is there a limit to the proportion of loan capital?

When determining the Tier 1 and Tier 2 ratios, hybrid Tier 1 and Additional Tier 1 capital should be treated as Tier 2 capital in the CATA. However, if shifting the hybrid Tier 1 capital to Tier 2 pushes the Tier 2 capital over the 50% of total regulatory capital, the Tier 2 ratio may need to be capped so that it does not exceed the PRA’s 50% limit.

What if the UK branch has “excess equity”?

If the hypothetical independent bank would have less Tier 1 equity than the real branch does, then there is “excess equity”. In this case, the reasons for the excess should be considered, to find out whether this was for either “commercial” or “non-commercial” reasons. Where the excess is for reasons which a separate, independent bank would not have followed, the branch may be entitled to re-classify an appropriate amount of equity into debt in the CATA methodology, so as to bring the deemed equity down to the presumed commercial level, thus providing a greater interest deduction.

Where the excess is for reasons which a separate, independent bank would adopt, the equity capital attributed by Step 3 is considered correct and no further deduction is made.

How can the branch calculate its “market funding rate”?

There is some scope for establishing how a UK branch calculates its market funding rate. Some branches may use LIBOR + a spread, if they can borrow at that rate, whereas others may look at their profit and loss accounts and balance sheets to see what their funding cost has been. HMRC’s guidance does not mandate a specific method. It says that the rate will depend on a number of factors including the functional currency of the PE, the hypothetical mix of types of loan capital held by the PE and the rest of the bank, as well as rates of interest thereon.

It appears there may be multiple methodologies that would be acceptable to HMRC, as long as the result is consistent with the separate enterprise principle. HMRC confirm that, “If appropriate comparables can be found, then these can be used as an indicator of the amount of equity and loan capital that the PE would have had at arm’s length.”

Why does the attributed loan capital matter?

Attributed loan capital matters, because attribution to the branch of additional loan capital (beyond that allotted) would hypothetically displace other debt (such as customer deposits) and so reduce the branch’s interest expense at the market funding rate. At the same time, it would hypothetically introduce interest expense at the cost for subordinated debt, which is usually above the market funding rate. For this reason, the CATA often features just the net effect, which is the “Tier 2 spread” between the cost of Tier 2 (subordinated) loan capital and the market funding rate. The CATA methodology allows the branch to benchmark both the quantum and cost of Tier 2 capital.

Conclusion

Ultimately, the attributable interest deduction is driven by the theoretical equity and loan capital amounts attributed to the branch in the CATA methodology, as well as by the market funding rate and the Tier 2 spread. The result of these factors is that a branch that is thinly capitalised may have to disallow some of its interest expense in its tax computation. Conversely, a branch with an excess of equity attributed under the separate enterprise principle over that which was actually allotted, may receive a deduction as a result of the CATA. Now that Finance Act 2021 has confirmed that a deduction of this sort is not to be disallowed by the hybrid mismatch rules, it may be time for UK branches to review their CATA calculations.

Despite the apparently normative nature of the CATA process, judgement is required in arriving at each of its contributing factors, and there is scope for departing from a formulaic approach, so long as the bank is guided by the separate enterprise principle, of identifying and costing the capital structure which the UK branch would have if it were a separate and independent bank.

The CATA deals with big numbers, meaning that small differences, used in the implementation of specific rules, have a big effect. So, UK branches of foreign banks may be entitled to a deduction where they are currently not getting one. Alternatively, they may be obliged to disallow costs that they are currently allowing. It may therefore be worth having a health check of the branch’s methodology against the HMRC guidance and benchmarking against comparable rates and ratios. There may well have been changes in the branch or in the bank’s business since the CATA methodology was last looked at, potentially meaning that threats and opportunities may lie hidden in the figures. A timely review of a branch’s CATA may lead to tax savings in the event of an overpayment of tax or may reduce the risk of penalties and the cost of an enquiry in the case of underpayments.

National contact

Mark Hubbard Tax Partner - Banking & Capital Markets

Detailed profile

Ian Thomson Associate Director - Banking & Capital Markets