Overseas banks that want to expand into the U.K. have two main options: they can either open a branch office (or have a permanent establishment), or they can incorporate a subsidiary company in the U.K. Both options have their advantages and disadvantages for setting up operations in the U.K., not least regulatory requirements which often drive businesses to go down one route.
This article focuses on banks that have set up branches or have permanent establishments (PEs) in the U.K. and the pitfalls we often see from a tax perspective.
Pitfall 1: Attribution of Profits to U.K. PEs and U.K. GAAP Compliance
A non-U.K. bank may be subject to U.K. corporation tax if:
- it has a PE in the U.K.; or
- it is treated as resident in the U.K. by virtue of it being centrally managed and controlled in the U.K.
Determining whether a U.K. PE exists can be a complex process with many issues to consider. However, where a U.K. PE does exist, it will be subject to U.K. corporation tax on all profits that are attributable to it.
The U.K. applies the authorized Organization for Economic Co-operation and Development (OECD) approach to the attribution of profits to PEs—see the 2010 OECD Report on the Attribution of Profits to Permanent Establishments (OECD PE Report). As a matter of principle, it is very important that U.K. branches of foreign banks have a robust attribution process which can clearly be articulated to the U.K. tax authority, HM Revenue & Customs (HMRC), in the event that this question is raised.
A common pitfall with the attribution of profits is not preparing accounts for the U.K. branch under U.K. rules, which can sometimes mean that the finance function does not apply a strict U.K. generally accepted accounting practice (GAAP) approach to the allocation of revenues and costs to the branch. This can create two significant tax compliance risks:
- if the allocation approach does not comply with the OECD PE Report principles, there is a risk of HMRC challenge and a tax adjustment; and
- the U.K. has a legal requirement that the profits of a trade be computed in accordance with U.K. GAAP.
It is a common misconception that non-U.K. incorporated banks can prepare their U.K. corporation tax computations based on the GAAP of the overseas parent company. However, for U.K. corporation tax purposes, U.K. GAAP must be used unless the accounts are prepared under International Financial Reporting Standards (IFRS).
From U.K. tax purposes, the branch must disclose to HMRC its profit or loss and a pro forma balance sheet separately from the overseas parent company, if this is not shown separately in the parent company accounts. Figures for both of these need to be calculated under U.K. GAAP or IFRS. Where the accounts of the parent company are not prepared in accordance with U.K. GAAP or IFRS then it should undertake a comparison between the different sets of accounting standards and identify any tax adjustments.
Pitfall 2: Loan Impairments
U.K. legislation sets out specific rules for loans and the attribution of financial assets and profits, and provides that profits on loans made by a branch or PE must be attributed to it. So it is vital to document functions performed, the corporate actions step process involved in the loan origination, and ongoing risk management of any branch booked loan to prove where the profits should be taxed. This typically will come under scrutiny where significant loan impairments are recognized.
Following the implementation of IFRS 9, we are seeing an increasing number of inquiries from HMRC on loan impairment charges and whether the loan should have been allocated to the branch or elsewhere (to establish if a tax deduction is applicable to the U.K. branch).
Failing to prove that the branch exercised sufficient functions and authority over the loan origination process and ongoing risk management can mean it does not get a deduction for the loan impairment in the U.K.
Pitfall 3: Capital Attribution Tax Adjustment
U.K. branches of overseas banks are not subject to specific regulatory capital requirements, so it is possible to fund the activities of the branch solely with debt—potentially a competitive advantage over U.K. bank entities as the branch can possibly fund its business at a lower cost of capital. The U.K. has Capital Attribution Tax Adjustment (CATA) rules, again based on the OECD PE Report, to address this: a CATA calculation must be included in the U.K. corporation tax return for any U.K. bank branch which holds financial assets on its trading book.
A common pitfall arises where the CATA methodology and calculation has been in place for a number of years, and simply rolled forward without much consideration as to whether the resulting funding adjustment is appropriate. Subject to the underlying facts, the potential funding adjustments can be significant, therefore U.K. branches of foreign banks should be revisiting their current CATA methodology and calculations to ensure that they are still fit for purpose.
Pitfall 4: Anti-Hybrid Legislation
While a U.K. PE should not automatically be seen as a hybrid entity, they nonetheless fall within the scope of the U.K. anti-hybrid rules. Large parts of these rules focus on “multinational companies,” i.e. any company with a branch/PE in another jurisdiction.
The “double deduction” legislation is a particular area of concern for U.K. branches of foreign banks because expenses of a U.K. PE are likely to be deductible for both U.K. corporation tax purposes and under the laws of parent jurisdiction (obviously income can also risk being taxed in both jurisdictions).
However, where the U.K. branch makes a loss in a particular accounting period, such that its double deducted expenditure is likely to be greater than its double taxed income, there can be a disallowance of the loss in the U.K. under the U.K. hybrid rules. This could arise where that loss is used by the parent to shelter other income not generated by the U.K. branch for the purposes of its local tax law.
This situation can lead to disproportionate outcomes, and significant U.K. tax in the future, where a large loss is suffered in particular year (e.g. a sizable impairment charge in a particular period).
Changes to this legislation have been announced in the recent Finance Bill 2021, so foreign banks with U.K. branches should carefully consider the potential impact on their U.K. tax charge.
Pitfall 5: Research and Development Tax Credits
U.K. branches of overseas banks should not overlook the availability of research and development (R&D) tax credits to offset the costs of software development projects, for example to enhance the “parent” banking platform to accommodate business in the European market and the associated regulatory reporting.
Based on HMRC statistics and BDO’s AI benchmarking toolkit, we estimate that on average a U.K. subsidiary or branch of an overseas bank could be making R&D tax credit claims worth 50,000 pounds ($70,400) to 100,000 pounds per annum, depending on the size and expertise of their U.K. IT development team.
In addition, it may also be possible to include a proportion of the head office IT recharge in the U.K. R&D claim, thereby further boosting the qualifying expenditure for R&D purposes.
Pitfall 6: U.K. Value-Added Tax Rules
U.K. branches of overseas banks are subject to increasingly complex value-added tax (VAT) legislation. A key reason for this complexity is that the majority of banks are partially exempt; meaning VAT represents an (at least partly) irrecoverable cost to the business.
The key VAT pitfalls we commonly see arising for U.K. branch banks are summarized below:
- U.K. VAT grouping—supplies between U.K. VAT group members are disregarded for VAT purposes and therefore VAT-free (subject to anti-avoidance provisions) so many banks chose to VAT-group U.K. branches in order to mitigate irrecoverable VAT costs incurred on services supplied by overseas group companies (this was particularly common for services bought-in from group companies located in non-EU countries such as India). However, HMRC are actively challenging and issuing assessments in respect of supplies between overseas companies and their U.K. VAT-grouped branches—HMRC often take the view that the U.K. branch may lack the necessary substance to constitute a “fixed establishment.” We recommend any U.K. branch bank in a U.K. VAT group to review its position to assess the risk of an HMRC challenge.
- Reverse-charge VAT—U.K. branch banks are required to self-account for U.K. VAT due in respect of taxable supplies bought-in from overseas under the reverse-charge mechanism. This VAT generally represents a cost to partly exempt businesses. U.K. branch banks may fail to account for the correct amount of reverse-charge VAT due, either because they are not aware of the requirement to do so or because their accounting software misses some or all of the purchases upon which reverse-charge VAT is due.
- EU VAT grouping rules—after the Skandia and Danske Bank cases, supplies between different establishments of the same legal entity that were previously outside the scope of VAT are, in some cases, now treated as being made between different legal entities, making them subject to VAT. This applies where one of the establishments in question is in a VAT group and the supply is between (at least one) EU member state that operates “local establishment” VAT grouping rules. Banks that have European VAT groups should review cross-border inter-company charges.
- Open Market Value (OMV) and intra-U.K. legal entity charges—charges between U.K. entities (including branches) are generally subject to OMV rules where the recipient entity (such as a U.K. branch bank) is partly exempt. A common error we come across is where the U.K. group company supplying the U.K. branch bank either has not recognized a supply taking place at all (often because the only “payment” is via inter-company accounts), or has accounted for VAT at less than OMV.
- Partial exemption—if a U.K. branch bank makes supplies that carry the right to VAT recovery it must use a partial exemption method to work out the proportion of “residual input VAT” (i.e. on overheads) it can recover. This could be the “standard method,” but will in most cases be a “special method.” Businesses are required to monitor and update their method to ensure it remains a fair and reasonable reflection of how the business uses input tax, and tell HMRC of any changes. Often, once a method is agreed, it is not revisited or updated in line with business changes, and requirements regarding monitoring and testing “use” are often missed, so the U.K. branch could also be losing out on VAT recovery: for example, businesses making “specified supplies” of financial services to EU customers can recover the VAT from January 1, 2021 as a result of Brexit changes.
- Making Tax Digital (MTD) for VAT—since April 1, 2021, phase 2 of the U.K.’s move to fully online VAT returns and compliance requires businesses to introduce “digital linking,” so that there are no manual adjustments to the VAT return and it is compiled automatically from the business’s accounting data. A common pitfall is that U.K. branch banks’ VAT return preparations involve a number of “manual interventions” (beyond the few exceptions such as the partial exemption calculation): businesses can face penalties for such compliance failings.
Naturally, there are many other issues that banks setting up in the U.K. face: more information can be found here.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
David Britton is a tax partner at accountancy and business advisory firm BDO, with over 20 years’ experience of advising start-ups, challenger banks, multinational inbound and outbound banks, fintechs, and more recently crypto-asset clients on structuring advice, due diligence, ad hoc advisory to tax risk management, process and controls and local/multi-country tax compliance engagements.
The author can be contacted at: firstname.lastname@example.org