Overseas banks looking to expand into the UK have two main options: they can either open a branch (or have a permanent establishment) or they can set up a subsidiary in the UK. Both options have their advantages and disadvantages for setting up a business in the UK, not least regulatory requirements that often lead companies to take a path.
This article focuses on banks with branches or permanent establishments (PEs) in the UK and the pitfalls we often see from a tax perspective.
Pitfall 1: Allocation of Profits to UK PEs and UK GAAP Compliance
A non-UK bank may be subject to UK corporation tax if:
- it has an operating facility in the UK; or
- it is treated as resident in the UK as it is centrally administered and controlled in the UK.
Determining whether a UK PE exists can be a complex process with many aspects to consider. However, if a UK permanent establishment exists it is subject to UK corporation tax on all attributable profits.
The UK uses the Organization for Economic Co-operation and Development (OECD) approved approach to the allocation of profits to permanent establishments – see the 2010 OECD Report on the Attribution of Profits to Permanent Establishments (OECD-PE Report). In general, it is very important that UK branches of overseas banks have a robust attribution process that can be clearly attributed to HM Revenue & Customs (HMRC) in the event that this issue is raised.
A common pitfall in allocating profits is the failure to create accounts for the UK branch under UK regulations, which can sometimes result in the finance function not applying a strict UK Generally Accepted Accounting Approach (GAAP) to the allocation of income and costs the industry. This can lead to two significant tax compliance risks:
- If the allocation approach does not conform to the principles of the OECD PE report, there is a risk of a challenge to the HMRC and a tax adjustment; and
- the UK has a legal obligation that the profits of a trade in U.K. GAAP will be calculated.
It is a common misconception that non-UK. registered banks can make their UK corporate tax calculations based on the GAAP of the overseas parent company. However, for UK corporation tax purposes, U.K. GAAP should be used unless the financial statements are prepared in accordance with International Financial Reporting Standards (IFRS).
For UK tax purposes, the HMRC branch must disclose its profit or loss and a pro forma balance sheet separately from the overseas parent company if this is not separately disclosed in the parent company's accounts. The numbers for both must be U.K. GAAP or IFRS are calculated. If the parent company's financial statements are not in accordance with U.K. GAAP or IFRS, it should compare the various accounting standards and identify any tax adjustments.
Pitfall 2: Loan impairment
UK legislation lays down specific rules for loans and the allocation of financial assets and profits, and provides that profits from loans must be attributed to a branch or permanent establishment. Therefore, documenting the functions performed, the process of Corporate Actions steps in lending and the ongoing risk management of each loan booked by the branch is critical to provide evidence of where the profits are taxable. This is usually checked when a loan is found to be significantly impaired.
After the implementation of IFRS 9, we see an increasing number of inquiries from HMRC about credit allowances and whether the loan should have been allocated to the branch or elsewhere (to determine if the UK branch is tax deductible).
Failure to demonstrate that the branch has exercised adequate functions and authority for the lending process and ongoing risk management may result in the branch being unable to receive a credit impairment allowance in the UK.
Pitfall 3: Adjustment of the capital allocation tax
UK branches of foreign banks are not subject to specific regulatory capital requirements, so it is possible to finance the branch's activities entirely with debt – potentially a competitive advantage over UK banks as the branch may be able to fund its business at a lower cost from the capital. The UK has Capital Attribution Tax Adjustment (CATA) rules, also based on the OECD-PE report, to remedy this: A CATA calculation must be included in the UK corporate tax return for each UK bank branch that holds financial assets in their trading book.
A common pitfall occurs when the CATA methodology and calculation has been in place for several years and simply continues without thinking too much about whether the resulting funding adjustment is appropriate. Depending on the underlying facts, the potential funding adjustments can be significant, so UK branches of foreign banks should reconsider their current CATA methodology and calculations to ensure that they continue to be useful.
Pitfall 4: Anti-Hybrid Legislation
Although a UK permanent establishment should not automatically be considered a hybrid company, they still fall within the scope of UK anti-hybrid rules. Much of these rules focus on "multinational companies"; H. every company with a branch / PE in a different legal system.
“Double Deduction” legislation is a special area for UK branches of foreign banks as UK permanent establishment expenses are likely to be deductible for both UK corporate tax purposes and under parent company laws (income may of course be taxed as well). in both areas of law).
However, if the UK branch is making a loss in a given accounting period so that its double-deducted expenses are likely to be greater than its double-taxed income, the loss cannot be recognized in the UK under UK hybrid rules. This could occur if this loss is used by the parent company to protect other income not generated by the UK branch for the purposes of local tax law.
This situation could lead to disproportionate results and significant UK taxes in the future if a large loss is incurred in a given year (e.g. a significant depreciation in a given period).
Changes to this legislation were announced in the recent Finance Act 2021, so foreign banks with UK branches should carefully weigh the potential impact on their UK tax burdens.
Pitfall 5: Research and Development Tax Credits
UK branches of overseas banks should not overlook the availability of research and development (R&D) tax credits to offset the cost of software development projects such as upgrading the “parent” banking platform to do business in the European market and related regulatory reporting enable .
Based on HMRC statistics and BDO's AI benchmarking toolkit, we estimate that a UK subsidiary or branch of a foreign bank could claim an average of £ 50,000 (US $ 70,400) in R&D tax credits to £ 100,000 per year, each their UK IT development team in terms of size and expertise.
In addition, it may also be possible to include some of the Headquarters IT billing in the UK R&D entitlement, further increasing the qualifying expenditure for R&D purposes.
Pitfall 6: UK VAT rules
The UK branches of foreign banks are subject to increasingly complex VAT laws. A major reason for this complexity is that the majority of banks are partially exempt; which means that VAT is (at least in part) a non-recoverable cost to the business.
The main VAT pitfalls that we often see with UK branch banks are summarized below:
- U.K. VAT grouping– Deliveries between members of the UK VAT group are not counted for VAT purposes and are therefore VAT exempt (subject to tax avoidance provisions), so many banks have chosen to establish UK branches of the VAT group to reduce non-refundable VAT costs incurred for Services incurred by foreign group companies (this was particularly common for services that were purchased from group companies in non-EU countries such as India). However, HMRC is actively raising and reviewing complaints regarding supplies between overseas companies and their UK-based VAT-liable branches. The HMRC often takes the view that the UK branch may lack the substance to form a "permanent establishment". We encourage any UK branch bank in a UK VAT group to review their position to assess the risk of an HMRC dispute.
- Reverse VAT-UNITED KINGDOM. Branch banks must self-account for UK VAT on taxable supplies purchased abroad under the reverse charge scheme. This VAT generally incurs costs for partially exempt companies. UK branch banks may not consider the correct amount of VAT reversal due, either because they do not know the requirement or because their accounting software is missing some or all of the purchases that are due for VAT reversal.
- EU VAT grouping rules—According to the Skandia and Danske Bank cases, supplies between different branches of the same legal person, which were previously outside the scope of VAT, are in some cases now made as between different legal persons and are therefore subject to VAT. This applies if one of the branches in question belongs to a VAT group and the delivery is made between (at least one) EU member state that applies the VAT group regulation for "local branches". Banks with European VAT groups should review cross-border intercompany fees.
- Open Market Value (OMV) and Intra-UK legal entity fees—Charges between UK companies (including branches) are generally subject to OMV rules, some of which are exempt from the receiving entity (e.g. a UK branch bank). A common mistake we encounter is that the UK group company supplying the UK branch bank either failed to detect a delivery at all (often because the only "payment" is made through group accounts) or the VAT at a lesser amount has shown as OMV.
- Partial exemption—When a UK branch bank makes supplies that give rise to a right to a VAT refund, it must use a partial tax exemption method to calculate the proportion of “residual input tax” (i.e. overheads) that it can recover. This could be the "standard method", but in most cases it will be a "special method". Companies have a responsibility to monitor and update their methodology to ensure that it remains a fair and reasonable account of the company's use of input tax and to notify HMRC of any changes. Once agreed, a method is often not re-examined or adapted as business changes, and requirements related to monitoring and auditing of "use" are often neglected, which could leave the UK branch a loser when it comes to VAT refunds: For example, companies With "specified deliveries" of financial services to EU customers, VAT can be reimbursed from January 1, 2021 due to the Brexit changes.
- Make Tax Digital (MTD) for VAT– As of April 1, 2021, Phase 2 of the UK's transition to full online VAT returns and compliance requires companies to adopt a "digital link" so that VAT returns are not manually adjusted and automatically generated from company accounting data. A common pitfall is that the preparation of the VAT return of UK branch banks involves a number of "manual interventions" (apart from a few exceptions such as the calculation of the partial exemption): Companies can be penalized for such compliance violations.
Of course, there are many other problems that banks in the UK face: more information can be found here.
This column does not necessarily represent the opinion of the Bureau of National Affairs, Inc. or its owners.
David Britton is a tax partner at the auditing and management consultancy firm BDO with over 20 years of experience in advising start-ups, challenger banks, multinational inbound and outbound banks, fintechs and, most recently, crypto asset clients in the areas of structuring consulting, Due diligence, ad hoc advice on tax risk management, processes and controls as well as local / multi-year tax compliance obligations.
The author can be reached at: firstname.lastname@example.org