Tax deductibility of interest costs of UK permanent establishments of foreign banks

Thu 19 Oct 2017

The First tier Tribunal (FTT) has held that the attribution of a notional amount of capital to the UK branch permanent establishments (PEs) of two Irish banks, was not precluded by the terms of the UK/Irish treaty for attributing profits to a PE.  This resulted in the disallowance of interest expense based on the amount of capital deemed to be used by the PEs, not the actual capital used.

The taxpayers had argued that the interest costs on payments to their head offices were incurred wholly and exclusively for the purpose of the trades of the UK branches so should not be disallowed.

The dispute arose from the fact that original interpretation of the method for attributing profits to the UK branch of a foreign bank had been based on a 1978 decision of Michael Nolan QC (later Lord Nolan). This decision stated that there was no authority to attribute a level of capital to a branch which the branch itself does not have.  The OECD began a project in the 1990s that lead in 2008 to a documented approach for the attribution of profits to PE, by treating it as a separate independent entity operating at arms’ length.  This prompted a change to UK law in 2003 to incorporate ICTA 1988 s.11AA, subsection 3 of which has now been re-written as CTA 2009 s.21(2) and s.30.

While acknowledging there had previously been different practices, HMRC maintained that the OECD’s work and the amended UK legislation only provided greater clarity on how the attribution of profits to a PE was to be established. They considered it did not provide a new method of attribution.

The FTT held that the requirements for determining the profits to a permanent establishment were firstly to apply domestic law, and only change that if the double tax treaty expressly provided for a change. Examining the UK/Irish treaty the FTT considered its terms could incorporate an interpretation based on the UK legislation introduced in 2003.

Permanent establishments can create a number tax issues for international groups and determining precisely how the rules apply and whether there is in fact a PE, can be complex. In addition to determining the profit or loss of a permanent establishment, there may be a range of direct tax issues to consider.  Examples could include those around around royalty payments and those concerning group relief.  For a further discussion of the tax issues affecting permanent establishments, please get in touch with the Mazars international tax team.