Colin Davis, Technical Officer at the CIOT, looks at the possible combined effects of three proposed changes affecting banks operating in the United Kingdom. This article appeared in the January 2003 issue of Tax Adviser.KEY POINTS
- A change in the basis of computation of the profits of UK branches for corporation tax purposes as from 1 January 2003.
- The introduction, in 2004, of a new European Community (EC) Capital Adequacy Directive amending the existing directive (93/6/EEC).
- A possible change in the basis of taxation of non-domiciled individuals working in the UK, many of whom work for the UK branches of foreign banks.
The Capital Adequacy Directive will, of course, affect banks operating throughout the European Union (EU). It may require an increase in capital in order to support the credit risks that are regarded as being the greatest element in banks’ businesses. Insofar as its provisions will be applied by the Inland Revenue to determine the deemed capital of a UK branch under the ‘distinct and separate enterprise’ rule, there may be an increased disallowance of interest on branch borrowings. This is foreshadowed in Budget Note 25/02.
Although draft guidance on Capital Attribution to Banks has now been published, very little general guidance on how the tax changes would operate has been given despite the imminence of the start date for branch taxation. However, in his 2002 Budget Report (p. 155, item 32), the Chancellor has estimated that an additional £650m per annum will be raised from the corporation tax change. No details at all have been given of proposed changes, if any, to the taxation of non-domiciled individuals.
The announcement of important changes without giving details of the changes has caused some consternation in the City. There is widespread concern that the introduction of the tax changes will undermine significantly the attractiveness of the City of London as one of the world’s major financial centres.
Computation of the profits of UK branches
It is proposed that the profits attributable to the branch should be the profits which it would have made were it a distinct and separate enterprise, engaged in the same or similar activities under the same or similar conditions, dealing wholly independently with the non-resident company of which it is a branch. In particular, it will be deemed to have the same equity capital as it would be required to have as a separate enterprise. However, it will be deemed to have the same credit rating as the company.
The amount of equity capital attributable to a bank will clearly depend on the revised capital adequacy rules, which are still under discussion. At present, however, capital requirements are ascertained at entity level, whereas the new tax rule will require a notional calculation at branch level. The combined effects of the new tax rule and the new capital adequacy rules could have a significant impact on UK branches of foreign banks.
If the branch were a separate enterprise, carried on by a separate legal entity, that entity would be able to enter into transactions with the parent entity. However, a branch of a company cannot enter into transactions with the company of which it is a branch, since it is part of the same legal entity. Therefore, it appears that a branch will have to be deemed to enter into notional transactions, being the transactions that it would enter into if it were a separate legal entity. If this is right, then the question arises as to whether the transfer pricing legislation should apply to the notional transactions.
The next step is to identify the notional transactions and consider how the transfer pricing rules are to be applied to them. The Chartered Institute of Taxation’s response paper attempts to identify some of these notional transactions and to formulate the questions that need to be answered before any new rules should be introduced.
To date, no guidance has been forthcoming from the Inland Revenue on these fundamental issues.
The Organisation for Economic Cooperation and Development (OECD) is considering the problems of applying the separate entity approach to branch taxation and has produced a lengthy discussion draft on the subject. Considerable further work remains to be done. However, the British Government appears to be ‘jumping the gun’ and attempting to introduce changes in the law before the EC capital adequacy rules are amended and before the OECD has concluded its deliberations on the computation of branch profits.
The taxation of non-domiciled individuals
As noted above, no details have been given of proposed changes, if any, to the taxation of non-domiciled individuals. This has left plenty of room for speculation, some of which will probably turn out to be unnecessarily alarmist.
The point is that under the present rules non-domiciled individuals are taxed on the remittance basis on non-UK source income. In what circumstances should they be taxed on worldwide income on the arising basis?
Under the Inheritance Tax Act 1984 (IHTA 1984), s 267 an individual who has lived in the UK for 17 years out of the last 20 is deemed to be domiciled in the UK for inheritance tax purposes. The application of a similar rule for income tax purpose would catch long-term residents in the UK, but not individuals who work in the UK on short or medium term secondments.
The fear is that a more Draconian measure will be introduced. It might, perhaps, impose the arising basis on individuals who become ordinarily resident in the UK. This might catch individuals who come to live and work in the UK on a secondment of three years or more.
All of this is without prejudice to the provisions of any relevant double taxation agreement, and to the availability of tax credit relief under unilateral double taxation arrangements.
It is vital that the start date for the new rules for taxing UK branches should be deferred until the EC capital adequacy rules have been finalised and the OECD has completed its deliberations. The Revenue should then issue detailed guidance on the application of the ‘distinct and separate enterprise’ rule.
As far as the taxation of non-domiciled individuals is concerned, the government should take early steps to eliminate the uncertainty that has been caused by announcing a possible fundamental change to the tax system without giving any details of the change.
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January 2003 by