D4.118 Determination of profits attributable to permanent establishment
The rules described in this article will not apply if different rules are included in the relevant double taxation agreement; in such a case the rules in the agreement take precedence.
Profits are attributed to the UK permanent establishment (PE) on the basis that the establishment is a distinct entity, dealing independently with the non-resident company1.
The legislation describes these provisions as 'the separate enterprise principle'2.
For this purpose, it is assumed that the PE has the same credit rating as the non-resident company and that it has such equity and loan capital as would be reasonably expected in such a distinct entity3. Regulations applying this rule to insurance companies provide a different basis for attributing capital to a UK PE4.
This rule is designed to prevent thin capitalisation, as the interest and other funding costs of the PE are calculated so that the PE only obtains a tax deduction for an arm's length amount of those costs. In relation to banks, HMRC have issued guidance as to their approach to funding costs in terms of five distinct steps5.
1. Determine the assets applicable to the permanent establishment
2. Risk weight