The Finance Bill 2019 (FB 2019) contains provisions that will replace the existing tax rules relating to regulatory capital, with new provisions dealing with so-called hybrid capital instruments.
What is the background to this measure?
The UK tax code maintains some fundamental distinctions between the treatment of debt and equity. Interest payments on debt instruments are typically tax deductible, whereas dividends paid on equity instruments are not deductible. Withholding tax applies to coupons on debt but not equity. The transfer of shares, but not debt, is generally subject to stamp duties.
The challenge presented by so-called hybrid capital instruments is that they have some features that look debt-like but in other respects they can resemble equity.
The determination of the tax treatment of these hybrid instruments is particularly relevant to the financial sector, where banking and insurance companies must hold a certain amount of regulatory capital. The instruments used to raise this capital must contain certain features to allow for loss-absorbency in the event of the bank or insurer coming under financial strain and having depleted levels of capital.
To provide certainty on the tax position of these instruments, HM Treasury introduced the Taxation of Regulatory Capital Securities Regulations 2013, SI 2013/3209 (RCS Regulations). From 2013 until now, the treatment of hybrid capital issued by banks and insurers has therefore been relatively straightforward.
In June 2018, the Bank of England finalised its approach to setting a minimum requirement for own funds and eligible liabilities (MREL). These are the requirements for the minimum loss-absorbing capacity that financial institutions must hold. The MREL requirements took effect from 1 January 2019.
In order to meet the MREL requirements, financial institutions are permitted to issue hybrid capital instruments which would not have been covered by the RCS Regulations. As a result, the new provisions dealing with hybrid capital instruments are introduced in FB 2019 to ensure that the tax treatment of all instruments issued to meet MREL requirements remains effective and consistent with policy decisions regarding these instruments.
How are hybrid capital instruments defined and what will the new tax rules provide?
The definition of hybrid capital instruments will be contained in the new section 475C of the Corporation Tax Act 2009. This provision states that a loan relationship is a hybrid capital instrument if:
- it makes provision under which the debtor can defer or cancel a payment of interest;
- it has no other significant equity features; and
- the debtor has made an election in respect of the loan relationship which has effect for the period. This election is ineffective where there are arrangements, the main purpose, or one of the main purposes, of which is to obtain a tax advantage for any person.
A loan has no other significant equity features if:
- there are no voting rights in the debtor, nor a right to exercise a dominant influence over the debtor;
- any provision for altering the amount of the debt is limited to write-down or conversion events in qualifying cases; and
- any provision for the creditor to receive anything other than interest or repayment of the debt is limited to conversion events in qualifying cases.
Qualifying cases include the debtor experiencing solvency or liquidity problems. They also include where the conversion or reduction of debt is permitted in order to comply with a regulatory or legal requirement.
If an instrument falls within the hybrid capital instruments regime:
- coupons are treated as interest rather than distributions, even if accounted for as distributions;
- instruments are treated as ‘normal commercial loans’; and
- transfers are exempt from all stamp duties.
Unlike under the RCS Regulations, there is no provision dealing with the treatment of instruments in terms of withholding tax. HMRC takes the view that such a provision is unnecessary due to the quoted Eurobond exemption, the UK’s participation in many double tax treaties and the UK corporate taxpayer exemption.
Are there any kinds of regulatory capital instruments currently covered by the existing tax regulations that would not be covered by the proposed new rules?
Quite possibly. The old regime was based on regulatory concepts, such as:
- additional Tier 1 capital;
- restricted Tier 1; and
- Tier 2.
So long as an instrument met the regulatory definition (and in the absence of tax avoidance arrangements), the tax treatment was certain regardless of what the actual terms of the instrument were.
That said, as long as an instrument carries a cancellable or deferrable coupon, it would be unlikely that such an instrument (if it is currently treated as a regulatory capital instrument) would not be treated as a hybrid capital instrument under the new rules. However, there is a significant possibility where an instrument contains additional features beyond what is required by the MREL requirements, it will not enjoy the same tax treatment as under the old rules. An example of this would be an instrument which includes terms allowing for optional conversion.
The new rules are intended to apply across all sectors. Do you see any opportunities for non-regulated groups to issue deductible equity-like instruments?
Yes. Following the changes to the rules, there is no requirement that instruments represent regulatory capital securities from a regulatory (i.e. banking or insurance) perspective. These rules should be equally applicable across all sectors.
With regard to whether this regime will be used in practice by non-regulated groups, this appears highly possible. The utilities sector has long been interested in instruments of this sort, as their business model depends on raising funds efficiently without putting pressure on their degree of indebtedness. Now that they can be certain of the tax treatment of these types of instruments, they may take the opportunity to do so more regularly and as such may benefit from this regime.
When will the new rules come into effect?
The new hybrid capital instruments rules came into effect on 1 January 2019 (i.e. there is an element of back-dating on the enactment of the Finance Act 2019).
Do you envisage any challenges posed by the new rules?
The new rules will require more complex and in-depth analysis by tax advisers than was previously required.
The analysis under the RCS regulations simply required a determination that the instrument met the regulatory capital requirements and that the targeted anti-avoidance rule was not in play. Under the new rules, advisers will need to check the terms and conditions of each instrument to ensure that it meets the definition of hybrid capital instrument for tax purposes and will then need to test separately each part of the tax code which may be relevant to the instrument (distributions, deductibility, results dependency, withholding tax and so on).
Additionally, some reliance will need to be placed on HMRC guidance when carrying out this analysis. For example, HMRC guidance is relevant to the question of whether provisions to ‘bail in’ an instrument issued by a financial institution make that instrument results-dependent. HMRC accepts that terms providing for a write-down or conversion, that are included to meet regulatory requirements will not normally make an instrument results-dependent. It also accepts that, following the same reasoning, such terms will not normally render an instrument a non¬commercial security within section 1005 of the Corporation Tax Act 2010.
Finally, the question of what happens on a conversion or write down of a regulatory capital security is left open in the new rules. The old rules stated specifically that no credits or debit arose in this situation. Under the new rules, there may still be an exclusion, but that will need to be based on the general exceptions in the loan relationships code (for example on an insolvency).
This article was first published on Lexis®PSL Tax on 18 January 2019.
