BKLM315613 - Chargeable equity and liability: adjustments: step 2 in paragraph 15N: equity and liability: netting

Paragraphs 15S to 15U of Schedule 19

Netting: background

Under certain specified circumstances the rules permit liabilities that are recognised on a balance sheet of a UK resident entity to be reduced as far as possible (but not below zero) by netting off any asset balances that are recognised on the balance sheet of that entity or another member of the relevant group. The remaining net balance is the figure to be taken into consideration when calculating the chargeable equity and liabilities.

The specific circumstances are where the liabilities and assets that are recognised on the relevant balance sheets are:

  • with the same counterparty (or a member of the counterparty’s group)
  • covered by the same netting agreement (see below)
  • where certain further specified conditions apply, and
  • where the counterparty is either a third party or a group company whose liabilities are not subject to the Bank Levy.

The legislation refers to the entity’s ‘net settlement liabilities’ by which it means the entity’s liabilities (which are not ‘excluded liabilities’ - see BKLM330000) to the extent they are covered by the same netting agreement.

It also refers to the entity’s ‘net settlement assets’ which means the entity’s, or where relevant another member of the relevant group’s, assets to the extent they correspond to the counterparty’s net settlement liabilities.

To enable netting to take place there must be a legally enforceable agreement (see below) in place which allows, where a netting event occurs (these being termination of the arrangements as a result of the bankruptcy or insolvency of one of the parties), for any amounts owed to be set off against any amounts due such that there is one single net sum either due to or payable by the relevant member to settle all of the liabilities and assets in question that are covered by the agreement.

For guidance on when netting should be brought into the Bank Levy calculation for designated FPE entities or relevant foreign banks (see BKLM315800 and BKLM379000).

Definition of a netting agreement

For the purposes of Bank Levy a netting agreement is an agreement which:

  • is between a chargeable UK resident entity (see BKLM315140) or UK sub-group (see BKLM315130) and a counterparty or a member of the counterparty’s group (either through a bilateral or multilateral arrangement);
  • provides for single net settlement of all of the assets and liabilities covered by the agreement if a netting event occurs; and
  • is legally effective and enforceable.

A “netting event” occurs if:

  • in relation to M, the insolvency or bankruptcy of M or a chargeable UK resident entity or member of a UK sub-group gives rise to the termination of the netting agreement; or
  • in relation to N, the insolvency or bankruptcy of N or a member of the N’s group gives rise to the termination of the netting agreement.

HMRC’s view is that a “netting event” occurs when either party becomes bankrupt or insolvent and this gives rise to the termination of the netting agreement. For the purposes of Bank Levy a netting agreement must provide for a single net settlement whenever a netting event occurs. This means that a netting agreement must cover both M and N’s bankruptcy or insolvency.

‘Legally effective and enforceable’ means that the entity has a well-founded legal basis for concluding that the agreement is legally effective and enforceable.

Chargeable UK resident entities or UK sub-groups may undertake a number of financial instrument transactions with a counterparty (or members of the counterparty’s group) and may enter into a ‘bilateral or multi-lateral master netting arrangement’ with them.

Providing the netting agreement meets the above conditions, the chargeable UK resident entity or UK sub-group will be able to net off from their liabilities any asset balances recognised on a relevant balance sheet and covered by the master netting agreement for the purposes of determining their Bank Levy liability - see, for example, CFM13100 regarding the ISDA Master Agreement for swaps and similar derivatives.

Optional netting provisions

In some netting agreements it will be optional whether single net settlement takes place. In these agreements it must be possible that either party could be in a position to elect for net settlement. If net settlement is at the option of only one specific party (and the other party neither has the optional nor automatic right to effect single net settlement) then this will not be a netting agreement for the purpose of the Bank Levy.

Some market standard agreements with netting provisions such as the ISDA Master Agreement and the Global Master Repurchase Agreement (GMRA) contain terms for optional early termination whereby, if there is an event of default (such as either party’s insolvency), the non-defaulting party may specify the relevant event of default and designate an early termination date, with the effect that single net settlement occurs. HMRC’s view is that netting can occur under the ISDA Master Agreement and GMRA as these market standard agreements provide that insolvency of each counterparty is an event of default, and either party may be the non-defaulting party (and so both can effect net settlement either through automatic early termination or by exercising an option for early termination).

Other Conditions for netting

There are three additional conditions which must all be met:

1. the liabilities that are recognised on the balance sheets of the chargeable UK resident entity or UK sub-group and the net settlement assets recognised by a member of the relevant group must be with the same counterparty (or members of the counterparty’s group);

2. the liabilities and assets must be covered by the same netting agreement which the entity has a well-founded legal basis for concluding is legally enforceable and effective on the insolvency of the counterparty; and

3. the counterparty must either be a third party or group company whose liabilities are not subject to the Bank Levy.

Netting calculation

To calculate the Bank Levy the chargeable UK resident entity (see BLKM315140) or UK sub-group’s (see BLKM315130) net settlement liabilities should be reduced by the amount (but not below nil) of the entity’s net settlement assets by taking the following steps:

1. total the relevant liabilities covered by the netting agreement (other than excluded liabilities);

2. deduct the total of any relevant net settlement assets covered by the same netting agreement from the liabilities (but not below zero); and

3. the result is the netted liabilities.

Where net settlement liabilities include amounts due from a foreign bank with a UK permanent establishment in the same group (see BKLM375000), ignore X% of any net settlement assets that correspond with liabilities of the permanent establishment.

Net settlement assets are to be included only once.

Where M’s net settlement liabilities include long-term and short-term liabilities, these are netted in the same proportion.

General comments on collateral flows

The net settlement assets and net settlement liabilities include any assets or liabilities recognised in respect of cash collateral which are also subject to the same netting agreement.

Where net settlement assets include securities provided as collateral, those securities must be recognised on the balance sheet of the collateral provider in order to be eligible for netting.

Netting examples

Some examples are set out below. These assume M and N have a legally effective and enforceable netting agreement that qualifies for netting for Bank Levy purposes.

1. Derivatives and cash collateral example
2. Offsetting loans and deposits
3. Reverse repo
4. Repo of on-balance sheet securities
5. Repo of off-balance sheet securities
6. Stock loan of on-balance sheet securities held by another group entity

1. Derivatives and cash collateral

M has following balances with counterparty N:

  • Derivative asset of 100
  • Derivative liability of 90

M receives cash collateral from N of 10 - for which it must recognise a liability of 10.

For Bank Levy netting purposes, M’s net settlement liabilities include the derivative liability of 90, and the liability reflecting the obligation to return collateral of 10.

M’s net settlement assets include the derivative asset of 100.

Thus in this case the effect of netting is to reduce M’s liabilities to N for Bank Levy purposes to nil (90+10-100).

2. Offsetting loans and deposits

M has balances with a number of entities in the N group. N is a financial counterparty (so deposits do not qualify for the reduced rate - see BKLM331105)

M’s financial statements include the following balances:

2 year fixed rate deposit from N1 of 100

Short-term loan to N2 of 80

Overnight deposit from N3 of 20

For Bank Levy netting purposes, M’s net settlement liabilities include the 2- year fixed rate deposit from N1 of 100 and the overnight deposit from N3 of 20.

M’s net settlement assets include the short-term loan to N2 of 80.

M’s netted liabilities are therefore 40 (100+20-80).

The netted liabilities should be apportioned between long and short-term in the same proportions as the gross liabilities. Thus the netted liabilities would be split thus:

Short term: 7 [i.e. 40 x 20/120]

Long term: 33 [i.e. 40 x 100/120]

Such netting could also be effective where the balances are between different entities in the M group and different entities in the N group, as long as the relevant netting agreement is viewed as being legally effective and enforceable.

3. Reverse repo

M enters into reverse repo with N (M transfers cash 100 to N and receives securities with same value from N). M then sells (shorts) securities into the market (to CP).

Upon entering into the reverse repo, M derecognises the cash, and recognises a repo debtor of 100:

  • Cr cash 100
  • Dr repo debtor 100

Upon sale of the securities, M must recognise an obligation to return the securities:

  • Cr obligation to return security 100
  • Dr cash 100

M’s net settlement assets and liabilities are each 100 from this transaction. M’s liability for Bank Levy purposes from the transaction is thus nil.

If M does not sell the securities received, then it has no net settlement liabilities (and no liability for Bank Levy purposes from the transaction).

The same analysis applies where the legal form of the transaction is a stock loan for cash collateral.

4. Repo of on-balance sheet securities

M holds securities as assets on its balance sheet. M enters into a repo with N (M receives cash 100 from N and transfers the securities with same value to N).

Upon entering into the repo, M recognises a repo liability of 100, recognises cash of 100 and continues to recognise the securities of 100. Netting of 100 is available, so M’s netted liabilities are nil.

5. Repo of off-balance sheet securities

M enters into a reverse repo with N1 (M transfers cash 100 to N1 and receives securities with same value from N1). M then enters into a repo of those reversed in securities with N2 (M receives cash 100 from N2 and transfers the securities with same value to N2). M does not have any holding of those securities on its balance sheet. N1 and N2 are unconnected.

Upon entering into the reverse repo, M derecognises the cash, and recognises a repo debtor asset of 100 with N1. Upon entering into the repo, M recognises a repo liability of 100 with N2, and recognises cash of 100. No netting is available as the securities provided by M as collateral to N2 are not recognised on M’s balance sheet.

6. Stock loan of on-balance sheet securities held by another group entity

M1 (a non-UK resident entity not in the scope of the Bank Levy) and M (a UK resident entity in the scope of the Bank Levy) are members of the same relevant group. M1 holds securities as assets on its balance sheet.

M1 enters into a stock loan with M of the above securities it holds on-balance sheet (M1 receives cash 100 from M and transfers the securities with same value to M). M enters into a stock loan with N (M receives cash 100 from N and transfers those securities with same value to N).

Upon M1 entering into the stock loan with M, M1 continues to recognise the securities of 100. Upon borrowing the securities from M1, M recognises a cash collateral asset of 100, derecognises cash of 100, although M does not recognise the securities of 100 borrowed from M1.

Upon M entering into the stock loan with N, M recognises a liability to return the cash collateral to N of 100 and recognises cash of 100.

Netting of 100 is available for M as the securities provided as collateral to N are those securities that are held as on-balance sheet securities by M1, another member of the relevant group.

Netting is not available if M1 does not hold the securities on its balance sheet (for example, if M1 has borrowed the securities that were loaned on to M); or where M has lent the securities to N, but M has borrowed the securities from an entity that is not a member of M’s relevant group (rather than borrowing the securities from M1’s own on-balance sheet assets).