CFM37810 - Loan relationships: hybrid capital instruments: overview

Some companies raise funds by issuing instruments (referred to here as “hybrid capital”) that sit close to the border between debt and equity. Their features often include an entitlement for the debtor to defer or cancel interest payments. They are often long-dated or perpetual and while they have a fixed capital value at the outset, their terms may provide for release or conversion into shares in certain circumstances.

The distinction between debt and equity is important for the UK tax system. In particular, coupon payments on instruments that are considered to be debt are typically deductible for tax purposes, whereas dividends paid on equity instruments are normally disallowed. However, by their nature, determining the correct treatment for hybrid capital can be problematic and this can lead to uncertainty for companies.

This is a particular difficulty for the financial sector, where banking companies and insurance companies are required to hold a certain amount of regulatory capital by Basel III and Solvency II respectively (see CFM37820). The idea behind regulatory capital is that companies in financial difficulties call upon it to remain in business which protects customers’ interests and avoids disrupting the economy. It acts like a buffer, absorbing losses and preventing the capital position becoming depleted to critical levels.

Basel III and Solvency II specify what type of regulatory capital is required and in what proportion. This includes Tier 1 and Tier 2 capital, and certain hybrid capital counts towards Tier 1 capital requirements. These instruments must contain the feature to write down or convert to equity in the event of the bank or insurer coming under financial strain.

The Treasury made the Taxation of Regulatory Capital Securities Regulations 2013 (SI 2013/3209 as amended by SI 2015/2056) (“RCS Regulations”) to provide certainty of tax treatment for these instruments (see CFM37890).

Basel III includes a requirement that global systemically important banks (G-SIBs) must allow all regulatory capital instruments and certain types of debt liabilities to be written off or converted to equity if a bank is judged to be non-viable. The aim is to move the responsibility for ‘bailing out’ a bank deemed ‘too big to fail’ from government and taxpayers to shareholders and creditors.

The Financial Stability Board issued its total loss absorbing capacity (TLAC) standard for G-SIBs in 2015 and this was brought into EU law via the EU Bank Recovery & Resolution Directive (BRRD). Under the BRRD, resolution authorities were given the power to direct all banks, building societies and certain investment firms to comply with a minimum requirement for own funds and eligible liabilities (MREL). This was adopted in the UK in an amendment to the Banking Act 2009. The resolution authority for UK banks is the Bank of England.

In June 2018, the Bank of England finalised its approach to setting MREL for UK banks including UK subsidiaries of non-UK G-SIBs. Under these new requirements banks are permitted to issue types of hybrid capital instruments that are not covered by the existing RCS Regulations.

This provided the opportunity to review the operation of the RCS Regulations to ensure the tax rules remained effective for all instruments counting towards MREL requirements. HMRC policy aims to provide tax certainty, reduce tax volatility, and allow coupon deductibility for hybrid capital instruments in all sectors, but only so long as they are, in essence, debt instruments, not equity.

As a result of the review, the RCS Regulations were revoked with effect from 1 January 2019 and replaced with new tax rules for:

• hybrid capital instruments, which are debt-like instruments that can be issued by any sector (CTA09/S475C); and
• tax mismatches, which align the tax treatment of linked loan relationships (CTA09/S320B).