CFM37840 - Loan relationships: hybrid capital instruments: definition of hybrid capital instrument: definition of hybrid capital instrument for tax purposes

CTA09/S475C

The tax rules for hybrid capital instruments (HCIs) were introduced in FA19/Schedule 20. The policy intention is to provide coupon deductibility for commercial hybrid capital instruments that are, in essence, genuine debt instruments.  The rules define what a hybrid capital instrument is (this page) and set out the tax provisions that apply to instruments meeting this definition (CFM37850). The transitional rules are in CFM37860.

Definition of hybrid capital instrument for tax purposes

S475C defines “hybrid capital instrument” for tax purposes. It is a loan relationship which meets all the following conditions:

• the debtor is allowed to defer or cancel interest payments
• the loan relationship must have no other significant equity features
• the debtor must have made an irrevocable election into the new rules within six months of issue, or on or before 30 September 2019 where the instrument was issued before 31 December 2018.

The election is ineffective where there are arrangements with a main purpo­­se of obtaining a tax advantage for any person.

Alternative deadlines for elections

Alternative deadlines for making an election into the new rules apply in the following two circumstances:

• Where a loan relationship is only able to qualify as an HCI due to the amendment made to the definition of an HCI in SI 2019/1250 (see "Conversion event," below). In this circumstance, the deadline is six months from 4 November 2019, which is the date that SI 2019/1250 came into force.
• Where the terms of the loan relationship are themselves amended so that it will be able to qualify as an HCI. In this circumstance, the deadline is six months from the beginning of the accounting period following the accounting period in which the amendment was made.

In the second circumstance, the earliest point at which the loan relationship will be able to qualify as an HCI is the first day of the accounting period following the accounting period in which the amendment was made. This is because the definition of an HCI refers to the features of a loan relationship "for an accounting period of the debtor" (s475C(1)). If the loan relationship does not meet the definition for any part of the debtor's accounting period, it will not be able to qualify as an HCI in that accounting period.

Application of the distribution rules to hybrid capital instruments

Even where a loan relationship meets the conditions to qualify as an HCI, the debtor will need to consider how the distributions rules at CTA10/PART23, as modified for HCIs by CTA09/S420A and CTA10/S1015(1A), apply to the loan relationship.  (See CFM37850, CFM37870 and CTM151000).

References to "provision"

There are a number of references in section 475C to “provision” under or made by the loan relationship. These can refer to contractual provisions within the terms and conditions of the instrument. They can also cover side agreements between the parties that govern the instrument.

However, rights and obligations imposed under a statutory provision or regulatory requirement which are not reflected in the terms and conditions do not have to be taken into account in determining whether the loan relationship meets the definition of an HCI in section 475C.

Debtor is allowed to defer or cancel interest

S475C(1)(a) requires a hybrid capital instrument (HCI) to be a loan relationship which, “makes provision under which the debtor is entitled to defer or cancel a payment of interest”. 

An instrument will meet this criterion if it gives the issuer the right to cancel or defer interest payments in the accounting period.  It will not meet this criterion if the entitlement to cancel or defer does not exist in the accounting period. 

The following are examples of instruments that we would expect to meet this condition:

• An instrument that gives the issuer discretion to cancel interest payments at any time.
• An instrument that gives the issuer discretion to defer interest payments at any time.

The following are examples of instruments that would not meet this condition:

• An instrument that only allows the issuer discretion to defer or cancel interest payments when the issuer makes a loss
• An instrument that only allows the issuer discretion to defer or cancel interest payments after a certain number of years
• An instrument that requires the issuer to defer or cancel interest payments when it has insufficient distributable reserves
• An instrument that requires the issuer to defer or cancel interest payments when certain regulatory requirements are not met

An instrument that gives the issuer discretion to cancel or defer interest payments at any time is not precluded from being an HCI because it also includes a provision requiring the issuer to defer or cancel interest payments when it has insufficient distributable reserves or when certain regulatory requirements are not met.

Some instruments include a requirement to give paying interest on the loan relationship priority over paying dividends.  For example, the instrument may require payment of the interest if the issuer has elected to pay a dividend in the previous 12 months. Instruments with these terms can still meet the s475C(1)(a) condition.

Similarly, an instrument which requires payment of the interest if the issuer has elected to repay or purchase junior or parity securities in the previous 12 months may still meet the s475C(1)(a) condition.  This is because the issuer has discretion as to whether to pay the dividend or repay or purchase the securities.

No other significant equity features

The loan relationship will have no significant equity features if:

• it gives no voting rights in the debtor, or, at most, insignificant voting rights;
• there is no right to exercise a dominant influence over the debtor;
• it contains no provision for altering the amount of the debt other than in write-down or conversion events in qualifying cases; and
• the creditor is only entitled to receive more than interest and repayment of the debt principal on conversion events in qualifying cases.

A loan relationship will only qualify as an HCI if it has no significant equity features throughout the accounting period. Where a loan relationship is amended early in an accounting period so it no longer has any significant equity features, it cannot qualify as an HCI until the next accounting period.

Insignificant voting rights

Voting rights are only insignificant voting rights where those rights are limited to one vote per creditor regardless of the size of the creditor's holding. The legislation permitting insignificant voting rights has general application but it will be most relevant to mutuals and other membership organisations such as building societies which typically grant a single vote to all financial creditors. It ensures that the rules apply appropriately to such organisations.  

Section 475C(2)(a) refers specifically to voting rights in the debtor. A loan relationship may provide creditors with voting rights that relate only to the debt itself, such as a right for creditors to vote on changes in the terms of the debt. Where these rights do not provide any wider ability to influence the way the debtor carries on its affairs, they will not generally constitute voting rights in the debtor and so will not prevent eligibility as an HCI.

Dominant influence

Dominant influence is defined to mean the right to give directions with respect to the debtor’s operating and financial policies with which it is obliged to comply.

Write-down event

A reduction of the debt may be permanent or temporary provided that, where the reduction is temporary, any subsequent write-back cannot increase the debt beyond its original amount. A credit arising on a temporary write-down will be a taxable credit (CFM37850).

Conversion event

Conversion of the debt must be into ordinary shares of the debtor or of a company that controls the debtor (s475C(5)).  “Control” is defined at CTA10/S1124 and refers to the power to secure that the affairs of a company are conducted in accordance with a person’s wishes, which could be through holding shares, possession of voting power or through other powers (CTM80175).

To decide whether a company, C, has control of the debtor, s475C(5)(b) also allows attribution of rights and interests of companies connected with C. “Connected” is defined at CTA10/S1122.

Conversion of the debt into ordinary shares includes conversion of the debt into core capital deferred shares issued by a building society (Regulation 3(1)(d) The Building Societies (Core Capital Deferred Shares) Regulations 2013 (SI 2013/460)).  

As originally enacted, s475C(5) referred to conversion into shares of the debtor or of the debtor's quoted parent company. However, this excluded certain debt-like instruments the HCI rules were intended to include, as these instruments included in their terms a common form of takeover or change of control provision. S475C(5) was amended by SI 2019/1250. with retrospective effect from the HCI rules' commencement date of 1 January 2019. The guidance above reflects the amended version of s475C(5).

Some instruments issued by financial institutions reflect the language of the EU Directive 2014/59/EU, from which the bail in stabilisation powers in the Banking Act 2009 derive. They may permit conversion which is ostensibly not restricted to ordinary shares, nor into the shares of the debtor or controlling company. However, the parameters applied by the UK regulator mean that the only reasonably foreseeable outcome involves conversion into ordinary shares. These shares are likely to be shares of the debtor or a controlling company and therefore we would expect them to fall within the definition of “conversion event” in S475C(5) (as amended by SI 2019/1250)...” The inclusion of these terms will not prevent the instruments from coming within the HCI rules.

Qualifying cases  

Instruments that make provision only for qualifying cases include:

• instruments which make provision that the debt is altered or converted only if the debtor is experiencing certain solvency or liquidity problems
• instruments whose terms allow conversion or reduction of the debt in order to comply with a regulatory or other legal requirement

Instruments are not HCI if these rights are exercisable by the investor rather than the issuer.  

Regulatory and other legal requirements can include overseas requirements such as those of an overseas regulator, where these apply to the debtor.

Whether a provision is made to comply with a regulatory or other legal requirement needs to be considered on a case by case basis.

The fact that a provision is not mandatory will not necessarily preclude it from being included to comply with a regulatory or other requirement. For example, the Bank of England expects banks to include a contractual trigger in instruments that count towards their intra-group minimum requirement for own funds and eligible liabilities (internal MREL).  These internal MREL instruments are designed to be written down or converted to equity to recapitalise the entity that issues them without the need to use resolution powers on that entity so it can continue to provide critical banking services. In this particular circumstance, HMRC would accept that the provision has been included in order to comply with a regulatory requirement.

In each case, one would need to consider what statements have been made by the relevant regulatory authority and to what extent that the relevant provision had been included in response. Whether a provision has been included in an instrument because of a "need" to comply with a regulatory requirement is not determined by focussing on a particular regulatory capital threshold at the time of issuance.  HMRC's view is that it is determined by whether the instrument reflects a commercial response by the issuer so that it can continue to meet its regulatory capital requirements.

Where a company has included a conversion or write down trigger that could alter the amount of the debt, and the relevant provision

• allows such conversion or write-down outside of circumstances where the debtor is experiencing certain solvency or liquidity problems (s475C(6)(a)-(b)), and
• has not been included in order to comply with a regulatory or other legal requirement (s475C(6)(c),

the instrument will not come within the rules.

Provision for withholding tax gross up

The purpose of section 475C(2) is broadly to identify “significant equity features” and ensure that HCI do not have these features. In the context of this section the word interest in section 475C(2)(c) is to be read to include a withholding tax gross up term provided under the terms of the instrument. Therefore the inclusion of such a term would not, by itself, stop a loan relationship being an HCI.

Provision for substitution

Certain debts may include terms that allow the debtor to make substitutions in certain circumstances. In particular:

• substitution of the debtor with another party, for example by allowing a company in the same corporate group to take the place of the debtor with regard to the loan relationship, or
• substitution of the debt itself with another debt of the same amount between the same parties.

The mere fact that the debt allows for substitution will not of itself exclude it from qualifying as an HCI.

However, in each case, the debtor will need to consider what precisely these terms enable, in order to determine whether they include any provision to alter the amount of the debt or for the creditor to receive something other than interest or repayment. An instrument whose terms allowed a substitution that changed the overall economics of the loan relationship would be unlikely to qualify as an HCI.

In addition, if a substitution takes place it will be necessary to consider whether there is a new loan relationship and if so, whether this meets the definition of an HCI. If the existing loan relationship continues, but in altered form, it will similarly be necessary to consider whether this loan relationship still meets the definition of an HCI.

Small Redemption premiums

Some corporate bonds including hybrid corporate bonds may include a provision for the creditor to be paid a small premium on redemption in certain circumstances.  Depending on the facts and circumstances, this might be considered to be an additional amount of interest. Where that is the case it would not be a provision for the creditor to receive something other than interest or repayment of the debt and the inclusion of such a term would not, by itself, stop a loan relationship being an HCI.

An example of an instrument where the additional amount might be considered as interest is one that provides for a small premium on redemption where the securities are redeemed before the first call date as a result of a change in tax or accounting rules or a change in the assessment criteria applied by rating agencies.  A typical premium is 1%.

Where the instrument provides for a premium on redemption of more than 1%, or where there is any doubt that the premium can be regarded as interest, please refer to the Financial Services Team in Business, Assets and International (BAI).

Prescription Clauses

Commercial debt will often include a prescription clause.  This will typically provide that notes must be presented for payment within a set period of falling due (usually 10 or 12 years for principal and 5 years for interest) and that failure to do so will mean no amount is payable in relation to the relevant note. These clauses are typically included for administrative reasons and do not alter the expected economic cashflows. The holders of the instruments are fully entitled to the principal and interest (assuming that they take the appropriate steps). The inclusion of such a provision is not expected to have any impact on payments and will not prevent the instrument from qualifying as an HCI.

If you find a prescription clause which contains any unusual or contrived features, or one where notes must be presented for payment within a period of less than 5 years, you should refer this to the Financial Services Team in Business, Assets and International (BAI).

Main purpose test

The HCI rules include a main purpose test which excludes an instrument from being an HCI where ‘the main purpose, or one of the main purposes of, the arrangements is to secure a tax advantage for the company or any other person’.

HMRC will take the following into consideration in applying this test:

• Whether a tax avoidance purpose is the main, or one of the main, purposes is ultimately a question of fact which depends on all the circumstances of the particular case.
• In line with HMRC’s general approach in this area, HMRC will not give clearance covering the application of the anti-avoidance rule. HMRC’s guidance on non-statutory clearances can be accessed at www.gov.uk/guidance/non-statutory-clearance-service-guidance
• Companies have a choice between debt and equity in raising funds. If they choose a debt instrument and it includes permitted coupon waiver/deferral features or write down/conversion features (whether to qualify as regulatory capital/MREL or for another commercial purpose) then the inclusion of those features would not normally in itself indicate a tax purpose.
• If a company issues hybrid debt to protect or enhance its credit rating in respect of more senior debt instruments this would not normally alone indicate a tax purpose.

Making an Election

The HCI rules require the issuer to make an irrevocable election into the new rules within six months of issue of the relevant instrument.

However, for instruments that were in existence before 1 January 2019 the deadline for making the election is extended and should be made on or before 30 September 2019.

An alternative deadline applies in circumstances where the loan relationship is only able to qualify as an HCI due to the amendment made in SI 2019/1250 or following an amendment to the terms of the loan relationship itself. See "Alternative deadlines for elections," above.

Where a group or company has a Customer Compliance Manager (CCM) it should send the election to the CCM. In addition, in all cases, whether or not the group or company has a CCM, the election should be sent to the following email address: hybrid.loanrelationshipelection@hmrc.gov.uk

The election should include:

• the name of the entity making the election
• details of the instrument (a copy of the term sheet will suffice)
• the date of issue of the instrument
• a declaration to the effect that all the particulars given are correctly stated to the best of the information and belief of the person making the election

Date of issue - there is nothing to stop the debtor making an election prior to, or at the date of issue of the instrument (see also STSM021245). 

Declaration - the company will not have received a notice to file at the point it is required to make the election therefore this can only be made outside the CT return under Schedule 1A TMA70. 

The election is ineffective where there are arrangements with a main purpose of obtaining a tax advantage for any person.