CFM37870 - Loan relationships: hybrid capital instruments: tax rules - interaction with other rules

The new rules introduced by FA19/Sch20 contain some specific provisions on how hybrid capital instruments (HCI) that meet the definition in CTA09/S475C are treated for tax purposes (see CFM37860). This section of the guidance considers the application of other tax rules to these instruments. It also applies to non-HCI instruments previously covered by the Regulated Capital Securities (RCS) Regulations (CFM37890) and other non-HCI instruments issued to meet regulatory or other legal requirements.

The following points are covered in this section:

In addition, information on interactions with Stamp Duty and Stamp Duty Reserve Tax can be found at STSM021245A.

Credits arising on the write down of debts

The RCS Regulations provided an exemption from tax for credits arising on the write down or conversion of debt to equity, but there is no such exemption for HCI. The normal corporation tax rules apply and any credits that arise are taxable subject to the provisions of other tax legislation.

As a result of the application of CTA09/S320B, this will include any credits recognised in respect of HCI that are accounted for as an equity instrument for accounting purposes. The effect of section CTA09/320B is to put the HCI on a similar tax basis to debt that is accounted for as a liability.

However, there are some exceptions for releases in CTA09/S322, of which it is expected that Conditions B, D and E will be most relevant for HCI and other instruments with write-down or conversion features included to meet regulatory or other legal requirements.

In order for CTA09/S322 to apply there must be a release and that must take place in an accounting period for which the amortised cost basis of accounting is used for the loan relationship.

Release of debt

When its conditions are met, CTA09/S322 exempts a release credit when a debt is released.

A debt is released when the creditor has permanently waived the debtor’s obligation to repay. This includes a formal, legal waiver and permanent releases (or write-downs) to comply with the law or regulatory requirements.

A temporary write-down is not a release. This is because the reduction in the contractual liability reflects the provision in the loan agreement for the amount repayable to change in certain circumstances, rather than the creditor permanently giving up any rights to repayment. A temporary write-down does not extinguish the debt. This means that a credit on a temporary write down is taxable.

Amortised cost basis of accounting

Conditions B, D and E apply only where the release takes place in an accounting period for which the amortised cost basis of accounting is used for the loan relationship. HCI may be classified as an equity instrument for accounting purposes. On initial recognition these will be recognised at the amount of proceeds received (at ‘cost’) less any costs of issuance. In such cases there are no amounts to be amortised over the term of the instrument. HMRC considers that HCI accounted for in this way will meet the amortised cost condition in CTA09/S322(1)(b).

The reference to amortised cost accounting is a reference to the accounting applied for tax purposes. If deemed amortised cost accounting applies to an external liability under the eliminating tax mismatch rules in CTA09/S352B, those loan relationships will be eligible for the exemptions in section 322 subject to meeting the specific conditions. Similarly, if deemed amortised cost accounting applies to fair valued RCS instruments under the grandfathering rules in FA19/Sch20/para 12, those loan relationships will be eligible for the exemptions in section 322 subject to meeting the specific conditions.

Conditions B, D and E

Condition B applies if the HCI is released in consideration of shares forming part of the ordinary share capital of the debtor. In this context “ordinary share capital” includes core capital deferred shares that form part of the capital of a building society.

Condition D applies if the release is in consequence of the exercise of a stabilisation power under the Banking Act 2009 or certain other powers the Bank of England may exercise when a bank is in financial distress.

Condition E applies if, immediately before the release, it is reasonable to assume that, without the release and any arrangements of which the release forms part, there would be a material risk that the debtor company would be unable to pay its debts within the next 12 months. To determine whether this test is met it may be necessary to consider how markets would react if there was no release, particularly where this would leave the institution with equity levels below the accepted minimum for the industry or in breach of requirements placed upon it in law. For example if the write-down occurs only at a level where, without a release, there would be a material risk of a collapse of confidence in the institution within 12 months, then condition E is likely to be met.

See also CFM33200+.

Intra-group hybrid capital instruments

Connected company debtors and creditors, with some exceptions, are not taxable on debits and credits arising on release or conversion of loan relationships.

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Exception from duty to deduct income tax

The RCS Regulations included an exception from the duty to deduct income tax on interest paid on regulatory capital securities as defined in regulation 2 of those Regulations. For regulatory capital securities issued before 1 January 2019 this exception will be maintained until 31 December 2023.

HCI issued on or after 1 January 2019 will not be subject to the exception in the RCS Regulations so income tax may be deductible from interest paid in accordance with ITA07/Ss874 and 889. Other existing exceptions, including those in ITA07/Ss875 to 888E, will continue to apply.

Eurobond exemption

ITA07/S882 provides that the duty to deduct income tax under ITA07/S874 does not apply to a payment of interest on a quoted Eurobond. ITA07/S987 defines “quoted Eurobond” and this includes the requirement that the instrument “carries a right to interest”. HMRC accept that an HCI can carry a right to interest even if its terms provide the debtor with the right to cancel a payment of interest under the loan relationship. An amount payable in respect of an HCI can therefore be a payment of interest on a quoted Eurobond if all other conditions are met.

Other exemptions

Following the withdrawal of SP4/96 in 2017, interest paid on regulatory capital by banks and authorised persons whose business consists wholly or mainly of dealing in financial instruments are covered by the exemptions from withholding tax in ITA07/S878 and ITA07/S885. These exemptions do not apply if the characteristics of the transaction giving rise to the interest are primarily attributable to an intention to avoid UK tax.

Tax treaty provisions

A small number of the UK’s tax treaties contain provisions relating to interest that are broadly similar to the “results dependent” conditions in the distributions legislation in CTA10/S1015.

Where the interest paid meets these conditions it may be taxed by the State in which the interest arises. This is in contrast to the general treatment in the relevant treaties which provide that interest is only taxable in the State in which the beneficial owner is resident. Where the instrument is an HCI within CTA09/S475C then, in the absence of special factors, HMRC will apply the treatment generally applicable to interest. As a result, interest arising in the UK and paid to a beneficial owner resident in the other State will be taxable only in that other State.

When considering the position under tax treaties we will adopt a similar approach to that adopted for deferral of interest and ‘bail in’ provisions in the context of the distribution rules in CTA10/Part 23, as set out below.

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Bifurcated accounting (embedded derivatives) and fair value measurement

Under the RCS Regulations a regulatory capital security (as defined by regulation 2 of the RCS Regulations) that was accounted for at fair value or as including an embedded derivative was taxed as a single loan relationship at amortised cost. For regulatory capital securities issued before 1 January 2019 this treatment will be maintained until 31 December 2023 (with split treatment for accounting periods straddling that date).

HCI issued on or after 1 January 2019 will not benefit from this special treatment and, if accounted for at fair value, will need to bring debits and credits into account in accordance with generally accepted accounting practice, subject to any other statutory override.

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Distributions

CTA10/Part 23 contains provisions about what is, and what is not, a distribution (see CTM15100).

For HCI there are some limited modifications of these rules:

• The entitlement to defer or cancel a payment of interest is ignored so far as determining whether the instrument is results dependent (CTA09/S420A, CTA10/S1015(4)).
• An HCI cannot be an equity note for the purposes of considering if the instrument is a special security (CTA10/S1015(6)).

For HCI and other securities issued by companies whose capital base, and the terms of instruments issued as part of that capital base, are subject to regulation by jurisdictional authorities, some specific questions may arise on the application of the distributions code. The subsections below give HMRC’s view on these questions.

The subsections below relate to the specialised context of securities issued by companies whose capital base is subject to regulation by jurisdictional authorities. For guidance on the application of the distributions code more generally, see CTM15100.

Results dependency

Deferral of interest where the obligation to make the payments remains will not make an instrument results dependent for the purposes of CTA10/S1015(4).

HMRC Brief 24/14 (now archived) set out HMRC’s views about whether provisions to “bail in” an instrument issued by a financial institution make that instrument results dependent for the purposes of CTA10/S1015(4)). It said that ‘for all securities (not just AT1 and T2) any possible change in terms triggered by an exercise of regulatory intervention powers is outside the scope of section 1015(4). Thus, the fact that the statutory bail-in regime may apply to a particular instrument will not in itself make that instrument “results dependent”. This will be the case regardless of whether or not the instrument in question specifically refers to the regulatory bail-in regime, either in its terms of issue or in the prospectus.’

The return on all securities depends on the solvency of the borrower, but this does not make those instruments results dependent within CTA10/S1015(4). This logic extends to viability rules short of insolvency imposed by a jurisdictional authority. Terms providing for write-down or conversion that are included to meet regulatory requirements will not on their own make an instrument results dependent. This includes terms that contractually acknowledge a statutory or regulatory bail-in regime and contractual bail-in provisions included in response to a requirement of the issuer’s or issuer’s parent’s regulator.

On the same reasoning, such terms will also not on their own make an instrument a non-commercial security within CTA10/S1005.

A similar approach is taken to the application of the stamp duty loan capital exemption, see STSM021245A

Instruments convertible into shares

Under section CTA10/S1015(3), interest payments can be treated as distributions if the instruments are convertible into shares and “are neither listed on a recognised stock exchange nor issued on terms which are reasonably comparable with the terms of issue of securities listed on a recognised stock exchange”. HMRC’s view is that instruments that are not listed on a recognised stock exchange will be on “reasonably comparable” terms if those terms would have been entered into by independent parties and are of a type similar to those found on listed securities. HMRC expects genuine instruments that are issued commercially to meet this requirement.

Principal secured

When considering whether CTA10/S1000(1) conditions E and F (non-commercial securities and special securities) apply, the amount of the principal secured must first be determined. As set out in CTM15501, this is taken to be the minimum amount the holder of the security is entitled to receive on maturity of the security under the terms of issue, subject to specific adjustments provided for in statute. However, where an instrument has a write-down or conversion feature which is only activated in a “qualifying case” (as defined in CTA09/S475C(6)), that feature would not be regarded as reducing the minimum amount the holder is entitled to receive.

Normal commercial loan

As a broad principle, we take the view that terms providing for conversion that are included to meet regulatory requirements will not on their own make an instrument a non-commercial loan within CTA10/S162.

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Interaction with Hybrid Mismatch Rules

The Hybrid and other Mismatch rules in TIOPA10/Part 6A previously contained a specific exemption for regulatory capital at Section 259N(3)(b), which exempted all regulatory capital that fell within the definition provided by the RCS Regulations (see INTM551060). This carve out ceased to have effect following the revocation of the RCS Regulations on 1 January 2019.

A new carve out covering the year ended 31 December 2019 was provided by ‘The Hybrid and Other Mismatch (Financial Instrument: Exclusions) Regulations SI 2019/1251’. This mirrors the scope of the earlier exemption and also exempts instruments that count towards MREL.

With effect from 1 January 2020 the 2019 Regulations were replaced by ‘The Hybrid and Other Mismatch (Financial Instrument: Exclusions) Regulations SI 2019/1345 which implement the requirements set out in the Anti-Tax Avoidance Directive, which came into force in January 2020. For further guidance on the application of these Regulations see INTM551065.

Instruments classified as equity for accounting purposes: tax treatment of coupon for the issuer and for any connected party holder

The issuer (borrower)

Where an instrument is accounted for as an equity instrument of the issuer, it is likely that the company will hold the instrument at ‘cost’ in the company’s statement of financial position and present it within equity. The accounts will typically recognise the coupons through equity on a ‘paid’ basis. This is because the company will normally have no obligation to pay the coupon until it is declared.

Under the new rules at CTA09/S320B any amount recognised in equity in respect of a hybrid capital instrument will be brought into account in the same way as if it had been a profit or loss item (except for exchange gains and losses). As a result, the company will typically be entitled to tax relief for the coupons on a ‘paid’ basis.

Where the legislation mandates an amortised cost basis for tax purposes, for example in respect of loans between connected companies, HMRC does not expect there to be any need for adjustments to be made and, as a result, the tax treatment should simply follow the accounting entries recognised in the company’s statement of changes in equity.

The holder (lender)

The holder is likely to measure the instrument at fair value although in some limited circumstances it may be at ‘cost’. Any income or expenses in respect of the instrument will be recognised in profit or loss.

Where the legislation mandates an amortised cost basis for tax purposes and the company holding the instrument adopts a fair value basis of accounting for the instrument, the company will be required to adjust the amounts recognised for tax purposes. In such cases, HMRC would expect the tax treatment to align with the position of the issuer in respect of an instrument classified as equity for accounting purposes, with the instrument recognised at ‘cost’ and the coupons recognised on a ‘paid’ basis.

Where the legislation mandates an amortised cost basis for tax purposes and the company holds the instrument at ‘cost’ HMRC does not expect there to be any need for adjustments to be made and, as a result, the tax treatment should simply follow the accounts. The amounts brought into account for tax should therefore mirror the position of the issuer as described above.

Attribution of capital to UK permanent establishments of foreign banks

INTM267776 discusses the interaction between the HCI rules and the attribution of capital to UK permanent establishments of foreign banks.

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