INTM551065 - Hybrids: financial instruments (Chapter 3): overview: ATAD compliant Hybrid Regulatory Capital Exemption with effect from 1 January 2020
The EU Anti-Tax Avoidance Directive (ATAD) (EU Directive 2016/1164) sets out minimum standards for various anti-avoidance measures. ATAD was amended by EU Directive 2017/952 (ATAD 2) which set out more detailed rules concerning hybrid mismatches.
From 1 January 2020, any exemption for hybrid regulatory capital as to meet the conditions set out in Article 9(4)(b) of ATAD (‘the Directive’). From 1 January 2020, the exemption for regulatory capital is provided by Statutory Instrument 2019/1345 – which are referred to as ‘the Regulations’ below.
The Regulations provide an exemption from the hybrid and other mismatch rules in Part 6A TIOPA 2010 for those financial instruments which meet the detailed conditions of the Directive. These Regulations came into force on 1 January 2020.
This exemption replaced the previous exemption provided by Statutory Instrument 2019/1251, which in itself replaced the exemption which was based upon the 2013 Regulatory Capital Security Regulations (SI 2013/3209).
As with the previous exemptions, these Regulations work by excluding certain instruments from the definition of ‘financial instruments’ within Section 259N, Part 6A TIOPA 2010. However, whilst the previous exemptions applied to specified types of financial instrument, the new exemption will apply by reference to a number of detailed conditions set out in the Directive.
The Regulations operate by a simple cross-reference to the detailed conditions set out in Article 9(4)(b) of the Directive. This approach was considered to be more straightforward than transposing those conditions into UK law. The relevant text of the Directive is as below, except that 9(4)(b) will continue to apply after 31 December 2022 (see Statutory Instrument 2022/1144)
“Article 9
4. A Member State may exclude from the scope of:
(a)…..
(b) ….. hybrid mismatches resulting from a payment of interest under a financial instrument to an associated enterprise where:
(i) the financial instrument has conversion, bail-in or write down features;
(ii) the financial instrument has been issued with the sole purpose of satisfying loss absorbing capacity requirements applicable to the banking sector and the financial instrument is recognised as such in the taxpayer’s loss absorbing capacity requirements;
(iii) the financial instrument has been issued
— in connection with financial instruments with conversion, bail-in or write down features at the level of a parent undertaking,
— at a level necessary to satisfy applicable loss absorbing capacity requirements,
— not as part of a structured arrangement; and
(iv) the overall net deduction for the consolidated group under the arrangement does not exceed the amount that it would have been had the taxpayer issued such financial instrument directly to the market.”
This guidance therefore provides a brief explanation of those conditions and sets out how HMRC’s proposed interpretation of those conditions, to enable taxpayers to consider whether the exemption will apply.
Hybrid mismatches resulting from a payment of interest under a financial instrument to an associated enterprise
The Regulations refer to payments and quasi-payments, as defined in the Hybrid and other Mismatch rules in Part 6A TIOPA. They do not provide a definition of interest. Given the nature of regulatory capital financial instruments, and the payments made under those instruments, it was not considered necessary to provide any further definition on this point. However, in order for any hybridity mismatch to arise, any such payments or quasi-payments would have to be treated as deductible payments in one jurisdiction, and non-taxable receipts in the other jurisdiction.
The Regulations adopt the definition of an associated enterprise provided by Article 2(4) of ATAD, which provides that, in relation to hybrid financial instruments, an associated enterprise is one where
- An entity in which the taxpayer holds directly or indirectly a participation in terms of voting rights or capital ownership of 25% or more or is entitled to received 25% or more of the profits of the taxpayer;
- An individual or entity which holds directly or indirectly a participation in terms of voting rights or capital ownership in a taxpayer of 25% or more or is entitled to receive 25% or more of the profits of the taxpayer;
if an individual or entity holds directly or indirectly a participation of 25% or more in a taxpayer and one or more entities, all the entities concerned, including the taxpayer, shall also be regarded as associated enterprises.
The financial instrument has conversion, bail-in or write down features
This condition is a matter of fact in each case, but the expectation is that a range of regulatory capital will have one of these features – it is noted that the features listed are alternatives. So, for example, Additional Tier 1 instruments, as defined by section 3(1) of the Banking Act 2009, will meet this condition, as would other internal instruments issued in order to meet minimum requirements for own funds and eligible liabilities (MREL) as set by the Bank of England.
The financial instrument has been issued with the sole purpose of satisfying loss absorbing capacity requirements applicable to the banking sector
We consider that this condition will be met by financial instruments which have been issued in order to meet regulatory capital requirements. We do not consider that the fact that capital has a general function of supporting the business activities of a bank alters the analysis of the essential purpose of such instruments.
We do not consider that this condition requires financial instruments to be issued in response to specific regulatory capital requirements imposed on individual banks. In practice, the expectation is that such instruments will have been issued in order to ensure that regulatory requirements will be met, rather than being issued in response to such requirements.
With regard to the quantum of regulatory capital issued by a bank, it is accepted as a matter of practicality that banks will hold more regulatory capital than the minimum level set by the relevant regulatory authorities. However, we do not consider that holding a buffer over and above the minimum requirement will alter the analysis in terms of the purpose of issuing such instruments.
We anticipate that banks will be able to support any exemption claimed by reference to the actual regulatory requirements imposed upon them.
The Directive does not provide a definition of the banking sector. HMRC consider that, in accordance with the Prudential Regulatory Authority (PRA) Rulebook, the banking sector can be defined for the purposes of these Regulations as UK banks, building societies and investment firms that are currently subject to the EU Capital Requirements Regulation.
The Bank of England has responsibility for setting minimum standards in relation total loss absorbing capacity requirements for banking entities, in line with the approach set out by the Financial Stability Board (FSB). The Bank of England’s approach can be summarised as follows
The Bank will set MREL (Minimum Requirement for own funds and Eligible Liabilities) on a firm-specific basis, informed by the resolution strategy for that firm.
The Bank of England 2018 policy statement in relation to MREL can be found at The Bank of England’s approach to setting a minimum requirement for own funds and eligible liabilities (MREL).
The financial instrument is recognised as being taken into account in relation to the taxpayer’s loss absorbing capacity requirements
This condition simply requires that the financial instrument is accepted as appropriate regulatory capital that is taken into account by the Bank of England when assessing whether the minimum loss absorbing capacity requirements have been met. Specifically, the Prudential Regulatory Authority (PRA) reporting requirements in relation to MREL would be an appropriate starting point for taxpayers seeking to confirm that particular financial instruments have been taken into account in relation to their loss absorbing capacity requirements.
The financial instrument has been issued in connection with financial instruments with conversion, bail-in or write-down features at the level of a parent undertaking
This condition is intended to ensure that any internal (intra-group) financial instruments can be linked with similar regulatory capital instruments that have been issued higher up the group structure. HMRC consider that this is primarily a measure of quantum, which tests whether sufficient regulatory capital has been issued at the level of a parent to match or exceed the amount of regulatory capital issued in the UK.
So, to take a simplified example, if a UK subsidiary of a US parent bank issues internal financial instruments of £100m, this condition requires that the US parent has issued financial instruments with appropriate features of at least £100m.
There is no specific requirement that the instruments issued by a parent undertaking need to have been issued externally. Nor is there any requirement that the parent undertaking is the ultimate parent of the group.
The Directive does not include a definition of ‘parent undertaking’. For the purposes of these Regulations, HMRC consider that any entity of which the relevant UK bank is at least a 51% subsidiary will qualify as a parent undertaking.
We do not consider that this condition requires the instruments to have been issued in a particular order – the condition does not specify, for example, that the first instrument has to be issued in advance of the issue of similar instruments at the level of the parent undertaking. We consider that this condition can be met so long as there is some link between the internal issuance and the issuance by the parent undertaking.
The financial instrument has been issued at a level necessary to satisfy applicable loss absorbing capacity requirements
We consider that this condition refers to the structural level within the group at which the relevant instruments have been issued, rather than any measure of quantum. Therefore, taxpayers will need to demonstrate that the instruments can be taken into account in meeting regulatory requirements, on the basis that they have been issued at the appropriate level within the group structure.
This condition is clearly closely linked to the requirement that the instruments have been issued to satisfy loss absorbing capacity requirements. Evidence that an instrument has been so issued should be sufficient to indicate that the requirement for instruments to have been issued at the right level will also have been met.
The financial instrument has not been issued as part of a structured arrangement
The Directive defines a “structured arrangement” in Article 2 as
“an arrangement involving a hybrid mismatch where the mismatch outcome is priced into the terms of the arrangement or an arrangement has been designed to produce a hybrid mismatch outcome, unless the taxpayer or an associated enterprise could not reasonably have been expected to be aware of the hybrid mismatch and did not share in the value of the tax benefit resulting from the hybrid mismatch”
(Article 2 of ATAD as amended by ATAD 2 (EU Directive 2017/952))
Whilst it will be a matter of fact in relation to each relevant instrument, we consider that it would be unusual for regulatory capital to be issued as part of a structured arrangement designed to seek a mismatch, or that any mismatch will have been specifically priced into the arrangement, notwithstanding that the effect of such instruments may be that there is a hybrid mismatch outcome.
With regard to whether an arrangement has been designed to achieve a mismatch outcome, it may be relevant that in order to meet the purpose condition considered above, the primary purpose of the relevant financial instrument will already have been considered.
The overall net deduction for the consolidated group under the arrangement does not exceed the amount that it would have been had the taxpayer issued such financial instrument directly to the market
The Directive does not provide a definition of ‘arrangement’. HMRC’s view is that the arrangement to be considered must be limited to the issuing of relevant internal financial instruments to associated enterprises, rather than any wider arrangement which also takes into account any external issuance. So, we do not consider, for example, that any connected issue by a parent undertaking is relevant to this condition.
This condition requires a consideration of whether the tax deductions which arise as a result of the issuance of relevant financial instruments exceed the deductions that would have arisen if those instruments had been issued externally to the market. This will be a matter of fact in each case.
The exemption no longer has an end date
The Directive requires that the detailed requirements in order for exemption to apply, as set out in Article 9(4)(b), will apply from 1 January 2020. The Directive used to provide that any exemption could not apply after 31 December 2022. This end date has been removed.
This point is dealt with in the Regulations, which specifies a commencement date of 1 January 2020 and provides straddling period rules for accounting periods that run across that date.