Policy paper

Taxation of hybrid capital instruments

Published 29 October 2018

Who is likely to be affected

Corporate issuers and holders of certain types of debt (known as hybrid capital) that have some equity-like features are likely to be affected.

Companies that raise loan capital from third parties and distribute that capital within a group in such a way that the internal and external loan relationships would be taxed on different bases, are also likely to be affected.

General description of the measure

This measure provides certainty of tax treatment for hybrid capital instruments which allow deferral or cancellation of interest payments. If these instruments meet certain specified conditions then any interest payable will be deductible for the issuer and taxable for the holder and no Stamp Duty or Stamp Duty Reserve Tax will be payable on transfers of those instruments.

This measure also eliminates differences in the way that 2 linked loan relationships are taxed. Such differences are often caused by one of them having hybrid features.

Policy objective

This measure ensures that interest payments arising from certain debt instruments (known as hybrid capital, with some limited equity-like features) are deductible from the issuer’s profits. It also ensures that the tax treatment of linked loan relationships is aligned. This provides tax certainty for issuers and holders and reduces tax volatility.

Background to the measure

The measure was announced at Budget 2018.

The changes included in this measure have not been subject to prior consultation.

Hybrid capital often includes a right for the issuer to cancel or defer interest payments. It is often long-dated or perpetual. Whilst it has a fixed capital value at the outset, the instrument may contain terms that allow this to be released or converted into shares in certain circumstances. These features can lead to uncertainty as to whether the payments under the hybrid instrument should be taxed as interest (which is typically deductible) or as distributions (which are not).

Previously this uncertainty has only been addressed for companies in the financial sector, where banking companies (under Basel III) and insurance companies (under Solvency II) are required to hold a certain amount of capital. The instruments issued to raise this capital must contain certain features to allow for loss-absorbency in the event of the bank or insurer coming under financial strain and having depleted levels of capital. The Taxation of Regulatory Capital Securities Regulations 2013 (RCS Regulations) currently provide certainty of tax treatment for these instruments.

In June 2018 the Bank of England finalised its approach to setting a minimum requirement for own funds and eligible liabilities (MREL) that banks, building societies and investment firms need to maintain, ensuring that these institutions’ own financial resources can be used to absorb any losses and recapitalise the business. To meet these requirements banks are permitted to issue types of hybrid capital instruments that are not covered by the RCS Regulations. HMRC has taken this opportunity to review the treatment of hybrid capital instruments across all sectors to ensure that, subject to certain conditions, interest payments on all debt-like instruments are deductible, thus removing tax uncertainty.

The RCS Regulations are to be revoked and replaced with new tax rules for:

• hybrid capital instruments, which are debt-like instruments that can be issued by any sector
• tax mismatches, which align the tax treatment of linked loan relationships

Detailed proposal

Operative date

The changes included in this measure will have effect for accounting periods beginning on or after 1 January 2019.

Accounting periods beginning before and ending after 1 January 2019 are treated as 2 separate accounting periods with the latter accounting period beginning on that date.

Current law

Taxation of Regulatory Capital Securities Regulations 2013 (S.I. 2013/3209) apply to certain hybrid capital instruments issued by the banking and insurance sectors.

Part 5 Corporation Tax Act 2009 contains the loan relationships rules.

The Disregard Regulations (S.I. 2004/3256) contain particular rules to align the tax treatment in certain cases involving hedging relationships.

Part 10 Taxation (International and Other Provisions) Act (TIOPA) 2010 contains the corporate interest restriction provisions.

Part 23 Corporation Tax Act 2010 contains rules on company distributions.

Sections 78 and 79 Finance Act 1986 contain the rules on loan capital and Stamp Duty and Stamp Duty Reserve Tax.

Proposed revisions

The principal changes made to ensure the tax rules provide the necessary tax certainty to all relevant issuances of hybrid capital instruments are as follows.

The following new sections are introduced into Part 5 Corporation Tax Act 2009:

• section 475C which defines a hybrid capital instrument
• section 320B which directs how debits and credits are brought into account if a hybrid capital instrument is recognised in equity or shareholders’ funds, providing tax deductions for interest payments on equity-accounted hybrid capital instruments, subject to the rules on company distributions
• section 420A which confirms that certain amounts payable in respect of hybrid capital instruments are not distributions and that such an instrument is not an equity note for the purposes of section 1015 Corporation Tax Act 2010

Section 162 of the Corporation Tax Act 2010 is amended to confirm that, for the purposes of that section, a hybrid capital security is a ‘normal commercial loan’.

The Disregard Regulations 2004 (S.I. 2004/3256) are amended to ensure that exchange gains or losses arising on loan assets or derivative contracts intended to hedge exchange rate risks on a hybrid capital instrument that is equity accounted are disregarded. This mirrors the treatment that previously applied to regulatory capital securities.

Transfers of hybrid capital instruments are exempted from Stamp Duty and Stamp Duty Reserve Tax.

The corporate interest restriction rules are amended. In the calculation of adjusted net group-interest expense the reference to ‘regulatory capital security’ is replaced with a reference to a ‘hybrid capital instrument’. In the calculation of qualifying net group-interest expense the reference to ‘regulatory capital security’ is removed. The Taxation of Regulatory Capital Securities Regulations 2013 (S.I. 2013/3209) are revoked.

Commencement and transitional provisions have effect from 1 January 2019 except for Stamp Duty and Stamp Duty Reserve Tax and the duty to deduct Income Tax interest payments, for which the Taxation of Regulatory Capital Securities 2013 will be revoked from the date of Royal Assent. The transitional provisions include an exception from the duty to deduct Income Tax under sections 874 and 889 of the Income Tax Act 2007 for instruments that were regulatory capital securities as at 31 December 2018. Transitional provisions also allow such instruments to continue to be taxed as a single loan relationship on an amortised cost basis, even if they are accounted for at fair value or bifurcated. Both transitional provisions expire on 1 January 2024.

Transitional provisions also allow insurers and reinsurers to not bring into account for tax any credits and debits arising from the conversion or write down of a regulatory capital security. This transitional provision expires on 30 June 2019.

The principal change made to ensure the tax treatment of linked loan relationships is aligned is the introduction of section 352B of the Corporation Tax Act 2009 which eliminates tax mismatches for loan relationships that have a qualifying link.

Summary of impacts

Exchequer impact (£m)

2018 to 2019	2019 to 2020	2020 to 2021	2021 to 2022	2022 to 2023	2023 to 2024
negligible	negligible	negligible	negligible	negligible	negligible

This measure is expected to have a negligible impact on the Exchequer.

Economic impact

This measure is not expected to have any significant economic impacts.

Impact on individuals, households and families

This measure’s impact on individuals is to provide certainty on the tax treatment of receipts arising from the instrument and on disposal. Otherwise it only affects businesses.

The measure is not expected to impact on family formation, stability or breakdown.

Equalities impacts

This measure is not anticipated to impact on any of the groups with protected characteristics.

Impact on business including civil society organisations

This measure will have a negligible impact on the small amount of businesses that issue hybrid capital instruments. One-off costs include familiarisation with the new rules. Ongoing costs will include the requirement for an election into the hybrid capital regime for each instrument issued.

There is no impact on civil society organisations. There is no impact on small and micro business who have no need to issue hybrid capital instruments.

Operational impact (£m) (HMRC or other)

The operational costs for HMRC in implementing this change are anticipated to be negligible.

IT costs for this measure are expected to be in the region of £400,000 for compliance purposes.

Other impacts

Other impacts have been considered and none have been identified.

Monitoring and evaluation

This measure will be monitored through information collected from elections and through communication with affected tax payer groups.

Further advice

If you have any questions about this change, contact:

• Darryl Wall on 03000 585977 or email darryl.wall@hmrc.gsi.gov.uk
• Ursula Crosbie on 03000 589086 or email ursula.crosbie@hmrc.gsi.gov.uk