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HMRC internal manual

Corporate Finance Manual

Loan relationships: hybrid capital instruments: what is hybrid capital?

The Hybrid Capital Instrument rules apply to loan relationships that fall within a bespoke definition of hybrid capital instrument for tax purposes - see CFM37840.

This section of the guidance provide a general description of the commercial background to hybrid capital.

Hybrid capital is a form of capital that combines characteristics of bonds and equities. There are a wide variety of hybrid capital instruments, but the new tax rules only apply to instruments which, despite limited equity-like features, are debt in substance.

Hybrid capital differs from normal debt instruments in that they contain some limited equity-like features.

The Corporation Tax rules allow businesses to deduct interest expenses (and other costs of borrowing) in determining taxable profits, but not to deduct distributions of profit to shareholders.

Hybrid capital may include a right for the issuer to cancel or defer interest payments and/or the instrument may contain terms that allow the principal to be released or converted into shares in certain circumstances.

These features can lead to uncertainty as to whether the payments under the hybrid capital instrument should be relieved as interest or treated as distributions of profit.

Who issues hybrid capital?

Banks and insurance companies are required to hold a certain amount of regulatory capital. This capital usually includes a mixture of share and debt funding. The regulations covering this regulatory capital require that debt instruments issued to raise these funds must have features that allow the bank or insurer to continue operating in the event of the bank or insurer coming under financial strain and having depleted levels of capital. This means the principal on some debt instruments issued by banks and insurers (or their parent companies) can be written down or converted to equity in certain circumstances. For some types of capital the issuer must also have the right to cancel or defer interest payments.

Hybrid capital is also issued by some companies outside the regulated financial sector to protect their credit rating. Such capital is most commonly issued by companies in the utilities and communications sector to support long term investment projects, such as infrastructure.

Perpetual Debt

Hybrid capital can often be undated or ‘perpetual’ instruments and where issued by banks or insurers as Additional Tier 1 or Restricted Tier 1 it must be undated.

Perpetual instruments where the holder has no right to repayment in any circumstances (sometimes referred to as “true” perpetual instruments) are not loan relationships as they do not give rise to a money debt. However, ‘perpetual’ instruments issued by banks, insurers, utilities and telecoms companies normally provide the holder with the right to repayment of principal in the event of liquidation. The fact that principal is only repaid on a liquidation does not, of itself, prevent an instrument from constituting a money debt, and will normally be considered as giving rise to a money debt. Therefore these are not true perpetual instruments and may be loan relationships.