CFM37890 - Loan relationships: hybrid capital instruments: tax rules - RCS Regulations - 1 January 2014 to 31 December 2018

The Treasury made the Taxation of Regulatory Capital Securities Regulations 2013 (“RCS Regulations”) to provide certainty of tax treatment for certain regulatory capital securities (“RCS”) issued by banks and insurers. The RCS Regulations were introduced to coincide with the date the EU Capital Requirements Regulations (CRR) had legal effect. The tax regulations ensured that the tax rules were consistent with the regulatory framework

The RCS Regulations were revoked with effect from 1 January 2019 and new rules introduced for hybrid capital instruments see CFM37810.

Regulatory capital security - definition

The RCS Regulations as introduced applied to RCSs that satisfy the criteria of being either Additional Tier 1 (AT1) or Tier 2 instruments that were not shares (except in the case of an AT1 instrument issued by a building society) for the purposes of the CRR, issued directly or indirectly by a UK entity.

Transitional provisions ensured that CRR compliant AT1 and Tier 2 securities issued before 1 January 2014 were covered by the RCS Regulations.

The RCS Regulations were amended with effect from 1 January 2016 to include Solvency II compliant Restricted Tier 1 (RT1) and Tier 2 loss absorbing instruments issued by insurers.

Transitional provisions ensured that Solvency II compliant Tier 1 and Tier 2 securities issued before 1 January 2016 were covered by the RCS Regulations.

Tax treatment of regulatory capital security

Once the security satisfied the criteria, the tax treatment set out in the RCS Regulations would apply throughout the life of the security, subject to the anti-avoidance provisions.

Distribution rules

All distribution rules in CTA10/Part 23 were switched off so coupons payable on RCS (which are not repayments of principal) would not be “distributions” and would therefore potentially be deductible for UK tax purposes.

Loan relationship treatment

Regulatory Capital Securities were treated as loan relationships for corporation tax purposes and taxed/relieved under CTA09/Part 5. The normal tax rules applied to loan relationships between connected parties i.e. they were taxed as if accounted for on an amortised cost basis and any credit or debit on write down or conversion into shares was not brought into account.

The following special rules applied to all other loan relationships:

Equity accounted instruments

Coupons payable on equity accounted instruments were tax deductible under normal rules prior to changes in respect of corporate debt introduced in Finance (No 2) Act 2015. As a result of those changes, coupons on equity accounted instruments issued in accounting periods beginning on or after 1 January 2016 were no longer deductible under normal rules. Grandfathering rules preserved the existing treatment for equity accounted instruments already in issue.

The RCS Regulations were amended to ensure that payments of coupons in respect of regulatory capital securities that were equity accounted continued to be deductible, subject to transfer pricing limitations on interest deductibility and anti-avoidance provisions.

The treatment provided by the Regulations did not apply to amounts that are recognised as items of profit or loss or as items of other comprehensive income. It also did not apply to amounts of exchange gains or losses recognised in specified statements.

Fair value accounting and embedded derivatives

The RCS Regulations provided that, so far as the issuer and connected creditor were concerned:

  • fair value accounting would not apply to RCSs (or any part of them); and
  • the corporation tax bifurcation rules governing loan relationships with embedded derivatives would not apply to RCSs (so they are treated as a single loan relationship).

The effect is that RCSs would be treated as if they were accounted for on an amortised cost basis, except to the extent that all or part of the instrument is recognised in equity – in which case that equity component should be brought into account for tax purposes.

Write down or conversion into shares of external instruments

The RCS Regulations provided that the issuer or any connected corporate creditor should not bring into account any profit or loss for the purposes of corporation tax in respect of:

  • a write-down of the principal amount or its writing back up following a write down; or
  • the conversion of the security to a Common Equity Tier 1 instrument (in other words, ordinary share capital).

This applied so long as the write-down, write-up or conversion was “in accordance with any regulatory requirements or the provisions governing the security”.

Issuers of RCSs were therefore able to avoid credits being taxable if their RCSs were written down or converted into shares at the regulator’s order.

Grouping

The RCS Regulations provided that RCS constituted “normal commercial loans”, and were not treated for UK corporation tax grouping purposes as equity of the issuer. This ensured that third-party holdings of RCSs did not deprive issuer groups of the benefit of the UK corporation tax and stamp duty grouping rules.

Individual holders

Where RCS were held by individuals, the RCS Regulations provided that payments would be income chargeable under ITTOIA 2005/Part 4/Chapter 2 for income tax purposes. This included coupon payments and any premium paid or discount received.

Under the RCS Regulations, individual UK-taxpaying holders would not realise a capital gain or loss on disposal of RCSs that were denominated in sterling.

Individual holders of RCSs issued in a currency other than sterling would realise a capital gain or loss on disposals of RCSs.

Withholding Tax

The RCS Regulations provided for a blanket exemption from withholding tax on payments of coupons on RCSs, whether listed or not, subject to anti-avoidance provisions.

Stamp Duties

The RCS Regulations ensure that dealing in RCSs would be exempt from stamp duty and stamp duty reserve tax (SDRT), unless anti-avoidance provisions apply.

Anti-avoidance

If an RCS was issued as part of arrangements the main purpose, or one of the main purposes, of which is to obtain a “tax advantage”, some of the benefits of the RCS Regulations would be disapplied. In particular:

  • payments made in respect of RCSs would not automatically qualify as “interest”, so may not be deductible for tax purposes;
  • the blanket exemption from withholding tax on payments of interest would not apply;
  • any disapplication of the derivative contract rules would be ineffective;
  • transfers of RCSs might be subject to stamp duty and SDRT subject to being able to benefit from other exemptions;
  • third party holdings of RCSs might deprive issuer groups of the benefit of the UK corporation tax and stamp duty grouping rules, unless issued by the top holding company in the issuer group; and
  • individual holders in the UK would recognise a capital gain or loss on disposal of all RCSs (even if denominated in sterling), if the interest on them was results-dependent.