INTM551060 - Hybrids: financial instruments (Chapter 3): overview: regulatory capital securities
The definition of financial instruments at s259N is intended to exclude anything that is a regulatory capital security.
Regulated financial businesses are required to fund a proportion of their activities through loss-absorbent forms of capital called regulatory capital. This applies to banking and insurance businesses, and to some regulated financial firms.
The UK’s regulatory framework for banks, building societies and investment firms gives effect to the Capital Requirements Directive IV (CRD IV). This Directive, effective in UK law, is derived from Basel III (the international regulatory framework). CRD IV, which requires these firms to hold certain amounts of regulatory capital, as prescribed within its texts.
The rules for insurers are under Solvency II, which requires insurers to issue financial instruments to meet their Tier 1 and Tier 2 capital requirements.
The issuance of instruments for regulatory capital purposes reflects the fact that ordinary share capital is expensive, so regulators allow banks and insurers to meet a proportion of their capital requirements by issuing these instruments. AT1 has certain characteristics of both equity and debt as they pay a regular coupon but are perpetual and can be converted to equity in a time of stress and, as such, are hybrid capital instruments.
These financial instruments may be treated differently under different countries’ tax systems and, as a result, can give rise to hybrid mismatch outcomes. Without the exemption these instruments could be caught by the hybrid rules even though they are issued to satisfy mandatory regulatory requirements. This would disadvantage regulated financial institutions that operate cross-border.
Exemption for Regulatory Capital from 1 January 2017 to 31 December 2018
s259N specifically excludes anything that is a regulatory capital security for the purposes of the Taxation of Regulatory Capital Securities Regulations 2013 (SI 2013/3209) as amended by SI 2015/2056.
Exemption for Regulatory Capital from 1 January 2019 to 31 December 2019
The 2013 Regulatory Capital Security Regulations (SI 2013/3209) were revoked with effect from 31 December 2018.
From 1 January 2019, the exemption for regulatory capital provided by Section 259N applies by reference to the Hybrid and other Mismatches (Financial Instrument: Exclusions) Regulations 2019 (SI 2019/1251).
These Regulations are designed to exempt all regulatory capital instruments that previously fell within the scope of the 2013 RCS Regulations. In addition, the 2019 Regulations also cover other instruments which could be used to meet Bank of England MREL requirements. The instruments covered by the exemption are set out in paragraph 3 of the Regulations, as follows
Exclusions from the meaning of “financial instrument”
3. The following are specified exclusions from the meaning of “financial instrument” for the purposes of section 259N(3)(b) of the Taxation (International and Other Provisions) Act 2010—
(a) Additional Tier 1 instruments,
(b) Tier 2 instruments,
(c) an item listed in point (a)(iii) or (b) of Article 69 of CDR which is a Tier 1 item under—
(i) Article 69 or 79 of CDR, or
(ii) rule 4.1 in the Annex to the Transitional Instrument,
(d) an item listed in point (a)(iii) or (b) of Article 72 of CDR which is a Tier 2 item under—
(i) Article 72 or 79 of CDR, or
(ii) rule 4.2 in the Annex to the Transitional Instrument, or (e) own funds and eligible liabilities which are not excluded under article 123(4) of the Bank Recovery and Resolution (No. 2) Order 2014(9).
The Regulations have effect in relation to payments made on or after 1 January 2019, and quasi-payments where the payment period begins on or after that date.
These Regulations are revoked with effect from 1 January 2020, and replaced with new regulations which provide an exemption for regulatory capital which meets the detailed requirements of the EU Anti-Tax Avoidance Directive (ATAD) see next section at INTM551065.