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HMRC internal manual

International Manual

HM Revenue & Customs
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Arbitrage: practical guidance - examples demonstrating the application of the arbitrage legislation: Example 3 Part 1 - subordinated debt

Example 3 Part 1 - subordinated debt

Facts: A bank issues long-dated subordinated debt to meet regulatory capital requirements. The debt is issued freely to the market.

The equity features of the debt (its maturity and subordination) mean that it (or part of it) is treated as equity for accounting and regulatory purposes. Some tax jurisdictions also treat the instrument as equity and so payments are treated as dividends. The issue of the debt has been structured in a way that the holders may benefit from exemption or relief from tax in respect of these dividends.


Condition A is met, because the debt is a hybrid instrument (debt treated as equity).

Condition B is also met because the instrument is treated as debt under the loan relationships legislation, and so payments qualify as UK interest deductions for the issuer. For the purposes of this example, we assume that the amount is not minimal and so Condition D will also be met.

If Condition C is met, such that the legislation applies then Rule B (F2A05/S25(11)) will apply to the extent that the holder is not taxed for any of the reasons given in the Rule.

Therefore, the key point is whether Condition C is met, i.e. whether the scheme that is represented by the issue of the subordinated debt has as its main purpose or one of its main purposes the achievement of a UK tax advantage. Long-dated subordinated debt is more expensive than ordinary debt, and so the questions that arise are:

  • whether the debt would have been issued at all in the absence of the tax advantage represented by the interest deductions; and
  • whether there is sufficient non-tax reason to incur the additional cost of subordinated debt.

In this example, it is considered unlikely that achieving a UK tax advantage would be a main purpose, because:

  • the need to meet regulatory capital requirements represents a clear non-tax purpose for the issue of subordinated debt; and
  • the bank does not seek to control or influence who holds the debt

In view of these two circumstances - a clear non-tax purpose for the choice of hybrid instrument, and genuine issue to market - it is reasonable to suppose that there is not a main purpose of achieving a UK tax advantage, and so Condition C is not met. The legislation therefore does not apply.