MTT21300 - Calculating the effective tax rate: Adjusted profits: Qualifying tier one capital

Entities in the banking and insurance sectors are subject to regulatory requirements to hold a certain amount of capital. The regulations allow groups to raise part of this capital through hybrid capital instruments that 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. These features include discretionary coupons and mandatory triggers, whereby the instrument is converted to equity or written down if the bank or insurer’s capital falls below a designated threshold. Instruments that meet these regulatory requirements are typically called Additional Tier One Capital in the banking sector and Restricted Tier One Capital in the insurance sector.

These instruments are usually treated as equity for financial accounting purposes. In such cases, the coupon payments on the instruments will be reflected in equity, and no expense will be recognised in the underlying profits.

However, these instruments are often treated as debt instruments for tax purposes. In this case, payments in respect of Additional or Restricted Tier One Capital are deductible as interest expense by the issuer and included as interest income of the holder for tax purposes. This results in a permanent difference between financial accounting and taxable income.

Section 155 of Finance (No.2) Act 2023 ensures that these instruments are also treated as debt instruments for the purposes of Multinational Top-up Tax and Domestic Top-up Tax, by requiring any amounts in respect of distributions payable and receivable on these instruments to be reflected in the adjusted profits of the member. An adjustment is required to achieve this where the instrument is recognised as equity.

Definition

For MTT purposes, qualifying tier one capital is an instrument that:

  • is issued by an entity pursuant to regulatory requirements applicable to the banking or insurance sector,
  • is convertible to equity, or is written down if a pre-specified trigger event occurs, and
  • has other features designed to aid loss absorbency in the event of a financial crisis.

In practice, the definition will be satisfied so long as the instrument meets the regulatory requirements to form part of the bank or insurer’s additional or restricted tier one capital.

Adjustment for member making distribution

Where:

  • an amount is recognised by a member as a decrease to its equity in an accounting period,
  • that amount is attributable to distributions paid or payable in respect of qualifying tier one capital issued by that member, and
  • the amount is not reflected in the underlying profits of the member for that period as an expense,

an adjustment is required to ensure that the amount is reflected as an expense in the adjusted profits.

Note that an expense that is required to be included under this rule will not be subject to the rules on intra-group financing arrangements (see MTT21240).

Adjustment for member receiving distribution

Where:

  • an amount is recognised by a member as an increase to its equity in an accounting period,
  • that amount is attributable to distributions received or receivable in respect of qualifying tier one capital held by that member, and
  • the amount is not reflected in the underlying profits of the member for that period as income,

an adjustment is required to ensure that the amount is reflected as income in the adjusted profits.

Instrument written down

The adjustment is restricted to distributions and so any write-down of the principal (for example, through conversion to equity) would not be adjusted by this section.

This means the write-down of an instrument will not lead to a credit being recognised in the adjusted profits of the issuer if the instrument is accounted for as an equity instrument.

If the instrument is accounted for as a liability instrument, the credit in respect of the write-down of the instrument will be taken to the income statement and will therefore be included in the adjusted profits of the member, unless the rules on companies in distress apply (see MTT42040).