The Capital Requirements Directive IV and the Capital
Requirements Regulation (collectively "CRD IV")
implement, within the European Union, the Basel III reforms and
provide for the prudential rules for banks, building societies and
investment firms. Although CRD IV entered into force on 17 July
2013, the greater part of these new rules will apply from 1 January
2014.
HM Treasury ("HMT") and HM Revenue & Customs
("HMRC") have been aware for some time that the ability
of the banking sector to continue to raise tax-deductible
regulatory capital (as has historically been permitted) would be
much more challenging in relation to instruments that qualify as
Additional Tier 1 or Tier 2 under CRD IV when compared to pre-CRD
IV regulatory capital debt instruments.
With CRD IV coming into full effect in a matter of months, and in
response to the banking sector's concerns regarding
deductibility, the UK Government published the draft Taxation of
Regulatory Capital Securities Regulations (the
"Regulations") on 16 July 2013, which seek to confirm
that Additional Tier 1 and Tier 2 securities under CRD IV will be
treated as debt for UK tax purposes. The Regulations also deal with
various other related issues including the characterization of
payments under such securities, exclusions of debits and credits
relating to loss absorption features, the application of the
derivative contract rules, withholding and stamp taxes.
This Commentary describes the key features contained
within the Regulations and reports on the outcome from the informal
consultation held by HMT and HMRC following the publication of the
Regulations.
Confirmation of Debt Treatment for Additional Tier 1 or
Tier 2 under CRD IV for UK Tax Purposes
The Regulations confirm that securities issued by a "credit
institution" or an "investment firm" as defined in
the Capital Requirements Regulation (the "CRR") (or a
parent undertaking thereof) and which qualify as Additional Tier 1
or Tier 2 under CRD IV will be treated as a loan
relationship—effectively as debt—for UK tax
purposes.
Generally, shares will not fall within the scope of the
Regulations. One exception is in relation to building society
deferred shares. To the extent building society deferred shares
qualify as Additional Tier 1, such shares will be treated as a loan
relationship, thereby enabling deductions to be claimed by building
society issuers in respect of the return on such shares.
To address concerns that interest payments in respect of Additional
Tier 1 or Tier 2 securities under CRD IV could, given the inclusion
of certain equity like features, fall to be regarded as
nondeductible distributions for UK tax purposes, the Regulations
state that payments in respect of such securities (other than a
repayment of principal) will be treated as payments of interest in
respect of a loan relationship.
Withholding Tax and Stamp Taxes
Helpfully, the Regulations introduce two new exemptions in relation
to Additional Tier 1 or Tier 2 securities under CRD IV: a new
withholding tax exemption for payments of interest in respect of
such securities and an exemption from all stamp duties (including
stamp duty reserve tax) on transfer of such securities.
The pre-existing quoted Eurobond exemption would typically have
been relied upon in order to address UK withholding tax concerns in
respect of interest payments on such securities. In contrast, the
new withholding tax exemption contained in the Regulations is
generous in that it does not require the Additional Tier 1 or Tier
2 security in question to be listed on a recognised stock exchange,
and it could also potentially benefit parent undertaking issuers of
such securities.
Credits and Debits Arising in Respect of Loss Absorption
Mechanisms
The inclusion of loss absorption features within the terms of a
regulatory capital security (for example, a temporary or permanent
write down of an Additional Tier 1 security or a conversion
mechanism into Common Equity Tier 1 on the occurrence of certain
triggers) and the future introduction of a statutory bail-in regime
gives rise to the possibility of accounting debits and credits
arising to both the issuer of, and the investor in, such
securities, which would also need to be taken into account for tax
purposes.
The Regulations address this issue by providing that no credit or
debit is required to be brought into account under the loan
relationship rules as a result of a temporary or permanent write
down of the regulatory capital securities, on a conversion into
Common Equity Tier 1, or on a write up of such a security that was
previously written down.
The exclusion of the recognition of credits and debits under the
loan relationship rules in the circumstances described above is a
relief from the perspective of issuers of such securities on the
basis that taxable credits are most likely to arise at a time when
the bank is already in financial difficulty. Whilst the bank may
have tax losses available to it at the time that such loss
absorption feature were to be triggered that could be used to
mitigate the effect of recognising a taxable credit, the removal of
the uncertainty of whether that would definitely be the case is to
be welcomed.
The sting in the tail, however, is that this same exclusion of
debits and credits applies to investors in such securities too.
Accordingly, the Regulations in their current form would deny an
investor tax relief for the loss the investor would suffer in
respect of its investment in the securities that might otherwise be
available to it if the debit in question arises in the
circumstances detailed above. Based on comments made by HMRC after
the publication of the Regulations (as to which see below), it is
anticipated that the final form of the Regulations will remove the
exclusion on the recognition of debits and credits relating to the
application of a loss absorption mechanism in relation to
investors.
Embedded Derivatives
The Regulations currently provide that the derivative contracts tax
rules will not apply in respect of securities that are Additional
Tier 1 or Tier 2 under CRD IV. Accordingly, debits and credits
relating to embedded derivatives that might be recognised for
accounting purposes in respect of such securities (for example,
recognition of an embedded derivative might be appropriate where a
conversion feature is included within the terms of the security)
will not need to be brought into account under the derivative
contracts tax rules. See, however, below for HMT and HMRC's
further views on the approach they may adopt in relation to the
application of the derivative contracts tax rules to such
securities.
A Targeted Anti-Avoidance Rule
No piece of new UK tax legislation would be complete without its
own targeted anti-avoidance rule, and the Regulations do not
disappoint in this regard. Where there are arrangements whose main
purpose, or one of the main purposes, is to obtain a tax advantage
for any person as a result of the application of the Regulations to
the relevant regulatory capital security, certain aspects of the
Regulations do not apply. In particular, the treatment under the
Regulations of payments (other than repayments of principal) in
respect of the regulatory capital security as interest would not
apply and there would then be a material risk of such payments
being nondeductible for tax purposes.
Consultation and Next
Steps
In keeping with the informal consultation approach and the positive
engagement with the banking sector and advisors since early 2011 in
relation to the tax treatment of regulatory capital securities, two
meetings were held by HMT and HMRC following publication of the
Regulations to invite comment. The key points which came out of
those discussions were:
- In its current form, the Regulations apply only to a security issued by a credit institution, an investment firm or a parent undertaking thereof where that security qualifies as either Additional Tier 1 or Tier 2 capital resources of the credit institution or the investment firm. It seemed to be accepted by HMT and HMRC that the Regulations as drafted may be unduly restrictive in their application when compared to what may be permissible under the CRR (for example, issuances of regulatory capital securities by subsidiaries of banks or special purpose vehicles would not currently fall within the scope of the Regulations even if permissible under the CRR). HMT and HMRC stated they would consider what amendments could be made to the Regulations to bring them closer to what is permissible under the CRR.
- The Regulations apply criteria and definitions that are contained in the CRR to identify which regulatory capital securities potentially fall within its scope. In its current form, there is some uncertainty whether or not regulatory capital securities issued in compliance with non-EU regulatory regimes would fall to be taxed in accordance with the Regulations. For the same reason, there is some doubt whether branches of foreign banks would similarly fall within the scope of the Regulations. HMT and HMRC have recognised that there may be some unintended gaps in the Regulations and have resolved to consider how best to address those issues.
- HMT and HMRC confirmed that they intend to amend the restriction in the Regulations on an investor in a regulatory capital security, bringing into account a debit for tax purposes following the operation of a loss absorption mechanism (see above). The expectation is that an investor will be permitted to bring into account for tax purposes any accounting debits that arise in relation to a regulatory capital security as a result of the operation of the loss absorption mechanism.
- Consideration is to be given by HMT and HMRC as to whether the tax treatment afforded by the Regulations should be based on a day 1 analysis of whether the securities in question qualify as Additional Tier 1 or Tier 2 under the CRR or whether this should be a rolling test. Under the current form of the Regulations, the test would appear to be a rolling one so that securities might benefit from the tax treatment prescribed by the Regulations on issue; however, if, for whatever reason, those securities ceased to qualify as Additional Tier 1 or Tier 2, the Regulations would then no longer apply.
- Although the Regulations currently provide for the tax rules on derivative contracts not to apply to regulatory capital securities (see above), HMT and HMRC are rethinking their approach to excluding such securities from those rules. HMT's and HMRC's concerns stem from the possibility of asymmetrical tax results arising if the derivative contract rules were not to apply to such securities. It is possible, therefore, that the next draft of the Regulations may remove or modify the current exclusion of the application of the tax rules on derivative contracts.
HMT and HMRC currently plan to issue a revised draft of the Regulations soon and will continue to engage in an informal consultation with the banking sector and advisors until the end of September 2013. Their stated aim is for the Regulations to be enacted in final form by the end of November 2013, just prior to the date on which the greater part of the provisions in CRD IV take effect. Whilst the first draft of the Regulations has certainly been welcomed in trying to address many of the tax issues that Additional Tier 1 and Tier 2 securities under CRD IV potentially give rise to, there is still much work to be done if these deadlines are to be met.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.