Following a series of meetings with members of the financial services industry and various advisory firms, in August 2011 HM Revenue & Customs ("HMRC") published their initial views on the UK tax treatment of additional tier 1 and tier 2 regulatory capital instruments. Those views were in respect of instruments that are designed to be compliant with the proposed CRD IV Directive and Capital Requirements Regulation ("CRD IV"), a package of reforms that will replace the existing Capital Requirements Directive (2006/48/EC and 2006/49/EC).
Under CRD IV, in order for an instrument to qualify as additional tier 1, there are various characteristics that it must possess. The conditions for recognition as regulatory capital include, for example, a requirement that the instrument be perpetual and that the issuer should have full discretion to cancel any distributions on the instrument on a non-cumulative basis. Furthermore, the terms of such instruments must provide for a mechanism to absorb losses either by permitting the principal amount of the instrument to be written down or otherwise converting the instrument into common equity on the occurrence of certain trigger events (a "contractual bail in right").
On 26 June 2012, HMRC published their views on certain UK tax issues that are relevant to regulatory capital instruments. The HMRC paper details their views on two issues: (i) whether a perpetual instrument would satisfy the relevant conditions to be taxed in accordance with the UK tax regime for corporate debt; and (ii) the scope of the UK tax rules that can recharacterise interest payments (and other amounts) that are "results-dependent" as non-deductible distributions for tax purposes.
Our comments on this latest HMRC publication are set out below.
Taking into account the totality of the likely terms of a CRD IV compliant additional tier 1 instrument, the view expressed by HMRC back in August 2011 was that it was "not able to confirm agreement to a debt analysis" for such instruments to be taxable as debt in accordance with the loan relationships regime for the taxation of corporate debt.
The latest HMRC paper distinguishes between "truly perpetual" and "contingent perpetual" instruments. HMRC take the view that only the latter are capable of falling within the loan relationships regime. "Truly perpetual" instruments are described as those where the holder has no right to repayment of the principal subscribed in any circumstances whilst "contingent perpetual" instruments are described as those where the sum to be repaid on the happening of the contingent event is ascertainable at the time of issue.
HMRC have historically accepted that "debt" that is perpetual is capable of satisfying the requirements to be treated as debt for tax purposes, both in their published technical manuals and in clearances given for previous regulatory capital issuances on such terms. Helpfully, HMRC have confirmed in the latest publication that they will not seek to change the existing tax treatment of any perpetual instruments, which would otherwise be taxed in accordance with the loan relationship rules, issued prior to 26 June 2012 (see below).
HMRC state that under CRD IV, additional tier 1 instruments "must be truly perpetual in that the holder of an additional tier 1 instrument has no right to repayment of the principal" and that "there can be no debt where there is no obligation to repay the principal." However, CRD IV provides for the possibility of the terms of an additional tier 1 instrument to include a right on the part of the issuer to call the instrument at its discretion (subject to receiving regulatory consent).
Putting to one side the possibility of an inconsistency between the base case set out in the latest HMRC publication and CRD IV, as a practical matter it is difficult to envisage an additional tier 1 instrument being marketable (and therefore being issued) where there is no right in any circumstances to redeem the instrument. Accordingly, the types of additional tier 1 instruments that HMRC consider to be "contingent perpetual" instruments become particularly important.
HMRC state that a contingent perpetual instrument is one that has a contingent repayment term and, provided that the sum to be repaid on the occurrence of the contingency is ascertainable at the time of issue, HMRC will regard it as a contingent debt (and potentially debt for tax purposes). HMRC use the example of an instrument carrying an investor right to a determinable sum on the liquidation of the issuer as being a contingent perpetual debt.
What about other contingencies on the occurrence of which the instrument may be redeemed—for example, a change of law issuer call right or a general issuer call after a fixed period of time, in each case with regulatory consent? HMRC state that any other contractual contingencies will be considered on a case-by-case basis. For proposed new issuances of regulatory capital instruments designed to qualify as additional tier 1, consideration will need to be given to the circumstances in which the instrument may be redeemed and whether a determinable sum that is to be repaid to investors can be identified. Inevitably, a dialogue will need to be had with HMRC to agree whether such instruments fall to be taxed in accordance with the loan relationships regime.
Even if an instrument will be taxed in accordance with the loan relationships regime, there are circumstances in which interest payments (and other amounts) can be recharacterised as non-deductible distributions for tax purposes. One such circumstance is where, under the terms of the instrument, payment of the coupon depends to any extent on the results of the issuer's business or any part of the issuer's business.
HMRC have reaffirmed their previously published view that the coupon on a CRD IV compliant additional tier 1 or tier 2 instrument is likely to be "results-dependent" and therefore non-deductible for tax purposes. The paper states that the characterisation of the coupon as discretionary and non-cumulative in respect of CRD IV compliant instruments is a strong indicator that the coupon will be results-dependent. HMRC have not expanded on the basis of this conclusion, and it is not clear how an amount payable at the absolute discretion of the issuer is, in and of itself, results-dependent.
HMRC have also expressed a view on the extent to which contingencies that are not part of the terms of an instrument will be taken into account in considering whether or not the coupon or interest payment should be regarded as results-dependent and non-deductible. They say that, in analysing whether the consideration on an instrument is results-dependent, the analysis is broader than simply an examination of the terms of the instrument itself.
The matters that HMRC believe should be taken into account, beyond those contained in the terms of the instrument, are those that exist (or are at least considered likely to exist) at the time of issue where there may be some direct or indirect causal connection between the possible variation in the consideration provided under the instrument and the results of the issuer's business. Whilst of particular importance in the context of issuances of regulatory capital instruments, the views expressed by HMRC in relation to the scope of the results-dependent interest provisions will also be of interest in other contexts.
In relation to regulatory capital instruments where a contractual bail in right is part of the terms of the instrument, HMRC have previously stated that such instruments are likely to carry a return that is results-dependent. Similarly, HMRC have now stated that where the terms of an instrument explicitly provide that the terms are subject to any statutory bail in regime introduced in the future, it is likely that the return on such instrument will be results-dependent (assuming that the statutory bail in regime is worded in such a way as to be linked to the results of the issuer's business). There is no requirement for a contractual bail in feature at the point of non-viability in the original proposed CRD IV measures, notwithstanding this is a feature of the Basel III proposals. However, a proposed amendment to Article 60 of the Capital Requirements Regulation has been inserted by the European Parliament's Economic and Monetary Affairs Committee in the CRD IV reports it published on 21 June 2012, and this version will be debated by the EU Parliament later this year.
Where the terms of an instrument are silent as to the application of a statutory bail in regime, HMRC are of the view that the return is likely to be results-dependent (and therefore non-deductible) after the statutory bail in regime comes into force but not prior to that.
Grandfathering and the Introduction of Future Tax Regulations
HMRC have stated that notwithstanding the views it has expressed in its latest publication, it will not seek to change the existing tax treatment of perpetual instruments issued before 26 June 2012. The Finance Bill 2012 currently provides for the power to enable HM Treasury to enact regulations to determine the tax treatment of regulatory capital instruments. HMRC have stated that draft tax regulations will be published for consultation once the CRD IV proposals are finalised. The CRD IV proposals are expected to be finalised after the plenary session of the EU Parliament on 22–23 October this year. In the meantime, HMRC's latest publication will be particularly relevant to the tax analysis of instruments that are designed to be compliant with CRD IV but that will be issued prior to any new tax regulations taking effect.
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.