Regulatory Capital Requirements

Transcription

1 UK Enacts Tax Regime for New Additional Tier 1 and Tier 2 Regulatory Capital Instruments SUMMARY The UK Parliament has approved regulations setting out the tax treatment of Additional Tier 1 and Tier 2 regulatory capital securities issued by UK financial institutions to reinforce their regulatory capital base under Basel III. Long-anticipated, the regulations offer welcome clarity and certainty for issuers of Basel III-compliant capital instruments in particular, and evidence the UK s willingness to create a benign corporate tax environment for issuers of regulatory capital instruments in general. The most important features are these: coupons payable in respect of such regulatory capital securities (but not dividends on share capital) will be deductible as interest; income tax will not be required to be withheld from payments on regulatory capital securities; transfers of regulatory capital securities will be exempt from stamp duties; and no tax will be crystallised for issuers as a result of the writing-down or writing-up of regulatory capital securities. Changes from the previous draft include: filling in several cracks which could have allowed regulatory capital securities to fall out of the regime after starting off inside it; and allowing corporate creditors not related to the issuer to recognise a tax loss on the write-down or conversion of regulatory capital securities. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 BACKGROUND UK TAX TREATMENT OF DEBT AND EQUITY The classification of regulatory capital instruments is important because of the differences in the way the UK taxes subordinated debt and share capital. Share Capital Payments servicing share capital (dividends) are not deductible for corporation tax purposes or subject to UK withholding tax. Many UK investors are exempt from tax on dividend income. 1 Transfers are generally subject to stamp duty/stamp duty reserve tax ( SDRT ) at 0.5% if the issuer is UK-incorporated. Subordinated Debt Payments servicing debt (most obviously interest) are generally taxable for UK investors and deductible for UK issuers, and listed debt securities are generally free of UK withholding tax. Transfers are generally exempt from stamp duty/sdrt. HMRC S PREVIOUS ANALYSIS OF REGULATORY CAPITAL In June 2012 HM Revenue and Customs published a technical note on the tax treatment of instruments intended to qualify as regulatory capital under both the then current rules (Basel II for banks, implemented within the EU by Capital Requirements Directive III; Solvency I for insurers) and, more importantly, the rules replacing them (Basel III and Capital Requirements Directive IV; Solvency II). The new regime for regulatory capital instruments requires additional features that were not necessary under the old regime. These features affect the UK tax treatment of the instruments, in particular whether the coupon payable on them is deductible. Additional Tier 1 Instruments To comply with the new regime, Additional Tier 1 capital will require certain features that HMRC considered would make it truly perpetual debt. HMRC did not think that truly perpetual debt could be debt for UK tax purposes since the holder has no right to repayment in any circumstances (unlike contingent perpetual debt where the right to repayment only arises as a result of a contractual clause providing for the return of principal in the event of [an insolvent] liquidation ). HMRC concluded in their June 2012 note that payments of interest on these Additional Tier 1 instruments would therefore not be treated as interest on debt for UK tax purposes, and would not be deductible. 1 Shares in building societies are only treated this way if they are core capital deferred shares; if they are not, dividends on the shares are generally treated as interest, and thus taxable on the recipient, deductible for the payer and potentially subject to withholding. -2-

3 Tier 2 Instruments Where an issuer is close to insolvency, its new Tier 2 instruments may be converted into common equity or written off (whether as a result of their contractual terms or under a statutory resolution regime) a bail-in. HMRC indicated that the presence of a conversion or bail-in option meant that the return to holders of new Tier 2 instruments would be dependent on the results of the issuing company s business. Therefore, interest payable on Tier 2 instruments would be treated as a non-deductible distribution for UK tax purposes. By contrast, under the Basel II rules it was generally possible to structure innovative Tier 1 and Tier 2 instruments to give the issuer a UK corporation tax deduction for the coupon. 2 INTERIM CHANGES On 26 October 2012 HMRC published interim draft legislation to ensure that interest payable on Tier 2 instruments complying with the new regulatory regime would not be classed as a nondeductible distribution simply because those instruments had features required by the new regulatory regime. This draft legislation was enacted as Section 43 Finance Act 2013 and had effect from the announcement on 26 October Interest payable on Basel III-compliant Tier 2 instruments has therefore been deductible in principle for UK tax purposes since then. 3 THE DRAFT REGULATIONS On 16 July 2013 HMRC published for consultation draft regulations on the tax treatment of Additional Tier 1 and Tier 2 instruments. These were intended as a deliberate legislative override of the general UK tax position, particularly the position set out in respect of Additional Tier 1 capital in HMRC s June 2012 note. The key proposals were: to allow for coupon payments on the instruments to be deductible; to exempt coupon payments from withholding; and to exempt transfers of such instruments from stamp duty and SDRT. 4 THE REGULATIONS HMRC revised the draft regulations in several respects to reflect comments received in consultation. The more significant changes are highlighted below. The revised regulations were approved by Parliament on 18 December. HMRC followed this up with a technical note on the regulations, published on 24 December The June 2012 note is discussed in detail in our client publication of 10 July 2012, available at The October 2012 draft legislation is discussed in detail in our client publication of 5 November 2012, available at The draft regulations are discussed in detail in our client publication of 9 August 2013, available at -3-

4 The regulations apply to the issue of regulatory capital securities ( RCSs ) by UK financial institutions. As revised, all issues of securities 5 that qualify or have qualified at any time as Additional Tier 1 and Tier 2 instruments and form or formed a component of the relevant tier of capital for the purposes of the EU Capital Requirements Regulation are covered by the regulations. HMRC have eradicated a risk created by the draft regulations that changes in the relative ratios of Tier 1 and Tier 2 regulatory capital of some financial institutions could take securities already in issue and benefiting from the regulations abruptly out of their ambit: this could have happened where an instrument ceased to count towards a BIPRU firm s tier two capital resources for the purposes of the Prudential Regulation Authority Handbook because its tier one capital resources were reduced. 6 The final form of the regulations also makes clear that the amortisation of Tier 2 securities during their final five years to maturity will not affect their UK tax treatment. The regulations may also apply to a non-uk financial institution with a branch in the UK if, when the institution calculates the notional regulatory capital to attribute to its UK branch, that notional capital includes Additional Tier 1 or Tier 2 securities qualifying under the Capital Requirements Regulation. TREATMENT OF ISSUERS AND HOLDERS Issuers and Corporate Holders 1. Coupons Coupons payable on RCSs will not be distributions and will therefore potentially be deductible for UK tax purposes. 2. Loan relationship treatment RCSs will be treated as loan relationships (in other words, debts) for corporation tax purposes. 3. Issuers and connected creditors Crucially, however, the regulations provide that neither the issuer nor any connected corporate creditor shall bring into account any profit or loss for the purposes of corporation tax in respect of: a write-down of the principal amount (whether on a permanent or temporary basis) or its writing back up; or the conversion of the security to a Common Equity Tier 1 instrument (in other words, ordinary share capital), 5 6 Other than shares, unless they are deferred shares issued by a building society. Both types of capital resources as defined in the PRA Handbook published by the UK s Prudential Regulation Authority. (The PRA has now announced that it intends to rewrite the PRA Handbook over the coming years to create a PRA Rulebook.) A BIPRU firm is essentially a bank, a building society or an investment firm which is defined as such for the purposes of the BIPRU Prudential sourcebook for Banks, Building Societies and Investment Firms, also published by the PRA. The PRA is the part of the Bank of England responsible for the prudential regulation of banks, building societies, credit unions, insurers and major investment firms; it took over those functions from the Financial Services Authority in April

5 so long as the write-down, write-up or conversion is in accordance with any regulatory requirements or the provisions governing the security. Surprisingly, HMRC s technical note claims that this does not cover a liability management exercise (even, presumably, where that is allowed by the terms of the security) unless the regulator has formally exercised its powers to require it; and that, even if the regulator has required it, the circumstances should be discussed with HMRC. Issuers of RCSs should therefore avoid unexpected tax charges (and hence income statement volatility) if their RCSs are written down at the regulator s order. Consistently with the position on write-downs, the regulations provide that, so far as the issuer and any connected creditor are concerned: fair value accounting will not apply to RCSs (or any part of them); and the corporation tax bifurcation rules governing loan relationships with embedded derivatives will not apply to RCSs. The effect, according to HMRC, is that the RCSs should be treated as if they were accounted for on an amortised cost basis, except to the extent that all or part of the instrument is recognised in equity in which case the equity component should be brought into account for tax purposes. Where exchange gains or losses arise on loan assets or derivative contracts intended to hedge exchange rate risks on the company s share capital, those gains or losses are not recognised for tax purposes. In October 2012 the government extended these rules to cover Additional Tier 1 capital instruments and deferred building society shares accounted for as equity instruments as well as share capital. The regulations further extend the rules to cover Tier 2 instruments. They also restrict the issuer s discretion to choose how derivative contracts over interest rates which hedge regulatory capital securities will be treated for tax purposes, if it accounts for the securities on a fair value basis. 4. Unconnected creditors By contrast with connected creditors, unconnected creditors will be entitled to recognise debits in respect of write-downs. Similarly, if they bifurcate an RCS for accounting purposes, they will follow that treatment for tax purposes and recognise any fair value movements in the embedded derivative. Under the published draft of the regulations, all UK corporate holders of RCSs (including those issued by non-uk financial institutions) were to be denied a loss on a write-down or bail-in : investors (and issuers) will welcome the relaxation for unrelated creditors. 5. Grouping RCSs will constitute normal commercial loans, and will therefore not be treated for UK corporation tax grouping purposes as equity of the issuer. This will ensure that third-party holdings of RCSs will not deprive issuer groups of the benefit of the UK corporation tax and stamp duty grouping rules (the UK equivalent of tax consolidation). -5-

6 Individual Holders Under the regulations, individual UK-taxpaying holders will not realise a capital gain or loss on disposals of RCSs that are denominated in sterling. By contrast, individual holders of RCSs issued in a currency other than sterling would realise a capital gain or loss on disposals of RCSs. This distinction is strange when compared to the capital gains tax treatment of individual holders of ordinary share capital. That said, it is unlikely that individuals will invest extensively in RCSs. WITHHOLDING TAX Issuers have traditionally listed regulatory capital instruments on a stock exchange that is recognised by HMRC so they can rely on the quoted Eurobond exemption from withholding tax on interest payments. HMRC s position (reflected in the regulations) is that interest payments on regulatory capital securities are not within the withholding tax exemption for interest paid in the ordinary course of business of a bank or authorised dealer in financial instruments, nor within the exemption for interest paid by building societies in respect of advances to them. The regulations provide for a blanket exemption from withholding tax on payments of coupons on RCSs, whether listed or not, subject to anti-avoidance provisions (see below). This is a positive development, although in practice RCSs are likely to be listed, and so would qualify for the quoted Eurobond exemption in any event. STAMP DUTIES Regulatory capital instruments issued under the previous regime did not always qualify for the exemption from stamp duty and SDRT for transfers of loan capital and various techniques (including the issue of immobilised bearer convertible debt ) had to be used instead to avoid stamp duty and SDRT. The features required by the new regulatory regime, such as conversion to equity on a bailin and a right to interest that is arguably results-dependent, potentially disapply the loan capital exemption. The regulations, however, ensure that dealing in RCSs will be exempt from stamp duty and SDRT, unless anti-avoidance provisions apply (as to which see below). There should therefore be no need for more complicated structuring alternatives to prevent stamp duty and SDRT charges from arising. ANTI-AVOIDANCE If an RCS has been issued as part of arrangements the main purpose, or one of the main purposes, of which is to obtain a tax advantage, some of the benefits of the regulations will be disapplied. In particular: payments in respect of RCSs will not automatically qualify as interest, so may well not be deductible; the blanket exemption from withholding tax on payments of interest will not apply; but, as discussed above, listing instruments on a recognised stock exchange would still allow issuers to take advantage of the quoted Eurobond exemption from withholding tax; any disapplication of the derivative contracts rules will be ineffective; -6-

7 transfers of RCSs may be subject to stamp duty and SDRT, unless they qualify for the loan capital exemption or other structuring techniques can be used (see above); third-party holdings of RCSs may deprive issuer groups of the benefit of the UK corporation tax and stamp duty grouping rules, unless issued by the top holding company in the issuer group; and individual holders in the UK will recognise a capital gain or loss on disposals of all RCSs (even if denominated in sterling), if the interest on them is results-dependent in theory they might prefer this, as the risk of a loss is more obvious than the chance of a gain, but if they have fallen into the anti-avoidance rules in the regulations their claim for a loss may be disallowed by the antiavoidance provisions of the capital gains code. These anti-avoidance rules are not expected to be often invoked. EFFECTIVENESS The regulations came into force on 1 January The transitional rules in Section 43 Finance Act 2013 providing limited assistance to issuers of Tier 2 regulatory capital instruments are repealed with effect from that date. The regulations do not apply retrospectively, although they will apply to instruments existing before they came into force. BANK LEVY REVIEW The UK introduced a bank levy in It is charged on banks chargeable equity and liabilities over 20 billion. One of the design intentions of the levy is to encourage banks to hold stable sources of funding: longer-term liabilities are charged at half of the rate of short-term liabilities, and there is an exclusion for retail deposits covered by a deposit protection scheme or guarantee and for Tier 1 capital. Over the summer the government conducted a review of the bank levy (as it had said it would do in 2013 when it introduced the levy). The review document raised the question of how the bank levy fits with the wider tax treatment of regulatory capital. It noted that issuers of Additional Tier 1 instruments were expected to benefit both from deductions for coupon payments (like Tier 2 instruments and debt more generally) and from exclusions from the bank levy (like Common Equity Tier 1 instruments). In other words, Additional Tier 1 instruments would be taxed more favourably than the more lossabsorbent Common Equity Tier 1 instruments. The review document therefore raised the possibility that the bank levy exclusion should apply only to Common Equity Tier 1; the tone of the question suggested that this was the government s preferred option. According to the response document published by the government on 10 December, however, Responses overwhelmingly favoured retaining an exclusion for all Tier 1 capital, and the government has been persuaded. The bank levy exclusion will therefore continue to apply to Additional Tier 1 instruments, which gives issuers an added incentive to raise capital in this form. SOLVENCY II The new Solvency II regulatory capital regime for insurers has been further postponed. HMRC will look at the rules for regulatory capital under Solvency II, and the need for matching changes to the UK tax rules, when appropriate. The government does, however, intend to avoid being held hostage by -7-

8 the EU legislative programme: it plans to extend HM Treasury s regulation-making powers to allow it to make regulations on the tax treatment of regulatory capital securities before the relevant EU legislation is passed. Changes to achieve this were included in the draft Finance Bill for 2014 published on 10 December. COMMENT The regulations are a long-anticipated and welcome clarification of the tax position for issuers of Additional Tier 1 and Tier 2 instruments that comply with the new Basel III regulatory regime. Taken with the proposed statutory amendment to HM Treasury s regulation-making powers, they demonstrate the UK government s willingness to create a benign corporate tax environment for institutions issuing regulatory capital generally. * * * Copyright Sullivan & Cromwell LLP

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