Regulatory Capital Requirements

Transcription

1 UK Sets Out Proposed Tax Treatment of New Additional Tier 1 and New Tier 2 Regulatory Capital Instruments SUMMARY HM Revenue and Customs have published draft regulations (the Draft Regulations ) on the tax treatment of Additional Tier 1 and Tier 2 regulatory capital securities issued by UK financial institutions to reinforce their regulatory capital base. While significant amendments to the current Draft Regulations are expected, the long-anticipated Draft Regulations are a welcome indication of HMRC s position on the taxation of new regulatory capital instruments, and of their willingness to create a benign corporate tax environment for issuing such instruments. The most important features are 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. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 BACKGROUND A. REGULATORY CAPITAL CHANGES On 26 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 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. 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 non-deductible distribution simply because such instruments have features required by the new regulatory regime. This draft legislation has now been enacted as Section 43 Finance Act 2013, with effect from 26 October Therefore, interest payable on Basel III-compliant Tier 2 instruments is already deductible in principle for UK tax purposes. The June 2012 note and the October 2012 draft legislation are discussed in detail in our client publications dated 10 July 2012 and 5 November B. 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 nor subject to UK withholding tax. Many UK investors are exempt from tax on dividend income. Transfers are generally subject to 0.5% stamp duty/stamp duty reserve tax ( SDRT ), if the issuer is UK-incorporated. Subordinated Debt Payments servicing debt (e.g. interest) are generally taxable for UK investors and deductible for UK issuers, with listed debt securities generally being free of UK withholding tax. Transfers are generally exempt from stamp duty/sdrt. C. HMRC S PREVIOUS ANALYSIS OF REGULATORY CAPITAL Prior to the publication of the Draft Regulations on 16 July 2013, HMRC s position was as follows. -2-

3 Additional Tier 1 Instruments To comply with the new regime, Additional Tier 1 capital will require certain features that HMRC consider will 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. Tier 2 Instruments New Tier 2 instruments will give power to the regulatory authority to forcibly boost the issuer s regulatory capital by converting the instruments into common equity, and/or writing off the instruments (whether as a result of their contractual terms or under a statutory resolution regime) a bail-in. Prior to the October 2012 changes discussed above, 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. As noted above, legislation came into force on 26 October 2012 to ensure that interest payable on such Tier 2 instruments is deductible in principle for UK tax purposes. THE DRAFT REGULATIONS The Draft Regulations are 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 Draft Regulations apply to the issue of regulatory capital securities ( RCSs ) by UK financial institutions. As currently drafted, Additional Tier 1 or Tier 2 capital securities must actually count towards the relevant institution s capital base to benefit from the Draft Regulations. This creates a risk that certain changes in the relative ratios of Tier 1 and Tier 2 regulatory capital of an institution could inadvertently disapply the Draft Regulations to securities in issue, for example where an instrument ceases to count towards an institution s Tier 2 capital base because its Tier 1 capital base becomes depleted. However, HMRC have indicated 1 that all issues of securities that qualify as Additional Tier 1 and Tier 2 instruments when issued are intended to be covered by the Draft Regulations. It is anticipated that the Draft Regulations will be modified accordingly. 1 HMT/HMRC joint meeting with stakeholders, 5 August

4 A. TREATMENT OF ISSUERS AND HOLDERS Issuers and Corporate Holders 1. Coupons Coupons payable on RCSs will not be distributions for corporation tax purposes. They will be treated as interest payable under a loan relationship, and therefore potentially deductible for UK tax purposes. 2. Write-downs and write-ups RCSs will be treated as loan relationships (i.e. debts) for corporation tax purposes. However, crucially the Draft Regulations provide that no profit or loss is to be brought into account for the purposes of corporation tax when the principal amount is written down (whether on a permanent or temporary basis) or written back up; or the security converts to a Common Equity Tier 1 instrument (i.e. ordinary share capital), so long as the write-down, write-up or conversion is in accordance with the provisions governing the security, i.e. arising either under the contractual terms of the securities, or by operation of statute. Issuers of RCSs will therefore avoid unexpected tax charges (and hence income statement volatility) if their RCSs are written down. However, UK corporate holders of RCSs (including those issued by non-uk financial institutions) will be denied a loss on a write-down or bail-in. Encouragingly, HMRC have suggested they may reconsider the treatment of UK corporate holders. 3. Derivative contracts rules The current Draft Regulations propose that the corporation tax rules governing derivative contracts will not apply to RCSs. Where RCSs have an embedded derivative, such as a right to conversion, this means that any movement on the derivative element of the RCSs would not be brought into account for tax purposes by a UK corporate issuer or a UK corporate holder of the RCSs. However, HMRC have now indicated that a blanket disapplication of the derivative contracts rules may not work in the light of the accounting treatment of RCSs. This aspect of the Draft Regulations is therefore likely to change. 4. Grouping RCSs will constitute normal commercial loans, and will therefore not be treated for UK 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 tax grouping rules (i.e. the UK equivalent of tax consolidation). Individual Holders Under the current Draft Regulations, individual UK-taxpaying holders will not realise a capital gain on or loss on disposals of RCSs that are denominated in Sterling. However, individual holders of RCSs issued in a currency other than Sterling would realise a capital gain or loss on disposals of RCSs. -4-

5 However, the Draft Regulations are likely to change, so that all RCSs (regardless of currency denomination) will be qualifying corporate bonds. Capital gains and losses on such instruments will be ignored if the holder is a UK-taxpaying individual. Such taxpayers will therefore be denied tax relief for losses on a bail-in, even though the financing return on the instrument will be fully taxable. B. 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 Draft 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 Draft Regulations will provide for a blanket exemption from withholding tax on payments of interest 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. C. STAMP DUTIES Regulatory capital instruments issued under the previous regime generally qualified for the exemption from stamp duty and SDRT for transfers of loan capital. However, the features required by the new regulatory regime, such as conversion to equity on a bail-in and a right to interest that is arguably results-dependent, would potentially disapply the loan capital exemption. Under the Draft Regulations, dealing in RCSs will be exempt from stamp duty and SDRT, subject to antiavoidance provisions (see below). D. 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, certain of the benefits of the Draft 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. However, 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; transfers of RCSs may be subject to stamp duty and SDRT, unless they qualify for the loan capital exemption (see above); and individual holders will recognise a capital gain or loss on disposals of all RCSs. -5-

6 These anti-avoidance rules are not expected to be invoked often. NEXT STEPS The consultation period on the Draft Regulations runs until 15 September, and amendments to the current draft regulations are expected before the end of the consultation period. It is anticipated that the Draft Regulations will come into force in late November 2013 at the earliest. The new regulatory capital regime for insurers (Solvency II) 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. COMMENT The Draft 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 regulatory regime. Transitional rules in Section 43 Finance Act 2013 providing limited assistance to issuers of Tier 2 regulatory capital instruments will be superseded once the Draft Regulations become effective. The Draft Regulations will not apply retrospectively, although, once in force, they will apply to existing instruments. Therefore, issuers will be keen to ensure that the timeline envisaged by HMRC does not slip, and that the final regulations are in force by the end of the year. * * * Copyright Sullivan & Cromwell LLP

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