Hybrid capital is most often seen in the context of financial institutions which, in order to satisfy certain regulatory capital requirements, issue debt containing a number of equity features.  These features can include a right for the issuer to cancel or defer interest payments, with the instrument in question often being long-dated or perpetual.  While it has a fixed capital value at the outset, hybrid capital often contains terms that allow the capital to be released or converted into shares in certain circumstances. These features can lead to uncertainty as to whether the payments under the hybrid instrument should be taxed as interest (which is typically deductible) or as distributions (which are not). 

UK Government Policy on Hybrid Capital

The UK’s historic policy has been to treat banks and insurers which issue debt securities containing certain equity-like features in order to meet regulatory capital requirements as being entitled to deductions for the coupons on those instruments, thereby treating such instruments as being debt for UK tax purposes.  In 2013, the Taxation of Regulatory Capital Securities Regulations 2013 (the RCS Regulations) were made in the UK Parliament permitting companies in the financial sector to obtain deductions for coupons on hybrid capital, owing to banking companies (under Basel III) and insurance companies (under Solvency II) being required to hold a certain amount of capital containing certain equity-like features to allow for loss-absorbency in the event of the bank or insurer coming under financial strain and having depleted levels of capital. The RCS Regulations have effectively made the treatment of hybrid capital much simpler for taxable years since 2013.

However, a number of events have triggered a change in the taxation framework for hybrid capital.  First, there is a concern that the RCS Regulations could run afoul of European State Aid requirements — considered to be a reason for the repeal of similar provisions in Holland in 2018.  Second, the impending rules of the Bank of England on the minimum requirement for own funds and eligible liabilities (MREL), which take effect in January 2019 for the UK banking sector, are not covered adequately by the RCS Regulations.

Accordingly, the Government announced in the October 2018 Budget that the RCS Regulations would be revoked with effect from 1 January 2019, subject to some limited transitional provisions, and replaced by a new hybrid capital instrument (HCI) regime applicable to accounting periods beginning on or after 1 January 2019.  The HCI regime will not be limited to the banking and insurance sectors; any UK company is subject to the new rules, which may lead other sectors (such as energy and utilities) considering HCI issuances.

Hybrid Capital Instruments: Identification

The rules for HCI’s are set out in the Finance (No. 3) Bill to be enacted by the UK Parliament in early 2019. Under the new rules, a loan relationship will be an HCI if the three following requirements are all satisfied:

• it makes provision under which the debtor (but not the creditor) is entitled to defer or cancel a payment of interest.
• it has “no other significant equity features”. A loan has no such “significant features” if (i) there are neither voting rights in the debtor  nor a right to exercise a dominant influence over the debtor; (ii) any provision for altering the amount of the debt is limited to write-down or conversion events in qualifying cases; and (iii) any provision for the creditor to receive anything other than interest or repayment of the debt is limited to conversion events in qualifying cases (not including rights exercisable by the creditor).  In both of (ii) and (iii), “qualifying cases” are permitted only if the debtor is experiencing solvency or liquidity problems or where the instrument must include a term allowing conversion or write down for regulatory or other legal requirements.
• the debtor has made an irrevocable election in respect of the instrument within 6 months of issuance, or for loan relationships already in existence on 1 January 2019, by 30 September 2019.

Where these requirements are present in the features of an HCI, then any coupon arising for payment on the HCI will be treated as interest (and not a company distribution, other than for securities on uncommercial terms), regardless of whether the HCI is itself accounted for as a distribution. 

In consequence, the amount of the coupon will be deductible for the issuer and taxable for a UK corporate holder.  The HCI would be treated as a “normal commercial loan”, thereby preventing the inadvertent de-grouping of an HCI issuer.  In addition, no Stamp Duty or Stamp Duty Reserve Tax will be payable on the issue and transfers of the HCI.

While there is no automatic exemption from UK withholding tax on interest payments under an HCI (as there had been for an instrument under the RCS Regulations), this adverse change can be ameliorated by configuring the HCI as a quoted Eurobond.  

Consequences

The HCI regime is broader in scope than the previous RCS Regulations. The approach of the HCI legislation only prevents interest being re-characterised as a distribution in limited situations — namely where the HCI issuer defers or cancels an interest payment (which HMRC would treat is an indicator of equity) or where debt is structured to be long-dated or perpetual.  As a result of HCI regime being broader in scope, and providing fewer safeguards, loan relationships which are intended to constitute HCIs will require careful analysis under the UK’s rules for re-characterising payments as non-deductible distributions.