Finance Act 2019 introduced a set of rules for hybrid capital instruments. These are certain loan instruments which are on the borderline between debt, where the coupon is tax deductible, and equity, where the coupon is disallowed as a distribution. For banking and insurance companies the new rules replace existing regulations which applied to their regulatory capital, but in this article we look at the implications for companies more generally.
For example, the new regime could be relevant where a company issues a loan instrument which is accounted for as equity because the issuer has no obligation to make payments, such that the interest coupon is recognised as a distribution in the accounts. This can have commercial benefits in terms of raising other funding which ranks ahead of the instrument.
Background to the introduction of the hybrid capital rules
By way of background, for instruments issued in an accounting period beginning prior to 1 January 2016, the interest coupon is deductible even if it is treated as a distribution for accounting purposes and therefore reflected through equity. However, following a change to a “follow the profit and loss” approach for the taxation of loan relationships, relief was no longer available for companies for instruments issued in periods beginning on or after 1 January 2016.
An exception was made by way of limited scope regulations for regulated businesses (e.g. insurance businesses and banks). These regulations have now been replaced with rules applying to all companies, in part to deal with a concern that the regulations represented state aid because they only applied to certain sectors. The new regime is welcome because, although not common, we do see general corporates issuing such instruments. In this respect, we note that the guidance has evolved recognising that the rules are not only relevant to financial services businesses, and there are now examples of debt issuances in other sectors making use of the rules.
What is the scope of the hybrid capital instrument rules?
For corporation tax purposes, the new rules apply from 1 January 2019 whatever a company’s year-end. The rules can apply to instruments issued prior to that date.
The new rules apply to a hybrid capital instrument which meets the following requirements.
- The instrument represents a loan relationship. This requires that there is a debt due. For example, the instrument may provide that the principal is repayable on the liquidation of the issuing company such that there is an ascertainable time when payment is required.
- The borrower is entitled to defer or cancel a payment of interest.
- The loan relationship has “no other significant equity features”, e.g. no voting rights.
- The borrower has made an election in respect of the loan relationship. The normal deadline for making the election is six months after the issue of the instrument. However, where a company was a party to the instrument prior to 1 January 2019, the time limit was extended and the election could have been made until 30 September 2019. The election is irrevocable.
- Regulations apply from 4 November 2019 which provide for alternative deadlines for making an election in two circumstances; where a loan relationship is only able to qualify as an hybrid capital instrument as a result of an amendment to the statutory definition of a conversion event and where the terms of the instrument are amended so that it will be able to qualify as an hybrid capital instrument.
How are hybrid capital instruments taxed?
Some key points in the tax treatment of hybrid capital instruments are as follows.
- The interest coupon recognised in equity is, in principle, deductible under the loan relationship rules.
- The usual requirement for the interest coupon on instruments, which have equity like characteristics, to be tested to see if this should be disallowed as a distribution for tax purposes is subject to certain relaxations.
- The corporate interest restriction rules test the deductibility of the net tax-interest expense of UK group companies. With the fixed ratio rule, the limit is the lower of 30% of tax-EBITDA (taken from the tax computations) and a measure of the net interest expense based on the consolidated financial statements (known as the debt cap). Since the interest coupon on equity accounted hybrid capital instruments will not be included with the normal accounting interest charge, an amendment has been made so that the interest coupon will be added to the debt cap measure for the fixed ratio rule. It should be noted that for groups applying the group ratio rule, however, the interest coupon may still be excluded. Issuers of hybrid capital instruments considering making a group ratio election should therefore consider their position carefully.
- A loan instrument which has equity like characteristics may be characterised as not being a “normal commercial loan”. This can have a downside, for example because a tax grouping can be broken if such an instrument is issued outside the group. It is also relevant when determining whether the holder of the instrument is a related party for the purposes of the corporate interest restriction rules. Hybrid capital instruments are deemed to be normal commercial loans.
- Exchange gains and losses will not typically be recognised in the accounts on an instrument which is accounted for as equity, though an exchange difference might be recognised in the accounts on redemption. It is provided that exchange gains or losses on a hybrid capital instrument recognised in certain accounting statements by the issuer are not taxable or allowable. Similarly, exchange gains and losses on loan relationships and derivative contracts which are intended to hedge the issuer’s exchange exposure inherent in hybrid capital instruments are also not taxable and allowable.
- HMRC have confirmed in published guidance that a hybrid capital instrument which is carried at cost will meet a requirement of parts of the loan relationship rules which requires that a loan is accounted for on an amortised cost basis of accounting. This can be relevant if the instrument were to be released and reliance is being placed on statutory reliefs for releases of loan relationships. This is particularly important because, unlike the Regulatory Capital Securities regime which the rules replace, there is no blanket exemption for credits arising on a ‘bail in’ of the instrument (where creditors cancel part of the debt).
- Stamp duty is not payable on the transfer of a hybrid capital instrument.
Treatment disapplied where there is avoidance
There is an anti-avoidance rule which provides that an election to apply the hybrid capital instruments treatment is ineffective, such that the favourable tax treatment does not apply, if the borrower has a main purpose of securing a tax advantage for itself or another person. HMRC have provided some guidance on this anti-avoidance rule.
- In line with similar “main purpose” rules, it is acknowledged that purpose is a factual matter. Experience suggests that the relevant factual matters are contemporaneous documentation and the evidence of the decision makers.
- The issue of a hybrid capital instrument to protect or enhance the issuer’s credit rating will not normally indicate a “bad” purpose.
- The choice between debt and equity for raising funds will also not normally indicate a “bad” purpose.
- HMRC will not provide a non-statutory clearance on the application of the anti-avoidance rule.
If a company is looking use the new hybrid capital regime, it will be important to carefully structure or review the terms of the instrument to ensure that the expected tax treatment is achieved.