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relation to U.K. taxation that the company or group is prepared to accept and the approach to dealings with HMRC.
F. Solvency II Compliant Tier 1 and Tier 2 Capital – Clarification of U.K. Tax Treatment
To coincide with the coming into force of Solvency II, new legislation has been introduced to ensure that Tier 1 and Tier 2 compliant Solvency II instruments that are issued in the form of debt will be treated as debt instruments, and their coupon as interest, for U.K. tax purposes. As discussed in our article in the 2013 Year In Review, the tax treatment of these instruments under general U.K. tax law, including in particular the tax deductibility of the interest payments, is uncertain. The Finance Act 2014 granted power to make regulations to give certainty. HMRC carried out a public consultation over the summer, and regulations have now been made effective as of January 1, 2016, subject to certain transitional provisions.
Parallel issues have already been addressed in the context of banks and the classification of capital under CRD IV. The Taxation of Regulatory Capital Securities Regulations 2013 came into effect on January 1, 2014 in respect of Additional Tier 1 or Tier 2 capital of a bank. Essentially, these provisions are now being extended to cover Tier 1 and Tier 2 capital, in debt form, issued by an insurance company (defined for this purpose as a “regulatory capital security”).
These measures address the uncertainty caused by the fact that the features designed to boost permanence and loss absorbency (such as write-down or bail-in provisions, interest suspension or cancellation, perpetuity and convertibility into shares) place the instruments close to the borderline between debt and equity for U.K. tax purposes. The regulations:
confirm that a regulatory capital security represents a loan relationship but excludes any tax charge in respect of a contingent conversion or write-down, or on an actual write-down;
disapply the “results dependent” rule and confirm that the coupon on a regulatory capital security is characterized as interest, and not a (non-tax deductible) distribution, for U.K. tax purposes;
treat a regulatory capital security as a “normal commercial loan” for the purposes of the rules determining tax group relationships on the basis of equity ownership; and
confer an exemption from all stamp taxes on a transfer of a regulatory capital security.
In addition, interest on a regulatory capital security would in principle be subject to deduction of basic rate income tax at source. In practice, such a security would typically be listed on a “recognised stock exchange,” so as to constitute a “quoted Eurobond,” the interest on which is exempt from U.K. withholding tax as a matter of general law. However, the regulations helpfully confer a general exemption from withholding tax on regulatory capital securities, whether or not the security is listed. The tax regulations apply only to an instrument that takes the legal form of debt. However, the fact that the security may be recognized in equity or shareholders’ funds for accounting purposes, in accordance with GAAP or IFRS, is irrelevant.
All the tax relief provided by the regulations is subject to an anti- avoidance provision. Relief is denied if there are arrangements the main purpose or one of the main purposes of which is to obtain a U.K. tax advantage for any person as a result of the application of the regulations.
Although the coupon will not be disallowed on the ground that it is re-characterized as a dividend, other provisions of U.K. tax law, which potentially restrict the tax deductibility of interest, could still apply, such as transfer pricing rules where the securities are issued to an affiliate. In addition, although regulatory capital securities are expected to be outside the scope of the main “hybrid mismatch” regime, when this comes into force in 2017, the U.K. government has noted that it is considering whether a tailored application of the hybrid rules to the financial sector may be appropriate.
Under the transitional provisions, securities that were issued before January 1, 2016 but are subject to the Prudential Regulation Authority transitional arrangements, set out at rule 4.2 in the Annex to the PRA Rulebook: Solvency II Firms: Transitional Measures Instrument 2015, are also covered by these new tax regulations.
Developments and Trends in Insurance Transactions and Regulation 2015 Year in Review
VII.Tax