HM Revenue and Customs have proposed draft legislation to ensure that interest payable on Tier 2 regulatory capital instruments intended to comply with the new Basel III regime and the EU’s CRD IV and Solvency II regimes will be deductible for UK tax purposes. However, HMRC’s view remains that interest payable on Additional Tier 1 capital instruments under the new regime will not be deductible, at least under current law. It remains to be seen whether regulations will be introduced to improve the tax treatment of UK issuers of such instruments.


On 26 June HM Revenue and Customs published a technical note on the current 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
  • the rules replacing them (Basel III and CRD 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 tax treatment of the instruments, in particular whether interest payable on them is deductible. HMRC’s June note was discussed in detail in our client publication dated 10 July 2012.

Additional Tier 1 Instruments

In their June note, HMRC concluded that interest payable on instruments qualifying as Additional Tier 1 capital under the new regime would not be deductible for UK tax purposes, at least under current law.

To comply with the new regime, Additional Tier 1 capital will require certain features that HMRC consider will make it “truly perpetual” debt. HMRC do not think that “truly perpetual” debt is “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”). While this analysis is not beyond doubt, HMRC consider that payments of “interest” on these Additional Tier 1 instruments will not be treated as interest for UK tax purposes, and will not be deductible.

Tier 2 Instruments

HMRC also indicated in their June note that interest on Tier 2 instruments would not be deductible after the new regime comes into force. New Tier 2 instruments will have to give power to the regulatory authority to:

  • convert the instruments into common equity; and/or
  • write off the instruments (whether as a result of their contractual terms or under a statutory resolution regime) – a “bail-in”.

HMRC concluded that the presence of such a conversion or “bail-in” option means that consideration given to holders of new Tier 2 instruments would be “dependent on the results” of the issuing company’s business. Interest payable on Tier 2 instruments would therefore be treated as a “distribution” for UK tax purposes, and would in principle be non-deductible.

In HMRC’s view, however, until the new regime takes effect only a contractual term reducing or cancelling pay-outs on a bail-in would make the amounts payable on the instrument results-dependent and therefore fall to be taxed as distributions. On 25 September HMRC revised their June note to make clear that they would not see a general warning in a prospectus of the possibility of statutory bail-in as a contractual term which could make an instrument “results-dependent”.


On 26 October HMRC published draft legislation to ensure that interest payable on Tier 2 instruments complying with the new regulatory regime will not be classed as a “distribution” simply because the consideration given by the issuer is affected by features required by the new regulatory regime. Interest payable on Tier 2 instruments should therefore be deductible in principle for UK tax purposes.

The legislation will be treated as having come into force on 26 October, and will apply to Tier 2 instruments in issue and those yet to be issued.


This is a welcome clarification of the tax position for UK issuers of new Tier 2 instruments and was trailed in HMRC’s June note. However, the October note does not mention the treatment of Additional Tier 1 instruments. Under current law and the pre-Basel III/Solvency II regime, UK issuers have been able to obtain tax deductions for the accruing coupon on “perpetual debt” (please see our client publication of 10 July 2012 for further detail). It remains to be seen whether HMRC will use their power to make regulations (that have prospective effect only) to ensure that interest on new Additional Tier 1 instruments is deductible.