Tax treatment of tier 2 capital instruments under Basel III
Banking on Tax, Issue 8
As outlined in Banking on Tax #7 (June 2012, in the article titled, “Federal Budget announcements on banking tax reforms”), the Government announced in the 2012-13 Budget that it will ensure that, on commencement of the Basel III regulatory reforms on 1 January 2013, certain Tier 2 regulatory capital instruments will not be precluded from being treated as debt for income tax purposes.
On 16 July 2012, Treasury released a discussion paper on the income tax treatment of certain tier 2 capital instruments under the Basel III capital reforms. The paper set out a proposal to amend the Income Tax Assessment Regulations 1997 (the regulations) so that a loss absorbency clause does not preclude Tier 2 instruments issued by Australian Deposit-taking Institutions (ADIs) and related general and life insurers from being classified as debt interests for tax purposes. The loss absorbency clause will require the terms of Tier 2 capital instruments to include a permanent write off of the instruments or conversion to common equity where the financial institution would otherwise not be viable. A loss absorbency clause is likely to result in certain Tier 2 instruments which are currently classified as debt interests being treated as equity interests, with returns on those instruments being non-deductible.
The discussion paper requested views on whether the proposed amendment to the regulations would achieve the outcome of enabling those tier 2 instruments to be treated as debt for income tax purposes.On 31 October 2012, Treasury released exposure draft regulation 974-135F “Term subordinated note with non-viability condition” for comment. Submissions on the exposure draft and explanatory material are due by 14 November 2012.
The proposed amendment is consistent with the approach taken to ensure that obligations to pay amounts on term cumulative subordinated notes and perpetual cumulative subordinated notes are not prevented from being non-contingent obligations (regulations 974-135D and 974-135E). The Tier 2 notes considered in the discussion paper would have to have certain features, which it stated were consistent with regulation 974-135D:
- A maximum term of 30 years
- Distributions are cumulative and compounding
- Classified as an accounting liability
- Satisfy the tier 2 capital loss absorbency requirement.
However, while term cumulative subordinated notes covered by regulation 974-135D are required to be cumulative, they are not required to be compounding. Regulation 974-135E is similarly drafted. In the Explanatory Statements for both of these regulations, it was explicitly stated that the deferred payments are not required to compound. The proposal in the discussion paper went beyond the features in regulation 974-135D. However, the exposure draft regulation is consistent with regulations 974-135D and 974-135E as it requires the payment of principal or interest to “accumulate (with or without compounding)”.
The discussion paper stated that the proposed change would apply to certain tier 2 regulatory capital instruments issued by ADIs and related APRA-regulated entities on or after 1 January 2013. Obligations under the terms of instruments issued prior to that date would have continued to be considered under the existing law and regulations. This may have given rise to some difficulties if the terms of instruments issued prior to 1 January 2013 are amended to comply with Basel III on or after 1 January 2013. In contrast, regulations 974-135D and 974-135E apply to obligations to pay on/after a particular date, rather than to instruments issued on/after a particular date. The exposure draft regulation is consistent with regulations 974-135D and 974-135E, i.e. it will apply to obligations to pay principal or interest on a relevant term subordinated note on or after 1 January 2013.
Interestingly, the other questions in the discussion paper asked for submissions to reveal information that would be considered confidential by the parties responding. The questions included:
- If you are an APRA-regulated, non-ADI-related insurer, are you likely to issue Tier 2 capital?
- How much regulatory capital – in nominal and relative terms – do you plan to issue or have you issued under Basel III, for each category of regulatory capital and the proportion of your total capital base it will make up?
- What are the main characteristics of the instruments you plan to issue, or have issued, in each category?
- Do you anticipate that you will increase your level of Tier 1 regulatory capital as the capital conservation and countercyclical buffers are phased in?
No submissions on the discussion paper have been made available on the Treasury’s website. However, given the nature of the questions asked, if submissions included responses to the above questions, it is expected that those submissions would have been marked in whole or in part as “in confidence”, so that few submissions may become available to the public.