Treating eligible Tier 2 instruments as debt for tax purposes will ensure ADIs aren't at a competitive disadvantage.
In a discussion paper released on 16 July 2012, the Australian Government announced proposals to amend tax legislation to ensure that from the commencement of the Basel III capital reforms in Australia on 1 January 2013, eligible Tier 2 instruments issued by authorised deposit-taking institutions (ADIs) on or after that date can be treated as debt for tax purposes.
The policy objective behind the amendments is to ensure that ADIs and other entities regulated by APRA are not at a competitive disadvantage compared with non-ADI corporate taxpayers. The discussion paper follows a 2012/2013 budget announcement by the Government foreshadowing amendments to tax legislation to address this issue.
The proposed amendments will permit Tier 2 capital instruments issued by ADIs to be treated as debt for income tax purposes notwithstanding that their terms include certain equity features, colloquially referred to as " bail-in provisions", which will require the relevant Tier 2 instrument to be written-off or converted into ordinary shares if APRA decides that the issuing ADI would otherwise become non-viable.
ADIs will be required to include bail-in provisions in all Tier 2 instruments from 1 January 2013, as part of APRA's implementation of Basel III in Australia.
Debt/equity taxation and the prudential framework
APRA's prudential standards for ADIs will only recognise instruments for capital adequacy purposes if they have certain equity like characteristics which ensure, amongst other things, that they rank behind depositor claims. However, issuers of Tier 2 capital instruments often seek to classify their Tier 2 instruments as a debt interest under the debt/equity rules in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) with the corresponding ability to treat their interest payments on the instruments as tax deductible. This can result in tension between the desired tax and regulatory treatment of Tier 2 regulatory capital instruments.
Under the debt/equity rules in Division 974 of the ITAA 1997, an instrument is generally treated as a debt interest if the issuer has a "non-contingent obligation" (or an "effectively non-contingent obligation") to repay the amount invested.
An obligation is generally non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity), other than the ability or willingness of that entity or a connected entity to meet the obligation.
Further, an obligation is defined as "effectively non-contingent" if, having regard to the pricing, terms and conditions of the instrument, there is, in substance or effect, a non-contingent obligation (eg. if an instrument combines an issuer right of redemption with an interest step-up which makes it uneconomical for the issuer not to redeem the instrument at the step-up date).
The inclusion of a bail-in provision in a debt instrument issued by an ADI may render the ADI's obligation a "contingent" obligation for the purposes of the ITAA 1997, because payment would be contingent on the non-occurrence of a bail-in trigger event. Hence, the instrument would be treated as equity for tax purposes and interest payments made by the ADI to fund the instrument would not be tax deductible.
Under the proposed amendments, the inclusion of a bail-in provision in Tier 2 instruments will not preclude instruments being treated as debt for tax purposes.
The proposed amendments to ITAA 1997 are consistent with the current position under regulation 974-135D of the Income Tax Assessment Regulations 1997 (ITAR 1997), which ensures that Lower Tier 2 instruments under Basel II may be treated as debt for tax purposes even though the issuing ADI is, under the terms of such instruments, obliged or able to defer the payment of interest beyond its original due date in the event the ADI is, or would become, insolvent or breach its regulatory capital ratios (the so-called "solvency or capital adequacy conditions").
Without this exemption, solvency or capital adequacy conditions would constitute "contingent" obligations and the instruments would therefore be treated as equity interests under the debt/equity income tax rules.
What effect will the proposed change have?
Under the proposed amendments, the inclusion of a bail-in provision in Tier 2 capital instruments will not in itself prevent the instrument from being a "non-contingent" obligation and therefore treated as debt for income tax purposes.
The discussion paper states that in order for any Tier 2 capital instrument to benefit from the proposed exemption, it will need to satisfy the following criteria (consistent with regulation 974-135D of the ITAR 1997 in respect of Lower Tier 2 instruments under Basel II):
- must have a maximum term of 30 years;
- distributions must be cumulative and compounding; and
- must be classified as an accounting liability.
It is important to note that regulation 974-135D of the ITAR 1997 explicitly states that it does not apply to instruments that meet the requirements of Tier 1 capital instruments. We expect that this will also apply to capital instruments issued under Basel III.
Capital framework for insurers
The discussion paper notes that the proposed amendments will apply not only to ADIs but also to general and life insurers that are related to ADIs. As of 1 January 2013, capital rules similar to Basel III (including loss absorption requirements similar to the bail-in provisions) will apply to all general and life insurers equally.
This may result in uneven tax treatment for insurers depending on whether or not they are related entities of ADIs. To assist the Government's further consideration of this issue, the discussion paper seeks views on the likely impact of Basel III on insurers.
Comments on the discussion paper are due by 10 August 2012.
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