Global Tax practice
Tax Treatment of Additional Tier 1
Capital under Basel III
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Contents
Introduction 3
Executive Summary 4
Australia 13
Belgium18
France21
Germany24
Italy28
Luxembourg32
Netherlands36
Spain40
United Kingdom
45
United States
51
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Introduction
In December 2010, the Basel Committee on Banking Supervision published “Basel III:
A global regulatory framework for more resilient banks and banking systems” (revised
and republished in June 2011). This was followed, on 13 January 2011, with a press
release entitled “Basel Committee issues final elements of the reforms to raise the
quality of regulatory capital”. These documents comprise Basel III and contain rules in
relation to how much capital a bank must hold as well as what that capital must look like.
The Basel III rules are required to be implemented by 1 January 2013.
Tax issues associated with capital instruments meeting the Basel III standards will be key.
Today’s globalised banking business requires cross-border solutions particularly for such
tax questions. Hence, Allen & Overy LLP’s Global Tax practice has prepared a high-level
analysis of the most important tax issues for the major European jurisdictions, for the U.S.
and for Australia.
The first version of this brochure was published in 2011. The present updated version
includes the latest developments in the relevant jurisdictions, plus a brief analysis of the
Buffer Convertible instrument (the terms and conditions of which are included in the
brochure on the basis of the common term sheet published by the European Banking
Authority). An executive summary and an overview chart summarises the results and
outlines the main features for Additional Tier 1 Capital.
With tax experts in virtually all relevant jurisdictions Allen & Overy’s Tax practice has a truly
global footprint. In association with our outstanding Banking and Regulatory practice we
are in a position to provide seamless cross-border advice on any issue in connection
with Basel III.
We would be pleased if our publication would be useful to you. We are more than happy
to discuss with you the topics covered in this publication or any other question you may
have on our services.
Gottfried Breuninger
Global Head of Tax
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Executive Summary
Under Basel III, banks will be required to hold at least 6% of their risk-weighted assets (RWA) in the
form of Tier 1 capital. Of that, up to 1.5% of RWA may be in the form of “Additional Tier 1 Capital”.
An instrument meeting the eligibility criteria for Additional Tier 1 Capital would need to have the
following main features:
Subordinated
– to depositors, general creditors and subordinated debt
of the bank
Perpetual
– no fixed maturity date
Redeemable after five years
– with regulator consent
No step-ups in distribution rate
– or other incentives to redeem
Distributions can be cancelled
– at bank’s full discretion
Distributions paid only out of distributable items
– and cannot be based on the bank’s credit standing
Cannot contribute to liabilities
exceeding assets
– if such a balance sheet test forms part of national
insolvency law
Converts into ordinary shares or has
its principal amount written down at
a pre-specified trigger point
–o
nly if the instrument is classified as a liability for
accounting purposes
Converts into ordinary shares or has its
principal amount written down at a point
of non-viability of the bank
– this feature may be included in legislation or within the terms
and conditions of the instrument, depending on whether the
country of the issuer has appropriate legislation in place
Cannot contain a feature which hinders
the recapitalisation of the bank
– this may, for example, prevent a temporary as opposed
to a permanent write-down mechanism
– without penalty or event of default
On-loans in indirect issuance structures must
also meet the requirements for Additional
Tier 1 Capital
© Allen & Overy LLP 2013
–a
write-down must reduce the claim of the instrument
in liquidation, reduce the amount repaid when a call is
exercised, and partially or fully reduce the distribution
payments on the instrument
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
BUFFER CONVERTIBLE CAPITAL SECURITIES
EUROPEAN BANKING AUTHORITY
COMMON TERM SHEET
Issuer
[•] (“Bank”, “Issuer”)
Securities offered
Buffer Convertible Capital Securities ("BCCS")
Total issue size
Up to € [•]
Nominal value
€ [•]
Issue price
At par
Issue date
[•] To be determined on a case by case basis – minimum
requirement: not later than 30 June 2012
Status and subordination
The BCCS constitute direct, unsecured, undated and subordinated
securities of the Issuer and rank pari passu without any preference
among themselves. They are fully issued and paid-in.
The rights and claims of the holders of BCCS of this issue:
– are subordinated to the claims of the creditors of the Bank,
who are:
– depositors or other unsubordinated creditors of the Bank
– subordinated creditors, except those creditors whose
claims rank or are expressed to rank pari passu with the
claims of the holders of the BCCS
– holders of subordinated Bonds of the Bank
– rank pari passu with the rights and claims of holders of other
junior capital subordinated issues qualifying as
Tier 1 capital
– have priority over the ordinary shareholders of the Bank
For the avoidance of doubt, the BCCS will be treated for
regulatory purposes as hybrid instruments and will qualify as
Tier 1 capital.
The amount BCCS holders may claim in the event of a
winding-up or administration of the Bank is an amount equal
to the principal amount plus accrued interest but no amount of
cancelled coupon payments will be payable.
Cancellation of any payment does not constitute an event
of default and does not entitle holders to petition for the
insolvency of the Bank.
In the event of Conversion of the BCCS to shares, the holders
of BCCS will be shareholders of the Bank and their claim
will rank pari passu with the rights and claims of the Bank’s
ordinary shareholders.
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Maturity date
Unless previously called and redeemed or converted, the BCCS
are perpetual without a maturity date.
Coupon
The BCCS will bear an interest of [•]
To be determined on a case-by-case basis – minimum
requirement: no incentive to redeem to be included.
Interest payment and interest date
To be determined on a case-by-case basis – minimum
requirement: dates to be aligned with dividend payment dates
Conversion rate
To be determined on a case-by-case basis – minimum
requirement: either (i) specification of a predetermined range within
which the instruments will convert into ordinary shares, or (ii) a rate
of conversion and a limit on the permitted amount of conversion.
Conversion period
To be determined on a case-by-case basis. The provisions to
be included shall not undermine the conversion features of the
instrument and shall not in particular restrict the automaticity of
the conversion.
Issuer’s call option
The Bank may, on its own initiative, elect to redeem all but not
some of the BCCS, at their principal amount together with
accrued interest, on the fifth anniversary or any other Interest
Payment Date thereafter, subject to the prior approval of the [name
of the national supervisor] and provided that:
(a) the BCCS have been or will be replaced by regulatory capital of
equal or better quality; or
(b) the Bank has demonstrated to the satisfaction of the [name
of the national supervisor] that its own funds would, following
the call, exceed by a margin that the [name of the national
supervisor] considers to be significant and appropriate,
(i) a Core Tier 1 Ratio of at least 9% by reference to the
EBA recommendation published on xx, or (ii) in case the
recommendation referred to under (i) has been repealed or
cancelled, the minimum capital requirements in accordance
with the final provisions for a Regulation on prudential
requirements for credit institutions and investment firms to
be adopted by the European Union.
Optional coupon cancellation
© Allen & Overy LLP 2013
The Bank may, at its sole discretion at all times, elect to cancel
an interest payment on a non-cumulative basis. Any coupon not
paid is no longer due and payable by the Bank. Cancellation of a
coupon payment does not constitute an event of default of interest
payment and does not entitle holders to petition for the insolvency
of the Bank.
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Mandatory coupon cancellation
Upon breach of applicable minimum solvency requirements, or
insufficient Distributable Items, the Bank will be required to cancel
interest payments on the BCCS.
The Bank has full discretion at all times to cancel interest
payments on the BCCS.
The [name of the national supervisor] may require, in its sole
discretion, at all times, the Bank to cancel interest payments on
the BCCS.
“Distributable Items” means the net profit of the Bank for the
financial year ending immediately prior to the relevant coupon
payment date together with any net profits and retained earnings
carried forward from any previous financial years and any net
transfers from any reserve accounts in each case available for the
payment of distributions to ordinary shareholders of the Bank.
[Formulation to be amended as far as necessary according to
applicable national law]
Any coupon payment cancelled will be fully and irrevocably
cancelled and forfeited and will no longer be payable by the Bank.
Cancellation of a coupon payment does not constitute an event of
default of interest payment and does not entitle holders to petition
for the insolvency of the Bank.
Mandatory conversion
(1) If a Contingency Event or Viability Event occurs, the BCCS shall
be mandatorily fully converted into Ordinary Shares.
(2) Open option – to be determined on a case-by-case basis:
possibility to include a mandatory conversion at a fixed date.
The Issuer undertakes to take all necessary measures to propose,
at one or more general meetings to be convened for this purpose,
the increase of the authorised share capital of the Bank so as the
authorised share capital of the Bank is sufficient for the Mandatory
Conversion of all of the BCCS. All necessary authorisations are to
be obtained at the date of issuance of the BCCS.
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Contingency event(s)
“Core Tier 1 Ratio Contingency Event” means the Bank has
given notice that its Core Tier 1 Ratio is below 7% by reference to
the EBA recommendation published on xx. The Bank shall give
notice as soon as it has established that its Core Tier 1 Ratio is
below 7%.
For the purpose of this issuance, the Core Tier 1 Ratio is based
on the definition used in the European Banking Authority (“EBA”)’s
2011 EU-wide stress test (http://www.eba.europa.eu/News-Communications/Year/2011/The-EBA-details-the-EU-measuresto-restore-confide.aspx). This definition excludes all private hybrid
instruments which encompass all the BCCS to be issued under
this term sheet.
“Common Equity Tier 1 Capital Ratio Contingency Event” means
that, after 1 January 2013, the Bank has given notice that its
“Common Equity Tier 1 Capital Ratio”, in accordance with the final
provisions for a Regulation on prudential requirements for credit
institutions and investment firms to be adopted by the European
Union and taking into account the transitional arrangements, is
below 5.125% [or a level higher than 5.125% as determined by the
institution – to be determined on a case-by-case basis]. The Bank
shall give notice as soon as it has established that its Common
Equity Tier 1 Capital Ratio is below 5.125% [or a level higher than
5.125% as determined by the institution – to be determined on a
case-by-case basis].
The Common Equity Tier 1 Capital Ratio Contingency Event is
applicable as of 1 January 2013. In addition, the Core Tier 1 Ratio
Contingency Event remains applicable after 1 January 2013 as
long as the EBA recommendation published on xx has not been
repealed or cancelled.
Viability event
A Viability Event is the earlier of:
(a) a decision that a conversion, without which the firm would
become non-viable, is necessary, as determined by [name of
the relevant authority]; and
(b) the decision to make a public sector injection of capital, or
equivalent support, without which the firm would have become
non-viable, as determined by [name of the relevant authority].
[In case a statutory approach is claimed, the clause will have to
make clear that the jurisdiction has an equivalent regime in place.]
Holders right for conversion
© Allen & Overy LLP 2013
Open option – to be determined on a case-by-case basis:
possibility to include a right for holders to convert the BCCS
into shares.
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Substitution, variation, redemption for
regulatory/legal purposes
In case of changes in the laws or the relevant regulations of the
European Union or of the [name of the country] or the [name
of the national regulator], which would lead in particular to the
situation where the proceeds of the BCCS do not qualify after
January 2013 as Additional Tier capital in accordance with the final
provisions for a Regulation on prudential requirements for credit
institutions and investment firms to be adopted by the European
Union, the Bank may, with the prior consent of the [name of
the national regulator], redeem all the BCCS together with any
accrued interest outstanding.
Alternatively, the BCCS, with the consent of the [name of the
national supervisor], may be exchanged or their terms may be
varied so that they continue to qualify as Additional Tier 1 capital
or Tier 2 capital in accordance with the final provisions for a
Regulation on prudential requirements for credit institutions and
investment firms to be adopted by the European Union or qualify
as senior debt of the Bank. Substitution/Variation should not lead
to terms materially less favourable to the investors except where
these changes are required by reference to the final provisions for
a Regulation on prudential requirements for credit institutions and
investment firms to be adopted by the European Union.
Use of proceeds
The net proceeds of the Issue will be used to maintain a Core Tier
1 Ratio of at least 9% by reference to the EBA recommendation
published on xx.
For the avoidance of doubt, the BCCS features do not prejudge
for the future regulatory framework to be applicable in accordance
with the final provisions for a Regulation on prudential requirements
for credit institutions and investment firms to be adopted by the
European Union.
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Additional Tier 1 Capital/Basel III
Implications
General approach to Tier 1 Instruments
Australia
Belgium
France
Germany
Italy
Non-deductible
and classified
as equity for
tax purposes.
Generally, required
to be franked
(exception if issued
by overseas
branch). Dividend
WHT applies
unless franked,
issued by overseas
permanent
establishment
or tax treaty
exemption applies.
Deductible unless
(cumulatively) no
fixed repayment
date, no entitlement
to repayment, and
repayment only
out of distributable
reserves. No WHT
if cleared through
the X/N clearing
system operated
by Belgian National
Bank.
Generally
deductible and no
WHT if not treated
as equity for French
GAAP.
Deductible if not
participating in
the issuer profits
and liquidation
proceeds (including
instruments with
a maturity of more
than 30 years).
Generally liable
to WHT.
Deductible if
payments not
related to the
issuer’s economic
performance and
therefore classified
as interest for the
investors.
Luxembourg
Netherlands
Spain
UK
U.S.
Generally
deductible and
no WHT if not
classified as
equity in the forms
provided by the
Luxembourg
company law and
treated as debt
for accounting
purposes.
Deductible and
most likely no WHT
if the instrument
remuneration is not
dependent on the
issuer profits, it is
not subordinated to
all creditors or has
a maturity not in
excess of 50 years.
Deductible and
no WHT if not
classified as equity
for Spanish GAAP.
Specific legislation
in respect of
certain qualifying
tax deductible
instruments
including preferred
shares.
Deductible if,
inter alia, the
instrument is not
equity nor “truly”
perpetual debt for
legal purposes,
the payments are
not dependent on
the results of the
issuer’s business
and the payments
do not exceed
a reasonable
commercial return
on the principal
secured. No WHT if
listed on a suitable
exchange.
Generally
deductible if,
inter alia, fixed
maturity date and
fixed redemption
amount.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Current non-core Tier 1 structures
Australia
Belgium
France
Germany
Italy
Given the tax
treatment,
Australian issuers
have tended to
issue through a
PE or subsidiary in
overseas location
where a tax
deduction
is available.
Rulings by the
Belgian Ruling
Commission have
confirmed that
an instrument is
deductible if, inter
alia, the return of
the instrument
is not linked to
profitability, its
principal amount is
due at maturity (the
conversion in equity
instruments is OK),
it is recorded as
debt for Belgian
GAAP and there is
an implied maturity
(eg step-up).
Since 2003, direct
issues of undated
and deeply
subordinated titres
super-subordonnés
(TSS); the
remuneration
is defined with
extreme flexibility,
including
non-payment
of interest.
Deductibility
confirmed during
Parliamentary
debates.
Issue of tax
deductible silent
participations
by public sector
banks. Other banks
issue instruments
out of foreign
subsidiaries which
remit the proceeds
back to Germany
under straight tax
deductible loans
which also resolves
WHT issues.
The instruments
issued since
2004 have a fixed
maturity (the life
of the issuer),
a remuneration
not tied to
the economic
performance of
the issuer and are
principal protected
(irrespective of
temporary
write-down).
Luxembourg
Netherlands
Spain
UK
U.S.
Use of, inter alia,
Luxembourg typical
silent partnerships.
Also issue of
instruments out
of Luxembourg
special purposes
vehicles qualifying
as Tier 1 on a
consolidated basis
by foreign banks.
Alternative Coupon
Satisfaction
Mechanism
(ACSM) is not
available since
2009. Instruments
with a maturity of
more than 50 years
may be acceptable
if due to certain
incentives (eg
step-up) they
are likely to be
redeemed before
the 50-year period.
Direct issue of
tax deductible
instruments since
2003, whereby
Spanish special
purposes vehicles
(fully controlled
by the relevant
Spanish financial
institutions) issue
preferred shares
into the market
and on-lend
the proceeds
to the financial
institutions,
generally in
the form of
tax deductible
subordinated
deposits.
Issue of
instruments
with Alternative
Coupon Settlement
Mechanisms
(ACSM), or through
indirect issuance
structures (ie
partnerships
issue interests to
investors and use
the proceeds to
subscribe plain
vanilla notes issued
by the financial
institutions).
Issue of trust
preferred securities
(TRUPs) to
investors, whereby
the trust invests
the proceeds into,
typically, 30-year
subordinated
instruments issued
by the U.S. financial
institutions (with a
deferred interest
mechanism).
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Impact of Basel III
Australia
Belgium
France
Germany
Italy
The instruments
eligible under Basel
III as Additional
Tier 1 Capital will
likely be classified
as equity (subject
to finalisation of
terms by Australian
regulatory
authorities).
The requirement
that the issuer
must have full
discretion to cancel
distributions may
be a significant
difficulty to achieve
deductibility
(subject to the
Belgian Ruling
Commission taking
a flexible view).
The TSSs should
continue to be
used under Basel
III, subject to
clarification of the
feature whereby
the remuneration
is paid out of
“distributable
items”.
More difficult
to structure
tax deductible
instruments,
especially given
the fact the
remuneration
must be out of
“distributable items”
and the perpetual
feature. Contingent
convertible bonds
should be used
given that they can
avoid a taxable
cancellation of the
principal amount at
the point of
non-viability.
WHT liability may
become a more
critical issue.
The instruments,
eligible under Basel
III and issued by
Italian banks, are
treated as bonds
for the investors
and interests are
tax deductible for
the issuer pursuant
to standard rules
irrespective from
their accounting
treatment.
Luxembourg
Netherlands
Spain
UK
U.S.
Luxembourg
should be an
efficient jurisdiction
for the issuance
of the contingent
convertible bonds.
It will be difficult,
but not impossible,
to structure Dutch
tax deductible
structures under
Basel III, especially
given the perpetual
feature (without
incentive to
accelerate).
Basel III should
not prevent
Spanish financial
institutions from
continuing to use
the tax deductible
preferred shares.
Difficult to structure
UK tax deductible
instruments, given
that the ACSM
and the indirect
issuances would
not be available
anymore. Possible
future amendments
to UK tax law to
enable issuance
of tax deductible
instruments.
The instruments
eligible under Basel
III will likely not be
eligible for debt
characterisation
under U.S.
tax principles
(especially given
the lack of a fixed
or ascertainable
maturity), though
debt treatment
may be possible
depending on
trigger criteria and
rate of conversion.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Australia
General approach to Tier 1 instruments under Australian tax law
In 2001 Australia introduced specific tax rules to deal with the classification of instruments
as either “debt” or “equity” for tax purposes (the Debt/Equity rules). The classification
under the Debt/Equity rules will then generally determine whether payments/distributions
on the instrument are deductible and the withholding tax consequences.
An instrument issued by a financial institution to raise capital will generally be classified as
equity if it satisfies one of the following requirements and is not also characterised as a
debt interest (or forms part of a larger interest that is characterised as a debt interest):
– the holder is a member or stockholder of the issuer;
– the return is in substance or effect contingent on the economic performance of the
issuer (including related parties);
– the return is at the discretion of the issuer (including related parties);
– the holder has a right to be issued with an equity interest in the issuer
(or a related party of the issuer); or
– it will or may convert into an equity interest in the issuer (or a related party of the issuer).
In contrast, an instrument issued by a financial institution to raise capital will generally be
classified as debt if the following requirements are satisfied:
– the financial institution (including related parties) has an “effectively
non-contingent obligation” to provide financial benefits to the holder
of the instrument; and
– it is substantially more likely than not that the total value of the financial benefits provided
will be at least equal to the issue price of the instrument.
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Special rules apply for determining the value of the financial benefits to be provided by
the issuer. Generally, if the term of the instrument is less than ten years, then the amounts
are valued in nominal terms. However, if the term is greater than ten years (or may extend
beyond ten years), then a present value test applies.
There are also special rules for determining whether the issuer has an “effectively
non-contingent obligation” (ENCO) to provide financial benefits to the holder of the
instrument. This requirement is one of the key considerations for the classification of
regulatory capital for tax purposes, particularly for Tier 2 instruments, where the obligations
to pay principal and/or interest may be subject to insolvency or capital adequacy type
conditions under the relevant prudential standards.
Under the Debt/Equity rules an issuer will have an ENCO where, having regard to the
pricing, terms and conditions of the scheme, there is in substance or effect a
non-contingent obligation to provide financial benefits under the scheme or on terminating
the scheme. An obligation will be non-contingent if it is not contingent on any event,
condition or situation (including the economic performance of the issuer) other than the
ability or willingness of the issuer to meet the obligation.
As a result of the prudential requirements to qualify as Tier 1 Regulatory Capital, Tier 1
capital instruments will generally be classified as equity for Australian tax purposes based
on the principles outlined above. In particular, the issuer will generally not have an ENCO
to provide benefits to the holder. This classification will have the following consequences
for Australian tax purposes:
– distributions on the instrument will not be deductible to the issuer;
– the issuer may be able to frank the distribution under Australia’s imputation system1;
– the distribution will be deemed to be a dividend for withholding tax purposes with the
following treatment depending on whether it is franked or unfranked:
– franked dividends – exempt from withholding tax;
–u
nfranked dividends:
–d
efault rate of withholding tax is 30%, subject to an applicable Double Tax
Agreement (DTA);
1. Australia has a full imputation system and the aim is to prevent the economic double taxation of
company profits. Tax at the company level is imputed to shareholders. Dividends paid out of taxed
company profits are generally “franked dividends” and dividends paid out of untaxed company profits
are generally “unfranked dividends”. Franked dividends are generally exempt from withholding tax.
Franking credits are subject to a number of anti-avoidance rules.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
–D
TA rate is generally 15%, however, the rate can be reduced further (to nil under
some DTAs) where certain major shareholding requirements are satisfied which
are unlikely to be applicable in the present circumstances (eg under the United
States DTA the withholding tax rate is reduced to 5% where the U.S. corporate
shareholder holds more than 10% of the voting power of the Australian company);
–e
xempt from withholding tax to the extent the unfranked dividends consist of
“conduit foreign income”. Aim is to effectively allow foreign investments to
pass-through Australia in an efficient manner.
–m
ay be exempt from withholding tax to the extent that the Tier 1 capital
instrument is issued through a foreign branch and used to fund the operations of
that foreign branch.
We also note that regulations have been issued to facilitate the treatment of certain Tier
2 capital instruments as debt for Australian tax purposes. The regulations clarify when
payment obligations in relation to certain term and perpetual subordinated notes can be
treated as constituting non-contingent obligations and potentially qualify as debt for tax
purposes under the debt test outlined above.
That is, insolvency or capital adequacy conditions for term subordinated notes and
profitability, insolvency or negative earnings conditions for perpetual subordinated notes,
that may have the effect of deferring a payment obligation do not prevent the obligations
from constituting non-contingent obligations. The subordinated notes must satisfy a
number of requirements to be eligible for this concession, including the following:
– Does not constitute or meet the requirements for a Tier 1 capital instrument;
–D
oes not form part of the Tier 1 Capital of the issuer or a related party;
–D
eferred payments must accumulate (with or without compounding); and
–D
oes not give the issuer an unconditional right to decline to provide a financial benefit
that is equal in nominal value to the issue price of the note to settle the obligations
under the note.
In addition, term subordinated notes must not have a term of more than 30 years and
must not contain an unconditional right to extend the term of the note beyond a total
term of 30 years. Perpetual subordinated notes are subject to the additional requirement
that they would be a debt interest but for the obligation being subject to one or more
profitability, insolvency or negative earnings conditions.
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Current Australian Tier 1 structures
Australian financial institutions and their subsidiaries have commonly used as a component
of their regulatory capital certain innovative hybrid capital securities that could be
characterised as debt for income tax purposes, despite having certain equity features.
However, given the Australian tax treatment outlined above, they have recently tended to
issue such instruments through overseas branches or subsidiaries located in jurisdictions
where a tax deduction would be available such as the UK, U.S., and New Zealand.
For example, Macquarie Bank has issued hybrid capital instruments through its London
Branch. Macquarie issued MIPS (Macquarie Income Preferred Securities) which were
Tier 1 eligible hybrid securities through a special purpose partnership controlled by
entities within the Macquarie Group (see the UK section below).
Previously, a popular structure for Australian financial institutions was to issue innovative
hybrid capital securities through overseas branches located in jurisdictions where a tax
deduction would be available, but to market the innovative hybrid capital securities to
Australian resident investors and attempt to attach a franking tax credit to distributions
on the securities that would be valuable to Australian resident investors. However, the
Australian Taxation Office found it offensive that distributions on the securities would
be both frankable and deductible (albeit deductible in a non-Australian jurisdiction) and
sought to apply franking credit anti-avoidance provisions to such securities. The ability of
the Australian Taxation Office to apply the franking credit anti-avoidance provisions was
upheld by the Full Federal Court in Mills v Commissioner of Taxation [2011] FCAFC 158.
The issuer financial institution has sought special leave to appeal the decision to the High
Court, Australia’s final court of appeal.
Impact of Basel III
Under Basel III, it is likely that, under current law, instruments qualifying as Additional Tier 1
Capital will not be eligible for debt classification for Australian tax purposes under the Debt/
Equity rules outlined above as there will not be an effectively non-contingent obligation on
the issuer to repay the issue price. As a result, the Australian tax consequences outlined
above for an equity interest will follow, including that the distributions would not be
deductible and dividend withholding tax could potentially apply. The Australian Government
is considering introducing new regulations to ensure that distributions on such interests
could continue to be deductible under Basel III, but it is also possible that the Australian
Government will conclude that special treatment for bank hybrids is not warranted.
Australian financial institutions may continue to issue hybrid instruments through an
overseas branch in order to obtain a tax deduction, subject to the requirements of the
particular jurisdiction and the intended use of the funds. Subject to satisfying certain
requirements, distributions paid on such hybrid instruments should not generally be
subject to Australian withholding tax and also should not be frankable distributions.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Buffer Convertible
Payments on the BCCS instrument would not be deductible in Australia because the
instrument would be treated as equity for Australian tax purposes. All convertible instruments
are treated as equity for Australian tax purposes unless conversion can occur only at the
option of the holder of the instrument, and the BCCS instrument provides for mandatory
conversion on the occurrence of a Contingency Event or a Viability Event. Independently,
perpetual instruments are treated as equity for Australian tax purposes unless they provide
for guaranteed minimum interest payments, and the BCCS instrument is a perpetual
instrument that allows Optional Coupon Cancellation and Mandatory Coupon Cancellation
on a non-cumulative basis.
Andrew Stals
Partner
Tel +61 2 9373 7857
andrew.stals@allenovery.com
www.allenovery.com
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Belgium
General approach to Tier 1 Instruments under Belgian Tax Law
Belgian tax law does not provide general rules for the treatment of hybrid instruments such
as Tier 1 instruments.
Whether or not for Belgian corporate income tax purposes a Tier 1 instrument should be
regarded as a loan or equity, is determined by reference to the classification of such Tier 1
instrument under Belgian civil law. If the funds put at the disposal of the issuer are subject
to the corporate risks of that company, the payments will generally not be classified as
interest payments from a tax perspective, regardless of the classification given to the
payments by the parties. In that case, the payments will be viewed as non-deductible
dividend distributions attracting dividend withholding tax (but the issuer should be able to
include this financing in the calculation basis for the “notional interest deduction”, which is
a tax deduction calculated on the company’s equity).
Funds will typically be viewed as being subject to the corporate risks if (cumulatively) there
is no formal entitlement to repayment of the principal amount, there is no fixed repayment
date and the repayment is only due to the extent that the debtor has “distributable
reserves” within the meaning of Belgian Company Law.
The following features are “as such” not sufficient to classify a financing instrument as
equity financing:
– Perpetual. The existence – or not – of a maturity date is not essential to its
characterisation as a loan, as the Belgian Civil Code expressly recognises the perpetual
loan. The issuer must however have the right to repay the loan at any time.
– Profit-participating remuneration. The administrative guidelines expressly stipulate
that a profit-participating interest payment is classified as interest.
– Convertibility into shares in the debtor, including automatic conversion. The
administrative guidelines analyse the conversion as an attribution (by the issuer to the
investor) of the principal amount and unpaid interest to the investor, followed by the
contribution (by the investor) of its claim (relating to the principal amount and unpaid
interest) to the capital of the issuer in exchange for shares. As the investor is formally
entitled to the repayment of the principal amount, the convertible financing instrument
is technically debt financing. Furthermore, the Belgian Commission for Accounting
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Standards has stated that automatically convertible bonds should be analysed as debt
instruments until the conversion takes place.
– Payment of interest “in kind”, in the form of shares of the issuer (alternative coupon
satisfaction mechanism). Similarly to the conversion of a convertible bond, the payment
in kind should be analysed as an attribution of interest (by the issuer to the investor)
followed by a contribution of the interest claim (by the investor) to the capital of the issuer
in exchange for shares. Therefore, the interest is technically paid.
– Subordination and thin-capitalisation. The Supreme Court has ruled that funds (which
were formally put at the disposal of the company in the form of the subscription of a
bond) were not subject to the enterprise risk (and could therefore not be classified as
equity), in a case where the bond was not secured. The company was thinly capitalised
and the compensation was profit-participating.
In 2012, a new general anti-abuse provision was introduced, pursuant to which it will be easier
for the Belgian tax authorities to reclassify a debt instrument as an equity instrument, provided
that the tax authorities can demonstrate that the initial classification as a debt instrument
constitutes a tax abuse. We do not believe that this general anti-abuse provision should be
applicable to Tier 1 instruments, given the non-tax benefits of issuing Tier 1 instruments.
Current BELGIAN Tier 1 structures
The Belgian Ruling Commission has confirmed the principles outlined above in several
(all unpublished) advance rulings relating to (directly issued perpetual) Tier 1 instruments
issued by banks, insurance companies and corporates. In its advance rulings, the Ruling
Commission focuses on the intention of the parties: the Tier 1 instrument is classified as
a debt instrument if the parties’ intention is to enter into a loan relationship, and refers
typically to the following elements:
– the return is determined in advance (fixed rate or floating rate), and is not linked to the
profitability of the issuer;
– on redemption, the investors are only entitled to the principal amount, which is not the
case for shareholders;
– the investors have no voting rights as shareholders; they are only entitled to the rights
granted to bond holders;
– the instrument is recorded as debt for Belgian GAAP purposes (note that the IFRS
classification is not relevant); and
– although the instrument has no fixed maturity date, there is an implied maturity date
(eg step-up; underlying pricing; intention of the issuer to redeem taking into account
the high interest rate of the instrument).Note that, to our knowledge, no Tier 1
instruments have been issued whereby loss absorption was structured as a principal
write-down, due to “haircut” issues (the Belgian Regulator takes into account the
potential tax liability triggered by a write-down, despite the fact that it can be expected
that no effective tax liability will arise because of the availability of tax losses). The loss
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absorption has therefore been structured as a conversion to profit-sharing certificates or
shares at face value, which does not generate a taxable profit.
The classification of Tier 1 instruments as debt instruments is crucial, as no withholding tax
exemption is available in relation to dividend distributions. In relation to interest payments,
a withholding tax exemption is available if the financing instrument is cleared through the
X/N clearing system operated by the Belgian National Bank.
Impact of Basel III
Under Basel III, the biggest challenge for structuring tax-efficient Tier 1 instruments relates
to the requirement that the issuer must have full discretion to cancel distributions, as this is
not consistent with the concept of a loan relationship under Belgian civil law. However, as
the Ruling Commission takes into account all features of the financing instrument, it may
still be possible to convince the Ruling Commission that the parties’ intention is to enter
into a loan relationship. This will be very difficult, however, in case a write down/write up
mechanism is being used.
Buffer Convertible
It follows from the above that it is unclear whether Tier 1 instruments such as BCCS
Instruments could give rise to interest tax deductibility and withholding tax exemption.
Positive elements are that the claim of the investors in the event of a winding-up or
administration is an amount equal to the principal amount plus accrued interest, and
that a write-down takes the form of a conversion (assuming such conversion triggers a
capital increase equal to the principal amount plus accrued interest). The Optional Coupon
Cancellation is, of course, a negative element, as well as the investors’ option to convert
the instruments into shares (as this would affect the argument that the parties’ intention is
to enter into a loan relationship).
Patrick Smet
Stéphanie Houx
Partner
Tel +32 2 780 2431
Counsel
Tel +32 2 780 2487
patrick.smet@allenovery.com
© Allen & Overy LLP 2013
stephanie.houx@allenovery.com
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
France
General Approach to Tier 1 Instruments under French Tax Law
In principle, the French tax treatment of a given instrument would follow its French GAAP
characterisation (ie non-consolidated financial statement). Accordingly, the remuneration
due in respect of all types of instruments representing the share capital of the issuer
(whether ordinary shares, preferred shares, etc) would be non-deductible, whereas the
remuneration in respect of all other instruments would be tax deductible (subject to usual
caveats, such as thin-capitalisation limitations, arm’s length remuneration, etc). Similarly,
an equity linked instrument, such as a convertible bond (whether the conversion is optional
or compulsory), would be treated as tax deductible until any conversion, and as
non-deductible afterwards.
As exceptions to the above principle, the French tax administration has the right (subject
to courts’ review) to recharacterise a given instrument either:
– under the so-called abuse of law procedure (form versus substance), whereby, if the
structuring of a given instrument is fictitious or purely tax motivated, the tax treatment
would follow its substance rather than its legal form; or
– under the general power of the administration to interpret the various terms and
conditions of an instrument to decide its qualification (whatever the legal denomination
provided by the parties to the instrument).
In reality, the instances where the administration has effectively recharacterised a debt
instrument into an equity one, under the abuse of law test, are rather rare, and, to the
best of our knowledge, none of these instances have included the recharacterisation
of Tier 1 instruments.
As to the question of what type of terms and conditions may lead the administration
to qualify an instrument as debt, a regulation they have issued (in 2010) in respect of
Islamic bonds (sukuks) is probably a good indication of what would be their guidelines
in that respect:
– the instrument must be senior to all the shareholders of the issuer;
– there must be no voting rights attached to the instrument;
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– there must be no claim in respect of any liquidation “bonus” in case of liquidation
of the issuer;
– the remuneration of the instrument may be indexed to the profits of the issuer,
or to certain of its assets, without jeopardising the debt nature of the instrument; and
– the redemption amount of the instrument may be less than the issue price (as a
consequence of an indexation) without jeopardising the debt nature of the instrument.
Current French Tier 1 Structures
Over the years, a combination of relevant legislation and market practice has
enabled French financial institutions to issue tax deductible instruments eligible
to Tier 1 qualification.
In the 1990s, at the time where the French legislation would not allow a direct issuance of
Tier 1 type instruments, French financial institutions would use the so-called “double Tier”
structures, whereby:
– a non-French special purpose vehicle controlled by the financial institution (typically a
U.S. LLC) would issue preferred shares into the market (directly or through a trust); and
– the vehicle would then on-lend the proceeds of the preferred shares back to the
financial institution (or its subsidiaries) in France, in the form of a tax deductible
subordinated instrument.
In 2003, the French legislation was modified to introduce the so-called TSS (titres super
subordonnés) with the clear objective (as evidenced by the Parliamentary debates) to
enable the French financial institutions to issue direct tax deductible instruments eligible for
Tier 1 qualification. The TSSs are, essentially, undated, subordinated to all other creditors
of the issuer, and provide extreme flexibility in terms of definition of the conditions under
which any remuneration would be due. As a consequence, and given the fact that the tax
administration has been implicitly and explicitly (through private rulings) very liberal with
the tax deductibility of the TSSs, the latters are the preferred choice of French financial
institutions when issuing tax deductible Tier 1 instruments.
Impact of Basel III
The introduction of Basel III should not prevent the TSSs from continuing to be the
instrument of choice for French financial institutions, given that:
– subordination: the TSS is subordinated to all other creditors of the issuer, being only
senior to its shareholders;
– perpetual: the TSS is perpetual;
– conversion into ordinary shares: the TSS would be treated as tax deductible
until its conversion;
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
– write-down of the principal amount at specific trigger points: the French market practice
already includes tax deductible instruments the principal amount of which may be
reduced by reference to an index (obviously the written down amount would be taxable
for the issuer); as discussed above, the French administration, in its regulation on the
Islamic bonds, has accepted this practice; and
– distributions paid only out of distributable items: this should not be an issue, as long as
it is clear that the “distributable item” would be understood as an amount computed
by reference to certain elements of the issuer’s P&L, as opposed to the legal definition
of “distributable profits” which refers to the amount out of which only (non-deductible)
dividends could be distributed; as discussed above, the French administration has
accepted that the remuneration for debt instruments may be indexed to the profits
of the issuer without jeopardising its deductibility.
Buffer Convertible
The tax treatment of the BCCS, structured as a convertible TSS, should follow the same
principles as above, ie it should be analysed, in principle, as a tax deductible instrument.
Any conversion would not create any taxable item for the issuer.
Jean-Yves Charriau
Mathieu Vignon
Sophie Maurel
Partner
Tel +33 1 40 06 53 60
Partner
Tel +33 1 40 06 53 63
Counsel
Tel +33 1 40 06 53 72
jean-yves.charriau@allenovery.com
mathieu.vignon@allenovery.com
sophie.maurel@allenovery.com
www.allenovery.com
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Germany
General Approach to Tier 1 Instruments under German Tax Law
There are two issues to be considered when structuring Tier 1 instruments for German
issuers. One is the deductibility of interest expenses for the issuer, the other one
withholding tax on interest payments to the investors.
– German tax law does not provide general rules for the treatment of hybrid instruments
such as Tier 1 instruments. However, tax practitioners apply the existing rules for profit
participating rights (Genussrechte) as a benchmark when considering hybrid instruments
in general. Under these rules distributions on a debt instrument are non-deductible if the
investor participates in the issuer’s profits and liquidation proceeds.
A participation in the issuer’s profits obviously exists if distributions on the instrument
are linked to the issuer’s profits but also if the investor receives a fixed coupon which
is only payable from the issuer’s profits. However, the present practice does not regard
distributions related to other financial parameters, such as the debt/EBITDA ratio or a
dividend pusher as profit related. The same is true for subordinated debt instruments
and instruments with a mere loss participation.
A participation in the issuer’s liquidation proceeds will be presumed if the investor
participates in the issuer’s built-in gains or if the capital is only repaid upon liquidation
of the issuer, eg where the instrument is perpetual. Further, a participation in the issuer’s
liquidation proceeds is presumed if the instrument participates in losses but redeems at
par value or if the instrument is convertible into equity and the conversion is commercially
compelling. The tax authorities have held that an instrument with a maturity of more than
30 years will also be considered to participate in the issuer’s liquidation proceeds. However,
according to the German Supreme Tax Court an instrument not providing for a repayment
of principal does not grant a participation in the issuer’s liquidation proceeds although the
tax authorities announced that they will not follow this ruling.
– In general, Germany does not impose withholding tax on interest payments to
non-residents. However there are a number of important exceptions to this rule. In
particular, a German issuer is required to withhold tax at a rate of 26.375% from interest
payments on the following hybrid instruments: profit participating rights
(Genussrechte/Genussscheine), participating loans (partiarische Darlehen),
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
profit participating bonds (Gewinnschuldverschreibungen), convertible bonds
(Wandelschuldverschreibungen) and silent participations (stille Gesellschaften). Since
interest payments on hybrid instruments are generally contingent on the issuer’s profits
or other performance criteria, Tier 1 instruments are subject to the withholding tax if
issued out of Germany. No relief may be available under many of the recent German
double taxation treaties if the interest is contingent on the profits of the issuer or
otherwise performance related and deductible for the issuer in Germany.
Current German Tier 1 Structures
Closely held banks such as the public sector banks (Landesbanken, Sparkassen) often used
silent participations to raise Tier 1 capital. These were subscribed by their shareholders
allowing the bank to deduct interest payments on such instruments.
Other banks often issued Tier 1 instruments out of a foreign subsidiary (typically a
Delaware LLC). The foreign issuer forwarded the issuing proceeds to the bank under
a straight loan. This allowed the bank to treat the instrument as Tier 1 capital on a
consolidated basis while ensuring that the consideration payable to the ultimate investors
was deductible in Germany while at the same time avoiding German withholding tax.
Impact of Basel III
Basel III and its implementation by Capital Requirements Regulations (CRR) will
fundamentally change the structuring of Tier 1 instruments for German banks.
Distributions on Common Equity Tier 1 instruments will generally not be deductible if these
are issued by banks organised as stock corporations. Effectively, these banks may only treat
common shares as Common Equity Tier 1. The dividends payable on common shares are
not deductible.
Additional Tier 1 Capital must, among other things, have a perpetual term and distributions
must be discretionary and may only be made from “distributable items”. Under the rules
discussed above consideration payable under a financial instrument is non-deductible if the
instrument grants the investor a participation in the issuer’s profits and liquidation proceeds.
The CRR limits distributable items to the “profit of the period for which the distribution is paid
plus any reserves which according to national company law may be distributed following a
decision of the owners of the institution”. One may argue that this does not necessarily entail
a profit participation since distributions may also be made from profits that have accrued
prior to the issuance of the instrument. Also, according to the CRR the distributions must be
at the discretion of the issuer. One may conclude from this that Additional Tier 1 Capital is
not profit participating because, even if there is a profit, the bank may still cancel the coupon.
Under CRR, issuing out of a foreign subsidiary that on-lends the issue proceeds to the
bank may no longer be a means to overcome non-deductibility and avoid withholding tax
on distributions because under the CRR the on-loan itself must also meet the criteria of
the relevant category of regulatory capital.
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Additional Tier 1 instruments must either provide for a write-down of principal or a
mandatory conversion into common shares if the bank otherwise becomes non-viable.
For German issuers the conversion feature will generally be preferable because, unlike
a write-down, a conversion into equity does not give rise to taxable income from the
cancellation of debt. In this regard one may expect the issuance of contingent convertible
bonds (CoCos) by German banks.
Distributions on Additional Tier 1 instruments may suffer German withholding tax if the
interest payable is contingent on the issuer’s profits or is otherwise performance related
or if the instrument is convertible into equity of the issuer. To avoid withholding tax that
reduces the return for investors, tax efficient structuring should be used that effectively
eliminates the cost of the withholding tax.
Structuring Tier 1 instruments under the CRR in a tax-efficient manner will be more difficult
than before. On the one hand Tier 1 instruments must be more equity-like in order to
qualify as regulatory capital. This makes a tax deduction for distributions more difficult to
achieve prior to further guidance of the tax authorities being available. We would expect
that contingent convertible bonds would be the instrument of choice for German banks
when issuing Additional Tier 1 instruments since they avoid cancellation of debt income
if the trigger is breached. Further structuring will be required to avoid withholding tax on
distributions on financial instruments qualifying as regulatory capital.
Buffer Convertible
The same rules as explained above would apply to BCCS. This is because they have
similar features (perpetual term and interest payments only out of “distributable items”) as
Additional Tier 1 instruments under the CRR with a contingent conversion feature.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Eugen Bogenschuetz
Dr Gottfried E. Breuninger
Dr Asmus Mihm
Partner
Tel +49 69 2648 5804
Partner
Tel +49 89 71043 3302
Partner
Tel +49 69 2648 5796
Dr Heike Weber
Klaus D. Hahne
Partner
Tel +49 69 2648 5879
Counsel
Tel +49 69 2648 5474
eugen.bogenschuetz@allenovery.com
heike.weber@allenovery.com
gottfried.breuninger@allenovery.com
asmus.mihm@allenovery.com
klaus.hahne@allenovery.com
www.allenovery.com
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Italy
General approach to Tier Instruments under Italian Tax Law
– In principle, financial instruments are treated as equity for Italian tax purposes if they
participate in the stock capital or equity of the company for the purposes of the Italian
Civil Code or are linked to the economic performance of either the issuer, a company
of the same group or a certain business.
Consequently, interest payments are tax deductible for the portion of such payments that
is not linked to the performance of the issuer, a company of the group or a business.
Nonetheless, for IFRS adopters (ie entities which adopt IAS/IFRS in their balance
sheet, which include Italian banks) the taxable income is determined on the basis of the
qualification, imputation and classification criteria provided by IFRS.
Regarding the tax treatment of payments under Tier 1 instruments, it was debated
whether the accounting treatment of (a portion of) such instruments as equity according
to IFRS should have been adopted also for tax purposes, causing the non-deductibility
of the relevant payments or, if on the contrary, the tax classification criteria for financial
instruments should have, in any case, prevailed irrespective of the accounting analysis.
The Decree of the Italian Ministry of Economy and Finance of 8 June 2011, published
in Official Gazette No. 135 of 13 June 2011 (Decree 135), has finally set out that the
tax criteria should prevail over accounting principles in the classification of financial
instruments as debt or equity.
Therefore, if debt instruments pay proceeds at a rate unrelated to the issuer’s
performance (or the performance of a company belonging to its group or a business),
eg as per fixed rate or floating rate notes, the relevant payments should be tax
deductible for the issuer according to the provisions set out in the Decree 135.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
– Withholdings and deductions may apply to payments made under financial instruments
issued by Italian banks to non-Italian resident investors.
Limiting this analysis to financial instruments having an initial maturity of at least
18 months or more, if such instruments are classified as debt for tax purposes (see
above for the relevant classification criteria), the withholding tax regime applicable to
non-Italian resident investors would depend on their classification as either:
(i) bonds (obbligazioni) or securities assimilated into bonds (titoli assimilati alle
obbligazioni); or
(ii) “atypical securities”.
Debt instruments qualify as bonds or similar securities (see (i) above) if they are principal
protected, ie they embed the obligation of the issuer to repay 100% of the principal
invested upon redemption and (as a consequence) have a predetermined maturity
(ie they cannot be purely perpetual instruments).
Such instruments benefit from a tax exemption from Italian withholding taxes, provided
that the non-Italian investor: (a) is resident for tax purposes in a country which exchanges
information with the Italian tax authorities (so-called “white-listed” countries); (b) is the
beneficial owner of the payments; and (c) complies with certain formalities.
If the debt instruments are not principal protected or are “perpetual” (ie notes with no
maturity), they fall within (ii) above. Payments made under atypical securities are subject
to a withholding tax of 20%, which may be reduced under double taxation treaties
(typically to 10%), but are usually not completely eliminated.
Current Italian Tier 1 Structures
Tier 1 capital instruments issued in Italy before the Basel III provisions (ie those set up from
2004 onwards) were generally treated as bonds, on the following grounds:
(a) they had a fixed maturity (even if, in certain cases, linked to the duration of the issuer);
(b) payments were calculated as a fixed or floating percentage (eg 5% or EURIBOR plus
a margin) rather than on the basis of the economic performance of an entity or a
business (eg 5% of the issuer’s profits). Please note that ongoing payment clauses
per se do not affect this conclusion; and
(c) they were principal protected, irrespective of any temporary write-down provision.
Indeed, the nominal value was automatically written up in case of redemption of the
securities or liquidation of the issuer. This is a crucial difference with new Tier 1 capital
instruments, in which the write-down is permanent.
In general, being treated as bonds, previous Tier 1 capital instruments allowed non-Italian
resident investors (under certain conditions) to benefit from a tax exemption from Italian
withholding taxes (see paragraph 1 above).
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Impact of Basel III
As part of the bail-in provisions, Basel III requires a permanent write-down of Tier 1 capital
instruments if a trigger event occurs.
Such feature seems to prevent these instruments from qualifying as “bonds or securities
assimilated into bonds” for Italian tax purposes, since they cannot be considered
“principal protected”.
Nonetheless, the Italian Banking Act (see Article 12) qualifies these instruments as
obbligazioni bancarie, ie banking bonds.
On this basis, Law Decree No. 138 of 13 August 2011, converted into law by Law No.
148 of 14 September 2011 (Law Decree 138), provides that financial instruments which
are neither shares nor assimilated into shares, issued as of 20 July 2011 by financial
intermediaries subject to prudential supervision by the Bank of Italy or the Supervisory
Authority for Insurance companies (ISVAP), in compliance with the capital requirements set
out by EU regulations and Italian prudential regulations, are treated for Italian tax purposes
as bonds or securities similar to bonds.
As clarified by the Italian Revenue Agency (Agenzia delle Entrate) with Circular No.11/E
of 28 March 2012, in order to qualify for this tax treatment, these instruments should be
qualified for the supervisory capital of the issuer pursuant to EU and national regulations
applicable on the issue date. The Circular includes Basel III-compliant Tier 1 capital
instruments among those qualified to be assimilated to bonds for tax purposes.
This clarification allows non-Italian resident investors to benefit from an exemption from
Italian withholding taxes on payments received under the instruments.
From a different perspective, the deductibility of the relevant payments would depend
on the classification of the instruments as debt for tax purposes, ie on the absence of
any link to the performance of either the issuer, an entity of its group or a business in the
terms and conditions of the instruments (see paragraph 1 above), irrespective of their
accounting treatment.
Under these conditions, as clarified in the Law Decree 138, payments made under these
instruments should be tax deductible within the ordinary limits applicable to the issuing bank.
Contingent Capital Instruments (CoCos) generally provide for a mandatory conversion
of the original debt instruments into equity, upon the occurrence of a trigger event.
Also, these instruments should be qualified as Italian banking bonds subject to the
above tax treatment.
Tier 1 capital instruments must either provide for a write-down of principal or a mandatory
conversion into common shares upon the occurrence of certain viability events. There
is no official guidance on the tax treatment applicable to conversion or write-down, so
that each of these events should be further reviewed, also taking into consideration the
applicable accounting treatment. As far as the write-down is concerned, adopting a
conservative approach, a taxable event should in principle occur, irrespective of whether
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
such write-down is temporary or permanent. With reference to the mandatory conversion
of (all or part of) the principal into equity, different interpretations can be identified and the
absence of official guidelines do not allow us to reach a final conclusion. According to
the preferable interpretation, which would also be in line with the tax treatment applicable
in other European States, the conversion should in principle not lead to a taxable event,
if it does not result in a capital gain for accounting purposes. These conclusions should
be confirmed/revised according to the position that the tax authorities may take or the
development of a future practice.
Buffer Convertible
The calculation amount for the Coupon is not specified in the T&C. However, it is likely
that the Coupon will be calculated at a fixed or floating rate and, in any case, it will not be
expressed as a percentage of the economic performance of the issuer, a company of the
same group or a certain business. On this basis, proceeds accrued under the BCCS will
be deductible for Italian issuers within the general limits provided by the Italian corporation
tax law for interest payables. This tax deductibility is based on general provisions and,
as far as capital instruments are concerned, is also confirmed by Law Decree 138. The
cancellation of the Coupon on an optional or mandatory basis, as provided in the terms
and conditions of the BCCS, do not affect this analysis.
Francesco Guelfi
Francesco Bonichi
Partner
Tel +39 02 290 49659
Partner
Tel +39 06 684 27566
francesco.guelfi@allenovery.com
francesco.bonichi@allenovery.com
www.allenovery.com
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Luxembourg
General Approach to Tier 1 Instruments under Luxembourg Tax Law
There are no specific laws or regulations in Luxembourg governing the treatment of hybrid
instruments. This offers, to a certain extent and subject to Luxembourg public order
provisions, flexibility to credit institutions to devise instruments qualifying for additional
common equity Tier 1 for regulatory purposes combined with the ability to deduct
payments made thereunder from a tax perspective.
Schematically, if an instrument is classified as equity (eg equity in the forms provided for by
the Luxembourg company law such as ordinary shares, voting or non-voting preference
shares, founder shares), the remuneration on the instrument is not deductible and subject
to withholding tax. Conversely, if an instrument is classified as debt, remuneration on
the instrument is deductible and no withholding tax applies (subject however to certain
restrictions such as, for instance, thin capitalisation rules or the rules implementing in
Luxembourg the EU Savings Directive which should not, in principle, be relevant for
instruments issued by credit institutions to third parties to raise additional common
equity Tier 1).
In practice, due to the existence of instruments with hybrid features, the distinction
between equity and debt has become less easy. It is therefore necessary to form a view
on the basis of general principles of Luxembourg tax law and on the basis of an analysis
of the features of the instruments.
According to the so-called principle accrochement du bilan fiscal au bilan commercial,
Luxembourg corporate income taxes are generally based on the commercial accounts
subject however to the adjustments required by the Luxembourg tax law. As a result and
in the absence of any specific tax adjustments, the payments made by an issuer under a
hybrid instrument should only be tax deductible if the instrument is accounted for as debt
in the issuer’s commercial accounts and the payments are booked as an expense in its
P&L accounts.
However, in determining the classification of a tailored hybrid instrument as either debt
or equity, the Luxembourg tax administration may use the so-called wirtschaftliche
Betrachtungsweise (economic analysis) which basically corresponds to the “substance
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
over form” approach. The global assessment of the hybrid instrument should then result
from a bundle of indicators such as the long-term nature of capital invested, the ranking
of the instrument, the right for the investor to participate in the profits and/or hidden
reserves and/or liquidation proceeds of the issuer, the method of determination of the
remuneration of the investor (fixed/variable), convertibility features, the possibility for the
investor and/or the issuer to call the instrument, the corporate governance rights attached
to the instrument (voting rights, rights to participate in collective decisions or to obtain
information, etc).
Current Luxembourg Tier 1 Instruments
A circular issued by the Luxembourg regulator (Commission de Surveillance du Secteur
Financier) and transposing the provisions of CRD I and CRD II into Luxembourg banking
regulations (Circular 06/273 as amended) sets forth the characteristics of instruments
qualifying as original own funds (fonds propres de base) and provides some examples of
hybrid instruments that may be eligible for inclusion in this category, provided they meet
certain requisites (eg stille Beteiligungen).
The Luxembourg silent partnership concept (stille Beteiligungen or stille Gesellschaft)
derives from German law. From a Luxembourg tax perspective and subject to proper
structuring, a typical silent partnership where the silent partner contributes to the assets
of the issuer and participates in the issuer’s profits but appears to third parties as a simple
creditor may be used to get a tax deduction on the payments made to the silent partner.
As Luxembourg is one of the main financial centres in Europe, Luxembourg special
purpose vehicles have also been used by foreign banks to issue instruments in various
forms qualifying for regulatory purposes on a consolidated level.
Impact of Basel III
The existing Luxembourg banking regulations on original own funds already incorporate
certain of the Basel III requirements.
– While the current Luxembourg banking regulations require that hybrid instruments are
undated instruments or have a maturity of not less than 30 years, Basel III will require
the instruments to have no maturity date and no incentives to be redeemed. We will
have to wait for Luxembourg implementation measures to see how such requirement
could fit with the Luxembourg general principle of contractual freedom pursuant to which
any contractual agreement without a defined maturity may be terminated ad nutum
at the discretion of either party (principle of Luxembourg civil law likely to be regarded
by Luxembourg courts as a matter of international public policy). We will also have to
assess the impact of such perpetual requirement on the classification as debt or equity
of hybrid instruments for Luxembourg tax purposes.
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– Debt instruments convertible into shares of the issuer are in principle treated as debt
for Luxembourg tax purposes until their conversion and interest accruing on such debt
instruments are in principle tax deductible until such conversion. No registration duties
are due on the issuance of these instruments. The conversion of such instruments into
shares of the issuer upon the occurrence of solvency related trigger events is no longer a
taxable event for the issuer further to the abolition of capital duty in Luxembourg in 2009,
and may be tax neutral for a Luxembourg corporate holder.
If loss absorption is structured as a write-down of the principal of the instrument
(permanently), it will be treated as a taxable income for the issuer save the possible
so-called exemption “stabilisation gain” (debt waiver) which applies when the write-down
is granted with the intention of financially re-establishing the debtor but only to the extent
that the result of the write-down is a profit. If the debtor is in a loss position, its tax losses
carried forward will be reduced to offset the taxable profit up to the amount of the
write-down.
– It has been written that Luxembourg may turn out to be an efficient jurisdiction for the
issuance of CoCos by credit institutions that wish to raise additional common equity
Tier 1 in the coming years to meet their future requirements under Basel III/CRD IV.
CoCos are hybrid instruments and as such may be structured in different ways. For
a Luxembourg issuer eager to classify CoCos as additional common equity Tier 1,
contingent convertible bonds unsecured and unsubordinated with a fixed or floating
interest rate and convertible into a fixed number of shares of the issuer if capital
ratios fall below a certain level might be an attractive instrument from a Luxembourg
tax perspective. The issuance of CoCos should not be subject to any ad valorem
registration duties. Interest paid under the CoCos should in principle be deductible and
not subject to any Luxembourg withholding tax. Interest should in addition be nontaxable in Luxembourg for a non-Luxembourg corporate holder. Finally, the conversion
of the CoCos into shares of the issuer should not trigger any Luxembourg corporate
income taxes.
Buffer Convertible
From a Luxembourg perspective, to qualify the BCSS as debt or equity, one would have to
determine whether it has more debt or equity features. In the case it is qualified as a debt
instrument, the interest should be deductible and should not be subject to withholding tax,
except under the EU Savings Directive. The fact that the instrument carries an interest and
is senior to ordinary shares should point to the direction of debt qualification. However,
the Optional coupon cancellation and the Mandatory coupon cancellation are elements
of equity characterisation. A conversion feature as such is not problematic to establish
debt qualification, as convertible debt instruments are usually considered as debt, from
a Luxembourg tax perspective, prior to conversion. On balance it should be possible
to sustain the debt qualification, prior to conversion, under the assumption that such
qualification is in line with the accounting treatment applied by the issuer.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
Patrick Mischo
Jean Schaffner
Partner
Tel +352 44 44 55 429
Partner
Tel +352 44 44 55 410
patrick.mischo@allenovery.com
jean.schaffner@allenovery.com
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Netherlands
General Approach to Tier 1 Instruments under Dutch Tax Law
Whether or not for Dutch corporate income tax purposes a Tier 1 instrument should
be regarded as a loan or equity, is determined by reference to the classification of such
Tier 1 instrument under Dutch civil law. Under case law exceptions to this rule have
been formulated. For example, a loan granted under such conditions that the lender
is considered to participate in the business of the borrower is regarded as equity for
corporate income tax purposes. Hence the interest paid or accrued is not deductible for
corporate income tax purposes and may be subject to Dutch dividend withholding tax.
The relevant requirements for a reclassification developed in case law are:
(i) the remuneration on the loan is dependent on the profit;
(ii)
the loan is subordinated to all other lenders; and
(iii)the loan has no term or a perpetual term, which is, based on case law, considered
to be the case if the loan has a term in excess of 50 years, while the loan can only
be called in prematurely by the lender in the event of a liquidation, suspension of
payments or bankruptcy of the borrower.
If the remuneration on a loan is fixed but payable only in the case of a distribution of
profits, whilst at the same time any unpaid remuneration is accruing, such remuneration
is not dependent on the profit of the borrower.
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Current Dutch Tier 1 Structures
– In the past, to enjoy the debt classification of Tier 1 instruments for corporate income
tax purposes, instruments were commonly used subject to an Alternative Coupon
Satisfaction Mechanism (the ACSM). Under the ACSM payments of unpaid coupons
are deferred and paid from the cash raised by issuing shares in the market. The tax
authorities were usually willing to confirm the debt classification of such instruments
based on the fact that coupon payments on such instruments would (even though not
payable) always become due, with or without distributable items available. Therefore,
the coupon on such loans would not be considered to be dependent on profit.
Under the CEBS/EBA rules of 2009 and rules of the Dutch Central Bank currently in
force, this is no longer an option. It is no longer allowed to issue shares or other Tier 1
instruments in the market and pass on cash proceeds to pay any deferred coupons.
Instead the investors should be given the shares as payment in kind. Since this is not an
interesting structure for investors and interest cannot be deducted for Dutch corporate
income tax purposes if the interest is paid by way of shares, these instruments have not
been used in practice. The most recent Basel III rules even prohibit ACSM altogether and
require coupons to be cancelled instead of deferred.
– In individual cases issuers of Tier 1 instruments relied on the debt classification of their
instruments on the fact that their instruments, due to an interest rate step-up or other
similar incentives, would highly likely be redeemed before the 50-year period. As a result,
such instruments were not considered to have a perpetual term and issuers were able
to deduct interest on such instruments, despite the perpetual term of these instruments.
The Dutch tax authorities did grant some tax rulings confirming that such instruments
did not classify as equity for Dutch tax purposes, based on the fact that the Instruments
would highly likely be redeemed after 30 years. Tier 1 instruments can no longer have an
incentive to be redeemed under Basel III.
The only Tier 1 instruments that currently have been used in the Dutch market that classify
both as Tier 1 under Basel III and as debt for Dutch corporate income tax purposes are
perpetual instruments that have: (i) an option to be redeemed; and (ii) the issuer of such
instruments has undertaken that he will redeem these instruments after a 30-year period.
This undertaking is subject to certain restrictive conditions, including the restriction that
the instruments will only be redeemed in the case that the issuer of the instruments can
replace the Tier 1 instruments with capital or other Tier 1 instruments to the same amount
as the instruments that are redeemed. We understand that in the past the Dutch tax
authorities have granted tax rulings to confirm the debt classification of such instruments,
based on the likelihood that the instruments will be redeemed after 30 years.
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For the classification of an instrument the Dutch tax authorities strongly focus on the
presence of a legal obligation to repay the instrument within 50 years. If an instrument
does not have a legal repayment obligation within 50 years or in the case that such legal
obligation can be postponed at the discretion of the issuer, an instrument has, in the
view of the Dutch tax authorities, a term in excess of 50 years. In recent discussions, the
Dutch tax authorities have taken the position that an undertaking to redeem a perpetual
instrument after 30 years under the conditions that (i) the issuer of such instrument
declares or pays a dividend within a certain period before the redemption date, and
(ii) the issuer of such instrument has raised capital or equally qualifying instruments to
replace the instrument to be redeemed, is not sufficient to consider the instrument as a
dated instrument. Consequently, the tax authorities refused to grant a tax ruling on the
debt classification of such instrument. Since, in our view, there is a strong likelihood that
the instrument will, in fact, be redeemed within 50 years, we continue our discussions
with the Dutch tax authorities in order to persuade them to change their position.
Impact of Basel III
Due to the conditions set out in the Basel III guidelines: Tier 1 instruments have to be
subordinated, without a fixed maturity date, ie perpetual and can not have a step-up in
distribution rate or other incentives to redeem the instruments, it will be very difficult to
structure instruments that meet the conditions to qualify as Tier 1 under Basel III and do
not classify as equity under Dutch Tax law. In practice, there are no new or recently issued
Tier 1 instruments, that qualify as equity for Dutch tax purposes.
Buffer Convertible
The BCCS (i) are subordinated and (ii) do not have a maturity date. Therefore, they are
considered to be a perpetual instrument. The issuer of BCCS (iii) may, at its sole discretion at
all times, elect to cancel an interest payment on a non-cumulative basis. Considering (i), (ii)
and (iii), the BCCS shall very likely qualify as equity for Dutch tax purposes, ie no deduction
for payments on this instrument and Dutch dividend withholding tax on distributions on
the BCCS. An option to write down principal of the BCCS should not affect the equity
qualification of the BCCS for Dutch tax purposes. Only in the case that the write-down of
principal would replace the option to cancel interest on the BCCS, then the BCCS may be
considered as debt for Dutch tax purposes. However, this is not a possibility under the Tier 1
conditions set out in the Basel III guidelines.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
John Brouwer
Godfried Kinnegim
Jochem Kin
Partner
Tel +31 20 674 1541
Partner
Tel +31 20 674 1120
Counsel
Tel +31 20 674 1173
john.brouwer@allenovery.com
godfried.kinnegim@allenovery.com
jochem.kin@allenovery.com
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Spain
General Approach to Tier 1 Instruments under Spanish Tax Law
– As a general rule, the Spanish tax treatment of an instrument issued by a Spanish tax
resident entity depends on its legal characterisation and, in particular, on its Spanish
GAAP characterisation.
Spanish issuers are subject to Spanish Income Tax on their worldwide net profits which
are determined in accordance with Spanish GAAP but subject to the relevant tax
adjustments when expressly contemplated in the applicable tax laws. Consequently,
in the absence of any specific tax regulations, the remuneration due in respect of
instruments representing the issuer’s equity (whether ordinary shares, preferred shares,
etc) would be non-tax deductible, whereas the remuneration in respect of all other
instruments which do not represent an issuer’s equity would be deductible for tax
purposes (subject to usual caveats, such as potential limitations on the tax deductibility
of net financial expenses, transfer pricing rules, etc).
According to Spanish accounting principles, in order to qualify an instrument either as
equity (instrumentos del patrimonio) or as debt (pasivos financieros), it will be necessary
to look at the actual economics of the instruments. A debt instrument exists when the
issuer assumes a contractual obligation of, either directly or indirectly, making payments
either: (i) in cash; (ii) in kind through the delivery of another financial asset; (iii) exchanging
assets or liabilities with third parties under potentially unfavourable conditions (such as
financial instruments subject to compulsory repurchase by the issuer, or which grant the
holder the right to demand the issuer to repurchase at a given date and for a determined,
determinable or pre-established amount, provided that there are distributable profits
or not); or (iv) exchanging own equity instruments subject to a variable exchange ratio.
In particular certain redeemable shares and non-voting shares are regarded as debt
instruments for accounting purposes.
–H
aving said the above, Spanish Law 13/1985, as amended by Law 6/2011, dated 11
April 2011 (Law 13/1985) and developed by Royal Decree 771/2011, dated 3 June
2011 (Regulations), contains a special regulatory and tax regime for preferred shares
and debt instruments issued by: (a) Spanish credit entities and listed companies, either
directly or through a wholly owned special purpose vehicle; and (b) Spanish regulated
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
securitisation funds. Subject to the fulfilment of the applicable requirements, the
remuneration due in respect of the Law 13/1985 qualifying instruments is deductible for
Spanish tax purposes.
The main issues resulting from this special regime under Law 13/1985
are as follows:
(i)
the instruments must be listed in an organised secondary market;
(ii)the funds raised in the market by the issuing vehicle must be invested on a
permanent basis with the parent entity;
(iii)no guarantee from the parent entity is now required for the preferred shares
when issued by a special purpose issuing vehicle;
(iv)the issuing conditions shall set out the payment conditions. However, the
administration body of the issuer or of the issuer’s parent company:
(a)will be entitled to discretionary cancellation of its payment (if necessary) for an
unlimited period and with non-cumulative effect. According to Circular 4/2011 of
the Bank of Spain, dated 30 November (Circular), the issuer’s discretionary ability
to decide on the cancellation of this payment can not be limited by the terms of
the instruments. For example, the holder of the instrument should not be granted
with the right to conversion as a result of the payment being cancelled; and
(b)
shall cancel its payment when the issuing credit entity or its parent or its consolidated group or subgroup does not comply with the regulatory capital requirements.
In respect of issues made by a credit entity, the Bank of Spain may impose
the cancellation of its payment based on the financial and solvency situation
of the issuing credit entity or its parent or its consolidated group or subgroup.
In any event, the payment of remuneration is subject to the condition of
the existence of distributable profits or reserves in the issuing or dominant
credit entity. According to the Circular, the prospectus should expressly mention
that the payment of the remuneration based on the existence of reserves requires
the prior authorisation from the Ministry of Treasury and Bank of Spain;
(v)provided that the issuing conditions expressly so establish, the payment
of remuneration can be replaced by the delivery of newly issued ordinary
shares or a participative quota of the issuing or parent credit entity, subject to
the Regulations). The equity instruments can only be delivered if
– they are issued for such exclusive purpose and the issuer’s group does not take
any risk (as it would by securing their subsequent sale or guaranteeing their
market value) and
– the issuer has the absolute discretion not to pay the remuneration in cash and
moreover it can cancel the delivery of equity instruments when it becomes
necessary (such as, for example, the trigger of any of the loss absorption events);
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(vi)early redemption of the preferred shares is permitted only if it would not alter the
financial or solvency situation of the issuer and its group. In respect of issuances
made by credit entities, the Bank of Spain may request that the preferred shares
are replaced by instruments of the same or better quality. According to the
Circular, the terms and conditions of the instruments can neither directly nor
indirectly incentivise their early amortisation;
(vii)the preferred shares must be directly linked to the risks and financial situation of
the parent entity and of its group, so that holders participate in the absorption of
current and future losses. The issuing conditions must include a mechanism which
becomes applicable when the issuer, its parent company or its consolidated group
or subgroup:
(a)
suffers material accounting losses; or;
(b)
faces a material fall in the ratios showing the fulfilment of regulatory
capital requirements. In particular, such mechanism shall become applicable when
the core capital ratio is below 5.125% or, being below 6%, accumulated accounting
losses for the last four quarters have reduced the share capital and reserves by
a third;
(viii)by virtue of such a mechanism, the preferred shares:
(a) shall absorb the current or future losses; and
(b) shall not prejudice the issuer’s potential recapitalisation, either through the conversion of the preferred shares into ordinary shares or participative quota
or the reduction of their nominal value.
Current Spanish Tier 1 Structures
Since the late 1980s, Spanish credit entities institutions have been able to issue hybrid
instruments that qualified as Tier 1 for regulatory purposes (pursuant to the former wording
of Law 13/1985) through off-shore structures, which were guaranteed by the Spanish
parent company. These indirect structures enabled issuers to also achieve tax deduction
of the remuneration.
In July 2003 the Spanish lawmaker amended the then existing rules to allow a direct
issuance of Tier 1 type instruments by Spanish credit entities and listed entities, either
directly or indirectly, through a 100% (directly or indirectly) owned special purpose vehicle
(having the issue of preferred shares or debt instruments as its exclusive corporate
purpose). In addition, this vehicle could be established in either Spain or in a jurisdiction
within the European Union (except tax haven territories).
Since then, market practice shows that Spanish financial institutions have predominantly
(if not exclusively) used the so-called “double Tier” structures, whereby:
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
– a Spanish special purpose vehicle fully controlled by the financial institution would issue
preferred shares into the market;
– the issuing vehicle would then on-lend the issuance proceeds of the preferred shares
back to the financial institution (or its subsidiaries), in the form of a tax deductible
subordinated instrument (traditionally taking the form of a “deposit” which now should be
made as a permanent investment in the parent financial institution).
Law 13/1985 has very recently been modified to mainly make more flexible the payment
conditions under the hybrid instruments. As indicated above, the issuer’s group has
discretion as to when the remuneration should be due, maintaining the status of tax
deductible Tier 1 instruments.
Impact of Basel III
Law 13/1985 and its Regulations already contain a number of the requirements introduced
by Basel III. Therefore, the introduction of Basel III should not prevent Spanish preferred
shares to continue to be the instrument of choice for Spanish financial institutions to
achieve tax deductibility to the extent that they are structured as Law 13/1985
compliant instruments.
One of the issues to be considered is the implication of the loss absorption mechanism,
which may imply a certain degree of equity feature for these instruments (which would
adversely affect the tax deductibility of the remuneration due), as holders of these
instruments may be forced to bear current or future losses of the issuer or of its group
by way of a write-down of the principal amount of such instruments.
Having said the above, to the extent that the instrument falls within the scope of the
special regime under Law 13/1985, which expressly contemplates its loss absorption
feature (subsequently developed in the Regulations), the tax deductibility of the
remuneration due on the Tier 1 instruments should still apply.
As far as the issuer is concerned, the amount of principal which may be written down as a
result of the triggering of the loss absorption mechanism would constitute taxable income
in the hands of the issuer.
Alternatively, the conversion of the instruments into the issuer’s ordinary shares or quota
(as contemplated in the Regulations) may also trigger the relevant taxable event depending
on the difference in value of the instruments being converted and the newly issued
ordinary shares/quota.
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Buffer Convertible
BCCS instruments are regarded as tax deductible instruments in Spain to the extent that
their terms and conditions comply with the requirements set out in Law 13/1985, as listed
above. The particular terms and conditions of the BCCS instrument would, generally
speaking, comply with those requirements (although certain non-material adjustments may
be needed to fully qualify for the Law 13/1985 regime).
Carlos Albiñana
Partner
Tel +34 91 782 99 62
carlos.albinana@allenovery.com
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
United Kingdom
General Approach to Tier 1 Instruments under UK Tax Law
The UK currently has no specific tax rules for Tier 1 debt instruments, although the
Finance Act 2012 includes provisions enabling HM Treasury to implement regulations
dealing with the tax treatment of securities subject to “regulatory requirements”.
No regulations have yet been published and so, for now, general tax provisions apply.
– As a first step it must be determined whether an instrument is debt or equity.
If it is “equity”, payments made on it cannot be tax deductible. Current law allows tax
deductions only for payments made on “debt”.
Importantly, this determination is legal rather than an accounting one. There is, perhaps
surprisingly, no clear rule on what constitutes debt or equity despite the importance of
the issue for tax purposes. Usually it is clear – but there are often areas where debt has
so many “equity”-like features that the boundaries can be blurred.
Perpetuals are an area of potential sensitivity. HMRC published a paper in June 2012
expressing the view that a “truly” perpetual instrument (where the holder has no right to
repayment in any circumstance) is not a debt as a matter of law and so “interest” paid on
it cannot be deductible. This is in contrast to “contingent” perpetual instruments, being
instruments which include a contractual clause providing for the return of principal in the
event of a liquidation which HMRC consider are debt.
– If an instrument is debt then it should be taxable under the UK tax code for
“loan relationships”.
This code covers most forms of corporate debt and provides, broadly, for an issuer’s
tax treatment to follow its statutory accounts unless there are provisions which require a
departure from the accounts. The same applies for corporate holders.
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Expenses recognised in the accounts in respect of debt instruments should therefore be
generally deductible for tax purposes.
– There are various UK tax provisions which can limit deductions on debt instruments.
These fall into two broad categories. The first seek to deny or restrict the tax deductibility
of payments which might be regarded as distributions of profit rather than payments
of interest (the Distribution Rules). The second seek to deny or restrict the tax
deductibility of payments made on debt issued for UK tax avoidance purposes. This note
does not deal with the avoidance provisions.
The Distribution Rules most relevant in the context of Tier 1 debt instruments apply in
the following circumstances:
(i)
Payments in excess of a reasonable commercial return
Payments on debt are not fully deductible if they exceed a reasonable commercial
return “for the use of the principal secured” by an instrument. Where this provision
applies, the excess is treated as a non-deductible distribution of profit.
An issuer will not usually want to pay third parties more than it needs to – and this
provision may therefore seem irrelevant. The key issue here is however the meaning
of “principal secured” – which has been taken (subject to limited exceptions) as a
reference to the lowest amount at which a debt can be redeemed in accordance
with its terms of issue.
(ii)
Payments dependent to any extent on the results of the issuer’s business
Payments on debt which are linked in any way to the results of the issuer’s business or any part of it are, subject to limited exceptions, not deductible at all.
A right to interest which is dependent on the issuer’s performance or solvency is
therefore problematic.
(iii) Payments made on securities which are convertible into shares or other securities
of an issuer and which are not listed nor issued on terms reasonably comparable to
securities which are listed
Interest payments on these securities can be non deductible in certain circumstances.
Convertibility for this purpose is judged from a holder’s perspective and so an
issuer’s right to convert its debt should not make a security convertible for this
purpose. Further, as most Tier 1 debt issues are listed on suitable exchanges, this
provision is of limited relevance.
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(iv) Payments made on “equity notes”
A security is an equity note for this purpose if, broadly, it is undated or is redeemable more than 50 years from the date of issue. Payments made on these
notes can be non-deductible if the notes are held by a non-UK company associated with the issuer or funded by the issuer or an associate of the issuer.
This provision can be an issue for non-UK groups raising funding in the UK on
an intra-group basis. Here, to ensure deductibility it is necessary for the relevant
instruments to have a term of 50 years or less.
– If, for accounting purposes, a company treats an instrument as consisting of a loan
relationship and a derivative, it must bring profits and losses in respect of the derivative
into account separately under the UK code for taxing derivatives (the Derivatives Rules).
In the case of an issuer loan relationship a convertibility option could, depending on the
accounting, be regarded as an embedded derivative. A key issue here is that although
the Derivatives Rules provide for an accounts basis of taxation, derivatives which are
for accounting purposes “equity instruments” are essentially outside the scope of
taxation. No relief (and conversely no taxable profit) can therefore arise – giving rise to an
anomalous tax result in some circumstances.
Current UK Tier 1 Structures
The requirement for issuers to be able to stop paying interest in certain solvency related
circumstances can give rise to potential problems under the “results dependency”
provision mentioned above.
These problems are addressed, in practice, by making coupons cumulative and having
(a) coupon deferral mechanisms and/or (b) “alternative coupon satisfaction mechanisms”
under which, broadly, shares or other securities can be issued with the cash raised being
used to satisfy an issuer’s interest obligation. The rationale here is that it is can be said
that the legal right or entitlement to interest is unaffected by the issuer’s solvency or
performance – it is merely the timing of payment that is affected.
Where deferral is not sufficient and coupons cannot be cumulative, “indirect” issuance
structures are often used. Broadly, these involve a partnership subscribing for an entirely
vanilla note issued by a UK issuer. Investors then subscribe for interests in the partnership,
the members of which include members of the issuer group. The terms of the partnership
then govern what is paid out to the investors – and so interest paid by the issuer can
be streamed to or diverted away from investors as necessary. The rationale here is that
the partnership-sharing mechanics are outside the scope of the Distribution Rules – at
partnership level there is a contractual allocation of partnership profit which is distinct from
the payment of interest on a security.
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Impact of Basel III
The new loss absorbency requirements for Tier 1 debt instruments which are likely
to be adopted (at least in some form) by the EU from 2013 would make structuring
tax deductible or even tax efficient instruments exceptionally difficult (if not practically
impossible) under current law.
This is for a number of reasons including the following:
(i)
A requirement for instruments to carry fully discretionary and non-cumulative coupons
HMRC have taken the view that coupons of this nature would be “results dependent”
and therefore treated as non-deductible distributions.
There is no obvious way of structuring around this. Basel III requirements mean
that deferral or ACSM mechanisms will no longer satisfy the regulatory requirements.
Further, the indirect issuance route is also unlikely to be viable in these circumstances
as, under the new rules, the instrument issued to the partnership will also need to
satisfy the relevant Tier 1 criteria – the layering of a partnership on top of a vanilla debt
instrument will therefore cease to be effective.
(ii)
A requirement for an issuer to write-down principal (permanently) following solvency
related trigger events
This will have a number of potential consequences. First, as interest will be computed
by reference to a principal amount that may vary by reference to the performance
of the issuer’s business, HMRC have taken the view that the results dependency
provisions mentioned above would apply. Second, such a feature may also give rise
to potential reasonable commercial return issues. Third, if the issuer’s accounts show
a credit in respect of written-down principal, the issuer may be subject to a tax charge
under the loan relationship rules.
(iii) A requirement for instruments to be converted into equity following solvency related
trigger events
If such a contingent conversion provision is accounted for by the issuer as an equity
instrument relating to its own shares, its tax position may be skewed if it is not
required to recognise profit and losses attributable to the instrument. HMRC have
also taken the view that this feature would cause the results dependency provisions
to apply.
(iv) Uncertainty as to the accounting treatment
The accounting treatment applicable to Tier 1 debt instruments is currently uncertain
– and a range of different permutations could apply. A particular instrument could,
for example, be regarded as an equity instrument in its entirety, a financial liability
in its entirety, a financial liability together with an equity instrument or a financial
liability together with an embedded derivative. Given that the tax in this area follows
the accounts unless otherwise provided, this means that the tax treatment of new
instruments may not be settled until the accounting is settled.
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
(v)
The requirement for instruments to be “truly” perpetual
HMRC have taken the view that Tier 1 instruments must be “truly” perpetual, and
accordingly they would not be debt as a matter of law. If this view is correct it would
mean that “interest” paid on such instruments would not be deductible.
Group Relief/Stamp duty
It should also be noted that instruments which give rise to deductibility problems are also
likely to give rise to problems under the UK group relief rules and, possibly, to give rise to
stamp duty concerns.
In terms of grouping, loans which are not “normal commercial loans” can be regarded as
equity interests in a company rather than debt. Where this is the case they are taken into
account in determining a company’s group relationships – and, if large enough, can
de-group a company from its group relief group.
In terms of stamp duty, instruments which are not exempt loan capital for stamp duty
purposes can give rise to a stamp duty/SDRT liability in certain circumstances on issue
or transfer.
The features which give rise to deductibility issues are similar to those which can
prevent an instrument from being regarded as a “normal commercial loan” or as
“exempt loan capital”.
Depending on the actual situation these issues also need to be taken into account when
considering the full UK tax position.
UK Government Approach
The UK Government has recognised the difficulties posed by BASEL III and its European
implementation. It has also acknowledged the importance of this issue for financial
institutions in the UK and the EU generally and the significance of tax in this area.
A period of consultation was carried out during the course of 2011 during which these
issues were discussed at various working groups (of which we were part).
No decisions have yet been taken following this period of consultation on how to address
the issues or on whether the issues should be addressed – as this is both a technical
question and a political one. HMRC have stated that once the CRD 4 proposals are
finalised, HM Treasury will set out what the tax treatment of new bank instruments will be
and publish draft regulations for consultation (to be enacted under powers granted under
the Finance Act 2012).
A real difficulty here is, however, the fact that the regulatory regime is not yet settled.
Further, depending on the political position taken by the UK Government, changes to the
UK tax rules may – given the number of non-EU banks in the UK market – need to also
take into account the determinations of other non-EU regulators.
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Buffer Convertible
Interest paid on the BCCS, or similar instruments which include provision for loss-absorbency
through a write-down, would not be deductible in the United Kingdom under current law.
The features of the instruments which make the interest non-deductible are discretionary
and non-cumulative interest. The provisions for write-down/conversion into equity on the
occurrence of a contingency event or a viability event may also cause non-deductibility.
This treatment may change when HM Treasury implements regulations under the powers
given to it in the Finance Act 2012.
Lydia Challen
Christopher Harrison
David Hughes
Partner
Tel +44 20 3088 2753
Partner
Tel +44 20 3088 3638
Partner
Tel +44 20 3088 3630
Mark Middleditch
Vimal Tilakapala
Partner
Tel +44 20 3088 3698
Partner
Tel +44 20 3088 3611
lydia.challen@allenovery.com
mark.middleditch@allenovery.com
© Allen & Overy LLP 2013
christopher.harrison@allenovery.com
vimal.tilakapala@allenovery.com
david.hughes@allenovery.com
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
United States
general Approach to Tier 1 Instruments under U.S. Tax Law
Although U.S. federal income tax law does not define debt or equity, the Internal Revenue
Code of 1986 (section 385) provides several factors to indicate a debtor-creditor
relationship, one of which is whether there is a written, unconditional promise to pay on
demand or on a specified date a sum certain. Other factors cited have included:
(i)whether the holders of an instrument have the right to enforce payments of principal
and interest;
(ii) whether the rights of the holders are subordinate to the rights of general creditors;
(iii)whether the instrument gives holders the right to participate in management of the
issuer;
(iv)whether the issuer is thinly capitalised;
(v) whether there is an overlap between instrument holders and shareholders of the issuer;
(vi) the label used by the parties; and
(vii) treatment of the instrument for non-tax purposes, including regulatory, rating agency
or financial accounting.
The courts have developed a debt-equity analysis that commonly weighs, among other
factors, whether an instrument has a fixed repayment schedule. Moreover, according to
its Notice 94-47, the U.S. Internal Revenue Service (IRS) will consider certain key factors
in determining the proper characterisation of an instrument for U.S. tax purposes, one of
which is whether there is an unconditional promise to pay a certain sum on demand or
at a fixed maturity date that is in the reasonably foreseeable future. Accordingly, a fixed
maturity date is a major feature of a debt instrument. Even a distant maturity date can
suggest equity because it exposes an investment to a greater risk of an issuer’s business
and creates uncertainty regarding both the timing and certainty of repayment, and the IRS
has expressed an intention to scrutinise instruments with “unreasonably” long maturities.
What will be considered a “reasonable” maturity date varies according to the particular
circumstances of an issuer or instrument, but a perpetual maturity date is a strong
indicator that an instrument would be treated as equity for U.S. tax purposes.
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Current U.S. Tier 1 Structures
International financial institutions and their subsidiaries have commonly used as a
component of their regulatory capital certain innovative hybrid capital securities that
could be characterised as debt for U.S. federal income tax purposes, despite having
certain equity features. Among these instruments are trust preferred securities (TRUPS).
Examples of such preferred securities in the U.S. markets have included USbancorp USB
Capital VIII income capital obligation notes (ICONs) and Lehman Brothers’ Enhanced
Capital Advantaged Preferred Securities (E-CAPS), which have been treated as debt for
U.S. tax and financial reporting purposes, but as equity for purposes of credit ratings and
included as Tier 1 capital.
TRUPS generally represent interests in a trust that invests in subordinated extended-date
(typically 30 years) debt securities of a financial institution under which the issuer has the
option to defer interest payments (typically for up to five years), at the price of not being
permitted to pay dividends on its common stock. More recently issued TRUPS have
featured 60-year terms and 12-year interest deferment options. The IRS has classified
TRUPS as debt, taking the view that an interest deferral option and extended maturity
date were not deciding factors for equity treatment under the circumstances. In the IRS’
view of the particular TRUPS at issue, the risk of deferral of interest payments was remote
because the issuer had an extensive history of dividend payments on its common stock
that it was presumed to have a substantial economic incentive to maintain. In addition,
the issuer was well capitalised when the TRUPS were issued and the issuer’s
debt-to-equity ratio was within market norms.
Starting in 2013 trust preferred securities will be phased out from eligibility as Tier 1
capital of U.S.-regulated financial institutions under the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank), even before Basel III is implemented by U.S.
regulators. It is uncertain how regulators will harmonise Basel III with Dodd-Frank, as each
involves different capital requirements and implementation schedules. However, Dodd-Frank
creates a statutory floor for regulatory capital such that it is unlikely that innovative or hybrid
instruments will be eligible as Tier 1 capital under any implementation of regulatory reform in
the United States.
Impact of Basel III
Most instruments qualifying as Additional Tier 1 Capital under Basel III will likely not be
eligible for debt characterisation under U.S. tax principles because a perpetual maturity
date mandates equity treatment. Certain features of some instruments that meet Basel III
requirements may, however, fall at various points on the debt-equity continuum for U.S. tax
purposes. Contingent capital instruments could be designed to have a conversion trigger
or rate that would make debt treatment more of a possibility. For example, the specified
conversion trigger could be considered sufficiently remote such that the perpetual
© Allen & Overy LLP 2013
Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
nature of the resulting equity would be disregarded under U.S. tax principles relating to
debt instruments. In addition, the conversion rate could be such that the value of equity
received upon conversion is sufficient to provide a level of principal protection typical
of debt.
Nevertheless, under currently available authority, a fixed or ascertainable maturity date
is generally considered to be essential to debt classification. Moreover, the promise to
pay upon maturity of a debt instrument is generally expected to be unconditional, and
not conditioned upon the performance of the issuer. Accordingly, contingent capital
instruments or other instruments qualifying as Tier 1 capital under Basel III standards will in
most cases likely be treated as equity for U.S. tax purposes.
Buffer Convertible
In particular, the BCCS would not be eligible for debt characterisation under U.S. tax
principles and, accordingly, payments on such instruments would not be deductible as
interest payments for U.S. tax purposes.
The BCCS would likely be treated as equity for U.S. tax purposes, principally because
their perpetual term mandates equity treatment. In addition, features of the BCCS that
also indicate equity treatment include the prohibition on any incentive for the issuer to
redeem the securities, as well as the issuer’s unconditional ability to cancel non-cumulative
payments of interest. To the extent that a write-down feature reduces a holder’s likelihood
of receiving a sum certain at a set date, such a feature similarly makes debt treatment
unlikely under U.S. tax principles, unless holders are guaranteed to receive a certain
threshold amount of principal despite any write-down. As discussed above, an issuer’s
unconditional promise to pay a certain sum upon maturity of an instrument, and a holder’s
ability to enforce payments of principal and interest on such instrument, are each key
features of a debtor-creditor relationship under U.S. tax principles, and these features are
absent from the terms of the BCCS.
Additional considerations
− Payments on Additional Tier 1 Capital instruments that are equity for the U.S. tax
purposes would not be deductible as interest payments in calculating an issuer’s U.S.
federal income tax liability.
− Dividends received before 31 December 2012 by individuals from U.S. and certain
foreign corporations are eligible for a preferential 15% tax rate.
− The “portfolio interest exemption” from U.S. withholding that is generally available to
certain non-U.S. persons does not apply to dividends.
− A dividends received deduction is generally available to qualifying U.S. corporations.
Certain anti-deferral regimes apply to ownership of equity interests in a controlled foreign
corporation or passive foreign investment company, which may make Additional Tier 1
Capital instruments issued by non-U.S. institutions unattractive to certain U.S. investors.
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
London – U.S. Tax
Stephen Fiamma
Partner
Tel +44 20 3088 3657
stephen.fiamma@allenovery.com
New York
Jack Heinberg
Dave Lewis
Partner
Tel +1 212 610 6383
Partner
Tel +1 212 756 1147
jack.heinberg@allenovery.com
© Allen & Overy LLP 2013
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Global Tax practice | Tax Treatment of Additional Tier 1 Capital under Basel III
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This is a document published in September 2012.
Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that the U.S. federal tax discussion contained herein
(1) was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax-related penalties under the Internal Revenue Code and
(2) was not written to support the promotion or marketing of any transaction. Taxpayers should seek the advice of their own independent tax advisors based on
their own particular circumstances.
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