Global Tax practice. Tax Treatment of Additional Tier 1 Capital under Basel III.

Transcription

1 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III

2 2 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III Contents Introduction 3 Executive Summary 4 Australia 13 Belgium 18 France 21 Germany 24 Italy 28 Luxembourg 32 Netherlands 36 Spain 40 United Kingdom 45 United States 51 Allen & Overy LLP 2013

3 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 3 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 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 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

4 4 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 Perpetual Redeemable after five years No step-ups in distribution rate Distributions can be cancelled to depositors, general creditors and subordinated debt of the bank no fixed maturity date with regulator consent or other incentives to redeem at bank s full discretion without penalty or event of default Distributions paid only out of distributable items Cannot contribute to liabilities exceeding assets Converts into ordinary shares or has its principal amount written down at a pre-specified trigger point Converts into ordinary shares or has its principal amount written down at a point of non-viability of the bank Cannot contain a feature which hinders the recapitalisation of the bank On-loans in indirect issuance structures must also meet the requirements for Additional Tier 1 Capital and cannot be based on the bank s credit standing if such a balance sheet test forms part of national insolvency law only if the instrument is classified as a liability for accounting purposes 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 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 this may, for example, prevent a temporary as opposed to a permanent write-down mechanism Allen & Overy LLP 2013

5 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 5 BUFFER CONVERTIBLE CAPITAL SECURITIES EUROPEAN BANKING AUTHORITY COMMON TERM SHEET Issuer Securities offered Total issue size Nominal value Issue price Issue date Status and subordination [ ] ( Bank, Issuer ) Buffer Convertible Capital Securities ("BCCS") Up to [ ] [ ] At par [ ] To be determined on a case by case basis minimum requirement: not later than 30 June 2012 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.

6 6 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III Maturity date Coupon Unless previously called and redeemed or converted, the BCCS are perpetual without a maturity date. 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 Conversion rate Conversion period Issuer s call option To be determined on a case-by-case basis minimum requirement: dates to be aligned with dividend payment dates 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. 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. 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 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. Allen & Overy LLP 2013

7 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 7 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.

8 8 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 ( 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 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 Open option to be determined on a case-by-case basis: possibility to include a right for holders to convert the BCCS into shares. Allen & Overy LLP 2013

9 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 9 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.

10 10 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

11 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 11 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 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).

12 12 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

13 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 13 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.

14 14 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 system 1 ; 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; unfranked dividends: default 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

15 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 15 DTA 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); exempt 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. may 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; Does not form part of the Tier 1 Capital of the issuer or a related party; Deferred payments must accumulate (with or without compounding); and Does 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.

16 16 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

17 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 17 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 andrew.stals@allenovery.com

18 18 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 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

19 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 19 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

20 20 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 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 Partner Tel patrick.smet@allenovery.com Stéphanie Houx Counsel Tel stephanie.houx@allenovery.com Allen & Overy LLP 2013

21 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 21 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;

22 22 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 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

23 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 23 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 Partner Tel jean-yves.charriau@allenovery.com Mathieu Vignon Partner Tel mathieu.vignon@allenovery.com Sophie Maurel Counsel Tel sophie.maurel@allenovery.com

24 24 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 % from interest payments on the following hybrid instruments: profit participating rights (Genussrechte/Genussscheine), participating loans (partiarische Darlehen), Allen & Overy LLP 2013

25 Global Tax practice Tax Treatment of Additional Tier 1 Capital under Basel III 25 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.