CRD IV. Global Banking & Capital Markets. Tax treatment of regulatory capital instruments

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1 May 2014 Global Banking & Capital Markets CRD IV Tax treatment of regulatory capital instruments This briefing is intended to provide an overview of the tax treatment of regulatory capital instruments issued by banks in a number of European jurisdictions. It focuses on the important questions for issuers, including the tax deductibility of financing costs, withholding taxes on coupons, application of tax charges on certain capital triggers and taxes on issuance or transfer, as they relate to the banks issuing the instruments. These topics will be of interest to banks issuing regulatory capital instruments and their advisers, as well as investors and prospective investors in such instruments. The global financial crisis highlighted a number of vulnerabilities in the regulation and supervision of the banking system. Some financial institutions entered the financial crisis with capital of insufficient quantity and quality and, in order to maintain financial stability, governments were required to intervene and provide a significant amount of financial assistance to prevent the collapse of the European banking sector. The CRD IV package, consisting of Regulation (EU) 575/2013 and Directive 2013/36/EU, is the European Union s (EU) implementation of Basel III the global regulatory standard agreed by the Basel Committee on Banking Supervision in response to the financial crisis. The new rules which are contained in CRD IV have been designed to strengthen the resilience of the European banking sector so that it is capable of withstanding future economic shocks, while ensuring continued economic activity and growth. CRD IV is intended to address a number of issues identified during the financial crisis, including by increasing the level and quality of capital held by banks. Under CRD IV, the eligibility criteria for regulatory capital instruments, classified as additional tier 1 capital (AT1 capital) and tier 2 capital (T2 capital), become more stringent, in order to improve the ability to absorb losses in times of financial stress.

2 The conditions for instruments to qualify as AT1 capital and T2 capital are outlined in CRD IV. AT1 capital The key features of AT1 capital are that: The instruments must be perpetual and not subject to any step up or incentive to redeem. The instruments must not be subject to an issuer call option within five years. The coupons must be paid out of distributable profits and must be wholly discretionary. On the occurrence of a trigger event (broadly, reduction of core tier one equity capital below a certain level), the instruments must either be written off or convert into core equity. T2 capital CRD IV compliant T2 capital is broadly subordinated debt with a minimum issue period before maturity of five years. Commencement and effect CRD IV entered into force on 17 July 2013, and applies from 1 January

3 Country summaries Tables 1 and 2 summarize the position with respect to the tax treatment of AT1 capital instruments and T2 capital instruments across a number of European jurisdictions. Additional detail is provided below. All responses are based on the prevailing tax laws, and published public guidance and rulings of the tax authorities in the respective jurisdictions at the date of publication of this alert. In addition, please note the following with respect to each column: Deductibility: availability of a deduction for corporate income tax purposes may require a review of the instruments on a case-by-case basis. Withholding taxes: response may be no where certain exemptions are available such that, in practice, a withholding tax obligation does not generally arise. Taxes on issuance or transfer: includes stamp taxes, financial transaction taxes and similar transaction taxes. Note that the potential introduction of an EU Financial Transaction Tax has not been considered for the purposes of this alert. Tax charge on trigger events: trigger events includes write-off, write-down or conversion into equity of an instrument previously classified as debt for tax purposes. 3

4 Table 1: Additional Tier 1 capital Additional Tier 1 capital raised in (a) Deductibility of coupon for corporate income tax purposes (b) Withholding tax (c) Taxes on issuance or transfer (d) Tax charge on trigger events Belgium Yes No No * Write-down: Yes France Yes No No Write-down: Yes Germany Yes * No * No Write-down: Yes * Conversion: Yes * Ireland No No No Write-down: No Italy Yes No No Write-down: No * * Portugal Yes No * No Write-down: Yes Spain Yes No * No Write-down: Yes Sweden * No No Write-down: * Conversion: * Switzerland Yes No * No * Write-down: Yes The Netherlands Yes * No No Write-down: Yes United Kingdom Yes No No Write-down: No * Refer to detailed text below. 4

5 Table 2: Tier 2 capital Tier 2 capital raised in (a) Deductibility of coupon for corporate income tax purposes (b) Withholding tax (c) Taxes on issuance or transfer (d) Tax charge on trigger events Belgium Yes No No * Write-down: Yes France Yes No No Write-down: Yes Germany Yes No No Write-down: Yes * Ireland Yes No No Write-down: No Italy Yes No No Write-down: No Portugal Yes No * No Write-down: Yes Spain Yes No * No Write-down: Yes Sweden * No No Write-down: * Conversion: * Switzerland Yes No * No * Write-down: Yes The Netherlands Yes No No Write-down: Yes United Kingdom Yes No No Write-down: No * Refer to detailed text below. 5

6 Belgium Under Belgian tax law, regulatory capital instruments are generally regarded as debt and any associated financing costs are therefore deductible. In principle, the tax treatment should follow the accounting treatment of the instruments. There are certain features which may trigger specific anti-avoidance rules in certain situations. However, it is also possible to obtain a ruling from the Belgian tax authorities in order to provide certainty. There is some uncertainly regarding the tax effect of the impairment of these instruments. However, it is currently thought that the write-down of the instruments should give rise to a tax charge for the issuer, but that no tax charge should arise for the issuer on a conversion of the instruments into shares. Where the instruments are issued via the Belgium National Bank s clearing system, and assuming certain conditions are satisfied, an exemption from Belgian withholding tax on the coupons should apply. No stamp taxes or similar transaction taxes should arise in respect of the issuance or transfer of the instruments. However, where a Belgian financial intermediary is involved, the transfer of the instruments could be subject to the Belgian tax on stock exchange transactions. France For French tax purposes, all financing costs related to regulatory capital instruments should be deductible, provided that the instruments qualify as debt securities under French tax law. As a general rule, the instruments must be accounted for as a liability for accounting purposes in order for the instruments to qualify as debt for tax purposes. Assuming the instrument is debt, any holder of the instrument within the charge to French corporate income tax (e.g., a French resident company) will be subject to French corporate income tax on the related coupons, in addition to any redemption premiums which may arise. If a conversion event is triggered and the instruments are converted into shares, the holder may benefit from the deferral of taxation on receipt of the shares until such time as those shares are transferred or disposed of. The conversion of an instrument into shares should not give rise to a tax charge for the issuer. However, the write-down of the instruments would generally give rise to taxable profit for the issuer. Subject to certain exceptions, no withholding tax should arise on coupons paid in respect of such instruments. There are no stamp taxes or transaction taxes on the issuance of the instruments and French financial transaction tax should not apply to any transfers, provided that they are treated as debt instruments for French tax purposes. 6

7 Germany Broadly, regulatory capital instruments will be treated as equity for tax purposes (hence, associated financing costs will not be deductible) if they provide a participation in the profits of the issuer and in the assets of the issuer upon liquidation. As such, instruments which qualify as AT1 capital under CRD IV would not in principle generally qualify as debt for German tax purposes. However, according to a letter ruling of the German Ministry of Finance dated 10 April 2014, certain AT1 instruments, in particular Contingent Convertible Bonds, which take a particular form may (under current German tax law) be treated as debt instruments for German tax purposes, and thus allow the issuer of such instruments to obtain a deduction for the coupon payments. The letter from the German Ministry of Finance has a narrow scope; therefore it is necessary to consider the specific terms and conditions of the instruments in question. T2 instruments should be treated as debt, and hence the coupon thereon should be deductible, for German tax purposes. The accounting treatment of the instruments should not generally influence the German tax treatment of the issuer or the holder (although it may sometimes be considered a factor). A write-down of debt instruments would generally trigger a taxable profit for the issuer. Any subsequent write-up would generally be tax deductible. The conversion of the Contingent Convertible Bond within the scope of the above-mentioned letter ruling, into shares of the issuer will initially result in a profit for the German issuer. However, this could be offset by the fair market value of the instrument at the point of conversion. For example, where there is a conversion of a Contingent Convertible Bond with a nominal value of 100, the conversion would according to the letter ruling result in a profit of 100 for the issuer. However, if the market value of the Contingent Convertible Bond is 30, this amount would be regarded as a contribution of the holder into the equity of the issuer. As such, the net amount of 70 would represent the taxable profit of the issuer upon conversion. Whether a payment of interest is subject to withholding tax will depend on the terms and conditions of the instruments. Under current law and practice, payments made in respect of equity-like or debt-like participation rights, profit participation rights and convertible bonds should generally be subject to German withholding taxes and the German non-resident taxation rules. A reduction in the level of withholding tax may be available. For certain specified AT1 instruments, the German Ministry of Finance has confirmed in the above-mentioned letter ruling that there is no tax to be withheld in the case of coupons paid on such instruments to a non-german tax resident holder. There is withholding tax on such instruments for German tax resident holders. However, this withholding tax of % is either equal to the final flat tax rate (for German private investors) or constitutes a prepayment that can be credited (for German business investors). No stamp taxes or similar transaction taxes should arise in respect of the issuance or transfer of the instruments. 7

8 Ireland Irish tax law does not contain any specific provisions on the characterization of an instrument as debt or equity. The Irish tax authorities have consistently denied the deductibility of interest or coupons on AT1 instruments. Similarly, any issuance expenses or fair value adjustments are also non-deductible for tax purposes. However, the Irish tax authorities generally allow a tax deduction in respect of the coupon paid on T2 instruments. Expenses associated with the issue of T2 instruments which are expected to be redeemed within 12 years are also tax deductible. Payments of interest (and principal) on the instruments will not generally be subject to Irish withholding tax. Although it is technically possible for withholding tax to apply to coupons paid on these types of instruments, it is expected that one of the broad range of exemptions would apply. No stamp taxes or similar transaction taxes would be expected to arise in respect of the issuance or transfer of the instruments. Italy For Italian tax purposes, regulatory capital instruments are generally treated as debt. The accounting treatment should not have any relevance to the tax classification for the Issuer (subject to the comments below on the 2014 budget). The deductibility of any financing costs will depend on whether or not the payments under the instruments are linked to the performance of the issuer. Where there is no link to the economic performance of the issuer, 96% of the financing costs will be treated as tax deductible. However, any amounts which are linked (directly or indirectly) to the issuer s economic performance are non-deductible for Italian tax purposes. In practice, this should mean that AT1 instruments carrying coupons which are not linked to the issuer s results and T2 instruments will be deductible. Amendments to the Italian 2014 budget have recently been introduced which affect the taxation of capital instruments. For instruments that were issued before 1 January 2014 and accounted for as debt (rather than equity), any write-down will give rise to a tax charge for the issuer. However, for instruments issued from 1 January 2014, regardless of how the instruments are treated for accounting purposes, the write-down will not give rise to a tax charge for the issuer. For instruments issued both before and after 1 January 2014, the conversion of capital instruments into shares will not give rise to any tax charge for the issuer. The accounting treatment of the instruments will continue to impact the tax treatment of the holder of the instruments (where such holder is within the charge to Italian corporate income tax). The holder will only be able to claim a deduction on a write down where the instrument is accounted for as debt and the amount claimed is recognized in that holder s profit and loss account. Payments of interest (and principal) under the instruments will generally be exempt from Italian withholding taxes where the payment is made to an Italian resident or where the recipient is in a white list of countries. No stamp taxes or similar transaction taxes would be expected to arise in respect of the issuance of the instruments, and Italian financial transaction tax should not apply to any transfers, provided that they are treated as debt instruments as a matter of general Italian law. 8

9 Portugal The Portuguese tax authorities will consider the overall features of regulatory capital instruments in order to determine their debt or equity characterization. The accounting treatment of the instruments is a factor in this analysis but it is not decisive. For Portuguese tax purposes, any financing costs associated with AT1 and T2 instruments should generally be deductible. Conversion of the instruments into the shares of the issuer is tax neutral for the issuer. However, a write-down of the instruments may give rise to a taxable profit for the issuer. As a general rule, payments of interest (and any redemption premiums) under the instruments will be subject to Portuguese withholding tax. There are various exemptions which may remove this withholding tax obligation. No stamp taxes or similar transaction taxes would be expected to arise in respect of the issuance or transfer of the instruments. Spain Under Spanish tax law, the tax treatment of each specific capital instrument depends on its characterization from an accounting perspective as tax generally follows the accounting treatment. Any coupon derived from an instrument recorded as debt qualifies as interest, and should be tax deductible. There are certain instruments (e.g., preference shares) which qualify as equity but which could generate tax deductible coupons pursuant to specific tax rules. There is a general limitation on the deductibility of net financial expenses of Spanish entities. However, this limitation does not apply to financial institutions. The conversion of the instruments into shares should not give rise to a tax charge for the issuer. However, a write-down of the instruments would give rise to taxable income for the issuer. Payments of interest (and premiums) under the instruments are generally subject to withholding tax where the recipient is a Spanish tax resident. However, payments of interest to non-residents are generally exempt. No stamp taxes or similar transaction taxes would be expected to arise in respect of the issuance or transfer of the instruments. 9

10 Sweden The classification of regulatory capital instruments as debt or equity for Swedish tax purposes will generally depend on the legal form of the instruments; however, the accounting treatment may be a relevant factor in some circumstances. There is very little guidance regarding this classification under Swedish law and each instrument would necessarily require detailed analysis on a caseby-case basis. If the instruments are classified as debt, any interest expense would generally be deductible for Swedish tax purposes, whereas any dividends on equity would be non-deductible. A proposal for new rules is expected to be introduced in June 2014 placing a limitation on the deductibility of interest expense. It is anticipated that this change may also affect the current definition of interest for Swedish tax purposes. As with the classification of the instruments, there is very limited guidance regarding the tax effect of the write-down or conversion of instruments into shares. Generally, payments of interest under the instruments will not be subject to withholding tax unless the payment could be considered a dividend for Swedish tax purposes. No stamp taxes or similar transaction taxes would be expected to arise in respect of the issuance or transfer of the instruments. Switzerland The Swiss tax position of an issuer of regulatory capital instruments will generally follow the accounting treatment. If the issuer accounts for the instruments as debt, then interest and other financing costs should be deductible for Swiss corporate tax purposes. A write-down of the instruments would give rise to taxable profit for the issuer. However, no tax charge will arise for the issuer on conversion of the instruments into equity. Interest paid on the instruments is currently specifically exempt from Swiss withholding tax, provided that the instruments have been issued pursuant to Swiss banking law and approved by the Swiss regulatory authority. This exemption relates to contingent and mandatorily convertible bonds, in addition to instruments which are subject to write-down on certain trigger events. This exemption is temporary and currently only applies to debt instruments issued between 1 January 2013 and 31 December No stamp taxes would be expected to arise in respect of the issuance of the instruments. However, Swiss stamp tax of 0.15% may apply to the transfer of the instruments where a Swiss securities dealer is involved and the instruments are traded. 10

11 The Netherlands The accounting treatment of regulatory capital instruments by the holder and issuer does not influence the Dutch tax treatment of the instruments. Coupons and expenses in respect of T2 capital are generally deductible for tax purposes when the term of these loans is less than 50 years or the coupon is considered profit dependent. However, there are exceptions for loss absorbent T2 instruments which are convertible into equity. Any unrealized fair value adjustments on the instruments is not deductible or taxable. The Dutch Ministry of Finance has recently published a letter indicating the Dutch tax treatment of AT1 instruments under the CRD IV framework as applicable from 1 January In order to ensure that banks in The Netherlands operate on a level playing field with those in other EU Member States, the Ministry announced that legislation will be introduced providing that coupons on AT1 issued under the new CRD IV framework (whether issued prior to or issued on or after 1 January 2014) should in principle be deductible for Dutch tax purposes. A write-down of the instruments should give rise to taxable profits for the issuer to the extent that the issuer of the instrument has tax loss carry forwards. A conversion of the instruments into equity is unlikely to result in taxable profits for the issuer. United Kingdom Following the introduction of new regulations, with effect from 1 January 2014, coupons on all AT1 and T2 instruments issued by banks incorporated in the UK are deductible for tax purposes to the extent that they are not shares in legal form. The accounting treatment of the instruments does not preclude the availability of a tax deduction. For example, coupons paid on an instrument which is treated as equity for accounting purposes remains deductible for the issuer and taxable for a holder who is within the charge to UK corporation tax if the instrument is debt in legal form. A coupon paid in respect of the instruments should be deductible as it is recognized in the accounts. The issuer will be required to account for the instruments on an amortized cost basis and so fair value movements will have no tax effect. The issuer of the instruments should not be subject to tax when there is a conversion or a write-down although a UK resident holder should still receive a tax deduction on a write-down. Payments of interest (or coupons) on the instruments will not be subject to UK withholding tax, nor will any UK stamp duty or stamp duty reserve tax apply to the issue or transfer of the instruments. Coupons that are tax deductible should not be subject to Dutch withholding tax. No stamp taxes or similar transaction taxes would be expected to arise in respect of the issuance or transfer of the instruments. Note: This Alert includes Switzerland which is not part of the European Union and therefore not within the scope of CRD IV. Switzerland has been included for completeness as it will be within the scope of the Basel III framework. 11

12 How EY can help EY has advised on the recent issuance of regulatory capital instruments across several European jurisdictions. Where there is uncertainty about the tax treatment of regulatory capital, we have experience of successfully obtaining clearances on deductibility and other tax issues from the relevant tax authorities. Our market knowledge and experience mean that we can keep you appraised of the latest developments and market sentiment in each jurisdiction. This alert is intended to provide a high level overview of the tax treatment of certain regulatory capital instruments in a selection of European jurisdictions. The content in this alert should not be regarded as comprehensive or sufficient for making decisions. We recommend that professional advice is sought on the tax treatment of specific instruments. 12

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