Taxation on conversion of Basel III compliant tier 2 subordinated debt
Banking on Tax, Issue 13
Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111) requires that Additional Tier 1 (AT1) and Tier 2 (T2) capital instruments must be written-off or converted to ordinary shares if relevant loss absorption or non-viability provisions are triggered.
Further, APS 111 requires that the maximum number of ordinary shares issued on conversion cannot exceed the price of the T2 capital instrument at the time of issue divided by a percentage of the issuer’s ordinary share price at that time.
There are differing views on the application of the commercial debt forgiveness (CDF) provisions in circumstances where the conversion would result in a prima facie gain to the issuer of the debt due to the cap on the number of ordinary shares that can be issued on conversion.
Section 245-35 of the Income Tax Assessment Act 1997 (ITAA97) states that a debt is forgiven if “the debtor’s obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full”.
The tax implications upon conversion of a T2 capital instrument into ordinary shares in the event that a non-viability provision is triggered, are less than clear.
Section 245-37 of the ITAA97 states that: “If an entity subscribes for shares in a company to enable the company to make a payment in or towards the discharge of a debt it owes to the entity, the debt is forgiven when, and to the extent that, the company applies any of the money subscribed in or towards payment of the debt”.
Essentially, the difference in views comes down to whether a debt/equity swap is within the general CDF definition, which the Explanatory Memorandum to the original Bill appears to contemplate and, if it isn’t, whether the ordering of transactions is critical to the operation of the specific CDF debt/equity swap provision.
One view is that a debt/equity swap was intended to be included in the general definition of CDF, and that the specific CDF debt/equity swap provision was included to apply where the timing of transactions was thought to be critical to the operation of the CDF provisions.
Assuming a debt/equity swap is not included in the general definition of CDF, the alternative view is that, if the ordering of transactions is critical to the operation of the CDF debt/equity swap provision, extinguishing a pre-existing debt in return for the allotment of shares should not give rise to a CDF.
Financial institutions tend to prefer conversion of a T2 debt into ordinary shares rather than a write-off in the event of a non-viability trigger. The preference is, in part, due to the tax uncertainty created by the interaction of the CDF provisions and the taxation of financial arrangement provisions. However, as outlined above, conversion of the debt into ordinary shares has its own uncertainties.