Income tax treatment of Tier 2 capital under Basel III

Treasury has released a discussion paper on the implementation of the Government’s proposal to ensure that on commencement of the Basel III capital reforms on 1 January 2013, eligible Tier 2 capital instruments, issued on or after that date, by ADIs can be treated as debt for income tax purposes so that funding costs would be tax deductible.

It is proposed that the Income Tax Assessment Regulations 1997 be amended so that the inclusion of a loss absorbency clause as required by APRA does not preclude Tier 2 instruments from being classified as debt interests for tax purposes.

Assuming that the Basel III Tier 2 capital is akin to Lower Tier 2 capital, eligible notes would have to have the following features under the proposed changes, consistent with the current drafting of regulation 974‐135D of the ITAR 1997:
• have a maximum term of 30 years;
• distributions are cumulative and compounding;
• be classified as an accounting liability; and
• satisfies the Tier 2 capital loss absorbency requirement.

Currently the minimum standards that an instrument must comply with to be included in an ADI’s regulatory Tier 2 capital include:
• subordination to all but Common Equity Tier 1 and Additional Tier 1 capital;
• no guarantee on amounts paid in or payable;
• a minimum term of five years;
• no acceleration of repayments, except under certain circumstances;
• a loss absorbency clause that is triggered at the point of non‐viability; and
• a pre‐determined payment schedule.

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