Solvency clauses, term subordinated notes, and debt/equity tax rules

The Federal Government has released exposure draft regulations that would allow certain term subordinated notes to be treated as debt under the debt/equity tax rules, despite the presence of a solvency clause. While the clauses are commonly found in Lower Tier 2 term subordinated notes issued by Authorised Deposit-Taking Institutions, the regulation will apply to all issuers.

This is a long-awaited reform (one which the previous Government had announced nearly four years ago) and will bring some certainty to issuers seeking to claim deduction on the interest payable on these notes.

What features would the term subordinated note need to qualify?

Under the exposure draft regulations, term cumulative subordinated notes containing a solvency clause must have certain features to be treated as debt:

The starting point is the term of the note, which cannot be more than 25 years. In addition, there cannot be a power to extend the term of the note beyond that.

The next requirement is the obligation to pay interest on the note. This must be subject to one or more of the following conditions:

• a condition under which the issuer of the note is able to defer the payment of interest beyond the date on which it would otherwise be due and payable if, immediately before payment, the issuer is insolvent; or
• a condition under which the issuer of the note is able to defer the payment of interest beyond the date on which it would otherwise be due and payable if, immediately after payment, the issuer would be insolvent; or
• if the issuer is an approved deposit-taking institution — a condition under which the issuer is required to maintain its capital adequacy ratio under prudential standards issued by the Australian Prudential Regulation Authority (APRA); or
• if the issuer is a foreign approved deposit-taking institution — a condition under which the issuer is required to maintain its capital adequacy ratio under equivalent prudential standards issued by a foreign regulator comparable to APRA.

Finally, under the terms and conditions of the note, the issuer does not have 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.

What notes are excluded?

A term cumulative subordinated note that, at its time of issue:

• constitutes or meets the requirements of a Tier 1 capital instrument; but
• does not form part of Tier 1 capital of the issuer, or a connected entity, on the basis that the instrument is in excess of the Tier 1 capital required for the purposes of prudential standards that deal with capital adequacy

is not included.

How far back would this apply?

The Government is proposing that the regulations would apply to payments under notes that meet the requirements made on or after 1 July 2001.

A payment of interest to a person that is made under a term cumulative subordinated note before 1 July 2001 however will be treated as debt but only to the extent that:

• the rights of a person (other than the Commonwealth or an authority of the Commonwealth) as at 1 July 2001 would not be affected so as to disadvantage that person; or
• liabilities would not be imposed on a person (other than the Commonwealth or an authority of the Commonwealth) in respect of anything done or omitted to be done before 1 July 2001.

Next steps

Submissions on the exposure draft regulations must be received by Treasury by 22 May 2009.