Basel III Capital Reforms - Taxation treatment

Funding costs on certain capital instruments will be tax deductible under reforms announced in the Federal Budget.

Under the accelerated implementation timeframe previously announced by the Australian Prudential Regulatory Authority, the Basel III capital reforms applicable to authorised deposit-taking institutions will progressively come into effect from 1 January 2013. These reforms aim to increase the amount and quality of capital held by ADIs. The government has now confirmed that, on commencement of the Basel III reforms, certain capital instruments issued by ADIs under the reforms will be treated as debt rather than equity for income tax purposes, thereby allowing the funding costs of those instruments to be tax deductible.

The government has indicated that the change will apply to certain Tier 2 regulatory capital instruments issued by ADIs and other similar entities regulated by APRA. The change should apply to Tier 2 subordinated debt which, under the non-viability requirements to be applied by APRA, may be required to be written-off or converted to equity if APRA makes such a determination. Without the change, these instruments would be considered to be equity under current tax law for income tax purposes and their funding costs would not be deductible.

The market has seen a flurry of bank subordinated debt issuance. This clarification may encourage further issuance of that type, as the tax treatment of these capital instruments was left open following APRA's Response to Submissions: Implementing Basel III capital reforms in Australia  (30 March 2012).

Limited recourse debt - amended definition

The government has also stated that it will amend the definition of "limited recourse debt" for the purposes of Australia's taxation legislation. The amendments will clarify that "limited recourse debt" includes arrangements where the creditor's right to recover the debt is effectively limited to the financed asset or property over which security is provided for the debt.

The government’s rationale for making the amendment is to ensure that tax deductions are only available for capital expenditure on assets that have been financed by limited recourse debt where the relevant taxpayer is effectively at risk for the expenditure and makes an economic loss.

The amendment clarifies the intent behind the phrase and moves away from the decision in Commissioner of Taxation v BHP Billiton Limited [2011] HCA 17 (1 June 2011), in which the High Court expounded a narrow view of the phrase "limited recourse debt", as defined in section 243-20 of the Income Tax Assessment Act 1997. The amendment is relevant to a wide range of project, infrastructure and other asset or structured financings where the debt is secured solely against the financed asset, commodity or project company and may encourage financiers to expand capex financing, rather than turning to export credit agencies for the financing of that type of expenditure.