Two recent events are clear signals of easing the impact of the approaching Basel III implementation imposing higher capital adequacy requirement for banking and other financial institutions: the release of the exposure draft on ‘covered bonds’ and the making of the Income Tax Assessment Amendment Regulations 2011(No 2). The tax implications of the two are critical for issuers and holders of bonds in financial institutions.
The first allows banks to issue bonds under which holders can either look for recompense to a cover pool of assets or failing which, to the issuer itself. The second allows deduction for payments made by the issuer in respect of specified perpetual subordinated bonds even though such payments are subject to earnings by the issuer of such bonds. The amending Regulation effectively excludes the consequences of Div 974 of the Income Tax Assessment Act 1997 (debt-equity tests) which may have classified the subordinated bonds as equity and thus disallowed deductions to the issuer, for payments made under it.
Although covered bonds have had wide spread acceptance, there are two significant sticking points. The assets that can be in the pool are restricted to what are defined as ‘eligible assets”. These are cash , government debt, certain loans secured by first ranking mortgage over residential and commercial property and certain hedging derivatives.
Then there is a cap on covered bond issuance, 8 % of the bank’s assets in Australia. This is to prevent bondholders making claims in excess of that limit and threatening shareholder funds.
The above moves have been to remove obstacles in the way of financial institutions raising capital and at the same time not jeopardising the equity investors in the institutions.
Mercifully in Australia, the GFC did not push ‘too big to fail’ financial institutions into seeking public sector rescue. Reports of banks in other countries continuing to be in trouble keep on coming: Tests Show Irish Banks Still Ailing
Isn’t it time that regulations are made in Australia which aim to avoid a public sector bail out of troubled financial institutions in the future, while providing opportunities for the institutions to raise adequate capital at the same time?
CoCo’s (Contingent Convertibles bonds) combine both the tax and prudential advantages and are been increasingly used in other countries.
European Banks Blaze A Trail For Contingent-Convertible Bonds
CoCo’s are debt instruments that convert to ordinary shares when the capital of a financial institution falls below predetermined levels, at which stage the debt (bonds) will automatically convert into equity (with the knowledge of the bond holder).
Bondholders will not be disadvantaged. They will be made aware of the risks involved and compensated for any possible conversion with higher interest payments. This will prevent public sector assistance to financial institutions when things become shaky with the issuers and their capital falls below mandatory prudential levels.
There may well be a snag. Div 974 may disallow deductions in respect of payments under CoCo’s, especially because of the possibility of mandatory conversion to equity (capital). Like in the case of perpetual subordinated bonds legislative initiative (regulations) may well be the answer?