Germany: Ministry clears tax treatment of AT1 capital
Germany has been notable by its absence in the burgeoning market for Additional Tier 1. But a key obstacle has been removed thanks to a letter from the Federal Ministry of Finance. By Florian Lechner, partner, tax, Linklaters LLP
Florian Lechner, Linklaters
On 10 April the German Federal Ministry of Finance issued a circular letter clarifying the tax treatment of Basel III-compliant hybrid regulatory capital, so-called Additional Tier 1 (AT1) instruments. The position taken by the Ministry is mostly favourable for banks, in particular as it treats the AT1 instruments as debt, which allows for the tax deductibility of coupons.
The Ministry’s release was keenly awaited in the market. Many German banks have waited to issue AT1 instruments until tax treatment became clear, putting them at a disadvantage to, for example, banks in the UK, where the legislator had earlier passed specific rules to ensure favourable tax treatment.
Germany does not have specific legal provisions dealing with the tax treatment of regulatory capital. Under the old CRD II rules, AT1 instruments could be structured as debt for tax purposes, which allowed for favourable tax treatment. The requirements for Basel III-compliant instruments are, however, much stricter, which led to the question whether the new instruments could still be seen to be closer to debt than equity for tax purposes. Under the new rules, AT1 instruments must, for example, be truly perpetual, interest can only be paid out of “distributable items”, and losses of the issuer must be absorbed either through a write-down of the principal (“Write-down Instruments”) or a contingent conversion of the instrument into shares of the issuer (“CoCo Instruments”).
Based on model terms released by the Association of German Banks (Bundesverband deutscher Banken) for both Write-down and CoCo Instruments, the Ministry has now taken the following positions:
Recognition as debt item in the issuer’s tax balance sheet
Most importantly, the Ministry confirms that AT1 instruments are — despite their perpetual nature and their participation in losses of the issuer — to be recognised as debt items in the issuer’s tax balance sheet. This is irrespective of potential equity treatment of the instruments for commercial accounting purposes. A de-recognition would have led to fully taxable cancellation of debt income in the amount of the instrument’s principal and hence have been prohibitive for the use of such types of capital.
Tax deductibility of coupons
The coupon on AT1 instruments is tax deductible as regular interest expense. There were concerns that the combination of perpetuality and the requirement to pay interest only out of distributable items could lead to the non-deductibility of coupon payments. The Ministry has now confirmed that the favourable treatment of CRD II-compliant instruments will not change for instruments issued under the new rules.
Withholding tax on coupons
As is the case for every debt instrument issued by German banks, coupon payments are generally subject to German withholding tax, which can be fully credited by German tax resident investors. For both types of AT1 instruments held by foreign investors the Ministry confirms that no such withholding obligations apply. This is most important for tax exempt foreign investors like pension funds for whom the German withholding tax would otherwise have resulted in a definitive tax leakage.
Taxation of write-down and conversion
The views taken by the Ministry as regards the taxation of the loss compensation through a write-down (in case of Write-down Instruments) or a mandatory conversion into shares of the issuer (in case of a CoCo Instrument) are less favourable.
In case of a write-down, that Ministry holds that the write-down amount leads to a fully taxable gain at the level of the issuer. Correspondingly, if the terms of the instrument provide for a write-up in case of a future recovery of the issuer, this leads to deductible expenses.
As regards the conversion of CoCo Instruments, this shall only be tax neutral for the issuer to the extent that the AT1 instrument is not distressed. If a bank has, for example, issued a CoCo Instrument with a nominal value of 1,000, the fair market value of which has decreased to 600, a conversion of the instrument would lead to taxable profit in the amount of the difference between 1,000 and 600, i.e. 400.
Although in this respect the German tax treatment is less beneficial than, for example, instruments issued in the UK, where both the write-down and the conversion are tax neutral, this will in practice often not lead to an actual cash tax burden of the issuer, as in a loss absorption scenario it will likely have ongoing tax losses against which the taxable profits can be offset. It is, however, important to note that tax loss carry forwards from previous years can only be offset against up to 60% of current profits, so that pure tax losses from the past are not sufficient to fully shelter against profits from write-downs or conversions.
Application only to banking association’s model terms
The Ministry’s circular letter explicitly only applies to AT1 instruments in line with the model terms released by the Association of German Banks. The circular letter is not binding for instruments with deviating terms. Certainty regarding the tax treatment of such instruments can only be reached through an advance tax ruling by the competent tax authorities, which is time consuming and subject to significant administrative fees. •
Michael Kemmer, general manager, Association of German Banks
Michael Kemmer, general manager of the Association of German Banks, welcomed the Ministry’s letter:
“We welcome today’s release by the Federal Ministry of Finance of the long-awaited administrative rules governing the tax treatment of banks’ so-called Additional Tier 1 capital instruments. Now, as in other countries, there is a tax framework in place for banks in Germany, too.
“This gives German banks the legal certainty they need to protect themselves against crises by raising Additional Tier 1 capital in the form of bonds that can be converted into shares or contain write-down mechanisms.”