Forget me not

Determining the right capital structure for a financial services organization, especially for a bank which is part of a multinational group, has long been a key strategic priority. However, capital restructuring is likely to be given a major stimulus by regulatory action to boost banks' stability in the wake of the crisis. Either way, Jane McCormick, Paul Op de Beeck and John Bush argue it is critical to consider the tax implications of alternative transaction structures before decisions are finalized.

Changes in the structure and disposition of capital assets between different companies within a banking group, may be triggered by changes in the balance of business, disposal of certain business lines etc. However, it is an issue which is becoming more important as many regulators step up their scrutiny of the banking industry, and put increasing pressure on banks to strengthen their capital reserves. The danger of a hasty response is that it may fail to take into account the tax implications - to the detriment of the underlying business.

Where a multinational group needs, for business or regulatory reasons, to increase the Tier 1 capital of a subsidiary, typically in a different jurisdiction from the parent, one of the obvious solutions is to transfer capital from elsewhere in the group. However, this is not simply a matter of transferring cash. It is normally achieved by capital restructuring, for example by payment of special dividends or share buyback. The hidden danger is that in many cases (see panel) such transactions can trigger tax liabilities in both jurisdictions. Paying careful attention to the tax implications in the design phase of such restructuring is crucial. It can allow the selection of beneficial arrangements and potentially avoid large costs; but is often overlooked.

Banks often fail to take into account the fact that some forms of capital are more tax-efficient than others. Innovative Tier 1 capital is particularly efficient. Here, certain forms of debt issued to the market can count towards Tier 1 capital, and rank alongside equity shareholding. However, the coupon, as an interest payment, is deductible for tax purposes. The current focus is clearly on 'core' Tier 1 capital. In many cases, regulators will accept innovative Tier 1 capital as 'core' Tier 1 capital. Under Basel II and domestic regulations which embody it, innovative Tier 1 capital is limited to a maximum of 15 percent of the total. But it can still afford substantial tax advantages.

Regulators and fiscal authorities naturally monitor the use of innovative Tier 1 capital closely. In the UK, HM Revenue & Customs generally only approve the deductibility of coupon payments for tax computation where the capital raised by the instrument is either new capital, or is used to replace existing tax-deductible capital. However, where there is a genuine business case, and the main purpose is not to achieve a UK tax advantage, the tax deductibility may be approved. The position may change in the future. At present, however, it should be considered seriously as an option in intra-group capital transfers.

KPMG member firms have seen, in some cases, that regulators request banks to refrain from coupon payment if banks are in a loss position and/or received State intervention. This request fits in the capacity of an equity instrument to absorb losses.

The impact on deferred tax assets of any capital restructuring and transfers can also be complex, and benefit from careful design. Many banks, especially in the current economic environment, have substantial historic tax losses carried forward. These count towards Tier 1 capital requirements. In these circumstances, the core priority should be to ensure that any capital restructuring does not extinguish these tax assets, for no net regulatory capital gain. Once again, careful planning can result in significant tax benefits. Many banks appear increasingly likely to have to consider capital restructuring in the aftermath of the crisis. Tax considerations are rarely the prime motivation in these situations.

Nevertheless, careful attention to the tax consequences of alternative options can result in significant tax advantages, and ensure that Tier 1 capital is maximized in the most cost-effective manner.

Article Authors

Jane McCormick
Partner
KPMG in the UK +44 20 7311 5624 Jane McCormick View all articles by this author

John Bush
Managing Director
KPMG in the US +1 212 954 6429 John Bush View all articles by this author

Paul Op de Beeck
Partner
KPMG in Belgium +32 2 708 4211 Paul Op de Beeck View all articles by this author