By David H Salzman
IN RECENT YEARS, non-US banks raising tier 1 capital have regularly turned to the US capital markets. The instruments used, commonly known as yankee tier 1 issues, might become even more attractive with the introduction of new US tax rules.
Following the signing into law of the Jobs and Growth Tax Relief Reconciliation Act earlier this year, US individuals who receive “qualified dividend income” will be taxed on it at a maximum rate of 15%. Dividends from properly structured tier 1 capital securities can qualify for the reduced rate whether they are received directly by US individuals or indirectly through investment partnerships or US mutual funds.
The 15% tax rate on dividends is equal to the new maximum capital gains rate and almost 60% lower than the maximum income tax rate on salaries and interest income (which currently stands at 35%). Although it is perhaps premature to assess US individuals’ appetite for dividend-producing securities, the wide gap between the federal income tax treatment of interest and of qualified dividends seems likely to arouse interest among investors.
Over the past decade the goal of issuer tax-efficiency has enticed financial engineers to fashion new structures for raising tax-deductible tier 1 capital. The hurdle for obtaining a tax deduction on tier 1 products has been that non-US bank regulators afford tier 1 capital treatment only to securities that demonstrate substantial equity features. Nonetheless, non-US issuers and their advisers have persuaded taxing authorities to allow deductions for payments on deeply subordinated, non-cumulative, often perpetual securities that do not provide holders with meaningful creditor remedies.
| Indirect tier 1 structure |
From a US federal income tax perspective, these types of tier 1 qualifying securities generally constitute equity. This uncontroversial conclusion accords with non-US bank regulators’ assessment that non-cumulative, perpetual capital available to absorb an entity’s losses on a going-concern basis deserves to be treated as equity.
Nonetheless, the terms of these tier 1 issues can affect the certainty of the equity characterization and the availability of the reduced dividend rate. With proper planning, however, a product that’s a winner for both issuer and investors can be marketed: tax-deductible tier 1 capital subject to reduced tax in the hands of US individual investors.
Tax-deductible tier 1 structures The optimal structure for raising tax-deductible tier 1 capital depends on the tax, regulatory, legal and accounting regimes of the jurisdictions in which a bank operates. In a number of jurisdictions, including the UK and the Netherlands, banks can issue tax-deductible tier 1 qualifying securities directly to investors.
In other jurisdictions, such as France, Germany and Italy, tax-deductible tier 1 is issued indirectly through a special purpose vehicle. One common structure involves issuing a deeply subordinated note to a Delaware limited liability company. The preferred shares of the LLC are held by a Delaware business trust that issues preferred shares to investors. Other variations have used German silent partnerships or special purpose vehicles in the Cayman Islands or Jersey.
Although both direct and indirect issues can qualify for tier 1 treatment, the Basle Committee on Banking Supervision in October 1998 issued special guidance for indirect issues involving a consolidated subsidiary. Critically, structures must be able to absorb losses within the bank on a going-concern basis, must be junior to depositors, general creditors, and subordinated debtholders, must be non-cumulative and perpetual, and cannot be called before five years (10 years where the rate on the securities includes a limited step-up).
US courts have identified numerous factors that may be relevant in determining whether an instrument should be characterized as debt or equity from a US tax perspective. No one factor is conclusive; it is necessary to consider all of the facts and circumstances that are connected with an issue.
Auspiciously, the key features of non-US tier 1 capital securities are the hallmarks of equity under US tax law. Although some issues may contain meaningful debt features (for example, the right to sue for interest, but not principal), the equity characteristics generally outweigh these debt features.
Certain indirect issues of tier 1 securities run a limited risk of debt treatment for US tax purposes. In these structures the underlying note issued to the special purpose vehicle is dated (with a maturity of 30 years or less) and affords creditor rights to the special purpose vehicle when principal is not repaid. The terms of the note do not permit the regulator to prevent repayment, and principal cannot be reduced if the bank is below key capital thresholds.
When all aspects of the transaction are considered together, the structure represents an equity investment in the issuing bank and the “creditor rights” on the underlying note seem somewhat illusory. This is because non-US regulators typically require that (i) investors hold a non-cumulative and perpetual interest in the special purpose vehicle that holds the dated note and (ii) the special purpose vehicle is required to reinvest the principal of the note in an entity related to the issuer if the issuer is in financial difficulty.
In contrast with the tier 1 arrangements approved by non-US bank regulators, the Federal Reserve, with a nod to the demands of US tax law, allows tier 1 treatment to US bank holding companies for dated and cumulative trust preferred securities, such as MIPS, QUIPS, TOPRS and TruPS. In these transactions the US bank holding company that issues subordinated debt to a consolidated trust can deduct interest for tax purposes. US investors who purchase preferred interests in the trust are treated as owning the underlying subordinated indebtedness, rather than equity from a US tax perspective. Accordingly, US individuals are subject to tax on the interest (even when accrued but unpaid) at the maximum 35 % rate.
The new 15% maximum tax rate applicable to US individuals for “qualified dividend income” includes dividends received from “qualified foreign corporations”, as well as from most US corporations. In this regard the new law differs from recent US Treasury and Senate proposals that would have eliminated tax on dividends only to the extent that amounts distributed as dividends had been subject to US federal income tax at the corporate level.
Overview of the favourable US tax law developments Under the new law “qualified foreign corporations” include, first, foreign corporations eligible for benefits of a comprehensive income tax treaty with the US that the Internal Revenue Service deems satisfactory and that has an information exchange programme. Secondly, it includes foreign corporations whose tier 1 instruments are readily tradable on an established US securities market. With respect to tax treaty qualifications the legislative history provides that until the IRS issues guidance, any income tax treaty (other than the Barbados Treaty) with exchange of information programmes will qualify. Publicly traded European banks located in jurisdictions that have a tax treaty with the US generally will be qualified foreign corporations, provided, among other limitations, that the bank is not a passive foreign investment corporation. While financial institutions that conduct active banking operations (whether directly or through a subsidiary) will not be treated as passive foreign investment corporations, sophisticated issues can occasionally arise in applying existing legal authorities to an issuer’s particular circumstances.
Indirect tier 1 offerings through special purpose vehicles generally should allow US individuals to claim the reduced dividend rate. In the typical Delaware LLC/trust structure, qualified dividend payments received from an eligible foreign bank pass through the LLC and trust to US individual investors and US mutual funds with US individual investors. Each special purpose vehicle must be treated as a pass-through entity from a US tax perspective and not as a corporation.
In the unlikely event that the foreign bank is in a jurisdiction that has not entered into a qualifying income tax treaty with the US, the reduced dividend rate can be claimed if the dividend-producing securities are readily tradable on an established US securities market. Certain special purpose vehicles, however, may prevent qualified dividend treatment because the underlying securities would not be readily tradable.
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Maximum marginal US federal tax rates for individuals |
Qualified dividend treatment is available only if US individual investors satisfy certain holding period rules. Generally, an investor must hold a security with a dividend preference for 90 days during the 180-day period commencing 90 days before the ex-dividend date (except where the investor holds for only part of the year, in which case the stock must be held for 60 days during the applicable 120-day period). For these purposes the 90-day (or 60-day) holding period is suspended when an individual has diminished its risk of loss on the preferred securities through a hedge or the existence of creditors’ rights.
US tax and business issues
Perhaps the most significant limitation on the new reduced dividend rate is that it expires at the end of 2008. While the legislation’s supporters know that there will be considerable pressure to prevent a sunset, there is no certainty that the concession will be extended. This raises difficult pricing issues. Although an issuer call right five years after the issue date could dovetail with the scheduled dividend rate sunset, the Basle rules only permit moderate coupon step-ups in conjunction with a call right a minimum of 10 years after the issue date. Neither approach is likely to eliminate investor concerns.
One solution might be for issuers to pay a limited gross-up in the event the dividend rate is not extended after 2008, but with a call in year 10. This solution would require the approval of bank regulators and possibly the Basle Committee. Arguably, regulators would have an incentive to permit a limited gross-up if the pricing benefits through 2008 are substantial and the gross-up thereafter does not exceed the yield the issuer would have paid if the initial offering had not been directed to US individuals.
Providing investors with a put right if the reduced dividend rate is not extended would presumably deny tier 1 treatment. Further, a put with creditor rights could prevent the holder from claiming the reduced dividend rate even before 2009. Pursuant to a 1994 US Treasury ruling, corporations that hold equity instruments with creditor rights are not treated as satisfying holding period rules identical to those required to qualify for the reduced dividend rate.
More generally, even structures that clearly receive equity treatment under US tax rules will need to be carefully reviewed to ensure that holders can qualify for the reduced dividend rate. As the 1994 Treasury ruling makes clear, eliminating meaningful creditor rights will be crucial. Similarly, under US Treasury regulations, a guarantee can toll the holding period rules, preventing favourable dividend treatment. Although this rule was primarily directed at third-party guarantees and other credit enhancement techniques, even related party guarantees should be scrutinized. Limited guarantees required under securities laws to ensure payment to investors of funds received by the special purpose vehicle should not raise a concern. Because the Basle guidelines do not afford tier 1 treatment for securities with full guarantees, most structures should not raise significant tax issues. Finally, the issuer must not take the position at issuance that the instruments are debt for US tax purposes. Investors in this case could only treat the instrument as equity if they reported the contrary position on their tax return.
Other opportunities Certain non-US banks may have additional opportunities for issuing debt/equity hybrid securities. Upper tier 2 capital securities in many countries are perpetual, deeply subordinated and can absorb continuing losses. Accordingly, they can qualify as equity for US tax purposes, notwithstanding their home-country debt treatment. Although payments are cumulative on most tier 2 capital instruments, this debt-like feature generally should not overcome the absence of a fixed maturity date and the lack of creditor rights to sue for principal.
Other regulated entities with equity capital requirements, such as insurance companies, may be able to take advantage of the new US dividend rules. Even companies in low tax jurisdictions may find the opportunity attractive. For companies located in non-US treaty jurisdictions such as Bermuda, the securities would need to be readily tradable on a US securities exchange. The insurance company also could not be treated as a passive foreign investment company from a US tax perspective, which may raise significant issues for insurance companies with very significant reserves.
Outside of the regulatory capital arena, non-US corporate issuers in low tax jurisdictions or with no need for home-country interest deductions (because of net operating loss carry-forwards or minimal projected taxable income) might find US-targeted preferred equity offerings attractive. Historically, the preferred market in the US has been limited to US issuers. Dividends on preferred shares of US corporations, in contrast to foreign corporation preferred shares, qualify for reduced tax in the hands of US corporate investors.
Non-regulated issuers outside the US may also explore the opportunity to issue debt/equity hybrids if a significant US market for dividend-producing securities develops. Of course, because these issuers may be able to issue straight debt to achieve their capital objectives, any pricing benefit available from issuance of qualified dividend securities will be reduced by the incremental yield payable to investors for the equity risks inherent in the security.
