Netherlands: Tax treatment of AT1 capital G.C.F. van Gelder ; S. Frankenberg 1. Introduction As of 1 January 2015, the newly introduced article 29a of the Dutch Corporate Income Tax Act 1969 (CITA) deals with the tax classification of Additional Tier 1 capital (AT1 capital) issued by banks and insurance companies. [1] In brief, Dutch banks must satisfy the capital requirements under the Capital Requirements Regulation and Capital Requirement IV Directive (CRD IV Directive) in order to increase their required equity capital. [2] The requirements under the CRD IV Directive and the Capital Requirements Regulation derive from the Basel III accord, the purpose of which is to improve the ability of the banking sector to absorb shocks arising from financial and economic stress. [3] The reason for implementation of the Basel III accord is to reform both the quality and quantity of the regulatory capital base and enhance the risk coverage of the capital framework of banks. As of 1 January 2016, insurance companies must comply with the stringent conditions of the Solvency II Directive. [4] The main purpose of this Directive is to protect the interests of policyholders. This objective is achieved by quantitative capital requirements, requirements as regards the quality of the operational management and increased transparency to the public and regulators. Consequently in the 2015 Dutch Tax Plan, article 29a of the CITA is amended such that a tax deduction is allowed for payments on subordinated liabilities, which are part of AT1 capital, but do not form part of the share capital, share premium, capital guarantee, member contributions, surplus funds or reconciliation reserves of insurance companies. The Dutch State Secretary for Finance has commented several times on the Dutch tax treatment of AT1 capital. The question was whether payments on AT1 capital should be deductible at the level of the issuing party and taxed at the level of the recipient. [5] During the parliamentary proceedings of the 2014 Dutch Tax Plan, the Senate finance committee indicated in its final report that the enactment of this legislative proposal can be dealt with as a formality. [6] Notably, the committee also expressed a reservation in its final report, stating that the exchange of views on AT1 capital must be continued at a later time. It is the authors’ hope that this article will contribute to the discussion on AT1 capital. 2. Background: AT1 Capital The Basel accords set out the capital requirements relating to the solvency of banks. [7] Considering the size and function of such financial institutions, there is a need to strictly regulate the extent to which they are able to absorb potential losses on risk-adjusted assets with their capital. The defined solvency ratios are formed by the credit risk, market risk and operational risk which banks are exposed to with regard to their assets, although in different weighting percentages. The capital of banks consists of two main categories, namely core capital (Tier 1 capital) and additional capital (Tier 2 capital). Tier 1 capital (also referred to as “going-concern capital”) does not contain any contractual repayment obligations for the issuer and is therefore placed permanently at the disposal of the bank. The main elements of this capital consist of ordinary share capital, share premium reserves and retained profits. On the other hand, Tier 2 capital includes long-term subordinated debt and Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 revaluation reserves. With regard to Tier 2 capital (also referred to as “gone-concern capital”), there are more obligations from the issuer’s perspective in comparison to Tier 1 capital and as such, these assets are considered to be less valuable than the assets included in Tier 1 capital from a financial regulator perspective. Consequently, one can say that while Tier 1 capital is focused on preventing insolvency, Tier 2 capital contributes to depositors and preferential creditors’ being reimbursed if such financial institution were to collapse. An intermediate category is formed by AT1 capital. The distinguishing features of this capital relate to the perpetual character of such instruments and the fact that the provisions governing them include no incentive for the institution to redeem them. Furthermore, the instruments may be “called”, “redeemed” or “repurchased” only where the conditions laid down in article 72 of the above-mentioned EU Capital Requirements Regulation are met, and not prior to five years after the date of issuance with consent of the financial regulator. Moreover, some additional requirements are laid down with regard to AT1 capital under which the instruments may not be subject to any arrangement – contractual or otherwise – enhancing the seniority of the claim under the instruments in the case of insolvency or liquidation, and in addition rank the instruments below Tier 2 instruments. The provisions governing the instruments require the principal amount of the instruments to be written down, or the instruments to be converted into Common Equity Tier 1 instruments, upon the occurrence of a triggering event (for example if a bank drops under a certain solvency ratio). Under the new Basel III rules, banks will be required to hold at least 6% of their risk-weighted assets in the form of Tier 1 capital. Of that, up to 1.5% of the risk-weighted assets may be in the form of AT1 capital, and 4.5% of risk-weighted assets in the form of Common Equity Tier 1. The total capital ratio will remain 8% of risk-weighted assets and as such, the Tier 2 ratio is 2% of riskweighted assets. With regard to future capital requirements under Basel III, an overview is shown below. [8] Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 An example of an AT1 instrument is a (perpetual) convertible subordinated debenture loan (contingent convertibles, popularly abbreviated as CoCos). Recently, Rabobank was the first Dutch bank to issue such instruments. Rabobank postponed the issuing of CoCos until it was clear that the payments on these coupons would be tax deductible. Furthermore, another Dutch major bank, ABN AMRO Bank, announced that it intends to issue CoCos in order to strengthen its capital position. [9] 3. Classification AT1 Capital for Dutch Corporate Income Tax Purposes First, article 29a of the CITA focuses on the determination of profit. This is seen in the wording of article 29a: “with the determination of profit”. It could therefore be argued that this provision does not make any judgement related to the tax classification or form of AT1 instruments, but solely concerns the determination of profit. In this regard, one should consider the Caspian Sea case, in which the Dutch Supreme Court made clear that the essential characteristic of a loan is the repayment obligation of the debtor.[10] This is the relevant criterion to determine whether a financial instrument qualifies as a loan under civil law, in accordance with the decision of the Supreme Court. The parliament issued a classification for tax purposes on AT1 instruments in article 29a of the CITA. Here, the question is whether this classification is correct and whether the classification will hold in cross-border situations. With his letter of 16 December 2013, the State Secretary for Finance intended to inform the Dutch parliament in advance with regard to the proposed changes to the Dutch tax law related to AT1 instruments. [11] However, the State Secretary stated therein only that such financial instruments issued by banks have a hybrid character and – without the intervention of the parliament – the tax treatment of these hybrid instruments would change as a result of the Basel III accord. In the authors’ opinion, the State Secretary for Finance has been inconsistent with his remarks in advance of the implementation of article 29a of the CITA, and has insufficiently clarified the definition of his interpretation of hybrid instruments. In a letter dated 10 April 2014, [12] the State Secretary initially made a reference to Supreme Court case law dating from 7 February 2014 (the Bank Consortium case [13] and the Australian redeemable preference shares (RPS) case) [14] and claims for hybrid instruments to be assessed on the essential characteristics that apply to capital funding. In this regard, the State Secretary refers to the fact that this capital becomes part of the risk-sharing capital which is affected in the event of losses and is liable to the company’s debt. It is noteworthy that the State Secretary cited this passage from the Bank Consortium case in his letter, as the Supreme Court did not agreed that hybrid instruments (which are regarded as equity under civil law) could qualify as debt for tax purposes. The Supreme Court made clear that if a hybrid instrument is regarded as equity under civil law, it may never be reclassified as debt for tax purposes. [15] During the parliamentary proceedings of the 2014 Dutch Tax Plan, the State Secretary once more made a remark about the classification of hybrid instruments, in which he explicitly refers to the subordinated and perpetual characteristics of capital funding. [16] However, in contrast to his previous letter, the State Secretary takes a different approach. He previously pointed out the essential characteristics that inhere to hybrid instruments (i.e. part of the risk sharing capital which is affected in the event of losses and is liable to the company’s debt). The State Secretary Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 now solely refers to civil law characteristics of equity, namely the exclusive right to repayment of the principal amount in the event of a bankruptcy or liquidation and to take a similar position in the ranking order of debtors as (usually preferred) shareholders. In the authors’ opinion, the only right assumption is that the civil law classification of hybrid instruments should be based only on the applicable civil law. The applicable civil law could be Dutch civil law, as well as foreign civil law, as decided by the Supreme Court in the Australian RPS case. Thus, the 7 February 2014 judicial doctrine remains in place: if a loan is regarded as equity under civil law, it may never be reclassified as debt for Dutch tax purposes. As regards the comments made by the State Secretary in April 2014 which refer to the right of repayment and the position in the ranking order of debtors, the question concerns the extent to which the civil law assumption has led to the correct classification. It is to be examined whether there is an actual obligation of repayment with these hybrid instruments. Furthermore, under certain circumstances it is obligatory to convert the hybrid instrument into share capital. In such case, it can be argued that the position of the owner of the hybrid instrument is similar to that of a shareholder. However, until the instrument is converted, it cannot be considered a share. 3.1. Dutch dividend withholding tax position of AT1 capital Article 29a of the CITA solely relates to Dutch corporate income tax. The State Secretary of Finance did not make any comments in his letter dated 16 December 2013, nor in his letter dated 10 April 2014, regarding the treatment of hybrid instruments from a Dutch dividend withholding tax perspective. However, Senate members asked some questions about this matter during the parliamentary proceedings before the Senate. [17] In his response, the State Secretary indicated that the coupon payments on AT1 instruments will not be subject to Dutch dividend withholding tax. The State Secretary commented that if article 29a of the CITA would not have been implemented, AT1 instruments would have been classified as capital. So it seems – following the comments by the State Secretary – that if article 29a would not have been implemented, this AT1 instrument would qualify as capital whereby any payment on that capital could be subject to Dutch dividend withholding tax. In this regard, there must be income deriving from shares, profit-sharing certificates or participation loans, before any payment will be subject to Dutch dividend withholding tax. 3.2. Cross-border situations The State Secretary of Finance indicated that as a result of the introduction of article 29a of the CITA, international mismatches will be prevented. In his letter of 16 December 2013, as well as in his letter of 10 April 2014, the State Secretary indicated that the payment on the hybrid instrument from the issuing party’s perspective is tax deductible, but that the recipient of the payment will be subject to tax thereon. The authors endorse this point of view in a solely (Dutch) domestic situation. The question is whether this holds true in cross-border situations. It cannot be excluded that the jurisdiction of the recipient of the AT1 instrument payment will classify the payment as a dividend (for which an exemption is given) or it might not tax the income from the AT1 instrument at all. Of course, this depends on the national legislation of the country of residence of the recipient and whether there is a tax treaty between the Netherlands and the country of residence of the Tier 1 instrument recipient. Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 In this context, paragraph 25 of the Commentary on article 10 of the OECD Model Convention (2014) states that, under certain circumstances, interest payments may be classified as dividends for purposes of the application of tax treaties. [18] These conditions relate to whether: – a loan very heavily outweighs any other contribution to the enterprise’s capital (or was taken out to replace a substantial proportion of capital which has been lost) and is substantially unmatched by redeemable assets; – the creditor will share in any profits of the company; – the repayment of the loan is subordinated to claims of other creditors or to the payment of dividends; – the level or payment of interest would depend on the profits of the company; and – the loan contract contains fixed provisions for repayment by a definite date. Clearly, these characteristics show some similarities with the conditions as set for AT1 capital. [19] Some tax treaties have explicitly incorporated provisions under which payments arising from instruments that show characteristics of AT1 instruments are considered to be a dividend for tax treaty purposes. In this respect, one should consider the new tax treaty between the Netherlands and Germany and, in particular, article 9 of the protocol to this treaty. [20] It cannot be excluded that if a foreign entity holds an AT1 instrument and owns a participation in the issuing entity, the benefit may qualify as an exempt dividend under the participation exemption rules. This would be the case if the income in the jurisdiction of the beneficiary were to qualify as a dividend and an equivalent of the Dutch participation exemption rules is applicable. In the authors’ opinion, instead of avoiding international mismatches, a new international mismatch will be created. [21] Alternatively, one could argue that this international mismatch relates to the fact that other jurisdictions classify such AT1 instruments as debt and therefore allow the payment to be tax deductible at the level of the issuing entity. It seems that the State Secretary for Finance is referring to this, as in his letter dated 10 April 2014, he explicitly brings attention to the unfair playing field between Dutch banks and other European banks. However, in the authors’ opinion, it is a feeble argument to implement an article in the CITA which has as its guiding argument that other countries have a similar provision in their respective national laws. The State Secretary wants to level the unfair playing field by allowing Dutch banks a deductible expenditure. However, by doing so, the State Secretary, in the authors’ opinion, creates a new unfair playing field. When a specific group of taxpayers (for example banks and insurance companies) receives an advantage on a specific basis, this could be regarded as State aid. Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 4. Forbidden State Aid? The introduction of article 29a of the CITA raises the question as to whether the facility smacks of forbidden State aid as mentioned in article 107 of the Treaty on the Functioning of the European Union. Pursuant to established case law of the European Court of Justice (ECJ), State aid is present if (i) the relevant measure is financed directly or indirectly through State resources, (ii) it has an effect on intra-Community trade, (iii) the advantage is selective and distorts or threatens to distort competition and (iv) the measure confers an economic advantage to undertakings exercising an economic activity. [22] The latter condition will be discussed further, as this criterion is the most debatable, in the authors’ opinion, with regard to the introduction of article 29a of the CITA. Where the State Secretary for Finance characterizes the provision as a generic defining position that falls within the scope of the current legislation and case law and, moreover, explicitly indicates that similar instruments in other European countries already are being treated as debt capital, it is debatable whether the State Secretary has drawn a correct conclusion. First and foremost, in order to assess whether forbidden State aid is present, the potential aid measure must be assessed on a national level. In the letters of the State Secretary for Finance, reference is made several times to the fact that the payments on these hybrid instruments are already deductible in other EU Member States. However, the existence of a potential State aid measure must be reviewed in accordance with Dutch standards. Hence, it is of importance whether such measure falls within the scope of the Dutch legal methodology and, in that context, whether the measure can be regarded as generic. The frame of reference is therefore being formed by the relevant provisions of the domestic law of the Member State itself. [23] One can argue that article 29a of the CITA formally is open to all taxpayers and, therefore, can be regarded as (sufficiently) generic. However, the relevant provision refers unsparingly to the EU Regulation on prudential requirements for credit institutions and investment firms and the EU Directive on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms. [24] If (Dutch) entities not falling within the scope of the EU Regulation or Directive would like to issue such “hybrids”, it becomes quite apparent that article 29a of the CITA is, materially, far from open to all taxpayers. [25] Consequently, the selectivity criterion for forbidden State aid is fulfilled in the authors’ opinion. In this regard, the State Secretary for Finance has indicated as a counterargument that this distinction is a logical result of the fact that only banks (and insurers) must comply with the new capital regulations. Although this is a correct observation, the State Secretary disregards the fact that such institutions, in comparison to other – regular – companies, are the least capitalized entities. These other companies must maintain proportionally more capital to carry out their activities properly. Therefore, in the authors’ opinion, the comments of the State Secretary are therefore not very well founded. Moreover, the State Secretary, in fact, strengthened the existence of forbidden State aid by his comments relating to the international playing field for banks and other financial institutions. As a justification for the introduced measure, the State Secretary asserted that this measure is prompted by a competitor perspective in the context of the international “level playing field” between Dutch banks and banks in other EU Member States. In the authors’ opinion, with this remark the State Secretary, in fact, emphasizes that the introduction of article 29a of the CITA Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 was expressly prompted from a perspective under which a specific group of taxpayers is being favoured and hence – to use the words of the ECJ – “forms a departure from the general tax rules, which cannot, in principle, be justified by the nature or logic of the tax system in question”. [26] Finally, one should consider the Unicredito Italiano case in which the ECJ ruled that if an advantage is attributable to a whole economic sector, the selectivity criterion is fulfilled. [27] That case concerned a tax relief for the (Italian) banking sector. The ECJ ruled that this relief was not for the benefit of companies in other sectors of the economy and, moreover, that this relief within the banking sector was only for the benefit of companies that were involved in the underlying transactions. In the authors’ opinion, it therefore requires no further explanation that article 29a of the CITA should have been notified, prior to its introduction, to the European Commission. However, if the State Secretary for Finance were to reconsider granting the same benefit also to companies other than solely banks and insurers to issue such hybrid instruments (in conjunction with the deductibility of the payments on these instruments), the selective economic advantage would cease to apply, as the arrangement of article 29a of the CITA in such case would be open to all taxpayers. 5. Conclusion The introduction of article 29a of the CITA raises various questions with regard to the Dutch tax implications of AT1 instruments. The difficulty relates to the fact that these kinds of instruments contain specific characteristics which cannot be defined in an unambiguous manner. That such “hybrid” instruments are permanently placed at the disposal of the bank and do not contain any contractual repayment obligations are already familiar features with regard to the classification of capital under Dutch tax law. However, the fact that such instruments may be “called”, “redeemed” or “repurchased”, contributes to the conclusion that the tax classification of AT1 capital is not as straightforward as may be assumed. More specifically, the question concerns whether this classification should be in accordance with the essential characteristics pertaining to such capital payments or, on the contrary, solely in accordance with the characteristics of such payments under civil law. It seems that the State Secretary for Finance is not very consistent in his approach, especially with regard to his rather unfortunate reference to specific Dutch case law (i.e. the Bank Consortium case and the Australian RPS case). In addition, some critical comments can be offered with regard to its application in dividend withholding tax and cross-border situations, which make one wonder whether the parliament did succeed in preventing international mismatches. The level playing field that was pursued by the State Secretary for Finance also resulted in another undesirable outcome. Equal treatment for financial institutions was intended, but the State Secretary in fact created a specific preferential treatment for the banking sector that smacks of forbidden State aid as mentioned in article 107 of the Treaty on the Functioning of the European Union. As a consequence, in the authors’ opinion, article 29a of the CITA should have been notified prior to its introduction to the European Commission. As the Dutch Senate committee already stated at the time of the introduction of article 29a that an exchange of views should be continued at a later stage, the authors urge the State Secretary for Finance to clarify any remaining uncertainties with regard to the application AT1 capital for Dutch tax purposes. Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 Voetnoten [*] Gabriël van Gelder is a senior tax manager affiliated with EY Netherlands and Sebastian Frankenberg is an associate affiliated with DLA Piper Netherlands. [1] For banks art. 29a CITA has retroactive effect as to 1 Jan. 2014. [2] Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (CRD IV Directive) and Regulation (EU) No. 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No. 648/2012. [3] From Basel III: A global regulatory framework for more resilient banks and banking systems (http://www.bis.org/publ/bcbs189.pdf ). [4] The Solvency II Directive will not be applicable to funeral insurance companies and most small insurance companies. [5] NL: Parliamentary notes, II 2013/2014, 32 013, no. 48: letter from the State Secretary of Finance, 16 Dec. 2014, DB/2013/593M; Parliamentary notes, II 2013/2014, 32 013, no. 58: decision of the State Secretary of Finance, 10 Apr. 2014, FM/ 2014/670M. [6] NL: Parliamentary notes, I 2014/2015, 33950, D. [7] Basel Committee on Banking Supervision, Basel Capital Accord, 1988 (Basel I); Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards, 2007 (Basel II); Basel Committee on Banking Supervision, Nov. 2010, G20 Seoul meeting (Basel III). [8] Source: http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf . [9] Rabobank stort zich op de coco, Dutch Financial Times (14 Jan. 2015), available at http://fd.nl/ondernemen/1088570/rabobank-stort-zich-op-de-coco. [10] NL: Hoge Raad (HR), 8 Sept. 2006, BNB 2007/104. [11] NL: State Secretary of Finance, Letter of 16 Dec. 2014, DB/2013/593M. [12] NL: State Secretary of Finance, Decision of 10 Apr. 2014, FM/2014/670M. [13] NL: HR, 7 Feb. 2014, 12/04640, BNB 2014/80. [14] NL: HR, 7 Feb. 2014, 12/03540, BNB 2014/79. Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 [15] Note in V/N 2014/19.9. [16] NL: Parliamentary notes, I 2014/2015, 33 950, p. 1. [17] NL: Parliamentary notes, I 2014/2015, 33 950, B, p. 1 and 2. [18] The Netherlands did not make a reservation for this section of the Commentary on the OECD Model. [19] In this regard, the criteria from the Commentary on the OECD Model do not correspond integrally with the provisions in the treaty, but there are similarities. It cannot be excluded that certain AT1 instruments have the same characteristics as mentioned in the Commentary on the OECD Model. [20] Convention between the Kingdom of the Netherlands and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains (12 Apr. 2012), Treaties IBFD. This treaty will be effective from 1 Jan. 2016. [21] The question concerns whether this mismatch will continue to exist following the proposal from the European Commission to amend the Parent-Subsidiary Directive, Proposal for a Council Directive amending Directive 2011/96/EU on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States European Commission, COM(2013) 814 Final, 25 Nov. 2013, 2013/0400 (CNS), EU Law IBFD. [22] DE: ECJ, 24 July 2003, Case C-280/00, Altmark Trans en Regierungspräsidium Magdeburg. [23] See A.F. Gunn, Reactie op formele onderzoeksprocedure vermeende staatssteun Starbucks, Nederlands Tijdschrift voor Fiscaal Recht 2014 (2737) (arguing that, as a result, Member States preserve their sovereignty in relation to direct taxes). [24] EC Regulation 575/2013 of the European Parliament and the Council of 26 June 2013 amending Regulation 648/2012 (PbEU 2013, L 176); Directive 2009/138/EG, PbEU 2009, L 335. [25] In this regard, see ES: ECJ, 15 Nov. 2011, Case C-106/09_P and C-107/09_P, European Commission and Kingdom of Spain v. Government of Gibraltar and United Kingdom of Great Britain and Northern Ireland, ECJ Case Law IBFD. It follows from this case that a potential aid measure must be assessed on the basis of material selectivity. [26] IT: ECJ, 10 Jan. 2006, Case C-222/04, Cassa di Risparmio di Firenze. [27] IT: ECJ, 15 Dec. 2005, C-148/04, Unicredito Italiano, legal ground no. 45. Netherlands: Tax treatment of AT1 capital / G.C.F. van Gelder ; S. Frankenberg. - IBFD dfi 2015/05/04 Ernst & Young LLP Accountancy | Belastingen | Transacties | Advies Over Ernst & Young Ernst & Young is wereldwijd toonaangevend op het gebied van accountancy, belastingen, transacties en advies. Onze 135.000 mensen delen wereldwijd dezelfde waarden en staan voor kwaliteit. Wij maken het verschil door onze mensen, onze cliënten en de samenleving te helpen hun mogelijkheden optimaal te benutten. Gabriël van Gelder is verbonden aan Ernst & Young Belastingadviseurs LLP Tel: 088-4079265 E-mail: [email protected] Voor meer informatie: www.ey.nl Disclaimer Dit bericht is met grote zorgvuldigheid samengesteld. 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