Understanding corporate finance: the legal and regulatory framework: tiers of capital: innovative Tier 1 capital
Innovative Tier 1 capital
The Financial Services Authority (FSA) allows banks to hold 15% of total Tier 1 capital in the form of debt issued to the market. This is known as innovative Tier 1 capital. As it is debt, the bank can obtain a deduction for the cost of paying interest on this capital. This will often be more attractive than issuing additional shares because dividends paid on share capital are not an allowable tax deduction. Also increasing share capital decreases earnings per share. The 15% ceiling on this type of capital is set by the FSA in line with guidance from the Basel Committee; see CFM14150.
Example of an innovative Tier 1 issue
- Investors subscribe for securities in an intermediate company. These are usually described as ‘preferred securities’ and have similar characteristics to preference shares. The investors may be wealthy individuals or companies.
- The intermediate company uses the proceeds of the issue of securities to acquire an interest in a Jersey limited partnership.
- The partnership lends the funds on to the bank.
- The bank pays interest to the partnership for which it receives a tax deduction.
This or a similar structure is necessary because if the bank issues preference shares it will not get an interest deduction for dividends paid on the shares. Similarly if the bank issues bonds directly to investors they may not qualify as Tier 1 capital of the bank. Using the partnership both objectives are met. Interest is paid by the bank and can be deducted for tax purposes. The partnership is treated as a minority holding that counts as Tier 1 capital of the bank.
HMRC issued guidance in 2005 on the circumstances in which it would accept the tax deductibility of payments representing the return on innovative Tier 1 issues.
TONS (Tier One Notes)
Some banks issued instruments with tax deductible interest payments as part of their core Tier 1 capital (rather than the 15% range). The FSA stopped approving these instruments as part of core Tier 1 in late 2003 although existing issues are grandfathered.