Mutual financial institutions and Tier 2 capital instruments

Mutual financial institutions and Tier 2 capital instru

Anetta Johnston and Matthew Darling discuss proposed changes to taxation regulations following the Hammond Report.

A pen, calculator and chart.

In an announcement on 21 January 2019, Assistant Treasurer Stuart Robert released for consultation the draft Treasury Laws Amendment (2019 Measures No. #) Regulations 2019 which proposes to change the taxation rules relating to the treatment of certain financial instruments issued by Mutuals. 

The draft regulations are part of the government’s response to implementing the recommendations from Greg Hammond’s Report on Reforms for Cooperatives, Mutuals and Member-owned Firms (Hammond Report) released in July 2017.  In addition, on 13 February 2019 the Treasury Laws Amendment (Mutual Reforms) Bill 2019 was tabled in the Upper House of Federal Parliament which incorporates other recommendations from the Hammond Report.  We reported on the two exposure drafts released for this Bill on 18 October 2018 and 4 December 2018.

The draft regulations seek to rectify the current disadvantage experienced by Mutuals due to there being different income tax treatments of Tier 2 capital instruments convertible into mutual equity instruments and those convertible into ordinary shares.

Tier 2 capital instruments

The Australian Prudential Regulation Authority (APRA) currently requires Tier 2 capital instruments issued by authorized deposit-taking institutions (ADIs) to include a ‘non-viability condition’. Under this condition, where a non-viability trigger event occurs, the relevant capital instrument is to be either:

(a) Converted into ordinary shares of the ADI or its parent entity;

(b) Converted into mutual equity interests (in the case of mutually-owned ADIs); or

(c) Written off.

Current taxation treatment of convertible capital instruments

Division 974 of the Income Tax Assessment Act 1997 provides rules to distinguish between debt and equity for various income tax purposes. One important implication of the debt-equity distinction is that returns on debt interest may be tax deductible but are not frankable, while returns on equity interests may be frankable but are not tax deductible. Instruments cannot be both debt and equity interests for income tax purposes. Where both definitions are met, the tiebreaker rule will deem the interest to be debt.

Broadly, under the current debt and equity income tax rules, the characterisation of a capital instrument as a debt interest as opposed to an equity interest generally depends on whether the issuer has an “effectively non-contingent obligation” to repay the investment. This test operates with regards to the economic substance of the rights and obligations under the scheme.

Ordinarily the non-viability condition required by APRA would create a contingent obligation to repay an investment on a capital instrument, thereby precluding the instrument in being treated as debt for tax purposes. Currently, as a result of regulation 974-135F of the Income Tax Assessment Regulations 1997 (ITAR97) Tier 2 capital instruments convertible into ordinary shares do not cease to be debt interests merely because they are subject to a non-viability condition.

However, regulation 974-135F refers only to capital instruments convertible into equity shares which a Mutual is precluded from issuing. This means that capital instruments convertible into mutual equity interests are currently precluded from being treated as debt for tax purposes due to the non-viability condition and are instead treated as equity interests.

Proposed tax regulations

The proposed regulations will rectify this by amending regulation 974-135 so that capital instruments convertible into mutual equity interests (such as the newly proposed mutual capital instruments or “MCIs” from the Treasury Laws Amendment (Measures for a later sitting) Bill 2018: Mutual entities (tranche 2)) are treated in the same manner as capital instruments convertible into ordinary shares.

It is important to note that while the updated regulations will facilitate the debt treatment of capital instruments issued by mutually-owned ADIs, they will not necessarily deem such instruments to be debt interests (which would preclude franking).  The broader debt and equity rules will need to be considered for each instrument and the outcome will be dependent on the specific terms and conditions of the MCI. 

The draft regulations are a welcome development for the Mutuals sector and are another step towards levelling the playing field between Mutuals and investor-owned financial institutions in respect of capital raising, and promoting growth, innovation and competition in the broader banking industry.

To read other articles like this, please log on to KPMG Tax Now.

Register for KPMG Tax Now if you have not already done so.

KPMG Australia acknowledges the Traditional Custodians of the land on which we operate, live and gather as employees, and recognise their continuing connection to land, water and community. We pay respect to Elders past, present and emerging.

©2023 KPMG, an Australian partnership and a member firm of the KPMG global organisation of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. All rights reserved. The KPMG name and logo are trademarks used under license by the independent member firms of the KPMG global organisation.

Liability limited by a scheme approved under Professional Standards Legislation.

For more detail about the structure of the KPMG global organisation please visit

Connect with us

Save, Curate and Share

Save what resonates, curate a library of information, and share content with your network of contacts.