Unpacking the TP dimension of funding arrangements in the banking sector

As in any good recipe, there is one key ingredient. Capital is the one for safe and sound banks. The financial sector takes on risks and may suffer losses if risks materialise. To protect depositors and investors, and ensure the stability of the financial sector, banks need the financial capacity to absorb losses and keep going, in good and in bad times. That is what bank capital is used for.

In simple terms, every bank has two sources of funding: capital and debt.

• Capital is the money that a bank has obtained from its shareholders or any profits that it has made and subsequently not paid out. Consequently, if a bank wants to expand its capital base, it can do so, for example, by issuing more shares or retaining profits, rather than paying them out as dividends to shareholders.

• Debt is the money that it has borrowed from its lenders and will have to pay back. Debt includes (i) deposits from customers, (ii) securities issued in the international financial markets, and (iii) debt funding obtained in the short-term intra-bank market (i.e., from third-party banking institutions) or as medium- to long-term loans from its parent or other related parties in the same banking organisation.

Where it becomes tricky for tax purposes is that certain medium- to long-term debt funding can also count towards the regulatory capital (as so-called tier 2 or supplementary capital); as such, combining features of debt for tax purposes and capital for regulatory purposes.

While most parents of banking groups have the ability to issue securities to the financial markets to obtain additional debt funding (e.g., via additional tier 1, or AT1, bonds), this option is typically not available to the international subsidiaries of these banking groups.

Their options to raise medium- to long-term debt funding are limited to their parent or related parties only, directly putting any such funding arrangements into the scope of transfer pricing regulations and on the radar of tax authorities.

Following the ongoing implementation of the Basel accords, effectively raising the level of capital requirements, international banking groups face the need to introduce additional medium- to long-term debt funding towards their international banking subsidiaries to ensure compliance with new regulatory standards such as the net stable funding ratio (NSFR). The NSFR requires banks to hold sufficient levels of long-term funding as a measure to counter over-reliance on short-term wholesale funding.

These additional debt funding arrangements are typically very sizable in view of the capital base required to run a banking operation, with principals often covering billions of euros or US dollars. They also contain features that tax authorities are typically not familiar with, such as the subordination of all loans (as they would otherwise not meet the criteria for tier 2 capital) and loss absorption features.

In addition, the loan pricing is typically synthetic, using a bottom-up pricing approach based on different yield curves, the credit rating, related spreads, and adjustments, with no direct market comparables being available. This makes the outcome testing to support the arm’s-length nature of the interest rates for transfer pricing rather challenging under audit.

Furthermore, the credit rating guidance for banking institutions differs fundamentally from that used for corporates, which is something that some tax auditors may not be aware of.

Lastly, it is often local regulators that would be involved (formally or informally) in setting the capital and funding profile of the local banking subsidiaries in their respective jurisdictions, making the ex post documentation of the business rationale (for introducing additional debt funding) and defence of the debt nature of the loans for tax purposes (vis-à-vis their features as capital for regulatory purposes) even more challenging.

All the factors above are driving a wholly new range of tax audits in the banking sector, where tax functions of all international banking groups need to be prepared to defend the funding arrangements within their banking organisation, given the amounts of tax at stake and common challenges in resolving these audits.

Let us revisit more of the regulatory basics first. Pursuant to the definitions in the Basel regulatory framework, a financial institution is subject to minimum capital requirements and the capital it needs to hold has to fulfil certain criteria. Total available regulatory capital is the sum of tier 1 capital, comprising common equity tier 1 (CET1), AT1 capital, and tier 2 (T2) capital. Banks are required to maintain specified minimum levels of CET1, AT1, and T2 capital, with each level set as a percentage of risk-weighted assets.

In the Basel accords, bank capital has been divided into two tiers, each with subdivisions:

• AT1 capital, the more important of the two, consists largely of shareholders' equity and disclosed reserves; and

• T2 capital comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments, and subordinated term debt.

The two debt instruments that are of relevance for transfer pricing purposes are hybrid debt instruments and subordinated term debt:

• Hybrid debt instruments consist of instruments that combine certain characteristics of equity as well as debt. They can be included in supplementary capital for regulatory purposes if they are able to support losses on an ongoing basis without triggering liquidation.

• Subordinated debt is classed as lower T2 debt. It usually has a maturity of a minimum of 10 years and ranks senior to AT1 capital but subordinate to senior debt in terms of claims on liquidation proceeds.

Although hybrid debt instruments and subordinated term debt can be included in T2 capital for regulatory purposes, they meet the earmarks of debt for tax purposes. They have a predetermined repayment obligation, have an obligation to pay interest, and are fixed by a loan agreement.

In a cross-border context, these nuances provide an opening for transfer pricing challenges by tax authorities.

Tax authorities across various jurisdictions attempt to recharacterise hybrid debt instruments and subordinated term debt into capital under audit, ultimately trying to deny the deductibility of interest in its entirety. The primary driver of these adjustments is a lack of understanding of the regulatory dimension and the characteristics of these instruments. Anyone seeing such funding arrangements for the first time might wonder about the rationale and why all the instruments are subordinated in nature and contain features such as loss participation that are unusual in the corporate sector.

It is also essential to understand that the funding profile/requirements are typically determined based on the requirements or guidance provided by local regulators, in light of their interpretation of the Basel regulatory framework. The subordination is required per se as a prerequisite for being considered T2 capital.

While some tax auditors might be familiar with the pricing of loans in the corporate sector, they would typically not have seen intra-bank funding arrangements in the transfer pricing context. It is important to remember that even the credit rating approach/guidance, which is issued by all major rating agencies, differs fundamentally between financial institutions and corporates.

Furthermore, there are no market comparables. Although there is an intra-bank market where banks can obtain funding from third-party banks, such funding is only short term (typically overnight, with a maximum tenure of one week) but by no means matching the medium- to long-term profile required under the Basel regulatory framework and NSRF requirements.

Lastly, banks apply a synthetic approach to the pricing of such medium- to long-term debt funding that is different from how the interest on corporate loans is determined.

All the factors above explain the tendency of tax authorities to attempt a recharacterisation of such debt funding into capital under audit. As such, it is essential to properly document the ex ante pricing of the debt funding arrangements, their nature, and, even more importantly, the business rationale based on the discussions, guidance, and/or instructions of local financial regulators.

Once the hurdle to sustain the characterisation as debt has been cleared, the focus is on moving to defend the interest deductibility and level of interest charged.

The second challenge is to defend the pricing of the debt instruments for transfer pricing purposes. Here, the main hurdle is that the pricing is determined based on synthetic approaches using yield curves based on the credit rating of the related-party banking subsidiaries in the group and applying spreads/adjustments on top of the yield curve.

The pricing can only be determined on an ex ante basis and there are no market comparables. Again, while there is a market for intra-bank funding with third-party banks, the market is only for short-term (overnight to one week) maturities and not comparable to the medium- to long-term funding required under the Basel regulatory framework.

All international banking groups need to be mindful of the new challenges created by tax audits on related-party funding arrangements. Tax authorities may challenge the nature of these arrangements as debt funding and try to recharacterise the funding as a capital injection.

Even if the challenge of recharacterisation is overcome, the tax function needs to ensure that tax authorities understand the fundamental differences between the pricing of loans in the corporate sector and the pricing of intra-bank funding in the financial services sector, which materially impact the pricing and comparability. The pricing of intra-bank funding tends to be synthetic, using bank-internal pricing models and showing features, such as subordination and loss-participation, that are not commonly observed in other sectors or loan arrangements.

Given the increased importance of medium- to long-term funding for the foreign subsidiaries of most banking groups, tax functions need to actively prepare for challenges by local tax authorities and prepare their audit defence.

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