In Brief

In welcome news for foreign banks operating through branch structures in Australia, Treasury has recently released Exposure Draft^[1] legislation^[2] to amend Schedule 1 of the Income Tax Assessment (1997 Act) Regulations 2021. The proposed changes align the Australian tax treatment of certain financial instruments issued by foreign regulated entities, known as bail-in bonds, to that of domestic entities regulated by the Australian Prudential Regulation Authority (APRA).

Under the proposed changes, certain term subordinated notes issued through branches of foreign banks in Australia will continue to be classified as “debt interests” for the purposes of Division 974 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). This classification ensures that returns on these instruments are deductible to the issuer, allowing for consistency in how the Australian Taxation Office (ATO) administers the law with respect to the debt/equity classification of such instruments between Australian headquartered banks and foreign inbound banks.

What Are Bail-In Bonds?

Broadly speaking, bail-in bonds are a type of financial instrument, typically term subordinated notes, that are issued by regulated entities and may be subject to regulatory intervention under specific conditions. In the event of financial distress affecting the issuer, these instruments can be written off or converted into common equity at the direction of the relevant regulator, which may be APRA or a foreign regulatory body.

Background

The Basel III capital reforms, which were announced by the Basel Committee on Banking and Supervision in December 2010, mandated that all regulatory capital include a non-viability condition such that it was capable of absorbing losses of the entity, or group, if required to do so, in a period of financial distress.

This non-viability condition required that a regulatory capital instrument issued by an APRA-regulated entity be capable of being written off or converted to common equity in a period of financial distress. This feature introduced a level of contingency to the issuer’s payment obligations, which would typically cause the instrument to fail the debt test under Division 974 of the ITAA 1997. In particular, it would not satisfy the requirements for an effectively noncontingent obligation, a key requirement in satisfying the debt test.

To address this, the Australian Government announced in the 2012–13 Budget that it would amend the tax law to ensure that unintended tax consequences did not arise. As a result, the Income Tax Assessment Regulations 1997 (subsequently remade as the Income Tax Assessment (1997 Act) Regulations 2021 (Principal Regulations)) were amended such that the non-viability condition would be disregarded when determining if certain financial instruments issued by entities regulated by APRA (generally Australian authorised deposit-taking institutions (ADIs)) and their subsidiaries were non-contingent obligations. The amendments applied from 12 December 2012.

The Proposed Amendments

The Exposure Draft proposes to repeal paragraph 974-135.05(3)(a) of the Income Tax Assessment (1997 Act) Regulations 2021 and replace it with language that extends the same treatment to entities regulated by a comparable foreign regulator. A comparable foreign regulator in the context of these amendments is one that, like APRA, issues and administers prudential standards and has regulatory powers and responsibilities relating to capital adequacy.

Specifically, the provision will apply to:

(i) An entity regulated for prudential purposes by APRA or a comparable foreign regulator; or

(ii) A subsidiary of an entity that is regulated for prudential purposes by APRA or a comparable foreign regulator [emphasis added]

Importantly, the amendments will apply to an obligation to pay the principal or interest on a relevant term subordinated note at a particular time on or after 12 December 2012. The retrospective application provides for consistent treatment of instruments containing non-viability conditions since their introduction for APRA regulated entities.

A&M’s Insights

The proposed amendments are a welcome departure from the administrative treatment proposed to be adopted by the ATO on the application of Division 974 of the ITAA 1997 to certain bail-in bonds. More specifically, in August 2024 the ATO advised stakeholders of a change in their administrative treatment, that in the absence of a law change the ATO would commence applying their view that bail-in bonds with a non-viability trigger event would fail the “debt test” in Division 974 of the ITAA 1997 for relevant instruments issued after 1 July 2025.

The Exposure Draft therefore provides much needed certainty for the financial services industry, specifically the foreign owned banking sector, regarding the tax law and the ATO’s approach to debt/equity classification for certain instruments issued by foreign inbound banks in Australia. Importantly, the Exposure Draft provides that these relevant instruments will retain the debt classification and that the ATO’s proposed administrative treatment should no longer be relevant.

The release of the Exposure Draft legislation also comes at a time of change to the regulatory capital requirements for domestic banks in Australia. On 8 December 2024, APRA confirmed the phase-out of the $43 billion Additional Teir 1 (AT1) bank hybrid market, noting that these AT1 instruments also contain non-viability triggers are and classified as “equity interests” and frankable for tax purposes. The updated regulatory framework comes into effect on 1 January 2027, and AT1s for banks will be entirely phased out by 2032. We expect this change may prompt investors to explore alternative “hybrid investment options,” to fill the AT1 investment gap.

In this evolving landscape, commercial subordinated term notes issued by foreign inbound banks may offer a compelling investment alternative, particularly for those investors not seeking frankable returns.

Consultation on the Exposure Draft remains open, with submissions invited until 5 August 2025.

[1]“Foreign bail-in bonds exposure draft consultation,” The Australian Government, Treasury, https://consult.treasury.gov.au/c2025-674586

[2]Income Tax Assessment (1997 Act) Amendment (Term Subordinated Note) Regulations 2025, https://classic.austlii.edu.au/au/legis/cth/consol_reg/ita1997ar2021370/notes.html