According to a King & Wood Mallesons (KWM) note seen by KangaNews, on 2 August the Australian Taxation Office (ATO) notified the Australian Financial Markets Association (AFMA) that it was changing its approach to the taxation of bonds subject to bail-in. Specifically, the ATO has concluded that the inclusion of bail-in language causes these bonds to fail the “debt interest test” of division 974 of the Income Tax Assessment Act 1997.

Distributions from instruments that are eligible for bail-in may not be tax deductible unless the security passes a debt interest test. However, the debt test operates as a tie-breaker in the case of securities that share characteristics of debt and equity. Tim Sherman, partner at KWM in Sydney, says securities that satisfy the equity test and the debt test in the tax rules are treated as debt for tax purposes.

In this case, however, the ATO has determined that the ability of parent regulators to convert bail-in securities to equity is sufficient for these notes to fail the debt interest test. The judgement comes down to the view that the possibility of mandatory convertibility makes bail-in bonds effectively contingent liabilities, and therefore not suitable for treatment as debt interests.

Market participants involved with the issue are confident a resolution can be achieved – and indeed that one may already be in process. But getting there involves engagement with Australia’s federal Treasury and it is important that focus be maintained, they say: the risk for offshore authorised deposit-taking institutions (ADIs) in Australia is significant even if it is also remote.

The problem only applies to a subset of bank bonds issued in Australia. According to Sherman, Treasury updated the regulations more than a decade ago in the case of Australian banks to provide that their bonds may continue to be treated as debt even if subject to regulatory bail-in. The ATO has maintained this position.

The problem also does not arise if the issuing bank’s parent jurisdiction does not have bail-in language in its regulatory regime. This means that ADIs with Chinese parentage, for instance, currently remain debt interests for tax purposes. Covered bonds generally are also typically explicitly excluded from bail-in conversion.

Finally, bonds issued in Australia by offshore banks for the purposes of funding outside Australia would generally not be subject to Australian tax and no Australian interest deductions are sought in this case. As such, the application of the same theoretical interpretation of their parental bail-in regimes is moot.

While this means the ‘true Kangaroo’ bank market is unaffected, it also negates a potential work-around for local branches. In theory, the parent could issue in Australia and make the funds available to the local branch – but, Sherman explains, where this happens it is also necessary to test the deductibility of interest and applicability of withholding tax.

Still, the affected issuers represent a substantial contribution to bond supply in Australia – and, more importantly, a significant source of funds for banks that are active locally. According to KangaNews data and based on a conservative estimate of the banks likely to be affected, combined issuance by this group is nearly A$16.5 billion since the start of 2022 (see chart).

Some market sources suggest the outcome is somewhat perverse, as one arm of the Australian regulatory regime is effectively making it hard for domestic branches of offshore banks to raise money in the local capital market while another – the Australian Prudential Regulation Authority – is keen for branch ADIs to demonstrate that they can fund themselves, including via wholesale issuance, independent of offshore support from headquarters.

Furthermore, there is some debate about the idea that bail-in provisions make senior debt securities contingent liabilities. The KWM note highlights three reasons why bail-in bonds should be treated as debt for tax purposes. The first is that bail-in provisions are not typically included in the provisions of a bond but exist under foreign law and regulation, which should not disqualify a bond from being a debt security.

The second is that the likelihood of bail-in of senior bonds as a consequence of regulatory intervention is sufficiently remote that it should be disregarded when applying the debt interest test.

Finally, KWM’s note argues: “Any bail-in would only occur where [the bank’s] home regulator has determined that the issuer is not viable or is close to nonviability and certain classes of debt should be bailed in. Nonpayment in these circumstances should not cause the bond to fail the debt interest test.”

The risk, should the issue not be resolved, is that the removal of tax deductibility from affected bonds will make issuing uneconomic – negating the affected banks’ best source of direct wholesale funding and a source of issuer diversity in the Australian dollar credit market. Rob Colquhoun, director of policy at AFMA in Sydney, tells KangaNews not having tax deductibility would add 42 per cent to the cost of issuing senior bail-in debt – which he says would mean local issuance would be commercially prohibitive.

The ATO has said it will begin administering the current law on instruments issued on or after 1 July 2025. In effect, it is granting a moratorium on outstanding notes and any issued in the next few months. But the onus is on market participants to change the rules before the mid-point of next year: in the absence of action, tax deductibility will be denied from then on.

The agency with the most immediate power to change the outcome is Treasury. It was responsible for the clarification of tax rules for Australian domestic banks’ bail-in instruments and market participants say it should be relatively straightforward to extend the same treatment to issuance by offshore bank branches. The Treasury media department did not respond to multiple requests for comment by KangaNews.

The ATO, by contrast, effectively has its hands tied. Its role is to administer the tax code and market sources say, while there are arguments contrary to the ATO’s, its interpretation is not definitively wrong. One source familiar with the dialogue suggests the tax office agrees that the situation is the product of a technicality but it needs definitive guidance from Treasury in order to change its approach.

Market participants tell KangaNews their sense is that it is a bandwidth issue for Treasury. In effect, initially the issue may have fallen between the cracks: industry may have assumed it would simply be resolved while Treasury has not prioritised it given a relative absence of noise about it.

AFMA and others have made representations to the ATO and Treasury, confirming the advice that the former provided to the latter that the instruments should be debt from a tax policy perspective.

Colquhoun says there are good reasons to hope for a positive resolution – especially on the basis that engagement with Treasury has been very constructive. “There needs to be an update to the tax code but this has happened before – including for Australian banks issuing subordinated debt with a bail-in trigger,” he explains.

Doing so will require some commitment of time and resources, albeit likely not an excessive one. “This sort of change wouldn’t need to be voted on by parliament in the same way as legislation, but regulations would need to be issued by the governor general – it can’t just be done via a statement, there is a formal process to go through,” Sherman explains.

Colquhoun continues: “Importantly, though, all the ATO needs is an assurance from government that it will fix the issue at some point in the future – it doesn’t need to be right now. My hope is that the ATO putting a deadline in place will accelerate Treasury’s thinking.”

On the other hand, timing may not be on the side of those advocating clarification. Colquhoun acknowledges that the government’s tax agenda has been “very full” for the past two years while the looming federal election – which must take place by 27 September 2025 and could come sooner – could scupper progress if it is left too long. The optimal window for action is probably the last weeks of this year and early next.

“The perfect time for a statement of commitment from the government that it will fix the issue is the upcoming mid-year economic and fiscal update, in early December,” Colquhoun suggests. “Once the government has made the announcement, which will prevent a change of ATO approach, all stakeholders – including issuers, arrangers, government and the ATO – can work together to find a legislative solution that will ensure similar issues will not arise in future.”