Many corporate development teams within banks are increasingly optimistic that they will be turning their attention to acquisition pipelines soon, following years of executing disposal programmes. Similarly, private equity funds backed by large investor demand are increasingly showing an interest in challenger banks and other regulated businesses.
Whether it is buyers that are subject to Prudential Regulatory Authority (PRA) regulation in relation to regulatory capital, or the potential targets themselves, capital management and planning are essential in the context of an acquisition given i) the impact the acquisition can have on existing capital ratios of an acquiring bank, and ii) the increasingly onerous capital requirements and stress tests that PRA regulated businesses have to meet more broadly, with their knock on impact on profitability and investor returns.
Focus on both regulatory capital and tax jointly
The following highlights some key areas that should be considered by a potential buyer. By focusing on regulatory capital and tax together, upfront as well as ongoing value can be created. It is not an exhaustive list, but instead highlights opportunities that may arise from planning around the use of different legal entities or tax assets on the balance sheet. It is often thought that planning and management of the effective tax rate alone is the key way in which tax departments and advisers can help contribute to the continual need to improve capital. However focusing on balance sheet items can also crystallise immediate capital benefits, whether these are subsidiaries, deferred tax assets (DTAs), or other assets that can lead to material capital inefficiencies if held in the wrong entity.
Focussing on the target business
Some easy wins may be possible simply by focusing on the balance sheet of the target business. By understanding the underlying cause of DTAs and other tax balances, it may be possible for them to be offset against other items in the balance sheet (whether through additional planning or simply understanding an alternative accounting treatment that will be permissible post-acquisition). For instance, DTAs will often arise in respect of a pension fund deficit, but it might be possible or appropriate to offset that DTA against the deficit itself. Similarly, DTAs and current tax liabilities may be inter-related and be able to be offset.
The result of netting off these opposing balances is neutral from a book perspective, yet can improve the regulatory capital position given their different capital treatments.
Form of acquisition and structure
The acquisition structure itself can be absolutely key in driving value; often the type of funding required to meet regulatory capital objectives will not be aligned with the desired tax treatment, however if proper planning is undertaken the structure can be designed to help ensure both sets of objectives are met, to the ultimate benefit of investors. This can be a complicated area, and one which will be expanded upon in a future article.
Other opportunities will arise depending on whether the business being acquired is in the form of subsidiaries or assets/liabilities. For a bank looking to acquire the latter, the post-tax returns of the new business will depend on the choice of acquiring legal entity and whether it is subject to the 8% banking surcharge. The choice of entity may be determined by regulatory requirements, but to the extent there is flexibility this issue should be among the many to be considered in making this decision, particularly as acquiring it into an entity subject to the surcharge could mean profits of the business continue to be subject to the surcharge even if it is transferred to a ‘non-surcharge’ group entity at a later date - given tax anti-avoidance rules addressing internal restructuring to avoid the surcharge.
Once the business is acquired, what can be done?
Management of capital intensive assets between entities is a key area to look at. It can improve, perhaps materially, the solus capital position of the respective entities and, whilst moving such assets will not necessarily improve the consolidated capital position in itself, it can mean excessive group capital can be released if it has arisen simply to fund inefficient underlying solus capital positions.
DTAs are one such type of asset. In an entity with Core Tier 1 capital requirements the capital treatment of DTAs is determined according to their size relative to the entity’s “DTA threshold” (broadly 10% of its solus Core Tier 1 capital); the proportion of the DTA in excess of this threshold is treated as a total deduction from capital, while the amount below the threshold is treated as a risk weighted asset. Hence solus capital improvements might be possible if DTAs can be transferred from an entity where they exceeded that entity’s DTA threshold to one in which they will instead be treated as risk weighted assets. Both acquisitions and restructurings can give rise to opportunities in this space.
Another capital inefficient asset to consider is intangible property, representing a total deduction from capital. If it is possible to transfer it out of the regulated entity into a separate group company (eg a service company) an immediate improvement in the transferor’s solus regulatory capital might be achieved.
Tax needs to be given consideration when structuring the transfer to help ensure, for instance, that any taxable gains in the UK (or other jurisdictions that may claim part ownership) are understood. However transferring it from the regulated entity as a user of the asset to a new owner, may also represent a further opportunity in which ongoing capital returns can be increased through qualification for the UK Patent Box regime (whereby ‘profits’ arising from patents and falling within the regime are subject to a lower tax rate of 10%). This is an area of focus for banks and others in the financial services sector due to the increasing importance, and development of technology and related patents. The ability to separate the owner of the asset from the user can mean it is now possible to identify such profits, an issue that groups have struggled with in the past when a single entity both owns and uses the asset.
Opportunities arising from regulatory reform
The comments above are made in the context of an acquisition. However many of these issues should be considered if an internal restructuring is being planned too, whether driven by external factors (eg Brexit) or due to internal operational or business change.
Whether in the context of an acquisition or restructuring, proper due diligence and giving consideration to tax and regulatory capital together can result in potential opportunities being identified that have the ability to realise material value.