Many banks’ corporate development teams are increasingly optimistic that they will soon be focusing on acquisition pipelines, after years of primarily executing disposal programmes. Similarly, private equity funds, backed by large investor demand, are showing a growing interest in challenger banks and other regulated businesses.
Whether it’s a case of those buyers subject to PRA prudential regulation in relation to regulatory capital, or the potential targets themselves, capital management and planning are essential parts of an acquisition. That includes:
This article highlights the opportunities that may exist to drive value from an acquisition and subsequent structuring, if due diligence and planning are undertaken jointly in terms of both tax and regulatory capital. It also demonstrates why tax specialists are well placed to help achieve these benefits banks and other regulated businesses.
It is often thought that management of the effective tax rate alone is the main way in which tax departments and advisers can boost a regulated business’s capital position. However, focusing on balance sheet items can also highlight immediate capital benefits, including:
A tax specialist is well placed to look at these issues holistically, With some regulatory capital knowledge, they can work with their Corporate Development and Treasury colleagues to help create value for the 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, these could be offset against other items in the balance sheet (perhaps by simply understanding whether an alternative accounting treatment might be available post-acquisition). For instance, DTAs will often arise in respect of a pension fund deficit, but it might be possible to offset that DTA against the deficit itself. Similarly, DTAs and current tax liabilities may be inter-related and so eligible to be offset.
The result of netting off these opposing balances is neutral from a book perspective, but can improve the regulatory capital position, given their different capital treatments.
All tax advisers know that the acquisition structure and related funding can be absolutely key in driving value. However, in the context of a regulated business, there is an extra dimension; often the type of funding required to make the structure tax efficient will not count towards regulatory capital funding and ratios. Proper consideration is therefore essential, as it may be possible to introduce a structure that achieves both sets of objectives.
For a bank looking to acquire assets/liabilities, 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. That, broadly, means banks and building societies with profits in excess of the £25m annual allowance (see Chapter 4 of the Corporation Tax Act (“CTA”) 2010). The choice of entity may be determined by regulatory requirements, but to the extent that there is flexibility, this issue should be one of many considered before the decision is made. That is particularly true because acquiring it into an entity subject to the surcharge could prevent that business being transferred out to a different entity at a later date, without it still being subject to the surcharge given anti-avoidance provisions contained in s269DN of CTA 2010. Additionally, for those larger banks subject to the UK bank levy or close to the £20bn bank levy threshold, consideration needs to be given to the bank levy impact of acquisitions and / or financing through the UK.
It is therefore important that these issues are raised with the appropriate decision makers at the very outset, to ensure the transaction is carried out in the right way and analysis on the capital returns is undertaken correctly.
Management of capital intensive assets between entities is a key area and should be considered at the time of the acquisition, and/or post-acquisition. It can improve, perhaps materially, the solus capital position of the respective entities. While 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 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 (risk weighted at 250% - see Article 48 of the Capital Requirements Regulation. These regulations also take into account a regulated entity’s investment in subsidiaries in determining the size of the DTA threshold – hence the importance of legal entity structures and positioning of subsidiaries).
In relation to an acquisition, improving solus capital efficiency might therefore be possible if a target business with related DTAs can be acquired into an entity where the DTA threshold will not be exceeded (or indeed an entity that has no solus prudential capital requirements if possible). Given the creation of large DTAs as a result of the introduction of IFRS 9 and the amendments to the Loan Relationships and Derivative Contracts (Change of Accounting Practice) Regulations 2004 that spread the deduction over 10 years, the acquisition of loan portfolios is one area where this could be relevant.
On a post-transaction basis, or if internal restructuring is to be undertaken, the same opportunity exists. Transferring DTAs from an entity where they exceed that entity’s DTA threshold to one in which they will instead be treated as risk weighted assets should be considered, or even transferring them to a non-regulated entity, depending on the nature of the assets and related DTAs involved. This might be possible, for example, through the use of an election under s198 of the Capital Allowances Act 2001. However, this may need to be balanced against the impact of having to write down the value of the DTA and its one-off impact on group returns, to the extent that the DTA has moved to a relatively lower taxed entity (in other words, one whose profits are not subject to the banking surcharge).
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 (for example, a service company) an immediate improvement in the transferor’s solus regulatory capital can potentially be achieved.
Tax will need to play a key part in structuring the transfer to ensure, for instance, that potential taxable gains in the UK (or other jurisdictions that may claim part ownership) are understood. However, transferring it from the regulated entity as user of the asset to a new owner may also represent a further opportunity where ongoing capital returns can be increased, through qualification for the UK Patent Box regime under Part 8A of CTA 2010, so that profits arising from patents are taxed at 10%. This is an area of focus for banks and others in the FS 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 with which groups have struggled in the past when a single entity both owned and used the asset.
The insights above have been made in the context of acquisitions. However, many of these issues should also be considered if an internal restructuring is being planned, whether driven by external factors, such as Brexit, or due to internal operational or business change.
Whether in the context of an acquisition or restructuring, proper due diligence and planning involving both tax and regulatory capital at one and the same time can realise material value. Tax specialists with some regulatory capital knowledge, or in regular dialogue with their Corporate Development and Treasury colleagues, are well placed to help achieve these benefits.