In an age where risk determined performance management is increasingly getting into board level agendas and where moves towards capital convergence are the order of the day, banks are compelled to look at innovative ways of continuously shoring up their capital base.

Over the years since Basel I, banks have been providing for expected credit losses on credit portfolios, based on their historical defaults. Banks are currently required to provide for adequate capital for both credit and market risks on their banking and investment portfolios respectively.

Under Basel II, banks can expect to put aside capital according to the "riskiness" of their credit portfolios and are now required to have a capital cover for operational risks. Though Basel II is not a legal document, to synchronise with global trends and expectations of all stakeholders, banks are planning to adopt these guidelines as per local regulatory directives.

In India, the transition to the new capital adequacy framework in accordance with Basel II norms (originally scheduled for March 2007 but recently extended), would require banks to raise additional capital, particularly for some of their credit portfolios and operational risk.

Till now banks have not had many options to raise capital. It is here that the recent RBI guidelines, which allow banks to raise capital by issue of Innovative Perpetual Debt Instruments (IPDIs) and debt capital, open the doors for looking at "innovative instruments" to raise further capital. Let's take a look at the salient features of these instruments and the minimum qualifying requirements:

IPDIs

Innovative Perpetual Debt Instruments are eligible to be issued as Tier I capital. It can be issued in rupees or with prior approval in foreign currency. Maximum amount that can be raised is 15 per cent of Tier 1 capital reduced by intangible assets. As the name suggests, the maturity period is perpetual. The instruments can be issued at fixed or floating rate referenced to a market-determined rupee interest benchmark rate.

As regards trading in options, investors are not allowed to exercise put options. Call options are exercisable only after 10 years and with RBI approval. Step option can be exercised in conjunction with the call option, and the step-up not more than 100 bps. If the capital adequacy ratio is not met, then there can be lock-in period for the interest payment. In case of losses, RBI approval is required for payment of interest.

Debt capital instruments are eligible to be issued as Upper Tier II capital. Maximum amount that can be raised should not exceed Tier 1 capital reduced by intangible assets. The maturity period is minimum of 15 years. The instruments can be issued at fixed or floating rate referenced to a market-determined rupee interest benchmark rate. As regards trading in options, investors are not allowed to exercise put options. Call options are exercisable only after 10 years and with RBI approval.

From the aforesaid features one can note that these instruments can be termed as what are globally known as hybrid instruments, that is, those having characteristics of both equity and debt capital which exhibit all the benefits of debt but can be treated as equity, creating a powerful proposition. This enables spacing out of maturity profiles of instruments.

However, the true comparison of cost of hybrid capital would be with COE (cost of equity) and not cost of debt. The underlying concept of such hybrid instruments was the deferability of risk.

Tax implications

What about the tax implications of such instruments under the existing laws? Apart from the aforesaid regulatory requirements, the issuer banks would have to comply with the requirements under the tax laws. The issuer bank will have to ensure that the tax required to be deducted/paid on interest payments is deposited with the government. Failure to do so would result in not getting deduction of entire payment for its corporate tax purposes, apart from penal consequences for such failure.

Further, such compliance will have to be made only after carefully determining whether payments to investors would be characterised as interest payment or dividends. This exercise would of course involve analysis of established principles laid down by the courts under tax laws and taking clues from the RBI guidelines, ECB regulations, FII regulations, etc. Further, the characterisation would also depend on whether the issuer/borrower bank is an Indian or foreign bank. In case of foreign banks, provisions of tax treaties would have to be kept in mind.

Investors whether Indian or overseas would obviously be liable to taxation based on such characterisation and would accordingly need to comply with tax laws.

Another related tax issue could arise when an overseas branch of an Indian bank issues these instruments to foreign investors. In such cases, the taxability of investors' income and withholding obligations of the issuer bank would also depend on place of use of such funds.

(Sunil Gidwani is Associate Director (Tax & Regulatory) and Robin Roy is Principal Consultant (Banking & Financial Services), PricewaterhouseCoopers (P) Ltd.)