10 April 2019

Revolutionary reforms to raise the stakes for mutuals

This article was written by Marina Lauer, Sylvester Urban, Ricky Melamdowitz, Jo Dodd, Ian Paterson, Rhys Casey and Darren McClafferty.

The Treasury Laws Amendment (Mutual Reforms) Act 2019 (Cth) (Act) fundamentally changes the way in which mutual entities may raise capital with effect from 6 April 2019.

The reforms are expected to significantly increase growth, innovation and competition throughout the customer owned sector and, with around 8 out of 10 Australians being members of a mutual entity or co-operative, the wider Australian economy.

The Act gives effect to recommendations 5, 8 and 9 of the Hammond Review by introducing a new form of capital instrument known as “mutual capital instruments” or “MCIs”, defining “mutual entity” in the Corporations Act 2001 (Cth) (Corporations Act) for the first time and amending the demutualisation provisions in the Corporations Act to facilitate capital raising by mutual entities without risking their mutual status.

Within the next three years, mutual entities can amend their constitutions via the “special procedure” set out in new Part 2B.8, Division 3 of the Corporations Act to enable them to take full advantage of the reforms going forward.

Further, giving effect to recommendation 7 of the Hammond Review, the Treasury Laws Amendment (Mutual Equity Interests) Regulations 2019 (Cth) (MEI Tax Regulations) have commenced to align the tax treatment of Tier 2 Capital notes convertible into mutual equity interests (which are a type of MCI) with that of the equivalent instruments issued by other authorised deposit-taking institutions (ADIs).

Recognition at last: a definition of “mutual entity”

The Act inserts a new definition of “mutual entity” in sections 9 and 51M of the Corporations Act. A mutual entity has been defined as a company registered under the Corporations Act whose constitution provides that “a person has no more than one vote at a general meeting of the company for each capacity in which the person is a member of the company”.

Section 51M expressly clarifies that a company’s constitution providing for joint members, proxy voting or a person otherwise voting in their capacity as another’s representative does not prevent a company from falling within the definition of “mutual entity”.

While this definition has been introduced primarily for practical reasons — to facilitate the amendments to the demutualisation provisions, discussed below — including a definition of “mutual entity” in the Corporations Act gives mutual entities greater regulatory certainty and for the first time expressly recognises mutual entities as a type of corporate organisation.

However, it is important to note that the definition of “mutual entity” only applies to companies registered under the Corporations Act and the reforms introduced by the Act will therefore not apply to other entities (such as co-operatives registered under State and Territory legislation).

Removing mutual uncertainty: amended demutualisation provisions

The Act significantly amends the demutualisation provisions in Part 5 of Schedule 4 of the Corporations Act, which will now apply only to proposed constitutional amendments that would result in a mutual entity ceasing to fall within the definition of “mutual entity”.

The demutualisation provisions were applicable to building societies, credit unions, friendly societies, and other regulated financial institutions which transferred to Commonwealth regulation from State and Territory regulation in 1999 and were intended to provide members with an enhanced disclosure regime where a demutualisation was proposed.

However, in practice, the provisions were sufficiently broad to pose a risk to the mutual status of an entity even if it sought to enter into a transaction which was not intended to be a demutualisation. This, together with a wide discretionary exemption power, resulted in substantial regulatory burden and uncertainty which prevented many mutual entities from entering fundraising transactions or which significantly increased their costs in doing so.

The reforms focus “demutualisation” more narrowly on the fundamental membership right of members of mutual entities: “no more than one vote per member”. In addition, ASIC’s exemption power has been restricted to apply only to entities which it is satisfied are not “mutual entities”.

This means that to access capital, mutual entities will not need to demutualise into a corporate form which may be inappropriate to their purpose.

These amendments to the demutualisation provisions are expected to assist mutual entities to grow without risking (or being perceived as risking) their mutual status and to provide mutual entities with certainty and speed, greater flexibility and lower costs in doing so.

Raising the stakes: introducing the new mutual capital instruments (MCIs)

MCIs are a bespoke type of share which can be issued by mutual entities where:

  • the mutual entity is a public company — including companies limited by shares, companies limited by guarantee and companies limited both by shares and by guarantee — which does not have voting shares (other than any MCIs) quoted on a prescribed financial market and which is not a registered entity within the meaning of the Australian Charities and Not-for-profits Commission Act 2012 (Cth); and
  • the mutual entity’s constitution states the entity is intended to be an MCI mutual entity for the purposes of the Corporations Act.
In addition to the above, a share must meet the following requirements to be an MCI:
  • the rights attached to the share can be varied or cancelled only by special resolution of the company and either (a) by special resolution passed at a meeting of the class of members holding shares in the same class or (b) with the written consent of members with at least 75% of the votes in the class; and
  • the mutual entity’s constitution must provide that the share can only be issued as a fully paid share and that dividends in respect of the share are non-cumulative. It must also set out the rights attached to the share with respect to participation in surplus assets and profits (including any rights of an MCI holder to repayment of the face value ahead of other claims to surplus assets in a winding up).

Where these requirements cease to be met, the share ceases to be an MCI (but continues to operate as a type of share).

The Act has also made certain adaptations for mutual entities issuing MCIs, being a new form of equity interest, for example:

  • mutual entities are not required to treat holders of MCIs in the same way as members who do not hold MCIs;
  • mutual entities cannot be demutualised, except by court order, for as long as MCIs remain on foot; and
  • mutual entities which are companies limited by guarantees are treated as companies with share capital for certain purposes and may pay dividends in respect of an MCI in certain circumstances.

Consequential amendments have also been made to the share capital reductions and share buy-back provisions of the Corporations Act, the Financial Sector (Shareholdings) Act 1998 (Cth), the Insurance Acquisition and Takeovers Act 1991 (Cth) and, as discussed below, the Tax Acts.

These reforms give mutual entities critical access to equity capital, but the Act will especially assist mutually owned ADIs, and other prudentially-regulated mutual entities, to make significant investments in technology and infrastructure to comply with recently updated prudential standards and to build and maintain “unquestionably strong” capital reserves.

Since updated prudential standards for the direct issuance of mutual equity interests (MEIs) were published in late 2017, mutually owned ADIs have been permitted to count directly issued MEIs as Common Equity Tier 1 capital wherever the relevant requirements are met. However, the reforms in the Act (and the special procedure for constitutional amendments described below) should make it much easier for mutually owned ADIs to raise CET1 capital.

“Modernisation without corporatisation”: transitional relief for constitutional amendments

Given the constitutions of many mutual entities currently include demutualisation provisions which align with the formulation previously included in the Corporations Act, transitional relief has been granted to allow mutual entities to update their constitutions to the new formulation by following a specified “special procedure” by 6 April 2022.

The special procedure also permits constitutional amendments to be made which will allow the mutual entity to issue MCIs, such as the inclusion of a statement that the entity intends to be an “MCI mutual entity”, power to issue MCIs, provisions specifying the rights and obligations which are to attach to MCIs it issues and any incidental or ancillary changes required.

The special procedure overrides the mutual entity’s constitution and, to the extent a meeting is considering or voting on an MCI amendment resolution, applies instead the quorum requirements specified in section 249T of the Corporations Act.

In summary, the special procedure will be available only where all of the following apply:

  • the mutual entity is a public company which does not have voting shares (other than any MCIs) quoted on a prescribed financial market and which is not a registered entity within the meaning of the Australian Charities and Not-for-profits Commission Act 2012 (Cth);
  • the proposed constitutional amendments are limited to the types specified in the Act and will not result in the mutual entity ceasing to be a mutual entity;
  • the mutual entity has provided notice of the proposed resolution in accordance with the existing requirements of section 249L(1)(c) of the Corporations Act and no other matters are to be dealt with in the resolution;
  • the proposed constitutional amendments are passed by a 75% majority of the votes cast by members present at the meeting (including by proxy) and entitled to vote on the resolution, by 6 April 2022; and
  • the resolution must pass within three attempts — that is, there must not have been more than 2 “MCI amendment resolutions” (as defined in section 167AI of the Corporations Act) considered at previous meetings of the mutual entity’s members.

However, mutual entities may separately continue to make constitutional amendments in accordance with their constitutions and the Corporations Act.

Tax status preserved: consequential amendments to the Tax Acts

The Act also amends the Income Tax Assessment Act 1997 (Cth) and the Income Tax Assessment Act 1936 (Cth) (together, the Tax Acts) to preserve two integral features of a mutual entity’s income tax treatment, while aligning them with the reforms in the Act.

These are:

  1. mutual status (ie, the entity will not demutualise for tax purposes) — an entity’s status as a mutual entity will not be impacted by the issuing of MCIs, paying dividends or profits in respect of issued MCIs and having members by virtue of persons holding MCIs. The protection against demutualisation operates by prescribing that these matters are disregarded when applying the test for a mutual entity; and
  2. the mutuality principle in respect of mutual receipts — the amendments ensure that the power to issue MCIs does not displace the principle of mutuality, which provides a tax exemption for mutual receipts from members. Deductions for rates and land tax enjoyed by mutual entities are also preserved.

However, it appears that some of the practical tax impacts of MCIs have yet to be fully addressed, for example:

  • the extent to which MCI distributions may be franked (ie, whether current and prior year franking credits can be utilised); and
  • whether MCIs are regarded as ordinary shares for the purposes of the withholding tax laws and Australia’s double tax treaties. This is relevant to the extent that MCIs may be held by foreign residents.

It is possible that clarification will be provided by the ATO on these matters.

Update on MEIs: new MEI Tax Regulations

Giving effect to Recommendation 7 of the Hammond Review, the MEI Tax Regulations were made on 21 March 2019 and came into effect on 26 March 2019. The MEI Tax Regulations amend the Income Tax Assessment Regulations 1997 (Cth).

The MEI Tax Regulations seek to ensure that certain Tier 2 subordinated notes issued by credit unions, building societies and mutually owned ADIs which may convert into mutual equity interests (which are a type of MCI) on non-viability of the issuer are regarded as “debt interests” for tax purposes.

This change brings the tax treatment of such instruments issued by credit unions, building societies and mutually owned ADIs in line with the treatment of equivalent capital instruments by other ADIs (ie, that are convertible into ordinary shares).

This addresses the risk that a Tier 2 capital instrument convertible into MEIs may, under the general debt/equity rules, otherwise be regarded as equity for tax purposes, bringing greater certainty for issuers and holders and levelling the playing field for mutually owned ADIs.

What’s next?

The Act heralds a new era for mutual entities and, together with the new MEI Tax Regulations, forms part of the series of reforms following the Hammond Review which are intended to facilitate mutual entities to invest, innovate, grow and compete.

Mutual entities will want to consider amending their constitutions to position themselves to take full advantage of these reforms and to assess their capital position in light of the new possibilities presented by the amendments.

In the meantime, it is hoped that regulatory guidance will be updated by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority in relation to mutuality, directors’ duties, section 66 of the Banking Act 1959 (Cth) and the issuance of MEIs and notes convertible to MEIs as well.

Please do not hesitate to contact us if you would like guidance on what the reforms mean for you – we are here to help.

Further background to these changes is outlined in our earlier alerts on the Hammond Review, the updated prudential standard for mutual equity interests and the Treasury consultation on the first tranche of proposed amendments.

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