Major Canadian banks across the Great White North have recently started issuing ‘limited recourse capital notes’ (LRCNs), as a public offering to institutional investors. The first of these have hit the Royal Bank of Canada back in July 2020.
According to the relevant authorities, the capital notes have a multi-faceted instrumental value; one are deeply subordinated interest-paying LRCNs, with a maturity term lasting more than 60 years and are issued by the banks directly to the individual investing in these. Secondly, a batch of perpetual, non-cumulative preferred shares that are issued by the bank to a trust to satisfy the recourse of LRCN holders upon the occurrence of certain events described beforehand.
The banks, holding the LRCN’s state that the legal form of the LRCN will be debt but with a dated maturity. The initial interest rates have been in the range of 4.30 per cent to 4.50 per cent, with the pay-out resetting in the duration of every five years at the initial credit spread over the aforementioned five-year Government of Canada yield. The dividend rate on the preferred shares matches the interest rate on the LRCNs.
The banks have further asked the investors and firms to be cognizant of the fact that no dividends are expected to be declared on the preferred shares while said shares are held by the trust, although different transactions employ different mechanics for achieving that result. In the initial transactions, the terms of the preferred shares provided that the trust as holder was not entitled to dividends. In the more recent transactions, the terms of the preferred shares were the same whether held by the trust or the holders of the LRCNs, but instead the trust provided the bank a revocable waiver of its right to receive any and all dividends on the preferred shares.
Since the LRCNs are debt that constitutes borrowed money and the bank is required to pay interest to holders, the bank is entitled to an interest deduction for Canadian federal income tax purposes provided the bank uses the proceeds of the LRCNs for an eligible income-producing purpose. The fact that in certain events the recourse of holders of the LRCNs is limited to the assets held by the trust does not detract from the lender-borrower relationship between the bank and the holders of the LRCNs or the obligation of the bank to pay interest on the LRCNs. The LRCNs are thus, treated as equity for accounting purposes.
