Should gross-up cases on Tier 2 be allowed only in relation to coupon withholding tax (and not principal)?
Article 20(2) of the RTS for Own Funds requirements for institutions includes in the forms of incentive to redeem AT1 and Tier 2 a call date combined with an increase in the credit spread and / or the redemption amount. To avoid the creation of a strong redemption incentive through a gross-up event, the EBA AT1 Monitoring Report (last version published on 11 July) clarified that gross-up should be limited to interest payments only and that gross-up on principal is not allowed.
According to Article 20(1) of the Commission Delegated Regulation (EU) No 241/2014 (RTS on own funds) incentives to redeem means all features that provide, at the date of issuance, an expectation that the capital instrument is likely to be redeemed.
In this context, Paragraph 36 of the second updated version of the EBA report on the monitoring of Additional Tier 1 (AT1) instruments of EU institutions (EBA report published on 10 October 2016) states that gross-up clauses are acceptable only if it gets 1) activated by a decision of the local tax authority of the issuer, and not the investor, 2) if the increased payments do not exceed distributable items, and 3) if the gross-up is in relation to dividend and not on principal.
There is no prudential rationale to have a different treatment for AT1 instruments and Tier 2 (T2) instruments regarding the first and the third conditions. The second condition related to distributable items is not relevant for T2 instruments, as T2 coupons are not restricted by the amount of available distributable items. Therefore, T2 gross-up clauses can be considered as acceptable if they get activated by a decision of the local tax authority of the issuer, and if they relate to dividend and not on principal.