Tier-two capital instruments that include a loss absorbency clause - as the Australian Prudential Regulation Authority will require from next year - will not be precluded from being classified as debt for tax purposes.This is the position outlined in a Treasury discussion paper issued yesterday, setting out changes the Government will make to the tax treatment of tier-two instruments under the Basel III capital reforms.The changes will cover authorised deposit-taking institutions and certain other related entities regulated by APRA, and will take effect from January 1 next year.Under Basel III, tier-two capital must include a loss absorbency clause that is triggered at the point of non-viability.What this means is that tier two instruments will have to be written off or converted into ordinary equity if APRA decides that the ADI would otherwise become non-viable.Tier-two capital includes perpetual cumulative subordinated debt and term subordinated debt.Current tax law classifies an interest as a debt if there is a non-contingent obligation on the issuer to repay the amount invested - that is, payment must be made irrespective of whether the borrower is profitable or not.If the current tax law applied to tier-two instruments as they will have to be structured from next year, it is likely they would be treated as equity for income tax purposes and their funding costs would not be tax-deductible.The paper says: "The capital adequacy standard in the prudential framework encourages instruments with equity-like characteristics, while issuers looking for tax deductibility seek to stress the debt-like characteristics of hybrid financing instruments."This creates a tension that needs to be balanced. Income tax regulations ensure that ADIs are not at a competitive disadvantage compared with non-ADI corporate taxpayers that could raise capital through the issue of debt without being restricted by the pricing, terms and conditions imposed by prudential standards."The Government will amend the Income Tax Assessment Regulations to achieve this balance. It is calling for submissions, in response to the discussion paper, by August 10.