Loss Is More Taxing the Wealth of Nations Passport to Europe

frontiers in tax thinking beyond borders in financial services June 2008

FINANCIAL SERVICES

Loss is more Managing tax during a credit crunch Taxing the wealth of nations Sovereign wealth funds – their privileged tax status?

Passport to Europe Finding the most suitable entry point Introduction frontiers in tax June 2008

Welcome to the second edition of Frontiers in Tax. Thank you for all those of you who provided comments and feedback on our first edition. Our editorial objective is to regularly feature articles on topical issues that monitor trends and developments in the financial sector, and assess how tax can influence the impact these have on financial institutions. We also want to keep you abreast of international

Paul McGowan developments in taxation which are being driven by the OECD and Global Chairman tax authorities around the world, and the affect that regulating these Financial Services Tax changes has on taxation. The financial services sector has been in a very dynamic or perhaps even frantic mode since the last edition. The sector has experienced the impact of the credit crunch on the liquidity of major financial institutions, watched the rise of investment in the financial sector by Sovereign Wealth Funds and has begun to understand the greater financial strength that the rise in oil prices has given the Gulf region generally. This edition addresses the tax considerations relevant to some of these issues. Transfer pricing is coming to the attention of more banks in recent times, as the OECD turns its attention more towards the activities of financial institutions. John Neighbour and his colleagues explain why transfer pricing, while certainly a tax risk, can also be an opportunity for effective tax rate management. We are also seeing the development whereby many third country financial institutions are looking at Europe as a focus for their international expansion and we look at the issues such banks should consider when choosing an attractive entry point for this expansion. We also look at a number of other hot topics as they affect the financial services industry. Amongst others these include the changes in the treatment of financial services income from a VAT perspective, the impact of Solvency II on the European insurance market and the variety of approaches that tax authorities take to the taxation of financial derivatives. We hope that you will find this publication both informative and thought provoking!

Loss is more Topics 6 Loss is more 2 Passport to Europe 6 Financial Services Where is my value? 12 Crossed wires across borders 18

Passport to Europe The rise and rise – Islamic finance 24 12 Taxing the wealth of nations 30 Chinese puzzle 34 An open and shut case? 40 Broadening European horizons 46 Singing from the same songbook 50 Trading on their reputation 54 Financial Services Where is my value? 30 Knowledge In this section: 58 Latest financial services Thought Leadership, contacts 40 Taxing the wealth of nations

An open and shut case? 50

54 Singing from the same songbook

Broadening European horizons

L SS IS M RE Managing tax during a Credit Crunch Making the best of the situation. Jane McCormick and Hans-Jürgen Feyerabend explains how losses incurred during the Credit Crunch might be used to ease the pain.

necessarily follow the accounting treatment. In some countries, gains or losses on securities or derivatives are not recognized, for tax purposes, until the securities are sold or the derivatives have terminated. In these countries, no current tax benefits will be recognized and the question is one of deferred tax asset recognition. Even in countries that do allow some categories of taxpayers to mark to market for tax purposes, valuation s in other business methods used for tax may differ from areas the current the accounting valuation. For example, turmoil in financial in the U.S., “fair value” for U.S. GAAP markets is creating purposes is not the same as “fair The rationale for a new challenges for tax market value” for U.S. Federal Income transfer pricing policy management. It has Tax purposes. There are regulations could seem less robust Abeen a while; for one thing, since tax that allow book/tax conformity in managers in the financial services certain situations. when losses rather sector have had to spend much time Some of the write-downs are for than profits are being worrying about how to treat losses. assets classified as “available for sale” allocated, so it’s wise The virtual closure of the securitization securities, which, under IFRS and U.S. markets and wider liquidity problems GAAP are taken through equity, rather to review the position have also obliged companies to seek than the income statement. In the and check the logic new sources of capital and make U.K., immediate tax relief is available significant changes to third party for such write-downs, but this is before the tax and intra-group funding structures. unusual; in many tax jurisdictions such authorities do so. This article seeks to examine the write-downs would only result in the deductibility of booked losses in various potential for a deferred tax asset on tax jurisdictions, and explores the tax the balance sheet. implications of the changes in corporate Transfer pricing should also be financing strategies as a result of the taken into account when determining lack of liquidity in capital markets. what deduction is available for on- balance sheet losses. Tax authorities The deductibility of losses may look closely at transfer pricing and For groups that have sustained attribution questions when they see significant losses, one of the key large credit or valuation losses, questions for tax purposes is the value coupled with claims for repayment of of the tax relief that can be claimed for tax from loss carry-back claims. There them. Clearly if tax or deferred tax have been cases when losses have benefits can be recognized for losses been rejected by tax authorities, with this should significantly mitigate their each insisting that the assets or impact on balance sheets and, in some activity that incurred the loss should be cases, regulatory capital. Whether, and attributed elsewhere. It’s true that tax to what extent, these benefits can be treaties and the Mutual Agreement realized will depend on the territory Procedure should give some comfort where the loss arises for tax purposes, that the losses should be deductible but some general principles apply in somewhere, but this procedure does many cases. not guarantee that the affected tax Many of the losses reported in the authorities will reach agreement within press result from write-downs in the a reasonable time frame. The rationale value of assets recorded on balance for a transfer pricing policy could seem sheets and income statements. In less robust when losses rather than principle, such losses ought to be profits are being allocated, so it’s wise deductible, but the rules for the to review the position and check the recognition of profit and loss do not logic before the tax authorities do so.

In some countries, such as Germany, anti-avoidance provisions may prevent the carry forward of losses following a change in ownership of the company concerned.

Off-balance sheet vehicles Getting value for losses planning will be taken into Some of the losses reported by banks Ultimately losses only have value if account when assessing a DTA. in recent months were incurred on they can be used to reduce tax costs It may be necessary to use profit assets in “off-balance sheet” vehicles, either now or in future. Once it has projections, to establish if there and consequent financial restructuring been determined that the losses are will be sufficient profit over a has sometimes resulted in these deductible in principle, their value, reasonable period of time to absorb vehicles coming on to the originating in reducing either current or future the losses. These profit projections group’s balance sheet, or in losses on liabilities, remains to be decided. will be particularly important in transactions between the vehicles As noted above losses arising in countries that limit the period during and the originators or others, such off-balance sheet, orphan vehicles are which a loss can be carried forward. as capital providers. In these cases, it likely to be trapped in those vehicles, Note also that losses sustained in may be difficult to determine whether and have no real value. Where the loss one period, in addition to creating the resulting losses are deductible. arises within a group, there is a much a potential DTA, could affect the Again, the tax rules vary from country better chance of obtaining value for it. profit projections supporting the to country, but it is prudent to identify If a group records an overall loss, most continuing recognition of DTAs exactly how the loss arose. Points to countries now allow some kind of tax booked in prior periods. watch out for include: consolidation or group relief that In some countries, such as allows the losses of one company to Germany, anti-avoidance provisions Losses may arise in the vehicle be set against the profits of another. may prevent the carry forward of while it’s unconnected. Although Moreover, it is often possible to carry losses following a change in the losses are deductible in theory, back losses for offset against previous ownership of the company there will never be profits in the years’ profits, triggering a tax concerned. This could include either vehicle to offset them against. repayment. Much routine planning a change in overall ownership, or a There could be anti-avoidance is needed to seek to ensure these group restructuring leading to a provisions that disallow losses on offsets and carry-backs can be change in the direct ownership of transactions between an originator maximized and that tax repayments the company. (or sponsoring group) and the are obtained as soon as possible. vehicle, especially if they have Techniques to achieve this include After the losses been, or have become associated managing the timing of interest In today’s capital markets many entities (see below). payments, disclaiming allowances, companies are now unwinding If losses have arisen from the managing tax credits and accelerating or restructuring existing financing write down in the value of shares filings of tax returns. structures and seeking new ways held by the originator or its parent Losses which cannot be used to fund their businesses. in a special purpose vehicle (SPV) immediately must be carried forward the losses may not be deductible and the question arises of whether Unwinding existing structures either because the relevant tax they can become deferred tax assets Unwinding securitization and CDO regime operates a participation (DTAs). Although some differences structures raises some interesting exemption or because the losses exist, many of the basic principles issues, one of the most significant are unrealized. for recognizing DTAs under U.S. of which is the question of whether Losses which do not arise GAAP and IFRS are similar: an “orphan” vehicle taken on-balance from contractual responsibilities, sheet during a restructuring has but are assumed by the originator Carried forward losses are often become an associated company of the to protect its reputation and good ‘streamed’, so that they can only originator or funder (or indeed whether standing,may not be deductible be set against future profits of the this action indicates that it always was in all countries. same legal entity, or the same associated). If it is associated, certain In some countries, losses arising source of income. Planning may be anti-avoidance measures may apply, from an employee’s default may used, to ensure losses and profits including rules designed to prevent not be deductible. match. In some cases such double deductions for losses and

In today’s capital markets many of our firms’ clients are now unwinding or restructuring existing financing structures and seeking new ways to fund their businesses.

transfer pricing rules. It’s possible example, in which the appointment should be borne in mind. More that these provisions will not prevent of liquidators has changed the tax significant, from a tax perspective, tax avoidance and may instead create residency of an SPV, by changing the are the changes in intra-group funding, a tax charge where none should exist location of effective management particularly where subsidiaries or eliminate useful tax reliefs relating and control. Depending on how the previously able to finance themselves to actual commercial losses. For unwind is conducted, questions may have had to rely more on their parent example, in the U.K. there is an anti- also arise as to whether the company companies. In such cases, the goal is avoidance measure that disallows continues to satisfy conditions for usually to devise funding structures relief for a loss incurred on a loan to special tax regimes for securitization that are as efficient as possible from a connected party. A loss arising in a and similar vehicles. both regulatory and tax perspectives. CDO vehicle suffered by an originator It may be possible, for example, for in the form of a write-off of a liquidity Setting up new structures a group that previously employed facility made available by the originator We are now seeing a number of securitization, to structure funding to the vehicle, may be disallowed if the banks looking to transfer portfolio so that it has the same effect as vehicle has become an associate. of debt off their balance sheet and securitization from the subsidiary’s Losses on the underlying assets in the into new vehicles. These transactions point of view, by funding in the form vehicle may be deductible in theory, also give rise to some complex tax of tier 1 capital or taking assets off but are trapped in the vehicle and are issues including withholding tax on the subsidiary’s balance sheet. effectively useless. the underlying loans and the tax status Where structures come within of the vehicle (e.g. whether it qualifies Conclusion transfer pricing rules, other problems for inclusion in special securitization We’re living through interesting times, can arise. Transactions between an regimes) and the question of the but by managing the value of tax relief originator and a securitization or CDO value at which assets are transferred and if possible, reducing tax costs, you vehicle may be so unusual that it is not for tax purposes. can seek to ease the pain of losses and easy to find market comparables. A help pave the way for profitable growth. number of separate transactions may Another question is whether active be involved, and the question could management of such a portfolio can arise of whether it is necessary to look result in the creation of a permanent For further information please contact: at each of them separately to establishment of the SPV in the determine whether they are at an country where the management Jane McCormick Partner, Tax arm’s length rate, or whether they takes place. KPMG in the U.K. can be looked at together. Even when Tel: +44 (0)20 7311 5624 there is a clear market comparable, New sources of funds e-Mail: [email protected] the huge variation in market spreads As financial services groups go may make benchmarking difficult. to the market for new funds the tax Hans-Jürgen Feyerabend Partner, Tax As Special Purpose Vehicles (SPVs) treatment of rights issues, of dividends KPMG in Germany are wound up, further issues may in the form of shares and of less Tel: + 49 69 9587 2348 arise. There have been cases, for conventional equity instruments e-Mail: [email protected]

London and Dublin are both attractive entry points for foreign banks planning assaults on the European market. In this article we look at their similarities and differences.

ntering a new continent General banking tax framework can be a daunting The U.K.’s tax system aims to prospect for any achieve parity in treatment between company, not least for a U.K. stand-alone bank, and the U.K. financial services firms, branch of an overseas bank, whose which can face particularly U.K. activities constitute a taxable Erigorous regulatory environments in ‘permanent establishment’ (PE). practically every country they enter. The parity is achieved by requiring the This article seeks to examine how profits of a branch to be calculated as the tax environments in the United though it were a separate enterprise Kingdom (U.K.) and Ireland offer a bank engaged in the same or similar from outside the European Union (EU) activities, under the same or similar opportunities to establish a conditions operating independently commercially attractive, tax-efficient from its head office. Profits are presence within the EU. It focuses on taxed at the prevailing corporate such key areas as the company tax tax rate; currently 28 percent for profile for domestic banking activities large companies. in Ireland and the U.K., tax issues A U.K. branch capital calculation relating to cross-border expansion is needed, setting out the capital within the EU through branches or adequacy requirement of each branch subsidiaries, permanent establishment for tax purposes, as if it had been concerns, employee and staffing agreed directly with the FSA. This considerations, and VAT. calculation is then used to determine the extent to which a branch is deemed Regulatory Considerations to be over-geared, compared to a stand The choice of vehicle, when entering alone bank. Irrespective of whether the a new market, normally raises a funding is obtained from third parties or number of tax and regulatory issues. head office, interest on borrowing This article does not deal with the deemed excessive will be disallowed regulatory requirements of setting up under transfer pricing rules. (The U.K. a bank and trading through a branch in does not have thin capitalization rules the U.K. or Ireland, apart from noting separate from those contained in that bank capital requirements in transfer pricing legislation). Ireland and the U.K. are derived from Banks operating in Ireland are liable the EU Capital Requirements Directive to corporation tax in the same way as (the EU’s implementation of Basel II). other companies. The government is The bodies responsible for financial committed to maintaining Ireland’s services regulations, including 12.5 percent corporation tax rate, consumer protection, prudential among the lowest in the EU, which supervision and capital adequacy, has helped to make Ireland an in the U.K. and Ireland, are the attractive location for companies Financial Services Authority (FSA) and entering the EU. As in the U.K., bank the Financial Regulator, respectively. branch profits are calculated in the Both of them have reputations for same way as those of a separate bank. maintaining high regulatory standards Ireland has no transfer pricing, thin and being competitive with many other capitalization or branch capital regulatory regimes in terms of flexibility legislation per se, so it is an attractive and timeliness of approvals, etc. regime as far as interest expenses are

The government is committed to maintaining Ireland’s 12.5 percent corporation tax rate, among the lowest in the EU, which has helped to make Ireland an attractive location for companies entering the EU.

concerned. Tax deductions are usually Capital taxes acquiring a reputation as an available for interest cost allocations to No capital duty is charged on the international financial services centre an Irish branch from a head office. creation of a subsidiary in either country. in the early 1990s, Irish regulatory and Tax deductions are generally tax authorities have amassed similarly available for interest charged at arm’s Currency comprehensive experience in the length rates and paid by banks Companies can manage tax exposures taxation and regulation of international licensed in both the U.K. and Ireland, on foreign exchange movements via banks in respect of both their core or elsewhere in the EU, whether or not matching and/or functional currency banking activities and other financial the interest is paid to an overseas elections in both countries. services, such as big ticket leasing, affiliate as long as the interest is paid in insurance, reinsurance and the ordinary course of the bank’s U.K. Losses fund management. or Irish banking business respectively. Neither country operates a compulsory consolidation regime, but both allow Structure Withholding taxes loss-making companies to surrender One of the main questions for any The funding strategy used for losses, as needed, to other profitable bank when expanding into Europe is banking activities will also determine group members within the jurisdiction. whether to use a holding company, or the significance of each country’s Branch losses may be available to branch structure. Using subsidiaries in withholding tax (WHT) provisions for offset the profits of other businesses of either country will increase regulatory the venture. No WHT is due in either the branch in both countries and losses compliance costs and, in the U.K., may country on interest paid by a branch on of local branches can be surrendered to expose the group to controlled foreign debt capital funding from its head other local group companies in certain company (CFC) rules at the level of the office. Generally, an Irish or U.K. bank limited circumstances. holding company. has no obligation to deduct withholding Ireland’s lack of a CFC regime is tax if it pays interest in the ordinary Expansion into Europe a significant advantage, which offers course of its business. In the rare cases Banks established in an EU country planning opportunities. The U.K.’s CFC when exemptions are not available a can now “passport” their services rules can be an administrative and a 20 percent withholding tax could apply and activities across the European tax headache, but in its ‘Taxation of subject to treaty relief or other Economic Area on a cross-border basis, Foreign Profits’ consultation domestic exemptions, such as those or by establishing branches in other document, the U.K. government applicable to Quoted Eurobonds. member states, without obtaining proposes to simplify the CFC rules and When establishing a local subsidiary further regulatory authorizations. This also offer an exemption for dividends the returns on equity must also be allows a bank to operate from a single from overseas subsidiaries. The next considered. There are no WHT capital base under the supervision of stage in this exercise will occur in obligations for dividends paid from the a single home country regulator. summer 2008 with the release of a U.K. Ireland imposes WHT on dividends London has long been recognized further consultation document. In the at 20 percent, but there are exemptions as a major global banking center and meantime, structural solutions are on dividends paid to shareholders its regulators are used to dealing with available to limit the impact of the resident in EU and treaty countries, banks operating through U.K. U.K. CFC rules. or controlled by residents of those headquarters, offering the whole Using the U.K. or Ireland as a countries or controlled by companies spectrum of traditional banking holding company location for European whose equity is traded on recognized and broader financial services on a operations may also require the bank’s stock exchanges in those countries. worldwide basis. Since Ireland began parent company to review its own CFC

rules. It may be possible to escape That usually results in the creation their application by a simple election of a taxable PE in the U.K. with those (such as the check the box election to profits, calculated in accordance with disregard the entities and so avoid any branch capital requirements (see U.S. Subpart F issues), or it may be above), subject to the U.K.’s 28 percent that there are no CFC rules at present corporation tax rate. One way to The rate at which profits from the foreign branches of the Irish bank are taxable. (for example, India). Structures must mitigate this exposure is carefully to be kept under review, because the control the level of activity outside the situation is constantly changing. For territory of incorporation so that it example, China has recently introduced doesn’t amount to a taxable PE in the CFC rules, which may apply to the other jurisdiction. Since this may be undistributed profits of subsidiaries in difficult in practice it’s essential to jurisdictions where the effective tax consider these issues at an early stage. rate is less than half China’s 25 percent The preferred location for a rate, unless there are “reasonable business and its employees will also The rate at which the U.K. imposes WHT on dividends. business needs” for keeping the profit be determined by cultural differences abroad. (On the face of it Ireland’s 12.5 and employment law within each percent corporate tax rate may be high EU territory. As businesses expand enough therefore to allow Irish employees are often ‘seconded’ from subsidiaries to fall outside these rules). their home country. The tax With their extensive treaty implications for those expatriates can networks outside the EU, Ireland and be an important consideration from the U.K. also offer advantages over both the employee’s perspective and other holding company locations that the bank’s. The U.K. and Ireland both are worth exploring when expansion provide favorable tax regimes for beyond the EU is contemplated. expats relocating to those countries. The rules differ significantly and have Permanent Establishment concerns been curtailed recently in both In the U.K. there is a saying that when countries (the U.K. changes have been buying a property, the three key criteria the subject of some controversy), but are ‘location, location, location’. It’s the it is still possible for expats to achieve same when considering the expansion a favorable basis of assessment, of businesses. A recurrent theme which limits their overall tax liability recently is for companies to be to some extent, based on income established outside the U.K. to benefit or gains actually remitted to the U.K. from a low tax rate on profits (for or Ireland. example, Ireland’s 12.5 percent rate on trading profit). However, on a practical Double Taxation Relief and the basis, the company may find that it is treatment of dividends necessary to have a large physical According to HM Revenue & Customs presence in London, say, where much (HMRC) web site, the U.K., with well of the bank’s business is done. over 100 Double Tax Treaties, has the

largest such treaty network in the foreign branches of the Irish bank are world. This provides a high degree taxable in Ireland at the 12.5 percent of certainty in the U.K. on the tax rate, but relief is available for foreign treatment of cross-border transactions. taxes suffered and there is a facility to The U.K. rules tax a company on pool any tax credits across branches. world-wide profits, including branch The result is that foreign taxes at rates The U.K. has the largest Double Tax Treaty network in the world. profits, but Double Taxation Relief above or below the Irish rate are gives credit for foreign tax incurred by evened out across branches. overseas branches. Although this is Ireland offers a broad tax exemption favorable treatment, it will increase the to holding companies on capital gains effective tax rate on branch profits on the disposal of EU and treaty-based generated outside the U.K. to the trading subsidiaries if certain standard 28 percent U.K. corporation conditions are satisfied. At the same tax rate. The tax efficiency of such an time dividends from EU or treaty expansion will depend on the funding countries originally paid mostly from The number of double tax treaties Ireland has signed, with another profile of the U.K. activities and the trading profits are subject to the low 14 currently being negotiated. level of profits generated in other 12.5 percent corporation tax rate. jurisdictions, but it should be possible If the foreign tax exceeds the Irish tax to efficiently manage the tax position liability on a dividend, the excess can of the U.K. bank. Losses of overseas be pooled against liabilities on other branches may be available for offset foreign dividends. against profits of the U.K. bank, All of this helps to make Ireland subject to certain criteria. an attractive location for the European Dividends received from overseas HQ of a bank considering expansion subsidiaries are taxed with credits for via a branch or a subsidiary network foreign taxes paid on the underlying or a combination of both, depending profits. Excess credits may be available on local market requirements. for pooling or carry-forward/carry-back. The rules are currently the subject of a Transfer Pricing consultation process (see above) that When a U.K. business engages in may lead to the introduction of a any transaction with a business in a participation exemption regime. When country that has no transfer pricing combined with the U.K.’s Substantial rules (for example, Ireland), U.K. Shareholding Exemption – essentially a transfer pricing legislation, in capital gains tax exemption for disposals conjunction with OECD rules, governs of trading subsidiaries, by trading the transaction. Any such transactions groups – the U.K.becomes an attractive should, therefore, be undertaken on base for a European expansion. an arm’s length basis. The absence of Ireland has signed 45 double tax transfer pricing statutes in Ireland can treaties and is currently negotiating reduce the tax complexities of another 14. Domestic legislation also international operations, but the rules provides extensive, unilateral relief for of other jurisdictions must always be overseas tax. The profits from the taken into account.

The preferred location for a business and its employees will also be determined by cultural differences and employment law within each EU territory.

The U.K. rules tax a company on world-wide profits, including branch profits, but Double Taxation Relief gives credit for foreign tax incurred by overseas branches.

Loss Relief rate on trading income is extremely For further information please contact: Following a European Court of Justice low and interest withholding tax decision, both Ireland and the U.K. exemptions, foreign tax credit pooling, Brian Daly introduced legislation which allows substantial shareholding exemption, Partner, Tax resident companies to claim relief for a and the lack of CFC rules add to the KPMG in Ireland Tel: +353 (1)410 1278 loss-making company resident in an Republic’s attractions. The U.K. also e-Mail: [email protected] EU Member State or a European has much to offer in its withholding Economic Area state subject to certain tax exemptions, its extensive treaty Jane McCormick conditions, such as that the losses network and the combination of its Partner, Tax can’t be used in the jurisdictions of the existing capital gains tax exemption KPMG in the U.K. Tel: +44 (0)20 7311 5624 loss-making company. with the proposed participation e-Mail: [email protected] exemption for dividends. Value Added Tax (VAT) Using a European holding company Elliott Gingell EU VAT Directives should mean that, as a base for expansion into Europe Senior Manager, Tax KPMG in the U.K. apart from rate differences, VAT via subsidiaries may require some tax Tel: +44 (0)20 7694 2979 regimes are broadly similar throughout planning, to avoid unpleasant surprises e-Mail: [email protected] the EU, but it might not feel like that. in the form of CFC or PE exposures, Many services provided by U.K. and but a properly managed use of Maura McCormack Irish banks are exempt from VAT and branches can be a very tax-efficient Associate Director, Tax KPMG in Ireland thus do not entitle the banks to recover way for a bank to “passport” its Tel: +353 (1)410 1818 VAT on costs. This means VAT positions operations into the EU. The U.K. and e-Mail: [email protected] must be managed to limit the cost Ireland both provide plenty of scope bases of the European activities. This for adapting holding company/branch restriction applies to banks throughout structures to the local circumstances. Europe, but there may be ways to In some cases, it may make sense to mitigate the exposure by actively use the U.K. for some activities and managing VAT in the business and Ireland for others, to exploit benefits using measures such as VAT groupings. peculiar to each jurisdiction. In a rapidly changing economic Conclusion world both the U.K. and Ireland offer Both Ireland and the U.K. offer many commercially-focused tax regimes potential benefits to non-European and stable fiscal and regulatory banks that may be looking into environments for any non-European expanding their businesses into banks considering expansion in the Europe. Ireland’s 12.5 percent tax EU marketplace.

Financial institutions that consider transfer pricing when structuring their operations for commercial success may resolve disputes more quickly as well as generating sustainable effective tax rate improvements, says John Neighbour, Jan Martens, Matthias Kaut and Michael Nixon.

Financial n December 21, 2006, the OECD finally issued its report on the attribution of profits to permanent Oestablishments (“the Report”) after years of hard work, tough negotiations between the OECD’s member states, and at times animated consultation sessions with industry representatives and consultancy firms. Part I of that Report provides general guidance on how to analyze, for tax purposes, the activities of permanent establishments (PEs) in order to determine a taxable result to such entities. Part II and III, however, focus on the activities of that the tax authorities would use PEs in the financial industry only, the guidance provided to scrutinize thus recognizing that the question multinational banks’ intra-group of transfer pricing in a PE context is transactions. Today, a year-and-a-half a prominent one for banks. Whereas later, KPMG member firms have seen Part II focuses on lending activities, increased audit activity in several Part III is dedicated to global trading, jurisdictions. Financial institutions are totalling 60 pages with additional and therefore well-advised to carefully frequent references to Part I. consider the impact this Report could Moreover, the Report clearly states have on their business as double that some of the principles contained taxation issues (including non in Parts I to III, most notably in relation recognition of losses) could potentially to analyzing the value drivers of the impact the group’s profit and dividend business, can be applied to subsidiaries generation, hence drawing the as well. Part III in fact covers global attention of the stakeholders. trading between subsidiaries. On the other hand, the OECD At the publication of the Report, Report could instead be seen as it was widely expected by tax providing significant opportunities, consultants and taxpayers alike notably in structuring the value

Where is my value?

Services market) risk. In this respect, it is important to note that the OECD rejects the idea that, within a single legal entity, risk, and therefore margin, automatically resides in the location where capital is held. The Report advocates that remuneration follows risk(s), which in turns follows function(s), and no function can be performed without people. As such, in order to allocate or attribute margin to a certain location/jurisdiction, active decision-making processes need to be taken place by physical persons present in that geographical location. ‘Merely’ attributing Tier 1 and Tier 2 capital to a location does not, from a chain in such a way that not only tax perspective, justify locating taxable operational efficiencies can be profits in that jurisdiction. In today’s achieved (e.g. centralization of credit market conditions, it is worth noting risk management functions), but an that the same reasoning applies to economically robust and fiscally situations where losses, instead of defensible transfer pricing strategy profits, occur. may be implemented. This can then Having due regard to the Report’s be enhanced by looking at this in a focus on the interaction between tax context, e.g. by locating operations remuneration, risks, functions and (and therefore people) in lower people, the OECD’s guidance does tax regimes. provide for certain opportunities in A pivotal element in structuring structuring a bank’s value chain in a tax a financial institution’s value chain effective manner. This article aims to in such a way is the OECD Report’s explore how perceived threats, posed notion of a Key Entrepreneurial Risk by the Report, could be turned into a Taking (KERT) function. The OECD financial institution’s advantage by Report defines a KERT as the function incorporating the ideas and concepts that actively decides to take on and/or detailed within the Report by using subsequently manage (credit and/or a value chain analysis framework.

Value Chain Analysis (‘VCA’)

The value chain of a business is the structure and associated work flows that coordinate and orchestrate the overall activity of that business. For financial institutions such value chains can be extremely complex, employing internal and external contributors and generating large numbers of transactions. Analyzing this overall picture should reveal (amongst other things) important value drivers for the business. Conceptually, the reward in an entity Some of the Ideas and Concepts However, the AOA recognizes is matched to the value created at each Contained in the OECD Report that risks may be transferred to link in the chain. Crucially, VCA focuses As noted, Part I defines the Authorized other parts of the enterprise in the on value created, as distinct from costs OECD Approach (AOA) and describes event that active management of incurred by all the elements of the business operations of a group. how to apply this to a PE. It states that: those risks is transferred. One of the key outputs of the VCA is to “the profits to be attributed to a PE Finally, step one involves devise and implement a range of options are the profits that the PE would have the attribution of free capital which for the business that reflect expected earned at arm’s length if it were a should be, “sufficient to support the business changes, which will improve legally distinct and separate enterprise functions (the PE) undertakes, the future transfer pricing arrangements and tax efficiency, resulting in an optimal group performing the same or similar assets it economically owns and the tax strategy – and crucially, while functions under the same or similar risks it assumes.” remaining consistent with the commercial conditions, determined by applying Once the (PE) enterprise has strategy of the business. Options might the arm’s length principle.” been hypothesized based on a range from ensuring full documentation The AOA describes this as a functional and factual analysis and to strengthening the existing tax strategy, through to moving functions and/or risks two-step process. its functions, assets and risks have to a central location, and possibly moving The first step involves hypothesizing been determined, the approach of a particular centralized function to a low the PE as the distinct and separate the OECD Guidelines should be used tax jurisdiction. enterprise and requires looking at the by analogy to attribute profits to a PE Incorporating the ideas and functions performed, the assets used by applying the traditional transaction concepts contained in the OECD report into a value chain analysis can help provide (including fixed and current, tangible methods, or where such methods an analytical framework to enable the and intangible assets), and the risks cannot be applied reliably, the review and clarification of such a value assumed by the PE in order to: transactional profits methods. chain using a method authorized by the This represents Step Two of the OECD. Therefore one could expect that “… identify the significant people AOA. Note that because there are employing these ideas carefully in any analysis, and incorporating these ideas functions relevant to the assumption no ‘controlled transactions’ between into any recommendations made, should of risk and the significant people a PE and the enterprise of which it is improve the robustness and defensibility functions relevant to the economic legally a part, the AOA uses the of those recommendations – using ownership of assets…”. concept of “dealings”. internationally accepted principles also make disputes easier to settle and avoid double taxation and non-loss recognition. Parts II and III use the term KERT The Functional and Factual Analysis Such a carefully constructed value functions in relation to the creation The functional and factual analysis chain analysis may for example be used and management of financial assets, performed under the AOA represents to provide a review and justification of the instead of significant people functions. the critical step in analyzing a financial commercial substance behind the actual This is merely to recognize that the institution’s value chain, given that the operational arrangements, and therefore also may be used as foundation for any financial assets created and the profits of the enterprise will be transfer pricing documentation. This assumption of risk is usually more attributed on the basis of the should in turn provide an effective and – aligned in the financial sector to the respective allocation of functions, critically – sustainable defence against any functions performed. assets and risks and the respective transfer pricing audit. Furthermore, it may Step One also involves determining value of performing, owning, assuming provide a part of the information necessary to analyze the costs and benefits of which assets (including any valuable and managing those functions, assets restructuring operations by moving value intangible assets) are “economically and risks between the PE and the adding functions (which implies moving owned” and/or used by the PE broader entity. The functional and the people that perform them), assets (as if it were a separate and distinct factual analysis should identify these and risks to lower tax jurisdictions with the objective of achieving sustainable enterprise), in addition to attributing value drivers (i.e. the KERT’s), which effective tax rate reductions. risks to the PE “inherent in or created in turn will provide the necessary by the PE’s KERT functions”. foundation to determine the value

The identification of the KERT functions is critical in supporting the remuneration and transfer pricing strategy employed by the business to ensure that it is robust and supportable for tax purposes.

chain and subsequently underline The key functions involved in functions relevant to the assumption the tax and commercial substance managing the loan asset are identified of risk are performed by the personnel behind the operational arrangements. as Loan support, Monitoring Risks of the PE at the PE’s location”. Moving forward, this analysis assumed as a result of entering Performing a detailed review in could also be extended to review into the loan, Managing Risks initially the functional analysis on each of how it is possible to restructure these assumed and subsequently borne as these KERTS will show where non- operational arrangements to achieve a result of entering into the loan, routine (and routine) returns should a more commercially desirable result, Treasury – e.g. managing the bank’s be allocated, as it identifies value for example by process improvements overall funding position – and drivers within the relevant value chain. and/or cost reduction, and combining Sales/Trading. The “risk management Below is a short example showing this globally with tax-effective planning function” is seen as the KERT in the such a typical analysis on KERT’s to minimize the institution’s effective “ongoing management” of an existing relating to credit risk assumption and tax rate and/or achieve a more financial asset. management, and how this is used to compliant transfer pricing position. In addition to these key functions, support value chain structuring from Part II of the OECD Report it is recognized that capital is required a tax optimal perspective. identifies typical functions of a banking to support the risks assumed operation. In particular it identifies (whereby capital follows the risks Example the KERT’s involved in creating and assumed) for the bank to be able to ABC Bank is active in the subsequently managing a financial carry out the loan and absorb any loss. commercial lending business and is asset (it uses the example of a loan). Two key risks may be considered for headquartered in Berlin with branches The KERT functions are those which these purposes: credit risk (where the in London, Luxembourg, New York require active decision-making with customer cannot meet its obligations) and Singapore. regard to the taking on and day-to-day and market risk (where changes in It is in the process of undertaking management of individual risks and financial markets impact asset an internal review of its commercial portfolios of risks. It is these KERT values/returns). functions that are likely to impact most Part II, in referring to Part I of the directly on the profitability of the bank OECD Report, acknowledges that it is and so will normally be rewarded by the enterprise as a whole which legally having the financial assets and the bears commercial risks. However, the associated residual profit or loss OECD also concludes that it is possible attributed to the location performing to treat the PE as assuming risk for tax those functions. purposes, notwithstanding the legal It logically follows that the position. Specifically, the OECD Report identification of the KERT functions concludes that, “the PE should be is critical in supporting the considered as assuming any risks for remuneration and transfer pricing which the (significant people/KERT) strategy employed by the business to ensure that it is robust and supportable for tax purposes.

KERTS for Banking Operations In the case of a loan, the key functions involved in creating a new financial asset are identified as Sales/ Marketing, Sales/Trading, Trading/Treasury and Sales/Support.

lending business model with the aim Figure i: Application of VCA-credit risk of improving operational efficiency and profitability, particularly in the tough Strategic Management Capital provision current operating environment. - Brand management - Provision of regulatory capital - Policies select which type of clients and/or - Loss absorption One idea that seems particularly currency products to focus on - Sets and manages risk stategy and limits Human Resources attractive to the board is centralizing - Entrepreneurial and operational control - Procurement its loan and risk management Infrastructure functions in Luxembourg.

This seems to imply a number of Sales and Back Office Middle Office Front Office commercial benefits. As a starting Marketing - Loan servicing - Credit approvals - FX management Customer - Develops and - Cash settlements - Credit management - Credit trading point, the centralization of a function maintains customer - Operational risk - Credit monitoring - Takes market risk Market relationships - Capital management - Develops trading currently duplicated in several - Idetifies leads for - Compliance margin locations should generate a better commercial lending - Accounting - Treasury - Structuring - Market research commercial result, given that this will - Limited involvement in pricing and lending enable harmonization of commercial decisions objectives and the people charged with achieving it. Centralization will Settlement software Software for pricing therefore enable ABC Bank to better Exchange links etc and portfolio IT management control its business operations, have clearer reporting lines, more easily implement best-practice policies, Source: KPMG International, 2008 attain cost reductions and therefore be more profitable in a tough framework to show the location may simplify and enhance commercial environment. of KERT’s across the value chain. the efficiency of the operating Further benefits can be realized Figure i presents the results of the environment. Furthermore, the pool by recognizing tax as a real cost of the analysis, with italicized lettering of talent relative to the type of financial business at the outset of the review. indicating those functions deemed assets that ABC Bank would like to The review of the desirability and to be value adding, i.e. KERT’s. invest in differs quite significantly. tax defensibility of this proposed This approach emphasizes that it is Why would ABC Bank want to have structure can be undertaken using vital that the value chain is reviewed operations in several locations with the principles of a value chain analysis, from a practical as well as simply a such distances between them if they incorporating the concepts outlined in conceptual perspective. One may were operating in a fully globalized the OECD report. This example will be tempted when looking at this from market environment and buying into illustrate how, but note that there is the conceptual perspective to assume thoroughly standardized products? no standard ‘model’ in relation to such a globally standardized functional Additionally, it is also vital that the analysis: the facts and circumstances profile of the market facing investment analysis is looked at from a dynamic of each case will determine the results advisors; however, there are also perspective than simply a static within the framework. practical implications in real life from perspective. As stated earlier, a key the fact that Singapore is six hours output of the VCA is to devise and The VCA Analysis ahead of Luxembourg (as is implement solutions for the business Brainstorming about a lending Luxembourg from New York). that reflect expected business institution’s business model reveals The centralization of these functions changes, which will improve future that this is just one example of what the value chain of a lending institution might look like. There are many other potential possibilities. What an analysis It is vital that the analysis is looked at of the value chain itself reinforces, however, is that credit risk is intrinsic from a dynamic perspective than simply to the success of nearly everything the a static perspective. business does. It drives the business’ value. The management of credit risk pervades nearly all functional areas, especially those of strategic management, capital provision and the middle and back office functional areas. A detailed functional and factual analysis is performed in line with the OECD AOA, using a value chain

transfer pricing arrangements and KERT function and associated risks to of the OECD AOA with a value chain tax efficiency, resulting in an optimal be realized there. Considering this as a analysis. Any analysis should be placed group tax strategy – and crucially, tax-effective jurisdiction would not only in the context that there is no specific whilst remaining consistent with the mean the realization of commercial model which may be deployed and the commercial strategy of the business. benefits (if properly implemented) final results will be determined by the The business set up is likely to but also tax benefits in the form of individual facts and circumstances. constantly change and of course what a reduced ETR in times of profit or Critical to the success of is true today may no longer be true recognition of losses in leaner times. implementing such business change tomorrow, for example after some key The movement of such functions is a thorough and detailed analysis of personnel have been replaced by new from one location to another raises a the options from a commercial and tax hires with different preferences with multitude of tax considerations which perspective, from a static and dynamic regard to where they are prepared to will need to be reviewed as part of the perspective and taking into account do the job. overall analysis. Certain tax authorities conceptual and practical considerations. Taking into account these consider such functional transfers to be It is of course no simple matter to practical considerations has in this the transfer of an asset and therefore achieve and implement such complex case conferred greater support for taxable in their hands, and of course it business change, but using the the centralization model in relation is vital to mitigate such challenges for approach identified in this article to the loan and risk management the project to be commercially may help achieve a more defensible functions of ABC Bank. successful. Additionally, IT systems transfer pricing policy, mitigate the We then progress to defining and and procedures will need to be tailored effectiveness (or likelihood) of tax implementing the arrangements and to the new operating environment, authority audits and generate ETR associated transfer pricing policies. legal contracts will need to be novated, improvements. Finally, it can help For this analysis it is essential to HR will need to define and implement resolve disputes (or stop them from distinguish between the initial an effective migration strategy for the happening in the first place) and avoid assumption of such risk (e.g. decision people and so on. double taxation, or non-recognition to grant the loan) and the subsequent Given that remuneration above of losses. bearing and managing of that risk. that which is considered to be a We assume that the analysis routine return (in the long run) is due determined that the risk assumption to the entity that performs the KERT role undertaken by the ABC Bank functions, then it is obviously important Credit Committee was key to this to show both documentation and business line and corresponds with the substance showing where, and by sales/trading role that is outlined in the whom, these functions are performed. AOA. This function is considered to be If performed properly, this should help a KERT and should give rise to a non credibly convey (as it uses the AOA, For further information please contact: routine return and the initial attribution i.e. internationally accepted principles) John Neighbour of the loan and its associated income what a defensible transfer pricing Partner, Global Transfer Pricing Services and expenses. policy should be and subsequently the KPMG in the U.K. In this case, the initial pricing of tax result for the enterprise and the PE. Tel: +44 (0)20 7311 2252 the credit risk is considered to be a In this example we also highlight how e-Mail: [email protected] smaller part of the risk assumption/ the potential restructuring of Jan Martens KERT activities. Pricing in itself is not a operations surrounding KERT functions Partner, Global Transfer Pricing Services KERT activity, and so remuneration for can be used for the commercial benefit Fidal* in France this activity should be on a service fee of a financial services institution Tel: + 33 1 5568 1618 basis, taken out of the overall reward combined with tax benefits through e-Mail: [email protected] for the risk assumption activities. locating people performing KERT Matthias Kaut However, the portfolio management functions in tax-effective jurisdictions. Partner, Global Transfer Pricing Services role undertaken closely corresponds KPMG in Germany with the risk management role as Conclusions Tel: +49 211 475 7390 identified by the AOA and therefore This article has highlighted that having e-Mail: [email protected] is also considered to a KERT function. due regard to the OECD r eport’s focus Michael Nixon This function should also give rise to on the interaction between Manager, Global Transfer Pricing Services a non routine return. remuneration, risks, functions and KPMG in the U.K. Moving these KERT functions to people, certain opportunities are Tel: +44 (0)20 7694 4624 Luxembourg, and therefore the people conferred on taxpaying entities in e-Mail: [email protected] associated with them, should provide structuring a bank’s value chain in a tax *Fidal is an independent legal entity that support under the OECD AOA for effective manner. The framework of is separate from KPMG International and profits (or losses) in line with the analysis is based upon an interaction KPMG member firms.

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1 2 2.1 Introduction Current use of article 132(1)(f) Variations on a theme in the EU The EU VAT Directive, and the 6th Legal form of the Cost Sharing Directive which preceded it, provides Article 132(1)(f) of the VAT Directive Group (CSG) an exemption from VAT for certain cost provides that Some Member States allow any sharing arrangements. Initially it was form of cooperation to be the basis of proposed that this exemption would be “Member States shall exempt … a CSG, provided that the cooperation applicable only to services supplied by the supply of services by independent is based upon some formal structure. independent professional groups of a groups of persons, who are carrying This may be a separate legal entity or medical or like nature to their members on an activity which is exempt from it may be no more than a contract. for the purposes of their exempted VAT or in relation to which they are not Other countries are more demanding, activities. Reflecting this, the relevant taxable persons, for the purpose of allowing only specific corporate bodies legislative provision (now article rendering their members the services to qualify as an “independent group of 132(1)(f) of the VAT Directive) still lies directly necessary for the exercise of persons”who can apply this exemption. under the heading “Exemptions for that activity, where those groups certain activities in the public interest”. merely claim from their members Eligibility conditions However, as the provision itself exact reimbursement of their share In most Member States, non-EU contains no such limitation, some of the joint expenses, provided that persons cannot be a member of a Member States apply the exemption such exemption is not likely to cause CSG (e.g. Austria) while in some they much more widely. This broader distortion of competition”. can (e.g. Netherlands). There is treatment was implicitly accepted as significant variation in the degree of correct by the ECJ in the For various reasons, at least pro rata recovery a CSG member is Taksatorringen1 decision. Application 10 out of the 27 Member States allowed, e.g.10 percent in Austria of the provision varies widely across have not implemented this provision and Spain, 20 percent in France, the EU, with many Member States at all, despite the mandatory “shall” 30 percent in Luxembourg. having not implemented it at all, and apparently requiring it to be significant differences in scope and implemented. In the countries where Eligible expenses and mark-up conditions applying in those the exemption has been implemented, The criteria that apply to the activities jurisdictions that have implemented it. there is wide variation of parameters of a CSG and to the eligible costs vary Recently, in a draft Directive and limitations. materially, as countries have different prepared by the EC for modernising views of what can be seen as services and simplifying VAT rules for financial “directly necessary” for the core- and insurance services, an additional activities of the members. cost-sharing exemption provision was Only the exact reimbursement for proposed specifically for this sector. services supplied that correspond to The purpose of this article is to set the members' proportional or out how the existing cost-sharing distributive share in the joint expenses exemption is currently applied and how may be charged on by the CSG. Where the new proposals may change this. a transfer pricing element has to

In the Netherlands the financial and insurance industry can make use of the CSG-exemption both in domestic and cross-border situations.

be taken into account there is again It should be noted that the Supreme no consistency of treatment across 2.2 Court of The Netherlands has referred the implementing Member States. Examples of Member States that a preliminary question to the ECJ in Some treat the mark-up as taxable have implemented 132(1)(f) for the September 2007 (SCBIT, case while retaining exemption for the finance and insurance industry C–407/07). The case is about whether actual recharge (e.g. Netherlands), the CSG exemption applies where the but most treat it as disapplying the The Netherlands CSG recharges a cost only to one or exemption completely. In the Netherlands the financial and more members, rather than to all insurance industry can make use of members. This case is still pending Distortion of competition the CSG-exemption both in domestic and, if answered negatively, will have Although the issue of distortion and cross-border situations. The cost a great impact on the CSG-structures of competition was addressed by sharing group can have multiple forms. already implemented. the ECJ in Taksatorringen, it remains If corporate income tax is payable on difficult to have a common view on a deemed profit by the CSG, there are Belgium the test that determines if there is examples where it was ruled that CSGs are often used in Belgian by a genuine risk that the exemption these tax costs may be regarded as financial institutions such as banks may by itself, directly or indirectly, joint expense for the members and and insurance companies in order immediately or in the future, give so fell within the exemption. to reduce VAT arising on recharges rise to distortions of competition. As regards ‘directly necessary’ between group companies. These Therefore different interpretations services for a CSG with members in might include charges for the common (still) exist on this requirement in the the finance or insurance industry, development of specialized software, various Member States. services consisting of payroll finance services, strategic services for administration, financial administration the group, audit, legal and tax services Input VAT deduction and general ledger administration do in the interests of all group members, Generally, VAT incurred by the CSG not qualify for exemption. and HR services. on costs is irrecoverable, and this Furthermore, based on the distortion In Belgium two types of CSG can be forms part of the costs recharged to of competition requirements a general distinguished: a CSG can be created members. However, some Member exception is made for the supply of on a contractual basis between States (e.g. Luxembourg) have a staff, certain hardware or software members or through establishment mechanism enabling the member to supplies, some services relating to of a separate legal entity (such as a recover an appropriate share of this property maintenance and specific non-profit association, an Economic VAT on the basis of their pro rata. services regarding insurance or claim Interest Grouping etc). A member handling (such as expertise services). of a CSG must have a pro rata VAT In practice the exemption is widely recovery rate of less than 10 percent. used for all sorts of services, including Only services which are in the back office, printing, advertising and common interests of the members consultancy services. can be supplied by the CSG. The VAT The members of a CSG are in most exemption will not apply where a CSGs are often used cases in a pro rata recovery position. member receives specific individualized The issue that requires the most services. The exemption extends to a in Belgian by financial attention when the CSG is up and supply of goods if the goods are clearly institutions such as running, is to make sure that all ancillary to the services rendered. expenses are charged out to the According to the Belgian Tax authorities, banks and insurance members in due course, and no supplies of goods are ancillary to companies in order to charges higher than the costs are services if the value of the goods is reduce VAT arising on made, although some tax inspectors less than 50 percent of the total price. seem more willing than others to go The charges made by a CSG must recharges between along with prepayments for expenses be limited to the reimbursement of the group companies. yet to come. member’s share of the joint expenses.

Those expenses include the input A CSG can make supplies to VAT incurred by the CSG, VAT which non-members, although these will is not deductible for the CSG. On the be subject to VAT, and the total value assumption that the members have of such supplies cannot exceed not exceeded the 10 percent threshold, 50 percent of the total turnover the services rendered by the CSG are of the CSG. in principle VAT exempt. However in so Interestingly, services supplied far the members use those services by the members to the CSG can also for the purpose of carrying out be VAT exempt provided they are ancillary taxable transactions, they can charged at cost. deduct the input VAT included in the price charged to them by the CSG in Ireland respect of the services. CSGs are specifically provided for under Regarding the distortion of the Irish VAT Act, but are not widely < % competition requirement, the Belgian used in practice. One example of use 20 authorities have always preferred a has been for a group of unrelated The pro rata recovery rate a CSG pragmatic approach, i.e. they only banks who share common marketing member must have in France examined possible distortions of type costs on various projects. competition when they received a The CSG is required to be set up as specific complaint. an independent entity. In practice this It should be noted that the Belgian entity has generally been a corporate Court has referred a preliminary body, but there is no specific < % question to the ECJ asking whether requirement in the Irish legislation 10 the fact that a CSG provides services to be so. To qualify as a CSG the The pro rata recovery rate a CSG to non-members frustrates the independent entity must be member must have in Belgium application of the exemption on the established for the purposes of services to members as well (AXA “administrative convenience” (not a Belgium SA, case C–168/07). This condition set out in the VAT Directive) case is still pending and, if answered and the services provided by the entity negatively, this could have a great must be “the services directly impact on some CSG structures necessary for the exercise of” already implemented. the members activities. The activities of the members for France which the CSG supplies are used must As with Belgium, in France a CSG be “exempt from or not subject to can be a separate legal entity from tax”, but there is no specific pro rata its members, or it can be created by threshold for the overall activities a simple contract between the of a member. members. This latter situation requires The independent entity must only no prior approval by the French tax recover from its members “the exact authorities, and entails one of the reimbursement of each member’s members being designated as the share of the joint expenses”. This is manager of the CSG and declaring the not defined under Irish legislation, CSG supplies on its own VAT return although it would appear to mean that (often with the creation of a specific any mark-up would lead to exemption sector of activity). being disapplied on the whole value To gain exemption, a member of a of the supply. CSG must have a pro rata VAT recovery Non-EU entities are not specifically rate of less than 20 percent. Entities prohibited from membership of a CSG, established in other EU member but as Irish Revenue confirmation states can be members of a French would be needed as to whether the CSG, but entities established outside CSG provisions apply there may be the EU cannot. resistance from the Revenue to such Expenses must be reimbursed at a proposal if it led to a material cost by each member, so any mark-up reduction in tax. would debar the entire supply from There is no specific provision exemption. There is no mandatory preventing a CSG from making share of expenses – they are shared supplies to non-members although depending on the effective use of the these would clearly fall outside services by each member. the exemption.

A CSG in France can be a separate legal entity from its members, or it can be created by a simple contract between the members.

supply services which are exempt for membership: there is no 3 pursuant to Article 135(1)(a) to (g); requirement for a member to have The new cost sharing provision for 5. the group claims from its members a minimum level of exempt activity. the financial and insurance industry only the exact reimbursement of This should not present a loophole, (article 137b proposal) their share of the joint expenses, as a member without an exempt excluding any transfer-pricing activity would have no right to receive The new provision, set out in the adjustments made for the purposes an exempt service from the CSG proposed article 137b of the draft of direct taxation.” (although of course it wouldn’t Directive, is specifically targeted at the need to). finance and insurance industry. Like The proposals appear quite broad and Mark-ups for direct tax purposes 132 (1)(f) (which is intended to remain flexible, perhaps necessarily so in the will not taint exemption on the within the Directive), 137b facilitates light of the extensive variations we recharged element, but the mark-up cost sharing by granting an exemption have note in implementations of the will be taxable. There is no restriction on certain supplies made by a cost- current provisions. on the making of other profitable sharing group to its members. The CSG must act as an supplies, to group members or third independent entity, although it does parties, but no part of these will be The text reads: not appear required to be one. eligible for exemption. “Member States shall exempt “Independent” simply refers to the To qualify for exemption, the services supplied by a group of legal status of its activities; it does not services must be “necessary” for taxable persons to members of the appear to refer to control. In theory the the performance of the exempt group where the following conditions CSG could have two members, one activity. This is a less demanding test are fulfilled: paying 99 percent of the expenses. than “specific and essential”, which There is no need for its members had been proposed, but is still likely 1. the group itself and all its to make contributions, whether cash to exclude a range of general members are established or or kind, in order to become part of a overhead supplies such as, say, resident in the Community; CSG. The only requirement is for cleaning services. 2. the group carries out an members to pay their share of the There is no distortion of autonomous activity and acts CSG’s expenses. That share need competition-provision in the new as an independent entity towards have no relationship to a member’s provision. This may solve the issue of its members; interest in the CSG, so may having to decide “if there is a genuine 3. members of the group are presumably be determined risk that the exemption may by itself, supplying services which are on a project-by-project basis. immediately or in the future, give rise exempt under Article 135(1)(a) to (g) While membership is restricted to to distortions of competition”, as or other services in respect of which persons established or resident in the decided in the Taksatorringen case. they are not taxable persons; EU (which should include fixed However, it would appear that general 4. the services are supplied by the establishments in the EU), potentially European principles on distortion of group only to its members and are any business in the EU which makes competition would apply anyway, so a necessary to allow members to some exempt supplies can be eligible specific provision may be redundant.

On the basis that it is now generally simply to avoid creating an accepted that article 132 (1)(f) is not unnecessary VAT charge. An effective, restricted to public interest bodies, flexible and practicable CSG why should it not continue to be the mechanism would allow those CSG provision? What real need is inefficiencies to be removed, so there for an additional CSG provision? strengthening the business, without It has to be said that the Commission’s producing a revenue shortfall for view that 132 (1)(f) will remain in force governments. A further message may does rather fuel this argument. How be that business would find it helpful if after all are the two provisions going to a common approach to CSGs were be used meaningfully? Is article 132 adopted in every Member State. going to be limited to public bodies? If That, however, may be a little so, why should public bodies suffer too much to ask! more restrictive conditions than the finance sector will encounter in using article 137b? There may also be concern about potential revenue loss. One of the driving forces for the new provision was a perception in the Commission that small players in the financial sector were being put at a competitive disadvantage to large organizations 4 because they suffered VAT on a range General Agreement on Tariff of supplies which a large organization and Trade GAT Trites could procure internally. The CSG provisions were intended to reduce The draft Directive was submitted this disadvantage. In line with that to the Council of Ministers at the reasoning, the amount of VAT at issue end of last year, and now national would be only that incurred by such administrations are considering how small players. However, in the absence they should address the proposals of any restriction on the size of entities in Council. acting as members of a CSG, national For further information please contact: There is clearly a lack of detail administrations may become Richard Iferenta in the current draft, and no additional concerned about the risk of potentially Partner, Indirect Tax provisions are contained in the draft substantial revenue loss. KPMG in the U.K. Regulations proposed by the The draft Directive is expected to be Tel: +44 (0) 20 7311 2837 Commission in parallel with the one of the priorities of the French e-Mail: [email protected] Directive. The need for further detail, Presidency of the Council, which starts Tony Lynne and its content, will no doubt be onJuly 1, 2008. By then, the Member Director, Indirect Tax addressed at regular intervals. States must have completed their KPMG in the U.K. However, there are also some major internal discussions and decided what Tel: +44 (0) 20 7311 2401 e-Mail: [email protected] points of principle that need to be their stance in the coming negotiations resolved. One of these is the restriction will be. So this is now the time to Philippe Norre of membership to EU-established engage with national tax Partner, Indirect Tax businesses. This will be a major administrations, many of which will be KPMG in Hungary impediment to adoption of the looking to consult with the business Tel: +36 (1) 887 7449 e-Mail: [email protected] procedure by multinational community to understand the potential organizations, such as U.S. banks, importance of the CSG proposals to Peter Ackerman whose commercial arrangements for business, the potential risk to revenue Partner, Indirect Tax sharing costs would not fit an EU-only collections, and the nature and KPMG in Belgium CSG model. At one point it was practicality of the range of Tel: +32 (0) 2708 3813 e-Mail: [email protected] thought that GATT rules would prevent administrative processes that will be the EU from discriminating in this way required to control the arrangements. Marije Harthoorn in favour of EU businesses, but there It should be possible for businesses Director, Indirect Tax now appears to be considerable doubt to provide them with enlightenment KPMG in The Netherlands about this. and encouragement. A key message Tel: +31 20 656 1070 e-Mail: [email protected] It needs to be recognized that some to convey is that at the moment Member States are skeptical about inefficiencies are often built into whether this provision is needed at all. commercial cost-sharing processes 1 C–8/01 Taksatorringen

ne of the most dramatic developments in the global financial services industry in recent years has been Othe extraordinary growth of Islamic financial products. The Islamic finance market has grown at roughly 10 percent per year over the past decade or so, and there is no sign of a slow down. On the contrary; the growth rate has escalated in the past three years to 15 percent per year. The Islamic finance market today probably accounts for over US$500 billion of assets worldwide, and the value of Islamic securitization is expected to exceed US$100 billion within the next two years.

History of Islamic finance When western banks wanted to expand in the middle-east and the colonies of their home countries in India and South East Asia towards the end of the 19th century, they were confronted by a Muslim financial culture in which the charging and paying of interest was haraam (forbidden). This meeting of apparently incompatible financial cultures, combined with an acknowledgement of the importance of banking as a lubricant of economic development, inspired Muslim scholars in India and Malaysia to begin to develop a system of finance that complied with Shari’a principles. RISE The first Islamic bank was founded in Egypt in 1963, although it did not last long. With the oil boom of 1970s, and the tidal waves of money that began flowing into the Islamic Gulf states as a consequence, the Shari’a compliant finance and banking began to grow rapidly. The Dubai Islamic Bank was formed in 1975 and a few years later the Islamic Development

THE Bank (IDB) was set up to invest in & RISE infrastructure and other economic development projects in the Muslim ISLAMIC FINANCE world, and to foster the development of Muslim economic thought. Islamic finance is now worth more than $500bn but an even handed treatment by tax authorities could boost The basic principles the sector further with beneficial effects for the global The key defining characteristic of Islamic finance is generally thought economy, says Kashif Jahangiri, Tony Urwin and to be the proscription of interest, Abdelhamid Attalla. but there is more to it than that.

Figure i: Mudaraba and Musharaka

Mudaraba / Musharaka investment

Investor Islamic Financial Entrepreneur Institution

Periodic profits & return of investment

Source: KPMG International, 2008

The Islamic financial system also The U.K. began to amend its requires all transactions to comply taxation laws to accommodate the The economic with Shari’a principles. Investments Islamic finance system in 2005, in an in ‘unethical’ goods and services are effort to ensure that Islamic financial benefits may induce not permitted, for example, and one products were taxed in a similar financial institutions cannot make investments that are manner to their conventional speculative or excessively risky. counterparts. These changes have to persuade their The Islamic financial system is generally been well received and have ordinary customers based on the principle of sharing risks contributed, over the past few years, to consider Islamic and rewards from Shari’a-compliant to a rapid growth in the Islamic investment. Trading transactions can mortgage market in the U.K. which finance products. be crafted in ways that enable has surpassed the £500 million mark. entrepreneurs to raise finance for their Encouraged by this success, the U.K. business needs. New Islamic financial Government is now considering products must usually be approved by issuing Sukuk (Islamic equivalent of a board of Shari’a scholars, but the securitization) bonds in the system is constantly evolving, and the international market. A consultation views of scholars on the compliance paper on this possibility was issued of a particular transaction may differ. by the Treasury’s Debt Management This offers some flexibility when Office in November 2007. introducing new products. How tax laws haunt Islamic The opportunity finance products Although from a retail perspective Islamic finance transactions must one may argue that Islamic finance be structured in ways that will allow products are only of interest to investors to receive returns in forms Muslims, however the opportunity other than interest. This usually of securitizing these products to requires additional transactional investors in the oil-rich Gulf States steps, which in the absence of may induce financial institutions to specific tax provisions, may be bn persuade their ordinary customers looked at individually by tax US$500 to consider Islamic financial products. authorities, and taxed in isolation. This small but growing group of This may result in additional tax Islamic funds and banks that is unable costs, which make Islamic financial The amount the Islamic to invest in conventional finance products less competitive to their finance market accounts for products may be willing to invest on conventional counterparts. today, worldwide. relatively low yields as this would Although it is obvious to all facilitate them to better manage their concerned that the additional steps portfolio risks. It is important to note, in an Islamic finance transaction are however, that when assessing part of the overall financing % compliance with Shari’a principles, arrangement, tax laws in many 10 Muslim investment boards look countries don’t treat them as such. through funds to the underlying The main Islamic finance The approximate annual rate at investments to prevent Islamic products are described below with which the Islamic finance market investors from indirectly investing a summary of the key tax issues that has grown over the last 10 years. in non-compliant products. arise with each.

Figure ii: Diminishing Musharaka

Payments to aquire ownership share Islamic Financial Client Institution Rent for use of the asset

80% ownership share 20% ownership share, increasing – diminishing Asset sole user of the asset

Source: KPMG International, 2008

Figure iii: Murabaha

Islamic Financial Client Institution Sale for deferred payment 120 Sale for cash payment 100 Sale for cash payment 100

Commodity Seller Commodity Buyer

Source: KPMG International, 2008

Mudaraba and Musharaka to the following tax issues that do not deposits under a Mudaraba Mudaraba and Musharaka are equity- arise with their equivalent conventional arrangement. These deposits would based investment arrangements finance transaction: then be invested in any Islamic finance similar to partnerships. In a Mudaraba, product, some of which are discussed the project is financed by the investor The profit received by the IFI and in the ensuing paragraphs. and the entrepreneur (borrower) the investor may be considered a contributes skills and experience. distribution of profit, rather than Diminishing Musharaka In a Musharaka each party involved interest. The recipient may pay a A Diminishing Musharaka is a form of contributes cash to the venture. In higher tax on the distribution, and Musharaka (partnership) that caters for both, a Mudaraba and a Musharaka, the payer may be denied a tax asset-backed finance transactions and profits can be distributed according to deduction for the amount of also covers mortgages. As the name any previously agreed ratio, but losses ‘profit’ paid. suggests, it is a partnership which can only be shared according to the Because Mudarabas and diminishes to zero over time. A typical original investment. Thus in a Musharakas are very similar to Diminishing Musharaka arrangement Mudaraba investors bear all the losses. partnerships they may be subject is illustrated above (Figure ii). In an Islamic banking system the to special provisions in a jurisdiction In this arrangement the IFI and Islamic financial institution (IFI) is the where partnerships are treated as the client jointly acquire the asset entrepreneur when it receives separate taxable entities. This could or property chosen by the client. deposits from the investors (deposit create an additional tax charge as, The IFI’s share in the asset is divided holders), and contributes services being a separate and distinct entity; into a number of units and the asset (and cash) to the venture by managing the ‘partnership’ would also be is rented to the client for an agreed the depositors’ funds. When the IFI distributing profit to the periodic rent payable to the IFI. invests funds in different ventures entrepreneur (borrower) and not Under a separate agreement the (replacing conventional lending), it just to the investor. client promises to purchase the becomes an investor and the ultimate Financial services are not usually units of the IFI over an agreed period. user of the funds (a borrower in subject to VAT. In the absence of a This agreement usually maintains the conventional finance) becomes the specific exemption, additional VAT acquisition price of the units at an entrepreneur. The IFI thus plays a cost may arise in Mudaraba and agreed level regardless of any change dual role. This structure is illustrated Musharaka structures. in the asset’s market value. on page 25 (Figure i). The rent replaces interest in a A Mudaraba/Musharaka Typically, an Islamic financial conventional asset-backed finance or structure would usually give rise institution would receive customer property mortgage. With each rental

payment the client makes a separate payment towards the acquisition of the IFI’s share in the asset. The Dubai Islamic Bank was formed in 1975 A Diminishing Musharaka would generally give rise to the following tax and a few years later the Islamic Development issues that do not arise with its Bank was set up to invest in infrastructure and equivalent conventional transaction: other economic development projects in the The rental payment received by Muslim world. the IFI is likely to be treated as leasing or property rental income, as opposed to interest in a conventional arrangement. This could lead to a higher tax charge, because expense deductibility may Figure iv: Ijara be limited or rental income may be subject to a higher tax rate.

If the asset is a real property (like Asset leased – title may a mortgage), the client may not be Cash sale or may not transfer entitled to mortgage interest relief Islamic Financial Lessee Vendor rentals Lessee that is generally available in a Institution conventional mortgage. Transfer Purchase In a conventional, asset-backed of title consideration finance (or mortgage) transaction title to the asset only transfers at one stage, when the asset is Source: KPMG International, 2008 acquired by the client. In a Diminishing Musharaka there are two transfers of title, because the records a loss equivalent to the an interest rate (IFRS 39 would IFI remains co-owner of the asset IFI’s mark-up. The deferred liability not be applicable to Islamic finance for a certain period. The two with the IFI is discharged over the transactions), an IFI might have to transfers of title may result in an agreed period. recognize all the income (and so additional stamp duty or transfer If the objective is to replace an asset pay all the tax) in the year of the tax costs. backed finance or mortgage, the client transaction. (Some Islamic scholars As the asset is co-owned by the chooses the asset to be purchased by have recently suggested that the IFI and used by the client in its the IFI. For an asset with a long useful difference between the original and trade, a situation may arise when life (e.g. plant or machinery) a the marked-up price could be neither the IFI, nor the client is able Murabaha can be effected under amortized over a period of time, to claim capital allowances. a sale and buy-back arrangement. but as yet it is unclear what basis As the structure will not be deemed The IFI acquires the asset from the would be used for the amortization). a financing transaction extra VAT client and re-sells it to the same client As can be seen the arrangement costs may arise. at a marked up price payable on a would involve several transfers of deferred basis. title for the same asset, which could Murabaha A Murabaha transaction would expose the parties to additional A Murabaha is an outright sale, at give rise to the following tax issues stamp duty or transfer tax costs. a marked-up price, where the selling that do not arise with its If an IFI is actively entering into IFI discloses its profit margin to the conventional counterpart: Murabaha arrangements, it may be purchasing client. It can replace a term considered as being engaged in loan and can also be used for asset- In a conventional finance making taxable supplies from a VAT based financing transactions, and arrangement, interest takes the perspective. Such VAT cost may not mortgages. The complete Murabaha form of an effective annual yield, be fully recoverable for the parties cycle is illustrated on page 26 (Figure iii). which apportions recognition of to the transaction. The IFI buys a freely traded income and the tax charge over the commodity, such as platinum or life of the transaction. In the case of Ijara copper (not gold or silver, because they a Murabaha transaction, the IFI may Ijara replicates operating and finance are taken as currency under Shari’a be deemed to be engaged in the lease arrangements, and can also be law) and sells it to the client at a trade of selling commodities for used to replace asset-backed financing marked-up price payable on a deferred deferred payments. Since Shari’a transactions and conventional basis. The client sells the commodity principles don’t allow deferred mortgages. The IFI either holds an in the open market for cash, and payments to be discounted using inventory of assets, in anticipation

Figure v: Sukuk

Cash purchase Investment into or assets Sukuk

(Originator) Lease/ SPV Investors Company Mudaraba (Sukuk Issuer)

Rentals/profit Sukuk profit + return of capital

Transfer of title Asset

Source: KPMG International, 2008

of customer demand for leases, or Sukuk buys an asset in response to a client A Sukuk arrangement is akin to a bn request. The asset thus acquired by securitization of an asset. A typical US$100 the IFI is leased to the customer for an Sukuk arrangement is illustrated above agreed rent payable for an agreed (Figure v). The value the Islamic securitization period of time. The beneficial ownership of the is expected to exceed within the At the end of the lease period the assets is transferred from the next two years. asset may be returned to the IFI (as originator company to a ‘special with an operating lease) or transferred purpose vehicle’ (SPV), which finances to the lessee for an agreed value (as the purchase by issuing Sukuk bonds with a finance lease). An Ijara structure to investors. The SPV then leases is illustrated on page 27 (Figure iv). those assets back to the originator for As compared to the comparable use in its trade in return for periodic conventional finance transaction an rent paid to the SPV. The amount of Ijara transaction would give rise to the rent paid to the SPV would match the following additional tax issues: profit payable by the SPV to investors (Sukuk holders). At the expiry of the If the tax law distinguishes between term of the Sukuk bonds, the assets operating and finance leases the would be transferred by the SPV back taxation of an Ijara may not equate to the originator for cash. The SPV to that of a conventional finance would use the cash to redeem the leasing arrangement from the IFI’s Sukuk bonds. perspective, since the IFI may be The arrangement between the considered to be earning rental as originator and the SPV can also be that opposed to interest. However, it of a Mudaraba or a Musharaka (equity may be possible for the lessee to based). If this approach is adopted, the claim a tax deduction for the entire SPV would employ the acquired assets rental payment. in the originator’s trade in return for an As the asset is owned by the IFI agreed profit, which would match the and is used by the client in its trade, profit payable to the Sukuk holders. At a situation may arise where the the end of the Sukuk term the assets client may not be entitled to claim are bought back by the originator and capital allowances. the proceeds are used by the SPV to In a conventional asset-backed redeem the Sukuk bonds. transaction the asset is bought by The following tax issues are specific the client in its own name. With an to the Sukuk, and are in addition to tax Ijara, the IFI buys the asset and then issues related to the retail structure transfers title to the client. This which have been discussed earlier: second transfer of title from the IFI to the client may entail additional The transfer of income generating stamp duty or other transfer taxes. assets to the SPV and then back to

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established in 1990 and is registered in Bahrain as an autonomous, not-for-profit body. It has published some accounting standards for Islamic financial institutions and industries which are being followed in certain Gulf States. In addition, certain other countries have also issued local accounting guidelines for Islamic finance products and services.

Conclusion The strength of the opportunities embedded in Islamic finance rests in what may be considered as its weakness; ie, the limited retail market. Due to this very limitation, the Islamic The limited retail market may persuade financial institutions are restricted to invest in certain specific markets. They Islamic funds to invest in securitization of are constantly looking for ways and investment portfolios at comparatively means to better manage their credit risk by diversifying their investment cheaper interest rates. portfolio. Taking advantage of their appetite, investment portfolios can be the originator could give rise to an mortgages. Moreover, a Sukuk securitized to those Islamic investors additional stamp duty (or transfer issuing SPV set up in a foreign at comparatively cheaper interest tax) charge. country may be subject to tax in the rates. At a time when economies all Profits paid by the Sukuk SPV originator’s country of residence on over the world are struggling with would have to be analyzed to the basis of deriving rental income or increasing interest rates, a cheaper establish whether they constitute business profits from that country. source of funding may provide a sigh a distribution of profits by the With reference to double tax of relief to everyone. With oil prices at SPV or business income from treaties, profit payments to the all time highs and huge quantities of the underlying investment as Islamic financier would generally be cash flowing into Gulf economies this opposed to interest in a considered as dividend (distribution could be an ideal time to explore this conventional transaction. of profits) rather than interest with opportunity. If this can be achieved by consequential tax affects. simple fine tuning of taxation laws Cross border transactions In some situations, the tax without loss of revenues, there is A number of financial transactions in residence of the borrower may be definitely some merit in taxation today’s world have a cross-border affected owing to ‘control and authorities to consider this. As they element in one form or the other. In management’ issues arising with a say, the early bird catches the worm! the context of Islamic finance non-resident Islamic finance partner. transactions, cross-border elements This should not be the case in most For further information please contact: would generally give rise to the situations. However, if it arises and following additional tax issues: the tax residence is impaired, the Kashif Jahangiri entrepreneur may not be entitled Director, Tax KPMG in Ireland For partnership-based financing to avail of tax treaty benefits. Tel +353 (1) 700 4060 arrangements, the Islamic financier e-Mail: [email protected] may be considered to have a Accounting for Islamic permanent establishment in the finance products Abdel Hamid Attalla entrepreneur’s (borrower’s) country The expansion of Islamic finance Partner, Tax KPMG in Egypt of residence and thus exposed to creates a pressing need for Tel +20 (2) 3536 2211 tax in that country. harmonized international accounting e-Mail: [email protected] Sourcing of income may be an issue standards as the International as this would generally have Accounting Standards (or the Tony Urwin consequential tax effects. This will International Financial Reporting Partner, Tax KPMG in the U.K. be common in asset backed Standards) cannot be applied across Tel: +44 (0)20 7311 5744 financing arrangements and the board to Islamic financial products. e-Mail: [email protected]

in highly liquid markets, to aggressive purchases of equity stakes in particular companies. They’re typically formed to support the long-term stability of the State and usually focus primarily on one or more of four aims: (i) smoothing out short and medium term fluctuations in global prices of commodity exports (ii) maximizing returns (iii) acting as a reserve of wealth for future generations when natural resources will have been depleted and (iv) developing or revitalizing domestic industries. overeign Wealth Funds US$7.5 billion stake in Citigroup, They may also seek to acquire access h (SWFs) have existed the following month the Government to Intellectual Property and political since the mid 1950s, of Singapore Investment Corporation capital in the investee country. but it is only very and an un-named Saudi investor recently that their injected a much needed US$11.8 Concerns about SWF investments increasing size, number, billion in UBS, and later that month, Concerns have been expressed about Spotential financial and political the China Investment Corporation the recent tendency of some SWFs influence have brought them to (formed in 2007) took a US$5 billion to buy stakes in ‘strategically sensitive’ prominence, and helped to make them stake in Morgan Stanley. areas in developed countries. Western a focus of a certain amount of This article aims to describe some governments want to protect their controversy and concern. They are of the key tax issues associated with strategic sectors, and worry about the here to stay, however, and are likely to SWFs including: ‘Sovereign Exemption’ lack of transparency in the investment become more powerful and important (what it is and who’s eligible?); how objectives of certain SWFs which as the continuing imbalances in world to achieve such eligibility; and under could, by their nature, be used as trade swell the coffers of a new breed what circumstances might a SWF vehicles for furthering non-economic of state investor from countries such choose not to take advantage of interests. The closer SWFs come to as China and Russia. Sovereign Exemption? exercising control and influence, the Doubts about the significance of louder the calls for more SWFs were emphatically laid to rest What is a SWF? transparency2. Concerns such as towards the end of 2007, when they A SWF is a fund owned by a sovereign these led to the decision by the rode to the rescue of major banks state, rather than by a regional or local German Chancellor to stop Russia’s reeling from the liquidity shortage state entity. It is not a national pension Mischkonzerns Sistema from buying (the ‘credit crunch’) caused by the fund and not a central bank (or an a stake in Deutsche Telekom in 2006. problems in the U.S. sub-prime loan authority that performs a role It was far from clear, however, market. In November the Abu Dhabi characteristic of a central bank)1. This from conversations with close advisors Investment Authority acquired a definition is not exclusive, however. to SWFs, whether recent SWF A growing number of regional entities, investments reflected a strategic such as the Permanent Reserve Fund shift in focus or were just examples of the State of Alaska (US$40.2 billion), of them taking advantage of economic and pension funds, such as Australia’s conditions to acquire undervalued Future Fund (US$42 billion), are also assets. SWFs have no experience in involved in multi-national investment the ‘active investment’ techniques and pursuing investment strategies used by private equity funds, for similar to those of “traditional” SWFs. example, and are unlikely to be The strategies of SWFs vary, using their investments to acquire ranging from passive investment such experience.

the sovereign state is not engaged in commercial activity anywhere in the world. If either of these two criteria is not met the sovereign state will be taxed on its U.K. income in the same manner as other non-U.K. investors.

Australia and the U.S. Foreign corporations in Australia and the U.S. are subject to taxes on income from their business activities and their investments in those countries, but gains from the disposal of shares in a U.S. corporation are The protectionist backlash usually exempt from tax, with the against SWFs may be inspired by the exceptions, in the U.S., of real property �US$40.2bn suspicion that they may be using, or holding companies and, in Australia, of The Permanent Reserve Fund could use, their formidable financial income that is deemed to be sourced of the State of Alaska ‘clout’ to pursue political objectives is in Australia, such as capital gains on being given an added edge, however, assets which have a “necessary by the favorable tax treatment they connection” with Australia. enjoy in some tax jurisdictions as a The current practice in both consequence of the principle of jurisdictions is to exempt certain US$40bn ‘Sovereign Immunity’. income earned within them by foreign � governments from tax, in accordance Australia’s Future Pension Fund Sovereign exemption with the international law doctrine of A sovereign nation may qualify for sovereign immunity. These special exemption from the taxes of exemptions only apply to sovereign another country on the returns, such income from ‘passive’ investments as interest, dividends or capital gains, (income from commercial investments on investments in that country. is not tax exempt) and the sovereign As with any other tax exemption, immunity doctrine only applies to the sovereign exemption is subject foreign governments and agencies to various limitations and restrictions, engaged in governmental functions. particularly on eligibility, but the A foreign sovereign state and its sovereign exemption regimes in the wholly-owned entities organized U.K., the U.S. and Australia all provide under the laws of the foreign state SWFs with scope to enhance their may, therefore, be eligible for the eligibility for sovereign exemption. sovereign exemptions in Australia and the U.S. on dividends and interest The U.K. from Australian and U.S. sources and Generally speaking non-U.K. investors on capital gains from the sale of shares A sovereign nation are subject to income tax on any in Australian/U.S. corporations. may qualify for special income derived from business There are plans, in Australia, activities and investments in the U.K. to amend the 1997 Income Tax exemption from the Gains on disposals of a U.K. holding by Assessment Act (ITAA 1997) to codify taxes of another a foreign investor are exempt from income tax exemptions currently capital gains tax, unless the investment provided to foreign governments and country on the returns, is made in the course of a trade carried their investment bodies. In particular, such as interest, on at least partly in the U.K. these amendments will clarify which dividends or capital The U.K. has a well established foreign government investment bodies principle of sovereign immunity, based are exempt and what income qualifies gains, on investments on common law. The immunity applies for the exemption. in that country. to all income earned directly by a Clearly the effectiveness of these sovereign state, but not income options to enhance eligibility depends earned indirectly, through a separate on the criteria in each tax jurisdiction. legal entity wholly-owned by the state. A SWF must be ‘sovereign’ in its The eligibility criteria also require that ownership and not involved in any

commercial activity in all three spoken with the Qatar Investment Enhancing eligibility jurisdictions but there are some Authority, which was involved in differences. It is possible, for example, negotiations to buy J Sainsbury plc, to use a ‘corporate veil’ when investing which has agreed to sign up, along To become eligible for sovereign in the U.S. and Australia, but not when with several others. Victor Fleischer, exemptions, SWFs should consider investing in the U.K. a law professor at the University of the following simple planning options: Tax jurisdictions should also give Illinois, has similarly suggested that – Avoid deriving directly, or through some thought to the consequences the U.S. congress could use the issue ‘transparent’ entities such as of not granting sovereign exemption of sovereign exemption as leverage, partnerships, income from at all, or imposing onerous criteria on to demand more openness from commercial activities anywhere in eligibility. Many European jurisdictions SWFs about ownership and strategy. the world by, for instance, holding all such investments through do not recognize any form of sovereign Some SWFs have invested in subsidiary corporations. exemption from tax and thus deny pooled investment vehicles, alongside – Separate investments that are themselves access to SWF capital other non-sovereign investors. In commercial activities or that are in for investments that do not offer certain structures, a strict interpretation controlled commercial entities not returns that are high enough to of the rules mean that, in so doing, they eligible for the sovereign exemption from those that qualify for the compensate for the absence forfeit their exemption, but so far the sovereign exemption. of the sovereign exemption. U.K. Revenue authorities have allowed – Hold investments eligible for such pooling by SWFs on the condition sovereign exemption through one Why a SWF may choose not to take that the ultimate beneficiary is or more government or SWF-owned advantage of sovereign exemption disclosed to the tax authorities but not entities organized under the laws of that state, none of which engage in One of the main concerns about necessarily to co-investors. It seems commercial activities. SWFs mentioned by commentators likely that this partial disclosure will – Hold investments that do not qualify is their alleged lack of transparency. become more common. for the sovereign exemption in “Most are not transparent or publicly subsidiaries based in a favorable tax accountable, and we know little Summary and conclusions jurisdiction, such as the Cayman Islands, the British Virgin Islands, about their governance structures The influence and financial clout of or the Channel Islands. But political or fiduciary controls” (U.S. Joint SWFs is set to grow, particularly in the issues should be taken into account Economic Committee Chair, current financial climate. Companies here. A sovereign state might not Charles E. Schumer). SWFs, such hungry for new capital are approaching want, for example, to expose itself to the risk of being criticized for as the Abu Dhabi Investment them and the tax exemption available engaging in such aggressive tax Authority, which tend to acquire in some jurisdictions is helping SWFs planning for its SWF while it’s small stakes in companies to avoid to invest successfully. Their lack of clamping down on such practices disclosure requirements, are often transparency may be cause for in its own jurisdiction. singled out for particular criticism3. concern in rare cases, but general In some cases, this reticence paranoia is probably misplaced. may influence the SWF’s tax strategy. Moreover, the value of the privilege It may choose to forego an exemption, of sovereign exemption itself appears so that it is free to structure its to have been overstated. Since many investment in an opaque way or it may collective investment schemes are simply not be willing to provide the designed to minimize tax leakage necessary level of disclosure required through the scheme for all investors, to obtain the exemption. If so, the the main differentiator for SWFs is For further information please contact: SWF will find itself in the same their local tax status. What is clear position as any other foreign investor from the current activity is that these Sara Clark in the target jurisdiction. funds are flush with cash, open for Director, Tax KPMG in the U.K. business and looking for good Tel: +44 (0)20 7311 1431 Future developments investment opportunities. e-Mail: [email protected] Governments may use sovereign exemption as bargaining points, in Mike Smith Director, Tax their demands for more transparency KPMG in the United Arab Emirates about SWF investment strategies. Tel: +971 (6) 572 2772 In the U.K. Sir David Walker, the author e-Mail: [email protected] of an influential report on disclosure by private equity firms, has been in Richard Ross Partner, Tax discussions with a number of SWFs on 1 ‘State Capitalism: The rise of sovereign wealth funds’, Dr Gerard Lyons, Standard Chartered, October 15, 2007 KPMG in the U.K. signing up to similar standards when 2 ‘Divide and conquer’, Financial Times, London, January 24, 2008 Tel: +44 (0)20 7694 2991 3 ‘Abu Dhabi’s big place in the Citi’, Financial Times, London, they invest in U.K. companies. He has January 24, 2008 e-Mail: [email protected]

frontiers in tax – June 2008 chinese puzzle

Hong Kong and Singapore are popular jurisdictions in which to operate and conduct funds management activities for good reasons. The Singapore government seems eager to enhance the island state’s already considerable attractions for the fund management industry even more and the government of Hong Kong is pursuing a similar strategy. This article describes and compares the taxation regimes and different exemptions available for funds operating in Hong Kong and Singapore.

General Taxing Regime carrying on business in Hong Kong, Both Hong Kong and Singapore only income sourced in Hong Kong impose tax on a territorial basis and would be subject to Hong Kong tax. funds, like other entities, are subject to Hong Kong source is generally the same tax rules in both Singapore determined by where the activities and Hong Kong. giving rise to the profits are conducted. Hong Kong operates a territorial The Inland Revenue Department (IRD) system of taxation. To the extent that has issued guidelines which are helpful a person is carrying on business in in establishing the source of some Hong Kong and deriving Hong Kong types of fund income. Under these sourced revenue profits, Hong Kong guidelines investment gains and profits tax is payable at 16.5 percent losses on listed shares have a source from April 1, 2008 (subject to where the stock exchange is located legislation). Income sourced outside and unlisted share have a source Hong Kong is not taxed in Hong Kong. where the contracts of sale and In addition, Hong Kong does not levy purchase are effected. tax on capital gains (generally a difficult Funds that are not exempt still argument to sustain for most types of enjoy the exclusions from Hong Kong fund) and dividends in general. tax of dividends, capital gains, Funds, like other entities, are prima certain interest income and offshore facie subject to Hong Kong tax on sourced profits. Hong Kong sourced profits attributable The Hong Kong tax position of a to a business carried on in Hong Kong. fund is unaffected by whether or not If a fund’s investment activities in the income of the fund is distributed or Hong Kong amount to a business whether the fund is a hedge fund or a either in its own right or through an private equity fund. However, the investment advisor, it could have a operating model that the fund adopts technical exposure to tax on its Hong will be relevant in determining its Hong Kong sourced profits from that activity Kong tax position. unless it qualifies for one of the Hong Kong does not impose any statutory exemptions for widely held withholding tax on dividends, interest, or offshore funds described later in this trust distributions and capital gains. article. As an example, if a fund employs In addition, Hong Kong does not an investment manager effectively impose goods and services tax or making all investments decisions and value-added tax. executing trades in Hong Kong, it is Similarly, Singapore only imposes highly likely that the fund would be income tax at 18 percent with effect considered as carrying on business in from the year of assessment 2008 on Hong Kong through an agent. income which is accrued or derived As only Hong Kong sourced profits from Singapore. Foreign sourced are subject to tax in Hong Kong, even income is subject to Singapore income though a fund could be regarded as tax only when it is received or deemed

© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or 35 bind any member firm. All rights reserved. frontiers intax–June2008 r tax onlywhenitis receivedordeemed income isonlysubject toSingaporeincome derived fromSingapore. Foreignsourced 18 percentonincome whichisaccruedor Singapore onlyimposesincometax at Singapore’s foreign exemptiontargets licensed personsinHongKong. qualifying transactionsviaappropriately fundsthatundertakecertain offshore supervisory authorityandtogenuine requirements ofanacceptable for Kong offersexemptionstowidely-held exemptions toforeignfunds.Hong Both HongKongandSingaporeoffer Exemptions forForeignFunds subject toSingaporeincometax. innatureandhence treated asrevenue investments byafundislikelytobe general, anygainfrom thesaleof nature. Duetothenatureoffunds,in whether suchgainsarerevenuein Singapor by thefundsmaybesubjectto realised fromthesaleofinvestments trades onthefunds’behalf.Gains investment decisionsandexecute discretionary powerstomakeall managers inSingaporearegrantedthe its investmentincomewherefund be subjecttoSingaporeincometaxon undertakings. Foreignfundsmayalso rules applicabletonormalbusiness investment incomebasedonthesame Singapore incometaxontheir dividend distribution. does notimposewithholdingtaxon income taxinSingapore.Singapore revenue innaturewillbesubjectto capital gainbutgainsconstruedas Again, Singaporedoesnotlevytaxon Singapore subjecttocertainconditions. income taxevenifitisreceivedin may beexemptfromSingapore and foreignsourcedserviceincome branchprofits foreign dividend, specified foreignincomesuchas received inSingapore.However, 36 eceived in Singapore. eign fundsthatcomplywiththe Generally, fundsaresubjectto bind any member firm. All rights reserved. bind any memberfirm. Allrights reserved. no clientservices. No © 2008KPMG Inter e incometax,dependingon national.

member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-visthird parties,nordoesKPMG Internationalhaveanysuch authoritytoobligate or member firm hasanyauthoritytoobligate orbindKPMGInternational oranyothermember firm KPMG International isaSwiss cooperative.Memberfirms of theKPMGnetworkof independent firms areaffiliated withKPMGInternational. KPMGInternational provides from theIRD. fundstoseekthisapproval offshore exemption. However, itisrarefor approval forthepurposeof list mayapplytotheIRD,seeking Luxembour Guernsey, Isle ofMan,Jersey, Ireland, countries areFrance,Germany, regimes. Broadly, theacceptable within thelistedacceptableregulatory requirements ofasupervisoryauthority foreign fundmustalsocomplywiththe to achievethisresult.Inaddition,the and genuineef established forwidepublicpar fund iswidelyheldifthewas Hong KongIRDmaystillacceptthe where atnotime: accept thatafundiswidelyheld guidelines indicatingthattheywill exemption fordomesticfunds. exemption undertheheadingof could qualifyfortheauthorisedfund within anacceptableregulatoryregime requirements ofasupervisoryauthority is widelyheldandcomplieswiththe established outsideHongKongthat similar collectiveinvestmentvehicle established outsideHongKong. offer exemptions There aretwobroad owned bySingaporeresidents. funds notwhollyandbeneficially of theincome/propertyinfund. entitled tomorethan75percent not lessthan21personswer shares (units)inthefund;and not lessthan50personshold Funds inregimesnotontheabove If theabovetestisnotmet, The HongKongIRDhaspublished Firstly, amutualfund,unittrustor ed byHongKongtofunds g, U.K.andU.S. for ts havebeenmade ticipation e categories. However, itdoes exclude will fallintooneormoreofthe above transactions undertakenbymost funds r management andcontrol requirement guidelines statingthatthecentral a non-resident. Hong Konginorder toqualifyas of thefundmustbeoutside The centralmanagementandcontrol central managementandcontr determined bythelocationofits qualifying transactions. and transactionsincidentalto than thequalifyingtransactions that involvesanytransactionother carries onanybusinessinHongKong not applywhereanon-residentfund person. However, theexemptiondoes arranged byappropriatelylicensed transactions carriedoutthroughor certainqualifying profits from partnership ortrust)andderivesits non-resident (acompany, individual, Kong profitstaxwherethefundisa Hong exempt anoffshorefundfrom Exemption provisionoperatesto foreign fund. exempts abroadercategoryof exemption inMarch2006which which include: “Qualifying transactions”, from only appliestoincomederived take theactualmanagementdecisions. Directors ortheirequivalentmeetsto taken tobewheretheBoardof management andcontrolisusually fund restswiththeboard,central central managementandcontrolofa management. Therefore,where of thefundratherthanday-to-day efers tothehighestlevelofcontr commodities. Transactions inexchangetraded Transactions inforeigncurrencies; making ofadeposit; Transactions consistinginthe contracts; T Transactions infuturescontracts; Transactions insecurities; It ishighlylikelythatmost The IRDhasissuednon-binding A fund’s residency statusis Broadly, Fund theOffshore Hong Kongalsoenactedan The offshorefundexemption ransactions inforeign exchange

ol. ol chinese puzzle chinese puzzle designated investments specified income That is,exemptionisgrantedto thatinHongKong. basis differentfrom for incometaxexemptions,butona managers inSingaporecanalsoqualify conditions fundsmanagedbyfund back intoHongKong. fund investing throughanoffshore the OffshoreFundsExemptionby Hong Kongresidentinvestorsabusing “anti-avoidance” provisiontoprevent incidental andqualifyingtransactions. of thetotalprofits derivedfrom both transactions cannotexceed5percent incidental profits derivedfrom qualifying transactions.However transactions thatare incidentaltothe also appliestoprofitsderivedfrom Hong Kongprofitstax.Theexemption transactions wouldbeexemptfr fundfromqualifying offshore satisfied, allprofitsderivedbythe sourcedprofitsorgains. offshore transactionstoderive care tostructure infrastructure fundswhichmusttake private equity, and property exemption. Thisismostrelevantto overseas donotfallwithinthe companies ortheirequivalent transactions inHongKongprivate certain transactionsandinparticular, the taxburden (ifany)fromthefundto concept isthatitallowstheshifting of purpose inthe‘QualifyingInvestor’ “Qualifying Investor”.Thecritical namely “QualifyingFund”and Investor ExemptionScheme’ are and the‘ResidentFundofForeign ‘Foreign InvestorExemptionScheme’ Investor ExemptionScheme’. and the‘ResidentFundofForeign ‘For schemes forforeigninvestors:the bind any member firm. All rights reserved. bind any memberfirm. Allrights reserved. © 2008KPMG Inter no clientservices. No As forSingapore,subjecttocertain The regimealsocontainsaspecific are Where therequirements Two keyconceptsintegraltothe eign InvestorExemptionScheme’ national.

member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-visthird parties,nordoesKPMG Internationalhaveanysuch authoritytoobligate or member firm hasanyauthoritytoobligate orbindKPMGInternational oranyothermember firm 1 earned byafundon KPMG International isaSwiss cooperative.Memberfirms of theKPMGnetworkof independent firms areaffiliated withKPMGInternational. KPMGInternational provides 2 under two om , (c) A designatedperson bonafide,non-resident, (b)A (a) An individual investor; (d)An investorotherthanthoselisted (d)An conditions aremet: as aQualifyingFundifthefollowing outside Singapore,itwillberegar or atrustadministeredbytrustee company notresidentinSingapore residency ofitsinvestors. investments regardlessofthe income derivedfromdesignated will begrantedexemptiononspecified qualifying. Thus,a‘QualifyingFund’ any investorsdeemedtobenon r including resident individuals, indirectly, investors, bySingapore beneficially owned,directlyor Singapor (administer of thecompanyortrustfund The valueoftheissuedsecurities carries onnobusinessinSingapore. (other thanafundmanager)and Singapore) hasnoPEinSingapore (administered byatrusteeoutside The companyorthetrustfund in Singapore;and permanent establishments(PEs) the QualifyingFund; Singapore operationstoinvestin PE, butdoesnotusefundsfromits business inSingaporethrougha business inSingapore orcarrieson manager) andeithercarriesonno PE inSingapore(otherthanafund non-individual investorthathasno associates an investor(aloneorwithhis less than10investorsandsuch Where thequalifyingfundhas – in (a),(b)and(c): A QualifyingInvestorincludes: For afundthatissetupas esident non-individualsand e) arenot100per ed byatrusteeoutside 4 ) beneficiallyowns not 3 ; and cent ded would havetopaya“financialamount qualifying InvestorinaQualifyingFund new rulesaninvestorwhoisanon rule. But,asindicatedabove,underthe uncontrollable breachesofthebase unintendedand where thereare much neededflexibilityincases reasonable control.Thisprovides r investment limitisexceededfor if Authority ofSingapore(IRAS) allowed bytheInlandRevenue investment limitssetoutabove. in thefund,tomeetallowable his orherpercentageofownership period ofuptoonemonthr financial yearcouldbegrantedagrace Investor onthelastdayoffund’s an investorwhoisnotaQualifying Qualifying Fund’s financialyear, but determined onthelastdayof is aQualifyingInvestorusually the domesticfund isauthorised, Kong basesitsexemptionon whether exemptions todomesticfunds. Hong Both HongKongandSingapore offer Exemptions forDomesticFunds to attractforeignfundsintoSingapore. the taxexemptionschemedesigned effective deterrentagainstabuseof circumstances, andmaybean hit forSingaporeinvestorsincertain tax rules.Thisamountstoadouble Fund undernormalSingaporeincome of distributionsfromtheQualifying be liablefortaxonhis,heroritsshare that thenon-qualifyinginvestormay “financial amount”isnotatax,and (or apenaltypayment)totheIRAS. easons beyondtheinvestor’ fund (beingatrustfund). or thetotalvalueofqualifying qualifying fund(beingacompany) value oftheissuedsecurities more than50percentofthetotal associates) beneficiallyownsnot investor (aloneorwithhis 10 ormoreinvestorsandsuchan fund (beingatrustfund);or or thetotalvalueofqualifying qualifying fund(beingacompany) value oftheissuedsecurities more than30percentofthetotal The graceperiodwillonlybe Whether ornotaninvestor Wherethequalifyingfundhas – It shouldbenotedthatthe frontiers intax–June2008 s educe

the the 5 37 ” frontiers in tax – June 2008

whereas Singapore bases its exemption on whether the domestic fund is held in majority by non- A fund manager carrying on business in Singapore residents. Hong Kong are liable to tax on management Hong Kong offers an exemption to fees derived from the Hong Kong business Hong Kong based funds provided that they are authorised by the Securities at the rate of 16.5 percent from April 1, 2008 and Futures Commission (“SFC”). (subject to legislation). Trustee companies are Where the Hong Kong fund is taxed at 16.5 percent on the fees they received authorised under the Hong Kong Securities and Futures Ordinance, for trustee services carried out in Hong Kong. all profits of the fund will be exempt from profits tax to the extent that the profits arise from investment activities resident company the control and DTAs with over 50 countries. One of which are in accordance with the management of which is exercised the treaties investors are particularly fund’s constituent documents and the in Singapore; interested in is the Singapore-India requirements of the regulatory regime It must employ a Singapore-based DTA, which could provide capital gains under which it operates. fund administrator; tax exemption in India. And because The conditions for authorization The fund must be managed or there is no withholding tax on dividend are specified in the Code on Unit advised by a Singapore fund repatriations from Qualifying Funds to Trusts and Mutual Funds issued by management company that holds a its investors (both resident and non the SFC. The general requirements capital markets services licence for resident), this has further strengthened for a fund to receive authorisation in the regulated activity of fund Singapore as a viable base for funds. Hong Kong include: management under the Singapore Securities and Futures Act (SSFA), or Taxation of income derived Appointment of an acceptable is exempted from the need to hold by managers trustee/custodian; such a licence under the SSFA; Hong Kong taxes management fees Appointment of a management It must incur at least S$200,000 of derived from the Hong Kong business company; expenses in each financial year; of fund managers or trustee Appointment of an auditor; It must not change its investment companies at the normal corporate tax Operations requirements, e.g., objective/strategy after gaining rate. Singapore also taxes Singapore register of members, investment approval for the Resident Fund of sourced management fees derived plans, pricing, general meetings; Foreign Investor Exemption by fund managers, however, at a Investment guidelines; and Scheme; and concessionary rate of 10 percent if On going requirements, It’s (i) not a person that previously FSI-fund manager status is received e.g., documentations and carried on a business in Singapore, subject to meeting certain conditions. reporting requirements. and (ii) not one where the business generated income would not have A fund manager carrying on Hong Kong has entered into been tax-exempt. business in Hong Kong is liable to double tax agreements with Belgium, tax on management fees derived from Luxembourg, PRC and Thailand. Where The rules for Singapore resident the Hong Kong business at the rate of a fund is constituted under Hong Kong funds essentially mirror the rules of the 16.5 percent from April 1, 2008 (subject law or normally managed and controlled Foreign Investors Exemption Scheme. to legislation).Trustee companies are in Hong Kong, it could qualify to use That is, for a fund to be regarded as taxed at 16.5 percent on the fees they these double tax agreements in which a Qualifying Fund, for the purposes received for trustee services carried Hong Kong has entered into. of the exemption, it can not be 100 out in Hong Kong. Similarly, Singapore has a Resident percent beneficially owned by Where the fund manager is not Fund of Foreign Investor Exemption Singapore investors, including resident solely carrying on business in Hong Scheme, which shelters the Singapore individuals, resident non-individuals Kong then some part of management tax exposure of a Singapore resident and PEs in Singapore. fees may be foreign sourced and not fund company. To enjoy this tax Funds find this incentive attractive, taxable in Hong Kong. This is an area of exemption a fund must meet, among because it enables Qualifying Funds to some complexity and requires careful others, the following conditions: take advantage of the Double Taxation structuring to achieve and to ensure Treaties (DTAs) Singapore has entered the manager’s activities are conducted The relevant fund must be a into with other countries, while still to provide the optimum tax outcome company incorporated in Singapore; enjoying tax exempt status in for both the manager and the fund. The fund must be structured as a tax Singapore. Singapore has concluded From a Singapore perspective,

fees earned by a fund management year of assessment relating to the the relevant income is creating company in Singapore are subject to financial year of the Qualifying Fund more of a challenge in structuring Singapore tax at the normal corporate in which the breach occurs. offshore funds. tax rate of 18 percent. However, Many other non-tax factors are under the Financial Sector Incentive Conclusion involved in fund location, such that tax (“FSI”) Scheme, income derived by Both Singapore and Hong Kong have will only be one of a number of factors a fund management company that thriving funds management industries. in choosing which jurisdiction is has been granted the FSI (Fund From a tax perspective the fund selected as the primary fund Management) Company award exemptions offered by both provide management location in a fund’s (“FSI-FM”) from the following similar exemption benefits and it will particular circumstances. activities is taxed at 10 percent: be the facts and circumstances of a 1 “Specified Income” includes (amongst others): particular fund’s operating model that – Interest and dividends derived from outside Singapore and received in Singapore in respect of any Designated managing the funds of a Qualifying see one or the other prevail. Investments; and – Gains or profits realised from the sale of Designated Fund, where there is no non- Singapore offers a more attractive Investments. 2 “Designated Investments” includes (amongst others) the Qualifying Investor, for the purpose rate of tax on the manager fee income following: – Stocks and shares denominated in any foreign currency of any designated investments; or but ensuring carry is not taxed requires of companies which are neither incorporated in Singapore nor resident in Singapore, excluding stocks and shares of providing investment advisory careful structuring for both jurisdictions. companies incorporated in Malaysia which are listed on the Singapore Exchange or on the Kuala Lumpur Stock Exchange; services to a Qualifying Fund, where Singapore’s extensive network of – Securities (other than stocks and shares) denominated in any foreign currency (including bonds, notes, certificates of deposit there is no non-Qualifying Investor in double tax treaties is a clear advantage and treasury bills) issued by foreign governments, foreign banks outside Singapore and companies which are neither respect of designated investments. for certain types of funds. However, incorporated in nor resident in Singapore; and – Stocks, shares, bonds and other securities listed on the the substance required, site of Singapore Exchange or on the Kuala Lumpur Stock Exchange and other stocks, shares, bonds and securities issued by If any of the investors of the decision making activities and the companies which are incorporated in Singapore and resident in Singapore. qualifying fund is a non-qualifying requirement for an entity to suffer tax 3 A “designated person” means: – The Government of Singapore Investment Corporation investor the concessionary tax rate of in Singapore requested by some Pte Ltd; – The MAS; or 10 percent under the FSI-FM scheme countries before they will respect that – Any company which is wholly owned, directly or indirectly, by the Minister (in his capacity as a corporation established would not be applicable for the full the fund or its SPVs beneficially owns under the Minister for Finance (Incorporation) Act (Cap 183)) and which is approved by the Minister or such person as he may appoint. 4 For the purpose of determining whether an investor of a To Summarise Qualifying Fund is an associate of another investor of the fund, the two investors shall generally be deemed to be associates Hong Kong Singapore of each other if: – At least 25 percent of the total value of the issued securities in one investor is beneficially owned (directly or indirectly) by General Taxing Operates a territorial tax regime. Operates a territorial tax regime. the other; or Regime Only taxes Hong Kong sourced income Only taxes Singapore sourced income – At least 25 percent of the total value of the issued securities derived by funds carrying on business derived by funds. Foreign sourced income in each of the two investors is beneficially owned (directly or indirectly) by a third party. in Hong Kong. Income derived by Funds taxable if received or deemed received in 5 The “financial amount” or penalty is computed based on the are taxed at 16.5% (subject to legislation). Singapore. Tax at 18%. Singapore also prevailing corporate tax rate (currently at 18 percent) multiplied Hong Kong does not tax dividends, capital does not tax capital gains that are not of by the percentage of the non-qualifying investor’s ownership in the fund and the amount of income derived by the fund. gains not of a speculative nature and a speculative nature. No withholding tax The non-qualifying investor is required to declare the certain interest income. No withholding is imposed on dividends. “financial amount” in its own tax return for the relevant year tax is imposed on dividends, interest and of assessment. trust distributions.

Exemptions for Exemption for domestic funds authorised Exemption for domestic funds that are set Domestic Funds by Hong Kong SFC. If a fund is authorised, up as companies in Singapore, managed For further information please contact: all income derived is exempt from by a Singapore fund manager and owned Hong Kong tax. in majority by non-residents. All income Chris Abbiss derived would be exempt if qualifies for Partner, Tax the exemption. KPMG in Hong Kong Exemption for Exemption for foreign funds that are Exemption for foreign funds that, do Tel: +852 2826 7226 Foreign Funds widely held and comply with the not have a permanent establishment in e-Mail: [email protected] requirements of an acceptable supervisory Singapore, invest in designated authority. All income derived would be investments and are not beneficially exempt if qualifies for this exemption. owned by Singapore residents. All income Hong Beng Tay Further exemption for offshore funds derived by the foreign fund is exempt if Executive Director, Tax that involve in “qualifying transactions” qualifies for the exemption. KPMG in Singapore in Hong Kong carried out through Tel: +65 6213 2565 appropriately licensed person. All income derived from “qualifying e-Mail:[email protected] transactions” would be exempt if qualifies for the exemption. Alex Lau Senior Manager, Tax Taxation of Hong Kong taxes Hong Kong sourced Singapore taxes on Singapore sourced Managers management fees derived by fund management fees derived by fund KPMG in Hong Kong managers or trustee companies from managers and trustee companies. Tel: +852 2143 8597 their business carried on in Hong Kong. Management fees derived are generally e-Mail: [email protected] Management fees derived from non-Hong taxed at 18%. However, if the fund Kong business are not taxable. manager received an FSI-fund manager Management fees are taxed at 16.5% status, a concession rate of 10% will apply. Caley Mac (subject to legislation). Manager, Tax KPMG in Singapore Tel: +65 6213 2706 Source: KPMG International, 2008 e-Mail: [email protected]

European tax authorities whose withholding tax rules appear to discriminate against foreign funds face a deluge of claims for repayment. Jonathan Bridges, Kit Dickson, Andreas Patzner, Yves Robert and Paul Te Boekhorst explain the main issues, and examine the practicalities of claiming.

An open and shut case?

onsiderable interest has Fokus Bank claims – basic principles been generated within Any Fokus Bank claim – so-called the European Union (EU) because of a seminal judgment in a of late regarding the case of that name on which claims for taxation of dividends. repayment of WHT are largely based In January, the European (see below) will center on differences CCommission (EC) sent letters of formal in the tax treatment of domestic funds notice (the first step in an Article 226 and foreign funds in the state of the infringement procedure), to Germany dividend or interest paying company and Estonia concerning their rules (State A). which tax dividends (and, in Germany’s In many cases State A-resident case, interest too) paid to foreign funds do not pay tax on income and pension funds more heavily than those in most member states, no WHT is paid to domestic pension funds. The levied on payments to domestic funds. Commission sent similar notices to the Where a WHT is levied, it’s often Czech Republic, Denmark, Spain, reclaimable insofar as it exceeds the Lithuania, the Netherlands, Poland, fund’s tax liability on dividend income. Portugal, Slovenia and Sweden in However, WHT is often levied on May 2007, and to Italy and Finland in dividend payments to foreign funds July 2007. Following complaints, it is (resident in State B) with no reclaim examining the situation in other available in the source state (State A). member states, with a view to initiating Where such a fund is exempt from tax more infringement procedures. on its income in State B, the tax It is not just dividends paid to withheld in State A becomes an pension funds. The EC has also sent absolute cost (see Figure i on page 42). a letter of formal notice to the Czech The difference in treatment Republic about rules taxing dividends illustrated in Figure i can result in a paid to foreign companies more heavily lower post-tax return on investments than those paid to domestic in foreign companies, and is clearly companies, and announced its decision a disincentive to invest in a state in January, 2007, to refer Belgium, imposing a final withholding on Spain, Italy, the Netherlands and payments to foreign funds. It’s Portugal on this matter to the European arguable that this breaches Article 56 Court of Justice (ECJ). The EC sent of the EC Treaty, guaranteeing the free reasoned opinions on the taxation of movement of capital and payments dividends paid to foreign companies between member states. This breach to Luxembourg in July 2006 and to raises the possibility of a claim Germany and Austria in July 2007. challenging the legality of domestic It terminated its infringement WHT rules. Figure ii (see page 42) procedures against Latvia in January identifies EU territories (excluding 2007, and Luxembourg in May 2008, EFTA, May 2004 and January 2007 EU after these countries passed laws accession states) where treatments removing the discrimination. differ and claims by pension and/or The EC challenges to the investment funds, may be viable. withholding tax (WHT) rules of EU But to pursue a claim successfully, and EFTA member states raise the the claimant would have to show that question of whether taxpayers could the domestic and foreign funds treated reclaim WHT levied on dividend and differently in State A are comparable, interest payments. Although a and the difference cannot, therefore, successful claim could yield be justified by State A. Given the wide substantial repayments, the decision variety of funds operated in Europe, on whether or not to proceed with a comparability cannot be assumed claim isn’t as straightforward as it and must be established on a case- might seem at first sight. This article by-case basis. summarizes the main principles of The starting point in looking at such claims, highlights some of the comparability is to compare the WHT practical issues, and considers in positions of domestic and foreign more detail the position in three funds of the same nature (thus key countries: Germany, France avoiding the need to look through the and the Netherlands. funds at the position of each individual

Figure i: the disincentive to invest abroad

State A fund – State A dividend State B fund – State A dividend

Dividend 100 100

WHT Nil 15

Fund level

Taxable income Nil Nil

Overall tax suffered Nil 15

Source: KPMG International, 2008

investor) that are both exempt from shareholders. Dividends paid to the ECJ decided that there was no tax on dividend income in their states Norwegian tax residents were subject infringement of the freedom of capital of residence. Where such clear to tax at 28 percent, but this was movement in the inability to offset comparables don’t exist, each case wholly offset by an imputation tax foreign WHT tax, when the State of must be considered on its own merits. credit of the same amount. Thus residence applies the same tax rate dividends paid to Norwegian to domestic and foreign dividends. Case law shareholders were effectively tax The ECJ’s decision thus addressed As the ECJ and EFTA courts have exempt, while those paid to foreign the question of whether a denial of historically accepted that residents and shareholders were subject to a WHT. offsetting leads to a discriminatory non-residents may be taxed differently, Since no imputation tax credit was effect in the State of residence. The subjecting domestic and foreign funds granted to non-residents in Norway, argument that the State of residence to different tax rules does not seem the WHT was inescapable. The is obliged to offset tax deducted at to be inherently unlawful. However, granting of a tax credit to residents, but source in a foreign country was recent cases have identified not to non-residents was seen by the rejected by the ECJ. Correspondingly, circumstances where discrimination Court as an infringement of the the refund of WHT must be made by has occurred – see, for instance, freedom of movement of capital. the source State, to avoid the ECJ’s comments in the Gerritse Thus the judgment established that discrimination that infringes EU law. (C-234/01) case and other decisions discrimination on the grounds of the Arguably this matter was recently put may also be used to support a claim, residence of the shareholders alone is beyond doubt by the ECJ in the notably the EFTA Court’s decision in unjustifiable. It is true that the Fokus Amurta case (decision dd. November Fokus Bank. judgment only concerned the denial of 8, 2007 C-379/05), which concerned The facts in the Fokus Bank a corporation tax credit, but since the dividend taxation rules in the case were that Norwegian law only WHT suffered by corporate investors Netherlands. taxed distributions by a Norwegian is essentially an advance payment of corporation if taxpayers who were corporate income tax, the principle, Pursuing a claim not fully liable for tax in Norway in this judgment, that discrimination To recover WHT, a claim must be participated in the distribution. solely on the grounds of the residence made in a member state. The initial In other words, tax was not levied of the shareholder is unlawful, is step is to request that the relevant tax on distributions to Norwegian arguably of general application. authority repays the WHT levied, with The ECJ has gone on to develop the claim being quantified, and the principles established in the Fokus appropriate supporting documentation Bank decision. In the Denkavit case provided. The detailed procedures and Figure ii: where Fokus Bank claims maybe possible (decision dd. December 14, 2006) formalities for pursuing claims will the court stated that unlawful differ from territory to territory. Viable ‘Fokus Bank’ claim territories discrimination exists to the extent Action is therefore likely to be

Austria Italy that the dividends on which the required in a number of member WHT is levied are tax exempt in the states and a number of claims in each Belgium Luxembourg country of residence of the recipient member state may be required if more Denmark Netherlands as in such a case, the WHT incurred than one fund is operated. Differing

Finland Portugal cannot be credited and thus becomes levels of information (ultimately, tax a final cost. vouchers in some cases) may also be France Spain The principles established in needed depending on the claim Germany Sweden these cases were also affirmed in territory concerned. Kerckhaert-Morres case (judgment dd. The administrative costs of these Source: KPMG International, 2008 November 14, 2006, C-513/04), where requirements should be taken into

account when evaluating the potential Figure iii: the disincentive to invest abroad benefits of pursuing a claim. These issues, and others, such as the impact Simplified example* Percentage of dividends received a claim may have on unit pricing, are as important as understanding the German investment fund 100 technical merits of a claim. The Foreign investment fund (entitled under the treaty) 85 potential benefits for funds incurring Foreign investment fund (not entitled under treaty) 78.9 substantial WHT costs may however be considerable. Clearly, there are pros German corporation pays 100 100 100 and cons and both must be evaluated. *Assumes the (deemed) distribution is regarded as a dividend under relevant treaty; cost allocation at investment fund level not taken into account.

Source: KPMG International, 2008 Claims in Germany Technical merits of the claim Dividends paid by German corporations are subject to 20 percent There is clear discrimination at fund (withholding) tax paid on their behalf. WHT (rising to 25 percent from 2009), level, when comparing foreign with The above is not true for recipients not carrying a 5.5 percent solidarity German funds, and at fund unit holder domiciled in Germany. They do not qualify surcharge. That amounts to a level discrimination may arguably for any refunds, because they are not 21.1 percent WHT burden. persist, particularly if the foreign fund subject to the German tax assessment Foreign recipients of German is not entitled to a WHT refund under procedure. The tax withheld at source of sourced dividends may be entitled to a the relevant treaty and where the WHT 15 percent is usually definitive (see Article 6.1 percent refund under their Double paid by a German fund to a unit holder VI (1) DTA Germany-UK). Any tax credit Tax Agreement (DTA) with Germany is reduced by cost allocation. system under the applicable DTA does (the treaty rate is usually 15 percent). not improve matters if the applicant is In the case of a foreign investment Taxation of pension funds tax-exempt in its State of residence, and fund, such a refund would not usually in Germany there is thus no tax against which apply to transparent fund vehicles or A foreign pension fund is German WHT could be credited. to funds not regarded as persons comparable to a German pension, under the treaty. relief or superannuation fund. Taxation of companies in Germany German investment funds are Both pension funds and relief funds Dividend income is tax exempt for tax-exempt corporations under are exempt from corporation tax German companies subject to 5 percent Germany’s Corporation Income (subject to some conditions). Pension of the dividend amount being regarded Tax Act (Körperschaftsteuergesetz). funds and (tax-exempt) relief funds can as non-deductible expenses connected If a German investment fund receives reclaim half of the investment income with the tax exempt divided income (§ 8 a German dividend, the Federal Tax tax paid on their behalf through a b German Corporation Income Tax Act). Office repays the full amount of section 44c German Income Tax Act Foreign WHT is, therefore, usually not withholding tax and solidarity refund procedure for distributions creditable, because there is no German surcharge to the fund. As a result, made before January 1, 2004 and for tax levied on the dividend income. from a German tax perspective, it can distributions made after December 31, German WHT however, is creditable or be seen (Figure iii) that the German 2003, through a collective application refundable. Again, this is not true for fund is treated more favorably than to the German Federal Tax Office recipients not domiciled in Germany. a foreign fund. under sections 44a (8) and 45b of the Besides a potential refund procedure It should be noted that once a German Income Tax Act. under a DTA, they do not qualify for any German fund distributes the dividend These refund procedures are not refunds, because they are not subject to income (distributing fund), or is applicable to German superannuation the German tax assessment procedure. deemed to distribute the dividend funds, because they’re not exempt income to its investors at year-end, from tax in Germany. However, the Practicalities in the case of an accumulating fund), operating income and expenses of Foreign investment and pension funds or it is obliged to withhold the WHT and superannuation funds normally offset foreign companies that want to reclaim solidarity surcharge of 21.1 percent each other, as a result of the German WHT under EU law, should file (the distribution is regarded as a recognition of provisions for the refund their claims with the German Federal Tax dividend payment). The assessment of contributions, and thus these funds Office (Bundeszentralamt für Steuern) basis of the 21.1 percent WHT is the do not usually pay any taxes. Within the within four years after the end of the gross dividend received by the fund assessment procedure framework calendar year in which the dividend minus costs (for example, they can thus offset investment payment has been received. There is no management and audit fees) allocated income tax paid on their behalf against standard claim format, but a claim should to that dividend income under the their own corporation tax. Since they contain details of the gross/net dividend German Investment Tax Act’s cost do not usually pay corporation tax, they amount, the dividend receipt date, allocation rules. also effectively receive a refund of the deposit receipts, details of WHT

of the French tax authorities has been to request further information (on the Our discussions with the German Ministry of grounds that the claims are incomplete) rather than reject Finance and the Federal Tax Office suggest them outright. that, because of the large sums being claimed, In particular, the tax authorities have requested evidence, such as specific German legislators are now contemplating the mandates, that the fund has the abolition of the existing tax exemptions of authority to act on behalf of its unit dividend income for German companies and holders. In our view, mandates should not be compulsory in France when a pension funds. fund acts on behalf of unit holders, so this could simply be an example of the tax authorities throwing up hurdles for refunded under the DTA and a letter should arguably be considered at claimants to overcome. setting out the EU law arguments on the fund level, as opposed to the which the claim is based. investor level. Claims in the Netherlands Current position Practicalities Technical merits of the claim At the time of writing, many claims Foreign funds wishing to reclaim their Subject to certain conditions Dutch had been filed by EU investment funds, French WHT should file their claims by funds may qualify for a special zero pension funds and companies with the letters to the French tax office dealing rate of corporate income tax (this German tax authorities and, given the with the affairs of non-residents. should not be confused with the substantial German investments held As in Germany, there is no standard Dutch Exempt Investment Institution by many European funds, more are claim documentation, but a claim must regime introduced in August 2007). expected. Our discussions with the quantify the WHT reclaimed and give Furthermore, such funds may claim German Ministry of Finance and the details of the factual and legal a refund of Dutch dividend WHT, Federal Tax Office suggest that, arguments justifying the claim. levied at 25 percent until 2007 and because of the large sums being Supporting documents should be 15 percent thereafter. claimed, German legislators are now attached identifying the dividends From January 1, 2007, EU-resident contemplating the abolition of the and the WHT payments to which corporate entities not subject to existing tax exemptions of dividend the claim relates). The claim letter corporate income tax in their country income for German companies and should be signed by the fund’s legal of residence, and which would not pension funds. representative, such as the have been subject to corporate income management company, and must also tax if they had been based in the include evidence of the signatory’s Netherlands, may also be eligible for a Claims in France authority to sign. refund of dividend WHT (15 percent Technical merits of the claim Fidal’s experience to date indicates unless reduced by a DTT). The law French funds are fully tax exempt; that the tax authorities will seek to explicitly states that, as from August 1, they are not subject to corporate tax, enforce one procedural requirement; 2007 investment institutions are or WHT on domestic dividends. that claimants of repayments provide a ineligible for this refund, which means Foreign funds are subject to WHT on French contact address/French this relief typically benefits overseas French source dividends at a rate of domiciliation where notices and pension funds (see below). 25 percent (subject to any DTT rates), communications from the French tax A claim can be considered and receive no tax credit. There is thus administration may be sent. (This may particularly strong when the foreign a clear, prima facie case for a Fokus not be easy for some non-resident fund possesses a legal personality and, Bank claim. taxpayers and may itself be open to if resident in the Netherlands, would It is important to note that certain challenge on EU principles). have qualified for the zero rate of French funds (for example, the SICAV The time limits for reclaiming are corporate income tax. For a fund – société d'investissement à capital not straightforward. They depend on to qualify, its sole purpose must be variable) are deemed to be taxable whether the claimant is the paying investment. Financing with loan rather than pass-through entities. entity, or the beneficiary of the capital is permitted up to a maximum This is relevant when seeking the dividends. This difference could also of 60 percent of the book value of ‘comparable’ needed to pursue a claim be seen as discriminatory and thus investment in immovable property and successfully (see above), particularly open to challenge. up to 20 percent of the book value of given that other EU member states other investments. Furthermore, treat certain funds as fully transparent. Current position profits must be distributed within eight If the fund concerned has a distinct A number of claims have been filed months after the close of the financial personality (and possibly even if it does in France by German, Irish, U.K. and year. Additional shareholder not) the question of discrimination Luxembourg funds. The initial reaction requirements also apply.

As of January 1, 2008 the refund under tax treaties which the but many additional claims are procedure for investment funds was Netherlands has concluded with these expected as awareness of the Fokus converted into a remittance reduction; countries is limited to shareholdings Bank case widens. There has also that is to say an investment institution of at least 10 percent in the treaty with been speculation, corroborated, to may reduce the dividend WHT it remits Iceland, and 25 percent in the treaty some extent, by a statement from the to the tax authorities by the amount of with Norway. State Secretary of Finance that Dutch dividend WHT withheld from it. This There is another possible claim WHT on dividends may be abolished. remittance reduction will apply to non- in the case of shareholdings of less This suggests the Dutch government Dutch WHT (including interest WHT) than five percent owned by foreign is aware that its rules are vulnerable to too, subject to a maximum of 15 corporate shareholders; these no challenge. For the time being, percent of the revenue. Thus for longer qualify for the exemption of however, the Dividend Withholding investment funds, Dutch law now dividend WHT, unless the Tax Act remains in force. seems to be neutral, and Fokus Bank grandfathering rule applies. This allows claims are unlikely to be appropriate. corporations holding less than five No time to lose The position changes with foreign percent of the capital of a subsidiary A large number of Fokus Bank claims pension funds. They suffered Dutch that qualified for the exemption on have already been made with tax dividend WHT at 25 percent until 2007. December 31, 2006 to continue to authorities throughout the EU and, This was not recoverable, unless benefit until 2010. The possibility given the substantial rewards of recovery was granted by a relevant of a claim arises because the successful claims and the duty that treaty. This difference in treatment grandfathering rule does not apply funds owe to their shareholders and gave rise to a possible Fokus Bank to corporate shareholders beneficiaries, many more may be claim by the foreign fund until 2007. resident abroad. expected. Claiming, while in many Claims could still be possible, because cases advantageous, does need to be the Dutch requirement that, to qualify Claim practicalities carefully considered and the rewards for the refund, funds resident in Claims supported by information will take time to come to fruition. For another EU Member State must be similar to that required in Germany and those that choose to make claims, the exempt from corporate income tax France should be filed with the Dutch sooner well documented, well argued both in that state and in the tax office dealing with international claims are lodged, the stronger position Netherlands, may breach the EC affairs. A three-year time limit from the claimants will find themselves in. Treaty. Arguments on this point may end of the year in which the WHT was be considered in the ECJ’s judgment incurred normally applies. in the pending Aberdeen Property For further information please contact: Fininvest Alpha Oy case (C-303/07). Current position Jonathan Bridges Claims can still be made i.e. for A number of claims have been filed Senior Manager, Tax post-2007 periods for Dutch WHT on with the tax authorities seeking KPMG in the U.K. dividends paid to holding companies recovery of Dutch WHT. The claimants Tel: +44 (0)20 7694 3846 resident in Iceland or Norway, because include foreign investment and e-Mail: [email protected] the WHT exemption is limited to pension funds, including some of the Kit Dickson dividends paid to holding companies U.K.’s largest pension funds. Senior Manager, Tax resident in other EU member states. The Dutch tax authorities have yet KPMG in the U.K. Such claims would focus on the to acknowledge any obligation to repay Tel: +44 (0)161 246 4503 requirement that the relief granted the WHT suffered by the claimants, e-Mail: [email protected]

Andreas Patzner Senior Manager, Tax KPMG in Germany Tel: +49 69 9587 2696 As of January 1, 2008 the refund procedure e-Mail: [email protected] for investment funds was converted into a Yves Robert remittance reduction; that is to say an Partner, Tax Fidal* in France investment institution may reduce the Tel: +33 1 55681576 dividend WHT it remits to the tax authorities e-Mail: [email protected] by the amount of dividend WHT withheld Paul Te Boekhorst Senior Manager, Tax from it. KPMG in the Netherlands Tel: +31 20 656 14 62 e-Mail: [email protected]

*Fidal is an independent legal entity that is separate from KPMG International and KPMG member firms.

t’s widely believed that the An insurer operating through a by the need to plug deficits in European Economic Area subsidiary structure must respond subsidiaries’ distributable reserves (EEA) insurance market would to the interests of regulators and the before paying dividends will be be best served by a single insurer, credit rating agencies in the flexibility avoided. A simpler, more transparent operating through a branch of the capital backing of each global operating structure will enable structure. Reinsurance has subsidiary. Because risks can only better brand management, and there Ibeen brought within the insurance be written to the level of risk the may also be internal staff and regulatory framework1 and major consolidated group can bear, other savings. reinsurers, (for example Swiss Re) subsidiaries will typically have entered are adapting their operating structures into non-proportional intra group Residence accordingly. This article considers reinsurance contracts such as excess Two basic tax questions must be the tax issues that must be of loss or stop-loss contracts, or both. answered by an insurer before moving addressed when designing such Moreover, to improve the control of to a branch structure. Will the new a branch structure. the global acceptance and structure result in more or less tax? management of risk, and investment How much will it cost to move to a The benefits of branches of assets, proportional quota share branch structure? To answer them, A basic EEA principle is that regulation contracts between a parent and its it is first necessary to select the EEA of an authorised insurer of a member subsidiaries are common. business of which the branches will be state is the responsibility of the These issues do not arise with a part. There is a wide range of company regulator of that state, irrespective branch structure, because there’s a tax rates in the EEA. Ireland offers a of where its branches and/or agencies single legal entity, all the assets of low 12.5 percent rate on worldwide operate2, subject to the overall which are available to meet claims profits and a good spread of double direction imposed by the Insurance intra group reinsurance becomes less taxation agreements (DTAs). Groups Directive3. A distinctive necessary, because policy holders and Luxembourg seeks to attract insurers, advantage of a branch structure is cedants benefit automatically from the despite its relatively high tax rate of the requirement to respond only to parent’s credit rating – there is no need 29.63 percent4, with an exemption a single financial regulator. Whether to assess the value of the group’s for Permanent Establishments (PEs) insurance groups will have a group brand or parental guarantees and in states with which it has DTAs. regulator and the responsibilities contractual ‘cut through’ clauses. It is Because Luxembourg is a relatively assumed by such a regulator are easier to manage external reinsurance small market, local operating income matters of current debate. and investment management with the will be low and the exemption should A branch structure enhances an branch model; fewer financial produce a global tax charge equivalent insurer’s capital efficiency, because statements have to be prepared and to the PE’s aggregated tax charge. there is a single source of capital. audited and ‘dividend traps’created Luxembourg’s network of DTAs EuropeanBroadening

horizonsLong before Solvency II creates a single European insurance market in 2012 major players must consider structural changes to improve tax efficiency, writes Ian Rogers, Jean-Pierre Dumazaud and Sandra Grote.

is less comprehensive than either Ireland’s or the U.K.’s (where the corporation tax rate is currently 28 percent). A location decision should not be made on tax grounds alone, but as far as direct tax is concerned, the important factors are the tax rate (newer EEA entrants tend to have lower rates), computation of the tax basis and the method of taxing international profits: an exemption system or a worldwide tax base with credit relief.

Converting a general insurer to a parent entity Since 1990 the European Mergers Tax Directive (EMTD)5 has facilitated intra- EEA cross border mergers, divisions, transfers of assets and exchanges of shares. Since 2005 it has applied to European Companies (Societas Europaea:SE). National company law But, as the following example The company’s operations are had to conform to it from December demonstrates, companies will prefer purely domestic. Equities and bonds 2007, to permit the restructurings to work within national laws that are carried at fair or market value7. contemplated by the directive. conform with the EMTD rather than Insurance technical provisions are In the absence, to date, of a the EMTD itself. carried at ultimate value on an European Company law directive SEs Assume that a U.K. general insurer undiscounted basis8. There is a 60 are broadly subject to the company (UKCo) owned by a non-EEA company percent quota share and stop loss law of the states of their registered (PInc) transfers its operations to a treaty with PInc. UKCo reinsurance offices, which effectively means their general insurer resident in another EEA contracts will be cancelled but ‘head offices’. But SEs can move their member state (MCo) also controlled by renewed between MCo and PInc. registered offices between EEA PInc and that the transfer is part of an member states. On the face of it, this EEA-wide restructuring designed to From subsidiary to branch should encourage tax competition allow MCo to carry on a general Ignore for a moment the form of within the EEA. insurance business throughout the EEA the transfer. Will the U.K. tax base Branch structures (as defined through branches. The value chain is on the profits of the U.K. PE change? by the EMTD) can be realised through not changed – MCo’s U.K. PE inherits The most recent authoritative answer transfers of assets, partial divisions or all the staff, premises and other to this question comes from the mergers. The laws of some member operational resources of UKCo. The Organisation for Economic Co states allow other methods. The transfer will require the consent of the operation and Development (OECD), Directive defines a branch of activity Court as an insurance business transfer which has laboured for many years to as part of the company, which, from scheme to ensure that the rights of develop a model for attributing profits an organisational point of view, policyholders are not prejudiced6. to PEs (i.e. branches and dependent constitutes an independent business At the transfer date UKCo’s agencies) in general and to PEs in the n able to function on its own. If the simplified balance sheet is as follows: financial sector in particular. A three- business of a company in one member part OECD revised report and a draft state is transferred to a company in Share capital 120 fourth part dealing specifically with another member state, the transferor Retained earnings 180 insurance enterprises, appeared in has to retain a PE in the former state, Shareholder funds 300 20079. Following consultations a final to limit the potential loss of tax by the Equities 200 Part IV is eagerly awaited, and work state of the transferor. This potential Bonds 1130 continues on new text for Article 7 loss is further reduced by the Total assets 1330 of the model treaty and an requirement that a transfer of assets Insurance technical provisions (net) 1000 accompanying commentary. must be in exchange for securities in Equalisation reserves 30 Virtually all OECD member the capital of the receiving company. Total provisions and reserves 1030 countries now follow its model This ensures the transferor retains Net worth 300 convention10 when negotiating bilateral a stake in the taxable profits of the DTAs. Article 7 sets out two basic continuing or successor operation. Source: KPMG International, 2008 rules, which are standard in DTAs.

taxation of the net result, including an appropriate share of MCo’s investment return. How would the tax authorities in other countries react to this? Assume MCo is resident in France which taxes the active French business profits of resident companies. France exempts profits of foreign branches, but taxes global passive income. Since investment returns of a general insurer are regarded as active income, it seems likely that France would exempt both the underwriting profit and the investment returns attributable to the U.K. PE, provided that it was satisfied that the OECD approach had been followed. If MCo were resident in Germany which taxes worldwide profits, the treaty with the UK should exempt the profits of the UK PE. But suppose UKCo’s reinsurance The first is that the business profits of some cumbersome EEA mutual before the transfer was with MCo. of an enterprise of a Contracting State agreement and arbitration procedures In this case the reinsurance would are only taxed in that state unless the applicable in very limited collapse after the transfer, because enterprise carries on business in the circumstances12, taxpayers cannot a company cannot reinsure with itself. other state through a PE. The second normally compel resolutions of such The U.K. should then claim taxing is that, where an enterprise does carry disagreements. rights over the gross result of the on business through a PE “there shall The draft of Part IV of the OECD’s U.K. branch (including an appropriate in each Contracting State be attributed report identifies the attribution of investment return) and, to avoid to that permanent establishment the assets and thus investment returns to double taxation, MCo’s state of profits which it might be expected to PEs and head offices as the crucial residence has to forgo taxing the make if it were a distinct and separate issue, because the underwriting “expanded” U.K. branch. Ceding enterprise engaged in the same or results of a local operation can usually commissions previously paid to UKCo similar activities under the same or be determined, albeit with some would disappear, and MCo’s profit similar conditions and dealing wholly difficulty when there are complex under the reinsurance agreements independently with the enterprise reinsurance arrangements. The would be subsumed in the profits of of which it is a permanent identification of the ‘key its U.K. PE. Depending on the state of establishment”. entrepreneurial risk-taking functions’ residence this might result in the tax Given Article7’s‘distinct and (KERTS) is fundamental to the OECD on a slice of profits falling from the separate enterprise’definition of a attribution model. The emphasis is on French rate of 33.33 percent or the PE there might seem, at first sight, where insurance contracts are German rate of 38.86 percent, to the to be little difference between the negotiated and underwriting decisions U.K. rate of 28 percent. If the ceding taxable profits of operations taking are made. The model sees ‘internal’ commission had been set at the PE or company forms. This is not reinsurance arrangements as merely correct level neither tax authority necessarily the case. The problem, allocations of assumed risks, and would suffer, but it’s likely that as explained in Part IV of the OECD specifically denies any need to considerable effort would be required report, is that there’s “considerable attribute a “surplus” to the head to satisfy the respective tax authorities variation” in laws of OECD member office, on the grounds that this is on these points. This lack of intra countries for the taxation of PEs and unnecessary if the risk has been group reinsurance may be significant “no consensus” on how to interpret properly attributed to the KERTS. when deciding the location of Article 7.“This lack of a common Another important feature of the KERTS and thus the allocation interpretation and consistent OECD approach is its attribution to the of investment return. application of Article 7” warns the PE of a proportion of assets, rather OECD “can lead to double, or less than specific assets. Form of transfer than single, taxation”. Given all this it seems reasonable, For EMTD purposes, a transfer of Most DTAs contain ‘mutual following the restructuring outlined assets results in the transfer of a agreement procedures’11 to resolve above, for the U.K. tax authorities to branch of activity in exchange for disputes between fiscal authorities on allow the reinsurance deduction shares representing the capital of the taxing rights, but, with the exception sought by MCo’s U.K. PE, but to claim transferee company. The U.K. capital

gains legislation, which gives effect treated as sustained, not in carrying on purchased goodwill, or take the form of a to the directive, allows MCo’s U.K. its trade, but in bringing it to an end14. full merger, if MCo issues shares to PInc. PE to inherit the capital gains cost base It is also possible that some technicality Refinements to each transfer route, value of the assets of UKCo’s trade. But this might make the loss succession rules chain alterations and the introduction of is of little benefit to a general insurer, inapplicable and, more significantly, innovative Tier I and 2 capital, will all add because virtually all of its profits are that a transfer pricing adjustment to the analysis required, and indirect tax, taxed as income. Bonds and equities will be made, although in this case, pensions and payroll compliance will will have been taxed already as income because of the domestic nature of the also have to be considered. on a mark to market basis; untaxed transfer, the transferee would claim a Let us end by highlighting that returns will be confined to the returns corresponding adjustment15. We’ll any group contemplating such a since the end of the last period of assume for the purposes of this article reorganisation will need to undertake a account. Instead, different legislation that the tax law applicable to PInc, the thorough evaluation of the commercial allows the transfer to be disregarded parent of UKCo and MCo, would not advantages sought, a full analysis of the to permit continuity of treatment take issue with the gratuitous transfer current and future regulatory and capital between transferor and transferee. of value from the shares of UKCo to impacts, a comparative selection of the Similarly goodwill is dealt with in the shares of MCo. The directors of state of residence, a functional analysis the code dealing with intangible UKCo will, however, need to consider of the KERTS and it goes without saying fixed assets. the company law implications. a tax study to identify ‘carve outs’ from a branch structure and how to implement it. Route 1 Route 2 1 Directive 2005/68/EC of the European Parliament and of the Council A simple way to achieve this transfer In a more arm’s length transaction of November 16, 2005 on reinsurance and amending Council Directives 73/239/EEC, 92/49/EEC as well as Directives 98/78/EC to the U.K. PE would be for it to UKCo could transfer its insurance and 2002/83/EC. 2 73/239/EEC First Non-Life Co-ordination Directive assume all the insurance technical technical provisions to the U.K. branch 73/240/EEC Non-Life Insurance Establishment Directive 88/357/EEC Second Non-Life Co-ordination Directive provisions/ reserves (of 1,030) for a of MCo for a like amount of assets16. 92/49/EEC Third Non-Life Insurance Directive 2002/83/EC Directive of the European Parliament and of the premium of 1,330 (i.e. including the However, thus would make it harder Council concerning life assurance Directive of the European Parliament and of the Council value of shareholder funds), satisfied for the parent, PInc, to release the (2002/92/EC) on insurance mediation 3 98/78/EC Directive of the European Parliament and of the Council by a payment in specie (equities and capital previously supporting UKCo on the supplementary supervision of insurance undertakings in an insurance group bonds). Both asset classes can be to MCo, or elsewhere within its group. 4 KPMG’s Corporate and Indirect Tax Rate Survey 2007. A corporate tax rate of 22.88 percent includes a 4 percent employment fund transferred without triggering any A winding up to release this capital contribution. The municipal business tax varies, eg the rate for the City of Luxembourg is 6.75 percent. untaxed income gains. Continuity of should have no adverse U.K. tax 5 90/434/EEC 6 FSMA 2000 Part VII Control of Business Transfer Schemes treatment should be possible for consequences, because the U.K. 7 CA 1985 Sch 29A paras 22,25 and 29A 8 CA 1985 Sch 9A paras 47 and 48 equalisation reserves for which a tax claims no taxing right over a gain 9 Report on the attribution of profits to permanent establishments Part IV (Insurance); Revised public discussion draft August 22, 2007 deduction has been given. Assuming realised by a non resident when it OECD Centre of tax policy and administration. 10 Model Tax Convention on Income and Capital OECD Committee on that any goodwill was internally disposes of its shares in a U.K. Fiscal Affairs Updated as of 2005 11 Article 25 Mutual Agreement Procedure of the Model Convention created by the transferor it would not resident company. However, since 12 90/436/EC EC Convention of July 23, 1990 on the elimination of double taxation in connection with the adjustment of profits of be recognised in UKCo’s financial this gain might be taxed in PInc’s state, associated enterprises. 13 TA 1988 s343 statements and passes without it might prefer the winding up to be 14 TA 1988 s74 15 TA 1988 Sch 28AA para 6 payment to the transferee. preceded by a dividend to receive a 16 ‘the appropriate amount’ – FA 2007 s42 Sch 11 para1 But since shareholders’ funds better tax treatment such as an have moved to the U.K. PE at a exemption or double tax credit relief premium this transfer is clearly not for the tax paid by UKCo on its profits. ‘arm’s length’. The transferor sustains For further information please contact: a loss and the transferee books an Evaluating the options Ian Rogers underwriting or merger profit. In theory Which transfer route is better Senior Technical Adviser, Tax the domestic legislation should allow depends, of course, as much on PInc’s KPMG in the U.K. that loss to be used by the transferor, circumstances, as the tax analysis Tel: +44 (0) 20 7311 5239 or passed to the transferee to offset its above, and, if the form of the EMTD e-Mail: [email protected] profit on the transfer13. But there’s a is observed, the issue of securities by Jean-Pierre Dumazaud risk that the transferor’s loss will be MCo might also involve recognition of Partner, Tax Fidal* in France Tel: +33 1 5568 1470 e-Mail: [email protected]

Sandra Grote Partner, Tax KPMG in Germany For EMTD purposes, a transfer of assets Tel: +49 89 9282-1382 results in the transfer of a branch of activity e-Mail: [email protected] in exchange for shares representing the *Fidal is an independent legal entity that is separate from KPMG International and KPMG capital of the transferee company. member firms.

The global rules on withholding tax relief are set for a major overhaul but will the new system be any more harmonious than the current regime? Iain Hebbard, Steven McGrady and Mark Naretti describe various reform initiatives that could soon bring new order and consistency.

he complex array of impact of Giovannini’s Barrier 11, EU withholding taxes but developed into a wide-ranging for dividends, the study into the differences in tax interest income from collection and relief procedures across portfolio investments the various EU markets. and associated The report identified the following Tprocedures have long been a areas as having the potential to create challenge for financial intermediaries significant obstacles: and investors alike. Withholding tax collection and relief Responsibility for deducting procedures vary between member withholding taxes; states. In some cases there are Timing of withholding tax deduction; different procedures, for different Reporting obligations associated types of security in the same state. with withholding tax collection; Procedures include a wholly tax Relief methods; reclaim process, a relief at source Documentation requirements mechanism and a mixture of the two for obtaining relief; depending on either asset type or the Varying statutes of limitations beneficiary making the claim. for refund claims; and Tax authority arrangements The impetus for change for processing refund claims. The first Giovannini report1 identified a large number of barriers to the free FISCO’s second report, published movement of capital within the EU. in late 2007, focused on potential This article focuses on proposals for solutions to the barriers identified the removal of ‘Barrier 11’, which in the first report and set out the restricted the responsibilities for following criteria for collection and withholding tax to domestic entities. relief procedures: The report deemed this to be a disadvantage to foreign Sufficient audit and enforcement intermediaries. (Another important mechanisms for tax authorities to constraint was Giovannini ‘Barrier 12’ ensure the proper collection of – the requirement that taxes on withholding tax; securities transactions be collected Appropriate reliefs to be available via local systems). without requiring excessive In response to the Giovannini documentation or exposing issuers, reports, the Fiscal Compliance Experts intermediaries and investors to Group (FISCO) studied compliance unnecessary risks and costs; procedures relating to clearing and All procedures should work equally settlement within the EU and efficiently, irrespective of where the published its first report in 2006. securities are held, where transactions are settled (local, FISCO 1 and 2 versus foreign intermediary, or CSD) The objective of FISCO’s first report and investment and settlement was to determine the extent to which arrangements chosen by investors withholding taxes and associated and intermediaries (direct, versus procedures acted as a barrier to cross- indirect access); and border investment within the EU. Foreign and local intermediaries The initial investigation was into the should be treated equally.

In addition to these goals intermediary’s choice. Following Audit and tax surveillance the FISCO study group identified the U.S. Qualified Intermediary (QI) When preparing its recommendations a number of guiding principles: regime, Responsible Withholding on audit and tax surveillance the study Agents who are obliged to assume group considered the merits of similar National tax administrations the tax withholding responsibility, and regimes, including the U.S. QI should have the necessary relevant Responsible Non-Withholding Agents, system, Japan’s QFI regime, and information and there should be have been proposed, to allow the Elective Dividend System used no loss of tax revenues; intermediaries to choose the level by the U.S. DTC. To ensure the free EU provision of their responsibilities. The study group concluded that of investment services foreign A Responsible Withholding Agent tax authorities and external auditors intermediaries should have the would be obliged to deduct, and then should work together in the audit same access to national clearing deposit withholding tax with the issuer process, but the actions required and settlement systems as country’s tax authority, to collect the of the external auditor should be local operators; documentation/information proving confined to periodic system checks Local intermediaries shouldn’t be the beneficial owner’s right to receive and tax authorities would focus on at a competitive disadvantage in the income at a reduced rate of audit actions as cases arose. One terms of the level of responsibility withholding, and to hold that question yet to be resolved is which they assume with regard to local information for inspection. It would tax authority will be involved in the tax authorities; also be responsible for depositing tax, audit process – the tax authority Intermediaries should not face any filing harmonized electronic returns where the investment income tax liability if mistakes in information and making information available for arises or the intermediary’s home provided or errors in tax possible audit. It is also proposed that authority, via some kind of mutual withholdings are not the result of a Responsible Withholding Agent assistance program? negligence or misrepresentation by would have a process for refunding tax the intermediary. Nor should there possibly by adjustments against taxes Increase efficiency of quick and be any liability in the case of the to be paid to the relevant tax authority. standard refund procedures negligence or misrepresentation In contrast the Responsible Non- The report also proposed that refund of any other party, particularly the Withholding Agent would have many procedures should be harmonized owner of the securities. of the same responsibilities, but throughout the EU by using similar would not be required to deduct and application forms and harmonizing the The FISCO proposals deposit withholding tax. To achieve time-limit for the application for Relief at source the relief at source envisaged, the refunds. It is also envisaged that a FISCO’s preferred relief method is the Responsible Non-Withholding Agent quick standard refund process be relief at source process. Few existing would be able to pass tax rate developed and adopted by all EU procedures take sufficient account information on a pooled basis to the member states. of the multi-tiered nature of modern security issuer/agent, or (more likely) holding structures and often put the an up-stream Responsible The ISSA model tax collection responsibility on entities Withholding Agent. While the FISCO team was unconnected with the beneficial To achieve the most efficient considering the operation of EU owners of the income. To overcome process, FISCO envisaged that a withholding taxes, the International this, procedures often require a single model contract be developed Securities Services Association (ISSA) transfer of information and certificates between the intermediary on the one was developing a new tax relief between intermediaries. This is costly hand and the various EU tax authorities model in response to the Group of and inefficient for intermediaries and on the other. Thirty (G30) ‘recommendation 8’, the final withholding agents, makes timely certification difficult and can create confidentiality issues. FISCO’s proposed solution is to allow all intermediaries in the chain to take responsibility for granting withholding The objectives of the tax relief and to harmonize national ISSA model are to: procedures as far as possible. – Standardize tax relief arrangements; Shifting withholding tax – Facilitate the automation of associated responsibilities procedures and the electronic communication of associated data; FISCO proposes that it should be – Provide each party involved in the tax possible to shift a withholding tax relief process with an opportunity to responsibility cross-border at the limit associated costs.

and investigating the need to automate and standardize tax relief arrangements. The proposals published by ISSA have been endorsed by both ISSA and the G30. The ISSA proposals were designed to limit the costs and resources associated with the relief at source method. The model uses existing technology and self-certification methodologies to satisfy the needs of tax authorities and enable intermediaries to set up efficient and reliable processes. It was developed with the requirements of market participants in mind and differs significantly from the proposals of the FISCO group. Perhaps most Over the course of the next few years, significantly, it does not envisage the regulatory environment for obtaining a withholding role for foreign relief from withholding taxes will change intermediaries. Rather, the focus is on the ability of intermediaries to dramatically both in EU and other global ‘certify’, through pooled accounts markets covered by the G30 and the OECD. structures, eligibility for reduced rates of withholding at source. ISSA also envisages agreements between intermediaries and their home It is true that previous attempts before the end of 2008. The initial country tax authorities with limited over the years to bring some order indications are that a hybrid version audit requirements. and simplicity to this important area of the current proposals may emerge The models also differ significantly have failed to find sufficient common that will combine new withholding in identification of beneficial owners. ground for all parties including the tax responsibilities and standardized and The ISSA model employs a standard authorities, foreign and local financial more efficient ‘relief at source’ self-certification process while intermediaries and withholding agents. procedures, with a system for passing the FISCO model requires more Given the caliber and reputations of information between intermediaries, official methods, including tax the various organizations now and a non invasive audit approach. certification and Know Your Client considering the issue there is reason 1. The Giovannini Group – Report on EU Clearing and Settlement (KYC) documentation. to be hopeful that these current Arrangements, November 2001 and April 2003 proposals will come to fruition. The Future If their concerns that the correct In addition to these FISCO and ISSA tax revenues can be collected, and initiatives the IFA/OECD is also looking the necessary level of supervision into this area, so it seems likely that, maintained can be met, the tax over the course of the next few years, authorities have potentially much For further information please contact: the regulatory environment for to gain from these reforms. But it’s a obtaining relief from withholding big if. Intermediaries are naturally keen Iain Hebbard Director, Operational Taxes taxes will change dramatically both to reduce the compliance costs and KPMG in the U.K. in the EU and other global markets complexities of any new regime as Tel +44 (0)20 7311 5327 covered by the G30 and the OECD. much as possible, so it may not be e-Mail [email protected] The ISSA and OECD proposals easy to reach agreement on are aimed at harmonizing and certification and compliance Mark Naretti Senior Manger, Tax simplifying existing procedures requirements (including audit) KPMG in the U.S. and can thus be implemented that will satisfy the tax authorities. Tel: +1 212 872 7896 independently of the FISCO proposals. The next few months are crucial. e-Mail [email protected] It seems inevitable, however, that all In February a joint OECD – European three sets of proposals will eventually Commission working group met for Steven McGrady Partner, Tax coalesce into a coordinated approach the first time to agree on a set of KPMG in the U.K. to the problems currently facing proposals for extending provision of Tel +44 (0)20 7311 4002 market participants. treaty relief to cross border investors e-Mail [email protected]

The growth of complex derivatives in financial services has led to a debate about how they should be taxed. However this debate does not always seem to follow logic.

ax policy often potential abuse. Changes in tax policy ‘emerges’ in response in response to the growing importance to macroeconomic of derivatives are now being fundamentals or contemplated in many tax jurisdictions. particular developments. A sudden surge in a The story so far Tparticular sector or area of activity, Policy makers in some countries for instance may be seen as evidence have been concerned about the of some kind of abuse from a impact of derivatives on tax statutes government or taxation point of view. for some time. The very sophisticated Derivatives, which consist of accounting rules, particularly IAS 39, synthetic financial transactions, relating to derivatives have led some play a role in many sectors, but are legislators to wonder whether particularly important in financial accounting treatment could be services. Because of their complexity, the solution to a lack of sufficiently sophistication and explosive growth, sophisticated tax rules. This has led they too have acquired, in the minds to the emergence of three main of some tax authorities, an aura of approaches to the taxation of derivatives:

It is not surprising, given the pragmatic motivations for accounting approaches to taxing derivatives, that a number of variations on the theme have emerged.

Application of general tax principles; and obligations, so, at first sight, there Accounting standards Legislative codification; and seems no need for the changes in the Countries, such as the U.K. and An acceptance of the rules for derivatives already New Zealand, that have moved, or accounting treatment. implemented or proposed in many are contemplating moving, towards developed and developing countries. an accounting-based approach to This article examines the question taxing derivatives do not, by and large, of whether derivatives tax policy should Codification seem to have given much thought to be based on legislative codification, The codification of tax laws around the the fundamental principles of tax law. accounting standards or the world is often inspired by a perceived Instead, they have focused on the fundamentals of taxation law, based misuse of arbitrage opportunities, or same practical concerns that have on the recognition of income and a perceived need for a preventative tax shaped Australian policy. It is expenditure. The ‘recognition’ principle avoidance measure. A general anti- somewhat surprising, given the history relates directly to the contractual rights avoidance rule is usually seen as and traditions of U.K. tax legislation, and obligations in a derivative contract. sufficient to deal with transactions the that no academic or legal rationales The ‘interpretation gap’ between sole or main purpose of which is tax have been proposed for the the legal rationale for a change in policy avoidance. Countries, such as the U.K., accounting-based approach to in many jurisdictions and public that have not seen fit to introduce legislation. The U.K. and other perception of such a need is also general anti-avoidance measures, countries adopting this approach addressed in this article. The must, of course, rely on specific appear to be relying on accounting development of accounting rules has anti-avoidance rules as and when standards, particularly IAS 39, for been or should be driven by the basic a perceived need arises. recognition of gains and losses. principles of matching and prudence. The introduction of specific tax The crucial event under IAS 39 is the It is to be hoped that any policy shifts rules may provide added clarity and establishment of a derivative contract, in accounting for derivatives will also consistency, but may also inhibit the which then triggers the recognition be guided by these principles. evolution of tax principles based on of the gains or losses associated with contractual rights and obligations. the contract. Applying general tax principles When specific tax rules override IAS 39 defines a derivative The fundamental principles of most general tax rules, the general principles according to three fundamental tax law relate to the recognition of of tax law are at risk. This became criteria: contractual rights and obligations. The evident when Australia embarked on ‘A derivative is a financial conditionality of rights and obligations a reform of tax law relating to financial instrument or other contract within the is important when recognising income instruments in 2001. It was not until scope of this Standard... with all three and expenditure for tax purposes in late 2007 that the legislature of the following characteristics: most tax regimes, because it’s at the introduced new, codified law – its value changes in response to the point that conditions crystallise that governing the taxation of gains and change in an underlying variable; recognition of income and expenditure losses on derivatives. The law is – it requires no initial net investment or is triggered. effective for years of assessment little initial net investment relative to Applying the principle of recognition commencing on or after July 1, 2009. other types of contracts that have of rights and obligations to a derivative Its main objectives are1: similar responses to changes in contract poses no particular problems, market conditions; and because rights and obligations are the Lowering of compliance costs; – it is settled at a future date.’ essence of any derivative contract. Providing clarity and certainty; In principle existing tax rules can deal Compliance with financial with the recognition of these rights accounting concepts.

The term ‘financial instrument Netherlands There’s also a danger, given the or other contract’ in this definition principles of matching and prudence is significant and welcome, because There are no definitions, or specific and the fact that the parties to it implies a legal agreement is the rules in Dutch tax legislation relating derivatives contracts will often be essence of a derivative contract, and, to derivatives, apart from recent Dutch subject to different accounting rules, traditionally, accounting standards case law which held that “complete” that a widespread adoption of setters have been very reluctant to hedges have a neutral tax effect. accounting-based approaches will acknowledge the legal enforceability Common practice is to follow create arbitrage opportunities. of contracts. This departure from business practice, which follows What’s required is for countries standard-setting practice means the accounting treatment. that have already adopted or intend to that a derivative contract is legally adopt accounting-based approaches enforceable, by definition, and, New Zealand to derivatives taxation to make a good therefore, its gains or losses should legal, as well as a pragmatic case for be recognised and recorded in Tax practice in New Zealand is the reform. Compliance cost reduction financial statements. governed by the Financial Arrangement and simplicity, although desirable, do The fundamental flaw in the Rules, which recognise gains and not constitute a legal case. Moreover, accounting-based approach is the losses irrespective of whether they given the enormous complexity of lack of correlation to the legal are capital or revenue, allocate income IAS 39 and some other accounting fundamentals. This is not to say that and expenditure between the parties standards, a tax reform based on legal substance is ignored. It is clear to the arrangement, and spread the an accounting approach should, from the discussion above that IAS 39 gains and losses over the period of in principle, take into account does recognise the legal rights and the arrangement. Going forward the accounting rules as a whole, including, obligations in a derivative. The basic primary method for spreading gains for example, IAS 17 governing the difference between recognising a and losses will be to follow the application of straight line accounting derivative for accounting purposes, accounting treatment under IAS 39, for leases. under IAS 39, and applying general tax however there are some alternative So, codify the taxation of derivatives principles is that the former recognises options that can be applied in by all means, but explain how the the instrument or contract as a whole, specific circumstances. codification is consistent with whereas the latter only recognises the established legal principles and rights and obligations it incorporates. Towards a global tax policy particularly the recognition of rights It is not surprising, given the for derivatives and obligations. A tax reform based pragmatic motivations for accounting A global market, such as the purely on practical considerations risks approaches to taxing derivatives, that derivatives market, requires consistent violating fundamental tax principles a number of variations on the theme tax policies and legislation throughout established by statute and the courts. have emerged: the world if taxation is not to prevent 1. The Parliament of the Commonwealth of Australia, House of the free movement of capital to its Representatives, Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2007, (Explanatory Memorandum, Circulated Ireland highest value use. As manifestly by Authority of the Treasurer, The Hon Peter Costello MP) effective instruments for managing Derivatives are generally taxed currency, interest and credit risks, and according to their accounting commodity price volatility, derivatives treatment. Gains and losses are are a vital lubricant for the free flow recorded in the income statement of global capital. and are recognised as such for tax The tax treatments of derivatives For further information please contact: purposes. The same treatment is will inevitably vary, depending on the applied to ‘embedded derivatives’ – particular tax rules of each jurisdiction. Michael Rudnicki Partner, Tax synthetic derivatives embedded in It is vital, however, that insertions of KPMG in South Africa other contracts, such as an option accounting standards into tax rule Tel: +27 (11) 647 5725 in a convertible security to acquire books pay due regard to fundamental e-Mail: [email protected] an underlying equity instrument legal and philosophical principles, and or position – which have no do not preclude the full recognition Greg Knowles Partner, Tax legal substance. of legal rights and obligations. Since KPMG in New Zealand most, if not all, of the recent shifts to Tel: +64 (9) 367 5989 Belgium accounting-based taxation of e-Mail: [email protected] derivatives fail this test, the There are no specific rules for administration of the taxation of Michael Hayes Partner, Tax taxing derivatives in Belgium so derivatives might as well be handed KPMG in Ireland the default is reliant on the over, lock, stock and barrel, to the Tel: + 353 (1) 410 1656 accounting treatment. international accounting bodies. e-Mail: [email protected]

New KPMG Thought Leadership:

2008 Global Fund and Fund Frontiers in Finance Management Survey The latest edition of frontiers in finance Our annual survey covering taxation, focuses on ‘hot’ topics in the financial accounting and regulation is updated by services sector in general, and the retail the investment management practices banking sector in particular. KPMG firms’ of KPMG member firms around the partners examine new ways to help retail world. It is a broad ranging and banks to become more innovative, authoritative point of reference for customer-focused and better prepared financial services companies marketing to deal with payments fraud. investment funds around the world. State of the Investment Management 2008 Global Hedge Funds Survey Industry in Asia Pacific In recent years the hedge funds industry The latest edition of SIMI in Asia Pacific has experienced explosive growth. refers to entities that are actively engaged As sophisticated investors increasingly in the management of pooled assets. accept hedge funds as an integral part This specifically includes traditional of their investment strategies, large mutual fund managers and life insurance institutions and entrepreneurial money companies as well as managers using managers are seeking access to, or alternative investments strategies expanding their presence in the hedge through vehicles such as hedge funds. fund arena. Launched in 2007, this KPMG international Survey covers 24 countries Basel Briefing 13 dealing with both taxation and regulation. A series of technical updates highlighting issues pre- and post-implementation. Taxation of Mergers and Acquisitions The 2008 edition reveals a tightening of tax rules relating to interest cost recovery in several major economies, which may require many global companies to review their M&A financing strategies. The latest report, a must read for tax directors Headroom 4 of acquisitive multinationals, includes This edition of Headroom explores how details of M&A tax laws and regulations enterprise risk management has moved in 52 countries. decisively up the corporate agenda and considers whether its inclusion in ratings Derivatives: International Tax Handbook agencies’ criteria will prompt improved In 1996, KPMG conducted a survey of transaction risk management. the taxation of derivatives in 25 countries. The survey focussed on the key features of each regime and highlighted territorial differences and similarities. Now, some 12 years later, the survey has been updated in the form of this more broad KPMG member firms provide a wide-ranging offering of ranging Derivatives: International Tax studies, analyses and up-to-date periodicals on the trends Handbook. Covering 49 countries, the and sector developments in the Financial Services industry. 2008 edition of the Derivatives Handbook contains commentary covering corporate You will find the above publications available as free income tax, VAT, withholding taxes and downloads at: http://www.kpmg.com/Global/WhatWeDo/Industries/ transfers taxes and clearly illustrates that FinancialServices there is a great variety in the tax http://www.kpmg.com/Global/WhatWeDo/Tax treatment of derivatives around the http://www.kpmg.com/Global/WhatWeDo/Advisory world. Available July 2008

Paul McGowan Ron Harvey Global Chairman Americas FS Tax Regional Co-ordinator Industry Leader for Global Investment KPMG in the U.S. Management and Funds Tax Tel: +1 212 872 6729 KPMG in Ireland e-Mail: [email protected] Tel: +353 (1) 410 1225 e-Mail: [email protected]

Chris Abbiss Jane McCormick ASPAC FS Tax Regional Co-ordinator Industry Leader for Global Banking Tax KPMG in Hong Kong KPMG in the U.K. Tel: +852 2826 7226 Tel: +44 (0) 20 7311 5624 e-Mail: [email protected] e-Mail: [email protected]

James Dodds Victor Mendoza ASPAC FS Tax Regional Co-ordinator LATAM FS Tax Regional Co-ordinator KPMG in Japan KPMG in Spain Tel: +81 (3) 6229 8230 Tel: +34 914 563 488 e-Mail: [email protected] e-Mail: [email protected]

Hans-Jürgen Feyerabend Hugh von Bergen EMA FS Tax Regional Co-ordinator Industry Leader for Global KPMG in Germany Insurance Tax Tel: +49 69 9587 2348 KPMG in the U.K. e-Mail: [email protected] Tel: +44 (0) 20 7311 5570 e-Mail: [email protected]

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‘Sometimes it just needs a spark’

Ideas are among our most At KPMG, we celebrate Our member firms’ valuable commodities. this kind of thinking. Around financial services tax But the best ideas are not here, we believe in the professionals combine always radical or power of applying our minds in-depth experience with a revolutionary. More often, to find better ways to detailed understanding of they take something that respond to the complexities international tax issues. already exists and make of tax and work with financial Our global mindset and it better. institutions advising on the industry knowledge helps development and execution deliver practical advice that Which is why Gustaf Erik of effective global multi can add real long term value Pasch comes to mind. disciplinary methodologies for our clients. He took the dangerous aimed at achieving the volatility of the then required balance between Like Gustaf Pasch back standard matchstick, the risk and opportunity. in 1844, we love to think Lucifer and made it safe. beyond the limitations The safety match was born. of the present to create something that lasts well into the future.

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