Transcript Taxation of Banks

Taxation of Financial Markets
Vienna, 7-9 December 2009
3a. - Taxation of Banks
Types of Commercial Banks
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Retail Banks
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Wholesale Banks
Nature of Banking Business
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Main business is the intermediation of savers and
borrows (pooling of savings).
Other deposit-taking institutions include:
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credit unions
co-operatives
savings and loan corporations
trust companies
Core business activities:
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–
–
lending
investments in shares and bonds
financial intermediation
risk management
Recent Trends
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Business is becoming global
Income becoming more varied due to investments in
new financial products (e.g. discounts, premiums,
foreign exchange gains and losses)
Transaction fees are replacing investment margins as
the main income source
Derivatives are becoming increasingly a part of
banking businesses
International accounting standards for banks are
changing
Typical Balance Sheet
L
1
2
3
4
5
6
7
8
9
10
11
12
Assets
Liabilities
Cash balances at central
bank
Deposits by banks
Loans and advances
Customer accounts
Treasury and other bills
Debt securities in issue
Securities
Other liabilities
Shares
Accruals/deferred income
Intangible fixed assets
Subordinated liabilities
Tangible fixed assets
Provisions (pension, tax)
Other assets
Capital And Reserves
Prepayments, accrued
income
Subscribed capital
Retained earnings
Revaluation reserve
Other reserves
Profits of Banks
1
Interest on loans & advances Interest, discounts and premiums accrued as
revenue (in loan account)
2
Return on securities and
shares
Traded assets: valued a market value or lower
of market value and cost.
Investment assets: gains on disposition of
shares may be capital gains, and interest,
discounts and premiums on debt securities
accrued.
After-tax financing: preferred shares
3
Fees and lease income
Guarantee fees and fees on other off-balance
transactions
After-tax financing: leasing
4
TOTAL REVENUE
5
Interest expenses
Interest, discounts, premiums, prepayments of
interest and other expenses may be accrued as
expense against revenue
6
Increase in loan losses
provision
Bad debts deductible and in some countries
specific provisions and general provisions
7
Net operating expenses
Accrual of prepaid expenses
8
TOTAL DEDUCTIONS
9
PROFIT (LOSS)
Small profit margin relative to assets
Definition of Banking Business
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Banks and banking businesses are often referred to
in tax legislation
Should tax legislation defines “banking”?
– What is your country’s approach?
Taxation of Profits of Banks
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Should banks be taxed on the basis of “best”
accounting practice, the normal company tax rules or
special taxation rules for banks?
– Different items of income/expenditure of banks may require
different solution
– A complex issue
– Need to understand how each items of income/expenditure
is dealt with under these different approaches
– Mainly dealing with timing issues
Timing of Recognition
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Accounting for income and expenses
– i.e... when should amount of interest be recognised for tax
purposes
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Four possibilities
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received or paid (cash basis)
receivable or payable (realisation basis)
allocable as earned or incurred (accruals)
cash flow valuation (mark to market)
Example: Allocation of Income
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12% interest on 100 debt :
– lent Dec. 1 1995 (31/12 accounting date)
– term of one year, single interest payment
– interest not received until Jan. 1 1997
1995
1996
1997
Cash
0
0
12
Receivable
0
12
0
Accrual
1
11
0
Mark to market (MTM)
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Market valuation includes gains and losses as they
accrue
– value related to market movements as well as accruing
income
– should be on income account not capital gains
– parallel treatment of assets and liabilities
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International Accounting standards – ‘ fair value’
Tax Issues : Cash or realisation basis
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If recognise and tax on cash or realisation basis, then
could be problematic because
– Easy to defer or accelerate income or deductions : non
payment/prepayment
– Accounting date games : straddles
– mismatching between assets and liabilities (recognised on
accrual basis)
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Need complex anti-avoidance legislation to counter
these problems
Tax Issues : Accrual basis
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Taxation of interests and their surrogates on accrual
basis is the most commonly accepted method
Type of accrual
– daily versus monthly accrual
– calculation based on simple or compound interest within the
year
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Reliance on accounting rules
– Concept of fiscal conservatism or prudence
– Not necessarily acceptable for tax
Tax Issues : Mark to market
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Valuation may be difficult
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illiquid or dominant market positions
adjusting for ancillary costs
bid-ask spread could be large
adjustment for credit risks could be complex/impossible
Collection problems as taxing unrealised gains
– cashflow problem not too severe for banks
– large fluctuations in income/losses will make provisional tax
estimation difficult
– usually exempt smaller taxpayers and those with small
number of financial assets
Taxation of Interest Expense
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Interest expense is the main cost of banking business
resulting from bank’s borrowings
– A mixture of long term, medium term and short term (e.g. ondemand accounts)
– A mixture of costs: from mostly cost-free borrowing such as
current accounts to fixed rate bonds
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When is the expense deductible for tax purposes?
– Accrual under accounting practice
– Realisation under normal tax rules
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What is your country’s practice?
Special Rules
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Interest expense is subject to many special rules
– particularly for banks but also true generally
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Mainly avoidance focus
– Limit deductions if higher than normal commercial rate
– Limit deductions if interests are related to non-recourse
loans, etc. that are in substance equity instruments
– Limit deductions under thin capitalisation rules if paid to
related parties under specified circumstances (e.g. in
substance equity)
– Earnings stripping rules
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What limitations do your country’s tax rules impose
on interest expense of banks?
Taxation of Interest Income
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Interest income of banks are derived from a range of lending
activities
– Different holders (e.g. governments, other banks and financial
intermediaries, corporate issuers, individuals)
– Different commercial rates depending on lengths, credit risks and
market conditions
– Using different types of instruments (e.g. commercial/government
bonds carrying rights to interests at market rate or with discounts or
premiums; zero coupon bonds; fixed rate preference shares;
convertible bonds; foreign currency bonds)
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When are these incomes of banks are brought to tax in your
country?
– accrual or realisation
Taxation of Fees
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Increasingly an important part of banking profits
Also becoming more important as substitutes for
margins (i.e. net interest income)
Fees can be derived from a wide range of financial
services (e.g. guarantee and credit reference, advice
on corporate finance, intermediation of innovative
arrangements such as securitisation etc.)
When should fees income be subject to tax?
– Accrual basis as in accounting practice or realisation basis
as in normal tax rules?
– What is your country’s practice? Why?
Taxation of Non-Interest Income
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Banks hold many current assets
– funds which a bank needs to maintain and invest to enable it
to meet any likely demand from depositors; and
– Securities which are held for trading purposes
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These give rise to income other than interests (e.g.
gains on capital, forex gains, dividends, etc.)
Should these income be brought to tax on an accrual
basis or realisation basis?
– Marked to market trading securities for tax purposes?
– What is your country’s approach?
Taxation of Gains and Losses on Fixed
Assets
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Fixed assets of banks are similar to other commercial
companies
Gains or losses can be realised in more innovative
ways (e.g. securitisation)
When should gains and losses on fixed assets be
brought to tax?
– Gains and losses are taxed under normal tax rules on
realisation basis
– Have you come across any innovative ways of realisation?
What can you do in those cases?
Tax Treatment of Impaired Debts
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Two aspects:
– Unpaid interests on impaired debts
– Principals of impair debts
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Interests on impaired debts
– Following “best” accounting practice
– Usually bypass taxable profits, brought into tax if received
eventually
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What kind of evidence do you require that a debt is
impaired before interests could stop accruing?
What Effort is Required to Determine if a
Loan is Impaired?
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Calculation and charging of interest ceased and the
account is closed (in suspense account)
Reminder notices issued and telephone and mail
contact attempted
Reasonable period has elapsed since original due
date for payment of debt (depends on type of credit
whether 90, 120, 150 days overdue)
Formal demand notice is served
Tax Treatment of Principals of Impaired
Debts
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Two types of provisions possible
– Specific provisions – relate to a specific debt or bundle of debts
– General provisions – where no problem has been identified but
allowed
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Some only allow deductions for bad debts written off
Country practices vary on
– allowance of neither, either or both types of provisions
– Methods of calculations (e.g. commercial accounting approach or
regulatory approach)
– Limits imposed on the allowable deductions
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What is your country’s practice in allowing deductions for
principals of impaired debts?
Specific Provisions for Principals of
Impaired Debts
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Taken when bank determines that value of the loan is
impaired due to doubtful repayment
– May be before the loan is determined to be bad and
removed from company’s books.
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Computation based on accounting
– computed on a loan-by-loan basis based on the probability
of recovery net of salvage value (partial write-off)
– classes of small loans may have experience-rated reserves
based on historical data.
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Computation linked to regulatory reserve
– provides protection on excessive claims, but generally
conservative so there may be some deferral of tax
General Provisions
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General provisions
– Not usually tax deductible
– Additional provisions for unidentifiable loan losses in the overall loan
account.
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They are designed to smooth income and may be:
 country risk provisions linked to countries with high sovereign debt
 sector specific provision based on the performance of a sector
(e.g., real estate)
 hidden reserves: inner reserves or contingency accounts included
as deposits and other accounts.
EU Directive permits the creation and maintenance of general reserves
 loans and advances to be stated at the lower of the face value,
market value or realizable value
 a maximum general provision of 4% of loans
When Is A Debt Bad?
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A debt is not bad until the debtor has:
 died without assets (or insufficient assets)
 cannot be traced and creditor is unable to ascertain the
existence or whereabouts of any assets
 become insolvent and estate has been distributed
 the debt is statute barred and the debtor is relying on this as
a defense (or may use as a defense)
 for corporate debtors, the creditor received final amounts
from the liquidator or the debtor is wound up
 judgement entered into on delinquent debtor
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Need to have rules for recovery of previously claimed
bad debts.
Impairment: Example
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Old accounting treatment
– Bad debts
– Specific reserves
– General Reserves
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Some countries only allow bad debts
Others allow bad and specific
Is the credit card example specific or general?
Impairment: Example
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Under IAS distinction between general and specific is
lost
Need objective evidence that an event has affected
future cash flows
The loss could be calculated using statistical data the
bank has gathered over a number of years
That could show that a rise in interest rates leads to
an increase in credit card default by this customer
group
Impairment: Example
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In 2007 interest rates were raised by all major credit
card providers
In 2007 a bank recognises an impairment loss on its
portfolio of credit card debts owed by customers with
a poor credit history.
Should the tax administration accept the write down?
Why?
Impairment Example
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Country responses to IAS
UK
– previously allowed only bad debts and specific provisions
– Took view that IAS impairment standard equivalent to old
specific provisions
– Changed legislation to follow IAS
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NZ
– Still too prudent for tax, bad debts only.