• Service: Topics, Tax Reform, AFTS Review
  • Industry: Financial Services, Banking
  • Type: Business and industry issue
  • Date: 26/05/2010

Banking Newsletter - May 2010

We look at the Half Yearly Survey, Henry Review, conglomerate groups, strategic procurement, financial risk management, and core systems replacement.

Banking Newsletter

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Looks like thumbs up for Henry Review and banking sector 

At first blush, Australian banks seem to have emerged largely unscathed from the Henry Review of Australia’s taxation system while looking forward to potential future benefits.

Like its several predecessors, the Henry Review promises a major shake-up of tax collection and parts of the superannuation and social security systems.


Canberra’s response to Henry to date has been relatively muted. The Government has rejected several of the review’s more contentious proposals and has deferred making a decision on others.


The controversy surrounding the decision to embrace Henry’s proposed Resource Super Profits Tax (RSPT) illustrates the political difficulties surrounding tax changes. Indeed the focus on the RSPT has overshadowed other recommendations of the review that are worthy of further scrutiny, in particular, several matters relevant to the banking industry.


Funding - limited phase out of IWT

Both the earlier Johnson Review and Henry recommended an abolition of interest withholding tax (IWT) on banks raising funds offshore. It is a key measure that the banks were expecting. However, what was announced in the Budget is only a limited phase out of IWT. Further ‘aspirational’ reductions are noted, but not guaranteed.


Whilst it is pleasing to see the Government support most of Henry’s IWT recommendations, in practice, IWT simply restricts funding sources for Australian banks to certain specific forms of funding that are not subject to withholding tax. Reducing the rate to 7.5 percent or 5 percent does not overcome this limitation.


The decision to exclude, on integrity grounds, Australian deposits of non-residents is also disappointing. This is a funding source that has the potential to bolster the robustness of the Australian banking system by reducing reliance on offshore wholesale funding.


Case study part 1

Consider where an Australian bank borrows offshore funds by issuing publicly offered debentures/debt interests with a 7 percent interest rate. The interest paid is not subject to Australian withholding tax, such that the total cost of funding would be 7 percent.


Alternatively, the Australian bank could access cheaper funding from an unrelated offshore bank with a lower 6.75 percent interest rate (a 25 basis points saving). However, the interest payments would be subject to Australian withholding tax, which would typically be borne by the Australian bank under an IWT gross-up clause.


The reduction of IWT rates as announced would have the following impact:

  • Where a 10 percent IWT applies to the interest payments (the current position), the total costs of the alternative funding would be 7.5 percent, being the 6.75 percent rate plus 0.75 percent IWT gross-up (ie an overall increase compared to the alternate funding source rate of 7 percent of 50 basis points).
  • Where a 7.5 percent IWT applied to the interest payments (2013-14), the total costs of funding would be 7.3 percent, being the 6.75 percent rate plus 0.55 percent IWT gross-up (ie an overall increase of 30 basis points).
  • Where a 5 percent IWT applied to the interest payments (2014-15), the total amount costs of funding would be 7.1 percent, being the 6.75 percent rate plus 0.35 percent IWT gross-up (ie an overall increase of 10 basis points).


As such, even where the IWT rate is reduced to 5 percent, the Australian bank would need to access funding with a 6.65 percent interest rate (ie 35 basis points saving) at a minimum in order to opt for this form of funding over the publicly offered debentures/debt interests.


In other words, the reduction to 5 percent is unlikely to significantly open up new funding sources for Australian banks.


Case study part 2

The Government view appears to be that the proposed phase-down of IWT paid by financial institutions on interest paid on offshore borrowings to an aspirational rate of 0 percent will result in a cost to revenue for the Government.


However, our view is that the reduction, and ultimate abolition, of IWT is more likely to increase revenue.


For example, if an Australian bank currently acquired offshore funding where the total costs of funding was 7 percent, the Australian bank might lend out to client at a rate of 9 percent, making a 2 percent margin.


If IWT is abolished, the margin derived by the Australian bank would increase. For example, if the Australian bank accessed the alternative source of funding with the 6.75 percent interest rate and there was no IWT gross-up, the funding costs would reduce to 6.75 percent, giving rise to a margin for the Australian bank of 2.25 percent. This increases the Australian taxable income of the Australian bank by 25bps (and effectively increases tax revenue for the Government by 7.5bps).


Of course, the Australian bank may pass on some of the reduced costs of funding to the borrowers, thereby reducing their taxable profit margin. In this case, the borrowers would benefit from the reduced rates, but also increase their own taxable income (which is still an increase in revenue for the Government).


Cutting corporate tax

For a start, banks will welcome Henry’s proposal to cut the company income tax rate to 25 percent. The Government’s response has been to promise a reduction in the corporate tax rate to 29 percent for the 2014 income year and to 28 percent in 2015. Further reductions will depend on revenue considerations at the time.


Reducing tax on bank deposits

Henry has clearly identified that bank deposits are structurally tax disadvantaged versus other forms of investment, and makes the link with Australia’s relatively low retail deposit levels.


KPMG strongly supports Henry’s view that the introduction of explicit savings incentives would help lift the domestic savings rate, reduce Australian banks’ reliance on offshore wholesale funding and generally benefit the banking system.


Accordingly, Henry recommended introducing a 40 percent discount on savings income received from bank deposits, bonds, rental properties and capital gains. The discount would also be applied to investment losses (e.g. negative gearing). The review suggests the uniform discount could be extended to dividends and business income as part of a long-term alternative to dividend imputation. It could also allow elimination of the separate discount for long-term capital gains and removal of the existing capital gains tax exemption for assets acquired prior to the enactment of the CGT.


The Government has already rejected the recommendations concerning a separate CGT discount, abolishing dividend imputation, discounting negative gearing deductions and eliminating the tax exemption for pre-CGT assets. It has stated that it will consider savings incentives as part of its second-term agenda.


As part of the 2010 Federal Budget, the Government announced a 50 percent tax discount on up to $1,000 interest income earned by individuals. Broadly, this provides a maximum saving of $232.50 for an individual taxpayer on the top marginal tax rate receiving more than $1,000 of interest. This measure falls well short of the Henry recommendation to address the punitive taxation of bank deposits through an uncapped 40 percent discount on interest. KPMG consider it unlikely to have any significant effect on the level of bank deposits.


Currency transactions tax - Tobin Tax

A currency transaction tax — a so-called ‘Tobin Tax’ — introduces a small tax on foreign exchange transactions to discourage speculative FX trading.

Henry considers ‘Tobin-type’ taxes, and concludes that there is little rationale for these types of taxes.


There has been no formal Government response to the idea and no mention of it in the Federal Budget.


Banking super profits tax

Despite its absence from both Henry and the Budget, there has been speculation about the possible introduction of a ‘banking super profits tax’, along the lines of the tax proposed for the mining industry. Arguments for such a tax revolve around the notion that official regulation and, more recently, explicit funding guarantees effectively underwrite bank ‘super’ profits.


Others have noted that, unlike the resources sector, the banking sector does not consume non-renewable resources. Also, the effective tax rate of retail banks is close to the nominal corporate income tax rate, with retail banks being some of our biggest corporate taxpayers, year-in year-out throughout the economic cycle.


As an industry, banks need to understand that, in an era of increased pressure on government revenues, the idea of a ‘banking super profits tax’ may well appeal to significant sections of the Australian electorate, and convincingly argue their position.

Ian Pollari

Ian Pollari
National Sector Leader, Banking

+61 2 9335 8408