Interviewers Opening Remarks

In the response to the financial crisis, regulators in the EU and in the US -- where the impact was most severe -- have taken the lead in formulating and implementing measures to prevent a recurrence.

Now, regulators in the Asia-Pacific region need to deal with the impact on financial services companies in their region. The tax implications of their reactions could be profound, but there is likely to be some room for maneuver. Asia-Pacific banks need to brace themselves not only for demanding new regulations but also for significant adverse tax consequences. Joining me to provide their insights on the impact of these regulatory responses on financial institutions in the Asia-Pacific region products are John Timpany and John Kondos from KPMG in Hong Kong and Alan Lau from KPMG in Singapore.

Interviewer

As the US and Europe establish new regulatory frameworks for financial services, how is this changing the tax and regulatory landscape for banks operating in the Asia Pacific?

John T

Traditionally, tax considerations have been among the important drivers in strategic decisions about banks’ corporate structure and their location. They’ve influenced choices regarding branch versus subsidiary structures, and have also guided decisions over outsourcing, shared services centre and intra-group trading. The opportunity to configure operations and legal structures to derive tax efficiencies and reduce costs have brought significant benefits to many stakeholders. But now, with the regulators in Asia-Pacific turning close attention to how banks operate and how they are structured, the outcome will likely see serious constraints being imposed on banking groups in the future.

Interviewer

What specific concerns are arising for Asia-Pacific regulators?

John T

Regulators in Europe and the US are taking action to ensure that banks do not have to be bailed out by public funds again in the future. Their priority is to protect domestic financial operations, especially retail banking. As a result, global banks need to give priority to managing the constraints imposed on their Western operations and have de-emphasized those in Asia-Pacific. Local regulators are rightly concerned. New regulations in the West are going to require major restructuring of big banks, and at least significant separation of retail from investment banking. The Volcker Rule in the US, the UK’s Vickers Report and most recently the EU-commissioned report all point in that same direction. A further factor is that many European banks are still deleveraging, disposing of assets in Asia and elsewhere and rationalizing geographical operations. In this restructuring process, Asian regulators are trying to protect their own positions, imposing their own constraints on structure, for example, by requiring increased subsidiarization.

Interviewer

Clearly, these structural changes will have important tax consequences. How should banks in the region be responding?

Alan

Ah yes. I think first and foremost the banks in the Asia-Pacific region, they first need to understand with the new regulatory regime what they can and cannot do. Now, first and foremost, top on their radar screen, they need to understand that with Basel III coming in there will definitely be a more stringent definition of regulatory capital. Now, regulators in each jurisdiction; they are clearly going to look more intensively at each bank and especially for those banks that are considered to be carrying higher systemic risks, they will definitely face a higher level of regulatory scrutiny. So, in our experience, we think, especially for banks in the region that carries a significant retail presence, is our knowledge that some of these banks are actually exploring such subsidiarization in response to the regulatory demands and requirements for more oversight. Now, obviously, subsidiarization does carry a certain degree of regulatory cost in due of the fact that if you do incorporate a new subsidiary in the local jurisdiction, the local subsidiary would not be able to leverage on the balance sheet of the head office in the home country. Now, having said that, from a tax perspective, incorporation in certain countries can also bring about more choices in terms of tax treaty coverage but, having said that, banks need to watch out for the fact that the tax costs of repatriating profits back to the home country may differ between a branch model and a subsidiary model. And in an instance, as well, there could also be local instances where the domestic tax positions would only apply to local incorporated subsidiaries but not a foreign branch.

Interviewer

A key issue for banks having to establish local subsidiaries is how to capitalize them most effectively and tax-efficiently. How will local regulations affect these decisions?

Alan

Now, it is important to understand that under the previous Basel II rules, non-core Tier 1 capital is allowed a certain degree of flexibility in terms of the utilization of hybrid instruments that are able to satisfy regulatory purposes as well as at the same time achieve tax efficiency concurrently. Now, obviously, with the introduction of more stringent rules under Basel III, the definition of regulatory capital has been has been up and the ability to plan around hybrid around hybrid instruments would be severely curtailed. Now, however, having said that, we still believe that even under Basel III, there are still certain possible avenues to explore tax efficient issuance of regulatory capital. Now, for instance, in Singapore, the Singapore tax authorities generally respect the legal form of the financial instrument in determining whether such instruments are to be regarded as a debt or equity for Singapore tax purposes. So, all in all, it means that there are still opportunities to structure regulatory capital that meets the increased requirements under Basel III but, at the same time, are regarded as a debt for Singapore tax purposes.

Interviewer

These developments will obviously limit the tax-planning opportunities that could be achieved through subsidiarization. Beyond the implications for tax planning, what other implications do banks need to consider?

John T

These developments will raise a host of questions that currently have no clear answers:

• How can liquidity be ensured?
• Will intra-group funding be permitted?
• Will regulators recognize offshore parent guarantees?
• What charges for liquidity will be admissible?
• How will debt be treated?
• Will historic losses be transferable into a new subsidiary?
• And can they be utilized in tax planning?

In China, for example, one or two recent local incorporations have triggered disputes with the tax authorities over the treatment of the asset cost base being carried over.

John K

I think from a transferring pricing perspective, you know, clearly these changes are going to result in a need for the update of the policy and with subsidiarization that raises a whole issue of, just in terms of the funding and the treatment of capital. Clearly there are going to be some need, maybe opportunities and challenges, for example, introducing capital charges, guarantees, just rethinking the transfer pricing consequences in general and potential changes to the booking structures for a lot of financial institutions will raise additional considerations such as liquidity buffers.

Interviewer

Given the high dollars involved in the taxation of global bank subsidiaries, are banks likely to seeing more challenges and disputes from tax authorities in the region?

John K

Absolutely. I mean, right now we’re already beginning to see tax authorities challenging claims for relief and exemptions and these are most likely to increase in the future. The very fact that the regulators are, sort of, imposing conditions on operational infrastructures for banks, clearly they are concerned and want to see more local incorporated subsidiaries. And as a consequence, obviously, the local processing, back-office and, sort of, local infrastructure has to be built. And this isn't always tax or cost efficient but clearly there is a consequence and it’s a decline in profits and there are questions as to, you know, who should bear what costs within a group and that clearly does lead to tax controversy. The other main issues go beyond transfer pricing into corporate governance, risk management and contingency planning. And more often than not, it’s not just answering to the tax authorities but very clearly being able to articulate the recovering resolution plans and obviously how they impact the tax becomes very prominent. From a tax authorities perspective, all this restructuring and relocation draws a number of key challenges and most significantly is proving the economic and business logic behind a particular move. Really, ultimately, to show that they’re not tax motivated. And where these moves do occur we’ve increasingly seen the tax authorities wanting to, maybe, have exit charges or some kind of compensatory tax measures to, sort of, compensate for the changes, especially where the taxable income after the restructure might decline. We are increasingly seeing disputes on the interpretation and who should bear the costs of restructuring. We anticipate more double tax disputes are likely to occur much more frequently as a result of all this change.

Interviewer

And banks that are forced to restructure will also have to deal with the practical business implications.

John K

That’s correct. Within group structures, the result of reconfiguring tax and cost structures between different branches and subsidiaries can be unwelcome. Naturally, groups and teams that were profitable under one configuration and tax and regulatory framework can very quickly become unprofitable when subject to a different regime. This raises serious consequences for morale, performance and retention. If high-performing teams are to be relocated, naturally, special steps may need to be taken to preserve their value in the medium and longer term. And banks also need to prepare for these implications with very in-depth analysis, foresight and careful planning.

Interviewer

John, Alan and John, thank you for sharing your insights on the impact of the new regulatory landscape for banks in the Asia Pacific. Before we sign off, do you have any final words of advice for our listeners on this topic?

John T

As we have seen, restructuring forced by Western regulators will almost certainly have knock-on implications for Asia-Pacific structures, operations and therefore the tax results in this region. Even if the scope to minimize adverse tax consequences may be more limited than normal, forward planning is still important. It will also be critical to document the reasons for decisions to create an audit trail that records the clear strategic business analysis and commercial drivers behind specific decisions. Existing transfer pricing policies may also need to be revisited to reflect the regulatory considerations and changes made, in particular to verify whether the commitments and guarantees provided by the Western counterparts remain fully valid and enforceable for the purposes of transfer pricing. Many banks will find themselves having to make the best of a bad situation. But it will be a lot better than nothing at all.

Interviewer

Thank you John, John and Alan.

Listeners can find more details on this topic in the December 2012 edition of KPMG’s frontiers in tax publication.

Other podcasts in this series include a FATCA Update and how it will affect the insurance industry.

Thank you and we look forward to you joining us again next time.