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The Great Aussie bank swindle

By Deborah Hill Cone

Friday 3rd September 2004

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This story combines two things New Zealanders love to loathe ­ Australians and banks. Aussies? Well they get the better of us at sport, so 'nuff said. And banks? They make huge profits, they charge usurious fees and they don't even take any real risk half the time since they secure everything over property these days.

At least that's what talkback callers think, so they didn't take much persuading who the villain of the piece was when the National Business Review revealed Reserve Bank figures showing the five major banks had an "effective tax rate" of under 10%, rather than the usual corporate rate of 33%.

The banking public wasn't very happy and neither was the industry.

"Reserve Bank releases on Aussie bank tax underpayments: no good news," UBS global equity research in Sydney warned its clients in response to NBR's story.

"Big four under fire from New Zealand regulators on structured finance deals," Macquarie told its clients.

The reason for the low taxes continues to be explained rather vaguely as being due to "structured financial transactions," although the naivety of this sort of description makes financiers snigger.

As they point out, you'd be hard pressed to find a transaction that isn't structured to the client's best advantage in tax terms.

If that makes you squeamish, remember it's a director's duty under s131 of the Companies Act to act "in the best interests of the company" ­ which probably means not paying more tax than you need to ­ although how aggressive or conservative a position that should be depends on the how-long-is-a-piece-of-string concept of what is reasonable.

And trying to understand the nuts and bolts of the banks' tax planning is just as hard.

Don't expect any of the usual accountancy talking heads to want to go on the record about these transactions ­ the professional services firms can't discuss the deals publicly because of client confidentiality.

Even industry specialist Andrew Dinsdale, who oversees KPMG's financial institutions survey, has to stay silent on this topic; ANZ is a client.

With all four major banks ­ ANZ, Westpac, ASB and BNZ ­ in the gun with Inland Revenue, every big firm is involved.

And as with their interest rates, the banks are pretty much in the same boat.

  • Westpac seems to be in the strongest position, having got a binding ruling on one transaction that the commissioner of Inland Revenue signed off, but the IRD is still investigating the bank, claiming $113 million. Westpac's total contingent liability is estimated at $647 million;
  • ANZ, which now owns National Bank, is believed to have been first off the block to use the structure in a transaction, which is now past the five-year statute bar, but it is also being pursued by the IRD;
  • ASB has kept a low profile on the issue, although it has defended its tax paid, saying the refund it got last year was a one-off; and
  • BNZ was reassessed as owing $57 million in taxes and interest for the 1998 and 1999 years after being served with a notice of proposed adjustment in late March, just hours before the five-year deadline for the IRD to take action expired.

Disappointingly, there was no lightbulb "Eureka" moment in which a Russell Crowe-type whistleblower in a brown cardy burned the midnight spreadsheet in his Terrace office in Wellington and realised banks were seemingly paying too little tax.

But it was dramatic enough for someone in the tax department to do the sums and realise "Uh, Beehive, we have a problem."

Tax rates paid by banks have fallen 30% in the past four years.

That is, tax revenues have remained static while bank profits have risen more than 50%

IRD deputy commissioner, policy ­ and international tax star ­ Robin Oliver says the department identified possible issues in terms of the level of tax paid by the major trading banks two years ago.

"This is the result of normal analysis of different industry profiles. Our audit people had a lot of input into that because they have access to the actual amounts of tax paid, so this was a joint effort of all parts of the IRD," Oliver says.

So how did banks do it?

Banks have reduced their tax liability in various ways ­ one of them even signed up as an investor in the aggressively structured Trinity tax scheme.

IRD documents show the banks have also used film investment and foreign tax credits to minimise their tax. But the main way has been through what is known as the conduit regime.

This country is uncompromising at taxing companies based here ­ the bottom line is you have to pay tax on all your revenue wherever you earn it.

That discourages overseas-owned companies from using their New Zealand-based subsidiaries to invest offshore.

To remedy that the conduit regime, an amendment to the Income Tax Act, was introduced in 1999.

The new rules were formulated after lobbying by Carter Holt Harvey, which had a major investment in Chile. It wanted the government to make it more attractive for New Zealand to be used as a base to generate international business deals.

Under these rules a New Zealand-resident company owned by an overseas parent, such as a multinational branch office, could invest overseas and pay no tax on the transaction, being liable only for 15% of non-resident withholding tax on distributions from that deal (or the proportion by which the company was overseas owned.) And even that tax could be deferred indefinitely by paying dividends out of retained earnings.

It didn't take long for banks to realise the rules had a particular advantage for them. That's because the banks could use the regime to make loans rather than investments. After all, loans are their business.

"Banks saw it for what it was ­ a great tax planning opportunity," one tax accountant explained.

They could make loans to an offshore entity from their New Zealand company and write off the interest deductions.

And they could even do this using capital that was shunted through this jurisdiction from their international parent.

"At the extreme end capital was routed through New Zealand so they could claim the interest deduction. It wasn't used for anything here."

Companies can usually claim interest against tax if it is incurred in the course of their business. For banks their business is borrowing and lending, which makes this easier.

"In effect the entire amount of gross revenue associated with the offshore investments is removed from the New Zealand tax base," IRD officials' papers released to NBR explain.

It would be harder for a widget-maker to use this to their advantage because it could not claim the same level of interest deductions, unless the interest related, for example, to money borrowed to start a widget-making factory.

There are already rules in place designed to limit the amount of conduit relief that can be obtained, known as the interest allocation rules, but these effectively don't apply to banks.

One rule that puts a brake on interest deductions, the on-lending provision, does not apply to banks because they are in the business of borrowing and lending.

The extent of bank use of the conduit regime is shown in the IRD's figures, with the number of conduit disclosures rising from only four in 1998 to 23 in 2002.

In 1998 $1.5 billion was invested in conduit-relieved arrangements; five years later, in 2003, that had risen to over $8 billion.

And so much for conduit relief helping counter "branch office syndrome" ­ in the past 12 months banks claimed 90% of all conduit relief used by New Zealand taxpayers.

The key point is that these were legitimate transactions ­ even the minister of finance's office concedes this.

But it doesn't mean the government wanted it to continue, with hundreds of millions of dollars escaping the tax net.

It is always hard to tax banks because they have the flexibility to shuffle money around the world.

"[But] the unique nature of the New Zealand banking industry, where the main trading banks are all foreign-owned, makes the problems particularly acute here," the IRD warns.

What is the government doing about it?

Last year officials considered various ways of solving the problem from the finger-in-the-dyke approach of simply exempting banks from the conduit regime to imposing minimum tax rates.

These were rejected, the first because the IRD doesn't like to discriminate against particular sectors of the economy.

Minimum taxes, used in Canada, were ruled out because they would be less effective here as all banks are foreign-owned.

The solution officials have chosen ­ and which will get presented to the cabinet in a couple of weeks ­ is an elegant "systemic" method that strengthens what are known as the thin capitalisation rules.

It's based on the idea that income for banks arises from the use of capital in supporting their business ­ and so targets the debt to capital ratio.

"It is a basic tenet of international taxation that income on equity should be taxed in the country where it is effectively employed. Thin capitalisation rules are intended to apply to ensure this result," an officials' consultation document reads.

What this means is that banks will have to increase their capital to ensure New Zealand has a fair share of the worldwide equity of the bank.

IRD figures show the debt to asset ratio for the five largest New Zealand banking groups from 1997 to 2002 was between 92.8% and 98.8% (representing capital of 1.2% to 7.2%).

That is a low level of capital compared with figures for 45 international banks, which had a median debt to asset ratio of 91.9% (capital of 8.1%)

New Zealand banks could have such high levels of debt because of the concession that removes debt that is "on-lent" from a company's balance sheet when the thin capitalisation rules are applied.

Officials say this should be scrapped and recommend introducing a new and simpler regime which depends on a bank's regulatory capital.

Under international banking regulations, known as Basel (pronounced "barl" rather than as the stuff in pesto), there are two types of capital for banks.

Tier one represents what is closer to a company's ordinary share capital ­ it could be seen as the true equity in the company as it is freely available.

Tier two includes fluffier stuff such as goodwill and other intangible assets, tax losses and what are known as "hybrids" ­ such as subordinated debt ­ which are not as much use if the bank gets into trouble.

Australia allows banks to include a portion of their hybrids, also known euphemistically as innovative capital, in tier one ­ and banks would like New Zealand to do the same. At the moment tier one capital must not be less than 4% of the banking group's risk weighted exposures (RWE).

One of the proposals Dr Cullen will be presenting to the cabinet in a couple of weeks is a law change to lift this to closer to 8%.

The decision will be about not only the level ­ Australia opts for a flat 4% of tier one capital ­ but also how the figure is worked out.

One method involves judging the banking group's worldwide assets and ensuring New Zealand had its "fair share."

But whichever way the cabinet decides to go, the risk-weighted exposures of the bank's New Zealand group will need to be determined ­ something that hasn't been done before.

Assets are risk-weighted according to broad categories of risk. For example, cash holdings carry a risk weighting of 0%, meaning the bank doesn't have to hold any capital to support such a safe asset.

But at the other end of the spectrum ­ corporate loans, for example ­ the risk weighting is 100%, meaning the bank needs the full 4% tier one capital to RWE ratio to support those assets.

Banks aren't happy about the proposed changes.

The Bankers Association argues policy changes should not discriminate against its sector and is worried the policy is being driven by the issue of tax avoidance.

It provides data that it says shows New Zealand banks already have substantial levels of free capital, exceeding the regulatory requirements.

The association's chart shows the banks have tier one regulatory capital of between 6% (Westpac) and 9.5% (National Bank).

These figures, taken from their own balance sheets and Reserve Bank data, differ from the IRD's, which shows a capital range from 1.2% to 7.2%, because the IRD includes the bank's holding company as well, which can shelter more debt.

But the IRD says for the large trading banks the impact of the strengthened thin capitalisation rules would not require significant new capital to be injected into their New Zealand operations.

Why will this work?

It will work because the transactions will be rightly classified as loans and be taken into account when calculating the banks' capital to debt ratio.

Outbound investments by banks, such as conduit-relieved transaction, will have to be fully funded by capital.

"Interest deductions would be denied on New Zealand liabilities to the extent that they exceed the allowable level of debt," the officials' paper concludes.

So the law change will fix the problem in future but won't solve the disputes of the past.

The current audit of banks' structured finance arrangements for 1998 -2003 could involve significant tax payments.

"Banks will certainly try to link the two issues to argue that the combined effect would be onerous," officials say.

The impact of the proposed changes would be to increase the amount of equity in New Zealand from $8 billion for the largest five banks in 2002 to $23 billion, the officials' paper says.

They estimate tax revenue could increase by $50-150 million in 2005/06 and by $90-150 million in later years.

But the banks complain the proposed changes will require them to hold far more capital than they need to operate their businesses ­ and inevitably that cost will be passed on to the customer.

So the punter might be the one to end up paying the cost in the end. And we know what the talkback callers will make of that.

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