Nov 24, 2009 (LBO) – The corporate debt market in Sri Lanka is being held back by the complex way a tax is charged by the government which has killed secondary market trading in debt securities, market participants have said. “But the way it’s collected allows secondary market trading without any problem. They basically collect it upfront at the date of issue; after that the market operates without any issue at all
“But in the corporate debt market somehow that tax system is not being implemented, despite numerous requests.
“It’s collected at different points which means the person buying it at some point really doesnâ€™t know what’s going to happen to his taxation.”
In theory people could either pay tax at the beginning or at maturity. To avoid the uncertainty people simply refrain from trading.
Withholding tax is charged as an early collection of the ultimate income tax liability. At the moment interest on securities is under a 10 percent withholding tax.
Withholding taxes are put in place because a government is desperate for cash and cannot wait for taxes to be paid up.
“Government wants withholding tax because it has a cash flow problem,” Chanaka Wickramasuriya, head of Fitch Sri Lanka said.
Sri Lanka has been deficit spending and also printing money for decades, resulting in high inflation and high interest rates.
But now with interest rates and inflation falling there is an opportunity for corporate bond markets to pick up.
“The primary dealers also did not market corporate debt aggressively since government debt rates were 15-18 percent and everyone was happy,” says Ravi Abeysuriya, head of strategic business at Hayleys, a diversified group, and a former head of Fitch Ratings Lanka.
“Now investors will look at other investments since the rates are coming down.”
Market participants are puzzled as to why the decision-makers in government are not willing to make simple procedures like clearing up the withholding tax.
“It has been requested so many times but it has not happened; itâ€™s merely because they don’t understand,” Abeysuriya said.
Abeysuriya who has been a member of the Securities and Exchange Commission said attempts have been made to clear up the problem.
“The Securities and Exchange Commission tried and it didn’t work because the political animal is so powerful; they need to finance the budget.”
This has raised questions whether the tax ambiguity has been put in to deliberately scuttle the corporate bond market, by a cash strapped state that would prefer to take all the savings of the people for itself.
But in the case of government securities market, market participants say there was a ‘champion’ to take it forward.
Before the tradable bond market was developed from the mid-1990s, the Treasury used to appropriate savings of the people – especially private sector pension funds – at low rates far below inflation through an instrument known as a ‘rupee security’.
The central bank’s public debt department raises money for the treasury and also runs the Employees Provident Fund of private sector workers, a situation which is riddled with conflicts of interest.
“Central Bank was under tremendous pressure not to develop the market, I remember in 1989 when they were talking about this the Treasury was unhappy because the treasury wanted to keep the rates at whatever rate they wanted to,” Fernando said.
“So Central Bank actually took a bold step and actually went against their own customer, virtually.”
The Central Bank went on a comprehensive program appointing primary dealers for government securities, changing laws to issue tradable securities, building an auction system, having monetary policy announcements, and extending the yield curve.
The Central Bank also put in place infrastructure in the form of a central depository, scrip-less trading and also liquidity facilities.
“The government debt sector was developed by the Central Bank. The corporate debt sector didn’t have a champion,” Fernando said.
The central bank has now also decided to allow primary dealers to move into private debt, he said.
Unlike loans, debt securities can be sold to another buyer in the secondary market allowing a quick exit mechanism, for buyers.
“There is no way a primary market can develop without a secondary market,” says Ajith Fernando, who heads Capital Alliance, a group which deals in private and government debt.
“The secondary market in corporate debt died after the withholding tax on secondary market transactions.”
He was addressing a group of senior executives at the 05th LBR-LBO Chief Financial Officer forum on ‘Developing a vibrant corporate debt market: issues and challenges’ in Colombo.
Another reason is that tax administration is weak and the financial sector, where records are kept, is an easy party to ‘outsource’ tax collection.
But nobody objects to the tax. The problem is with the way it is charged on corporate bonds.
“When you take the government securities market you also have a withholding tax,” says Fernando.