Just under a billion bucks. That’s how much the Inland Revenue will scoop up as retrospective taxes from bond trading profits when business ends on Tues

Just under a billion bucks. That's how much the Inland Revenue will scoop up as retrospective taxes from bond trading profits when business ends on Tuesday. Just under a billion bucks. That's how much the Inland Revenue will scoop up as retrospective taxes from bond trading profits when business ends on Tuesday. Financial markets milked money during the bond market bonanza, but the honeymoon was cut short after secondary market rates began to shoot up last year.

The Problem

The trading profits under unbiased rate movement expectation are only a zero sum game, where gain of one is offset by the loss of other. Since the interest coupon is fixed at the time of the issue, the government does not pay any additional interest beyond the agreed fixed coupon.

Similarly the government’s tax collection is purely based on interest income and hence the projected tax revenue from a Treasury Bill or Bond is independent from its trading profit or loss.

Taxing trading activity would not affect government tax revenue, but on the other hand active trading will help the government securities market and the government in several ways:
• High level of trading will introduce liquidity to the bonds where as low trading will add a liquidity premium
• If liquidity is low then a liquidity premium is added to the interest rates thereby the government’s borrowing costs go up
• The total outstanding marketable government debt is Rs. 873 bn, an increase of one percent will amount to an annual debt service charge of Rs. 8.73 bn.

As the repo (repurchase) market is essential to finance the government securities portfolios of primary dealers, banks and others both state sector as well as the private sector it is important to ensure that the repo market remains liquid and efficient.

There is a very high correlation between the repo rate and the treasury bills and bond rates.

Any upward movement in the repo rate will immediately push up the long term yield curve, resulting in higher borrowing costs for the government.

The cash starved Treasury was keen to share the loot and the Inland Revenue Dept pushed ahead with legislations to amend its Act to tax interest income.

What came out of an ambiguous legislation and subsequently rushed through parliament as an urgent bill this year, was a little clause that demanded back taxes on trading income during 2002 and 2003.

The amendments dropped Section 15(t) of the existing Act and created a new tax on trading income of government debt, which were up until now, exempted to enable a vibrant gilt-edge securities market to develop.
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The net impact is that trading of government securities now comes under the full corporate tax rates.

But the move to demand back taxes, which is considered abrupt, arbitrary, and unjust in established tax regimes world over, effectively wipes out primary dealers profits, but also chunks off banks, financial institutions and even state pension funds who made a tidy profit during the bond party.

Retrospective taxes not only erode investor confidence, but also forces current shareholders to pick up a tax liability, after dividends were paid out two years ago. In developed markets, such a move would lead to shareholders dumping stocks of companies affected by the decision.

But in Sri Lanka the situation remains largely swept under the carpet, with vested interest and the fear of losing government business, coming ahead of back taxes that have created chaos in the financial markets.

Primary dealers – an elite group appointed by the Central Bank to exclusively access primary treasury bill and bond auctions – are the worst affected. Dealers, who also act as market makers for gilt-edge securities, may also have to top up capital as current year profits are diverted to pay back taxes.

Market players themselves are divided, falling into groups like foreign banks, state banks, private banks, privately owned dealers and so forth – all collectively making noises at various cocktail circuits, but privately going along with the Treasury to maintain good relations.

The money is due on Nov. 30, and market players are paying under duress, after the Treasury refused to budge.

Tax experts say back taxes will account for a mere 0.6 percent of total government revenue. But some primary dealers will have to cough up to Rs. 200 mn individually.

Dealers who spoke on the condition of anonymity say taxing trading activities will kill the secondary market in government securities and ultimately drive up interest rates, which the government is keen to avoid.

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The total outstanding marketable government debt is Rs. 873 bn, an increase of one percent will amount to an annual debt service charge of Rs. 8.73 bn.

An active bond market enables proper price discovery. Taxing trading activities could lead to a built in margin to the buy-sell spread which increase interest rates, resulting in government borrowing costs going up.

Lower trading activity will in turn further push up the return demanded by the investors.

The reality is that investment decisions are usually made on present laws and not on the possible future legislations that pop up with retrospective effect.

Uncertainty on the nature of instruments issued, also puts the government bond market in a spot, with some institutional investors questioning as to whether government securities are indeed risk free to investors.

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As one dealer explained, default risk does not mean that the issuer will not pay the capital and coupon, but also deal in paying of capital or coupon, payment of a lower coupon than that agreed at the time of issue and other indirect means of redirecting funds such as introduction of taxes.

Another institutional investor said his fund would opt to park funds in short term instruments which give flexibility to switch strategies whenever policy changes emerge.

The episode may not end here, warn tax experts. The move could be used as a precedent to tax another sector that made profits during boom times.

The Amendment

The issue cropped up when Parliament passed the Inland Revenue (Amendment) Act of 2004 on Sept. 8, 2004 as an urgent bill. The move bypassed the normal process, which allows public to make their comments during a short time frame.

The Section 6 (5) of the Act, repealed Section 15 (t) of the principle enactment, i.e. Inland Revenue Act No: 38 of 2000, thereby creating a new tax on trading income of government securities which were up until now exempt with an intention of developing a vibrant government securities market.

However, the repealing was backdated by giving retrospective effect under Section 60 of the Inland Revenue (Amendment) Act. Financial markets kept their fingers crossed that the budget would scrap the decision. But the only change was to make it effect from April 1, 2003 instead of April 1, 2002.

The subject Section 15(t) required some clarity and amendments to eliminate the ambiguities which were correctly incorporated into the Inland Revenue (Amendment) Bill dated Dec 1, 2003 consequent to the budget speech of 2003.

This Bill did not become law as parliament was dissolved before the Speaker could certify it.

The present government says they are carrying forward revenue policies put forward by the previous government for the purpose of continuity.

However, the amendments that have been made is entirely different where the amendment is to real the Section 15(t), where as the previous Bill contained a comprehensive amendment only to clarify the ambiguities but not to introduce a new tax with retrospective effect.

-LBO Newsdesk: LBOEmail@vanguardlanka.com

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