Treasury Tax Management

More specifically, treasury transactions such as loans and deposits and foreign exchange transactions often have tax consequences. Treasury arrangements such as on behalf of may also have tax consequences in the form of VAT or sales tax processing.

Taxes impacting treasury transactions include:

1. Taxes on interest such as withholding taxes and VAT and withholding tax on deemed dividends,
2. Taxes on funding transactions such as stamp tax,
3. Withholding tax on dividends,
4. Taxes on derivative transactions including foreign exchange, and
5. Specific rules for calculating corporate income tax such as calculating tax on derivatives on a realisation (or cash) basis rather than on a mark to market (or fair value) basis.

Tax impacts of treasury arrangements may include:

1. Customs duties,
2. VAT or sales tax,
3. Corporate income tax, and
4. Tax implications of capital structures.

In this article, we will focus on the tax issues related to funding and cash management. Taxes on foreign exchange are rare, and they typically relate primarily to risk management.

Capital structure

Balance management gives rise to two principal tax issues. The first is the impact on funding decisions on the operating company’s balance sheets. Many tax authorities limit interest deductibility for tax purposes depending on the leverage of the operating company. In most markets, this relates to the tax deductibility of intercompany interest, but in some markets leverage can also influence the deductibility of interest paid to third parties.

Such rules governing the tax deductibility of interest are often called thin capitalisation rules, and they tend to be expressed in terms of debt to equity ratio. In some countries, debt to equity limits tend to be 3:1 (i.e. debt is limited to three times of equity) whilst for others, 2:1 (i.e. debt is limited to two times of equity). Some markets allow higher leverage for tax purposes.

When such debt to equity ratios are exceeded, interest corresponding to the excess debt will not be tax deductible. In instances where the debt to equity ratio applies only to intercompany debt, some markets use the total debt (including third party debt) to determine the tax deductibility of intercompany interest, while others consider only the intercompany debt.

For treasurers, this means that, when operating companies in the aforementioned markets need additional funding, it is important to check their current and forecast debt to equity ratio. If the operating company is likely to exceed the tax authority’s prescribed debt to equity ratio, the company may prefer to fund using bank debt or equity rather than with an intercompany loan.

In recent times, there has been a shift to limit tax deductibility of interest payments by way of introducing earning stripping rules, which has broader rules, in place of thin capitalisation. Essentially, the earning stripping rules limit the deductibility of interest where it is disproportionate to benchmark income of the operating companies. The benchmark used in Japan is the percentage of the Adjusted Taxable Income whilst in Malaysia, it is percentage of the Tax - Earning Before Interest, Tax, Depreciation and Amortisation.

Tax authorities have a variety of different anti-avoidance rules to ensure compliance. The broadest are general anti-avoidance rules which basically invalidate any arrangement deemed to be designed primarily for its tax benefits. Some tax authorities (such as the ATO in Australia) deem third party funding covered by a related party guarantee to be an inter-company debt for tax purposes.

Withholding tax

Tax authorities, such as the IRD in Hong Kong, who do not tax offshore income (which is generally a good thing) may create issues for treasurers. In the Hong Kong case, the IRD argues, not unreasonably, that since offshore income is tax exempted, therefore offshore expense cannot be tax deductible. Thus, interest on a debt from an offshore entity such as a treasury centre or IHB may not be tax deductible. IRD has mitigated this issue with its corporate treasury centre scheme, but its eligibility criteria for the scheme applies.

The second common tax issue arising from balance management is withholding taxes on interest. Most markets have withholding tax on cross-border interest payments. Some markets have withholding tax on domestic interest payments as well. For example, Indonesia imposes domestic witholding tax at the rate of 15% on interest, including premiums, discounts and loan guarantee fees (but certain interest payments such as time or saving deposits are final withholding tax in nature). In some countries like China, VAT is also imposed on interest (replacing its previous business tax on interest).

Most markets have a standard withholding tax rate, typically between 15% to 30%. This withholding tax rate is reduced when there exists a tax treaty between the interest payor country and interest payee country and payee is a tax resident of the payee country. Treasurers, therefore, would be better off locating their treasury centers and IHBs in markets that have a wide tax treaty network.

Why is it important?

In cross-border loans, the recipient could suffer both paying country withholding tax and receiving country corporate income tax on the same interest payment. Being taxed twice in this way is called double taxation. Tax treaties mitigate such double taxation scenarios by allowing the receiving entity to recover the withholding tax paid by the paying entity as an offset against its own corporate income tax.

Foreign withholding tax may be claimable by the payee in its own tax returns in the payee country against its taxable income, subject to fulfilling conditions in the tax treaty and domestic tax law of the payee country. However, if there is insufficient taxable income in the payee's tax returns to offset the foreign withholding tax, there is a likelihood that the excess may be lost. In some countries, payee may be given the benefit of unilateral tax relief from income earned from countries where the payee country does not have tax treaty with. 

Generally, domestic withholding tax are prepaid tax and claimable against the taxable income. However, where it is marked as final withholding tax, this amount cannot be claimed against the taxable income.

Withholding tax recoverability is often an issue for treasurers, especially when loans are made from a treasury centre. Treasury centers often have small profits; typical net interest margins may be between 0.5% and 1.0%, and this is often insufficient to generate an amount of corporate income tax that can offset withholding tax credits. For this reason, withholding tax on intercompany interest is often not recoverable, thus making it in effect a final withholding tax and a material additional expense in intercompany funding.

Banks are often but not always exempt from interest withholding tax. For this reason, a bank loan may be cheaper on an after tax basis than an inter-company loan, even though it is sub-optimal from a cashflow optimisation perspective.

The impact of withholding tax can be mitigated by denominating intercompany loans in currencies that have very low interest rates, and providing a foreign exchange swap to cover the currency risk. In some jurisdictions this might run up against general anti-avoidance provisions.

In summary, every company has its own unique tax profile, so it is essential validate all arrangements with your tax advisor.