Financial Markets Operations Management (45 page)

The above list of the different types of tax might give you the impression that anything and everything you have as an individual or a corporate entity is constantly subjected to taxation of one form or another. For our purposes, it is the last tax, dividend tax, with which we are concerned in this section.

It is normal market practice for the company paying a cash dividend to deduct (or withhold) the standard rate of tax and pay only the net amount to the shareholder. So, whilst this is a dividend tax, we normally refer to it as a
withholding tax
(WHT).

If a WHT rate is 10% and a company wishes to pay a (gross) dividend of 100, then the shareholder will receive 90, i.e. 100 minus 10. If the shareholder is a basic rate taxpayer, then there is no requirement to pay any further tax. However, if the shareholder is a higher rate taxpayer, then this next dividend is grossed up to 100 and the higher rate of tax applied to this gross amount.

This approach appears to be straightforward, as both the company paying a dividend and the shareholder receiving a dividend are located in the same country. A problem arises, however, when the shareholder is a non-resident of the country in which the company is located. It is quite possible that the dividend is initially taxed at the company's domestic rate (i.e. at 10% as quoted above) and paid to the shareholder, who is then charged tax at his domestic rate. If this domestic rate is, say, chargeable at 20%, then the shareholder will receive a net amount of 72 (i.e. 90 − 18). What we have here is an example of double taxation; in other words, the same dividend has been taxed initially in the country of the company and finally in the country of the shareholder.

On the one hand, the tax authority in the company's home country receives tax and on the other hand, the tax authority in the shareholder's home country also receives tax. Whilst good for the respective tax authorities, this situation is patently unfair on the shareholder, and it has been for global tax authorities to come up with a solution that enables the tax authorities to receive taxation and for the shareholder to pay tax at his normal domestic rate.

To protect against the risk of double taxation where the same income is taxable in two countries, both tax authorities will enter into bilateral agreements known as
double taxation treaties
(DTTs) whereby the two tax authorities concerned agree to charge a lesser rate of tax (known as a
treaty rate
). Many, but not all, countries have DTTs in place; there are more than 3,000 DTTs worldwide.

According to Article 10: Dividends in the OECD “Model Tax Convention on Income and on Capital (2010)”,
^16
16
withholding tax charged should not exceed 15% of the gross amount and it is up to the two countries to mutually agree how they will apply this limit. The rate agreed between the two countries is known as the
treaty rate
. Where there is no DTT in existence, the full tax amount is deducted at a rate known as the
non-treaty rate
.

Shown in
Table 11.37
is a fictitious example involving Country
_(INV)
(the country of the investment) which has a treaty rate with Country
_(TR)
and a non-treaty rate with Country
_(NTR)
.

Not only do we need to know the country of issue of a security and its DTT status, we also have to know the country of residence and the tax liability status of the investor/beneficial
owner. This information will be held within the relevant reference information databases and will enable the correct amount of income to be received by the investor. In order to benefit from the DTT, investors will be expected to provide appropriate documentation proving their tax status and enabling their custodian to claim any over-paid taxes.

The traditional means of ensuring that the correct amount of dividend was received was a method known as a
tax reclaim
. In a reclaim situation, the investor would initially be overtaxed and would subsequently reclaim the difference. This proved to be problematic for many countries and, as a result, investors would frequently not bother to make a reclaim.

In more recent years, investors were persuaded that they should expect their custodians to make these claims on their behalf; something which the custodians were not particularly able to do well. As servicing tax reclaims became more important for the investors, the custodians had to find a way to provide this service in a cost-effective manner. The custodians also lobbied tax authorities and found a way to work with them in designing a reclaim service.

A key part of this was to persuade the tax authorities to allow the custodians to certify the tax status of their clients and, in so doing, enable dividends to be paid with the correct amount of tax deducted at source rather than through a subsequent reclaim. Investors were therefore able to receive the correct amount of dividend on the payment date and not have to be concerned with subsequent reclaims.

So that the custodians could ensure that the correct amount of tax was deducted, their records needed to indicate the tax status of their clients (e.g. fully taxable, partially taxable or non-taxable) as well as the DTT status of the countries in which the investment had taken place.

Consider the following example. A custodian is holding 50 million shares in ABC Group on behalf of clients that are either fully or non-taxable and that are resident in countries which do and do not have a DTT with the country in which ABC is located. ABC announces a dividend of 0.50 per share.
Table 11.38
illustrates how this position of 50 million shares can be subdivided by the investors' country of residence and its DTT status.

Please note that although Client D is a non-taxpayer, the dividend has suffered a 20% deduction. This is because there is no treaty rate between the client's country of residence and the country of the investment. In this situation, the client (or its custodian) might have to reclaim this tax as a separate exercise.

As with other operational functions, Corporate Actions do not work in isolation. There are interdependencies that should be recognised and efforts made to provide information and assistance where necessary. Here are some thoughts on these interdependencies.

The main issue is that it might be the responsibility of Corporate Actions Operations to update the Front Office position systems with details of an event (e.g. entering a transaction that represents a bonus issue). This activity could be described as unusual, as the Front Office normally enters transaction details into its own systems.

Trading for normal settlement ahead of a corporate action event taking place might be inappropriate if the resultant securities are received after the normal settlement date, i.e. the transaction will fail due to insufficient securities.

New securities may not rank
pari passu
with the old securities, and the Front Office might decide to sell the total position. In this situation, there should be two separate trades – one for the old shares and one for the new. If the Front Office is unaware of the
pari passu
status, it might over-sell the old shares only, causing settlement problems.

As the Front Office is the internal client for its proprietary positions, it is the responsibility of the Corporate Actions Operations to let it have sufficient information to make timely and accurate decisions. Other issues to be aware of include:

• Obtaining instructions from the Front Office for voluntary events;
  
• Executing instructions within the issuer's deadlines.
  

Clients and their agents (e.g. fund managers) are the external equivalent of the Front Office and should be treated in the same way. Again, it is the responsibility of the Corporate Actions Operations staff to let them have sufficient information to make timely and accurate decisions. Other issues to be aware of include:

• Providing sufficient information to clients so that they can make timely and accurate decisions;
  
• Obtaining instructions from the clients for voluntary events;
  
• Executing instructions on behalf of the clients within the issuer's deadlines.
  

Settlements are responsible for ensuring that transactions settle on time and actively managing failed transactions. Corporate Actions Operations should be made aware of any fails that might affect the correct allocation of entitlements.

Under the terms of the Securities Lending Agreement (SLA), the securities lender is entitled to benefit from corporate action events as they occur, with the possible exception of voting. Lenders that wish to vote generally need to recall loaned securities ahead of any voting opportunities.

In much the same way that benefits are allocated to a seller in the event that a settlement fails (see above), with securities lending it is the borrower that initially receives the benefit. It is necessary for both lenders and borrowers to ensure that any corporate action events are apportioned to the correct party.

Although cash and securities reconciliations are reactive events, nevertheless any corporate action events that have been missed or input incorrectly should be identified at this stage. Here are two examples:

1. Yell Group plc. changed its name to Hibu plc. in May 2012. You have a holding in Yell Group shares and fail to notice that the name has been changed. As a consequence, you have not made the necessary updates to your securities positions. A typical securities reconciliation is shown in
   Table 11.40
   .
   
2. Reconciliations would identify this as a reconciliation break that would be rectified by passing entries to debit Yell Group ordinary shares and credit Hibu ordinary shares. At first sight, it may not be obvious that these two positions are closely related, although either contacting the custodian or researching both companies would show the reason for the reconciliation break.
   
3. A more serious situation would potentially arise if a bond were to be called for early redemption. If the position records are not updated and the Front Office attempts to sell the original position, there will be no bonds with which to make a delivery. The result will be that the Front Office has sold bonds it does not own and therefore has sold short.
   

We have seen that share prices can change as the result of a corporate action (e.g. a 1:1 bonus issue will tend to reduce the share price by 50%). Failure to enter corporate action events into the position records could mean that the Front Office might assume that a security is either undervalued or overvalued and might be tempted to trade accordingly.

The information held in the securities database must be accurate and up to date, otherwise potential opportunities for predictable/voluntary and certain mandatory events might well be missed.