The financial instruments countdown

The next six months could be the most significant for the long running reforms of financial instrument accounting under IFRS. During that time we expect the International Accounting Standards Board (IASB) to issue:

  • an Exposure Draft proposing changes to IFRS 9 Financial Instruments on classification and measurement of financial assets;
  • an Exposure Draft on impairment of loan assets; and
  • a Review Draft on general hedge accounting which will be the stage before it is finalised into IFRS 9.

It is worth considering what these milestones say in light of the convergence efforts of the IASB and US Financial Accounting Standards Board (FASB). Up until recently, the IASB and FASB have made good progress in closing the gap between their proposed financial instrument standards. One of the key reasons for the IASB proposing changes to its classification and measurement model is to bring the model closer to the FASB model by introducing a new classification category for loan assets. In addition, the FASB has been looking to IFRS 9 in determining its new financial asset classification criteria, and the two Boards have been working on a joint model for impairment of loan assets. It was expected that they would issue exposure drafts proposing the same model, however, divergent views have crept in and as a result, different proposals will now be issued. Consequently, the signals on convergence for this project at this stage are mixed. Perhaps after comments from constituents on the proposals are in, the direction will become more certain. Either way, the IASB will have to move forward with its proposals swiftly if it is to stick with the current effective date of 2015 for IFRS 9.

Classification and measurement

The IASB completed its classification and measurement phase back in 2010, before the FASB completed its deliberations. This has given rise to some pressure to change the model on two fronts: the first is the convergence effort to align with the US model; the second is to address some concerns around practical application of the standard that have arisen since it was originally issued. This has resulted in a number of small tweaks and one significant change that will be proposed in the upcoming exposure draft expected to be issued in the fourth quarter of this year.

The main proposed change is to introduce a new fair value through other comprehensive income (FVTOCI) category for loan assets. Absent this change, under current IFRS 9, loan assets can only be held at amortised cost or fair value through profit or loss (FVTPL). The proposed change would result in a model with three potential classifications for loan assets. However, this approach would differ to what we currently have in IAS 39 as the criteria for the classification categories is not the same. IFRS 9 is more principles based in classifying loan assets, focusing on the cash flow characteristics of the asset and the business model in which the asset is held. There are similarities, however, with the proposed FVTOCI classification and the available for sale category under IAS 39. Both classifications use other comprehensive income (OCI) to recognise fair value changes prior to the instrument being derecognised, with profit or loss used to recognise interest income on an effective interest rate basis and gains and losses recycled from OCI on derecognition. However, one of the key differences is in relation to the recognition of impairment. The available for sale classification recognises impairment based on the fair value of the impaired asset. Under the proposed FVTOCI classification, impairment would be recognised on an amortised cost basis. This allows the IASB to continue to pursue a single impairment model for loan assets based on an amortised cost measurement that will be an expected loss model and addresses the concerns around comparability of impairment charges. This new classification category would address concerns that there is no middle ground for assets that fail the criteria for amortised cost (i.e. they would default to FVTPL). One common cited example is loan assets held in liquidity portfolios where the assets churn regularly. In respect of convergence, the FVTOCI will match a similar classification proposed under the FASB model.

Impairment

The upcoming impairment Exposure Draft will be the third proposal the IASB has published during the development of its new expected loss model. As it addresses a number of concerns previously raised, it should stand a better chance of gaining acceptance.

At a high‑level, these proposals will require loan assets measured at amortised cost or FVTOCI to be categorised within one of three buckets which will drive the amount of provision recognised against them. Generally speaking, bucket one would contain originated and purchased assets where there has not been a more than an insignificant deterioration in credit quality since the asset was first recognised. Bucket two and three would contain assets where there has been more than an insignificant deterioration in credit quality and a reasonably possible likelihood that some of the asset's cash flows may not be collected, or purchases of distressed assets.

For bucket two and three, the provision would be measured as lifetime expected credit losses on these assets. The only difference between the two buckets would be that the provision for bucket two is calculated on a portfolio basis whilst for bucket three it is on an individual asset basis. As a comparison, the provision under the IAS 39 model would be a subset of the bucket two and three provision.

For bucket one items, the provision would be equal to expected losses over the life of the assets, but only from loss events expected to occur over the next 12 months. This compares with IAS 39 which does not permit provisions for losses arising from future events.

The proposed model would therefore increase and accelerate the recognition of impairment provisions. It would also result in a single model for all loan assets, as the measurement would be based on amortised cost for both loan assets measured at amortised cost and at FVTOCI.

Although the proposals would increase provisions under IFRS, the FASB are concerned that they would not create sufficient provisions for US reporters. There are also concerns over determining the bucket one provision and knowing when to transfer between buckets. To address this, the FASB has chosen to spend more time developing an alternative based on the principles of an expected loss model. This will mean two different models will be exposed for comment and depending on responses, still leaves scope for convergence.

Hedge accounting

The IASB issued its hedge accounting proposals back in 2010 and it was, at least by preparers, generally well received as it removed many of the obstacles to achieving hedge accounting when derivatives are used to hedge market risks. Amongst other things, the proposals removed the 80‑125 per cent effectiveness test requirements; introduced less volatile profit or loss accounting when options are used to hedge; and allowed risk components of non‑financial items to be hedged. Those set to benefit most from this are the non‑financial corporates who feel they have their risk management wings clipped by the current hedge accounting rules. This may lead to more hedge accounting and may make the use of financial options more attractive.

The imminent issue of the Review Draft (which is broadly consistent with the 2010 Exposure Draft) brings us one step closer to a final standard as it is intended as a fatal flaw review rather than an exposure draft. The final standard will form the next stage in the completion of IFRS 9. Many will be eager to adopt the new regime early, but those in the European Union will have to wait longer because IFRS 9 is not expected to be endorsed until all phases are complete. On a positive note, those eager for endorsement are less likely to have to wait for the IAS 39 interest rate portfolio hedging model to be re‑written as the IASB has moved this sub‑phase of the hedge accounting phase out of the IFRS 9 project, making it a standalone project for which the next milestone is a discussion paper, also to be issued later in the year.

On the convergence front, the FASB is yet to evaluate the IASB's proposals on hedge accounting. The likelihood of convergence in this area appears low because there is less appetite for the changes proposed by the IASB in the US than there is elsewhere. Given there is still more work to be done on classification and measurement and impairment, and that the use of hedge accounting is optional not mandatory, it is unlikely hedge accounting will be at the front of the Boards' convergence efforts.

The Fundamental Review of the Trading Book – how radical will this be?

The Basel Committee on Banking Supervision recently consulted on proposals to revise the framework for the trading book. Just how 'fundamental' will this review be? And what issues does it set out to address? To answer these questions we first need to understand some of the background to where we are now.

Some history

The capital regime for banks agreed in Basel in the 1980s was very broad‑brush, and covered only credit risk. Trading risks such as those from foreign exchange and interest rates were not included (though the UK used simple proxies to capture these) and there was no specific regime for asset classes such as equities or commodities. As a result, important risks were ignored. In addition, banks that hedged their risks could end up with higher capital charges than those that did not, if the hedge involved some element of credit risk. Even at a time when trading activities were relatively limited, this situation was very unsatisfactory.

To address these issues, a separate trading book regime was devised in the mid‑1990s. Because of the difficulties of devising a simple standardised approach for hedged portfolios, this regime allowed the use of value‑at‑risk‑based models (VaR), subject to a range of qualitative and quantitative factors, including back‑testing and a multiplication factor of (at least) 3. It also covered some instruments with credit risk such as corporate bonds which were said to be held for much shorter periods (and to be of higher creditworthiness) than other loans. To reflect these facts, investment‑grade paper in the standardised approach attracted a lower risk weight than in the banking book, as in practice it also did in the model‑based approach used by most large players.

As a result, the capital requirements for banks differed depending on whether the positions were in the 'trading' or 'banking' book. Moreover, since the definition of the former was intent‑based, the boundary was difficult to police, creating an incentive for some firms to park positions in the book with the lowest capital requirement. Although the Basel II rules in the early 2000s introduced a more sophisticated approach to credit risk, much more suitable to an investment‑grade book than the Basel I regime, only relatively modest changes were made to the trading book regime at that time. As the volume of business soared, increasingly positions with significant credit risk were placed in the trading book, putting the VaR approach under strain.

Weaknesses in the trading book regime and reforms to date

As the credit crisis hit, it became clear that a number of assumptions on which some VaR models were based were faulty. Some used only the recent (benign) past as a guide to the future. Some assumed returns were normally distributed, with relatively few extreme observations (and even those not that extreme). Most assumed that – as specified in the rules – positions could be exited within a ten‑day holding period, and that credit markets in particular would not become almost totally illiquid. As a result, these models greatly underestimated the losses incurred, and the Basel Committee determined that the rules needed to be tightened up forthwith.

In July 2009 it finalised its so‑called 'Basel 2.5' package, tightening up the rules on certain credit risk products (including securitisations), introducing stressed value‑at‑risk measures in an attempt to prevent unduly rosy assessments based on recent history, and implementing an incremental risk charge, to capture the sharp movement in prices not only on default but also on moving from one rating grade to another. While this significantly increased the level (and complexity) of trading book capital requirements, the Committee also stated it would launch a more fundamental review of the regime.

The Review and its possible impact

In May, the Committee published its initial proposals. These included a "more objective" definition of the trading book boundary (including the possibility that market risk charges would apply in all cases where changes in fair value flowed through to capital); a move from VaR models to an "expected shortfall" approach (estimating the size of the loss when value‑at‑risk is breached); a more granular approach to model approval, with limits on assumed diversification benefits; and more account of market illiquidity (rather than assuming a 10‑day holding period for all positions). The standardised approach would become more complex and risk‑sensitive, so it could be a credible fallback for a large model‑using bank: its calculation would be mandatory even for those using models and might be used as a floor or surcharge to model results.

What might the impact be of such changes?

The new trading book boundary is potentially important. An accounting‑based definition, capturing all fair‑valued assets in the banking book, would probably result in more firms coming under the trading book rules, making it important these could be easily applied by such firms. It would also make the supervisory regime more dependent on the rules of other standard‑setters and might be less well aligned with current risk management practices. Any change (either in this direction or alternatively to a trading‑evidenced approach) would also involve implementation costs.

Equally important in system terms are the introduction of liquidity horizons (i.e. assuming different holding periods for different instruments), and the limits on the treatment of diversification. Both of these increase process complexity and capital requirements on an ongoing basis, and may therefore prove controversial. It is likely that in the latter case, some banks will argue that the result is a non‑risk‑based capital measure that fails the 'use' test; i.e. would not be used by firms to manage their own risk.

Finally, the mandatory calculation of standardised rules is likely to be unpopular both with large firms and small players. The latter may argue that the new regime is too complicated, particularly if the trading book boundary is expanded to include some who are not currently subject to any trading book rules. Larger firms will say that at best, the calculation is an unnecessary burden, and at worst (if used as a floor or a surcharge to model results) will tend to discourage risk management improvements. Regulators are likely to respond that if such calculations are not mandatory, it will be in practice impossible to move a model‑using bank to a new approach even if the model in question has broken down irretrievably.

Conclusion

The fundamental review of the trading book could have been more radical still – abolition of the banking/ trading book boundary was one possibility and no longer recognising models for capital requirements was another. But although neither of these is currently proposed, it would still be a mistake to under‑estimate the importance of these proposals, nor indeed their potential implementation costs. All in all, they represent another challenge to trading‑orientated banks as they negotiate the plethora of proposals governing their activities.

Managing operational and transactional taxes: Opportunity as well as risk

All financial institutions will at some stage buy, hold or sell capital markets securities such as shares or bonds, or enter into derivatives. Taxes relating to these banking and securities transactions can be complicated, are subject to change and their application can vary depending on the type of transaction and security, as well as the residence and status of the institution involved. Tax authorities are increasing their scrutiny of these transactions at the same time as imposing further obligations on the financial sector in relation to the burden of applying and collecting any taxes due.

Opportunities also exist for taxpayers, however, both in terms of obtaining optimal tax treatment at the time of payment and in terms of reclaiming any tax which can be reclaimed.

Increased scrutiny by tax authorities

In the current environment, tax authorities are increasing their scrutiny of banking and securities transactions. The imposition of a financial transaction tax (FTT) on certain French shares, which is intended to raise EUR1.1billion per annum for the French Exchequer, is a notable example (and has the potential to be adopted more widely across European markets). But this focus is not only on new or increased taxes. Tax authorities are also challenging the treatment of existing taxes such as:

i. dividend withholding taxes, specifically whether an investor is entitled to reduced rates of tax;

ii. whether a non‑resident investor has a liability to capital gains tax in the country of investment; and

iii. the application of transfer taxes such as the UK's stamp duty reserve tax (SDRT).

At an extreme level, a tax authority may argue that simply holding or trading securities issued in a country is sufficient to trigger a liability to register for and pay taxes in that country. This increased scrutiny and more robust approach enables revenues to be raised from banking and capital markets transactions without the need to increase tax rates or impose new and potentially unpopular taxes.

Furthermore, the burden of compliance and payment of operational and transactional taxes is also imposed upon the financial sector. Examples of this fiscal outsourcing include the French FTT and the US Foreign Account Tax Compliance Act (FATCA) requirements. In each case, the financial sector needs to invest in systems and solutions in order to enable taxpayers to comply with new tax rules by reporting trades, identifying recipients of payments, and collecting the tax on behalf of tax authorities.

In risk management terms, the stakes of mismanaging securities taxes are high. Securities taxes are imposed on gross flows and transaction values rather than spreads or net profits. The amounts due can be large and soon dwarf any potential profit from a transaction if not properly managed. Understanding and managing the tax risks in relation to securities are therefore essential risk management and compliance tasks.

Securities or operational taxes arise in relation to buying, holding, selling and other dealings in capital markets securities such as shares, bonds or derivatives. Withholding tax, capital gains tax and transfer or financial transaction taxes are prominent securities taxes. There is no uniform methodology to taxing securities: each country has its own rules, in some cases depending on both the type of the security and the location and tax status of the holder.

Obtaining optimal tax treatment

Against this backdrop, implementing a strategic approach to risk management is key, including identifying tax risks and taking practical steps in a consistent and sustainable manner to minimise risk.

A practical checklist to identify risks and take advantage of potential opportunities available is set out below.

  • Risk must be identified before it can be managed. Establish on entering into a transaction or entering a new market whether any risk of a taxable presence, withholding tax, transaction tax or obligation to report the transaction to tax authorities, for example, arises in the country of investment.
  • Update this information and review transactions regularly (e.g. annually) as tax rules and practice can change.
  • Implement practical steps to minimise or eliminate any tax risk. Set up accounts and file tax forms in advance to benefit from preferential tax treatment where available.
  • Cash‑flow is king. Where possible, ensure payments are made gross at source (rather than reclaiming after the net amount has been paid).
  • Claim all reliefs and beneficial tax treatment where available and file reclaims where due (see further below). Sometimes the reclaim process can seem daunting and require further internal time and resource, but subject to a cost‑benefit analysis, this is worth doing where the amount at stake is sufficient.
  • Where taxes arise, consider alternative methods of achieving the same economic result. Can an alternative entity in a double tax treaty jurisdiction enter into the trade to reduce withholding tax? Could entering into a derivative rather than purchasing shares outright produce a preferable tax outcome and is this accepted by tax authorities? " Assign organisational responsibility for these securities taxes to avoid issues falling into the cracks.
  • Audit risk management process regularly to test and sustain effectiveness.

Reclaim opportunities

Finally, reclaim opportunities are worth a specific mention. In the first instance, this entails reclaims pursuant to double tax treaty or domestic law exemptions, such as where payment always suffer deductions at source (e.g. Swiss dividends) and are subject to a reclaims process, or where a tax form was not timely filed and so tax was deducted but can be reclaimed once the correct form is submitted.

Further, opportunities also exist under European Community non‑discrimination legal principles to reclaim taxes suffered on portfolio investments in European shares. Where an EU member state imposes a higher rate of tax on dividends paid to a non‑resident investor than on dividends to a comparable resident investor, this may breach 'free movement of capital' principles. Following cases decided by the Court of Justice of the European Union, a number of member states have already repaid tax which was incorrectly withheld from payments to a range of portfolio investors (including those outside the EU).

For other markets, it is a case of quantifying amounts of tax withheld and filing a reclaim within specified time limits in order to protect the right to reclaim in each relevant investment market. Portfolio investors such as pension funds, investment funds, insurers, sovereign wealth funds and in some cases corporate entities should consider whether such an opportunity exists, even where they are resident outside the EU.

Conclusion

As the focus on securities transactions increases, and the compliance and reporting burden expands, it is more important than ever before to understand and identify the tax risks arising in relation to those transactions in order to take steps to manage and reduce tax risk. There are also opportunities, including reclaims, which are worth being aware of and pursuing as part of any sustainable tax risk management strategy.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.