Taxation of Securitization with Chinese Characteristics

2006-05-17T22:15:00.000-07:00

Taxation of Securitization with Chinese Characteristics

The regulatory framework for asset securitization - a landmark initiative in China's financial markets – is finally completed with the issuance of the Notice of the Ministry of Finance and the State Administration of Taxation on Relevant Issues Concerning Taxation Policies on the Securitization of Credit Assets (the "Tax Notice") by the Ministry of Finance ("MOF") and the State Administration of Taxation ("SAT") on February 20, 2006.

Asset securitization is the transformation of non-liquid assets into securities; for example, into an instrument that can be traded in a capital market. Since its origination in the United States in the 1970s, securitization has become an increasingly important financial instrument in modern finance. It bridges the currency and capital markets by eventually translating assets into a cash flow, which is of vital importance to investors and the financial markets. In China, however, securitization transactions are fairly new, with only some quasi-securitization transactions having been executed thus far, such as Huarong Asset Management Company and the Industrial and Commercial Bank's trust-based quasi-securitization transactions to dispose of non-performing loans ("NPLs").

To regulate the securitization transactions and protect the legitimate rights and interests of the parties concerned, the People's Bank of China and the China Banking Regulatory Commission promulgated the Administrative Measures for the Securitization of Credit Assets ("Administrative Measures"), which for the first time provide a framework for securitization in China. The promulgation of the Administrative Measures has removed most of the existing impediments to using conventional securitization structuring techniques in China and was very soon followed by the issuances of various relevant regulations[1] concerning the supervision, registration and accounting treatment of securitization transactions.

A tax rule, however, was not promulgated until two months after the launch of the two pilot asset backed securities projects by the China Development Bank and the China Construction Bank. The recently issued Tax Notice, which provides the governing rules for the tax treatment of various parties involved in securitization transactions, follows the general principle of tax neutralization, but still has some Chinese characteristics. This article aims to provide an overview of the Tax Notice and a discussion on some unclear issues.

Transactions

The Administrative Measures describe the procedure for securitizing credit assets as follows:

(1) A financial institution, acting as a sponsor ("Originator"), entrusts its credit assets ("Trust Assets") to a trustee ("Trustee");
(2) The Trustee establishes a special purpose trust ("SPT") and appoints a loan servicer and a fund custodian ("Servicers") to manage the credit assets;
(3) The Trustee issues asset backed securities ("ABS") in the form of trust beneficiary certificates rated by qualified rating agencies in the China inter-bank bond market to institutional investors ("ABS Investors"); and
(4) The ABS Investors are paid by the proceeds of the ABS with cash generated from such assets.

The Tax Notice addresses the relevant tax treatment of transactions using the above structure.[2]

Stamp Duty

A stamp duty is a kind of tax levied on the execution and receipt of evidence of economic activities or economic association, such as certain types of economic contracts, certificates of transfer of property rights, business account books and certificates, permits for rights, etc.

The Tax Notice exempts the following documents (for now) from stamp duties:

§ The trust deed established between the Originator and the Trustee;
§ The management agreement between the Trustee and the Manager;
§ The service agreement between the Trustee or Originator and the Custodian;
§ The transfer papers for the sale of ABS by the Trustee or by an Investor; and
§ The capital account established for the securitization transaction.

As securitization involves an abundance of contracts and documents, the above exemptions are crucial to reducing the transaction costs of securitization transactions from a tax perspective.

Business Tax

A business tax is a kind of turnover tax levied on the sales revenue gained from the sales of taxable services, immovable property or transferred intangible assets. The Tax Notice provides the following treatment of business taxes for securitization transactions:

§ Interest income of the Trustee derived from lending to the Trust is subject to business tax.
§ Service fees received by the Trustee, Manager, Custodian and other service agents are subject to business tax.
§ The net gains made by a Financial Institution Investor on the sale of ABS are subject to business tax; Non-Financial Institution Investors are not subject to business tax.

The Tax Notice treats interest as the income of the Trustee and levies business taxes on the Trustee, which follows neither the practice of western countries which treat special purpose vehicles as transparent entities, nor the principle that "the Trust Asset is separate from the Trustee" established by the Administrative Measures. It also runs counter to the accounting principle that "the SPT is a separate accounting entity." However, it is a logical result of the current Chinese tax system which does not regard a trust as an entity and thus does not treat it as a tax payer.[3] It is also consistent with the current tax treatment of other trust-related transactions where a Trustee pays China taxes on the gains of the trust.

The Tax Notice does not provide whether the proceeds received from the Trustee should be subject to business tax at the level of Investors. However, based on the principle adopted in the income tax policy (see below), SAT seems to take the view that such proceeds are "dividends" in nature, as opposed to "interest income." As such, such proceeds should not be subject to business tax for Investors. This is a reasonable assumption, otherwise double layers of business tax would be levied, which is contrary to the spirit of tax neutralization cited by SAT.[4]

Another issue is whether the Originator should pay business tax for the gains made on the disposal of Trust Assets to the SPT, which is not addressed by the Tax Notice. As per the Administrative Measures for the Filing of Business Tax for Banking & Insurance Industry (Guoshuifa[2002]No.9, Circular 9) issued by SAT on January 30, 2002, transfer of financial commodities is subject to business tax on the gain of the transfer. Transfer of financial products indicates a transfer of ownership of foreign exchange, securities or non-commodity futures, including stock, bond, foreign exchange and other financial products. Transfer of credit assets is not explicitly included in the scope of business tax by Circular 9; however, such a transaction can be reasonably classified as a "transfer of other financial products" and thus subject to business tax. If that is the case, then the Tax Notice has left another issue unresolved, i.e., double business tax for the portion of the gain achieved by the Originator for disposal of Trust Assets to the SPT, since it fails to define a "step-up basis" for the business tax treatment of the SPT (through the Trustee).

Income Tax

§ The Originator

The Originator's gain or loss on transferring a Trust Asset is subject to corporate income tax as taxable profits or deductible losses. Redemption or swapping of assets is treated as a sale and purchase and is taxable accordingly.

The Tax Notice seems only to address "true sales" securitizations, otherwise transferring a Trust Asset should not be a taxable transaction if the transaction is only a "pledge for debt."

§ SPT

Per the Tax Notice, tax treatment of the SPT depends on the distribution policy of the SPT:

o Proceeds derived through the Trust are not subject to income tax if distributed to the Investors in the current year.

o If proceeds are not distributed in the current year, the Trustee has to pay corporate income tax.

The treatment of income tax shares the same principle with that of business tax, i.e., taxes on relevant gains achieved by the SPT are paid by the Trustee instead of the SPT.

§ Investors

The tax treatment at the level of Investors depends on the distribution policy of the SPT and subsequent tax treatment of the SPT:

o If distributions are made in the current year and the Trustee does not pay income tax, then the Investors should recognize their gains and income through the Trust on an accrual basis, and pay corporate income tax accordingly.
o If the distributions are not made in the current year and the Trustee pays income tax at the trust level, then the Investors will treat the subsequent distribution as an after-tax gain.[5]

Though ABS are issued and traded in the national inter-bank bond market, the Tax Notice seems not to treat ABS as a debt instrument; instead, it effectively treats ABS as an equity instrument (i.e., treats the proceeds from ABS as a dividend to the Investors). Through such an arrangement, tax neutralization is achieved without double taxation of income tax for the Investors. However, there are still some disadvantages compared with the traditional "tax transparent" treatment of pass-through entities in Western countries. The most significant disadvantage is that such treatment will make ABS less attractive to Investors with low applicable tax rates, such as financial institutions located in Shenzhen and Shanghai Pudong, whose income tax rate is 15%. If the Trustee pays income tax at 33% while the Investor's tax rate is 15%, the Investor cannot claim a tax refund under the current Chinese tax regime (see note 5). As such, the after-tax return for those investors is lowered for tax reasons. In this regard, proper choice of the Trustee and distribution policy may be necessary unless there is a unification of the Foreign Enterprise Income Tax and the Domestic Enterprise Income Tax, which is expected to cancel geographical tax incentives.

Tax treatments for trading and liquidating ABS are similar with those for other financial products:

o Gains and losses derived from the sale of ABS are taxable or deductible for corporate income tax purposes.
o Gains or losses upon the liquidation of the Trust attributable to an Institutional Investor are taxable or deductible for corporate income tax purposes.

§ Servicers

The service fees received by the Trustee, the Manager, the Custodian and other servicers are subject to corporate income tax, respectively.

Tax Reporting

The Trustee and the Custodian are obligated to report detailed financial information and distributions of proceeds to the tax bureaus in charge of the SPT and the Investors.

Further Development

The Tax Notice has marked a milestone for the development of China's taxation system for financial products. It observes the rule of tax neutralization and provides a favorable treatment for securitization transactions. However, further development, including clarifying the aforementioned unclear issues, as well as tax treatment of other types of securitization transactions, should be expected in order to foster the development of securitization products.

[1] Besides the Administrative Measures and the Tax Notice, regulations governing securitization include the following:
§ Regulations on the Accounting Treatment of Pilot Projects of Credit Asset Securitization issued by the Ministry of Finance on May 16, 2005;
§ Pilot Notice of the Issue of Registration for the Change of Lien Associated with the Securitization of Mortgage Loan issued by the Ministry of Construction on May 16, 2005;
§ Rules for the Information Disclosure of Asset-backed Securities issued by People's Bank of China on June 13, 2005; and
§ Measures for the Supervision and Administration of the Pilot Securitization of Credit Assets of Financial Institutions issued by the China Banking Regulatory Commission on November 7, 2005.
[2] Actually the Tax Notice is the combined lobbying effort of the China Development Bank and the China Construction Bank. Judging from its content, its major objective is to prescribe the tax treatment of "true sales" securitizations of credit assets. Other types of securitizations are still not covered.
[3] Under China's tax system, only enterprises or organizations that conduct independent business accounting are regarded as the taxpayers of enterprise income tax (Article 1 of the Provisional Rules of the People's Republic of China on Enterprise Income Tax); and only units and individuals are taxpayers of business tax (Article 1 of the Provisional Rules of the People's Republic of China on Business Tax).
[4] http://www.chinatax.gov.cn/view.jsp?code=200603021557257983
[5] According to the Detailed Rules for the Implementation of the Provisional Rules of the People's Republic of China on Enterprise Income Tax, if a taxpayer derives after-tax profit from another enterprise, the amount of tax directly paid may be credited when calculating enterprise income tax. As such, if the investor's tax rate is higher than the investee's, then the investor need pay corporate income tax at the difference of the tax rates. However, if the investor's tax rate is lower than the investee's, the investor cannot claim refund for the tax paid by the investee for the portion of different tax rate.

Kevin Wang

Taxation of Securitization with Chinese Characteristics