The Joint Congressional Committee on Taxation just released a large report on tax implications of sovereign wealth funds (pdf).
One outcome of the crush of attention on sovereign wealth funds in the last year or so has been an outpouring of information both on funds themselves and on the legislation that might be relevant. More information on both helps increase predictability for all actors. It may also mean that some investors shy away from some investments or that they build in time and money for CFIUS presentations or other regulatory hurdles. But, at the end of the day, funds will invest where they see a good opportunity, and the outlook for specific US sectors will be uppermost. So far there have been no policy changes relating to SWFs (nor have there been any bills presented, to my knowledge). But we have had clarification of existing legislation (the new implementing regulations for CFIUS are one example). This report on tax policy will also help understand the structure and incentives relating to recent deals.
As previously pointed out by Victor Fleisher and noted on this blog, US tax code includes an income tax exemption for passive investment by foreign governments, including sovereign wealth funds. Tax law includes a carve out for commercial endeavors by foreign governments, but passive portfolio investment is not deemed to be commercial. But investment proceeds by subsidiaries of foreign governments are – and are subject to tax. Thus it seems this is another important reason to have a clearer understanding of active management and control by sovereign wealth funds – since a controlling stake might mean that sovereign investors would be liable for taxes like a comparable private stake. Fleisher (who previously suggested taxing carried interest) worries that these provisions might crowd out private investment.
The JCT: SWFs may benefit from a long-standing exemption from U.S. income tax that applies to certain passive income received by foreign governments, which first became part of the U.S. income tax laws in 1917, long before the first SWFs were created.
Some of the most important statutory U.S. income tax advantages that a foreign sovereign investor enjoys over a foreign private investor are: exemption from U.S. withholding tax on all U.S. source dividends paid by noncontrolled corporations; exemption from U.S. withholding tax on interest paid by a corporation where the foreign sovereign owns at least 10% but less than 50% of the payor; and exemption from U.S. tax on certain gains from real estate transactions
There are others much more qualified than I to parse the tax code but overall the report adds a lot to our understanding of how our existing regulatory framework affects and is affected by sovereign wealth funds and how their deals are structured.
Most significantly, it compares the US tax treatment to that of other countries drawing on an attached comparative paper which begins on page – Japan and the Commonwealth countries of Australia, Canada and the United Kingdom have each adopted a general policy of exemption for foreign governments from taxation on passive income, though it does not always apply to SWFs and in some cases is decided on a case by case basis. The UK has perhaps the least restrictive regulations – others exempt foreign governments only in bilateral tax treaties, though SWFs are not always included
– Germany does not exempt foreign governments, charging the same income tax as foreign private entities, yet Germany exempts most non-residents from capital gains. So do many countries.
The paper also draws attention to the structure of SWF capital transactions, a subject which has attracted more attention given the likely capital raising by Barclays from sovereign funds . Although national trends differ, tradeoffs between issuing convertible securities, preferred shares and rights issues are emerging. Most of the past SWF deals involved the issue of preferred or convertible shares rather than selling of common stock which might dilute the holdings of existing share holders. These tended to come with significant annual interest payments until conversion (see this table for more details).
The JCT notes:
“The mandatory convertible securities issued in the ADIA-Citigroup and CIC-Morgan Stanley investments provide significant tax and regulatory benefits to the issuers.
In fact convertible securities have become more attractive to a whole range of investors (see Avi-Yonah testimony)
The JCT regulatory concerns, especially the need to ensure that the funds counted towards Tier 1 capital that likely had a more significant influence on the deal structure than any exemption
JCT: The equity units acquired by ADIA and CIC qualified as Tier 1 capital, whereas the issuance of a debt security alone would not have so qualified.
Furthermore “a nongovernmental foreign investor would have enjoyed most, but not all, of the U.S. tax benefits obtained by ADIA and CIC. In particular, in the hands of a nongovernmental foreign investor, the portion of the return attributable to interest paid on the debentures underlying the trust preferred securities generally would have been eligible for the portfolio interest exemption. any capital gains or the stock received on maturity of the forward contracts”
Similarly, the use of preferred stock by Merrill and Citi “suggests that the availability of an exemption under section 892 was not a significant consideration in the choice of convertible preferred securities. A more significant concern may have been the qualification of the preferred stock as Tier 1 capital for bank regulatory purposes.
SWFs may also be participating indirectly in more private sector led-recapitalizations some of which have included common stock. Furthermore, many sovereign funds may eschew controlling stakes in the US or other G7 countries but take active management in other countries (as noted in the recent monitor Group report). the JCT suggests a sovereign fund might ensure that it does not lose its tax-exempt status
“by having its controlled entity (“Corp A”) create (at least) two subsidiary brother-sister corporations (“Sub B” and “Sub C”). Corp A would then function solely as a holding company for Sub B and Sub C, making no investments itself. Sub B would make all non-U.S. investments (including any investments in non-U.S. partnerships). Sub C would invest solely in the U.S., and would not invest directly in any partnership. If Sub C desired to invest in a U.S. partnership, such as a U.S. hedge fund or private equity fund, it would do so only by investing in a corporate entity that it would not control, such as the foreign feeder corporation commonly found in many U.S. hedge fund or private equity fund structures.. …Sub C’s income would not be tainted because it would not engage in any commercial activities itself and would have no commercial activities attributed to it as a result of any investment in a U.S. hedge fund or private equity fund because the foreign feeder corporation would block any potential attribution”
Again, I’m not the best one to parse the tax code, but it does seem to explain why we may be seeing such a proliferation of different investment management structures. Testimony from the Federal Reserve board several months ago detailed its oversight role for banks and financial institutions. As with CFIUS, which surveys all investments for any possible negative national security implications, existing banking legislation was not created with sovereign funds in mind, but its dealings with foreign government investors including state banks are a precedent.
Some of these concerns may be contributing to reported delays in a decision whether to allow Chinese state banks ICBC and CCB to open up branches in the U.S. Since the creation of CIC, it has managed the the controlling stakes in Chinese state banks, having encompassed the state holding company Central Huijin. Those with a controlling stake must provide a certain level of transparency.
The US believes the two sides were close to agreement before China reorganised its holding companies, putting Huijin under the control of CIC, the sovereign wealth fund. Fed officials are considering whether CIC should itself be treated as a bank holding company and subject to the same obligations as Huijin, as the ultimate controlling shareholder in the banks. The Fed position is that a sovereign wealth fund should be treated no differently from any other controlling shareholder.
Perhaps it will be another reason pushing the CIC towards more transparency of motivations. It is currently being pulled in a number of directions– but more than that it is yet another long-term issue on the agenda of 4th semi-annual Strategic Economic Dialogue which kicked off today and ends tomorrow. Delays in Chinese banks operations in the U.S. surely won’t make China more likely to open up its financial sector.
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