Hidden Treasures – Further Analysis
10 August 2003, 3:12 pmThe Second Interim GOAL Report on losses sustained through unreclaimed withholding tax on cross border securities.
Examining the proportion of the $6 billion global losses incurred by US, UK, German, Japanese, Dutch, French, Swiss, Luxembourg and Italian investors.
Key Findings
- Largest losses from unreclaimed withholding tax on cross-border securities in the last year, were incurred by US investors ($830 million), UK investors ($689 million) and Japanese investors ($678 million)
- Two clear further tiers of loss value were identified
- Tier 2 losses were incurred by German investors ($365m), Luxembourg investors ($372m) and French investors ($296m)
- Tier 3 losses were identified with Swiss investors ($220m), Dutch investors ($219m) and Italian investors ($216m)
- Despite the typical US portfolio having only 12%+ foreign securities, US investors still make up almost 17% ($1.97 trillion) of the current value of all cross-border holdings ($11.78 trillion)
Main Implications
M Major losses are still being incurred through the inefficient or ineffective reclamation of overwithheld tax on income from cross-border securities
- Growth continues in the use of dividend payments to indicate a company’s operating health
- Major corporations that have never paid dividends have now begun to do so, including Microsoft
- US investors are often unaware of the need to reclaim foreign withholding tax, especially when their investments are ‘wrapped up’ into American Depositary Receipts (ADRs)
- US custodians, because of the lower typical cross-border proportion of their clients’ portfolios, are increasingly turning to outsource providers to process their tax reclaims
- Some European custodians are improving their tax reclaim capabilities in order to help retain clients who are being encouraged by tax amnesties to repatriate funds
- STP software vendors are turning to corporate actions solutions as a major new market for process automation, but are tending to partner with expert organisations to ensure that manual tax reclamation does not undermine their clients’ return on investment
The Report
The Return to Mrs Bennett’s Preoccupation with Income
To March 2003, the market capitalisation of global equities markets fell by some 18.9%. US markets, which represent around half of all world markets saw capital values fall a full 20%. Over the same period, the global bond market grew in outstanding debt by somewhere between 5% and 7.5% (depending on which market analyst one favours).
This spring also saw a much publicised report from an international consultancy, themed around the irritating Mrs Bennett from Jane Austen’s Pride and Prejudice. The report amusingly suggested that Mrs Bennett was not so stupid a character after all, especially in respect of her obsession with income over capital. The report reminded us that in a world of dramatically reduced equity capital values, a re-focus on income was required from investors and corporations alike.
Dividends Re-emerge
We have already seen evidence of this sea-change in investment attitudes. The number of American companies announcing increased payouts to shareholders, or dividend increases, rose 7.5 percent in 2002 — the first annual increase since 1996. Microsoft announced its first ever dividend on January 13th, and no doubt more will follow. The increasing popularity of dividends may reflect investors’ welcome for the Bush administration’s dilution of dual taxation (where corporates are taxed on earnings and individuals are taxed on dividend income) to bring dividend taxation in line with the capital gains 15% maximum.
According to Standard & Poor’s, there were 1,425 announcements of dividends increases in 2002, up from 1,326 the previous year. Similarly, dividend reductions or omissions declined last year by 34.1% to 135 from 205, after rising in the previous year. The trend was most evidently visible in December, the month when Bush’s resolution to cut dividend taxation was confirmed. 150 increases were announced — up from 121 in December 2001.
The rise in popularity of the dividend is not simply the result of Mr Bush’s taxation strategy, nor is it a phenomenon limited to the United States. Dividend payouts have been declining since 1996, as companies adopted share-buyback strategies to boost capital gains – but the trend now seems to be reversing. Analysts explain that the bear market globally has been far harder on companies not paying dividends than on those that did. They say investors are becoming more interested in receiving dividends, rather than just being concerned with the value of their stocks, particularly because a healthy dividend is a strong indicator of a company trading profitably.
As a result of the bear market, dividend yields have become a far more important element of the investor’s portfolio, with consequent pressure on fund managers to devote greater attention to maximise this element of return in the troubled portfolios they are managing.
This leads us topically into our main theme – the losses that different countries’ investment communities are suffering by not effectively reclaiming withheld tax on their cross-border dividends and fixed income earnings.
Cross-border securities (equities and bonds) average 20% across all world markets. Our research shows that, globally, 27% of reclaimable tax lies unreclaimed every year. And it is worth emphasizing that tax reclamation is as much an issue for American Depository Receipts (ADRs) as it is for direct cross-border holdings. Around 20% of US cross-border portfolio investment is held in the form of ADRs. Investing in ADRs avoids costs associated with direct foreign investment, such as international settlement, global custody, foreign brokerage, currency conversions and multi-currency accounting; however it does not preclude investors from claiming back their foreign withheld tax. Under the ‘wrapper’ of an ADR, or as direct stockholding, technology is now available to automatically perform the highly complex task of reclaiming withholding tax, a process which has to incorporate up to date information, formats and procedures from a multiplicity of different legislatures around the globe.
Despite the fact that it holds almost $2 trillion in foreign securities, the US investment community is, compared to its European cousins, characterized by its marked preference for domestic shares and bonds. Just looking at equities, US investors at March 2003 held an average 12.18% in foreign stocks. The global average portfolio proportion in cross-border equities is 20.12%, giving the non-US investment community a typical foreign equity holding of nearer 30%. Although this tends to make the loss represented by unreclaimed withholding tax proportionately greater for non-US investors, these averages often mask individual portfolio balances that are highly exposed to the problem. For instance, US investors hold around $76bn worth of stocks in Swiss domiciled companies. In Switzerland, the withholding rate is 35% and the reclamation rate 20%. A portfolio biased towards this geography could therefore suffer a considerable loss of earnings if withholding tax is not efficiently and effectively reclaimed.
Given that US cross-border holdings represent a smaller proportion of the average portfolio than in Europe, international custodian banks tend to site their tax reclamation operations in Europe, and invest in software solutions for that European center. Custodians with a primarily US client base often cannot obtain a suitable return on investment for such a software investment. Increasingly, therefore, the US-only market is increasingly served through outsourced tax reclamation, rather than installed software solutions. A large part of successful automated tax reclamation relies on an up-to-date and comprehensive knowledge-base of the changing rules across scores of country tax regimes across the globe. Even large international custodians will often choose to outsource the knowledge-pool provision to an expert. For smaller national custodians, full outsourcing is the only economic option.
For European investors, a further topical issue is the current vogue for tax amnesties. For instance, Germany approved an amnesty on February 19th this year, and Italy did the same just the previous day. Italy’s tax amnesty initiative in 2002 had managed to encourage over €50 billion by the mid-year. Many wealthy individuals in countries that have punitive tax rates hold much of their wealth abroad in more favourable tax regimes. Germans are required to pay income tax rates up to 48.5%, whereas in Switzerland the withholding rate is only 35%. The point of the recently confirmed amnesties, however, is to encourage the repatriation of assets held abroad. Cash-poor governments are increasingly using or considering tax amnesties to encourage funds repatriation, including Ukraine, Brazil, Portugal and Poland.
If these tax amnesties have any substantial effect, they will also pose a major client retention headache for custodian banks. Moreover, since a proportion of the client’s assets will remain in foreign stocks, the process of efficient (automated) tax reclamation becomes all the more crucial to maximizing earnings once the arbitrage between home country taxation regime and that of the former location of the funds is no longer in play.
There are also issues for vendors of STP software solutions. STP in settlement is now a mature initiative and the return on investment obtainable from enhancements to straight through settlement systems is diminishing rapidly. Technology vendors have therefore turned to corporate actions as a new area where STP can deliver appreciable returns.
Corporate actions – processing rights issues, dividends and various other elective and non-elective shareholder announcements – was traditionally labour- and paper-intensive. However, the full introduction of ISO15022 in 2002 has created a standardised messaging environment where automation can be more effective, leading to greater return on investment. Yet corporate actions automation faces a potential stumbling block – reclaiming withholding tax on cross-border shareholdings.
Corporate actions automation can save administration costs. If it also includes an automated tax reclamation capability, it can also recover reclaimable withheld tax. Put together, these two factors add up to a return on investment model that is much more compelling than either can be separately.
Vendors ignore this piece of the corporate actions STP picture at their peril. The authors of this report predict an increasing number of vendor alliances to achieve this end. The pressure is mounting equally from the buyer-side – seen as critical to customer retention. Already, a quorum of leading custodians have recognised the need to enhance service provision through effective and efficient tax reclamation services, both for their fund manager clients, and as an interbank services opportunity. This pressure can only increase.
Summary
Unreclaimed withholding tax remains a problem for investors, fund managers and custodians alike, amounting to losses of around $6 billion per annum for the global investor community. This is set to grow as the focus turns from pure capital growth to equity and bond income streams, especially with dividends increasingly being taken as a barometer of company health, and a steady stream of corporations starting to pay dividends where they have never done so before.
Awareness of the financial importance of effective tax reclamation on cross-border securities earnings is rising appreciably amongst investors keen to maximise the return on their investments in a time of depressed capital values.
Custodians are using the advantages of automated tax reclamation to improve their client service and to help their competitive differentiation. In Europe, this tends to be through installed software solutions, whereas in the US the outsourcing approach is favoured. Finally, corporate actions systems are now emerging which incorporate automated tax reclamation to improve their customer return on investment.
Sources:
The International Monetary Fund
The World Bank
NYSE
LSE
Moody’s
Bloomberg
Standard and Poors
Merrill Lynch
Citytext
Deutsche Börse
Euronext
World Federation of Exchanges
International Financial Services Association
Institute of International Finance
