SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

CHALLENGES & OPPORTUNITIES

Recent developments

3.2.2

• The progressive disappearance of tax-driven arbitrage opportunities As for regulation, disparate taxation is a challenge for the business but it has also offered so far many opportunities for market players. Indeed, in securities lending as in repo, some strategies may focus on these taxation gaps to enhance yields. However, it should be underlined that a variety of tax initiatives, including withholding tax re- lief at source, the renegotiation of double taxation treaties on more favorable terms and the tax harmonisation drive led by the European Commission, today pose an existential threat to the yield enhancement transactions on which equity lending has traditionally thrived. In the repo market as in the securities lending market, arbitrage opportunities are progres- sively disappearing as tax harmonisation occurs. A number of European Court of Justice cases have emerged in recent years which successfully challenged the withholding rules applied to dividend payment arising from various member states. The most recent case, the Aberdeen decision, was in line with the Denkavit and Amurta decisions which dealt with tax discrimination in regards to withholding taxes on outbound dividends. These cases have provided the basis for reclaim of withholding taxes by investors on the grounds that rules applied by some member states result in a different treatment between domestic and over- seas recipients of dividends. The issue of whether and how the case law should apply for entities making claims to recover withholdings taxes on manufactured payments on certain stocks (rather than actual dividends) raises fundamental questions around the impact on securities lending agreements, including the pricing of contracts. We would expect some of these issues to be further explored in the coming months 24 . • The impact of the new FATCA Act in the United States FATCA, the Foreign Account Tax Compliance Act which came into effect on 18 March 2010, will have a considerable impact on the financial sector, as it forces financial institutions all over the world to submit detailed information on their customers to the US tax authority (IRS) which goes far beyond the current Qualified Intermediary (QI) regime. The new rules will apply to payments from the start of 2013 and to some dividend-equivalent payments even as early as autumn 2010. In particular, total return swaps and securities lending, among others, are affected 25 . The following table provides an insight of the most important changes to come. > Foreign financial institutions are required to enter into an agreement with the IRS; Otherwise they will force imposition of a 30% withholding tax > The withholding tax is set at 30% and shall apply as of 2013 to interest, dividends and sales returns paid to uncooperative institutions and customers from US sources > Products previously exempt from withholding tax, such as total return swaps or securities lending, which are referenced to US securities, now qualify as US source payments > Foreign (non-US) securities held directly or indirectly by US persons are now also included in reportings > The definition of foreign financial institutions (FFIs) is wide-ranging, such that FATCA applies to between 50,000 and 100,000 institutions > Completely new reporting and withholding obligations in addition to (and further-reaching than) those of the existing QI regime > Identification and documentation of customers becomes considerably more laborious, whereby the burden of proof partly resides with the financial institutions > Annual (very detailed) reporting to the IRS Source: Ernst & Young, 2010 Figure 32: An overview of the most important changes related to new FATCA Act in the US

3.2

24 Source : Deloitte, “A taxing year for the lending industry ”, 2010 25 Source: Ernst & Young, “Foreign Account Tax Compliance Act (FATCA), Mastering the challenges of the new US regulation”, 2010

Securities Lending & Repo markets | page 49