December 20, 2017 / 12:48 AM / in a year

Confusion over U.S. tax treatment could dampen $2.2 trillion repo market

* Banks fear repos will be subject to special tax

* Experts disagree about language in final tax bill

* U.S. Treasury may take a year to issue guidance -lobbyists

By Michelle Price

WASHINGTON, Dec 19 (Reuters) - Wall Street was mired in confusion on Tuesday over how the U.S. tax overhaul working its way through Congress would treat a critical $2.2 trillion market used by banks to secure short-term financing, lobbyists and tax experts told Reuters.

They said a provision in the final version of the bill could disrupt the so-called repurchase agreement, or repo, market used by banks and investors for everyday funding needs. Congress is expected to vote to pass the bill this week.

The provision aims to stamp out practices employed by corporations to reduce U.S. tax obligations by shifting money earned in the United States to less heavily taxed overseas affiliates. Reversing this “base erosion” among U.S. tax-paying companies has been a top priority for Republican lawmakers.

Wall Street is seen as one of the major winners in the Republican effort to rework the U.S. tax code but tax experts said the full implications of the overhaul for big banks remained unclear amid confusion over the treatment of repos.

Experts said the issue is so complex that it could take the government a year to issue guidance about the tax changes. The lack of clarity could dampen the $2.2 trillion-a-day repo market as banks try to work out what their ultimate tax liability may be, said lobbyists and tax experts.

“This is a critical issue that we would all like to see clarified as it doesn’t put anybody in a good situation to not know the status of a major marketplace like this and to not be clear on the impact,” said Mark Kendall, a tax partner at global accounting firm EY.

The final code aims to impose a tax of 5 percent, effective Jan. 1, on payments made by a U.S. company to its related foreign company. For banks and securities dealers the figure would be 6 percent. These rates jump to 10 percent and 11 percent respectively in 2019.

Reuters reported this month that bank lobbyists were pushing for repos to be explicitly included in a broader exemption that covers a range of derivative transactions.

This week, those lobbyists said their reading of the final bill did not provide for an exemption, but other tax experts said the language is ambiguous and repos may still qualify under the definition of a derivative.

The repo market is key source of bank funding which is also used by investors and companies as a way to invest spare cash.

A repo involves one party selling assets, such as a portfolio of bonds, in return for cash with a promise to repurchase the assets in future, typically the following day. Repos require global banks to make payments between their U.S. and overseas entities to help manage their risk.

Net profits on repos are already taxed. Under the new code, they would continue to be taxed at the new 21 percent corporate income tax rate. But the intra-group payments may also be taxed at 6 percent for 2018 and 11 percent thereafter.

Though the daily notional volume of repos is massive, the margins on such transactions are typically very small. The extra duty, if applicable, could therefore make many such deals uneconomical, with the tax on the payments potentially higher than the total profit on the deal.

Data on how many U.S. bank repos involve an overseas leg or the potential cost of the extra tax was not available, but the repo market is global with U.S. banks major participants.

“It’s going to be pretty significant to a lot of the banks,” said Kendall, adding that some would have to rethink the way they operate as a result.

Clarifications to the code could come in the form of a technical corrections bill or, more likely, through further regulatory guidance provided by the U.S. Treasury.

But this could take between nine months and a year due to the complexity of the code as it applies to global companies, said Gavin Eakins, research economist at the Tax Foundation, a think tank.

“They are going to be in this gray zone for a year.” (Reporting by Michelle Price; Editing by David Gregorio)

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