In the crowded firmament of the global custody universe, there are many bright and shining stars that custodian banks are only too pleased to point out, such sexy ‘added value’ offerings as performance analytics, securities lending, execution services and middle office outsourcing. Tax reclamation, however, does not figure in this illustrious roll call.
Big mistake. Having taken it upon themselves to shine a light into this neglected corner of the custody basement, withholding tax reclamation specialists Global Operations & Administration (GOAL) have released research showing that institutional investors are losing in excess of E5.58bn annually in unreclaimed withholding tax on cross-border securities holdings, of which the UK accounts for £327m (E494m).
According to the report, as of September 2002, the annual tax withheld on cross-border securities dividends/ income stood at $70bn worldwide, of which just over $24bn was reclaimable by investors and their fund managers. In major markets, an average of almost 8% of investors’ returns on those dividends/income are reclaimable, says GOAL, and these returns are at risk if withholding tax is not efficiently reclaimed. However, the firm’s research estimates that only 73% of overwithheld tax is actually reclaimed from foreign tax authorities each year.
As investment portfolios have switched from equities and into bonds, dividend/income yields – as opposed to equity capital growth – has taken on greater significance as a contributor to earnings. This, in turn, means that the proportion of returns represented by reclaimable withholding tax has dramatically risen in importance, says GOAL. “It is notable that the institutional investors with the longest views – pension funds – have fundamentally reengineered their portfolio balance from equities to_bonds,” the report says.
Investors and their managers certainly have a right to be miffed if custodians, as the report’s findings intimate, have taken their eye off the ball as regards tax reclamation – after all, unglamorous they may be, but the report puts the potential annual fee income market derived from these services in the region of $483m globally.
“There is now little excuse for custodians not to reclaim withholding tax,” the report adds. “Indeed the leading custodians are adding to their competitive differentiation by making a play of their reclamation capabilities… the advent of automated reclaim technology has removed the burden of manual forces and the need to retain scarce tax experts.”
According to Wendy Cohen, sales and marketing director at GOAL, one of the big problems is that the whole business of withholding tax reclamation is steeped “in myth and mystery”. “The reclamation process is extremely complex and each country in which you invest has its own variation on the theme,” she says. “So the first big challenge for custodians if they are to run the process efficiently and cost effectively is to stay close to the ground so as to be aware of what individual tax authorities are doing.”
Certainly, the majority of variations to national tax frameworks do not enjoy as a high profile as President Bush’s recently announced plan to scrap the withholding tax on US dividends. “France, for instance, has not only just changed its tax rates, but in addition the authorities have backdated those changes by a year, so means custodians will have to go back and effectively reclaim the reclaim,” says Cohen.
In fact, so complex is the existing web of tax treaties that GOAL estimates that there are in excess of 900,000 potential reclamation combinations. Custodian must factor in four elements when reclaiming withholding tax: the client’s home market; the market they are reclaiming from; the type of institution in question – for instance, a pension fund will have a different tax treatment to a corporate body; and the type of instrument in question – again, a normal dividend stock will be treated differently from bond interest.
“This is a very dynamic area and hence it is a labour intensive job to keep track of any changes, particularly as there are no freely-available centralised databases out there detailing all the double taxation agreements between goverments,” Cohen adds. “There is no getting away from the fact, however, that there is definitely a knowledge amongst custodians, which – while not huge – they are struggling to make up.”
Her advice to investors and their managers is that they prioritise automated reclamation services when they go through the RFP process with custodians, as well as studying past performance and statistics illustrating what kind of results they can expect and, importantly, the timelines involved.
“Fund managers should be looking at automated methods to predict not only investor portfolio returns but also to get a sense of how withholding tax reclamation flows are coming in,” says Cohen. “When you are dealing with a market like Switzerland you can usually expect to get your money back within a couple of months, but in the case of Italy, for instance, it can take literally years for the reclaimed funds to come back to you.”