Investment bankers, deal structures and taxes


Investment bankers are synonymous with money and deal making.

Why is this so? When businesses are in need of significant chunks of money, investment bankers typically are the go-to guys for putting together a deal with the most optimal terms.
If what is required is debt, optimal terms would usually equate to the lowest interest rate for either a bond issue or a term loan, in whatever currency, that the investors or lenders, whether local or offshore, could bear. An important consideration for the investment banker in structuring a deal is the impact of taxes.

Why? Taxes translate to an additional cost (for a borrower) or yield (for an investor) in any type of a deal that must always be factored in. There are always two sides, running in parallel for every structure, the coupon rate or interest for the issuing corporation or borrower, and the yield for the investor. In structuring a deal, the investment banker needs to be cognizant of what will make a structure work for both the issuer and the investor.

For example, a debt instrument such as a bond that is distributed to the public, defined as selling to more than 19 investors, will be subjected to a 20 percent final withholding tax reducing the net yield to the investor. On the other hand, a private placement, which is a debt issue sold to fewer than 19 investors, will not be subjected to any withholding tax but however will still be subjected to the regular corporate or personal income tax rate.

From the point of view of the corporation raising funds, the impact in so far as taxes are concerned will be the same because the interest expense in both instances will be deductible from the company’s taxable income. However, from the perspective of the investor, the structure makes a big difference. The public debt issue structure that is subjected to a 20 percent final withholding tax on its interest income, although reducing the net yield, is a final tax. This is referred to as non-taxable income which means no additional income tax will have to be paid, thus making it more attractive to an investor who could be subjected to a final personal income tax rate of as much as 35 percent (for individuals) or 30 percent (in the case of a corporation). Bottomline, investors buying an instrument that is subjected to a final withholding tax potentially saves 10 percent to 15 percent in taxes depending on their tax position.

On the other hand, the interest income of a private placement debt issue, which is not subjected to any withholding taxes, could be more attractive for certain types of investors.

Specifically, I am referring to corporations which might already be in a negative tax position.

This means that the investor corporation no longer has an income position that could still be subjected to the regular corporate income tax rate of 30 percent. This could be because the corporation may have already racked up enough expenses versus its taxable income thus no additional income taxes would be due. Or, it may be that its income profile is primarily non-taxable income. A holding company, for instance, whose income comes primarily from dividends which are not subjected to any inter-corporate taxation or is not taxable, would be needing taxable income to offset against its expenses. Another example would be financial institutions such as banks or insurance companies with an income position heavily dependent on interest income arising from final tax withheld instruments such as government securities.

A non-taxable, not-for-profit entity such as a foundation would also find it attractive to invest in debt securities not subjected to any withholding tax. For that matter, a high net worth investor registered as a QIB or a qualified investor deemed to be financially knowledgeable and who has the necessary investible capacity, would also find it attractive to invest in a debt instrument not subjected to any withholding tax. Foreign currency denominated bond instruments of local companies or even the National Treasury which are issued abroad are also not subjected to any withholding taxes. The investors of these instruments are deemed to be offshore investors thus not within the ambit of our local revenue regulations. In these instances wherein the interest is not subjected to any withholding, it is important to note that the income nevertheless is not tax exempt. The interest income is still subject to the regular income tax rate. It is left to the concerned investor to make the final determination of their pertinent tax liability. Simply put, even if the transaction does not entail the withholding of tax, the investor is ultimately still held liable for any income taxes due.

The tenor or maturity of a bond issue is also another feature that can result in a tax break for the investor. If structured to mature beyond five years, investors who opt to trade or sell these debt instruments in the secondary market will be exempted from paying taxes on the trading gains. Particularly for banks, there is also a similar tax break that is linked to the maturity of deposit instruments called Long Term Negotiable Certificates of Deposits (LTNCD) which go beyond five years. Interest income of LTNCD, if purchased by individuals, are exempted from any taxes. A close cousin is a Tier 2 instrument of banks used to shore up its capital. The interest income of this instrument beyond five years is likewise tax-exempt.

Another unique funding instrument that is quite popular for both the issuer and the investor because of its tax breaks is a Perpetual Preferred share. Although technically an equity instrument, the features are practically that of a bond because it has no voting rights and investors’ yield are limited to a fixed dividend rate. The tax play is on the tax exempt feature for corporate investors and the 10 percent final withholding tax for individuals.

All of the above are covered directly or indirectly in the TRAIN Package 4 which I will share with you in my next few articles.

Until then…one big fight!

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