Discussion Paper

TDP 2019/1

Proposed compliance framework - liquidity management

• This document incorporates revisions made since original publication. View its history and amending notices, if applicable.

Mr Robert Colquhoun
Australian Financial Markets Association
Level 25, Angel Place
123 Pitt Street
SYDNEY NSW 2000

 

30 July 2019

RE: Liquidity Management Discussion Paper

Dear Rob,

We refer to the meeting with representatives from the Australian Financial Markets Association (AFMA) on 26 June 2018 to consider the proposed compliance framework for intra-entity liquidity charges outlined in the Discussion Paper prepared by the Australian Taxation Office (ATO), and AFMA's submission dated 29 November 2018.

1. Background

During the Global Financial Crisis (GFC), the importance of liquidity management by the banking industry became apparent.

In response to the deficiencies in financial regulation revealed by the GFC, the Basel Committee on Banking Supervision developed the Basel III regulatory framework on bank capital adequacy, stress testing and market liquidity risk. Under this global prudential framework, banks are expected to maintain certain levels of liquid assets that could be used in periods of severe stress.

From a tax administration perspective, the period following the GFC led the ATO to review the funding and liquidity models employed by banks in greater detail. To date, the ATO has reviewed a number of global liquidity models at a high level under various compliance products and private ruling applications. Through these reviews, the Commissioner has been made aware of mechanisms used by multinational banks to pass on the costs of holding centrally managed liquid assets to their Australian permanent establishments via intra-entity charges.

In determining the deductibility of intra-entity charges in one specific fact pattern, the ATO developed and published three ATO Interpretative Decisions (ATO IDs):

•

ATO ID 2012/90 Income tax - Deductions: Internal estimates of notional funding cost

•

ATO ID 2012/91 Income Tax - Deductibility of net amounts on borrowings

•

ATO ID 2012/92 Income Tax - Deduction: interest expense to fund general reserve liquid assets

The ATO subsequently undertook an internal review of the above ATO IDs and met with representatives from AFMA on 12 December 2016 to discuss liquidity management. It was confirmed the principles outlined in the IDs would continue to apply to intra-entity charges generally.

There was nonetheless a general desire from industry for positive guidance from the ATO establishing acceptable principles for the deductibility of intra-entity charges associated with liquidity management. However, progress on the development of this guidance was put on hold while technical issues were being resolved in specific audit cases.

On 6 April 2018, a Discussion Paper was issued to industry outlining the ATO's proposed compliance framework for the deductibility of intra-entity liquidity charges, and a meeting with AFMA representatives was held on 26 June 2018 to consider the technical points outlined in the Discussion Paper.

AFMA provided its feedback on the Discussion Paper to the ATO on 29 November 2018.

This letter addresses some of AFMA's comments and is to be read in conjunction with the Discussion Paper.

2. Scope

The Discussion Paper issued on 6 April 2018 applies to:

•

Australian resident banks with foreign branches; and,

•

Foreign banks that carry on business in Australia through a permanent establishment.

It does not address liquidity charges between separate legal entities.

The Discussion Paper is intended to apply only to liquidity charges that seek to allocate the funding costs associated with liquidity risk management activities. The Discussion Paper defines 'liquidity charges' as credit or debit amounts allocated between different parts of a bank that purport to be an allocation of the costs incurred in the management of that bank's liquidity. These credit or debit amounts may, or may not be, accounted for in the bank's books of account as separate charges. Where the relevant costs are purported to be allocated as a component of an amount recorded as 'interest' in the bank's books of account, whether or not the Commissioner will accept that amount is deductible for Australian tax purposes is subject to the proviso that the accounts have been properly prepared and the allocation or attribution outcomes are the best estimate of branch profits that can be made in the circumstances (refer to paragraph 18 of TR 2005/11).

Liquidity risk management charges will generally fall within one of the following broad categories:

•

Liquidity reserve negative carry, being the net loss derived from holding assets in the reserve; and,

•

Tenor mismatch, being the difference in tenor between the funding and asset profile of a bank.

3. Overview

The Discussion Paper provides indicative guidance on the Commissioner's compliance expectations in relation to the deductibility of funding costs associated with liquidity management by banks. In particular, this is illustrated through:

•

An overview of the ATO's understanding of different centralised and decentralised liquidity management frameworks employed by banks;

•

An explanation and examples of "red flags", whose presence in a liquidity management framework would indicate a high risk that the liquidity adjustments themselves are not a reasonable proxy for the actual costs incurred; and,

•

The provision of "green zone" examples for given aspects of the liquidity management framework.

4. Response to AFMA's submission dated 29 November 2018

Industry "green zone" examples

AFMA provided two scenarios that it considers to be within the green zone.

a.

Central liquidity buffer:

In this scenario, the bank's head office holds a central liquidity buffer for both itself and its overseas branches (including the Australian branch). There are no legal, regulatory, or operational impediments to using the proceeds of the liquidity buffer to fund a branch that is in need.

b.

Centralised funding approach:

In this scenario, a bank centralises its term borrowings in a central hub location and arranges for the overseas branches to fund themselves at short term tenors. The term funding liabilities held in the centralised hub benefit the overseas branches.

The ATO considers that these scenarios are substantially similar to the centralised models illustrated in the Discussion Paper, whereby some of the costs incurred by the head office or hub in maintaining the liquidity buffer for the relevant overseas branches are charged to those branches. However, the ATO does not consider that these liquidity frameworks will necessarily be within the "green zone" and factors such as the use of assets will need to be considered. Further, in reviewing the deductibility of any intra-group charge, the ATO must still be satisfied the costs apportioned and allocated both represent the actual third party costs incurred and reflect an arm's length amount under Division 815-C.

Sufficient nexus determined by prudential regulatory requirements.

AFMA has proposed an assumption that the assets necessarily held to satisfy regulatory requirements would have sufficient nexus to the Australian operations for the purposes of determining deductibility particularly in circumstances where an ADI satisfies the requirements of Prudential Standard APS 210 Liquidity (APS 210).

At paragraph 18 of the Discussion Paper, it is stated that adherence to a prudential regulatory framework is informative when considering nexus, but is not necessarily determinative that the requisite nexus is satisfied. In reviewing the deductibility of liquidity charges of an ADI, the ATO will take into consideration whether or not the relevant assets are held consistent with the requirements of APS 210. For example, a liquidity model which satisfies APS 210 could still present one or more of the red flags detailed in the Discussion Paper and would therefore be considered to be at 'high risk' of not being deductible.

It is also noted that prudential regulatory requirements are regularly reviewed and, from time to time, may be changed by the regulator. To keep the Discussion Paper contemporaneous in future years, the ATO has limited reference to specific regulatory requirements and focussed on the taxation principles which underpin the deductibility of intra-group charges.

Distinction from existing guidance

AFMA is of the view that the Discussion Paper is inconsistent with the ATO view in the following advice and guidance products:

•

TR 2001/11 Income tax: international transfer pricing - operation of Australia's permanent establishment attribution rules

•

TR 2005/11 Income tax: branch funding for multinational banks

•

PCG 2017/8 Income tax - the use of internal derivatives by multinational banks

The ATO does not agree that the material contained in the Discussion Paper is inconsistent with the views expressed in the guidance products referred to.

TR 2001/11 states that amounts attributable to a PE are the actual income and expenditure, not notional or deemed income or expenditure.^[1] However, it is noted in paragraph 5.1, that, 'notional transfer prices calculated in accordance with the arm's length separate enterprise principle can be taken into account' when allocating income and expenditure.

In considering the tax issues related to the funding of a permanent establishment of a multinational bank, TR 2005/11 follows the principles set out in TR 2001/11 in regards to trading stock,^[2] acknowledging the difficulties in tracing funds to determine the relevant actual third party income or expenses to be attributed. The ATO's practice is to:

accept the allocation of income and expenses on the basis of the transfers in a bank's accounts prepared on a separate entity basis rather than allocating the actual third party income and expense. This is on the proviso that the accounts have been properly prepared and the allocation or attribution outcomes are the best estimate of branch profits that can be made in the circumstances.^[3]

PCG 2017/8 takes a similar approach, providing guidance on the circumstances in which the ATO will accept the outcomes from internal derivatives by multinational banks. A low complexity transaction must relate to and closely mirror the terms of an actual third party derivative.

Similarly, in the Discussion Paper it is noted that liquidity adjustments may be deductible where they represent a reasonable allocation of actual third party income and expenses incurred by the bank, or are otherwise a reasonable proxy for such amounts.

However, the red flag scenarios identified in the Discussion Paper address liquidity costs that are charged to the branch on a basis other than an allocation of the actual third party income and expenses incurred by the head office. The red flag scenarios instead feature liquidity costs that are based on internal inputs, hypothetical constructs or based on estimates or modelling. While these amounts may be what the bank's accounts reflect, these would not be considered to be the 'best estimate' of the actual liquidity costs, and the principles set out in TR 2001/11 and TR 2005/11, even if extended to liquidity charges, would not apply.

The Discussion Paper states, at paragraph 44:

Where a liquidity framework displays one or more red flags, then the Commissioner will require a significant level of analysis and documentary evidence to be satisfied that the resulting liquidity charges are a reasonable proxy for assessable or deductible amounts. Given the fungible nature of liquidity and liquid assets, the presence of one or more red flags means that the liquidity charges are unlikely to be deductible.

Instead, a claim for a deduction for liquidity costs would need to be based upon the general principles of deductibility and profit attribution.^[4]

Tracing

As stated in paragraph 18 of TR 2005/11:

The nature of the business of a bank means that it is not ordinarily practicable or possible to trace either the source or end use of funds transferred between branches such that the entity's actual third party income or expense associated with those funds can be allocated or attributed between branches.

Similarly, paragraph 57 of the Discussion Paper recognises that 'in a complex banking business it is not always possible or feasible to quantify all costs directly, and that some costs can only be quantified by estimation or modelling.'

The focus, instead, is on ensuring that any estimated or modelled costs are a reasonable proxy for those actual third party expenses, as set out in paragraph 58 of the Discussion Paper. In compliance work undertaken to date, the ATO has not yet reviewed a liquidity model which would produce an output that satisfies the requirement of being a reasonable proxy for actual third party expenses.

5. Reasons for not progressing from a discussion paper to formal public guidance

The ATO has considered the proposal by industry for formal guidance to be published on the deductibility of liquidity charges. However, following our consultation on this issue, we have determined that this issue does not warrant further public guidance.

We consider that the relevant legal principles are sufficiently explained in the existing ATO IDs. Given the diverse range of models implemented to manage liquidity risk, it would not be possible to publish detailed guidance on the application of the law to each of the various potential approaches.

The ATO has also observed a trend towards self-funding models and a decline in the number of branches allocated a separate intra-group charge for liquidity management. This has the practical effect of reducing the circumstances in which guidance is required on the deductibility of the funding costs associated with liquidity risk management.

Further, as noted above, the Commissioner has yet to review a centralised liquidity management model which uses a reasonable proxy for allocating actual expenses such that the liquidity charges could satisfy the requirements for deductibility (i.e. a centralised "green zone" model). During consultation, AFMA put forward two models described as centralised "green zone" models. The ATO considers that these models are similar to examples detailed in the Discussion Paper, and as such would still need to be evaluated having regard to all the matters set out in the Discussion Paper.

6. Summary of position

The Commissioner's view in relation to liquidity charges is outlined in the ATO IDs and the Discussion Paper.

The following legal principles have been stated in the ATO IDs:

•

A foreign bank branch cannot deduct an internal estimate of a notional funding cost (ATO ID 2012/90);

•

A net amount (excess of interest expense over asset income) cannot be the loss or outgoing under section 8-1 of the ITAA 1997 (ATO ID 2012/91); and,

•

Interest expense incurred on funding the bank's general reserve liquid assets, managed and controlled for use outside Australia, is not deductible by the Australian branch to due insufficient nexus with the Australian business (ATO ID 2012/92).

In the Discussion Paper the Commissioner acknowledges that amounts equivalent to a liquidity charge may be deductible to an Australian permanent establishment where the charge represents a reasonable allocation of actual third party expenses, or a reasonable proxy for such expenses.

However, the existence of red flags would indicate that the liquidity adjustments are at high risk of not being a reasonable allocation of, or a reasonable proxy for, actual third party income and expenses (refer to Appendix 1 on page 18 for summary of red flags).

7. Reliance on Discussion Paper

The Discussion Paper was prepared for the purpose of setting out and consulting on the ATO's expectations regarding the factors which must be present for liquidity management costs to be deductible. It is not formal public advice or guidance and does not represent a binding ATO view. However, it does contain factors that the ATO may consider in determining the deductibility of intra-entity charges in relation to liquidity management. As such, banks are encouraged to have regard to the matters addressed in the Discussion Paper in determining the deductibility of intra-entity liquidity charges and the ATO's expectations regarding supporting documentation.

The 'red flags' listed in the Discussion Paper are not exhaustive, but rather reflect the concerns identified in the liquidity management models observed by the ATO to date. The ATO may, in the future, identify additional factors that give rise to 'red flags' as liquidity models change.

As liquidity models are unique across the industry, any concerns with a specific model need to be considered on a case by case basis. AFMA members who would like to discuss their specific circumstances or have any queries regarding this letter should contact James Campbell on (02) 9374 8867.

Yours sincerely

Rebecca Saint
Deputy Commissioner of Taxation
Per James Campbell

References

File

Legislative References:
ITAA 1997
ITAA 1997 6-5
ITAA 1997 8-1
ITAA 1997 Subdiv 815-B
ITAA 1997 Subdiv 815-C
ITAA 1997 815-225(3)
Banking Act 1959

Case References:
Max Factor & Co v Federal Commissioner of Taxation
84 ATC 4060
15 ATR 231

Other References:
ATO ID 2012/90
ATO ID 2012/91
ATO ID 2012/92
TR 2001/11
TR 2005/11
APRA, 2014, Prudential Standard APS 210 Liquidity
Bank of International Settlements, 2013, Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, Basel Committee on Banking Supervision, Basel.
Bank of International Settlements, 2014, Basel III: the net stable funding ratio, Basel Committee on Banking Supervision, Basel.