US embassy cable - 05ANKARA4494

UNCLAS SECTION 01 OF 04 ANKARA 004494 
 
SIPDIS 
 
DEPT FOR EB/OMA AND EUR/SE 
TREASURY FOR CPLANTIER 
 
SENSITIVE BUT UNCLASSIFIED 
 
E.O. 12958: N/A 
TAGS: EFIN, EINV, BEXP, TU 
SUBJECT: FOREIGN PORTFOLIO INVESTORS FIGHT WITHHOLDING TAX 
ON FINANCIAL INSTRUMENTS 
 
 
1.(U)Summary: The Turkish Parliament approved a tax bill at 
the end of 2004, which introduced a withholding tax of 15 
percent on all gains on all financial instruments, including 
equities and fixed income securities.  The law comes into 
effect as of January 1, 2006. The law is designed to 
increase tax revenue and both to level the playing field 
between foreign and domestic investors and between different 
types of financial instruments.  As the implementation date 
approaches, with some uncertainty over the law's 
application, it has become increasingly controversial, with 
major international investment banks, many of them U.S.- 
headquartered, trying to convince the GOT that the law as 
written discriminates against foreign investors, will damage 
the derivatives market, is unworkable, and could disrupt the 
market.  Turkish Treasury seems to be sympathetic to some-- 
but not all-- the investors' complaints but needs to 
convince a recalcitrant Finance Ministry.  Investors have 
tried to draw in the IMF, but the Fund seems disinclined to 
get heavily involved.  End Summary. 
 
International Investment Banks Press the GOT: 
--------------------------------------------- 
 
2. (SBU) The Turkish Parliament adopted a bill in December 
2004 to introduce a 15 percent withholding tax on income 
from all financial instruments.  For the first time, 
government securities will be taxed.  The tax will become 
effective as of January 1, 2006. The law's passage was not 
widely-noticed at first-there was negligible press coverage 
and Embassy Ankara only began to hear about the issue in 
June from visiting foreign bankers.  According to London- 
based investment bankers such as Credit Suisse First Boston, 
Lehman Brothers and Merrill Lynch, the GOT consulted the 
financial community at an early stage but relied on banks 
with a local presence.  Though foreign banks with local 
presence, such as Citigroup, were included, the interests of 
the other major international banks, who represent the bulk 
of the foreign portfolio investors were not taken into 
consideration.  The visiting international bankers claim 
that Citibank, as the leading custodian bank, was mainly 
interested in avoiding having  responsibility for collection 
of the tax being placed on the custodial institution. 
 
3. (SBU) Since June, the major international banks, many of 
them with headquarters in the U.S., have been visiting 
Ankara frequently and pressing the GOT to take their 
concerns into account, even while trying to enlist IMF and 
U.S. Government support.   The CSFB and Lehman Brothers 
bankers pointed out to econoff that out of some $20 billion 
of foreign investor holdings in Turkish financial markets, 
they estimate that 40 or 50% ultimately come from U.S. 
investors, whether wealthy individuals, pension funds, hedge 
funds, or financial institutions. 
 
Treasury Listening to Investors: 
------------------------------ 
 
4. (SBU) To the GOT's credit, when the foreign banks 
ratcheted up their complaints, Turkish Treasury and the Tax 
Administration (under the Ministry of Finance) met with the 
bankers and allowed them to make their case.  Though the Tax 
Administration proposed the tax and has the lead on tax 
policy, Turkish Treasury has long been careful not to have 
the GOT take actions that could disrupt the market.  Though 
Turkey's financial vulnerabilities have come down 
substantially over the past two years, Treasury still has to 
roll over billions of dollars of short-dated securities 
every month. The Tax Administration, on the other hand, is 
driven by a desire to capture more tax revenue, and to have 
a coherent tax policy that taxes all financial instruments 
equally.  As such, it reportedly has not been sympathetic to 
the bankers' arguments. 
 
Is the Tax Discriminatory? 
------------------------- 
 
5. (SBU) The international bankers assert that the law will 
have a greater impact on foreign investors than on local 
investors. If the law will be put into application as 
currently drafted, it requires a retrospective taxing on the 
gains of fixed income securities issued prior to January 1, 
2006 for foreigners and/or foreign investment banks. 
Accordingly, the tax will be levied on fixed income 
securities with no offsets for losses, funding or 
administrative costs. 
 
6. (SBU) The foreign banks also claim that even if the new 
legislation avoids double taxation of foreign investment in 
equities, there is a risk of double taxation of fixed income 
securities.  Some press reports claim that the Finance 
Ministry (MoF) opposes exempting foreign investors from the 
withholding tax, but there have been repeated press reports 
that the GOT might decrease the rate to 10 percent from 15 
percent for all investors as the 2006 draft Budget is 
finalized on October 17.  On August 2, however, the 
financial daily Referans reported that Minister Unakitan has 
rejected any lowering of the tax rate.  Turkish Treasury 
Deputy Director General Volkan Taskin told econoff and econ 
specialist that the GOT was also working on an amendment to 
prevent discriminatory application against foreign investors 
and may decide to apply the withholding tax only on the 
instruments issued as of January 1, 2006 for all investors. 
The MoF is expected to reach at a decision on the issue this 
week. 
 
7. (SBU) The allegation of discriminatory treatment relies 
principally on the question of the applicability of double 
taxation agreements. The new law will actually replace the 
financial instruments tax law adopted in 1999, and aims at 
bringing a single tax rate to all financial instruments, 
including bank deposits, in Turkey.  Turkey has double 
taxation agreement with 60 countries, including Netherlands, 
Britain, France, Germany, Italy, and the U.S.  The agreement 
already regulates taxing of gains on securities in the 
source state. The agreed rates range from 10 to 25 percent 
depending on the country. For example the rate is 10 percent 
on interest gains with the U.S. and 15 percent with the U.K. 
 
8. (SBU) London's leading investment banks submitted a joint 
report to Minister State Babacan on July 6 explaining the 
concerns of foreigners on these developments. In the report, 
bankers highlighted the following aspects of the law: 
 
-- Differentiation in the treatment between local and 
foreign participants.  Local investors would appear to have 
greater scope to deduct the new tax, whereas in certain 
situations-such as when there is a group loss-foreign 
investors might not be able to deduct the tax.  Moreover, 
according to the foreign bankers, there is a considerable 
confusion and misunderstanding with respect to the different 
tax treatment of securities issued earlier and held as of 
December 31, 2005 with respect to different classes of 
investors. 
 
-- Availability of Double Tax Treaty benefits: The law 
causes uncertainty regarding the applicability of Double Tax 
Treaties to foreign investors holding t-bills.  In most 
markets, Double Tax Treaties would exempt relevant foreign 
investors from local tax, which is not always the case under 
Turkey's double taxation treaties.  One key issue is whether 
government securities are considered "listed securities," 
which is necessary for them to be covered by double-taxation 
treaties. Currently, there are different interpretations: 
with Treasury asserting government securities are listed and 
MoF disagreeing. 
 
-- Risk of Limiting development of the derivatives market: 
Uncertainty of withholdings on underlying instruments will 
limit the development of the derivatives market. 
 
--   Application of the new law: Neither investors, 
intermediaries nor custodians will be able to administer the 
draft law effectively, and the market will be affected by 
uncertainty and excessive compliance cost. 
 
-- For all these reasons, the banks assert there is a risk 
of market disruption, as foreign investors reduce their 
holdings. They also point out that foreign investors played 
a critical role in Turkish Treasury's recent success in 
issuing longer-dated securities, extending the yield curve 
with three- and five-year issues. 
 
Treasury Generally Sympathetic: 
------------------------------ 
 
9. (SBU) Econoff and Econ specialist met with Volkan Taskin, 
DDG of the Public Finance Department of the Turkish 
Treasury, which is the office managing the Turkish state's 
domestic borrowing. According to Taskin, Treasury never 
favored taxing any financial instruments, but it the MoF had 
insisted on the law to increase its revenue collection. 
Capital Markets Board Chairman Dogan Cansizlar also told us 
he had opposed the new law, preferring a smaller transaction 
tax, an idea the foreign bankers told us they would be more 
amenable to.  The business daily Referans reports that the 
MoF estimates it will collect an additional 5.7 billion YTL 
(about $4.2 billion).  Taskin also noted that this law will 
enable Turkish authorities to track the investors who are 
investing in Turkish securities. According to Taskin, the 
new law actually brings benefits to custodians since it will 
reduce the 30 percent tax rate on their gains to 15 percent, 
but will be negative for foreign investors and 
intermediaries.  Taskin agrees that current double taxation 
treaties do not adequately address the issue.  Taskin also 
expects some sell-offs towards end of the year because of 
the tax's effect on government securities, but could not 
estimate the real impact and how much rates may increase as 
a result of this tax.  He also agrees that the new 
arrangement will require banks, intermediaries to rearrange 
their accounting systems, and will bring an additional IT 
cost. 
 
10. (SBU) Econoff also heard through an IFI official that 
Treasury Under Secretary Ibrahim Canakci, who sat through 
several long meetings with the foreign bankers, is 
sympathetic to some-but not all-of the foreign bankers' 
complaints.  For example, he is unsympathetic to the 
bankers' allegations that tracking and administering the tax 
is impossibly expensive, an allegation that one Turkish 
investment banker also made to econoff.  Taskin and, 
reportedly, Canakci, see the need to make government 
securities unambiguously subject to double-taxation treaties 
by specifying that they are "listed securities." Taskin even 
asserted Treasury would and could do this with or without 
the Tax Adminstration's agreement.   The IMF Resrep told 
econoff that by making the securities listed, the foreign 
investors' problems would largely be solved. 
 
Local Banks Begin to Complain: 
----------------------------- 
 
11. (SBU) On July 29, the local financial press began to 
report that local banks had become alarmed about the tax and 
had met with bank regulators and GOT officials to express 
their concern. According to the press reports bankers had a 
meeting with MoF officials this week, but could not convince 
the officials about negative implications of the withholding 
tax. Bankers met with e BRSA (Bank Regulation and 
Supervision Agency) July 29, and reportedly asserted that 
the 15 percent withholding tax will also lead to an increase 
in banking costs. Bankers mainly focus their complaints on 
the withholding tax to be applied on financial derivatives, 
like swaps. Turkish banks, that have recently increased 
borrowing from foreign banks through syndicated foreign 
exchange-denominated loans, hedge themselves through swap 
operations.  This complaint echoes the foreign banks' fears 
of the impact on derivatives: the foreign bankers explained 
to econoff they market complex structures such as "total 
return swaps" which could unravel if the underlying 
securities start to be taxed. 
 
How Disruptive? 
-------------- 
 
12. (SBU) The local bankers are also reportedly concerned 
about the potential outflow of foreign portfolio investors, 
many of whom hold Turkish bank deposits, in addition to 
government securities and equities.   In the equity market, 
foreigners are widely-considered to hold roughly 60% of the 
free float on the Istanbul Stock Exchange.  Some analysts 
comment that 21 percent of Turkey's traded domestic debt is 
held by foreign investors. According to Turkish Treasury DDG 
Volkan Taskin, this amount can go up to 55- 60 percent from 
time to time. 
 
13. (SBU) Clearly, foreign investors play a critical, even 
dominant, role in Turkish financial markets and in financing 
Turkey's yawning current account deficit.  The key question, 
then, is whether the foreigners would really pull out if the 
tax is not made more foreign-investor friendly.  It would 
appear that efforts to list and other doable changes make a 
major market disruption unlikely. 
 
14. (SBU) The IMF seems to be of this view, given its 
apparent reluctance to get too involved.  When econoff 
raised the issue with the Resrep he seemed disinclined for 
the Fund to get too involved, preferring to let Treasury 
work things out with investors.  The Fund has grudgingly 
agreed to have its tax mission take a look at the issue, but 
he said it will only have limited time to spend on the 
matter. 
 
15. (SBU) If, on the other hand, the confusion over 
government securities being listed is not cleared up, and/or 
the foreign banks are correct about the tax being 
unworkable, there could be disruption, particularly if 
combined with significant market-unfriendly news flow over 
the IMF and EU, or a reduction in global liquidity.  While a 
small correction would actually be desirable, since foreign 
investors pulling out would disproportionately affect the 
foreign exchange market and correct the overvalued lira, a 
large correction would be highly disruptive. 
 
 
 
McEldowney