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Cablegate: Foreign Portfolio Investors Fight Withholding Tax

This record is a partial extract of the original cable. The full text of the original cable is not available.

030819Z Aug 05





E.O. 12958: N/A

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.

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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

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

-- 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

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

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.


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