Accounting & Tax Issues in Developing the Malaysian ABS Market - A Regulator’s Perspective

Workshop on the Rise of Securitization in East Asia 7 – 9 November 2005 Accounting & Tax Issues in Developing the Malaysian ABS Market - A Regulator’s Perspective Wong Sau Ngan SECURITIES COMMISSION, MALAYSIA Shanghai 8 November 2005

Agenda Overview of ABS market in Malaysia Accounting matters Impediments & Issues Initiatives taken Tax matters Impediments & Issues Initiatives taken Moving forward 2

Efforts to develop ABS market in Malaysia accelerated after 1997 financial crisis Size of ABS market vs MGS and PDS • Prior to 2001, ABS market was non-existent due to a wide range of legal, regulatory, tax & accounting impediments • As at end-September 2005, 21 ABS have been issued, amounting to RM 17.76 billion (USD 4.75 billion equivalent) • However, size of ABS market is relatively small compared to MGS and PDS markets • More developmental initiatives required to further boost the ABS market

Accounting and Taxation treatments are crucial to ABS transactions Market Infrastructure Government Market Participants Legal & regulatory Issuer • Issuance of ABS into market Intermediaries • Facilitate issuance of ABS into market Accounting ABS Market Taxation Investors • Provide liquidity Regulators

Significance of accounting treatment for ABS transactions Benefit to originator in ABS transaction is possible off-balance sheet treatment for its asset transfers Why is it important to the originator? • Improve performance ratio • Reduce gearing • Fulfill capital adequacy requirements

Significance of tax treatment for ABS transactions Tax treatment impacts the viability of ABS transactions Why is it important to the originator and SPV? • Important for originator to determine tax impact of entering into ABS transactions • Crucial for SPV to budget its cash flows to meet its obligations which could otherwise be severely impacted by any unexpected tax charges

Lack of clarity on accounting treatment of ABS transactions 1. Criteria for “true sale” – the “off-balance sheet” issue relating to the transfer of assets from originator to SPV • Currently, most ABS transactions in Malaysia are “off-balance sheet” • IAS 39 – Financial Instruments: Recognition & Measurement took effect internationally from 1 January 2001 • Crux of the matter is whether the transfer of asset in an ABS transaction is a true sale, hence be taken off-balance sheet • Based on IAS 39, the sale will constitute a “true sale” if originator has surrendered its control over the asset and the transferee has obtained benefits of the transferred assets • Principle of “substance over form” approach

Lack of clarity on accounting treatment of ABS transactions (con’t) 2. Uncertainty on treatment of SPV by the originator SPV – to consolidate or not to consolidate? • Originators may have to consolidate SPV that they, in substance, “control” • There is a concern that the SPV would need to be consolidated with the originator, thereby defeating the purpose of derecognising the assets in the first place

Accounting issues have major implications on developing ABS market • Derecognition and consolidation rules • Introduce more stringent rules on the removal of assets from balance sheet of originator • Intended objective of transfer of assets from originator to SPV may not be achieved • Even if assets are taken off-balance sheet (derecognised), there is a possibility of consolidating the SPV at originator’s level, hence, bringing the assets back to the books of the originator • Fair value measurement for investments in ABS • Absence of consistent transacted prices and quotes • Difficulty is compounded by illiquid bond market • Reliability of valuation models • Significant implication to the ABS industry • Adverse impact on the development and growth of ABS market

SC’s role in ABS accounting issues • SC is represented on Malaysian Accounting Standards Board (MASB) and Working Group on IAS 39 • Ensure that interpretation of IAS 39 is in line with international practice to provide clarity and certainty to market practitioners • Promote discussion and debate with the view to enhance awareness of ABS structures that are allowed under SC’s ABS Guidelines from the structures seen in the financial debacles • Active engagement with accounting practitioners, particularly, top 4 accounting firms in providing SC’s development perspectives on ABS transactions • Strike balance between extent to which risks, rewards & control over securitised assets have been transferred resulting in a transaction being deemed as off-balance-sheet vs. on-balance-sheet

Malaysia has adopted IAS 39 • The adoption follows the approval recently by MASB of IAS 39, known as FRS 139 in Malaysia • Adopted after five years of lengthy deliberation involving major constituents such as bankers, auditors, investment analysts, professional bodies, the unit trust industry and insurance industry & consultation process with the public • Takes into account various changes to IAS 39 by IASB over the years, as well as the ongoing changes • FRS 139 is part of MASB’s plans to issue 21 financial reporting standards in Malaysia in the current year to serve the investing community better through greater transparency in financial reporting • In view of the far reaching implications on companies, companies are encouraged to get ready for FRS 139’s implementation on 1 January 2006

Lack of certainty on tax treatment of ABS transactions Issues ABS Sale of asset Originator SPV Investors Issues • How would originator be taxed on sale of asset? • How would SPV be taxed? • Implications of transaction taxes (e.g RPGT, Stamp Duty & Service tax)? • Tax implication for investors? Lack of specific tax legislation that deals with securitisation • Case-by-case approach according to specific facts and circumstances by reference to existing general tax legislation and practices give rise to tax uncertainties

Tax issues for originator • How would proceeds of originator from sale of assets be taxed? • Tax upfront; or • Taxable over tenure of ABS • Could the disposal price of asset transferred be challenged? • Uncertainty as to how the disposal price should be determined and what should be the consequential gain or loss on the sale of assets by the originator • Are costs associated with the asset transfer deductible? • If answer is affirmative, there is a need to determine the timing of deduction • Will the transfer be subject to transaction taxes (e.g stamp duty and RPGT)? • Would service fee received by the originator from SPV be subject to service tax? • Need for tax certainty and clarity for ABS transactions • Need to reduce tax cost of ABS transactions • Consider exemptions from transaction taxes

Tax issues for SPV • Basis of taxation • Uncertainty on the tax status of the SPV in terms of whether it is considered carrying on a business or an investment holding company Carrying on a business • enjoys maximum tax deduction Investment holding company • subject to restrictions on deductibility of expenses • Given the bankruptcy remote status of the SPV, the tax burden of an SPV arising from ABS transactions should be kept to a minimum • This objective would not be accomplished if the SPV is considered to be an investment holding company as it attracts a significant tax burden for the SPV

Tax issues for investors • Tax treatment of interest received on ABS issued by the SPV • Witholding tax implication of interest paid to non-residents Tax incentives required to encourage investment in ABS

Tax Neutral Framework for Originators & SPV The Government has proposed in Budget 2004 that ABS be given equal tax treatment as other conventional securities to promote issuance of ABS as a means of cost-efficient fund-raising • Established a set of specific tax treatment based on the principle of tax neutrality between ABS and other private debt securities to ensure tax neutrality and tax certainty for ABS transactions • E.g Proceeds and capital charge arising from transfer of receivables and assets respectively between the originator and the SPV would be spread out over the securitisation period, rather than charged upfront • Tax deduction is granted to expenses incurred in the issuance of ABS for a period of 5 years • Payment received by the servicers of the assets is deemed exempted from service tax under the Service Tax Act 1975 • Originator and SPV not to be over-burdened by additional tax • Clarification on treatment on income and expenses by originator and SPV • Specific tax treatment based on the principle of tax neutrality

Tax incentives for Originator and SPV • Stamp Duty (Exemption) (No.12) Order 2001 • Stamp Duty (Exemption) (No. 4) Order 2005 • Generally, all instruments (Conventional and Islamic) executed for the purpose of securitisation will be exempted from stamp duty • Real Property Gains Tax (Exemption) Order 2001 • RPGT exemption for the following disposals in a securitisation transaction approved by SC: • Disposals to purchase by SPV; and • Repurchase of the chargeable assets, to or in favour of the person from whom those assets were acquired

Tax incentives for investors Resident • Exemption of interest income received by individuals, close end funds and unit trust funds Non-resident • Blanket exemption from withholding tax granted by the Government with effect from 11 September 2004 • Interest income derived by non-residents from investments in RM-denominated Malaysian Government Securities (MGS) and corporate bonds is exempted from withholding tax

Malaysia’s experience in relation to accounting & tax issues on ABS transactions Accounting and tax issues and uncertainties impede securitisation transactions and hinder the development of the ABS market Consultations with industry bodies, accounting and tax practitioners, Malaysian Accounting Standards Board and Inland Revenue Board Formulate an efficient, facilitative and transparent accounting and tax framework for the ABS market

Next steps Accounting • SC is constantly engaging with industry bodies & MASB to provide greater certainty on the interpretation & application of IAS39 (e.g clarification on de-recognition of asset) Taxation • Educating tax authorities on ABS transactions and structures • Constantly engaging with industry participants, tax consultants and tax authorities to clarify uncertainties and ambiguity

Other related initiatives to develop ABS market Establishment of Bond Pricing Agency • Provides independent and objective fair value for ABS Financial Guarantee Insurer (FGI) • Credit enhancement from an external party for ABS deal • Without external credit enhancement from the FGI, issuers of ABS would depend on the costly over-collateralisation of assets to achieve higher credit rating • Helps originator transfer substantial risk and maintain off-balance sheet treatment

Thank you

Accounting & Tax Issues in Developing the Malaysian ABS Market - A Regulator’s Perspective