The FX market intervention of the Bank of Japan is evidence of Tokyo’s continued importance as a global financial hub. But is this position at risk? One indicator of foreign banking presence (arguably only a part of the story) is not positive. The number of employees at foreign financial institutions operating in Japan dropped nearly 17 percent between March 2008 and June 2010.
Additionally, low GDP growth forecasts and high corporate tax rates do not bode well for Japan’s continued status as a global financial hub. Multinational banks are focused on investments in emerging markets where estimated GDP growth (expected to exceed eight percent in China and India) are substantially higher than estimated Japanese GDP growth (optimistically forecast at two percent). At the same time, the corporate tax rates of Asia’s other two financial service hubs, Singapore (approximately 18 percent) and Hong Kong (approximately 16.5 percent), are markedly lower than the Japanese effective corporate tax rate (approximately 42 percent).
Are there new policies or changes to old policy that could reduce Japan’s disadvantage in competing for new banking sector investment? Senior Vice Minister of Finance Fumihiko Igarashi, who is steering debate at the government’s Tax Commission, noted recently that Prime Minister Naoto Kan has given instructions to his team to evaluate ways to reduce the effective corporate tax rate. Many believe this would spur private sector economic growth.
At another level, the Ministry of Finance could address inconsistent positions on the risk transfers, returns, and capital mobility held by financial service regulators and tax examiners. This inconsistency is on the minds of CFOs, regulatory reporting or compliance officers, and tax directors at banks involved in cross border businesses in Japan.
To illustrate, the capital requirements established by the Financial Services Agency (FSA) take into consideration certain types of market risk transfers, recognizing that a bank affiliate to which the market risk is transferred has the capital and legal obligation to assume such risk. This market risk transfer typically involves a Japanese affiliate of a bank entering into a trade (for example, selling an over-the-counter Japanese yen/U.S. dollar option) with a Japanese customer and entering into a mirror trade (continuing with the same example, buying a similar over-the-counter Japanese yen/U.S. dollar option) with an affiliate in another financial hub.
The FSA’s treatment of these types of market risk transfers is broadly in line with the treatment by financial service regulators in the U.S., UK, Hong Kong, and Singapore. These types of mirror trades and the centralization of market risk are at the core of Japanese and foreign banks’ cross border business models. The concentration of capital and global market risk in one affiliate and centralizing operational and risk management in the same affiliate are two major strategic goals of many multinational banks.
Where the FSA typically associates the risk and return on capital with the affiliate that has the necessary capital and the legal obligation to bear the market risk, the National Tax Agency (NTA) often associates risk and return on capital with the entity in which key business decisions are made. The result has been a number of very large, publicly disclosed tax disputes involving the NTA and the Internal Revenue Service or Her Majesty’s Revenue and Customs.
Against a background of tepid economic growth and a relatively high corporate tax rate, this conflicting treatment puts Japan at even more of a disadvantage in attracting new banking sector investment. Is there an opportunity for the NTA to establish a new position for the post financial crisis world?
There is such an opportunity and it involves listening to Japanese banks. Nomura Holdings is slowly and successfully integrating Lehman Brothers’ European and Asian franchises. The Bank of Tokyo-Mitsubishi UFJ has a strategic capital and business alliance with Morgan Stanley. Daiwa Capital Markets has acquired the global convertible bond and Asian equity derivatives businesses of Belgian financial services firm, KBC Group. Mizuho and Sumitomo Mitsui Banking Corporation are equally focused on investments in Hong Kong, Singapore, London, and New York operations.
This renewed focus on global expansion by Japanese banks makes consistency in how the FSA and NTA deal with market risk transfers a critically important issue for Japanese banks, where it may have been of marginal importance just a few years ago. Japanese banks’ need for clarity on the issue will hopefully contribute to a reconsideration of the pre-crisis NTA position on risk transfers, returns, and capital that may now be detrimental to Japan’s tax base.
In rethinking the issue, stakeholders and observers can only hope that the NTA’s views will gravitate towards the FSA’s for the sake of cross border banking in Japan and of Tokyo’s role as a global financial hub.
Samuel Gordon is the Director of International Tax Services/Financial Services Transfer Pricing at Ernst & Young ShinNihon Tax.
samuel.gordon@jp.ey.com
