NEW TAXATION RULES ON TSE SECURITIES BORROWING AND LENDING

01/01/2005

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In an interpretation dated 16 September 2003, the Ministry of Finance set out various taxation rules relating to the securities borrowing and lending (SBL) system then newly introduced by the Taiwan Stock Exchange Corporation (TSE) for participation by specific corporate entities. However, the interpretation covered only the following matters:

Whether securities transaction tax or income tax liability arises at the time of the lending or return of securities.

Whether securities transaction tax liability arises when loan collateral is disposed of by the TSEC or by a securities lender after default by a borrower.

Whether income tax liability arises on substitute payments made by a borrower to compensate a lender for income generated by the borrowed shares during the life of the loan.

However, the tax issues relevant to the SBL transactions go well beyond the above three ar-eas. Moreover, in the above interpretation the MOF appeared to consider only domestic enti-ties' participation in the SBL transactions, and did not touch upon participation by foreign enti-ties. Since many foreign institutional investors are interested in SBL transactions through the TSE, there is a need for clarification of the relevant tax implications. Acting on behalf of a foreign client, Lee and Li requested the MOF to clarify various tax issues concerning the SBL transactions in Taiwan. The MOF responded with a legal interpretation dated 9 November 2004. The content is summarized below:

Issues of business tax and income tax in con-nection with stock lending fees charged by lender

1.Business tax:

Pursuant to Article 1 of Business Tax Act, business tax is levied on the sale of goods or services in Taiwan. According to sub-paragraph 2, Article 3 of the same law, Sale of services is defined as supply of services to others or the provision of goods for the use of others for a consideration. The SBL transaction entails an act where a lender agrees to loan the securities to a borrower and the borrower is obliged to return to the lender securities of the same class and volume, which is consumption lending in nature. Therefore the lending fees paid by the borrower to the lender is a consideration charged by the lender for the provision of securities for use by the bor-rower. It constitutes an act of sale of ser-vice by the lender, on which the lender should pay business tax according to law. With respect to the filing of business tax return, if the lender has a fixed place of business in Taiwan, the fixed place of business should issue a uniform invoice according to the stipulated time limit, or in ten (10) days after the buyer of service settles the exchange in the case where the fixed place of business did not handle the consideration for sale of service, and file tax return as required. If the lender does not have a fixed place of business in Tai-wan, the borrower should pay business tax according to the first paragraph, Article 36 of Business Tax Act, unless the borrower is a business entity as described in Section 1 of Chapter 4 who purchases goods or services used solely in the conduct of business in taxable goods or services.

2.Income tax:

Stock lending fees are income generated from securities lending inside the ROC, and thus, income derived from sources in the Republic of China under Article 8 of the Income Tax Act and subject to busi-ness (profit-seeking) income tax according to Article 3 of the same law.

Issues of business tax and income tax in con-nection with manufactured dividends (cash and securities dividends) paid by the borrower to the lender

1.Business tax:

According to Section 3 of the MOF ruling dated September 16, 2003 (Ref. No. Tai-Cai-Shui-Zi-0920454057), manufactured dividends paid by the borrower to the lender are compensatory in nature, which are not dividend income, but consideration received by the lender for the sale of service (lending the securities to the borrower), on which, the lender should pay business tax as required by law. With respect to the filing of business tax return, the same procedures as mentioned before also apply.

2.Income tax:

According to Section 3 (3) of the MOF ruling dated September 16, 2003 (Ref. No. Tai-Cai-Shui-Zi-0920454057), manufac-tured dividends, whether paid in cash or by stocks, are considered other income of the lender. The borrowed securities are properties in Taiwan. Since dividends and bonuses not received by the lender due to an SBL transaction need to be returned by the borrower, and are considered income from securities lending in Taiwan, such income is income derived from sources in the Republic of China under Article 8 of the Income Tax Law and subject to busi-ness (profit seeking enterprise) income tax according to Article 3 of the same law.

3.Rules on recognition of manufactured dividends:

(1)Fixed-price and competitive-auction transaction

Pursuant to Article 35 of the TSE Securities Lending and Borrowing Regulations (the "SBL Regulations"), the return of dividend, bonus or other benefits by borrower which were not received by the lender in fixed-price transaction or competitive- auction transaction due to the lending of securities should be effected in the following manner:

(a)Cash dividend:

The borrower must deposit, via a securities firm, the cash into the bank account designated by TSE on the distribution date, and key in via the securities firm the TSE securities borrowing system for confirmation. The TSE will transfer the securities via the se-curities firm to the lender on the same day or on the following business day. As such, the manufactured dividends received by the lender should be based on the amount distributed to the borrower on the date the cash dividend is distributed.

(b)Securities dividend:

The TSE will notify, via the securities firm, the lender after the ex dividend date, to choose the return of securities dividends by securities or cash in equivalent value. If the lender fails to indi-cate preference before a given date, the TSE will return the securities. In case of return of securities, the borrower must, within 3 business days after the distribution date, notify the Securities Central Depository Enterprise via the securities firm through the securities borrowing system of TSE to transfer to the lender through book-entry from the central depository account of the borrower. In case of return of cash in equivalent value, the amount should be calculated based on the "ex-dividend refer-ence price" [closing price on the trading day before the ex-right date / (1 + stock dividend ratio)] and returned on the distribution date. As such, the manufactured dividends paid by borrower to lender on securities borrowed should be the actual amount re-turned by the borrower if the lender elects return by cash in equivalent value, or the "ex-dividend reference price" if the lender elects return by securi-ties.

(2)Negotiated transaction

Pursuant to Article 38 of the SBL Regulations, the return of dividend, bonus or other benefits by borrower which were not received by the lender in negotiated transaction due to the lending of securities should be nego-tiated and determined by the lender and the borrower as follows:

(a)Cash dividend:

Manufactured dividends are cal-culated based on the actual amount paid by the borrower to the lender.

(b)Securities dividend:

In light of the fact that manufactured dividend paid in the form of stock are TSE listed or OTC-traded stocks, their valuation is the same, that is, based on the ex-dividend reference price regardless whether the transaction is a fixed-price, competitive- auction or negotiated transaction.

Business tax and income tax in connection with dividends on the collaterals provided by the borrower

1.Business tax:

Dividends on the collateral provided by the borrower during the lending period are dividend income of the borrower, not consideration received by the borrower for sale of goods or service, and hence, not subject to business tax.

2.Income tax:

According to Paragraph 5.1 of the Guide-lines for Administration of Collaterals for Transactions of Fixed-Price Transaction and Competitive-Auction Transaction of Securities Lending promulgated by TSE on June 13, 2003, TSE only handles the transfer and distribution of dividends arising from the securities provided by the borrower as collateral, and such dividends are deemed the dividend income of bor-rower, not the income of the lender or the TSE. In the case of negotiated transaction, if the borrower pledges stocks as collateral to the lender, the beneficiary of the stock dividends derived from the pledged stocks is the shareholder (the pledgor) according to MOF letter issued on August 20, 1975 (Ref. No. Tai-Cai-Shui-36048). Thus the borrower (the pledgor) is the recipient of the dividends. As such, the dividends on stocks provided by the borrower as col-lateral should be treated as income of the borrower, regardless whether the transac-tion is a fixed-price, competitive-auction or negotiated transaction.

Business tax and income tax in connection with interest earned on cash collateral pro-vided by the borrower

1.Business tax:

Interest earned on cash collateral provided by the borrower or interest paid by TSE during the lending period that is returned to the borrower by the lender is not con-sideration for sale of goods or service by the lender and hence not subject to busi-ness tax. However in reference to the in-tent of MOF letters dated November 20, 1992 (Ref. No. Tai-Cai-Shui-811676144) and March 30, 1993 (Ref. No. Tai-Cai-Shui-821480043), such interest is subject to business tax according to Article 1 of Business Tax Act if the borrower is in the banking or investment trust business.

2.Income tax:

(1)Fixed-price and competitive-auction transaction

According to Paragraph 5.2 of the Guidelines and Article 34 of the SBL Regulations, TSE should pay interest on the cash collaterals provided by the borrower based on the interest rate of the saving deposit account of the bank where TSE opened such an account. Such interest income is income from sources in the Republic of China under Article 8.4 of the Income Tax Act and subject to business (profit seeking enterprise) income tax according to Article 3 of the same law.

(2)Negotiated transaction

According to Article 37 of the SBL Regulations, the terms and conditions for the collaterals, stipulated collateral ratio, collateral maintenance ratio, minimum collateral ratio, and the manner of transfer of collaterals of a negotiated transaction should be de-termined through negotiation by the lender and the borrower. Thus the interest paid on cash collateral of the borrower by the lender according to the agreed rate is considered interest income of the borrower from sources in the Republic of China under Article 8.4 of the Income Tax Act and subject to business (profit seeking enterprise) income tax according to Article 3 of the same law.

Business tax and income tax in connection with pay received by an agent of the lender or borrower for handling the transaction

It is a common practice in the international market that an insurance company or an in-stitutional investor interested in participating in securities lending and borrowing will ap-point a domestic or foreign firm as agent to negotiate the terms of the securities loan on their behalf, sign necessary documents and execute the transaction. The agent (domestic or foreign) will receive a pay for the service rendered.

1.Business tax:

Pay received by an agent for handling the loan transaction on behalf of the lender or borrower is consideration received by the agent for the sale of service, and subject to business tax if the place where the service is provided or utilized in Taiwan. With respect to the filing of business tax return, the same procedures as mentioned above also apply.

2.Income tax:

The act of an agent (whether its head of-fice is located in or outside the Republic of China) handling SBL transactions on be-half of the lender or borrower is conducted both inside and outside Taiwan. Its scope of business under the SBL Regulations includes entering a letter of entrustment for securities lending and borrowing transaction with a local securities firm entrusting the securities firm to handle SBL transactions and provide collateral; in case of negotiated transaction, entering a contract of negotiated securities borrow-ing transaction with the counterparty and filing with a securities firm for concluded transactions; and handling default and reporting to TSE with regard to the han-dling of default. Thus the pay received by an agent for performing the aforesaid ser-vices is income from sources in the Re-public of China under Article 8 of the In-come Tax Act and subject to business (profit seeking enterprise) income tax ac-cording to Article 3 of the same law.

Tax withholding and filing of tax return on income received by lender, borrower and agent

1.Withholding

Income received by the lender, borrower or agent in connection with a SBL trans-action from a business entity having fixed place of business in Taiwan is subject to tax withholding according to Article 88.1(1) and 88.1(2) of Income Tax Act and handled according to the third para-graph of Article 89 of the same law.

2.Manner of filing tax return:

(1)If the head office of a taxpayer is in Taiwan, the taxpayer should file an annual tax return on gross profit-seeking income according to Article 71 of Income Tax Act.

(2) If the head office of a taxpayer is out-side Taiwan:

(a)The taxpayer has a fixed place of business or a business agent in Taiwan:

According to Article 41, 71, and 73 of Income Tax Act, the busi-ness entity or business agent should set up a separate book for the taxpayer, compute the tax-payer's profit-seeking income, and file the tax return.

(b)The taxpayer does not have a fixed place of business, nor a business agent inside Taiwan:

For payment received by such taxpayer from a profit-seeking enterprise having a fixed place of business in Taiwan that is subject to profit-seeking income tax, the tax withholder (payer) should withhold tax at the time of payment per the prescribed tax rate according to the first paragraph, Article 88 of Income Tax Act and Article 3 of Income Tax Withholding Standards. For payment received by such taxpayer from a profit-seeking enterprise not having a fixed place of business in Taiwan, the taxpayer should, after receiving approval from the tax authority, appoint an individual residing in Taiwan or a business entity having a fixed place of business in Taiwan as agent to handle in-come reporting and filing tax return on its behalf according to the first paragraph, Article 73 of Income Tax Act and the second paragraph, Article 60 of the Enforcement Rules for Income Tax Act.

Whether written documents made under the SBL system are subject to stamp tax?

Pursuant to Article 5 of Stamp Tax Act, types of documents subject to the levy of stamp tax include receipts for monetary payment, deeds for sale of movable properties, contracting agreement, contract for sale, transfer or parti-tion of real estate. The conclusion of a letter of entrustment for securities lending and bor-rowing transaction between the lender or borrower and securities firm and the conclu-sion of a contract of negotiated securities borrowing transaction between the lender and the borrower under the SBL system do not fall within the scope of taxation described above.