NEW TURKISH WITHHOLDING TAX ROILS BROKERS AND

UNCLAS SECTION 01 OF 03 ISTANBUL 000392

SIPDIS

SENSITIVE
SIPDIS

TREASURY FOR CPLANTIER

E.O. 12958: N/A
TAGS: ECON EFIN TU
SUBJECT: NEW TURKISH WITHHOLDING TAX ROILS BROKERS AND
BANKS BUT HAS MINIMAL MARKET IMPACT



1. (SBU) Summary: Turkey's new 15 percent withholding tax on
capital gains and interest from government securities has had
little of the market impact that market players predicted
last year. A number of analysts profess surprise at how
limited the impact has been, with some noting that the
Treasury wisely reduced its rollover ratio at the same time
that it introduced the tax, thereby minimizing its impact.
Interest rates on government debt have risen slightly in
recent weeks, most analysts ascribed the increase to the
impact of increasing rates in the U.S. and other developed
countries on flows to emerging markets. The withholding
tax's impact on stock prices has also been minimal, with many
noting that the negative hit from the new tax has been more
than counterbalanced by gains resulting from the reduction in
Turkey's corporate tax rate from 30 to 20 percent. Still,
the tax has had an important impact in several derivative
markets, most notably in that for American depository
receipts (ADRs) for Turkish companies. Local custodians note
that because of uncertainty surrounding tax issues, new ADRs
are not being issued, and while existing ones continue to be
traded, they are not being cancelled or reissued. Concerned
depositary institutions, including notably the Bank of New
York (BONY),which holds 70 percent of the local market, have
lobbied without success for the exclusion of ADRs from the
tax. From a big picture policy perspective, the withholding
tax has considerable merit as it is part of a broader,
IMF-supported effort to tax all financial instruments
equally. End Summary.


2. (SBU) A Controversial Measure: The new withholding tax
sparked extensive concern and opposition last year, with
leading local and international brokerages making the journey
to Ankara to argue that the measure could bring a sharp spike
in the interest rates Turkey pays on its government debt, as
investors took on board a new cost that would significantly
diminish the return they received on their investments. In
the event, however, the new tax made its debut not with a
bang, but with a whimper, with an almost imperceptible impact
on Turkey's broad market indices. Local brokerages we
surveyed (including Global, EFG Securities, EkspresInvest,
and Finansinvest) admit to being surprised by the low-key
reaction. They attribute it to several factors, including a
wait-and-see attitude adopted by many investors in the first
months of the tax's implementation, and the fact that the
measure does not apply to bonds purchased before the tax's
entry into force on January 1. Cem Akyurek at Global also
noted that the Treasury's decision to reduce the rollover
ratio on Turkish debt helped to minimize the impact. Some
analysts believe, however, that the tax's full effect will
only be visible in 6-10 months, as more existing treasuries
expire and investors must select another investment vehicle.
Baturalp Candemir at EFG, notes that with the interest banks
pay on deposits matching (and in many cases exceeding) the
rates on treasury bills, more and more investors are opting
to take their money out of government bonds when their
existing holdings mature and put them in deposit accounts.
He attributes the slight uptick in rates at the end of
January and early February in part to this phenomenon, and
predicts that this trend will intensify.


3. (SBU) Localized Impact: Though the broad market impact of
the new tax has been limited, certain of its provisions have
severely roiled some market segments, including particularly
the market for American Depository Receipts (ADRs) of Turkish
companies. That market has been frozen since the beginning
of the year, as the way in which Turkish tax authorities
apply the tax leaves the final purchaser of such an
instrument liable for tax on the capital gain over its entire
life when it is cancelled or reissued, potentially eclipsing
any capital gain he or she earned from it. The Bank of New
York (BONY) has pursued this issue with the Turkish
Government without success, and warns that if the rules are
not reworked to permit the ADR market to function, BONY,
which controls 70 percent of that market in Turkey, may be
compelled to close its local office. "We have lost our
entire revenue base," BONY's Istanbul Representatiave
Neslihan Tombul told us recently. Tombul characterized her
meetings with government officials in Ankara as unproductive,
noting that officials there seem intent on maintaining an
approach to taxing these instruments that is out-of-step with
world practice. Others who participated in the meetings note
that while the Ministry now understands the problem, it is
not inclined to correct it, as it believes it would be unfair
provide special treatment to one type of instrument. They
note that local brokers have lined up on the other side of
the issue out of fear that exempting ADRs will shift
transaction volume out of the Istanbul Stock Exchange and

ISTANBUL 00000392 002 OF 003


overseas. Tombul appealed for the Embassy to raise the issue
with the GOT, given its impact on BONY's bottom line.


4. (SBU) Swaps: Complicating the story is the fact that for
the time being at least, authorities are not applying the
withholding tax to swap contracts in countries such as the
Netherlands or the U.S. which have double taxation treaties
with Turkey. Local brokers characterize this market as a
"gray area," which is neither completely legal or illegal. A
number of them, however, have looked into the market and
decided that the risks are too great, as the custodian in the
Netherlands or other tax treaty country may be left with the
tax liability if, for instance, the transactions are
investigated and it is determined that the end beneficiary of
the swap was not a resident of the Netherlands who was
entitled to benefit from the tax treaty. This specific issue
has also been raised with the U.S. Mission by concerned
investors, who note that Turkish authorities are considering
a regulation whereby they will make this exclusion explicit.
This, investors note, would prevent them from establishing
special purpose vehicles (SPVs) in Holland to benefit from
the treaty. In seeking an explicit statement from Turkish
tax authorities that existence of such a vehicle conforms to
the requirements of the Dutch-Turkish tax treaty, Raymond
James Securities made the argument to us that such a
statement would level the playing field for all foreign
investors, and asked rhetorically, "where is the fairness in
permitting one group of international investors to invest in
Turkey without paying the withholding tax while another group
has to pay the tax?"


5. (SBU) Local brokers are not swayed by the argument,
however. They prefer that all investments be taxed equally,
arguing that otherwise foreigners (including "mustachioed
foreigners"-- another term for Turkish capital held overseas)
will shift their investment activity offshore. In this
regard, one analyst at a local brokerage told us, ADRs are a
much greater risk than swaps, since many funds are either
prohibited from engaging in the latter or have strict limits
on them. Exclusion of ADRs from the tax, he argued, would
lead to a dramatic rise in their use, above and beyond the 40
companies that currently issue them.


6. (SBU) Treaty Violation?: Beyond these specialized issues,
some tax analysts suggest to us that the withholding tax is
in violation of the U.S.-Turkey bilateral tax treaty, full
stop, though they note that investors have been reluctant to
draw attention to themselves by pressing the point. Umurcan
Gago, tax division manager at Pricewaterhouse Coopers, notes
that under the treaty American investors are subject to tax
only in their home jurisdiction so long as the following
three conditions apply: they held their assets for more than
a year, they sold them to a non-Turkish resident, or they
consisted of stocks or bonds that are quoted on a stock
exchange in Turkey. Historically, however, he notes, the
Turkish Ministry of Finance has interpreted the conditions
more stringently, arguing that a stock or bond must be
registered, quoted and listed, and "actively traded" in order
to benefit. Investors have been unhappy with this
stipulation since it was first introduced in the late 1990s.
The provision has become much more problematic since January
1, however, as investors no longer benefit from the tax
exempt status they enjoyed on assets such as government
securities. In addition, the Finance Ministry has been
insistent that treasury bonds are not technically "quoted" on
an exchange, and hence cannot benefit from the "quotation
release."


7. (SBU) Though our financial market contacts are
understandably focused on the considerable and sometimes
unfavorable impact the new tax is having on their business,
the tax itself is part of a broader IMF-supported reform to
tax all financial instruments at the same rate. In addition
to withholding at source in an attempt to maximize
compliance, the single rate was designed to get the
government out of the business of favoring one instrument
over another. This change is particularly beneficial in
lessening the "crowding out" by government securities, since
until 2006 these securities were not taxed. The change is
also likely to encourage the badly-needed deepening of the
banking sector, since bank deposits can now compete on a
level playing field with government securities.


8. (SBU) Comment: These exceedingly technical and arcane
issues are likely to keep investment professionals occupied
for quite some time to come. While the macroeconomic impact
of the new tax has been minimal, in the face of the global

ISTANBUL 00000392 003 OF 003


flood of liquidity that continues to wash over Turkey, the
impact has been dramatic on some specific markets. In
response to BONY's requests for Embassy intercession with the
GOT on the ADR issue, we have suggested that they first
pursue their efforts to secure support from ADR issuers such
as Turkcell, who also stand to be signficantly affected, as
well as from the local brokerage community, whose resistance
to ADRs appears to have stiffened the Ministry's back on the
issue. To date, however, they have not been successful on
either front. Local brokers remain staunchly opposed to
exempting ADRs, while issuing companies do not see the issue
in the same "life and death" terms as BONY, given that their
other investment vehicles are flourishing in Turkey's buoyant
markets. End Comment.
JONES