It has been observed that in the absence of a developed capital market, banks in Bangladesh are the only funding source for investment and economic growth[i]. However, this over-dependency on the banking sector means that there is no room for diversification of risks beyond this sector and no alternative source of capital for business growth.
Over the years, in the developed western economies and in particular, the US, we have seen the rise of “shadow banking system” – the alternative capital source for business industries. Shadow banking system includes the non-depository institutions like investment banks (called merchant banks in Bangladesh), private equity funds, and hedge funds and also includes sale and repurchase agreements (repo) and structured investment vehicles (SIVs) created as part of the securitization process.
In the recent past, much has been talked about the effect of the securitization process on the worldwide financial crisis. However, it must not be forgotten that securitization is an important aspect of the modern financial engineering. Indeed, it has been stated by the International Monetary Fund (IMF) that securitization plays an important role in bank wholesale funding and credit extension[ii].
In Bangladesh’s corporate landscape, we have so far seen only one securitization transaction but that is in the microfinance sector[iii]. Despite the Securities and Exchange Commission’s rules for asset backed securitization[iv], we have not seen any securitization deal coming through from the banking sector.
One of the biggest impediments in closing a securitization deal in Bangladesh is the prevalent taxation regime. In a simple securitization involving banks, traditional banks (i.e. commercial banks) sell their loan receivables (i.e. repayments under mortgages, credit card bills etc.) through a special purpose vehicle (SPV). The main advantage of the SPV and for the traditional banks to sell its loan receivables to this SPV is that the SPV is ‘bankruptcy remote’ – that is – in the event of the bank’s insolvency, the loan receivable portfolio owned by the SPV is not subject to any of the bank’s creditors’ claims. To be able to buy the assets from the originator (i.e. the bank), the issuer SPV issues tradable securities to fund the purchase. Investors (here, institutional investors like the investment/merchant banks, hedge funds, etc.) purchase the securities at prices that reflect their credit ratings conducted by credit rating agencies. Thus, the performance of the securities (issued by the SPV) is then directly linked to the performance of the underlying assets (i.e. the mortgage/loan receivables).
The Income Tax Ordinance 1984 (ITO) hits the securitization transaction with two spheres. Firstly, section 43(5) of the ITO states that (a) in case of income from settlement or disposition (whether revocable or not) to the transferee from assets remaining the property of the transferor, the income is taxable in the hands of the transferor and (b) in case of income from revocable transfer of assets, the income is taxable in the hands of the transferor. Secondly, section 95 of the ITO states that a representative of another person shall be liable to tax in respect of income of the person such representative represents. Section 43(5) of the ITO has to be evaluated from the originator’s (i.e. the bank) point of view and section 95 should be considered from the SPV’s point of view.
With respect to the originator, the term settlement or disposition is defined in section 43(6)(b) of the ITO which includes any disposition, trust, covenant, agreement or arrangement. Therefore, if the originator (i.e. bank) transfers the loan/mortgage receivable to the SPV while keeping the legal title to the underlying loan/mortgage portfolio in its name, such a transaction will be regarded as a settlement or disposition under section 43(5) of the ITO and the income from such loan/mortgage receivable will be regarded as the income of the originator and not the income of the SPV. This is a problematic position from the originator’s point of view, as in commercial reality, the originator has assigned the right to future installment of the loan/mortgage to the SPV and yet is being taxed for income that it does not earn. One of the ways to deal with this problem is to consider the second limb of section 43(5) whereby if the transaction is not structured as a ‘revocable transfer’ and the originator transfers all its right, title and interest in the underlying loan/mortgage portfolio to the SPV, such transfer could be seen as an irrevocable transfer and in that case, any income arising from such underlying loan/mortgage portfolio will be taxed in the hands of the SPV. The term irrevocable transfer is not defined in the ITO. Also, it should be mentioned here that the term settlement or disposition as defined in section 43(6)(b) of the ITO does not include the word transfer which is defined in section 2(66) as, among others, sale or relinquishment of the asset or extinguishment of any right therein. Thus, it could be argued that an irrevocable transfer by the originator to the SPV would not attract the second limb of section 43(5) of the ITO.
With regard to the SPV, it should be noted that generally the SPV would be formed as a trust and the investors would be regarded as the beneficiaries of the income that is earned by the SPV from the loan/mortgage receivables. Under the representative taxation system, as per section 95(3) of the ITO, direct taxation of the beneficiaries (i.e. the person on whose behalf the SPV receives the income) is permissible. Also under section 97, the SPV would be entitled to claim (or deduct from the moneys payable) the tax paid by it from the person on whose behalf it receives the income. However, it should be noted that the ITO does not state the tax neutrality status of the SPV in a securitization transaction and in the absence of such express stipulation, there remains the uncertainty of the SPV’s tax status.
Another problem for the SPV is that it may be taxed as an association of person (AOP) under section 44(2)(a) of the ITO on the premise that by agreeing to participate in the SPV formed solely for the purpose of investing in the underlying loan/mortgage portfolio, the investors come together for a common object of earning income, profits or gain. In such a case, the beneficiaries of the payment received by the SPV (i.e. the Investors) would not be taxed on that part of the income which has already been taxed in the hands of the SPV (See Rule 15 of Part B of the 6th Schedule of the ITO). The objective of this taxing provision is to ensure that income is not taxed twice. Based on this taxing objective, it could be argued that if the income is taxed in the hands of the beneficiaries (i.e. Investors) under section 95(3) of the ITO, then under section 44(2)(a), the SPV should not be taxed as an AOP because that would mean the same income is taxed twice (once in the hands of the beneficiaries and once with the SPV), which is not allowed under section 16 of the ITO.
The above discussion shows that the existing Bangladesh taxation laws create obstacles for a cost-effective securitization process. More importantly, there is no tax neutrality treatment for the SPV in Bangladesh tax law which is essential for securitization purpose. Given the importance of this unique financial arrangement in the context of global financial market, appropriate amendments should be made in the Bangladesh tax laws to encourage more securitization process, thereby helping the local financial market become more mature and at par with the international standards.
Written by Junayed Chowdhury, Managing Partner
† Disclaimer: The opinions and comments expressed in this Blawg are not to be regarded or construed as legal advice by and from Vertex Chambers or any of its members. It is highly advisable that any person should seek independent legal advice before relying on any of the contents of this Blawg
 Getting Finance in South Asia 2010, Indicators and Analysis of the Commercial Banking Sector, Kiatchai Sophastienphong and Anoma
Kulathunga, The World Bank Publication
 See http://pages.stern.nyu.edu/~igiddy/cases/brac_m icrofinance_abs.htm
 সিকিউরিটিজ ও এক্সচেঞ্জ কমিশন (সম্পদ ভিত্তিক সিকিউরিটি ইস্যু) বিধিমালা, ২০০৪