Financial Analysis:

BNZ and Westpac

- by Sue Newberry

Sue Newberry is Associate Professor of Accounting at the University of Sydney. She plays no role in the Roger Award nominating or judging process. Her only involvement is as the financial analyst. Ed.

The judges’ decision that the Roger Award should go to the BNZ and Westpac cites their tax practices as a key reason for the award. Both banks are under investigation by the Inland Revenue Department (IRD) in relation to particular structured finance transactions. Evidently, the IRD regards these transactions as tax abusive and is seeking payment of additional tax. The two banks acknowledge a combined total potential tax obligation of NZ$1.23 billion (including penalty interest) from these transactions, all of which occurred between 1999 and 2005. This analysis reviews the banks’ tax disclosures in their financial reports back to 1999.

The corporate tax rate in New Zealand is 33%.For simplicity, the tax information shown below draws on the amounts reported as tax expense in the banks’ financial reports even though that is not the actual amount paid. As many people know, the information reported to the IRD in tax returns typically differs from the information reported in published financial reports. The tax returns are not publicly accessible, and so there is no choice but to use the information provided in the companies’ audited annual reports in the hope that it provides a reasonable approximation.

The audited financial reports of companies like these are required by law to comply with financial reporting standards. The required practice for accounting for income tax is known as tax effect accounting. It emerged in the United States in the late 1960s after companies had been criticised for paying very little tax. Tax effect accounting is dubious and controversial, and it tends to confuse rather than inform. With variations, tax effect accounting is now part of financial reporting standards in many countries, including Australia and New Zealand. The move to a single set of international financial reporting standards will not bring relief from the confusion caused by tax effect accounting. In late 2003, Sir David Tweedie, the chairman of the International Accounting Standards Board which has now produced the first financial reporting standards for application globally, denounced tax effect accounting as stupid but admitted that the international financial reporting standards would continue to require it. According to Tweedie, requiring tax effect accounting in the international financial reporting standards will at least mean all countries apply the same stupid standard tax accounting practice.

Under tax effect accounting, the amount reported in audited financial reports as operating profit before tax is not the same as assessable income as reported to the IRD, and neither is the amount of tax expense reported the same as the actual amount of tax assessed for the year. The actual tax information is not publicly available. The tax information reported below is drawn from the tax figures shown in the banks’ audited financial reports in the hope that it might provide a reasonable approximation, but it most likely overstates the actual amounts of tax.

Bank Of New Zealand

The BNZ reports in its 2005 Annual Report on the Inland Revenue Department’s “industry-wide review of structured finance transactions.” At that time, the IRD had issued the BNZ with amended assessments relating to structured finance transactions relating to the 1999 income year. The amended assessments were for $47 million, on top of which would be interest and any penalties. According to the BNZ, if the IRD were to reassess income tax for all structured finance transactions of that type up to 30 September 2005, the total tax liability would be $416 million plus interest of $117 million, giving a combined total of $533 million. All transactions of the type under investigation had matured or terminated by 30 June 2005.

The BNZ reports its confidence that it had correctly applied the law and that it had “obtained legal opinions that confirm that the transactions complied with New Zealand tax law.” The BNZ argues that it should not, therefore, have to pay further tax. The table below shows the figures reported in the BNZ’s audited financial reports for the last seven years and the reported tax expense.

Table 1

Bank Of New Zealand: Tax Expense Compared With Operating Profit Before Tax

The BNZ reports total operating profits before tax of $4,375 million, and total tax expense of $1,046 million. Over the seven years, tax expense averages 24% of reported operating profits. If the BNZ’s acknowledged potential tax liability of $416 million is added to the total reported tax expense of those seven years that would give a total tax expense of $1,462 million, raising the proportion of tax expense to 33% which is the level of the corporate tax rate.

Westpac

Westpac’s 2005 Annual Report also explains that the Inland Revenue Department in New Zealand is taking action against Westpac in respect of some of its structured financing transactions between 1999 and 2005. The total potential tax liability is NZ$611 million. With penalty interest included the amount rises to approximately NZ$750 million. Like the BNZ, Westpac reports it is defending this effort by the IRD. It states that in 1999 the IRD issued a binding ruling on the first of that type of structured finance transaction and confirmed that binding ruling in 2001. Westpac further states that the tax principles underlying all of the subsequent transactions were the same, and that it has obtained independent tax and legal opinions which confirm its tax treatment was “consistent with New Zealand law.” It has already paid NZ$110 million to the IRD, that amount including interest, but regards the amount paid as still in dispute and therefore has not recorded it as a tax expense. Westpac reports confidence that payment of additional income tax is unlikely.

Identifying Westpac’s profits and income taxes in New Zealand is not straightforward. Westpac is registered in Australia and all of its financial activities in New Zealand are included in its Australian financial reports. Westpac does provide financial reports in New Zealand for its New Zealand Banking Group, but it is not clear that the New Zealand reports cover all of Westpac’s financial activities in New Zealand. A comparison of the tax information reported in New Zealand against that reported in the Australian financial reports for Westpac reveals anomalies. For this reason, I have provided both New Zealand and Australian information. All of the information below is taken from Westpac’s published financial reports as audited by Price WaterhouseCoopers.

Table 2

Westpac NZ Banking Group: Tax Expense Compared With Operating Profit Before Tax

Table 2 shows that its New Zealand Banking Group financial reports published in New Zealand, Westpac reports total operating profits before tax of NZ$4,972 million, and total tax expense of NZ$1,398 million. Over the seven years, tax expense averages 28% of reported operating profits. If the potential tax liability of NZ$611 million is added to the total tax expense of those seven years, that would give a total tax expense of NZ$2,009 million, raising the proportion of tax expense to 40% which is higher than of the corporate tax rate, the difference being about NZ$369 million. That seems odd.

Westpac’s Australian financial reports cover the whole Westpac group whereas the New Zealand reports relate only to the New Zealand Banking Group. For comparison I extracted from Westpac’s financial reports issued in Australia information about Westpac’s financial activities in New Zealand. Because all of the figures below are taken from the Australian financial report, they are in Australian dollars.

Every large company is required to provide detailed financial information about its different lines of business and the different geographical locations where it operates. To do this it must re-present and analyse key figures from the financial reports twice. This disclosure, found in the notes to the financial statements, is known as group segment information. In Westpac’s Australian financial reports it may be found at Note 29.

Table 3

Westpac: Segment Profits From Ordinary Operations Before Tax; And Tax Expense (From Note 29)

Table 3 shows the information from Note 29 in the Australian financial reports. In the segment information by business segments, Westpac identifies five segments, one of which is New Zealand Banking. For that segment, operating profits before tax total A$3,296 million and tax expense reported totals A$1,078 million, an average of 33% which is exactly the corporate tax rate. In the segment information by geographical segment, Westpac identifies three segments, Australia, New Zealand and other. The operating profit before tax for the New Zealand geographical segment (A$3,454 million) is A$158 million higher than that for the New Zealand Banking segment. Clearly the Westpac Group has activities in New Zealand other than those shown in the New Zealand Banking segment information. For example, another of the business segments shown in the Australian report is called Westpac Institutional Bank which “services the financial needs of corporations, institutions and government customers that are based in or have interests in Australia and New Zealand.” Because there are additional activities and additional profits in New Zealand it would seem logical for there to be additional tax but the information disclosed for New Zealand as a geographical segment does not show tax expense (and is not required to show it).

Although the figures above are in Australian dollars, neither set seems to compare with the New Zealand Banking Group information as reported in New Zealand. For example, the New Zealand Banking segment information reported in the Australian reports (Table 3) shows total tax expense of A$1,078 million but this is less than the tax expense as reported in New Zealand (NZ$1,398 million) (Table 2), even after allowing for translation of the NZ$ figures to Australian dollars. The NZ$292 million tax expense reported in the New Zealand financial report for 2005 (Table 2) would translate to the A$192 million tax expense shown for the NZ Banking segment in the Australian reports (Table 3) only if the exchange rate were 65 cents. But the exchange rate in September 2005 was closer to 90 cents. Further analysis seems to be required.

The amount of tax reported on all of Westpac’s activities outside Australia is disclosed in the Australian financial reports at Note 6. For this reason, Table 4 adds together the profits from Westpac’s New Zealand and “Other” geographical segments as shown in the Australian financial reports at Note 29, and then compares those profits with the tax expense reported in Note 6 as incurred outside Australia. As may be seen from these figures, over the last seven years, Westpac’s total reported profits from outside Australia amount to A$4,881 million, and the reported tax expense on those profits to A$744 million, an average of 15%. It has ranged from a high of 38% in 1999 to a low of 6% in 2004.

Table 4

Westpac: Segment Profits From Ordinary Operations Before Tax; And Tax Expense

These Table 4 figures raise a puzzling question. In its Australian financial reports Westpac’s reported total activities outside Australia include its activities in New Zealand. The profits reported on all of activities outside Australia ($A4,881 million) are greater than the profits reported on its New Zealand activities A$3,454 million). But the tax expense on all activities conducted outside Australia (A$744 million) is less than the tax expense reported in the Australian report as incurred in relation to Westpac’s New Zealand Banking segment’s activities (A$1,078 million) (see Table 3, Tax expense business segments NZ Banking). And yet the total tax expense on all Westpac’s activities outside Australia must include all of the tax expense on Westpac’s New Zealand activities.

An interesting aspect of the difference reported in Westpac’s Australian financial reports between the income tax expense relating to the New Zealand Banking Group segment activities (A$1,078 million) and that reported as relating to all of the Westpac’s financial activities outside Australia (A$744 million) is that the figures suggest Westpac incurs lower taxes from higher profits. The implication is that the higher profits earned outside Australia somehow generate tax gains to Westpac. Structured finance transactions frequently flow through international tax havens (activities outside Australia), and they tend to make little commercial sense other than to conceal, and to exploit a tax base or tax bases. Possibly, signs of the basis for the tax dispute between Westpac and the IRD are buried in these tax figures on all of Westpac’s financial activities outside Australia.

Why the three sets of audited tax figures Westpac publishes are so different and which is correct is, perhaps, something Westpac and/or its auditors might like to explain. Even then though, tax effect accounting means that identification of the “correct” amount will not help with identification of the actual tax for the year. I can only agree with Sir David Tweedie’s views on tax effect accounting and wonder why the financial reporting standard requiring it has not been dumped. At the very least, corporate financial reports should be required to show the amount declared as assessable income for the year and the actual amount of income tax.

In summary, at the 2005 financial year end, both Westpac and the BNZ reported that they were under investigation by the IRD in relation to certain structured finance transactions which they were defending. The combined total of the potential obligation they faced (including interest) was $1.23 billion. Both banks are required by law to observe financial reporting standards, but those standards do not allow clear identification of actual tax assessed, and tax records filed with the IRD are not publicly accessible. There is little in their financial reports to help with assessing the banks’ tax activities other than the disclosures provided by both banks of the amount of tax under dispute. The outcome of the IRD’s action against both banks will be interesting to see.

And What Will Come Next?

There are many variations of structured finance transactions and the potential tax liability reported by the BNZ and Westpac relates to a particular set of such deals. Both the BNZ and Westpac seem to have stopped engaging in those particular transactions. Recent permissions issued to Westpac by the Overseas Investment Commission (OIC) (1) , however, suggest the need to remain alert for the effects of other structured finance arrangements. Details from the OIC approvals reveal that the amounts involved are around $2 billion.

On July 19, 2005, the OIC issued approval for Westpac to sell for an undisclosed amount “up to 100 percent of certain specified securities” in a company called Pacific Funding to Linvest LP an organisation with its beneficial ownership in Germany. The rationale stated that “entities associated with Linvest LP undertake nationally and internationally, the business of financing and investment banking. The financing of Pacific Funding is a continuation of those activities.”

On August 12, 2005, the OIC issued approval for Westpac to purchase from Linvest LP for an undisclosed amount “up to 100% of the specified securities” in Pacific Funding. The rationale stated that Westpac would “provide finance to Pacific Funding, a New Zealand incorporated unlimited liability company, which it partly owns. In order to protect its position, in certain circumstances it may wish to ensure that it has full control of Pacific Funding by exercising the option to acquire specified securities in Pacific Funding from Linvest LP.”

On November 1, 2005, a company called Pacific Funding was registered in New Zealand, with 20,294,118 shares. Company register documents reveal that 98.8% of Pacific Funding’s shares are owned by Linvest LP, which is registered in the Cayman Islands, a tax haven. The remaining 250,000 shares are owned half each by two companies, Tasman Funding No 1 and Tasman Funding No 2 which are included in the NZ Banking Group financial reports published in New Zealand. Both Tasman Funding No 1 and Tasman Funding No 2 are owned by Infrastructure Australia (No 1) Limited. Westpac’s 2005 Australian annual report reveals that it controls Infrastructure Australia (No 1) Ltd and all of the New Zealand operations, including Tasman Funding No 1 and Tasman Funding No 2. (2)

Westpac has not issued financial reports since September 2005 so whether anything about sale of securities in Pacific Funding will be apparent in such reports is not known. The structuring of what is disclosed so far makes it seem likely that most of the arrangement will be “off-balance sheet”, that is, it either will not show in any of Westpac’s published financial reports or will be barely visible. Even from what is disclosed, it seems reasonable to suggest that any funding Westpac received by “selling” the securities in Pacific Funding could be regarded as a loan secured over those securities rather than the sale of those securities. This is because of Westpac’s desire to protect its “full control” of Pacific Funding through the options arrangement. Given that the OIC’s permission is for around $2 billion, the amount is sufficiently large that Westpac and its auditors should regard themselves as obliged to ensure sufficient explanation is provided to allow the public to understand this arrangement. Westpac’s next financial reports will be interesting to see.

Endnotes:

(1) Note that these were among the last approvals given by the OIC. From August 25, 2005, it was replaced by the Overseas Investment Office, part of Land Information New Zealand.

(2) Tasman Funding No 1 and Tasman Funding No 2 are owned by Infrastructure Australia (No 1) Ltd, but that company does not seem to be included in the NZ Banking Group financial reports published in New Zealand. Consequently, it is difficult to see why the two Tasman Funding entities would be included. The NZ Banking Group financial report suggests this is part of a messy resolution to the debate with the Reserve Bank over what must be included in the New Zealand Banking Group’s financial reports. The banking group is reported as “including those entities whose business is required to be reported in financial statements for the Overseas Banking Group’s New Zealand business”.