I am pasting the sub questions and the solutions for the reader's benefit. Q2. Your firm has a proprietary trading desk that makes the following trade: • buy and then swap a cash Corporate Bond at par • the corporate bond’s coupon is at LIBOR + 70bps • finance through Repo at LIBOR • buy full Credit Default Swap (CDS) Credit protection on the Bond at a cost of 55 basis points per annum (v) Explain the main features of this trade. The counterparty applies a reduction of 4% to the notional value of the corporate bond. The required risk capital for this trade is 1%. (vii) Calculate the expected return on capital. (viii) State with reasons whether the trade would profit from the unexpected widening of credit spreads. Solution: (v)Effectively an arbitrage trade that exploits the relative mispricing of credit between the cash corporate bond and the CDS • Convergence trade that can be held to maturity • Provides positive carry • Assumes no credit risk • Requires simultaneous execution of the cash bond and the CDS to minimise risk • Small spread – likely to require leverage to earn an acceptable return on capital (vii) Spread between Repo and Swap = 70 bps Net spread after paying for CDS = 15 bps Total capital required = 4% (haircut) + 1% (risk capital) = 5% Return on capital = LIBOR + (15 bps / 5%) = LIBOR + 3% (viii) Expect outperformance in widening credit markets as the CDS should widen more than the cash bond. I did not quite understand throw the trade is structured and hence the following responses. Could some one kindly throw some light? Q1. The ABC group is comprised of three companies namely, ABC Ltd, ABC Singapore and ABC Sydney. ABC Ltd wholly owns both ABC Singapore and ABC Sydney. ABC Ltd’s fiscal year end is December 31. ABC Ltd made a pre-tax loss of £25m in 2006. This was the only year that ABC has made a loss. At December 31, 2007: • ABC Ltd’s unrealised gains made in 2007 on its derivatives book totalled £45m. • ABC Ltd’s pre-tax profit excluding the unrealised gains was £90m. During 2007: • ABC Australia declared a pre-tax profit of £20m. It paid tax at the rate of 33% on the profit. It paid a £10m dividend to ABC Ltd. This dividend was not subject to any withholding tax. • ABC Singapore declared a pre-tax profit of £15m. It paid tax at the rate of 10% on the profit. It paid a £5m dividend to ABC Ltd. This dividend was subject to a 15% withholding tax. (v) Calculate, stating your reasons for making the various calculations, ABC Ltd’s UK tax owing for fiscal year 2007 based on the above information. Solution: The reasoning behind the calculations. • ABC Ltd. is UK tax resident. The subsidiaries are not. • ABC Ltd. is a 30% corporation tax payer. • ABC Ltd. is deemed to be a financial trader and so all gains are treated as income and not capital. • Tax treaties between UK-Australia and UK-Singapore means that ABC Ltd. will receive tax credits for both the corporation taxes paid in Australia and Singapore subject to a maximum of the UK rate and the withholding tax paid in Singapore. • ABC Ltd. is not taxed on profits retained in the subsidiaries. • ABC Ltd. is taxed on an accruals basis including income and realised gains. Unrealised gains on the derivatives book are not taxable. • ABC Ltd. can offset the prior year’s losses from its pre-tax profit prior to calculating its UK tax liability. Corporation tax before foreign tax offsets = 0.3 * (90 - 25) = 19.5m Australian corporation tax credit = 10 * (1/0.7 - 1) = 4.285 Singapore corporation tax credit = 5 * (1/0.9 -1) = 0.555 Singapore withholding tax credit = 5 * 0.15 = 0.75 UK 2007 tax charge = 19.5 - 4.285 - 0.555 - 0.75 = £13.91m Where is it mentioned in the core reading that there are tax treaties between Australia and Singapore? If the treaties hold, what about the UK tax on dividends received? Why are the retained profits not taxed? The core reading states that the profits earned for a UK based company are taxed in the UK.
Hi Ivanhoe I don't teach SA5, but I wonder if the Prop Desk: - borrows money via a repo - uses this to purchase a corporate bond, which has fixed coupons (I would expect?) - undertakes an asset swap, paying away the fixed coupons on the corporate bond and receiving LIBOR + 70 bps? - takes out a CDS on the bond, paying 55bps for this? So overall it has got a net income of 15 bps? Does that help? Gresham
Hi Ivanhoe I've no SA5 experience and I'm not an expert on the UK taxation arrangements, but the first para of Core Reading on page 19 of Chapter 4 of the 2014 SA5 CMP, says something along the lines of "Profits tax or corporation tax paid in overseas countries can be offest against any UK corp tax on that slice of earnings ...". It seems to me that that cover the point the examiners made about tax treaties in Oz / Singapore, albeit much more vaguely? Are you sure the retained profits aren't taxed? It looks to me that the pre-tax profits are taxed at 30% in the examiners' calcs? Finally, it seemed to me that the Example on page 20 of Chapter 4 was pretty similar to this calc. And the advice on page 21 was also pretty relevant - might be worth looking at those again to see whether they help? Apologies in advance if I have misunderstood the issues here! Gresham
Hi Ivanhoe Just realised that the arbitrage constructed by the Prop Desk is explained some way down the SA5 FAQ thread here: http://www.acted.co.uk/forums/showthread.php?t=565 Looks like the wording in the question was somewhat confusing! Gresham
It is given in the assumptions that retained profits in the subsidiaries are not taxed. So, I am fine with that. Sorry. However, they have not taxed the net dividends received from the subsidiaries at the UK tax rate, whereas the acted problem in the notes does consider the UK tax paid on dividend from the subsidiary, and then takes credit for the double taxation later. So, it seems that the examiners considered the dividends received to be a part of 90 million pre tax profits. Please let me have your thoughts on this. Also, I am not sure how they could just assume 30%. There corporation tax was 30% above 1.5 million then. Here they have taxed the entire 65 million at 30%. Could you please respond? Regards, Nandan
It is given in the assumptions that retained profits in the subsidiaries are not taxed. So, I am fine with that. Sorry. However, they have not taxed the net dividends received from the subsidiaries at the UK tax rate, whereas the acted problem in the notes does consider the UK tax paid on dividend from the subsidiary, and then takes credit for the double taxation later. There is a difference. the past paper says that the holding company's pre-tax is 90m. The examiner assumed that this included the foreign dividends (pre-tax is after "finance received" which includes dividends and interest received by the company). The ActEd question says "total UK earnings" which suggests that this only includes the UK operations. So to get to the pre-tax, the finance received has to be added. Although I am not 100% certain this is how it workds, as I modelled the Acted question on the examiners solution. So, it seems that the examiners considered the dividends received to be a part of 90 million pre tax profits. Please let me have your thoughts on this. yes - I agree with this., Also, I am not sure how they could just assume 30%. There corporation tax was 30% above 1.5 million then. Here they have taxed the entire 65 million at 30%. Could you please respond? the main rate of corporation tax was indeed 30% up until 2007, so it would have been 30% in the notes when the question was written. Regards, Nandan
