Tax: Levelling the playing field

Special report: Focus on Spain

The Spanish government has achieved the seemingly impossible. Thanks to sweeping changes to taxation regulations last month, returns on all investments, including structured products, are now taxed at the same level regardless of the wrapper used. This means that structured products will now be treated in the same way as unit-linked policies for tax purposes, which is clearly good news for providers. And whereas structured funds have dominated the Spanish retail market until now, the creation of a level playing field for investments could usher in a deluge of structured equity-linked notes.

"From both a marketing and product design perspective, Spanish banks have been heavily influenced by tax-planning considerations," says Rodrigo Ogea, a partner at law firm Baker & McKenzie in Madrid. "Now we have a flat rate of 18% for all financial products, and the same rule applies to both pension funds and unit-linked policies, for example. Returns on structured products are taxed at the same rate as the interest payable on bank deposits and current accounts. As a result of the changes, some products will lose part of their attraction."

Structured funds are now likely to hold fewer advantages, for example. Previously, investors were eligible for a reduced tax rate on long-term capital gains if they chose to invest in funds, as long as the investment term was longer than one year. The removal of this benefit is therefore potentially beneficial for any product with a shorter tenor, including structured notes, say market participants.

Foreign issuers such as ABN Amro, Societe Generale, Citigroup and ING have been tapping the Spanish retail structured products market by passporting structured notes into the country since July 2005, when the European Union's Prospectus Directive was implemented.

The directive allows structured products that have been approved in one EU member state to be sold in another member state automatically - all the issuer has to do is inform the relevant financial regulator in writing.

One of the advantages of distributing structured notes with an EU passport is that an issuer can offer the same product across multiple jurisdictions simultaneously.

Passports at the ready

The directive allows more issuers to target the retail market. "There was considerable growth in deal numbers and volumes of structured notes in 2006," says Pablo Yravedra, a Madrid-based director at ING Financial Markets, equity derivatives. "In terms of retail distribution, Spanish retail banks and saving banks dominate the market. We believe that passporting notes is the best way to distribute our ideas."

ING has been distributing structured products in fund and note form since 2001. "We have been selling cliquet structures, autocallables, Asian payoffs (selective and best average) and, towards the end of last year, digital correlation."

Autocallable structures linked to equity indexes have been a big hit with retail investors. "During 2006 we were active in autocallables on single names, multi-underlying and digitality," Yravedra says. "There was a change in the nature of the underlyings, with a move from the more traditional local equities towards Asian and emerging markets exposure."

He adds that ING, which has been active in Spain's retail market since the implementation of the Prospectus Directive, is now considering whether to launch notes there on a more regular basis. "There were only a few examples where our clients needed a European passport," he says. "At present for us, passported offerings are much more common in the Netherlands, Belgium, Germany and Luxembourg."

ING's first retail note for Spain, Siempre Gana, had a notional issue size of EUR1.7 billion. Launched in September last year, Siempre Gana is a three-year, capital-guaranteed product that offers 40% participation in the Ibex 35 index. The note also provides quarterly liquidity at zero cost, which means investors can either sell the product at 12 fixed observation dates or receive a coupon of 3.33% at maturity if the underlying index has underperformed.

ING also launched a hybrid capital-guaranteed note in October last year. Rentabilidad Activa was a five-year product with a notional issue size of EUR126 million, linked to a basket of equity indexes: the Iboxx Sovereigns Eurozone index, European Real Estate index (EPRA) and the Dow Jones AIG Commodity index. The indexes are weighted according to three portfolios, each with a separate risk profile. The best-performing portfolio is selected each year and the payoff is the average of the five best annual performances.

Other structured products providers are also passporting structured notes into Spain. French bank Societe Generale's (SG) current offering, for example, is a three-year non-capital-guaranteed capital-at-risk autocallable structured note linked to the Ibex 35. The note offers a return of 3.5% after the first six months if index performance exceeds the initial strike level.

"Our products were first approved by the regulator in Luxembourg," says SG's Jose-Antonio Lopez Jimenez, head of equity derivatives, structured and listed products for Spain in Madrid. "We are proposing one offering every month in Spain."

Citigroup also distributes structured notes in Spain. Its latest offering, the Outperformance Note, launched in December last year and is linked to the Citigroup S&P Global Stars Net Total Return Index and the MSCI World Net Total Return Index. The former index consists of 25 stocks from across Europe, the US and Asia. According to Juan Pablo Ruiz-Tagle, Citigroup's Madrid-based head of equity derivatives in Spain, note is also available in Portugal, Greece and Poland.

If the performance of the Citigroup S&P Global Stars Index outperforms the MSCI World Index by 5%, at the closing date of year two-and-a-half, investors can receive a coupon of 20% (8% annualised). Otherwise, investors will receive the outperformance of the Citigroup S&P Global Stars Index.

The five-year, capital-protected note is distributed under Citigroup's own brand, Equity First. "Our first public offering was launched in April 2006," Ruiz-Tagle says. "In addition to the Spanish banks and saving banks, we are also selling to the product to the broker-dealers."

Fund appeal

However, even though structured notes look like they will prove popular, investors are unlikely to abandon the tried-and-tested fund format. In fact, some market participants believe the excitement about structured notes is unfounded. "For one thing, the tax changes mean that investors can still shift from one fund to another without being taxed. Investing in funds remains a good way to defer any tax payments," says one structurer.

In addition, a number of issuers that want to increase their retail market share are looking into Ucits III-compliant structures. The Ucits III directive allows fund managers to use derivatives to generate higher returns. ING, for example, has been distributing actively managed funds in addition to capital-guaranteed funds, and it has plans to develop funds that can generate alpha. But that's a subject for another article altogether.

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