The European Savings Directive - impact for hedge funds

Schulte Roth & Zabel International LLP examines the significance of the European Savings Directive to hedge fund managers.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />


 


1. General

 


July 2005, the European Union Savings Directive finally came into force.1 The Directive is intended to counter money laundering and tax evasion by individuals receiving cross-border payments of savings Income.


 


To this end, the Directive requires the Implementation of a Europe-wide regime under which Member States of the European Union and certain dependent or associated territories of such Member States (e.g. Jersey, Guernsey, the Netherlands Antilles and Cayman Islands) and a number of third countries (including Uechtenstein and Switzerland)2, (together, the "Signatory Jurisdictions") will exchange information with each other about payments of interest made cross-border to individuals (or certain residual entities3) resident in the European Union. It now appears that most hedge funds are unlikely to be subject to the rigours of the Directive although there are still some unanswered questions.


 


In summary, the Directive provides that where an "interest payment" is made to an individual "beneficial owner" (or certain residual entities3) resident in a Member State of the European Union by a "paying agent" established in a Signatory Jurisdiction, the paying agent (which could be a fund administrator) may be required to provide information about the interest payment to the tax authorities of the administrative jurisdiction where it is established.


 


Those tax authorities will in turn provide this information to the tax authorities of the <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Member State of the beneficial owner. The definition of "interest" is widely drafted and extends to payments made by funds whose investments Include to any significant degree debt securities or other interest bearing instruments. Three Member States (Austria, Belgium and Luxembourg) have been allowed a transitional period during which they will not be required to exchange information, but will instead levy a withholding tax {at a rate 01 Initially 15 per cent, gradually increasing to 35 per cent by 2011) on Interest payments to individual beneficial owners resident in other Member States.


 


Under bilateral agreements concluded with the European Union, six of the dependent territories (the British Virgin Islands, Guernsey, the Isle of Man, Jersey, the Netherlands Antilles and the Turks and Caicos Islands) and all third countries, which are Signatory Jurisdictions (Andorra, Liechtenstein, Monaco, San Marino and Switzerland) have also opted for a withholding tax regime. Further, all third countries and seven of the dependent territories (Aruba, the British Virgin Islands, Guernsey, the Isle of Man, Jersey, Montserrat and the Netherlands Antilles) will also be entitled to receive information In respect of residents of the European Union with "interest Income" in these jurisdictions. At the time of writing, the bilateral agreements with Anguilla, the Cayman Islands and the Turks and Caicos Islands did not have reciprocal effect.


 


2. Paying agents

 


A "paying agent" is any person who makes an "Interest payment", or secures the making of an "interest payment" for the immediate benefit of an individual beneficial owner established In another Member State. In the hedge fund context, this can include administrators or sub-administrators located in a Signatory Jurisdiction, which are responsible for processing and paying distributions or redemption proceeds to investors. If the paying agent is located outside the Signatory Jurisdictions, the EU Savings Directive does not apply to any payments made by such paying agents. Therefore, the EU Savings Directive does not need to be applied by a paying agent located, for example, in Bermuda, the Bahamas or the US. However, if an individual investor holds his interest in the fund through a nominee or residual entit:y3, that intermediary, if located In a Signatory Jurisdiction, could - depending on the circumstances - itself be required to apply the Directive.


 


3. Interest payments

 


A "paying agent" is any person who makes an "Interest payment", or secures the making of an "interest payment" for the immediate benefit of an individual beneficial owner established In another Member State. In the hedge fund context, this can include administrators or sub-administrators located in a Signatory Jurisdiction which are responsible for processing and paying distributions or redemption proceeds to investors. If the paying agent is located outside the Signatory Jurisdictions, the EU Savings Directive does not apply to any payments made by such paying agents. Therefore, the EU Savings Directive does not need to be applied by a paying agent located, for example, in Bermuda, the Bahamas or the US. However, if an individual investor holds his interest in the fund through a nominee or residual entit:y3, that intermediary, if located In a Signatory Jurisdiction, could - depending on the circumstances - itself be required to apply the Directive.


 


In respect of redemption payments, Signatory Jurisdictions have the option of treating only the proportion of debt assets held by the fund as "Interest" payments. This option is not available for other interest distributions. Further, if a paying agent is unable to determine the proportion of assets constituting debt investments, he is required to treat the whole redemption payment as an "interest payment",


 


4. Location and classification of funds


 


The location and classification of investment funds can also determine whether a fund will fall within the scope of the Directive. Thus, the Directive will only apply if a fund is either (a) located in one of the Signatory Jurisdictions and is a UCITS or UCITS-equivalent fund (i.e., a fund which would qualify as a UClTS fund if it were located in the EU) or (b) located outside any of the Signatory Jurisdictions.


 


Accordingly, an administrator acting for a fund that is located in a Signatory Jurisdiction but which is not a UCITS or a UCITS-equlvalent fund is not required to operate the Directive even if the above debt assets test would otherwise be met. Broadly, a UClTS (an Undertaking for Collective Investment in Transferable Securities) is a fund that complies with various investment restrictions and is authorised within the European Union to be sold widely across the EU to retail investors. The majority of hedge funds are very unlikely to be UCITS or UClTS-equivalents.


 


In addition it should be noted that:


 


• Most Signatory Jurisdictions will need to confirm whether they agree with the UclTS equivalent classification of each dependent or associated territory or third country which is a Signatory Jurisdiction. For example, the Cayman Islands authorities only regard Cayman funds licensed under section 5 of the Cayman Islands Mutual Fund law as UCITS-equivalents. Funds registered under section 4(3 )of the Mutual Fund law - constituting 90 per cent of Cayman hedge funds - will not be treated as UCITS equivalents. So far, the UK, Ireland and Luxembourg have confirmed that they will accept the Cayman Islands classification so that payments deriving from these funds and made to and from these countries will be outside the scope of the Directive.


 


• Other jurisdictions, like Switzerland, may follow the "home country rule" whereby the fund classification by the jurisdiction in which the fund is established is followed without need for further confirmation. Switzerland, for example, has established an online database system through Telekurs which registers funds as "in scope" or "out of scope" and on which Swiss paying agents can rely.


 


The obligation to determine whether the Directive applies is on the paying agent and fund administrators are approaching funds for confirmation that it is correct for the administrator acting as paying agent to regard the fund as a non-UClTS equivalent and therefore out of scope.


 


5. Beneficial owners and residual entities


 


Generally speaking, for the Directive to apply, the "beneficial owner" receiving the interest payment must be an individual. Consequently, "interest payments" made by a paying agent to corporate or institutional investors will not be within the scope of the Directive even if the fund is in scope and fails the asset test.


 


However, there is also a reporting obligation (but no withholding tax), where a paying agent makes an interest payment to a residual entity established in another Member State even where that residual entity is not an individual. The residual entity Itself would then be a paying agent with potential reporting (or withholding) obligations. A "residual entity" is defined as any entity to which interest is paid for the benefit of the "beneficial owner", but does not include a legal person, an entity whose profits are taxed under general arrangements relating to business taxation or a UCITS. Entities that would otherwise be "residual entities" also have the option to elect to be treated as a UCITS and so avoid being a "residual entity". The extent of "residual entities" depends on law of the relevant Member State - for example, in the UK they are extremely limited and partnerships are not included, whereas under Irish, Spanish and Italian legislation, certain partnerships may be regarded as residual entities.


 


6. Entry into force


 


The Directive came into force on 1 July 2005 and requires implementation from that date in each Signatory Jurisdiction through national law. There will invariably be scope for differences in national treatment due to the fact that Member States (and in this case, Signatory Jurisdictions) are left to determine the actual implementation of the Directive for themselves


 


7. The way forward for hedge funds

 


The Directive should have no effect on payments received by hedge funds located in Signatory Jurisdictions. A fund, not being an individual, will not be a relevant "beneficial owner". However, the Directive may be relevant to payments made by funds where the fund is not out of scope. Whilst the current trend suggests that the majority of funds will be deemed to be out of scope by virtue of their classification as non-UCITS or UCITS equivalent funds in most Signatory Jurisdictions, confirmation is needed from each Signatory Jurisdiction that it accepts these classifications and until then some uncertainty remains.


 


Where payment of "interest" as defined (see section 3 above) is made to an individual investor resident in a Member State from a fund which is classified as "in scope", the Directive is likely to impose a reporting or withholding requirement for the paying agent located in a Signatory Jurisdiction.


 


In addition, even where no legal reporting requirements exist, several administrators are approaching funds with Information requests about nominee arrangements as nominees will need to know whether they, in turn, fall within the scope of the Directive.


 


As will be evident from the above, although the Directive has been in force since 1 July 2005, there are still significant legal issues to be finalised (particularly as the Directive is implemented in each of the Signatory Jurisdictions through national legislation). This was also recognised by the European Commission in a recent press release.4


 


We continue to monitor developments, such as the recent approach to Bermuda by the United Kingdom to discuss the adoption of measures, which would lead to Bermuda taking an active part in the application of the directive, and are hopeful that many of the initial uncertainties will be sorted out once the system is tested.


 


1 European Union Council Directive 2003/48/EC of 3 June 2003 on taxation of savings income in the form of interest payments. On 1 July 2005 application of the Directive became mandatory for Austria. Belgium, Denmark. Finland, Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Sweden and the United Kingdom; and on I January 2007 application will become mandatory for the recent "accession countries" Cyprus, the Czech Republic, Estonia. Hungary, Latvia, Lithuania. Malta. Poland, Slovakia and Slovenia.


 


2 The full list of the associated or dependent territories and third-country signatories is: Andorra, Anguilla, Aruba, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man, Jersey, Liechtenstein, Monaco, Montserrat, Netherlands Antilles, San Marino, Switzerland and Turks and Caicos Islands. Neither Bermuda, the Bahamas nor the USA has signed up to the Directive.


 


3 See section 5 above


4 "Savings Taxation - frequently asked questions'", European Commission Press Release 30/06/2005, which states that the European Commission does not believe «that it is realistic to expect that every aspect of operating this Directive and these Agreements can be resolved with complete certainty before the arrangements take effect".


 


This briefing was prepared by Philippe Benedict, Steven J Fredman (New York) and Daniel Lewin (London) of Schulte Roth & Zabel International LLP.

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