Paul Hale (partner) and Martin Shah (solicitor) in the Corporate Tax Group at City firm Simmons & Simmons in <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />London examine the potential impact of the EU Savings Directive.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
The EU Savings Directive (Council Directive 2003/48/EC of 3 June 2003) is intended to take effect on 1 January 2005. However, certain of the reporting obligations under the Directive will require information to have been obtained from 1 January 2004.
Note that the Directive is not yet in force (and possibly may be delayed, or never become operative at all): Member States are required only to have passed enabling legislation by 1 January 2004. Its implementation will depend upon a number of non-EU countries such as Switzerland and the US enacting similar measures.
The Directive will require a paying agent in a Member State who pays savings interest payments to individuals tax resident in another Member State to pass on information to the paying agent's domestic tax authority or (in certain jurisdictions) levy a withholding tax.
The principal purpose of the Directive is to allow a taxpayer's local tax authority to identify that the taxpayer is in receipt of savings income which may otherwise not be declared.
The paying agent will provide information to its home state tax authority about the payment of savings income to individuals. That tax authority will in turn provide information to each individual's local tax authority so that the local tax authority can check that the correct amount of tax has been paid on the savings income in question.
The Directive's regime will not just apply to paying agents in EU Member States. Paying agents in dependent or associated territories of EU Member States such as Jersey, Guernsey, the Isle of Man and the Cayman Islands are also covered. In the case of these countries, the Directive requires the UK to procure the introduction of equivalent legislation.
The Cayman Islands is currently in discussion with the UK Government as to whether it can be forced to introduce such legislation. The UK Government's stated position is that it will if necessary pass UK legislation to do so.
The EU is negotiating with certain third countries outside of the EU that they will also enact provisions equivalent to those of the Savings Directive, which will apply if savings income is paid by a paying agent resident there to individuals in the EU.
Without such measures, the Directive's aim of reducing tax evasion would be unlikely to be achieved. Paying agents in, for example, the US and Switzerland would therefore also be required either to provide information to relevant tax authorities or to withhold tax.
Information or withholding?
Paying agents in all EU Member States except Austria, Belgium and Luxembourg will exchange information. Paying agents in Austria, Belgium and Luxembourg will operate a withholding tax in place of provision of information during a transitional period, due to concerns about the impact of the Directive on their banking sectors' competitiveness.
In these jurisdictions, however, an individual can elect to have information reported or can provide a tax certificate from his home state tax authority, rather than have tax withheld by the paying agent in question.
Certain offshore jurisdictions such as Jersey, Guernsey and the Isle of Man have stated that they will introduce a withholding regime similar to that in Belgium, Luxembourg and Austria. It is likely that the Cayman Islands will adopt the same approach in the event that the Directive is implemented there.
Who is the paying agent?
Identification of the paying agent is central to the operation of the Directive, as the paying agent must determine whether the provisions of the Directive apply to a payment of savings income.
If so, the paying agent must report the payment of savings income or, in appropriate jurisdictions, deduct withholding tax, unless the recipient of the savings income has elected for reporting to apply or provides a tax certificate from his home state tax authority.
There is no fixed definition of 'paying agent', so identifying a paying agent may be difficult. Generally, a paying agent should be taken to be the last person in the payment chain, though establishing who this is may not be clear cut particularly where certain services, such as administration, have been outsourced. It includes a person acting on behalf of an individual.
A paying agent must apply the provisions of the Directive to both individuals resident in another Member State and 'residual entities'. As with paying agents, the identification of residual entities can be problematic as these are defined by exclusion, with entities deemed to be residual entities where they are not legal persons, not taxed as a business and not UCITS.
Note that the Directive looks to beneficial ownership, so that payments to nominees of individuals resident in another Member State fall to be reported.
Collective investment schemes
At the time of negotiation of the Directive, it was recognised that collective investment schemes could be used as a wrapper to hold reportable investments and avoid reporting requirements. Certain payments relating to investment funds are therefore brought within the scope of the Directive.
Income from funds with 15% or more of the fund's assets invested in money debts or held in cash is taken to constitute savings income for the purposes of the Directive. In addition, amounts derived from the sale and redemption of shares or units in collective investment schemes which hold more than 40% of their assets in money debts or cash are subject to the Directive. This latter threshold will fall to 25% in 2011.
A practical difficulty with the implementation of the Directive is establishing how the percentage holdings are to be determined for the purposes of the 15% and 40%/25% tests.
The Directive proposes that this should be done either by reference to the fund's investment policy as set down in its rules or constitution, or by looking at the actual composition of the fund's assets. The latter approach would require continuous monitoring of asset values by funds and so be an additional administrative complication.
In addition, measurement by reference to the composition of an actual portfolio could give unexpected results - many long/short equities funds will be more than 15% invested in cash from time to time.
Guidance is awaited from the UK Inland Revenue on this point, although it is hoped a pragmatic solution, perhaps by reference to a fund's last set of published accounts, may be reached.
Data collection and maintenance
Paying agents have responsibility for collecting the necessary identity and residence information required by the Directive. Where contractual relations between the paying agent and the payee begin on or after 1 January 2004, the paying agent will need to establish the relevant payee's name, address, country of tax residence and his Tax Identification Number (TIN).
The TIN is an official identification number allocated by some territories to their residents. Unfortunately, there is no common format to this number, and no example available, so identifying precisely what is meant by this may be difficult. In respect of payees with whom contractual relations existed before 1 January 2004, information required to be obtained for money-laundering purposes is sufficient. However, new contractual relations arising with such clients on or after 1 January 2004 will require the additional information to be provided.
The information about the savings income required to be reported by paying agents is the type, destination and amount of savings income payment they make.
Bonds issued prior to March 2002 under a pre-March 2001 prospectus will be outside the regime, but will be brought into the scope of the Directive from 2011. This adds a further layer of reporting for bond funds and their paying agents.
Impact for fund managers
Whether a manager will have substantive obligations under the Directive will depend upon whether the manager is a 'paying agent'. In practice, however, whether it is the manager or (for instance) the fund's administrator which is the paying agent, it will be necessary, from the outset, for the manager to consider the applicability of the Directive and, if appropriate, ensure systems for compliance are in place.
In order to permit compliance with the Directive, should it come into force, managers will need to determine if payments by their funds will be within the scope of the Directive.
If so, they, together with their administrator, should establish whether each investor (whether direct or through a nominee holding) is an individual who is tax resident in a Member State or is a 'residual entity' and, in either case, obtain the relevant information so that this can be provided to the paying agent acting for the fund, if the paying agent is located in a Member State or other jurisdiction with equivalent legislation.
That information would need to be obtained in respect of investors with whom contractual relations are established, even though the Directive is not yet in force.
Can the Directive be avoided?
The Directive is not all- encompassing. It may be possible for fund managers or investors to avoid compliance. Various non-EU states have undertaken to introduce parallel measures: Switzerland will impose a modified withholding tax/elective reporting regime; Jersey will impose a withholding tax unless the recipient elects that Jersey should collect information and exchange it with other territories on request; other offshore jurisdictions will probably take a similar line to Jersey.
Therefore, the use of a non-EU paying agent may not avoid the reporting or withholding requirements in the future. Norway and Singapore, however, are jurisdictions which are not in the EU and which currently are not proposing to introduce similar provisions.
Bermuda is a further jurisdiction where a paying agent could be located, as the Directive has not (at least currently) required that the UK should ensure equivalent legislation is enacted there.
Other options include appointing a paying agent in the home state of individual investors. As the Directive only applies cross-border, its application may be avoided in this manner, although domestic rules may still apply which require reporting and/or withholding.
It seems that some types of entity, including certain trusts, are not 'residual entities'. Investors may choose to invest through these in order to avoid the effects of the Directive. Managers may also ensure that particular funds are not treated as giving rise to savings income by limiting the debt instruments and cash held by those funds.
The Commission will announce by the end of June 2004 whether the Directive will take effect from 1 January 2005. While some actions can be delayed until then, the collection of information from 'new' customers should be put in hand immediately.
Although currently it seems solutions to the issues raised by the Directive are available, it should be noted that built into the Directive's terms is a review mechanism to be conducted every three years.
It will be interesting to see what measures may be taken in 2006 to protect its integrity.
Copyright hedgeweek 2004