European Witholding Tax

There has been much debate and speculation on the proposed new European Withholding Tax. It seems that one of the most disturbing features of the proposals is their vagueness. Such vagueness is disturbing both because of the uncertainty which it causes and also because of the random nature of what could be suggested in future.

It is perhaps not immediately obvious that the withholding tax proposals are intended to apply not only to the bond market, which is relatively sophisticated, but also to mundane arrangements such as ordinary deposits held by individuals with banks in London. Until now, it has always been the case that interest on such a deposit would be paid gross. Indeed, interest on any normal deposit held with a bank in the UK would be paid gross.

Clearly, however, if there is to be a European-wide withholding tax of the sort put forward by the Commission, then the rules would have to change. Complications would inevitably ensue, because banks would no doubt have to distinguish between different categories of depositors, including the nature of such depositors (ie whether they were corporate or individual) and the residence and/or nationality of such depositors. In the worst case, UK residents might themselves wish to start holding their deposits off-shore. The bureaucracy generated would also be most unwelcome and could apply in a large number of cases.

There is a suggestion that if any relevant deposit is held by a nominee, then whatever the status of the beneficial owner there would be no requirement on the bank to make a deduction in respect of tax on the deposit interest. If this suggestion is adopted, the result would doubtless be that all relevant deposits would in practice be held through nominees. However, the eventual draftsman of the legislation in the UK might decide to “rectify” such an absurd result by requiring banks to investigate further as to the true nature of the beneficial owner of the deposit. One is accordingly left with the double uncertainty of what Brussels proposes and how the UK legislature disposes.

As far as bonds are concerned, the assumption has been to date that if the directive applies only to individuals and if the relevant threshold amount (as to that individual’s holding in the bond issue) is sufficiently low, then it should be only in very few cases that a paying agent would have to concern itself as to whether a withholding should be made. In making this assumption, it has been thought that bonds held through an institution such as Euroclear or Cedel should not be subject to the withholding tax. It should be noted at this point (as a further example of the vagueness of the proposals) that it is by no means clear that such an exemption is being offered. However, on the assumption that it is, it is true that such an exemption should allow interest to be paid gross in the vast majority of cases, given that the great majority of bonds in issue are held through Euroclear or Cedel or similar institutions.

Even in the favourable circumstances outlined above, it is of interest to consider the position of the lone individual bondholder (resident in the EU) who, exceptionally, holds a definitive bond which he proposes to present for payment. Clearly, in such a case a deduction in respect of tax would be required to be made at the time such interest is paid, whether presentation of the bond was made in London or (say) Luxembourg. Such deduction would in turn almost certainly trigger a grossing-up obligation on the part of the issuer of the bond, which would normally also allow the issuer to redeem the bonds held by the individual concerned, at par.

Even if the issuer of the bond were required to gross-up in such an unusual situation, the damage need not be too severe, unless the result of grossing-up were such that the issuer was entitled to redeem all the bonds then in issue, whether or not held by the individual concerned. It will be appreciated that in such cases it could well be advantageous for the issuer to effect such a general redemption, because the level of interest accruing on the bonds was substantially in excess of present market rates. It will also be appreciated that any such general redemption would be highly disruptive to the market.

Although the scenario described above may seem far-fetched, the likelihood of such a situation arising might be increased if the relevant issuer were somehow to engineer for a particular individual under its control to become a holder of one of its bonds and to present it in the manner described above. The issuer might wish to bring about such situation in order to engineer a general redemption of the bonds.

In practice, it may be necessary to review very carefully the terms of individual bond issues to check whether they may be under any such danger as described above. In cases where the bonds are to be held in global form, there should normally be no problem. However, some of the older-fashioned issues which are more liberal in permitting individuals to hold definitive bonds, may be more at risk.

Ultimately, all this highlights is the lack of depth of the analysis given to the new withholding tax, as well as the danger that “solutions” agreed by politicians in the future (such as the applicability of withholding tax to individuals) may prove to be dangerously flawed.