European Commission Proposal on Taxation of Savings

Background

This note briefly outlines the main points arising from the European Commission’s proposal for a Directive on the taxation of savings income. The stated objective of the Directive is “to ensure a minimum of effective taxation of savings income in the form of interest payments within the Community”. This note looks at its impact on, primarily, bond issues. It is important to note at this point that the draft Directive applies to “payments” of premiums and discounts as well as to actual payments of interest. In addition, it potentially affects deposits placed with UK banks, by residents of other Member States on which interest is currently paid gross (either under the “banking exemption” (Section 349 ICTA 1988) or under an exemption for non-residents).

The draft Directive was prompted by concerns among some of the Member States (predominantly Germany) that individual investors were avoiding tax on interest by entering into crossborder investment arrangements with counterparties in other Member States. Those arguing for the introduction of the Directive state that tax avoidance creates economic distortions within the Community which are incompatible with the proper functioning of a single market. Whilst this may be true it is only one aspect of a much wider agenda for those seeking tax harmonisation which, if carried through to its logical conclusion, would mean the eradication of tax advantages offered by Belgian Co-ordination Centres and Dublin IFSC’s amongst others. Because of strong opposition from the UK Government (and latterly from the Luxembourg Government) it is far from certain that the draft Directive will ever be adopted. In addition, much uncertainty surrounds the exact extent of the draft Directive which, as presently drafted, only applies to interest (and other) payments to individual and not institutional or other corporate investors.

The draft Directive gives each Member State a choice between adopting an “information reporting system” or a “withholding tax system”. The information reporting system obliges Member States to provide information on income from savings paid from that Member State to an individual resident for tax purposes in another Member State. The withholding tax system obliges “paying agents” (a widely defined term) in one Member State to levy a minimum 20% withholding tax on interest (and other) payments made to individuals resident in another Member State. It is the withholding tax system with which this note is most concerned as the operation of a withholding tax could trigger rights to redeem bonds, obligations to gross-up interest payments and, obviously enough, obligations to withhold and account for tax to relevant tax authorities contained in bond documentation.

It should be noted at the outset that many of the key definitions in the draft Directive (such as “paying agent” and “beneficial owner”) and other important provisions are in some ways defective and not clearly drafted. However, if and when the draft Directive is adopted (and it is far from certain that the UK government will agree to its implementation) important changes in the draft will undoubtedly be made and it will be necessary to review their impact at the time. For current purposes, however, concern centres on what provisions should be included in bond issue documentation to:

(a) protect the parties from the operation of any withholding tax should one be imposed; and

(b)allocate risk between issuer and investor.

A final important point to appreciate is that a beneficial owner in one Member State receiving a payment of interest to which the draft Directive applies from a paying agent in another Member State (which has opted for the withholding tax system) can obtain (and provide to the paying agent) a certificate of exemption. This is obtained from the beneficial owner’s own local Member State tax authority and may exempt that individual from all or part of the withholding (see further at paragraph 2.5 below).

Specific provisions

As stated, the draft Directive only applies to individuals - referred to as “beneficial owners”. However, much press comment has indicated concerns that it may be extended to cover institutional and other corporate investors - hence the clamour for an exemption for the wholesale market. The definition of beneficial owner (Article 3) is “any individual who receives an interest payment for his own benefit;”. This, therefore, currently excludes interest payments made not only to companies for their own benefit but also companies or individuals who receive interest payments in a capacity as agent, trustee or nominee. For example, interest paid by a UK paying agent on bonds issued by a UK issuer will not be required to withhold under the terms of the draft Directive when making a payment to an agent established in France of a beneficial owner resident in France. However, if the beneficial owner were, instead, resident in Belgium the draft Directive would apply to the French agent. It is wide enough to bring the agent in France within the definition of paying agent by virtue of its activity of collecting interest on behalf of the beneficial owner in Belgium.

On a rather more technical point, it has been suggested that because of the definition of “beneficial owner” investors who hold bonds through a clearing system would not be affected by the draft Directive. The basis for this view is uncertain. If corporate bodies receiving interest are not expressly brought within the scope of the Directive by specific amendments prior to its adoption by Member States then a common depositary for a clearing system which holds a global note is not going to be affected by it because it is a corporate entity. On the other hand, if corporate entities were to be brought within the scope of the Directive then for it not to apply to a common depositary for a clearing system holding a global note the clearing system would have to be properly characterised as not beneficially owning interest payments on the relevant bond. This is a difficult conclusion to reach without considering each particular case. This is because the structure of many bond issues will mean that the holder for the time being of the bonds (almost invariably, nowadays, a common depositary - bonds are now hardly ever issued in and rarely held in definitive form) will have the benefit of the issuer’s covenant (with the trustee) to pay interest on the relevant bonds. This confuses the correct characterisation of beneficial ownership of interest somewhat but means that “underlying” investors may not be the beneficial owners of interest paid on global bonds in which they invest on issue; the position will of course be different in relation to definitives which will not be held by the common depositary for the clearing system. Traditionally, what the “underlying” investor participating in the euro-bond market through Euroclear or Cedel has always had is a contractual right against the relevant clearing system for payments of principal and interest equal to principal and interest on the relevant bond - not a direct right as against the issuer for payments of principal and interest on that bond. This is not, admittedly, a picture that is always presented by bond issue documentation which will often describe underlying investors as “beneficially entitled” to or “beneficial owners” of interest on bonds. Often, a careful analysis of the arrangements shows that payments made from a paying agent directly to the clearing system are, in fact, separately credited by the clearing system to the relevant cash account of each “underlying” investor/bondholder and all that an investor/bondholder has is a contractual right as against the clearing system for payment of that cash amount. In that case, the common depositary for the clearing system may well beneficially own the interest paid on the bonds.

In any event, the practical answer to this rather academic question is that it is difficult to establish categorically that interest is beneficially owned by “underlying” investors and the argument that it is should not be relied upon as guaranteeing that the draft Directive does not apply. (Indeed, if beneficial ownership of interest by underlying investors could be established the “bearer” status of any eurobond may be called into question. This point is, however, beyond the scope of this note.)

A paying agent is defined (Article 3) as “any economic operator who is responsible for payment of interest for the immediate benefit of the beneficial owner, whether he be the debtor of the capital which produces the interest itself or the operator charged with the payment of interest by the debtor or by the beneficial owner, in cases where the economic operator is established within the Community outside the Member State in which the beneficial owner is resident for tax purposes.” This means that where interest is paid via a number of intermediaries, the “paying agent” is only the last party (established in the Member State of the EU different from that of the beneficial owner) which makes a payment for the immediate benefit of the beneficial owner. To take the same example as above, a UK paying agent of a UK issuer of bonds which makes a payment of interest to a French paying agent which then pays a French beneficial owner of that interest is not required to withhold under the terms of the draft Directive. In addition, although the definition of paying agent is wide enough to catch the original issuer of bonds, the Directive should not, as currently drafted, apply so as to trigger a gross-up obligation on UK issuers provided standard Offering Circular wording is included. This is because gross-up obligations will usually apply, on a UK bond issue, only where the withholding is imposed as a matter of UK law. Even then the gross-up obligation (under most eurobond Terms and Conditions) will be subject to important exceptions. One of the standard exceptions is where a bondholder presents the interest coupon for payment in the UK. With the inclusion of this exception to the gross-up an investor/bondholder will know that if it does present a coupon for payment in the UK and withholding tax applies under the terms of the draft Directive no gross-up applies. The investor/bondholders only other option in these circumstances is then to go to an overseas paying agent and obtain payment outside the UK. However, because the draft Directive will be given effect to under the law of each Member State any withholding imposed by the Directive on interest payments made by an overseas paying agent to an overseas beneficial owner will be imposed as a matter of the relevant home jurisdiction law and not as a matter of UK law. Therefore, standard bond issue gross-up obligations will not be triggered as the withholding will not be made as a result of the operation of UK law but as a result of the operation of the law of the Member State where the overseas paying agent is established and makes payment.

This argument can be relied upon in practice provided

(a)the gross-up obligation is only triggered if withholding is required as a matter of UK law and

(b)the standard carve-out from the gross-up for coupons presented for payment in the UK is included.

“Interest” is defined widely (Article 5) and includes premiums and discounts. It also includes income distributed from certain collective investment vehicles which derive their income, predominantly, from debts. It will apply to payments of interest (premiums or discounts) made on or after 1st January 2001.

Importantly for bond issues, an exemption from the withholding is provided for under Article 9. Under Article 9 if a beneficial owner of interest to be paid by a paying agent supplies information to its home jurisdiction tax authority that tax authority will issue a certificate. The certificate is to be provided to any beneficial owner who requests it within 2 months and will contain a statement as to the identity of the beneficial owner, the identity of the paying agent, the amount of interest payable and the date of payment. Article 8 paragraph 2 provides that if a beneficial owner presents the paying agent with the Article 9 certificate (drawn up in that beneficial owners name by the competent tax authority and otherwise complying with the requirements of Article 9) no withholding tax will be levied - provided the amount of interest stated as payable on the certificate matches the interest actually payable by the agent. In practice, a second standard exception to the gross-up obligation prevents investors who are able to claim exemption from withholding but do not do so from being grossed-up (and ensures that the issuer does not bear the risk of the withholding under the draft Directive).

Suggested political compromise

A compromise solution has been suggested which involves creating a distinction between the retail and wholesale market. Under this compromise, eurobond holdings valued at more than 40,000 ECU would be exempt from the scope of the Directive; the theory being that this arbitrary level will distinguish between retail (individual) and institutional investors with much larger holdings. At the moment, following the meeting of European finance ministers on 25th May 1999, the future of the draft Directive, the extent of any exemption and the future of European tax harmonisation proposals generally are all uncertain. The UK Government appears to have continued with its opposition to the draft Directive in its current form but equally remains willing to discuss possible compromises.