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A sense of directive

Our panel of experts look at the savings tax directive, what it covers, how the tax will be implemented and who is affected.

What is your impression of the European Union savings tax directive?

Travis: It is unnecessarily complex, it has been badly drafted and has too many loopholes. For example, assets held within an offshore company, an offshore discretionary trust and portfolio bond wrappers are all excluded. It will drive capital away from the EU to other areas, particularly the Far East. Complying with these regulations will cost the product providers. These costs for compliance will eventually be passed on to the consumer in the form of higher charges or lower investment returns.

Brown: We welcome the directive. The aim is to ensure that EU-resident individuals are taxed on savings income in accordance with the laws of the country in which they are resident. The directive aims to counter tax evasion. If evaded tax can be recovered or future evasion prevented, then this must benefit the average EU citizen who complies with his/her tax reporting duties. The directive will not hinder legitimate tax planning using available reliefs and allowances.

Kennedy: The preamble to the directive tells us that residents of EU countries are often able to avoid taxation on interest by investing in another country. Whether this arises through the innocent misbelief that tax is only payable when the interest is repatriated or whether through deliberate tax evasion is another debate. The point is that individual EU countries are losing tax revenue because people invest cross-border and the ultimate aim is therefore of bringing about effective tax-ation of interest through the exchange of information. However, many EU citizens invest not in fellow EU countries but in the traditional offshore haunts and it is the voluntary acquiescence of these jurisdictions to apply the effect of the directive which creates the biggest bite. That an institution which has no effective legal control over them has persuaded 16 non-EU jurisdictions to apply the measures is testament indeed to the effective muscle of that institution, that is, assuming that the directive does come about, as intended, on July 1, 2005.

Does it only cover bank accounts? Does it cover any type of investment funds?

Travis: The directive refers to savings income so it does not just cover interest on deposit accounts but also interest from fixed-interest securities. This means that funds which invest in cash or fixed interest are also included. It does not include equity dividends or property or capital gains.

Brown: The directive covers savings income in the form of interest payments. The term interest is comprehensively defined and the scope of the directive clearly goes beyond interest on bank or building society deposits. For example, income distributed by a collective investment fund derived directly or indirectly from interest will be regarded as savings income. This would bring a cash unit trust within the ambit of the regulations. Life insurance policies will not be within the scope of the directive.

Kennedy: The directive has a broad scope extending beyond simple deposits, covering interest from debt claims of every kind. This includes traditional interest from deposit accounts, income from government and other bonds and prizes attaching to debt claims, for example, premium bonds.

The definition extends to include interest accrued and capitalised on sale or redemption of debt-based instruments (for example, National Savings certificates). Collective investments are not exempt. The interest element included in distributions is reportable (or taxable) although member states are given an option to exclude collectives with less that 15 per cent in money debt. Where collectives invest more than 40 per cent (reducing to 25 per cent in 2011) of their assets in debt claims income realised on sale or redemption is similarly report-able (or taxable).

How will the tax or exchange of information be imp-lemented in practice? What rate of tax will be levied?

Travis: In countries which opt for tax at source, the rate starts at 15 per cent and gradually rises to 35 per cent by 2011. The tax deducted will be passed by the product providers to their own government. Individual taxpayers will not be identifiable. Each country will then retain 25 per cent of this tax take for themselves and pass on 75 per cent to the country of residence of the investor.

The remaining countries will exchange information and pass on the details to that individual’s country of residence. If they cannot determine what their country of tax residence is, the information will be passed on to their country of nationality.

Brown: Detailed regulations have been published at EU and UK levels setting out the mechanics of the deduction system and the exchange of information requirements.

The entities most affected will be banks and other interestpaying institutions which will have to do all the donkey work for the various national revenue authorities.

When the directive comes into force, any individual who gets savings income from an entity established in another member state may have details about them collected and reported to that entity’s own tax authority, who will pass it on to the tax authority of the country in which the individual is resident.

Initially, tax will be ded-ucted at a rate of 15 per cent for the first three years following implementation of the directive, 20 per cent for the following three years and 35 per cent thereafter.

Kennedy: From July 1, 2005, the investment or deposit pro-vider will be under certain obligations. In many countries, including the UK, relevant information will be reported by the paying agent to the local tax authority in the country where the investment is held and then forwarded to the tax authority of the country in which the customer is resident (disclosure of information).

This is the ultimate aim between all 40-plus countries but, for the time being, some countries, including the Channel Islands and Isle of Man, have elected not to automa- tically disclose information but instead to operate a withholding tax.

The provider will deduct tax at source from the interest initially at 15 per cent, becoming 25 per cent and then 35 per cent. Each country operating the withholding tax will then pool all the withheld taxes together, deduct a bit for themselves and then send the majority back to the authorities where the underlying customers reside. No names or any other information will be disclosed.

What should clients do if they have money in bank accounts in offshore centres or other European Union countries and by when?

Travis: The directive comes into force on July 1. If investors have funds in countries which tax at source and they are non-taxpayers, they can notify their provider and so long as they get confirmation from their country of residence, they may be able to avoid the imposition of tax. Equally, those individuals who are fiscal nomads, that is, non-resident in any country, and the big number of international civil servants who fall into a fiscal no man’s land should consider tax shelters.

Brown: IFA clients with offshore bank accounts or acc-ounts in other EU countries and associated jurisdictions need do nothing. The plethora of money-laundering reporting requirements mean there should be no clients with offshore bank accounts which have not been disclosed to the Inland Revenue and/or the National Criminal Intelligence Service. IFAs which have clients with undisclosed offshore banks acc-ounts should urgently take legal advice as to their own position. There has already been a successful prosecution of a non-reporter.

Kennedy: First, establish whether you are investing in a reporting jurisdiction or a withholding tax jurisdiction. Countries operating a reporting regime will simply be reporting relevant information to the UK authorities which in theory the investors will have been declaring in any event, so nothing much changes. When investing in a withholding tax jurisdiction, more thought is required as options exist. All investors must be given one of two options to avoid the withholding tax being deducted.

The first is that they can expressly instruct the provider to disclose information to the UK authorities. The second is that they can get a certificate from the UK authorities and submit this to the provider. Individual countries applying the withholding tax must allow one or both of these options. If not electing the disclosure route, then the withholding tax will be applied although the investor will be given full tax credit within their tax returns and where relevant the withheld tax will be refunded by the Revenue.

Should clients pay the tax or go for exchange of information where they have a choice? Under which circumstances should they choose either of these options?

Travis: My advice would be to opt for exchange of information rather than tax deduction at source. It would ensure that the individual investor does not pay any more tax than they need to and they can maintain the benefits of a gross roll-up. This applies in particular to the Channel Islands and Isle of Man which seem to be offering their investors a choice of tax or information exchange.

Brown: Tax deducted under the directive is credited against the individual’s liabilities and can be repaid if the individual has no liability. To that extent, there should be no financial detriment to using exchange of information as opposed to suffering a tax deduction.

However, there are practical problems and costs in getting a repayment of tax already deducted and non-taxpayers should be going for an exchange of information approach where possible.

Kennedy: There will be no choice in a reporting jurisdiction whereas in a withholding tax jurisdiction, a choice must be given. Only if the investment provider is offering automatic exchange of information will an investor be able to instruct them to disclose information. Otherwise, the investor has to go to the UK authorities, disclose the details, get a certificate and send it to the provider.

Either way, the investor has to make this happen. Suffering the withholding tax seems a poor option and it is difficult so see where this will offer any real benefit to legitimate UK investors. Eventually, the withholding tax will rise to 35 per cent. This rate will exceed tax deducted at source on UK accounts and personal rates of tax for all but higher-rate taxpayers. Any excess can be reclaimed but who in reality will want to pay more tax than necessary and then have to get a refund?

Withholding tax will deny any possibility of gross return and seems set to complicate further an already complex self-assessment tax regime. Technically, disclosure means you can enjoy gross interest for a few months before your UK tax is due but it is marginal and it may be better to reconsider the type of investment altogether.

Is there likely to be an increase in demand for certain types of trusts or companies or other investments that are outside the savings tax directive?

Travis: Undoubtedly, there will be an increase in demand from clients for advice to cope with the directive. It might mean investors moving their deposits from the EU to Hong Kong or Singapore, which are presently outside the scope of the directive. Otherwise, the loopholes created by incorporating companies or offshore discretionary trusts or offshore personal portfolio insurance bonds will surge in popularity.

Brown: Despite the theoretical fairness of the directive, many investors will be irked by the intrusive nature of these arrangements and may choose to invest in products and through structures which legitimately avoid the deduction and reporting requirements. These could include use of offshore life insurance policies and/or trust structures (particularly discretionary trusts). The use of companies may also be considered but establishing offshore companies is usually expensive and these costs must be weighed against the potential benefits to the investor.

Kennedy: Offshore insurance policies are not within the scope of the directive but this in itself should not fuel demand. What should create demand is the fact that offshore bonds offer legitimate gross roll-up opportunities. An offshore investment bond can be linked to cash alone or where an investor now wants to reconsider the appropriateness of cash, it offers access to many classes of investment, providing an ideal vehicle for asset diversification.

Crucially, for personal UK taxpayers, there is no income tax payable on a year-by-year basis as there is with an offshore account, irrespective of whether the investor opts for disclosure or withholding tax.

Liability to income tax is deferred until the bond is cashed in. The accruing effect of gross on gross alone can create a bigger net pot even after UK tax and the investor can also take more control of when income tax is paid. Even grea-ter benefits can be realised if gains can be deferred until a time when they are paying lower rates of income tax.

For investors intending to leave the UK, this could mean no liability to UK income tax even though most of the interest or growth has accrued while they were in the UK. The 5 per cent allowance and segmental assignments offer yet more tax planning opportunities. Add to this ease of admin, self-assessment friendly with no ongoing annual return and it is a persuasive alternative.

Steve Travis, manager, international division, The Fry GroupGerry Brown, technical manager, Scottish Life InternationalPaul Kennedy, tax-ation & trusts manager (investment), Prudential


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