European Savings Directive

A challenge for the fund industry

Rolf Majcen, Legal & Compliance Officer, FTC, Vienna and Director FTC Futures Fund Ltd., Bahamas

The Council Directive 200348EC of June 3rd, 2003 on taxation of savings income in the form of interest payments (“European Savings Directive”, ESD) came into effect on July 1st, 2005. At the same time also several savings taxation agreements with dependent and associated territories of the UK and the Netherlands and some third countries became effective.

The ESD, which is implemented by the EU in co-operation with some non-EU member states, shall decrease tax evasion. The ESD itself could not go into effect earlier as it was necessary that all additional taxation agreements were concluded for avoiding capital flight towards these “signatory countries”. The ultimate aim of the ESD is to enable savings income in the form of interest payments made in one member state to beneficial owners who are individuals resident for tax purposes in another member state to be made subject to effective taxation in accordance with the laws of the latter member state. However, the ESD is not only focussed to the 25 EU member states, its impact is more extensive and ramified: By way of entering into bilateral agreements with EU member states – predominantly with the UK, Ireland and Switzerland – it also applies to Anguilla, Aruba, the British Virgin Islands (BVI), the Cayman Islands, Guernsey, the Isle of Man, Jersey, Montserrat, the Netherlands Antilles and the Turks and Caicos Islands (EU dependent and associated territories) and Andorra, Liechtenstein, Monaco, San Marino and Switzerland.

Common speaking, the ESD applies to cross-border payments of interest, when interest is paid by a paying agent (f.i. fund administrator, credit institution, fund, custodian) based in an ESD-country to a natural person residing in another ESD- country. Paying agents are the last economic agents in the chain, paying interest to the individual. They have to look closely at the jurisdiction of their funds, their structure and portfolios (asset tests may be very complex especially where leverage or derivatives are used) and the domicile of their investors, to establish if they are under any duty to identify affected customers, to automatically process and transfer information relating to customers and their financial position and even to identify the particular financial instruments on which interest income must be declared or from which tax should be deducted. There is no duty for paying agents based outside the ESD-countries.

Automatic exchange of information is the spirit of the ESD. However, for a transitional period, Austria, Luxembourg, Belgium, Switzerland, the Isle of Man Jersey and Guernsey are allowed to apply a withholding tax system, instead of providing information due to concerns about the impact of the ESD on their banking sectors’ competitiveness (bank secret). The tax is at a rate of 15 per cent up to June 30th, 2008, 20 per cent up to June 30th, 2011 and 35 per cent from July 1st, 2011 onwards until the end of the transitional period, which has not already been fixed with an exact date.

ESD covers interest from debt-claims of every kind (e.g. saving accounts, term deposits) whether obtained directly or as a result of indirect investment via collective investment undertakings (“funds”) and other similar entities. In the fund context, taxation will apply to income distributions received from distribution-funds which have invested more than 15% of their assets in debt-claims or to redemption proceeds in respect of interests in funds (both, distribution-funds and accumulation-funds) whose debt-claim-investments exceed 40% (25% from January 1st, 2011 onwards) of their assets. It does not apply to equity holdings or capital gains and it is only the proportion of debt assets held by the fund which is classified as interest when payments are made. Therefore, if a fund invests exclusively in equities, for example, the ESD will have no impact at all even if the fund gains strong returns for its unit holders.

Provided that the fund assets tests (4015) are satisfied, the ESD applies to UCITS (85611EEC), entities which qualify for the opinion to be treated as UCITS (“UCITS-equivalent”) and “undertakings for collective investments” established outside the ESD-countries (“non-UCITS”). Given this range of affected fund constructions it follows the particularity that non-UCITS, like hedge-funds, based in ESD-countries are, in principle, not subject to the ESD. Thus, domiciliation could become a new important point of view for the hedge fund industry, whereas this subject is irrelevant for UCITS. Marketing advantages seem to be preassigned: Luxembourgian so-called Part II SICAV/SICAF funds, established under Part II of the law of 20 December 2002, or hedge-fund-structures according to the Irish Part XIII Companies Act 1990, Unit Trusts Act 1990, Investment Limited Partnerships Act 1994, for instance, are out of scope, although domiciled and having their fund administrators and paying agents within an EU-jurisdiction. Same structured non-UCITS domiciled in certain Caribbean tax havens do not benefit from that tax-exemption: If such funds are held by ESD-taxable individuals and cross border payments take place (for instance a German resident gets a redemption payment by a paying agent in Luxembourg which keeps his accounts), then such a payment falls within the rules of the ESD. By entering into bilateral agreements and applying measuresequivalent to those provided by the ESD “signatory countries” like Cayman Islands or BVI brought, in particular, their hedge funds out of scope. In consequence of that it already can be seen that Caribbean hedge funds – also advised by their European fund administrators – are moving to Caribbean signatory countries, where they are automatically exempted from the ESD. Not to forget the possibility of domiciliation to one of the three most popular European off shore domiciles, Dublin, Luxembourg or the Channel Islands.

However, it has to be said, that in signing the ESD EU member states will receive information or tax relating to EU individuals with interest income from savings in signatory countries. Roughly speaking some of the signatory countries abandoned their private banking business in favour for their (hedge-) fund sector. But it has to be known, that the fund business is much bigger in the Cayman Islands, for instance, than in other Caribbean hedge fund countries, and it seems that the latter did not want to make the same sacrifices for a much smaller fund business and excluded themselves from the neotiation process on the grounds that the ESD is disadventageous to their over all financial industries.

The technical requirements of the ESD for the fund industry and their paying agents are challenging: See Austria, for instance, whose “EU-Quellensteuergesetz” – transporting the ESD – rules that any relevant Fund has to calculate TIS (taxable income per share / the amount included in the NAV that corresponds to gains directly or indirectly derived from interest payments) for delivering dates to Oesterreichische Kontrollbank AG, Austria’s central provider of financial services and information to capital markets . Its not a problem for domestic single (UCITS-)funds, slightly difficult for domestic funds of funds and could be a challenge for foreign (non-UCITS-)funds. When delayed or not delivered, paying agents have to calculate EU-Withholding Tax in a lump sum: 0,9 % of the last repurchase price fixed in the calendar year – irrespective the fact, if the Fund has produced interest gains or not!

Not only national jurisdictions but also the ESD itself knows the principle of flat rate taxation. First, in case the paying agent has no information concerning the proportion of the income, which derives from the interest payments, the total amount of the income shall be considered an interest payment! Second: Where the paying agent cannot determine the amount of income realised by the beneficial owner, the income shall be deemed to correspond to the proceeds of the redemption of the units! Moreover in case of redemptions: When a paying agent has no information concerning the percentage of the assets invested in debt-claims (“in scope”/”out scope”) the percentage shall be considered to be above 40%, which brings the fund automatically in scope. Also it remains to be seen, how funds, whose assets ongoing vary up and down the 4015 limits (by nature of their asset allocation) will be classified in practice and how matters of liability will be resolved, as the paying agents are the institutions, who are responsible to comply with the tax formalities.

Flat rate taxation can, depending on the fund structure, lead to unwanted effects – but just on first sight! In the hedge fund context, for instance, derivative funds will, by their nature, remain directly or indirectly deposited in cash and debt-claims and also long/short funds can hold considerable cash, but not the interests are the gains, which loom large, the capital gains are the one. Even though the part of “debt claim products” of the fund assets can be approximately up to 100%, the proportion of the income, which derives from interest payments is virtually negligible. Tax, which is calculated exactly, will influence the performance of the fund scarcely, should not be a competitive disadvantage – but in case of flat rate taxation? No trouble whatsoever for unit holders, which declare all their cross-border income to the taxman! Paid flat rates can be credited in the course of annual tax declarations and do not lead to economical disadvantages for the unitholders in the end!

However, there are some ways for the fund industry as well as the shareholders to avoid the application of the ESD: Regardless the structure of the fund they are invested to, investors could remove their accounting connections to jurisdictions outside the ESD-countries, where interest reporting/withholding tax is not an issue and paying agents are not obliged to comply with the ESD. Shareholders of non-UCITS moreover could decide to switch their investments into funds that are out of scope – without abandoning their existing accounting connections. UCITS and non-UCITS could look for administrators, which are not based in an ESD-country. However, this just avoids the appliance of the ESD for such individuals, who are directly registered with the administrator (registrar) but does not change anything to the other unit holders who have their shares deposited by paying agents in an ESD-country. Finally non-UCITS could take into consideration to domicile into jurisdictions where they are out of scope, which – in some cases – could done within a few weeks.

Time will tell the real impacts on the fund industry. Maybe hedge funds, which are out of scope, will have some kind of marketing advantage as paying agents, like banks, tend to recommend their clients to invest monies into products which are out of scope. Maybe a significant changeover of hedge funds to tax havens will take place. Be that as it may be. But it has to be clear in mind that just cross-border payments of interests are ruled by the ESD. According to the ESD the Commission has to report every three years on the operation of the ESD and has to propose to the Council any amendments that prove necessary in order better to ensure effective taxation of savings income and to remove undesirable distortions of competition. Thus, 2008 will be interesting and one can be anxious to see which further steps the EU member countries will take in their ongoing struggle against tax evasion…