The European Union Savings Directive

The European Union Savings Directive

Lynne Ed and Neil Oliver, Ernst & Young

The EU Savings Directive (EUSD) could potentially have a significant impact on a large number of hedge fund managers and their agents when it comes into effect later this year. This article provides a synopsis of the EUSD and its impact on hedge fund managers. It summarises the key technical issues and the current state of negotiations in the EU and in other jurisdictions such as Switzerland and the Cayman Islands and also sets out a contextual background to the EUSD listing the affected non-EU jurisdictions. Finally it provides an analysis of the impact on hedge fund managers and some suggested actions.

The EUSD is a Brussels directive that was accepted by the ECOFIN Council in early June 2003. It is designed to ensure that all individuals resident within the EU are taxed on any cross-border interest income they receive from another Member State. The EUSD will result in yet another reporting obligation falling on a number of participants in the financial services industry.

Debates relating to the actual implementation have been complicated significantly by ambiguity in the wording of the EUSD and by differences in the application of the rules in the various jurisdictions. As a result much of the discourse has unfortunately concentrated on semantics rather than substance with the inevitable result that the detailed application of the EUSD may vary between jurisdictions.

Background to the EUSD

The EUSD is designed to enable effective taxation on individuals in relation to cross border savings income. It deals with EU individuals who have investments that yield 'savings income' from a territory other than their country of residence. Under the EUSD, information will be collected relating to such interest payments and exchanged automatically with the taxing authorities of the individual's country of residence.

While this information exchange has long been agreed, a number of member states, namely Belgium, Austria and Luxembourg as well as dependent or "third countries" including the Channel Isles and Switzerland will apply a withholding tax regime as part of a transitional arrangement under the EUSD. Following delays in negotiating the agreement with the Swiss authorities, the EUSD is due to take effect from July 1, 2005.

Non-EU jurisdictions, commonly referred to as the 'Dependent Territories' and 'Third Countries', have also undertaken to adopt 'equivalent measures'. These countries are:

Definitions

The Directive will apply where:
 

  • there is a payment of "savings income",
  • by a "paying agent" in one territory,
  • to an individual beneficial owner in another territory covered by the Directive.

There has been a good deal of discussion in relation to the interpretation of these three key definitions contained in the EUSD. In broad terms they are:

a. Savings income

This includes income from any kind of debt claim including bank accounts, sovereign and corporate bonds, debentures and other similar securities. Moreover, it will include interest accrued or capitalised on the sale, refund or redemption of such debt claims, and original issue discount and redemption premiums. Specific provisions exist to include in this definition, distributions from and the proceeds of sales or redemptions of certain collective investment schemes (which may include hedge funds) that hold a certain percentage of their portfolio in interest bearing investments. As explained below such investments include broker deposits and collateral so 'equity' hedge fund managers need to read on!

b. Paying agent

The reporting, and where applicable, the tax withholding obligation falls on the paying agent. This is an 'economic operator' who pays interest or secures the payment of interest for the immediate benefit of an Individual Beneficial Owner (see below). If there is a chain of paying agents, the reporting obligation rests solely with the Final Paying Agent ('FPA') in the chain, and this could include custodians. It is often difficult to identify the FPA despite it being crucial to the EUSD. This problem can be exacerbated in the hedge fund industry when such functions are outsourced.

c. Individual Beneficial Owner ('IBO')

This is any individual who receives an interest payment or any individual for whom an interest payment is secured, unless that individual acts as a paying agent. The IBO must be resident in a different Member State to that in which the paying agent is established. Detailed information needs to be obtained on the IBO to determine whether or not the EUSD applies to that person.

State of Negotiations

The ten new entrants to the EU in 2004 have agreed to participate in the exchange of information.

The United Kingdom and the Netherlands have agreed to procure that equivalent measures are introduced in their dependant territories in the Channel Islands and the Caribbean. These equivalent measures may be the operation of a tax withholding regime, although the Cayman Islands have announced that they will apply reporting, rather than withholding arrangements. These arrangements do not extend to Bermuda as it is outside the Caribbean nor to independent nations within the Caribbean such as Barbados and the Bahamas.

The inclusion of 'Third Countries' and 'Dependant Territories' is designed in part to prevent the flight of capital from EU financial institutions to non-EU jurisdictions, especially to those with banking secrecy.

The Cayman Islands are currently in the process of drafting relevant agreements and until these are finalised it is unclear as to what extent Cayman hedge funds anticipate an exemption from the regime, whether the FPA is based in the Caymans or elsewhere.

Operation

In terms of the actual reporting mechanism, qualifying interest paid by local paying agents to individual beneficial owners in other EU jurisdictions will be reported to the authorities in the paying agent's country of residence. This information will then be forwarded to the authorities in the beneficial owner's jurisdiction. In cases where there is a tax withholding in place, the monies withheld will be shared between the jurisdiction in which the paying agent is located and the beneficial owner's country of residence. For collective investment schemes it is important to remember that withholding or reporting can apply to the capital of the fund and not just the income element.

Classification of Funds

Complex rules govern reporting obligations in relation to investment funds. To the extent that a separation between interest income and non-interest income or gains is not possible due to a lack of information, all of the income distributions as well all sales or redemptions will be subject to reporting or withholding.

If a collective investment scheme issues bonds or structured notes to investors then any distributions and redemptions fall within the scope of the EUSD on the basis that the asset held by the individual investor is interest bearing.

An investment fund including a hedge fund or feeder fund may be in scope depending on the domicile, structure and portfolio of the fund. Whilst, broadly, it is anticipated that EU domiciled non UCITS funds will not be in scope, there is little clarity at present as to whether equivalent hedge funds domiciled outside the EU will be exempt. The definitions are wide and complex and include the circumstances where it is necessary to look through other funds in the portfolio to determine the classification. The key points for a fund which is in scope are that:

a. If more than 15% of the underlying
investments are in interest bearing assets, then distributions from the fund are caught by the EUSD.

b. If more than 40% of the fund's underlying
investments are in interest bearing assets then redemptions and transfers of shares, units or other assets in the fund will be caught by the EUSD and the withholding or reporting would apply subject to the detailed rules applicable to the FPA.

For this purpose, interest bearing assets include bank deposits, loan securities, collateral and broker deposits. A number of hedge funds will operate in such a way that their assets are collateral or deposits and could therefore exceed the "debt" levels depending on their investment objective.

While these are, very broadly, the rules which will apply, in addition there is extensive guidance on atypical situations such as the treatment of funds which, on occasion, exceed the 15% or 40% hurdles.

Distribution Channels

The distribution channel of the fund itself might change the location of the final paying agent and this is best illustrated by an example. Assume an individual investor who, through a Swiss bank acting as nominee makes an investment in a fund. If the fund had a Dublin based paying agent then prima facie that is where the reporting obligation would rest. However, in view of the fact that the individual investor is actually receiving the interest income from the Swiss bank as nominee, then that bank may be deemed to be an active paying agent and therefore the final paying agent in this case. As such, a reporting or withholding obligation would rest with the Swiss nominee rather then the Dublin based paying agent.

Critical Issues for Hedge Funds

The impact of the EUSD will be far reaching and may necessitate action by a number of hedge funds, their managers and their agents. At the very least, a high level due diligence exercise should be undertaken to ascertain whether or not the EUSD applies. The three key questions to ask are:

a. Are you managing funds that are within the scope of the EUSD?

b. Do individual investors resident in a covered territory invest in those funds?

c. Where is the final paying agent (FPA)?

The answer to each of these questions may not be straight forward and there may be unintended results as the analysis includes more than one country in most situations.

Whichever jurisdiction the fund (or feeder) is resident in, if the FPA is located outside the scope of the EUSD, then the risk of there being a reporting or withholding requirement is low. It should however be considered whether there is a likelihood that the paying agent or distribution channels could bring the fund back into scope.

Conversely, irrespective of the jurisdiction in which the fund is resident, if the location of the paying agent brings the interest payment is within the scope of the EUSD, then a full analysis of the impact should be undertaken with reference to the rules in the jurisdiction of the FPA.

For all other scenarios, which would include both funds and FPAs resident in EU Member States, Dependent Territories and Third Countries, it is suggested that a full review is undertaken to establish whether any exemptions are available and to review documentation and processes to determine where responsibility lies for reporting or withholding.

In addition to the points above, all hedge fund managers should consider the business impact of the EUSD going forward.

Further Information

All EU Member States are currently in the process of enacting legislation to ensure compliancewith the EUSD. A vast amount of guidance literature has already been and will continue to be published by the authorities in the Member States. In addition, Ernst & Young have set up a pan European steering committee to prepare for implementation of the EUSD.

For further information please contact: Lynne Ed – 020 7951 2893 led@uk.ey.com

Kevin Charlton – 020 7951 2987 kcharlton@uk.ey.com

Neil Oliver – 020 7951 1198 noliver@uk.ey.com