EUROPEAN SAVINGS TAX DIRECTIVE

The European Savings Tax Directive (ESD) was implemented in the UK with effect from 1 July 2005.

The ESD is one of the three measures relating to tax which together are known as the EU Tax Packet. In summary the ESD is an arrangement between the Member States of the European Union to automatically exchange information with each other about customers of financial institutions who earn savings income in one EU Member State but reside in another (the automatic exchange of information option).

Whilst the automatic exchange of information is the ultimate objective of the ESD, three member states (Austria, Belgium, Luxemburg) have opted to apply alternative arrangements during the transitional period. Under these tax arrangements tax will be deducted at source from income earned by EU resident individuals on savings held in other EU countries (the withholding tax option).

Which Countries and Territories are affected?

Although the European Savings Tax Directive cannot extend outside the EU, its implementation will also affect the UK Crown Dependencies (the Channel Islands and the Isle of Man) and UK Overseas Territories (Anguilla, Monserrat, British Virigin Islands, Turks and Cacos Islands and Cayman Islands), the dependent territories of The Netherlands, and certain other “third countries” which have all voluntarily agreed to apply the same or equivalent measures to those contained in the ESD.

The Main Thrust of the Directive

The directive imposes reporting obligations on “paying agents” who pay interest to individuals resident elsewhere in the EU, but as an alternative to imposing such obligations, as mentioned above, the three states Austria, Belgium and Luxemburg, the dependent territories of the EU members and the third countries will/may withhold tax from such payments instead during a transitional period. For the first three years tax will be withheld at 15%, for the next three years at 20% and at 30% thereafter.

Some at least of such dependent territories and most of the third countries will enable paying agents to offer investors the choice of authorizing them to comply with reporting obligations instead of suffering the withholding. This seems to apply to Andora, Guernsey, Jersey, the Isle of Man, Lichenstein, San Marino and Switzerland.

“Paying Agents” include banks and any other entities which pay an individual income of an interest nature (eg corporate bonds, guilds, market retail funds, etc). Such entities could therefore include stockbrokers, solicitors and, under some circumstances, trustees of settlements if they receive savings income and they or the beneficiary or the paying agent are resident in any of the overseas jurisdictions mentioned.

A trust has no separate legal personality and accordingly all payments to trusts are made to the trustee. If the trustees receive savings income and under the terms of the settlement the beneficiary has an absolute entitlement to the savings income (eg for a life interest trust) the trustees would need to consider whether the beneficiaries are relevant payees. If so, the trustees will be viewed to be a paying agent in respect of that income and would need to consider whether an exchange of information or a withholding tax should be applied. (ie is the beneficiary resident in an EU member state, and if so has the beneficiary elected for exchange of information?).

Conversely if a trust beneficiary does not have the sort of entitlement to receive the savings income (eg for a discretionary trust arrangement) then the trustee is the relevant payee and not the paying agent. Providing the trustee is a corporate trustee, or not resident within an EU member state, the payment of savings income will not be subject to withholding tax or exchange of information requirements.

How does the ESD Operate?

For most of the EU countries the directive only concerns the exchange of information. For example, if one has a bank account in France and receives interest from it, the French bank will inform the French authorities how much interest you have received and the French tax authorities will inform the Revenue authority in the state of residence; conversely if one lives in France with an interest bearing account in the UK, the UK Revenue will inform the French tax authorities. For other countries it will mean the option of a new withholding tax. ESD does not apply to persons (including EU Nationals) who are not resident in the EU.

What is the Withholding Tax option and how will it work?

Under the withholding tax option, banks and other paying agents will automatically deduct tax from interest and other savings income and pass it to the local tax authority, indicating how much of the total amount relates to the customer in each member state. The local tax authority will then keep 25% of the total amount collected paying 75% to the various tax authorities within the member states. The receiving member states receive a bulk payment and will receive personal details in respect of individual customers.

What is the Automatic Exchange of Information option and how will it work?

If a customer chooses the exchange of information instead of withholding tax, details and the customers’ identity and residence, their paying agent and level of savings income received in the period to which exchange relates will be reported to the local tax authority in the country in which the account is held, and then forwarded to the tax authority in the country in which the customer is resident.

Certain jurisdictions, such as Austria, Belgium and Luxemburg will allow a customer to choose to have tax deducted instead of releasing information to the EU state of residence Revenue authority. Some of the interest providers in the dependent territories and third countries will not deduct tax nor exchange information if a customer provides an official exemption certificate to show that they are not liable to pay tax on the interest earned in their country of residence. Although if the customer chooses to permit the bank to inform the tax authority and thus in due course the UK Revenue, or one decides to pay the special withholding tax, the basis of liability to pay tax in the UK does not change.

Re-locating your assets to Jersey/Guernsey

Channel Islands draft guidance notes indicate that paying agents will not need to withhold tax or exchange information on payments made to non UK domiciled individuals who did not make taxable remittances to the UK. This would mean that income arising on assets held in Jersey, Guernsey or the Isle of Man would not be subject to either withholding tax, or necessitate an exchange of information on the basis of the customer’s non domiciled status.

There may be some additional benefits in moving personal funds to Jersey, Guernsey or the Isle of Man. If the funds are held in personal accounts in other jurisdictions or transferred in their entirety and the accounts then are closed, this may present a re-structuring opportunity whereby personal funds can be clearly apportioned between capital and income, making additional capital available for tax free remittance in the future.

Holding assets personally in one of the above British Dependencies appears a favourable option, especially if simplicity is desirable, although the Inland Revenue acceptance of this position is provisional at this stage. The ESD has not been implemented with the intention of penalizing non domiciled individuals and/or those who pay tax correctly. It is therefore to be hoped that a specific guideline relating to non disclosure for individuals whose income is outside this scope of tax in their resident member state will not amended.

Re-locating Overseas Assets out of the EU

We are aware of individuals moving their non UK assets outside of the EU in order to escape the directive. We understand that some investors are considering moving assets to Singapore. Other potential jurisdictions would be Hong Kong and Bermuda. It is important that one feels comfortable with whichever jurisdiction is adopted.

If followed, this course of action would ensure that the ESD would not require the paying agents to make a disclosure about payments made to such EU resident. It does seem possible that a diluted version of this strategy could be adopted whereby the custody of funds is maintained in a non EU jurisdiction while management remains, say, with one’s existing advisors. Clearly, in this respect it will be important to ensure that additional fees are not incurred.

Re-structuring via Investment Products

The ESD only catches interest payments and there are a number of investment types whose return may not fall within the definition, however, the position is not simple and great care would need to be taken in identifying investment types which do not fall foul of the directive. This clearly restricts the assets classes available to one for investment and may result in investment decisions being made for tax reasons.

Nominee Arrangements

It may be possible to set up corporate vehicles in order to bypass the exchange of information obligations. This would be effective in avoiding the impact of ESD, as the reporting guidance indicated companies are specifically excluded as reportable entities.

Placing one’s funds within a company does not complicate the UK tax position for any amounts later brought into the UK as well as introducing a new person into the equation.

However it may be possible to use a company as a “nominee” holding accounts for one’s benefit. This will be similar to a bare trust arrangement whereby one remains absolutely entitled to the funds although the assets are held in the company name.

Based on the current interpretation of the ESD and jurisdiction specific guidelines, some advisors in Switzerland and Jersey currently believe that a “nominee” in either country could work to avoid the exchange of information obligations.

It is not clear how strictly the authorities will view this arrangement but in any event it will be necessary to have the nominee company structure outside the EU – a situation similar to having a non EU trustee. New Zealand is thought to be a very suitable jurisdiction for non EU trustees.

Use of discretionary Trusts

Funds held in a discretionary trust are not covered by the ESD and one may wish to consider further whether this is an appropriate vehicle. It is very important that advice is taken before taking any action in transferring assets to trustees as this may result in an immediate charge to UK inheritance tax.