52008SC0559

[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 29.4.2008

SEC(2008)559

COMMISSION STAFF WORKING DOCUMENT

Refining the present coverage of Council Directive 2003/48/EC on taxation of income from savings (“Savings Taxation Directive”)

INTRODUCTION: CHALLENGES AND CONSTRAINTS

Recent events have shown clearly how important it is to establish international cooperation with a view to preventing, in the direct taxation area, fraud and evasion linked to cross-border financial investments. The Savings Taxation Directive, together with the related agreements concluded by the European Community with five non-EU European countries and by all Member States, on a bilateral basis, with 10 dependent and associated non-EU territories, should certainly be considered as an important step in this process, developing further the principles already provided for by Directive 77/799/EEC on mutual assistance between tax authorities in the field of direct taxation. For the first time, a coordinated effort in this area has been agreed and simultaneously applied by a wide number of jurisdictions with different interests and traditions.

However, as with any new instrument, the Savings Taxation Directive could benefit from a number of possible improvements. On 27 November 2000[1], the Council made the deliberate choice to limit the scope of these measures to interest payments made to individuals and to rely on the cooperation of market operators acting as paying agents. But the wish to provide, as far as possible, simple and clear rules for these market operators led to the measures being drafted in a way which, unintentionally, further limits their actual coverage.

In some cases, more attention seems to have been devoted to the formal aspects of transactions than to their economic substance and to the actual way in which the market operates. Conversely, provisions such as the so-called “paying agent on receipt” mechanism in Article 4(2) seem not to have been fine-tuned so as to provide market operators with the degree of legal clarity needed to achieve the expected results.

The review process undertaken so far clearly shows that the current coverage of the Savings Taxation Directive is not as wide as intended according to the conclusions unanimously adopted by the Council on 27 November 2000.

Against this background, the Council meeting (Ecofin) of 4 March 2008 “reiterated its resolve to broaden and improve the network of the savings tax agreements concluded by the EU and the Member States, expressing support to the Commission in its efforts to conclude savings tax agreements with a further group of third countries. It also called on the Commission to accelerate preparation of a report on the implementation of the Directive 2003/48/EC since its entry into force on 1 July 2005, and to make it ready in May.”

This working paper deals only with the application of the Savings Taxation Directive inside the EU. It has been prepared by Commission staff with a view to the forthcoming Council (Ecofin) meeting in May. It is an interim step towards a comprehensive report and highlights the main problems that have been identified and possible solutions for refining the current coverage of the Savings Taxation Directive. It does not carry out an evaluation of the Directive as such, but draws attention to the loopholes in the scope of the measures. Such loopholes are detrimental to the effectiveness of the Directive, whether it is applied in the form of automatic information exchange or, transitionally, through the levying of a withholding tax. An assessment of the effectiveness of these two systems is not possible at this stage.

The document cannot therefore be seen as the first report after three years of application of the Directive within the meaning of Article 18 of the Savings Taxation Directive.

In view of the reporting obligation under Article 18, Commission staff have been examining the operation of the Savings Taxation Directive and its interpretation with experts from the tax administrations of Member States since the end of 2005. In parallel, as of the beginning of 2007, the Commission has consulted external stakeholders within the Expert Group on Taxation of Savings, which brings together qualified representatives of different categories of market operators.

The report under Article 18 will be presented by the Commission later this year, in parallel with proposals aimed at strengthening both the Savings Taxation Directive and the general framework of administrative cooperation in the area of direct taxation provided for by Directive 77/799/EEC.

Challenges

The aim of the Directive as stated in Article 1 is to enable effective taxation of savings income in the form of interest payments in accordance with the laws of the Member State of residence of the beneficial owner. Pursuing this aim requires that interest payments obtained by an individual through intermediate vehicles are consistently put on an equal footing with interest payments directly received by the individual. Although the Directive already contains useful starting points in this direction, further effort would be needed in order to ensure consistent treatment of other comparable situations, otherwise not only is the effectiveness of the Directive endangered, but also compliance with the rules of the Internal Market and fair competition between comparable financial products and structures.

Constraints

The Savings Taxation Directive essentially relies on paying agents for the execution of its provisions. Therefore, while outlining ways forward to refine the coverage of the Savings Taxation Directive, due account has to be taken of the Lisbon Strategy and the better regulation initiative, which involves, for example, reducing administrative burdens on and unnecessary costs for businesses. Member States should therefore be prepared to explore solutions whereby any additional administrative burden for making the provisions of the Directive more effective would be placed as far as possible on the tax administrations, which would benefit from an increase in tax revenue, or on market operators that are currently less involved, rather than on those market operators (such as banks and asset managers) that already make an important contribution to the functioning of the Directive.

The time constraint should also be mentioned: the rate of the withholding tax levied by the three Member States entitled to the transitional regime of Chapter III of the Directive (as well as by the non-EU territories and countries applying the same or equivalent measures), which is currently 15%, will increase to 20% on interest payments made on or after 1 July 2008, and to 35% on interest payments made on or after 1 July 2011. Any delay in finding an agreement between Member States (and possibly with non-EU territories and countries), on solutions for ensuring fairer and more consistent coverage of the savings taxation measures, could result in increased market distortions between comparable products and vehicles in these withholding tax countries.

Another well-known constraint is the relatively limited territorial coverage of the Savings Taxation Directive as well as of the agreements providing for the same or equivalent measures. In the era of globalisation, the relative ease with which customer relationships can be established and maintained via the internet and the advantage of open markets make Member States’ tax systems more vulnerable to tax evasion. The Commission continues to pursue the objective of promoting the application, by important non-EU financial centres, of measures equivalent to those applied by Member States and third parties participating in the savings taxation mechanism.

However, as long as the geographic coverage of the savings taxation measures remains limited, it may also be useful to consider, while having due regard to the free movement of capital laid down in the EC Treaty, whether steps should be included in the review process aimed at tackling the attempts of EU resident individuals to circumvent these measures by channelling interest payments, made in the EU, through “shell” entities or arrangements located outside the territory of the EU and of the jurisdictions cooperating with the EU.

Problems IDENTIFIED AND POSSIBLE SOLUTIONS

The consultations by Commission staff have mainly focused on the analysis of three essential elements of the Directive which have a decisive influence on its effectiveness, irrespective of the system under which the Directive is applied: (i) the definition of the beneficial owner; (ii) the definition of the paying agent and its obligations; and (iii) the definition of an interest payment.

However, at the March Ecofin meeting, a number of Member States expressed their wish to extend the scope of the Savings Taxation Directive beyond the Council conclusions of 27 November 2000 and to include payments to legal persons and all other types of investment income (dividends, capital gains, “out payments” from genuine life insurance contracts and pension schemes etc.).

Commission staff has already started seeking further advice from Member States in this respect. An issue which should usefully be discussed at the present stage is not only whether all these more ambitious targets would have to be pursued or only some of them, but also to what extent this should be done within the Savings Taxation Directive or rather by strengthening the cooperation within the framework of Directive 77/799/EEC on mutual assistance.

There is anecdotal evidence that, for payments made within the European Union, the Savings Taxation Directive can be circumvented by EU resident individual investors by:

1. making use of intermediate investment vehicles leaving them outside the current purely formal definition of beneficial owner, and/or

2. selecting for their portfolio financial/investment products which do not fall within the scope of the Directive, such as, for instance, products whose income remains outside the definition of interest payment.

A balanced solution needs to be found that takes into account all three essential elements of the Directive, namely “beneficial owner”, “paying agent” and “interest payment”, and seeks to improve each of these concepts at the same time, whilst fairly distributing the administrative burden for the implementation of the measures and respecting the need for competitiveness of the EU financial sector.

Definition of beneficial owner (individuals vs. legal entities)

Under the present scope of the Directive, and in line with its aim, paying agents have to report (or to withhold tax) only on interest payments made directly to individuals, whereas payments made to companies and other legal entities or arrangements generally do not fall within the scope of the Directive.

Experience shows that the exclusion of all legal entities from the scope opens opportunities for individuals to avoid the application of the Directive by setting up companies (or other legal entities or arrangements) in another country. Although the extension of the provisions of the Savings Taxation Directive to all payments made to all legal persons established in other Member States would seem to guarantee that its provisions could no longer be circumvented, such an unconditional extension of the scope could require disproportionate resources at the level of the tax administrations and create an overwhelming administrative burden on the paying agents.

An effective and efficient improvement to the Directive should not be in contradiction with the underlying principles of the Directive itself, where only the last link in a chain of paying agents is required to report (or, transitionally, to levy a withholding tax) on interest payments. If all interest payments made to all recipients resident or established in another Member State were to be subject to exchange of information, the same taxable income could be communicated several times with reference to different recipients, creating information noise, and the information received would therefore not necessarily be useful. When the paying agent does not know the identity of the individual beneficial owner, the objective of the Directive cannot be achieved, because there is no certainty that all the individual beneficial owners resident in other EU Member States are traced and that all these States are properly informed (or properly credited with the tax revenue from the withholding tax levied on payments to their residents). In addition, it is difficult to see how the transitional measures in the form of withholding taxes could be applied if such a broad extension of the scope of the Savings Taxation Directive were to be made.

Furthermore, limiting such an extension of the scope to interest payments made to legal entities or arrangements established in the EU would not provide any guarantee of effectiveness and would be likely to encourage an outflow of capital from the EU and the establishment of offshore companies based in non-cooperating third countries.

It does not therefore seem appropriate to suggest extending the scope of the Savings Taxation Directive to interest payments made to all kind of recipients. A more targeted solution would consist in reasonable application of a “look-through” approach by paying agents, requesting them to identify, as far as possible on the basis of the information already available to them, the individual beneficiaries behind the legal entities or arrangements which are the immediate recipients of the interest payments. A similar approach is already required by the Directive for payments made to individuals who are not the actual beneficial owners.

One possibility would be to apply the rules for detecting beneficial ownership under the Third Anti-Money Laundering Directive[2] also for the purposes of the Savings Taxation Directive.

However, the consultations by Commission staff have shown that, at least at this stage, it may be premature and disproportionate to impose this kind of “look-through” approach on paying agents for payments made to legal entities and arrangements established within the EU . At the present stage, this could lead to the same kind of conflict as has been described above with the principle of the paying agent as the “last link in the chain of payment”.

Nevertheless, these conflicts would not arise for payments to recipients established outside the geographic scope of the savings taxation measures. An appropriate solution may therefore be to apply the look-through approach to interest payments made to legal entities and arrangements established outside the EU (and outside those countries of the EEA that are able to exchange information in tax matters with Member States and those other cooperating non-EU countries that accept the same approach) when any of the beneficial owners of these entities and arrangements as identified for anti-money laundering purposes is an individual resident in another EU Member State.

This solution would not substantially modify the current scope of the Directive insofar as it is limited to interest payments made to individuals resident in an EU Member State. An effort towards acceptance of the “voluntary disclosure” provisions [the current Article 13(1)(a)] as the statutory alternative to the levying of a withholding tax would, nevertheless, be needed on the part of those Member States that are entitled to the transitional withholding tax regime, in order to ensure that the so called “look-through” approach is compatible with the obligations arising from the free movement of capital and from the bilateral conventions against double taxation concluded by these Member States with their non-EU partners.

Definition and obligations of the paying agent

Under Article 4(2) of the Savings Taxation Directive, some entities (mostly lacking legal personality, with the exception of certain Finnish and Swedish entities) are treated as paying agents at the moment of the receipt of the payment instead of at the moment when the interest is distributed to the beneficial owner(s). This “paying agent on receipt” approach can be justified because the income obtained by the entities concerned is generally allocated for tax purposes to the participants in the entity regardless of the moment of effective distribution by the entities to the participants (“tax transparent” entities).

Bearing in mind that these entities may not be subject to close supervision by the tax authorities, the mechanism for ensuring compliance with the “paying agent on receipt” obligations of these entities currently relies on the cooperation of the upstream economic operators making interest payments to these entities when established in another Member State. The Directive is then applied in two stages: the upstream economic operator (who does not know the individual beneficial owner) records the payment made to the entity and the entity (who knows the individual beneficial owner) must apply the Directive when it receives the payment. Switzerland and the other four non-EU countries that apply equivalent savings taxation measures did not accept the “paying agent on receipt” provisions within the agreements signed by them with the Community.

Experience gained in the first years of application of the Savings Taxation Directive provides anecdotal evidence that the “paying agent on receipt” provisions have been less effective than expected by the Council. This is partly due to the lack of legal certainty for the upstream economic operators paying interest to the entities, in the absence of a reliable positive list of the entities concerned on a cross-border basis, but also to a number of inconsistencies in the definition of the scope of the provisions: the lack of a reference to legal “arrangements” that can also be “transparent” for tax purposes; the exclusion of almost all legal persons, irrespective of their tax regime; and the exclusion of “transparent” entities whose profits are taxed under the general rules for business taxation, notwithstanding the fact that they can have non-resident participants and that individual “entrepreneurs” are not excluded from the scope of the Directive.

To make the “paying agent on receipt” provisions more operational without placing an excessive additional administrative burden on the upstream economic operators, the possibility could be considered of drawing up a positive list of the types of entities that each Member State considers to be covered by the paying agent on receipt provisions when established in its territory. This list would form an annex to the Savings Taxation Directive. However, a formal amendment to the Directive for any change does not seem an easy solution. A more dynamic and flexible approach would be to assign the task of updating the list to a committee in order to adapt to market and legal developments. With a positive list of the entities concerned, the administrative burden and the legal uncertainties for the upstream economic operators would decrease, and the “paying agent on receipt” mechanism could be easier to present to third countries that are willing to cooperate with the EU on savings taxation.

Drawing up such a list could also enable the scope of the paying on receipt provisions to be extended to all “transparent” entities and arrangements established in the EU, irrespective of their legal form and with the sole exception of those collective investment vehicles that are taken into account in the definition of interest payment in Article 6 of the Directive.

However, ensuring that all “transparent” entities and arrangements are covered by the scope of the Savings Taxation Directive, as shown by recent instances of tax fraud and evasion on a cross-border basis, would still not be enough to consistently ensure equivalent treatment between savings income obtained directly by an individual and the same income channelled through an intermediate structure. In a number of Member States, foundations and other kinds of non-commercial entities and arrangements, with or without legal personality, not only cannot be defined as “transparent” for tax purposes but, in addition, very rarely pay savings income to their participants[3], who normally benefit from the income obtained by the entity or arrangement through the distribution of its assets.

A similar situation arises for discretionary trusts and similar arrangements, where the beneficiary is not immediately entitled to the income when obtained by the trust and is frequently not even known at that moment. Member States that are more familiar with trust deeds normally solve the problem by subjecting the trustee to annual taxation on the income of the trust, but if the trustee is established somewhere else, such annual taxation may be completely avoided.

It is therefore worthwhile examining possible ways for ensuring the application of the Directive to interest payments channelled through these types of “non-transparent” entities and arrangements, when these entities and arrangements are established in the EU and are not set up exclusively for genuine charitable purposes.

There are two possible ways to ensure that the Directive is applied to interest payments channelled through these entities and arrangements: (i) extend the provisions of “paying agent on receipt” to them, at least when their income is not taxed on a yearly basis at a significant rate (but this approach would not ensure accurate reporting of all the actual individual beneficial owners to their Member States of residence); or (ii) explore an alternative solution, whereby these entities and arrangements would be considered as paying agents of interest payments at the moment of the first distribution of cash assets or other liquid assets (for instance, listed securities with an official market value at the date of distribution) which follows the date at which an interest payment as defined under Article 6 of the Directive was made to the entity or arrangement.

If a positive list of the types of entities and arrangements concerned could be established, the cooperation of the upstream economic operators could possibly be relied on and a combination of the two solutions built.

Definition of income covered

At present, the Savings Taxation Directive is relatively easy to circumvent, because beneficial owners can rearrange their financial affairs in such a way that their income, whilst benefiting from limitations of risk, flexibility and agreed return on investment that are equivalent to debt claims, remains outside the formal definition of interest payment provided by the Directive.

Some anecdotal evidence of distortions has been reported with reference to the possibly too broad exclusion from the compulsory scope of the Savings Taxation Directive of revenues from innovative financial products . Some of these products, notably in the category of structured securities , provide income which may be seen as comparable to that produced by classical debt claims or by UCITS investing in debt claims, especially when instruments or transactions are combined in such a way that the final performance of the structured securities is linked to the income of debt claims or UCITS investing in debt claims. However, it should be taken into account that a substitution effect between products within the scope of the directive and others (e.g. savings flows from UCITS towards structured securities) can be due to other factors not inherent to the directive, e.g. cultural preferences, regulatory arbitrage by distribution channels; tax treatment at domestic level; etc.

The general exclusion of all innovative financial products was decided in May 1999 and November 2000 by the Council in order to avoid complicating the difficult discussions on the first adoption of the Directive, but it was also decided to re-examine the issue on the occasion of the first review of the Directive. In order to establish which derivatives and structured securities should fall within the compulsory scope of the Savings Directive, inspiration could be sought in the commentaries to Article 11 of the OECD Model Convention on income and capital, since Article 6(1)(a) of the Savings Taxation Directive defines interest income in conformity with Article 11 of the OECD Model. One of these OECD commentaries suggests that the definition of interest payment should apply “to the extent that a loan is considered to exist under a ‘substance over form’ rule”. It seems to be worth examining whether the inclusion of a reference to the “substance over form” principle in the Directive would be helpful.

The application of the “substance over form” principle as a key for interpreting the Savings Taxation Directive was largely supported by Member States during the informal consultations, but market operators observed that a simple reference to this concept without further clarification could create more problems than it solves (lack of legal certainty; risk of disputes with customers).

Some experts think an appropriate solution could be to find a technical definition providing more clarity than a generic reference to the “substance over form” principle, and to supplement this provision/definition with a positive list of the types of financial products that can be equated with debt claims. This list would form an annex to the Savings Taxation Directive. However, a formal amendment to the Directive for any change does not seem an easy solution. A more dynamic and flexible approach would be to assign the task of updating the list to a committee in order to follow the evolution of the market.

The exclusion from the scope of the Savings Taxation Directive of the issues related to taxation of pension and insurance benefits was also a deliberate choice by Council.

On the impact of the exclusion of these benefits, the scarce data provided by market operators does not allow any particular conclusion to be reached. While some experts working in the field of collective investment vehicles believe that the exclusion of some life insurance products leads to distortions (especially so-called “unit-linked” insurance whose performance is linked to the performance of an underlying investment in units/parts of investment funds), the three main European trade associations in the insurance sector claim that they have not found any evidence of competition being distorted because of the exclusion of their contracts from the Directive.

Under these conditions, it seems difficult to envisage general inclusion, in the scope of the Savings Taxation Directive, of the income from life insurance contracts and pension schemes, notably because there are many cases in which these contracts and schemes cannot be considered comparable alternatives to interest-bearing products and therefore the Savings Taxation Directive would not be the appropriate tool to ensure taxation.

Nevertheless, if Member States considered it useful to include in the scope of the Directive some derivative and structured securities, in accordance with the “substance over form” approach described above, they could also consider whether to include, in any “positive list” of “debt-claims equivalent” products covered by the Directive, some specific types of life insurance, pension and annuity contracts where the mortality or longevity risk covered is merely ancillary and which are clearly perceived as equivalent to debt claims by investors. This would be the case, for example, when interest-generating securities are “wrapped” in pensions, life insurance or annuity contracts that are easily redeemable at limited cost.

On collective investment vehicles, the consultations showed that there were few opponents to possible extension of the current scope of the Savings Taxation Directive to interest income obtained through incorporated non-UCITS established within the EU, and to the introduction of more clarity in the definition of those “undertakings for collective investment which are established outside the EU territory” that are already within the scope of the Directive. As far as non-UCITS are concerned[4], the present limitation of the Directive to income obtained through UCITS (and through “non-UCITS” only when they lack legal personality and therefore are caught by the provision on “paying agent on receipt”) is considered illogical by many Member States and some experts. Indeed, both UCITS and non-UCITS can invest in debt claims; non-UCITS are regulated at national level and could be used as intermediate vehicles for investing in UCITS. An investor transferring his savings to another Member State is not subject to any restriction in buying units/parts of non-UCITS which can be marketed only in that Member State. Moreover, the current difference in treatment between incorporated and non-incorporated “non-UCITS” is unfair (as really linked only to form and not to substance) and constitutes a source of distortions. However, including these instruments in the scope of the Directive could imply major modifications to market operators' systems and processes. The costs implied should be weighed against the expected benefits. It should also be taken into account that an amendment to the Directive might simply shift the boundaries of any distortion (between investment funds and other types of product excluded from the scope of the Directive).

Given these concerns, the main trade association at EU level in the field of collective investment vehicles opposes extension of the scope of Article 6 to non-UCITS, if this amendment is not accompanied by a parallel extension of the scope of the same Directive to the income that individuals can obtain through competing life insurance contracts and structured financial securities.

An appropriate solution could be to refine the definitions of the collective investment vehicles within the scope of the Savings Taxation Directive according to criteria which could be shared with other parties outside the EU and which would ensure that interest income channelled through these vehicles is appropriately taken into account, irrespective of their geographic location. Investment funds registered within the EU are clearly defined at European level or at Member State level, and these definitions could be referred to in Article 6 of the Directive. Although it may prove difficult to establish an effective concept for collective investment vehicles established outside the EU that cannot be easily circumvented by "legal innovation", the existing OECD definition of “collective investment fund or scheme” used in the tax field seems a good basis for a possible amendment to Article 6 of the Directive regarding these vehicles.

As far as other types of investment income are concerned, some Member States expressed the wish to extend the scope of cooperation between tax authorities to dividends and capital gains . The disadvantages linked to the possible multiple applications of withholding taxes for dividends, and the different treatment of capital gains between Member States, have nevertheless to be taken into account. Exchange of information would seem the most appropriate instrument in this respect in order to prevent the unlawful non-reporting of these types of income by taxpayers in their state of residence.

A possible alternative to the inclusion of these payments in the Savings Taxation Directive could be envisaged at Community level by strengthening the cooperation between Member States within the framework of the Mutual Assistance Directive (Directive 77/799/EEC).

Summary

To sum up, a list (though in no way final) is given below of key issues that need to be clarified:

- whether there is a wish to go beyond the current definition of beneficial owner for the purposes of the Savings Taxation Directive and extend its scope to interest payments made to all legal persons, entities and arrangements, or rather maintain the current definition of beneficial owner and supplement the current possibilities with a “look-through” approach for payments leaving EU territory, as described in section 2.1 of this document;

- whether drawing up a positive list of the entities concerned would be an appropriate solution to make the “paying agent on receipt” mechanism work better;

- whether paying agent obligations under the Directive could be imposed on certain non-transparent entities and arrangements at the moment of the first distribution(s) of cash or other liquid assets following on any interest payment to these entities/arrangements;

- whether a well defined “substance over form” principle should be enshrined in the Directive in order to ensure, as far as possible, that it will apply to all financial products that are equivalent to debt claims in terms of risk, flexibility and agreed return on investment, in order to close possible loopholes and prevent market distortions that can arise irrespective of the system adopted (exchange of information vs. transitional withholding tax) for implementing the Directive;

- whether and, if so, how, as for the purpose described in the above point, it would be appropriate to improve the definition of investment funds and similar vehicles within Article 6 of the Directive;

- whether the Savings Taxation Directive is, or is not, an appropriate legal instrument to accommodate rules on cooperation between Member States for enabling taxation of types of investment income which are substantially different from interest, such as dividends, capital gains and “out payments” from those life insurance contracts and pension schemes where the mortality or longevity risk covered is not merely ancillary.

[1] Council press release 13861/00 (Presse 453) following the Council meeting (Ecofin) of 26/27 November 2000.

[2] Directive 2005/60/EC of the European Parliament and of the Council of 26 October 2005 on the prevention of the use of the financial system for the purpose of money laundering and terrorist financing; fully applicable as of December 2007.

[3] It is important to note that foundations and similar structures (e.g. Anstalten or Stiftungen ) are at present included in the definition of paying agent for the purposes of the Directive or the related agreements for equivalent measures signed with third countries. However, the scope of the Directive is limited to interest payments.

[4] Non-UCITS are investment funds which are not authorised in accordance with Directive 85/611/EEC on Undertakings for Collective Investment in Transferable Securities, and cannot be marketed outside their country of establishment.