EUSD Solutions

Are any solutions feasible?

Possible Strategy

Flaws

Paying Agent - Bank move customer account to branch / subsidiary outside EUSD jurisdiction, most likely Singapore, Hong Kong or Bahamas.

This obvious strategy is the EU Commission's prime concern to combat:
→ See page 10 of EU PDF document

working document 27.03.2008 review of EUSD.

"As consultations have revealed, there is support from a number of Member States on the idea of including specific provisions in the Savings Directive to prevent the risk of deliberate routing of interest payments and the fictitious establishment of customer relationships - at the request of the beneficial owners – through branches that EU paying agents have established outside the territory of the EU. Also in the view of some members of the Expert Group, there would be cases where it is legally and practically feasible to impose an obligation on the head office established within the EU to report (or to withhold) on interest payments made through non-EU branches, provided that the client has not opened the account in direct contact with the non-EU branch without informing the head office in the EU.

Similar solutions have recently been introduced in the United Kingdom regarding residents’ accounts held in overseas branches of British banks or foreign banks operating in the UK. Nevertheless, transposing at EU level this experience, as an additional element of the Savings Directive, does not appear easy or practical at this stage, before more in-depth discussion has taken place between Member States. The main doubt expressed by those Member States and market operators that do not support this solution as an obligation at EU level relates to its problematic compatibility with the bank secrecy provisions in third countries. Other significant concerns refer:
to the risk of affecting the competitiveness of financial intermediaries having their head office in the EU

to the risk of distorting competition between financial intermediaries depending on the kind of international structure adopted by them (branches rather than subsidiaries) and
to the risk of encouraging an outflow of capital outside the EU and outside the network of financial intermediaries having a presence in the EU.

Note: Effectively, the banks defence is "if you close the loopholes, EU-resident owned money will flee EU banks to avoid tax". These are the same arguments EU financial institutions propounded against the initial introduction of the EU Savings Tax Directive, to no avail.

Faced with these concerns, the Commission services suggest a three steps approach to prevent the deliberate routing of interest payments outside the geographical scope of application of the savings taxation measures, to be pursued in parallel with discussions with other financial centres (Hong Kong, Macao, Singapore, Bermuda) aimed at extending such geographical scope:
Short-term, the Commission services incorporates in Article 4 of the Directive an obligation for all Member States to implement the same anti-abuse measure which has been foreseen by Luxembourg in its guidelines for the application of the current text of the Savings Directive.
Art 4 Par 1 - An economic operator established in a Member State shall also be considered to be a paying agent for the purposes of this Directive where the following conditions are met:
it makes an interest payment to, or secures such a payment for, another economic operator, including a permanent establishment or a subsidiary of the first economic operator, established outside the territory referred to in Article 7 and outside the territorial scope of agreements and arrangements providing for the same or equivalent measures to those of the Directive, and
the first economic operator has reasons to believe, on the basis of available information, that the second economic operator will pay the income to, or secure such a payment for the immediate benefit of a beneficial owner who is an individual known by the first economic operator to be a resident of another Member State, having regard to Article 3.
The EU Commission notes: "Such a provision would probably not solve the problem of relocation of the customer relationship outside the current geographical scope of the savings taxation measures, but would set a term of reference for the good conduct of Paying Agents within the EU".

Simulataneously, it would be useful to open a discussion allowing Member States to share their experiences and views on measures such as those implemented at national level by the UK (see above). Such a discussion would allow progress in the mutual understanding between Member States, ensure the compatibility of the measures taken at national level with the EU fundamental freedoms and provide a basis for future coordinated action to tackle the problem of the relocation of savings investments in order to circumvent tax rules.

Medium-long term perspective, the Commission services would suggest to explore with Member States and market operators the possibility of introducing, at EU level, certain general reporting obligations for all financial intermediaries established in the EU regardless of their structure (and thus for instance applicable also to branches and subsidiaries of intermediaries having the head office or the holding company outside the EU). These reporting obligations would in principle be unrelated to the paying agent function under the Savings Directive and could, for instance, cover any significant (15,000 EURO?) outflows or inflows of capital (with the possible exclusion of those justified by commercial reasons) to and from non-EU territories (at least those which do not apply equivalent measures to the Community acquis in the area of cooperation between tax authorities), realised by customers who are individuals resident in the EU according to the identification rules of Article 3 of the Savings Directive. Where the customer would not be resident in the jurisdiction in which the financial intermediary is established and to which it reports the information, use should be made of the Mutual Assistance Directive 77/799/EEC and, more particularly, of the mechanism for automatic exchange of information provided under that Directive. It could also be considered whether the financial intermediaries should be obliged to report to the tax authorities information available to them about the existence of possible customer relationships outside the EU (and outside the territories applying measures equivalent to the Savings Directive) for their individual customers. An extended application of these provisions could significantly impact the activity of financial intermediaries established in the EU, so a specific impact assessment could be necessary and this would require appropriate time and resources. Such a substantial impact assessment could be justified only if and when all Member States would be available to examine the possible introduction on their territory of such provisions."

See PDF document

initial questions by EU Commission in March 2007 to industry experts on feasibility of banks with EU head office applying the savings tax to branches & subsidiaries outside the EUSD jurisdiction.
3.3. Preventing the deliberate routing of interest payments through branches of the paying agents located outside the territorial scope of the Savings Directive
According to 4(1) of the Savings Directive, when the payment is made via a number of intermediaries charged by the debtor or the beneficial owner with paying interest or securing the payment of interest, paying agent means only the last intermediary which pays interest directly to, or secures the payment of interest for the immediate benefit of the beneficial owner. Therefore, the Savings Directive may be avoided by beneficial owners by diverting the last payment of the interests through paying agents established outside the EU and outside any of the ten dependent and associated territories or any of the five European countries that apply the same or equivalent measures to those of the Savings Directive.

Paying agents established within the EU could currently be tempted to accept requests from customers well known by them to take care of the establishment of a fictitious customer relationships with an unincorporated branch of the same paying agent established in third jurisdictions that will formally make the interest payment. The customer concerned could then make use within the EU of this untaxed income through means such as a credit card issued by the branch.
Deliberately routing interest payments outside the territorial scope of the Savings taxation measures through unincorporated branches of intermediaries established in the EU undermines the underlying principles and aim of the Savings Directive.Therefore, reasonable efforts could be asked in order to prevent such deliberate circumventions of the Savings Directive’s provisions.

The extension of the application of equivalent measures to those provided in the Savings Directive to other third jurisdictions reduces the possibilities for beneficial owners to escape the application of the Directive. However, this process requires the agreement of the rest of jurisdictions on the applications of those measures and this may be a time consuming and difficult process.

An alternative solution within the context of the Savings Directive could be explored. For example, the guidelines for the application of the Directive in Luxembourg provide that, when a paying agent established in Luxembourg routes an interest payment through a third country for the benefit of the beneficial owner, who is an individual with residence in another Member State, the payment is still within the scope of the Directive. Although the Luxembourg guidelines do not provide any guidance on how the paying agent should trace the interest payments, the approach taken doesn’t seem too burdensome or legally difficult to apply in cases where the head office knows the beneficial owner and interest is deliberately routed through unincorporated branches located in third countries. When the head office itself takes care of the contractual relationship between the beneficial owner and the branch and orders its branch to carry out the interest payment, it possesses all necessary information on both the payment itself and the beneficial owner. Moreover, the problem of potential breach of secrecy law in the third countries does not arise in most cases because the information needed is already in the hands of the head office and, in addition, because the said branches are frequently business that do non-banking business such as stock brokerage, fund management, etc.

Therefore imposing an obligation of reporting (withholding) on those interest payments which are knowledgeably and deliberately routed through the non – EU branches of the head office established within the EU seems to be a feasible solution.

Q14: Would it be legally and practically feasible to impose an obligation on the head offices established within the EU to report (or to withhold) on interest payments made through non-EU branches, provided that such head offices have access to the information about the beneficial owner and the interest payment?
Q15: Can the above objective be achieved by a common broad interpretation of Article 1(2) of the Savings Directive or should the Directive provide specific rules for cases of EU paying agents deliberately routing interest payments through their non-EU branches?

→ Consequently, the EUSD amendment contains initial provision against this strategy Art 4 par 1.

The EU Parliament adopted a resolution in February 2010 furthering the EU Commission's proposals of penalties for transactions against non co-operating jurisdictions... see Par 27. Urges the EU to examine a range of options for sanctions and incentives to promote good tax governance, such as a special levy on movements to or from non-cooperative jurisdictions, non-recognition within the EU of the legal status of companies set up in non-cooperative jurisdictions and a prohibition on EU financial institutions establishing or maintaining subsidiaries and branches in non-cooperative jurisdictions.

Paying Agent Upon Receipt
Avoid savings tax responsibilities by appointing management based in a territory outside savings tax jurisdiction, e.g. Singapore.

Place of effective management of an entity:

with or without legal personality, shall mean the address where key management decisions are taken that are necessary for the conduct of the entity’s activity as a whole. Where key management decisions are taken in more than one country or jurisdiction, the place of effective management shall be considered to be at the address where most of the key management decisions are taken relating to the assets producing interest payments within the meaning of this Directive;

Where a board of directors formally finalizes and/or routinely approves key management, commercial and strategic decisions necessary for the conduct of the entity’s business in one State but these decisions are in substance made in another State, the place of effective management will be in the latter State. In determining the place where a decision is in substance made, one should consider the place where advice on recommendations or options relating to the decision were considered and where the decision was ultimately taken.

Indeed, the place where the board of directors meet is overruled as the place of effective management when it appears that the key management decisions are in substance made in another State.

For an offshore company managing a portfolio for a private individual, the most likely place of effective management is the permanent address of the majority shareholder.

Beneficial Owner - Utilise untaxed entities and arrangements omitted from Annex I and III.

Tax planners may mistakenly propose the use of under the radar solutions such as Israeli foreign trusts, Singapore non resident companies or imminent new tax havens such as Jamaica.

The Annexes are only an indicative list. It is still mandatory for the Paying Agent to apply the EUSD if the entity / arrangement is not subject to effective taxation.

Beneficial Owner - Utilise agency agreement with a taxable entity. For example set up Israeli or New Zealand company for non-residents. Have this taxable company collect the interest and pay it away via an agency agreement with an offshore international business company.

Not cost efficient. Taxable entity requires accounting, directors, etc plus costs of offshore company.

Beneficial Owner - Structure ownership of untaxed entities where each shareholding is 25% or less, i.e split ownership amongst four or more family members. See PDF document

2005/60/EC - Art 3 Par 6a(i) on the prevention of the use of the financial system for the purpose of money laundering and terrorist financing

The EUSD will then deem the effective manager who controls the entity as the Beneficial Owner. There is support under way from EU Members to reduce the ownership of entities in the anti-money laundering directive to beneficiaries holding 10% or more.

Beneficial Owner - Use of discretionary trusts / foundations outside the EUSD jurisdiction

Unlike arrangements mentioned in Annex I, the EUSD amendment does not deem the contributor of assets as the Beneficial Owner for trusts & foundations located outside the EUSD jurisdiction when an individual beneficiary is not identifiable upon receipt of interest. For these arrangements / entities, the EUSD amendment relies solely on anti-money laundering procedures to identify the beneficiary. As no individual is entitled to interest upon receipt, no Beneficial Owner can be identified for EUSD purposes, perhaps creating a tax planning opportunity.

This is short-term loophole. This is well known to the EU Commission and only temporarily exists while the EU Council focuses on agreeing to the entities / arrangements listed in Annex I. It is only a matter of time before this particular anomaly between non-jurisdiction arrangements and jurisdiction arrangements are equally treated.

Beneficial Owner - Use of untaxed charitable arrangements / legal entities for private purposes.

It is illegal to use arrangements established for charitable purposes for private use. The EU Commission is aware that some foundations are established for the purpose of say, Save the Panda Bear, while the income is diverted to private accounts with only the wind-up settlement going to the charity.

Beneficial Owner - Hide ownership by using nominee shareholders and nominee directors of entities, or nominee settlor / founder of arrangements.

Confuse ownership via circular or cross-ownership of entities.

Anti money laundering procedures should ensure the Paying Agent bank knows the true underlying account beneficiary

If a nominee is used for the arrangement / entity such as the settlor of a trust or founder of a foundation as is common in Liechtenstein where the law firm establish the foundation, then the arrangement/ entity becomes a Paying Agent, and must keep track of interest earned and apply the EUSD upon distribution.

Interest - Funds and insurance policies with less than 25% debts

If the collective investment is registered within the EUSD jurisdiction as per Annex I part 2, or Annex III, then the fund will potentially become a paying Agent which must apply the EUSD

Interest - Take a portfolio for an individual. Establish a non tax paying entity legal entity as defined in Annex III to hold that portfolio. Then as per Art 4(3) opt to being treated for the purposes of this Directive as an undertaking for collective investment, collective investment fund or scheme

As per Art 6.1(d) ii, as long as the portfolio remains below a 25% debt threshold , the portfolio, like a fund, will avoid the EUSD. Else holding the portfolio as an individual will result in the debt portion being within scope.

Interest- Grandfathered bonds with gross-up and early recall clauses

The transitional period for withholding tax allowed by Luxembourg / Austria is obviously going to be extended well beyond the 31 December 2010 deadline. This means the grandfathered bonds exemption will be extended for Austrian / Luxembourg paying agents which have two specific clauses dealing with gross roll-up and early recall as per clause 15.

However, should the transitional period referred to in Article 10 continue beyond 31 December 2010, the provisions of this Article shall only continue to apply in respect of such negotiable debt securities:
- where the paying agent as defined in Article 4 is establishedin a Member State applying the withholding tax referred toin Article 11 and that paying agent pays interest to, orsecures the payment of interest for the immediate benefitof, a beneficial owner resident in another Member State.

In the case of bond issues, a "grandfathering clause" is included in the proposal to avoid market disruption. Most existing issues of domestic and international bonds and other negotiable debt securities contain so called "gross-up" clauses. A gross-up clause commits the issuer to compensate the investor (i.e. to "gross-up") for any tax withheld by the issuer's state of establishment. However, an early redemption clause usually allows the issuer the alternative of redeeming (or "calling") the whole bond issue at par value. Such early redemption would take place at par value and not at the current market value of the bonds and this could entail financial losses for the bondholders depending on market conditions. There is a risk that the imposition of a withholding tax by Austria, Belgium or Luxembourg during the permitted transitional period could trigger the application of such gross-up clauses. The grandfathering clause would therefore ensure the exemption of bonds and other negotiable debt securities issued before 1 March 2001 from the scope of the Directive for the duration of the transitional period. In order to avoid competitive distortions between paying agents in different Member States, this exemption or "grandfathering clause" would apply irrespective of whether the paying agents were established in Member States which levied a withholding tax or exchanged information.

Provision is also made in the proposal for special 'grandfathering' treatment where there were further issues of bonds on exactly the same conditions as an existing bond issue (i.e. where a "tap" occurred on an existing bond issue) after 1 March 2002.

Interest - Use derivatives linked to interest not classified as interest, e.g. the EUSD PDF document

Swiss Guidelines interpret the following as not interest:

static bond "certificates / baskets" comprising at least 5 investments
mixed "certificates / baskets" comprising at least 5 investments
Low Exercise Price Options (LEPOS) on bonds
SWAPS on interest

These are clearly not the intention or spirit of the directive, and these loopholes have been extensively reviewed - see page 8 & 9 PDF document

of EUSD working document. These loopholes are tackled along with capital protected structured products. The Swedish Presidency revision of the amendment specifically states in Art 6 Par 1 (aa) Any income paid or realised, or credited to an account, relating to securities of any kind, except where the income is directly considered to be an interest payment ..., and

where the conditions defined at the issuing date provide for a link of at least 95% of the income from the security to interest or income

The above part ii definition affects derivatives linked to interest which currently escape the EUSD.

It is highly likely that the definition of interest will be refined in the next EUSD review to fall in line with interest in funds and life insurance products, to a 25% debt threshold rather than a 95% link. Contracts between two parties such as equity swaps, which are not marketable are not securities and would not be within scope.

Interest - Reverse Convertible Bonds less than 12 month maturity if there is no separate coupon.

A study of the extended definition of interest:
Any income paid or realised, or credited to an account, relating to securities of any kind, ..., and where:

the conditions of a return of capital defined at the issuing date include a commitment towards the investor that he receives, at the end of the term, at least 95% of the capital invested, or
the conditions defined at the issuing date provide for a link of at least 95% of the income from the security to interest or income.

There is a risk of conversion of the bond to a lower value equity, which clearly falls beyond the definition of pt. i of the interest definition, as the investor is not guaranteed 95% of his capital. However the option income which is always stated as a percentage of the investment, is obviously an interest payment, even if it is capitalised or not. This income falls squarely into the definition of pt. ii i.e. the conditions defined at the issuing date provide for a link of at least 95% of the income from the security to interest.

Interest - Utilise derivative contracts such as interest swaps, interest rate caps / floors, etc. as a substitute for interest. Currently the income on these are excluded from interest definition.

Some institutions have established funds utilising these derivatives purely to avoid the EUSD.

Although the income is based on an underlying, the income easily falls within definition of Art 6 Par 1 (aa) part ii i.e. income is 95% linked to interest.

Interest - Islamic financial instruments such as Sharia deposits and Sukuk bonds.

A Sharia-Compliant deposit is a fixed-term investment involving the purchase and sale of commodities (murabaha, usually base metals). For example, under a Sharia-Compliant deposit the depositor buys base metals from a commodity supplier and sells these to their bank. While the cash price for the purchase of the base metals is settled on the spot, the sale price is paid on a deferred basis and incorporates an element of profit for the depositor. Sharia-Compliant deposits offer full capital protection and market-related returns. Sharia prohibits the payment or acceptance of interest (Riba, usury) for the lending and accepting of money respectively, for specific terms.

Although gains on Sharia deposits and Sukuk bonds are not regarded as interest per se, the EUSD amendment includes income similar in nature to interest, viz. Art 6 Par 1 (aa) deems Any income paid or realised, or credited to an account, relating to securities of any kind, and where:

conditions of a return of capital defined at the issuing date include a commitment towards the investor that he receives, at the end of the term, at least 95% of the capital invested.

As the Sharia deposit offers full capital protection these deposits will definitely fall within scope of the EUSD amendments. It is possible if the depositor does indeed carry risk of loss, then this type of deposit would not be within scope. However, currently all Sharia-Compliant deposits are risk free.

Interest - Set the capital guarantee for protected structured products below the 95% threshold to avoid the definition of interest i.e. at 94.9%

This is a short-term strategy. The next EUSD review will likely reduce the threshold on structured products according to the same definition as funds and other debt products within EUSD scope i.e. any structured product with more than 25% debt (i.e. zero coupon bonds) will be within scope.

Interest - Structure collective investments below the 25% debt threshold.

Many banks established funds with 60% non interest investment such as grandfathered bonds, derivatives, equities, etc. As this was successful, one can expect funds to reduce debt below the 25% debt threshold to avoid the EUSD amendment

Note: Collective investments not caught by the 25% threshold and if not taxed, are indeed candidates for:

Paying Agent upon receipt according to Article 4 Par 2, or
Look through entities or legal arrangements according to Article 2 Par 3, or
Some collective investments, notably ETFs, when marketed to private individuals and not held by financial intermediaries, might also be regarded as wrapper products found in Art 6 Par 1(aa), rather than investment funds.

Interest - Variable annuities without life cover

Fixed annuities (otherwise known as temporary or certain) with less than 5 year duration payout is mentioned in the EUSD amendment Art 6 par 1 e II. Payouts from variable annuities with life cover will be defined as a benefit of a life contracts

The EU Commission PDF document

working document page 7 pt. 11 - defines Annuities without mortality or longevity risk are payments made under a legal obligation and are pure income profit. They can be characterised as annual, so being capable of recurrence on a periodic basis by reference to an annual time frame. The purchase sum passes absolutely to the provider of the annuity and no debtor/creditor relationship is created in relation to that sum; it is replaced by the annuity. The annuitant’s only right is to demand payments when due. Annuities used for pensions are commonly called a purchased life annuity. The payments for the annuity are not installments of pre-existing debt. Annuities without mortality or longevity risk are therefore deposits of money and should be exempt under the definition of deposits.

Interest - Variable annuities with life cover

Usually not marketed as a life insurance policy. However variable annuities are a contract issued by a life insurance company and thus will be within scope as a benefit of life policies.

Interest - Capital Redemption Policies.

A capital redemption bond is a hybrid of a variable annuity and an annuity certain. The insurer promises the policyholder a certain value ofter a certain time, usually 99 years. Invariably the annuity is surrendered early for a variable value with no penalty.

The the EU Commission refers to PDF document

working paper definition to determine what are deposits for VAT purposes. It states on page 6 Pt. 9 that Capital Redemption Bonds should be excluded from the definition of insurances, as it is a deposit.

Under these policies, there is no risk covered but rather money being deposited. One or more fixed sums are paid to an insurer under a contract pursuant to which one or more specified amounts are paid out at some later time or times, on the basis of an actuarial calculation. Typically the contracts take the form of an annuity certain, where a capital sum is used to buy an annuity for a fixed term not contingent on life, or a sinking fund where regular sums are paid in to secure a capital sum at some later date, for example against the need to find a premium payment to renew a lease. Capital RedemptionBonds should therefore come under the definition of deposits.

Interest - Convert interest into pensions, capital gains or dividends.

Difficult to implement pensions, dividends or capital gains as a substitute for interest
Pensions within insurance policies are already mentioned in the EUSD amendment Art 6 Par 1 e(ii)
Pensions, dividends and capital gains are expected to be included in amendments to the Directive on administrative cooperation in the field of taxation. See page 8 of the EUSD amendment proposal COM/2008/727:

Summary of loopholes in EUSD amendments

Trusts / Foundations outside EUSTD territory with no beneficiary at time of interest payment
Complex financial products with less than 95% capital guarantee or less than 95% link of income to debt
Complex financial transactions such as swaps that are contracts between two parties and are not marketable would be out of scope.
Insurance pensions / annuities paid out over at least five years
Permanent grandfather exemption to complex financial products and structured products
Non life insurance contracts such as capital redemption bonds (but may be deemed a deposit according to EU directive on VAT on financial services)
Individual contracts not a security e.g. interest swap between two parties

- EU Savings Tax Expert -
Although I regularly consult with the EU Commission, not all my interpretations of the directive have been confirmed by them.