Fund managers who believe that tax harmonisation in the EU will not significantly affect them or their funds should think again. European Commission draft directives, European Court of Justice (ECJ) judgements and the Code of Conduct Group looking at harmful tax competition all have implications for fund managers.
The last two years have seen a rapid increase in the pace of developments in direct tax harmonisation including an increase in activity by the ECJ in direct tax issues; the establishment of the code of conduct on harmful tax competition in the EU; and the latest EC proposals on direct taxes.
A number of these developments have direct implications for mutual funds and the financial services industry generally. Will Dublin be allowed to keep its preferential tax regime and will it be allowed to introduce the new country wide 12.5% corporate tax rate from 2003 onwards?
Will the draft directive on interest withholding tax apply to EU bond funds and will some countries’ bond funds be more adversely affected than others?
Is it going to be harder to obtain tax rulings looking at favourable tax treatments in such countries as Luxembourg and Netherlands in the future?
The pace of development towards the creation of a single market within the EU in non-tax areas is fast and there are a whole range of new directives and regulations that increasingly enable the financial services community to regard the EU as a single market with largely similar rules in each country.
Certain governments within the EU have become increasingly concerned that recent laws, such as the Ucits directive, that permit easier cross-border investment and capital flows within the EU have led to large-scale tax evasion by EU taxpayers in certain countries in relation to their investment income.
As presently drafted, the witholding tax directive only applies to withholding tax on payments of interest to individuals resident within the EU. Payments between companies and to individuals resident outside the EU are not covered.
As redrafted, it seeks to impose on member states either: an obligation to withhold tax at the rate of 20% (more at their discretion!); or to pass information to the tax authorities of the member state where the individual beneficial owner resides relating to interest received.
It is important to note that countries have to adopt one system or the other. They cannot mix and match such that certain bonds are subject to the withholding system and, say, mutual funds the information system.
Of importance to mutual funds is that the directive will also apply to income distributed by Ucits that invest directly, or indirectly, more than 50% of their assets in ‘debt claims or corresponding securities’. Therefore, in relation to Ucits that are balanced funds, holding both equity and bond investments, it could be the case that equity distributions would be subject to the withholding or information provisions. It is unclear how this might operate in the context of umbrella funds – would a bond sub-fund of a Ucits escape this provision because the Ucits overall is more than 50% invested in equities?
The two countries most affected are the UK and Luxembourg and, indeed, vociferous opposition has come from the UK, not least because London is a centre for Eurobond debt issues and there is a fear that the imposition of a withholding tax could simply lead to Eurobonds being issued outside the EU and operated through clearing systems based outside the EU. Both Cedel and Euroclear, the current main Eurobond clearing systems, are based within the EU. Given the need for a unanimous vote for this measure to become a directive, the UK Government’s attitude is crucial.
There is a good deal of sympathy for the aims of the directive, in particular the effort to strike at tax evasion. But there is real concern that the directive would not achieve its purpose as long as other major financial centres outside the EU do not have similar systems in place.
Mutual funds would need to operate the withholding tax system (if bond funds with more than 50% invested in bonds or similar securities) unless they could establish that the beneficial owner of the interest was not an individual or resident outside EU; or they would have to operate the information system.
The choice of system would not be in their hands and the governments in their countries would choose which regime must be followed for the whole country.
Most EU mutual funds established as corporates should not be subject to withholding tax as a result of the directive in relation to income received as they are not individuals. However, payments of interest to, for example, a Luxembourg FCP which is a look-through vehicle may be considered differently as, arguably, the beneficial owners of interest received by the FCP could be individual investors residing within the EU. The directive, if implemented, would take precedence over agreements in double tax treaties between EU members that run contrary to the directive.
The code of conduct for business taxation within the EU stems from a concern on the part of some of the larger EU countries (particularly Germany and France) that preferential tax regimes in countries such as Dublin, Belgium (for co-ordination centres), some aspects of the Luxembourg tax system and preferential tax regimes generally are undermining the tax base of the EU by attracting business away from one centre to another, purely on tax saving grounds.
Harmful tax measures, however, depend on your point of view. Doubtless the Irish government does not see the IFSC as harmful – although it has modified the tax regime to take it outside the terms of reference of the code of conduct.
A code of conduct group (business taxation) popularly known as the Primarolo Group identifies and reviews potentially harmful measures. The group will report on progress throughout 1999, concluding its work in December. It is reputed to be looking at some 85 measures, including some which relate to financial services and offshore companies, as well as other sectors’ specific regimes.
Also of note is the fact that, if the code of conduct Group concludes that particular provisions are harmful, there is no mechanism to enforce a change in the EU state concerned. It would appear that the EU is relying on the power of persuasion and moral pressure to influence countries to change their tax laws.
In practice, if a particular tax regime in one EU country is ultimately regarded as harmful by all the other EU member states, then it is quite likely that the offending member state will wish to rectify the position fairly quickly. The arm-twisting capacity which the larger EU states have in relation to the smaller EU states should not be underestimated.
It is too early to tell of the effects of the code of conduct, but, anecdotally, ‘ruling requests’ have become much more difficult in certain countries and mention of the code of conduct committee to practitioners in certain countries around Europe is usually followed by a sharp intake of breath. It will be interesting to see how the committee’s work develops in 1999.
It remains to be seen whether Ireland will come under pressure to move to a more generally accepted corporation tax rate over the next few years. Interestingly, its low corporation tax rate creates some difficulties for the Irish tax system. For example, where is the dividing line between trading and investment activity? One attracts a corporation tax rate of 12.5% and the other 25%.
A number of fund managers are seeking to devise 401K-type defined contribution (DC) pension products for sale around the EU. Often, these DC pension plans are structured as life policies, albeit that the life elements are a very small part of the total contract.
The sale of such pension schemes is made much easier by the insurance directive, which broadly permits insurance companies based in EU member states to sell their insurance or pension products around Europe, without the need for a local subsidiary or branch and without the need to be locally regulated.
However, the introduction of such products will be frustrated if either corporate contributors cannot obtain a corporation tax deduction or individuals are discriminated against in some way through their domestic tax system if they purchase such products from insurance companies based in other EU states.
The Safir and Bachmann cases suggest that countries which currently discriminate in favour of home country providers of life assurance and related pension products may be in breach of the Treaty of Rome.
In France, for example, it is understood that certain types of DC pension plans must be sold by a French insurance company. These French rules would appear to be contrary to the treaty.
The slippery nature of the tests that determine whether direct tax measures are contrary to EU law make it difficult, in many cases, to form a clear view of whether EU law is being infringed. Some of the measures of interest to the mutual fund industry, where it would seem that an argument could be advanced that they are contrary to EU law, include:
p UK offshore fund legislation – as it applies a discriminatory tax regime to capital gains made in relation to non-UK mutual funds held by UK residents compared to those same capital gains made in relation to UK mutual funds
p Mutual funds where tax exemption is available to foreign investors but not to domestic investors (as is the case with certain Dublin-based funds)
p Transfer pricing rules that only apply to transactions between non-residents but not to the same transactions between domestic taxpayers
p Rules denying deductions for payments to pension plans or seeking to subject them to benefits in kind legislation because insurance companies are based outside the EU state of the payer
p UK OEICs which, in effect, give credit to UK investors in relation to underlying withholding tax suffered by the fund. Similar benefits are not available to UK investors in a Luxembourg Sicav which suffers withholding tax on investment income
p German imposition of draconian tax rules in relation to EU mutual funds held by German investors where the fund has not appointed a German tax representative. Investors in such funds are taxed on undistributed income and capital gains in the fund. This is less advantageous than the tax treatment for domestic investors in domestic funds
p Spanish rules that tax ‘tax-haven funds’ differently to domestic Spanish mutual funds. Tax-haven funds include, in this case, Luxembourg funds
p The Netherlands arguably discriminates against other EU funds as its tax system taxes Dutch residents on deemed distributions from such funds (regardless of actual distributions). No similar provisions exist for domestic fund investments. This position may alter as new Dutch tax legislation is introduced in 1999.
While tax harmonisation is unlikely, significant moves to synchronise EU tax systems so that they work effectively to facilitate the single market are very much on the agenda. The control of tax raising powers is, of course, at the heart of who wields political power in the EU and the extent to which the people in each state will continue to exercise control over a significant part of their national lives will be an interesting issue to watch in the near future.
David Newton is a partner in the investment practice of PriceWaterhouseCoopers in London.