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In May of 1998, the European Commission adopted a proposed directive which would harmonise interest income compliance systems within the European Union. The proposed directive would require the Member States either to enact a 20 % withholding tax on interest income paid to individuals resident in the European Union by paying agents established in a different EU country or to implement an information reporting system with respect to such income. The following article discusses the general contours and key provisions of the proposed directive, identifies various problems existing with respect thereto, and contrasts the proposed directive with existing German interest withholding law in certain respects.
Recommendations are also given with regard to the negotiation process now under way which will determine the final form taken by the proposed directive. The banking industry in particular is urged to study the proposed directive in detail so as to voice constructive criticism at a stage at which it still stands a good chance of being heeded.
The proposed directive would take effect on 1 January 2001.
1. General contours
The proposed directive is referred to as a "coexistence model" (cf. Art. 2) because it attempts to reconcile compliance systems based on administrative exchanges (information reporting systems), such as are used by certain EU countries, with compliance systems based on withholding taxes, such as are used by other EU countries, so as to permit each Member State to retain the system it presently uses.
The fundamental idea of the proposed directive is therefore that each Member State shall decide whether it wishes to employ a withholding system or an information reporting system in order to ensure taxation of interest earned by residents of other EU Member States. Where a withholding tax is in effect, the investor may in addition elect to avoid its imposition by himself reporting the income.
Unlike the EU interest withholding directive proposed in 1989, the new proposed directive provides for withholding by the paying agent in all cases. This eliminates a number of technical difficulties which were discussed at the time without any tangible result.
The most important step to make the proposal acceptable appears to be Article 6, which provides that the dependent territories within the meaning of Article 227 of the European Community Treaty are to be included in the system. This provision may well prove to be the litmus test which will decide the fate of the proposed directive, since it makes demands in particular on Great Britain, which was already unfavourably disposed towards interest compliance measures at the EU level.
While substantive harmonisation of tax law relating to income from capital is not a goal of the proposed directive, it is achieved as a necessary by-product in some secondary respects. The provisions which would have to be introduced under the directive would apply exclusively to investors with their tax residence in another EU Member State, in other words, not for third country investors located outside of the European Union. The provisions in question need likewise not apply to a country's own tax residents, because they are not the harmonisation target of the proposed directive. Therefore, this may mean that in each Member State the paying agents would have to apply different provisions. This would not be limited to formal matters, but would affect the tax base as well, as is explained below in the comments on Article 3.
It should be a political objective to avoid the creation of different withholding tax systems by applying the same provisions whether the investor is a domestic resident or resident in another Member State. The administrative burden is already considerable in light of the coexistence principle and the aforementioned elective avoidance by the investor. In these respects as well, one should consider whether simplification is not possible in the course of the further negotiations.
2. Article by article commentary
2.1 Article 1 - Aim
Par. 1: Individuals
The directive only covers payments of interest to individuals who are resident for tax purposes in a Member State other than that in which the paying agent is established. The aim of the proposed directive is to ensure minimum taxation of such interest.
The meaning of the term "individual" is unclear. While it certainly does not include corporations in the German sense, it may or may not extend to partnerships, such as civil law partnerships and general and limited commercial partnerships. It is also unclear whether the directive will apply to independent property funds such as trusts. The taxation of investment funds is specifically addressed.
Par. 2: Paying agent
The responsibility for withholding or information reporting is to rest exclusively with the paying agent. The place of establishment of the debtor (obligor) is irrelevant.
This constitutes a considerable technical improvement compared with the 1989 draft, which ignored the problems resulting from the two different types of withholding systems which exist in Europe, one of which assigns withholding responsibility to the debtor and the other to the paying agent. In some cases (for instance in Germany), the two systems exist side by side (25 % source withholding by the debtor in most cases but interest withholding by the paying agent). In spite of intensive efforts, it was not possible at the time of the 1989 draft to harmonise the two systems, which created the danger of double taxation or zero taxation within Europe. However, the present exclusive focus on the paying agent will also necessitate changes in the German withholding tax system, at least to the extent that instruments for which the debtor currently has withholding responsibility fall within the scope of the directive.
2.2 Article 2 - Coexistence model
Par. 1: Member State Option
The Member States make the basic decision to establish either a withholding system or an information system for individuals resident in another EU country. The recipient of the interest payment is here for the first time referred to as the "beneficial owner" of the payment, on whom the compliance system is to be based.
Par. 2: Uniform application
Each Member State must apply the system it elects to all interest payments made by a paying agent established within its territory to individuals who are resident for tax purposes in another EU Member State.
2.3 Article 3 - General definitions
a) Beneficial owner
The beneficial owner is the individual who receives an interest payment for his or her own benefit.
This again poses the issue as to whether, in the case of partnerships or special purpose funds such as trusts, the beneficial owner is the entity or the partners or other beneficiaries standing behind the entity. Under German legal principles, partnerships are transparent entities for certain tax purposes. However, the partners are not automatically the economic owners of the partnership's debt claims, which are instead owned either jointly by the partners as a group or, in the case of commercial partnerships, by the partnership itself, since the Commercial Code permits commercial partnerships to acquire rights in the name of the partnership. For special-purpose funds, the issues posed are very complex and the case law of the Federal Tax Court involves many fine distinctions.
In the case of fiduciary relationships of the sort referred to in German domestic tax law under 39 AO (tax procedure act) and dealt with in the case law of the Federal Tax Court, which attributes property for tax purposes based on its effective control, it at least seems clear that the principal should be regarded as the beneficial owner. For purposes of German withholding tax as well, the creditor within the meaning of sec. 43 ff. EStG (income tax act) is always the principal (under certain sorts of fiduciary relationships).
b) Paying agent
The paying agent is defined as the "economic operator" who is responsible for direct or final payment to the beneficial owner. This can be the debtor himself in the event he does not make use of a third party remitter, or it can be the entity which makes the payment on behalf of the debtor or the beneficial owner. An "economic operator" is only a "paying agent" if it is established in an EU country different from that of the beneficial owner.
This definition should apply in particular to paying agents within the meaning of the German interest withholding provisions. However, it is new to treat entities acting on behalf of the beneficial owner as paying agents. This aspect is likely to be of relevance especially with regard to fiduciary relationships and possibly with regard to relationships between partners and partnerships as well. Here as well, one should bear in mind that the definition set forth above only applies for purposes of the directive, that is, only for payments to non-residents, and does not necessarily mandate any change in the provisions of domestic law applying to domestic taxpayers.
Considerable administrative complication will, however, result if domestic law is not revised to conform to the system of the directive. A conflict is likely to occur, for instance, when the paying agent under domestic tax law fails to recognise that an interest payment is being made to a fiduciary whose principal is resident in another EU Member State. Under domestic tax law, the paying agent is required to withhold tax on the payment if the fiduciary is a domestic person. Under EU law, this responsibility would appear to fall on the fiduciary itself. Depending on which interpretation one follows, qualification problems are likely to arise in other circumstances regarding partnerships when certain partners are domestic persons while others are resident in other EU Member States or in non-EU third countries. Reconsideration of the current proposals in this area is urgently needed.
Special problems are known to exist in identifying the paying agent in the case of security safekeeping chains. However, these appear soluble with regard to the following constellations:
Remembering that only the entity which makes the direct or final payment to the beneficial owner is a paying agent, safekeeping institutions making payment to other safekeeping institutions will not withhold tax because the law regarding safekeeping relationships makes clear that they cannot be the beneficial owners. The same applies with regard to the proprietary holdings of the upstream custodians at least as long as they operate in corporate form and are thus outside the scope of the directive to begin with.
If , based on the above, the first custodian in the chain must presume that the upstream safekeeping institution is not the beneficial owner, then it will refrain from withholding both under EU law and under domestic law.
If the last safekeeping institution in the chain is resident in the same country as the beneficial owner, no withholding obligation results under the EU directive. Such an obligation is likely to exist under domestic law, however (as is the case in Germany). Still, it is not clear whether the drafters of the proposed directive recognised the problems posed by safekeeping chains, which are very common, and therefore the possibility of gaps cannot be ruled out. Here as well, for the sake of practicality, one should strive for a uniform system in which the same rules apply to both domestic taxpayers and EU residents.
c) Residence for tax purposes
Once the beneficial owner has been identified, the provisions of Art. 3 (c) apply in cases involving conflicting indicia to determine the Member State in which the beneficial owner is resident for tax purposes. The procedure established is similar to the tiebreaker rules for determining the residence of individuals under the OECD model tax treaty.
2.4 Article 4 - Identification of beneficial owners
The Member States are to implement procedures for identifying the beneficial owner and his or her tax residence.
Regrettably, the proposed directive provides no details regarding the identification methods. The drafters may have in mind a system similar to that which applies under Article 3 par. 5 of the EU Money-Laundering directive of 28 June 1991. However, this system differentiates depending on whether one acts in one's own name or for that of another, whereas for present purposes differentiation would appear necessary depending on whether one acts for one's own benefit or account or that of another. Such a system can, however, result in considerable complications and create unmanageable liability risks because the paying agent, at least to the extent it acts on behalf of the debtor, will often be unaware of the internal relationships on the recipient's side.
A practical solution to this dilemma is absolutely necessary and could be modelled after German law in this area, which permits reliance on the account documentation as a basic matter. One should also consider the system of "attestations sur l'honneur," to which initial consideration was given on a European level in 1989. These issues become particularly difficult with respect to over-the-counter trading. Present circumstances do not permit investigation of the identity of the beneficial owner. Here it is necessary to prescribe either withholding or an information report as a general matter or to permit reliance on the customer's representations. At the least, the paying agent should be exempted from liability as a matter of EU law in such situations.
2.5 Article 5 - Definition of interest
Article 5 defines four subcategories of income constituting "interest" to which the directive applies.
a) Debt claims of any kind
The first and most inclusive interest subcategory is "income from debt claims of any kind". The term would appear to refer to sums of money paid periodically in fixed relation to a principal amount transferred. In addition, certain payments linked to profits also fall under the directive, such as those from silent partnerships, jouissance rights, participating bonds, or participating loans.
Inclusion of the aforementioned profit-linked instruments means that these would no longer be subject to 25 % withholding by the debtor under German law where the creditor is resident in another EU Member State. Instead, withholding would be performed by the paying agent. Since the debtor, who is required to withhold the current 25 % source tax, is unable to differentiate according to types of recipient, it seems likely that Germany would have to abandon withholding by the debtor for the instruments in question and implement another system, such as one similar to that prescribed by the directive. This should be cause enough to consider whether, as a matter of domestic law, the current dual withholding system of sec. 43 EStG still makes sense. The questions raised when the interest withholding tax was first introduced as to the advisability of retaining 25 % withholding by the debtor should be reopened and extended to include other profit-linked instruments, such as stock, as well. Parallel systems of domestic and EU law in this area seem not only inadvisable, but also virtually unfeasible.
The term "interest" also includes premiums. This term would appear to include premiums and original issue discount (cf. the legislative justification given at the time for Art. 2 par. 1 of the 1989 Directive). Finally, "interest" also includes "prizes", which would appear to mean indices.
All in all, the definition of interest in the directive is not materially different from its meaning in German law as interpreted by the courts since the 1980s. Only the inclusion of profit-linked payments constitutes a material extension of scope for tax purposes. Premiums already constitute income from capital (under sec. 20 (1) no. 7 and (2) no. 1 EStG). The same is true of indices as a form of premium paid under a condition.
b) Contractually agreed increases in value
Interest also includes appreciation in value to the extent contractually agreed. Here withholding takes place at the time of redemption. The taxable interest is the difference between the emission price of the security (or the debt claim) and the redemption amount.
This provision would appear applicable to zero bonds, discount bonds, and analogous debt claims. It is noted that there is no de minimus provision. In light of the use of the term "redemption," it may still be assumed that the provision relates only to redemption by the issuer, not to the sale of such debt claims prior to their maturity. The taxation differences compared with German law are obvious (sec. 20 (2) no. 4a, sec. 43 (1) no. 8 EStG). The same is true of the sale of individual interest coupons and for accrued interest.
c) Investment funds
Interest also includes the payments of investment funds, as defined by European law, which directly or indirectly invest more than 50 % of their assets in debt claims.
d) Investment fund units
The difference between the redemption price and the issue or purchase price of shares or units in investment funds as defined by European law also constitutes interest income to which the proposed directive would apply.
2.6 Article 6 - Territorial scope
The directive is to apply to all paying agents located in the territory to which the EC Treaty applies pursuant to its Article 227.
This would mean that the various dependent territories of the different Member States, which are not themselves members of the European Union (such as the Channel Islands, Madeira, and perhaps the French Overseas Departments) would fall within the scope of the directive. This is clearly one of the most politically controversial provisions in the directive since some Member States, for instance Great Britain, do not have a unilateral right to establish laws for their territories and must instead secure the approval of the territorial legislative bodies. On the other hand, it should be realised that the directive stands almost no chance of being enacted if it does not include these territories, since they are located, so to speak, on the very "doorstep" of the European Union. Here Luxembourg is correct in its assertion that the failure to include the territories would be tantamount to planning loopholes into the structure of any European norm in this area and would lead to distortions of competition.
2.7 Article 7 - Information system
Member States which elect to implement the information reporting system are required to submit information reports instead of levying a withholding tax in the circumstances described above. The information reports are transmitted by the Member State in which the paying agent is located to the Member State in which the beneficial owner is resident for tax purposes. The minimum content of such reports is the amount of interest paid, the date of payment, and the identity and residence of the beneficial owner. This information is to be provided at least once a year within the first six months of the year following the year of payment.
The directive is silent as to how the Member State is to assemble the relevant data. A corresponding requirement must be created under domestic law for the paying agent to provide the necessary information to the competent authorities in its Member State. Any bank secrecy laws recognised under the domestic laws of particular Member State are overridden pursuant to Article 7 (4). Article 8 of the EC Administrative Assistance directive cannot be invoked in this context.
2.8 Article 8 - Withholding system
Par. 1: 20 % minimum rate
Member States electing to implement a withholding tax instead of an information reporting system must provide for withholding at a rate of at least 20 %. No additional withholding tax is permissible for beneficial owners resident in the EU.
Par. 2: Optional self-reporting
No tax is withheld if the beneficial owner reports the income in his or her home jurisdiction and provides the paying agent with a corresponding certificate issued in the taxpayer's name by the competent authority in his or her home country.
The beneficial owner thus has the option of avoiding withholding by presenting this certificate. Paragraph 2 provides that the withholding exemption only applies to the extent the interest payable does not exceed the amount stated in the certificate.
The country of residence of the beneficial owner thus receives a sort of advance self-issued report from the beneficial owner concerning the interest he or she will receive from foreign sources. This naturally assumes that the beneficial owner is able to make an accurate estimate of such foreign source income. This procedure does not appear particularly practical, not only because of the need to forecast interest income, but also because at least as many certificates are required as there are paying agents.
2.9 Article 9 - Issue of certificates
The certificate provided for by Article 8 is issued by the tax authorities of the beneficial owner's country of residence. The certificate must identify the beneficial owner and the paying agent, state the anticipated amount of the interest, and show the date of payment. Certificates are to be issued to the beneficial owner within two months of the filing of a request.
As noted under Article 8, a beneficial owner who exercises this option would have to request a separate certificate for each debt claim in light of the different payment dates and amounts. This is likely to constitute a considerable obstacle not just for the beneficial owner, but even more so for the tax authorities, who would be compelled to issue new certificates each year every time one is requested. The tax authorities would also have to verify that the request has been filed by the true beneficial owner of the various interest payments. It thus seems likely that the option for an exemption certificate will in most cases not be viable as a practical matter.
2.10 Article 10 - Elimination of double taxation
Par. 1: Double taxation avoidance
The first paragraph of Article 10 provides as a general matter that the Member States shall take the measures necessary to avoid double taxation as a result of the new compliance systems. The threat of double taxation arises only to the extent Member States implement a withholding system, as opposed to an information reporting system. In this case, double taxation would result if interest income on which tax has been withheld in one Member State is taxed in the different Member State in which the beneficial owner of the income resides.
Par. 2: Tax credit but no inter-state clearing system
The beneficial owner's country of residence will grant a credit for tax withheld up to the amount of the income tax it levies. Excess withholding tax will be refunded to the beneficial owner directly by the country where tax was withheld.
From this provision it is evident that there will be no clearing system between the various national tax authorities. In other words, the country where the investment is made will be the country which will profit from the tax withheld. This will lead to compliance differences between the Member States since it appears probable that Member States with an intact bank secrecy law will continue to possess a certain attraction. In particular investors who moved their capital abroad in the past will - absent an amnesty in their home country - scarcely be inclined to re-transfer it. De facto, this means that, with regard to income from capital, the countries comprising the European Union are abandoning the principle of taxation of worldwide income in the taxpayer's state of residence in favour of taxation of such income in the source state.
Par. 3: Investment funds
Special rules exist for investment funds:
a) If the paying agent's Member State has opted for the information system, the beneficial owner's Member State will grant the beneficial owner a credit for the tax paid by the investment fund (if any), to the extent interest covered by the directive has been paid to the beneficial owner.
b) If the paying agent's Member State has opted for the withholding system, the paying agent (the investment fund) will reduce the withholding tax by the income tax it has paid with respect to the income.
The operation of these rules is not entirely clear, at least not at present. They would appear to apply to funds which are themselves subject to taxation, that is, to funds not treated as transparent entities. These rules still require detailed study.
Par. 4: Adjustment for non-EU withholding tax
The withholding agent's Member State is to reduce the tax withheld inside the European Union by the amount of any non-refundable withholding tax imposed in a non-EU third country (i.e. presumably refund the reduction amount).
This provision as well must be considered in detail with regard to its feasibility.
2.11 Article 11 - Negotiations with third countries
The Community will enter into negotiations with third countries with the goal of ensuring effective taxation of interest there as well.
2.12 Article 12 - Transposal
The Member States are to enact the necessary national implementing measures by 31 December 1999. These are to enter into force on 1 January 2001.
2.13 Article 13 - Review
The Commission is to present a report on the operation of the directive to the Council by 1 January 2004. In so doing, it will suggest any amendments which have proven to be necessary in the interim.
3. Overall Assessment and Recommendations
Certain improvements of a purely technical nature have undoubtedly been made compared with the 1989 draft. On the other hand, the proposal is weakened by the coexistence system which, for political reasons, permits withholding systems and information reporting systems to exist side by side with one another. This results in considerable complications, particularly when one recalls the conditions for the exemption certificate under Articles 8 and 9.
The proposal raises problems in particular in the following areas:
The focus on the beneficial owner necessitates a substantive investigation of status by the paying agent and/or the tax authorities. All experience to date with this concept indicates that this will prove to be unfeasible both with regard to the identity of the beneficial owner as a legal matter, for instance in the case of interposed partnerships, and with regard to the procedures to be applied when investors use undisclosed fiduciaries as intermediaries. In the impending negotiations, advocacy is urgently needed for amendments permitting reliance on formal criteria or on certificates similar to the "attestation sur l'honneur". The paying agent must under all circumstances be exempted from liability. This is clearly justified because the paying agent will not have at its disposal the legal means which are available to government agencies for investigating situations of the sort discussed above.
The existence of bearer instruments and the concomitant possibility of over-the-counter trading seems to have been completely overlooked by the proposed directive. Given the present situation in this area, it will be completely impossible to determine whether the recipient of payments is also their beneficial owner.
The definition of the paying agent also needs reconsideration. In light of the fact that the determination as to which entity is the paying agent can be made both by the debtor and by the beneficial owner, there is a manifest danger of conflicting determinations. This may lead to a conflict between two entities, both of which correctly consider themselves to be the paying agent based on their contractual relationship to their customer. The definition should instead provide that the determination whether another entity exercises payment functions on the debtor's behalf is made solely by the debtor itself. Furthermore, the feasibility of the system outlined in the directive with regard to chains of safekeeping institutions must be studied in detail. A satisfactory solution in this area is indispensable. Since chains of custodial entities are prevalent throughout Europe, no withholding or information reporting system can exist without explicitly addressing the related issues.
The bureaucratic requirements contained in Articles 8 and 9 and especially in Article 10 are quite daunting. Here as well, liability problems lurk beneath the surface which cannot be permitted to impact the private institutions which act as paying agents. Taxation must remain a fundamentally governmental concern, and government must bear the ultimate responsibility for liability issues.
The proposed directive must in particular be reviewed with regard to its effect on domestic law. With regard to Germany, it would, for instance, require either (1) maintenance of two different compliance systems side by side (one system according to the directive for taxpayers resident outside Germany but inside the EU, and a second system for German residents, perhaps along the lines of the current general 25 % source withholding tax, perhaps analogous to the interest withholding tax) or (more likely) (2) complete revision of the entire German withholding structure of sec. 43 EStG. A demand should be voiced for a uniform system which provides for either for withholding or for information reporting, irrespective of the tax residence of the beneficial owner. This is also the only approach which is in keeping with the harmonisation principle underlying EU directives. One should naturally bear in mind that the directive seeks to avoid compelling countries which currently do not have a compliance system for their own taxpayers to institute such a system. The aforementioned demand should therefore be raised primarily at the national level, which creates the need for specific proposals in Germany for completely rethinking the system of sec. 43 ff. EStG.
The demand that business recipients of interest be exempted from tax compliance measures should be raised in connection with the reconsideration process. This demand dates back to the introduction of the German interest withholding tax, but has so far not been politically feasible. It seems absurd, however, to exempt business recipients in foreign countries (who would presumably not be "individuals" in the sense of the directive, although this requires further study), but to include such recipients in Germany (based on the national law).
When one considers adopting the outlined European system for German domestic purposes, one notes that the proposed directive fails to provide for a number of necessary withholding exemptions. This is the case for all types of tax-exempt recipients above all. Thought could be given to extending the provisions of Article 9 in this respect.
The interest definition contained in Article 5 is also problematic. While certain of the primary characteristics of income from capital are definitely listed here, discussion at the European level of at least the basic features of innovative financial instruments is indispensable if tax equality is an objective.
The interest income compliance directive currently under consideration in the European Union appears to stand a good chance of adoption in some form. In light of the impact this would have on the banking and investment industry throughout the European Union, one is well-advised to study the proposed directive closely and express criticism in timely fashion.
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