Offshore: Channel Islands

On 1 July the EU directive on the taxation of savings income will come into force. It will also become effective in the Channel Islands via agreements with individual countries within the EU.

The directive allows three member states to adopt withholding tax for a transitional period, while the other 22 member states will adopt the automatic exchange of information option. The two options were extended to the non-EU jurisdictions, including the Crown dependencies of Guernsey, Jersey and the Isle of Man. At the end of the transitional period, every jurisdiction will have to notify the revenue authorities of the jurisdiction in which the individual is resident of the interest they have received from a paying agent in the jurisdiction (typically a Crown dependency) that has paid the interest. This is the automatic exchange of information option.
The terminal date for the transitional period has not been determined, but a marker has been put down for the rates of withholding tax (or retention tax, as it will be known in the Channel Islands). For the first three years it will be 15 per cent, then 20 per cent for the following three years and thereafter 35 per cent. It follows that the policy objective is to ensure that there is automatic exchange of information by around 2012. Of the retained tax deducted by the jurisdiction, 25 per cent will be retained locally and 75 per cent will be transferred to the income tax authorities of the member state in which the beneficial owner of the interest is resident.

After 1 July, where a paying agent (for most practical purposes a financial institution) makes a payment of interest to a resident of the EU, they will be faced with a choice. If the EU resident does not consent to the disclosure of the interest paid to the fiscal authority where they are resident, the paying agent will have to deduct the retention tax from the interest paid.

It will be necessary, therefore, for a financial institution, where the automatic exchange of information is being implemented, to not only provide a customer’s identity, but also their tax identification number in the jurisdiction in which they are resident. Should the individual not want to take advantage of this option for whatever reason, the retention tax will be deducted from the interest and that amount paid over to the local tax office, together with details of the individual’s resident status, but no other details.

The local tax authority will act as a conduit by remitting the total amount received for each jurisdiction to that jurisdiction, but without any further detail. There will be no disclosure of the individual’s name and so on. One point which arises immediately from a macro point of view is that the recipient country will be able to make a reliable estimate of the funds outside its jurisdiction and will be able to put pressure on the EU administration for changes in the directive before the end of the transitional period, should the take from the tax be sufficiently large. It is acknowledged that some jurisdictions may be affected more than others, for example Luxembourg, but this is a matter which will take several years to work out.

Who is affected by the new legislation?

In very broad terms, the directive applies only to interest paid to individuals and to life tenants in receipt of interest from a trust. It follows that companies and discretionary trusts are outside the scope of the legislation, at least as regards the current legislation. In addition, dividends, including preference dividends, paid from companies are outside the scope of the provisions, as are distributions from partnerships, including limited partnerships.
One group that will be affected is UK resident married women who have transferred the funds to the islands on the basis of receiving the interest gross and having no other source of income. Another will be expatriates who are temporarily in an EU jurisdiction pending a decision to go to another jurisdiction. The biggest group as regards the islands is likely to be UK resident but non-UK domiciliary individuals. Where an individual falls into this category, the financial institution that has responsibility for the implementation of this legislation may have to make difficult decisions. These will concern where the individual’s status has yet to be determined and, as a consequence, the institution’s already existing administrative burden as a financial policeman will be further increased.

Why the Crown dependencies had to implement this directive

In all the discussions with the Organisation for Economic Co-operation and Development (OECD) countries, and others such as the Financial Action Task Force on Money Laundering, the plaintive cry of the dependencies and others has been for a ‘level playing field’. The EU countries appear to have used this against the dependencies and others subject to the provisions by arguing that, if the provisions of the directive were not implemented, there would be a flight of capital to those jurisdictions which would not be fair. Undoubtedly, this is a factor, as was the possibility that, if the Channel Islands (and others) did not implement this legislation, retaliatory action might be taken by them against the islands’ (and others’) lucrative collective investment funds industry.

What can be said about the effects of this legislation? It is obviously easy to circumvent it by using a company, albeit that this might be expensive from a transactions costs point of view. But what about a collective investment scheme based on preference shares, or a protected cell company based on a similar share structure? The latter would reduce significantly the administrative costs as regards each investor.

There are more deep-seated fears. In recent years, despite the celebrated conflict of laws rule, that one jurisdiction will not enforce the tax debts owed by a resident of another jurisdiction, this rule has been eroded in the EU both in terms of tax debts and provision of information. How long will it be before this legislation is extended to the Crown dependencies which traditionally have had sovereignty over their fiscal affairs? The directive is an inroad into this sovereignty whichever way ones looks at it.

This itself may be a damp squib if most of the islands’ work comes from outside the EU. It does suggest that the Channel Islands should conduct an economic audit to determine who its clients are and what their economic importance is to the respective economies.

Raymond Ashton is a partner at Ashton Allen Barnes in Guernsey