EU directive on taxation of interest income
EU directive on taxation of interest income
Background of the directive
Harmonizing the taxation of personal interest income has been the topic of discussion among the EU countries for many years. An agreement was finally achieved in July 2003.
The purpose is to stem tax evasion and ensure that EU citizens file tax returns for their interest income in their countries of residence. Please note that if you trade or invest via an offshore company you are not bound by these rules.
In effect from July 1, 2005
The date of entry into force was originally set to the 1st of January 2005, but as the implementation and negotiation process has proven to be more demanding than expected, the date has been postponed to the 1st of July 2005. Details concerning entry into force continue to be discussed and, in particular, the situation regarding Switzerland is still rather uncertain. However, the EU countries seem to be very much in agreement that the 1st of July 2005 will be the final date for entry into force.
Banking secrecy or exchange of information
The EU countries have the opportunity to choose between exchanges of information or to retain banking secrecy in return for introducing a withholding tax at source on interest income. Luxembourg and Switzerland have chosen to retain banking privacy and introduce a withholding tax at source. The withholding tax at source is 15% for the first 3 years; thereafter, the tax increases to 20%, and finally, to 35% in 2011.
Where does the EU directive on taxation of interest income apply?
As mentioned above, the directive will apply to the entire EU. To ensure that the directive is being enforced, a number of other countries and controlled territories have agreed to introduce rules corresponding to those adopted by the EU countries. Switzerland, Liechtenstein, Monaco, San Marino, and Andorra have also agreed to adopt similar precautions regarding interest payments to persons who are residents of EU countries. These countries will bring in a withholding tax at source, but the account holder will also have the opportunity to choose exchange of information instead. The Channel Islands, Isle of Man, Cayman Islands, Gibraltar, and a number of other territories will either introduce a withholding tax at source or exchange of information.
Who will be included?
The directive is of importance to you if you are physically residing in an EU country and you hold a bank account in one of the countries, which have agreed to adopt the directive. This also means that if you reside in a non-EU country such as the USA, Thailand, or China, you will not be bound by the directive.
Procedure – withholding tax at source
In those countries where the tax on income at source is, as a principal rule, enforced, e.g. in Luxembourg and Switzerland, the financial institution will automatically withhold 15% tax of your interest income. The whole amount of the tax on income at source is paid to the local tax authorities, who forward 75% of the total amount to the country where you reside and retain the remaining 25%. Authorities do not receive information about your name or addresses.
Which investments are covered?
The directive covers interest income as defined in the directive, e.g. interest on cash deposits and interest-bearing instruments of debt such as bonds, junk bonds, and some investment trusts with interest-bearing products. Stocks, foreign exchange trading, and financial instruments are not included under the directive.
Specific investments
Cash deposits
These are covered under the directive; tax on income at source is withheld on accrued interest.
Bonds
Basically, tax on income at source is withheld on interest received from bonds.
Private and corporate bonds issued prior to the 1st of March 2001 are exempt (the so called grandfather bonds). The same applies to government bonds if the same series has not been previously issued. This has been the situation in, for example, Denmark; therefore, all Danish government bonds are covered under the directive.
Shares and dividends
These are not covered by the directive.
Derivatives
For instance, future contracts, options, futures, etc. are not covered by the directive.
Structured products
In the recent years a number of structured products have been issued. The consequence for these products still remains uncertain, but in principle it is only the yield, if any, exceeding the purchase price that will be considered as interest income.
Investment trusts
In general, investment trusts are considered dependent on investment politics and the underlying investments; thus, bond-based trusts are generally included, while share-based trusts are exempted. Hedge funds are also exempt from the directive. However, there is a difference between the handling of allocation and accumulation trusts.
Allocation trusts
If an allocation trust has invested a share of its assets in included products (e.g. cash or bonds) tax on income at source will be withheld on the part of the distribution that does not stem from interest income. Capital gains will be taxed in the same way as accumulated investment trusts. Luxembourg and Switzerland have chosen a 15% limit; therefore, if less than 15% of the trust’s assets are placed in included investments, neither the distribution nor the capital gains are covered under the directive.
Accumulation trusts
If an accumulation trust has invested more than 40% of the assets in the included products, tax on income at source will be withheld when the share in the investment trust is redeemed/sold. However, it is only the share of the profit, which stems from interest income that is subject to tax on income at source, if a division of the profit on interest income and other income is carried out.
Investment trusts outside EU
Investment trusts established outside of the EU will possibly be treated differently than trusts established within the EU. We will, therefore, need to wait for the legislation on the area from Switzerland and Luxembourg.
Investments that are not covered under the directive
As previously mentioned, if you are physically residing in an EU country and you hold an account in Switzerland, the share of your investments that are covered under the directive will be affected by tax on income at source.
However, the investments mentioned below and legal entities, etc. are not covered under the directive.
Pension insurance
Investment through pension insurances or so-called pension capital insurances is not subject to tax on income at source.
Companies and trusts
Legal entities are not covered under the directive. This means that joint-stock companies, etc. are exempt from the directive. This has no significance if the company pays income tax.
The consequences for "trusts" depend on the form. A discretionary trust administered by a professional trust company is not covered under the directive.