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INTERNATIONAL BONDS AND THE DRAFT DIRECTIVE ON TAXATION OF SAVINGS

A paper by the United Kingdom

HM Treasury
Inland Revenue
September 1999

Contents Page

I. Introduction

II. Context

III. EU tax and economic reform

IV. Tackling tax evasion

V. The main features of the international bond market

VI. The risks to the international bond market from the current draft directive

VI a: Financial market uncertainty

VI b: Competitiveness and innovation in financial markets

VI c: Administrative costs

VII. Approaches for amending the draft directive

VIII. Conclusion

INTERNATIONAL BONDS AND THE DRAFT DIRECTIVE ON TAXATION OF SAVINGS

I: Introduction

1. At ECOFIN on 25 May, the Chancellor of the Exchequer promised that a UK Paper would put forward approaches to the draft Savings Directive designed to safeguard the competitiveness of EU financial markets. The approaches outlined in this Paper take into account both the way in which the bond markets operate and the objectives of the Directive, consistent with the Council conclusions of 25 May.

II: Context

2. The ECOFIN Council of 1 December 1997 held a wide-ranging debate on a Commission Communication entitled 'A package to tackle harmful tax competition in the European Union'. This followed discussions first initiated by the Commission at the informal ECOFIN in Verona in April 1996.

3. The discussion concerned the need to tackle harmful tax competition within the European Union in order to help achieve various objectives including:

- reducing the continuing distortions in the single market;

- preventing excessive losses of tax revenue and

- encouraging tax structures to develop in a more employment-friendly way.

4. Following that debate three areas were highlighted: business taxation, taxation of savings income and cross-border interest and royalty payments between companies.

5. On taxation of savings, the ECOFIN conclusions noted that:

"To ensure a minimum of effective taxation of savings income within the Community and to prevent undesirable distortion of competition, the Council calls upon the Commission to present a proposal for a Directive on the taxation of savings."

6. The UK Government has made clear that it fully supports the need for enhanced co-operation in the fight against tax abuse and evasion. However the UK also notes two important elements of the December 1997 Council conclusions concerning any Directive on the taxation of savings:

"The provisions of such a Directive should take into account the need to preserve the competitiveness of European financial markets on a global scale" and, consistent with this,

"The United Kingdom delegation considers that such a Directive should not apply to Eurobonds and similar instruments."

7. These two elements have been consistently argued by the UK in Council Working Groups and at Council meetings. The UK therefore notes the ECOFIN Council Conclusions of May 25 on the Savings Directive where the relevant section on International Bonds reads:

"The Council recognises the treatment of interest paid on international bonds as provided for under the Draft Directive might give rise to problems regarding competitiveness of financial markets, in particular wholesale markets. Member States are prepared to consider the possibility of a compromise solution that takes into account the way the bond markets operate and the objectives of the Directive. Pending clarification of the UK position on this issue, however, the Financial Questions Group was not yet able to conclude its examinations as requested."

III: EU tax and economic reform

8. The UK approach to EU taxation issues was summarised by the UK Prime Minister shortly before the Vienna European Council:

'our objective is a reformed European economy which combines high employment, economic dynamism and social justice.'

This echoes the conclusions of the Cardiff European Council, for Europe:

'to promote growth, prosperity, jobs and social inclusion'.

9. Competitiveness is now the key for EU business in a global economy where capital moves far more freely than before. Any proposals on tax must match-up to the challenge of building European competitiveness and jobs. And any proposal must therefore take account of the need for efficient capital markets in the EU. These markets, including the international bond market, form an important part of the foundation for increased job creation, greater investment and higher productivity.

10. It has long been the UK view that the effect of the Savings Directive, as currently drafted, would be to risk undermining the competitiveness of EU financial markets at a time of great opportunity for Europe. It risks the relocation to non-EU centres of a large, liquid and efficient EU-based international bond market which has the potential to rival the depth and breadth of the US capital market, which has played such a key role in maintaining the growth and expansion of the US economy. This, in turn, risks EU companies being placed at a competitive disadvantage relative to their international competitors.

11. This risk to EU financial markets comes at a time when the Commission have put forward an Action Plan on 11 May 1999 on 'Implementing the framework for financial markets'. This followed an initiative during the UK Presidency, including by the Chancellor of the Exchequer at the York Informal ECOFIN and by the Prime Minister at the Cardiff European Council. When this was discussed at ECOFIN on 25 May, the Council strongly supported the Action Plan as a substantial step towards a single market in financial services which will bring significant benefits:

• better choice and security for consumers;
• better pension prospects for those in work today;
• easier access to funding for Europe's businesses; and
• for the economy as a whole, enhanced growth and more jobs.
  

IV: Tackling tax evasion

12. The UK Government has made clear that it fully supports the need for enhanced co-operation in the fight against tax abuse and evasion.

13. On the international front the Government has:

• worked actively to secure the OECD ministerial agreement to tackle harmful tax practices, including the activities of tax havens; and
• in the UK Presidency, promoted and seen to a successful conclusion, a G7 Initiative which seeks better flows of information from money laundering authorities and better information from tax havens.
  
  

14. The single most effective means of tackling tax evasion is through exchange of information on as wide an international basis as possible. This is the first best solution in effectively targeting international tax evaders. But continued insistence on out-dated arguments for banking secrecy in some Member States and in (important) third countries is preventing a solution to tax evasion based on exchange of information. Banking secrecy is an issue that the UK believes should be addressed more widely both within the EU and the OECD.

15. As the OECD's Report on Harmful Tax Competition notes: "provisions which unduly restrict access by tax authorities to banking information required for the assessment of taxes are a serious impediment to...

• "the fair and effective implementation of tax rules; and
• "may distort the allocation of financial flows between countries by providing an unfair competitive advantage to those financial centres which operate such provisions".
  
  

16. But, there are other arguments too why exchange of information is preferable to a directive which provides Member States with the option of operating a withholding tax:

• exchange of information allows the right amount of tax to be paid to the right country;
• a withholding tax will not normally produce the right amount of tax from the investor. The 20 per cent withholding rate is unlikely to be the marginal rate at which the investor should be paying tax in his state of residence. The honest investor would disclose the income to their tax authority. The dishonest investor will not and will continue to evade (some) tax;
• withholding also means that the tax is not paid to the correct country ie. where the taxpayer is resident. That is why Denmark, Netherlands and Sweden have been arguing for Revenue Sharing. The UK believes that this is an issue which requires further work by the Commission and the Council.
• withholding can involve complex calculations, particularly if it is being applied to an accrued interest or where it is necessary to give double taxation relief, ie to give relief for any third country withholding taxes which have already been applied;
• with exchange of information it would be sufficient to draw the attention of the country of residence of the investor to the existence of the income-producing asset - the tax authorities could then seek sufficient information from the investor to work out the tax liability.
• exchange of information draws the attention of the country of residence to the existence of an asset. Often the money used to buy an asset will have arisen from activities which themselves have been hidden from the tax authorities. In turn, these activities too could now be taxed.
  
  

17. In the absence of exchange of information on as wide an international basis as possible, any directive will need to focus on those elements of tax evasion which can be tackled and in a way that does not have damaging side effects. The risk with the current draft Directive is that it will neither effectively tackle tax evasion nor prevent excessive loss of revenue because evasion of tax on income from savings will simply be achieved through third countries. In the UK view, third countries are very unlikely to apply equivalent measures, regardless of the eventual coverage of the Savings Directive. But in attempting to meet its declared objectives, the draft directive risks serious damage to EU financial markets and, in particular, the international bond market.

V: The main features of the international bond market

18. International bonds have the following main characteristics. They are: issued by large companies, national and local governments and international organisations such as the World Bank and European Investment Bank; denominated in any currency; marketed mainly to international investors through syndicates of international intermediaries; not subject to deduction of tax at source from interest payments (although it should be noted that not all pay interest; some carry discount only or a mixture of discount and interest); and issued in bearer form (usually a global note) but largely held within electronic central clearing systems.

19. The international bond market:

• is the largest fixed income capital market in the world; over 4,000 billion euros of bonds are outstanding; almost half of these are EU based borrowers⁽¹⁾.
• is a wholesale market: it is estimated that 90 per cent of bonds are held by institutional investors . Of the 10 per cent held directly by individuals, it is estimated that only about one half are held by EU residents⁽²⁾. Bonds are traded on the secondary market, but are more often purchased and held to maturity.
• is successful because it provides EU borrowers with access to a very large, liquid, low-cost pool of funds, and provides investors with good returns, and an opportunity to spread risk over a range of currencies, countries and credit ratings. The size and liquidity of the market means that both borrowers and investors can achieve efficiency gains;
• has bonds with a typical life of 5-10 years;
• has three major centres: London, New York and Tokyo, with London handling 60-80 per cent of primary issuance and about 75 per cent of trading;
• over 100,000 jobs depend on the international securities market in London alone. Paying agents and custodial services, which would be most directly affected by the Directive, employ over 6,000 people.
  
  

VI: The risks to the international bond market from the current draft directive

23. Apart from the cash-flow costs to investors of a withholding tax, the potentially damaging effects on the international bond market and on investment more widely from the current draft of the directive come from a number of sources. These include: financial market uncertainty; loss of competitiveness and reduced financial market innovation. This section looks at each of these elements in turn.

VIa: Financial market uncertainty

24. A huge risk inherent in the current draft of the directive is 'gross-up' and 'call' of existing bond issues. Typically international bonds include a clause which commits the issuer to compensate the investor ("gross up") for any tax withheld by the issuer's State. But usually the issuer can instead choose to redeem ("call") the entire issue at its par value.

25. Given the significant decline in interest rates across the yield curve which has occurred over the last few years, issuers are more likely to choose to call outstanding bonds. This would be a logical step. They would avoid the cost of grossing up and have the potential to make large windfall gains. The significant reduction in interest rates means that they could refinance at considerably lower interest rates, and thereby increase returns to shareholders. One or two large issuers have already signalled their intention to call should the directive be implemented as it currently stands.

26. If a large number of issuers called bonds it would lead to massive market disruption and uncertainty. It is estimated that between 80 per cent and 90 per cent of fixed-rate international bonds are trading above par (100), with some of the longer dated, high coupon bonds trading up to 20 per cent above par.

27. This would not only affect liquidity in international bond markets but it would be exacerbated by the effect on liquidity in the derivatives market. Derivatives are routinely used, in parallel with bond issues, to hedge the holdings of bonds. The resulting loss of confidence by investors in both the bond and derivative markets could take many years to undo.

28. The scale of this problem is huge. There are a large number of institutional investors who have wide-ranging investment portfolios including bonds with many different forms of gross-up and redemption clauses. There is no easy way for investors to know what their precise exposure is to these 'gross-up' and 'call' provisions. Even with the benefit of substantial legal advice the position, in many cases, will be unclear. The problem is that a gross-up clause triggered on just one individual holding of a bond could lead to the whole issue being subject to call. Even though EU individuals only hold a small proportion of the outstanding value of the bonds, the distribution of their holdings is thought to be very broadly based.

29. It has been suggested that withholding tax under the Directive would not generally trigger gross-up clauses, because those clauses usually only apply where the issuer and the paying agent are in the same State and the recipient in another. But a detailed study by the London Investment Banking Association and International Primary Markets Association indicates that, even after taking account of this, at least 170 billion euros of current EU issues could still be subject to gross-up and hence early redemption. It should be emphasised that this estimate is based on the most conservative assumptions based on UK law only and the actual figure could be considerably higher. The reason for the high level of uncertainty is that the terms of bonds can vary widely. In each country of issuance whether gross-up would be triggered would depend on the precise legal interpretation of each clause.

30.On that narrow assumption, the loss to both individual and corporate investors (and the corresponding gain to issuers) has been estimated to be in the range from 7.5 billion⁽⁴⁾ to 18 billion euros⁽⁵⁾, but it could be even higher. Much of this cost would be borne by pension funds and by financial institutions with long term exposure. This could affect the level of contributions or premiums to be paid to achieve defined benefits. It could affect the solvency of some providers. It would also reduce the money available for pensioners. This would represent a huge, entirely arbitrary and unprecedented transfer of funds from investors to issuers, with pensioners bearing most of the cost.

31. Some have suggested that gross-up could be avoided if tax withheld was later repaid, or if an Article 9 certificate was provided. However this would not solve the problem. Gross-up clauses do not cease to apply if the tax is later repaid. And while a certificate might avoid withholding in many cases, just one case of tax being withheld through absence (or lateness) of a certificate would be enough to jeopardise the whole issue.

32. It has been suggested too that the problem could be avoided by changing the terms of bonds. And there is evidence that new issues of international bonds are being documented in a form which would circumvent the directive. But large amounts remain outstanding on existing bonds, and the terms of existing bonds cannot normally be changed retrospectively particularly, as here, where the interests of issuer and investor may diverge so significantly.

33. The point then is how this disruption can be avoided. Potential early call of bond issues and resulting market disruption can only be avoided via a "grandfathering" provision for existing issues whereby all international bonds in existence on the date at which the Directive is implemented would be exempt from its provisions.

34. Partial grandfathering, for example, as some have suggested, to cover only bonds with gross-up and call provisions could still lead to widespread market disruption. Considerable legal uncertainty would result as issuers and investors argued over the status of bonds, and the likelihood is that it would all be fought out, over a long period, at great expense, in the courts. Partial grandfathering would also lead to market fragmentation, creating a two-tiered market in exempted and non-exempted bonds, with all the associated market inefficiencies reflected in bond prices and liquidity.

35. An example of the introduction of a withholding tax and its impact on the market is when the US decided in 1987 to terminate the US-Netherlands Antilles tax treaty. As a result, $32 billion of outstanding bonds issued through companies in the Netherlands Antilles became subject to a withholding tax. After the price on these bonds fell by an average of 15-20 per cent, the US government announced, within two weeks, that interest paid to residents of the Netherlands Antilles was exempt (i.e. companies incorporated in the Netherlands Antilles were therefore covered).

36. The proposed directive is already having an impact on the market - there are signs of movement and evidence of nervousness which is reflected in the behaviour of investors and issuers. Swiss bankers have been reporting unprecedented capital inflows since the Spring of last year.

37. Uncertainty about whether and when the Directive will be adopted, what it will cover and what obligations it will entail for whom, is leading to adjustments in the terms of new bond issues with the aim of leaving them squarely outside the Directive. (New issues of international bonds are now largely being set up with the option of Swiss paying agents to ensure that the Directive will not apply). Continuing uncertainty is also likely to lead investors to demand higher returns, and this in turn will increase the likelihood that borrowers will look for alternative sources of finance outside the EU.

38. The overwhelming consensus among those involved in international bonds business is that the risk of damage to the EU financial services industry is very grave.

VIb Competitiveness and innovation in financial markets

39. Of critical importance to capital markets is the ability to operate in an environment which is efficient, predictable and low cost. Many international financial centres have already learnt that the imposition of a withholding tax which is not matched by other financial centres serves only to encourage the industry to move elsewhere. The recent global trend has been to announce the removal of withholding on non-resident bonds (e.g. Japan, Australia and Greece). And it should be remembered that the market developed in Europe in the 1960s following the introduction of the US Interest Equalisation Tax (IET) in 1963.

40. The international bond market has a tremendous capacity for innovation, with issuers and corporate financiers constantly seeking out the most competitive and economically tax efficient way of raising and distributing capital. It thrives on innovation, competition, speed and flexibility; the imposition of a new constraint or boundary, no matter how wide it may appear, is likely to restrain and restrict market innovation.

41. The current international bond market, based in the EU, permits investors and issuers to choose where to place their funds and where to issue their bonds. Procedures that slow down transaction speed and increase the cost of issuance and trading will reduce market flexibility. For participants the effect of the directive as currently drafted would be to change the nature of the market. It could become:

• relatively difficult and costly (with the parameters of the Directive: too wide in coverage; too restrictive for market innovation; and too costly in terms of administration) and
• simply, just inconvenient.

Instead of tapping the international bond markets through EU financial centres, the participants and the market are likely to go elsewhere.

42. Indeed there is no reason, other than competitiveness, why any of the activities connected with the international bond market must remain in EU financial centres. If other financial centres gain a competitive advantage the market will migrate. This risk is particularly acute given:

• the significant and continuing advances in electronic trading and settlement technology;
• the increased globalisation of banks and securities firms which means that firms already have branches in the major non-EU financial centres;
• the very high capacity for innovation in international capital markets which means that firms are continually consolidating activities and seeking out the most cost effective and tax efficient way of raising and distributing capital; and
• the keen competition for business from non-EU financial centres, in particular, Swiss and US centres. Indeed, some non-EU financial centres have already been preparing for greater business by amending legislation and increasing the capacity of their trading and settlement systems.
  
  

VIc Administrative costs

44. The directive as currently drafted would have a significant impact on the operating costs of paying agents. The paying agent business is particularly vulnerable because it is a business characterised by very low margins and very high volumes. Even a small increase in unit costs, therefore, may have a dramatic impact on margins and hence locational decisions.

45. For example, the paying agent does not now generally need to: track the issue price of bonds held or Collective Investment Vehicle (CIV) holdings; know the investment profile or amount of underlying tax borne by a CIV; account for tax; or collect information.

46. Paying agent business is already subject to global consolidation trends. The directive will encourage issuers to appoint non-EU based paying agents to circumvent the directive. This means that operational and middle and back office jobs in the EU paying agent business are immediately at risk. There is, therefore, a significant risk that the EU will lose it pre-eminent position and some or all of its current international paying agents and, given the integrated nature of this business, depositary, custody and other associated financial activities are potentially vulnerable to re-location.

47. The costs of applying the Directive would vary according to the final details of the Directive. But the increased costs would fall into three categories:

• the costs of changing IT systems,
• the one-off administrative costs of introducing the Directive; and
• the continuing extra administrative costs of applying the Directive.

48. These costs would be incurred in the first instance by custodians. There are 15 such operators (though not all of the same size) operating in the UK market at present. However, the systems (IT and administrative) which would have to be set up would not be confined to custodians but all participants who make interest payments direct to individuals. A much wider group would need to have the ability and therefore the systems capability to operate similar procedures. There is a risk that this could multiply the overall costs of implementing the draft directive or narrow competition in some sectors of the market; reducing competition and choice.

49. It has been objected that relatively few international bonds are held by individuals. But, the important point is paying agents would have to apply some of the Directive's procedures to every payment - retail or wholesale.

50. In order to retain the paying agent and associated activities in the EU it will be necessary to minimise the impact on the wholesale market in international bonds. The May 1999 ECOFIN conclusion recognised the importance of the wholesale market activities such as issuance and trading not being hindered or adversely affected by the provisions of the Directive. Given that almost all bond issues will, even in small part, be held by individuals, there is considerable scope for problems to infiltrate through to the wholesale system through higher system costs, checking procedures which slow down the transaction and trading process, potentially differing tax treatments between different holders and the increased overall level of uncertainty. The best way of dealing with this is to provide some exclusions from the Directive which will minimise the extra costs for the wholesale market while still pursuing the objectives of the Directive through focussing on the main forms of investment of tax evaders.

VII: Approaches for amending the draft directive

51. As noted earlier, the UK believes that the single most effective means of tackling tax evasion is through exchange of information on as wide an international basis as possible.

52. To continue with the current approach of the draft directive will make it necessary to define an international bond for the purposes of securing an exemption from the directive.

53. Traditionally, the term "Eurobond" has been associated with transferable bonds which have one or more of a number of characteristics, including:

• denomination in a currency other than that of the issuer;
• underwritten and distributed by an international syndicate;
• placed with investors in more than one country;
• accepted at one or more centralised securities depositories; and
• free of tax at source.
  
  

54. However, most of the definitions based on this approach are now out of date. For example, the term "Eurobond" would now not necessarily be understood as excluding bonds denominated in the issuer's own currency, if they were marketed internationally. As the ECB made clear at 25 May ECOFIN the distinction between eurobonds and domestic bonds is breaking down, particularly in the single currency area where a "domestic" bond is by definition denominated in an international currency, the euro. Rather than trying to maintain an increasingly artificial distinction between eurobonds and other bonds we think it is simpler to give the same treatment to both and call them all 'international bonds'. Any definition will need to be simple, practical and easy to understand.

55. The UK puts forward two possible approaches for amending the draft directive.

Approach 1

56. Approach 1 would construct a definition for an exemption for international bonds based on three elements. It requires:

a) that bonds in existence on the date at which the Directive is implemented, will be exempt - so-called 'grandfathering';

b) all future issues, where the bonds are held in a clearing system will be exempt from the terms of the Directive; and

c) for all future bond issues held outside a clearing system, the Directive will only apply to holdings below 40,000 euros.

a) existing issues

57. For existing bonds, the only satisfactory way of avoiding the serious market disruption outlined in section VI is a "grandfathering" provision. All bonds issued before the coming into force of the Directive would need to be excluded from its application. Although this would initially be a wide exemption, it would have a limited life: 75 per cent of bonds have a life of less than 10 years, and by 2004 about two-thirds of bonds in issue today will have matured.

58. In this respect it is worth noting that this is by no means a solely UK concern. A number of Member States and international institutions are likely to ask for a similar, transitional, exemption for existing bonds.

b) and c) future issues

59. On the basis of the current wording of the draft Directive we believe that a proposal which excluded all bonds held in clearing systems and any large bonds holdings held outside clearing systems could effectively protect the wholesale markets, as envisaged by the May ECOFIN.

60. The benefits of this approach are that it:

• provides an effective way of distinguishing the wholesale market;
• helps protect the competitiveness of the wholesale market by potentially covering almost all bonds aimed at it;
• it will keep the great bulk of physical bonds held in physical form by individuals within the scope of the directive;
• reduces the costs on EU paying agents; and
• follows the approach taken by the draft directive.
  
  

61. However, even if the Directive incorporates an approach along the lines outlined above it will still be necessary to resolve a number of other outstanding issues including the definition of an interest payment, the definition of a paying agent, the issue of revenue-sharing and the potential administrative burdens placed on Banks and other paying agents. The acceptability of this approach will thus depend on the final details of the Directive.

Approach 2

62. An alternative approach would be to change the way the current draft Directive has been set out. Rather than starting by including all forms of interest and then specifying exceptions, approach 2 would instead list the forms of interest which should be included within the scope of the Directive. This would avoid the need to define an international bond for the purpose of an exclusion and would allow the Directive to be targeted more specifically on the problem areas. For example, if this approach were adopted the Directive might be drafted to cover deposit taking business and perhaps consideration could be given to including other retail instruments.

63. The benefits of this approach are that it would:

• maintain market competitiveness and the potential for financial market innovation;
• give greater clarity on the instruments covered and would be easier to operate; and
• could help to resolve many of the outstanding problems on the draft directive with regard to the definition of interest and the definition of a paying agent.
  
  

VIII: Conclusion

65. The UK Government is committed to tackling tax evasion. It therefore supports the general aims of the draft Savings Directive. But, the Government is of the firm view that the approach of the current draft of the Directive will not effectively tackle tax evasion. It will also have the unintended side-effect of seriously damaging EU financial markets. This, in turn, would jeopardise the EU's programme of Economic Reform. The UK Government therefore puts forward two potential approaches for amending the draft directive to safeguard the competitiveness of EU financial markets.

HM TREASURY

INLAND REVENUE

September 1999

1. Source: BIS quarterly data from International Banking and Financial Market Developments

2. Source: International Primary Market Association (IPMA).

3. either in euros or euro legacy currencies

4. International Primary Market Association (IPMA)

5. Centre for Policy Studies, London.

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