TAXATION OF CROSS-BORDER DIVI-

Transcription

1 DG Taxation and Customs Union TAXATION OF CROSS-BORDER DIVI- DEND PAYMENTS WITHIN THE EU IMPACTS OF SEVERAL POSSIBLE SOLUTIONS TO ALLEVIATE DOUBLE TAXATION 22 JUNE 2012

2 COLOPHON Disclaimer This report has been produced by Copenhagen Economics following the commissioning of a study by the European Commission, Directorate-General for Taxation and Customs Union. It is the result of independent work carried out by Copenhagen Economics, and does not necessarily reflect the opinions or position of the European Commission or of the experts or stakeholders. Any errors are our own. Author: Client: Partner Sigurd Næss-Schmidt (project manager), senior economist Eva Rytter Sunesen (team leader), economist Martin Bo Hansen (team member) and analyst Holger Nikolaj Jensen (team member) DG TAXUD Date: 22 June 2012 Contact: SANKT ANNÆ PLADS 13, 2nd FLOOR DK-1250 COPENHAGEN PHONE:

3 TABLE OF CONTENTS Preface 8 Executive summary Dividend flows and their taxation Distortions to investment and the Internal Market Key impacts on Member States' budgets and possible welfare gains Chapter 1 Current cross-border equity investments and taxation of dividends Structuring of cross-border portfolio equity investments Current cross-border investments between member states Current cross-border dividend flows between Member States The current taxation of cross-border dividends Chapter 2 Option 1: Revenue effects from the current taxation of crossborder dividends A preliminary assessment of the current tax regime Impacts on EU Member States of the current tax regime Impacts on investors of the current tax regime Impacts on the Internal Market of the current tax regime Chapter 3 The economic impacts of the proposed options Option 2: Abolition of WHT on cross-border dividends Option 3: Full credit for WHT levied on cross-border dividends Option 4: Net rather than gross taxation in the source country Option 5: General EU-wide reduced WHT rate with information exchange Option 6: Limited taxation of dividend income and credit for corporate tax Option 7: No WHT and no income tax on cross-border dividends Summing up the economic impacts of proposed options Chapter 4 The legal impacts of the proposed options Option 1: Maintaining the existing situation Option 2: Abolition of WHT levied on cross-border dividends Option 3: Full credit for WHT on cross-border dividends Option 4: Net rather than gross taxation in the source country Option 5: General EU-wide reduced WHT rate with information exchange Option 6: Limited taxation of dividend income and credit for corporate tax Option 7: No WHT and no income tax on cross-border dividends Summing up the legal impacts of the proposed options Chapter 5 Cross-cutting issues related to the proposed options Impacts of the proposed options on different investors Macroeconomic impacts of the reduced cost of capital Impacts on third countries

4 5.4. Impacts on the Internal Market Interaction with the Parent Subsidiary Directive Sensitivity analysis

5 LIST OF TABLES Table 0.1 Impacts of the various options on compliance and administrative costs Table 0.2 Impacts of the various options on distortions to investment decision Table 0.3 Quantifiable costs to investors in the different options Table 1.1 Outbound portfolio equity investments Table 1.2 Inbound portfolio equity investments Table 1.3 Outbound portfolio equity investments as a share of total outbound equity investments Table 1.4 Inbound portfolio investments as a share of total inbound equity investments Table 2.1 What is at stake for individual EU Member States? Table 2.2 Current tax revenues from WHT in EU Member States (Option 1) Table 2.3 Tax revenues from WHT compared with corporate income taxes Table 2.4 Administration of the refund procedure in selected source countries Table 2.5 Current tax burden of investors in EU Member States (Option 1) Table 2.6 Current tax burden of different investor types (Option 1) Table 2.7 Summary of findings from two meta analysis Table 3.1 Impact of Option 2 on tax revenues (compared to the current situation) Table 3.2 Tax burden of investors under Option 2 (compared to the current situation) Table 3.3 Tax burden by investor type under Option 2 (compared to current situation) Table 3.4 Impact of Option 3 on tax revenues (compared to the current situation) Table 3.5 Tax burden of investors under Option 3 (compared to the current situation) Table 3.6 Tax burden by investor type, Option 3 (compared to the current situation) Table 3.7 Taxes faced by investors in source and residence countries Table 3.8 Impact of Option 5 on tax revenues (compared to the current situation) Table 3.9 Tax burden of investors under Option 5 (compared to the current situation) Table 3.10 Tax burden by investor type, Option 5 (compared to the current situation) Table 3.11 Impact of Option 6 on tax revenues (compared to the current situation) Table 3.12 Tax burden of investors under Option 6 (compared to the current situation) Table 3.13 Tax burden by investor type, Option 6 (compared to the current situation) Table 3.14 Impact of Option 7 on tax revenues (compared to the current situation) Table 3.15 Tax burden of investors under Option 7 (compared to the current situation) Table 3.16 Tax burden by investor type, Option 7 (compared to the current situation) Table 3.17 Quantifying juridical double taxation Table 3.18 Foregone tax relief Table 3.19 Impacts on compliance costs for investors and administration cost for Member States Table 3.20 Quantifiable impacts on compliance cost Table 4.1 Domestic WHT rates on dividends paid to residents and non-residents Table 4.2 Gross or net basis taxation Table 4.3 Withholding taxation vs. taxation by assessment Table 4.4 Relief at source or refund Table 4.5 Domestic taxation of dividends from resident and non-resident companies and CIVs Table 4.6 Method for relieving international juridical double taxation

6 Table 4.7 Legal impacts of Option Table 4.8 Legal impacts of Option Table 4.9 Legal impacts of Option Table 4.10 Legal impacts of Option Table 4.11 Legal impacts of Option Table 4.12 Legal impacts of Option Table 4.13 Legal impacts of Options Table 5.1 Change in tax burden of investors (compared to the current situation) Table 5.2 Impact on GDP from a reduction in cost of capital Table 5.3 Expected positive impact on the Internal Market of the proposed options Table 5.4 Sensitivity analysis on CIV s treaty entitlements

7 LIST OF FIGURES Figure 0.1 EU taxation of portfolio and individuals' cross-border dividends Figure 1.1 Individual investing in equity Figure 1.2 Individuals investing in equity via domestic financial companies Figure 1.3 Individuals investing in equity via foreign financial companies Figure 1.4 Composition of intra-eu portfolio equity investments Figure 1.5 Total inbound portfolio dividends in Member States as a share of GDP Figure 1.6 Total outbound portfolio dividends in Member States as a share of GDP Figure 1.7 The potential distortions and other problems appear to be getting worse Figure 3.1 Change in tax revenue (compared to the current situation) Figure 5.1 Distribution of current tax liabilities from cross border dividend flows on investor type Figure 5.2 Macroeconomic impacts of the reduced cost of capital Figure 5.3 The organisational structure of EU firms

8 PREFACE The European Commission has asked Copenhagen Economics to undertake a: Study on the impact of several alternative solutions to the taxation problems that arise when dividends are paid across borders to individual and portfolio investors within the EU. The study relies on readily available information on legislation on domestic taxation of dividends as well as withholding tax (WHT) rates in respect to dividends received by individuals and companies. Information concerning the domestic taxation and WHT on dividends received by collective investment vehicles (CIVs) is obtained by a survey of nine EU countries carried out by Deloitte offices in the countries concerned. The scope of the study has been narrowed in several ways: We exclude venture capital as returns from such investments are mostly in the form of capital gains. We exclude equity investments in shares that are not listed since dividend taxation in some resident States depends on whether the shares are listed or not. Issues related to dividend payments to portfolio investors/ individuals who are resident in non-eu Member States are out of scope of the study. The impact of all options on the revenue and cost factors for the Clearing and Settlement Industry does not have to be looked into or reported on. Finally, the following issues are outside the scope of the study because they are the subject of separate Commission work: The tax issues related to Real Estate Investment Trusts (REITS) and open-ended property investment funds. The tax issues related to UCITS IV recast 1. The tax treatment of cross-border venture capital funds which was the subject of discussions in a Commission expert group and on which a report 2 was published in The functioning of the EU Savings Directive covering bond funds, which is being dealt with in the discussions on the Commission's proposal to amend the Directive. Interest and royalty payments. 1 Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (recast). 2 re_capital/tax_obstacles_venture_capital_en.pdf. 8

9 EXECUTIVE SUMMARY The basic premise for the discussion is that the present overall structure of taxation of crossborder portfolio and individuals' equity investments creates distortions to investments in two ways. First, it may lead to a higher overall taxation of dividends from non-domestic than domestic equity investment and hence require a higher compensating pre-tax return. This reduces the incentive to invest in other EU Member States and conflicts with the objective of a common Internal Market for capital. Second, procedures to relieve such over-taxation (e.g. the necessity to claim refund where relief at source is not available) may entail compliance burdens that likewise reduce the incentive to undertake cross-border investments. The European Commission has, on the basis of stakeholders suggestions, identified several possible options on how to improve the current taxation of cross-border dividends. The economic and legal impacts of the six options (in addition to the option to do nothing) have been assessed in this report. The executive summary outlines the main results from the study under three headlines: Dividend flows and their taxation Distortions to investment and the Internal Market Key impacts on Member States budgets and possible welfare gains 0.1 DIVIDEND FLOWS AND THEIR TAXATION In this section we recap the essential characteristics of the present tax regime in all its complexity. The report only reviews portfolio investments (i.e. where the investor is a company or individual which owns less than 10 per cent of the shares) as well as direct investments by individuals. Investments by companies with shareholdings of more than 10 per cent are covered by the Parent-Subsidiary Directive and are outside the scope of this study. In the simplest case, an individual in residence country A undertakes a portfolio equity investment in a company in source country B (see Figure 0.1) in the hope of receiving a return on his investment for example in the form of dividends. Such a dividend stems from profits which have initially been taxed at the company level. When it is paid to the individual as dividends it will be subject to a withholding tax (WHT) in the source country generally ranging between 5 to 30 per cent (some countries also levy no WHT). Tax treaties between Member States normally reduce the WHT to 5-15 per cent. However, to benefit from the reduced rate the investor will need to apply for a relief at source or a relief by refund of excess WHT, i.e. the difference between the non-treaty and the treaty rate. Then the investor is also taxed in the country of residence. Recognising that the dividend has already been taxed at source, the residence country usually relieves international juridical double taxation. 9

10 Figure 0.1 EU taxation of portfolio and individuals' cross-border dividends Residence country Tax on dividend income Tax relief for WHT paid in source country Intermediate country Direct equity investment Source country WHT on dividends Refund of excesswht (if applied WHT rate is higher than treaty rate) Portfolio equity investment Portfolio equity investment Individual Foreign/domestic financial company Foreign company Cross-border/domestic dividend payment Cross-border dividend payment Source: Copenhagen Economics. Cross-border dividend payment However, most cross-border portfolio investments are carried out by institutional investors (pension, mutual and insurance funds and companies etc.) that manage investments on behalf of the ultimate investors. This also implies that the flow from such institutional investors to the ultimate investors may take many forms e.g. an annuity at retirement, an ongoing dividend payment or a capital gain when selling out shares/units in a mutual fund. In the most straightforward version, the ultimate investor invests in a foreign company through an institutional investor resident in the same country as the ultimate investor. In this case, taxation in the source country depends on how this country treats the institutional investor in question. In some cases, institutional investors are not treated like separate entities for tax purposes (tax transparent), implying that source taxation depends on the characteristics of the ultimate investors. In other situations, institutional investors are recognized as separate entities for tax purposes and are taxed as other portfolio investors, including the possibility of relief at source or relief by refund. In addition to this, taxation of the institutional investor takes place in the residence country. In the residence country, and at the level of the institutional investor, dividend income can be tax exempt, subject to tax at relatively low tax rates or subject to a low effective taxation because provisions made for obligations towards the ultimate investors are deductible. Consequently, a foreign tax credit for the amount of WHT suffered in the source country may not be obtained in the residence country. In this case, the WHT tax becomes a final tax unless the ultimate investors are entitled to claim a foreign tax credit for the WHT suffered by the institutional investor. The most dominant result is that a foreign tax credit is not obtained for full WHT amount paid by institutional investors. 10

11 0.2 DISTORTIONS TO INVESTMENT AND THE INTERNAL MARKET Our assessment is that the current tax regime in many cases leads to compliance costs for investors, administrative cost for Members States, and distortions to investments linked to the following outcomes: Compliance costs for investors: o Liquidity costs that arise where relief is granted by refund (due to the long time period investors have to wait to get a refund) o Difficulties encountered when applying for relief by refund (i.e. documentation requirements and need to deal with foreign tax administrations) o Documentation requirements when applying for relief at source o Foregone WHT relief in the State of Source when tax relief procedures are too costly, burdensome and time-consuming Administrative costs for Member States: o Administrating a relief at source system in the source country o Administrating relief by refund claims (i.e. costs for handling refund claims made by investors) in the source country o Administrating tax credits to residents for foreign WHT Direct distortions to investment decisions: o Created by economic double taxation, i.e. if the same profits are taxed in the hands of two different taxpayers (e.g. at the company level and shareholder level). - distortions of investors incentive to carry out portfolio investments by choosing debt rather than equity financing, - related incentive to distribute profits in forms other than dividends - distortion to the decision whether the profits shall be retained or distributed. o Created by juridical double taxation, i.e. if the excessive withholding tax is not fully credited in the residence country for the WHT paid abroad. - distortions to incentives to invest abroad. - distortions to the choice of investment location due to different degrees of taxation and tax credit schemes - distortions to the choice of the legal form and legal arrangements used This is particularly important for CIV s that are often unable to credit withholding taxes in their residence country due to lack of taxable income. To deal with these potential distortions, the European Commission has on the basis of stakeholders' suggestions identified several alternative solutions that might improve the current situation: 11

12 Option 1: Keeping the existing situation unchanged Option 2: Abolition of withholding taxes on cross-border dividend payments to portfolio/individual investors Option 3: The residence country grants full credit for the withholding taxes levied in the source country Option 4: Net rather than gross taxation in the source country. Option 5: Application of a general EU-wide reduced rate of withholding tax with information exchange (Neumark solution) if the taxpayer opts for information exchange Option 6: Limitation of both source and residence taxation of dividend income and granting of limited underlying tax credit for foreign corporate taxation Option 7: No WHT in the source country and no taxation of foreign source dividends in the residence country In this study, we have reviewed the extent to which these options help address the distortions created by the current system of taxing cross-border dividends. Option 2 would eliminate discrimination of outbound and domestic dividends provided that it would encompass all relevant entities including pension funds and CIVs with EU investors. Option 2 would eliminate juridical double taxation but would not in itself eliminate economic double taxation. Option 2 will by definition remove the administrative costs associated with refund of excess WHT and will considerably reduce compliance costs for investors associated with withholding tax relief procedures, although investors will still need to document that they are entitled to be exempt from WHT. Moreover, the tax systems in most source Member States will be simplified so that the cost of administrating withholding tax relief procedures will be reduced. Furthermore the cost of administrating tax credits to residents for foreign WHT is completely removed. Option 3 will eliminate juridical double taxation of cross-border dividends when it is implemented so that full credit of the withholding tax is provided independent of the taxes imposed in the residence state. 3 This will therefore help deal with cases where domestic tax liabilities of individual tax investors, for various reasons, is insufficient to allow full credits for source taxes paid abroad. Option 3 however, will not remove discrimination of outbound dividends in the source state and will not in itself eliminate economic double taxation. This option is not expected to have a major impact on compliance costs for investors or administrative costs for Member States. Whether Option 4 would eliminate juridical double taxation of cross-border dividends depends, among other things, on how foreign tax credit is calculated in the residence state, the level of expenses that may be allocated to the dividend income under the domestic tax laws 3 This would imply that governments in some cases would refund the surplus tax to the investors levy negative taxes) if there were no sufficient tax liabilities to credit from. This assumption is based on the description in the Terms of Reference to this study 12

13 of the source state and residence state and the level of the tax rates of the source state and residence state. If the residence state calculates foreign tax credit on a gross income basis (Italy, the Netherlands, France, Ireland and the UK cf. Table 4.6) juridical double taxation would normally be eliminated provided that sufficient taxes are imposed in the residence state to accommodate an ordinary credit. If the residence state calculates foreign tax credit on a net income basis (Germany, Luxembourg, Spain and Sweden), juridical double taxation would normally be eliminated provided that the level of expenses allocated to the dividend is almost identical in the source state and residence state and that the tax rate in the source state does not exceed the tax rate in the residence state. Option 4 would not remove all discrimination of cross-border dividends in the source state and residence state. In addition, Option 4 would not of itself eliminate economic double taxation and seems to be difficult to implement in practice. Option 5 would in most cases reduce existing problems by reducing the level of WHT. Whether juridical double taxation of cross-border dividends would be eliminated depends, among other things, on how foreign tax credit is calculated in the residence state, the level of expenses that may be allocated to the dividend income under the domestic tax laws of the source state and residence state and the level of tax rates in the source state and residence state. However, given that the withholding tax rate would be low, it is likely that this will happen in most cases, besides those where there is no actual taxation at the CIV level. Option 5 would not remove all discrimination of cross-border dividends in the source state and residence state. In addition, Option 5 would not of itself eliminate economic double taxation. By implementing an EU wide information exchange system, this option would provide tax administrations with adequate safeguards and would justify the application of the reduced rate at source rather than by means of refund. It should also reduce the compliance cost for investors of crediting WHT in the residence country since the residence state would dispose of the necessary information. Option 6 and 7 are far more far-reaching. Under Option 6, juridical double taxation of cross-border dividends would normally be eliminated by requiring the residence state to provide a full credit relief. As in Option 3 this would imply that governments might refund surplus tax. Option 6 would reduce economic double taxation to a very large degree by requiring the residence state to grant ordinary credit relief for underlying corporate tax in the source state. The solution will remove compliance costs for the tax payer of applying for refund, but could also imply that the resident tax payer is allowed to credit foreign, but not domestic, corporate tax rates when calculating the dividend tax burden. If Option 6 was to be implemented, it should be accompanied by a proposal that credit for underlying corporate tax should also apply to domestic dividends in order to avoid a new distortion between domestic and cross-border investments. Option 7 would remove both juridical and economic double taxation of cross-border dividends. Moreover, discrimination of cross-border dividends would be removed. Unless domestic dividend income tax is also eliminated this option would introduce distortions be- 13

14 tween dividends obtained domestically and abroad. As in Option 6, this option should also be accompanied by an exemption for domestic dividends in order not to create new distortions between domestic and cross-border investments. The options from an economic perspective The report touches upon the economic impacts of the current tax regime and the economic impacts of the proposed options. In particular, the report discusses impacts on compliance and administrative costs cf. Table 0.1, and impacts on current distortions, cf. Table 0.2. We find that Option 2 eliminates almost all of the distortions, but it is only Option 6 or 7 that reduce or eliminates economic double taxation. In addition, we find that Option 4 and 5 are the only options that do not fully eliminate juridical double taxation. Table 0.1 Impacts of the various options on compliance and administrative costs Compliance cost for investors reduced Option 2 Option 3 Option 4 Option 5* Option 6** Option 7 Liquidity costs reduced Full No No Full Full Full Compliance costs for applying for refund reduced Compliance costs for relief at source reduced Full No No Full Partial Full Partial No No Partial No Partial Less foregone tax relief Full No No Full Full Full Compliance costs of documenting WHT payments in order to receive credit in residence country reduced Administrative costs for Member States reduced Simplification of tax system in source country Simplification of tax system in residence country Improved information exchange Full No No Partial No Full Yes No No Yes No Yes Yes No No Partial No Yes No No No Yes No No Note: * Under the assumption of full information exchange. ** Assuming that treaty rates are not below 7.5 per cent. In these (rather few) situations there will be compliance costs associated with refunding excess WHT and liquidity costs Source: Copenhagen Economics, based on the analysis in Chapter 3. 14

15 Table 0.2 Impacts of the various options on distortions to investment decision Distortion Option 2 Option 3 Option 4 Option 5* Option 6** Option 7 From economic double taxation Debt rather than equity financing Incentive to distribute profits in forms other than dividends Distortion of individual investors incentive to carry out portfolio equity investments Distortion to the decision whether profits should be retained or distributed From juridical double taxation No No No No Partial Full No No No No Partial Full Full Full No Partial Full Full Full Full Partial No Full Full Full Full Partial No Full Full Full Full Partial Partial Full Full Distortions to invest abroad Full Full Partial Partial Full Full Distortions to different investment locations Distortions to the choice of the legal form and legal arrangements used CIV s inability to credit WHT in residence country Investing in non-zero WHT country Full Full Full Full No Full Full Full Partial No Full Full Full Full No No Full Full Note: N.R means Not Relevant. * Under the assumption of full information exchange. ** Assuming that treaty rates are not below 7.5 per cent. In these (rather few) situations there will be compliance costs associated with refunding excess WHT and liquidity costs Source: Copenhagen Economics, based on the analysis in Chapter 5. The options from a legal perspective We find that parts of the existing tax law in all Member States infringe internal market principles from a legal perspective. So doing nothing would seem to be a non-acceptable route to take. The six proposed possible options to change the taxation have been evaluated on six criteria applied to dividend flows in 9 countries from a legal and compliance perspective as outlined in Table

16 Table 0.2 Legal impacts of the options to change dividend taxation in 9 selected Member States 4. Problem Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Simplification of MS s tax systems Practical difficulties and new administration Conflict with principle of source-country entitlement to tax Costs related to the introduction of automatic exchange of information Need to amend domestic legislation * Need to amend Double Tax Conventions Note: The table depicts how many countries in the survey (9 countries in total) that could answer yes to the question in column 1. Note that when 7 countries have answered yes, the two countries answering no is consistently UK and Ireland. * The Mutual Assistance Directive introduces automatic information exchange from 2015 of some income categories, however not dividend income. However, by having such a system in place already, the costs of introducing automatic exchange of information in dividend income will be reduced. Source: Copenhagen Economics based on Deloitte survey of withholding tax rates in selected EU countries. It can be noted that all options require all (or most) Member States to amend domestic legislation. Moreover, only Option 2 and 7 (abolishing withholding taxes and abolishing all portfolio dividend taxes respectively) are the only options simplifying Member States tax systems. Option 4, 5 and 6 may give rise to new administration and practical difficulties. 0.3 KEY IMPACTS ON MEMBER STATES' BUDGETS AND POSSIBLE WELFARE GAINS Our study suggests that there are several welfare effects of the proposed options. Firstly, the current situation leads to economic and juridical double taxation of portfolio/ individual investors. The different options will to varying degrees resolve this double taxation. Secondly, the cost of investing in portfolio equity is reduced primarily due to a lower tax burden, but also due to reduced compliance costs. 4 The survey includes Italy, Spain, Luxembourg, Netherlands, Germany, France, Sweden, Ireland and the UK. These 9 countries have been selected in order to cover as much of the dividend flows as possible. The group of countries receive 89 percent and 86 percent of ingoing dividends and outgoing dividends respectively. 16

17 Our calculations suggest that the amount of juridical double taxation in the current situation corresponds to 3.7 billion, cf. Table This is fully reduced in Option 2, 6 and 7. In Option 5, the double taxation is reduced to app. 2.0 billion, while in Option 3 juridical double taxation is almost eliminated but totals to 0.1 billion. Moreover, some simple calculations suggest that the reduced cost of capital will increase the capital stock and lead to an increase in EU's total GDP between per cent (app billion) per year. This is due to the growth effects of increasing the supply of capital. Moreover, compliance costs for investors will be reduced in some of the options. We have been able to quantify liquidity cost and compliance cost related to applying for refund respectively, cf. Table 0.3. Since we have only quantified some of the compliance cost reductions, the total macroeconomic impacts can be expected to exceed these numbers. In addition, the capital stock may also increase since the reduced taxation of cross-border dividend payments between EU countries will make such investments more attractive relative to investing in other locations (domestically or in a non-eu country) or relative to making other types of investments. Table 0.3 Quantifiable costs to investors in the different options Impacts Option 1 Option 2 Option 3 Option 5 Option 6 Option 7 Direct impact on investors Liquidity costs Compliance costs for applying for refund Juridical double taxation 3, , Note: All figures are in million EUR. Liquidity cost is found by considering the total amount excess collected WHT. Compliance cost for applying for refund is found by considering the refundable amount which is 70 per cent of the excess collected WHT. Source: Copenhagen Economics. All options will also lead to some direct reductions in tax revenues which vary across the different options from app. 1.7 billion in Option 5 to 8 billion in Option 7. The reduction in tax revenue corresponds to the same amount as the reduction in investors tax burden. The relevant question is thus whether the proposed options to reform is a good investment compared to other uses of public revenue. This should also be seen in the perspective that a vast amount of Member States current tax revenue from dividend taxation occurs through double taxation and foregone tax relief, which investors are entitled to. Hence, by improving the current situation, investors will receive a larger share of what they would have received were it not for double taxation and foregone tax relief. We find that in most options put very crudely - the welfare gain from reducing the cost of capital outweighs the loss in tax revenue as a per centage of GDP. Moreover, there are also legal reasons to improve the current situation, since it may be infringing EU law. 17

18 Chapter 1 CURRENT CROSS-BORDER EQUITY INVESTMENTS AND TAXATION OF DIVIDENDS When a company is making profits it may choose to pay out dividends as a return to the equity investments made by its shareholders. There is an inherent risk of double or multiple taxation of dividends when they are paid across borders. In such cases there are generally three layers of taxation: - Corporate income tax on the profits of the dividends distributing company in its Member State of residence - Withholding tax on the dividend payment to the non-resident investor in the source Member State and - Income tax in the investor's Member State of residence. Dividend payments between Member States' associated companies are in principle exempt from withholding tax under the Parent-Subsidiary Directive 5 provided that certain shareholding and other requirements are met. However, as these requirements are not met in the case of individual shareholders and of companies with a mere portfolio shareholding, dividend payments to such recipients are not covered by the Directive. Withholding taxes play an important role in dividing taxing rights between a source state of income and the state of residence of an investor. They also help to enforce taxation, thereby preventing tax avoidance and evasion by taxpayers. Nevertheless, the fact that cross-border dividend payments are subject to taxes in two Member States can lead to several problems. Withholding taxes may give rise to juridical 6 or economic 7 double taxation, there may be discrimination of non-resident investors and there may, consequently, be distortions of investment decisions (e.g. with regard to the type or location of the investment, etc) in the Internal Market. Double Tax Conventions (DTCs) based on the OECD Model reduce juridical double taxation on dividends typically by limiting source State taxation on the dividends and by requiring a State of residence of an investor to grant relief for source State taxation through a credit or exemption mechanism. However, source State withholding taxes, even when reduced under DTCs, may not be completely creditable in the State of residence. 5 Council Directive 90/435/EEC of 23 July 1990 on the common system of taxation application in the case of parent companies and subsidiaries of different Member States, amended by Council Directive 2003/123/EC of 22 December "Juridical double taxation" occurs when the same income, such as a dividend, is taxed twice in the hands of the same person: first in the source Member State, when the dividend is distributed (normally by means of withholding tax), and then in the residence Member State, when it is taxed as a part of the same shareholder's taxable income. Juridical double taxation normally occurs in cross-border situations. 7 "Economic double taxation" occurs when the same profits are taxed in the hands of two different persons, such as dividends taxed first at the level of the company paying the dividends and then in the hands of the shareholders. Such taxation can take place both at a domestic level and at an international level. 18

19 The Court of Justice of the European Union (CJEU) has stated 8 that in principle, juridical double taxation is not in itself unlawful, as there is no obligation for Member States to adapt their own tax systems to the different systems of tax of other Member States in order to eliminate the double taxation arising from the exercise in parallel of their fiscal sovereignty. Nevertheless, juridical double taxation represents an obstacle to cross-border activity and investment within the EU, thus distorting the effective functioning of the Internal Market. Relief from economic double taxation (i.e. for underlying corporate taxes paid by the distributing company in States of source) is often available in purely domestic situations, but not internationally. Thus, such relief is generally not addressed in Double Tax Conventions. Member States are not per se required to relieve economic double taxation (except in the cases covered by the Parent Subsidiary Directive). Nevertheless, the CJEU has found that economic double taxation might be contrary to EU law if it reflects a difference in treatment between domestic and cross-border situations, leading to discrimination. Removing discrimination in the tax treatment of dividends paid to portfolio and individual investors is a basic requirement of EU law and a Member State may treat cross-border situations differently from domestic situations only if this is justified by a difference in the taxpayer s circumstances. This CJEU ruling may reduce the scope for economic double taxation of dividends, at the level of the source state, but does not address the problem of economic double taxation by the country of residence. Even when source State withholding taxes are reduced under Double Tax Conventions, non-resident portfolio and individual investors may suffer interest costs and cash flow disadvantages if relief at the reduced DTC rate is not provided at source. Investors may even forego the tax relief to which they are entitled under Double Tax Conventions if source States' claim procedures are complicated, costly or time-consuming. In this respect the Commission's Recommendation on withholding tax relief procedures of 19 October 2009 suggests solutions aimed at improving the existing procedures for the reduction of the withholding taxes levied by the source Member States to the lower Double Tax Convention rates. It suggests that financial intermediaries could claim relief on behalf of their investors at source rather than by refund in return for the financial intermediaries agreeing to provide information to tax authorities on the investors on behalf of whom they are claiming relief. This Recommendation would, if applied by Member States, ensure the proper and timely implementation of solutions to the problem of juridical double taxation to the extent that those solutions are provided for by Double Tax Conventions. However, it would not resolve problems of juridical double taxation not addressed in Double Tax Conventions, nor would it resolve the problem of economic double taxation. 8 See cases C-513/04, Kerckhaert and Morres, of 14 November 2006, C-67/08, Block, of 12 February 2009 and C- 128/08, Damseaux, of 16 July

20 Finally, the reality that the majority of portfolio and individual investors hold their investments indirectly via collective investment vehicles (CIVs) rather than directly in companies, creates additional layer of issues related to the tax treaty entitlement in the source state and availability of foreign tax credit in the residence state of the portfolio/individual investor. All these legal and economic problems arising when cross-border dividends are paid to portfolio/individual investors result in numerous distortions presented in more detail above. The purpose of this chapter is to review the current cross-border equity investments and the taxation of cross-border dividends in the EU. In Section 1.1 we outline how portfolio investors may structure their equity investments. In Section 1.2 we provide an overview of the current cross-border portfolio dividend flows between EU Member States to understand the importance of such payments both for the EU as a whole and for different EU Member States STRUCTURING OF CROSS-BORDER PORTFOLIO EQUITY INVESTMENTS There are many ways in which an investor in one country can make an equity investment in another country and each alternative has different tax implications in the source and residence country. Below we will describe some of the mechanisms that are at play when investors make equity investment abroad. We will provide more details on the taxation of dividends in Section 1.3. When an individual buys shares in a foreign company it makes a direct equity investment (shareholding>10%) or a portfolio equity investment (shareholding<10%). In most cases, the source country charges a WHT on outbound dividends. Most countries have domestic WHT rates (called non-treaty rates throughout the report) but these rates may be reduced through a tax treaty between the source and the residence country (the treaty rate). When there is relief at source and the investor is able to prove that he is eligible for the reduced rate under the tax treaty, the WHT is automatically reduced to the treaty rate. When relief at source is not granted, the investor will pay the non-treaty rate. The excess WHT (the difference between the non-treaty and the treaty rate) may be refunded if the investor applies for this in the source country. Portfolio/ individual investors are also generally subject to tax on the dividend income in the residence country. International juridical double taxation is in most cases relieved in the residence country by way of a foreign tax credit. The mechanisms at play in this type of investment are sketched in Figure 1.1. We note that the same situation arises in cases where a non-financial company makes a portfolio equity investment although the WHT rate on outbound dividends in the source country and the tax on dividend income in the residence country are in many cases different for the two investor types. 20

21 Figure 1.1 Individual investing in equity Residence country Tax on dividend income Tax relief of WHT Equity investment (sharehold > 10%) Portfolio equity investments (sharehold <10%) Source country WHT on dividends Refund of excess WHT Individual Foreign company Cross-border dividend payment Source: Copenhagen Economics. Cross-border equity investments by individuals are usually made with a financial purpose as opposed to a strategic ownership purpose. This would typically be with the objective of placing low-return liquid assets in an asset with higher return. Such an investment will, except for extreme circumstances, be a portfolio investment. In order to undertake a direct investment (with shareholding exceeding 10 per cent) a significant amount of money must be invested in one firm typically with the intention of establishing a lasting interest in a firm/enterprise, e.g. by influencing the decision-making, management and strategy of this firm. Such a cross-border direct investment is typically not made by individuals and even though there may be exceptions we assume only very few individuals will engage in direct investments. This assumption is supported by information from Central Banks and Statistical Authorities in the EU. Only one institution collects data on individuals direct investments and most respondents argued that this was because the category was deemed not to be relevant in size. The one respondent that collects relevant data is the UK National Statistics and the data shows that 0.6 per cent of inbound dividends from foreign direct investments (FDI) were distributed to a category consisting of both individuals and non-profit institutions serving individuals. Since no data is available for individuals direct investments we do not include this category in the analysis. Rather than making the equity investment directly, an individual may invest through a domestic financial company such as a bank, a life insurance company, a pension fund or a Collective Investment Vehicle (CIV). The WHT rate on outbound dividends to CIV s is in a few cases different from the WHT rate applicable to individuals and non-financial companies while life insurance companies are usually taxed similarly to non-financial companies. Foreign CIVs may be entitled to claim tax treaty benefits (see Section 1.3). Where this is not the situation, the non-treaty rate will be applicable unless the ultimate investors of the CIVs apply for treaty benefits. 21

22 The residence country taxation of cross-border dividends of a domestic financial company depends on the type of financial company. CIVs are often tax exempt on dividend income (or are entitled to a tax deduction for provisions set up for obligations towards the ultimate investors). However, an individual is typically taxed on its dividend income from a domestic financial company. Other financial companies (such as life insurance companies and pension funds) typically accumulate the dividend income with the individual investor being taxed once the accumulated savings are paid out. The taxation may be either of a capital gain or capital income character at this stage. If the original investment were tax deductible against income, then their payout will typically also be taxable as income. The residence country usually offers a foreign tax credit for WHT paid by a domestic financial company on inbound dividends. The mechanisms at play in this type of investment are sketched in Figure 1.2. Figure 1.2 Individuals investing in equity via domestic financial companies Residence country Tax on dividend income Tax relief of WHT Source country WHT on dividends Refund of excess WHT Portfolio equity investment Portfolio equity investment Individual Domestic financial company Foreign company Dividend payment Cross-border dividend payment Note: In official statistics an individual investment in a financial company will be classified as an equity investment even though the individual purchases an investment certificate and not equity per se. Moreover, investments from individuals in pension funds and insurance companies are not considered investments as such but pension contributions and insurance premiums. Consequently, returns from such vehicles are not dividends but other types of capital income such as pension and/or insurance disbursement. Source: Copenhagen Economics. The individual investor may also invest through a foreign financial company. When the foreign financial company makes an equity investment in a third country, there will be two cross-border dividends: (i) the foreign company in the third country pays out dividends to the financial company, and (ii) the financial company pays out dividends to the individual. From a tax perspective, the consequence of such an intermediate country depends on whether the foreign financial company is eligible or non-eligible for tax treaty benefits. Here, it is important to note that the tax status may be different in the three countries involved (cf. Section 1.3). When the financial company is non-eligible for tax treaty benefits in the source country, information on the ultimate investor (the individual) is often unknown to the source country and the WHT rate charged will be the non-treaty rate which is often higher than the treaty rate. When the financial company is eligible for tax treaty benefits in the source country, the 22

23 WHT rate charged on dividends from the foreign company to the financial company will be in accordance with the tax treaty between the intermediate and the source country. Likewise, dividends from the financial company to the individual will be subject to a WHT at a rate as stated in the tax treaty between the intermediate and the residence country in the cases where the individual is eligible for a reduced rate. The mechanisms at play in this type of investment are illustrated in Figure 1.3. Figure 1.3 Individuals investing in equity via foreign financial companies Residence country Tax on dividend income Tax relief of WHT Intermediate country Source country WHT on dividends Refund of excesswht Portfolio equity investment Portfolio equity investment Individual Foreign financial company Foreign company Cross-border dividend payment Source: Copenhagen Economics. Cross-border dividend payment 1.2. CURRENT CROSS-BORDER INVESTMENTS BETWEEN MEMBER STATES In the EU, outbound portfolio equity investments constitutes app. 20 per cent of GDP, cf. Table 1.1. This masks a large variation between countries. Besides Luxembourg and Ireland that invest more than 100 per cent of GDP, it ranges from 44 per cent in Belgium to 0-1 per cent in Bulgaria, Romania, Slovakia and Poland. 23

24 Table 1.1 Outbound portfolio equity investments Country Total outgoing portfolio investments (EUR) Outgoing portfolio investments as a share of GDP Luxembourg % Ireland % Belgium % Netherlands % Sweden % Finland % Germany % Italy % Denmark % France % United Kingdom % Austria % Portugal % Malta % Estonia 888 6% Spain % Cyprus % Hungary % Greece % Czech Republic % Slovenia % Lithuania 822 3% Latvia 388 2% Poland % Bulgaria 271 1% Slovak Republic 409 1% Romania 394 0% EU % Note: Data from Source: Copenhagen Economics based on data from Coordinated Portfolio Investment Survey Database (CPIS)- IMF (extract April 2012). GDP data is from Eurostat. Inbound portfolio equity investments in EU similarly constitute 20 per cent of GDP (per definition). Luxembourg s inbound investments as share of GDP is a massive 2,000 per cent while Ireland s is 104 per cent, cf. Table 1.2. In addition to these two countries, Portugal has a share of 26 per cent of GDP while Lithuania, Latvia, Romania, Slovenia, and Slovakia has app. 1 per cent inbound portfolio investments as share of GDP. 24