22 years ago, the Giovannini report on Cross-Border Clearing and Settlement Arrangements in the European Union was published, and one of the barriers that the working group had identified was the tax withholding process for cross-border financial investments within the European Union. The practical application of a correct withholding tax rate for both the source and the target country – according to their double taxation agreement – is problematic. The crux is that the issuer of a security is obliged to withhold tax on income payments on a maximum level in the source country (some exceptions apply) and that the country of the beneficiary will perform another withholding at a local tax rate. To facilitate the correction of this overwithholding, the beneficiary needs to get the two tax authorities to agree on his/her tax status and the taxation of the payment according to a double taxation agreement (DTA). The beneficiary also needs to either apply the correct tax rates at the time of the payment or to correct the withholding afterwards.
Despite several attempts, the fundamentals of the barrier have remained intact. Now, with the recent proposal by the Commission (https://taxation-customs.ec.europa.eu/taxation-1/corporate-taxation/faster-initiative_en), the EU financial markets will experience an initiative to solve the issue on a regulatory level.
The initiative builds on a combination of three different concepts for tax relief.
The most conservative approach is the long-form reclaim after the payment and the overwithholding have been performed, where it is up to the beneficiary to supply the necessary documentation about his/her tax status and tax residence and to provide the tax authorities in the source country with appropriate documents. While this task can be handed over to a tax advisory or intermediary, the cost and the time for a refund can be significant and may force investors to waive their right to a proper taxation.
Quick refund is in principle the same, but the documentation is provided up front, and the relief can be granted much faster, at least in undisputed cases. In addition, the relief procedure may be outsourced by a tax authority to a withholding agent, which makes quick refund a process that runs within the financial industry and their well-honed systems, communication channels and procedures.
Relief at source is a fundamentally different process, where the issuer in the source country or an intermediary has upfront knowledge about the tax rates that have to be applied on the income payments and only withholds at a rate in accordance with the DTA. The intermediary who makes a payment to the beneficiary in the receiving country applies the reduced local tax rate. Relief at source is without a doubt the most elegant and efficient of the three models, but it is seen as being more prone to tax fraud than the other two.
To learn more about the three models, their pros and cons, and how they work in detail, take your time to download the first part of our series of whitepapers on EU FASTER.