Tax reform in the EU: the future of withholding taxes

Change on the horizon for EU Withholding Taxes

For too long, a fragmented European Withholding Tax landscape has stifled cross-border investments while resource-intensive reclaim procedures have left surplus tax going spare. Xceptor Senior Tax Solution Manager, Carlos Silva, explores how the launch of an EU-wide system for Withholding Taxes looks set to deliver transformational change.

In early 2023 the European Commission (EC) is due to announce the next steps in its initiative to launch an EU-wide system for withholding taxes. Following a public consultation, which closed in June 2022, the EC has been analysing the results of its research and discussing the findings in more detail with relevant stakeholders. The impact assessment is set to conclude this December, with a proposal Directive for a new withholding tax framework expected to be published by the end of Q1 2023. The implementation of the Directive, which on current timeframes is likely to happen between 2024-2025, will have significant implications for investors in securities (retail and institutional) and intermediaries serving the space such as custodian banks and asset managers. Though an EU initiative, the impact of the changes will also be felt in the UK. Several intermediaries are based in or manage important parts of their operations from the UK and will also need to adapt to the new processes being introduced.

The plans to reform the withholding tax system have been largely well-received, with widespread recognition that change is needed. There is huge complexity in the current system, which is deterring investors from making cross-border investments. Typically, those making an investment in an EU member state are subject to withholding tax in the country of that investment (known as the source country) on any interest or dividend received. However, they are often paying more tax than they need to and missing out on the reduced rates available to them through bi-lateral Double Tax Conventions (DTCs), which protect against being taxed twice on the same income by two contracting states. The majority of markets operate on a reclaim basis, which means investors have to apply for a refund on excess tax paid; this is often a costly, lengthy and resource-intensive process, which some investors choose to forgo due to the efforts involved. And in those markets that do offer Relief at Source (RaS), there are often a number of time-consuming manual processes.

Although the market is awaiting concrete next steps, the direction towards a simplified, standardised EU process for withholding taxes is clear. At EY’s EMEIA Wealth and Asset Management Operational Tax Conference in early November, the EC stated that it is currently focusing on three building blocks, namely:

  • The creation of a common Electronic Tax Residence Certificate (e-TRC)
  • The introduction of a quick withholding tax refund mechanism as a minimum standard
  • Enhanced transparency through common reporting

Each of these building blocks stands to bring significant improvements to the current withholding tax landscape.

Electronic Tax Residence Certificate (e-TRC)

The proposed e-TRC, which is expected to be issued with verifiable credentials and electronic seals using EU blockchain services and electronic authentication, would bring much needed digitisation to the withholding tax process. Currently, there is a high prevalence of paper documents, with most EU tax authorities only accepting – and issuing - paper documents to claim for tax relief at source or apply for refunds. Furthermore, most tax authorities require tax forms to be physically stamped and certified by local authorities and demand wet signatures from investors’ representatives, bringing a high level of bureaucracy to the process. This proved particularly problematic during the COVID-19 pandemic, when many tax offices were closed and meant that investors were not able to get the paper certificates or authorisation that they needed to support claims, resulting in material losses. The introduction of electronic documentation together with electronic signatures and stamps would considerably simplify processes and enable a greater degree of automation of workflows The UK is also likely to have to make changes to adapt to this process. For example, the current paper certificates of residence issued by HMRC to get tax relief in the EU would probably need to align with the new e-TRC model.

Quick withholding tax refund mechanism

The plans to propose a quick withholding tax refund mechanism aim to make the reclaim process faster for investors regardless of where they invest. Those markets that operate on a RaS basis are expected to continue to do so, but outside of these markets the processes to claim a refund currently tend to be lengthy, paper-based procedures, that also vary notably between member states. These markets will be expected to adopt the new quick refund mechanism as a minimum standard. A quick refund process will also be advantageous to the UK, as UK intermediaries and resident investors will also receive refunds more promptly, ultimately benefitting underlying portfolios.

The introduction of a quick refund process will require intermediaries to work to tighter deadlines, highlighting the importance of appropriate data controls and processes. Refund processes rely on high volumes of complex data and having in place best-in-class technology that provides good quality data and proper audit trail mechanisms that will be key to enabling timely and accurate responses.

Enhanced transparency through common reporting

There is a strong argument for standardised reporting and the EC is currently working on a common set of information to be provided to the source country of the income in a common format. At present, there is no standardised approach for accessing or sharing data. This is problematic, because for any given dividend distribution, there is a lot of associated tax data, such as investor details, tax documentation, stock holding information that needs to be shared. There are also a number of parties, such as custodians, asset managers, and tax administrators that this information passes through between the company making the payment and the end investor. However, the lack of standardisation means that each organisation adopts its own method to transmit data to other parties, resulting in significant inefficiencies across the industry.

A standardised approach to reporting would also improve tax transparency. Currently, the concept of tax transparency means different things in different member states. In some countries, it relates to how income beneficial ownership information is collected through omnibus accounts or fund structures when there are multiple levels of beneficial ownership. In other countries, the definition of tax transparency is more extensive, for instance, there may be requirements to perform additional due diligence on the end-investor for anti-tax evasion purposes. This divergence in definitions means it is hard to reap the benefits of automation for tax transparency rules. Harmonisation of the rules, regardless of the definition adopted, would mitigate this challenge and enable technology providers to develop and adapt the functionality to enable automation of processes.

Withholding tax developments in individual member states

Finally, it is important to note, that while there is largely industry consensus that a move towards a single, standardised system across the EU for withholding taxes would bring numerous benefits, there is also concern that the plans could clash with withholding tax developments in individual member states. For instance, in 2021 Finland became the first country to adopt the OECD’s TRACE (Treaty Relief and Compliance Enhancement) model for reporting, while both Sweden and Germany are introducing withholding tax reforms to go live in 2024 and 2025 respectively.

Clearly, there is a lot of detail to be worked out, yet most agree that too much tax is currently left on the table and the investment world keenly awaits the next developments in the reform of the EU withholding tax system.

This article first featured in Accountancy Daily.