Bermuda triangle to swallow EU savings tax directive?

Well, not quite the Bermuda triangle - but the Cayman Islands might do just that.

In what is likely going to become a case study regarding the complexities of European multilevel governance, pooled sovereignty, and the complex relations of institutional Europe and the world, it seems a legal challenge brought forth by the government of the Cayman Islands, a British dependency, and thus an EU associated territory, could at least severely delay the EU savings tax directive’s implementation - after a mere 13 years of negotiations to come up with a common solution to taxing capital gains without tampering too much with the capital’s mobility and important privacy issues.

The directive, agreed unanimously by the EU’s ECOFIN council on June 3 this year, obliges member states to automatically exchange tax relevant information about cross border interest payments from January 2005 on, or, in the case of Belgium, Luxembourg, and Austria, to apply a withholding tax, increasing from 15% in 2007 to 35% in 2010, for a transitional period. Member states will receive 75% of the taxes paid by their nationals in those countries implementing a withholding tax.

While it’s certainly possible to criticise the directive for a number of reasons (privacy concerns are on top of my list) it is obvious that capital taxation is more necessary these days than ever before in industrialised countries where more and more income is generated through capital gains instead of easily taxable immobile labour. Thus, it is important to guarantee wide-ranging participation in the effort and to limit loopholes which clever and well paid tax consultants will certainly identify faster than the directive can even be turned into national law by the member states. Accordingly, the directive will only become binding for member states should the Council decide unanimously on June 30, 2004, that all relevant third parties have agreed to exchange tax-relevant information to a degree satisfactorily in compliance with Chapter II of the directive (Article 17).

The biggest obstacle that Chapter II poses is the attempted automatic exchange of tax relevant information information that many of the relevant third-parties, most notably the US and Switzerland, have objected to. They only support information exchange to support criminal investigations under a proposed OECD scheme to reduce “harmful tax evasion” - but, in the case of Switzerland this would not include foreign tax evasion. However, Switzerland has agreed to impose a withholding tax instead and it seems the US’ position will be judged as satisfactory for the moment (according to this PWC analysis in German)

But the case of the Cayman Islands’ opposition to the directive has become more tricky to politically manoeuvre around (KPMG Caymans report). The implementation rules set out in Article 17 of the directive clearly state that

“(ii) all agreements or other arrangements are in place, which provide that all the relevant dependent or associated territories (the Channel Islands, the Isle of Man and the dependent or associated territories in the Caribbean) apply from that same date automatic exchange of information in the same manner as is provided for in Chapter II of this Directive, (or, during the transitional period defined in Article 10, apply a withholding tax on the same terms as are contained in Articles 11 and 12).”

But the the Caymans challenged the validity of the British claim that the directive can be implemented without even seriously talking to the them first and now hold a verdict signed and sealed by the European Court of First Instance that agrees with their position -

“…the Court found that with the Directive in its current form, it would not be credible for the UK, as a member state of the European Union, to argue that the UK was legally required by the Directive to impose “the same measures” on the Cayman Islands.” (from the above KPMG document)

While there seems to be limited agreement regarding the exchange of information related to criminal investigations, a favourable decision according to Article 17 will be difficult to make given the verdict and the Caymans’ resolve not to implement the directive without further negotiations. Thus, there are good reasons to believe that the directive’s implementation schedule is stillborn (capital.de, in German).

But then again - it will be up to the ECOFIN council to politically decide whether the partner countries’ efforts to comply with the directive’s provisions have been sufficient to apply the directive in January 2005, and my best guess is that the council will find a clever way to legally save the directive’s implementation even when the Caymans’ are de facto in non-compliance - and therefore in a position to swallow an even larger share of EU savings taxes than before.