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As multinational companies are using every trick in the book to avoid paying tax, it is worth remembering that in some instances finding a loophole is encouraged.
In Europe, pension funds are allowed to collect income on shares earned outside their home nation without being hit by withholding tax. Other individual and corporate investors have to pay this levy, but the pension loophole has been enshrined in European Union regulation because retirement provision is not seen as a wealth-creation activity.
However good these intentions are, though, not all investors are taking advantage, and many have been paying up to 15% of their equity-return income to the taxman. This might seem like madness in an age when every basis point counts, but this “leakage” is understandable when you consider that all assets held in pooled funds in most large European countries are subject to withholding tax-whether they belong to pension investors or not.
To get around this extra cost, some investors have used specially-created tax-efficient vehicles parked in major fund centres such as Luxembourg and Dublin. Whole economies have been built around these solutions-providers, and other European nations now want a piece of the action.
When bulge-bracket banking was all the rage, London and Frankfurt were happy to let these relative minnows (fund managers) swim in provincial backwaters. Since the crash, however, their attentions have been piqued by the potential new income stream.
In July, the United Kingdom’s Treasury will launch its Authorised Contractual Scheme (ACS), designed to help catapult the country to a domicile status rivalling the current European leaders.
The ACS is a complicated name for a pooled fund that allows investors to get around paying withholding tax on their investments made outside the UK’s borders. It is the first venture of this type for the country that is arguably the European funds hub in terms of where the managers themselves are based and investment decisions are made.
The UK will not find this market a pushover, however. Plenty of tax-savvy investors already hold their money in Luxembourg or Ireland-using the Fonds Commun de Placement or Common Contractual Funds—and these domiciles, for their part, have been quietly adding to their suite of products. The Netherlands recently launched the Fondsen voor Gemene Rekening, and Germany is also joining the party with a similar fund aimed at attracting institutional investor cash.
“It’s a healthy development,” says Jarkko Syyrilä, deputy director general at the European Fund and Asset Management Association (EFAMA), “and shows that European countries are thinking about long-term asset management and savings.”
Syyrilä predicts that investors will be the ultimate beneficiaries as governments move to make these different types of tax-efficient structures available, because the savings should be passed directly to clients. Of course, fund managers themselves can benefit, too: Instead of running several segregated mandates to avoid clients paying withholding tax, they can now pool these vehicles and cut down administration (and costs) significantly. At least some of these savings ought to be passed on to the end investor.
“In the UK, the government’s tax office has really been trying to help the fund industry and its clients,” says Aaron Overy, a specialist in this area at Northern Trust. “The new ACS and German model will challenge the status quo predominantly set by Luxembourg and Ireland.”
These new fund options are not being created purely to help pension funds-these countries have not suddenly become good Samaritans. A booming funds sector also boosts the economy as a whole.
“Every £1 billion of investment in a fund is worth almost £1 million for the domicile,” says Nathan Hall, partner in KPMG’s financial services tax practice. “This can come through income tax and VAT [value added tax] that arises on local services supplied to the funds, but job creation more generally boosts the economy. These moves by the major European economies shows an appreciation that fund domicile matters, and the industry is strong here. It is a fairly recent appreciation.”
It is unlikely that there will be huge swings as investors and fund managers pull assets out of the already established fund centres-Hall says it would be too expensive and difficult to undo what has been in place for years-but the competition is heating up for new money. “It is all about capturing new business,” he says. “The UK government is ready to start a road-show outside its own borders to showcase what the ACS is about and how it can help investors.”
Estimates put the cost savings for investors in the tens of millions of euros, which can be reinvested to try and shore up funding of stubbornly large pension deficits.
“Investors are already asking their consultants to ask fund managers about where they stand on the issue and what they have done to create new vehicles,” says Overy. “The larger pension funds, which belong to multinational companies, have also been looking into it themselves. Through one of these vehicles they can consolidate assets-which could help to produce better investment performance.”
Don’t crack open the champagne just yet, though: There are still some significant hurdles to overcome.
“For the moment, there is so much new regulation for fund managers to deal with as it is,” says EFAMA’s Syyrilä. “They face a real challenge to be compliant with the new UCITS structure, the Alternative Investment Fund Managers Directive, and other rules that have been imposed since the financial crisis. Too much time has been taken by this regulatory avalanche, which has left less time to look at new fund structures that could help investors.”
So, we shouldn’t prepare for London to resemble Grand Cayman, or for Frankfurt to swipe Luxembourg’s crown, just yet. But there is appetite from the largest financial centres in Europe-and, most importantly, momentum behind the move from the top of their governing bodies.