On 1st July, the EU Savings Tax Directive turned three years old. Also on 1st July, the withholding tax rate applied under the terms of the Directive jumped from 15% to 20% - an unwelcome reminder that keeping savings offshore is no longer effective tax planning.

At the launch of the Directive, the withholding tax rates were scheduled as follows:

1st July 2005 – 30th June 2008 – 15%

1st July 2008 – 30th June 2010 – 20%

1st July 2011 onwards – 35%

The increase from 15% to 20% means that anyone paying the withholding tax is now paying 33% more tax than a month ago. When it hits 35%, it will be a 133% increase from the launch rate. To make it even worse, most of those affected will remember the days when no tax at all was deducted from their offshore accounts.

It is important to point out what while no tax was deducted at source prior to 2005, anyone earning interest from an offshore bank account was still legally obliged to declare them on their Spain tax return - under local laws their worldwide income should be declared for tax purposes. The same rules apply in the UK for UK resident domiciles. So these interest earnings were never actually tax free… though that did not stop some people ‘forgetting’ to declare them.

This is precisely why the EU set up the Savings Tax Directive (STD). EU countries lose tens of billions of Euros each year to tax evasion. The STD was conceived a means of ensuring that an EU resident paid tax on their interest income, regardless of where the interest was generated and regardless of whether they actually declared it or not.

The STD is one part of a major tax package launched by the European Commission in 1997. Its original intention was for a uniform “information exchange” regime to apply across the EU, with all countries agreeing to report interest on savings paid to the citizens of other Member States to those States’ tax authorities – thus making it impossible for EU residents to hide their offshore savings income from their local taxman. The plan was also for EU Member States to impose the same rules on their dependent territories, which make up a substantial portion of the world’s tax havens.

A long battle followed, however, with various objections raised regarding automatic exchange of information which would effectively end banking secrecy within the EU.

Opposition came from within the EU itself and not just the dependent territories. In the end, a compromise was reached and under the terms of the STD, the withholding tax is applied by Andorra, Austria, Belgium, British Virgin Islands, Guernsey, Isle of Man, Jersey, Liechtenstein, Luxembourg, Monaco, Switzerland and Turks & Caicos Islands. All other EU Member States, plus Anguilla, Aruba, Gibraltar, Madeira, Montserrat, Netherland Antilles and San Marino apply automatic exchange of information, as will any future EU members. Bermuda and the Bahamas are currently not covered by the STD.

The withholding tax regime is only meant to be a “transitional arrangement”. The EU’s “ultimate aim” is for all participating jurisdictions to automatically exchange information on the interest earnings of EU residents in future. While there will obviously be strong resistance to this from some countries, the EU will fight every step of the way to eventually achieve this.

The European commission is also escalating efforts to persuade other jurisdictions to abide by the terms of the deal, including Hong Kong, Macao and Singapore. EU officials are negotiating with all three on a double-taxation agreement, giving the Europeans some leverage.

In the Isle of Man, Jersey and Guernsey, the withholding tax is referred to as “retention tax” (but it is exactly the same thing), and clients can authorise their banks to automatically exchange of information rather than pay withholding tax.

This gives you the option to pay tax in Spain instead of having tax deducted at source.

Since the start of 2007 interest income is taxed at a flat rate of 18% in Spain. This means that if your bank account has withholding tax deducted you are now effectively opting to pay extra tax (11% more). From July 2011 you’d pay 94% more tax!

It’s important to note that even if withholding tax is deducted, you are actually still obliged to declare the interest earnings in Spain since it forms part of worldwide income.

Anyone who has not previously declared this income in Spain should probably seek advice from a financial adviser before switching to the exchange of information system to benefit from the lower Spanish tax rate – your local tax authority may make enquiries as to why you had not previously declared this account – which would have been liable for wealth tax until this year as well as income tax on the interest income.

It’s often worth a chat with a financial adviser in any case, to establish if you can legitimately reduce your tax rate further. While 18% is lower than 20%, you may be able to pay less than this using appropriate structures.

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