UK: why information exchange beats withholding taxes every time

Courtesy of the fascinating paper by Itai Grinberg which we blogged recently, and a careful reading by Markus Meinzer, we have found a stunning endorsement for information exchange from a rather surprising source: the UK Treasury. This paper was written in February 2000, while the EU Savings Tax Directive was still being thrashed out, and it is unequivocal.

This is important, because Swiss bankers and others are telling everyone they can that it is far better to apply withholding taxes on dirty money sitting in or routed through Swiss and other banks, than to shine daylight onto them, because . . . well, we find it hard to follow their line of argumentation. And the current UK government appears to have swallowed the Swiss line, wholesale.

Although it is theoretically possible to have both effective information exchange and withholding taxes, in practice the UK has placed itself in a position of either one or the other. This is because it has chosen to sign a deal with Switzerland which endorses withholding taxes - but whose main purpose, sotto voce, has been a political one: to sabotage wider European efforts to produce transparency through the European-wide transparency project, the Savings Tax Directive. (Read more about some of the subtleties involved in that particular political chess game here and here.)

So here is what the UK Treasury had to say, back in 2000.

The UK believes there are seven key advantages to exchange of information.

First, exchange of information allows for the right amount of tax due on the income from savings to be collected. For those countries which tax the savings income of their residents at the marginal rates which apply to income in general, a withholding tax is unlikely to be the marginal rate at which the investor should be paying tax in his state of residence.

Second, exchange of information allows savings income to be taxed in the right country - that is, the investor's state of residence rather than solely in the state of source for the investor's savings income. The "co-existence approach" [TJN: permitting E.U. states to choose to apply either withholding tax or information exchange] does not allow for this and this is why several Member States have argued for revenue sharing.

Third, exchange of information encourages compliance with the tax system. It provides a deterrent to the non-declaration or under-declaration of income. In contrast a withholding system, without exchange of information, might appear to give the impression of legitimising tax evasion since it fails to deter non-declaration. Acceptance by the EU of the "co-existence" model in Community legislation might be interpreted by taxpayers as a signal that non-declaration to the taxpayer's state of residence will be tolerated.

Fourth, exchange of information helps wider compliance with the tax systems of Member States, including tackling the serious problem of cross-border "laundering" of the proceeds of tax evasion. Exchange of information will often draw the attention of the country of residence to the existence of an asset which may have been funded from income, profits or gains which have themselves been hidden from the tax authorities. In turn, these activities could now be taxed. Withholding conveys none of these advantages.

Fifth, exchange of information is easy and efficient. It would be sufficient to draw the attention of the country of residence to the existence of the income-producing asset - the tax authorities could then seek sufficient information from the investor to work out the tax liability. In contrast, applying withholding might in some circumstances require a financial institution to perform complex calculations not needed for its own purposes. In addition, a withholding system would require additional administrative costs in order to manage tax deductions or investor certification.

Sixth, exchange of information is good for the honest investor, since it does not lead to the cash flow disadvantages associated with a cross-border withholding tax system.

Seventh, exchange of information produces equity between Member States. It precludes the likelihood of capital flight from countries providing information to countries opting for withholding under "co-existence" arrangements. Dishonest investors determined to evade tax will generally prefer to suffer a (minimum) withholding tax rather than have information passed to their country of residence, and will choose where to invest their savings accordingly. This would lead to undesirable distortion of competition, by putting financial institutions in withholding countries at a tax-driven competitive advantage.

Exchange of information for tax purposes is consistent with the trend to greater international co-operation and transparency in international financial systems, encouraged by international initiatives in both tax and non-tax fields. Even if withholding arrangements were adopted by all countries globally, this would not provide an effective solution to evasion of tax on savings income. They would not allow Member States to collect the full amount of tax due on their residents' savings income, nor to deter and detect the "laundering" of the proceeds of tax evasion through investment abroad.

Exchange of information arrangements on a wide international basis is the only way in which an effective solution to the evasion of tax on savings income can ultimately be achieved. And it is the only way that the Helsinki European Council Conclusions can be delivered. Such an approach requires EU countries (as well as important third countries) to set aside those bank secrecy laws which are standing in the way of a solution to tax evasion based on exchange of information. This has already been recognised in a number of important initiatives on the international front aimed at tackling tax evasion, harmful tax competition and international financial crime.

That is a good start. Disappointingly, the list does not contain the word 'automatic.' We have noted on numerous occasions how the OECD has sought to impose its woefully inadequate "on request" system of information exchange on recalcitrant secrecy jurisdictions, calling it the internationally agreed standard - when we have demonstrated beyond doubt, on several occasions, that the far more comprehensive system of automatic information exchange is superior. Grinberg adds:

"Anonymous withholding arguably represents the tax administration forswearing any independent effort to collect tax that is due. Thus, it may well legitimize tax evasion not only through offshore accounts but also more broadly.

A cross-border anonymous withholding system also undermines the expressive role that taxation plays within a liberal democracy. A cross-border anonymous withholding system also undermines the expressive role that taxation plays within a liberal democracy.

(and he develops this important point further, particularly on pp 41-42l we also noted further additional points he made in our recent blog on his paper.)

It would seem odd, on the face of it, to see the UK endorsing information exchange, given its recent displays of abhorrence for financial transparency. However, the history of all this isn't a simple one.

We know from discussions with participants that the UK - led by its gigantic financial sector in the City of London - has for years played a long game in eviscerating the European Savings Tax Directive, inserting loophole after loophole to ensure that it will collect only a fraction of its potential. (The latest Swiss deal is just a continuation of that longer game: we have demonstrated beyond doubt that it will collect only a tiny fraction of what has been promised: perhaps one tenth, but no more.)

But we note in this 2003 paper by the International Tax and Investment Organisation (ITIO,) no friend of TJN's, that despite having done all this, the UK has, at times in the past, been more comfortable with automatic information exchange than with withholding taxes.

"Following a concerted lobby effort by the United Kingdom (directed at preserving the London-based Eurobond market), member states agreed that automatic exchange of information, rather than withholding tax, was the ultimate objective of the E.U. approach to policing the taxation of savings."

This on the face of it might make sense, since that lobbying effort would have been happening at a time when the final scope of the Savings Tax Directive was unclear, and they might have worried that a withholding tax might have been applied to the super-massive Eurobond market, from which City bankers and lawyers earn vast rents. Note here that the Eurobond market is a tax-free, largely regulation-free offshore market, one of the keys to understanding the size and power of the global financial services sector and to the rebirth of the City of London from the 1950s (read all about about that in this book.) But -- surprise, surprise -- in pushing for information exchange, the UK was being more devious than it would appear! From the New York Times, in February 2000:

"Britain proposed Friday that governments exchange information to crack down on investors who evade taxes by stashing their money abroad, as an alternative to a proposed European Union withholding tax on savings income that is favored by most EU governments.

But EU officials said the British offer appeared to be a ploy aimed at undermining the withholding plan, which Britain vehemently opposes as a threat to the dollars 3 trillion Eurobond market in London. Britain says the 20 percent withholding tax would drive holders of Eurobonds into other markets.

A senior official at the British Exchequer, Dawn Primorolo, proposed the information exchange at a high-level EU working group that is seeking to solve the tax conundrum before a summit meeting in Lisbon in June.

"It is difficult to regard the latest U.K. contribution as being very constructive," Jonathan Todd, a spokesman for the European Commission, said.

Officials said Britain had produced the new approach without warning or preparation at the group meeting.
. . .
In London, a spokesman for the Treasury said Britain had not altered its position on a withholding tax, adding, "We won't agree to anything that damages the City's interests.""

For international tax wonks, the twists and turns of international tax are fascinating, and the existential crisis now facing the European Union itself adds a whole new dimension of uncertainty into all this.

Still, we will stick with that official and strong UK endorsement of information exchange. Whatever happens, the basic principles are timeless.

One more for our permanent information exchange page.