Institutional investors every year miss out millions of euros because they do not recover withholding tax paid abroad. The reason: suboptimal communication and cooperation between institutional investors and a «custodian» that does not or not always fully perform the service formally assumed.
Institutional investors sometimes - wrongly - expect that their custodian always reclaims all withholding tax. In practice, custodians do make such reclaims when they are sure their clients are fully entitled to, but when they are not fully convinced, they often fail to do so.
Reclaiming withholding tax is a service provided by custodians that is part of the all-in fee paid by clients as institutional investors, says Jeroen van der Wal, managing director of Taxology, a Rotterdam-based international tax consultancy that helps institutional investors and asset managers reclaim withholding tax in countries where clients have investments.
For an equity portfolio that takes the MSCI world index as its benchmark, for example, the issue could, where appropriate, be about a missed «return» of 30 to as much as 70 basis points, Van der Wal said.
€8.4 billion down the drain
Van der Wal refers to a 2016 European Commission report which made clear that reclaiming withholding tax in the EU is complex due to too many different procedures and the existence of many different documentation requirements. Brussels estimated that around 8.4 billion euro per year goes down the drain - not only in withholding tax, but also in missed «opportunity costs», as it sometimes takes years before you get your money back and can invest it again, Van der Wal said.
Institutional investors generally seem satisfied with the broader services offered by custodians, with the exception of withholding tax relief. This is often left unaddressed, Van der Wal said, referring to feedback from his clients. Sub-optimal communication and cooperation between institutional investors and their custodian is a reason. Despite often having access to their source data at the custodian, institutional investors often do not have sufficient insights into what they need to provide to enable them to perform all agreed services on time.
Institutional investors often learn about the requirements when it is too late, resulting in a source exemption or a reclaim being missed. In that case, returns can be missed from hundreds of thousands to sometimes several million euros per year per client.
Withholding tax service monitor
“Although custodians usually offer exemption at source or reclaims in many countries, there are still situations and countries where they do not offer a service,” Van der Wal said. “This is the case, for instance, for ‹ECJ reclaims› - reclaims based on the freedom of capital movement in the EU treaty - or in countries where the reclaim process is decentralised and very complex, or on special instruments such as ADRs. Institutional investors sometimes assume, wrongly, that custodians do all that is possible. In practice, this often is not the case.”
Taxology has developed a software platform called «Protocol». This allows the custodian’s withholding tax service to be monitored at a detailed level and can be used as an «interface» between the custodian and its client. In addition, the software identifies reclaims that are not covered by the custodian’s service and which it will therefore not execute. Van der Wal said it allows for continuous monitoring of the global portfolio. Also, five years back in time can be looked at, so reclaims can still be made.
Taxology’s clients are institutional investors with assets under management ranging from two billion euro to almost 200 billion. For these clients, Taxology monitors the custodian’s withholding tax services and reclaims them for institutional investors if the custodian fails to do so.
Online central workplace
Taxology aspires to play a bigger role in the relationship between custodians and institutional investors in terms of collecting double withholding tax. Other tax advisers to institutional investors could also be connected to this platform, said Van der Wal. He aims to create a central online workplace, where institutional investors, their custodians and other service providers can cooperate efficiently on optimal services in the field of reclaiming withholding tax. Van der Wal hopes for a network effect.
The custodian market, also known as custody banks, consists of large global financial services companies, such as State Street Corporation, J.P. Morgan, Citigroup and BNP Paribas Securities Services. They hold securities on behalf of their clients at a Central Securities Depository, the central, nationwide depository for all exchange-traded securities. They hold amounts for their clients between 13,000 billion and 21,000 billion dollars. They also administer securities positions for their clients.
This article originally appeared in Dutch on InvestmentOfficer.nl.
Double taxation: Luxembourg traffic lights are red
Given its position as an international fund and asset hub with investors from dozens of countries using Luxembourg-domiciled investment products, reclaiming taxes paid in the grand duchy can be rather complex. Luxembourg’s general withholding tax rate is 0% for both Sicav and FCP investment funds. Its dividends are taxed at 15%, while there is 0% on capital gains.
In general, the withholding tax reclaim process is a tedious and time-consuming exercise that has proven to be burdensome in terms of costs and resources both for the taxpayers and tax administrations.
“These challenges are not only relevant in Luxembourg but in most jurisdictions as well,” said Jordi Andrea, senior associate at Norton Rose Fulbright. “It is in that context that the European Commission is preparing a withholding tax initiative which aims to improve withholding tax procedures. Our Luxembourg tax team is involved in the on-going process concerning this initiative. However, due to the complexity of the topic, it is unlikely that a solution be adopted in the short term.”
The asset management practice of KPMG Luxembourg has published a study analysing the withholding tax (WHT) rates of different jurisdictions with respect to Luxembourg investment funds, in order to provide a snapshot of each jurisdiction’s situation. The 2022 study looked at 124 countries and considered a range of different taxes applicable to Sicav and FCP investment funds.
Using a traffic light system, it ranked the ease or difficulty with which WHT can be reclaimed or reduced. A glance at the KPMG study quickly makes clear that reclaiming WHT is ‘difficult’ in dozens of cases. A German investor for example may find it difficult to reclaim WHT under EU law, but it would be easy to do so under domestic law. INvestors from Poland and Portugal face a difficult situation in both cases. A Dutch investor looking to reclaim WHT in Luxembourg under EU law will also find it difficult.
At well over 60 cases in the ‘difficult’ category, the KPMG study on WHT reclaims highlights more than three times as many cases as in the ‘easy’ category.
Some 56 countries have a double taxation treaty applicable to Luxembourg Sicav funds. Not every treaty is the same. Specific clauses for example apply to German investors, where the double taxation treaty only applies up to the percentage of the unitholders who are tax resident in Luxembourg.
Huge burden for all
EY, in a report published issued last November, said the current setup in the EU “not only results in a huge burden for all stakeholders including custodians, fund administrators, asset managers, investors as well as the tax authorities, but also results in an inherent systemic double taxation”.
The European Commission has acknowledged the complexity around investment funds and WHT reclaims and is preparing a new EU system to avoid double taxation.
Insurance industry association ACA Luxembourg has told the European Commission it believes that cross-border investment and simplified taxation should be a priority for the EU, and that tax barriers to cross-border investment should be removed.
“The amount of lost withholding taxes and the related costs in applying for refunds in the EU markets is estimated to be in the billions,” said EY in its report. “This situation is contradictory to the fundamental ambition of the EU to remove all barriers to cross-border investments and to ensure fair taxation.”