Why a tax management function such as the tax reclaims is essential and deserves more attention today and even more tomorrow?

In brief

In today’s global economic context, the actors of the Financial Institutions are experiencing pressure on their investment performance and margins. To remain competitive, these players are launching initiatives focusing on investment strategies, costs reduction and offering/ pricing strategies. One pragmatic solution with direct impacts on investment performance, investors/client’s satisfaction and cost management is management optimisation of the withholding tax applied on the income derived from investments.

This solution, already offered to some extent by Custodian Banks and regularly requested by clients of Investment or Private banks, triggers many challenges due to the very complex and diversified withholding tax relief and reclaim procedures around the world. As an obvious illustration, in 2016 the European Commission estimated the foregone tax relief and opportunity costs under the scope of double tax treaties to a value of more than EUR 8.4 bn annually. This amount is significantly higher when considering European case law ad National law based reclaims.

It has always been important to focus on operational taxes and for the dedicated scope of withholding taxes, we see an acceleration over the last years requiring from the banks to develop a robust framework to tackle these burdensome withholding tax relief and reclaim procedures as well as their related challenges.

The latest challenge that is coming under Banks responsibilities at least for those which are offering an in-house tax reclaim service is ATAD3 that we illustrated in the preceding article.

In detail 

Why do you need to focus on it?

Tax reclaims have always been a complex topic as tax authorities require more and more transparency on the designation of the beneficial owner, the numerous stakeholders involved in the chain of payment need to align, the non-harmonization of procedures across countries, etc. 

Keeping a close eye on the tax reclaims’ activity will further increase in importance over the short to medium term. Lately, there have been several factors contributing to this: the recent developments within the EU case law based reclaims area, notably in Italy, the new CSSF Circular 20/744 which is a complement to the Circular CSSF 17/650 and TRACE, the new regulation that will increase responsibility to financial institutions.

All these developments are showing that operations related to withholding tax reclaims as well as the outsourcing of such activities are at different levels a challenging topic with multiple layers of complexity.

What developments and challenges have we seen?

1. A constantly changing tax framework: e.g., fokus reclaims in Italy

On 7 February 2022, the Pescara Tax Court of First Instance ruled that a Luxembourg SICAV is comparable to an Italian investment fund and, therefore, it entitled to the refund of the full withholding tax suffered on the dividends received from Italian companies, which means that the Luxembourg SICAV would be entitled to the refund of the full withholding tax suffered on the dividends received from Italian companies.

This judgment has a fundamental importance as it represents the first official confirmation by an Italian tax court of the discriminatory tax treatment suffered by foreign investment funds in Italy on the dividend payments received.

Last year, the European Commission sent a letter of formal notice to France urging to change its withholding tax rules on dividends paid to Unit Linked Insurance companies established in other European Economic Area (EEA) Member States and when reviewing the reclaim introduced by a British life insurance company, the Council de France indeed stated that the difference in the taxation of dividends is likely to constitute an infringement of the free movement of capital, which constitutes a strong encouragement for European insurance companies to continue filing withholding tax reclaims based on EU cases laws.

These decisions show the obligation to be up to date on tax reclaims news. In addition to the complex process, not having reclaims expert in the area of the said reclaims can bring complexity to the claimants to understand and determine the subtleties of each country requirement in term of tax residence definition, comparability characteristic among the investment vehicles, etc. 

Whether on reclaims based on European, DTT or national law, it should be noted that each country has its own tax reclaim procedure, which vary in complexity from one tax authority to another and from a financial institution to another. As a consequence, this leads to limited operational efficiency/consolidation when dealing with low volumes. 

On top of this, significant volumes of documents provided by various stakeholders are required. These requirements are quickly evolving and vary across countries.  An excessive amount of dedicated resources and time are spent on these documentation collection, reconciliation, validation and mailing processes, which prevent financial institutions to focus on their core activities and stay efficient on these functions. 

2. CSSF Circular – AML tax fraud and Tax Function within the AM industry

On 3 July 2020, the CSSF issued the Circular 20/744 which is a complement to the Circular CSSF 17/650 related to the extension of laundering offence to aggravated tax fraud and tax swindle. With this Circular, the CSSF expands the list of indicators to specifically target the collective investment activities and the professionals providing services in the Asset Management sector. The CSSF expects professionals under its AML / CFT supervision to take these new indicators into account and to build / reinforce their tax function and increase the governance oversight.

The new indicators are now fully part of the AML controls done by the CSSF during their onsite visits, as it was already done within the Circular 18/698 framework. The first visits took place in mid-2021 and the CSSF already prepared several remediation letters to the actors in this framework. 

Therefore, when tax reclaims functions are delegated to bank institutions, the clients from the asset management will require more evidence of controls, status report and key performance indicators to justify a correct governance on their tax risks, both at corporate and managed funds levels.

In view of the above, financial institutions are required to develop reporting tools allowing to manage the information based on a robust data quality framework, share transparent overall and detailed status of their tax reclaim process. 

3. Increasing responsibilities moved to the financial institutions: TRACE

It has always been complicated for portfolio investors to effectively reclaim the reduced rates of withholding tax due to, among others, administrative barriers. The OECD Treaty Relief and Compliance Enhancement (TRACE) initiative launches the framework of a standardised system allowing the reclaiming of withholding tax relief at source on portfolio investments. This will help minimise administrative costs for all stakeholders and allow them to ensure proper compliance with tax obligations.

When TRACE suggests a commitment for future harmonisation and will allow digitalisation, this will however increase the legal liabilities and responsibilities of the financial institutions with the Authorised Intermediary status as they will be the main actor of such tax reliefs. 

Since the new system was implemented in Finland on 1 January 2021, we already saw key financial institutions who choose to change their market offering by not implementing relief at source of Finnish dividends anymore as they are not willing to cope with an increased risk exposure, legal liabilities and responsibilities.

Although the implementation of TRACE will be limited in the coming years, following the emergence of the so-called "cum-cum" and "cum-ex" systems, which have given rise to significant tax evasion and avoidance, tax authorities have become increasingly cautious and eager to ensure compliance with tax obligations and to avoid exploiting weaknesses in national or treaty tax provisions, particularly when it comes to identifying the beneficiary of income.  Acting as first, on the provision of financial documentation and sometimes the preparation of reclaim forms, financial institutions need to define a robust control framework and identify red flags at every step of the process.

How should you react to this?

While it is the obligation of the tax applicant to understand the duties and tax requirements when requesting the implementation of relief at source or a reclaim of an unduly withholding tax levied, it also imposes substantial compliance obligations upon the financial institutions involved by, among others, implementing extra-checks before the payment of the incomes, deploying a robust data quality procedure and, replying to the tax requirements of the tax authorities. Such obligations require to be the gatekeepers of the financial and tax system and take a more involved role. This can generate some risks for the financial institutions such as: operational risk due to complexity and the charge of the tax administration requirements, manual and burdensome processes, reputational and legal risk of failure to meet the tax authorities’ requirements. 

We understand the challenges that are facing the financial institutions as they must manage the tax operations with various stakeholders, taking into consideration numerous obligations and requirements and can therefore encounter lack of efficiency when facing such issues and initiating new development, which generates not negligible costs.

Besides, it is more than complicated to stay up to date on the various new legislations / legal developments without creating a specific watch with dedicated trained tax experts.

When (re)designing the tax reclaims operations, the financial institutions should consider stream-lined deployments focusing on it:

• A robust governance supported by robust risk management: given all the channels affected by the operational tax system, the governance in place must integrate transversal functions to create synergies between the area of operations, AML, risk management, reporting, data management and finance and act as a support structure for management and compliance. In addition, it is paramount to have a control framework and risk management processes to identify red flags and define mitigating actions along the entire process. 

Reliable and accurate data quality management:  you must be sure that the information in your systems is correct, reliable and timely updated to run efficiently withholding tax reclaim or relief operations and to capture the full potential of reclaimable amount with a clear strategic spotlight on how data is handled through people’s responsibilities, processes and IT systems.

• Clear and documented operational processes: this provides up to date and transparent guidelines on how relief at source/refund application should be prepared considering specificities across investment countries and type of claims. This will define the roles and responsibilities of the dedicated people in charge among the organisation and give more clarity on the investments in technology that would be required.

• Smart and efficient tax operating model to cope with increasing volumes and complexity: when designing your tax operating model, it is paramount to target efficiency gains and agility to adapt to ever changing reclaim procedures and requirements. For example, setting up delegation of tax reclaims operations to specialised service providers can help you tackle operational challenges in the different phases of your tax reliefs/reclaims. 

• Dedicated tax functions with a good balance of tax expert and operational profiles: tax experts help financial institutions to understand and comply with the requirements, avoiding multiple risks and assessing the impacts. Specialised operational tax teams can relieve resources and offer stability in the tax reclaim process of their clients and allow to concentrate on the core business activities.

• Anticipation of the client’s expectations: the demands of clients are increasing in pace and complexity. Demonstrating that you understand your clients’ needs is a cornerstone of the business development strategy. By showing awareness on the tax consequences within you and your clients’ structures, developing reporting and indicators on the monitoring of the portfolio taxation, you will create full transparency to your internal stakeholders and clients in order to anticipate their needs and provide feedback.

Takeaway

Staying up to date on tax news and opportunities, understanding every specificity of each tax reclaim process and complying with tax authorities’ requirements and the client’s expectations at the same time can sound like a tricky mission for financial institutions and generate substantial risks for them. 

Of course, there are several ways to tackle these heavy procedures and ease financial institutions’ operations, and this could be the right time to assess your tax reclaims’ strategy and rethink the model in place. Looking at the future with for example ATAD3, we clearly see additional complexities and risks that Financial Institutions should carefully anticipate and manage.

^{1. “Why banks need to continue to focus on operational taxes now more than ever” – July 2021 edition}

^{2.TRACE: Finland gets the ball rolling - March 2021 edition (details here: (details here: https://www.pwc.lu/en/banking/docs/pwc-keeping-up-banking-and-capital-markets-march-2021.pdf#page=5)}