It doesn’t have to be taxing
08 Dec 2021
This industry panel explains why tax reclamation is so important and what factors are currently driving change within this service sector
Image: pcess609.stock.adobe.com
Peter Grant, partner, KPMG LLP, explains dividend withholding tax and double taxation relief
In many countries, dividend (and in some cases interest) payments may be subject to the deduction of tax at source – that is to say, withholding tax.
In paying a dividend to a non-resident, the paying company (or its agent) may be required to deduct tax at the prevailing rate (statutory rate) and pay this over to their domestic tax authority.
Where the investor is subject to tax in its country of residence (or intended to be exempt from tax, as might be the case for certain pension funds for example) this withholding tax can result in double taxation.
For this reason countries have negotiated double taxation treaties (DTTs), which typically contain provisions to mitigate the impact of this potential double taxation.
Tax relief is generally obtained in one of two ways. Either via relief at source (RAS), where the tax relief is granted upon payment of the dividend, typically based on information provided through the payment chain to identify the end beneficial owner, or through a retrospective tax reclaim, submitted to the overseas tax authority after the dividend has been paid.
Reclaim opportunities may also be granted under domestic tax legislation with regard to the nature of the recipient.
Our Panel
Ali Kazimi, Managing director, Hansuke Consulting
Sarah Cooper, Global head of research and product development, Goal Group
Peter Grant, Partner, KPMG LLP
What are withholding tax reclaims, and why is reclamation so important?
Peter Grant: A withholding tax reclaim opportunity can arise where an investor holds a security, such as an equity, which generates dividend income. The source country will often, but not always, impose a withholding tax on the dividend payment. For example, the UK does not impose any withholding tax on dividends.
Where the security is held cross-border, the respective countries might negotiate a bilateral tax treaty which agrees to, among other things, the maximum amount of withholding tax investors each country should suffer. For example, the Canadian statutory withholding tax rate on dividends is 25 per cent, but the DTT between Canada and the UK is 15 per cent. This should mean the UK investor, assuming they meet certain stipulations — such as the residency and beneficial ownership requirements under the treaty — can recover any excess withholding tax above the level of the treaty.
A tax reclaim is often required to include certain supporting documents to affirm the eligibility of the investor and ensure they meet the requirements of the tax treaty. For example, a certificate of tax residence issued by the local tax office of the investor might need to be included with the tax reclaim application.
The dividend and tax reclaim payment chain is often highly intermediated — the investor might appoint a bank to act as global custodian, who in turn will use a local sub-custodian (potentially a third-party bank). This bank might interface with local paying companies, tax authorities and a central securities depository. Information, as well as physical paper forms, typically need to flow between these intermediaries, often in very short timeframes, to enable a withholding tax reclaim or RAS payment to be made.
In some cases, the position is even more pronounced. For example, the statutory withholding tax rate on a US dividend is 30 per cent, which can be reduced under the US-UK DTT to 0 per cent for a UK pension fund. The impact of this tax relief could be up to 60 basis points on income flows if you assume a 2 per cent dividend yield, not insignificant when investors are searching for better returns.
The preference of investors and service providers will always be to obtain RAS as this provides improved cash flow. However, not every country makes this available, while some that do impose onerous requirements which can make it practically impossible to achieve.
Sarah Cooper: Operationally, investors can receive dividends and interest payments on cross-border securities. However, a withholding tax is imposed on non-residents by the foreign tax authority, which can be as high as 35 per cent.
If a DTT exists between the market of investment and the market of residence, investors may qualify for a tax reduction, either via RAS or a reclaim. Where markets offer both, the investor elects the method, but each requires lengthy documentation and reporting.
Filing for a refund of over-withheld tax can take from six months to several years — even as long as a decade — depending on the jurisdiction. Generating and populating reclaim forms is a daunting task. Certification and supporting documents are required, which vary according to the jurisdiction. Reclaims have to be submitted and initiated with the relevant tax authorities, and then tracked closely until the reclaim has been processed.
Due to the multitude of different requirements and reclaim life cycles across the globe, the withholding tax reclamation process is one of the most complex and time-consuming aspects of tax operations.
Yet it is a vital element of a fund manager’s fiduciary duty to maximise investment returns, as funds that reclaim tax typically boost returns by 25-50 basis points annually. This is why it is so important for investors to be aware that they could be leaving money on the table that is rightfully theirs, and to ensure that reclamation takes place.
Ali Kazimi: In general, withholding taxes are those taxes that are suffered on investment returns (dividend and interest) at source at the time that the income item is paid. The withholding tax being suffered can often be reduced by a DTT or a domestic law exemption. An example of a domestic exemption is the Portfolio Interest Exemption that applies to coupon interest arising on US treasury bills.
Where the amount withheld is in excess of the applicable treaty rate or domestic exemption, that gives rise to an entitlement to reclaim that excess. Withholding tax reclamation processes take two operational forms; either RAS or the certification method.
The importance of reclamation lies in investment returns drag for the investor and in the legal and commercial obligations that are created for intermediaries.
What is driving the market for tax reclaims?
Cooper: We are seeing a marked increase in demand for our tech-driven, automated withholding tax relief and reclamation solutions. Part of the reason for this is the growing recognition that failure to perform this historically complex and laborious task accurately and efficiently costs investors dearly. Also, thanks to advancements in fintech, it is now much more efficient and cost-effective for custodians and agents to provide a high-quality, comprehensive reclaim service to their clients, either as a managed service or in-house. Large banks often prefer the latter for reasons of client confidentiality.
I know from first-hand experience that it is proving harder and taking longer for investors and their intermediaries to jump through all the hoops required to qualify for RAS, which can lead to a delay in trading. In markets where there is a choice between RAS or a reclaim, such as the US, France, Italy, Ireland and Sweden, many clients now prefer the reclaim option so they can start trading as soon as their service provider has carried out know-your-client checks.
We are also finding that many institutions are currently reassessing their service provision in the area of withholding tax reclaims, and this is reflected in rising numbers of new business enquiries. Many recent industry reports have indicated that dividend payouts are rebounding globally and have almost returned to pre-pandemic levels. This undoubtedly sharpens the focus on efficient tax recovery services.
Grant: Tax reclaims exist to mitigate the impact of excessive taxation. In many cases, the tax reclaim function is outsourced to a service provider, typically a global custodian for large institutional investors or private banks for high-net-worth investors, who might in turn use a global custodian.
Competing forces of higher volumes, greater tax authority scrutiny, and a growing discomfort by service providers to take on the operational or tax risk of providing tax reclaim services has resulted in situations where cross border investors are not always able to recover withholding tax — which they might be due — under a DTT.
Increasingly, other service providers with specialist expertise are stepping in to help — specialist reclaim providers and tax advisers with global capability and expertise. However, the cost dynamics for these providers is very different compared to a global custodian running this on an industrial scale.
We find investors are not always fully aware of the areas where service providers support tax reclaims, often down to highly complex market requirements, assets with non-standard tax treatment, or when a global custodian is simply not able to act for the beneficial owner. This situation can lead to a mismatch of understanding of service scope and, if investors are not fully informed, it can leave available tax relief unclaimed.
Kazimi: Global investors, be they individuals or institutions (sovereigns, investment funds and pension funds, insurance companies), often end up paying more tax on their cross-border investments than legally due from them. Accordingly, and rightfully so, there is a strong call for investors not to suffer excessive taxes on their investments.
The investor activism is driving international organisations such as the Organisation for Economic Co-operation and Development (OECD), United Nations and EU to look into ways to improve the mechanisms and processes to enable investors to secure their entitlements. A research study by the Goal Group estimated that as much as £13.2 billion is lost due to excess withholding taxes not being fully reclaimed. Many are now looking to the promise of new technologies such as blockchain to solve the problems of antiquated paper-based reclamation systems.
How has COVID-19 affected the tax reclaims process?
Kazimi: The immediate and direct impact of COVID-19 has been to slow down the processes of tax authorities in the processing of reclaims. For an overseas lender to establish themselves to obtain RAS, the UK HMRC’s DTT passport process used to take circa four weeks. That process is now taking between 15 and 16 weeks just on account of the applications backlog. From the investor’s perspective, there is now far greater focus on investment returns. The easy way to enhance performance is to tighten up the tax reclaim process. Many investment portfolios, in search for higher returns, are switching asset allocation towards the more frontier and exotic markets. This switch to international investing creates further issues with respect to withholding tax reclaims.
Cooper: The pandemic put unprecedented strain on normal operations across all areas of society but, as far as our business area is concerned, we managed to maintain business as usual. Part of the reason for this is the flexibility and helpfulness shown by foreign governments and tax authorities, many of whom worked together to adapt quickly, for instance by extending submission deadlines and accepting digital documents to a far greater degree than ever before.
In fact, I would say that COVID-19 has certainly advanced the industry’s shift to digital. The cross-border withholding tax reclamation process has always been quite reliant on physical documentation but, as in so many areas of life, the pandemic proved that it is perfectly possible (and of course ultimately quicker and more efficient) to operate digitally. We are one step closer than we were before.
The importance of choosing the right service provider has been amplified by COVID-19. For instance, it is vital to have access to the very latest changes in deadlines and procedures to submit accurate and timely reclaims on behalf of investors. It is very hard to do this without tapping into the knowledge of a dedicated global research team.
Grant: The tax reclaim world has not changed much over the last 20 years and certainly has not kept pace with the digitisation successfully implemented by tax authorities in other areas. I can file my tax return online, but claiming withholding tax often means using physical paper forms and wet ink signatures.
Under a process so reliant on paper forms and wet ink signatures, remote working and lockdowns could have brought the tax reclaim process to a standstill. Thankfully, that did not happen in most cases, as investors, service providers, industry bodies and tax authorities made efforts to mitigate the effects with several temporary fixes.
In some cases, tax authorities agreed to receive forms electronically with electronic signatures and even agreed to temporarily extend the statute of limitation (the time limit available to submit the reclaim). In addition, where tax reclaim forms needed to be certified (by the investors tax office) before being sent to the overseas tax authority, some authorities agreed to accept an electronic version of this certification.
We will need to wait to see how much of this process change sticks, or whether it will act as a catalyst to change. Some of these measures will improve the process but ultimately, it is the lack of consistency across countries which causes the most complexity.
Why is so much money left unclaimed each year?
Grant: The estimates for the amount of lost withholding tax relief varies, but the European Commission estimates €8.4 billion per annum was lost in 2016. If this is even close to the correct amount, it represents an enormous amount of money that does not get collected each year.
The reclaim process is often complicated, cumbersome and in many cases lacks prescriptive rules as to how to obtain relief. Furthermore, the tax reclaim process differs significantly across countries, making automation very challenging. There is no standardised set of beneficial owner documentation, or even consistency of the data points which need to be collected or how beneficial ownership is evidenced, across different countries.
Information about the beneficial owner is often held by the investor’s global custodian and then needs to be transmitted to a tax authority (usually through a long chain of intermediaries). Completing this in very tight timeframes can mean the opportunity to obtain tax relief is not cost-effective or simply impractical. As the process becomes harder and the global custodian is expected to apply judgement or take a technical view on eligibility, they quite understandably might be inclined not to support that claim.
Recent high-profile cases of alleged tax fraud (such as the so-called cum-ex and cum-cum transactions) have heightened concerns by tax authorities and prompted them to increase the level of scrutiny they apply and the information they request before issuing a withholding tax refund.
Some have raised the argument that if countries are serious about removing withholding tax relief barriers, then why not reduce the statutory tax rate to the level of the common treaty rate and remove the need to process burdensome reclaims? Thus, reducing costs and administration for tax authorities and eliminating the issue altogether for investors could also help address concerns of fraud by removing the need for tax reclaims.
Clearly, it is not this simple, as tax authorities would need to balance this against the likely outcome of reducing their tax take, both as a result of a wider range of investors benefitting from the lower withholding tax rate, as well as some investors who might not previously have been able to navigate the complexities of claiming refunds.
Cooper: We know that US$15 billion of withholding tax on foreign shares and bonds is left unclaimed by investors and their intermediaries every year. There are many reasons for this. Traditionally, many in the industry have felt that the burden of reclaiming withholding tax outweighed the benefits. Although awareness is growing that reclaiming tax is a fiduciary duty and that digital technology has transformed the process and cost model, there is still much progress to be made across the industry.
The industry is also hampered by the false assumption that other parties in the custody chain are already handling tax recovery. For instance, asset managers might rely on their custodian but actually it is very unusual for tax reclamation services to be included in their standard service offering. This is a significant contributory factor to beneficial owners missing out on their rightful returns. The reality is that institutional investors are still often short-changed.
Kazimi: There are a multitude of reasons that result in money being left on the table. The withholding tax reclamation processes across the globe are not uniform, overly manual, and are often in foreign languages and painfully slow. The onerous processes are further complicated by the following factors:
Multi-tiered investment holding structures supported by complex network of intermediaries
Uncertainty of tax treatment of certain investment vehicles (opaque or transparent)
Tightening of tax definitions and requirements (beneficial ownership and substance requirements) as well new limitation of benefits clauses in DTT
Greater circumspection by tax authorities in the aftermath of the cum-ex fraud
How does non-reclamation impact the investment community?
Kazimi: At a societal level, deficient pensions and savings represent a genuine social cost. Such deficiencies arise, in part, due to the dysfunctional reclamation processes. The investment drag creates inefficiencies distorting proper asset allocation.
At the micro level, firms that are better able to monetise their tax reclaim positions will ultimately perform better in the long run. Hence, the greater focus by industry on tax reclamation whether they be exchange-traded funds, hedge funds or sovereign investors — everyone is seeking to avoid leaving money on the table.
More soberingly, intermediaries that are expected to secure reclaims of excess withheld taxes could face legal action for negligence or breach of fiduciary responsibility for their failure to safeguard assets of their principals.
Grant:The delay, or worse still the inability to recover tax reclaims, on cross-border investment ultimately impact investment flows to individual savings or pension funds, which has a real impact on pension provision for individuals through reduced cash flows, preventing the reinvestment in capital markets. Furthermore, the administrative cost for processing, monitoring and following up with claims indirectly gets passed indirectly back to the investor.
Cooper: Losses hit nearly US$7 billion for investors domiciled in Europe; $4.5 billion for US and Canadian investors; and $3 billion for investors in Asia Pacific.
These alarming sums reveal the true impact of non-reclamation on the global investment community.
It is therefore imperative that the industry addresses the huge disparity in the scope and quality of reclamation services so that investors no longer needlessly miss out on such significant proportions of their rightful returns.
What other trends are you seeing in the world of tax reclaims?
Kazimi: The big debate across the EU is the exploration of a self-regulating tax reclaim system called Tax Relief and Compliance Enhancement (TRACE). It is being trialled in Finland as we speak. It is largely modelled on the US Qualified Intermediary regime, whereby the authorised intermediary will take on the responsibility of granting treaty benefits based on proper documentation and reporting, and subjecting themselves to external audits to police their compliance.
Spurred on by the OECD, the EU is expected to play a much greater role in establishing tax standards. A leading European think-tank recently called for a common withholding tax across the EU. In coming years, deals such as the OECD’s minimum global tax rate will become politically more attractive for the post-COVID-19 depleted treasuries.
Cooper: The world of international tax and the regulatory landscape is constantly evolving and it is imperative for the asset servicing industry to be in a position to analyse the implications of new rules, rates and risks as they present themselves.
One key trend we are seeing is tax authorities across the globe conducting a rising number of audits of the various parties in the tax reclamation ecosystem. The frequency and requirements of the audits vary from authority to authority, but they all rely on an extremely robust digital audit trail and workflow in order to produce the necessary documentation and certifications on behalf of clients. This is driving many institutions to outsource back-office tasks, with tax reclaims being a prime example, so they can leverage the scale and digital infrastructure of a specialist provider to ensure watertight processes and handle audits more efficiently.
As part of the shift to digital, tax authorities are moving to real-time reporting. This further increases the industry’s reliance on highly advanced digital solutions that are able to seamlessly manage these emerging requirements in the field of tax reclamation.
More generally, institutions are looking to improve operational efficiency, streamline processes, create a competitive edge, build scalability into their service offering and maximise returns for investors – all the while containing costs. Digital, cloud-based technologies are producing truly transformative results in all of these areas. Regardless of the maturity of an institution’s in-house digital transformation programme, they can leverage the power of cloud via outsourced or subscription-based solutions. This presents a real opportunity to turn tax reclaims from a fiduciary duty into a valuable service advantage.
Grant:As cross-border capital flows increase, so does the complexity. Tax authorities want more information from investors and the definition of beneficial ownership is being challenged more and more. Questions about certain investors continue to be debated, for example, should a collective investment vehicle benefit for tax treaty relief at the fund level? Should this be applied at the investor level or should some form of analysis to establish the percentage of investors resident in treaty locations be considered? These questions do not seem to go away and tax authorities are applying even greater scrutiny to reclaims received.
Collective investment vehicles which pool money from multiple investors (in a retail fund, often many thousands of investors) have found it increasingly difficult to obtain tax treaty benefits in some jurisdictions. The determination of treaty eligibility and beneficial ownership is not consistently applied, with some countries asking collective investment vehicles to provide information about the underlying unit holders, something which is difficult or even impossible, as it is common for funds to be held through a series of distributors, platforms and local banks, meaning the fund often will not know exactly who the end investors are or where they are tax resident.
These growing demands for additional information to evidence treaty entitlement are being pushed down to the global custodians, who typically act for institutional investors. This, in turn, is increasing the tension between the traditional role of a global custodian, how they are remunerated, the level of risk they are absorbing, and expectations on them to apply some level of tax-related assessment as to the eligibility for treaty relief by their clients. There is a head of steam building which does not yet have an easy outlet.
Global custodians are looking for ways to bring automation into the process and make it easier for their clients. For example, the use of automated prefilled reclaim forms with beneficial owner information has become a more common service for some global custodians — but we still see these paper flows being managed via email, without any significant automation in place. The global custodian community has taken steps to address some of these automation opportunities, but the lack of consistency across countries does make this quite difficult.
How do you see the future of tax reclaims?
Cooper: Withholding tax reclamation is a niche, complex and labour-intensive area. It is very hard to straight-through process this, and it is only with the latest fintech — combined with a knowledge base that is continually updated — that the process can become efficient, accurate and cost-effective.
As investors become more aware of the imperative to reclaim tax, and as fiduciaries embrace digital solutions more widely in response to both market and regulatory demands, we will undoubtedly continue to see strong growth in tax reclaims across all markets. In addition, cross-border investment is projected to maintain its long-term upward trajectory which will drive a need for efficient tax recovery services.
Increasing numbers of institutions are outsourcing the whole reclamation process, or ‘insourcing’ a digital solution to take the pressure off the in-house team and scale up their service proposition cost effectively. With the right approach, tax recovery can be turned into an area of competitive advantage, both for clients and as an interbank services opportunity.
In terms of wider trends, tax harmonisation across the EU has been on the agenda for several years. It is a well-intended initiative but hugely complicated to implement. We will continue to keep our clients up to date with the latest thinking and announcements on this. The shift to digital is also gaining momentum in the world of withholding tax. One thing is for certain — institutions already using the latest digital, cloud-based solutions to manage their tax reclaim processes are in a strong position to respond quickly and efficiently to new requirements as they emerge.
Grant: Investors should benefit from enhanced returns, global custodians from lower operating costs and tax authorities will get access to better information to help prevent tax fraud and ensure relief is only given to those who are entitled.
There are numerous reasons why TRACE did not get off the ground. Primarily it is an issue of trust between governments and different areas of the financial sector, which has not been improved by large scale alleged tax fraud identified in recent years. The so-called cum-ex trading scandal which has been estimated to have cost governments nearly €10 billion has left a particularly bad taste with tax authorities, making them sceptical about any suggestion from the financial services industry to simplify the withholding tax relief system. This will need to be overcome to move forward as well as better articulation of the benefits for each of the stakeholders, especially governments and tax authorities.
Discussions about the use of a blockchain or distributed ledger technology (DLT) to enable the secure and real-time tracking of ownership and dividend entitlement, leading to the ability to attribute a tax reclaim. The technology itself does not deal with the issues of country level consistency or a uniform approach to assessing beneficial ownership, we therefore have to be careful not to replace 27 inconsistent manual regimes with 27 inconsistent digital regimes. In my mind, as well as the multiple technical issues, there are two major barriers which need to be overcome for a distributed ledger solution to take hold.
Firstly, regaining trust between stakeholders that this will not just facilitate an elaborate way for investors to artificially reflect ownership and overclaim tax relief will be vital. This is arguably exacerbated by the lack of general understanding of DLT, which despite a lot of discussion, is still far from ubiquitous. DLT is still in its infancy and convincing governments of the latest shiny new technology being endorsed by large, global banks, is not going to be an easy sell.
Secondly, the cost-benefit ratio for the different stakeholders needs to be better understood. Will governments invest time and money in transforming the withholding tax relief system to help ensure the estimated €8.4 billion of unclaimed tax relief can be claimed more easily? The argument that this will make capital markets more attractive and accessible is nebulous; alternatively, arguing that it will reduce tax fraud might not be enough to convince governments. After all, Finland has introduced their own TRACE and Germany has legislated to stamp out withholding tax fraud through a central beneficial ownership register — in both these cases it is not clear what additional benefits a blockchain will bring.
That said, I can certainly see a future where blockchain plays a significant part of the withholding tax process, but I do wonder if this will not be the by-product of digitisation of the overall securities ownership and movement sector, as opposed to a standalone initiative for withholding tax.
Kazimi: The EU protective reclaims are anticipated to gather further momentum and pay downs by tax authorities should follow suit. The systematic siding by the The Court of Justice of the European Union in favour of the taxpayers against the discriminatory practices that undermine the effective working of the single market, has emboldened more investors to lodge claims. Obviously, such claims need to be substantiated by a proper analysis of the entitlements.
There is much debate around DLT solving the problem of unclaimed excess withholding taxes. European Fund and Asset Management Association, the umbrella organisation of European asset management trade associations, is leading the debate with its Blockchain for Taxes project. It has laid down the fundamental design principles and different institutional clusters are working on the design.
Some have sought to directly apply blockchain technology to solving the tax reclamation conundrum. We are ideologically in the other camp and believe that you do not “bolt-on” a withholding taxes blockchain solution to an antiquated engine.
Our solution seeks to fix a deeper and more fundamental issue of how investments are to be made on a blockchain, the tax benefits will be many and wide and will not be restricted to withholding taxes alone.
“The more fundamental solution brings withholding solutions but also encompasses transfer taxes, capital gains and investor tax reporting.”
In many countries, dividend (and in some cases interest) payments may be subject to the deduction of tax at source – that is to say, withholding tax.
In paying a dividend to a non-resident, the paying company (or its agent) may be required to deduct tax at the prevailing rate (statutory rate) and pay this over to their domestic tax authority.
Where the investor is subject to tax in its country of residence (or intended to be exempt from tax, as might be the case for certain pension funds for example) this withholding tax can result in double taxation.
For this reason countries have negotiated double taxation treaties (DTTs), which typically contain provisions to mitigate the impact of this potential double taxation.
Tax relief is generally obtained in one of two ways. Either via relief at source (RAS), where the tax relief is granted upon payment of the dividend, typically based on information provided through the payment chain to identify the end beneficial owner, or through a retrospective tax reclaim, submitted to the overseas tax authority after the dividend has been paid.
Reclaim opportunities may also be granted under domestic tax legislation with regard to the nature of the recipient.
Our Panel
Ali Kazimi, Managing director, Hansuke Consulting
Sarah Cooper, Global head of research and product development, Goal Group
Peter Grant, Partner, KPMG LLP
What are withholding tax reclaims, and why is reclamation so important?
Peter Grant: A withholding tax reclaim opportunity can arise where an investor holds a security, such as an equity, which generates dividend income. The source country will often, but not always, impose a withholding tax on the dividend payment. For example, the UK does not impose any withholding tax on dividends.
Where the security is held cross-border, the respective countries might negotiate a bilateral tax treaty which agrees to, among other things, the maximum amount of withholding tax investors each country should suffer. For example, the Canadian statutory withholding tax rate on dividends is 25 per cent, but the DTT between Canada and the UK is 15 per cent. This should mean the UK investor, assuming they meet certain stipulations — such as the residency and beneficial ownership requirements under the treaty — can recover any excess withholding tax above the level of the treaty.
A tax reclaim is often required to include certain supporting documents to affirm the eligibility of the investor and ensure they meet the requirements of the tax treaty. For example, a certificate of tax residence issued by the local tax office of the investor might need to be included with the tax reclaim application.
The dividend and tax reclaim payment chain is often highly intermediated — the investor might appoint a bank to act as global custodian, who in turn will use a local sub-custodian (potentially a third-party bank). This bank might interface with local paying companies, tax authorities and a central securities depository. Information, as well as physical paper forms, typically need to flow between these intermediaries, often in very short timeframes, to enable a withholding tax reclaim or RAS payment to be made.
In some cases, the position is even more pronounced. For example, the statutory withholding tax rate on a US dividend is 30 per cent, which can be reduced under the US-UK DTT to 0 per cent for a UK pension fund. The impact of this tax relief could be up to 60 basis points on income flows if you assume a 2 per cent dividend yield, not insignificant when investors are searching for better returns.
The preference of investors and service providers will always be to obtain RAS as this provides improved cash flow. However, not every country makes this available, while some that do impose onerous requirements which can make it practically impossible to achieve.
Sarah Cooper: Operationally, investors can receive dividends and interest payments on cross-border securities. However, a withholding tax is imposed on non-residents by the foreign tax authority, which can be as high as 35 per cent.
If a DTT exists between the market of investment and the market of residence, investors may qualify for a tax reduction, either via RAS or a reclaim. Where markets offer both, the investor elects the method, but each requires lengthy documentation and reporting.
Filing for a refund of over-withheld tax can take from six months to several years — even as long as a decade — depending on the jurisdiction. Generating and populating reclaim forms is a daunting task. Certification and supporting documents are required, which vary according to the jurisdiction. Reclaims have to be submitted and initiated with the relevant tax authorities, and then tracked closely until the reclaim has been processed.
Due to the multitude of different requirements and reclaim life cycles across the globe, the withholding tax reclamation process is one of the most complex and time-consuming aspects of tax operations.
Yet it is a vital element of a fund manager’s fiduciary duty to maximise investment returns, as funds that reclaim tax typically boost returns by 25-50 basis points annually. This is why it is so important for investors to be aware that they could be leaving money on the table that is rightfully theirs, and to ensure that reclamation takes place.
Ali Kazimi: In general, withholding taxes are those taxes that are suffered on investment returns (dividend and interest) at source at the time that the income item is paid. The withholding tax being suffered can often be reduced by a DTT or a domestic law exemption. An example of a domestic exemption is the Portfolio Interest Exemption that applies to coupon interest arising on US treasury bills.
Where the amount withheld is in excess of the applicable treaty rate or domestic exemption, that gives rise to an entitlement to reclaim that excess. Withholding tax reclamation processes take two operational forms; either RAS or the certification method.
The importance of reclamation lies in investment returns drag for the investor and in the legal and commercial obligations that are created for intermediaries.
What is driving the market for tax reclaims?
Cooper: We are seeing a marked increase in demand for our tech-driven, automated withholding tax relief and reclamation solutions. Part of the reason for this is the growing recognition that failure to perform this historically complex and laborious task accurately and efficiently costs investors dearly. Also, thanks to advancements in fintech, it is now much more efficient and cost-effective for custodians and agents to provide a high-quality, comprehensive reclaim service to their clients, either as a managed service or in-house. Large banks often prefer the latter for reasons of client confidentiality.
I know from first-hand experience that it is proving harder and taking longer for investors and their intermediaries to jump through all the hoops required to qualify for RAS, which can lead to a delay in trading. In markets where there is a choice between RAS or a reclaim, such as the US, France, Italy, Ireland and Sweden, many clients now prefer the reclaim option so they can start trading as soon as their service provider has carried out know-your-client checks.
We are also finding that many institutions are currently reassessing their service provision in the area of withholding tax reclaims, and this is reflected in rising numbers of new business enquiries. Many recent industry reports have indicated that dividend payouts are rebounding globally and have almost returned to pre-pandemic levels. This undoubtedly sharpens the focus on efficient tax recovery services.
Grant: Tax reclaims exist to mitigate the impact of excessive taxation. In many cases, the tax reclaim function is outsourced to a service provider, typically a global custodian for large institutional investors or private banks for high-net-worth investors, who might in turn use a global custodian.
Competing forces of higher volumes, greater tax authority scrutiny, and a growing discomfort by service providers to take on the operational or tax risk of providing tax reclaim services has resulted in situations where cross border investors are not always able to recover withholding tax — which they might be due — under a DTT.
Increasingly, other service providers with specialist expertise are stepping in to help — specialist reclaim providers and tax advisers with global capability and expertise. However, the cost dynamics for these providers is very different compared to a global custodian running this on an industrial scale.
We find investors are not always fully aware of the areas where service providers support tax reclaims, often down to highly complex market requirements, assets with non-standard tax treatment, or when a global custodian is simply not able to act for the beneficial owner. This situation can lead to a mismatch of understanding of service scope and, if investors are not fully informed, it can leave available tax relief unclaimed.
Kazimi: Global investors, be they individuals or institutions (sovereigns, investment funds and pension funds, insurance companies), often end up paying more tax on their cross-border investments than legally due from them. Accordingly, and rightfully so, there is a strong call for investors not to suffer excessive taxes on their investments.
The investor activism is driving international organisations such as the Organisation for Economic Co-operation and Development (OECD), United Nations and EU to look into ways to improve the mechanisms and processes to enable investors to secure their entitlements. A research study by the Goal Group estimated that as much as £13.2 billion is lost due to excess withholding taxes not being fully reclaimed. Many are now looking to the promise of new technologies such as blockchain to solve the problems of antiquated paper-based reclamation systems.
How has COVID-19 affected the tax reclaims process?
Kazimi: The immediate and direct impact of COVID-19 has been to slow down the processes of tax authorities in the processing of reclaims. For an overseas lender to establish themselves to obtain RAS, the UK HMRC’s DTT passport process used to take circa four weeks. That process is now taking between 15 and 16 weeks just on account of the applications backlog. From the investor’s perspective, there is now far greater focus on investment returns. The easy way to enhance performance is to tighten up the tax reclaim process. Many investment portfolios, in search for higher returns, are switching asset allocation towards the more frontier and exotic markets. This switch to international investing creates further issues with respect to withholding tax reclaims.
Cooper: The pandemic put unprecedented strain on normal operations across all areas of society but, as far as our business area is concerned, we managed to maintain business as usual. Part of the reason for this is the flexibility and helpfulness shown by foreign governments and tax authorities, many of whom worked together to adapt quickly, for instance by extending submission deadlines and accepting digital documents to a far greater degree than ever before.
In fact, I would say that COVID-19 has certainly advanced the industry’s shift to digital. The cross-border withholding tax reclamation process has always been quite reliant on physical documentation but, as in so many areas of life, the pandemic proved that it is perfectly possible (and of course ultimately quicker and more efficient) to operate digitally. We are one step closer than we were before.
The importance of choosing the right service provider has been amplified by COVID-19. For instance, it is vital to have access to the very latest changes in deadlines and procedures to submit accurate and timely reclaims on behalf of investors. It is very hard to do this without tapping into the knowledge of a dedicated global research team.
Grant: The tax reclaim world has not changed much over the last 20 years and certainly has not kept pace with the digitisation successfully implemented by tax authorities in other areas. I can file my tax return online, but claiming withholding tax often means using physical paper forms and wet ink signatures.
Under a process so reliant on paper forms and wet ink signatures, remote working and lockdowns could have brought the tax reclaim process to a standstill. Thankfully, that did not happen in most cases, as investors, service providers, industry bodies and tax authorities made efforts to mitigate the effects with several temporary fixes.
In some cases, tax authorities agreed to receive forms electronically with electronic signatures and even agreed to temporarily extend the statute of limitation (the time limit available to submit the reclaim). In addition, where tax reclaim forms needed to be certified (by the investors tax office) before being sent to the overseas tax authority, some authorities agreed to accept an electronic version of this certification.
We will need to wait to see how much of this process change sticks, or whether it will act as a catalyst to change. Some of these measures will improve the process but ultimately, it is the lack of consistency across countries which causes the most complexity.
Why is so much money left unclaimed each year?
Grant: The estimates for the amount of lost withholding tax relief varies, but the European Commission estimates €8.4 billion per annum was lost in 2016. If this is even close to the correct amount, it represents an enormous amount of money that does not get collected each year.
The reclaim process is often complicated, cumbersome and in many cases lacks prescriptive rules as to how to obtain relief. Furthermore, the tax reclaim process differs significantly across countries, making automation very challenging. There is no standardised set of beneficial owner documentation, or even consistency of the data points which need to be collected or how beneficial ownership is evidenced, across different countries.
Information about the beneficial owner is often held by the investor’s global custodian and then needs to be transmitted to a tax authority (usually through a long chain of intermediaries). Completing this in very tight timeframes can mean the opportunity to obtain tax relief is not cost-effective or simply impractical. As the process becomes harder and the global custodian is expected to apply judgement or take a technical view on eligibility, they quite understandably might be inclined not to support that claim.
Recent high-profile cases of alleged tax fraud (such as the so-called cum-ex and cum-cum transactions) have heightened concerns by tax authorities and prompted them to increase the level of scrutiny they apply and the information they request before issuing a withholding tax refund.
Some have raised the argument that if countries are serious about removing withholding tax relief barriers, then why not reduce the statutory tax rate to the level of the common treaty rate and remove the need to process burdensome reclaims? Thus, reducing costs and administration for tax authorities and eliminating the issue altogether for investors could also help address concerns of fraud by removing the need for tax reclaims.
Clearly, it is not this simple, as tax authorities would need to balance this against the likely outcome of reducing their tax take, both as a result of a wider range of investors benefitting from the lower withholding tax rate, as well as some investors who might not previously have been able to navigate the complexities of claiming refunds.
Cooper: We know that US$15 billion of withholding tax on foreign shares and bonds is left unclaimed by investors and their intermediaries every year. There are many reasons for this. Traditionally, many in the industry have felt that the burden of reclaiming withholding tax outweighed the benefits. Although awareness is growing that reclaiming tax is a fiduciary duty and that digital technology has transformed the process and cost model, there is still much progress to be made across the industry.
The industry is also hampered by the false assumption that other parties in the custody chain are already handling tax recovery. For instance, asset managers might rely on their custodian but actually it is very unusual for tax reclamation services to be included in their standard service offering. This is a significant contributory factor to beneficial owners missing out on their rightful returns. The reality is that institutional investors are still often short-changed.
Kazimi: There are a multitude of reasons that result in money being left on the table. The withholding tax reclamation processes across the globe are not uniform, overly manual, and are often in foreign languages and painfully slow. The onerous processes are further complicated by the following factors:
Multi-tiered investment holding structures supported by complex network of intermediaries
Uncertainty of tax treatment of certain investment vehicles (opaque or transparent)
Tightening of tax definitions and requirements (beneficial ownership and substance requirements) as well new limitation of benefits clauses in DTT
Greater circumspection by tax authorities in the aftermath of the cum-ex fraud
How does non-reclamation impact the investment community?
Kazimi: At a societal level, deficient pensions and savings represent a genuine social cost. Such deficiencies arise, in part, due to the dysfunctional reclamation processes. The investment drag creates inefficiencies distorting proper asset allocation.
At the micro level, firms that are better able to monetise their tax reclaim positions will ultimately perform better in the long run. Hence, the greater focus by industry on tax reclamation whether they be exchange-traded funds, hedge funds or sovereign investors — everyone is seeking to avoid leaving money on the table.
More soberingly, intermediaries that are expected to secure reclaims of excess withheld taxes could face legal action for negligence or breach of fiduciary responsibility for their failure to safeguard assets of their principals.
Grant:The delay, or worse still the inability to recover tax reclaims, on cross-border investment ultimately impact investment flows to individual savings or pension funds, which has a real impact on pension provision for individuals through reduced cash flows, preventing the reinvestment in capital markets. Furthermore, the administrative cost for processing, monitoring and following up with claims indirectly gets passed indirectly back to the investor.
Cooper: Losses hit nearly US$7 billion for investors domiciled in Europe; $4.5 billion for US and Canadian investors; and $3 billion for investors in Asia Pacific.
These alarming sums reveal the true impact of non-reclamation on the global investment community.
It is therefore imperative that the industry addresses the huge disparity in the scope and quality of reclamation services so that investors no longer needlessly miss out on such significant proportions of their rightful returns.
What other trends are you seeing in the world of tax reclaims?
Kazimi: The big debate across the EU is the exploration of a self-regulating tax reclaim system called Tax Relief and Compliance Enhancement (TRACE). It is being trialled in Finland as we speak. It is largely modelled on the US Qualified Intermediary regime, whereby the authorised intermediary will take on the responsibility of granting treaty benefits based on proper documentation and reporting, and subjecting themselves to external audits to police their compliance.
Spurred on by the OECD, the EU is expected to play a much greater role in establishing tax standards. A leading European think-tank recently called for a common withholding tax across the EU. In coming years, deals such as the OECD’s minimum global tax rate will become politically more attractive for the post-COVID-19 depleted treasuries.
Cooper: The world of international tax and the regulatory landscape is constantly evolving and it is imperative for the asset servicing industry to be in a position to analyse the implications of new rules, rates and risks as they present themselves.
One key trend we are seeing is tax authorities across the globe conducting a rising number of audits of the various parties in the tax reclamation ecosystem. The frequency and requirements of the audits vary from authority to authority, but they all rely on an extremely robust digital audit trail and workflow in order to produce the necessary documentation and certifications on behalf of clients. This is driving many institutions to outsource back-office tasks, with tax reclaims being a prime example, so they can leverage the scale and digital infrastructure of a specialist provider to ensure watertight processes and handle audits more efficiently.
As part of the shift to digital, tax authorities are moving to real-time reporting. This further increases the industry’s reliance on highly advanced digital solutions that are able to seamlessly manage these emerging requirements in the field of tax reclamation.
More generally, institutions are looking to improve operational efficiency, streamline processes, create a competitive edge, build scalability into their service offering and maximise returns for investors – all the while containing costs. Digital, cloud-based technologies are producing truly transformative results in all of these areas. Regardless of the maturity of an institution’s in-house digital transformation programme, they can leverage the power of cloud via outsourced or subscription-based solutions. This presents a real opportunity to turn tax reclaims from a fiduciary duty into a valuable service advantage.
Grant:As cross-border capital flows increase, so does the complexity. Tax authorities want more information from investors and the definition of beneficial ownership is being challenged more and more. Questions about certain investors continue to be debated, for example, should a collective investment vehicle benefit for tax treaty relief at the fund level? Should this be applied at the investor level or should some form of analysis to establish the percentage of investors resident in treaty locations be considered? These questions do not seem to go away and tax authorities are applying even greater scrutiny to reclaims received.
Collective investment vehicles which pool money from multiple investors (in a retail fund, often many thousands of investors) have found it increasingly difficult to obtain tax treaty benefits in some jurisdictions. The determination of treaty eligibility and beneficial ownership is not consistently applied, with some countries asking collective investment vehicles to provide information about the underlying unit holders, something which is difficult or even impossible, as it is common for funds to be held through a series of distributors, platforms and local banks, meaning the fund often will not know exactly who the end investors are or where they are tax resident.
These growing demands for additional information to evidence treaty entitlement are being pushed down to the global custodians, who typically act for institutional investors. This, in turn, is increasing the tension between the traditional role of a global custodian, how they are remunerated, the level of risk they are absorbing, and expectations on them to apply some level of tax-related assessment as to the eligibility for treaty relief by their clients. There is a head of steam building which does not yet have an easy outlet.
Global custodians are looking for ways to bring automation into the process and make it easier for their clients. For example, the use of automated prefilled reclaim forms with beneficial owner information has become a more common service for some global custodians — but we still see these paper flows being managed via email, without any significant automation in place. The global custodian community has taken steps to address some of these automation opportunities, but the lack of consistency across countries does make this quite difficult.
How do you see the future of tax reclaims?
Cooper: Withholding tax reclamation is a niche, complex and labour-intensive area. It is very hard to straight-through process this, and it is only with the latest fintech — combined with a knowledge base that is continually updated — that the process can become efficient, accurate and cost-effective.
As investors become more aware of the imperative to reclaim tax, and as fiduciaries embrace digital solutions more widely in response to both market and regulatory demands, we will undoubtedly continue to see strong growth in tax reclaims across all markets. In addition, cross-border investment is projected to maintain its long-term upward trajectory which will drive a need for efficient tax recovery services.
Increasing numbers of institutions are outsourcing the whole reclamation process, or ‘insourcing’ a digital solution to take the pressure off the in-house team and scale up their service proposition cost effectively. With the right approach, tax recovery can be turned into an area of competitive advantage, both for clients and as an interbank services opportunity.
In terms of wider trends, tax harmonisation across the EU has been on the agenda for several years. It is a well-intended initiative but hugely complicated to implement. We will continue to keep our clients up to date with the latest thinking and announcements on this. The shift to digital is also gaining momentum in the world of withholding tax. One thing is for certain — institutions already using the latest digital, cloud-based solutions to manage their tax reclaim processes are in a strong position to respond quickly and efficiently to new requirements as they emerge.
Grant: Investors should benefit from enhanced returns, global custodians from lower operating costs and tax authorities will get access to better information to help prevent tax fraud and ensure relief is only given to those who are entitled.
There are numerous reasons why TRACE did not get off the ground. Primarily it is an issue of trust between governments and different areas of the financial sector, which has not been improved by large scale alleged tax fraud identified in recent years. The so-called cum-ex trading scandal which has been estimated to have cost governments nearly €10 billion has left a particularly bad taste with tax authorities, making them sceptical about any suggestion from the financial services industry to simplify the withholding tax relief system. This will need to be overcome to move forward as well as better articulation of the benefits for each of the stakeholders, especially governments and tax authorities.
Discussions about the use of a blockchain or distributed ledger technology (DLT) to enable the secure and real-time tracking of ownership and dividend entitlement, leading to the ability to attribute a tax reclaim. The technology itself does not deal with the issues of country level consistency or a uniform approach to assessing beneficial ownership, we therefore have to be careful not to replace 27 inconsistent manual regimes with 27 inconsistent digital regimes. In my mind, as well as the multiple technical issues, there are two major barriers which need to be overcome for a distributed ledger solution to take hold.
Firstly, regaining trust between stakeholders that this will not just facilitate an elaborate way for investors to artificially reflect ownership and overclaim tax relief will be vital. This is arguably exacerbated by the lack of general understanding of DLT, which despite a lot of discussion, is still far from ubiquitous. DLT is still in its infancy and convincing governments of the latest shiny new technology being endorsed by large, global banks, is not going to be an easy sell.
Secondly, the cost-benefit ratio for the different stakeholders needs to be better understood. Will governments invest time and money in transforming the withholding tax relief system to help ensure the estimated €8.4 billion of unclaimed tax relief can be claimed more easily? The argument that this will make capital markets more attractive and accessible is nebulous; alternatively, arguing that it will reduce tax fraud might not be enough to convince governments. After all, Finland has introduced their own TRACE and Germany has legislated to stamp out withholding tax fraud through a central beneficial ownership register — in both these cases it is not clear what additional benefits a blockchain will bring.
That said, I can certainly see a future where blockchain plays a significant part of the withholding tax process, but I do wonder if this will not be the by-product of digitisation of the overall securities ownership and movement sector, as opposed to a standalone initiative for withholding tax.
Kazimi: The EU protective reclaims are anticipated to gather further momentum and pay downs by tax authorities should follow suit. The systematic siding by the The Court of Justice of the European Union in favour of the taxpayers against the discriminatory practices that undermine the effective working of the single market, has emboldened more investors to lodge claims. Obviously, such claims need to be substantiated by a proper analysis of the entitlements.
There is much debate around DLT solving the problem of unclaimed excess withholding taxes. European Fund and Asset Management Association, the umbrella organisation of European asset management trade associations, is leading the debate with its Blockchain for Taxes project. It has laid down the fundamental design principles and different institutional clusters are working on the design.
Some have sought to directly apply blockchain technology to solving the tax reclamation conundrum. We are ideologically in the other camp and believe that you do not “bolt-on” a withholding taxes blockchain solution to an antiquated engine.
Our solution seeks to fix a deeper and more fundamental issue of how investments are to be made on a blockchain, the tax benefits will be many and wide and will not be restricted to withholding taxes alone.
“The more fundamental solution brings withholding solutions but also encompasses transfer taxes, capital gains and investor tax reporting.”
NO FEE, NO RISK
100% ON RETURNS If you invest in only one asset servicing news source this year, make sure it is your free subscription to Asset Servicing Times
100% ON RETURNS If you invest in only one asset servicing news source this year, make sure it is your free subscription to Asset Servicing Times
