Select Committee on European Communities Fifteenth Report


116. There are a number of proposals relating to taxation currently on the table; these are discussed in this Part. The next Part (Part 5) deals with the ideas for more fundamental reforms which have been floated.


117. A 1996 Commission Communication on the development of tax systems[57] suggested the need for a permanent group to co-ordinate tax policies within the EU, and drew attention to the need for further work, especially of harmful tax competition. The resulting Taxation Policy Group developed the current proposals in the field of direct taxation, which received political agreement at ECOFIN on 1 December 1997, reflecting the Council's discussion of "the need for co-ordinated action at European level to tackle harmful tax competition in order to help achieve certain objectives such as reducing continuing distortions in the Single Market, preventing excessive losses of tax revenue or getting tax structures to develop in a more employment-friendly way" (p 39).

118. The proposals are contained in the Package to tackle harmful tax competition in the European Union[58]. It has three elements, which we consider in turn below:

  • a Code of Conduct on business taxation;
  • a proposal for a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States;
  • a proposal for a Directive to ensure a minimum of effective taxation of savings income within the Community (commonly known as the "withholding tax" Directive[59]).


119. The Code of Conduct for business taxation concerns "those measures which affect, or which may affect, in a significant way the location of business activity in the Community", including laws, regulations and administrative practices[60]. Measures are to be regarded as "potentially harmful" if they "provide for a significantly lower effective level of taxation … than that which generally applies in the Member State in question"[61]. Potentially harmful measures are then evaluated to judge whether they are actually harmful, on the basis inter alia of the criteria laid out in the Code, which the Paymaster General paraphrased as follows:

     "Does the measure favour only non-residents? Is it ring-fenced from the domestic market? Is there any real economic activity that goes with that measure? Do the rules of profit determination follow the internationally accepted principles…? Is the measure transparent so that everybody can see what is going on? Finally, a measure is harmful if it significantly affects the location of business interest in the Union".

She drew attention to the Code's recognition of incentives for regional development "as long as [they are] proportional to the end target" (Q 448).

120. Member States commit themselves not to introduce new tax measures which are harmful within the meaning of the Code[62], and to amend their laws and practices as necessary with a view to eliminating any harmful measures as soon as possible "taking into account the Council's discussion following the review process"[63].

121. The Code provides[64] for the establishment of a Group to take the work forward by selecting and reviewing the tax measures under assessment; this Group is chaired by the Paymaster General. Its reports are to be "forwarded to the Council [ECOFIN] for deliberation, and, if the Council so decides, published"[65].

122. We have a number of concerns about the Code of Conduct and the proceedings of the Code of Conduct Group, which we consider in turn below.


123. There are precedents within the European Union for the use of a Code of Conduct. Colin Mowl of HM Treasury told us that this procedure, rather than legislation, "can be used to make progress where it is unlikely that progress would be made under unanimity" (Q 137). The Paymaster General quoted the precedents of the employment guidelines agreed at the 1997 Luxembourg Summit (requiring an annual report from Member States)[66] and the agreement at the 1998 Cardiff Summit on product and capital markets[67] (Q 424), though she later agreed that these were not "models on which we can rely" (Q 448). She assured us that the Code of Conduct was a political agreement with no legal standing:

    "It is important to remember that the Code of Conduct is not legally binding on Member States … [It] is not beginning the process for a legal Directive; it is a political agreement to explore issues. At the end of it, Member States will be free to make their own decisions as to how to respond to the final report" (Q 420).

124. That seems clear-cut. Yet in his oral evidence Colin Mowl, one of the United Kingdom representatives on the Code of Conduct Group, had said: "Although [the Code] is not legally binding the Government has entered into an international commitment which it expects to honour and expects other people to honour" (Q 151). Asked what might happen in relation to particular United Kingdom measures being examined by the Group, he said that if they were found to be harmful "the terms of the Code would come into effect. There is a commitment in there that Member States will roll back according to certain timescales (which are also set out in the original agreement) any actually harmful measures" (Q 154). He said that he did not "know precisely" how the final stage of the process was going to work (Q 161). "If some Member State disagrees with some aspects of the conclusions then its view is put forward in the report of the Group. To some extent this is uncharted territory, but there will then be a collective discussion in ECOFIN no doubt, but because this process reflects national competence any action taken is for individual Member States to take. It is not as though you need unanimity formally" (Q 159). The Paymaster General confirmed that the Code of Conduct Group itself did not take votes, but was "charged to reflect the views expressed in the discussion of the subject" (Q 429). Invited to comment on how the Code of Conduct would be carried forward, she said: "That is not an issue for me. When the report is produced to ECOFIN that body will decide how or if to respond to it" (Q 430).

125. We considered the views of other governments on the nature of the commitment implied by agreement to the Code of Conduct. The Irish Government saw it as "a political agreement which is without prejudice to Member States' rights and obligations under the Treaty", but supported its implementation (p 174). But the German Government said in written evidence that it was "absolutely necessary for Member States to conscientiously fulfil their political commitments" (p 66). Ulrich Wolff of the German Ministry of Finance expanded on that point by describing the Code of Conduct as

    "an international agreement on fair competition to eliminate what we see as being aggressive and unfair … competition. This is why we seek international agreement, not at a legally binding level … but at the political level. [In] our experience … there is no big difference between legally binding instruments and politically binding instruments in the area of international conventions. That would mean, very bluntly, that legally binding instruments would be broken if considered necessary by a particular state, and politically binding instruments would be followed so long as there is a will to follow [them] … We expect other Member States to fulfil their political commitments as Germany is willing to do … It is up to the Member States to see what they have to do [by way of adapting their national legislation] in order to comply with the Code of Conduct" (QQ 207 and 213).

For the French Government, M le Floc'h-Louboutin said: "[The Code] is not legally binding but only because there are no legal sanctions, at least at this stage … I do think we shall sooner or later have to look into this and see what legal power we can give the work of this Group" (Q 250).

126. Commissioner Monti did not think that that the Code of Conduct process should be a cause of concern to Member States. He argued that the agreement did not contravene the principle of subsidiarity because it was agreed inter-governmentally, and because he could "hardly see how it can be left to each individual Member State to decide whether a measure of that Member State is a measure of harmful tax competition" (Q 242). The CBI considers that the Code of Conduct approach might be a useful way of striking the "balance between the principle of subsidiarity under which Member States take control over their own tax matters and the need in specific areas to take action to tackle distortions of the Single Market … Perhaps that is a pragmatic, useful way to bring Member States who practise discrimination into line without having to go through the whole process of putting legislation in place" (Q 331).

127. Others feel differently - and strongly. Keith Marsden suggests that

     "a Code of Conduct for business taxation is really a dishonest device to sidestep EU treaties that require unanimity among Member States before tax harmonisation can be legally imposed … Of course, members of a club who have agreed to a new 'Code of Conduct' would be expected to honour it … Once there's a commitment, it will become as powerful as any [EC] Directive, because no country will want to be seen breaking its word"[68].

Judith Mayhew of the Corporation of London said: "I think we might share that view, but perhaps our language might be slightly different" (Q 118). Peter Wilmott refers in more measured tones to "the lure of the Code of Conduct, in which co-ordination replaces harmonisation and where a sense of Community duty is mitigated by the subtler political advantages of consensus between equal and sovereign states" (p 144). And he raises the question of what redress there is for those affected by decisions taken under the Code of Conduct, "exactly whom do they go to and on what basis if they are not happy with what is going on"? (Q 411).

128. The resolution on a Code of Conduct for business taxation was unanimously adopted at ECOFIN. We remain unclear about the implications for the United Kingdom of having agreed to this Code, in particular in relation to national sovereignty and to the principle of unanimity in tax matters. However often the Government repeats that the Code is not legally binding, it seems to us that agreeing to it has obviously created a moral if not a legal obligation on the Government to "roll back" tax measures which are ultimately deemed to be "harmful", and not to introduce new measures of the same kind. The actual impact on the United Kingdom will of course depend on which (if any) of our tax measures are deemed harmful. But there remains the risk that the process could lead to the United Kingdom being obliged - in practice if not in law - to adopt tax measures damaging to the interests of the economy or of citizens. This would matter less if all other Member States took the same view as to how binding the Code was, but we are not convinced that they do. This raises the fundamental question of whether a Code of Conduct approach can work, and work equitably, in a body with such diverse styles of government as the European Union. We think that Parliament deserves a much clearer explanation of how the system is supposed to work than the Government has so far provided.


129. The views of the Code of Conduct Group on whether particular tax practices are harmful within the terms of the Code are obviously crucial. The first annual report from the Commission to ECOFIN on the implementation of the package[69] went into no detail on this issue, so we asked the Minister for a copy of the interim report which the Code of Conduct Group had made to ECOFIN on 1 December 1998, which had not been made public. In her reply of 15 February 1999, she said:

    "I should explain that because the ECOFIN Council has agreed that the work of the Group is confidential I am not at liberty to make the report available to you nor to divulge details concerning other Member States."

We were disagreeably surprised by this response, and told the Minister of our "great concern that this agreement among Member States' governments to carry on negotiations over a long period in secret denies national parliaments the possibility of scrutinising what is happening". We continued:

    "While we quite understand that you personally are in a difficult position if Ministers from other countries insist on their input remaining confidential, we trust that you will use your best endeavours to overcome this lack of transparency. It is clearly outside the spirit of the Amsterdam Treaty and makes a mockery of the professed intention of the European Council to bring Europe closer to the citizen"[70].

130. Many of our witnesses shared our alarm that matters of this kind should be removed from the scrutiny both of the European Parliament and of national parliaments. Graham Mather said: "It seems to me to be unacceptable that elected parliamentarians are reduced to having to work on the basis of gossip and hunches and that profoundly important measures for the future of national economies are completely withdrawn from parliamentary purview" (Q 179). Peter Wilmott considered that "the opacity of the EU's chosen apparatus—informal committees meeting in secret, not within the Council but not wholly outside it either—offers little reassurance about the accountability of those taking decisions" (p 145).

131. Various justifications have been offered for this confidentiality. According to the German representative on the Code of Conduct Group, the decision not to publish had been made to avoid press speculation (Q 214). Commissioner Monti argued that "there are cases where the instant application of transparency might undermine the objective of the process itself … If there were to be full intermediate knowledge … there would probably be a reaction in the market place and among business operators discounting certain measures perhaps wrongly, because a certain measure that is being scrutinised may in the end not be declared to involve harmful tax competition … I understand, especially given the need to have a confidence building process among Member States in this exercise, the desire not to have each document on the different measures exposed to public attention immediately" (Q 242)[71]. The Paymaster General said: "These are sensitive issues for all Member States. If we are to have meaningful discussions and transparency and develop mutual understanding we need to have such deliberations. It is not unusual for such discussions to be confidential" (Q 420).

132. Asked how the German Parliament had reacted to the secrecy of the proceedings, Ulrich Wolff (for the German Government) said: "We … asked our Parliament to waive specific questions on the proceedings within the Code of Conduct Group for the moment and they accepted that" (Q 214). For the French Government, M le Floc'h-Louboutin agreed that confidentiality was unavoidable at this stage, since otherwise "there would be a total blockage imposed by certain States which would refuse to take part in the process". He did not think that the lack of involvement of Parliament was a problem at this preparatory stage, but he did see confidentiality as a problem for companies, which "are a little bit wary of what is happening" (Q 250).

133. Others are quite clear that—quite apart from the deplorable breach of the principle of transparency—more damage is being done to the interests of business by the speculation which is occurring than would be likely if the proceedings of the Group were public. The CBI said: "Most of the matters reported to the Code of Conduct Group should be a matter of public record: they are part of the tax law of the country concerned. If there are some behind-closed-door special deals being done that are not a matter of public record the Code of Conduct Group should investigate those properly and publicise them … Keeping it secret in the way that has happened and prolonging the procedures for such a long period has heightened rather than lessened speculation" (QQ 322- 323). Barclays Bank told us that the secrecy exacerbated fears that the result would be a levelling up of taxes (p 2), and commented that it "may lead people to make the wrong presumption as to what that group is up to" (Q 25). Graham Mather feared that "it may be possible to achieve [changes to tax measures] through arm-twisting and peer review pressures in closed meetings in which those affected by the changes … are unable to make their voices heard" (Q 178)[72]. The Institute of Directors pointed out that issuing reports for discussion would give the Group the benefit of feedback from "tax professionals, business interests and all sort of other interested parties … that will be very valuable in deciding which [measures] really are harmful and which are not" (Q 296). Peter Wilmott said: "If the Code of Conduct leads to an increased amount of discussion behind closed doors at the Council, I think that is intrinsically bad … and it is worrying from the point of view of the accountability of the people who then take decisions and actions based on those decisions" (Q 411).

134. There are different perceptions about the degree of consultation which has taken place in the United Kingdom. In their oral evidence, the CBI said that although they had had discussions with the Paymaster General and with Treasury officials, "it would be an overstatement to say that we have been consulted. We are no more privy to the details of what [the Code of Conduct Group] is doing than, I imagine, is this Sub-Committee. We still feel that we are on the outside looking in. We prefer to be on the inside being consulted. We believe that is perfectly possible without infringing the secrecy of government" (Q 322). These discussions do not sound quite like what the Paymaster General described to us as "a forum in which we could hear [the CBI's] opinion and exchange views on some of the substantive matters, [which] met for the first time on 17 March of this year, [and] has had general discussions across a range of issues" (Q 416).

135. It is the secrecy shrouding the work of the Code of Conduct Group which has resulted in scare stories in the press[73]. But the Government remains adamant that it cannot publish more than the list of United Kingdom measures which it has already put in the public domain[74]. The Paymaster General told us that the initial list of measures was drawn up by the Commission "using information sources available to it. Member States assisted in that process in accordance with paragraphs E and I of the Code. The Code goes on to say explicitly in paragraph F that any other Member State can request additional matters for consideration". The Commission would add those measures to the list, without revealing which Member State had suggested them (Q 433).

136. We are left in as much ignorance as anyone else about the way in which this Group is going about its business. We think that the lack of transparency in the handling of this matter shows both the Council of Ministers and the Government in a very poor light. It leaves the Code of Conduct open to being described as an obnoxious method of inflicting secret taxation, when in fact it may be little more than an innocuous discussion group. We note that the Government has now had some contact with United Kingdom industry about the proposals. We are not aware of the content of these discussions, but they have clearly been insufficient either to elicit a useful response or to calm fears. And contact with industry does nothing to remedy the deplorable lack of accountability to Parliament. We recognise the difficulty of changing the rules of a game which is already in progress, but we consider that given the extent of the leaks which have already occurred (and are likely to continue) there can be no justification for refusing to reveal the facts. We call upon the Government to seek agreement from other Member States that the progress reports which the Code of Conduct Group makes to ECOFIN should be published, and should be subject to Parliamentary scrutiny in the normal way.


137. During an evidence session with the Economic Secretary to the Treasury in January 1999[75], the House of Commons Treasury Select Committee expressed particular concern over how the Code of Conduct might apply to the United Kingdom's Overseas and Dependent Territories. It subsequently announced its intention of carrying out a short enquiry into this aspect of the proposal. Accordingly, we decided not to address this issue specifically in the course of our own enquiry.

138. We have nevertheless been approached by individuals from the Channel Islands expressing extreme concern about the proposals. We have also received written evidence from the Bermuda Government, arguing that the territory's absence of income tax should not be regarded as inherently harmful within the wording of the Code; Bermuda has the power to determine its own separate system of taxation and has chosen a system based on consumption tax rather than on income tax, which has "evolved to meet internal needs" (pp 167-173).

139. It is not surprising that there has been confusion over this point. Paragraph M of the Code of Conduct says:

    "The Council considers it advisable that the principles aimed at abolishing harmful tax competition should be adopted on as broad a geographical basis as possible. To this end, Member States undertake to promote their adoption in third countries [and] in territories to which the Treaty does not apply. In particular, Member States with dependent or associated territories … undertake, within the framework of their constitutional arrangements, to ensure that these principles are applied in those territories".

In its written evidence, having pointed out that "the Code is directly applicable to Gibraltar which is part of the EU", HM Treasury said:

    "The United Kingdom is committed, within the framework of the constitutional arrangements, to ensuring that the principles of the Code are also implemented in our other Overseas Territories and in the Crown Dependencies. It is only right that these territories should match up to the highest international standards and be part of international efforts to ensure fair tax competition. Of course the United Kingdom is also concerned to maintain a level playing field and to ensure that our territories are not disadvantaged vis à vis their competitors" (p 40).

140. That could be read as implying that the Government had made some sort of a commitment in relation to dependent territories. But in her oral evidence, the Paymaster General appeared to deny this. She volunteered the statement that the Code of Conduct "certainly cannot be legally binding on dependent territories given our constitutional arrangements with them. We do not have authority over the tax systems of our dependent territories" (Q 420). She elaborated:

    "Paragraph M of the Code calls for factual reports on the constitutional arrangements and a brief summary of the tax systems of the dependent territories. The dependent territories provided us with information on their tax systems on a confidential basis, but we have been at pains to make it clear that there are existing constitutional arrangements and the United Kingdom Parliament does not have jurisdiction over these tax systems. In terms of encouraging people to tackle harmful tax competition, we are prepared to do whatever we can to encourage them … As far as the dependent territories are concerned we believe that our constitutional arrangements cannot be questioned" (Q 433).

141. We would only comment that transparency is, if anything, even more important in the handling of matters concerning dependent or associated territories. We hope that they have been kept fully in touch with the Government's position. We fear that this may not have been the case, since rumours fed by continuing uncertainty—and alarmist, in the light of what the Minister told us—have been allowed to remain in currency for so long.


142. Article 87 EC provides that "any aid[76] granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, insofar as it affects trade between Member States, be incompatible with the common market". The Commission is given the power to implement this provision, subject to regulations made by the Council under qualified majority voting.

143. Commissioner Monti claimed that the logic of preventing harmful tax competition through an agreed Code of Conduct was very similar to that of the State aid rules, "on which … the United Kingdom is our keenest Member State. A fiscal incentive falling under the notion of harmful tax competition is not very different from a State aid and those who are in favour of a well-functioning, open, competitive market where competition is not distorted by … State aids can only favour the application of the same principle when those State aids take the hidden form of fiscal aids" (Q 237)[77]. The relationship between the two sets of measures is recognised in the Code of Conduct, which "notes that some of the tax measures covered by this Code may fall within the scope of the provisions on State aid in Articles [87-89] of the EC Treaty"[78]. The Commission undertook to provide guidelines on how it would apply those articles to State aid given through tax measures[79], and committed itself to "the rigorous application of State aid rules, taking into account, inter alia, the negative effects of aid that are brought to light in the application of this Code".

144. In its evidence to us, the Irish Government noted the need to ensure consistency between the two sets of measures, illustrated by recent experience:

     "While Ireland's 10 per cent rate of corporation tax for manufacturing and for the International Financial Services Centre have been listed as potentially harmful measures under the Code, these are being phased out under an agreement reached between the Irish authorities and the Commission … Leaving aside the question of whether [these provisions] are to be regarded as actually harmful or not under the Code of Conduct, the phasing out arrangements agreed with the Commission are in line with the timescale for rollback set out in the Code" (pp 174-175).

In the context of the Irish experience, Simon Morys (one of the United Kingdom representatives on the Code of Conduct Group) said: "With the Code of Conduct, we negotiated a paragraph which said that the Commission must be more robust in its application of the State aid rules… [which] do have legal force. What we think we have here is a two-pronged approach". Although it was under the State aid rules that the Irish Government actually responded, "the Code of Conduct itself has raised the profile" of those rules (Q 157). He further suggested that preferential and discriminatory régimes which would be caught by the Code of Conduct were "very likely to be harmful and discriminatory within the meaning of the State aid legislation … The Commission can already overturn a United Kingdom tax measure if it is discriminatory and contrary to the terms of the Treaty" (Q 161). He was using this argument in support of the Code of Conduct process, but one could equally well use it to suggest that the existence of the State aid rules renders the work of the Code of Conduct Group superfluous.

145. It also seems strange, when the Government is so insistent on unanimity in tax matters, that it is content for the State aid rules to be administered by the Commission. The Paymaster General explained that the State aid rules were part of the acquis when the United Kingdom joined the European Communities, and the Government had made it clear that it expected them to be "vigorously applied" (QQ 425-427). She did not see a contradiction between the two approaches.

146. We note that the policy controlling State aid, which the Government accepted as part of the acquis, is not just co-ordinated but unified, and is administered directly by the Commission. We wonder how this chimes with the Government's insistence on unanimity for tax measures, particularly when (at least as far as the United Kingdom is concerned) the Code of Conduct Group appears to be maximising the overlap with the State aid provisions by focusing on sectoral, tightly targeted measures. This causes us to wonder whether the Code of Conduct Group is actually being seen as a method for identifying measures to be tackled by the Commission under the State aid provisions, and whether this explains the Government's apparent lack of concern about the way in which the findings of the Code of Conduct Group will be implemented.


147. The draft Directive on the taxation of interest and royalty payments between associated companies[80] provides for the abolition of taxes collected at source on cross-border interest or royalty payments between such companies (defined as companies with cross-shareholdings of at least 25 per cent). It would not include payments of "interest" which are akin to distributions of profit, or payments which qualify for a special (lower than normal) tax rate in the destination Member State, and it would not preclude Member States from taking steps to combat fraud or abuse (occurring, for example, through transfer pricing). This Directive was welcomed in principle by the Government, although Dawn Primarolo (then Financial Secretary to the Treasury) said that work was needed on the details[81]. The German and Irish Governments also told us that they supported it (pp 67 and 175).

148. Although we have not yet seen the regulatory impact assessment promised by the Government, we gather that the proposal is generally acceptable to businesses. In its written evidence to us, Barclays Bank said that it was "to be welcomed as a simplification measure that would aid intra-EU transactions" (p 1). The CBI said that British business broadly welcomed the proposal (p 113), though - like Malcolm Gammie (p 142) - the paper from UNICE which it submitted pointed out that the limited provisions did not address the fundamental concerns of large companies[82].

149. There have been suggestions that this proposal should be decoupled from the other two elements of the package, since it is far less controversial and could be of immediate benefit. However, the conclusions of the discussion at ECOFIN on 25 May 1999 specify that "this Directive is part of the tax package adopted under the Luxembourg Presidency on 1 December 1997. Only in that context will final adoption take place". When we asked the Paymaster General whether the United Kingdom was pressing for the speedy adoption of the proposal, she explained that it would bring no significant advantage to the United Kingdom, which already had an extensive network of double taxation treaties. Belgium and Portugal had always insisted that it should be part of a wider package, but this was not a problem for the United Kingdom (Q 451).

150. We recognise that this proposal does not solve the fundamental problems of multinational corporations which operate in a number of Member States[83], but we consider that it would be a useful step in the right direction. We accept the Government's position that it is not sensible to stand on the letter of subsidiarity when the interests of British business could be furthered by the proposal. Subject to the results of the regulatory impact assessment being satisfactory and to any necessary amendments of detail being made, we therefore urge the Government to press for this proposal to be adopted as soon as possible.


151. This draft Directive[84] is the most controversial element of the package agreed by ECOFIN. Its objective is "to ensure a minimum of effective taxation of savings income within the Community and to prevent undesirable distortion of competition". It differs from the other two elements of the package in that it addresses taxes payable by individuals, rather than by companies.

152. Withholding taxes on income from savings are taxes which are deducted at source, before the income is paid to the recipient. They are normally introduced to ensure that domestic taxpayers pay tax on the interest from their savings, either by making it more likely that they will actually declare the income (since the incentive to conceal it will be reduced) or as an alternative to conventional income taxation. However, a side effect is to increase the incentive to invest abroad in countries which do not impose withholding taxes, or which levy a withholding tax at lower rates. Differences in withholding taxes (or gaps in coverage) will affect the international flow of savings.


153. There was a previous unsuccessful proposal for a withholding tax[85], prompted by the fear that the removal of exchange controls within the EU (which took effect in June 1990) might lead to an increase in tax evasion. It comprised two draft Directives. The first was for a common system of withholding tax on interest income, which Member States would be required to charge on all interest payments to Community residents (including their own domestic residents). A minimum rate of 15 per cent was proposed, with Member States free to set a higher rate in general or just for domestic residents. The proceeds were to be handed over to the authorities of the Member State where the taxpayer was resident. Importantly, Member States were left free to apply exemptions in various cases, including Eurobonds and interest which was automatically noted to the tax authorities. The second draft Directive was on mutual assistance, with the objective of extending co-operation between tax authorities - over-riding administrative, though not legal, restraints in the Member State receiving the request.

154. In its 1989 enquiry, the Committee agreed that closer co-operation between revenue authorities was desirable, and suggested that this might go even further than the draft Directive was proposing. But it was scathing about the withholding tax proposal:

    "A withholding tax is not the appropriate response to deal with tax evasion. Individuals would transfer funds to countries outside the Community where no withholding tax was imposed. The Commission's proposal that a withholding tax should be extended world-wide seems little more than a pious hope … Such a tax would certainly discourage overseas investment in the City of London … It seems ridiculous to impose such bureaucratic burdens when the chances of the tax having a real effect on evasion are negligible"[86].

The proposal was withdrawn, with mutual assistance being pursued through other proposals.


155. The new draft Directive relates only to the taxation of interest paid in one Member State to individuals who are resident in another Member State, covering all payments irrespective of the place of establishment of the debtor. It proposes a so-called "co-existence model", whereby Member States could choose either to impose a withholding tax at source on such payments at a rate of 20 per cent, or to provide the Member State where the recipient is resident for tax purposes with enough information about the payments to ensure that they can be taxed on receipt according to its legislation.

156. As far as the overall tax payment by individual taxpayers is concerned, the two systems are intended to result in the same final tax burden on any given transaction. The draft Directive requires that Member States treat withholding tax paid on interest received from abroad as an advance payment of the taxpayer's national income tax. If the amount of income tax due on the payment would be less than the withholding tax already deducted, the implication would be that the taxpayer should be refunded the excess. There are also provisions to allow taxpayers to obtain a certificate from their domestic tax authorities which would allow them to ask for interest to be paid in another Member State without the withholding tax being charged, so that individual taxpayers could in effect opt to be subject to the information system instead of the withholding system. Like the requirement that full credit should be given for the withholding tax, this provision appears to be intended to ensure that taxpayers do not pay more in withholding tax than their final tax liability. From the point of view of the taxpayer, there is a cash flow difference between the withholding and reporting options, because tax would be paid earlier under the withholding tax option. And if taxpayers receiving income subject to the withholding tax chose not to report it to the tax authority in their country of residence, they would gain if the uniform rate was lower than that in their country of residence (where they would be taxed under the reporting option).

157. Despite the existence of the reporting option, the proposal has become known in the United Kingdom—and reviled in the City of London—as the "withholding tax" proposal, and we shall so refer to it.

158. The Government's initial reaction to the proposal was measured. In her Explanatory Memorandum[87], Dawn Primarolo (then Financial Secretary to the Treasury) said:

    "The Government is in principle in favour of effective international action to tackle tax evasion. More limited measures (confined to the EC) may be a useful first step, but the Government would need to be satisfied that they would not do serious damage to financial markets … The Directive would involve some compliance costs for payers who would have to withhold tax and/or provide information. The Government is also concerned about its possible effects on the financial markets. The Government is holding discussions with interested parties and will publish a fuller [regulatory impact] assessment in the light of these".

159. The Treasury soon had its card marked. In a letter of 24 July 1998 to our Chairman, Dawn Primarolo said that "many City institutions have expressed grave concern about the effect which the Directive might have on the financial markets, in particular on Eurobonds for which London is the leading centre … It is essential that whatever stance the Government takes in the forthcoming discussions in Europe can be supported by firm evidence". At the time this Report was finalised, this evidence had still not been produced[88].

160. In view of the strength of opposition to the proposal, we looked carefully at why it had aroused such controversy, taking very extensive oral and written evidence from City representatives and others.


161. The proposal was clearly introduced as a measure to combat tax evasion. Commissioner Monti said that it was not a proposal for a new tax, because "in all our Member States of the European Union a private individual who is holding financial assets in another Member State is in principle liable to taxation on the capital income in his own country of residence": it would simply put in place "a mechanism so that a tax that in principle has to be paid will be paid in practice" (Q 231). If all income were reported to the domestic authorities, he said, the proposal would not be needed, but "we have reason to believe that … this behaviour is less frequent than the opposite behaviour". He claimed that the policy of the eleven Member States which did not currently tax interest on savings of non-residents fell clearly within the category of harmful tax competition (Q 232). It also distorted the pattern of personal investment, since dividend income was taxed at source but interest was not, whereas the policy was to stimulate equity investment (Q 234) [89]. He suggested that the alternative solution to the problem of tax evasion would be to re-impose controls on capital movements, which would obviously not be desirable in the Single Market[90]. "We are there to be guardians of these four freedoms [of the Single Market] … the freedom of [movement of] goods, services, people and capital. We do not believe that a fifth freedom should (undeclared) filter through - the freedom to use capital movements to evade taxes" (Q 239).

162. It is generally acknowledged that the proposal was prompted by the problem faced by the German Government, whose taxpayers invest outside the country in order to avoid taxation on the interest from their capital. The initial problem arose when a 10 per cent withholding tax was introduced in Germany (in 1987, to take effect in January 1989). As a result, the Corporation of London told us[91]:

    "There was a massive surge out of German domestic bonds by foreign investors in 1988, … a surge in the acquisition of foreign currency bonds by German investors, and a simultaneous shift of funds from Germany to Luxembourg, This outflow of capital put pressure on the Deutschmark, which fell sharply in early 1988" (p 30).

Cliff Dammers of the International Primary Market Association said that the—presumably unforeseen—result was that an estimated DM300-500 billion was moved to escape the tax (Q 28). The tax was quickly repealed, but the problem of German residents investing outside the country and failing to declare the income to the tax authorities still remains.

163. It can be argued that if an individual Member State is suffering from tax evasion, the solution to the problem lies in its own hands. Collecting domestic taxes is a matter for individual Member States. It is open to Member States to give their own tax authorities greater access to information about individual taxpayers[92], and to increase their enforcement efforts. Moreover, high tax rates increase the incentive for evasion, and any Member State has the option of reducing its tax rates on investment income to a level where domestic deposits can compete with untaxed investment in third countries. It was suggested to us by the Corporation of London that one reason for the continuing propensity of German residents to invest elsewhere might be that Germany imposed a disproportionately high tax on income from capital as compared with income from labour (Q 96). The German Government does not accept this argument. Its representative said: "If a Member State tries to regulate proper interest taxation at a national level it runs the risk of having massive tax evasion simply by way of taxpayers taking their money abroad, investing it in a country where our tax authorities have no jurisdiction [and] get no information, and where there is no withholding tax" (Q 208). Deutsche Bank supported the view that this was not primarily a German problem (Q 217), but a problem for the EU as a whole, since the distortions of capital flows resulting from the failure of Member States to tax payments to residents of other Member States were not compatible with the Single Market (p 74). From the other side of the frontier, the Luxembourg Minister of Justice and the Budget was equally clear in his views: "The bottom line is that some parties are doing all they can to ensure that their investments stay within their territory - and what's more they openly acknowledge it"[93].

164. Some witnesses suggested that investors might wish to receive their interest gross for perfectly respectable tax-planning purposes[94]. The British Bankers' Association said that the preference for receiving interest gross had "more to do with, among other things, the efficiency of holding the money. Many sophisticated investors prefer to receive their payments gross and make their own tax dispositions". Cliff Dammers cited the Italian experience of charging a withholding tax with a subsequent rebate for non-residents: the sooner the rebate was paid, the greater the flow of inward investment (Q 35). For the Corporation of London, Judith Mayhew said: "I do not believe people invest in [the Eurobond] market for the purposes of tax evasion. One hopes it is a minority. I think it is an effective way of investing private savings" (Q 116). She took the view that: "For the honest investor in [Eurobonds], presumably paying tax quite properly in the country of residence, it would be preferable to have the tax [rather than a reporting system which would impose additional costs], except that there may be cash flow implications (the individual may not want to pay the tax immediately at source but later on), and there may well be differential rates of tax" (Q 121). Karel Lannoo and Daniel Gros[95] suggest that "providing a safe haven for tax evaders has … never been an important business for places such as London, although it may be more the case for Luxembourg".

165. Moreover, there were "all sorts of reasons" for the popularity of off-shore centres: one should not assume that they prospered just because they were tax havens, said the British Bankers' Association (Q 49). For example, said Barclays Bank, some of them had "considerable expertise in running captive insurance companies. Therefore if one wants to set up a captive [company] one will do it there" (Q 17). And Jeffrey Owens from the OECD was at pains to point out that "low tax jurisdictions are not necessarily tax havens" (Q 271)[96].

166. For the French Government, M le Floc'h-Louboutin saw the issue as clear-cut. "Either we approve of a system where a French subject, for instance, who earns his living in Great Britain would no longer be taxed and in that case we are in favour of tax evasion—there is no other way to put it—or we refuse it. The French position naturally consists of the latter. We are rather stricter than others but we refuse to foster tax evasion within the European … Community space" (Q 251). As Dr Bosch from Deutsche Bank said, the United Kingdom "probably would not wish to be seen as a government favouring tax evasion" (Q 228).

167. The problem of tax evasion is not confined to Germany. We looked at the position in the United Kingdom. The Inland Revenue pointed out (p 134) that "measuring the size of the hidden economy—and consequently the likely scale of tax evasion as a whole—is very far from being an exact science"[97]. In 1997-98 the amount of evasion of direct tax detected by the Inland Revenue was £1.4 billion[98], but it was not possible to extrapolate from that to the total figure (including undetected evasion). Nor was there an estimate of the proportion of that evasion involving a cross-border element, though "it is clear from the experience of our investigators that there is plenty of it about" (p 134). For HM Treasury, Colin Mowl said: "We do not know whether we are losing significant amounts of tax that should be collected from United Kingdom residents. It is quite possible that our residents are evading tax in this way by investing elsewhere. In that sense, there is a United Kingdom interest in this Directive. All countries have an interest in preventing tax evasion" (Q 165)[99].

168. The City of London is adamant that, even if there is a general problem, this proposed Directive is not the solution to it. As Judith Mayhew of the Corporation of London told us:

    "This [proposal] is probably one of these unusual positions where the City has a united view … We do regard this as something which is not designed to remedy the defects which have given rise to the proposal, which would cause significant disruption to City markets and, indeed, substantial disruption to the financial markets in Europe as a whole" (Q 95).

Successive witnesses from the City confirmed this view. Barclays Bank claimed that the Directive would be "ineffective", and would damage capital markets in the EU (p 1). The Bank of England argued that withholding tax imposed in a limited environment could not be an effective way of combating tax evasion (Q 56). The Corporation of London took the view that the effect would simply be to drive investment away from the EU (p 30); the CBI (p 113) and the Stock Exchange (p 178) agreed. The Institute of Directors showed its views by referring to the withholding tax "episode" (p 106): Richard Baron explained that he hoped that the proposal would be killed:

    "I believe that by far the best thing, not just for Britain but the whole of the European Union, is for the British Government, or even the Luxembourg Government who are also not happy about the idea, to stand up and say: 'Forget it. When it comes to the vote we shall veto it'. That would send out a very clear message" (Q 290).

169. Payments on which interest is not deducted at source, and which are not reported to the tax authorities, offer scope for tax avoidance or tax evasion. When this occurs between EU Member States, it affects the pattern of capital flows. It also creates inequities: if people who are unable or unwilling to place their savings abroad pay more tax than those who do, the revenue lost must be raised in other ways. We believe that this must be constantly borne in mind.


170. The proposed withholding tax is perceived as posing particular problems in relation to the Eurobond market. Eurobonds were defined for us by the British Bankers' Association as "bonds sold outside the country of incorporation of the issuer" (p 9); they characteristically pay interest without tax being withheld. We were told that if a withholding tax as proposed came into effect holders of existing Eurobonds would be entitled to compensation, because of a clause (known as the "grossing up provision") which provides that the issuer will compensate the investor for any new tax levied by the country of residence of the issuer. Only a relatively small proportion of such bonds (estimated by the British Bankers' Association as 10-20 per cent (p 9) and by Deutsche Bank as around 10 per cent (p 75)) is held by individuals who would be liable to the new tax. But we are told that in "a significant minority of cases an issuer faced with making gross-up payments is entitled to redeem the whole amount of the issue, not just the proportion held by individuals" (p 9). Such redemption would be at par value, which is currently well below market value because of the recent decline in interest rates. So issuers would have an incentive to call in the bonds and refinance them at lower interest rates, with the result that investors (including institutions such as pension funds) would incur capital losses[100], and—said the Institute of Directors—"the issuers would do very well out of it" (Q 288). A study in 1998 suggested that if just 7% of bonds were called in a transfer of $5 billion from investors to issuers was possible: the amount involved would be greater today because of the fall in interest rates which has occurred since the study.

171. Even more significantly, it is claimed that the introduction of a withholding tax would be likely to give a major incentive to the Eurobond market to move out of the European Union so that investors could continue to receive interest payments gross. The City of London is recognised as the main Eurobond market. HM Treasury explained that Eurobonds "are a major source of income for the United Kingdom and an important source of business finance" (p 41). We were told that the City's Eurobond business "developed in Europe, rather than in the USA, as a direct result of the US Interest Equalisation Tax[101] in the USA which was introduced in 1963": this was cited meaningfully by the British Bankers' Association as "a classic example of how imposition of a tax can lead to a vast change in the location of a financial market" (p 9). We were not presented with any agreed estimate of the actual likely effect on the City if the Directive were introduced as drafted, but witnesses put forward various figures and arguments.

172. Since the tax would be triggered if the paying agent was resident within the EU, the initial effect would be to encourage issuers to appoint paying agents based in third countries. The Treasury explained that "the business of issuance, trading and coupon payment runs on a low-cost, low-margin basis and the markets are highly cost-sensitive and mobile" (p 41). The United Kingdom custodian and paying agent business (which is mainly foreign owned) employs over 5000 people; the British Bankers' Association foresaw that, as a result of the proposal, the bulk of that business might move outside the EU (pp 9-10). Although the withholding tax itself would affect only individual purchasers, Julian Reed (for the Inland Revenue) explained that the important question was not what proportion of the Eurobond market would be affected, but whether the market generally would go elsewhere because of the cost to paying agents of fulfilling the obligations which would be placed on them (Q 167). Even though institutional investors would not be subject to the withholding tax, the Bank of England pointed out that the existence of the tax[102] would impose costs which might drive business outside the EU, paralleling the US experience (p 19).

173. It is argued that that would not be the end of the matter. The Bank of England confirmed that although there would be a particularly strong incentive for paying agents to move, the Eurobond market "sits within a much wider group of capital markets of various kinds … The likelihood is that there will be some knock-on effects but it is quite hard to be dogmatic about just how serious they will be" (Q 64). Others were prepared to suggest orders of magnitude. The Corporation of London claimed that if the whole bond market were to move out of the European Union, the resulting loss could be $3 trillion in capital, and more than 100,000 jobs. They pointed out that financial services tended to cluster in order to benefit from economies of scale, and that the effects would not be confined to the City of London but would affect the EU as a whole: they quoted an estimate[103] that if a withholding tax were introduced on the basis of this proposal only 43 per cent of financial services business would remain within the EU, 28 per cent would migrate to the USA or Switzerland, and 29 per cent would not take place at all (p 31). The British Bankers' Association told us that in 1995 112,000 people were working in international securities and related industries in London, as well as many others elsewhere in the United Kingdom (p 9). The Stock Exchange agreed that "the proposed Directive is likely to prove particularly damaging to the Eurobond market, eroding London's critical mass and leading to job losses" (p 178). And we were told that there would also be an impact on private banking. This is a business of £600 billion, with a revenue of £4.5 billion and a profit of £1.6 billion: the British Bankers' Association estimated that 10 per cent of it might leave London (p 10).

174. Deutsche Bank doubted whether the impact would be as significant as was claimed. Dr Ulrich Bosch said that the crucial questions were:

    "To what extent do European non-British private investors who are not honest taxpayers have their accounts in Britain? To what extent would they be likely to withdraw their accounts? To what extent would that damage London as a financial centre?" (Q 222).

He referred us to a study by the Centre for European Policy Studies "bluntly stating there is no basis for [the] assumption" that the London market would be severely damaged. We asked the Centre about this study, and were sent by Karel Lannoo an extract from a forthcoming book (pp 176-178)[104]. It does indeed state that "the fear that EU financial centres would suffer as the Eurobond business shifts abroad because of the EU withholding tax are unfounded", but unfortunately it adduces no evidence for this statement[105].

175. Despite claims and counter-claims, we are left with no firm evidence about the likely scale of the effect of a withholding tax on the City of London. There is a genuine fear, reasonably based, that its introduction would damage the City by making Eurobonds issued from a tax haven relatively more attractive to EU investors. We accept that there would be damage as a result of an outflow of business. We tried to collect evidence which would enable us to quantify the likely extent of this damage, but such figures as were forthcoming were insufficiently substantiated and too disparate to be convincing. We expect the long-awaited paper which the Government is producing in conjunction with the City to shed further light on this matter; without it we are not able to reach a conclusion on the likely scale of the effect.


176. The "reporting option", which did not appear in the 1987 proposal[106], was intended as a concession to those Member States (like the United Kingdom) which would prefer to exchange information than to be compelled to impose a tax. A Member State selecting this option would be obliged to report to the relevant tax authorities details of all interest payments made to residents of other Member States - which it could do only if its own tax authorities had knowledge of the payments. It follows that only Member States which have or could introduce a domestic reporting system could adopt this option. Moreover, as the CBI suggested, exchanging this information between tax authorities might also raise legal or constitutional issues (Q 115).

177. The reporting option would have the advantage that it would not trigger the grossing-up of Eurobonds (according to Barclays Bank: Q 21). However, although the Paymaster General agreed that it was not in principle unreasonable to require paying agents to collect information, she said that "the Eurobond market is a low margin business. Therefore, anything that it is required to do in addition to what it is already doing can have a crucial effect … We believe that it could [make a difference at the margin], and for that reason we need to have detailed discussions with the City to gain a better understanding of that proposition" (QQ 439-440). Some witnesses considered that the reporting option would do at least as much damage to the City as a withholding tax. Cliff Dammers of the International Primary Market Association said: "We have no doubt that an information recording and sharing system would drive away a great deal of business, perhaps even more than a withholding tax"[107] (Q 40). The Corporation of London agreed (QQ 102-103).

178. Moreover, as the British Bankers' Association suggested, a system under the present proposal with some Member States applying a withholding tax and others choosing to report income of non-residents to their country of residence would lead to "patent absurdities" (Q 37). This is because the revenue from a withholding tax would accrue to the Member State where the interest payment was made, whereas under the reporting option the country of residence would receive the revenue from whatever tax it chose to impose. Member States choosing the withholding tax option would thus gain tax revenues at the expense of those choosing the cross-frontier reporting option, unless withholding tax receipts were passed on to the country of residence of the interest recipient[108]. The Paymaster General told us that Denmark, the Netherlands and Sweden had put forward the proposal that there should be such revenue sharing, but that there had been no discussion of how it would work (Q 450). It would presumably be possible only if information were collected from banks about the country of residence of investors - and the banking secrecy arrangements which may have led countries to opt for the withholding tax in the first place might also prevent the collection of information about residence. The Institute of Directors considered that as a result the co-existence model was "a bit of a fiction"; because of the revenue implications, no Member State would choose the reporting option (Q 291)[109].

179. Given the difficulties apparent if some Member States opted for the withholding tax option and other for the reporting option, we examined the possibility of the reporting option being adopted by all Member States. The obstacle to this is banking secrecy - or, more precisely, the fact that the tax authorities in some Member States do not have access to banking information.

180. We asked the Government for a summary of the position on banking secrecy in other Member States. This was put together with some difficulty, because—as the Note which was eventually produced (pp 132-133) explains—"the Government has not found it necessary to hold detailed information about the constitutional and legislative provisions of every EU Member States in order to carry out its day to day business. However, the Note gives details of the situation in each Member State, with the caveat that "legislative and administrative arrangements in other countries are a complex area on which the United Kingdom cannot speak with full authority".

181. Colin Mowl from HM Treasury summarised the position as follows:

    "Banks in all Member States offer their customers a degree of confidentiality and privacy, a degree of secrecy in other words. The means by which this is done varies from Member State to Member State. Some have explicit legislative provisions for banking secrecy and confidentiality[110] … In a number of other Member States it is a question of traditional administrative practice[111] … In the remaining Member States … confidentiality stems from the contractual relationship in common law between the bank and its customer[112]" (Q 340).

But, as the Note points out, "the key point in the present context is whether the law or practice make an exception as regards provision of information to the tax authority and the terms of that exception". It says that in some Member States the tax authorities can obtain no access. In Austria, banking secrecy has recently been made a provision of the constitution; in Germany, the tax law respects the relationship of strict confidentiality between the bank and its customer, and under the Fiscal Code tax authorities cannot request information on bank accounts to verify the correct reporting of interest[113]; in Luxembourg there is explicit legislative provision for banking secrecy. In other Member States, tax authorities can get access when they have reason to believe that a fraud might have occurred; this is the case in Belgium, Spain and Portugal. In a third group, there is legislation requiring banks to give access to the tax authorities; this applies in Finland, France, Ireland, the Netherlands and Sweden, as well as the United Kingdom. The fact that a Member State's own tax authorities had access to information would not of itself make that information available to another Member State; Colin Mowl said that this was the subject of current mutual assistance Directives (Q 343), and it would of course be covered by this proposal if it went through.

182. The representative of the British Bankers' Association said that the equivalent associations in Germany and Austria would "fight to the death" the proposal to relax bank secrecy laws (Q 37). Alastair Clark (Executive Director, Financial Stability at the Bank of England) said: "There is a general nervousness … about a very wide dissemination of information, whether it is about tax, financial positions, social security positions and so on … sometimes for bad reasons, often perhaps for good reasons". Pressed on what "good reasons" there might be for insisting on secrecy, he suggested that people might be nervous that information would leak from tax authorities (QQ 80 and 82). In response to a question as to whether banking secrecy might be "sacrificed on the altar of European harmonisation", the Luxembourg Minister of Justice and the Budget replied:

    "Many people think that [banking secrecy] is a means of protecting financial products from all kinds of offences. This is not the case, given that in prosecuting common law offences the judicial authorities can require confidentiality to be dispensed with … Our concept of banking secrecy … is a fundamental principle in safeguarding privacy. It has nothing to do with European legislation and we are resolutely determined to defend it"[114].

On the other hand, M le Floc'h-Louboutin said that the French Government "cannot really accept that one should be opposed to banking secrecy when tax authorities try and get some information" (Q 251). And the Institute of Directors confirmed that "the secrecy laws interfere with the ability to police the system properly" (Q 286).

183. The Paymaster General expressed some hope that this situation might change: "In our discussions in G7 we have concentrated on persuading Germany that exchange of information is the best way forward. That was something they had not previously accepted or publicly supported; now they do" (Q 419). On a broader international level, the OECD considers exchange of information to be of prime importance. And, for the Government, reporting is "the optimum global solution"; it supported the G7 conclusion to that effect (Q 343).

184. It has been argued that the additional costs and practical problems imposed by the reporting option would have effects just as disastrous as the imposition of the withholding tax. But in the absence of more concrete evidence than we received, we were not persuaded by this argument.

185. However, we have serious doubts that a co-existence model (with some Member States adopting the withholding tax option and others the reporting option) could work in the form currently proposed. The problem of distributing the resulting tax revenue is a major one, which the Commission's proposal does not address. We are puzzled by this, and we wonder whether it results from a wish to press all Member States into adopting the withholding tax rather than the alternative route; if so, we would regard it as disingenuous. We agree with the Government that, if any change is to be made, the adoption of the reporting option on an EU-wide basis would be preferable to the imposition of a withholding tax.

186. Considering whether this would be a practicable way forward, we find it difficult to accept that the insistence of a few Member States on maintaining bank secrecy should force others to adopt a manifestly unsatisfactory solution to the problem of evasion which undoubtedly exists. We were surprised that HM Treasury had needed time to assemble information on banking secrecy in other Member States; we would have thought that the Government would already have this information to hand to formulate its negotiating position on the Directive (and indeed that the Commission would have analysed it as part of the process of considering how to deal with evasion). But we were encouraged to hear the Paymaster General's claim that the German Government - previously one of the main proponents of bank secrecy - now accepted that exchange of information was the best way forward.


187. Negotiations on the proposal for a co-existence model have been looking for amendments which might mitigate the perceived adverse effects of the Directive without losing the benefits which some judge it to have. In particular, it has been vigorously argued that some sort of exemption should be made for Eurobonds under the withholding tax option. This would not be easy, not least because, as the Bank of England pointed out, it is hard nowadays to define Eurobonds: the market is increasingly fused with the domestic bond market (Q 67). However, the search continues for a compromise, which would need to address both the short-term and the long-term effects.

188. In the short-term, there is agreed to be a transitional problem because the withholding tax could trigger the call-in of existing Eurobonds, though there are differences of view as to how extensive the problem is. It has been suggested that it could be resolved by "grandfathering" (that is, allowing interest to continue to be paid gross on existing Eurobonds[115]). This would have the disadvantage of creating a temporary two-tier market, and (as the Corporation of London noted) it would not deal with the problem of "discounted" or "zero" bonds, where any tax due is not payable until the end of the bond's life, and it is not clear who would then be liable (Q 123). Deutsche Bank suggested that it might be more appropriate to limit any exemption to those issues specifically affected by the problem of the tax-redemption clause, which it estimated as being "well below 10 per cent of existing Eurobonds" - or even further, to those payments which would otherwise actually trigger gross-up clauses and tax calls (p 75).

189. The idea of a short-term exemption of some kind seems to have won fairly broad acceptance. For example, the Irish Government commented that "the position of existing debt instruments which have been issued on the basis that no withholding tax will apply will have to be dealt with through satisfactory transitional provisions" (p 175), and M le Floc'h-Louboutin said that the French Government was "open to discussion on this subject" (Q 254). It can however be argued that there is no justification for exempting existing issues[116]. Lannoo and Gros[117] suggest that there is no reason in principle why an ex post transfer to borrowers should be undesirable. As for the argument that doubts would be cast on the trustworthiness of the market, they maintain that: "It is up to borrowers to decide whether they want to use [for their own benefit] a clause inserted to protect investors … and thus lose the trust of savers" (p 177).

190. Even if some form of grandfathering were accepted, it would not solve the perceived longer term problem of business moving outside the EU. Possible solutions to this problem can be approached from two angles: by carving out exemptions for the most vulnerable sectors of the market, or by ensuring that similar measures are introduced in the non-EU countries which might be competing for the business.

191. The Commission recognises the importance of Eurobonds to the City of London - and thus, said Commissioner Monti to the EU as a whole, because "with your permission … we regard the City of London as an important asset for the whole of the European Union" (Q 231). But to carve out Eurobonds entirely would go counter to the objective of levelling the playing field, and to devise exemptions would create loopholes. M le Floc'h-Louboutin suggested that the French Government was not alone "in saying that the idea of a total ad hoc exemption for Eurobonds would be very difficult to swallow" (Q 254). The German Government maintained that to exempt Eurobonds altogether "would lead to large gaps in the Directive's terms of application and would therefore not be acceptable in the opinion of the majority of Member States and the Commission" (p 67).

192. Nevertheless, the Commission had persuaded other Member States to look at compromise solutions, and the United Kingdom Government has been invited to put forward suggestions. Julian Reed of the Inland Revenue confirmed that the Government was looking at "whether a revised form of Directive could be devised that would be acceptable to the United Kingdom but also to other Member States". There had been a suggestion from the City of London that this might be achieved by continuing to exempt "wholesale" holdings of Eurobonds, but charging withholding tax on "retail" holdings (perhaps below 40,000 euro). But this could obviously be evaded by individuals joining together to bring their holding above the limit (QQ 164 and 172). However, although there have been widespread press speculation on the nature of a possible carve-out the Government's proposal had still not come forward by the time we finalised this Report. This delay was a source of disappointment to Dr Kieschke from the German Ministry of Finance, who chairs the relevant Council Working Group (Q 197). The Paymaster General told us that consultation with the City was "very detailed, complex and taking some time … We rely very heavily on City representatives and different organisations to make sure that we are aware of their detailed views on the subject. Whilst we are making progress, it is not easy. We would rather get it right than do it quickly" (Q 434)[118].

193. It has therefore been suggested that this proposal should be accepted only if it can be applied outside as well as inside the European Union "to prevent an outpouring of capital" (Luxembourg Minister of Justice and the Budget[119]). Barclays Bank considered that "to the extent that at the moment people are evading their obligations [to report to the tax authorities interest paid to them gross], they will merely continue to do so but will just do it in a different location" (Q 16). Many witnesses suggested that the adoption of such a measure should be deferred until similar proposals were adopted elsewhere. While this might seem an attractive way forward, it would not satisfy Commissioner Monti, who claimed that further delay was not an option, when a political commitment to take action had been made as long as 11 years ago (Q 231). The German Government noted (p 67) that the Troika[120] was engaged in exploratory talks with some non-Member States, though the Paymaster General made clear that no agreement reached in such talks could be binding on Member States (Q 444). In any case, most witnesses considered that the main hope of progress in this direction lay with the OECD.

194. Our evidence from Jeffrey Owens left us convinced that the OECD was trying to move in the right direction, but less convinced that it could hope to achieve much, at least in the short term. He explained that its secretariat believed "that in the long run exchange of information is the answer, and this is the way that you counter most effectively international tax evasion and avoidance" (Q 262). He thought that if the withholding tax were adopted in the EU, this would encourage debate among other OECD members as to how they should react (Q 273) - but he held out no hope of a early solution.

195. It was further suggested that the game was simply not worth the candle, because there would be only negligible benefits to be set against the costs generated by the Directive. The British Bankers' Association suggested that the Directive would only create the ability "to levy a withholding tax on interest paid to a handful of cross-border investors who have not moved their holding outside the EU net" (p 10). The Corporation of London pointed to the absence of an evaluation report by the Commission (p 31). The Treasury judged that, whether the effect of the Directive was simply that new issues would be set up with paying agents outside the EU or that issuance and trading also left London, the problem of tax evasion would not thereby be solved (p 41).

196. The Paymaster General said: "The bottom line is that we shall not agree with anything that we believe causes serious damage to financial markets in the European Union, in particular the City of London, or forces the United Kingdom to impose a withholding tax. We need to have a mechanism to deal with the issue identified in the first place: cross border tax evasion … If the Directive does not deal with the issue it is for us to demonstrate why and then move on to next business which does address the issue of tackling international tax evasion: exchange of information" (QQ 436 and 443).

197. In relation to the short term effects if the proposal were to go ahead, we note the view that problems arising from private sector contracts, voluntarily assumed, should not be allowed to affect public policy decisions. Nevertheless, we can see that there is an argument for the adoption of a "grandfathering" arrangement (allowing interest on existing Eurobonds to continue to be paid gross) to avoid massive disruption of the market.

198. Looking at the longer term effects of the proposal, we note that the OECD is seeking a solution on a broader basis than simply the European Union, but we cannot see what small tax-haven countries outside the EU would gain from taking part in such an arrangement. It follows that if the proposal were adopted the danger of driving the Eurobond market out of the City of London - and indeed out of the European Union - would remain. We agree that this potential cost exists, and that the benefits from the Directive to set against those costs might be limited, but we have no basis on which to quantify either.

199. We have not therefore been able to reach agreement on the best way forward. It is argued in some quarters that there are no feasible amendments to the proposal which might make it acceptable, and that unless the proposal is withdrawn the United Kingdom should use its veto, even though this could mean paying a price in negotiating terms. Another view is that it may be possible to find an acceptable version of the proposal, either by making appropriate exemptions from the withholding tax (to limit damage to the Eurobond market, and hence to the City of London), or by ensuring that Member States choosing the reporting option do not thereby lose revenue. Without access to the evidence about the likely scale of impact on the City which the Government has been collecting for the past year, we have no basis on which to reach a conclusion on this proposal.

57   The so-called Monti report: COM(96) 546. Back

58   COM(97) 564. It is worthy of note that an earlier version of the Commission proposal (10427/97) had a fourth element, designed to "eliminate significant distortions in the area of indirect taxation", including some changes in VAT and in the taxation of energy products, which did not survive into the version of the package agreed by ECOFIN. Back

59   Though this does not reflects its full content: see paragraph 155. Back

60   Code of Conduct, paragraph A. References are to the final version adopted at ECOFIN and published as an Annex to the minutes of the meeting on 1 December 1997, which was substantially amended as compared with the version which had been submitted for scrutiny. Back

61   ibid, paragraph B. An idea of the types of measures being considered can be gained from looking at those on the list for the United Kingdom, which are International Headquarters Companies; special measures for the film industry; enterprise zones; 100 per cent first year capital allowances for SMEs in Northern Ireland; roll-over relief for balancing charges arising on the disposal of ships; independent investment managers; scientific research allowances; and 40 per cent first year allowances for SMEs (see p 56). It is not possible to gauge whether these are typical, because the full list has not been published (see paragraph 135). Back

62   ibid, paragraph C. Back

63   ibid, paragraph D. Back

64   ibid, paragraph H. Back

65   No such reports have yet been published: see paragraphs 129-136. Back

66   13115/97. Back

67   On which a progress report was presented as 5474/99. Back

68   op cit, p 48. Back

69   In the public domain as COM(98) 595. Back

70   Letter of 9 March 1999 from Lord Tordoff to Dawn Primarolo, Paymaster General.  Back

71   Commissioner Monti also pointed out that "in the end there will have to be full transparency on the decisions of the Council and on the reasoning measure by measure" (Q 242). Back

72   The Paymaster General agreed that the discussion in the Group stimulated peer pressure (Q 424). Back

73   For example, "Secret plan for 100 euro taxes" (Mail on Sunday: 23 May 1999). Back

74   See the Note supplied by HM Treasury at p 56. Back

75   House of Commons Treasury Committee, Minutes of Evidence, 26 January 1999, HC 186-i (1998-99).


76   With certain exceptions listed in Article 87(2) and (3). Back

77   Barclays Bank thought it ironic that the Member States pushing hardest for a withholding tax included those which tended to favour the use of State aid for their own domestic industries (Q 12). Back

78   loc cit, paragraph J: the relevant Articles were formerly numbered 92-94. Back

79   Which it has since done in 13347/98: Commission Communication on the application of the State aid rules to measures relating to direct business taxation. Back

80   6615/98. Back

81   Explanatory Memorandum of "April 1998.  Back

82   Company taxation in the Single Market: a business perspective, (op cit). Back

83   See paragraph 226. Back

84   8781/98. Back

85   4763/89, on which we reported in June 1989: Withholding tax: HL Paper 55, 11th Report Session 1988-89. Back

86   op cit, paragraphs 23-26. Back

87   Dated "June 1998". Back

88   See paragraph 192. Back

89   The British Bankers' Association claimed (Q 33) that the proposed Directive would introduce a similar distortion, since it would apply only to interest payments. The International Primary Market Association suggested that Eurobonds were "bystanders in the war against bank deposits" (Q 28). Back

90   And which in our view would anyhow be ineffective. Back

91   Quoting Professor Richard Dale, Consequences of regulatory impositions on financial markets, Corporation of London, October 1998Back

92   Though this might not help where income is not brought into the country: see also paragraph 181 below. Back

93   loc cit.  Back

94   The Bank of England judges, however, that in the German case the government probably sees its problem as "an overall tax incidence problem, not just a cash flow problem" (Q 89). Back

95   In their forthcoming book The Euro Capital Market, to be published by Wiley & Sons in October 1999, of which we reproduce an extract at pp 176-178. Back

96   For more discussion of tax havens, see House of Commons Treasury Committee Tax competition and co-ordination, Minutes of Evidence, Tuesday 4 May 1999, HC 425-i (1998-99). Back

97   Estimates of the size of the hidden economy range from £18 billion to £90 billion per year (3 to 15 per cent of GDP). Back

98   As compared with total direct tax revenue that year of £115 billion. Back

99   However, if Julian Reed of the Inland Revenue is right in saying that "a tax evader would be unlikely to put his money into another Member State" (Q 169), the Directive would not be of much help to the United Kingdom. Back

100   An illustration of the implications of Eurobonds being called in was provided by the Association of British Insurers (p 167). The provision of annuity benefits (running at some £27 billion per year) requires the liability to pay to be matched with fixed interest securities providing an equivalent cash flow. The terms offered in an annuity contract depend on the rate of interest prevailing at the time the contract is made. As well as other securities, the providers use Eurobonds denominated in sterling, The premium of these in relation to par is currently estimated at 25 per cent, so if the bonds were called insurance companies would suffer large unforeseen losses with a severe consequential impact on the provision of pensions and annuities. Back

101   In effect a withholding tax. Back

102   The same was argued to be true of the alternative reporting requirement; see paragraph 177. Back

103   From The City's importance to the UK economy, produced by the Centre for Economics and Business Research LtdBack

104   op citBack

105   Insofar as we understand the argument, it seems to be based either on the assumption that all interest payments to individuals within Member States would be subject to withholding tax (whereas in fact the tax would apply only to payments made by paying agents within the EU), or on the assumption that the EU markets for all financial instruments would suffer equally from the tax (which is not the case if Eurobonds are a preferred vehicle for tax evasion). Back

106   See paragraphs 153-154 above. Back

107   This would of course depend partly on the rate at which a withholding tax was levied. Back

108   This is a different issue from that of handling the revenues from a universally adopted withholding tax, which might either be retained by the source Member State, or be attributed to the Member State of residence of the recipient. Back

109   The Government has not taken a view yet on whether it would choose the reporting option (Q 342). Back

110   Austria, Denmark, Finland, France, Greece, Luxembourg, Portugal and Sweden. Back

111   Belgium and Italy. Back

112   Germany, Ireland, the Netherlands, Spain and the United Kingdom. Back

113   This seems to conflict with what we were told by Dr Bosch of Deutsche Bank, who said that "banking secrecy in Germany had "basically the same basis as in England, namely it is an implied contractual obligation to keep confidentiality", and that "for practical purposes in the tax area" it played a very small role (Q 225), but supports the information from the German Government that "fishing expeditions" were not allowed (Q 211). Back

114   loc cit. Back

115   The term has presumably been adopted by analogy with the "grandfathering" arrangements which apply to slots at airports, where it has some sense: the year is divided into summer and winter seasons, and there is a presumption that an airline is entitled to the slots which it used in the corresponding season of the previous year, two "generations" ago. Back

116   Conversely, the Institute of Directors argued that "if the European Union goes ahead, perhaps after a decent warning period, and introduces a withholding tax, even if it is only for bonds issued after the date of introduction, it will send out the message that the European Union is not a good place in which to do this kind of business. One never knows what rules it will introduce next that may disrupt the market" (Q 289). Back

117   op cit. Back

118   Though the Council's objective is to reach agreement on the package during the Finnish Presidency, that is by the end of 1999. Back

119   loc cit. Back

120   That is, representatives of the previous, present and next Presidency. Back

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