The European Union (EU) Savings Directive (2003) took effect on 1 July, 2005.

This article looks at the impact of the Directive in Bermuda, the Cayman Islands and the British Virgin Islands (BVI).

Given the fact the aim of the Directive is to ensure that individuals who are tax-resident within the EU are subject to effective taxation on interest income received by them, and that Bermuda is not included in the list of countries to which the Directive applies or which were required to implement 'equivalent measures', whereas the Cayman Islands and BVI are, the implementation of the Directive has had some rather surprising consequences.

Affected countries

The Directive relies on a system of automatic exchange of information between EU member states.

To make the measures more effective, certain other key jurisdictions were persuaded to adopt 'equivalent measures'(these jurisdictions, together with the EU member states are referred to in this article as the 'relevant territories').

A number of member states (namely, Belgium, Austria and Luxembourg), as well as many of the other relevant territories will initially apply a withholding tax regime as part of the transitional arrangement under the Directive, although investors have the choice of opting for reporting if they prefer.

How does the Directive work?

Essentially, the Directive applies to 'interest' paid to EU resident individuals by a 'paying agent' resident in a relevant territory.

'Interest' for this purpose includes income from debt claims of any kind, including income from bank accounts, corporate and government bonds, debentures and other securities.

There is also specific provision to extend the definition of interest to distributions from, and proceeds of sales or redemptions of interests in, certain collective

investment schemes (funds).

The responsibility for reporting the payment of interest, or withholding, falls on the paying agent.

Under Article 6 of the Directive 'interest payment' is deemed to include income deriving from interest payments distributed by:

. undertakings for the Collective Investment of Transferable Securities (UCITS);

. an entity which opts to be treated as a UCITS; or

. undertakings for collective investments established outside the EU member states.

In addition, depending on the investment policy of the fund, the definition also extends to income realised on the sale, refund or redemption of shares or units in such funds.

The effect of these provisions is to create two categories of funds for the purposes of the Directive.

In the parlance which has now been generally adopted, funds are either 'in scope' or 'out of scope'. Thus, for example, of funds established in the EU member states, only UCITS

(and certain funds which opt to be treated as UCITS) are 'in scope' and all other funds are 'out of scope'.

Even if a fund is prima facie 'in scope', there are two 'assets tests' which then have to be applied in order to determine whether or not payments by an 'in scope' fund are to be treated as interest payments.

The first of these is known as the de minimis test and does not apply in all relevant territories but only those which have adopted it.

Under this test, if the fund has less than 15% of its assets invested directly or indirectly in debt securities payments from it, it will not be treated as interest.

If the fund has greater than 15% of its assets held directly or indirectly in debt securities, then all distributions made by the fund may be treated as savings income under the Directive.

However, if it has less than 40% of its assets held directly or indirectly in debt securities, then redemption payments paid by the fund will be not treated as interest and it will be 'out of scope' to that extent.

Paying agents

The technical definition of a paying agent for the purposes of the Directive is "any economic operator who pays interest to, or secures the payment of interest for the immediate benefit of the beneficial owner". Examples of paying agents are: transfer agents; custodians; banks; stockbrokers; and nominee companies.

Identifying who the paying agent is in any particular case may not always be straightforward.

There can, however, be only one paying agent in respect of each payment and if there is a chain of transmission it is the person who makes the final payment to the individual who is the paying agent.

On the other hand, to be a paying agent one must be securing or instigating the payment.

For instance, a bank which is essentially taking a passive role by acting on instructions from others will not be a paying agent.

It is essential to be able to identify who the paying agent is in any case, since the Directive will only apply if the paying agent is in a relevant territory.

Impact of the Directive

One would expect that the Directive would have had most impact in the BVI and the Cayman Islands which, being relevant territories, have implemented 'equivalent measures' and little, if any, impact in Bermuda. In fact, the opposite is the case.

Although the Directive applies to all types of interest payments, its main impact in the offshore jurisdictions to date seems to have been in the context of investment funds.

This is because the provisions only apply to payments to EU resident individuals and there are few of them who have direct interests either in bank accounts or debt securities in the offshore relevant territories.

Because jurisdictions such as BVI and the Cayman Islands did not have the concept of a UCITS fund, the bilateral agreements that they have entered into with the EU member states in order to implement 'equivalent measures', introduced the concept of a 'UCITS-equivalent' fund. It is only payments from these UCITS-equivalent funds which are to be treated as interest for the purposes of the Directive.

Cayman Islands

In the Cayman Islands, therefore, the only funds which are to be treated as UCITS-equivalent and thus 'in scope', are those that are licenced under Section 5 of the Mutual Fund Law and also listed on the Cayman Stock Exchange. All other Cayman Funds will be 'out of scope'.

BVI

In the BVI, it is only 'restricted public funds' which will be treated as UCITS-equivalent and again, all other BVI funds are 'out of scope'. So, as a result of agreeing to implement 'equiva-lent measures' to the Directive, the Cayman Islands and BVI have managed to avoid most of its impact.

Bermuda

As a result of what is thought to have been an oversight, Bermuda was not included in the list of dependent territories of the UK required to adopt equivalent provisions to the Directive, and thus it is not a relevant territory.

Initially, this was thought to be an advantage for Bermuda, and it is the case that interest payments made from Bermuda directly to EU resident individuals, whether deriving from a bank account, an interest in a security or an interest in a fund, are not subject to any withholding or reporting.

However, Bermuda has not been able to adopt the approach of specifying a limited category of its funds which will be treated as UCITS-equivalent.

As a result, all collective investment schemes established in Bermuda (and indeed in all other countries which are not relevant territories, such as the US, Singapore and Hong Kong) are prima facie 'in scope'.

Whether or not the Directive will then have an impact on those funds depends on whether they have individuals as investors who are resident in the EU, whether those investors receive cross-border payments from a paying agent established in a relevant territory and whether the payments made by the fund are treated as being 'interest'.

There is also some difference of interpretation between the various relevant territories as to what constitutes a 'collective investment scheme' outside those territories, which is caught by the Directive.

All of this potentially places a considerable administrative and reporting burden on those affected funds established in Bermuda.

The biggest impact to date seems to be primarily in cases where the investors in such funds are holding through a paying agent in Switzerland.

On 30 September, 2005, the Bermuda Ministry of Finance issued a press release stating that it is in discussions with the Swiss authorities and "as the intended interpretation of provisions of the Directive are still being clarified, the Swiss tax authorities have indicated a willingness to reconsider how Bermuda-based funds will be treated under the Swiss guidelines on the basis of a different interpretation by European Union members of EU Savings Directive rules in respect to Bermuda funds."

No doubt over the coming months we will be seeing further efforts by the authorities in Bermuda to create a more level playing field with other offshore jurisdictions such as BVI and the Cayman Islands, which must now be feeling rather pleased that they were required to implement equivalent measures to the Directive.

Christopher Johnson-Gilbert is a lawyer in the London office of Conyers Dill & Pearman.