Offshore financial centres have carved out an important niche for themselves within the global financial system by offering confidential, no- or low-tax sanctuary for mobile capital deployed abroad by persons resident in “onshore” jurisdictions. However, many such jurisdictions assert tax claims on the interest, dividends, royalties and other income that their residents earn on such mobile capital.

The great dilemma for both onshore jurisdictions and OFCs has been that OFC secrecy rules may make it difficult – or impossible – to determine whether residents of onshore jurisdictions beneficially own assets located in OFCs.

Over the past few decades, onshore jurisdictions have used a variety of levers – accusations of harmful tax competition, blacklisting, the threat of economic sanctions – to pry open the confidentiality vault and secure more expansive information-sharing agreements from OFCs.

For example, the European Union proposed a savings tax directive under which each of its member states (as well as agreeable non-EU countries) would disclose any interest earned by a resident of another member state in order to insure that the interest was declared in the recipient’s country of residence. Thus, the Netherlands would be required to disclose to Germany any interest payments made by Dutch banks to residents of Germany so that Germany could tax those payments.

This sort of information sharing, however, does not work if the Dutch interest payment is routed to the German resident through a bank account in an OFC – such as Luxembourg – that has bank secrecy laws prohibiting the disclosure of interest payment recipients. The Netherlands would not know the identity of the beneficial owner of the Luxembourg account receiving the interest payment, and Luxembourg’s bank secrecy laws would preclude the bank from disclosing that information. This presented a real dilemma for the EU as Austria and Belgium, in addition to Luxembourg, objected to the proposed savings tax directive on the grounds that their bank secrecy laws prohibited disclosure of interest payment recipients.

The EU’s final savings tax directive addressed this problem by requiring most member states to provide information on interest payments made by paying agents established in their jurisdictions to individual residents of other member states. Non-EU OFCs, including the Cayman Islands, agreed to this information-sharing approach. Austria, Belgium, and Luxembourg were not required to immediately comply with the information disclosure provision of the directive.

Instead, they were required to withhold tax on interest payments made to individual residents of other member states and to transfer 75 per cent of the revenue from the withholding tax to the investor’s state of residence. Non-EU OFCs, including Switzerland, chose this latter source withholding approach, which preserves bank secrecy while insuring a minimum of effective taxation of interest income within the EU.

Apparently satisfied with the way source withholding has worked out so far, Switzerland recently agreed to enter into negotiations for an expanded savings directive agreement with the UK. The new directive would still require Swiss paying agents to withhold a flat-rate income tax on payments made to UK individuals, but the entire withholding tax, rather than just 75 per cent, would be remitted to the UK. The new directive could be online in 2011, and could serve as the basis for similar Swiss agreements with other countries.

Other features that may distinguish the proposed UK-Swiss directive from its predecessor include:

• A broader range of income – the directive may apply to dividends and other types of income.
• Application on a look-through basis to entities or arrangements associated with an individual UK resident.
• The withholding tax may be imposed at a single composite rate and may serve as a final determination of the UK resident’s tax liability.
• The rate of the withholding tax will be critical, as a rate that is too low will encourage UK residents to evade UK taxes in order to pay the lower composite rate applicable under the directive.
• Another critical factor, particularly if the withholding tax is a final settlement of a UK resident’s UK tax liability, is the ability of the Swiss to effectively administer the withholding regime.

A final source withholding tax doesn’t satisfy all relevant constituencies. Tax administrators claim that such taxes don’t satisfy OECD transparency standards because the residence country can’t see its own residents’ OFC-based income-producing assets on an individual basis. Taxpayers bent on evading taxes will not be satisfied with a regime that collects taxes on their income even when it can be done in a manner that preserves secrecy. Nonetheless, such arrangements may well be the wave of the future.