The Netherlands state secretary of finance recently informed the Dutch parliament about the renewed policy for future double tax treaty negotiations (notitie fiscaal verdragsbeleid 2020). The note amongst others describes that the Netherlands will strive towards a 0% withholding tax on portfolio dividends and interest received by pension institutions (read more about: Dutch dividend withholding tax).

Although this approach may seem obvious, it creates a distinction between various fiscal facilities in place to build a retirement provision and does have an effect on the final return on investment. Although this clearly is not the intention, the approach does not seem to consider there are other approaches towards building a pension that will be treated less favorable than pension funds when it comes down to the impact of withholding tax.

Why negotiate a withholding tax exemption for pension funds?

The note describes very short and high level that it is considered important to negotiate for a withholding tax exemption for portfolio investments of pension institutions, namely due to the fact that levying a withholding tax would lead to double taxation. Since most pension institutions are exempted from taxation on the investment income, this requires some further explanation.

EET

The Netherlands taxes pension cycles with a so-called “EET” system. Within an EET system, the pension premiums may be contributed out of an individual’s pre-tax income. This means that at the first stage (premiums) there is no taxation on the individual’s income that is being used for pension savings (hence Exempted).  Subsequently the premiums are invested and the return on investments, is Exempted from (corporate) income tax in the hands of the pension institution. When finally the individual gets its pension, the pension is Taxed with income tax in the hands of the individual.

As this system creates a deferral on pension taxation it offers certain advantages for the pension beneficiaries.

No double taxation?

So when another country withholds tax on a dividend and subsequently that dividend is not taxed in the hands of the pension fund, still at first it looks like there is no double taxation.

The note however explains that the pensions are taxed in the Netherlands. Such taxation however takes place in the Netherlands in a much later stage and in the hands of the pension beneficiary. In the view of the Netherlands this means there is economic double taxation faced with double taxation if the withholding tax are not reduced to 0%.

Of course from the perspective of the Netherlands the approach to negotiate a reduction of the withholding tax at source is much more pragmatic than creating a system that allows a carry forward of the withholding tax for pension beneficiaries to future years when the pension is being taxed. Other countries may of course see this differently and may perhaps not wish to provide relief from their local taxes for the sake of convenience of their treaty partner. Nevertheless, reduced rates for pension institutions are quite common and since treaties work two ways, a benefit provided is also a benefit received.

But what about non-pension institutions pension savings?

In the Netherlands individuals are allowed to use certain elements in the income tax legislation that create the EET system for individual tax exempted pension savings-accounts. Within these accounts contributions can be made out of an individual’s s pre-tax income, investment income is exempted and the pension is taxed.

Big difference however is that the individual savings accounts are not considered to be pension institutions within the meaning of a tax treaty. This means that the individuals face the standard portfolio withholding tax rate that is negotiated in tax treaties.

If this group of investors would have a way to ‘transport’ a credit for the foreign withholding tax incurred to the future phase  where they would receive a taxable pension income, the problem would be solved. This however is not allowed. The foreign withholding tax can also not be used to reduce tax in the current year on other sources of current income. This means that these accounts are being treated differently than accounts held by tax exempted pension institutions. On a well-diversified equity portfolio the difference can easily go up to tens of bps in investment return per year..

Another element that seems not to be factored into the playing field is the position of life insurance companies. Although there are countless differences between pension institutions and life insurance companies (latter for instance being taxed on profits), fact remains that the difference in withholding tax treatment on portfolio investments means a higher return for pension institutions than for insurance companies. Where insurance companies broadly speaking are entitled to credit the withholding tax on investment income, the credit is heavily reduced by the allocation of costs, which – for an important part – means its obligation to pay pension in the future. From a domestic corporate tax perspective it makes perfect sense that (costs for) future obligations offset the gains on some of the investment income (and reduced profits of the insurance company), but through that mechanism, the subsequent limitation to offset withholding tax reduces the return on investment.  When a beneficiary finally gets its pension, the credit also is not available.

As it is not directly likely that the approach to taxation of the investment period of life savings will be changed and asking treaty partners to expand the scope of withholding relief probably also is not fixed overnight, it is thus important to understand how to optimize your portfolio to mitigate the economic double taxation as much as possible.