OCTOBER 28, 2020 | ARTICLES
Institutional investors like pension funds, investment funds, and insurance companies spread their investments globally. Global portfolio investments are among their primary asset classes. The most common types of portfolio investments are stocks and bonds from listed companies. Every year, institutional investors collect millions in dividends and interest. Most countries apply a “withholding tax” to the outbound payment of dividends and interest. It is called a withholding tax because the payor must withhold and remit the tax to its revenue authority when it pays the dividends or interest. But as recipients of the dividends or interest, it is the institutional investors who are the actual taxpayer. The withholding tax directly reduces their return on investment. The rate of withholding taxes before withholding tax relief can add up to as much as 35% of the gross income amount.
The withholding tax is applied to the “gross income amount”: institutional investors are unable to deduct related expenses. They are unable to deduct expenses because they are subject to tax in the country that levies the withholding tax. This country is also referred to as the source country because it is the source of the investment income. And they are not subject to tax in the source country because they are not tax resident in that country. The only receive income from sources in that country. In their country of tax residence, the institutional investors are also taxed on the dividend or interest income. Unless they enjoy a specific exemption, as is often the case for pension funds and charities. As a result, double taxation (taxation of the same income by both the residence and source country) may occur.
In order to eliminate or reduce double taxation, many countries have concluded “double tax treaties”. These are bilateral agreements where the source country agrees to reduce or eliminate their withholding tax on dividends and interest. And the residence country agrees to exempt dividend and interest income from a source country. Or grant a tax credit for the source country’s withholding tax. And then there are other legal bases for a reduction or elimination of withholding taxes. Like provisions in the domestic tax laws of countries, or reciprocal recognition of sovereign immunity. Or the free movement of capital in the European Treaty.
In an ideal world, companies paying dividends and interest would apply the correct withholding tax rate at the pay date. That would mean taking into account the various available legal bases for reduction or elimination of withholding tax, all the time. In reality, financial markets are so complex that most companies often have absolutely no idea who their shareholders are. As a result, the highest withholding tax rate will be applied as a general rule.
It is therefore up to the institutional investor to ensure that the withholding tax on its dividend and interest income is reduced as much as possible. Or even eliminated. For that, institutional investors need to be constantly aware of all of these different legal bases for a reduction or elimination of withholding tax. In addition, they need to navigate their way through complex withholding tax relief (also referred to as “relief at source”) or withholding tax refund procedures (also referred to as “long form procedures” as they are reclaims after the pay date). And these are different in every country. Every country has its own conditions, forms and documentation requirements for relief at source and refund procedures.
Continuously monitoring the legal bases for mitigation of withholding tax, and working through recovery compliance procedures is extremely time consuming and expensive. Workflow processes are often put in place between institutional investors and their asset managers, custodians and tax advisors. But these processes lack effective and efficient communication, coordination and centralized responsibility. Moreover, the actual work involved in withholding tax recovery is still done mostly manually. Making it slow, reactive rather than pro-active, costly, and prone to human error. As a result, while custodians try to apply relief at source or reduced tax treaty rates whenever they can, institutional investors are still missing out on many substantial recovery opportunities every year.
Authoritative institutions such as the European Commission and the OECD have recognized this issue years ago. In 2017, the European Commission issued a report which estimated the cost of unclaimed withholding tax recovery at EUR 8.4 billion per year. That is in the EU alone. And the OECD has been working on recommendations to standardize and harmonize withholding tax recovery procedures since 2006 with its “TRACE Group”. Unfortunately, very few countries have done anything at all with these recommendations.
The only way to seriously mitigate this issue is to truly automate the entire recovery process. From collection, validation and processing of reclaim data, to preparation and filing and following up on reclaims. Protocol has been developed with exactly this clear mission in mind. Since its launch in December of 2017, Protocol has recovered tens of millions in withholding taxes for institutional investors in Europe and North-America.