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TAXATION

INTRODUCTION TO THE STANDARD INCOME

MODEL FOR FINANCIAL INSTRUMENTS

Copyright © 2018, AZEK / BRP TAX

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TAXATION

Copyright  2018, AZEK / BRP TAX

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording, or otherwise, without the prior written permission of AZEK /
BRP TAX.

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Table of contents

1. Introduction to the Standard Income Model for Financial Instruments ................ 1

1.1 Introduction..................................................................................................................................... 1
1.1.1 What is income? ............................................................................................................................ 1
1.1.2 Taxable income ............................................................................................................................. 1
1.1.3 Wealth Management: from Offshore to Cross-Border .................................................................. 1
1.1.4 Warning: AEI is NOT Taxation of Financial Assets ..................................................................... 2
1.1.5 Income tax, as a new constraint ..................................................................................................... 2
1.2 The jigsaw puzzle of income models .............................................................................................. 3
1.2.1 The net income method ................................................................................................................. 3
1.2.2 The breakdown method ................................................................................................................. 3
1.2.2.1 Definition .................................................................................................................................................. 3
1.2.2.2 Deferred taxation ...................................................................................................................................... 4
1.2.2.3 Advantages and disadvantages.................................................................................................................. 4
1.2.3 Traditional models ......................................................................................................................... 4
1.2.4 Treatment of non-descript financial instruments ........................................................................... 5
1.2.5 The Swiss Income Model .............................................................................................................. 5
1.2.6 The UK Income Model.................................................................................................................. 6
1.2.7 The omitted component ................................................................................................................. 6
1.3 The Standard Income Model ......................................................................................................... 7
1.3.1 Introduction ................................................................................................................................... 7
1.3.1.1 Definition .................................................................................................................................................. 7
1.3.1.2 Four types of income ................................................................................................................................ 7
1.3.1.3 Three categories of financial income ........................................................................................................ 7
1.3.1.4 Completeness and consistency of the Standard Income Model................................................................. 7
1.3.2 Definition of income under the Standard Income Model .............................................................. 8
1.3.2.1 Two sources of income ............................................................................................................................. 8
1.3.2.2 Two categories of income ......................................................................................................................... 8
1.3.2.3 Taxonomy: four atomic types of income .................................................................................................. 8
1.3.2.4 Caution: substance over form ................................................................................................................... 9
1.3.3 Actors in the taxation of financial assets ....................................................................................... 9
1.3.4 Relevance of tax reporting services to performance .................................................................... 11
1.4 Technical parameters of Standard Income Model ..................................................................... 11
1.4.1 The three factors of income ......................................................................................................... 11
1.4.2 Tax Rates ..................................................................................................................................... 12
1.4.2.1 Progressive tax rates ............................................................................................................................... 12
1.4.2.2 Fixed tax rate .......................................................................................................................................... 13
1.4.2.3 Differentiated tax rates............................................................................................................................ 13
1.4.3 Deductions of income .................................................................................................................. 14
1.5 The tax subject (the taxpayer) ..................................................................................................... 14
1.5.1 Introduction ................................................................................................................................. 14
1.5.2 Two categories ............................................................................................................................ 14
1.5.3 Private portfolios ......................................................................................................................... 15
1.5.4 Joint portfolios or accounts ......................................................................................................... 15
1.5.5 Transparent (look-through) entities ............................................................................................. 15
1.5.5.1 Definition ................................................................................................................................................ 15
1.5.5.2 Assimilation of beneficial owner to taxpayer.......................................................................................... 15
1.5.5.3 Bona fide entity....................................................................................................................................... 15
1.5.6 Ultimate Private Taxpayer (UPT)................................................................................................ 16
1.5.7 Confidentiality of the personal data of the UPT .......................................................................... 16
1.6 The tax object: the financial instrument ..................................................................................... 16
1.6.1 Definition .................................................................................................................................... 16
1.6.2 Assimilation ................................................................................................................................ 17
1.6.3 Classes of investment .................................................................................................................. 17

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1.6.4 The basic “molecules” of financial income ................................................................................. 17

1.7 The taxable event: introduction to transactions ......................................................................... 18
1.7.1 Taxable and tax neutral transactions ........................................................................................... 18
1.7.1.1 Taxable transaction ................................................................................................................................. 19
1.7.1.2 Tax-neutral transactions .......................................................................................................................... 19
1.7.2 Distributions ................................................................................................................................ 20
1.7.3 Disposals ..................................................................................................................................... 20
1.7.4 Birth of the tax debt and dates ..................................................................................................... 20
1.7.4.1 General principle .................................................................................................................................... 20
1.7.4.2 Principle of legally effective intention .................................................................................................... 21
1.7.4.3 Exceptions .............................................................................................................................................. 21
1.7.4.4 Primary market ....................................................................................................................................... 21
1.7.4.5 Secondary market ................................................................................................................................... 21
1.7.4.6 Definitions .............................................................................................................................................. 22
1.7.4.7 Delayed end-of-year payments ............................................................................................................... 22
1.7.4.8 Conversion of money flows in different currencies ................................................................................ 22
1.7.4.9 Conclusion .............................................................................................................................................. 22
1.7.5 A schematic history of the taxation of financial investment........................................................ 23

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Learning Objectives

By the end of this chapter, you will be able to:

1. Explain the characteristics of the Standard Income Model for the tax calculation of income
coming from financial assets.

2. Apply the parameters used by tax authorities to calculate the tax coming from income from
financial assets.

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1. Introduction to the Standard Income Model for Financial Instruments

1.1 Introduction

1.1.1 What is income?

For a number of years, national tax agencies have been applying income tax on the returns
from financial instruments.

In order to understand and generalize the principles of income tax on financial instruments, it
has been necessary to develop a theory of financial income, with its own concepts, specialized
definitions (which might be slightly different from common ones) and methods.

1.1.2 Taxable income

Tax systems use different methods for calculate income, and for considering fees and losses to
get taxable income.

The taxable income of a specific financial instrument, using a specific tax system, is called the
tax base. Understanding the tax base is an absolute pre-requisite for performing a correct
calculation of tax. The purpose of this course is to describe the methods for calculating this tax
base.

1.1.3 Wealth Management: from Offshore to Cross-Border

In most countries, domestic wealth managers have been taking income tax into account for a
long time, as something obvious and important.

Offshore wealth managers have, however, largely ignored the taxation systems of the country
of residence of their clients, because many of them omitted to declare their income to their tax
authorities. This could not last: the sovereign debt crisis between 2008-2013, followed by a
strong change in the practices of tax authorities, resulted in criminal prosecutions of taxpayers
and bankers, and a shift of several countries toward Automatic Exchange of Information (AEI)
in tax matters.

In the context of the global move towards tax transparency, most countries concluded, after
2012, an Inter-Governmental Agreement (IGA) with the US called FATCA. Over 50
jurisdictions started participating implementation of the Common Reporting Standard (CRS)
under the Organisation for Economic Co-operation and Development (OECD).

As a result, there was a strong trend of clients who were not in compliance with their tax system
toward regularisation. There was also a shift in language: we no longer use the term offshore
(as if the assets were somewhere at sea, out of reach from any jurisdiction), but cross-border
(to mean that they are firmly deposited on the territory of a different jurisdiction). Hence tax-
compliance of cross-border clients is now a pre-requisite in the field of wealth
management.

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1.1.4 Warning: AEI is NOT Taxation of Financial Assets

A very widespread misconception is to confuse Automatic Exchange of Information (AEI)
with Taxation of financial assets. These are two distinct subjects and confusing them may lead
to grave consequences for clients of financial intermediaries, and possibly for the financial
intermediaries themselves.
AEI is merely an obligation for custodian banks connected to the fight against tax evasion. Its
purpose is to identify the financial assets of taxpayers held in custody at foreign banks’, as
well as the gross cash flows deriving from those instruments. It is not to assess the tax base
of income from these financial investments. The information provided by banks in the context
of AEI, being very minimal, is not usable for that purpose. AEI does not exempt taxpayers
from their tax obligations in any way; on the contrary, AEI was created as a powerful means to
enforce those obligations.
A taxpayer, even though identified with AEI, still has the full responsibility of fulfilling
their tax obligations, especially to report their taxable income according to the tax rules
of their residence country. Clients who fail to submit valid tax returns and other disclosure
reports are liable to penalties, which may also involve criminal charges.
Financial intermediaries who fail to advise their cross-border clients about their
obligations of tax compliance, particularly their tax reporting and disclosure duties could,
as a minimum, be accused of failing in their duty of advice. In more serious cases, they could
be accused of negligence or complicity in tax evasion.
Furthermore, the notions of controlling person used by AEI (Common Reporting Standard) or
FATCA are abstract, a priori notions, which should not be confused with that of taxpayer, as
defined by tax laws. A bank confusing the two could fail to identify the real taxpayer and thus
commit errors.

1.1.5 Income tax, as a new constraint

As a result, there is a much stronger client demand of wealth management services that take
into account the taxation of the residence country. The benchmark of Wealth Managers has
become performance after tax.

1. This means in practice that rational choices of financial investment should take into account
a new constraint: income tax. Income tax reduces (sometimes dramatically) the expected
return for a given level of risk, on most asset classes.

2. For Wealth Managers, it implies first and foremost to master the underlying “mechanical”
principles of taxation applicable to income of each asset class.

3. Once this is achieved, Wealth Managers should consider the tax suitability of financial
instruments or even more, the tax optimization of portfolios through various techniques,
including the selection of a suitable envelope such as Life insurance or trusts (these are
separate courses). This can induce a growth in discretionary management mandates or
specific advice, and a corresponding decline of execution-only services, since clients are
left to their own devices with the tax impact of their financial investments with execution-
only services.

It is important to keep in mind that AEI is a merely preliminary step in a major process of a
broader aggiornamento of the financial industry toward tax services to clients.
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1.2 The jigsaw puzzle of income models

1.2.1 The net income method

How to calculate income? Traditionally, Wealth Managers have assessed the income of a
portfolio over a period (typically a year) by using a net method. This method consists of taking
the total value of the portfolio at the end of a period (𝑉𝑉𝑒𝑒𝑒𝑒𝑒𝑒 ), subtracting the value of this portfolio
at the start of the period (𝑉𝑉𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 ), and taking into account deposits and withdrawals during the
period. In its simplest form:

Income =Vend − Vstart − Deposits +   Withdrawals

Example:

Value Value Deposits Withdrawals Income

(end) (Start)
179'395.30 130'505.30 31'405.23 14'250.00 31'734.77

This is a top-down method, which starts from two valuations of the portfolio and works
backwards. It has the advantage of being relatively simple to calculate, since it only requires a
limited number of data, and does not require to go into the detail of individual positions of the
portfolio, and transactions. This method is called the net income method, because all losses
and fees are implicitly taken into account in the value of the portfolio at the end of the period.
This method is one of the methods used for calculating the performance of portfolios.

Note that with this method unrealized income is also considered in the calculation:

1. Unrealized capital gain (i.e. the increase of value of positions due to market change) is
considered as income.

2. Accrued discount (typically on zero-coupons or structured products) is also part of the

income.

3. Accrued interests are considered part of the income, since they are taken into account in
the valuation of the portfolio.

1.2.2 The breakdown method

1.2.2.1 Definition
The breakdown method, used by tax authorities, works the other way round. It requires to
assess the income of a portfolio position by position, according to the transactions (generally
the flows of money) that took place in relation to each position. This is a bottom-up method,
where each component is summed to give the total income.

For example, a position in shares will generate income from dividends, and eventually a capital
gain when it is sold on the secondary market. Each of these two elements will have to be
accounted separately. If the transactions took place in a currency other than the reference
currency of the tax system, each of these two elements will have to be translated into the
currency of the tax system with the appropriate exchange rate.

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1.2.2.2 Deferred taxation

As a result, the breakdown method leads to deferred taxation, i.e. the tax liability is generated
only by tax cash in hand (money received). This means in particular that the accrued interests
valued at the end of a year are not considered as income, since they have not been received yet.
Some tax systems may introduce limited exceptions to that principle, especially with investment
funds that accumulate income instead of distributing it.

1.2.2.3 Advantages and disadvantages

Clearly, the breakdown method requires more work because it requires a considerable amount
of information. It is also far beyond the capabilities (knowledge, resources) of a skilled investor,
let alone an average client of a bank.

By contrast, this method is also more verifiable, since each elementary position and operation
can be controlled separately. Breaking down the different elements of income also allows the
tax system to define different levels of taxation, by increasing the tax burden in some cases and
reducing it in others.

1.2.3 Traditional models

Another key issue is that the breakdown method of calculating income from financial
instruments has long suffered from a multiplicity of models, which is an indicator of their
inadequacy (if there was an adequate one, it would replace the others in the long term). Without
a consistent model, the calculation of income for a tax system becomes a jigsaw puzzle.

Most tax systems use some variant of the income model below:

Capital gain

Income “Special
from Funds income”
Interest Dividend
(Derivatives and
structured
products)

These models are imperfect, because they put the notion of type of income (capital gain,
interest and dividend) on the same footing with the type of some financial instruments:

1. It does not explain immediately how income from funds relates to the other categories.

2. “Special income” is a various and sundry category (especially derivatives and structured
products). This being an arbitrary category, all countries tend to treat it in different
ways.

This confusion between two types of concepts (income and category of financial instrument) is
a key reason why different income tax systems tend to use incompatible terminologies, and
why they tend to lose their internal consistency with structured products and funds.

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1.2.4 Treatment of non-descript financial instruments

A non-descript financial instrument is a financial instrument that has no explicit treatment
under the tax law of a country (special income).

There are three methods used by tax systems to deal with non-descript financial instruments:

What is not explicitly mentioned in the law is not taxable. Income from
1. Legalistic
non-descript financial instruments is tax exempt.

The tax agency applies a default, worst case solution for all products
for which the law does not provide a clear category (for example,
progressive rate taxation instead of fixed rate, non-deduction of losses,
2a. Case-by case
etc. This is typically the case for France when dealing with structured
products; they are taxed by default at progressive rates with no further
possibility to deduct the losses
2. Catch-all
The tax law contains an explicit category as financial innovations,
exotic/atypical products, other income, etc. All these terms often
obscure the tax system instead of clarifying it, since they acknowledge
2b. Legal category
that these products do not fit in clear categories, instead of clarifying
how they should fit. For example, Germany defines that physical gold
funds or ETFs are exotic products, leading to an unclear tax treatment.

The tax authorities instruct how to fit a new category of financial

instrument into some existing “slot”. To do so, they look at the
“behaviour” of the financial instrument, to fit it in the category that
3. Assimilation most closely fits the description of its income.

For example a tax system may consider a structured product as a bond

as long as it distributes coupons

1.2.5 The Swiss Income Model

The model of income in the Swiss system is an improvement:

Capital gains

Funds
Interest Dividend

This model is better, because it removed structured products from the picture, with the
understanding that they can always be broken down into their component parts, each of which
generates capital gain, interest or dividend.

It is also particularly applicable to the Swiss taxation system, since capital gains (including
from funds) are tax exempt in that country. The fact that fund distributions are treated separately
is not an issue in that particular context, because all fund income that is paid or capitalized is
taxed with the same tax rate and conditions.
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On the other hand, as soon as distributions from funds need to be split into separate types of
income, this model breaks down 1.

1.2.6 The UK Income Model

The UK tax system is, by far, one of the most complete and consistent models of financial
instruments 2:

Capital gains Funds

Interest Dividend Funds

Each of these categories has its own tax rates.

The funds do have a specific treatment (together with reporting obligations), but the UK tax
system explains how to break down their income into one of these three categories of
income.

1.2.7 The omitted component

The one drawback from the UK system is the confusion between interest and discount
(typically income from zero-coupons). At a higher level, discount is assimilated to interest (and
will generally be taxed at the same rates) but this hides the fact that the calculation of discount
income obeys to very specific rules 3. To complicate things further, interest income belongs in
reality to a larger category Other income under the UK system (which also contains work
income, real estate income, etc.).

This combined with the common misconception that capital gain includes discount (which it
does not), has created a considerable amount of confusion in Swiss banks that needed to
implement English taxation rules under the Rubik agreements. Fortunately, the Swiss Federal
Tax agency had provided a fairly good clarification of these points.

1
The conceptual flaw in the Swiss model goes a long way to explain why the application of the “Rubik”
agreements between Switzerland and UK (respectively Switzerland and Austria) resulted into an explosion of
unexpected cases and thus complexity.
2
This is more or less the diagram that served as a basis for the Document “Flat Tax Project” published by the
Swiss Banking Association in December 2009 (page 8) which served as a basis for the Withholding Tax
Agreements with the United Kingdom and Austria, entered into force in 2013. It is indeed possible that the
nickname “Rubik” comes from this diagram, where countries represent a third dimension; the result vaguely
evokes the complexity of “Rubik’s cube”, a three-dimensional jigsaw puzzle. The Standard Income Model
as described here, was developed as a theoretical and practical answer to that problem.
3
The UK tax system does recognize the existence of a subcategory of financial instruments called Deeply
Discounted Securities; but the income they generate is Other Income (which includes interest).

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Once it became obvious the discount was the missing piece of the jigsaw puzzle of income
models, this opened the door to the introduction of the Standard Income Model.

1.3 The Standard Income Model

1.3.1 Introduction

1.3.1.1 Definition
A consistent treatment of financial income requires a systematic model. A model, in that sense,
is a simplified representation of reality (financial instruments), which highlights the
relevant features (income) and consciously ignores irrelevant features, in order to facilitate
reasoning and calculations.

What is described here as the Standard Income Model was initially developed for the use of
Swiss banks between 2012 and 2013, to remedy the failings of existing models of income, and
to provide a standard body of concepts to master the complexity of different tax systems. Its
use was particularly required in the context of the Rubik agreements.

1.3.1.2 Four types of income

The Standard Income Model is based on four and only four atomic types of income:

Dividend Interest

Capital gain Discount

As we shall see, these four types can be derived from higher concepts.

1.3.1.3 Three categories of financial income

The Standard Income Model has three and only three categories of financial instruments:

A. Equity-like
B. Bond-like
C. Composite
The last category C contains mutual funds. The last category does not contain structured
products, except a few (rare and often theoretical) exceptions. The overwhelming majority of
structured products belong either to categories A and B.

1.3.1.4 Completeness and consistency of the Standard Income Model

To this day, no financial instrument has been found that could not be classified in an
unambiguous way under the Standard Income Model.

In other words, the Standard Income Model does not admit any non-descript financial
instruments.

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1.3.2 Definition of income under the Standard Income Model

1.3.2.1 Two sources of income

We define income as the surplus amount one gets from work or from an investment. There are
two and only two separate sources of surplus obtainable from financial instruments:

a. Distributions of cash (or equivalent) from financial investments, for example dividends
or interests.
b. Capital difference coming from an increase of value of the capital invested, this
difference will be materialized when the shares are sold or redeemed.
In order to assess the income, tax systems establish rules on the income they want to tax or not,
and how each component of the income should be taxed. Those rules need to be strict and
verifiable to make sure that all similar cases are assessed in the same way, and that no abuses
are taking place, either in favour of the taxpayer or the tax authority.

1.3.2.2 Two categories of income

From a fiscal point of view, financial income can be:

1. Variable: susceptible to varying unpredictably, independent from time, or

2. Guaranteed: increasing as a function of time.

1.3.2.3 Taxonomy: four atomic types of income

If we consider a combination of distribution/capital difference, as well as variable/guaranteed,
we get a taxonomy with four and only four atomic types of financial income:

Category

Source 1. Variable 2. Guaranteed

a. Distribution Dividend Interest

b. Capital difference Capital gain Discount

They are called atomic, because they do not need to be broken down further (this rule will be
crucial for mastering the complexity of composite products such as structured products or
mutual funds). Conversely, any income from any financial instrument can be broken down
in one or more of these four atomic types.

The whole theory and practice of the Standard Income Model is based on the combination
of these “atoms” into “molecules”.

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1.3.2.4 Caution: substance over form

When we use “equity” or “bond” in the context on the Standard Income Model, we are not
describing only financial instruments that legally bear that name, but precisely defined
categories of financial instruments that obey a set of assumptions and characteristics.

If the cash flows coming from a financial instrument behaves as the ones coming from “equity”,
we will assimilate the financial instrument to equity regardless of its content or legal status (e.g.
commodity is assimilated to a dividendless equity, some structured products even issued in the
form of certificates are assimilated to equity, etc.).

This follows the abductive reasoning (substance over form) used by tax authorities. This is
commonly referred to as: “If it looks like a duck, swims like a duck, and quacks like a duck,
then we will treat it as a duck”.

In order to avoid confusions and calculation errors, it is necessary to lay out all the properties
and limits of these classes, even though they would look “obvious” at first.

As already mentioned, these classes are ideal classes. When studying a particular tax system,
we will use the Standard Income Model as a yardstick, to focus on how this tax system diverges
from it.

With the Standard Income Model, it becomes possible to make detailed comparative
studies of the various tax systems.

1.3.3 Actors in the taxation of financial assets

In this course, we will consider seven different actors (functions) involved in the taxation of
financial instruments:

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Role Description Function for taxation

The investor holding a portfolio of Annually declares his income (if so

1. Client financial instruments. required) and pays the income tax.
(taxpayer)
1. Keeps into account the constraints of
income tax for investment decisions
Decides on the allocation of portfolios (purpose: performance after tax)
2. Wealth or advises clients on how to allocate 2. Quality control: Ensures that other
Manager their portfolio. actors provide all the necessary
services (notably: tax reports) so as
not to generate undue tax charges for
the clients.
Keeps the custody of the client’s 1. Provides high quality tax reports
assets, provides the settlement of 2. Provides necessary services for
portfolio transaction and performs the obtaining quick relief of the withholding
3. Custodian
administrative actions around them tax or submitting claims for refunds of
Bank
(including reporting). the withholding tax.
3. May provide reports to a tax authority
or to levy a withholding tax.
Is a Financial Market Infrastructure
(FMI): traditionally, it kept the original
paper securities in its vaults; today,
with the dematerialization of
4. Central securities, it updates registries of
Levies the withholding tax at source on the
Security financial instruments from the issuers
distributions (dividends or interests).
Depository of its country (securities and funds).
(CSD) When such an organization serves
more than one country, it is called
International Security Depository
(ICSDs).

Provides the tax relevant information to the

investor.
The issuer of a financial instrument.
5. Issuer
May also levy the withholding tax at source
in some countries.

Collects information relevant to calculate

Provides data about the financial
income tax on financial instruments,
instruments, needed to support the
according to a particular tax system, and
6. Data Provider work of a Wealth Manager and/or a
provides them to Custodian Banks and/or
Custodian Bank 4.
Wealth Managers.

An agency responsible for collecting the

income tax, within a tax system.

It can be divided into:

7. Tax agency
a. Tax agency of the residence country
of the client (the most relevant one)
b. Tax agency of the issuer’s country.

Note: For the sake of simplicity, we will often omit showing the Data Provider and Wealth
Manager in the diagrams of the interbank system.

4
Let’s mention for example SIX Financial Information for Switzerland, Interactive Data for the United
Kingdom, WM-Datenservice for Germany, Global Financial Data for the US, etc.

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1.3.4 Relevance of tax reporting services to performance

In practice, the institution having the custody of the assets (generally a bank) is in the best
position to make tax reports on a portfolio, since it has the necessary data. Otherwise, this
burden must be given to a tax accountant.

In any case, it is an administrative cost that must be appropriately transferred to the

investor and must be considered in the calculation of performance after tax.

Finally, correct and timely reports (preferably in the format prescribed by the country of
residence), are not only a necessity for the taxpayer: they are also the only way by which they
can claim tax deductions and refunds. Conversely, poor reports generally result in a higher
tax burden; the reason is that tax authorities invariably make assumptions of maximum income
when data are missing, or apply higher tax rates or deny deductions.

The important fact to keep in mind is that the quality of tax reports is crucial to portfolio
performance after tax.

1.4 Technical parameters of Standard Income Model

1.4.1 The three factors of income

The rules for establishing the tax base (as well as the tax rate) derive from a dynamic balance
between the interests of the state collecting the income (maximizing this tax base) and those of
the taxpayer (minimizing it). Different conditions in different countries may lead to a different
compromise.

Three and only three factors must be taken into account for any type of income:

1. Who is receiving the income: the tax subject (or taxpayer).

2. What (financial instrument) is generating the income: the tax object

3. When the income arises (becomes due): the taxable event. Taxable events can be a sale, a
distribution of interest, etc.

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This may be summarized in the following table:

Question Legal Term Jargon Term Example

Who? Tax subject Taxpayer Mr. X

Financial
What? Tax object 34 Shares of company Y
instrument

Taxable
When? Transaction Sale on 24.10.2015
event

1.4.2 Tax Rates

When a taxable income (or tax base) has been defined a tax rate should be applied on it. There
are various possibilities. A tax system may apply three types of rate to financial income:

• Progressive
• Fixed
• Differentiated

1.4.2.1 Progressive tax rates

A progressive tax rate (as for any other type of income) is applied. It means that the financial
income must be calculated alongside all other types of income.

Most tax systems have adopted a progressive scale of taxation, divided income brackets.

Example:

Bracket From To Tax rate

1 0 9'999.99 0%
2 10'000 19'999.99 18%
3 20'000 39'999.99 25%
4 40'000 59'999.99 30%
5 60'000 35%

The amount of income in the first bracket is taxed at the appropriate rate (here: 0%), the
remaining in the second at the appropriate rate (here: 18%) and so on. Hence the effective tax
rate (the total tax divided by the total income) will be known only after all elements of income
have been added.

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Example:

Assume that the total income is EUR 124’399.30.

Total income 124'399.30 EUR

Bracket From To Tax rate In that Tax Rate Tax Amount

bracket
1 0 10'000 0% 10'000.00 0% 0.00
2 10'000.01 20'000 18% 9'999.99 18% 1'800.00
3 20'000.01 40'000 25% 19'999.99 25% 5'000.00
4 40'000.01 60'000 30% 19'999.99 30% 6'000.00
5 60'000.01 35% 64'399.33 35% 22'539.77
Effective 124'399.30 28.41% 35'339.76

PS: The tax amount is rounded to two decimal places

In the above example, the investor must pay a total tax amount of EUR 35'339.76, which
corresponds to an effective tax rate of: 35’339.76 / 124’399.30 = 28.40%

The last bracket in which the taxpayer has taxable income defines the marginal rate.

1.4.2.2 Fixed tax rate

A fixed tax rate simplifies the tax calculation, since the income tax can be calculated without
knowing the total income of the investor; it can therefore be done separately for each portfolio
held by a client.

a. When the fixed tax rate applicable to financial income is lower than the progressive rate
clients would normally pay, it is an incentive to invest in financial instruments.
b. A fixed tax rate allows a country to introduce a final withholding tax, where the
custodian bank of the client levies the income tax; this tax is called final when the
taxpayer is considered to have fulfilled her/his obligations by paying this withholding
tax, and is no longer required to declare that amount in his/her tax return.

1.4.2.3 Differentiated tax rates

A country may define that some types of income should be taxed at a different rate – whether
fixed or progressive. For example, the United Kingdom defines that dividends should be taxed
(for higher income brackets) at 30.56% while capital gain is taxed at 20%. Italy has a lower
tax rate for state-issued bonds; Belgium also has a lower rate for retail savings account.

In practice, it is often a mix. Many countries that apply a fixed tax rate to income from financial
instruments apply a progressive (higher) tax rate to the income coming from some categories
of investments they wish to discourage (e.g. because they are speculative, the issuer’s country
is blacklisted, etc.). In that case, the progressive rate is used as a deterrent for the investors.

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1.4.3 Deductions of income

Another way of reducing the tax burden, is to reduce the taxable income by some factor.

A typical case is when a country applies an income deduction on dividends (the reasoning is
that since the company that distributes income has already been taxed with corporate income
tax, it would be unfair to tax it twice).

Example

Assume that country C applies a 60% income deduction on dividends and the tax rate is 45%.
The tax is calculated as follows:

Dividend % of Taxable Taxable Tax rate Total Effective tax

(gross) Dividend Income (progressive) rate
amount
A B C=A x B D E = CxD F=Bx D
1'506.20 40% 602.48 45% 271.12 18%

1.5 The tax subject (the taxpayer)

1.5.1 Introduction
The tax subject is the physical or legal person who, under the law is bound to pay the tax to
the tax authority. This term can be generally confused with the general term taxpayer, but it is
important to make a few distinctions:

1. When there is a withholding tax at source, another entity (the issuer or a bank) is the tax
subject, instead of the taxpayer.

2. Similarly for portfolios of some entities, the company is generally a tax subject for its
corporate income, but it can be different.

The field of tax compliance consists of determining who the tax subject is and whether she/he
fullfills her/his tax obligations.

1.5.2 Two categories

Tax subjects can be divided into two categories:

1. Private taxpayer: an individual who is subject to personal income tax.

2. Corporate taxpayer: any type of entity that is distinct (from a tax viewpoint) from the
individuals that compose it. An entity can be a commercial company, an offshore company,
a trust, a foundation, etc. It is, in principle, subject to corporate income tax.

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1.5.3 Private portfolios

In a private portfolio related to a single person, the account holder is almost always the same
person as the beneficial owner, unless the account is opened in the name of a middleman. It is
thus more precise to state that the taxpayer is the beneficial owner, in the sense of anti-money
laundering (AML) regulations.

1.5.4 Joint portfolios or accounts

In a private portfolio with two or more beneficial owners (whether it is the account holder and
another person, or two account holders), the income is generally split between the beneficial
owners, who are considered as the taxpayers.

1.5.5 Transparent (look-through) entities

1.5.5.1 Definition
Some entities that do not fit specific criteria (for companies, it is typically economic substance
and adequate level of taxation) are considered transparent or look-through from a tax point
of view. This means that any income related to that entity is split between the private persons
related to that entity (shareholders of the company, settlor or beneficiary in a foundation/trust,
etc.), at the time when it arises.

1.5.5.2 Assimilation of beneficial owner to taxpayer

Here again, the practice is to assimilate the beneficial owner (according to AML regulations)
to the taxpayer. It is a fairly good rule of thumb, which is used in a risk-based approach. Note
that in a minority of cases, the actual taxpayer (according to local tax regulations) might be
different!

The purpose of these look-through dispositions is to prevent tax evasion, by private individuals,
by funnelling their private income through abusive structures that benefit from tax breaks for
one reason or another, especially in jurisdictions that are lax or do not guarantee that the
information will be available. In some cases, a structure may be held by another structure, on
more levels. What really matters is to determine the private taxpayers who are ultimately
connected to these structures.

1.5.5.3 Bona fide entity

By contrast a bona fide entity (i.e. which fits for example the criteria of economic substance)
is non-transparent for tax purposes: as long as it does not distribute any income, the
individuals who hold a share of that entity should not be taxed.

An opinion by a tax specialist or lawyer or, better, a tax ruling (i.e. a written decision by a tax
authority on a specific entity) may help clarify a situation 5.

5
A tax ruling can be relied upon, unless the information provided by the entity to the tax authorities appears to
be incorrect or there is a change in legislation that makes it obsolete.

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A typical case of bona-fide, non-transparent, entities are companies with an economic activity,
established in a tax jurisdiction with a fair level of taxation; another is a foundation with a tax
ruling on its general interest or charity status. A last example relates to a proper discretionary
and irrevocable trust, where proper taxation applies at the level of the trustee.

1.5.6 Ultimate Private Taxpayer (UPT)

We therefore need a simple model that will work in all the cases above. Whether the account
holder of a portfolio/account is an individual, a group of individuals (joint account) or a
transparent entity, the question is always who the Ultimate Private Taxpayers (UPTs) related
to that portfolio are, as well as their:

a. Country of tax residence

b. Tax status
c. Percentage of ownership.
A bona fide, non-transparent, entity does not have any UPTs. The company itself is the UPT,
subject to corporate income tax (in the case of an operating business company), or rightfully
eligible to tax breaks (in the case of charity foundations, etc.).

A transparent entity, such as a Panama offshore company, does have UPTs; they are the
beneficial owners of the portfolio held in the name of the company.

1.5.7 Confidentiality of the personal data of the UPT

For a question of confidentiality of data (availability of private data on a “need-to-know” basis
only), a person who performs the calculation of taxes does not need to know any other personal
information about the UPT, such as name, address, age, etc. A simple, non-traceable identifier
for the UPT (i.e. a unique combination of letters or digits) will be sufficient.

Residence Portfolio Percentage of Personal

Person Tax Status
Country Income the portfolio Income
1005 CH 5'000.00 30% 1'500.00
1011 CH 5'000.00 30% 1'500.00

1015 UK Resident non-domiciled 5'000.00 40% 2'000.00

100% 5'000.00

The only time when the personal information of the taxpayer and the results of the calculations
need to be put side by side, is when the custodian bank produces tax reports to be shipped to
the client or a tax authority. At this point, particular confidentiality precautions should be taken,
as well as with the tax reports produced.

1.6 The tax object: the financial instrument

1.6.1 Definition
The term financial instrument is used in this textbook as an abstract term for any type of
financial investment in a portfolio.

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1.6.2 Assimilation
It is fundamental to understand that what matters about income (and taxation of income), is
what form of income is generated, not necessarily the legal form of the financial instrument.
In particular, the status of a financial instrument as a security or a contract is not fundamentally
relevant.

In order to define how income from a financial instrument should be taxed, the standard
question is “does this resemble a simple financial instrument I already know?” This process is
called assimilation.

1.6.3 Classes of investment

The following is a pragmatic classification of asset classes used in Wealth Management:

a. Equity
b. Bond
c. Bank deposit (cash)
d. Derivative
e. Structured product
f. Investment fund
g. Commodity
On the other hand, financial reports in Wealth Management tend to aggregate financial
instruments under “equity” and “bond”. The Standard Income Model systematizes that
approach.

1.6.4 The basic “molecules” of financial income

Since financial instruments come in many types, it is absolutely essential to have a firm
grasp of how they work (their purpose, how they generate profit or loss), before attempting to
calculate the income they generate.

To simplify the explanation we will study, in this course, the two types of financial instrument:
equity (shares) and bonds, which have been historically the basic securities in portfolios.
Bonds are divided into three sub-categories: vanilla, zero-coupon and mixed.

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Income
Financial instrument
1. Distribution 2. Disposal
a. Variable b. Guaranteed a. Variable b. Guaranteed

1. Ordinary Dividend Capital gain

A. Equity
2. Dividendless Capital gain

1. Vanilla Interest Capital gain

2. Zero-coupon Capital gain Discount

B. Bond
3. Mixed Interest Capital gain Discount

4. Guaranteed capital Interest

C. Complex (mutual funds) Dividend Interest Capital gain Discount

In the next chapters of this course, we will break down the calculation of income for each of
these “basic molecules” (rows of the table). We mentioned in bold the financial instrument
involved by a full description of each of the four atomic types of income (columns of the
table): Dividends, Capital Gain, Interest and Discount.

More specifically:

• Chapter 3 will deal with variable income financial instruments (i.e. with dividend and
capital gain) through equity.
• Chapter 4 will deal with guaranteed income financial instruments (i.e. with interest
and discount), through bonds.

1.7 The taxable event: introduction to transactions

1.7.1 Taxable and tax neutral transactions

For the income tax on financial instruments, it is necessary to consider only two basic types of
taxable transactions (i.e. that actually generate income tax).

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1.7.1.1 Taxable transaction

Definition Examples

A flow of income received in cash or in Typically a dividend, a coupon, a payment

Distribution
shares of interest on cash account, etc.

The holder of the financial instrument

Disposal disposes of the financial instrument (“gets • Redemption of a financial instrument
rid of”) against an amount in cash. • Sale of the financial instrument

These two terms are abstractions from the usual vocabulary used in financial markets. Thus,
unless there is a need to make a distinction, we will no longer talk about sale or redemption, but
only use the term disposals. Similarly, we will no longer talk about interests on deposits,
coupons, dividends, but only use the term distributions.

1.7.1.2 Tax-neutral transactions

Tax-neutral transactions are transactions that do not generate income. It doesn’t mean that they
are irrelevant. On the contrary, since these transactions determine the acquisition cost of
positions, they play a central role in the correct calculation of income at disposal time.

Definition
The act of taking ownership of financial
Acquisition
instruments.
The act, for the UPT, of depositing new
Deposit financial instruments on a portfolio
(whether physically or with a transfer).
The act for an investor of withdrawing
Withdrawal financial instruments from a portfolio
(whether physically or with a transfer).
Note
An acquisition of a financial instrument is
generally tax neutral. It rather opens a
new position, with a cost price.
1. A deposit is per se, not a taxable
event, if the amount was already in
the possession of the UPT.
2. Receiving assets from a third party
(i.e. different account holder and/or
UPT) is income or gift or inheritance.
But unless it is financial income it can
generally be ignored for our
purposes.
As a general rule, a withdrawal is always
tax-neutral (whenever a tax system
introduces exceptions, they are explicitly
described).

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1.7.2 Distributions
Distributions are of two types:

Type Description Examples Common Name

There is no contractual promise on their
amount, or even on their date. They • Dividend from a
Variable Dividend
depend, usually on how well a company is company
performing.
They are defined by an interest rate,
• Interest
which is either fixed or variable.
coupons from
A variable rate is usually known at the
Guaranteed bonds Interest
start of each interest period; but in some
• Interest from a
cases it is known at the end of an interest
bank deposit
period.

1.7.3 Disposals
The income from disposals is calculated with the capital difference:

=
Income Pricedisposal − Priceacquisition

This difference can be divided into two parts:

Type Description Examples Common Name

The difference between acquisition and • Equities
Variable Capital gain
disposal varies according to the market. • Vanilla bonds
This difference is partly defined by the
issuer, in the form of a promise to redeem
Guaranteed Zero coupons 6 Discount
the financial instrument at a later date,
with a pre-determined price.

1.7.4 Birth of the tax debt and dates

1.7.4.1 General principle

Similar to the processing of corporate actions, a key issue for taxation is to determine when the
income tax arises (becomes due) for a taxpayer. In principle a difference of a few days may not
be very relevant since taxation is on an annual basis. However, having a clear idea about this
subject can become crucial for a number of reasons:

1. For taxable events occurring at the end of a tax year: to determine whether they should be
reported in the current year or in the next one.

6
As we shall see, zero-coupons also have a variable part when they are traded on the secondary market, which
depends on market conditions.

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2. For tax systems where withholding tax is levied directly by the bank: the question may
become even more sensitive, since the tax is supposed to be levied on an immediate basis
from the client’s account (and paid by the bank to the tax agency on a monthly or quarterly
basis).

3. A related issue is that of date of the exchange rate to apply for income in foreign currency.

1.7.4.2 Principle of legally effective intention

In general, the principle that applies is that the tax arises with a legally effective intention
(rather than the date when the actual money flow or transfer of property occurred). The tax debt
is presumed to arise:

1. For spot events, which must materialize immediately (allowing a few days for settlement):
when the responsible party has legally manifested the intention to cause the event.

2. For forward events, which must materialize at a later date (maturity date), then this date
applies.

This tax principle is in line with the traditional principles of contractual law.

1.7.4.3 Exceptions
This (legal) presumption can be reversed when the event fails to materialize (no payment) or
when there is a delay in the materialization (or even an anticipation in the materialization).

This is a practical way of operating, since it is based on the (rational) assumption that the
banking system is reliable; tax systems thus presume that all events occur as planned, unless
an exception is raised.

1.7.4.4 Primary market

The general rule is that taxable events generated by an issuer of financial instrument (primary
market) occur at the decision or at later maturity date, if there is one. Typically, the tax debt
of the taxpayer for a distribution of interest coupons arises at the payment date.

If there is no contractual payment date (typically for the distribution of dividends for shares in
a company) then the debt arises when the responsible body (general assembly) takes the
decision to perform the distribution (spot event), unless it is specified that the dividends will
be paid at a later date (forward event: maturity date).

1.7.4.5 Secondary market

Taxable events that occur on the secondary market (stock exchange or OTC) start with a trade
between two parties. Hence, for spot transactions, the relevant date is the trade date. When
an event is unilaterally decided by one of the two parties (such as the decision to exercise an
option), then the relevant date is the date of such a decision.

For forward transactions, the relevant date is the maturity date.

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1.7.4.6 Definitions
Since there are several possible cases, a simple and systematic way of treating dates should be
adopted. For the purpose of this manual we will use the following definitions:

a. The trade date is the date when the client entered into an agreement (acquisition,
disposal) or the date when another party expressed its intention to cause the transaction.
The trade date of a dividend distribution is the date of the decision by the company.
b. The maturity date is the date when the decision will become effective (only for forward
transactions).
c. The value date serves for the calculation of late payment interests, as well as the
calculation of accrued interests on debt instruments (such as bonds) involved in a
transaction. It is generally assimilated to the settlement date, i.e. the date by which all
the immediate effects of the transaction must be realized (payment, delivery of the
security, transfer of ownership, etc.), though there might be exceptions with non-
standard financial instruments, particularly with hedge funds. On a forward transaction,
the value date is generally the same as the maturity date (but it could be later).

1.7.4.7 Delayed end-of-year payments

Note however that (for operations on the secondary market) the value date is not, strictly
speaking the payment date. This may have an impact in cases where a payment (for dividends,
interest, etc.) was expected to be received before the end of tax year and was delayed and
received after the end-of year (hence could be considered part of the following tax year). Most
tax systems solve this question by determining that the reference date is the contractual date
of the payment by the issuer; hence the value date of the payment can be used.

1.7.4.8 Conversion of money flows in different currencies

Income should be calculated in the reference currency of the tax system. We will assume that
each cash flow paid in foreign currency must be converted into the reference currency with the
applicable foreign exchange rate at the time when the tax debt arose.

1.7.4.9 Conclusion
In practice, you should consider the following, unless a tax system specifies otherwise:

1. For all spot transactions where there is no calculation of accrued interests involved,
consider only the trade date. We will indicate trade date or simply date.

2. When there is a calculation of interests involved, then the value date will be also indicated;
the value date will only be used for that purpose.

3. For forward transactions, the maturity date will be indicated alongside to the trade date;
the maturity date will be used in the calculations instead of the trade date (except for
accrued interests, where the value date is relevant).

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1.7.5 A schematic history of the taxation of financial investment

It is important to realize that the taxation of financial investment has evolved in time, in more
or less the same way in most countries. As for dates, some tax jurisdictions took the steps before
the others, but all followed a similar path. The most obvious source of financial income,
distributions of dividends and interest were the first to be taxed, and capital gain was the
last.

We could summarize this in the following (schematic) way:

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Standard
New income
Step Main issue to solve Note Income
taxed
Model
This was relatively easy to
achieve, by simply listing
the securities held and
looking at the cash
All dividends and statements. To prevent
Financial income interest were abuses (especially with Dividend,
I Distributions
escaped taxation taxed at full bearer shares or bonds Interest
value where distributions could
be paid cash in hand), tax
systems introduced a
source tax that could be
deducted from the tax bill.
1. This required
accountants or banks
to keep track of the
acquisition and disposal
To avoid taxation on dates and prices of the
distributions, issuers security.
were replacing vanilla Discount 2. Fortunately, most
bonds with zero- (guaranteed portfolios held one or
IIa Discount Discount
coupon instruments or increase of two of these financial
the like, where income capital) products which were
was obtained at designed to be held for
disposal time. long periods. As a
result, the loophole
could be plugged
without too much
administrative burden.
• Taxation of
the accrued
interest of
bonds at
1. The administrative
disposal
burden of keeping track
(accrued
Coupon washing: To of accrued interest
interest paid
avoid taxation on increased. This required
on
distributions, investors computers.
acquisition
were getting rid of 2. Fortunately, the banks
Pro-rata could be
bonds before they paid were already keeping
temporis on deducted)
IIb an interest coupon, track of accrued Interest
interest • Taxation of
thus achieving income interest, since that
coupon interest
at disposal time (since information needed to
coupons on
the total price of be computed and
pro-rata
bonds includes the checked for every
temporis
accrued interest). transaction of
(since the
acquisition and disposal
accrued
of bonds.
interest on
acquisition
could be
deducted)

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Standard
New income
Step Main issue to solve Note Income
taxed
Model
1. Investment funds and
structured products are
compound products,
which posed serious
conceptual and
practical issues to tax
legislators and tax
authorities.
2. This problem was
solved by shifting the
burden of tax
Taxation systems Dividends,
qualification and
Investment considered, so far, Taxation of Interest,
calculation to the
funds and only equity and bonds. investment funds Capital
III investment fund; in
structured New types of financial and structured Gain and
many jurisdictions,
products instruments entering products Discount;
structured products
the market. Class C
were treated in an
over-simplified (and
often unfavourable)
way.
3. Nevertheless, keeping
track of those data is
data-intensive and
required better
computer systems
connected to data
providers.
1. This not only applies to
equity, but also on
vanilla bonds, as well as
derivative instruments,
commodities and
structured products.
2. Calculating capital gain
is very data-intensive:
all these operations
A notable source of
require a good
income from financial
expertise in financial
instruments has Any variable
instruments and
always been the income on
require access to data
capital gain, i.e. the capital, coming Capital
IV Capital gain such as cost prices, fees
difference between purely from a gain
or exchange rates
acquisition and difference of
3. This is the first time
disposal prices coming market prices.
that the subject of
from the fluctuations
offsetting losses was
of market prices
seriously considered.
4. Since all financial
income is now
considered, this
requires a very
adequate internal
organization (people,
processes and
systems).

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