EU's plan to tax interest has small savers in a spin

A new directive from Brussels aims to stop cross-border investors from dodging the taxman. But it could hit the bond market and end up hurting the little man most.

UK small savers with money in corporate bond Peps would be among the victims if plans for an EU with-holding tax on interest payments go through. The fear is that the new tax would force many companies to withdraw existing bonds. The resulting uncertainty would not only create short- term volatility, but could also drive down the price which investors are prepared to pay for bonds. If the price of the underlying bonds falls, then so does the price of any Pep holding the bonds.

Liza Taylor, tax adviser at the Association of Unit Trusts and Investment Funds, says: "That sort of mass recall of investment would cause big slips in the value of people's holdings in the collective investment schemes. The value of the collective investment scheme depends on the value of the bond."

Allan Pelvang, director of tax at Fidelity, adds: "It's the same concern that's been raised on the Eurobond market. The volatility and the uncertainty has definitely been a concern."

Corporate bond Peps and ISAs are often held by nervous elderly savers, who want their nest egg to provide an immediate high income without undue risk. Autif's latest figures show a total of pounds 7.7bn in funds under management in these Peps and ISAs in July 1999. The average holding is just over pounds 7,000 per plan.

The planned new EU tax would make a 20 per cent levy on all interest payments made across national boundaries. It is mainly targeted at German investors who dodge their own country's tax regime by putting their savings abroad. The income received by UK savers would be unaffected by the new tax, but that is not the case elsewhere in Europe.

Many of the bonds held in corporate bond Peps include a clause in their prospectus which would allow even quite small investors to force a re- financing to compensate for the fact that their income from the bond is suddenly being taxed.

But anyone not declaring the gross income received to their own country's tax authorities would find the change particularly irksome.

Companies faced with this challenge to their bonds have a choice. They can either gross-up the bond's return to compensate for the tax being deducted or exercise their right to redeem the bond's debts early at par value - a practice known as "calling" the bonds. Many bonds trade as high as 20 per cent above their par value, so this would lead to a drop in price for bond investors.

In its response to the EU directive, the UK Treasury says: "If a large number of issuers called in bonds, it would lead to massive market disruption and uncertainty. . . the scale of this problem is huge."

Fundamental changes, like these, to the underlying investments in their corporate bond Peps could leave small savers with an investment that bears little or no resemblance to the one they originally bought. Ms Taylor says: "It would be like someone having the power to renegotiate your mortgage without asking what sort of product you wanted and how much you wanted to pay. It's quite a terrifying lack of control."

Gordon Brown, the Chancellor of the Exchequer, has two suggestions for making the directive workable.

His first approach would mean all bonds already issued on the date the directive came into force were exempted. This change, known as "grandfathering", would eliminate the danger of disgruntled investors forcing their bonds to re-finance.

Mr Brown's proposal would also exempt any bond investor with holdings worth more than 40,000 euros (about pounds 26,000) from the directive. In the case of collective investment vehicles such as Peps, the investor is taken to be the fund manager, which means small Pep holders would also escape. Germany remains opposed to this idea, saying people there would not understand why small direct investors should face a tax which big investors would not.

Mr Brown's second suggestion is that the directive's scope be much more tightly defined to include only deposit-based investments, such as bank accounts and "perhaps" other retail investments.

The next key test for the EU directive will come at the Helsinki summit in December, by which time Finland - which currently holds the EU presidency - says it will have drafted a new agreement.