AN A.S. PRATT & SONS PUBLICATION JANUARY 2006

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1 AN A.S. PRATT & SONS PUBLICATION JANUARY 2006 HEADNOTE: ENRON'S TENTACLES AND LETTER OF CREDIT LAW Steven A. Meyerowitz MAHONIA LTD. V. J.P. MORGAN CHASE BANK THE ENRON L/C AND THE ISSUING BANK'S DEFENSE OF ILLEGALITY Paul S. Turner THE USA PATRIOT ACT AND AML PROGRAM REQUIREMENTS FOR THE INSURANCE INDUSTRY Paul L. Lee CAN A JOINT VENTURE'S UNILATERAL PRICING DECISIONS FOR TWO OF ITS OWN PRODUCTS BE PER SE UNLAWFUL UNDER SECTION 1 OF THE SHERMAN ACT? Thomas A. Donovan, Jennifer F. Shugars, and Gregory T. Sturges CHECK 21: A WINNING HAND FOR BROKERAGE FIRMS, TOO? Donald J. Mosher and Joseph P. Vitale EUROPEAN UNION DIRECTIVE ON INTEREST AND ROYALTY PAYMENTS BETWEEN ASSOCIATED COMPANIES Keith Featherstone, Robert Gaut, Martin Rowley and Madeleine Fabre ELECTRONIC PAYMENTS: THE PERILS OF THIRD-PARTY DISTRIBUTION ARRANGEMENTS Judith E. Rinearson

2 JOURNAL OF PAYMENT SYSTEMS LAW VOLUME 1 NUMBER 8 JANUARY 2006 HEADNOTE: ENRON'S TENTACLES AND LETTER OF CREDIT LAW Steven A. Meyerowitz 731 MAHONIA LTD. V. J.P. MORGAN CHASE BANK THE ENRON L/C AND THE ISSUING BANK'S DEFENSE OF ILLEGALITY Paul S. Turner 733 THE USA PATRIOT ACT AND AML PROGRAM REQUIREMENTS FOR THE INSURANCE INDUSTRY Paul L. Lee 763 CAN A JOINT VENTURE'S UNILATERAL PRICING DECISIONS FOR TWO OF ITS OWN PRODUCTS BE PER SE UNLAWFUL UNDER SECTION 1 OF THE SHERMAN ACT? Thomas A. Donovan, Jennifer F. Shugars, and Gregory T. Sturges 795 CHECK 21: A WINNING HAND FOR BROKERAGE FIRMS, TOO? Donald J. Mosher and Joseph P. Vitale 801 EUROPEAN UNION DIRECTIVE ON INTEREST AND ROYALTY PAYMENTS BETWEEN ASSOCIATED COMPANIES Keith Featherstone, Robert Gaut, Martin Rowley and Madeleine Fabre 807 ELECTRONIC PAYMENTS: THE PERILS OF THIRD-PARTY DISTRIBUTION ARRANGEMENTS Judith E. Rinearson 813

3 Barbara Brewer Clark Commercial Law Institute Barkley Clark Partner, Shook, Hardy & Bacon LLP Chris Daniel Partner, Alston & Bird LLP John F. Dolan Professor of Law Wayne State University Law School Richard P. Eckman Partner, Pepper Hamilton LLP Jay N. Fastow Partner, Weil, Gotshal & Manges LLP Clayton P. Gillette Vice Dean and Max E. Greenberg EDITOR-IN-CHIEF Steven A. Meyerowitz President, Meyerowitz Communications Inc. MANAGING EDITOR Adam McNally EDITORIAL ASSISTANTS Whitney Pool and Erin Lee BOARD OF EDITORS Columnist: Electronic Payments Judith E. Rinearson Partner, Bryan Cave LLP Professor of Contract Law New York University School of Law Christian A. Johnson Professor of Law Loyola University Chicago School of Law Ronald J. Mann Professor of Law The University of Texas School of Law Donald J. Mosher Partner Schulte Roth & Zabel LLP Steven D. Walt Professor of Law University of Virginia School of Law The JOURNAL OF PAYMENT SYSTEMS LAW is published eight times a year by Sheshunoff Information Services Inc., 1725 K. St. NW, Suite 700, Washington, D.C., 20006, Copyright 2006 ALEXeSOLUTIONS, INC. All rights reserved. No part of this journal may be reproduced in any form by microfilm, xerography, or otherwise or incorporated into any information retrieval system without the written permission of the copyright owner. For permission to photocopy or use material electronically from the Journal of Payment Systems Law, please access or contact the Copyright Clearance Center, Inc. (CCC), 222 Rosewood Drive, Danvers, MA 01923, CCC is a not-for-profit organization that provides licenses and registration for a variety of users. For subscription information and customer service, call Direct any editorial inquires and send any material for publication to Steven A. Meyerowitz, Editor-in- Chief, Meyerowitz Communications Inc., 10 Crinkle Court, Northport, New York 11768, SMeyerow@optonline.net, (phone), (fax). Material for publication is welcomed articles, decisions, or other items of interest to bankers, officers of financial institutions, and their attorneys. Although the utmost care will be given material submitted, we cannot accept responsibility for unsolicited manuscripts. Unless specifically noted, no statement in this Journal should be attributed to a specific editor, an editor s firm or company, or the board of editors as a whole. POSTMASTER: Send address changes to the Journal of Payment Systems Law, Sheshunoff Information Services Inc., 1725 K. St. NW, Suite 700, Washington, D.C.,

4 European Union Directive on Interest and Royalty Payments Between Associated Companies KEITH FEATHERSTONE, ROBERT GAUT, MARTIN ROWLEY AND MADELEINE FABRE This article summarizes recent developments regarding taxation of cross border interest and royalty payments in the European Union. Recently, the Council of the European Union (EU) adopted the directive 2003/49/EC (the directive) on a common system of taxation applicable to interest and royalty payments made between associated companies of different European Union member states. The directive is part of the global tax package agreed on June 2, 2003, by the member states of the EU with the aim of tackling harmful tax competition in the EU, securing tax revenues and freeing up intragroup payments within EU. The package consists of three elements: (i) the Code of Conduct to eliminate harmful business tax regimes, (ii) the directive 2003/48/EC of June 3, 2003, on taxation of savings income in the form of interest payments, and (iii) the directive. The aim of the directive is to ensure that each interest and royalty payment between associated companies of different member states is subject to tax only once (and only in one member state). The directive is designed to eliminate withholding tax obstacles in the area of cross-border interest and/or royalty payments within a group of companies by: abolishing withholding taxes on royalty payments arising in a Keith Featherstone, Robert Gaut and Martin Rowley are tax partners resident in Fried Frank's London office. Madeleine Fabre is a European counsel resident in Fried Frank's Paris office. They can be reached at keith.featherstone@friedfrank.com, robert.gaut@friedfrank.com, martin.rowley@friedfrank.com and fabrema@ friedfrank.com, respectively. 807

5 JOURNAL OF PAYMENT SYSTEMS LAW member state, and abolishing withholding taxes on Interest payments arising in a member state in each case, provided that the beneficial owner of the payment in question is a company or permanent establishment in another member state. In order to achieve this goal, the directive sets up a common system of taxation described below. The directive has applied since Jan. 1, 2004, although certain provisions are being phased in over time. In addition, several amendments have been made since the directive came into force. The directive, as currently amended, has applied in full to all member states since July 1, SCOPE OF THE DIRECTIVE Interest 1 or royalties 2 paid by a company that is tax resident in a member state (the source state), or by a company s EU permanent establishment 3 that is situated in a member state, shall be exempt in that source state from any taxes levied on those payments, whether by withholding or assessment, if the following conditions are met: the payer, or the company whose permanent establishment is treated as the payer, and the beneficial owner of the relevant payment, or the company whose permanent establishment is treated as such a beneficial owner, are associated companies and the beneficial owner or its permanent establishment (as the case may be) is located in another member state; for purposes of the directive, a company is an associated company of another company if (a) the company has a direct minimum holding of 25 percent in the capital of that other company, or (b) that other company has a direct minimum holding of 25 percent in the capital of the company, or (c) a third company has a direct minimum holding of 25 percent both in the capital of the company and the other company, all of them being located within the EU; as under the merger and the parent-subsidiary directives, the companies are: 808

6 subject to corporate tax in the EU, tax resident in a member state, and of a type listed in the annex to the directive as currently amended; 4 the payments (a) are tax deductible expenses for the payer, and (b) represent income received by the beneficial owner in its own capacity (not as agent, intermediary or trustee) in respect of which it is subject to corporate income tax; 5 and any exemption procedure applicable in the source state is fulfilled (see below). The provisions of the directive do not apply to the portion of interest or royalties, if any, exceeding the amount that would have been agreed to by the payer and the beneficial owner in the absence of special relationship between them (i.e. the payments must be arm s length). Moreover there are exclusions with respect to quasi-equity. The source state may exclude the following payments from the benefit of the provisions of the directive: payments which are treated as a distribution of profits or as a repayment of capital under the domestic laws of the source state; payments on debt-claims which carry a right to participate in the debtor's profits; payments on debt-claims which entitle the creditor to exchange its right to interest for a right to participate in the debtor's profits; and payments on debt-claims which contain no provision for repayment of the principal amount or where the repayment is due more than 50 years after the date of issue. EXEMPTION PROCEDURE EUROPEAN UNION DIRECTIVE For each payment contract the source state may, at the time of payment require (i) a certificate that the conditions described above are fulfilled, and (at its option) (ii) that it has issued a decision granting the exemption. The certificate should contain the following information: 809

7 JOURNAL OF PAYMENT SYSTEMS LAW proof of the fiscal residence of the receiving company, and, as the case may be, the existence of the receiving permanent establishment, issued by the tax authorities of its member state of incorporation, or location in the case of a permanent establishment; the capacity in which the payments are received by the receiving company or permanent establishment; the shareholding percentage of the associated company and the period of time for which such holding has existed; confirmation that the corporate income tax requirement is satisfied; and the legal justification for the payments made by the payer company (i.e. the relevant contract between the parties, for instance, a loan contract or license agreement). Any tax unduly withheld in the source state on payments exempted under the directive may be refunded by the source state upon application submitted within one year from the date of payment of the interest or royalties. TRANSITIONAL RULES With effect from July 1, 2005, for a transitional period (subject to possible extension): Greece, Poland, Latvia and Portugal may withhold tax for eight years on interest and royalty payments at a rate which may not exceed 10 percent for the first four years and 5 percent the final four years; Lithuania may withhold tax for six years on (i) royalty payments, at a rate which may not exceed 10 percent, and (ii) interest payments, at a rate which may not exceed 10 percent for the first four years and 5 percent for the final two years of the transitional period; Spain and the Czech Republic may withhold tax for six years, on royalty payments at a rate which may not exceed 10 percent; and 810

8 Slovakia is authorized until May 1, 2006, to tax royalty payments under its domestic laws (consequently, not to exempt such royalties under the directive until that date). A tax deduction is granted to the company of a member state, or a permanent establishment situated in that member state of a company of a member state, which: receives interest or royalties from an associated company in Greece, Latvia, Lithuania, Poland or Portugal; receives royalties from an associated company in the Czech Republic, Spain or Slovakia; receives interest or royalties from a permanent establishment situated in Greece, Latvia, Lithuania, Poland or Portugal, of an associated company of a member state; or receives royalties from a permanent establishment situated in the Czech Republic, Spain or Slovakia, of an associated company of a member state. The deduction is equal to the tax levied in the source state with respect to such income, without exceeding the lower of (i) the tax payable on such income in, as the case may be, Greece, Latvia, Lithuania, Poland, Portugal, Czech Republic, Spain or Slovakia, or (ii) the portion of the tax due by the receiving company or permanent establishment, as computed before the tax deduction is applied, which is attributable to said income under the domestic law of the member state of the receiving company or in which the receiving permanent establishment is located. NOTES EUROPEAN UNION DIRECTIVE 1 The term "interest" means income from debt-claims of every kind, in particular income from debt securities and income from bonds or debentures, including premiums; penalty charges for late payment are not regarded as interest. 2 The term "royalties" means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work, including cinematograph films and software, any patent, trade mark, design or model, plan, secret formula or process, or for infor- 811

9 JOURNAL OF PAYMENT SYSTEMS LAW mation concerning industrial, commercial or scientific experience. 3 For purpose of the directive, a permanent establishment is a fixed place of business located in a member state through which the business of a company located in another member state is wholly or partly carried on. 4 The European Commission has proposed an amendment to the directive to provide for an update of the list of companies in the annex to the directive. The proposed new list would also include: the European Company (Council Regulation (EC) 2157/2000 and Council Directive 2001/86/EC) which may be created from 2004, and the European Co-operative Society (Council Regulation (EC) 1435/2003 and Council Directive 2003/72/EC), which may be created from In particular this addresses the situation of a company that, although subject to corporate tax, also benefits from a special domestic tax regime exempting foreign interest or royalty payments received. In such cases, the source state would not be obliged to exempt the payments in question from withholding tax under the directive. 812