Grandfathered Bond

What Is a Grandfathered Bond?

A grandfathered bond is a classification of bonds issued in Europe prior to March 1, 2001, that excludes payments made on these bonds from EU retention taxes. A retention tax is one that is automatically withheld or paid directly to the government.

The term grandfathered refers to the fact that tax laws introduced after their issuance do not retroactively apply to them.

Understanding Grandfathered Bonds

For a bond to be classified as a grandfathered bond, it had to have been issued before March 1, 2001, or had its prospectus certified before this date. In addition, the bond must not have had any re-issues at any point after Feb. 28, 2002. The transitional period during which these bonds were not treated as debt claims ended on July 2012.

The retention tax, which became effective on July 1, 2005, when the European Union Savings Tax Directive was implemented, is a withholding tax on interest payments. Simply put, this tax automatically withholds some of the interest on a bond, and the ultimate amount taxed on the interest will depend on several factors, including the individual's overall income.

This retention tax only applies to the residents of a European Union (EU) member state and also covers savings accounts, fiduciary deposits, and investment funds. It does not affect the interest payments made to non-EU residents and on these bonds.

These bonds were negotiable debt securities. The interest, premiums, and discounts derived from these bonds were not considered debt claims or savings income. Hence, investment in these bonds did not count when deciding if the thresholds, which determine whether income from certain collective investment funds is savings income, had been passed.

Special Considerations

Because they did not automatically withhold taxes, these bonds have been among the preferred securities used by tax evaders. In the absence of further taxation in the country of residence, tax-avoiding investors would prefer bonds that are exempt from the withholding rates over bonds that are taxed or from bonds that are deposited at banks in countries that provide information exchange between tax authorities.

The implementation of automatic withholding via the retention tax was an effort by the EU to avoid tax evasion. Once all of the existing versions of these bonds come to maturity, the tax loophole that they present will no longer exist.