Last time out I mentioned withholding taxes. If you are doing business abroad it’s crucial you understand what these are and broadly how the system works.

Essentially there are certain types of payment which have a ‘local source’ – that is to say they come from or are derived from a particular tax jurisdiction. In order that the local jurisdiction ensures that it gets its share of tax on the amount paid offshore to a recipient in another jurisdictions typically the local tax authority will require the paying company to withhold a proportion of the payment and hand it over to them instead of the recipient.

Withholding tax (WHT) rates can be pretty painful. In the US at the moment the rate is 30%, in the UK the rate of WHT is 20%. This is pretty typical for most countries – 25% is probably average.

If the recipient of the payment is resident in a jurisdiction with which the withholding jurisdiction has a double tax convention (DTC) then it’s likely that there will be provision for a reduced rate of WHT – probably 5 or 10% or maybe even sometimes zero. To get this reduction quite often you will need to apply locally for the reduced rate to apply and this can take months to process. It’s important therefore you get such permissions lined up well in advance of payment.

If there is no DTC then you are left with the higher amount of WHT. If you are looking at an intra-EU transaction then you might find that the parent – subsidiary directive, or the interest and royalties directive applies to reduce the WHT to zero. Be careful however, as there will be criteria to be met, and some jurisdictions (e.g. Gibraltar and other overseas territories) may not be inside the EU or EEA for these purposes. 

So what happens to the income when it is taxed on the recipient in the home country? Usually the home country will tax the income at its own domestic rate of taxation. Credit against that liability will be given for the foreign tax already paid, usually capped at the level of the UK tax due (i.e. it cannot produce a refund). Care has to be taken that expenses and other outgoings are carefully allocated in the most beneficial order available to allow the maximum offset of double taxation relief.

Clearly to the extent that the foreign rate is higher than the main local rate then the excess is lost. This excess can be ‘expensed’ to create a tax deduction but this is not as attractive as full offset. A mechanism exists for carry back or carry forward, but ordinarily this doesn’t yield much benefit.

So what types of payment does WHT apply to? Generally speaking it applies to dividends, interest, royalties and sometimes ‘technical services’ (management charges or consultancy type fees) – but others can crop up from time to time. Countries operate WHT in similar but often subtly different ways – it’s therefore important to make sure you have looked at the WHT in the specific jurisdiction. If you are looking at these types of transactions check the WHT position before you make a payment.

A payment for these purposes doesn’t necessarily have to be cash. It can be a credit to a loan account for example – however, whether this is actually deemed paid will depend upon whether the lender can recall the loan and whether the borrower could pay the amount if required.  

Some of you will have heard the phrase ‘Treaty Shopping’. Let’s imagine that a business in Country A transacts with a business in Country B. There is no DTC in place and so WHT is due at the full rate of 30% say. Painful. So the transaction is routed through a company in Country C. Country C has a DTC with Country A and one with Country B, both of which reduce WHT to zero. Tax authorities have got wise to this and the UK is in the process of beefing up their pre-existing legislation to prevent this type of planning. The US has had pretty stern WHT protection for several years known as the Limitation of Benefits provisions. More on this topic in a future blog.

In summary, when transacting with a foreign jurisdiction you need to have WHT high up on your mind. Even if the rate is zero you probably have some advance reporting to deal with. It’s important that this is done well in advance of any payments as sometimes it can take time to get the paperwork in order. Usually we get WHT queries when UK companies are waiting for payment for services – it’s then a mad dash to get the documentation done to enable payment to be received. Let’s see if we can get more clients paperwork done in advance.....