In this article we take a look at how Governments use withholding tax (WHT) to raise tax revenues, consider the circumstances in which this type of tax is most commonly a problem for corporate treasurers and examine some of the options for minimising WHT obligations.
Withholding taxes are relatively commonplace and are applied in numerous tax jurisdictions and for a range of different purposes. They are so named because the Government in question requires the payer of an item of income to withhold (in other words to deduct) tax from the payment and pay the tax direct to the Government. WHT can be applicable both to individuals and to companies.
In this article we will look at some of the key aspects of WHT and some of its more common applications.
Common applications of WHT
In the case of individuals the most common application of WHT is in respect of employment income, but it can also apply to payments of interest and to dividends. In situations where the recipient of the income is resident in a different jurisdiction there are often additional WHT obligations. It can also be applicable to royalties, rental payments and sales of real estate.
Within the EU perhaps the best known example of a WHT is the European Savings Tax Directive (ESD). This applies to ‘natural persons’ rather than companies and was introduced in 2005 in order to combat tax evasion by EU resident private individuals, particularly in respect of bank accounts held in locations perceived to be tax havens, such as Jersey. Under the ESD banks must automatically deduct tax, at the rate of 20%, from interest and other savings income earned, and pass it to their local tax authority. The rate of withholding will increase to 25% from July 2011.
Another example of how WHT can be used to combat tax evasion by individuals is under discussion at the moment between the UK Government and the Swiss authorities. The former are seeking to reach agreement with the latter to impose WHT on secret Swiss bank accounts held by Britons. A possible WHT rate of between 25% and 30% has been mooted on untaxed income in Swiss bank accounts – if an agreement is reached, and implemented, this could add an estimated £3 billion to £6 billion to the coffers of the cash-strapped UK Treasury within two years.
Governments are generally well aware of certain industries where tax evasion is perceived to be commonplace and they seek to use WHT to ensure that this is minimised, as far as possible. In New Zealand, for example, WHT regulations were changed in 2006 in a targeted effort to reduce tax evasion in the country’s fruit and wine-growing industries.
Governments which impose WHT usually try to back this up with a rigorous reporting regime so that amounts of tax being withheld are accurately reported and diligently collected. Some countries have more effective reporting and collection regimes than others. Copies of WHT reporting are usually given both to the person or company on whom the tax is imposed as well as to the levying Government.
It is common for WHT to be treated by tax authorities as a ‘payment on account’, with an amount being refunded if the taxpayer’s final tax liability for the period is less than the amount of tax that has been withheld.
Cross-border WHT
Corporate Treasurers, whose companies typically operate in multiple tax jurisdictions, will probably be more concerned with international WHT regulations than with domestic WHT regulations. The former can be more complex and more onerous to comply with than the latter. Any company doing business internationally needs to understand the WHT rules in those foreign countries in which any business is being done. Companies which fail to consider and take steps to minimise their WHT obligations can expect to see their after-tax income sharply eroded.
By way of a practical example of the implications of cross-border WHT let’s consider how it impacts a US software company selling its products in Korea. In this industry WHT can be 30% or more of gross software licensing income in some countries.
The Korean Government requires that the Korean client of the US company withholds a (large) portion of the invoiced amount and remits it to the local Korean tax authorities on the US company’s behalf. The US company may be able to claim these Korean WHT charges as a credit against their US tax liability, but if the US company is not paying US taxes as a result of recording operating losses the resulting tax credit could be of little use.
This example illustrates the importance for Corporate Treasurers of careful advance tax planning in order to reduce exposure to foreign WHT charges. Fortunately, most large corporates have in-house tax experts, whose role is to ensure that the financial impact on the business of cross-border WHT obligations is minimised and that the company is fully discharging all of its WHT reporting obligations to the tax authorities in the jurisdictions in which they operate.
WHT in some key markets
Let’s have a quick (and somewhat simplified) look at WHT legislation in some key markets and its potential impact on companies which do business in them:
United States
Companies making certain types of payments to non-resident aliens, foreign corporations and foreign partnerships are obliged to withhold Federal income tax. Payments subject to withholding include compensation for services, interest, dividends, rents, royalties and annuities.
Tax is withheld at the rate of 30% on the gross amount of the payment, although the rate can be substantially reduced under international tax treaties. Partnerships are also required to make withholding tax payments on behalf of foreign partners, regardless of whether income is actually distributed to the partner. The US also imposes a 10% WHT on the gross sale price of a US real property interest unless approval has been obtained in advance from the IRS for a lower rate.
United Kingdom
WHT (at 20%) is payable on interest on loans and other unlisted debt in the case of non-UK entities making or acquiring such loans to UK entities (including banks, funds and SPVs), and where companies are lending inter-group. (A ‘treaty passport’ scheme exists whereby relief can be claimed in certain situations.) Real estate investment trusts are required to withhold tax at the rate of 20% on dividend payments to non-residents (subject to any double tax treaties, or DTTs, which may be in place).
Germany
The dividend WHT rate is 25% but this can be substantially reduced subject to effective use of DTTs and other types of tax planning. There is no WHT on interest paid except in the case of publicly-traded debt, interest received through a German paying-agent, convertible bonds and certain types of loans where a German resident company is the debtor. The rate of WHT is 25% but it can be reduced subject to DTTs and/or certain specific EU directives. The WHT rate on royalty and lease payments on movable property paid to non-resident corporations is 15%.
China
WHT is levied on overseas companies providing services to China-based businesses. The Chinese tax authorities levy WHT on ‘China-derived income’ so many overseas companies who do not themselves have a legal presence in China are unable to receive the total gross amount due on their invoices to a China entity.
The standard WHT rate for non tax-resident enterprises in China for passive income is 20%, although this can be reduced to 10% in certain situations. WHT at 10% is also payable on dividends that a non-resident company receives from a resident company (unless there is a tax treaty in place with the relevant foreign government).
India
India’s tax treaties typically provide for a 10% WHT on royalties and technical service fees. Under new rules implemented last year every recipient of India-source income subject to WHT (whether resident of non-resident) must furnish a ‘Permanent Account Number’ (PAN) to the Indian payer before payment is made. Failure by a non-resident entity to supply a PAN can lead to tax being withheld at 20%.
WHT problems
The WHT regulations in one jurisdiction can sometimes give rise to unintended consequences in another. In economic ‘blocs’ such as the EU things can, and have, become very complicated as a result of attempts to harmonise the rules across multiple markets. Dividend withholding tax, for example, is a thorny issue within the EU. Current rules give rise to cash flow disadvantages and double taxation issues which can pose a significant disincentive for cross border investors as well as distorting the effective functioning of the internal EU market. The European Commission has recently set up a consultation to try to find solutions to these problems.
Tax authorities the world over are generally unforgiving of failures by businesses to maintain adequate records, make all required declarations – and associated tax payments. No business wants to get into dispute with tax authorities, whether local or overseas, as such situations can be protracted and costly, as well as bringing unwanted negative publicity.
Implications for corporate treasurers
In an international group of companies Corporate Treasurers face the constant challenge of how best to manage liquidity. Whether cash is physically swept into a single account, or notionally pooled, companies have to consider the underlying tax issues very carefully. Interest is often liable to being taxed at source, particularly when it is remitted cross-border, hence WHT is often a consideration and one that influences how cash pooling arrangements are established and managed.
Whether it is liquidity management or setting up a new overseas subsidiary it goes without saying that the correct structuring of international business operations is crucial in order to minimise tax. Getting expert tax advice on WHT before starting any new international venture is essential.
Ways for companies to minimise WHT
Can companies do anything to minimise their exposure to foreign WHT? Fortunately the answer is yes.
The first way is through international tax treaties. These provide for a reduced WHT rate on cross-border payments of royalties, interest and dividends. Typically, the treaty reduced rate is more favourable than the local country domestic WHT rate and in some case the rate can be reduced to zero%. In order to take advantage of the more favourable treaty rates companies will usually have to go through a fairly lengthy documentation process with their overseas clients and the tax authorities in the client’s country.
Another approach for reducing WHT exposure is for licence agreements to be drafted in such a way as to ensure, for example, that income streams are of a character that is not subject to WHT under the domestic laws of the country where business is being done.
While royalty payments are for the most part subject to local country WHT most countries do not impose WHT on income derived from services performed outside of their country or on income which is derived from the sale of tangible personal property.
It will be pretty tough to convince your overseas customers to stop withholding local country taxes after contracts have been signed and WHT collection has begun, so it’s far better to spend time researching and understanding exactly how overseas WHT rules work before business with clients in new overseas locations commences.
