sunset forest

Brexit, the new dawn and withholding taxes

Stuart Weekes, Partner, Corporate tax
23/11/2020
sunset forest
One of the key features of any multi-national enterprise (MNE) is understanding where profit is generated, and how it along with the associated cash can be extracted to the holding company or any other company in the group.

What are withholding taxes?

Cash management is fundamental to the health of an organisation. Cash is critical for the functioning of many operations within a business. Whether it is enabling the payment of a specific supplier, investment in a particular sector or geographic area, investment in research and development or even to enable the parent company to return value to the ultimate shareholders, having control of cash is fundamental.

Some countries restrict the movement of cash which can frustrate any head of finance and in some cases with inadequate planning, this could bring some businesses to their knees.

Tax leakage is a phrase commonly used when planning an MNE’s cashflow. Tax leakage focuses on the amount of tax that is ‘lost’ when tracing the sale of a good or service by a subsidiary in one country, through to the extraction of the profit in the hands of the parent company or ultimate shareholders.

Most countries charge a withholding tax when interest, royalties or dividends are paid by a company in one jurisdiction to another company located in another jurisdiction. The company paying the interest, royalty or dividend withholds a specific amount of tax and pays the net to the recipient. The tax is then paid to the tax authorities of the company that withholds the tax.

In many cases the recipient company can claim relief for the tax withheld, but often it cannot claim full relief, i.e. some tax leaks out of the profits at this point. This can cause real cash problems for affected companies.

Many countries have negotiated separate double taxation treaties (DTA). These are agreed on a country by country basis. The effect of the DTA is to agree how specific aspects of taxation will be dealt with between the two countries concerned.

The treaties usually contain provisions to agree rates of withholding tax for interest, royalties and dividends that are lower than the domestic rates for those countries. So, for example, while the domestic withholding tax rate on royalties from country A is say, 20%, country A may have negotiated a treaty with country B that the rate will be 5%.

In many cases the treaty rate will only apply where advance approval is obtained from the tax authority of the country in which the tax is withheld.

What are the rules within the EU?

The EU encourages the free movement of capital between Member States and there are certain directives to support this. Two of these directives apply to dividends, interest and royalties. The Parent Subsidiary Directive (PSD), which applies to dividends, and the Interest and Royalties Directive (IRD) apply a zero rate where a company in one Member State pays dividends, interest or royalties to a company in another Member State. The two companies have to be in a 10% relationship (25% for IRD) – e.g. one holds at least 10% / 25% of the share capital of the other company.

This is a real cashflow advantage for MNEs because this reduces the tax leakage on extracting profits. While the subsidiary would still be expected to pay corporate income taxes based on profits arising locally, it does not then have to withhold taxes on paying those profits to its parent company.

 

office buildings

How will Brexit impact this?

As outlined in our article withholding taxes and Brexit, one of the consequences of Brexit is that the UK will be unable to benefit from these EU directives. As a result, a UK company that receives interest, royalties and dividends from a company based in an EU member state will suffer withholding tax. The tax withheld will be at the domestic rate. While the UK does have treaties agreed with all 27 EU members, planning will be needed to determine how the UK can rely on the treaty tax rates.

Whilst the UK and EU are trying to resolve whether a trade deal can be reached some countries have taken action to introduce laws to try and smooth any adverse direct tax consequences of Brexit. However, such laws are temporary pending clarity about a trade deal.

For example, the Brexit Transitional Act allows Germany to treat the UK as if it were an EU member during a transitional period. Equally, Italy has passed a law to treat the UK as if it were a member of the EU for a limited period. Both cases are intended to provide a ‘soft landing’ and avoid a cliff edge moment while there is still uncertainty about the way ahead.

Whatever the future brings one thing is certain, MNEs will need to plan ahead where interest, royalties and dividends are part of the normal course of doing business in EU member states. Failure to properly plan will mean that tax may be payable unnecessarily and result in less cash with which to run the business.

For more information on how this could impact your company, contact Stuart Weekes or your usual Crowe contact.

Brexit: Prepare for the new start
Helping businesses and individuals prepare for the end of the transition period.

Contact us

Stuart Weekes
Stuart Weekes
Partner, Corporate Tax
Thames Valley