What’s the story Tobermory?
When businesses trade across borders, two countries may want to divvy-up the taxation spoils. The first, is the country in which the income is earned (the Source State), whilst the second is the country in which the business is based (the Resident State).
As it is difficult for the Source State to tax the income, given that it flows from the customer to the trader without going anywhere near the governments, they often levy withholding tax (WHT) upon payments made to non-residents. These can be very expensive for the trader, as WHT is usually levied upon the gross payment, whereas their profit on the transaction is usually on the net amount and this is subject to tax in the Resident State leading to double taxation.
Countries have entered into many bi-lateral double taxation agreements (DTA) to alleviate this problem. DTAs do this by allocating most taxing rights to the Resident State unless it has a taxable presence, a permanent establishment, in the Source State. This stops WHT on most business profits.
However, DTAs do give the Source State the right to levy WHT upon cross border payments for sources of income that are usually pure income profit (to borrow a UK taxation phrase) in the hands of the recipient. This is usually dividends, interest and royalties. Domestic rates run all the way from 0% to 35% (with France even managing 75%) and DTAs bring them down to around 0% to 15%.
As well as DTAs, the EU got in the act and, as part of the single market, said that payments between connected companies in different Member States should not suffer WHT. Hence, the Interest and Royalties and the Parent Subsidiary Directives were born. These two directives stop WHT being levied on many payments between connected companies.
For the Interest and Royalties Directive, the definition of connected is quite narrow, as it is only where one company has 25% of another, or a third company has 25% of both, but not any wider. Further, and not unreasonably, all of the companies must be within the EU. For the Parent Subsidiary Directive the connection is 10%, plus, of course, it only applies to the payer and the recipient company! Also, the directives do not apply to EFTA members.
Don’t look back in Anger
As the Directives are from the EU, they are within the scope of any turmoil following Brexit. However, and possibly much to the chagrin of Messrs Farage and Rees-Mogg, any immediate problems are likely to be UK companies awaiting payments from Europe and not any European companies awaiting payments from the UK!
The “Great Repeal Bill”, or to give it its proper name the European Union (Withdrawal) Act 2018, is now waiting in the wings to give effect to Brexit. This Act, although it repeals the European Communities Act 1972, actually ensures that EU legislation that applies directly to the UK is incorporated into UK law. It also ensures that UK legislation based upon other types of EU legislation, such as EU Directives, is preserved.
The principle is that the totality of UK law will be the same, both before and after, Exit Day. In other words, legislation covered by the Great Repeal Bill will work exactly the same post Brexit as it did pre-Brexit.
For withholding tax purposes, this means that the UK legislation giving effect to the EU Interest and Royalties Directive (IRD) will still be effective and unamended once we leave the EU. For groups that are investing into the UK, this will be a relief. For example, a fashion house holds its intellectual property in its design company in Italy and the UK operating subsidiary pays royalties to the Italian company. At the moment, as long as the UK company “reasonably believes” that the Italian company is within the terms of the Interest and Royalties directive, as transposed into UK law, they can pay the royalties without any WHT. Based on the Great Repeal Bill, this will not change after Brexit.
However, for UK headed groups, they will be reliant upon the legislation of the other country. Consider a group where the royalties are being paid by an Italian company to a UK company. Prior to Brexit, the Italian domestic legislation implementing the Interest and Royalties Directive allows the Italian company to pay the royalties gross. However, post-Brexit, they will not be able to do so. This is because the Italian legislation (Legislative Decree 30 May 2005, No 143 in case you were wondering) only applies to payments to a company within the EU, and post Brexit, that is not the UK.
This is what is likely to get Brexiteers hot under the collar: the UK company can pay money to companies within the UK “tax free”, whereas Europeans will have to deduct tax upon payments made to the UK!
Roll with it
DTA’s will come to the rescue in many situations, especially for royalties, as the trend is for DTAs to reduce WHT to 0%, but not all. The reason Italy was picked for the example above, was that the Italy/UK DTA only reduces WHT on royalties to 8%. Helpfully, some countries do not levy WHT on certain income sources, such as the UK on dividends or Luxembourg on interest and royalties.
That WHT has been deducted is not the end of the story. As well as reducing the rate of WHT, DTA’s also allow for the recipient to claim double taxation relief if it is not due unilaterally. However, the UK exempts most dividends negating the need for double taxation relief. This does, though, turn WHT into a cost.
Again, dividends paid from the UK do not suffer WHT although, as mentioned, that is a general provision and not due to the Parent Subsidiary Directive. However, a UK parent company receiving dividends from its German subsidiary, prior to Brexit, will be able to rely upon the German domestic legislation implementing the Parent Subsidiary Directive, to reduce any WHT to nil. Post Brexit, the UK will not be a Member State and this domestic provision will no longer apply, as it too only applies where the recipient of the dividend is an EU company. The UK company will have to rely upon the Germany/UK DTA which reduces WHT on such dividends to 5%. Assuming that the distribution exemption applies, the UK goes from receiving 100p in every £1 to 95p. It doesn’t sound a lot, but it will mount up.
Over time, the UK’s domestic legislation will either be amended, or fail to keep up with changes made to the two directives and so UK payers will be able to rely upon them less and less. But for now, Brexit is having a one way effect on WHT and not in a way expected by Brexiteers. Steps could be taken to level the playing field, by repealing the enabling legislation, but that is hardly showing that the UK is open for business – increasing the costs for foreigners investing in the UK.
Andrew is a Tax Director at Milestone International Tax Consultants. He can be reached at firstname.lastname@example.org.