 Withholding taxes on foreign income – maximising cash flow and profit margin
UK companies operating abroad may receive income on which foreign taxes have been withheld at source. Common examples are:
Tax withheld on the provision of services to customers abroad
Tax withheld from management fees
Tax withheld from dividends, interest and royalties
As the volume of cross-border transactions continues to grow, we are increasingly aware that this area may be problematic for businesses. In some instance, we have found that the foreign country imposes withholding tax at an excessive rate. In other cases, the tax could be eliminated entirely.
The impact of double tax treaties
Many double tax treaties concluded by the UK permit foreign countries to tax business profits only to the extent that the profits derive from a “permanent establishment” in that foreign country (usually, this means a fixed place of business through which the business of the UK company is carried on, or a person who habitually binds the UK company in the foreign country). In the absence of a permanent establishment, most UK treaties do not permit the foreign country to impose taxation on business profits, for example on services rendered by the UK company in the foreign country or to a customer in the foreign country. In a few cases, however, there are special provisions allowing the foreign country to impose withholding tax on “technical fees” or there may be an extended definition of permanent establishment which includes the provision of services.
The above rules relating to business profits do not apply to so-called “passive” income such as dividends, interest and royalties. However, the terms of many treaties limit the amount of withholding taxes that can be charged on such income between the two parties, in comparison to domestic rates, provided both parties satisfy the conditions for entitlement to treaty benefits. In addition, withholding taxes between member states of the European Union have in many cases been abolished by European Union directives.
What are the practical procedures?
There is no single procedure that the UK company needs to comply with in the foreign country in order to obtain the benefit of nil or reduced withholding tax rates under tax treaties; it varies from country to country. Some foreign tax authorities require a clearance procedure in advance; others will only repay any excess tax after the event. Detailed advice is needed on a case by case basis.
How can double tax relief be claimed?
In most instances, foreign taxes withheld may be claimed as a credit against the UK corporation tax on the same income, limited to the UK tax on that income. One important practical point is that, for business profits, the UK rules require an allocation of expenses in arriving at the UK measure of the profits - both direct costs and a proportion of overheads. It is therefore quite possible that a foreign withholding tax imposed on gross income may not be fully creditable against the UK tax on net income. In instances such as this, the foreign tax deducted will impact on the profit margins of businesses.
It is also important to note that credit can only be claimed to the extent that all reasonable steps have been taken to minimise the foreign tax, including making any claim to the benefit of reduced withholding tax rates under an applicable tax treaty. Any excess must be reclaimed from the foreign tax authority, not from HM Revenue & Customs.
In some instances, the foreign tax deducted represents a type of tax inadmissible for credit relief against the UK tax liability, in which case the amount may be eligible as a business expense.
Dividends are something of a special case. Since 1 July 2009 most, but by no means all, dividends received by UK companies, whether from portfolio investments or from subsidiaries, have been exempt from UK corporation tax. In such cases, the foreign withholding tax is always an absolute cost as there is no UK tax against which it can be credited. Some tax treaties only permit the foreign country to apply a lower withholding tax if the dividend income is subject to UK tax, which will not be the case if the UK dividend exemption applies. Exceptionally, it may be desirable to make an election to treat the foreign dividend as taxable in the UK, for example, if there are losses or excess management expenses.
How can PKF help?
It follows from the above that it may be worth considering whether the company’s exposure to foreign tax can be reduced or even eliminated altogether. Due to the different legislation of the countries concerned, and the complex interaction with tax treaties, each case generally needs to be examined on an individual basis.
We have International tax experts within the UK firm who have considerable experience of managing and mitigating our clients' overseas tax exposure arising from cross-border arrangements and transactions and we are accustomed to working with our counterparts in the PKF international network. PKF International is a worldwide network of legally independent member firms with representation in around 125 countries.
If you believe that your company may be affected by this issue, please click here to contact us.
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