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Withholding tax is the amount withheld by the party making a payment to another (payee) and paid to the taxation authorities. The amount the payer deducts may vary, depending on the nature of the product or service being paid for. The payee is assessed on the gross amount, and the tax to be withheld (the withholding tax) is computed in that assessment. The purpose of withholding tax is to facilitate or accelerate collection, by collecting tax from payers rather than a much greater number of payees, and by collecting tax from payers within the jurisdiction rather than payees who may be outside the jurisdiction. It may also be used to counteract tax evasion and tax avoidance.

Contents

Domestic withholding tax

Domestic withholding tax is often applied to earned income in circumstances where the payee might otherwise avoid declaring the income earned, for example when people work on a contract basis - neither as a registered business nor as an employee. Some countries require the employer to withhold a percentage of that person's income and submit it to the tax authority. In these circumstances, the payer is usually a business and would normally have to submit details of the identity of the person from whom tax has been deducted.

Domestic withholding tax is also applied to interest and/or dividend payments, typically at standard rate and paid directly to the Revenue authorities. This secures immediate payment of at least a substantial proportion of the tax due. In some jurisdictions, individuals whose total income does not exceed the higher rate tax threshold need not then complete a tax return.

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Dividends

Tax may be deducted at source from dividend payments, in addition to Corporation tax. In the United Kingdom, tax is not withheld at source, but the recipient is given a "tax credit" on the dividend statement, which has the effect that a basic-rate taxpayer has no more tax to pay: higher-rate tax-payers have further tax to pay. The tax credit once represented advance corporation tax (ACT) paid by the company, but ACT was abolished in 1999.

Interest

A minimum rate of tax may be deducted at source from savings interest payments. In the United Kingdom, tax is withheld at source unless the saver submits an R85 form (if a domestic non-taxpayer) or a R105 form (if a non-resident) to claim exemption. In the Republic of Ireland, the tax is known as Deposit Interest Retention Tax or "DIRT".

The United States is unusual in that it does not generally require withholding tax on payments to citizens and residents, other than wages and salaries. However, payers are required to apply backup withholding if the payee has failed to provide a proper Tax Identification Number, or if the payee has failed to report income in previous years.[1]

Employment

In most jurisdictions, employers are required to deduct tax from salary. (See Tax withholding in the United States, PAYE and Internal Revenue Code 3401). In contrast, in some jurisdictions such as the United Kingdom self-employed individuals pay income tax after the end of the year. In the United States, self-employed individuals are required to pay estimated tax each quarter or face interest.

Contract and consultancy work

In some jurisdictions, basic rate taxation is withheld from contract and consultancy payments. The consultant may continue to be liable for higher rate tax on the remainder.

International withholding tax

When a payment is made to a party in another country, the laws of the payer's country may require withholding tax to be applied to the payment. International withholding tax may be required for

  • financing, i.e. dividends or interest
  • the use of intellectual property, i.e. royalties and licence fees
  • consultancy fees and management fees
  • rental of real estate, and other payments connected with real estate

Dividends

If the shareholder is not resident in the same country as the payer, the payer may be required to apply withholding tax to dividends, even if (as in the USA) withholding tax is not required on dividends paid to domestic shareholders.

The United Kingdom does not impose withholding tax on dividends paid to non-residents. However, since January 1 2008, the UK has imposed a 20% withholding tax on distributions from REITs (Real Estate Investment Trusts).

A double taxation treaty may reduce the amount of withholding tax required, depending upon the jurisdiction in which the recipient is tax resident.

Interest

Some countries (for example the United States[2] and the United Kingdom[3]) do not require withholding tax to be applied on most interest paid to individuals, in order to encourage foreigners to deposit funds with banks or other institutions in that country.

However, many countries impose a withholding tax on interest payments to non-residents. The rate of withholding tax may be reduced or eliminated by a double taxation treaty.

European Union

In the European Union, some member states offer savers in other member states a choice of withholding tax or a report to the tax authority in the saver's home country. A similar rule applies to savings of European Union residents held in certain territories outside the EU, which have entered into agreements with the EU.

Under the Interest and Royalties Directive[4], no withholding tax should be levied on interest payments made by a company resident in one EU member state to an associated company resident in another EU member state. However, certain jurisdictions have obtained consent from the European Union to operate transitional arrangements which allow them to levy withholding tax on interest payments to residents of other EU member states for a specified period only[5]. These include Latvia, Poland and Lithuania which acceded to the European Union in 2004.

Avoidance of interest withholding tax

Many multinational groups have a requirement to finance overseas subsidiaries with interest-bearing debt which may give rise to tax leakage where withholding tax is levied on payments of interest.

Debt instruments may be structured to fall outside withholding tax provisions, for example by allowing for a return to the lender which does not constitute interest. For instance, a lender may choose to utilise a discounted note, on which no interest is paid but the redemption price on the loan note gives an economic return for the time value of money in relation to the loan principal.

Royalties

Many jurisdictions impose withholding tax on payment of royalties made by residents to non-residents in relation to the use of intellectual property.

The EU Interest and Royalties Directive applies to payments made by a company resident in one EU member state to an associated company resident in another EU member state, such that no withholding tax should be levied (subject to the transitional arrangements as described above in relation to interest).

Real estate

Most countries tax income from the rental of real estate located within their jurisdiction. A few countries enforce this requirement by requiring the tenant or other payer to withhold tax from rents paid to persons outside the jurisdiction. The United Kingdom has such a requirement, but it can be displaced by a claim by the payee showing compliance with UK tax filing obligations. Tax treaties do not generally remove or reduce withholding tax on rental income.

The United States of America has a requirement, known as FIRPTA, that a person purchasing US real estate from a nonresident alien or foreign corporation must generally withhold 10% of the sale price.[6]

Recovery of withholding tax

The tax withheld from a payment may be more than the recipient's tax liability in the country where the tax is withheld. This may be because

  • there is a tax treaty which reduces the liability below the statutory withholding tax rate; or
  • costs can be deducted from the income to reduce the tax liability

In these circumstances the recipient will need to file a tax return or other claim form in the source country, to recover the tax overpaid. Procedures and time limits for refund claims vary considerably.

Some countries permit the withholding tax itself to be reduced, thus avoiding the need for the recipient to file a refund claim. It is generally necessary to file documentary evidence of the reduced liability, for example evidence of residence if the liability is reduced by a tax treaty.

The recipient may be liable to tax on the income in his home country, but will be able to claim a credit for the withholding tax paid and not refunded or refundable. Some countries exempt income which has been taxed in another country.

See also

References

  • McGill, R. (2003) International Withholding Tax - a Practical Guide to Best Practice & Benchmarking Euromoney Books ISBN 1 84374 050 8
  • McGill, R. (2004) Relief at Source - An investor's guide to minimising internationally withheld tax Euromoney Books ISBN 1 84374 116 4

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