Withholding tax on royalties
The use of intellectual property rights to shift profits from the UK to low tax jurisdictions has implications for all businesses and close scrutiny from HMRC as it may appear that the business is withholding tax on royalties. However, there is the potential for double taxation of royalties received by UK businesses. We solve the problems.
Our services relating to withholding tax on royalties includes:
- Withholding of tax on royalties;
- Royalty payments to connected persons;
- Implications for the patent box regime;
- Considerations for licence agreements; and
- Examples of how withholding tax operates.
Withholding tax on royalties
Where a foreign company makes royalty payments to a UK company the royalty income can be subject to tax withholding obligations abroad as well as tax charges in the UK. Withholding taxes on royalties may be reduced or eliminated under the bi-lateral double taxation treaty network. UK tax treaties are based on the standard Organisation for Economic Co-operation and Development (OECD) model but the terms of each treaty vary.
Power to reduce or eliminate withholding taxes
Entitlement to relief depends on the:
- Payers’ location;
- The category of royalty and whether it is recognised as a royalty payment under UK law;
- Specific terms of the relevant double taxation treaty.
As a rule of thumb, UK tax will arise on any royalty payments which have their source in the UK. That is particularly important for foreign companies with UK branches which might be caught by the UK when making payments to their foreign offices.
Royalties paid by UK branches are presumed to have a source in the UK and documentary evidence is needed where that is not the case.
Preliminary review of withholding taxes
To maximise the opportunities available it is often necessary to:
- Identify and unbundle the intellectual property rights;
- Review the commercial supply chain associated with the underlying intellectual property being licensed.
European Union Interest and Royalties Directive
The European Union Interest and Royalties Directive may offer relief from withholding taxes, if the contracting parties are associates and resident in the European Union. It applies if the directive provides a lower withholding tax rate than the double taxation treaty.
Restrictions on foreign tax credits against tax withholding on intellectual property
The offset of foreign withholding taxes against UK corporation tax liability is capped at the equivalent UK tax liability attributed to the income (net of expenses). Where foreign withholding tax is greater than the UK corporation tax then the excess tax is irrecoverable.
Royalty payments to connected persons
UK government imposes tax on royalty payments made to connected persons who are resident outside the UK in the circumstances where the application of the double tax treaty would result in no tax being paid in either of the treaty countries.
Meaning of connected
Companies will be connected if the same company has control of both, or a person has control of one and persons connected with him or he and the persons connected with him have control of the other or if the same group of persons controls both companies.
Cases of control
Connection can also exist if one or more persons acting together have control of the companies. A person or a company has control if it is able to exercise, or is entitled to acquire, direct or indirect control over the company’s affairs and possessions, or is entitled to acquire the majority of the shares or voting rights or distributions or assets on an eventual winding up of the company. Often the position regarding who really controls the company might not be clear and we can review your corporate documentation to see if your companies are connected for the purposes of the legislation.
Impact of the anti avoidance royalty payment legislation
This anti-avoidance measure imposes a deduction of income tax in the UK where a taxpayer uses a double tax treaty in a way that is contrary to its purpose. This is particularly relevant to the companies which route their royalty payments through a third country to take advantage of the bi-lateral treaty network.
Implications for the patent box regime
UK companies will be entitled to an effective tax rate 10% on income derived from patents and exclusive patent rights.
A 10% rate is lower than many non-treaty withholding tax rates that apply to royalties. Securing entitlement to a reduced withholding tax under a double taxation treaty may be critical to ensure that the overall foreign and UK tax on royalty streams do not exceed the 10% rate available to a UK recipient under the patent box rules.
Considerations for licence agreements
We draft and review licensing agreements. Our review will include a consideration of the implications for withholding taxes on royalty payments. The areas we consider for you include:
- Provisions for the parties to take steps to minimise withholding taxes.
- To secure treaty benefits the right to disclose the necessary information to the relevant tax authorities.
- The right to take steps to protect the payer if there is suspected abuse which could have implications for the payee.
- Clear definitions on what is being licensed and from what jurisdiction.
- Indemnities and warranties protecting against the risk that the royalty payment infringes relevant transfer pricing legislation.
- Adjustments for tax credits.
Withholding tax 1st example
In the financial year 2017 a UK company receives patent royalties of £500,000 from a third party licensee who is resident in Portugal. The general withholding tax rate for royalties paid by a Portuguese resident is 25%. The withholding tax may be reduced to 5% by making a claim under the UK/ Portugal double taxation treaty.
Where a reduction in withholding tax is not available under the double taxation treaty then UK corporation tax, before double tax relief, on the gross patent royalty income will be £50,000 (i.e. at an effective rate of 10% under the patent regime, ignoring associated expenses).
However the patent royalties will have been received net of withholding tax of £125,000 (i.e. £500,000 @ 25%). The UK corporation tax will be reduced to nil by offset of £50,000 UK equivalent corporation tax. However the remaining £75,000 of withholding tax (£125,000 – £50,000) will be irrecoverable so that the overall effective tax rate on the royalties will be 25%. In this case the benefits of the UK patent box regime are lost.
By contrast where UK/Portugal double taxation relief is claimed the royalties will suffer withholding tax at 5%. The UK corporation tax will be £50,000 (as above), less £25,000 withholding tax (£500,000 @5%). The overall tax suffered will be limited to an effective rate of 10%, split between £25,000 withholding tax and £25,000 UK corporation tax.
A claim must be made to the relevant tax authorities to establish entitlement to pay royalties at the reduced treaty rate – in advance of making the payments. This may take some time to process as it requires the co-operation of the payer and recipient to provide the necessary information to their respective tax authorities in order to confirm that the conditions for treaty relief are met.
Withholding tax 2nd example
A UK company receives performance royalties from a license holder in Germany. The parties are not associates. The general withholding tax for royalty payments made by residents in Germany is around 15%. The UK/German double taxation treaty allows royalties to be paid gross, i.e. 0% withholding tax.
Since 2012 Germany has introduced additional anti-treaty shopping rules to restrict treaty benefits. The Revenue Administration in Germany will issue a questionnaire when a claim is made under the UK/German treaty in order to establish the UK residence of the recipient and the extent of its commercial activities. Entitlement to settle royalties without deduction of withholding tax by a German resident licensee will depend on the business activities undertaken by the UK company. A passive investment activity by the UK recipient may not be sufficient to claim treaty relief; e.g. in circumstances where the primary intellectual property rights are held by a non-UK resident parent company – in which case the structure of the ultimate legal ownership of intellectual property within the group may need to be addressed.
The consequences of withholding taxes should not be overlooked. It is sometimes the case that the licensee is bound to withhold certain taxes from payment, including royalties. At Gannons we will advice you on the best method to structure your intellectual property licences.