At the Autumn Budget, the Government published a consultation paper which focused on the manner in which certain businesses that operate within the digital economy are taxed under the current international tax framework.
That rather policy driven paper has been followed by a second paper, published on 1 December 2017, which includes more concrete proposals for the extension of withholding tax on royalties with effect from April 2019.
Before the Finance Act 2016 (FA 2016), the UK’s application of withholding tax to royalties was a mess. Some royalties were within the withholding regime whilst some others – most, particularly most trade mark royalties – were not.
Some coherence was brought to system by changes made in FA 2016. There were two main changes.
- The first was to extend the withholding tax regime to all royalties within the definition of royalties that is used in the OECD Model Convention. This change aligned the UK domestic regime with the allocation of taxing rights under most of its double tax treaties and brought most IP royalties, including trade mark royalties, within its scope.
- The second was to change the rules which determined whether or not a royalty was treated as having a UK source. Whilst withholding tax on royalties remained limited to payments with a source in the UK (not defined), FA 2016 expanded the source rules so that royalties paid by a non-resident company were treated as having a UK source if they were paid in respect of sales through made through a UK permanent establishment (PE).
As with the introduction of the new definition of royalties, the extension of the source rules to royalties relating to profits of a PE was broadly in line with the allocation of taxing rights under the OECD Model Convention. Whilst, at the same time, FA 2016 made adjustments to the calculation of Diverted Profits Tax (DPT) for payments made in connection with an avoided PE in cases where DPT could apply – essentially extending UK taxing rights beyond those specified by international tax norms – this could be dismissed as a logical extension to an anti-avoidance provision.
Contents of the consultation paper
The proposal contained in the consultation paper is expressed to be targeted at “payments for the exploitation of certain property or rights in the UK that are made to connected parties in low or no tax jurisdictions”. The policy aim would, at first sight, appear to be to prevent the undercutting of UK-based businesses by non-resident companies making sales in the UK operating at a competitive advantage derived from the tax system.
A simple example is given.
- A non-UK company makes sales in the UK but has no UK presence (either through a UK PE or an avoided PE) and so is not subject to UK corporation tax or DPT on the profits from those sales.
- It pays a royalty to a connected but non-resident entity in another jurisdiction. So even if it pays tax on those profits in its own jurisdiction of residence, those profits are reduced by a deduction for the royalty payment.
- A tax advantage is achieved if the royalty is received by an entity which is in a low or no tax jurisdiction.
The proposal to address this mischief has the following key elements.
- UK withholding tax on royalties is extended to payments made for the exploitation of IP “and certain other rights” in the UK by treating all such payments as having a UK source.
- The extended withholding tax will only apply to payments to “connected parties” where the recipient is resident in a jurisdiction with which the UK does not have a comprehensive DTT (i.e. a treaty that contains a non-discrimination provision). Although the examples given in the consultation paper relate to payments made between group companies, the proposal is wider than this. The consultation paper suggests that the transfer pricing definition of connected person should apply so, for example, the regime would apply to payments made by and to certain joint venture companies.
- The withholding tax will be collected and enforced by usual methods. Companies making payments will be required to file and account for tax quarterly. There may be an additional requirement for non-UK entities with no UK presence to register with HMRC.
- HMRC will rely on international cooperation agreements to enforce tax debts against non-UK entities. This is likely to be backed up by joint and several liability for the tax imposed on “connected parties”.
- The proposal is that the new withholding tax will not be limited to payments of royalties within the definition used in the OECD Model Convention (i.e. the definition adopted in FA 2016). The expanded withholding tax will also apply to payments for the exploitation of rights over IP and intangible assets such as the right to distribute certain goods or provide specific services in the UK. This change would take the scope of UK withholding tax beyond the allocation specified in most UK tax treaties.
- The UK has a substantial treaty network so, in many cases, this change will have no impact; the charge will not apply if the recipient is resident in a territory with which the UK has a comprehensive double tax treaty. However, it is potentially significant in the case of payments made to other jurisdictions. Although many of the cases in which the charge may bite may involve payments to tax haven companies, there are some significant gaps in the UK treaty network – for example, there is no treaty with Brazil - and it is quite possible that the charge will apply in cases where the royalty is fully taxable elsewhere in accordance with more traditional international tax principles.
- Even where the royalty is being paid to a tax haven jurisdiction, the proposal takes no account of the fact that the payment to the recipient may have been subject to withholding tax in the jurisdiction in which the paying company is resident (and so, in effect, has already been taxed in accordance with traditional international tax principles).
- These points are acknowledged albeit in passing in the consultation paper. But there is no indication as to how the risk of double taxation will be addressed. Relief will not be available under existing treaties because, by definition, the recipient who would want to claim relief will not be a resident of a jurisdiction which has a treaty with the UK.
- Where a licence covers a geographical area that is wider than the UK, it will be necessary to apportion royalty payments between a part which is attributable to UK sales (to which the withholding tax will apply and a part which is not attributable to UK sales (to which the withholding tax will not apply). The consultation paper suggests that the apportionment will be made by reference to UK sales, but in cases where that apportionment is inappropriate an apportionment will have to be made on a just a reasonable basis.
- The proposal is not limited payments made by the company that makes sales in the UK. It potentially extends to other payments in the licensing chain at wherever the recipient is resident in a jurisdiction which does not have a comprehensive double tax treaty with the UK.
Here is a simple example.
Company A (resident in a country which has does not have a double tax treaty with the UK) grants a worldwide licence at a royalty based on gross sales to company B (resident in a country which has a treaty with the UK) and company B grants the European rights at a royalty based on gross sales to company C (resident in a country which also has a treaty with the UK)
On these facts, a royalty payment made by C to B which is calculated, in part, by reference to sales made by C in the UK will fall outside the charge, but the onward payment by B to A will attract UK withholding tax.
As described above, the withholding will apply even if:
- the royalty payments are at arm’s length prices
- A is resident in a jurisdiction which taxes the receipt of the royalty at more than the UK corporation tax rate
- B has to apply withholding tax to the payments under the laws of the jurisdiction in which it is resident.
- The proposed extension to withholding tax goes well beyond the stated aim. If enacted – and assuming that HMRC would be able to enforce it effectively – it would impose tax on licensing chains even in cases where there is no material tax advantage in the structure.
- The proposal has to be seen in the context of the paper published by the Government at the time of the Budget on its approach to the taxation of the digital economy. That paper – while paying lip-service to the maintenance of the international tax framework and to the reforms championed by the OECD/G20 BEPS Project - then set out a series of proposals that ran counter to established international tax norms and reforms of the OECD/G20 BEPS Project (in particular in relation to the pricing of intangibles) by attributing value in supply chains to the market in which products are sold or services provided. This proposal on the extension of withholding tax on royalties would have similar effects.