Withholding taxes are a common anti tax avoidance measure employed by countries as a means of protecting their tax base.
They generally only apply where a payment is made cross border( ie from country A to country B) and most commonly, they apply to 3 types of payments:-
- Interest payments
- Royalty payments
- Dividend payments.
They are called withholding taxes because the obligation is on the payor to remit the tax rather than the recipient. Tax authorities like this because it is easier for them to collect payments from parties in their own country than parties who are resident overseas.
Interest: The UK withholding tax rate on interest payments is 20%. If a UK borrower (a company or person) borrows money from an overseas lender and interest of GBP20,000 is due, then the UK party is required to deduct and pay HMRC £4,000 (20%) of the interest amount before paying the balance of £16,000 to the lender.
Royalties: The US withholding tax rate on royalties and other licence payments is 30%. If a US party (a company or person) (Licencee) utilizes technology belonging to an overseas party (Licensor) and a licence fee of USD20,000 is payable to the Licensor, then the US party is required to deduct and pay IRS $6,000 (20%) of the licence fee before paying the balance of $14,000 to the Licensor.
The position is similar for dividends… Ireland imposes a 20% withholding tax on dividend payments….Germany (15%) France (30%) USA (30%) etc. (Note the UK does not impose dividend withholding tax)
Double Tax Agreements / Reduced Rates.
The withholding tax rates are not always the same for each country. This is because the countries enter into double tax agreements to reduce the withholding rates.
For example; under the UK / Ireland double tax agreement the withholding rates for Royalties and interest are reduced to 0% between those two countries.
Developed (high tax) countries tend to have lots of double tax agreements (UK has the most) whereas low tax places, like Isle of Man, BVI, Gibraltar have very few. This reduces the benefit of using offshore companies as holding companies / IP companies and financing companies.
See PWC’s list of withholding tax rates here