New UK withholding tax on royalties

New UK withholding tax on royalties

The government has recently been consulting on a proposal to extend withholding tax on royalties to certain payments made in connection with profits derived from UK sales, regardless of where the payer is based. These new rules will have effect from April 2019.

This is part of the government's drive to reform taxation of the digital economy and is aimed at activities such as selling goods or streaming content (e.g., music, films, television) over the internet. With the demise of high street retailers fresh in the news and the growth of online businesses continuing apace, it is easy to understand why this sector of the economy is under review – internet companies have huge customer bases in the UK (it is estimated that over a third of UK households are Amazon Prime customers, for example) and derive substantial profits from the UK market but there is often no taxable establishment in the UK to which value can be attributed for tax purposes. The UK may currently pick up a certain amount of VAT on the sales but misses out on direct tax, regardless of the amount or proportion of profit derived from UK customers.

In brief, the rules will apply a 20 per cent UK income tax liability on payments:

• relating to the exploitation of IP and other property rights in the UK;
•  to related companies;
• where the recipient company is in a country which does not have a double tax treaty with the UK containing a non-discrimination article.

Payments to unrelated parties or to parties resident in appropriate treaty countries will not be affected.  The current proposals may therefore be of relatively limited application but the UK approach does show an interesting direction of travel and one can imagine the rules being extended more widely in the future.

The application of a flat 20 per cent rate effectively equates to a revenue/turnover tax rather than one based on profits. Whether this is the right approach is, of course, open to question. In the EC's recent proposals for a common consolidated corporate tax base (CCCTB), the EC considered capturing the "digital presence" of a business by reference to benchmarks such as the number of users, digital contracts and the volume of digital content, e.g. personal data, collected for exploitation. These, however, would be factored into the calculation of taxable profits and subsequent allocation of tax liability to countries where the business operates (and require cooperation and agreement between the countries operating the CCCTB model) rather than using the simpler unilateral withholding model currently favoured by the UK. 

While digital businesses are the ostensible target, the proposals are not explicitly restricted in this way and indeed the types of payments in scope will be significantly extended. Other types of businesses, for example those receiving payments in respect of intangible property (IP) used by franchises operating in the UK, might also be caught despite there being no traditional nexus to the UK. 

All multinational businesses, and not just those operating predominantly online, will therefore need to consider the relevance of these new rules to their own circumstances.

What arrangements are affected?

The proposal is described as a "targeted rule" and is not intended to affect whether other types of payment have a UK source for withholding purposes. The simplified structure below illustrates the target of this proposal. 

Broadly, the "mischief" here is a multinational group entering into arrangements to achieve a low effective rate of tax through holding IP in low or no tax jurisdictions and the company exploiting that IP to make sales in the UK market taking a tax deduction for royalty payments against its profits. Under the new proposals, such payments will be deemed to have a source in the UK for the purposes of withholding tax.

As mentioned above, there are two key points to note:

1.  The withholding will only apply where the selling company and the IP company (A and B respectively in the above diagram) are related.

The government proposes to use the participation condition as found within the transfer pricing rules, i.e. that one party participates directly or indirectly in the management, control or capital of the other or another person participates directly or indirectly in the management, control or capital of both parties. Any use of unrelated parties within a structure will be dealt with by way of (as yet unspecified) anti-avoidance provisions.

2.  Although the consultation document refers to "low or no tax jurisdictions", the measure will apply where the payment is made to a jurisdiction with which the UK has no double tax agreement (DTA) or where a DTA is in force but it does not contain a non-discrimination article. 

This approach is also taken in the transfer pricing legislation and dividend exemption and generally provides a relatively reliable proxy for low tax jurisdictions. Nonetheless, there are some jurisdictions with which the UK does not have a DTA but which are not low tax - an obvious example being Brazil. The government acknowledges this in the consultation and asks for views on whether this is likely to be problematic in practice.

Double taxation

There will be a credit mechanism in circumstances where chains of licences and sub-licences with back-to-back payments could result in multiple UK withholding tax liabilities on the same amount but there is currently no provision for alleviating any double taxation that might arise if the payment is made either to a non-low tax jurisdiction with which the UK has no DTA, e.g. Brazil, or if the payer's jurisdiction also imposes withholding tax.

Similarly, where a licence or royalty payment relates to sales in both the UK and other jurisdictions, the proportion of the licence or royalty payment subject to UK withholding should be determined on a just and reasonable basis.

Compliance and liability

The same reporting and payment framework as for existing withholding obligations will be used so far as possible. As this includes an obligation to report payments which would have been within this measure but for the recipient being in a jurisdiction with which the UK has a DTA with a non-discrimination article or where the credit mechanism has been applied to sub-licensing arrangements, a significant additional compliance burden arises - even if no UK tax liability actually arises. This will be particularly hard for groups that have no UK taxable presence at all.

Where the payer does not have a UK taxable presence, there are also potential difficulties in enforcing both the reporting of payments and accounting for the tax withheld. To deal with this issue, the government proposes that the liability will be joint and several so that any liability of a non-UK resident can be paid and collected through any related party with a UK presence – another due diligence point in the M&A context. 

Overall, therefore, these proposals represent a significant shift in the taxation of the international market place and in the approach to and collection of revenue from businesses selling into the UK.  They will impose reporting and payment obligations on companies which, historically, will have regarded themselves entirely outside the UK tax net. They represent, however, probably only the first step in the development of a tax regime which seeks to address the issues associated with the digital economy and the international marketplace.