Deduction of Income Tax at Source from Royalty Payments

Fri 01 Apr 2016

One of the key developments announced at the Budget on 16 March 2016 concerned provisions to widen the withholding obligation in respect of payments of royalties.  This is aimed at multinationals which have arrangements in place to reduce taxable profits in the UK through payments in respect of IP owned overseas. 

The Technical Note issued by HMRC on Budget Day, provides details of the changes in three key areas:

• A targeted anti-avoidance rule denying treaty benefits for royalty payments between connected persons where there are ‘treaty shopping’ arrangements in place so that royalties are routed via a conduit company so that the royalties are ultimately paid tax free to a tax haven company;
• Widening the definition of ‘royalties’ so that the withholding tax obligation covers payments made in respect of intellectual property previously not caught unless they were ‘annual payments’, such as tradenames and trademarks;
• Providing a statutory definition make clear that payments made in connection with a UK permanent establishment (PE) or ‘avoided PE’ under the diverted profits tax rules will have a UK source (and hence a withholding obligation as a result). 

Draft legislation has now been included as Clause 40 in the revised draft Finance Bill, issued on 24 March 2016 in respect of the anti-treaty shopping changes.  This will insert new s917A into ITA 2007, and this will apply to payments made on or after 17 March 2016. 

Draft provisions for the other two points is included in HMRC’s Technical Note, but has not yet made it into the draft Finance Bill 2016.  HMRC has stated these will be introduced later in the Finance Bill 2016 process, most likely at the Report Stage, and the intention is that these changes will then apply to payments made on or after the date of Royal Assent.  Comments are invited on the Technical Note by 29 April 2016.

Anti-treaty shopping arrangements

New section 917A arrangements’ ITA 2007 ‘Tax avoidance arrangements’ will apply where a royalty payment is made to a connected person and the payment is made under ‘DTA tax avoidance arrangements’. Where this section applies, treaty benefits will be denied, so withholding tax will be payable which will not be deductible for corporation tax purposes.   

‘Connection’ for this purpose is directly imported from the transfer pricing rules. The term ‘arrangements’ is its usual wide definition, such that it includes any agreement, understanding, scheme, transaction or series of transactions, whether or not legally enforceable. ‘DTA tax avoidance arrangements’ is then specifically defined as arrangements where, having regard to all the circumstances, it is reasonable to conclude that the main purpose (or one of the main purposes) is to obtain a tax advantage by any provisions of a double taxation agreement, and that obtaining that advantage is contrary to the object and purpose of the treaty. 

Examples of the sorts of arrangements targeted by this new provision are provided in the Technical Note:

• Conduit arrangements – where royalties are first paid from the UK to a connected person in a territory which has a DTA with the UK, but then paid onwards, directly or indirectly to an affiliate elsewhere with a main purpose of gaining a treaty benefit (i.e. a reduced or zero rate of withholding tax).
• Where a multinational group assigns IP to an affiliate in a country which has a DTA with the UK, such that taxing rights over royalties are with the recipient territory (i.e. residence state).  As it stands, the Technical Note envisages that even if the recipient company has substantive operations, such as a large R&D function, if one of the main purposes of the IP transfer was to obtain a tax advantage, then new s917A would apply.   

Whereas the first bullet point deals with arrangements channelling royalties into tax advantaged locations (albeit potentially for good commercial reasons), the second scenario deals with much more commonplace and commercially driven business arrangements to hold IP in a central location for a number of reasons. Clearly HMRC has got fed up of IP being exported from the UK into offshore territories – where IP can be exported where it is still under development and its market value low, so that any ensuing exit charge from the UK is minimised.  The only way out of new s917A now will be if the taxpayer can show that either no tax advantage is obtained or that any such advantage is in accordance with objectives of the DTA.  

However, in many cases there will be a tax advantage, even though it is not the driving force behind the transfer of IP, so there should be a motive test included. 

An example given in the Technical Note of where s917A would not apply is a group reorganising offshore held IP (with taxing rights on the royalties in that offshore territory) into an offshore regional hub, and choosing the territory for the hub to be another territory which also has taxing rights over the royalties, as opposed to one where taxing rights would fall to the UK (the source state).

A further example is an MNC looking to set up an R&D centre in a European subsidiary, where that subsidiary would develop its own IP through its own staff and license the ensuing rights group and third parties.  In choosing the location of that hub, one factor taken into account might be the terms of the DTA between different territories and the UK.  However, as that subsidiary will have substantive operations, the Technical Note concludes that treaty benefits would likely be in accordance with the objectives of the DTA.   

Thus, in common with other BEPS driven initiatives, the importance of substance in determining tax outcomes is paramount, as opposed to simply the legal ownership of IP.   UK groups wishing to locate IP offshore are best placed by deciding that at the outset and developing in a suitable offshore location: exporting it later is now likely to come with an ongoing withholding tax obligation.

Widening the definition of royalties

Currently, withholding tax applies to the following types of IP (subject to override by the relevant DTA or EU Interest and Royalties Directive):

• Copyright (with restrictions);
• A right in design;
• Public lending right in respect of a book;
• Royalties etc. in respect of the use of patents;

• Payments of royalties etc. that are annual payments. 

Withholding tax only currently applies to IP like trademarks and tradenames if they are ‘annual payments’, so the proposed revision is to ensure that a withholding obligation arises on different types of royalties regardless of whether they are ‘annual payments’ or not. This would thus widen the types of IP to which withholding tax must be applied.  Affected royalty payments could nevertheless still be made gross, or at a reduced rate of tax under the relevant DTA, with the proviso that treaty benefits would now depend on not falling foul of new s917A ITA 2007 (so it would be necessary for the payer to reasonably believe that the payee is entitled to relief under the DTA). Although these changes will apply from Royal Assent, an anti-forestalling rule will counteract measures taken on or after 16 March 2016 e.g. to prevent groups from accelerating royalty and other IP payments which will now attract withholding tax to before Royal Assent.

Change of source rules- amounts connected with permanent establishments

In order for a withholding tax obligation to arise on royalties, the royalty income must have a source in the UK (s577(2) ITTOIA).  A change will be made specifically so that a payment made by a non-UK resident will nevertheless have a UK source (and thus a withholding obligation, subject to treaty override) where:

• The payer is a non-UK resident carrying on a business in the UK through a PE in the UK (including an ‘avoided PE’ under the diverted profits tax regime) ; and
• The obligation of the non-UK resident to make the payments (or part of them) arises in connection with the business of the non-resident carried on through its PE in the UK.  

Where royalties payable are determined by the level of sales, then the quantum of royalties with a UK source will be established by reference to the level of sales made by the UK permanent establishment.  Where the royalties are determined other than by level of sales, it will be necessary to consider other factors, but the key is that the royalties must arise from or be connected to activities carried out in the UK by the UK PE for there to be a withholding obligation.   So for example, if a non-resident company has a UK branch which sells goods or services, any royalty paid by the non-resident company in respect of those UK activities will have a UK source.  Determining the quantum of royalties to which there is a UK source under this rule will not always be as straightforward, but it will be necessary to calculate it on a just and reasonable basis.

It would not have made sense if this rule had only applied to actual UK PEs, and not activities which attempt to fall short of amounting to PEs, and which are caught as ‘avoided PEs’ by the diverted profits tax – so it is unsurprising to see this factored in. It is also proposed that the notional profits of an avoided PE for diverted profits tax purposes should include royalties that would have had a UK source, had there been an actual UK PE.   However, those notional profits would then be reduced on a just and reasonable basis if treaty relief would have been forthcoming on the royalty payments if the PE had been a real one, rather than an avoided one.

Again, anti-forestalling rules apply to counteract arrangements put in place on or after 16 March 2016 in an attempt to avoid these changes.  Certain pre-existing arrangements put in place to take advantage of other countries’ DTAs may also be affected – so ‘contrived’ arrangements cannot be relied upon to avoid UK withholding tax obligations by circumventing the new rules.