New royalty withholding rules effective from 28 June 2016

Fri 15 Jul 2016

The government announced at the Budget on 16 March 2016 that legislation would be introduced in Finance Bill 2016 to reform the rules governing the deduction of income tax at source from payments of royalties. At the time, a detailed Technical Note was issued by HMRC covering the various issues.

Of the various reforms, the targeted anti-treaty abuse rule, was introduced with effect from 17 March 2016 (s917A ITA 2007). This denies 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.

However, the other changes were originally intended to come into effect from the date of Royal Assent. However, due to the EU referendum, the timetable for Royal Assent has been pushed back, so rather than delay the introduction of these changes, they will apply to payments made on or after 28 June 2016 (the second of the two days allowed for the Committee of the Whole House to consider selected provisions of the Finance Bill).  A revised HMRC Technical Note has also been issued and the legislation itself will only be introduced at Public Bill Committee to the Finance Bill (which started on 30 June 2016), meaning a further example of legislation being enacted without proper Parliamentary debate (such as the 45% tax on restitution interest enacted last year). The affected changes are detailed below.

Widening the definition of ‘royalties’

The new definition of ‘royalties’ will, for example, now include royalties for the use of trade names and trademarks that are not annual payments. The effect will be that the definition for UK tax purposes will be aligned with the definition of royalties in the OECD model tax treaty. Broadly speaking, this will align the withholding position with the UK’s taxing rights under the relevant tax treaty. This will be achieved by amending sections 906 and 907 ITA 2007. Thus, in determining whether withholding applies sections 906 and 907 ITA 2007, the commentary to Article 12 of the OECD model treaty will be of great relevance.

The current exemption from withholding tax for copyright royalties, in respect of works exported from the UK for distribution outside the UK is retained. Similarly, exceptions for payments in respect of copyrights in films or video recordings (and the sound track if separately exploited) will apply, effectively retaining the current exemptions found at s907(2)(a) and (b) ITA 2007.

Although these rules generally apply to payments made on or after 28 June 2016, there are anti-forestalling rules, which results in arrangements being disregarded if they have a main purpose of avoiding the changes made to sections 906 and 907 ITA 2007. The practical effect is that if a payment has been accelerated in an attempt to avoid the withholding tax arising under the new rules, it will be treated instead if it had been made on the date it would normally have been made. Therefore, if royalty payments have been accelerated it will be necessary to account to HMRC for the withholding tax on the dates it would normally have fallen due.

Changes to source rules for payments connected with UK permanent establishments

The new rules make clear that payments of royalties made in connection with a trade carried on through 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). Thus, where the licence agreement provides for the amount of royalties to be determined by the level of sales, then generally speaking the quantum of royalties with a UK source made by a non-resident will depend on the level of sales by the UK PE (and not profits). If the royalties are not linked to sales, then some other methodology will be needed for establishing the quantum of royalties with a UK source. In all cases, there will be no direct link between the rules under which profits are attributed to a UK PE (s19 CTA 2009) and the rules for determining whether a royalty has a UK source. In other words, whether or not a royalty has a UK source or not will depend on whether the obligation of the non-resident to make the royalty payment is connected to the UK activities – and the question of whether or not it is deductible for corporation tax purposes is irrelevant. So, if activities in the UK fall short of the actual conclusion of contracts with customers, but nevertheless it was the activities of personnel in the UK which led to the sales concerned, they will have a UK source and UK withholding tax will arise on royalty payments attributable to those UK activities. In short, wherever activities carried out by a UK PE have contributed to sales of goods, services or other property by a non-resident, there will be the need to consider the UK withholding tax obligation, as these activities amount to a UK source. New s577A(3) ITTOIA 2005 provides that the apportionment of royalty payments to amounts connected with a UK trade must be computed on a just and reasonable basis, having regard to all the circumstances.

Again, anti-forestalling provisions disregard arrangements put in place before, on or after 28 June 2016 which have the main, or a main, purpose of avoiding these ‘UK source’ changes (so again, payments which have been brought forward in an attempt to side-step these changes, will be treated as made on the date they would have been made absent the arrangements).

More complex are the anti-avoidance provisions intended to counter double tax agreement tax avoidance arrangements. These apply where arrangements are put in place to benefit from specific treaties or the EU Interest and Royalties Directive in an attempt to avoid the new provisions.

Consequential changes are now also being made to ensure that entities subject to diverted profits tax do not achieve an advantage in determining whether a royalty has a UK source (i.e. where royalties are connected with an ‘avoided’ permanent establishment as opposed to an actual one). New s100(2A) FA 2015 prevents relief from diverted profits tax in respect of the withholding tax.