Withholding tax obligations for royalties and grossing up clauses

Fri 15 Jul 2016

At this year’s Budget on 16 March 2016, it was announced that a number of changes would be made to extend the scope of withholding tax on royalties. There are three key areas of change:

• 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 making it 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).

Currently, a withholding obligation only arises on payment of certain types of intellectual property, such as trademarks and trade names, if they are ‘annual payments’.  The meaning of the term ‘annual payments’ has been determined by case law as being payments which represent ‘pure income profits’ for the recipient (there are further essential features of annual payments; payable under a legal obligation that extends for more than a year, but these are not of direct concern as regards this note).  The effect of this is that where the recipient incurs business expenses in generating the income from intellectual property, the profits will not be pure income profits so the payments of the royalties would not be annual payments, hence not subject to withholding tax.   Changes to be included in Finance Bill 2016 will ensure that a withholding obligation arises on different types of royalties regardless of whether or not they are ‘annual payments’. More details are expected to be released at the Report Stage of the Finance Bill 2016 and the withholding obligation that will apply to a greater range of royalty payments will come into effect from Royal Assent, most likely this autumn.

Where a withholding obligation arises, tax must be withheld at 20% when payments are made to non-residents, although the rate may be reduced to nil under either the relevant double tax agreement or the EU Interest and Royalties Directive (subject to anti-avoidance such as the new anti-treaty shopping rule to be introduced at s917A ITA 2007, which would deny treaty benefits on royalty payments to connected parties under arrangements which include a main purpose of taking advantage of a double tax treaty that is not in line with its object and purpose).  Note also that 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.

An important implication of the widening of withholding obligations is the effect of ‘grossing up’ clauses in intellectual property licensing agreements.  If a withholding tax obligation now arises, such a grossing up clause will require the UK payer to compensate the recipient for the withholding tax suffered.  Therefore, UK businesses paying royalties overseas should assess whether treaty claims are needed to reduce or eliminate the withholding tax.  The widened scope of royalties should also be borne in mind in future licensing agreements, so that if, in economic terms, the risk of the cost of withholding tax rests with the UK payer, that both parties are obliged to ensure that appropriate treaty benefits are applied for.