Deduction of tax at source from royalties

The Chancellor has announced in his 2016 Budget that the Government intends to introduce legislation in Finance Bill 2016 to ensure that all royalties arising in the UK will be subject to the deduction of income tax at source unless the UK has explicitly given up its taxing rights under an double tax agreement; it will also be necessary to prove that the arrangement was not set up for a tax avoidance purpose, such as treaty shopping.

The first change will be to introduce a purpose based anti-avoidance rule to counteract arrangements involving the use of double taxation agreements. The Government considers that arrangements have been implemented by groups to hold their IP in jurisdictions as a result not of commercial considerations but based on where there is an appropriate double tax treaty, which disapplies the existing UK withholding tax obligation.

The new provision is modelled closely on the OECD anti-abuse rule (principal purpose test) that was designed as part of the OECD/G20 BEPS project. That rule is supported by commentary that explains how the rule will operate and how it is to be interpreted. The Government have confirmed HMRC will follow that commentary. This rule will apply to payments of royalties made between connected parties and will apply to payments made on or after 17 March 2016. Draft legislation has been published which imposes a double requirement. First, there cannot be a main purpose of obtaining a tax advantage and secondly the obtaining of a tax advantage cannot be contrary to the object and purpose of the provisions. Applying these tests is notoriously difficult; some of these issues come across in the examples given by HMRC in their Technical Paper on the changes. They state the fact that the licensor has a substantive operation in its jurisdiction will not of itself be enough.

The use of domestic measures in a treaty context has been tried before by the UK; it is interesting in a BEPS context as it marks another example of the UK seeking to introduce BEPS related measures into domestic law before the necessary international changes have been made.

The new rule applies to any payments made on or after 17th March, even if the license was in force before the date of the changes.

Secondly, changes will be made to widen the class of royalties that require the payer to withhold tax from the royalty payment and the new definition will, for example, now include royalties for the use of trade names and trademarks that are not annual payments with the definition of royalties in the OECD model tax treaty which the Government hopes will simplify the rules relating to royalties. The UK withholding tax rules on payments has historically had a piecemeal approach to the type of payments that are covered (such that there is only a withholding tax obligation if the payment is an “annual payment”; many payments made to an IP company that carries on a trade of developing and exploiting IP are currently likely to fall outside this definition). In the future, however, they will be subject to withholding unless the charge is relieved under a double tax treaty or the EU Interest and Royalties Directive. Unlike the first change, this will apply even if the licensor is not a group company.

The measure will apply to payments made on or after Royal Assent to the Finance Bill 2016, however, an anti-forestalling rule will be introduced to ignore the effect of payments being accelerated and to counteract the effect of any other arrangements put in place on or after 16 March 2016 to avoid the application of the changes.

Finally, changes to the Taxes Act and consequential amendments to the Diverted Profits Tax (DPT) will be introduced in the Finance Bill 2016 to provide a clear rule to determine whether a royalty has a UK source. A royalty that is connected with a permanent establishment (PE) that a non-UK resident person has in the UK, or an “avoided PE” for the purposes of the DPT, will be considered to be from a source in the UK.

The Government have clarified that it is only the proportion of the royalty payable in respect of sales made through the UK PE that will relate to the activities of the UK PE. The proportion of the royalties paid by the non-resident with a UK source will be calculated on a just and reasonable basis of the proportion of the total income that arises in connection with the part of the trade that is carried on through the UK PE. Apportionment of the royalty in the case of an “avoided PE” would be calculated on the same basis as for an actual PE. The measure will apply to payments made on or after Royal Assent to the Finance Bill, however, an anti-forestalling rule will be introduced (same as above).

While it is true to say that some of these changes will simplify the position, they mark a striking change to the UK tax rules on cross-border payments for IP and a deliberate attempt by the UK Government to extend the withholding tax net. Both multinational groups who have put IP holding structures in place and companies who pay royalties to non-UK licensors should look to see if they are going to be impacted.