Tax withholding

Withholding tax is an amount withheld by the party making payment to another (payee) and paid to the taxation authorities. The amount the payer deducts may vary, depending on the nature of the product or service being paid for. The payee is assessed on the gross amount, and the tax to be withheld (the withholding tax) is computed in that assessment. The purpose of withholding tax is to facilitate or accelerate collection, by collecting tax from payers rather than a much greater number of payees, and by collecting tax from payers within the jurisdiction rather than payees who may be outside the jurisdiction. It may also be used to counteract tax evasion and tax avoidance.

Domestic withholding

Domestic withholding tax is often applied to earned income in circumstances where the payee might otherwise avoid declaring the income earned, for example when people work on a contract basis - neither as a registered business nor as an employee. Some countries require the employer to withhold a percentage of that person's income and submit it to the tax authority. In these circumstances, the payer is usually a business and would normally have to submit details of the identity of the person from whom tax has been deducted.

Domestic withholding tax is also applied to interest and/or dividend payments, typically at standard rate and paid directly to the Revenue authorities. This secures immediate payment of at least a substantial proportion of the tax due. In some jurisdictions, individuals whose total income does not exceed the higher rate tax threshold need not then complete a tax return.

Dividends

Tax may be deducted at source from dividend payments, in addition to Corporation tax. In the United Kingdom, tax is not withheld at source, but the recipient is given a "tax credit" on the dividend statement, which has the effect that a basic-rate taxpayer has no more tax to pay: higher-rate tax-payers have further tax to pay. The tax credit once represented advance corporation tax paid by the company, however this was abolished in 1999.

Interest

A minimum rate of tax may be deducted at source from savings interest payments. In the United Kingdom, tax is withheld at source unless the saver submits an R85 form (if a domestic non-taxpayer) or a R105 form (if a non-resident) to claim exemption. In the Republic of Ireland, the tax is known as Deposit Interest Retention Tax or "DIRT".

The United States is unusual in that it does not generally require withholding tax on payments to citizens and residents, other than wages and salaries. However, payers are required to apply backup withholding if the payee has failed to provide a proper Tax Identification Number, or if the payee has failed to report income in previous years.^[1]

Employment

In most jurisdictions, employers are required to deduct tax from salary. (See Tax withholding in the United States, PAYE and Internal Revenue Code 3401). In contrast, in some jurisdictions such as the United Kingdom self-employed individuals pay income tax after the end of the year. In the United States, self-employed individuals are required to pay estimated tax each quarter or face interest.

Contract and consultancy work

In some jurisdictions, basic rate taxation is withheld from contract and consultancy payments. The consultant may continue to be liable for higher rate tax on the remainder.

International withholding

International withholding tax is applied when the payer is making a payment to another party in another country and the payment is either for financing or for use of intellectual property. Payments for financing are usually dividends or interest, while payments for the use of intellectual property or expertise are royalties, licence fees and management fees.

Dividend withholding tax

If the shareholder is not resident in the same country as the payer, the payer may be required to apply withholding tax to dividends, even if (as in the USA) withholding tax is not required on dividends paid to domestic shareholders.

The United Kingdom does not impose withholding tax on dividends paid to non-residents.

A double taxation treaty may reduce the amount of withholding tax required, depending upon the jurisdiction in which the recipient is tax resident.

Interest withholding tax

Some countries do not require withholding tax to be applied on interest paid, in order to encourage foreigners to deposit funds with banks or other institutions in that country.

However, many countries impose a withholding tax under domestic law on any payments of interest made to non-residents. The rate of withholding tax to be levied may be reduced or eliminated by a double taxation treaty.

European Union

In the European Union, some member states offer savers in other member states a choice of withholding tax or a report to the tax authority in the saver's home country^{[citation needed]}. A similar rule applies to savings of European Union residents held in certain territories outside the EU, which have entered into agreements with the EU.

Under the Interest and Royalties Directive^[2], no withholding tax should be levied on interest payments made by a resident of one EU member state to a resident of another EU member state. However, certain jurisdictions have obtained consent from the European Union to operate transitional arrangements which allow them to levy withholding tax on interest payments to residents of other EU member states for a specified period only^[3]. These include Latvia, Poland and Lithuania which acceded to the European Union in 2004.

Avoidance of interest withholding tax

Many multinational groups have a requirement to finance overseas subsidiaries with interest-bearing debt which may give rise to tax leakage where withholding tax is levied on payments of interest.

Debt instruments may be structured to fall outside domestic withholding tax provisions, for example by allowing for a return to the lender which does not constitute interest. For instance, some United States tax residents lending to United Kingdom tax residents choose to utilise an original issue discount note, on which interest is not paid but the redemption price on the loan note gives an economic return for the time value of money in relation to the loan principal.

Real estate

The United States of America's legislative body authorized the IRS to apply a withholding income tax on nonresident aliens and foreign corporations selling US real property interests.^[4]

References

[1] IRS Publication 505

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[4] IRS

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