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The UK’s Royalties withholding tax consultation: Pushing extraterritorial boundaries

Published on 19/04/18 at 10:49am

Norton Rose Fulbright’s Dominic Stuttaford, James Baillieu and Susie Brain discuss the implications regarding the recent reforms to cross-border royalties.

The UK government has commenced a consultation regarding the scope of the royalty withholding regime applied in the UK. This may have a significant impact on multinational companies operating in the pharmaceutical sector who make UK sales other than through a UK permanent establishment or a UK tax resident entity.

The UK imposes withholding tax on the cross-border payment of royalties. This is deducted at source and is charged at 20%. This reflects the familiar tax principle that non-residents are taxable on certain types of income with a UK source.

This taxing right is then often restricted by Double Tax Treaties (DTTs) which allocate taxing rights between jurisdictions (so that taxpayers do not pay double taxes on their income) or, at an EU-level, by the EU Interest and Royalties Directive, which contains an exemption from withholding for royalties paid between 25% associates in member states. 

Recent reforms

The cross-border tax treatment of payments for intellectual property (IP) and the potential for the use of those cross-border payments to shift profits to low or no-tax jurisdictions was one focus of the OECD’s Base Erosion and Profit Shifting project. It has also been the subject of high profile press reports discussing the taxation of some of the world’s largest multinationals and asking whether they pay a ‘fair’ amount of tax. 

Significant reforms were introduced to the UK’s royalty withholding regime in 2016. These reforms extended the scope of the categories of IP within the withholding tax regime; prior to the change, only a limited number of IP related payments were within its scope. The changes also extended the scope of the regime to non-UK residents making a payment in connection with a trade carried on in the UK through a UK branch or other permanent establishment. This change had significant implications for traditional IP holding structures which are commonly used by multinationals operating in the pharmaceutical sector. Payments between, for example, a US licensee and a low or no-tax jurisdiction in connection with the UK branch were now within scope.

The changes made in 2016 could, in broad terms, be disapplied if there was a DTT in place, provided that the arrangements did not involve the use of a conduit company which received the payment but then paid it on.

Whilst picking up payments made in connection with a trade carried on through a UK permanent establishment, the 2016 reforms did not pick up payments made where there was a non-resident without a UK PE. However, the reforms did not address the question presented by the digital economy of how taxing rights should be allocated in respect of cross-border sales made in the UK without any significant UK presence.

The 2017 consultation

The UK government announced its intention to expand the scope of the royalty withholding regime in the Autumn Budget 2017 and has since launched a consultation. 

The new tax will apply from April 2019 to royalty and certain other payments, such as franchise fees, made between related parties for the exploitation of IP or certain other rights in the UK, regardless of whether the payer has a taxable presence in the UK. This will extend the types of payment potentially subject to UK tax to include payments for the right to distribute goods or to provide services in the UK (but not to the payment for the provision of the services themselves). At its most simple, the proposals would pick up, for example, an EU licensee making UK sales of a drug while paying a royalty (in respect of the IP) to a licensor in a low tax jurisdiction (see below).

The stated target is arrangements that achieve a low effective tax rate through holding IP in low or no tax jurisdictions. To achieve this, the consultation proposes that the new tax only applies to payments made to jurisdictions with which the UK does not have a DTT with a non-discrimination article. However, this does not go far enough to restrict the scope as intended and structures which do not give rise to a low effective tax rate may be caught unless the proposals are revised. Some jurisdictions without a DTT, for example, Brazil, are not seen as tax havens but payments to these jurisdictions would nevertheless be subject to the withholding as currently proposed. 

The tax applies to payments between related parties. Examples provided in the consultation document are of payments made between members of multinational groups but the scope is potentially wider than that. The proposal to define the concept of payments between related parties by reference to the participation condition adopted by the UK transfer pricing regime means that payments between a joint venture vehicle and its participants or, for example between substantial portfolio investors would potentially be within scope. The participation condition relies on concepts of control which in turn import complex underlying tests of connection which are difficult to apply. However, in the transfer pricing realm the overlay of the requirement that the transaction is on non-arm’s length terms provides some level of comfort as arm’s length terms might be expected between parties without the requisite level of connection. By importing the transfer pricing terminology, it may be hard for some parties to determine whether or not they are within scope.  

Another issue is that a single licence may cover a wider geographic area, which raises questions as to how the underlying payment itself is calculated. Determining the tax charge will require apportionment of the payment between the UK and other jurisdictions involved. Allocation by reference to sales made in the UK is suggested as the default method, reflecting how royalties are commonly calculated under the terms of a licence, but it is acknowledged that this may not always accurately reflect underlying commercials and that it may be appropriate to use some other ‘just and reasonable’ allocation. How much leeway there will be in practice remains to be seen. 

There will also be an anti-avoidance rule which will apply to payments made under arrangements seeking to avoid the tax. There is no grandfathering for arrangements in existence before April 2019. The new rules (and anti-avoidance provision) will catch new and existing structures alike so it is important that companies revisit their existing IP holding structures. It will not come as a surprise that the simple insertion of parties in favourable DTT jurisdictions will be counteracted. The consultation suggests that the terms of a DTT will be ignored where arrangements are designed to obtain a tax advantage contrary to its object and purpose. The example given here by HMRC is of the artificial insertion of a conduit in a jurisdiction with which the UK has a DTT.

The imposition of royalty withholding tax where payments are made to jurisdictions without a DTT with the UK may cause multinationals to revisit whether valuable IP should be developed and retained in a territory with whom the UK has a suitable DTT or indeed in the UK itself. Groups with a US parent or significant US operations may in any event be looking at their structures in light of the US tax reforms

Sub-licencing 

Without more, the proposals would have the potential to impose a charge at each level where there is a sub-licence of IP rights to an entity that does not benefit from exemption. To address this, the consultation anticipates a credit system under which credit would be given for tax on payments for the same IP and rights so that, effectively, the amount of withholding tax suffered will be determined by the highest payment made in that chain.

Collection

The imposition of tax liabilities on entities without any taxable UK presence always raises the question of how it will be collected. The proposal is to make related parties joint and severally liable for the tax payable. This means that any liability of a non-resident can be collected in full from any related party with a UK presence. This joint and several liability would also extend to penalties in respect of underlying reporting obligations. Assuming that the reference in the consultation document to “related parties” is again to be determined on the basis of transfer pricing participation condition, this could impose liability on entities outside the multinational group itself, posing difficult questions for those trying to identify potential risks and liabilities.

Before being implemented the proposals may be refined in response to concerns raised by companies and the tax community. Nevertheless, the direction is now settled so multinationals making UK sales other than through a UK permanent establishment or tax resident entity will need to watch closely how the proposals are finalised before considering whether changes need to be made to their IP holding structures.

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