If a UK company is used to provide services overseas the payments made to the UK company by the client could be liable to withholding tax under the national tax law of the client’s country. Many countries apply withholding tax to a wide range of payments made to foreign companies. This should be checked before structuring the contract. Although double tax relief is available in the UK for tax paid abroad the tax could normally only be offset up to the amount of the UK tax liability. If the foreign withholding tax exceeds the UK tax liability on the profits from the overseas contract the excess will effectively be an additional tax liability. This is quite likely to be the case because the foreign withholding tax will be applied to the gross amount of the payment whereas the UK tax liability is computed on the net profit. Some double taxation agreements may reduce the amount of withholding tax that may be deducted at source from certain types of service fee (for example technical services).
Many countries impose withholding tax on payments of dividends, interest, royalties, technical service fees, management fees or other payments made to non-residents. The withholding tax generally applies to the gross amount of the payment, at rates that are often 20% or more. Even though double tax relief is available in the UK, the amount of tax withheld is often more than the amount that can be offset against UK tax on the income. The amount that cannot be offset is effectively an additional tax charge. Also, there may be a cash flow problem resulting from the time that elapses before any amount can be recovered by offset against UK tax.
In addition to the above types of withholding tax some countries also impose a branch profits tax, deducting a percentage of any remittance of profits from a branch to its non-resident head office. Although some double tax relief is available in the UK this still represents a cash flow disadvantage and potentially an increase in the overall amount of tax payable on the profits. The double tax treaty should be studied for any limit on charging the branch profits tax.
In drawing up the contract for services, the service provider should give some thought to the possibility of using a local company, such as a subsidiary of the UK company, to contract with the end client and then make the payment to the service provider in the host country. There may then be no withholding tax on the payment made within the host country (depending on the local tax law) and withholding tax would only be charged on any amount remitted to the UK.
About the author: Peter Hann is an accountant based in Croydon, UK who specialises in international taxation.