Withholding Tax: A Quick Summary
To understand the concept of withholding tax, it might be convenient to again put yourself in the position of the government. Let us consider an example of a foreign mining company in the developing country of Zambia.
The mining company would come into Zambia and use residents to extract the minerals from the mines, by almost any definition an economic activity that would create source-revenue taxation in the country where the mines are located. However, no tax is collected.
Why? In an International Monetary Fund (“IMF”) policy paper entitled “Tax Policy for Developing Countries”, the authors cite several causes including:
- Untraceable payments being made in cash
- Lack of sophistication and education of local tax authorities
- Inability to generate reliable statistics
- Disproportionate political power wielded by the wealthy that benefit from cooperation with the foreign mining company. [2]
The government of Zambia ends up becoming the biggest loser in this situation.
The motivation for governments to apply WHT is to ensure that the country receives some tax revenues from the economic activities of companies operating within its borders.
Withholding tax, in a general sense, is an emergency-brake mechanism for governments to ensure that they collect an appropriate amount of tax on transactions within their jurisdictional reach.
It is considered a “retention tax” that safeguards the ability to collect revenues at a point in time that is still feasible for the government, including several types of taxes, including payroll, social security, unemployment, and in the case of this article, cross-border withholding.
In a practical sense, WHT is a tax that is immediately applied at the source before a transaction is completed.
As explained in the preceding example, the complications of WHT can become much greater in developing countries than in developed (OECD) countries.
The UN Model Convention was created as a protection against developing countries’ interests by shifting the source of income more easily to the developing country (for example, the threshold for a permanent establishment is lower). In theory, the text of the Model Convention does exactly what it intended to do.
In practice, Tanzi and Zee proclaim that tax policy in developing countries is “often the art of the possible rather than the pursuit of the optimal.” [3] Developing countries are often bound by the positions of larger governments. Moreover, even if the income is sourced to the developing country, do they have the ability to collect on it?
From the perspective of the government, it is fairly easy to see the complications that they would have in collecting tax revenues from foreign businesses.
Particularly in countries without developed legal systems that are capable of pursuing income once it has left its borders, this is even the more problematic. This is exactly the reason that the concept of cross-border WHT has become embedded in international tax laws around the world.
About the author: Christian Wunderley, LL.M. is an international tax consultant and Managing Partner of the U.S tax firm, CD Tax Associates. He has several years of experience working in both financial services and international tax, including firms such as PricewaterhouseCoopers, BDO, and Citigroup. His specializations include withholding tax, particularly for non-U.S. businesses and investors that want to invest in the United States.
[2] Tanzi, Vito; Zee, Howell. “Tax Policy for Developing Countries.” 2001, International Monetary Fund.
[3] Tanzi, Vito; Zee, Howell. “Tax Policy for Developing Countries.” 2001, International Monetary Fund.
