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 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.
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 (ACT) paid by the company, but ACT was abolished in 1999.
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.
The United Kingdom does not impose withholding tax on dividends paid to non-residents. However, since January 1 2008, the UK has imposed a 20% withholding tax on distributions from REITs (Real Estate Investment Trusts).
A double taxation treaty may reduce the amount of withholding tax required, depending upon the jurisdiction in which the recipient is tax resident.
However, many countries impose a withholding tax on interest payments to non-residents. The rate of withholding tax may be reduced or eliminated by a double taxation treaty.
Under the Interest and Royalties Directive, no withholding tax should be levied on interest payments made by a company resident in one EU member state to an associated company resident in 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. These include Latvia, Poland and Lithuania which acceded to the European Union in 2004.
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 withholding tax provisions, for example by allowing for a return to the lender which does not constitute interest. For instance, a lender may choose to utilise an discounted note, on which no interest is 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.
The EU Interest and Royalties Directive applies to payments made by a company resident in one EU member state to an associated company resident in another EU member state, such that no withholding tax should be levied (subject to the transitional arrangements as described above in relation to interest).
The tax withheld from a payment may be more than the recipient's tax liability in the country where the tax is withheld. This may be because
In these circumstances the recipient will need to file a tax return or other claim form in the source country, to recover the tax overpaid. Procedures and time limits for refund claims vary considerably.
Some countries permit the withholding tax itself to be reduced, thus avoiding the need for the recipient to file a refund claim. It is generally necessary to file documentary evidence of the reduced liability, for example evidence of residence if the liability is reduced by a tax treaty.
The recipient may be liable to tax on the income in his home country, but will be able to claim a credit for the withholding tax paid and not refunded or refundable. Some countries exempt income which has been taxed in another country.