—–For general audience—-–
Withholding tax in general
Withholding tax (WHT) is a tax collection mechanism to withhold tax from interest, royalty or dividend payment. It is a tax country sourced income and often a pre-payment of corporate income tax. In principle, the tax is withheld from the company that makes the interest, royalty or dividend payment, but levied from the recipient. This is applicable for domestic and international transactions.
By Shining Lin
With help from:
Hiromi Nakayama (l) and Jiaxin Huang (r)
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If both the payer and the recipient are in the same jurisdiction as tax residents, the payer is obliged to withhold the tax on the gross payment and remit the tax withheld to local tax authority. For example, interest made by a bank to local entities or individuals on bank deposits is subject to income tax withholding. Dividend paid by a local entity to a local individual is subject to income tax withholding. Domestic WHT rates apply according to the type of payment made.
For international transactions whereby the payer and the recipient are in different jurisdictions, the practice is the same as in the case of domestic transactions. Non-resident companies (or individuals) are levied on income considered to be sourced from the resident country. Resident companies (or individuals) are obliged to withhold the income tax and pay to the local tax authority on behalf of the non-resident. For example, for international loans, WHT on loan interests are often borne by the borrower in loan agreement. This is because the banks only quote net interest rate.
Double taxation may occur in international transactions, whereby the same interest amount is taxed twice. For example, the interest payer pays WHT of interest in payer’s tax jurisdiction, while the interest recipient pays the corporate income tax for the same interest income in its jurisdiction for the tax year. Tax treaties mitigate such double taxation by giving exemption or reduction of WHT to the interest payer, in case the interest recipient is located in certain jurisdictions.
Netherlands has double tax treaties with over 90 countries worldwide, which gives exemption or reduction of WHT rate.
In general, for interest payment of loan/overdraft from banks (in the Netherlands), cost saving can be achieved if tax treaties offer more favourable or 0% WHT rate. In other situations, however, the Netherlands applies a conditional WHT (according to the Conditional Source Taxation Act as of 1st January 2021). For example, conditional WHT applies to interest and royalty payments to affiliated companies in designated low-tax jurisdictions and in certain (tax abuse) scenarios.
Comparison of total cost: cash pool borrowing vs. intercompany borrowing
There are different forms of cash pool. The nature of the cash pool (banking arrangement or related party borrowing) determines the classification of transactions in the pool. If the cash pool structure is a banking arrangement, the transactions (deposit or overdraft) in the cash pool are classified as bank deposit or bank borrowing. In this article, we discuss cash pool borrowing with bank in the Netherlands as counterparty.
In a cash pool whereby the borrowing entity and the bank are residents of different jurisdictions, the entity pays overdraft interest to the bank. The entity is obliged to pay the WHT of overdraft interest to local tax authority within the stipulated timeframe. This is because the bank directly debits net interest amount from the entity’s account. Also, the bank is not recognized as a tax resident by local tax authority in the borrower’s jurisdiction. Thus, the entity needs to pay WHT at their cost (unless the tax treaty exempts the WHT). Assuming the WHT rate is 10%, the following chart indicates the total cost of the entity: net interest amount (90% of total cost) plus WHT (10% of total cost).
There is perception that the costs of cash pool borrowing and intercompany borrowing with the same amount are different. To compare the costs, we take an example of a cash pool in the Netherlands, whereby a Hong Kong HQ and its Indonesia subsidiary both have USD accounts.
Hong Kong HQ places USD100 credit balance with the bank, and Indonesia subsidiary borrows USD100 from the bank. The same interest rate, for example, 2% is applied for the deposit and borrowing. The bank directly debits the overdraft interest from the account of Indonesia subsidiary. The bank doesn’t gross up the interest for the purpose of WHT payment since the entity takes care of the payment to local tax authority.
The bank pays credit interest 2 to Hong Kong HQ. The bank receives debit interest from Indonesia subsidiary for the same amount. WHT rate is 10%. In this case, while the interest payment from Indonesia subsidiary to the bank is 2, the Indonesia subsidiary will have to pay the WHT 0.22 (= 2 / (1-10%) – 2 ) to local tax authority in Indonesia. Total cost (WHT inclusive) as a group to use the cash pool to fund Hong Kong HQ is -0.22 (= +2.00-2.00-0.22).
Now we change the above example into an intercompany borrowing scenario. Indonesia subsidiary borrows USD100 directly from its Hong Kong HQ. For intercompany loan, the interest payer (Indonesia subsidiary) withholds a percentage of interest amount as WHT (to be paid to the tax authority in Indonesia) and remits the rest as interest payment to the lending entity (Hong Kong HQ). In this example, the interest rate will be grossed up to 2.22% to accommodate the WHT payment. Intercompany interest amount paid by Indonesia subsidiary is 2.22, among which 2 (90% of 2.22) is paid to Hong Kong HQ as interest and the remaining 0.22 (10% of 2.22) is paid to tax authority in Indonesia as WHT.
The interest rate of Indonesia subsidiary when borrowing from Hong Kong HQ is higher than borrowing from the cash pool, to accommodate WHT payment. However, the total cost in the two scenarios is the same.
WHT tax cost of cash pool and Corporate Treasury Center (CTC) solution
Banks are often (although not always) exempted from interest withholding tax. For this reason, to make tax administration simple, a bank loan may be used to replace intercompany loan in case that bank loan levies no or lower withhold tax rate.
Treasury centres often have small profits out from intercompany loans, typically net interest margins may be between 0.5% and 1.0%. This is often insufficient to generate an amount of corporate income tax that can offset withholding tax credits (WHT tax rate is between 5%-30% or higher) which are associated with intercompany borrowings. This can make the interest rate of intercompany loan higher than that of bank borrowing from a cash pool.
One way to mitigate the impact of withholding tax is to denominate intercompany loans in currencies that have very low interest rates, therefore lowering the interest amount and consequently the WHT amount. A foreign exchange swap can be used to cover the currency risk. However, in some jurisdictions this might run up against general anti-avoidance provisions.
Certain jurisdictions encourage regional Corporate Treasury Center (“CTC”) setup to attract liquidity by introducing favorable income tax rate for income derived from intercompany borrowing, since the tax authority recognizes WHT cost as an irrecoverable cost and a material additional expense in intercompany funding. Corporate Treasurers shall carefully examine (1) the reduced income tax paid by CTC and (2) WHT cost of all borrowings with CTC entity. The combination of (1) and (2) should be used to compare with WHT cost associated with borrowing from the cash pool.
Conclusion
WHT tax is in principle withheld from the company that makes the interest, royalty or dividend payment, but levied from the recipient. This applies to domestic and international transactions. In international transactions, double tax treaties which offers more favorable or 0% WHT rate save cost for the involved companies.
When treasurers assessing the cost of cash pool borrowing and intercompany borrowing, they shall take into account WHT payment as part of the cost. Thin profits of treasury centers from intercompany loans are sometimes insufficient to offset WHT cost. Thus, certain jurisdictions encourage regional CTC which offers favorable income tax rate for the income derived from intercompany loans. When comparing the benefits of using intercompany loans via CTC or borrowing from a cash pool, treasurers shall not only look at saved income tax, but also assess WHT cost.
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Featured image: Hong Kong (Photo: Jiaxin Huang).
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