Withholding tax explained

Often overlooked, withholding tax has a habit of surfacing during high-stakes moments like a company sale when buyers conduct due diligence when surprises are least welcome.

Many businesses remain unaware of their withholding tax obligations, with the consequences being costly: unexpected historic liabilities, interest charges, and penalties that have the potential to jeopardise transactions.

What is withholding tax?

Withholding tax isn’t in fact a separate type of tax – it’s a mechanism that HM Revenue & Customs uses to collect tax on certain types of payments. Think of it as a way for the tax authorities to shift the administrative burden of tax collection from themselves to businesses making payments. When a company makes certain types of payments, particularly to overseas recipients, you become responsible for deducting tax at source and remitting it to HMRC.

This system serves a dual purpose. For domestic transactions, it ensures tax collection at the point of payment. For cross-border payments, it provides HMRC with a way to tax non-UK residents who would otherwise be outside their direct jurisdiction, effectively making UK payers act as tax collection agents. 

When does withholding tax apply?

In the UK, withholding tax obligations primarily arise on two types of payments. 

Interest payments: As a general rule, UK companies making payments of UK-source interest must withhold tax at 20%, regardless of where the recipient is based. This catches many businesses that might assume withholding only applies to overseas payments.

Royalty payments: Companies making payments for patents, copyrights, designs, trademarks, brand names and know-how that arise in the UK must deduct withholding tax at 20%. However, certain royalties, may fall outside the withholding tax net.

Which businesses are most at risk?

Withholding tax obligations commonly affect: 

• Debt-funded companies: Businesses with loans from non-UK lenders or even UK lenders in certain circumstances may need to withhold tax on interest payments. 
• Technology companies: Those paying licensing fees for software, patents, or technical know-how. 
• Brand-focused businesses: Companies paying royalties for trademark use or brand licensing. 
• International groups: Subsidiaries making intragroup payments for financing or intellectual property.

The obligation falls squarely on the payer; it is the responsibility of the business to identify when withholding applies and act accordingly.

Can withholding tax obligations be reduced?

There are several routes that can be explored to reduce or eliminate withholding tax.

For UK companies, there are specific exemptions that include: 

• Interest payments between UK resident companies where both the payer and beneficial owner are UK resident. 
• Payments involving UK banks. 
• Certain ‘short-term’ interest on loans not exceeding one year (though this definition can be complex).

Where transactions have an international element, the UK’s extensive network of Double Tax Treaties often provides reduced rates or complete exemptions. However, there’s an important distinction in how these operate: 

• For royalty payments, businesses can often apply treaty relief without prior HMRC approval, provided there is a reasonable belief the relief is due. 
• For interest payments, the relevant paperwork typically needs to be in place before making the payment

The risks of getting it wrong

We regularly see cases where businesses discover historic liabilities, either during company sales or routine compliance reviews. The consequences can be substantial: 

• Historic liabilities: a business remains liable for the tax that should have been withheld. 
• Interest charges: HMRC will apply interest on late payments of withholding tax. 
• Penalties: penalties may apply for historic compliance failures.

As above, these issues frequently emerge during due diligence processes when selling a business. Potential buyers’ advisers routinely examine withholding tax compliance and any shortfalls can delay transactions or impact valuations.

How we can help

Given the complexities involved and the potential for significant liabilities, it’s important that businesses review payment arrangements regularly, particularly for interest and royalty payments.

Businesses should ensure proper procedures are in place before making payments that might trigger withholding obligations,and seek professional advice when establishing new financing arrangements or licensing agreements. Consider too treaty relief opportunities as part of tax planning.

Withholding tax might seem like a technical compliance matter,but getting it wrong can have real commercial consequences. The key is to identify potential obligations early and put the right processes in place.

For further information or advice on withholding tax, please contact us.