Here is another post written by John Garcia, CPA and Masters in Tax:
The Easy Answer
California CPA: June 2013
An Integrated Database Solution to Global Withholding Compliance
By John P. Garcia, CPA & Timothy C. Hart, CPA
As more companies—even relatively small ones—go global, setting up businesses and customers is almost always the first order of business. Many of the administrative functions, such as tax compliance, follow later—sometimes much later. Often, foreign affiliates are created to facilitate business overseas. A myriad of business transactions flow from this global effort. These transactions often have tax consequences, which are not immediately apparent.
While there are many tax consequences that can result from a global business, we’ll address withholding taxes, which apply to many transactions, and the rules and the withholding tax rates are always changing.
For example, 23 of 30 Organization for Economic and Co-operation Development countries routinely apply withholding requirements on a final, or creditable, basis to payments of dividend and interest income to investors.
To gain insight on this dilemma, it’s necessary to discuss some of the real-world scenarios. This includes the risks and opportunities generally describing how withholding tax works on a global basis and describing why the integrated database approach is the best solution for withholding tax compliance.
Let’s use two typical intercompany scenarios.
The Intercompany Loan Balance
Your domestic company purchases product from a third-party manufacturer for ultimate delivery to a foreign subsidiary. The sale to the foreign subsidiary creates an intercompany payable between the domestic company and the foreign subsidiary. If this intercompany balance is not paid within a reasonable time frame, say 60 to 90 days, it may become a loan subject to interest.
The loan interest would be subject to withholding tax depending on the relationship between the domestic entity and foreign jurisdiction. Withholding tax on interest is often between 5 percent and 30 percent. Assume that the balance has never been paid and the foreign tax authority has commenced an income tax audit and is questioning the intercompany payable of the domestic company.
The risk: The auditor will determine that the intercompany balance is a loan, and assess an arms-length interest rate with an associated withholding tax. The auditor will also likely assess penalties and interest on the under withholding. This does not even take into account the U.S. tax exposure. Also, the auditor might be reluctant to allow an interest expense deduction.
The result is the foreign affiliate pays the withholding tax, interest and penalties, and the U.S. parent is left to claim a foreign tax credit on an amended return. Of course, this means interest income must be recognized as well. While it would seem this should all net out, the usual result is that the enterprise is a net loser.
The Dividend
As part of the company’s cash repatriation policy, the foreign subsidiary is required to send an annually determined dividend to the domestic parent company. The foreign accountant has withheld 10 percent withholding tax based on the treaty between the subsidiary dividend payer and the parent recipient. Two years ago the company was reorganized and a new entity was put into place between the domestic parent and the foreign, dividend-paying subsidiary. The treaty rate between the new entity and the foreign subsidiary is 0 percent. The foreign accountant is not aware of the new entity.
The opportunity: The taxpayer can request a refund of the withholding tax on the dividend that was incorrectly remitted to the tax authorities. Again, this may not be possible. And, again, the enterprise can lose.
What Creates a Withholding Tax Obligation?
Whenever an enterprise conducts business through a Permanent Establishment (PE) in a foreign jurisdiction (i.e. a taxable presence) and earns income in that jurisdiction, the enterprise is typically subject to an income tax on that income in the foreign jurisdiction. If the enterprise does not have a PE in that jurisdiction, the in-country payer of the income is typically responsible for withholding taxes on certain types of income paid to the foreign enterprise.
The typical streams of income that attract withholding tax are dividends, interest, royalties, capital gains, sales, management services, insurance and rental income. Even in relatively small multinational organizations these intercompany income flows and related withholding taxes can quickly become unmanageable, particularly when it’s a small organization operating in many jurisdictions.
To further add to the complexity, taxing jurisdictions are increasingly requiring that multinational organizations report these intercompany income streams annually. One example of this type of reporting requirement is the U.S. Form 5471, Schedule M—Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons.
This form requires that U.S.-based multinationals report all of their intercompany income and expense streams. These income streams include sales of stock, services, rents, royalties, interest, dividends, insurance and loan balances. Canada also has a similar form: the T106—Information Return of Non-Arm’s Length Transactions with Non-Residents.
These types of tax forms provide a basic roadmap to withholding tax underreporting and refund opportunities around the globe. There are many ways for in-house tax personnel to mitigate these risks and discover hidden opportunities. The best way to approach this issue is through an integrated database solution.
Integrated Database Solution
Under this centralized approach, a real-time database is accessed to develop a reporting mechanism to calculate the withholding tax obligations associated with the various income flows on a global basis, as well as provide related reports.
In a large, sophisticated organization this database may be an Oracle or SAP application. In less sophisticated organizations this could be a Microsoft Access Database or structured query language application.
Outside experts are not necessary in most situations, which reduces the cost of compliance. Withholding tax obligations are being reported both timely and accurately.
As a result, the organization incurs little interest or penalties associated with the withholding taxes because of timely and accurate compliance.
There are many benefits of implementing the integrated database solution, the first and most evident being the lower cost as a result of reduced need to use outside experts. Another benefit is that a properly designed database will generate reports that support the correct withholding tax reporting and timely filing on a global basis. These reports can be used as audit support for both the various tax authorities and for internal and external financial auditors. The database essentially serves as an internal control system.
Secondly, a central database can track foreign tax credits, related documentation and when tax credits will expire [IRC Sec. 904(c)].
Lastly, such a system reduces the risks of double taxation by properly reporting and paying withholding taxes, as well as providing the income recipient with documentation to claim foreign tax credits on a timely basis.
In addition to withholding tax compliance, an integrated database can be used as a management decision tool to determine the withholding tax costs of business realignments and other what-if scenarios.
For example, once the database is fully implemented, it will be possible to determine the withholding tax consequences of adding a legal entity to an organization. Some countries—the United Kingdom in particular—have very favorable withholding tax rates under their tax treaties with other nations. Consequently, it may be advantageous for a UK entity to have intercompany income flows versus an entity in another jurisdiction with less advantageous tax treaties. This structure would have a business purpose, as well.
Conclusion
A good tax practitioner knows that it’s far better to manage the business narrative. If there is no narrative in place the tax authorities will create their own, which will most likely not be in the taxpayers favor.
As discussed here, withholding taxes present both a tremendous opportunity and risk for multinational organizations. The goal of a forward-looking tax practitioner is to identify this issue and convince an organization’s stakeholders of the need to implement a proactive solution. This would include an integrated database solution, which will serve as a strong narrative in audit support and a powerful business decision tool.
John P. Garcia, CPA is a director of tax at Targus Group International and Timothy C. Hart, CPA is a semi-retired tax consultant.
As more companies—even relatively small ones—go global, setting up businesses and customers is almost always the first order of business. Many of the administrative functions, such as tax compliance, follow later—sometimes much later. Often, foreign affiliates are created to facilitate business overseas. A myriad of business transactions flow from this global effort. These transactions often have tax consequences, which are not immediately apparent.
While there are many tax consequences that can result from a global business, we’ll address withholding taxes, which apply to many transactions, and the rules and the withholding tax rates are always changing.
For example, 23 of 30 Organization for Economic and Co-operation Development countries routinely apply withholding requirements on a final, or creditable, basis to payments of dividend and interest income to investors.
To gain insight on this dilemma, it’s necessary to discuss some of the real-world scenarios. This includes the risks and opportunities generally describing how withholding tax works on a global basis and describing why the integrated database approach is the best solution for withholding tax compliance.
Let’s use two typical intercompany scenarios.
The Intercompany Loan Balance
Your domestic company purchases product from a third-party manufacturer for ultimate delivery to a foreign subsidiary. The sale to the foreign subsidiary creates an intercompany payable between the domestic company and the foreign subsidiary. If this intercompany balance is not paid within a reasonable time frame, say 60 to 90 days, it may become a loan subject to interest.
The loan interest would be subject to withholding tax depending on the relationship between the domestic entity and foreign jurisdiction. Withholding tax on interest is often between 5 percent and 30 percent. Assume that the balance has never been paid and the foreign tax authority has commenced an income tax audit and is questioning the intercompany payable of the domestic company.
The risk: The auditor will determine that the intercompany balance is a loan, and assess an arms-length interest rate with an associated withholding tax. The auditor will also likely assess penalties and interest on the under withholding. This does not even take into account the U.S. tax exposure. Also, the auditor might be reluctant to allow an interest expense deduction.
The result is the foreign affiliate pays the withholding tax, interest and penalties, and the U.S. parent is left to claim a foreign tax credit on an amended return. Of course, this means interest income must be recognized as well. While it would seem this should all net out, the usual result is that the enterprise is a net loser.
The Dividend
As part of the company’s cash repatriation policy, the foreign subsidiary is required to send an annually determined dividend to the domestic parent company. The foreign accountant has withheld 10 percent withholding tax based on the treaty between the subsidiary dividend payer and the parent recipient. Two years ago the company was reorganized and a new entity was put into place between the domestic parent and the foreign, dividend-paying subsidiary. The treaty rate between the new entity and the foreign subsidiary is 0 percent. The foreign accountant is not aware of the new entity.
The opportunity: The taxpayer can request a refund of the withholding tax on the dividend that was incorrectly remitted to the tax authorities. Again, this may not be possible. And, again, the enterprise can lose.
What Creates a Withholding Tax Obligation?
Whenever an enterprise conducts business through a Permanent Establishment (PE) in a foreign jurisdiction (i.e. a taxable presence) and earns income in that jurisdiction, the enterprise is typically subject to an income tax on that income in the foreign jurisdiction. If the enterprise does not have a PE in that jurisdiction, the in-country payer of the income is typically responsible for withholding taxes on certain types of income paid to the foreign enterprise.
The typical streams of income that attract withholding tax are dividends, interest, royalties, capital gains, sales, management services, insurance and rental income. Even in relatively small multinational organizations these intercompany income flows and related withholding taxes can quickly become unmanageable, particularly when it’s a small organization operating in many jurisdictions.
To further add to the complexity, taxing jurisdictions are increasingly requiring that multinational organizations report these intercompany income streams annually. One example of this type of reporting requirement is the U.S. Form 5471, Schedule M—Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons.
This form requires that U.S.-based multinationals report all of their intercompany income and expense streams. These income streams include sales of stock, services, rents, royalties, interest, dividends, insurance and loan balances. Canada also has a similar form: the T106—Information Return of Non-Arm’s Length Transactions with Non-Residents.
These types of tax forms provide a basic roadmap to withholding tax underreporting and refund opportunities around the globe. There are many ways for in-house tax personnel to mitigate these risks and discover hidden opportunities. The best way to approach this issue is through an integrated database solution.
Integrated Database Solution
Under this centralized approach, a real-time database is accessed to develop a reporting mechanism to calculate the withholding tax obligations associated with the various income flows on a global basis, as well as provide related reports.
In a large, sophisticated organization this database may be an Oracle or SAP application. In less sophisticated organizations this could be a Microsoft Access Database or structured query language application.
Outside experts are not necessary in most situations, which reduces the cost of compliance. Withholding tax obligations are being reported both timely and accurately.
As a result, the organization incurs little interest or penalties associated with the withholding taxes because of timely and accurate compliance.
There are many benefits of implementing the integrated database solution, the first and most evident being the lower cost as a result of reduced need to use outside experts. Another benefit is that a properly designed database will generate reports that support the correct withholding tax reporting and timely filing on a global basis. These reports can be used as audit support for both the various tax authorities and for internal and external financial auditors. The database essentially serves as an internal control system.
Secondly, a central database can track foreign tax credits, related documentation and when tax credits will expire [IRC Sec. 904(c)].
Lastly, such a system reduces the risks of double taxation by properly reporting and paying withholding taxes, as well as providing the income recipient with documentation to claim foreign tax credits on a timely basis.
In addition to withholding tax compliance, an integrated database can be used as a management decision tool to determine the withholding tax costs of business realignments and other what-if scenarios.
For example, once the database is fully implemented, it will be possible to determine the withholding tax consequences of adding a legal entity to an organization. Some countries—the United Kingdom in particular—have very favorable withholding tax rates under their tax treaties with other nations. Consequently, it may be advantageous for a UK entity to have intercompany income flows versus an entity in another jurisdiction with less advantageous tax treaties. This structure would have a business purpose, as well.
Conclusion
A good tax practitioner knows that it’s far better to manage the business narrative. If there is no narrative in place the tax authorities will create their own, which will most likely not be in the taxpayers favor.
As discussed here, withholding taxes present both a tremendous opportunity and risk for multinational organizations. The goal of a forward-looking tax practitioner is to identify this issue and convince an organization’s stakeholders of the need to implement a proactive solution. This would include an integrated database solution, which will serve as a strong narrative in audit support and a powerful business decision tool.
John P. Garcia, CPA is a director of tax at Targus Group International and Timothy C. Hart, CPA is a semi-retired tax consultant.
