Withholding taxes are taxes that are part of a country’s income tax system and that the payer of a dividend, royalty, interest payment, etc., must withhold from each such payment and must pay over to his own tax authorities. In the case of non-residents, a withholding tax may be a final tax or it may only constitute the advance payment of tax.
The rates of withholding taxes are frequently reduced by tax treaties. Indeed, certain jurisdictions qualify as tax havens or IOFCs (international offshore financial centers) by virtue of the exemptions or the reductions in the rates of withholding taxes to which their residents become entitled in accordance with the provisions of one or more (sometimes a network of) tax treaties. The use of such tax treaties may thus permit the creation of a conduit whereby profits are transferred from one country to another via a third country, thus suffering the smallest possible total tax burden, thus facilitating the international tax planning process.
The cost of withholding taxes may not be immediately apparent. However, it may be costly to ignore the time value of money. Receiving a dollar tomorrow is not the same as receiving a dollar today. The dollar received today will enable you to pay back debt (thereby avoiding interest charges) or to make an investment (thereby producing a stream of income). The difference in value between a dollar tomorrow and a dollar today is precisely the return earned by today’s dollar between now and tomorrow. Hence the importance of these considerations in international tax planning.
This phenomenon, known as the “discount rate”, may be a key element in planning that has to be determined by each decision maker on the basis of an assumption about what an extra dollar today would earn in the future. The lowest reasonable discount rate is the current interest rate on risk-free securities such as treasury bonds. Most businesses, however, can expect to earn more than this (otherwise they would quite rapidly go out of business), and their discount rate should take account of the average return on their available investment opportunities.
Using a discount rate of x%, the value of a future dollar declines exponentially at a rate of x% per year. A few simple calculations show how dramatic the effect of discounting can be on deferred income. After ten years, a sum of money has lost 44% of its value at 6% p.a., 54% at 8%, 61% at 10%, and 75% at 15%.
Tax effects are typically over shorter periods, but they can still be significant. Overlapping connecting factors can lead to economically disadvantageous multiple taxation.
Tax treaties normally reduce the amount of tax a country is allowed to withhold on income being repatriated to another treaty partner country.
For example, a subsidiary transferring a $1,000,000 dividend to its parent in a foreign country may have to withhold say 30%, or $300,000, of tax from the dividend. That tax is paid over to the revenue. If the country of the parent has a Tax Treaty with the subsidiary’s country, then the withholding may be only 5%, or $50,000 (an up-front saving of $250,000). Where the withholding tax is not a final payment, the difference may eventually cancel out, but when one takes account of the time value of money, it may still be a material factor.
If the parent’s country does not have a treaty with the subsidiary’s country, then the parent may establish an intermediary company in a country that does have Tax Treaties with both the subsidiary’s country and that of the parent. The withholding tax burden using the intermediary structure may be reduced to $100,000, not as good as $50,000 but better than $300,000. If the intermediary company costs $10,000 yearly, then the parent realises a $190,000 savings.
In this example, the intermediary jurisdiction gains the extra 5% of tax plus the $10,000 cost of the company. The intermediary jurisdiction that allows a foreign corporation to borrow its treaties, as per the above example, is thus also an offshore jurisdiction.