What is a Withholding Tax Clause?
A withholding tax clause is a common provision found in many agreements that deal with one party making a payment to another. Withholding tax is a tax that is withheld from a payment by the recipient’s government and is paid directly to the government by the payer, generally, on behalf of the payee. A simple example is a salary payment which is subject to a withholding tax known as Pay as You Earn (PAYE) in the UK or through a withholding exemption ("exención" in Spanish) in Mexico.
In order to reduce the withholding tax charge imposed on a payment made under the agreement, the withholding tax clause should typically provide that the payer must gross-up the payment that it makes to the other party to take into account the amount of the withholding tax charged. The following example highlights the importance of agreements having the withholding tax clause and also demonstrates its basic purpose:
Companies A and B enter into an agreement under which Company A contracts to provide services to Company B. The payment made under the agreement is subject to withholding tax, which is payable by Company B to the government.
Scenario 2: Assume , for argument’s sake, that the withholding tax rate charged is 20%. Under the typical language for a withholding tax provision, Company A would receive a gross payment of 200 (ignoring the time value of money), or 100 more than in scenario 1, making the cost to Company B equal. Company B pays the same amount in either case, but the difference is that in scenario 2 Company A receives more money than Company A would have received in scenario 1.
Accordingly, if Company A is in a country with a low nationwide withholding tax rate and the payment receives a preferential withholding tax rate (due to a tax treaty or equivalent), or is otherwise exempt from withholding, then Company A will want to include the withholding tax clause in the agreement (or at least the agreement should be prepared with the language) because it allows the payment under the agreement to be made without the deduction of withholding tax, or at least at a reduced withholding tax rate. This means that the amount received by Company A will be greater than it would be if the provisioning withholding tax were applied to such payment.
Purpose and Significance of Withholding Tax Clauses
Withholding tax clauses in agreements are designed to accomplish certain purposes. One of the primary purposes is to achieve tax compliance for the parties. A withholding tax clause, if applicable to the transaction, provides clarity to performers by anticipating and raising the issue of withholding and prompting a discussion about withholding.
Including a withholding tax clause in an agreement also serves to counter a point that seemingly evidences the parties’ understanding of the applicable law. Under U.S. federal income tax law, the payer of income is responsible for withholding tax unless an exemption applies. Thus, the failure of the payee to make a claim for a reduced or zero rate of withholding may not be considered evidence that the parties consider the withholding tax rate to be zero.
Thus, by including the withholding tax clause, the parties not only provide a means for tax compliance, but they also effectuate a position that will support a position by the payer in case of an audit by the IRS.
Key Components of a Robust Withholding Tax Clause
When negotiating agreements where one party is foreign, such as a license, services or settlement agreement, parties will often require that any payments made under the agreement be made without withholding from the payment (or "gross up" as it is commonly called). These clauses are not always favorable to payors and warrant careful study and an understanding of the relevant tax law before signing.
An effective "no withholding" clause should contain the following identifiable elements:
Tax Rate
The tax rates should be set forth so all parties to the agreement understand the rates they are obligated to pay. If there are multiple jurisdictions involved or a disagreement about where the income is sourced this may need further specificity.
Jurisdiction
The jurisdictions in which the income is received should be specified. This is particularly true when there is a dispute about whether the income is received in the country where the payor is located or where the services are performed. This is essential when there is a dispute about where royalties are paid or whether payments for sponsored research are taxable.
Responsibility
The obligation to gross up payments can be placed on any party, but the payor is almost always responsible for paying the gross up. If the payor is responsible for paying the gross up use of loan proceeds are common obligations to gross up. The obligation can also be placed on the payee.
Common Issues and Pitfalls
One common pitfall is failing to recognize the tax implications of an agreement. For example, when entering into an asset purchase agreement, it is important to consider whether the sale price will be subject to sales tax, should it be allocated among the assets being purchased and/or should an issue of exemption from sales tax apply. Failure to allocate or to address exemption may result in the liability for the sales tax falling on the purchaser of the assets. Similarly, entering into a franchise agreement without understanding the difference between sales and use taxes and whether an exemption applies for the right to use a trademark may result in the obligation to pay sales tax on a monthly basis, rather than being structured as part of the upfront franchise fee. Without this awareness, it may not even occur to the franchisee that sales tax is due, and failure to pay such tax is subject to penalties, interest and ultimately, collection actions by the state.
A mistake that is often made, in the context of indemnification for taxes, is drafting a narrow clause applicable to specific types of taxes (state income tax or federal income tax) but not providing for cover on those taxes that are generally overlooked, such as sales tax or personal. This mistake could require one party, with no fault, to bear the cost of a tax in the absence of a provision requiring the other party to reimburse the owner for the amount of the tax.
Another pitfall is failing to qualify to issue a certificate. For instance, where a party issues certificates that require the purchaser to collect and remit withholding tax, and a purchaser fails to do so within the specified period (which may mandate the remittance of interest and/or penalties), a seller may not be able to prevail on its claim with the FTB to pay the withholding tax liability absent proof that the purchaser has in fact collected the withholding tax. This may be particularly problematic in instances where a seller has issued a certificate but neglected to remit the withholding tax (perhaps due to the purchaser’s nonremittance), because the FTB may have a difficult time determining whether the tax has been paid.
Legal Repercussions and Outcomes
Failure to comply with these withholding tax clauses may have consequences for the parties involved. As mentioned, these clauses are generally enforceable as long as they are clear on the mechanics of the withholding, the amount to be withheld, and the circumstances in which the obligation will arise . In the event of non-compliance with the clause, a party to the agreement may:
• pursue the breach of contract remedy against the other party, in addition to or instead of the indemnity remedy, depending on the circumstances;
• refuse to make the payment or to discharge the obligation unless the other party has made the withholding payment;
• claim a set-off for any amounts already paid into the authority against the enforcement or collection of the other party’s debt or obligation to the extent of the set-off;
• not be compelled to make payments until they have been relieved of their tax liability;
• an order for damages for any tax or loss suffered as a result of the withholding; and
• claim a constructive trust in respect of the amounts withheld at source.
Best Practices for Crafting Withholding Tax Clauses
To ensure the effectiveness of withholding tax clauses, it is essential to follow best practices when drafting them. Below are several recommendations for creating effective and unambiguous withholding tax clauses.
First, clarity is paramount. A well-drafted clause should clearly define its scope, the parties’ obligations in the event of withholding tax, and how disputes related to withholding tax will be resolved. It should also clearly state who will bear the financial burden of withholding tax and how the parties will address any increase in the applicable tax rate that may result from a change in applicable law.
Second, negotiations should consider local legislation and management service agreements. Many countries do not levy withholding tax on the fees paid in relation to the management of a subsidiary that is subject to corporate taxation in that country. In such cases, and subject to the bilateral tax treaty in place, payment may be made without deduction of withholding tax. It is necessary for the relevant parties to negotiate the mechanisms by which they will allocate the profits of the local subsidiary to the parent company.
Third, selecting foreign currency for payment is critical. Select the currency in which the price will be calculated and paid. If, at the time of payment, the foreign currency is no longer available in the country where the payment will be made, the parties need to agree on the relevant mechanism that needs to be applied, such as the replacement of the currency with another currency at the official rate.
Fourth, costs and expenses incurred by the service provider levied in relation to the withholding tax should not be deducted from the amount due for payment. If the taxed remuneration is delayed, for whatever reason, the amount of tax should be levied by the tax authorities from the date of payment, and the tax should not be calculated from the date of delivery of the services.
Fifth, the scope of the clause should include the following points:
(a) the applicable withholding tax
(b) the responsibility of the parties to obtain and send the certificates or documents
(c) how the tax authority will be notified, and how the parties will notify each other about tax provisions
(d) how the payments will be made
(e) the consequences of failure to comply with the provision, or
(f) how the taxes will be recovered if either party is liquidated or dissolved.
Withholding tax clauses are not typically included in large contracts. Such clauses are more likely included in the agreement with the local subsidiary to which the management services are provided.
Specific Industry Applications
Even as withholding tax clauses share certain similarities across various types of contracts, it is in the exclusions or exceptions to the standard definition where industry-specific considerations may come into play. In the energy industry, for example, the FERC-affiliated natural gas and electric cooperative tariffs limit withholding to "taxes based on or measured by net income," reflecting the well-established treatment of those taxes for federal income tax purposes. In the oil and gas industry, lenders often redact the provision all together by simply limiting the scope of the clauses to "taxes or similar charges" thereby excluding all withholdings from gross amounts payable to the lender, leaving questions of treatment entirely up to the parties to negotiate. The allocation of responsibility for any withholding or tax payments can also vary by the fit and purpose of the parties’ agreement. In the real estate sector, master leases or partnership agreements may shift the responsibility to pay foreign withholding taxes based on the proportionate share of foreign lessors or partners.
Global Opinions on Withholding Tax Clauses
International approaches to withholding tax clauses reflect the period in which many of them were drafted. In the 1950s, when the OECD prepared its Model Convention on Income and on Capital (the "Model"), the majority of taxes imposed by countries were taxes on corporate income. The Model therefore focused on tax treaties providing relief from double taxation of corporate income, primarily by allocating taxing rights to the country of residence of the parent company.
At that time, a number of countries, including France, Germany, Canada, and the UK, entered into bilateral double taxation treaties on the basis of the Model. These treaties did not contain provisions for the imposition of withholding tax or capital gains tax ("CGT"), so withholding tax clauses were not an area of focus.
Subsequent amendments to domestic laws in a number of countries (e.g., withholding tax on payments such as dividends, royalties, and interest), however, made rushing ahead with tax treaty negotiations to prevent the imposition of withholding tax essential. But not all countries approached this process in the same way. Certain nations, such as the UK, incorporated withholding tax clauses into their double taxation treaties. The UK model, for example, is intended to reflect an intention not to impose withholding tax on certain payments other than on dividends. In 1980, the UK agreed to treat interest and royalties as if they were dividends so that they would not be subject to withholding tax, except to the extent that the recipient was a bank or financial institution. Other countries, such as Canada, tried to negotiate specific rules preventing withholding tax on interest and royalties with the intention of gaining the same relief for dividend payments.
Over the years, and largely as a result of resultant double taxation treaties, withholding tax clauses became the norm. In contrast, however, Germany, France, the Netherlands , and Japan have much more extensive territorial taxing schemes. As a result, these nations negotiated treaty-based withholding tax clauses in a way that provides equivalent, but not necessarily identical relief.
In 1992, the OECD’s Model was updated with the intention of allowing tax treaties to continue to assist in the prevention of international double taxation in line with current developments in international taxation. The OECD Model now reflects a new approach to domestic taxation of international transactions. For example, there are provisions for the allocation of taxing rights to the source country in respect of the profits of foreign enterprises attributable to a branch operating in the taxing jurisdiction. The OECD Model continues to be updated and amended, with a revision in 2008 expressly addressing specific issues such as hybrid instruments.
The treatment regarding withholding tax clauses differs between Asia, Africa, Europe, and North America. Asian jurisdictions such as India have been advised to remove the definition and application of taxes covered. African tax treaties tend to retain this clause and apply definitions on the basis that the sovereign powers of a country take precedence. There appears to be greater uniformity among countries in Europe, where taxes covered is often included, although not always defined. The intention is usually to include all taxes, but it is important to refer to the treaty between the countries concerned to confirm the position.
The US treats withholding tax clauses more leniently than many other countries as it recognizes a deduction for tax imposed by a treaty country. Withholding tax clauses are generally located in "Article 1," the introductory article that describes the scope and purpose of the treaty. The United States also has a withholding tax exemption provision, which provides that no tax will be withheld in the United States when the beneficial owner is a resident of the other contracting state.