Brexit tax: watch out for withholding tax

With “Brexit day” now looking set for 31 January 2020, we will publish a series of blog posts by way of a reminder of the most significant tax implications of the agreement and the impending date. Let’s start with withholding tax.

One of the major implications of Brexit is the effect on the availability of relief from withholding tax under EU directives.

This has been fertile territory for a lot of the commentary written on Brexit and tax issues to date. With a transition period likely to be agreed in the Withdrawal Agreement, the benefit of the EU Parent Subsidiary Directive and the EU Interest and Royalties Directive should be secured until 31 December 2020. However, one of the more immediate implications of the UK formally leaving on 31 January 2020 is not in relation to the EU directives, but the effect of withholding taxes on payments between EU27 member states and third countries.

Unlike the directives that will still apply during the transition period, some provisions of tax treaties between EU27 countries and third party states that use of the definition of EU/EEA member states will be more difficult to rely upon. The transitional period will not have any effect in this respect; non-EU countries are not obliged to treat the UK as being part of the EU during the transitional period.

The issue arises where there are UK companies within corporate groups which may affect the ability of companies in EU27 states to claim the benefit of tax treaties with other third countries. The primary example of this effect is for EU27 companies that rely on double tax treaties with the US to reduce or eliminate withholding taxes on payments of dividends, interest and royalties where the relevant treaty contains a limitation on benefits (LOB) provision.

The LOB clause can, as the name suggests, limit the benefits in the tax treaty unless certain substance tests are met. There are circumstances when the usual test of control by residents in contracting states will not be met and when corporate groups need to rely upon some of the other tests in the LOB provisions in order to benefit from the treaty in question.

In such circumstances, the presence of a UK company in a group (or as a parent company of the group) may have an effect on the ability of an EU27 company to claim benefits under its treaty with the US. LOB provisions in EU27/US treaties often permit a company to claim treaty benefits, in circumstances where the EU company in question would not necessarily be a "qualified resident", by reference to tests which depend upon EU or EEA membership. As such, company structures that rely on UK owners as members of the EU could lose the ability to claim treaty benefits meaning the payment of dividends, interest and royalties will attract US withholding tax from 1 February 2020.

For some groups it may be relatively simple to restructure group holdings or borrowings to address this issue. Others may face an on-going withholding tax cost, in some cases, without an effective credit for cost incurred.