When you hear the term “Withholding tax,” you often find a description — tax at source. But what does it mean, in a language that everyone understands?
Withholding tax is a tax that a company incurs (that’s why at source) when it pays dividends, royalties, interest to citizens of other countries.
The complexity of the Withholding tax lies in the many rules of regulation, both at the national level and internationally.
But there are unified rules of assessment for withholding tax in any jurisdiction, namely:
- This is a tax on passive income — mainly dividends, royalties, interest;
- It arises in the case of payment of the above-mentioned income to a non-resident.
For example, a Polish company pays dividends to a Ukrainian, i.e., non-resident of Poland.
- The obligation to pay tax is on the company that distributes passive income.
For example, a Polish company will be a tax agent for Ukrainian founders and administer withholding tax.
- As a rule, you have to pay tax in two countries — the country where you have income and the country of residence of the recipient of income. But in each situation, you need to study Double taxation treaties separately!
To understand the source tax, it is necessary to study the income at payment in more detail.
What kind of income activates Withholding tax
The mechanism by which the Withholding tax is activated is simple. It must include dividends, royalties, interest. Below we will look at each case in detail, with clear examples. Let’s start with dividends.
Dividends
According to the Tax Code of Ukraine, dividends are a payment made by a legal entity in connection with the distribution of its profits. Both an individual and a company can receive it.
The payment of dividends is the most transparent way of distributing company funds for personal use, on a par with wages.
Dividend example
An American IT company owner has paid all the corporate fees and wants to withdraw the net profit into their personal account. But there is one nuance. If you are a non-resident of the country where the company is registered and want to withdraw the dividends, you must pay withholding tax. And you have to do this not only in the USA but also in the country where you are a resident — also check the tax consequences of receiving income abroad.
In most cases, a foreign citizen is subject to U.S. federal withholding tax at the standard flat rate of 30%. A reduced rate, including a tax exemption, may apply if there is a tax treaty between the foreign national’s country of residence and the United States.
So remember the withholding tax rule for dividends — it is usually withheld from the payment made to the foreign national.
What is royalty payment?
Royalties are another type of passive income and an activator of Withholding tax. It is accrued when the intellectual property of IT company A is used by IT company B.
The question of payment of royalties is especially relevant in the IT-sphere because, according to the Ukrainian legislation, a computer program is equal to actual work (for example, a composition or a song).
As a rule, the payment for using a software product or database leads to royalties for the use of an intellectual property. But there are a few exceptions, for example:
When the terms of a software agreement are essentially a sale of all substantive rights to use the product (e.g., purchased software in a box under a packaging license) — in simple terms, when you buy MS Office, you are purchasing a box. In that case, you are not subject to the royalty payment rule.
If you dig a little deeper and give a real example of how Withholding tax is assessed, Estonia is the best way to show it.
In Estonia, the Withholding tax when paying royalties to non-residents is charged by the general rule at a rate of 10%. Moreover, when paying royalties in Estonia, you are certainly not subject to double taxation. Estonia has concluded Double taxation treaties providing for preferential withholding tax rates on passive income (dividends, interest, and royalties), for example, with Ukraine, Poland, Lithuania, and other countries.
Percentage or interest
In international law, percentage or “interest” is also a type of passive income. In the corporate sphere, it is paid to the owner of shares in a company or to an investor who has made a capital contribution and is subject to withholding tax.
Each country sets its own rates for payment of passive income, but there are states where there is no withholding tax.
For example, Cyprus and UAE are the most popular jurisdictions that do not apply tax at source. But zero tax rates in these countries do not cancel the taxation of passive income in the country of residence.
In addition, you need to consider the rules for determining low-tax jurisdictions for your country because the tax rate for you can increase significantly.
Examples of Withholding Tax Rates in the World
Poland
The general withholding tax (WHT) for dividends is 19%.
The WHT rate can be reduced according to the specific provisions of the applicable income tax treaty, or an exemption can be granted based on the EU Parent-Subsidiary Directive.
The tax is payable monthly by the 7th of each month for the previous month. Tax exemption in Poland is not available if the dividends are paid to avoid paying taxes, which they try to “do” very often 🙂
Hungary
Dividends, interest, and royalties paid to resident and non-resident companies in Hungary are not subject to WHT.
Dividends, including advance dividends paid to individuals, are taxed at 15%. But it is important to remember that Hungary participates in Double Taxation Agreements with certain countries, which changes these rules.
Romania
A withholding tax of 5% applies to dividends, and withholding tax of 16% applies to royalties, interest, commissions, and other taxable income paid by a Romanian tax resident to a foreign person, subject to reduction or cancellation following the applicable tax treaty.
Dividends, interest, and royalties may be exempt from withholding tax if paid to a resident of another EU member state, provided that the minimum ownership criteria and special conditions relating to the payer’s legal and fiscal status and the payer recipient of the income are equally met.
In general, the process of accruing withholding tax depends not only on the type of income on which the tax is imposed but also on the agreements of the two countries, the source country of the income, and the country of residence of the resident who receives the income.
And before you “faint” from the fact that you have to pay another WHT — we recommend that you carefully read all the legal intricacies of the participating states. And also, clarify whether your financial transaction is subject to additional taxation.
We hope that our article has given you a basic understanding of withholding tax and how it is charged. But it’s important to remember that every case is different, and we recommend that you seek professional advice.
If you have any questions, the Finevolution team will be happy to advise you, just leave a message via the form or send us a message on Telegram/Viber.
