Musings: The law of unintended consequences
This is something (the law of unintended consequences that is) that often occurs in taxation. For instance, many of us will remember the 0% CT rate in 2002 to encourage the development of small business. The incorporation of 100,000’s of companies following the announcement came, bizarrely, as a huge shock to the Treasury, which then doubled down and introduced the non-corporate distribution rate before scrapping the rate entirely in 2006. Whilst the Treasury quietly cussed their bad luck, everyone else just asked “what did you expect?”
There is possibly another example arising from Brexit, although collateral damage may be a better term, and that relates to the taxation of cross border interest and royalty payments. The Interest and Royalties Directive (IRD) was designed to smooth the flow of such payments through the EU, although in quite limited circumstances as the payments could only be between companies where one held at least 25% of the other, or a third company held at least 25% in both.
This limited the benefits to corporate parent/child or sibling relationships. Anything wider, such as grandparent or cousins were right out the window.
As a directive, each member state had to design and enact its own legislation to give the IRD effect. This was done by referring to payments made to companies resident in, wait for it, member states. Therefore, for the UK, the national provisions applied where a UK company or the UK PE of an EU company made a payment to an EU company. Likewise, for, say, Italy, the rules applied where an Italian company made a payment to a company in another member state (which, pre-Brexit included the UK).
However, following Brexit, the UK is no longer a member state, but Italy is. This means that payments from an English company to an Italian company were still covered by the terms of the IRD due to our domestic legislation, whereas a reciprocal payment from Italy to the UK was not by virtue of their legislation. In the absence of the IRD the Italy/UK double taxation agreement applies. This meant that interest payments from Italy now suffered WHT of 10% and royalties 8%, whereas payments to Italy were tax free.
The Government noticed this “problem” and the UK’s enabling legislation was repealed from 1 June 2021.
This may cause problems where a group has been relying upon the IRD as it could now be facing WHT on payments that it didn’t have to worry about before. For royalties the issue is more manageable, as a UK payer can apply a treaty rate if it reasonably believes that the recipient is entitled to the benefit of the treaty. Therefore, if the treaty rate is 0%, no tax will be due, although the payer should at least have some evidence as to how it satisfied itself that it was reasonable to believe that the treaty rate was available. This is in case HMRC comes knocking and decides the treaty benefit is not due.
For interest, the problem is wider as there is no such “reasonable belief” test. If the benefits of the IRD were to be claimed for interest payments, an application still had to be made to HMRC to pay the interest gross. Any agreements issued by HMRC came to a crashing stop on 1 June 2021 and all interest payments made on or after that date need a new direction from HMRC under the relevant treaty.
Admittedly, HMRC have introduced a simplified process for applying for such permission where an agreement had been reached under the IRD, but the need for new authority is very much needed.
For payments that used to be covered by the IRD, we would expect HMRC to take a lenient view on penalties if permission has not been granted before an interest payment was made (or if the wrong rate of WHT was withheld on royalty payments), provided it is an unprompted disclosure within the next 12 months. However, the longer the delay, the more likely it is that HMRC may seek penalties, even if no tax is eventually due, that is, HMRC may seek penalties on the tax that should have been withheld even though they grant treaty relief and “repay” that tax. Plus, of course, interest.
Due to the repeal of the IRD for UK companies we recommend that groups review their payments to EU affiliates that may have been under the IRD, especially any long-standing arrangements, given that the IRD was enacted back in 2004 and the reason why the payment is being made without WHT may be lost in the mists of time (or since Gerald retired).
If you have any queries regarding withholding tax or reports to HMRC, please contact Miles Dean or Andrew Parkes:
Head of International Tax
M: +44 (0)7785 770 431 or
National Technical Director
M: +44 (0)7522 229 589 or