Hard as it may be to believe, just a few short months ago withholding tax was far more top-of-mind for cross-border tax and transfer pricing planning than were tariffs. Despite the new attention on tariffs, withholding isn’t going away.
Withholding is a levy on payments crossing borders and remitted to the source country's tax authorities. It primarily applies to specific types of cross-border income, such as dividends, interest, and royalties. Rates vary depending on the payment type and countries involved. Withholding scope and rates are often reduced by tax treaties. The source country determines the initial tax rates and collects the tax, while the recipient’s residence country may or may not offer compensatory tax credits or other relief.
Cross-border intercompany payments via transfer pricing are generally subject to the same (if not greater) withholding burdens as third-party payments. This means that the value and character of transfer prices affect the amount of withholding.
Bundling and "implicit" royalties
For example, reducing the royalty rate payable to an intellectual property owner results in a corresponding reduction in the transaction value subject to withholding. Other strategies, such as cost sharing arrangements or “bundling” multiple transactions into a product price, might eliminate withholding obligation altogether.
It’s not surprising that tax authorities often audit transfer pricing and withholding in tandem. Tax authorities in the U.S, Canada and Australia have successfully challenged taxpayer intercompany withholding. The tax authorities have asserted “implicit” royalties on bundled transactions, assessing withholding on transactions that did not actually take place but, in the eyes of the tax administration, should have.
It's not just taxable income
The key lesson here is that transfer pricing should always consider withholding and indirect tax implications. It’s dangerous to assume a transfer price is “low risk” simply because it does not reduce taxable income. For example, if a royalty rate paid by the US to Singapore is below the range of comparable agreements, it may seem safe because the lower outbound payment results in higher US taxable income. But the IRS might then notice that a properly-priced payment would result in higher withholding, opening an alternative - and potentially more expensive - avenue for IRS assessment.
How can tax function owners manage these distinct yet intertwined risks? Review rate tables and treaties, make cross-functional planning and review a habit, and lean on advisors who take a holistic view of providing tax advice.
