There is currently a significant project ongoing between global tax authorities and governments to seek the introduction of a more uniform approach to taxing what is defined as the ‘digital economy.’
Traditionally, companies tend to be subject to tax in an overseas location if they have some degree of physical presence in that location. There is now increasing understanding that requiring such physical nexus in a country in order to apply tax to profits which entities derive there struggles to keep pace with the manner in which the digital sector operates.
This feature focuses on one particular area of the UK taxation system, which HMRC intend on changing, in what could be seen as a unilateral measure from the UK to help tackle this complex subject.
At present, Royalties which are paid by a UK company, for the exploitation of Intellectual Property (IP) and similar rights, to overseas entities, are subject to the deduction of UK tax at 20% - unless this is reduced under an international agreement.
The UK Government have announced a planned extension to these rules, to also include payments made by a non-UK entity, to a fellow non-UK connected party in a jurisdiction with which the UK does not hold a suitable double tax treaty (which will often be a low or zero tax jurisdiction.) A simple diagram is shown below:
In the above example, company A derives UK income but has no UK taxable presence, and as such pays no UK tax. Company A may obtain a tax deduction in its location of residence for the Royalty it pays to B. If B is in a location, which has low or zero tax, it is clear that a very efficient structure is in place. The reform could see a 20% UK tax applying on the Royalty paid from A, to B.
This reform is targeting a set of arrangements which exploit a current gap in the tax system, but the scope could be wider in practice than is originally anticipated. What it also shows is the start of a radical shift away from the current principles of applying tax on cross border payments - away from the current requirement to have some UK presence.
We are closely monitoring developments in this area and also the wider question of digital taxation, and will be considering the impact of the digital economy tax reform in future posts.