A Blind Spot for CFOs

How Global Companies Can Successfully Address Threats to Withholding Tax Compliance

Introduction

With every Presidential election cycle, candidates on both sides of the political aisle frequently decry the complexity of the Internal Revenue Code and compliance burden it places on American taxpayers. While such talk is cheap given the Congressional gridlock that any proposed tax change faces, there is also much truth to it. The current Internal Revenue Code and Treasury Regulations have grown to entail more than 5.6 million words and 9,000 pages. While the complexity is indeed immense, it is but a drop in the bucket compared to the challenges facing businesses with global operations. When a business generates income in multiple foreign jurisdictions, simultaneously navigating overlapping and equally complex tax codes to properly meet the corresponding compliance burden of every jurisdiction can seem an impossible task.

One area of foreign tax compliance rife with complexity and room for error is withholding tax. Withholding tax mandates the payor of income to reduce the amount of payment to a payee by a calculated amount of tax that is ultimately remitted to the local government.  As a result, the payee's corresponding income is reduced by the withheld amount.  Consequently, to the extent tax is incorrectly withheld, the payee does not receive the full distribution of income to which it is entitled.

Most foreign tax regimes impose withholding on payments made to non-residents, and most often the task of administering this withholding falls on third-party withholding agents, who juggle the tax codes of both the payor and payee countries, as well as any tax treaty in force between them. The result is a large margin for error that many businesses are ill-equipped to mitigate. This article discusses some of the most common risks that companies face when it comes to withholding tax reporting and details solutions to best mitigate those risks.

Risk Mitigation Strategies

While mitigating the external risks associated with foreign jurisdictions' outsourcing of withholding tax, administration poses a host of challenges.  A number of strategies are available to reduce the internal risks of withholding tax complexity.  Indeed, with proper foresight and planning, a business can limit its exposure to over- and underpayment. These strategies chiefly involve integrating the tax processes of varying business units, improving the business processes for recording and verifying the accuracy of withholding payments, and ensuring the institutional knowledge of applicable withholding tax law within these units.

Integrate Your Business Operations

Situation:  The divisions of a business most directly impacted by withholding payments are the treasury, accounting and/or tax departments.  Payments from foreign operations are received after withholding tax has already been imposed.

Threat:  Payment accuracy is often unverified.  The amounts received by a company's treasury and recorded by accounting are often not examined by tax compliance employees until a company's fiscal year-end, at which point, erroneous withholding is less likely to be detected, if such payments' accuracy is examined at all.  Meeting tax filing deadlines is of such paramount concern that a line-by-line crosscheck of every foreign payment is simply not feasible for many tax departments.

Solution: Transmit documentation related to foreign payments as it is received.  Although seemingly obvious and quite simple, the fix for this dilemma often fails in implementation or execution amidst the day-to-day minutia of running a business. Communicating and transmitting all documentation related to foreign payments and corresponding withholding to a tax department as they are received allows for a real- time verification of amounts withheld.¹

Implement And Execute Robust Record-keeping Procedures

Situation:  Internally, foreign payments and withholding create a chronological paper trail for which proper record-keeping and communication allow a tax department to examine each withholding amount for accuracy:

• First, a business's treasury or accounting department issues an invoice to a foreign client for services rendered, items sold, or other amounts owed.
• Second, when payment is made by a client, it is customarily accompanied by the withholding agent's certificate documenting amounts withheld and remitted to the foreign tax authority.
• Third, treasury issues a receipt for payment to the foreign client.  The amounts receivable reported on the initial invoice, ideally, match the subsequent payments plus amounts withheld. 

Threat: Documentation overload increases potential for inaccuracies.  Partial payments, foreign currency fluctuations, and other complications often render the verification process no more than a simple exercise in addition and subtraction. Further, the volume of invoice documentation can easily lead to missed opportunities to identify discrepancies.

Solution: Tax departments need to receive invoices as they are transmitted.  When copies of invoices are transmitted to a tax department as they are issued, it allows the employees to record invoice amounts as well as anticipated final payments and withholding.  When these expectations are documented in advance of payment, it allows for the recognition of inconsistencies as they arise, rather than creating a backlog of potential inaccuracies that year-end tax compliance responsibilities can shift to the back-burner, often never to be addressed.

Threat:  Insufficient documentation leads to challenges in verification.  Another potential problem with this paper trail arises when the documents report insufficient or partial information necessary to verify accuracy.  One piece of critical information that is often lacking is a complete description of the underlying sale that generates the payment. Each type of payment typically has its own corresponding withholding tax rate, from general sales and business profits, to service payments, royalties, dividends, and interest. The more general in nature an invoice is, the more difficult it becomes to verify that withholding is proper.

Solution:  Work with treasury and accounting to ensure invoices are sufficiently detailed.  Ensuring that invoices provide sufficient detail about the nature of each payment is important not only because it allows for backend  verification of withholding accuracy, but also because it hedges against audit risk and future tax delinquency, interest, and penalties.

Threat: Lack of recordkeeping protocol results in missing documentation.  While contemporaneous communication and transmission of withholding documentation ensures a more seamless verification process, proper backend record-keeping is of equal importance for both compliance and verification purposes. Too often, the difficulties of day-to-day business administration allow for the mishandling or misplacement of critical documents, resulting in missing invoices, receipts, or withholding certificates. 

Solution: Store relevant records of each transaction together.  Storing all relevant records of each transaction together is of critical importance for any business that wishes to ensure that it pays only the tax it actually owes. Often, the opportunity to reclaim overpayment amounts is defeated by poor documentation and record-keeping, but properly managing where and how all records of transactions are stored can mitigate this risk.

Execute Compliance with Precision

Situation:  Non-tax personnel create invoices that do not contain the level of specificity needed for adequate compliance.

Threat:  Inattention to detail frustrates compliance efforts.  More than just the manner in which documentation is maintained, the character of the documents themselves presents separate risks.  Most significantly, overly general invoices quite frequently cause overpayment, especially if they aggregate different categories of payments that comprise one underlying transaction.

Particularly for businesses specializing in information technology, transactions often involve both product sales and service fees, two types of payments often subject to different withholding rates.  In many jurisdictions, withholding agents do not segregate portions of an invoice for withholding purposes, typically resulting in an agent imposing the highest applicable rate upon the entire payment.  Because withholding   rates can vary wildly between types of payments, this can result in significant overpayment.  When recovery expenses outweigh the overpayment, these amounts can be lost forever and affect the profitability of foreign operations and a company's bottom line.

Solution: Prepare separate invoices with required fields.  The easiest solution is to issue separate invoices for transactions involving multiple types of payment.  Although this increases the administrative burden on both the business and client, it ensures that a business's tax burden is no greater than necessary.

Additionally, it is important that invoices and receipts include all necessary information for verification.  The most important information to include are the date and amount of the underlying business transaction, the date of invoice issuance, the date and amount of payment, the foreign exchange rates between payor and payee country on the date of invoice issuance and the date of payment, and payment amounts in both local currency and that of the business's country of residence.  Unique identifiers for each transaction are also important for invoice, payment receipt, and withholding certificate alike.  They allow for simpler record-keeping and withholding verification. 

Create and Maintain a Knowledge Warehouse

Situation:  Reliance on internal personnel to identify and apply withholding tax relief provisions adds an increased burden to already busy tax departments.

Threat:  Insufficient knowledge results in missed opportunities for relief.  The daunting complexity of ever-changing foreign tax codes and superseding tax treaties often leaves a business with confused or insufficient internal knowledge of applicable withholding rates.

Solution:  Create and maintain internal knowledge warehouse.  While the ongoing task of maintaining proper institutional knowledge is indeed challenging, it need not be so great that compliance is frustrated.  The rate applicable to any payment can be distilled to three pieces of information:

• the type of payment;
• the statutory rate applicable in the foreign jurisdiction; and
• any rate designated by an applicable tax treaty. 

Again, most foreign jurisdictions impose separate withholding rates to different categories of payment.  Consulting the tax code of the country is usually simpler than one would think. There are many publicly available sources that report current foreign withholding rates, many of which report these amounts in English and are updated as changes are made.  Tax treaties in force between payor and payee country are always publicly available as well.

Consulting treaties is of particular importance, as they customarily supersede statutory rates and often provide relief from a higher statutory rate.  When these statutes or treaties are only available in a foreign language not easily translated, consulting a foreign expert may be necessary.

Nevertheless, maintaining a current repository of withholding rates by payment type, statute and/or treaty distinction, and by relevant foreign jurisdiction, enables a business to more readily verify the accuracy of withholding imposed on its foreign revenue.

Familiarizing tax personnel with the availability of this information and assigning the responsibility of properly maintaining it can reduce the time and effort necessary to ensure that one's compliance burden has been met and that no amounts were improperly withheld.

Conclusion

As businesses become more globalized and as world economies become more integrated, the challenge of meeting tax burdens will only increase.  Between open and closed economies, tax systems vary considerably in their laws, approaches and mechanisms for taxing income.   While the challenge of tax compliance will certainly increase as the world economy becomes more integrated, there are simple steps that businesses can take that mitigate the risks of over- and underpayment.  Foreign withholding tax is one such area that need not cause as much heartburn as it does presently.

Improving communication and record-keeping between business units with withholding  touch points, maximizing the utility and scope of information on sales documentation, and improving institutional knowledge of foreign withholding rates can significantly improve a company's compliance efforts and ensure that all revenue due a business is properly received.²

Charles Aikman
Director
Charles.Aikman@ryan.com

Patrick Roach
Consultant
patrick.roach@ryan.com

Ian Boccaccio
Principal and International Tax Practice Leader, Ian.Boccaccio@ryan.com