Pay attention to withholding tax on contracts with a foreign company

What are royalties?

A royalty is compensation of any nature whatsoever for the use of or right to use

• a copyright to a literary, artistic or scientific work, 
• a patent, an industrial trademark or trademark, a drawing, design, plan, secret recipe or secret method, or 
• information concerning experiences in relation to industry, trade or science.

The definition of royalty is very broad, therefore. If you receive compensation for the sale of any sort of software licence, copyright, patent ...this will often be considered a royalty.

In some countries, like India and Argentina, the term royalties is expanded even further to include compensation for technical assistance. As a result, a fee for providing advice or installing and updating software is also regarded as a royalty.

Tax consequences

The qualification as a royalty is mainly relevant in an international context. After all, a royalty is often subject to withholding tax in the source state, while tax is also levied on the same royalty in the recipient’s state of residence. 

If, for instance, a Belgian company sells a licence to a customer in Italy for EUR 1,000, withholding tax of 30% will be withheld from the fee in Italy. As a result, the Belgian company will only receive EUR 700. This EUR 700 will then be subject to Belgian corporation tax. 

Solutions?

Because this double taxation would pose a bottleneck in today’s globalisation, a number of measures have been taken to prevent or reduce double taxation.

In a European context, related taxable entities can invoke the Interest-Royalty directive to eliminate withholding tax. Unrelated companies can reduce or even avoid the withholding tax on the basis of the applicable double taxation treaty. In both cases, certain formalities do need to be satisfied.

In our previous example, it is possible to limit the withholding tax in Italy to 5% based on the double taxation treaty between Belgium and Italy. Pursuant to the application of the treaty, the Belgian company will receive EUR 950, as opposed to EUR 700 without application of the treaty.

Despite the fact that there is a double taxation treaty, certain countries will still withhold (limited) tax from the compensation. To further limit this double taxation, Belgium provides for set-off of the foreign withholding tax under certain conditions. This set-off is generally known as the ‘FBB system’. 

With the FBB system, the foreign withholding tax is set off with the tax owed in Belgium on a flat-rate basis. What is striking here is that pursuant to this flat-rate set-off, the total tax burden can be lower than if no tax were withheld in the foreign country. That is the case if the foreign withholding tax rate is lower than 15%. If the foreign withholding tax rate is higher than 15%, however, the application of the FBB system will result in a higher tax burden.

In our example, the Belgian company will be able to set off the foreign withholding in its corporation tax return via the FBB system. After this set-off and the corporation tax (29.58%) in Belgium, the Belgian company will have a profit of EUR 787.05. This results in a total tax burden of 21.30%.  In 2020, this tax burden will decrease even further to 16.18% when the Belgian corporation tax rate becomes 25%.

Royalties: blessing or curse?

When it comes to royalties in an international context, it is essential to investigate on a country-by-country basis how the royalty received will be taxed. The definition of royalty, the withholding tax owed and the measures to prevent double taxation can, after all, vary significantly from country to country.  

Do you receive royalties in an international context but are uncertain of what this entails? Do not hesitate to contact one of our specialists via contact@vdl.be.