What is Withholding Tax?
Withholding tax is a tax levied on payments made by a tax resident company to a non-resident company. For example, suppose you have a company in Country A, which imposes a 25% withholding tax. If Company B, a non-tax resident company before the eyes of Country A and incorporated in Country B receives royalty payments, rents, etc., from company A, these payments might be subject to ta withholding tax up to 30% (this varies per jurisdiction).
If a payment is not determined to be sourced from jurisdiction A, it will not be subject to withholding tax, even if the payor is from or the money is coming from that jurisdiction.
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Company A is required to withhold XX% of the payment made to Company B because Company B is not a tax resident of Country A, and the type of income Company B is receiving from Company A is deemed to be sourced from Country A and it also is taxed (not exempt) in jurisdiction A. This means that Company A must deduct this tax from the payment and remit it to the tax authorities in Country A. The rationale behind this is that since Company B is not a tax resident in Country A, it will not file a yearly tax statement there. Therefore, the withholding tax ensures that the income earned by Company B from sources within Country A is taxed appropriately so it the tax does not escape.
Withholding tax nature is to avoid an income sourced from that country or jurisdiction to avoid taxation because non-resident countries are hard to pursue and make them declare their Country A sourced income, so to basically to avoid this hassle, and to also avoid artificial shift of profit between companies, Country A levies a withholding tax on Company B formed in Country B, and at a higher tax rate than tax resident companies formed in Country A.
What type income is subject to withholding tax?
Any income can be subject to withholding tax when paid to a non resident in case this is not tax exempt. Withholding tax can applied to business income tax, capital gains, royalties, interests, loans, rents, etc.
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For a type of income to be subject to withholding tax, it must not be exempt from taxes, and to be deemed to be sourced in the Payor's jurisdiction.
Dissavantages of Withholding Tax
One of the cons of being subject to withholding tax, besides paying taxes, is that withholding tax does not allow you to deduct costs or expenses related to generating that income, unlike companies considered tax resident in Country A
Ways to avoid withholding tax
Tax Treaties
Double Taxation allow the payment receipimient to avoid paying Withholding Tax in the source jurisdiction
Forming a tax resident company in the Source Jurisdiction
Another way to avoid withholding tax is to form a tax resident company in Country A to avoid withholding tax, this way the income with not be taxed at the gross income value, but at the net income or less value.
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This way you can use the company in Country A to pay for expenses for generating that income, paying costs, salaries, etc.,
A specific option to avoid withholding taxes from the European Union
The European Union has a specific tax system, where basically and put simple, there is no withholding tax when the payment is made to a company tax resident in another European Union Jurisdiction.
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So if you were to receive income subject from a European Union Jurisdiction, by forming a company in Malta you can avoid this withholding tax, and only pay a 5% effective tax rate on your net income.
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