Withholding taxes are an essential component of tax compliance frameworks globally. These taxes are collected by requiring the payer to withhold a portion of the payment owed to a payee (being the recipient of the payment) and to remit the withheld amount to the relevant revenue authority. This mechanism ensures efficient tax collection, especially in cross-border transactions.

One significant application of withholding taxes arises in offshore intellectual property transactions, which can trigger withholding tax on royalties ("WTR"). This blog post highlights key considerations in transactions involving WTR. Failing to address these can lead to unintended liabilities and complications.

What is a "royalty" for the purpose of WTR?

WTR is governed by section 49A of the South African Income Tax Act.  Under this section, a "royalty" broadly includes amounts received or accrued concerning:

• the use, right of use, or permission to use intellectual property;
• the imparting of, or an undertaking to impart, scientific, technical, industrial, or commercial knowledge or information; or
• assistance or services rendered in connection with the application or utilization of such scientific, technical, industrial, or commercial knowledge or information.

The term "intellectual property" is expansively defined in section 23I(1) to cover a wide array of items. This broad scope captures not only licence fees for works such as software or trademarks but also payments for accessing proprietary information or related services.

What are the payer's obligations when WTR applies?

When WTR applies, the payer must deduct the applicable tax and remit it to the South African Revenue Service ("SARS") on behalf of the non-resident payee.  The triggering event is when the royalty becomes due or payable or otherwise accrues to the payee, as provided for in the underlying agreement.  This obligation arises regardless of whether the royalty has in fact been paid or not.

Key compliance points include:

• Applicable Rate: The WTR rate is determined by the double tax agreement (DTA) between South Africa and the payee's country of residence. In the absence of a DTA, a flat rate of 15% applies.
• Timing: According to section 49B(2), WTR must be withheld at the earlier of when the royalty is paid or when the royalty becomes due and payable.
• Payment Deadline: The withheld amount must be paid to SARS by the last day of the following month.

Consequences of Non-Compliance

While the non-resident payee is ultimately liable for the WTR, the payer is responsible for deducting and remitting the tax. Failure to comply can result in SARS holding the payer personally liable under section 157 of the Tax Administration Act.

If the payer becomes liable for underpaid WTR, section 160(1) provides them the right to recover the amount from the non-resident payee.

Addressing WTR in Commercial Agreements

The approach to WTR often depends on the relative bargaining power of the parties involved.  Below are two common scenarios:

"Gross-Up" Clauses

A payee with stronger negotiation power may insist on a "gross-up" clause, which increases the royalty amount to offset the WTR deduction. While this ensures the payee receives the agreed net amount, it can significantly increase costs for the payer without adding value. Additionally, gross-up clauses may face challenges in obtaining exchange control approval, as they may undermine the arm’s-length nature of the agreement.

Balanced WTR Compliance

To fairly manage WTR obligations, parties can adopt a neutral approach:

• The payee submits a valid withholding tax declaration ("WTRD") to the payer before the first royalty payment is due.
• The payee issues an invoice reflecting the royalty amount.
• The payer deducts the applicable WTR, remits it to SARS along with the appropriate return, and provides proof of payment to the payee.
• The payer supports the payee in reclaiming WTR from SARS, if applicable.

For long-term agreements, the payee renews the WTRD before its expiry (valid for five years) or as required under the Income Tax Act.

Conclusion

Proactively addressing WTR in agreements and ensuring compliance with relevant laws can prevent unforeseen risks and liabilities. Careful attention should be given to drafting terms that fairly allocate WTR obligations while avoiding unnecessary cost escalations, such as those arising from gross-up clauses.

For further guidance, refer to SARS' dedicated page on WTR, which includes resources such as DTA rates and relevant forms: Withholding Tax on Royalties - SARS.