Why Foreign Withholding Taxes Really Matter

I had never heard of foreign withholding taxes (FWT) until I founded a startup in the Philippines (See Starting a Philippine Business as a Foreigner for background.).   I quickly became acquainted with them after they nearly cost me my first customer.

What are Foreign Withholding Taxes?

Foreign withholding tax is a tax levied on business transactions between a domestic entity and a foreign entity.  The tax kicks in when a domestic business purchases a product or service from the foreign one.

The tax is applied on the buyer of the product or service, not the seller.    This is because the domestic government does not have taxing power over the foreign business, so they instead tax the transaction on the buyer’s side.  It is called “withholding” because the buyer has to withhold the tax amount from payment to the foreign business, and pay the withheld tax to local authorities.

Why do Foreign Withholding Taxes Exist?

If foreign withholding taxes did not exist, foreign companies would be able to avoid taxes in a way that domestic companies cannot.  Foreign companies could operate tax free in the local market,  reduce pricing below that of domestic sellers.  Domestic buyers would in turn prefer foreign providers over local.

Why is the Foreign Withholding Tax is such a big deal?

  1. It taxes costs.  For foreign businesses, foreign withholding taxes are not the equivalent of domestic taxes on local businesses.  One large difference is that domestic businesses can deduct their expenses from their tax burden.  The foreign business can deduct costs in its home country, but in the local market the foreign withholding tax is applied to the total sale price.  Thus, the foreign withholding taxes tax costs and profits in the local market.
  2. It taxes the buyer.  It is not uncommon for taxes to be passed along from the seller to the buyer.  The FWT however is often higher than domestic VAT or sale taxes, thereby pressuring foreign businesses to lower prices to compete with domestic competition.  That downward pressure squeezes margins.  Furthermore, though the tax makes it more expensive for the foreign company to operate in the local market, the FWT is not a expense that can be deducted from the seller’s end-of-year taxes.
  3. It is well…foreign.  Depending on the experience of the buyer, the foreign withholding tax may seem, well, foreign.  If taxes are normally levied on sellers, the foreign withholding tax may seem an unnecessary complication of choosing a foreign provider over a domestic one.

Personal Experience – Many businesses, especially small ones, may not know about the FWT.  In the Philippines, the FWT applies to consumer purchases as well as business purchases.  Technically, a website subscription to a non-Philippine website would be subject to FWT.  Of course no one pays it, and there is no effective enforcement measures either.  It does mean that few people have experience with the FWT unless they work for a company that makes major purchases from abroad.

How to reduce the Foreign Withholding Tax?

  • Tax Treatise –  The amount of foreign withholding tax owed can be reduced if there is a tax treatise in place.  A tax treatise is an agreement between countries that governs foreign withholding tax rates on business transactions between the two countries.  If a tax treatise does not exist, a default rate applies which is higher than if there was one.  Deloitte is a great resource to compare tax treaty rates.
    • Personal Experience  – In the Philippines, even if a tax treatise exists, the default rate applies until the buyer is able to file for tax relief under the treatise.  This process involves paperwork to prove that a product or service was purchased from a company that exists in a country where a tax treatise applies.  The buyer must be the entity to apply for relief as the seller has no local authority to file.   Each buyer must file separately too.  I would not be surprised if this is standard practice in most countries.  
  • Don’t be Foreign. Establishing a domestic entity can eliminate the FWT altogether.  It will expose a company to a whole new set of taxes, which may or may not be worth it.
    • Personal Experience – I established a local entity in the Philippines as a reseller of my product which was sold from our Hong Kong Entity.  It is a long story how this was and was not adventitious.  For more details, read Starting a Philippine Business as a Foreigner.

If you have any questions or comments, feel free to leave them in Comments.  I will reply as quickly as I can.