Should you be accruing for withholding tax recoveries on foreign investment income or should these recoveries should rather be accounted for on a cash basis?
In the accounting world, the eternal goal is to ensure that financial records accurately reflect the financial position of a particular entity at a point in time. This generally means accounting for transactions when they occur as opposed to when the cash implications are felt.
As a global withholding tax recovery specialist, WTax is constantly asked by its clients whether they should be accruing for withholding tax recoveries on foreign investment income or whether these recoveries should rather be accounted for on a cash basis.
In most markets, investment income attracts withholding tax for foreign investors which erodes investment income. There are a number of mechanisms which investors can take advantage of to recover some or all of this withholding tax. Investors can lodge claims for refunds of withholding tax which have been charged in excess of rates agreed in double taxation agreements. There are also other mechanisms available to recover additional withholding either based on domestic exemptions in particular investment jurisdictions or claims based on precedent set in court cases held by the European Court of Justice (ECJ). Claims are generally categorized into 3 classifications: double tax treaty claims, exemption claims or ECJ claims.
The question arises whether the right to recover excess withholding tax levied on offshore dividend and interest income constitutes a receivable\ which should be accounted for. Receivables are assets created in accounting records for amounts owed to an entity where payment has not yet been received. In order for a receivable to be justified, there must be a high probability of receiving the actual money which is owed and the amount owed must be quantified with a reasonable level of certainty.
WTax is not an accounting firm, however we do work with our clients to provide estimates on likelihood of success of refunds. There are a number of complexities in the decision around whether a withholding tax claim is valid and likely to be paid.
We discuss the below factors with fund accounting teams to ensure financial statements paint a realistic picture, when it comes to withholding tax receivables.
Different investment vehicles are treated differently in terms of double taxation agreements
For example, a foreign tax authority in a particular investment jurisdiction may recognize and grant treaty benefits to a pension plan structure but not a Rev. Ruling 81-100 collective investment trust structure.
Different claim types have varying levels of certainty
A double taxation treaty claim may have more certainty for a particular investment vehicle than a claim based on domestic exemptions in the local market.
Investment jurisdictions around the world have varying levels of commitment to paying out claims
Filing a double tax treaty claim for a US corporation in Germany is generally reasonably certain, provided documentation requirements are met. However, when claiming for the same structure for Italian securities, we find that there is a very low chance of success. This is despite the fact that a double taxation agreement exists between the US and Italy and a claim should therefore be a certainty.
Time value of money definitely needs to be considered when creating receivables for withholding tax recoveries
Anyone who has embarked on the recovery process understands that withholding tax recovery is a long process and recoveries can take many months if not years to materialize. It’s important that these factors are integrated into the accrual process to ensure that asset values are not overstated.
At WTax, we work with clients to develop a comprehensive probability matrix which shows likelihood of success per investment vehicle, claim type and investment jurisdiction. Combining all the above factors results in recommendations which help to fairly measure the receivables for withholding tax recoveries.
As our clients are subject to various global accounting standards and compliance requirements, we have seen varying approaches to the accounting treatment (i.e. accruing or not accruing) of withholding tax receivables. In all cases, our clients together with their accounting advisors, believe to be presenting their financial statements as accurately as possible, given the inherent uncertainty. Ultimately, the goal is to avoid subsequent write-offs while also avoiding any large once-off income that relates to prior periods. WTax believes that time spent evaluating the nuances and developing a streamlined process for accounting for withholding tax recoveries results in a well-balanced, more accurate balance sheet.