Withholding tax and interest rates

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Although
income tax withholding rules were in place in the mid-19th century, Mr
Beardsley Rumi, the director of the Federal Reserve bank of New York Federal
Reserve, is considered to be the author of the modern tax withholding system.
The US Congress enforced Rum’s proposals with the Current Tax Payment Act of
1943.

Today, the tax
withholding obligation is applied to the majority of distributions made by any
corporate entity. Withholding tax is deducted from gross payout and the
withheld amount is transferred forward to the tax authorities. By creating a
withholding tax obligation, the state ensures that any income is taxed before
it can be spent by the recipient. The income tax withholding system ensures
that the state receives its taxes first, on time and without any credit risk.

The most
well-known withholding taxes are income tax, social security tax, pension
contributions – they are applied to salary payments.

The taxation principles for crowdfunded investments

Any income
generated from crowdfunded investments is not different from any other type of
income and thus, it is taxed similarly to other income.

Majority of
governments are requiring the companies to withhold income taxes from any
distributions made to its investors.

If the
crowdfunding investors have concluded loan agreements with the company, and the
company makes an interest payout, it has an obligation to withhold income tax
from the interest paid out.

If the crowdfunding investors have invested in the company’s equity, and the company makes a profit distribution via paying dividends, the company has an obligation to withhold income tax from the dividend payout.

Applying proper income tax rate

The applicable
withholding tax rate generally depends on three major components:

  • the Sponsor’s tax residency, which determines the country where the
    withholding tax is payable and over which country’s withholding tax law is
    applied. For example, if the Sponsor is an Italian company, the Italian income
    tax regulation is used to determine the withholding tax rate and the withheld
    tax is transferred to the Italian tax office;
  • type of payee – individual or legal
    entity. Several countries have different approaches to taxing interest payments
    to individuals and companies, so it is important to differentiate between the
    type of person receiving the interest income. For example, if the interest is
    paid by an Estonian company and is received by a private person and a company,
    both Estonian tax residents, the interest income payments to the individual
    will be subject to a 20% withholding tax and the payments to the company will
    have a 0% withholding tax rate;
  • applicable cross-border double
    taxation avoidance treaties, where the payer of interest and the recipient of
    interest have different tax residencies (ie they located in different
    countries) and which seek to minimize the double taxation of the generated
    income generated. On the other hand, double taxation treaties generally ensure
    that the income earned by the investor is taxed in both countries. In the case
    of a double taxation avoidance treaty, part of the applicable income tax is
    withheld by the paying company, and part of the income earned has to be
    independently declared by the investor in his home country.

The tax withholding
obligation occurs at the time the income is paid out.

Applying the
correct income tax rate is significantly more difficult if the crowdfunding
platform has a secondary market, where its investors can buy and sell their
loan contracts. In a complex case, the Sponsor might have to withhold taxes
from different persons in different tax regimes – depending on the ownership of
the contract at each individual payout occasion.

Selected applicable withholding tax rates

Payee Private individual
Payer Legal entity

Crowdestate’s income tax withholding process

Crowdestate is
one of the few European crowdfunding platforms that helps its Sponsors to apply
proper withholding tax rates to their interest payouts.

In order to
make income tax withholding easier for the Sponsor, the income tax withholding
occurs as follows:

  • the Sponsor makes a gross
    interest payment to Crowdestate’s client account;
  • Crowdestate controls, at the
    time of distribution of the interest payment, the type of beneficiary, his tax
    residency, and the existence of a double taxation avoidance treaty and determines
    the proper withholding tax rate;
  • the gross interest payment
    received from the Sponsor is credited to the investor’s investment account and
    at the same time, his or her investment account is debited in the amount of
    withheld income tax. In the event that one investment opportunity or Sponsor
    makes multiple interest payouts within a single calendar month, the tax
    withholding procedure described above is applied to all interest payouts;
  • The withholding tax will remain
    on Crowdestate’s segregated client account until the end of the current
    calendar month;
  • On the first day of the next
    calendar month, Crowdestate shall automatically transfer the withheld income
    tax amount back to the Sponsor. At the same time, Crowdestate provides the
    Sponsor with all reports and files that are necessary for filing tax
    declarations;
  • The Sponsor uses the received
    tax payment and the reports to properly filing the tax declaration.

Regarding the
application of proper withholding income tax rate and the subsequent filing of tax
declaration, it is extremely important that Crowdestate has up-to-date
information on investor’s tax residency and its other personal data (including
his social security number or ID code) at all times. Incomplete or incorrect
data would lead to incorrect, potentially higher, withholding tax rates and
would cause technical problems for the Sponsor when filing its tax
declarations.

A good example of an impact of tax residence change is when Crowdestate’s investor who has lived in Estonia leaves the country to live and work abroad, duly notifies the Estonian Tax and Customs Board of a change in tax residence, but forgets to change his tax residence data in his Crowdestate investment account. Therefore, when calculating and applying the income tax withheld from the interest payments, the 20% withholding tax rate would be applied to him even if his new tax residence would allow the application of lower income tax rate. Also, incorrect tax residency data would require the Sponsor to manually adjust his tax declaration.

Income tax report

Crowdestate
prepares a full tax withholding report for each investor, the report can be
downloaded from the Investment Portfolio section.

The tax report
lists names and corporate details of each Sponsor along with the gross interest
income and amount of withheld income tax.

Income tax declaration

If the withholding income tax rate is lower than the investor’s domestic income tax rate, the investor would need to declare the non-taxed part of the income and, if necessary, pay additional income tax.

Examples

Sponsor 1 AS is an
Estonian tax resident company with two investors: Private Person A and Small
Business OÜ. Both investors are Estonian tax residents as well. Sponsor 1 AS
will pay interest to both investors in the amount of EUR 1,000.

While making
the interest payment, Sponsor 1 AS applies the following income tax withholding
rates:

  • Interest paid to Private Person
    A is subject to a 20% income tax withholding, so Sponsor 1 AS will withhold a
    sum of EUR 200, and the net payout is EUR 800;
  • Interest paid to Small Business
    OÜ is subject to a 0% income tax rate, so Sponsor 1 AS does not withhold income
    tax and Small Business OÜ receives the gross interest amount (EUR 1,000).

Sponsor 2 srl is a
Romanian tax resident company with three investors: Private person A is an
Estonian tax resident, Private Person B is a German tax resident, Private
Person C is an Italian tax resident and Small business srl is also an Italian
tax resident. Sponsor 2 srl will pay out interest income of EUR 1,000 to all
investors.

Under Romanian
tax laws, the Romanian company has an obligation withhold income tax from the
interest distributions.

In making the
payment, Sponsor 2 srl applies the following rates of income tax:

Interest paid to Private Person A is subject to a 10% income tax rate, so Sponsor 2 srl will withhold payment of EUR 100. There is a double taxation convention between Romania and Estonia, which also provides for a 10% income tax rate – so a 10% withholding tax rate must be applied anyway. NB! As the income of the Estonian private tax resident is taxed variably according to his or her actual income, the Estonian private tax resident is obliged to declare the untaxed part of the interest income independently. Assuming that income earned by Private Person A is subject to a 20% income tax rate, the person would have an additional income tax liability of 10%;

The interest
paid to Mr B is taxable at a rate of 10%, while there is a double taxation
agreement between Romania and Germany which provides for a 0% rate. Therefore,
Sponsor 2 srl has no obligation to withhold income tax on this payment. The
investor must declare all his income and pay income tax in accordance with
German income tax regulations;

The interest paid to private individual C is subject to a 10% income tax rate. At the same time, Romania and Italy have concluded the double taxation avoidance treaty, which provides for a 5% flat income tax withholding rate on the distribution made to private individuals. Therefore, Sponsor 2 srl will withhold the income tax in the amount of EUR 50. Italy taxes the income earned by private persons at a standard tax rate of 26%, so Private Individual C would be required to declare and pay the 21% difference;

Interest paid to a Small Business srl is subject to a 16% income tax rate, while a double taxation avoidance treaty between Italy and Romania provides for a 5% tax rate on the distributions made to legal entities. Therefore, Sponsor 2 srl will withhold payment of EUR 50.

Disclaimer

The
information above intends to give a broad and general overview of taxation and
tax withholding principles and should not be taken as tax advice. The provided
examples are general and illustrative. The final taxation and individual tax
rate of a particular investor may depend on many other individual factors.
Therefore, all specific tax questions should be addressed to a professional tax
advisor.

This article has not been coordinated with tax authorities in different countries and there is no assurance that tax officials will not take a different view. While writing the article, we have relied on the tax laws in force at the time, and we will not have any obligation to update the tax rates or other information contained in this article. Crowdestate is not responsible for any loss, damage or expense that may result from reliance on this information.

In case of
further questions, please contact a tax advisor.