Royalties, a Services Permanent Establishment and Excess Credits

The credit computation

The UK taxes the royalty gross, with credit for the foreign tax on the same income. The credit is the lower of:

• the foreign tax on that income, and
• the UK tax on that income.

With the treaty rate

• Foreign tax: 200,000 × 10% = £20,000
• UK tax on the same income: 200,000 × 25% = £50,000
• Credit = £20,000 (fully relievable)

Without the treaty claim

• Foreign tax: 200,000 × 20% = £40,000
• UK tax on the same income: £50,000
• Credit = £40,000 - still fully relievable, because the UK rate exceeds the foreign rate.

So the treaty claim saves cash flow, not tax: £20,000 of VAT-style timing benefit, i.e. £20,000 less to reclaim or carry as an overpayment position. It is worth doing, but it is not a permanent saving.

Where the treaty would matter

The UK credit is per source/income with no general carry-forward of excess foreign tax. If TIL's UK rate on that income were 19% (small profits rate), UK tax would be £38,000; at a 20% withholding rate £40,000 would be withheld and £2,000 would be permanently lost - so the treaty claim is crucial in a low-rate year.

Procedural points

• The credit must be claimed in the company tax return, within the usual claim time limit (four years after the end of the accounting period).
• Treaty relief at source requires a certificate of residence from HMRC; without it, State X withholds at the domestic rate.
• Deduction relief (treating the foreign tax as an expense) is almost never preferable where the UK rate exceeds the foreign rate, because it recovers only 25p per £1.

Is there a PE?

Yes. The services PE clause gives State X taxing rights where staff are present for more than 183 days in any 12-month period. Presence was 190 days, so a PE exists and State X may tax the profits attributable to the installation activity. The UK relieves the resulting double taxation by credit under the treaty's elimination article - the UK does not exempt PE profits under its standard model.

The credit is capped

• Foreign tax: £95,000
• UK tax on the same profits: 330,000 × 25% = £82,500
• Credit = £82,500
• Excess of £12,500 is lost - the UK does not allow excess credits to be carried forward (outside very limited rules)

So the effective State X rate of about 28.8% on the attributed profit leaves 3.8 points of unrecoverable tax.

But first challenge the attribution

A credit is only available for tax on profits that are also taxed in the UK on the same income. Before accepting the number:

• Is the £330,000 computed on an arm's length basis (proper allocation of direct and indirect costs, and no notional charges that the UK would not allow)?
• Does the assessment include items not in TIL's UK profit, such as a disallowed head office recharge? Credit may be denied on that slice.
• Are there deductions State X has refused which, if allowed, would reduce both the foreign tax and the excess credit?

Options: appeal locally within the domestic time limit, or ask HMRC to invoke the mutual agreement procedure under the treaty's competent authority article, especially where the attribution is inconsistent with the OECD approach.

Compliance

A PE creates State X filing, registration and possibly local indirect tax obligations, with penalties accruing from the local due date. The UK credit is not a substitute for local compliance.

The count itself

• The margin is only seven days. Presence is normally counted on a days-any-part-of-which basis: arrival and departure days count, as do weekends and public holidays spent on site or in the country.
• Days spent in State X on unrelated business, or on holiday attached to the project, can still be presence days for the PE clock.
• The 12-month window is a rolling window, not a calendar year, so the clock can start before the contract and finish after it.

Fragmentation

Splitting the work into two contracts, or into two group companies, is the obvious response and the obvious risk:

• Many treaties (and HMRC's interpretation of the OECD model) aggregate connected projects where the contracts are in substance one project, or where the parties are associated and the work is commercially indivisible.
• Even without aggregation, if the second contract uses the same personnel and the same site, the substance argument is strong.
• A contractual split with genuinely separate scope, separate mobilisation, separate pricing and separate personnel is defensible; a paper split is not.

The employees

The services PE is a corporate test. Each employee's own position depends on the separate employment income article, which typically has its own 183-day presence test plus conditions (employer not resident, cost not borne by a local PE). With 190 days' presence, the employees may also be taxable in State X, and TIL may face local payroll withholding and social security obligations (A1/coverage certificates should be obtained before travel).

Actions before the next contract

1. Build a day-count tracker from travel data, updated weekly, with a documented method for counting partial days.
2. Model the treaty position before bidding, including the local tax cost of a PE and the portion of foreign tax that will be uncreditable.
3. Obtain certificates of residence and any treaty relief clearances up front.
4. Check local VAT/GST registration thresholds for the site activity.
5. Keep contemporaneous evidence of genuine project separation if contracts are split - assume HMRC and State X will test it.