Anyone invested in a pension fund or an ISA, or who holds foreign shares or an interest in a fund is, somewhere down the line, having their returns reduced by DWT. Like a thief in the night, the tax is spirited away before most investors realise it has gone.
So what exactly is DWT?
The most obvious thing to say is that it is a withholding tax similar in nature to payroll withholding (or PAYE as it is known in the UK and Ireland) but applied to dividend payments. In broad terms, the dividend is scheduled to be paid to the shareholder, but before the payment can be made, the paying agent is required to deduct a certain percentage and pay it to the local tax authorities. Most investors receive their dividend vouchers, see foreign withholding tax has been deducted and assume the amounts are correct. After all, we are used to receiving our salaries with the correct amount of tax deducted, so for many the same logic automatically applies.
The reality, however, is quite different and it is probably only in the minority of cases that the correct withholding tax has been applied. The reason for this lies with double tax treaties – bilateral agreements which Governments regularly negotiate between themselves. As a general rule, double tax treaties set a lower withholding rate (known as the treaty rate) than the rate (also known as the statutory or domestic rate) which is normally applied. In many cases, however, the correct treaty rate is not the rate which is applied meaning that investors are regularly suffering over-withholding.
To get a better idea, it is necessary to look at countries which facilitate relief at source procedures (US, Ireland) and those that do not.
Relief at source does pretty much what it says on the tin: it allows the payer to apply DWT at the reduced treaty rate and so gives relief from the higher rate at source. Different countries have different requirements to receive relief at source, but most require the investor to provide some documentation to the payer showing where they are resident and what treaty rate they are entitled to. Failure to provide the documentation means the payer must deduct DWT at the higher statutory rate and the excess reclaimed from the foreign tax office after the dividend has been paid.
Other countries do not even give the investor the opportunity to apply for relief at source. Their default position is that the higher statutory rate must always be applied and the investor must reclaim the excess after the dividend payment.
£1bn overpaid tax
An investor who is unaware of how DWT operates and assumes that the amount withheld is correct, is needlessly overpaying tax. If the money is not reclaimed before the Statute of Limitations elapses it is lost to the investor and becomes part of that foreign government’s spending.
The concept is best illustrated with a short example: the domestic withholding rate in Switzerland is 35%. The UK/Swiss Treaty specifies a 15% rate (for portfolio investors). Switzerland does not support relief at source so investors need to make a reclaim after the event. On a dividend of £1,000, £350 is withheld leaving a net of £650. Of that £350, £200 is reclaimable; a significant amount on just one dividend.
A common misconception, especially amongst retail investors, is that there is little or no point reclaiming the £200 as they receive relief for the foreign tax against their UK tax. This is not quite right, unfortunately. While they do receive relief for 15% foreign withholding tax, they do not get relief for the tax which can be reclaimed. The failure to reclaim the £200 results in double taxation.
At first glance DWT can seem to be a minor irritant rather than a serious problem. It would be a mistake to underestimate how DWT can drag down a portfolio’s performance. Over the long term, failure to properly manage DWT and reclaim amounts over-withheld can have a serious impact.
Consider the following scenario: there are two pots of £1m – Pot A and Pot B. Let us assume that they are both fully invested in overseas equities and are returning 5% annually with all dividends being reinvested. Ignore capital growth. Furthermore, let us assume that Pot A reclaims over-withheld DWT while Pot B does not.
After 20 years the difference between the 2 pots is over £300,000. Put another way, because of the compounding over time, Pot A is 16% larger than Pot B. Quite an impact.
In the scenario above there are some assumptions which are not realistic – funds tend to be properly diversified and unlikely to be invested in 100% foreign equity. However, as an illustration it serves the purpose in showing how a failure to manage DWT reclaims can significantly alter portfolio performance. This is something which should be borne in mind by anyone managing money and owing a fiduciary duty to clients.
An analysis of the Pink Book (published by the UK Office for National Statistics) reveals that UK-based investors could be missing out on over £1bn in DWT annually. Allowing for the fact that Statutes of Limitation in foreign jurisdictions run between two and five years, the amounts at stake are significant.
