Reading time: 10+ min.
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
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.
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.
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.