Withholding tax on payments abroad

What is withholding tax and why it affects your payments abroad

This is a preventive mechanism by which the Czech state ensures the collection of income tax that would otherwise be very difficult to tax directly from the foreign recipient. The list of incomes from which withholding tax is levied is exhaustively defined in § 22 and § 36 of the Czech Income Tax Act.

Among the most common payments abroad where there is a risk of incorrect assessment of withholding tax are license fees for the use of intangible property and payments for services rendered. License fees include payments for the use of copyrights, industrial designs, patents, trademarks, or know-how. Services may include consulting, management, marketing, technical, or other types of services provided in the Czech Republic or for a Czech entity.

What is the basic withholding tax rate and when does it apply

The basic withholding tax rate is 15% of the gross income amount. As a payer, you must always apply this rate unless a double taxation treaty (DTT) exists between the Czech Republic and the state where the foreign recipient has their tax domicile.

The withholding tax rates set out in double taxation treaties are in most cases lower than the basic 15% rate under the Czech Income Tax Act. For example, the treaty with Germany sets a rate of just 5% for license fees, while with Slovakia it is 10%. For Czech companies, this means significant savings, provided they meet all the conditions for applying the reduced rate.

The strictest regime applies to payments directed to so-called tax havens, i.e., states with which the Czech Republic has not concluded a double taxation treaty or an agreement on the exchange of tax information. In these cases, an increased withholding tax rate of 35% is applied. This punitive rate is intended to discourage the use of offshore jurisdictions for tax optimization.

When you must withhold tax on payments abroad

The decisive moment for withholding the tax occurs upon the payment, remittance, or crediting of the payment in favor of the foreign recipient, but no later than the day you account for the liability in accordance with the Act on Accounting. This means that the obligation to withhold tax arises at the latest on the accounting date, even if the actual payment has not yet been made.

You are obliged to remit the withheld tax to the locally competent tax administrator by the end of the calendar month following the month in which the obligation to make the withholding arose. At the same time, you must file a statement of tax withheld at a special rate on the prescribed form.

Failure to comply with the reporting obligation can lead to a fine of up to CZK 500 if you do not file the statement at all, or up to 0.5% of the total tax amount for late filing. However, if you do not withhold the tax at all, you face much more serious penalties – the tax authorities can assess the tax, including a 20% penalty, and you will also have to pay late payment interest.

How double taxation treaties work and why they are key for you

The Czech Republic currently has nearly 90 double taxation treaties with various countries around the world. These international treaties take precedence over the Czech Income Tax Act and allow for the application of lower withholding tax rates or complete exemption of income from tax.

Double taxation treaties typically reduce the withholding tax rate on license fees to 5–10% instead of the basic 15%. For some types of services, the treaties even stipulate that the income is not subject to taxation in the Czech Republic at all, provided the foreign provider does not have a permanent establishment in the Czech Republic.

However, to apply the more favorable rate under a treaty, you must meet strict conditions. The key condition is to prove that the foreign recipient is the beneficial owner of the income and is a tax resident of the state with which the Czech Republic has a treaty. This is proven by a tax domicile certificate issued by the foreign tax authority.

If you do not have a valid tax domicile certificate for the foreign recipient at the time of withholding the tax, you must apply the higher rate under Czech law. It is subsequently possible to apply for a refund of the overpayment, but this process is administratively demanding and time-consuming.

The most common risks: When you face a tax assessment

During audits, the Tax Administration very thoroughly checks the correctness of the withholding tax procedure for payments abroad. The most common reasons for a tax assessment include the absence or invalidity of a tax domicile certificate, incorrect classification of the payment's nature, and the application of an exemption where it should not have been used.

If the Tax Administration discovers during a tax audit that you did not withhold the tax or withheld it in the incorrect amount, it will conduct a tax assessment. To the assessed amount, they will add a penalty of 20% of the assessed tax and, additionally, late payment interest. For larger amounts, the penalties can quickly climb into the hundreds of thousands or even millions of crowns.

A problem also arises when a foreign entity does not provide a tax domicile certificate on time or when this certificate contains incomplete or incorrect information. The burden of proof that the recipient is the beneficial owner of the income and a resident of the treaty state lies solely with the Czech payer. A lack of evidence can lead to the application of the basic or even the increased tax rate.

A specific risk involves payments for services provided by a foreign entity on the territory of the Czech Republic. If the provision of services exceeds the six-month time test, it may lead to the creation of a permanent establishment of the foreign entity in the Czech Republic. In such a case, withholding tax is not applied, but the foreign entity is obliged to file a tax return and tax the income in the standard way. Incorrect assessment of this situation can lead to serious complications.

When payments abroad are not subject to withholding tax

Not all payments directed abroad are automatically subject to withholding tax. Exemption from withholding tax applies, for example, to dividends paid between a parent and a subsidiary company within the European Union, provided that the conditions stipulated by law are met.

For dividend exemption, the parent company must hold a minimum 10% share in the subsidiary's share capital for at least 12 months, and it must be proven that the parent company is the beneficial owner of the income. This exemption is based on the EU Parent-Subsidiary Directive and is intended to prevent double economic taxation of profits.

Another exception is interest and license fees paid between related parties within the EU, provided the conditions set by the relevant EU directive are met. In these cases, there is no obligation to withhold tax, but a reporting obligation to the tax office remains if the payment amount to a single recipient exceeds CZK 300,000 per month.

Withholding tax is also not applied to payments for the purchase of goods or materials. However, beware of mixed transactions where the supply of goods also includes the provision of a service or license. In such cases, it is necessary to correctly allocate the price and assess each component separately.

Beneficial owner of income: A key concept for applying double taxation treaties

The concept of the beneficial owner of income is one of the most important, and at the same time most complex, requirements for applying the benefits of double taxation treaties. The beneficial owner is the person who has full and unrestricted control over the received funds and can dispose of them freely.

The mere fact that money flows into the account of a foreign entity does not mean that this entity is its beneficial owner. If the foreign entity acts merely as an intermediary and the income actually belongs to another person (for example, in another state), it is not the beneficial owner, and the benefits of the treaty cannot be applied.

A typical example of a problematic structure is payments directed to intermediary companies in jurisdictions with favorable double taxation treaties, when the ultimate beneficiary is an entity in a third country. If the Tax Administration proves that the foreign recipient is not the beneficial owner, it can apply a higher tax rate and make an assessment, including penalties.

To prove beneficial ownership, a tax domicile certificate alone is not sufficient. During an audit, the Tax Administration may request further evidence, such as license agreements from the actual owner of the rights, documents on the origin of the rights, information about the economic substance of the foreign entity's activities, and the reasons for the chosen structure.

License fees: Specifics and common errors in their taxation

License fees represent payments for the right to use copyrights, patents, trademarks, industrial designs, know-how, and similar intangible assets. It is precisely with license fees that errors in applying withholding tax very often occur, because the line between a license and the provision of a service is not always entirely clear.

Under the Czech Income Tax Act, license fees paid abroad are subject to a 15% withholding tax, unless a double taxation treaty provides otherwise. However, most treaties set lower rates – typically 5–10%.

A problem can be qualifying whether it is actually a license fee or a payment for a service. For example, if a foreign entity not only provides a software license but also carries out its customization, implementation, and user training, it may be a mixed transaction. In such a case, it is necessary to correctly allocate the price between the license part and the service part and tax each part according to the relevant rules.

Another common mistake is confusing license fees with the purchase of intangible assets. If there is a complete transfer of rights (not just their temporary use), it is not a license fee but a purchase of property, which is not subject to withholding tax. The content of the contract and the actual nature of the transaction are decisive, not just its name.

Payments for the use of software require special attention. In the case of standard "boxed" software, it is usually a purchase of goods, not a license. Conversely, if it is custom-made software or a license for industrial software, the license fee regime applies.

Services provided by foreign entities: When there is a risk of creating a permanent establishment

Payments for services provided by foreign entities represent another problematic area. The basic rule is that income from services provided in the Czech Republic by a foreign entity is subject to taxation in the Czech Republic only if a permanent establishment is created.

A permanent establishment can be created either by the existence of a fixed place of business (office, branch) or by exceeding a time test. When providing services of a consulting, management, or advisory nature, a permanent establishment is created if these activities last for a total of more than six months in any twelve-month period.

The problem is that if a permanent establishment is created, the foreign entity is obliged to file a tax return in the Czech Republic and tax the income in the standard way – withholding tax is not applied in such a case. If a Czech company applies withholding tax where a permanent establishment has been created, or vice versa, serious complications can arise during an audit.

Another risk is services provided remotely from abroad. If a foreign supplier provides services only from its headquarters abroad (e.g., consultations by phone, document processing, IT services), a permanent establishment is usually not created, and the income is not subject to taxation in the Czech Republic. In this case, withholding tax does not arise, but it is necessary to have evidence proving that the services were actually provided from abroad.

What to do when notified of a tax audit focused on withholding tax

If you receive a notification of the initiation of a tax audit focused on withholding tax, it is crucial to react immediately and prepare complete documentation. The tax administrator will require contracts with foreign suppliers, tax domicile certificates, proof of payments, accounting records, and withholding tax statements.

The first step is to map all payments abroad in the audited period and evaluate whether the withholding tax was correctly withheld and remitted. If you discover an error, it is better to report it to the tax administrator voluntarily and file a supplementary statement than to wait for the audit to uncover the problem. By voluntarily admitting the mistake, you do not incur the obligation to pay a penalty, only late payment interest.

During the audit, the tax administrator has the right to request explanations for individual transactions, the origin of goods or services, the reasons for the chosen payment structure, and proof of the beneficial owner of the income. The burden of proof lies with the taxpayer – meaning you must prove the correctness of your procedure, not the tax administrator its incorrectness.

The lawyers at the ARROWS law firm have extensive experience representing clients in tax audits focused on international transactions. Thanks to our cooperation within the ARROWS International network, we can quickly obtain documents from abroad. Our firm's liability insurance amounts to CZK 500,000,000, which means maximum security for our clients. For an immediate solution to your situation, contact us at konzultace@arws.cz. 

Exemption for dividends and interest between related parties in the EU

An important exception to the withholding tax regime is dividends paid between a parent and a subsidiary company within the European Union. If the parent company holds a minimum 10% share in the subsidiary's share capital for at least 12 months, the paid dividends are exempt from withholding tax.

This exemption is based on Council Directive 2011/96/EU on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States. The condition is that both companies are tax residents of EU member states and are subject to corporate income tax without exemption.

Similarly, under certain conditions, interest and license fees paid between related parties within the EU are also exempt from withholding tax. Although no tax is withheld, a reporting obligation to the tax office still exists. If the total amount of interest or license fees paid to one recipient in a calendar month exceeds CZK 300,000, you must report this fact by January 31 of the following year.

Incorrect application of the exemption can lead to a tax assessment with all penalties. It is crucial to have documents proving compliance with all legal conditions – especially the holding period of the share, the tax residency of both parties, and the beneficial ownership of the income.

The ARROWS law firm will help you assess whether an exemption from withholding tax can be applied in your situation and will prepare the necessary documentation for you. Thanks to our many years of experience providing services to more than 150 joint-stock companies and 250 limited liability companies, we can identify tax optimization opportunities while maintaining full legality. For a consultation, contact konzultace@arws.cz. 

Practical tips: How to minimize risk on payments abroad

The first step to minimizing risks is to build a compliance system for managing withholding tax. This means establishing internal policies on how to proceed with payments abroad, what documents to require from foreign suppliers, and how to check the correct application of withholding tax.

Before concluding a contract with a foreign supplier, always request their tax domicile certificate and verify that the respective state has a double taxation treaty with the Czech Republic. Check what withholding tax rate applies to the specific type of income under the treaty.

In the contract itself, clearly define the nature of the provided performance and the individual price components. If the contract includes multiple types of performance (e.g., a license, services, and supply of material), break down the price for each item separately. This will allow you to apply the correct tax regime to each part.

Regularly update the documentation from all foreign partners – a tax domicile certificate is usually valid for one calendar year. Create a register of foreign suppliers with an overview of when their documents expire.

A leading practice is to regularly review your foreign contracts with lawyers specializing in international tax law. The ARROWS law firm provides comprehensive reviews of contracts with foreign partners, assessment of tax risks, and preparation of optimized contractual documentation. Our clients appreciate that through regular reviews, we prevent problems and protect them from fines and penalties. Connect with us at konzultace@arws.cz.

When to turn to the ARROWS law firm

The issue of withholding tax on payments abroad is in practice substantially more complex than it may seem at first glance. Individual steps that appear simple have hidden exceptions, procedural details, connections to other regulations, and risks in the real world that a layperson often does not see.

Simply finding the relevant double taxation treaty and identifying the correct rate does not guarantee the correct procedure. It is necessary to assess whether the foreign recipient is the beneficial owner of the income, whether the payment actually falls under the given income category according to the treaty, whether it is necessary to split a mixed performance, and whether all formal requirements are met.

Errors in this area can lead to significant financial losses – the combination of an assessed tax, a 20% penalty, and late payment interest can amount to hundreds of thousands or even millions of crowns. Moreover, the time spent dealing with a tax audit and subsequent corrective measures represents a significant burden on the company's management.

The ARROWS law firm deals with this agenda daily, which allows us to significantly shorten the time for clients and minimize the risk of errors. It is therefore safer for companies to have the matter professionally handled and be certain that all obligations are met correctly.

Our services in the area of withholding tax include:

• Preparation and review of contracts with foreign partners with regard to tax implications and the correct setup of withholding tax. We prepare contracts to clearly define the nature of the performance and minimize tax risks.

• Legal consultations and analyses focused on specific transactions. We will help you assess whether a given payment is subject to withholding tax, what rate applies, and what documents you need from the foreign partner.

• Obtaining and verifying tax domicile documentation for your foreign partners. Thanks to our ARROWS International network, we can verify the validity of documents directly with the source authorities abroad.

• Preparation of policies and internal procedures for managing withholding tax in your company. We will set up a system that ensures all payments abroad are processed correctly and on time.

• Representation during tax audits focused on payments abroad and withholding tax. We will prepare a defense strategy, gather evidence, and represent you in negotiations with the tax administrator.

• Expert training for your accounting and finance departments in the area of withholding tax, including practical examples and the most common mistakes. The training concludes with a certificate of completion.

• Representation in licensing and administrative proceedings before tax authorities, including appeal proceedings. We will prepare and file all necessary submissions on your behalf.

We also commonly partner with in-house corporate lawyers to resolve special matters with an international element. Thanks to our international network, ARROWS International, we handle cases with an international element on a daily basis and have experience with the legal systems of dozens of countries worldwide. If you need an immediate solution to your situation, do not hesitate to write to us at konzultace@arws.cz. 

International scope: How we handle withholding tax abroad

The issue of withholding tax is not one-sided – Czech companies encounter it not only when making payments abroad but also when they themselves receive income from foreign sources. If your company receives a payment from abroad, the local withholding tax may be withheld in the foreign country.

In such a case, it is crucial to correctly apply the method for the elimination of double taxation, which is stipulated by the relevant double taxation treaty. The Czech Republic uses two basic systems – the exemption method and the credit method. With the exemption method, the foreign income is excluded from the tax base in the Czech Republic but is used to calculate the tax rate (progression). With the credit method, the foreign tax is deducted from the Czech tax liability.

If a higher tax was withheld abroad than is permitted by the relevant double taxation treaty, you are entitled to apply for a refund of the overpayment. However, this process is administratively demanding and requires knowledge of local procedures in the foreign country.

It is precisely in these situations that the strength of our international network, ARROWS International, becomes apparent. Thanks to a network of partner firms built over ten years, we can secure refunds of overpaid withholding tax in foreign countries, obtain necessary certificates and licenses abroad, and provide comprehensive legal support for international transactions.

If your company is planning to expand abroad or already trades with foreign partners, we can help you set up an effective structure that minimizes the tax burden while maintaining full legality. Do not hesitate to contact our firm – write to konzultace@arws.cz. 

Conclusion

Withholding tax on payments abroad is a complex area full of pitfalls and risks. Incorrect assessment of the payment's nature, lack of necessary documentation, or erroneous application of an exemption can lead to a tax assessment, a 20% penalty, and late payment interest. 

The lawyers at the ARROWS law firm routinely handle this issue and specialize in it. We help clients with contract preparation, documentation reviews, obtaining necessary certificates, and representation during tax audits. Thanks to our international network, ARROWS International, we handle cases with an international element on a daily basis.

If you do not want to risk mistakes, damages, or fines, safely leave the entire matter to ARROWS – just contact the office at konzultace@arws.cz.