Have you ever heard about a beautiful tax planning taking you to the courtroom? A meticulously arranged business structure will still fail when taxmen with his creative interpretation, derail it. Business conglomerates around the world have entangled into dramatic case laws while trying to infuse ‘royalty’ income in business planning and tax efficiency. What makes the ‘royalty’ tax attractive? Favorable tax treaties will turn your ‘royalty income’ into a tasty tax-free treat!
In simple terms, royalty is a payment made to the owner of the assets for using his or her created assets such as patents, copyrights, and franchises. Globally multiple transactions involve transferring amounts from one part of the country to another country for using the rights on the assets.
Article 12 of the OECD Model Tax Convention covers which State has the right to tax the royalty income.
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In this post, we will deal with the following:
What is ‘royalty’?
According to Paragraph 2 of Article 12, royalties means
- payment of any kind received as a consideration (so payment in cash, gold, ship, bitcoins and everything else is covered 😉)
- for the use of or right to use
- any copyrights of literary, artistic or scientific work
- including cinematograph films, any patent, trademark, design or model, plan, secret formula or process; or
- for information concerning the industrial, commercial, or scientific experience. (basically, many things.)
Royalty will not include a payment received as consideration for the transfer of the full ownership of an element of the property mentioned in the definition above.
The words “payments … for information concerning industrial, commercial or scientific experience” are used to include the transfer of unpatented information too. It consists of the knowledge which exists while the rights are transferred and do not include the new data created while performing the service requested by the payer.
Will alienation of rights in a geographic area form a ‘royalty’?
Identifying a portion of ‘royalty income’ in the agreement involving the transfer of rights to part of the property is an arduous task. Here the contracts require exclusive granting of rights to intellectual property for a limited period or all rights to the property in a restricted geographical area in a transaction structured as a sale.
As a general rule, a ‘royalty transaction’ will be identified based on:
- national intellectual property law applicable to the relevant type of property
- national law rules to determine what constitutes an alienation.
Note: Often, the payment received in consideration for the alienation of rights that constitute the distinct specific property are taxed under Article 7 as business profits or a capital gain within Article 13. The compensation received for separation of ownership of rights cannot be for the use of the rights. The essential character of alienation transaction is unaltered by the form of the consideration or the method of payment.
How to distinguish between the supply of know-how and supply of service?
The following criteria are relevant for making the distinction:
|Supply of Know-how||Supply of Service|
|In the know-how contract, one person imparts knowledge to the other so that he can use them for his account without revealing his specialized knowledge and experience to the public.||In the contract to supply services, one of the parties undertakes to use his skills to execute work himself for the other party.|
|The grantor of rights will play no role in the application of the formula and will not guarantee the result.||The supplier performs functions involving his knowledge, skill, or expertise but not the transfer of it.|
|It contains information that is existing and is developed and will mandate the confidentiality of that information.||The performance of the service might create information or product. Confidentiality is generally not mandated.|
Which country has the right to tax the royalty income?
According to Paragraph 1 of Article 12 royalty income earned by the beneficial owner who is resident of other country, will be taxed ONLY in that other country!
How to derive at royalty income in case of related party transactions?
Paragraph 4 of Article 12 restricts the operations of Article 12 concerning the taxation of royalties in cases where
- special relationships exist between the payer and beneficial owner and
- The amount paid as royalties is more than the arms-length price.
In such cases, the provisions of Article 12 will apply only at the value of arms-length price, and the excess amount would be taxed by the State of Source and State of residence according to their respective laws.
The paragraph only supports the adjustment of the amount of royalties and not the reclassification of royalties.
How to identify the beneficial owner of the royalty income?
Paragraph 1 of article 12 explicitly states royalties are taxed by the State, where the beneficial owner is the resident. Hence, the State of the source will not give up its taxing rights over royalty income merely because that income was paid directly to a resident of a state with the State of the source has a double taxation avoidance treaty.
The term ‘beneficial owner’ has to be understood in the broader scope and not influenced by the taxation laws of the contracting states.
State A and State B have entered into OECD Model Tax Convention. Mrs. Bells, a tax resident of State B, enters into copyrights agreement with Mr. Apple, a tax resident of State A. Mrs. Bell agrees in the capacity of Miss Celion’s agent, a tax resident of State C.
When royalty is paid to Mrs. Bells, State A will not provide the treaty benefit as it would be inconsistent with the object or purpose of the Convention for the State of the source to grant relief or exemption merely based upon the residential status of the recipient.
The report from the Committee on Fiscal Affairs entitled “Double Taxation Conventions and the Use of Conduit Companies” concludes that a conduit company is not the beneficial owner if it has limited power on the income concerned, i.e., fiduciary or administrative power.
In the given case, Mrs. Bells, the conduit person, does not have any rights to use or enjoy the royalty received and has contractual and legal obligation to transfer the money to Miss Celion and hence will not be treated as ‘beneficial owner.’
To qualify as the beneficial owner, the person receiving the royalty should have the right to use and enjoy the royalties unconstrained by the contractual or legal obligation to pass on the payment received to another person.