The international tax aspects of intellectual property

Different Forms of Intellectual Property Rights

Income from intellectual property rights may be derived by way of royalties. As with other sources of income, the tax planning of intellectual property should concentrate on maximising the after tax profits. To ensure that arrangements made to receive royalties are effectively constructed, it is necessary to analyse how various countries treat the payments of royalties, whether tax is withheld on such payments and how the income receipts and expenditures are treated.

Factors affecting the basis of taxation at source
The following are some of the factors which would affect the basis of taxation:

a) The form of payment in which the royalty is made, for example lump sum payment or annual payment or mixed (eg. franchise fees)
b) The type of intangible property right, for example patent, copyright, trade mark, etc
c) The domestic law of the licensor’s country
d) The specific domestic legislation of the country of the licensee’s residence
e) Double tax treaty provisions that may apply between the relevant countries
f) The permissible royalty rates

Patents
Patents are usually exploited by means of a royalty payment from the licensee to the licensor. The basic taxation could differ should the patent royalty be made as an annual payment or as a lump sum receipt. It would then be important to determine whether domestic legislation regards such payments as of a capital or of an income nature. If of an income nature, the payor may be required to deduct income tax at the basic rate from the payment and to pay this amount over to the local tax administration within a specified period. Should the payment be regarded as one of a capital nature, it would be important to determine whether capital allowances are deductible.

Intellectual property represents property which can be transferred and can in certain circumstances result in a chargeable capital gain or an allowable loss. This would normally be subject to capital gains tax provisions, and this is especially relevant when IPRs are transferred from a company in a high tax jurisdiction where they were started to an offshore low tax jurisdiction where they are required to be exploited. A transfer by an individual to, say, an offshore structure could also be a chargeable transfer for gift tax purposes.

Trade, Service Marks and Designs
For income received through trade, service marks and designs, generally, if the consideration is a fee, income would be taxable as a trading receipt; if a royalty is paid for the use of the trademark, service mark or design (where no services are performed by the licensor), it could be assessed as royalty income. If the trademark is sold for a lump sum the amount would normally be regarded as capital; however, if the lump sum was for the licence only, it would be taxed as income. Again, there may be specific legislative provisions regarding these different forms of income, and non-resident recipients could be totally exempt from tax in the absence of a permanent establishment.

Copyright
Royalties from copyright are normally taxable as income from a profession if the royalties are paid to the owner of the copyright, but if the royalties are paid to third parties under licensing agreements such income may be differently taxed. Certain countries regard lump sum payments as professional income rather than capital receipts. Where capital sums in respect of a copyright are received by a person not exercising a profession, they will not normally be chargeable to income tax but will be chargeable to capital gains tax, eg. the assignment of copyright in consideration for a lump sum by a person who is not a professional author. If a performer receives a capital sum which is ancillary to his professional work, it may not be chargeable to income tax eg. the sale of film rights by an actor may be held to be a capital transaction and not subject to income tax, as it is not part of an actor’s profession to dispose of copyrights. In addition to income and capital gains tax considerations, inheritance tax may be applicable for individuals where transfers are made at less than their arm’s length values. For a specific review of the taxation of entertainers and sportsmen, see the IFS Tax Briefing “The international taxation of Entertainers and Sportsmen”.

Franchises
Franchise payments usually take two forms, an initial lump sum payment and an ongoing annual royalty fee. The ongoing annual royalty fee is usually considered an income item subject to income tax. The lump sum payment could either be an income item or a capital receipt item and reference has to be made to the particular country of residence for the appropriate treatment in this regard. For example, a lump sum royalty fee in Canada is usually considered to be eligible capital expenditure which could take the form of both an income and a capital receipt depending on who the taxpayer is. The entity that makes the payment is allowed to depreciate 75% of the gross amount at a 7% rate on the declining balance.

Know-how
This is usually taxed as a trading receipt in the normal course of business. Where know-how remains with the licensor for further exploitation it is regarded as a trading receipt; if on the other hand a licence means that the information once imparted cannot be utilised commercially again, the receipt may be regarded as of a capital nature.

Under Article 12 of the OECD model double tax treaty, the definition of royalties includes know-how but excludes show-how. Under the model treaty, a withholding tax on royalties is only imposed in limited cases, that is on patent royalties, copyright and certain mineral royalties. In each case however one must look to the royalty article of any applicable double tax treaty in order to determine how that country will treat income paid to non-residents in terms of a royalty contract, or alternatively in the absence of a double tax treaty under unilateral law.

Taxation at source in various countries
From the above analysis, it is clear than many countries impose withholding tax (generally at rates between 20% and 35%) on certain types of IPR income, and in certain circumstances only. Thus in the UK, the standard rule in the UK for payment of royalties abroad is to deduct a basic rate of 23% withholding tax on UK patent royalties and copyright royalties but not for example on payments for trademarks or film rights. Moreover, no UK withholding tax is due on copyright or patent royalties paid in respect of rights exploited overseas out of foreign source income (this being the same in the US). This leads to the possible use of a UK or US intermediary licensing company similar to the well known Dutch route discussed below. Another example is Canada where there is no withholding tax on the production or reproduction of any literary, dramatic, musical or artistic work (other than a motion picture film or film or video tape for use in connection with television). There is also an exemption from withholding tax on payments made under a research and development cost sharing arrangement.

The Use of Intermediary Licensing Companies
The purpose of using an intermediary licensing company located in a jurisdiction with a beneficial double tax treaty with the country from which the royalties are payable, would be to reduce or avoid foreign taxation on such royalty income, limiting the amount of overall foreign tax being imposed. Royalty income would then not be received in the individual’s own name but into a company specifically chosen to achieve these objectives. For example, if the licensor and licensee are resident in countries which do not have a double tax treaty between them, or which have a double tax treaty which does not reduce the withholding tax on the payment of royalty income to nil, it may be beneficial to route such income through an intermediary company. Subject to double tax treaty limitation of benefits provisions and general anti-avoidance legislation, Dutch intermediary finance companies may be appropriate since:-

a) withholding taxes which are normally levied abroad on royalties are significantly reduced or avoided when paid to a Dutch company pursuant to the double tax treaties negotiated by the Netherlands.
b) concessions are given to group or other licensing companies by the Dutch tax administration in the spread of taxable income receivable.
c) there is no Dutch withholding tax on the payment of royalties to any non-resident.

Dutch licensing companies may own patent rights themselves, in which case the income therefrom in the form of royalties may be fully taxable in the Netherlands, or they may be sub-licensed by another company or individual that actually owns the patent rights. Where a relationship exists between the head licensor and the Dutch licensing company, the tax administration will require a minimum spread of royalties received and royalties paid of 7% of the amount of royalties received, with graduated rates down to 2% for royalty income above certain levels.

As stated above, UK, US, Irish, Cyprus, Hungarian and other intermediary jurisdictions may be used depending upon the facts of the case, the type of income, the contractual arrangements and the double tax treaty provisions applicable, if relevant.

Deductibility of Royalty Payments for the Payor
Generally, all expenditure which is necessarily incurred to produce income is deductible for tax purposes, although the tax authorities will look carefully into transactions between related parties and payments to shareholders. This is reflected in the standard OECD model treaty royalties article, in which an anti-avoidance provision states that royalty payments to non-resident parent companies or otherwise associated entities may be disallowed unless clear proof exists that they are reasonable and represent a commercial and viable license.

Looking at the deductibility to the payer of a royalty, the OECD report on Transfer Pricing and Multinational Enterprises stressed that the value of the benefit to the licensee is not necessarily the measure of the appropriate rate of payment to be made for such license. Although (the report says) it may be useful to look at the costs incurred in developing the property, the actual open market price of intangible property is not related in a consistent manner to the costs involved in developing it. In determining royalty rates at arm’s length, the following factors may be taken into account:

• The prevailing rates in the same industry for similar property;
• The offers of competing transferors or the bids of competing transferees;
• The terms of the transfer, including limitations on the geographic area covered and the exclusive or non-exclusive character of any rights granted;
• The uniqueness of the property and the period for which it is likely to remain unique;
• The degree and duration of protection afforded to the property under the laws of the relevant countries;
• The value of services rendered by the transferor to the transferee in connection with the transfer;
• The prospective profits to be realised or costs to be saved by the transferee through its use of subsequent transfer of the property;
• The capital investment and start up expenses required of the transferee;
• The availability of substitutes for the property transferred;
• The arm’s length rates and prices paid by unrelated parties where the property is resold or sub-licensed to such parties;
• The costs incurred by the transferor in developing the property; and
• Any other facts or circumstances which unrelated parties would have been likely to consider in determining the amount of an arm’s length consideration for property. In any event, royalties may generally only be deductible if:

• there is a written contract;
• documentation proves that the licence is used;
• technical attributes justify the rate;
• contractual provisions justify the rate;
• advantage to the licensee is evident.

Indirect Tax Consequences
The countries of the European Union each operate a value added tax in accordance with EU directives such that the basis system (although the rates vary) is broadly harmonised between the different EU countries. Under the VAT systems, value added tax will be charged on the importation of goods into a country and also on any supply of goods within the country. However, there will also be VAT consequences on the payment of royalties for IPRs, the nexus being regarded as the place where the recipient of the service is located. Thus the concept of choosing the right structure to minimise income and corporate taxes for royalties must also include the minimisation of VAT costs and the compliance costs associated with VAT.

The EU model calls for VAT to be levied in the country where the goods or services are consumed. The basic rule is that a service is regarded as supplied where the supplier has established his business or has a fixed establishment from which the service is supplied or, in the absence of such establishment, the place where he has his permanent address or usually resides. Cultural, artistic, sporting, educational and other similar services involving the presentation to an audience are supplied where performed; the supply of intellectual property is regarded as supplied in the place where the recipient of the service is located. For further information regarding VAT, read the IFS Tax Briefing “Value Added Taxation in the European Union”