Taxation of Intellectual Property under Domestic Law, EU Law and Tax Treaties [1 ed.] 9789087224646, 9789087224653

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Taxation of Intellectual Property under Domestic Law, EU Law and Tax Treaties

Taxation of Intellectual Property under Domestic Law, EU Law and Tax Treaties

edited by Prof. Guglielmo Maisto

Vol. 16 EC and International Tax Law Series

IBFD Publications BV Visitors’ address: Rietlandpark 301 1019 DW Amsterdam The Netherlands Postal address: P.O. Box 20237 1000 HE Amsterdam The Netherlands Telephone: 31-20-554 0100 Fax: 31-20-622 8658 www.ibfd.org © 2018 IBFD All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the written prior permission of the publisher. Applications for permission to reproduce all or part of this publication should be directed to: [email protected]. Disclaimer This publication has been carefully compiled by IBFD and/or its author, but no representation is made or warranty given (either express or implied) as to the completeness or accuracy of the information it contains. IBFD and/or the author are not liable for the information in this publication or any decision or consequence based on the use of it. IBFD and/or the author will not be liable for any direct or consequential damages arising from the use of the information contained in this publication. However, IBFD will be liable for damages that are the result of an intentional act (opzet) or gross negligence (grove schuld) on IBFD’s part. In no event shall IBFD’s total liability exceed the price of the ordered product. The information contained in this publication is not intended to be an advice on any particular matter. No subscriber or other reader should act on the basis of any matter contained in this publication without considering appropriate professional advice. The IBFD and/or the author cannot be held responsible for external content, broken links or risks within the external websites that are referenced as hyperlinks within this publication.

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ISBN 978-90-8722-465-3 (print) ISBN 978-90-8722-464-6 (ePub) ISBN 978-90-8722-463-9 (ePDF) ISSN 1574-969X NUR 826



Acknowledgements I wish to express my appreciation to Alberto Brazzalotto and Paolo Arginelli for their helpful assistance in organizing the publication of the EC and International Tax Law Series. A special mention of my appreciation is also made to Richard Casna, who carried out the linguistic editing of the contributors’ texts. Prof. Guglielmo Maisto Milan, March 2018

v



Foreword This book is the sixteenth volume in the IBFD EC and International Tax Law Series, which includes monographs focussing on issues of interpretation of EU tax and treaty laws with particular attention to the interaction between tax law and other branches of law, primarily comparative law and public international law. The EC and International Tax Law Series is based on multijurisdictional research carried out by legal scholars – including academic researchers – that is presented during annual invitational seminars. This volume of the series is based on the presentations made at the “Taxation of IPs under Domestic Law, EU Law and Tax Treaties” seminar that was held in Milan on 27 November 2017. The aim of the EC and International Tax Law Series is to promote the dissemination of studies on EU and international tax law that go beyond domestic domains. Applications requesting support for research or publication projects are welcomed and may be sent by e-mail to the attention of Prof. Guglielmo Maisto (Series Editor) at [email protected]. Prof. Guglielmo Maisto

vii



Table of Contents Acknowledgements

v

Foreword

vii Part One Intellectual Property under Domestic Tax Law

Chapter 1:  Taxation of Intellectual Property (IP) in Domestic Tax Law by Matthias Valta 1.1. Introduction 1.2. Role of domestic income tax law for the application of article 12 1.2.1. Qualification as IP under article 12(2) OECD Model/12(3) UN Model 1.2.2. Use (renting out) vs alienation 1.2.3. Use vs rendering services

3 3 5 5 7 8

1.3. Comparative studies 1.3.1. Taxation of residents 1.3.1.1. Royalty income 1.3.1.2. Expenses 1.3.1.2.1. IP owner 1.3.1.2.2. Licensee 1.3.2. Taxation of non-residents 1.3.3. Royalty income and CFC rules

11 11 11 12 12 13 14 14

1.4. Conclusions

16

Chapter 2:  Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test 17 by Robert J. Danon 2.1. Introduction 

17

2.2. General considerations on the PPT

21

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2.3. Relevance of substance and value creation under the PPT analysis

24

2.4. Relevance of BEPS Actions 5 and 8-10 in the PPT analysis26 2.4.1. IP company exercising DEMPE functions in the state of residence availing or not of a nexuscompliant patent box regime 26 2.4.2. Application of the PPT in licensing and sub-licensing situations 29 2.5. Conclusions

32

Part Two EU Law Tax Aspects of Intellectual Property Chapter 3:  An EU Free Movement and State Aid Perspective on the Development of IP in a Foreign PE 37 by Sjoerd Douma 3.1. Introduction

37

3.2. Countering harmful tax practices

39

3.3. EU free movement law 3.3.1. EU case law 3.3.2. Analysis

41 41 43

3.4. EU State aid law 3.4.1. Introduction 3.4.2. Advantage 3.4.3. Selectivity 3.4.4. Anti-abuse measures 3.4.5. IP regimes generally 3.4.6. The modified nexus approach

44 44 45 45 47 48 49

3.5. Conclusions 

50

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Chapter 4:  Open Issues in the Application of the Interest and Royalty Directive to Royalty Payments by Paolo Arginelli

51

4.1. Introduction

51

4.2. The definition of royalties 4.2.1. In general 4.2.2. The renvoi to domestic law 4.2.3. The relevance of EU private law instruments on IP rights 4.2.4. Using the OECD Model Commentary

51 51 52 55 58

4.3. The subject-to-tax requirement 62 4.3.1. A “subjective” or an “objective” requirement? 62 4.3.2. Attempts to modify the “subject-to-tax” requirement66 4.4. Beneficial ownership and abuse 4.4.1. Interpretation of the term “beneficial owner” 4.4.2. Means to tackle abuses of the Directive 4.4.3. The “minimum holding period” requirement

71 71 74 79

4.5. Procedural issues 4.5.1. Formal requirements introduced by Member States 4.5.2. Exemption applied in the absence of attestation or decision at the time of the payment 4.5.3. Recovery of the tax in the case of abuse

85 85 87 87

4.6. Policy perspective 89 4.6.1. The missing external dimension 89 4.6.2. A possible solution: The ATRiD 90 4.6.3. The EU external competence to conclude tax treaties91

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Part Three Tax Treaty Issues of Intellectual Property Chapter 5:  Source vs Residence Taxation of Royalties: A Historical Perspective by Jacques Sasseville

97

5.1. Introduction

97

5.2. The work of the League of Nations

97

5.3. The work of the OEEC

101

5.4. The 1977 OECD Model and after

114

5.5. Conclusion

115

Chapter 6:  Article 12 OECD/UN Models: Definition of Royalties and “Overlapping” between Articles 7, 12 and 13 by Adolfo Martín Jiménez

117

6.1. Introduction

117

6.2. The reasons for overlapping between the royalty definition and the concept of business profits/ capital gains in the OECD and UN Models

119

6.3. Historical evolution of article 12 OECD Model and the “unfinished job” in defining royalties 121 6.3.1. Why is there a royalty article in the OECD Model?  121 6.3.2. The evolution of the Commentary on Article 12 OECD Model in the period 1963-2017: An unfinished royalty definition with strong potential for overlapping with other articles 123 6.4. The concept of royalties in article 12 OECD Model and domestic law 125 6.5. The “contextual definition” of royalties in the Commentary on Article 12 OECD Model

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6.5.1. The move towards a “contextual definition” of royalties128 6.5.2. The contextual definition of “use” and “sale” in the Commentary on Article 12 OECD Model 128 6.5.3. The contextual definition of “know-how” and the problems of technical assistance 132 6.5.4. Conclusions 134 6.6. BEPS and overlapping of articles 7, 12 and 13 OECD Model

136

6.7. Building blocks? Conflicts of classification and the emergence of an “alternative UN context” for the taxation of royalties

138

6.8. Conclusions

141

Part Four International Developments Chapter 7:  Royalties in the Context of the Multilateral Instrument, the Principal Purpose Test and the Limitation on Benefits Provision by Sophie Chatel

147

7.1. Introduction

147

7.2. The BEPS Project and Action 6 (prevention of tax treaty abuse)

148

7.3. Implementation of the Action 6 minimum standard to prevent tax treaty abuse 149 7.3.1. Title and preamble of tax treaties 149 7.3.2. Principal purpose test 150 7.3.3. The LOB provision and its interaction with the PPT 152 7.3.4. The Multilateral Instrument and anti-abuse measures153

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7.4. Application of the Action 6 anti-abuse standard to cross-border payment of royalties

154

7.5. Conclusion

158

Chapter 8:  Transfers of Intangibles under Tax Treaties (Although all the Fun Stuff is in the Transfer Pricing Guidelines) by Patricia A. Brown 8.1. Introduction

161 161

8.2. The application of tax treaties to transfers of intangible property 8.2.1. Allocation of taxing rights under the OECD and UN Models 8.2.2. Treaty practice with respect to royalties and capital gains: Symmetry or cynicism? 8.2.3. Delineating the boundary between article 13 and article 12

162 162 164 168

8.3. Transfer of intangibles to a related party 8.3.1. Determining a price for the transfer of IP to a related party 8.3.2. Issues relating to contributions to capital 8.3.3. Ignoring separate entities entirely 8.3.4. Does it matter? 8.3.5. Transfers of “non-proprietary” intangibles

170

8.4. Conclusion

182

170 174 175 178 180

Part Five Country Reports Chapter 9:

Australia by Celeste M. Black

9.1. Introduction on private law aspects of IP 9.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law xiv

185 185

185

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9.1.2. Distinction under private law between alienation of IP and granting the right to use IP

189

9.2. Taxation of IP under the domestic tax law 9.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 9.2.2. Qualification of income deriving from IP and applicable tax regimes 9.2.3. Tax treatment of income from IP derived by nonresident taxpayers 9.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules

192

9.3. Taxation of IP under EU law

209

9.4. Taxation of IP under tax treaties 9.4.1. Taxing rights over royalties assigned by article 12(1) 9.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 9.4.2.1. Distinguishing royalties and payments for services or other rights 9.4.2.2. Cross-border equipment leasing 9.4.2.3. Payments for technical services and interaction of articles 7 and 12 9.4.3. Beneficial ownership and royalties 9.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 9.4.5. Time of taxation 9.4.6. Excessive royalty payments

209

Chapter 10:

Austria by Robin Damberger and Hans-Peter Gradwohl

10.1. Introduction on private law aspects of intellectual property (IP) 10.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law xv

192 199 203 208

209 213 214 217 221 225

226 226 227 229

229

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10.1.2. Distinction under private law between alienation of IP and granting the right to use IP 10.2. Taxation of IP under the domestic tax law 10.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 10.2.2. Qualification of income deriving from IP and applicable tax regimes 10.2.2.1. Categories of income 10.2.2.2. Income from renting, leasing and royalties 10.2.2.3. Income from self-employment 10.2.2.4. Income from commercial activities 10.2.2.5. Reduced tax rate for exploitation of patent rights 10.2.2.6. Taxation of corporations 10.2.2.7. Economic ownership concept in tax law 10.2.2.8. Tax premium for research activities 10.2.3. Tax treatment of income from IP derived by non-resident taxpayers 10.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 10.2.4.1. Switch-over for dividends stemming from low-tax jurisdictions 10.2.4.2. Comparability of the Austrian rules to the ATAD 10.2.4.3. Prohibition of royalty deduction in special cases

233 234 234 236 236 237 238 240 241 242 243 244 246 248 248 249 250

10.3. Taxation of IP under EU law 252 10.3.1. Issues of compatibility of domestic law with EU law 252 10.3.1.1. Inbound royalties 252 10.3.1.2. Outbound royalties 252 10.3.1.3. Research premium 254 10.3.2. Inbound and outbound royalty taxation with respect to third countries 255 10.3.3. Domestic tax regime and EU State aid rules 256 10.3.4. Open issues in the interpretation of the I&R Directive257 10.3.4.1. The notion of “royalties” included in article 2(b) of the I&R Directive 257 10.3.4.2. The introduction of a “minimum effective taxation clause” 258

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10.3.4.3. Anti-abuse provisions and beneficial ownership clauses258 10.3.4.4. Procedural issues 259 10.4. Taxation of IP under tax treaties 10.4.1. Taxing rights over royalties assigned by article 12(1) 10.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 10.4.3. Beneficial ownership and royalties 10.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 10.4.5. Time of taxation 10.4.6. Excessive royalty payments

259

10.5. Summary

270

Chapter 11:

Brazil by Leonardo F. de Moraes e Castro

260 262 266 268 268 269

273

11.1. Introduction on private law aspects of intellectual property (IP) 273 11.1.1. Private law meaning of terms used in tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the right protected under relevant private law 273 11.1.1.1. Brazilian private law on IP 273 11.1.1.1.1. Copyrights and scientific discoveries 274 11.1.1.1.2. Industrial property 274 11.1.1.1.2.1. Corporate distinctive factors 274 11.1.1.1.2.2. Biotechnology 276 11.1.1.1.3. Integrated circuit topographies and geographical indications276 11.1.2. Distinction under private law between alienation of IP and granting the right to use IP 277 11.1.2.1. Forms of exploring patents 277 11.1.2.1.1. The assignment agreement 277 11.1.2.1.2. The licence agreement 278

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11.2. Taxation of IP under the domestic tax law 11.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 11.2.1.1. Royalties definition and tax deductibility  11.2.2. Qualification of income deriving from IP and applicable tax regimes 11.2.2.1. Consideration for the assignment and licensing of trademarks and patents 11.2.2.1.1. Capital gains 11.2.2.1.2. Taxation of royalties paid for the exploitation of trademarks and patents 11.2.3. Tax treatment of income from IP derived by non-resident taxpayers 11.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules

279

11.3. Taxation of IP under tax treaties 11.3.1. Taxing rights over royalties assigned by article 12 11.3.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 11.3.2.1. Brazilian case law (judicial precedents) 11.3.2.1.1. Superior Court of Justice (STJ) 11.3.2.1.1.1. COPESUL case (2012) 11.3.2.1.1.2. Iberdrola case (2015) 11.3.2.1.2. Precedents from the lower federal courts 11.3.2.1.2.1. Ambev case (2017) 11.3.3. Beneficial ownership and royalties 11.3.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the resident state 11.3.5. Time of taxation  11.3.6. Excessive royalty payments

294 294

279 279 285 285 285 286 288 291

295 302 302 302 303 305 305 308 309 309 312

11.4. Practical issues on cross-border remittances of royalties316 11.5. Appendix: Taxation of WHT on IP payments from Brazil to tax treaty countries 318

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Chapter 12:

Canada by Joel Scheuerman

12.1. Introduction to private law aspects of intellectual property (IP) 12.1.1. Private law meaning of terms used in the tax treaty definition of royalties 12.1.1.1. Copyrights 12.1.1.1.1. Scope of protection 12.1.1.2. Patents 12.1.1.3. Trademarks 12.1.1.4. Industrial design 12.1.2. Distinction under private law between alienation of IP and granting the right to use IP

321

321 321 323 324 325 326 327 328

12.2. Taxation of IP under the domestic tax law 329 12.2.1. Meaning of royalties and qualification of income deriving from utilization of IP 329 12.2.1.1.  R. v. Saint John Shipbuilding & Dry Dock Co. 330 12.2.1.2. Is the payment for services rendered? 331 12.2.1.3. Is the payment actually business profit? 332 12.2.1.4. The Canada Revenue Agency’s view 333 12.2.2. Qualification of income deriving from IP and applicable tax regimes 334 12.2.2.1. Acquisition of IP 334 12.2.2.1.1. Current expenses 334 12.2.2.1.2. Capital expenditure 336 12.2.2.1.3. Know-how 337 12.2.2.1.4. Expenses incurred in the pursuit of SR&ED 338 12.2.2.2. Disposition of IP 339 12.2.3. Tax treatment of income from IP derived by non-resident taxpayers 340 12.2.4. Attribution to resident taxpayers of IP income by non-resident entities under controlled foreign affiliate and similar rules 341 12.2.4.1. Foreign affiliate and controlled foreign affiliate basics341 12.3. Taxation of IP under tax treaties 12.3.1. Taxing rights over royalties assigned by article 12(1)

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12.3.2. Meaning of royalties and overlapping between articles 7, 12 and 13 12.3.3. Beneficial ownership and royalties 12.3.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 12.3.5. Time of taxation 12.3.6. Excessive royalty payments Chapter 13:

China (People’s Rep.) by Na Li

345 346 347 348 349 351

13.1. Introduction on private law aspects of intellectual property (IP) 351 13.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law 351 13.1.1.1. Definition of the terms for or relating to “royalties” under Chinese private law 351 13.1.1.1.1. Copyright of literary, artistic or scientific work 351 13.1.1.1.2. Patent, design or model 352 13.1.1.1.3. Trademark 352 13.1.1.1.4. Plan, secret formula or process, information concerning industrial, commercial or scientific experience353 13.1.1.2. Whether qualification for private law purposes would have an impact on the qualification of the income from the IP for domestic tax and tax treaty purposes354 13.1.1.3. New trend and evolution of the rights which can be protected by IP or industrial property legislation 355 13.1.2. Distinction under private law between alienation of IP and granting the right to use IP  356 13.1.2.1. Domestic private law legislations governing (may result in applying different treaty provisions (article 12, 13 or 7)) 356 13.1.2.2. Whether the private law meaning of ownership of IP is based exclusively on legal ownership or if, in the context of certain transactions, it is recognized as the concept of economic ownership 357

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13.2. Taxation of IP under the domestic tax law 358 13.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 358 13.2.1.1. Domestic tax law meaning (definition of “royalties”)358 13.2.1.2. SAT’s interpretation for “royalties” used in Chinese tax treaty provisions 360 13.2.1.3. Whether technical assistance is treated or characterized as royalty, especially where technical assistance is connected with a licence of the relevant IP 363 13.2.1.4. Whether domestic tax law rules or practice exist on aggregation and/or disaggregation of transactions that include both technical assistance and licensing of IP 363 13.2.2. Qualification of income deriving from IP and applicable tax regimes 364 13.2.2.1. Categories or subcategories of income 364 13.2.2.2. Tax regimes applicable to IP income derived by resident taxpayers 364 13.2.3. Tax treatment of income from IP derived by non-resident taxpayers 366 13.2.3.1. Rules applicable to non-resident taxpayers in general366 13.2.3.2. Tax exemption for non-resident taxpayers 367 13.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 367 13.2.4.1. Taxation rules applicable to IP income derived by entities falling within the scope of CFC regulation 367 13.2.4.2. Other domestic anti-abuse rule targeted on IP income sourced in/connected to tax havens or countries with privileged tax regimes 368 13.3. Taxation of IP under tax treaties 13.3.1. Taxing rights over royalties assigned by article 12(1) 13.3.1.1. Maximum withholding tax rates on royalties are decreasing 13.3.1.2. Scope of royalties becomes narrower 13.3.2. Meaning of “royalties” and overlapping between articles 7 and 12 xxi

370 370 370 371 372

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13.3.2.1. Including rental income for “the use of, or the right to use industrial, commercial or scientific equipment” in “royalties” 13.3.2.2. A tax case for conflict of qualification between “royalties” and “business income” 13.3.3. Beneficial ownership and royalties 13.3.4. Anti-tax avoidance 13.3.5. Time of taxation

373 377 379 380

13.4. Conclusion

380

Chapter 14:

France by Mathieu Daudé

14.1. Introduction on private law aspects of intellectual property (IP) 14.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under French private law 14.1.1.1. Industrial property rights 14.1.1.1.1. Patents 14.1.1.1.2. Designs or models 14.1.1.1.3. Trademarks  14.1.1.2. Artistic and literary rights 14.1.2. Distinction under private law between alienation of IP and granting the right to use IP 14.2. Taxation of IP under the domestic tax law 14.2.1. Meaning of “royalties” and qualification of income derived from utilization of IP 14.2.1.1. Scope of IP rights eligible to the favourable regime of patents (article 39 terdecies of the FTC) 14.2.2. Qualification of income deriving from IP and applicable tax regimes 14.2.2.1. Corporate taxpayers 14.2.2.1.1. Ordinary regime 14.2.2.1.1.1. Taxation of IP income 14.2.2.1.1.2. Taxation of capital gains made on the disposal of an IP asset 14.2.2.1.1.3. Deduction of royalties paid in connection with IP assets xxii

372

383

383

383 383 383 384 385 385 386 387 387 387 389 389 389 389 389 389

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14.2.2.1.1.4. Transfer taxes/registration duties 390 14.2.2.1.2. Favourable regime applicable to patents and assimilated391 14.2.2.2. Individual taxpayers 392 14.2.2.2.1. Categories of personal income tax 392 14.2.2.2.1.1. Wages 393 14.2.2.2.1.2. Industrial or commercial profits 393 14.2.2.2.1.3. Non-commercial profits 393 14.2.2.2.1.4. Professional capital gains 393 14.2.2.2.2. Copyrights 393 14.2.2.2.2.1. Ordinary regime: Non-commercial profits 393 14.2.2.2.2.2. Option for a smoothing mechanism 394 14.2.2.2.2.3. Taxation of authors and composer’s copyrights as wages 395 14.2.2.2.3. Patent or trademark licence income 396 14.2.2.2.3.1. Professional income taxed as industrial or commercial profits 396 14.2.2.2.3.2. Income received by inventors or their heirs 396 14.2.3. Tax treatment of income from IP derived by non-resident taxpayers 397 14.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 399 14.3. Taxation of IP under EU law 14.3.1. Issues of compatibility of domestic tax law with EU law 14.3.2. Open issues in the implementation of the Interest and Royalty Directive 14.3.2.1. The notion of “royalties” included in article 2(b) of the Interest and Royalty Directive 14.3.2.2. The introduction of a “minimum effective taxation clause” 14.3.2.3. Anti-abuse provisions 14.3.2.4. Procedural issues

401

14.4. Taxation of IP under tax treaties 14.4.1. Taxing rights over royalties assigned by article 12(1) 14.4.1.1. Sourcing rules 14.4.1.2. Division of taxing rights 14.4.1.3. Procedural issues

406

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401 402 402 402 403 405

406 406 408 409

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14.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 409 14.4.2.1. Alienation of IP assets or rights 410 14.4.2.2. Use of industrial, commercial or scientific equipment410 14.4.2.3. Information concerning know-how and secret processes or industrial, commercial or scientific equipment411 14.4.2.4. Technical services 411 14.4.2.5. Transfer of software 412 14.4.2.6. Copyrights and similar rights 412 14.4.2.7. Royalties paid for the use of mines, quarries and natural resources 413 14.4.3. Beneficial ownership and royalties 413 14.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 415 14.4.5. Time of taxation 417 14.4.6. Excessive royalty payments 417 Chapter 15:

Germany by Florian Schmid

15.1. Introduction on private law aspects of intellectual property (IP) 15.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law 15.1.2. Distinction under private law between alienation of IP and granting the right to use IP 15.2. Taxation of IP under the domestic tax law 15.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 15.2.2. Qualification of income deriving from IP and applicable tax regimes 15.2.2.1. Income from rental and leasing 15.2.2.2. Business income 15.2.2.3. Self-employment income

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419

419 422 423 424 427 428 429 433

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15.2.2.4. Section 4j EStG: Recently introduced limitation of the deductibility of expenses for the right to use IP 433 15.2.3. Tax treatment of income derived from IP by non-resident taxpayers 436 15.2.3.1. Section 49(1)(2)(a) EStG: Business income 436 15.2.3.2. Section 49(1)(2)(f) EStG: Business income in the form of rental, leasing or sale 438 15.2.3.3. Section 49(1)(3) EStG: Independent personal services442 15.2.3.4. Section 49(1)(6) EStG: Rental and leasing 442 15.2.3.5. Section 49(1)(9) EStG: Know-how 443 15.2.3.6. Recent draft paper concerning software and databases443 15.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 445 15.2.4.1. CFC rules 445 15.2.4.2. Transfer pricing rules 447 15.2.4.3. General anti-abuse rule (GAAR) 449 15.3. Taxation of IP under EU law 449 15.3.1. Issues of compatibility of domestic tax law with EU law 449 15.3.2. Open issues in the implementation of the I&R Directive452 15.4. Taxation of IP under tax treaties 15.4.1. Taxing rights over royalties assigned by article 12(1) 15.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 15.4.3. Beneficial ownership and royalties 15.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 15.4.5. Time of taxation 15.4.6. Excessive royalty payments

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Chapter 16:

Italy by Alberto Brazzalotto

16.1. Introduction on private law aspects of intellectual property (IP) 16.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law 16.1.2. Distinction under private law between alienation of IP and granting the right to use IP

469

469

469 476

16.2. Taxation of IP under the domestic tax law 479 16.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 479 16.2.2. Qualification of income and applicable tax regimes485 16.2.2.1. Tax treatment of IP 486 16.2.2.1.1. Income assimilated to self-employment income 486 16.2.2.1.2. Miscellaneous income 489 16.2.2.1.3. Business income 489 16.2.2.1.3.1. Italian patent box regime 492 16.2.2.2. Tax treatment of neighbouring rights 495 16.2.2.3. Tax treatment of income from industrial, commercial or scientific equipment 496 16.2.3. Tax treatment of income from IP derived by non-resident taxpayers 497 16.2.3.1. Sourcing rules 497 16.2.3.2. Taxing rules 499 16.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 500 16.2.4.1. CFC legislation (article 167 ITC) 500 16.2.4.2. Rules on fictitious interposition of entities (article 37(3) Decree 600/1973) 503 16.3. Taxation of IP under EU law 16.3.1. Issues of compatibility of domestic law with EU law 16.3.1.1. Inbound royalties 16.3.1.2. Outbound royalties 16.3.1.3. Domestic tax regime and EU State aid rules xxvi

503 503 503 504 506

Table of Contents

16.3.2. Open issues in the interpretation of the I&R Directive508 16.3.2.1. The notion of “royalties” included in article 2(b) of the I&R Directive 508 16.3.2.2. Introduction of a “minimum effective taxation clause”509 16.3.2.3. Anti-abuse provisions 511 16.3.2.4. Procedural issues 513 16.4. Taxation of IP under tax treaties 514 16.4.1. Taxing rights over royalties assigned by article 12(1) 515 16.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 518 16.4.2.1. Definition of “royalties” under article 12 OECD Model and in Italy’s treaty practice 518 16.4.2.2. Overlapping between articles 12 and 13 OECD Model521 16.4.2.3. Overlapping between articles 12 and 7 OECD Model523 16.4.3. Beneficial ownership and royalties 529 16.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 532 16.4.5. Time of taxation 532 16.4.6. Excessive royalty payments 534 Chapter 17:

Netherlands by Zoya Zalmai

535

17.1. Introduction on private law aspects of intellectual property (IP) 17.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law 17.1.1.1. Patents 17.1.1.2. Plant breeders’ right 17.1.1.3. Copyright 17.1.1.4. Trademarks 17.1.1.5. Design or model

xxvii

535

535 536 539 540 541 541

Table of Contents

17.1.2. Distinction under private law between alienation of IP and granting the right to use IP

542

17.2. Taxation of income from IP under the domestic law545 17.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 545 17.2.2. Qualification of income deriving from IP and applicable tax regimes 547 17.2.2.1. Intangible asset 550 17.2.2.2. Self-developed 552 17.2.2.3. R&D asset and/or patent 554 17.2.2.3.1. R&D certificate 555 17.2.2.3.2. Patents 556 17.2.2.3.3. Definition of income 556 17.2.2.3.4. The nexus approach 560 17.2.2.3.5. WBSO 562 17.2.3. Tax treatment of income from IP derived by non-resident taxpayers 563 17.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 564 17.3. Taxation of IP under EU law 567 17.3.1. Issues of compatibility of domestic tax law with EU law 567 17.3.1.1. Compatibility with fundamental freedoms 567 17.3.1.1.1. Outbound investment through a PE vs outbound investment through a subsidiary 570 17.3.1.1.2. Investment through a domestic subsidiary vs investment through a foreign subsidiary 571 17.3.1.2. Compatibility of the Dutch innovation box with State aid rules 572 17.3.1.2.1. An economic advantage must be granted to an undertaking573 17.3.1.2.2. The aid is provided by a Member State and financed through state resources 574 17.3.1.2.3. The aid potentially distorts competition and affects EU trade 575 17.3.1.2.4. It favours certain undertakings or the production of certain goods (“selectivity”) 575

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Table of Contents

17.3.1.2.5. Review of the Dutch innovation box under article 107(1) TFEU 578 17.3.2. Open issues in the implementation of the I&R Directive583 17.4. Taxation of IP under tax treaties 17.4.1. Taxing rights over royalties assigned by article 12(1) 17.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 17.4.3. Beneficial ownership and royalties 17.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 17.4.5. Time of taxation 17.4.6. Excessive royalty payments Chapter 18:

Spain by Elizabeth Gil García

18.1. Introduction on private law aspects of intellectual property (IP) 18.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law 18.1.2. Distinction under private law between alienation of IP and granting the right to use IP 18.2. Taxation of IP under the domestic tax law 18.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 18.2.2. Qualification of income deriving from IP and applicable tax regimes 18.2.2.1. Qualification of income deriving from IP 18.2.2.2. Tax regime applicable to IP income 18.2.2.2.1. Qualifying taxpayers for the patent box regime 18.2.2.2.2. Eligible IP assets for the patent box regime 18.2.2.2.3. Calculation of the IP box base 18.2.3. Tax treatment of income from IP derived by nonresident taxpayers

xxix

584 584 587 589 591 592 593 595

595

595 598 599 600 601 601 604 605 607 610 613

Table of Contents

18.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules

614

18.3. Taxation of IP under EU law 616 18.3.1. Issues of compatibility of domestic tax law with EU law 617 18.3.2. Open issues in the implementation of the I&R Directive618 18.4. Taxation of IP under tax treaties 18.4.1. Taxing rights over royalties assigned by article 12(1) 18.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 18.4.3. Beneficial ownership and royalties 18.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of royalties in the residence state 18.4.5. Time of taxation

623

18.5. Annex 

635

Chapter 19:

Switzerland by Peter Hongler and Livia Schlegel

19.1. Introduction on private law aspects of intellectual property (IP) 19.1.1. Private law meaning of terms used in article 12 19.1.1.1. Patents 19.1.1.2. Copyrights 19.1.1.3. Trademarks 19.1.1.4. Design or model 19.1.1.5. Plan 19.1.1.6. Secret formula or processes 19.1.1.7. Information concerning industrial, commercial or scientific experience 19.1.2. Distinction between sale and licensing of IP rights 19.2. Taxation of income from IP under domestic tax law 19.2.1. Income and corporate income tax treatment xxx

623 624 630 631 634

639

639 639 639 640 641 642 642 643 643 644 645 645

Table of Contents

19.2.1.1. Income tax 19.2.1.2. Corporate income tax 19.2.2. Qualification of income deriving from IP and applicable tax regimes 19.2.2.1. IP box regime (Tax Proposal 17): Overview 19.2.2.2. Patents according to the EPC 19.2.2.3. Foreign patents corresponding to the patents mentioned in (a) and (b) 19.2.2.4. Supplementary protection certificates according to the Patents Act 19.2.2.5. Semiconductor topography rights 19.2.2.6. Varieties of plants protected by the Varieties Protection Act 19.2.2.7. Certain documents protected according to the Federal Act on Medicinal Products and Medical Devices 19.2.3. Tax treatment of income from IP derived by non-resident taxpayers 19.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules

645 646 647 647 648 649 649 649 650 650 651 651

19.3. Taxation of income from IP under EU law 651 19.3.1. Compatibility with the fundamental freedoms 651 19.3.2. Taxation of royalties according to the Savings Agreement651 19.4. Taxation of income from IP under tax treaties 19.4.1. Taxing rights over royalties assigned by article 12(1) 19.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 19.4.3. Beneficial ownership and royalties 19.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 19.4.5. Time of taxation 19.4.6. Excessive royalty payments

xxxi

652 652 653 654 655 655 655

Table of Contents

Chapter 20:

United Kingdom by Anne Fairpo

20.1. Introduction on private law aspects of intellectual property (IP) 20.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law 20.1.1.1. Meaning of terms: Overview 20.1.1.2. UK domestic law definitions of terms used in article 12(2): General 20.1.1.2.1. Copyright 20.1.1.2.2. Scope of copyright 20.1.1.2.3. Patent 20.1.1.2.4. Trade mark 20.1.1.2.5. Design 20.1.1.2.6. Model, plan, etc. 20.1.2. Distinction under private law between alienation of IP and granting the right to use IP 20.1.3. How is ownership determined?

657

657

657 657 657 657 658 660 660 661 662 662 663

20.2. Taxation of income from IP under the domestic law664 20.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 664 20.2.1.1. Definition of “intellectual property” for UK domestic tax law purposes 665 20.2.2. Qualification of income deriving from IP and applicable tax regimes 667 20.2.2.1. Qualification of income deriving from utilization of IP 667 20.2.2.1.1. Income derived from IP used directly by the owner667 20.2.2.1.1.1. Licensing: Distinguishing between grant of right to use and transfer of ownership 668 20.2.2.1.1.2. Licensing income: Whether business income or non-business income 669 20.2.2.1.1.3. Patent income derived by an individual 669 20.2.2.2. Tax regimes applying to income from IP 670 20.2.2.2.1. Corporate rules 670 20.2.2.2.2. General rules 670 xxxii

Table of Contents

20.2.3. Tax treatment of income from IP derived by non-resident taxpayers 672 20.2.3.1. Determining non-residence 672 20.2.3.1.1. Permanent establishment (PE) of a non-resident company672 20.2.3.2. Taxation of non-residents: Overview 672 20.2.3.3. Payments of royalties from the UK: Tax withholding673 20.2.3.3.1. Pre-2016 approach to withholding tax on royalties 673 20.2.3.3.2. Present approach to withholding tax on royalties 674 20.2.3.3.3. Withholding compliance: Payment via agents 675 20.2.3.3.4. PEs of non-resident companies: Withholding tax 675 20.2.3.4. Domestic law exceptions to the requirement to withhold tax 676 20.2.3.4.1. Creative professionals: Payments 676 20.2.3.4.2. Limited software licences 676 20.2.3.4.3. Copies of works 676 20.2.3.4.4. Payments to associated EU companies 677 20.2.3.4.5. Payments to recipients in treaty countries 677 20.2.3.4.6. Anti-treaty shopping rules 677 20.2.3.5. Sales of IP: Patents only 678 20.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 679 20.2.4.1. Companies 679 20.2.4.1.1. Transfer pricing 680 20.2.4.1.2. Diverted profits tax 681 20.2.4.2. Individuals and other non-corporates 682 20.3. Taxation of income from IP under EU law 683 20.3.1. Issues of compatibility of domestic tax law with EU law 683 20.3.1.1. Income received by UK residents 683 20.3.1.1.1. Payments made from the UK 684 20.3.1.2. State aid 685 20.3.2. Open issues in the implementation of the I&R Directive685 20.3.2.1. The notion of “royalties” included in article 2(b) of the I&R Directive (2003/49/EC) 685 20.3.2.1.1. Minimum effective taxation clause 686 20.3.2.1.2. Anti-abuse provisions 686 20.3.2.1.3. Procedural issues 686 xxxiii

Table of Contents

20.4. Taxation of income from IP under tax treaties 20.4.1. Taxing rights over royalties assigned by article 12(1) 20.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 20.4.3. Beneficial ownership and royalties 20.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state 20.4.5. Time of taxation 20.4.6. Excessive royalty payments 20.4.6.1. Special relationships Chapter 21:

United States by Larissa B. Neumann, Julia Ushakova-Stein, David N. de Ruig, Michael D. Knobler and Sean P. McElroy

21.1. Introduction to private law aspects of intellectual property (IP) 21.1.1. Private law meaning of terms used in tax treaty definition of royalties and evolution of rights developed under relevant private law 21.1.1.1. Taxation of IP centres on the taxation of royalties 21.1.2. Distinction under private law between alienation of IP and granting the right to use IP 21.2. Taxation of IP under US tax law 21.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 21.2.2. Qualification of income deriving from IP and applicable tax regimes 21.2.2.1. Copyrights 21.2.2.2. Patents 21.2.2.3. Trademarks, trade names and franchises 21.2.2.4. Costs of IP creation 21.2.2.5. Offshoring US IP 21.2.2.6. Deduction for foreign-derived intangible income 21.2.2.7. Transfer of IP vs transfer of an article 21.2.3. Tax treatment of income from IP derived by non-resident taxpayers

xxxiv

687 687 688 691 691 692 693 693 695

695 695 695 697 698 698 702 705 707 709 710 711 711 712 712

Table of Contents

21.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 21.2.4.1. Royalties 21.2.4.2. Sale of IP 21.2.4.3. Investment in US property 21.3. Taxation of IP under tax treaties 21.3.1. Taxing rights over royalties assigned by article 12(1) 21.3.1.1. Overview and 2016 Model Tax Treaty 21.3.1.2. Royalty withholding rates 21.3.1.3. Royalty sourcing rules 21.3.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 21.3.2.1. Definition of “royalties” under article 12 21.3.2.2. Comparison of treaty definition of “royalties” with US tax law definition of “royalties” 21.3.2.3. Treaty interpretation issues and considerations 21.3.2.3.1. Beneficial ownership and royalties 21.3.3. Exemption in source state in cases of favourable tax regimes applicable to the beneficial owner of royalties in the state of residence 21.3.4. Time of taxation 21.3.5. Excessive royalty payments

713 714 717 718 719 719 719 721 721 722 722 723 723 725 727 727 728

Contributors731 Other titles in this series735

xxxv

Part One

Intellectual Property under Domestic Tax Law

Chapter 1 Taxation of Intellectual Property (IP) in Domestic Tax Law by Matthias Valta1

1.1. Introduction A study of the country reports on domestic IP taxation is not only of encyclopaedic interest. Double taxation conventions (DTCs) commonly refer to domestic tax law concepts. Article 12(2) of the OECD Model (2017) and US Model (2016), and article 12(3) of the UN Model (2011) contain a definition of the term “royalties”. As a DTC itself provides an autonomous definition of “royalties”, domestic law cannot be used for its interpretation (cf. article 3(2) of the OECD Model).2 Domestic law, however, has to be used for the interpretation of the different terms in the catalogue of the paragraph, as they do not have a (full) autonomous definition in the treaties.3 If the domestic rules differ between the countries concerned, conflicts of qualification may ensue with the danger of double taxation or double nontaxation. Domestic law on IP consists of private IP law and tax law applied to IP. In principle, DTCs refer to domestic tax law. Yet, as domestic tax law regularly has no own definition of IP, further reference has to be sought from domestic IP law. Additionally, article 12 has the peculiarity of directly referring to certain items of IP (e.g. copyright, patents).4 Tax law deviations of domestic IP law must thus be seen with reservation, as they might violate the IP law-centred context of article 12. On the other hand, tax law deviations 1. Dr. jur., Professor for Public Law and Tax Law, Heinrich Heine University Düsseldorf, Germany. The author thanks Jochen Gerbracht and Stella Langer for their support. 2. IN: High Court (HC), 13 Dec. 1990, CIT v. Davy Ashmore India Ltd., ITR 190, 626 (1991); IN: Income Tax Appellate Tribunal (ITAT) Bangalore Bench, 24 Aug. 1993, AEG v. Commissioner, 48 ITD 359 Bang (1994) at m.no. 7.1. on the Ger.-India Income and Capital Income Tax Treaty (1959, as amended through 1984); R. Pöllath & A. Lohbeck, Art. 12, in DBA (K. Vogel & M. Lehner, eds., 5th edn, Beck 2008), at m.no. 42; F. Wassermeyer, Art. 12, in DBA (H. Debatin & F. Wassermeyer eds., Beck 2017) at m.no. 55; D. Grützner, Art. 12, in DBA (D. Gosch, K.-H. Kroppen & S. Grotherr, NWB 2017) at m.no. 31. 3. Cf. the references to domestic copyright law in OECD Income and Capital Model Tax Convention: Commentary on Article 12 paras. 12.2. and 13.1. (21 November 2017), Models IBFD. 4. Pöllath & Lohbeck, supra n. 2, at m.no. 60 (6th edn, Beck 2015).

3

Chapter 1 - Taxation of Intellectual Property (IP) in Domestic Tax Law

might be needed to capture the economic substance by disregarding formal structures if necessary. The importance of domestic IP law gives international tax law the opportunity to take advantage of IP law harmonization. National IP laws are to a great extent harmonized by multilateral conventions that provide minimum protection standards. The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), which must be signed by all World Trade Organization (WTO) members and thus applies to 157 countries, plays a prominent role. This harmonization of minimum protection standards has positive spill-over effects on DTCs as it reduces the danger of qualification conflicts. However, it should be kept in mind that no direct recourse can be made to harmonized international IP law5 and that an assessment of domestic law is still necessary for every case. Furthermore, the harmonization is limited to minimum protection standards and thus gives the state leeway in its domestic IP law that can ultimately lead to qualification conflicts in DTC law. This chapter will analyse the country reports with respect to these different interdependencies of DTC law, domestic tax law and domestic IP law (see section 1.2.). The country reports provide additional information which is of comparative interest. The further part of this chapter (section 1.3.) will take a look at the qualification of income for resident taxpayers, the tax treatment of nonresidents and the attribution of IP income under controlled foreign company (CFC) rules. While the issue of potential discrimination of non-residents under the EU fundamental freedoms have been resolved to a wide extent, domestic measures to foster research and development (R&D) have been shed into a twilight due to the recent dynamics in prohibition of State aid law. Royalty payments also raise attention to the OECD Base Erosion and Profit Shifting (BEPS) approach in regard to deductibility of income, tax preferences and potentially deficient CFC rules. This chapter is based on the 13 country reports that are also part of this book. Eight reports are from EU Member States and associated countries (Austria, France, Germany, Italy, the Netherlands, Spain, Switzerland and the United Kingdom), two are from North America (Canada and the United States), one from South America (Brazil), one from Asia (China (People’s 5. PL: Wojewódzki sąd administracyjny w Warszawie (WSA) (Regional Administrative Court, Warsaw), 4 Apr. 2008, III SA/Wa 2153/07, IBFD Tax Treaty Case Law, on the Ir.-Pol. Income Tax Treaty (1995).

4

Role of domestic income tax law for the application of article 12

Rep.)) and one from Australasia (Australia). Further details can be found there. From a methodological point of view, this general report and also the country reports provide only an overview and try to point out apparent peculiarities as assessed by the country reporters.

1.2. Role of domestic income tax law for the application of article 12 1.2.1. Qualification as IP under article 12(2) OECD Model/12(3) UN Model As already described in the introduction, the list of IP items covered by article 12 of the OECD Model makes reference to domestic tax law and potentially domestic IP law. The country reports confirm the assumption that domestic tax law regularly contains no own definition of IP items, but makes explicit or implicit reference to domestic private IP law. A direct reference from domestic tax law to domestic IP law has been noted in the country reports from Germany, Italy, Spain and the United States. Furthermore, a general reference clause from tax law to private law can be found in the law of Germany and Italy. A notable exception is indicated in the report from China (People’s Rep.). The implementation regulation for the personal income tax includes nonpatented and non-secret technology under the domestic tax definition of IP. This gives rise to potential conflicts of qualification: the payments are subject to Chinese withholding taxation as royalty, while another contracting state might qualify these payments as ordinary business income according to article 7 of the OECD Model, which are only taxable in the state of source if attributed to a permanent establishment (PE). Yet this conflict of qualification should be resolved with the autonomous interpretation of the IP definition in the treaties. The wording of article 12 indicates that the payments must be made for the use of or the right to use IP with the exception of experience knowledge that is just divulged. Thus, the systematic context requires that all items of IP apart from experience knowledge are subject to some extent of legal protection.6 Only if this condition is met under IP law, trade secret law or contract law, a right to use cannot be meaningfully granted. In the absence of such a protection, the technology cannot be rented out as the recipient can use it freely. 6. See M. Valta, Article 12 Income from Royalties, in Klaus Vogel on Double Taxation Conventions para. 78 (4th edn, E. Reimer & A. Rust eds., Kluwer Law International 2015).

5

Chapter 1 - Taxation of Intellectual Property (IP) in Domestic Tax Law

The first item of IP listed in article 12(2) of the OECD Model (2017) is the copyright of the author including related rights by performers of works. The copyright notably also includes the right to exploit, which can be transferred from the author to, for example, publishing companies. World trade law provides some minimum harmonization of copyright protection as it extends the protection of the Berne Conventions and the Rome Convention to all WTO member countries.7 While software is seen as a literary work under the Berne Convention according to article 10 of TRIPS, the states are free to qualify software in another manner as long as the equal protection is maintained. The country reports of Australia, Austria and Switzerland note that software is seen as a literary work. This is also the view of the OECD Commentary.8 Patents are monopoly rights on inventions in the field of engineering granted by administrative decision. They are partially harmonized under article 27 of TRIPS, which also calls for an included or at least equivalent protection of plant variety rights. The reports from Brazil and the Netherlands note separate plant variety rights that are nevertheless qualified as patents under article 12(2). The report from the United Kingdom states that the United Kingdom grants no patents over business processes and methods, unless there is a physical manifestation of the invention. As taxation as a patent is accessory to administrative acknowledgment, this might lead to qualification conflicts, unless the business process or method can be qualified as secret formula or process in the other contracting state. Trademarks are signs that are used to distinguish products of different enterprises.9 The country report of France notes the peculiarity that the use of an already exploited trademark is equated to the sale of a business, as the client base is deemed to be transferred. This leads to the application of an additional duty but does not seem to have further effects for DTC purposes. Plans are included in article 12 in a descriptive manner and thus have to be protected under domestic law in one way or another, e.g. with specific protection rights, copyrights or trade secrecy laws. As already mentioned, the implementation regulation for the Chinese personal income tax adds non-patented and non-secret technology under the domestic tax definition of IP. While it may be argued that this unprotected information falls under the category “plan”, the systematic context of “use or right to use” demands a protection of the information as already shown above. 7. 8. 9.

Arts. 9 et seq. and 14 TRIPS. Para. 13.1. OECD Model: Commentary on Article 12 (2017). See art. 16 TRIPS.

6

Role of domestic income tax law for the application of article 12

Secret formula or process generally covers all company, trade or business secrets.10 Article 37 of TRIPS prescribes a minimum protection and defines these secrets as any information that (i) is not generally known in the relevant circles that deal with such questions, (ii) is of commercial value, because it is secret and (iii) is subject to reasonable efforts to keep it secret by the person lawfully in control of it. The country reports note detailed secrecy standards in China and Italy with consequences for tax purposes. There are various possibilities of protection. The reports of Austria, China, Germany and Switzerland point out unfair competition law, the report from Australia mentions the common law concept of equity that can lead to confidentiality obligations. Australia as well as Italy further mention explicit and implied contractual terms. In that case, the secret enjoys no in rem protection, but relative contractual protections. As these have the same economic effect in regard to the contractually bound payer, this equation is not out of the context of article 12. Finally, article 12 also covers information concerning industrial, commercial or scientific experience (“know-how in the wider sense”). This experience knowledge can be defined as unprotected, not-secret-but-undisclosed knowledge that has been attained through experience and has practical applicability.11 The concept as such is not clear cut. The country reports show that domestic tax laws also give no relevant further guidance and mainly refer to the OECD Model Commentary.

1.2.2. Use (renting out) vs alienation Article 12 covers the transfer of the “use or right to use” and thus the renting out of IP. As information concerning experience knowledge is not protected as property interest, it cannot be taken back and thus not rented out. Transactions where the IP is not rented out but alienated are not covered by article 12 but by article 13 instead. Therefore, renting out has to be distinguished from alienation. In consequence, there is no right for a possible source taxation under article 12 in case of an alienation in contrast to a renting out. An exception applies under treaties following the old US Model before the 2016 update, as it also covered alienation gains under article 12.

10. 11.

See Valta, supra n. 6, at para. 146. Para. 11 et seq. OECD Model: Commentary on Article 12 (2017).

7

Chapter 1 - Taxation of Intellectual Property (IP) in Domestic Tax Law

The country reports deal with multiple well-known criteria for discerning renting out and alienation. A time limitation is reported as a sign for renting out in Austria, Canada, France, Germany, Switzerland and the United States. In contrast, the report from Brazil implies that a “time limited alienation” might be discussed. Grants without a temporal limitation are generally likely to be qualified as alienations. The French report makes an exception in the case of an extraordinary termination right which points back to renting out. In the US view, such termination rights do not hinder the qualification as alienation. Quite far-reaching and surprising is the view of a German tax court that even statutory reversion rights, e.g. in the case of non-use of a copyright, lead to a renting out opposed to a right to use.12 In consequence, copyrights in Germany cannot be alienated as long as there are statutory reversion rights by the author. Exclusivity is often taken as a sign for an at least partial alienation in Australia, Austria, Brazil, the Netherlands, the United Kingdom and the United States. The same applies for lump-sum payments in Canada. The United Kingdom takes exhaustion or diminishment in value by the transaction as sign of alienation.

1.2.3. Use vs rendering services In today’s science-based economy the use of IP is essential for the production of goods and the rendering of services. The delimitation can be difficult in certain cases, especially where IP is not (only) provided but where consulting services are also rendered. This has led to the inclusion of technical assistance within the scope of article 12 in many tax treaties. Furthermore, the United Nations plans to introduces a new article 12A on technical services in the forthcoming update of its Model Convention.13 The basis for the delimitation is the question whether the IP is really used by the payer himself or whether the IP is used by the payee for providing

12. See also DE: Finanzgericht (FG) Cologne (Tax Court), 25 Aug. 2016, 13 K 2205/13, Entscheidungen der Finanzgerichte 2017, p. 311 et seq. (appeal pending at the Bundesfinanzhof (BFH) (Federal Tax Court), I R 69/16) and DE: FG Cologne 28 Sept. 2016, 3 K 2206/13, Entscheidungen der Finanzgerichte 2017, p. 298 et seq. (appeal pending I R 83/16). 13. See United Nations Committee of Experts on International Cooperation in Tax Matters, 10 Oct. 2017, UN document E/C.18/2017/CRP.23.

8

Role of domestic income tax law for the application of article 12

services to the payee.14 For example, a consultant may possess IP in the form of experience knowledge. In most cases he does not share his general experience knowledge with the client; he only applies his experience knowledge to develop specific recommendations for his client.15 After all, the client normally does not want to become a consultant, but rather to receive specific advice by a consultant. This delimitation can be found in the OECD Commentary16 and can be convincingly deduced out of the wording of article 12 with “the use of or right to use the intellectual property”. However, this autonomous interpretation is not undisputed, which might lead to a recourse to national law. The report from China seems to confirm the OECD approach in principle. Although if IP is transferred, accompanying relevant support, guidance and other services for the application of the IP is attributed to the royalty income by the Chinese tax administration. While IP has to be transferred in some way and this can also be through seminars or personal demonstration, any further support and guidance regarding the application of the IP has to be qualified as a service under article 7.17 Although it is difficult to draw this line in practice and some pragmatism is legitimate, the Chinese approach seems to be overstretching source taxation on alleged royalties, if there is no explicit technical assistance proviso. Besides consulting the distribution of software or digital content is another important field for the delimitation between royalty and business income. Software and digital content have to be copied onto a computer or other devices to become usable. This affects the copyright on the software and may lead to a qualification of software and content sales as alleged royalty payments. In fact, these transactions are mixed ones: while the sale or provision of software and content as such lead to business income, the granting even of a limited copyright leads to royalty income in the first step. In consequence, the payment would principally have to be split into its components. However, the copyright is of only ancillary nature if it is limited to the extent necessary for the operation of the software and enjoyment of the content. The OECD Commentary therefore convincingly argues to disregard the copyright component and to qualify the whole payment as

14. Para. 11.2 et seq. OECD Model: Commentary on Article 12 (2017). 15. See P. Baker, Double Taxation Conventions Art. 12 at para. 12B.13 (3rd. edn, Sweet & Maxwell 2017). 16. Para. 11.2 et seq. OECD Model: Commentary on Article 12 (2017). 17. See Valta, supra n. 6, at para. 146.

9

Chapter 1 - Taxation of Intellectual Property (IP) in Domestic Tax Law

business income.18 The country reports from Germany, the United Kingdom and the United States report concurrence with this approach. Finally, the report from Canada points to another interesting case on the delimitation between royalty income and business income. In the Grand Toys Ltd. decision,19 a Canadian taxpayer had paid to a non-resident person “royalties” for the right to use the “names, characters, symbols, designs, likenesses and visual representations” of certain dolls in an “exclusive distribution agreement” for Canada. The taxpayer was obliged to buy the dolls at a per unit price that included a “buying commission and royalty amount” component. The denomination as “royalty” is of less importance, as the true legal nature has to be examined. The Canadian court argued that the payment cannot be qualified as a royalty, as it was charged on a per unit basis and thus not contingent on the profits of the taxpayer. The assessment of the Canadian court is correct. There is no royalty payment, as exclusive distribution rights are not IP covered by article 12. A trademark only grants the manufacturing monopoly, not a distribution monopoly.20 Thus, the IP was not used by the Canadian distributor, but already by the non-resident manufacturer of the dolls. In other words, the payment from the distributor was a payment for a good made with IP, not the use of IP itself. As the Canadian court correctly pointed out, the lacking exploitation risk of the Canadian distributor is a further sign that the IP is not used by the Canadian distributor but by his supplier;21 however, full contingency is not required. If the foreign manufacturer had granted the use of the trademark and the Canadian taxpayer had manufactured and distributed the dolls, a remuneration based on or orientated at the numbers sold would not change the qualification as a royalty payment. The Canadian taxpayer might be relieved of sharing in the R&D risk but would still bear the risk of applying the IP through manufacturing.

18. Paras. 12 et seq. and 14 OECD Model: Commentary on Article 12 (2017). 19. CA: Tax Court of Canada (TCC), 1990, Grand Toys Ltd. v. MNR, 1 C.T.C. 2165, 90 D.T.C. 1059. 20. See Valta, supra n. 6, at para. 142; DE: BFH, 27 July 1988, BFH I R 130/84, BStBl. II 101, 102 et seq.; DE: BFH, 27 July 1988, BFH I R 87/85, BFH/NV 393 (1989). 21. See Valta, id., at para. 101; F. Wassermeyer, in Wassermeyer, Art. 12 at m.no. 10.

10

Comparative studies

1.3.  Comparative studies 1.3.1. Taxation of residents 1.3.1.1. Royalty income Royalty income in most of the reporting countries is not a separate category in the taxation of residents. Income from renting out IP is either seen as business income, self-employment income, property income or mobile capital income. Income from alienating IP can be subject to separate capital gains taxation. If IP is created within an employment contract, the IP is usually assigned to the principal who has to compensate his employee subject to domestic rules (“work for hire”). In these constellations, the qualification as employment income can take precedence. There are some exceptions, e.g. where royalty income also forms an own category for resident taxpayers. Brazil applies withholding taxation on royalty income also on residents. The Spanish corporate income tax contains an own category of royalty income. Australia and Brazil treat so-called mineral royalties like IP royalties. Mineral royalties are remuneration payments by extraction enterprises to the holder of the mineral (extraction) right. They are not covered by article 12 but have to be subsumed under article 6.22 Royalty income is often privileged under special regimes called IP box, patent box or licence box. These privileges are either based on a partial exemption of the tax base or a reduced tax rate. China grants a full exemption up to a certain threshold and beyond that at 50%. The Swiss draft for cantonal and communal taxes allows for an exemption up to 90%. The Dutch IP box exempts up to 80% excluding acquired IP. The Spanish IP box excludes up to 60% of payments for the use of patents, industrial designs, drawing, models and plans. Italy and the United Kingdom grant up to 50%, the former with the exception of copyrighted software. Reduced tax rates apply in the patent box regimes of Austria and France (15% instead of 33.33%). The French rate advantage is partially being offset by restrictions on expense deductions. 22. E. Reimer, Article 6 Income from Immovable Property, in Klaus Vogel on Double Taxation Conventions para. 20 (4th edn, E. Reimer & A. Rust eds., Kluwer Law International 2015); Valta, id., at para. 13.

11

Chapter 1 - Taxation of Intellectual Property (IP) in Domestic Tax Law

As the survey shows, IP boxes reduce the tax burden very significantly. That has not been without critique. While classical R&D incentives take effect on the expense side and thus during the actual research, IP boxes only apply when IP has been successfully created and is being exploited. It is questionable why the already successful IP entrepreneurs need further incentives. The combination of classical expense side incentives and income side IP boxes have raised the issue of potential harmful tax competition under the pretext of research incentives. The OECD BEPS Project has mitigated the problem by introducing the modified nexus approach, whereas tax privileges on royalty income are only allowed to the extent the connected research expenditure has been borne in the country.23

1.3.1.2. Expenses 1.3.1.2.1.  IP owner A common feature of IP taxation are restrictions on capitalization. This usually leads to an expense deduction on a cash-flow basis. Prohibitions of capitalization are reported from Austria, Canada, Germany and Switzerland24 with regard to self-created IP. In Germany, the principle of conservatism is often cited, as self-created IP has not yet been evaluated under market conditions.25 However, at least in Germany, even the more conservative Commercial Code has been opened for limited capitalization. Further prohibitions of capitalization are reported with regard to secret information and experience knowledge in the reports from Australia and Canada. In the case of Canada, a special capital gains tax regime also takes effect. Trademarks are excluded from depreciation according to the French report. This might apply also to other countries, as trademarks are not time limited. The United Kingdom is reported to only allow depreciation for patents and know-how. Brazil allows resident taxpayers to opt for flat-rate gross taxation. Expenses in developing IP are often privileged. A classical method to foster R&D are so-called “super-deductions”. Besides cash-flow expense 23. OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5 ‑ 2015 Final Report, para. 26 et seq. 24. Only with regard to base research. 25. See Krumm, § 5 EStG, in Blümich para. 521 (B. Heuermann & P. Brandis eds., Vahlen 2017).

12

Comparative studies

deductions or capitalizations, they grant an additional tax credit. This tax credit amounts to 12% of the expenses in Austria, 15% or 35% in Canada, 50% in Italy on a 3-year average and 16%, 32% or 40% regarding the Dutch wage tax. France allows for a taxation on average income/expense ratios that have the effect of a smoothing mechanism. 1.3.1.2.2.  Licensee Royalty payments are usually fully deductible by the licensee. The country reports contain two exceptions, however. Brazil disallows 1% or up to 5% of the net sales revenue of the final product. This applies also with regard to technical assistance and only excludes copyright remunerations. Germany has recently introduced a cap on royalty payments in section 4j of the Income Tax Code that unilaterally tries to impose the OECD modified nexus approach. The limitation only applies when the payment is subject to privileged taxation, especially under an IP box regime. A privileged taxation is defined as an effective tax burden of less than 25%. The limitation does not apply to the extent the privileged taxation conforms to the OECD qualified nexus approach. The limitation works proportionally, gradually reducing the deductibility to the extent the effective burden goes below the 25% threshold or the burden applicable under the OECD qualified nexus approach. Thus, the German licence cap rule is in principle a proportionate unilateral tool for combatting “harmful” tax competition. Nonetheless, as Germany currently features neither specific IP expense privileges nor any IP box, its competitiveness as an investment location will be in danger in a changing economic landscape. Moreover, its compatibility with the EU freedom of capital movement is disputed. Although the rule also applies in domestic circumstances, when municipalities only impose a minimum trade tax. Furthermore, it might be argued that IP boxes that are not in line with the qualified nexus approach constitute State aid under article 107 of the Treaty for the Functioning of the European Union. This could constitute a justification with regard to the fundamental freedoms.

13

Chapter 1 - Taxation of Intellectual Property (IP) in Domestic Tax Law

1.3.2. Taxation of non-residents While royalty income commonly does not constitute an own income category for residents, it does in the case of non-residents, at least for the purposes of withholding taxations. These domestic notions of royalties are extended to technical assistance in Australia and Brazil and also to unprotected information as such in Australia. The Spanish report mentions the inclusion of payments for the use of, or the right to use, software, and industrial, commercial or scientific equipment. Gross-ups due to tax indemnity are reported to be subject to withholding tax on royalties in Australia. The UK report notes a special source rule for royalties. The United Kingdom thus requires withholding taxation on UK-registered patents, regardless to where the patent is actually used. While this source rule has its merits, as the state of registration provides a certain protection of the patent, it is rendered ineffective under standard double taxation treaties. Withholding taxation for royalty payments are still common, even though these taxes have to be refunded under the OECD Model. Notable exceptions are Switzerland and the Netherlands and these exceptions have become notorious as stepping stone for base erosion. The Netherlands is reported to introduce anti abuse legislation. The base erosion problem is further acerbated by the EU Interest and Royalty Directive that prohibits source taxation on royalty payments within the EU. The Netherlands have been the loophole, where royalty payments from the whole EU have been pooled and then transferred to third countries without any taxation at source. Reported withholding tax rates differ between 10 % (China EIT), 15 % (Brazil), 20 % (Austria); 22,5 % (Italy – effective rate), 25 % (Austria net; Brazil if recipient resident of low tax jurisdiction or subject to tax privilege without sufficient nexus; Canada) and 33,33 % (France).

1.3.3. Royalty income and CFC rules Royalty income is derived from a mobile source similar to debt and equity payments. IP is often hard to value and can be transferred to foreign companies with no active economic connection to them. It thus opens up opportunities for profit shifting to low-tax jurisdictions.26 CFC rules pierce the 26. OECD, Designing Effective Controlled Foreign Company Rules, Action 3 ‑ 2015 Final Report, para. 78.

14

Comparative studies

corporate veil of companies in low-tax countries that do not engage in active business but only passively accrue capital or IP income. The OECD has included a standard for CFC rules in its BEPS Action Plan that also applies to royalty income.27 The EU Anti-Tax Avoidance Directive (ATAD) also explicitly prescribes CFC rules that cover royalty income.28 There are two basic models to switch from non-transparent taxation to transparency. The attribution method directly attributes passive income to resident shareholders of the low-tax company without regard to actual distributions. This model is reported from Australia, Canada, China, France, Germany, Dutch draft legislation, Spain, the United Kingdom and the United States. In all cases there is a special escape clause for IP that is actively used in the low-tax jurisdiction, e.g. as it has been created by local research or management.29 The other model is that of a deemed dividend by the CFC and is only reported by Brazil. Both models are principally in line with the OECD BEPS standard.30 There are still a few jurisdictions without a CFC rule in line with the OECD work or the EU ATAD. Switzerland is reported to have no CFC rules or (part-)functional equivalents. Austria and the Netherlands employ switchover rules for dividend exemptions. They only apply in the case of repatriation of the profits and thus fall short of the above-mentioned standards. The Dutch rule, however, additionally includes the duty to annually reassess the value of major shareholdings in companies that are subject to low taxation and whose assets consists almost exclusively of passive ones like IP. This rule has the effect of CFC legislation but can easily be avoided due to its narrow scope. It will therefore be amended by a full-fledged CFC rule. The United Kingdom complements its CFC rule with special rules. UK non-corporate entities are also subject to CFC-similar rules for closely held companies and asset transfers. The United Kingdom has furthermore introduced the so-called diverted profit tax that applies to profits that have been shifted to a foreign country without sufficient economic substance. It would cover, inter alia, the transfer of IP to a foreign conduit company that lacks the managerial and technical capabilities for own research, administration

27. Id. 28. Council Directive (EU) 2016/1164 of 12 July 2016 Laying Down Rules Against Tax Avoidance Practices That Directly Affect the Functioning of the Internal Market, art. 7(2)(a)(ii), OJ L193 (2016), EU Law IBFD. 29. With the possible exception of the US sec. 956 regime as described in the US report. 30. See OECD, supra n. 26, at para. 118.

15

Chapter 1 - Taxation of Intellectual Property (IP) in Domestic Tax Law

and exploitation. The profits of the conduit company would then be subject to tax in the United Kingdom.

1.4. Conclusions Article 12 covers different types of IP, which have to be qualified in accordance to the context of the treaty and domestic tax law. Domestic tax law generally refers to domestic IP law, even though the reference is sometimes made implicit. Domestic IP law is partially harmonized by the TRIPS agreement. Thus, IP law harmonization under world trade law rules has positive spill-over effects on article 12 of the OECD Model as the danger of qualification conflicts are reduced. However, as the world trade law rules only provide for a minimum standard, there is still significant leeway for domestic IP law in detail. In consequence, the efforts for autonomous interpretation as pushed by the OECD Model Commentary are of great importance. This is especially true for the more amorphous concepts of plans, secret formulae and processes and experience knowledge. Notably in the case of experience knowledge, domestic law can be observed to heavily draw on the (rather limited) guidance of the OECD Model Commentary. The influence of autonomous interpretation in general and the OECD Model Commentary in particular can especially be observed in the definition of a “use or right to use”. Domestic law often draws on OECD work, e.g. in Germany, thus converging cases inside and outside the scope of DTCs.

16

Chapter 2 Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test by Robert J. Danon1

2.1. Introduction The OECD/G20 Base Erosion and Profit Shifting (BEPS) Project aims at “fixing” the international tax system on the basis of coherence, substance and transparency.2 The underlying policy objective is to operate, to the largest possible extent, a shift from unilateralism to multilateralism. From a tax treaty perspective, 7 June 2017 witnessed a historic example of this policy with the signing ceremony of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI).3 The BEPS Project, however, does not formally aim at revisiting the allocation of taxing rights provided, in particular, by the OECD Model. This position was clearly expressed by the BEPS Action Plan in 2013: While actions to address BEPS will restore both source and residence taxation in a number of cases where cross-border income would otherwise go untaxed or would be taxed at very low rates, these actions are not directly aimed at changing the existing international standards on the allocation of taxing rights on cross-border income.4

Hence, in the field of IP income, article 12(1) of the OECD Model remains unchanged and continues to provide that: “Royalties arising in a Contracting

1. Professor of International Tax Law, University of Lausanne; Founding partner, Danon & Salomé, an independent tax firm; Chair of the Permanent Scientific Committee (PSC) of the International Fiscal Association (IFA). The author may be contacted at: [email protected]. 2. See generally OECD, Action Plan on Base Erosion and Profit Shifting (OECD 2013) [hereinafter OECD Action Plan 2013]. 3. For a general overview of the functioning of the MLI, see, in particular, R. Danon & H. Salomé, The BEPS multilateral instrument: General overview and focus on treaty abuse, IFF Forum für Steuerrecht 3, p. 197 (2017). 4. OECD Action Plan 2013, p. 12.

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Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State.”5 At the same time, however, there is an obvious tension between, on the one hand, the predominance of residence taxation laid down by article 12 of the OECD Model and, on the other hand, the idea of reuniting income with value creation. In fact, the post-BEPS international tax system may even be considered as slightly hybrid with the residence versus source debate being the elephant in the room.6 In the area of IP income, BEPS Actions 8-10 (aligning transfer pricing outcomes with value creation)7 and 5 (modified nexus approach for patent box regime)8 aim, in particular, at putting the policy of value creation and substantial activities into effect, albeit to achieve different policy objectives. Because of the holistic nature of the BEPS initiative, there is an increased interference of the work conducted in the foregoing areas with tax treaty policy. A good example of this interference is the clause on special tax regimes suggested by the 2017 OECD Commentary. States may indeed wish to choose to include in the definitions of article 3 of the OECD Model a clause stipulating that the benefits of articles 11 (interest) and 12 (royalties) may be denied where income is paid to a connected person availing of a “special tax regime” in the state of residence.9 As regards IP income, the link with the modified nexus approach applying to patent boxes is very clear 5. By contrast, art. 12 of the United Nations Model for Double Taxation Convention provides for a tax sharing between the state of source and the state of residence. 6. This tension is now being exacerbated with the current debate on the taxation of the digital economy; see, for example, M.P. Devereux & J. Vella, Implications of digitalization for international corporate tax reform, WP 17/07, p. 8 (Oxford University Centre for Business Taxation 2017); R. Danon, Can Tax Treaty Policy Save Us?, in Tax Treaties After the BEPS Project: A Tribute to Jacques Sasseville (Canadian Tax Foundation, forthcoming 2018). In fact, the recently released OECD report Tax Challenges Arising from Digitalisation – Interim Report 2018: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project (OECD 2018), reaffirms that: “These broader tax challenges raised by the digitalisation of the economy go beyond the issue of how to put an end to BEPS, and chiefly relate to the question of how taxing rights on income generated from cross-border activities in the digital age should be allocated among countries” (p. 167). 7. OECD, Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project (OECD 2015). 8. OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project (OECD 2015) [hereinafter Action 5 Final Report]. 9. OECD Income and Capital Model Convention and Commentary: Commentary on Article 1 para. 85 (2017), Models IBFD [unless otherwise indicated, references to the OECD Model and Commentary are to the 2017 version].

18

Introduction

as the Commentary on Article 1 states that the special tax regime clause will only apply: [I]f a regime does not condition benefits either on the extent of research and development activities that take place in the Contracting State or on expenditures (excluding any expenditures which relate to subcontracting to a related party or any acquisition costs), which the person enjoying the benefits incurs for the purpose of actual research and development activities. Subdivision (ii) is intended to ensure that royalties benefiting from patent box or innovation box regimes are eligible for treaty benefits only if such regimes satisfy one of these two requirements.… Under either version of subdivision (ii), royalty regimes that have been considered by the OECD’s Forum on Harmful Tax Practices and were not determined to be “actually harmful” generally would not meet subdivision (ii) and, if so, would not be treated as special tax regimes.10

More important in practice, however, is the relevance of the policy of value creation under BEPS Actions 5 and 8-10 in the framework of the principal purpose test (PPT).11 Pursuant to the outcome of BEPS Action 6,12 the PPT has indeed now become the most important minimum standard dealing with tax treaty abuse.13 The PPT will be particularly relevant in relation to article 12 of the OECD Model, which, by allocating the exclusive right to tax royalties to the state of residence, traditionally places the state of source in a vulnerable position. In this respect, it is interesting to observe that the Commentary on Article 12 of the OECD Model now contains an explicit reference to BEPS Actions 5 and 8-10:

10. Para. 94 OECD Model: Commentary on Article 1. 11. For an in-depth analysis of the PPT and the author’s position thereon, see, in particular, R.J. Danon, Treaty Abuse in the Post-BEPS World: Analysis of the Policy Shift and Impact of the Principal Purpose Test for MNE Groups, 72 Bull. Intl. Taxn. 1 (2018), Journals IBFD. 12. OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project (OECD 2015). 13. In accordance with BEPS Action 6, states may choose to adopt the PPT alone or, alternatively, combine it with a simplified limitation on benefits provision (LOB). On the other hand, states wishing to opt out of the PPT and adopt instead a detailed LOB clause are required to supplement such clause with a mechanism designed to deal with conduit arrangements. This mechanism may take the form of a treaty PPT restricted to conduit arrangements, domestic anti-abuse rules or simply judicial doctrines achieving a similar result. A good example of this policy is of course the US conduit financing Treas. Reg. (§ 1.881-3 – Conduit financing arrangements). The policy principle, however, is that these various options should achieve a similar result to that of the PPT (para. 187 OECD Model: Commentary on Article 29). In essence, the PPT is therefore the only approach that is considered to be able to achieve the minimum standard on its own; for further details, see Danon, supra n. 11, at sec. 1. et seq.

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Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

The OECD/G20 Base Erosion and Profit Shifting (BEPS) Project and, in particular, the final reports on Actions 5, 6 and 8-10 produced as part of that project, have addressed a number of abuses related to cases such as the following one: the beneficial owner of royalties arising in a Contracting State is a company resident in the other Contracting State; all or part of its capital is held by shareholders resident outside that other State; its practice is not to distribute its profits in the form of dividends; and it enjoys preferential taxation treatment.14

This chapter aims to discuss the relevance of BEPS Actions 5 and 8-10 in the framework of the application of the PPT to IP structures. The author believes that investigating this issue is useful. First of all, although substance and value creation are core and common principles underlying the BEPS initiative, its various action items have not been necessarily developed in a coordinated fashion. Hence, in the field of IP income, for example, the exact connection between the substance analysis conducted under BEPS Action 6 (PPT rule) and that underlying transfer pricing (BEPS Actions 8-10) and patent boxes (BEPS Action 5) remains uncertain. This obviously raises difficulties for multinational enterprise (MNE) groups in practice that are now to comply with multiple standards. Last but not least, despite the existence of the OECD Commentary, it is widely accepted that the PPT is drafted in very broad terms and may thus lead to unpredictable results. From a policy perspective, we thus find that, where appropriate, a reconciliation between BEPS Actions 5, 6 and 8 may contribute to an increased level of tax certainty. In order to keep the discussion within manageable proportions, we shall here not discuss the relation of the beneficial ownership requirement with the PPT.15 We shall equally not address the matter in the framework of the EU Interest and Royalty Directive. We begin with general considerations on the PPT and its underlying policy objectives (section 2.2.). Next, we shall consider the relations between the PPT and BEPS Actions 5 and 8-10. For this purpose, the focus is on income stemming from self-developed intangibles, respectively the case in which an IP company located in the state of residence exercises so-called development, enhancement, maintenance, protection and exploitation (DEMPE) functions and avails (or not) of a nexus-compliant patent box regime (section 2.3.). Finally, expressly referring to an example laid down in the OECD Commentary, this situation will be contrasted with the case in which an IP asset is developed by another member of the group licensed to a parent company in the state of residence as part of a licensing and sub-licensing business model (section 2.4.). This should allow us to finally formulate 14. 15.

Para. 7 OECD Model: Commentary on Article 12. See Danon, supra n. 11, at secs. 2.2. and 4.8.4.

20

General considerations on the PPT

some conclusions and guidance for the purpose of applying the PPT to IP structures (section 2.5.).

2.2. General considerations on the PPT The PPT is now included in article 29(9) of the OECD Model dealing with entitlement to benefits. According to the Commentary, the inclusion of a PPT in the OECD Model is intended to allow states to address cases of treaty abuse even where their domestic law does not allow them to do so. The new policy also confirms that states may rely on their domestic general anti-avoidance rules (GAARs) to deny treaty benefits,16 provided, however, that these GAARs are in conformity with the PPT.17 Article 29 in general, and particularly its paragraph 9, puts into effect the new preamble of the OECD Model,18 stating that treaties are: [I]ntending to eliminate double taxation with respect to the taxes covered by this agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions).

Article 29(9) provides that: Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this Convention.

The PPT is applicable “in respect of an item of income or capital”. It therefore requires an item-by-item of income analysis. In other words, where an entity derives different kinds of income, the PPT could lead to the denial of treaty benefits for certain income streams, but not for others. Finally, the scope of the PPT extends to both conduits and abusive restructurings.19 The PPT incorporates a subjective and an objective element. Accordingly, a denial of tax treaty benefits by the source state may come into play where 16. 17. 18. 19.

Para. 168 OECD Model: Commentary on Article 29. Para. 77 OECD Model: Commentary on Article 1. Para. 1 OECD Model: Commentary on Article 29. For further details, see Danon, supra n. 11, at sec. 4.2.3.

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Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

“one of the principal purposes” of the arrangement or transaction was to obtain these benefits. While subjective in nature, this criterion, as is often the case with GAARs, is objectified by a “reasonableness” test. If this condition is satisfied, the taxpayer may then establish that granting the treaty benefit at stake “would be in accordance with the object and purpose of the relevant provisions of this Convention”. Under the OECD Commentary, however, the object and purpose of the treaty itself is rather referred to in order to determine whether treaty benefits ought to be granted. Hence, to deny treaty benefits, it is generally contended that “it would be contrary to the object and purpose of the tax convention to grant the benefit of that exemption under this treaty-shopping arrangement”,20 and in cases in which the PPT does not apply, the fact that “the general objective of tax conventions is to encourage cross-border investment” is put forward.21,22 This being said, the PPT raises several controversial issues, in particular, from a general policy and EU compatibility perspective, which we have addressed elsewhere23 and are beyond the scope of this chapter. A practical question arising in this context is whether the absence of increase of tax treaty benefits should automatically exclude the application of the PPT. For example, assume that in a licensing and sub-licensing structure involving an entity in State R 1 with its owners in State R 2 and deriving royalties from State S, the treaty rate applicable to royalties is identical under the S-R 1 and S-R 2 treaties. Irrespective of the purposes pursued by the structure, should the application of the PPT be automatically excluded on the mere grounds that the interposition of an entity in State R 1 does not increase tax treaty benefits? The question arises because unlike, for example, the conduit arrangement clause found in the United Kingdom-United States Income Tax Treaty (2001),24 and which inspired the OECD Commentary in relation to conduit arrangements,25 the PPT of article 29(9) of the OECD Model does not expressly provide for such a carve out. By contrast, the UK-US conduit arrangement indeed only applies if the ultimate owners in State R 2, 20. Para. 182, Example A, OECD Model: Commentary on Article 29. 21. Id., Example C. 22. For further details, see Danon, supra n. 11, at sec. 4.3.2. 23. Id., at sec. 4.4. 24. Convention between the Government of the United Kingdom of Great Britain and Northern Ireland and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains (24 July 2001) (as amended through 2002), Treaties IBFD [hereinafter UK-US Income Tax Treaty]. 25. See Danon, supra n. 11 at sec. 4.6.2.

22

General considerations on the PPT

[W]ould not be entitled under a convention for the avoidance of double taxation between the state in which that other person is resident and the Contracting State in which the income arises, or otherwise, to benefits with respect to that item of income which are equivalent to, or more favourable than, those available under this Convention to a resident of a Contracting State.26

In the author’s opinion, in the absence of an express carve out in article 29(9) of the OECD Model it is not possible to automatically exclude the application of this provision on the mere grounds that the arrangement put in place does not increase tax treaty benefits. Rather, this element should be taken into account to assess whether obtaining the benefit of the newly applicable tax treaty was really one of the principal purposes of the relevant arrangement or transaction. This position may also be derived from the OECD Commentary. First of all, in relation to an example involving a real estate fund, the Commentary notes, at the level of the analysis of the subjective element, that “RCO does not derive any treaty benefits that are better than those to which its investors would be entitled”.27 A similar conclusion also flows from the Commentary relating to the LOB discretionary relief clause provided by article 29(5) of the OECD Model. The Commentary to this clause, which also incorporates a main purpose test, stipulates that: [I]n the case of a resident subsidiary company with a parent in a third State, the fact that the relevant withholding rate provided in the Convention is at least as low as the corresponding withholding rate in the income tax convention between the State of source and the third State is not by itself evidence of a nexus or relationship to the other Contracting State.28

Finally, the same conclusion was also drawn in the Starr case involving the similar discretionary relief provision in the Switzerland-United States Income Tax Treaty (1996).29 This being said, if despite the absence of increase of tax treaty benefits the PPT is applicable, the issue of the recharacterization of the fact pattern under review arises (in the foregoing example the application of the S-R2 tax treaty). In this respect, we have argued that when the PPT is applicable, a jurisdiction should not be prevented from granting treaty benefits on the basis of a recharacterized fact pattern even if such jurisdiction has

26. Art. 3(1)(n) UK-US Income Tax Treaty. 27. Para. 182, Example M, OECD Model: Commentary on Article 29. 28. Para. 103 OECD Model: Commentary on Article 29. 29. US: US District Court (USDC D.D.C.), 14 Aug. 2017, Starr International Co. Inc v. United States of America, No 14-cv-01593 (CRC), 20 ITLR 94.

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Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

not expressly opted for the discretionary relief mechanism suggested by the OECD Commentary.30 Let us now specifically focus on the relevance of substance and value creation under the PPT analysis.

2.3. Relevance of substance and value creation under the PPT analysis There are numerous references in the OECD Commentary suggesting that the analysis governing the PPT is substance oriented.31 To begin with, the Commentary on Article 29 notes that “where an arrangement is inextricably linked to a core commercial activity, and its form has not been driven by considerations of obtaining a benefit, it is unlikely that its principal purpose will be considered to be to obtain that benefit”.32 More concretely, in an example involving a regional company providing intra-group services, the Commentary on Article 29 notes that: Assuming that the intra-group services to be provided by RCO, including the making of decisions necessary for the conduct of its business, constitute a real business through which RCO exercises substantive economic functions, using real assets and assuming real risks, and that business is carried on by RCO through its own personnel located in State R, it would not be reasonable to deny the benefits of the treaties concluded between State R and the five States where the subsidiaries operate unless other facts would indicate that RCO has been established for other tax purposes or unless RCO enters into specific transactions to which paragraph 9 would otherwise apply....33

A similar reasoning is followed in another example involving an institutional investor: The decision to establish the regional investment platform in State R was mainly driven by the availability of directors with knowledge of regional business practices and regulations, the existence of a skilled multilingual workforce,... RCO employs an experienced local management team to review investment recommendations from Fund and performs various other functions which,

30. See Danon, supra n. 11, at secs. 4.7.2. and 4.7.3 31. For a recent detailed discussion of these examples, see V. Chand, The Principal Purpose Test in the Multilateral Convention: An in-depth Analysis, 46 Intertax 1 (2018). 32. Para. 182, Example M, OECD Model: Commentary on Article 29. 33. Para. 182, Example G, OECD Model: Commentary on Article 29.

24

Relevance of substance and value creation under the PPT analysis

depending on the case, may include approving and monitoring investments, carrying on treasury functions, maintaining RCO’s books and records, and ensuring compliance with regulatory requirements in States where it invests.34

In the author’s opinion, it follows from the foregoing that substance and value creation in the state of residence are important elements to evidence that that one of the principal purposes of an arrangement (i.e. particularly the creation and maintenance of an entity in the state of residence, respectively to transfer to such entity of rights giving rise to income) is not to obtain the benefits of the treaty concluded by the state of residence with the state of source. From this perspective, the author believes that in the area of IP income the transfer pricing principles flowing from BEPS Actions 8-10 may serve as guidance. The same holds true as regards the modified nexus approach applying to patent box regimes (BEPS Action 5) which implements the concepts of value creation and substantial activities in an even stricter fashion. At the same time, however, it should be borne in mind that the PPT is not a specific anti-avoidance rule (SAAR) focusing mechanically and solely on the transfer pricing functions exercised in the state of residence to grant or deny treaty benefits. Nor, for example, may the PPT be equated to an active business test in an LOB provision. For this reason, all circumstances surrounding the arrangement or event must always be considered on a caseby-case basis.35 In my opinion, this has two main implications. First of all, the relation between the income and significant transfer pricing functions in the state of residence should only be considered as a strong indication that one of the principal purposes of the arrangement was not to secure treaty benefits. However, irrespective of the transfer pricing analysis, treaty benefits may still be denied on the basis of the PPT if additional factual elements suggest otherwise. Finally, and by mirrored reasoning, the absence of significant transfer pricing functions in the state of residence should not automatically lead to the denial of treaty benefits if other compelling factual elements reveal that the subjective element of the PPT is not satisfied (e.g. because the arrangement put in place is predominantly based on commercial and non-tax reasons). In light of the foregoing, we shall now examine how the proposed analysis fits in the specific context of IP income and BEPS Actions 5 and 8-10 (section 2.4.). For this purpose, we consider two sets of fact patterns. The first situation, the easiest to resolve as we shall see, concerns the case of an IP 34. 35.

Id., Example K. Para. 178, OECD Model: Commentary on Article 29.

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Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

company exercising DEMPE functions in the state residence availing or not of a nexus-compliant patent box regime (section 2.4.1.). Finally, we shall move to a licensing and sub-licensing structure (section 2.4.2.).

2.4. Relevance of BEPS Actions 5 and 8-10 in the PPT analysis 2.4.1. IP company exercising DEMPE functions in the state of residence availing or not of a nexus-compliant patent box regime In a recent contribution Martín Jiménez discusses the relationship of the PPT with BEPS Actions 5 and 8-10.36 He notes that if the substance required for transfer pricing purposes (control of risks and the capacity to bear them and DEMPE functions with regard to intangibles) is located in the residence country, the source country will not be able to use the PPT to deny treaty benefits.37 He goes as far as holding that BEPS Actions 8-10 create a sort of exception: “when MNLs comply with the standard of Actions 8-10 in terms of transfer pricing, it seems that the OECD wants to exclude the application of other anti-avoidance rules at treaty level”.38 This being said, the author is critical of this connection. He argues indeed that it may be easy to avoid the application of the PPT by means of a few people who control risks but outsource most tasks to related parties as long as they can demonstrate that control of risks (as well as the financial capacity to bear them) is in their hands.39 This author also sees a connection between the PPT and the modified nexus approach applying to patent boxes. While he concedes that the modified nexus approach requires a bit more substance, he maintains, however, that relying on the notion of substance provided by BEPS Action 5 is not appropriate to prevent treaty shopping: by placing a research and development (R&D) centre in that state, a resident of a third state may gain access to the treaties of the state in which the R&D centre is located.40 For the author, this facilitates treaty shopping and permits structures very

36. A.J. Martín Jiménez, Chapter 2: Tax Avoidance and Aggressive Tax Planning as an International Standard – BEPS and the “New” Standards of (Legal and Illegal) Tax Avoidance, in Tax Avoidance Revisited in the EU BEPS Context p. 25 et seq. (A.P. Dourado ed., EATLP International Tax Series, vol. 15, IBFD 2017). 37. Id., at pp. 52-54. 38. Id., at p. 55. 39. Id., at pp. 52-54. 40. Id., at p. 50.

26

Relevance of BEPS Actions 5 and 8-10 in the PPT analysis

similar to those used in a pre-BEPS world that enable erosion tax bases in source countries with limited substance. The present author does not share the foregoing analysis. First of all, with respect to self-developed intangibles, the fact that DEMPE functions are exercised by an entity does provide a good indication that the structure put in place is “inextricably linked” to a core activity in the state of residence. As is well known, the DEMPE functions require the legal owner of an intangible to perform and control the functions related to the development, enhancement, maintenance, protection and exploitation of the intangible.41 This especially holds true as regards important functions, inter alia, design and control of research and marketing programmes, direction and establishing priorities for creative undertakings including determining the course of “blue-sky” research, control over strategic decisions regarding intangible development programmes and management and control of budgets.42 It is true that for transfer pricing purposes, the legal owner of an intangible is not required to physically perform all of the functions related to the development, enhancement, maintenance, protection and exploitation of an intangible through its own personnel.43 Rather, as is often the case in practice, a portion of these functions may be outsourced to related enterprises residing in other jurisdictions.44 However, if the entity in the state of residence does not at least control the outsourced functions, it would then not be entitled to the return attributable to these functions.45 Hence, because the PPT requires an item-by-item of income analysis, it may be argued that where IP income is linked to functions exercised or controlled in the state of residence, such income should then be regarded as “inextricably linked” to a core activity in the state of residence. In my view, the case to grant treaty benefits becomes even stronger when IP income falls within the scope of a nexus-compliant patent box regime. Under the modified approach nexus, which is inspired from existing input incentives and proportionate in nature,46 the benefits provided by patent boxes are linked to the qualifying R&D expenditures incurred by the 41. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2017), ch. VI, para 6.71, special considerations for intangibles [hereinafter OECD TP Guidelines, ch. VI]. 42. Id., para. 6.56. 43. Id., para. 6.51. 44. Id. 45. Id. 46. For a detailed discussion of the modified nexus approach, see R.J. Danon, General Report, in Tax incentives on Research and Development (R&D) p. 43 et seq. (IFA Cahiers vol. 100A, 2015), Online Books IBFD.

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Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

taxpayer itself.47 This focus on expenditure seeks to ensure that patent boxes only apply to taxpayers that in fact engage in qualifying R&D activities.48 In essence, the proportion of privileged income is the same proportion as that between qualifying expenditure and overall expenditure.49 In other words, the proportion of qualifying expenditure serves as a proxy for substantial activities.50 With regard to MNEs, the most important effect of the nexus approach relates to the fact that expenses linked to outsourcing of R&D functions are, as a matter of principle, not taken into consideration.51 The nexus approach, however, allows an uplift of qualifying expenditure where related-party outsourcing is incurred. In other words, the exclusion of expenses linked to outsourcing (and acquisition costs) is slightly relaxed in the sense that companies are able to claim a maximum 30% uplift of their qualifying expenditure, subject to a cap based on actual expenditure. In the same vein, and again subject to a 30% uplift, costs relating to the acquisition of an IP do not qualify. This exclusion is consistent with the policy objective of the modified nexus approach, which is to promote actual future R&D activity and hence to only take into consideration expenditure incurred for improving the IP asset after it was acquired.52 In the author’s opinion, there are two elements of the modified nexus approach which may be relevant in the PPT analysis. First of all, because income falling within the scope of a nexus-compliant patent box regime is as a matter of principle only related to the R&D activities performed by the taxpayer himself (so-called personal model), respectively in the same state for jurisdictions that are not EU Member States53 (so-called territorial model), it may be argued that such income is by essence here linked to a core activity exercised in the state of residence. Secondly, the exclusion of the costs stemming from acquired IP serves as a good indication that the 47. Action 5 Final Report, p. 29. 48. Id. 49. Id. 50. Id. 51. By contrast, unlimited outsourcing to unrelated parties remains possible. Since the vast majority of the value of an IP asset rests in both the R&D undertaken to create it and the information necessary to undertake such R&D, it is indeed unlikely that a company will outsource the fundamental value-creating activities to an unrelated party, regardless of where that unrelated party is located. Therefore, allowing only expenditure incurred by unrelated parties to be treated as qualifying expenditure achieves the goal of the nexus approach, which is to only grant tax benefits to income arising from the substantive R&D activities in which the taxpayer itself contributed to the income. 52. Action 5 Final Report, p. 31. 53. See id., at p. 42 n. 16. The distinction between a subjective model (EU) and a territorial model (third countries) is linked to the application of the fundamental freedoms; see Danon, supra n. 46, at p. 49 et seq.

28

Relevance of BEPS Actions 5 and 8-10 in the PPT analysis

royalties for which treaty benefits are requested do not relate to assets transferred or assigned with the principal purpose of obtaining these benefits. Indeed, it flows from this exclusion that IP income linked to the value of the intangible created before its transfer to the state of residence will not avail of a nexus-compliant patent box regime. This being said, as already argued elsewhere,54 a mechanical connection between BEPS Actions 5 and 8-10 and the PPT in the sense that the latter may be automatically switched off on the basis of the transfer pricing and nexus approach analysis is not appropriate. In fact, contrary to what Martín Jiménez seems to suggest such a connection was never intended. Therefore, even where IP income is deemed to be associated with substantial activities under BEPS Actions 5 and 8-10, it is an appropriate policy to consider that the state of source should always be able to review independently, under the PPT, whether treaty benefits are to be granted. In other words, the conclusions drawn under BEPS Actions 5 and 8-10 merely represent a strong indication that the PPT should not apply.

2.4.2. Application of the PPT in licensing and sub-licensing situations Interesting in this respect is Example E of the OECD Commentary to the PPT in the framework of possible abusive conduit situations.55 In this example, a publicly traded company resident in state R is the holding company for a manufacturing group in a highly competitive technological field. The manufacturing group conducts research in subsidiaries located around the world. According to the business model of the group, any patents developed in a subsidiary are licensed by that subsidiary to the holding company in state R, which then licenses the technology to other subsidiaries that need it. The holding company in State R generally keeps only a small spread with respect to the royalties it receives, so that most of the profit goes to the subsidiary that incurred the risk with respect to the development of the technology. One subsidiary of the group, a company resident in a non-treaty jurisdiction, happens to have developed a process that will, in particular, substantially increase the profitability of another sister company located in State S. 54. 55.

Danon, id., at p. 30 et seq. Para. 187, Example E, OECD Model: Commentary on Article 29.

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Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

According to the standard practice of the group, the holding company thus sub-licenses the technology developed by the company in the non-treaty jurisdiction to its subsidiary in State S. The end result is therefore that the holding company is paying out to an entity located in a non-treaty jurisdiction substantially all of the royalties it derives from State S. The question thus arises as to whether, with respect to this particular income stream, the holding company could be regarded as a conduit arrangement and the benefit of article 12 of the R-S tax treaty denied pursuant to the PPT. The question is answered in the negative. In order to arrive at this conclusion, the OECD Commentary notes: In this example, there is no indication that RCO established its licensing business in order to reduce the withholding tax payable in State S. Because RCO is conforming to the standard commercial organization and behaviour of the group in the way that it structures its licensing and sub-licensing activities and assuming the same structure is employed with respect to other subsidiaries carrying out similar activities in countries which have treaties which offer similar or more favourable benefits, the arrangement between SCO, RCO and TCO does not constitute a conduit arrangement.56

The foregoing example is directly inspired from an identical fact pattern described in the exchange of letters to the conduit arrangement clause of article 3(1)(n) of the UK-US Income Tax Treaty. Unlike the PPT rule, this conduit arrangement clause incorporates two elements, namely a conduit test and a main purpose clause. The conduit test is met where the entity resident in State R: [R]eceives an item of income arising in the other Contracting State but that resident pays, directly or indirectly, all or substantially all of that income (at any time or in any form) to another person who is not a resident of either Contracting State and who, if it received that item of income direct from the other Contracting State, would not be entitled under a convention for the avoidance of double taxation between the state in which that other person is resident and the Contracting State in which the income arises, or otherwise, to benefits with respect to that item of income which are equivalent to, or more favourable than, those available under this Convention to a resident of a Contracting State.57

Pursuant to the second condition, the conduit arrangement clause must in addition have: “as its main purpose, or one of its main purposes, obtaining such increased benefits as are available under this Convention”.58 When 56. Id. 57. Art. 3(1)(n)(i) UK-US Income Tax Treaty. 58. Art. 3(1)(n)(ii) UK-US Income Tax Treaty.

30

Relevance of BEPS Actions 5 and 8-10 in the PPT analysis

placed in the position of the state of source, both the United Kingdom and the United States have agreed that treaty benefits should not be denied on the grounds that the main purpose test is here not satisfied. The US position notes that: Because UKCo entered into these transactions in the ordinary course of its business, and there is no indication that it established its licensing business in order to reduce its U.S. withholding tax, the arrangements among USCo, UKCo and XCo do not constitute a conduit arrangement.59

Similarly, for the United Kingdom: Because XCo is conforming to the standard commercial organisation and behaviour of the group in the way that it structures its licensing and sub-licensing activities and assuming the same structure is employed with respect to other subsidiaries carrying out similar activities in countries which have treaties which offer similar or more favorable benefits, the inference would be that the absence of a treaty between country X and the UK is not influencing the motive for the transactions described. Therefore even though the specific fact pattern, as presented, meets the first part of the definition of a “conduit arrangement” at Article 3(l)(n)(i), on balance the conclusion would be that “the main purpose or one of the main purposes” of the transactions was not the obtaining of UK/US treaty benefits. So the structure would not constitute a conduit arrangement.60,61

In my opinion, the foregoing example shows that the PPT analysis does not simply focus on the link between the treaty-favoured income and transfer pricing functions exercised in the state of residence. Indeed, in this example the holding company to which the patents are being licensed and which only keeps a small spread obviously does not exercise these functions. However, the outcome is that the PPT should not apply because, in light of the facts, one of the main purposes of putting the licensing and sub-licensing into effect is not to claim the benefits of the R-S tax treaty but rather and primarily to conform to the standard business model of the group. Therefore, the PPT rule is not just triggered because of the existence of an interdependence between two income streams (e.g. in the case of a licensing and sublicensing situation). Rather, obtaining the relevant treaty benefit must also be one of the principal purposes of the arrangement or transaction. 59. Art. 3(1)(n)(ii), Exchange of letters, Example 5, UK-US Income Tax Treaty. 60. Id. 61. The two positions refer to an exchange of letters between the United Kingdom and the United States concerning art. 3(1)(n) (conduit arrangement clause) of the UK-US Income Tax Treaty.

31

Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

That is, the arrangement must typically be structured to eliminate the withholding tax that would otherwise have been paid to the state of source.62 The question arises as to whether the outcome of the analysis would be different in the absence of a complete centralized business model, i.e. all patents are not being licensed to the same holding company in the group. In my opinion, this should not necessarily entail the application of the PPT and the denial of tax treaty benefits. For example, assume that the absence of centralization is linked to reasons that are unrelated to tax treaty benefits (e.g. the existence of a reorganization within the group or regional considerations). By contrast, more problematic and most probably leading to the application of the PPT, would be a structure involving the interposition of a stand-alone entity in the state of residence with a view to systematically eliminate the withholding tax on royalties in selected source states.

2.5. Conclusions This chapter has explored the relevance of BEPS Actions 5 and 8-10 in the framework of the PPT and arrives at the following conclusions: (1) The PPT analysis to detect a tax treaty abuse remains formally independent from that applying for transfer pricing purposes (BEPS Actions 8-10) or in the context of the modified nexus approach applying to patent boxes (BEPS Action 5). (2) There are, however, numerous references in the OECD Commentary suggesting that the analysis governing the PPT is substance oriented.63 The Commentary on Article 29 notes, in particular, that: “where an arrangement is inextricably linked to a core commercial activity, and its form has not been driven by considerations of obtaining a benefit, it is unlikely that its principal purpose will be considered to be to obtain that benefit”.64 Furthermore, several examples discussed in the Commentary confirm that the existence of substance should be assessed pursuant to transfer pricing principles. This position is illustrated, in particular, by several references to assets, functions and risks.

62. 63. 64.

Cf. para. 187, Examples A and C, OECD Model: Commentary on Article 29. For a recent detailed discussion of these examples, see Chand, supra n. 31. Para. 182, Example M, OECD Model: Commentary on Article 29.

32

Conclusions

(3) Following this line of reasoning and in the area of IP income, the author believes that with respect to self-developed intangibles, the fact that DEMPE functions are exercised by an entity does provide a good indication that the structure put in place is “inextricably linked” to a core activity in the state of residence. (4) The case to grant treaty benefits becomes even stronger when IP income falls within the scope of a nexus-compliant patent box regime. In my opinion, there are two elements of the modified nexus approach which may be relevant in the PPT analysis. First of all, because income falling within the scope of a nexus-compliant patent box regime is as a matter of principle only related to the R&D activities performed by the taxpayer himself (so-called personal model), respectively in the same state for jurisdictions that are not Member States of the European Union (so-called territorial model), it may be argued that such income is by essence here linked to a core activity exercised in the state of residence. Secondly, the exclusion of the costs stemming from acquired IP serves as a good indication that the royalties for which treaty benefits are requested do not relate to assets transferred or assigned with the principal purpose of obtaining these benefits. Indeed, it flows from this exclusion that IP income linked to the value of the intangible created before its transfer to the state of residence will not avail of a nexus-compliant patent box regime. (5) This being said, the relationship between the income and significant transfer pricing functions in the state of residence should only be considered as a strong indication that one of the principal purposes of the arrangement was not to secure treaty benefits. However, irrespective of the transfer pricing analysis, treaty benefits may still be denied on the basis of the PPT if additional factual elements suggest otherwise. Finally, and by mirrored reasoning, the absence of significant transfer pricing functions in the state of residence should not automatically lead to the denial of treaty benefits if other compelling factual elements reveal that the subjective element of the PPT is not satisfied. For example, as confirmed by the OECD Commentary to the PPT, this would be the case where, within a group, a centralized licensing and sub-licensing arrangement is put in place whereby all patents are being licensed to a holding company in the state of residence. In my opinion, treaty benefits could also be upheld even in the absence of a complete centralization, provided this is linked to reasons that are unrelated to tax treaty benefits (e.g. the existence of a reorganization within the group or regional considerations). By contrast, more problematic and most 33

Chapter 2 - Intellectual Property (IP) Income and Tax Treaty Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose Test

probably leading to the application of the PPT, would be a structure involving the interposition of a stand-alone entity in the state of residence with a view to systematically eliminate the withholding tax on royalties in selected source states.

34

Part Two

EU Law Tax Aspects of Intellectual Property

Chapter 3 An EU Free Movement and State Aid Perspective on the Development of IP in a Foreign PE by Sjoerd Douma1

3.1. Introduction In 2014, the EU Code of Conduct Group on Business Taxation reached a compromise on the so-called “modified nexus approach” for intellectual property (IP) regimes, in coordination with developments at the OECD.2 According to the Group, this is the appropriate method to ensure that patent boxes require sufficient substance.3 Member States needed to start in 2015 the legislative process necessary to change their patent box regimes: the regimes should be closed to new entrants from the end of June 2016 and end all benefits for existing claimants by June 2021.4 In respect of the situation going forward – i.e. the compatibility of new IP regimes with the modified nexus approach – the Commission Services have prepared draft guidelines on the interpretation of the nexus approach.5 Subsequently, the Group assessed – using OECD descriptions – whether the amended IP regimes respect the modified nexus approach and the Code criteria. In 2017, it agreed that the IP regimes of Belgium, Cyprus, Hungary, Ireland, the Netherlands, Portugal and the United Kingdom are not harmful.6 In 2018, the Group decided that the “2014 Guidance on nexus approach for IP regimes” should continue to be monitored.7 This is important because the Commission criticized the IP regimes as follows in 2014:

1. Professor, Amsterdam Centre for Tax law, University of Amsterdam; Partner, Lubbers, Boer & Douma. 2. Report of the Code of Conduct Group (Business Taxation) of 11 December 2014, 16553/1/14 REV 1 LIMITE, FISC 225 ECOFIN 1166 (Annex 1). 3. Code of Conduct Group (Business Taxation), Report to the Council of 28 November 2016, 14750/16, FISC 202 ECOFIN 1092, para. 12 et seq. 4. Report of the Code of Conduct Group (Business Taxation) of 24 November 2017, 14784/17, FISC 300, ECOFIN 999, para. 22. 5. Code of Conduct Group (Business Taxation), Report to the Council of 13 June 2016, 9912/16, FISC 97 ECOFIN 558, paras. 11-14. 6. Code of Conduct Group (Business Taxation), Report to the Council of 12 June 2017, 10047/17, FISC 133, ECOFIN 507, para. 37. 7. Code of Conduct Group (business taxation), Priority list for monitoring agreed guidance of 27 February 2018, 6603/18, FISC 83, ECOFIN 184.

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Chapter 3 - An EU Free Movement and State Aid Perspective on the Development of IP in a Foreign PE

Over the last ten years, several Member States have also introduced special tax regimes for IP rights that are supposed to stimulate innovation and investments in new technologies. Such regimes include “patent boxes”, which provide for tax reductions on income from patents. In 2008, the Commission reviewed such a regime in Spain and concluded that the scheme did not constitute aid (see IP/08/216). Since then, however, the Commission has received indications that special tax regimes seem to mainly benefit highly mobile businesses and do not trigger significant additional research and development activity. The Commission is therefore gathering information to assess whether the regimes grant a selective advantage to a particular group of companies, in breach of EU state aid rules.8

Specifically, with regard to the Luxembourg regime, the Commission noted that it was introduced allowing for tax exemption of 80% of profits derived from the use or licensing of IP rights such as patents, trademarks, designs, models, Internet domain names and software copyrights. The European Commission has not brought this action further because of the agreement reached in the Code of Conduct Group. As the European Commission’s Deputy Director-General in charge of State Aid, Gert-Jan Koopman, has said: “It doesn’t seem at this juncture particularly necessary to immediately open many cases given that the process in the Council seems to be on the right track, [so] we’re basically monitoring this.”9 It should be noted, however, that these words are heavily caveated: only if the process at Member State level is on the right track, the Commission does not see immediate need to open many State aid cases. If taxpayers want to avoid a State aid probe they should therefore carefully analyse whether the IP regime which they are using is fully aligned with the modified nexus approach. Indeed, the issue of patent box regimes has not disappeared from the Commission’s agenda. This is evident in its recently published DG Comp policy paper, where it characteristically states that “R&D&I support granted to larger firms is often less attractive than that granted to smaller firms” and that “[t]he specific design of the tax incentives should also be carefully considered.… Effects of multinationals’ cross-border tax planning strategies should also be looked at.”10 So, if Member States do not contribute to resolve this issue, the Commission may be tempted to argue that State aid has been granted. A Report on the 2017 EUCOTAX Conference “State Aid, Intangibles and Rulings” summarizes part of a discussion between Philip 8. European Commission (EC), press release of 24 March 2014, IP/14/309. 9. See https://www.bloomberg.com/news/articles/2015-02-02/-patent-box-tax-probeto-be-dropped-by-eu-boosting-gsk-arm (last accessed 28 Mar. 2018). 10. EC, How evaluation can help: The case of financial support to business R&D&I, Competition policy brief, 2016-03, May 2016.

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Countering harmful tax practices

Baker and Max Lienemeyer, Head of the Unit Tax Planning Practices at DG Comp, as follows: Baker argued that the selectivity of R&D&I tax incentives depends on the nature of each individual incentive. Upfront deductions of R&D expenditures are typically of a general nature. However, it is difficult to tie the tail-end advantage given through the IP boxes with the actual R&D&I activity. From this perspective, he doubted whether the modified nexus approach is fully compatible with State aid law. However, he also noted that if the OECD supports it, it would be very difficult for the EC to challenge IP boxes through State aid. Lienemeyer, albeit sharing some of the criticism on the selectivity of IP boxes, concurred with Baker.11

One could get the impression that the Commission, from a policy perspective, would not be inclined to open a formal investigation into an IP regime which fully respects the modified nexus approach, but might open such a procedure if the nexus approach has not been complied with. In this respect, this chapter focusses on one specific element of the agreed international approach under BEPS Action 5 regarding the development of IP in a foreign permanent establishment (PE). The relevant segments of the final report of BEPS Action 5 will be reviewed in section 3.2. Subsequently, section 3.3. contains EU free movement analysis, followed by a State aid examination in section 3.4. Conclusions will be reached in section 3.5.

3.2. Countering harmful tax practices Action 5 of the BEPS Project is entitled “Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance”.12 It builds on the OECD’s 1998 Report on Harmful Tax Competition: An Emerging Global Issue.13 It focuses on two factors, one of which is substance: Action 5 specifically requires substantial activity for any preferential regime. Seen in the wider context of the work on BEPS, this requirement contributes to the second pillar of the BEPS Project, which is to align taxation with substance by ensuring that taxable profits can no longer be artificially shifted away from the countries where value is created.14

11. A. Kardachaki & M. van Hulten, Report on the EUCOTAX Conference “State Aid, Intangibles and Rulings”, 26 EC Tax Rev. 5, pp. 284-288, at p. 287 (2017). 12. OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance Action 5: 2015 Final Report (2015). 13. OECD, Report on Harmful Tax Competition: An Emerging Global Issue (1998). 14. OECD, supra n. 12, at p. 23.

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In the context of IP regimes such as patent boxes, agreement was reached on the “nexus approach”. This approach: [A]llows a taxpayer to benefit from an IP regime only to the extent that the taxpayer itself incurred qualifying research and development (R&D) expenditures that gave rise to the IP income. The nexus approach uses expenditure as a proxy for activity and builds on the principle that, because IP regimes are designed to encourage R&D activities and to foster growth and employment, a substantial activity requirement should ensure that taxpayers benefiting from these regimes did in fact engage in such activities and did incur actual expenditures on such activities.15

The Final Report on BEPS Action 5 states that such “qualifying expenditures must have been incurred by a qualifying taxpayer, and they must be directly connected to the IP asset”.16 The Final Report defines qualifying taxpayers as follows: Qualifying taxpayers would include resident companies, domestic permanent establishments (PEs) of foreign companies, and foreign PEs of resident companies that are subject to tax in the jurisdiction providing benefits. The expenditures incurred by a PE cannot qualify income earned by the head office as qualifying income if the PE is not operating at the time that income is earned.17,18

This definition is important because there can be no “qualifying expenditures” – and hence no benefits from an IP regime – without a “qualifying taxpayer”. The question arises whether expenditure incurred at the level of a foreign exempt PE of a resident taxpayer are attributable, for purposes of the nexus approach, to a qualifying taxpayer. The just-cited text suggests that this is not the case.19 This is understandable if one recognizes that expenditure incurred by a foreign subsidiary of a resident taxpayer does not qualify for purposes of the nexus approach either because the income from both a subsidiary and a PE would be “exempt” in the state of the head office. Moreover, such an interpretation would lead to a symmetrical result between (i) a domestic PE of a non-resident taxpayer and (ii) a foreign PE of a resident taxpayer: in both situations the state of the PE is at liberty to grant the benefits of an IP box if the state of the head office does not exercise 15. Id., at p. 9. 16. Id., at p. 27. 17. Footnote in original: “Jurisdictions with IP regimes should ensure that the same IP asset is not allocated to both the head office and the foreign PE (e.g. because they apply the authorised OECD approach (AOA)).” 18. OECD, supra n. 12, at p. 25. 19. See S. Douma, EU report: BEPS and European Union Law, in Assessing BEPS: origins, standards, and responses p. 84 (IFA Cahiers vol. 102a, 2017), Online Books IBFD.

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tax jurisdiction over the PE. If this interpretation is correct, the question arises whether it creates a conflict with EU free movement law and whether a conflict with EU State aid law arises if an EU Member State would accept expenditure incurred at the level of a foreign exempt PE as “qualifying expenditures”. I will now turn to these questions.

3.3. EU free movement law 3.3.1. EU case law Laboratoires Fournier (Case C-39/04) is a leading case in this area.20 Under French tax legislation a tax credit, in respect of corporation tax, for research was available solely for research activities carried out in France. Fournier, which manufactures and sells pharmaceuticals, subcontracted to research centres based in various Member States numerous research projects and took the resultant expenditure into account in calculating its tax credit for research for the years 1995 and 1996. The French tax authorities refused to grant a tax credit in respect of that expenditure, however. The question arises as to whether this refusal restricts the freedom to provide services (article 56 of the Treaty on the Functioning of the European Union (TFEU)). The European Court of Justice (ECJ) stated that the French tax legislation, by restricting the benefit of a tax credit for research only to research carried out in that Member State, makes the provision of services constituted by the research activity subject to different tax arrangements depending on whether it is carried out in other Member States or in the Member State. Such legislation differentiates according to the place where the services are provided, contrary to article 56 of the TFEU. This differentiation could not be justified by the need to safeguard the coherence of the tax system: 20. Although it is true that … in Bachmann (paragraph 28) and Case C-30 0/90 Commission v Belgium [1992] ECR I‑305, paragraph 21, the Court accepted that the need to safeguard the coherence of the tax system could justify 20. FR: ECJ, 10 Mar. 2005, Case C-39/04, Laboratoires Fournier SA v. Direction des vérifications nationales et internationales, ECJ Case Law IBFD. See also DE: ECJ, 18 Dec. 2007, Case C-281/06, Hans-Dieter and Hedwig Jundt v. Finanzamt Offenburg, paras. 60-63, ECJ Case Law IBFD; ES: ECJ, 13 Mar. 2008, Case C-248/06, Commission of the European Communities v. Kingdom of Spain, ECJ Case Law IBFD; FR: ECJ, 8 July 1999, Case C-254/97, Société Baxter, B. Braun Médical SA, Société Fresenius France and Laboratoires Bristol-Myers-Squibb SA v. Premier Ministre, Ministère du Travail et des Affaires sociales, Ministère de l’Economie et des Finances and Ministère de l’Agriculture, de la Pêche et de l’Alimentation, ECJ Case Law IBFD and AT: ECJ, 16 June 2011, Case C-10/10, European Commission v. Republic of Austria, ECJ Case Law IBFD.

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a restriction on the exercise of the fundamental freedoms guaranteed by the Treaty. Subsequently, however, it has stated that, in Bachmann and Commis sion v Belgium, there was a direct link, with respect to the taxpayer subject to income tax, between the deductibility of the insurance contributions from taxable income and the later taxation of the sums paid by the insurers under pension and life assurance contracts, and that link had to be maintained in order to preserve the coherence of the tax system concerned (see, inter alia, Case C-484/93 Svensson and Gustavsson [1995] ECR I‑3955, paragraph 18, and Case C-319/02 Manninen [2004] ECR I-0000, paragraph 42). Where there is no such direct link, the argument based on the need to safeguard the coherence of the tax system cannot be relied upon (see, inter alia, Weidert and Paulus, paragraphs 20 and 21). 21. In a situation such as that in the main proceedings, there is no such direct link between general corporation tax, on the one hand, and a tax credit for part of the research expenditure incurred by a company, on the other.

This is understandable because the amount of the tax advantage was not linked to the (foreign) profits generated by any IP but was equal to a percentage of the expenditure incurred; it is difficult to see how the taxpayer could engage in artificial profit shifting in this context. Subsequently, the French government contended that the legislation was justified by the objective of promoting research. The Court replied that the promotion of research and development (R&D) may indeed be an overriding reason relating to public interest. The fact remained, however, that it could not justify a rule which refuses the benefit of a tax credit for research for any research not carried out in the Member State concerned: 23. Such legislation is directly contrary to the objective of the Community policy on research and technological development which, according to Article 163(1) EC [now Article 179(1) TFEU] is, inter alia, ‘strengthening the scientific and technological bases of Community industry and encouraging it to become more competitive at international level’. Article 163(2) EC [now Article 179(2) TFEU] provides in particular that, for this purpose, the Community is to ‘support [undertakings’] efforts to cooperate with one another, aiming, notably, at enabling [them] to exploit the internal market potential to the full, in particular through … the removal of legal and fiscal obstacles to that cooperation.’

As a result, the objective of the French tax credit was not compatible with the EC Treaty – or, at present, the TFEU – in so far as it was restricted to research activities on French territory. This tension between a territorial restriction of IP regimes and EU law is also evident from cases such as Baxter (Case C-254/97), Commission v. Spain (Case C-248/06) and Argenta

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(Case C-350/11).21 Compare also the Commission’s reasoned opinion of 21 March 2007 in respect of Ireland (2005/2427 C(2007) 1128). Another tension may be that the prohibition to outsource R&D to a related party may be avoided in purely domestic situations due to tax consolidation systems which would see only one domestic taxpayer (hence, no outsourcing). Here, the judgment in Groupe Steria (Case C-386/14) is important and may lead to a prohibited restriction on freedom of establishment in the European Union.22 Finally, the modified nexus approach may lead to a fragmentation of the EU’s internal market: independent operators will be favoured over related parties because the latter are not eligible for outsourcing. It is an unresolved question to which extent this unequal treatment may lead to a prohibited restriction on freedom to provide services.23

3.3.2. Analysis By not accepting expenditure incurred at the level of a foreign PE of a resident taxpayer as “qualifying expenditures”, the nexus approach infringes article 49 of the TFEU (freedom of establishment). This prima facie restriction on freedom of establishment may be allowed only if it pursues a “legitimate objective which is compatible with EU law” and is “justified by overriding reasons in the public interest”.24 In Laboratoires Fournier, the ECJ 21. Baxter (Case C-254/97), Commission v. Spain (Case C-248/06), BE: ECJ, 4 July 2013, Case C-350/11, Argenta Spaarbank NV v. Belgische Staat, ECJ Case Law IBFD. 22. FR: ECJ, 2 Sept. 2015, Case C-386/14, Groupe Steria SCA v. Ministry of Finance and Public Account, ECJ Case Law IBFD; NL: ECJ, 22 Feb. 2018, Case C-398/16, X BV, X NV v. Staatssecretaris van Financiën, ECJ Case Law IBFD. 23. Cf. DE: ECJ, 25 July 1991, Case C-76/90, Manfred Säger v. Dennemeyer & Co. Ltd., para. 12, 1991 I-04221; IT: ECJ, 30 Nov. 1995, Case C-55/94, Reinhard Gebhard v. Consiglio dell’Ordine degli Avvocati e Procuratori di Milano, para. 37, ECJ Case Law IBFD; DE: ECJ, 6 Dec. 2007, Case C-298/05, Columbus Container Services B.V.B.A. & Co. v. Finanzamt Bielefeld-Innenstadt, para. 34, ECJ Case Law IBFD; AT: ECJ, 10 Mar. 2009, Case C-169/07, Hartlauer Handelsgesellschaft mbH v. Wiener Landesregierung and Oberösterreichische Landesregierung, para. 33, 2009 I-01721; HU: Opinion of Advocate General Sharpston, 17 Dec. 2009, Case C-96/08, CIBA Speciality Chemicals Central and Eastern Europe Szolgáltátó, Tanácsadó és Keresdedelmi Kft. v Adó- és Pénzügyi Ellenőrzési Hivatal Hatósági Főosztály. 24. E.g. NL: ECJ, 16 Oct. 2008, Case C-527/06, R.H.H. Renneberg v. Staatssecretaris van Financiën, para. 81, ECJ Case Law IBFD; UK: ECJ, 13 Dec. 2005, Case C-446/03, Marks & Spencer plc v. Halsey (Her Majesty’s Inspector of Taxes), para. 35, ECJ Case Law IBFD; UK: ECJ, 12 Sept. 2006, Case C-196/04, Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd v. Commissioners of Inland Revenue, para. 47, ECJ Case Law IBFD.

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held that a tax measure the objective of which goes directly against the objectives of the Treaty – in this case article 179 of the TFEU which aims at strengthening the scientific and technological bases of the Union – cannot be considered to be legitimate. However, if the tax measure at issue also pursues another objective which can be considered to be legitimate, it may nevertheless be justified on that basis.25 As stated in section 3.2., the nexus approach aims to “align taxation with substance by ensuring that taxable profits can no longer be artificially shifted away from the countries where value is created”. In other words, the nexus approach stimulates that the allocation of taxing rights is such that the state of the PE is able to tax the profits generated by the IP. This seems to represent a legitimate objective of tax policy which the ECJ could very well be willing to accept as a justification.26 This means that an EU Member State which nevertheless accepts expenditure incurred at the level of a foreign PE of a resident taxpayer as “qualifying expenditures”, may attract the attention of the Commission from a State aid perspective, as discussed in section 3.1. We will now turn to this area of law.

3.4. EU State aid law27 3.4.1. Introduction The notion of State aid is defined in article 107(1) of the TFEU: “any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.” It is possible to discern a number of criteria from the definition which should be met before a tax measure can be qualified as State aid within the meaning of this provision. Firstly, only “undertakings” are subject to State 25. IE: ECJ, 10 July 1984, Case 72/83, Campus Oil Limited and others v. Minister for Industry and Energy and others, paras. 34-36; ES: Opinion of Advocate General Kokott, 9 Nov. 2017, Joined Cases C‑236/16 and C‑237/16, Asociación Nacional de Grandes Empresas de Distribución (ANGED) v. Diputación General de Aragón, EU:C:2017:854, at 94. See also S.C.W. Douma, Chapter 8: Optimization by the ECJ in Direct Tax Cases: Assessment of Current Practice and Future Developments sec. 8.3.1.2. in Optimization of Tax Sovereignty and Free Movement (IBFD 2011), Online Books IBFD. 26. Cf. NL: ECJ, 25 Feb. 2010, Case C-337/08, X Holding BV v. Staatssecretaris van Financiën, ECJ Case Law IBFD. 27. See S. Douma, State Aid and Direct Taxation, in European Tax Law, Vol. 1: General Topics and Direct Taxation, Chap. 22 (B. Terra & P. Wattel eds., Kluwer Law International 2012), from which parts of the present section are derived.

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aid control. Secondly, article 107(1) of the TFEU requires that there is an intervention by the state or through state resources. Thirdly, the measure at issue must confer an advantage (an “aid”) on the recipient. Fourthly, that advantage should be selective in that it favours certain companies or the production of certain goods. Fifthly, the intervention must be liable to affect trade between the Member States and distort or threaten to distort competition. For the present purposes, the focus should be on the third and fourth criterion – the presence of a selective advantage – because the other criteria will normally be met in situations involving the nexus approach.

3.4.2. Advantage The definition of aid is more general than that of a subsidy because it includes not only positive benefits, such as subsidies themselves, but also measures which, in various forms, mitigate the charges which are normally included in the budget of an undertaking and which thus, without being subsidies in the strict sense of the word, are similar in character and have the same effect.28 This means that in direct taxation cases, an advantage exists in relation to a certain benchmark rule. Indeed, the very existence of an advantage may be established only when compared with “normal” taxation or a “system of reference”.29 The level of this “normal” taxation should be derived from the national tax system at issue.

3.4.3. Selectivity The notion of “advantage” is closely connected to the requirement of selectivity: according to article 107(1) of the TFEU the advantage should favour certain undertakings or the production of certain goods. This close connection exists because the presence of an “advantage” presupposes that the tax measure at issue deviates from a “normal” rule and therefore almost automatically favours a certain group of undertakings. Indeed, as the ECJ has held in British Aggregates (Case C-487/06), measures which differentiate between undertakings are prima facie selective, unless that differentiation arises from the nature or the overall structure of the system of which they

28. AT: ECJ, 8 Nov. 2001, Case C-143/99, Adria-Wien Pipeline GmbH and Wietersdorfer & Peggauer Zementwerke GmbH v. Finanzlandesdirektion für Kärnten, para. 38, ECJ Case Law IBFD. 29. PT: ECJ, 6 Sept. 2006, Case C-88/03, Portuguese Republic v. Commission of the European Communities (“Azores”), para. 56, ECJ Case Law IBFD.

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form part.30 This approach is understandable when one acknowledges that the selectivity test is essentially a discrimination test or an application of the principle of equality that very much resembles the analysis under EU free movement law.31 This means that the fact that the number of undertakings able to claim entitlement under a national measure is very large, or that those undertakings belong to various economic sectors, is not sufficient to call into question the selective nature of that measure and therefore to rule out its classification as State aid.32 All that matters is whether any advantage granted by the tax measure at issue may be selective by demonstrating that the measure granting the advantage differentiates between economic operators who, in light of the legitimate objective assigned to the tax system of the Member State concerned – the system of reference – are in a comparable factual and legal situation.33 This means that the objective of the measure determines which characteristics of undertakings are relevant in the discrimination analysis; characteristics of undertakings outside of this reference framework are irrelevant.34 Similarly, the fact that only taxpayers satisfying the conditions for the application of a measure can benefit from the measure cannot, in itself, make it a selective measure; the distinction may very well be justified by the objective pursued by the measure.35 The objective pursued by the tax system is only capable of objectively distinguishing the advantaged undertaking from another if the tax measure at issue pursues a legitimate goal related to the nature or the overall structure of the system of which it forms part. Indeed, a measure which creates an exception to the application of the general tax system may be justified by the nature and overall structure of the tax system if the Member State concerned can show that that measure results directly from the basic or guiding principles of its tax system. In that connection, a distinction must be made between, on 30. UK: ECJ, 22 Dec. 2008, Case C-487/06, P British Aggregates Association v. Commission of the European Communities, para. 83, ECJ Case Law IBFD. 31. ES: ECJ, 21 Dec. 2016, Case C-20/15_P, European Commission v. World Duty Free Group and Others, paras. 54, 86 and 93-94, ECJ Case Law IBFD; IT: Opinion of Advocate General Kokott, 7 Feb. 2009, Case C-169/08, Presidente del Consiglio dei Ministri v. Regione Sardegna, para. 134, ECJ Case Law IBFD. See also P. Wattel, Comparing Criteria: State Aid, Free Movement, Harmful Tax Competition and Market Distorting Disparities, in State Aid Law and Business Taxation, MPI Studies in Tax Law and Public Finance, vol. 6, pp. 59-71 (I. Richelle, W. Schön, & E. Traversa eds., Springer 2016). 32. AT: ECJ, 3 Mar. 2005, Case C-172/03, Dr. Wolfgang Heiser v. Finanzlandesdirektion für Tirol, para. 42, ECJ Case Law IBFD. 33. IT: ECJ, 8 Sept. 2011, Case C-78/08, Amministrazione delle Finanze, Agenzia delle Entrate v. Paint Graphos Scarl; Adige Carni Scrl, in liquidation v. Ministero dell’ Economia e delle Finanze, Agenzia delle Entrate; Ministero delle Finanze v. Michele Franchetto, para 49, ECJ Case Law IBFD. 34. World Duty Free (C-20/15), para. 78. 35. IT: ECJ, 29 Mar. 2012, Case C-417/10, Ministero dell’Economia e delle Finanze, Agenzia delle Entrate v. 3 M Italia SpA, para. 42, ECJ Case Law IBFD.

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the one hand, the objectives attributed to a particular tax scheme which are extrinsic to it and, on the other, the mechanisms inherent in the tax system itself which are necessary for the achievement of such objectives.36 In other words, the measure at issue should pursue a legitimate aim in that it is not aimed at stimulating certain (economic) behaviour through the tax system, much in a way a direct subsidy would do.37 It is sufficient that one of the objectives pursued by the measure is legitimate.38 For State aid purposes an objective of a direct tax measure cannot be regarded as legitimate if it goes directly against article 107(1) of the TFEU (i.e. if the aim is to provide aid). All other aims should be regarded as being inherent in the tax system itself. Examples include goals such as setting the rate of taxation, depreciation rules and rules on loss carry-overs, the need to take into account specific accounting requirements, administrative manageability, the principle of tax neutrality, the progressive nature of income tax and its redistributive purpose, provisions to prevent double taxation or tax avoidance and evasion, and the objective of optimizing the recovery of fiscal debts.39 Once it has been established that any prima facie selective treatment can be justified by objectives inherent in the tax system, it is still necessary to ensure that tax measure at issue is consistent with the principle of proportionality and does not go beyond what is necessary, in that the legitimate objective being pursued could not be attained by less far‑reaching measures.40 When performing this proportionality analysis, the effects of the measure are of particular importance. They serve as a “check” on the “real” objective of the measure and as a way to make sure the measure is not over-inclusive in relation to its stated objective.41

3.4.4. Anti-abuse measures According to the Commission, anti-abuse rules may be justified as measures to prevent tax avoidance by taxpayers. However, such rules might be selective if they provide for a derogation (non-application of the antiabuse rules) to specific undertakings or transactions, which would not be

36. Azores (C-88/03), para. 81. 37. Paint Graphos (C-78/08), para. 75. 38. AG Opinion in ANGED (C‑236/16 and C‑237/16), para. 94. 39. Commission Notice 98/C384/03 of 11 November 1998 on the application of State aid rules to measures relating to direct business taxation, at 13; Commission Notice on the notion of State aid as referred to in Article 107(1) of the Treaty on the Functioning of the European Union (2016/C 262/01), at 139. 40. Paint Graphos (C-78/08), para. 75. 41. World Duty Free (C-2015), para. 67.

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consistent with the logic underlying the anti-abuse rules in question.42 An example is the German exception to change-of-control rules where ailing companies are restructured.43 Another example is provided by the exception to the UK rules on controlled foreign companies (CFCs) for group financing income.44 Indeed, the application of CFC legislation in certain situations but not in others may give rise to State aid if the differentiation is not based on objectives which are intrinsic to the tax system. It should be noted that this conclusion cannot be altered by the possibility that the CFC legislation at issue could amount to a restriction on freedom of establishment and should therefore not have been applied in the first place.45 A potential breach of EU free movement law by CFC legislation has no bearing on State aid investigations by the Commission.

3.4.5. IP regimes generally46 The question arises whether an IP regime of general application may give rise to selective advantages. This question is difficult to answer because, on the one hand, the advantage granted by the regime – the exception to the normally applicable rules (see section 3.4.2.) – is based objectives which are extrinsic to the tax system, but, on the other hand, the advantage is in conformity with another fundamental objective of the Union, namely the promotion of R&D (article 179(1) of the TFEU).47 This means that the advantage provided by the IP regime may – on this ground – after all be based on a legitimate objective which is able to objectively distinguish a taxpayer benefitting from that regime from a taxpayer which does not benefit from it (compare section 3.4.3.). In any case, the Commission has in the past accepted that IP regimes which are applied generally do not give rise to State aid.48 This is in line with the (now abolished) 1998 Notice on direct business taxation.49 The 2016 Notice of the notion of State aid no longer 42. Commission Notice on the notion of State aid as referred to in Article 107(1), supra n. 39, at 183. 43. DE: ECJ, 4 Feb. 2016, Case T-287/11, Heitkamp BauHolding GmbH v. European Commission, ECLI:EU:T:2016:60. 44. Commission Decision of 26.10.2017 (UK – Controlled Foreign Company rules), No. SA.44896. 45. IE: ECJ, 21 Dec. 2016, Case C-164/15_P, European Commission v. Aer Lingus and Ryanair Designated Activity Company, paras. 75-78, ECJ Case Law IBFD. 46. See on this topic C. Brokelind, Intellectual Property, Taxation and State Aid Law, in State Aid Law and Business Taxation, supra n. 31, at pp. 221-245. 47. Cf., in a fundamental freedoms context, Laboratoires Fournier (C-39/04). 48. E.g. Commission Decision of 13.02.2008, No. N480/2007 (Spain - reduction of tax from intangible assets). 49. Commission Notice 98/C384/03, supra n. 39, at 13.

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contains such a statement.50 However, in my view, IP regimes of general application should not give rise to a selective advantage because they pursue – in view of article 179 of the TFEU – a legitimate objective, provided that they do not go beyond what is necessary to achieve that objective. It is in this light that the 2014 press release of the Commission should be seen: Over the last ten years, several Member States have also introduced special tax regimes for IP rights that are supposed to stimulate innovation and investments in new technologies. Such regimes include “patent boxes”, which provide for tax reductions on income from patents. In 2008, the Commission reviewed such a regime in Spain and concluded that the scheme did not constitute aid (see IP/08/216). Since then, however, the Commission has received indications that special tax regimes seem to mainly benefit highly mobile businesses and do not trigger significant additional research and development activity. The Commission is therefore gathering information to assess whether the regimes grant a selective advantage to a particular group of companies, in breach of EU state aid rules.51

The Commission does not seem concerned about IP regimes as such but more about their practical effect in relation to their objective. Obviously, this gives the Commission some leeway in reviewing IP regimes: do they actually lead to more R&D?

3.4.6. The modified nexus approach It is precisely this practical effect that the nexus approach aims to address: IP regimes should promote R&D, not artificial profit shifting. This is the reason why expenditure incurred by both foreign subsidiaries and exempt PEs of a resident taxpayer arguably do not amount to “qualifying expenditures” (see section 3.2.). Since this should be regarded as a legitimate objective of tax policy – compare section 3.3.2. – a correct implementation of the modified nexus approach in domestic tax law should not lead to unlawful State aid. However, if an EU Member State would make an exception to this anti-abuse rule which does not reflect its underlying logic, it may provide State aid (compare section 3.4.4.). In my view, the acceptance of expenditure incurred at the level of a foreign exempt PE as “qualifying expenditures” indeed runs such a risk. After all, such a choice runs directly counter to the objective of countering artificial profit shifting. This advantage in

50. Commission Notice on the notion of State aid as referred to in Article 107(1), supra n. 39. 51. European Commission, press release of 24 March 2014, IP/14/309.

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comparison with a “normal” application of the nexus approach may very well amount to unlawful State aid.

3.5. Conclusions In this chapter I have reviewed the implementation of the modified nexus approach in the domestic tax laws of EU Member States. Section 3.2. has concluded that in the most likely interpretation of this approach, costs incurred at the level of an exempt foreign PE of a resident taxpayer do not amount to “qualifying expenditures”, as a result of which income produced by the IP in connection therewith should not benefit from an IP regime. After a review of EU case law, it has been concluded in section 3.3. that this limitation arguably does not infringe EU free movement law. In section 3.4., EU State aid law has been examined. It has been concluded that IP regimes of general application do not amount to unlawful State aid, provided that they are fit for purpose. However, an incorrect implementation of the modified nexus approach by EU Member States could lead to such a qualification. In this light, the remarks made by European Commission officials – see section 3.1. – make sense and should be taken very seriously.

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Chapter 4 Open Issues in the Application of the Interest and Royalty Directive to Royalty Payments by Paolo Arginelli1

4.1. Introduction Almost 15 years after its approval, Council Directive 2003/49/EC (hereinafter “I&R Directive” or “the Directive”)2 still presents several grey areas, on which this chapter aims at shedding some light. The following analysis focuses on the application of the I&R Directive to royalty payments, which is the topic of this book. In particular, section 4.2. deals with the interpretation of the definition of royalties included in the Directive, section 4.3. discusses the scope of the subject-to-tax requirement provided for in article 3(a)(iii), section 4.4. examines the proper construction of the beneficial owner clause and how instances of abuse of the Directive may be tackled, section 4.5. analyses certain procedural issues and section 4.6. concludes with some tax policy considerations.

4.2. The definition of royalties 4.2.1. In general The definition of the term “royalties” provided for in article 2(b) of the Directive is almost the same as the one included in article 12(2) of the 1977 OECD Model, except for the fact that it explicitly mentions “software” as an instance of copyright.3 1. Professor of European Union Tax Law and Corporate Tax Law, Università Cattolica del Sacro Cuore, Italy; Adjunct Postdoctoral Research Fellow, IBFD; Of Counsel, Maisto e Associati, Milan. The author can be contacted at [email protected]. 2. Council Directive 2003/49/EC, of 3 June 2003, on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (as later amended). 3. In 1992, para. 12 of the Commentary on Article 12 of the OECD Model made clear that the “rights in computer software are a form of intellectual property” and that, back in 1992, “all but one [OECD Member countries] protect[ed] software rights either explicitly or implicitly under copyright law”.

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Article 2(b) reads as follows: [T]he term ‘royalties’ means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work, including cinematograph films and software, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience; payments for the use of, or the right to use, industrial, commercial or scientific equipment shall be regarded as royalties.

The definition contains several undefined legal jargon (“technical”) terms,4 which themselves are not defined in the Directive, which begs the question how they should be construed for the purpose of applying the Directive. In particular, the interpreter might wonder whether reference to domestic law meaning should be allowed and what relevance, if any, should be attributed to EU law private law instruments dealing with intellectual property (IP) rights and to the OECD Model and its Commentary.

4.2.2. The renvoi to domestic law With regard to the first question, i.e. whether reference to domestic law meaning should be allowed, the answer should be in the negative. Indeed, unless it makes an explicit reference to domestic law definitions and meanings, or it may be inferred from its (con)text and objective that such a reference is implicit,5 secondary EU legislation should be interpreted uniformly and autonomously from the domestic law of the Member States. 4. On the interpretation of legal jargon terms used in tax treaties, see P. Arginelli, Multilingual Tax Treaties: Interpretation, Semantic Analysis and Legal Theory, sec. 8.5 (IBFD 2015), Online Books IBFD; P. Arginelli, Riflessioni sull’interpretazione delle convenzioni bilaterali per evitare le doppie imposizioni conformi al Modello OCSE, Rivista di Diritto Tributario 4, p. 148 et seq. (2016); further references therein. 5. In some cases, the European Court of Justice (ECJ) has recognized the possibility to read an implicit renvoi to the domestic law of EU Member States in the text of the relevant legal instrument. For instance, in a decision concerning the interpretation of art. 5(1) of the Brussels Convention on jurisdiction and enforcement of judgments in civil and commercial matters, after noting that “in the case of an action relating to contractual obligations Article 5(1) allows a plaintiff to bring the matter before the court for the place ‘of performance’ of the obligation in question”, the Court concluded that it was “for the court before which the matter [was] brought to establish under the Convention whether the place of performance is situate within its territorial jurisdiction” and that for such a purpose, the referred court had to “determine in accordance with its own rules of conflict of laws what [was] the law applicable to the legal relationship in question and define in accordance with that law the place of performance of the contractual obligation in question”. According to the Court, “in these circumstances the reference in the Convention to

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This norm of interpretation descends, as a corollary, from the principle of the autonomy of EU law, which was affirmed by the European Court of Justice (ECJ) already in the landmark Costa v. Enel decision.6 In particular, interpreting EU secondary legislation through a renvoi to the domestic laws of the Member States would entail a significant risk of jeopardizing the attainment of the objectives of that secondary legislation. In the words of the Court, the “integration into the laws of each Member State of provisions which derive from the Community [makes] it impossible for the States, as a corollary, to accord precedence to a unilateral and subsequent measure over a legal system accepted by them on a basis of reciprocity [i.e. the EU legal system]. Such a measure cannot therefore be inconsistent with that legal system. The executive force of Community law cannot vary from one State to another in deference to subsequent domestic laws, without jeopardizing the attainment of the objectives of [the EU legal system].”7 The principle of autonomous interpretation was fully developed in later decisions, in particular CILFIT,8 where the Court affirmed that “every provision of Community law must be placed in its context and interpreted in the light of the provisions of Community law as a whole, regard being had to the objectives thereof and to its state of evolution at the date on which the provision in question is to be applied”.9 This rule of interpretation closely resembles the one enshrined in article 31 of the 1969 Vienna Convention on the Law of Treaties,10 adding thereto that as a general rule, EU law should the place of performance of contractual obligations [could not] be understood otherwise than by reference to the substantive law applicable under the rules of conflict of laws of the court before which the matter [was] brought” (DE: ECJ, 6 Oct. 1976, Case 12/76, Industrie Tessili Italiana Como v. Dunlop AG, paras. 13 and 15). For the possibility to read an implicit reference to domestic law in international treaties, see, inter alia, A. Cassese, Il diritto interno nel processo internazionale p. 202 et seq. (Cedam 1962) and further references therein. 6. IT: ECJ, 15 July 1964, Case 6/64, Flaminio Costa v. E.N.E.L. 7. Id. 8. IT: ECJ, 6 Oct. 1982, Case 283/81, Srl CILFIT and Lanificio di Gavardo SpA v. Ministry of Health. 9. Id. p. 20. 10. Vienna Convention on the Law of Treaties (23 May 1969), art. 31: “1. A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. 2. The context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes: (a) Any agreement relating to the treaty which was made between all the parties in connection with the conclusion of the treaty; (b) Any instrument which was made by one or more parties in connection with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty. 3. There shall be taken into account, together with the context: (a) Any subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions; (b) Any subsequent practice in the application of the treaty which establishes

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be construed dynamically in the light of the evolution of the EU legal order.11 In this context, the ECJ recognized that as a consequence of the autonomous interpretation of EU law, “legal concepts do not necessarily have the same meaning in Community law and in the law of the various Member States”.12 The bias in favour of the autonomous interpretation of the “royalties” definition is further supported by the analysis of article 115 of the Treaty on the Functioning of the European Union (TFEU), which constitutes the legal basis for the adoption of the I&R Directive by the Council. Article 115 of the TFEU provides that the “Council shall … issue directives for the approximation of such laws, regulations or administrative provisions of the Member States as directly affect the establishment or functioning of the internal market.” The purpose of article 115 is to ensure that even in the field of direct taxation, the Council has the chance to issue directives in order to harmonize the domestic laws of the Member States, in so far as the differences existing among such domestic laws might jeopardize the establishment and the well-functioning of the internal market.13 There is therefore a causal link between the adopting a directive under article 115 of the TFEU and the existence of discrepancies among the relevant legislations of the EU Member States. In this respect, interpreting the definition of “royalties” included in the I&R Directive, which does not encompass any express reference to the national legislations of the Member States, by means of a renvoi to such legislations would run against the main objective of the Directive, i.e. harmonizing the domestic laws of the Member States in order to eliminate certain obstacles the agreement of the parties regarding its interpretation; (c) Any relevant rules of international law applicable in the relations between the parties. 4. A special meaning shall be given to a term if it is established that the parties so intended.” 11. M.P. Maduro, Interpreting European Law: Judicial Adjudication in a Context of Constitutional Pluralism, 1 European J. of Leg. Studies 2, pp. 144-145 (2007); R.A. Wessel, The Dynamics of the European Union Legal Order: An Increasingly Coherent Framework of Action and Interpretation, European Const. Law Rev. 5, pp. 141-142 (2009); N. Fennelly, Legal Interpretation at the European Court of Justice, 20 Fordham Int’l L.J. 3, p. 655 et seq. (1996); O. Pollicino, Legal Reasoning of the Court of Justice in the Context of Principle of Equality between Judicial Activism and Self-Restraint, 5 German Law J. 3, p. 289 (2004). 12. CILFIT (283/81), p. 19. 13. B. Terra & P. Wattel, European Tax Law p. 22 et seq. (Kluwer 2012); M. Helminen, Chapter 1: Concepts and Basic Principles of EU Tax Law in EU Tax Law – Direct Taxation pp. 11-12 (IBFD 2017), Online Books IBFD; F. Pocar & M.C. Baruffi, Commentario breve ai Trattati dell’Unione Europea Art. 115 (Cedam 2014); J. Malherbe et al., The impact of the Rulings of the European Court of Justice in the Area of Direct Taxation 2010, p. 15, available at http://www.europarl.europa.eu/document/activities/cont/201203/20120313ATT 40640/20120313ATT40640EN.pdf (last accessed 27 Mar. 2018).

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to the establishment and well-functioning of the internal market. Such interpretation, indeed, would preserve – and not reduce – the differences among the domestic legislations of the Member States. Thus, a teleological construction of the Directive, read in conjunction with article 115 of the TFEU, appears to clearly favour the autonomous interpretation of the “royalties” definition. Finally, it is worth mentioning that the 1998 Proposal presented by the Commission,14 which constituted the basis for the final text of the Directive, included in article 2(2) a reference to the domestic laws of the Member States in addition to the definition of “royalties” provided for in article 2(1). According to the Commentary attached to the 1998 Proposal, the “Directive applies not only to the payments of … royalties as defined under paragraph 1 but also to all payments regarded by Member States as such”.15 Indeed, article 2(2) of the 1998 Proposal provided that: In addition to the income and payments referred to in paragraph 1, any income or payments which are considered to be interest or royalties … either by virtue of a double taxation convention … or, in the absence of a convention, by virtue of the tax legislation of the Member State where the interest or royalties arise, shall be treated as interest or royalties for the purposes of this Directive.

This renvoi to the domestic laws of the Member States was dropped in the final version of the Directive adopted by the Council, which confirms the intention of the EU legislature to adopt an autonomous concept of royalties for the purpose of the Directive and thus an autonomous interpretation of the definition encompassed in article 2(b) thereof.

4.2.3. The relevance of EU private law instruments on IP rights The first source of interpretation for construing the definition of royalties provided in article 2(b) of the Directive should be the numerous private law instruments dealing with IP rights that form part of the acquis communautaire. Such instruments include definitions of the technical terms employed in article 2(b) and shed light on their interpretation by putting them in their context. Moreover, the case law of the competent courts (including the ECJ)

14. COM(1998) 67 final, Proposal for a Council Directive on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (4 Mar. 1998) [hereinafter the 1998 Proposal]. 15. See id., p. 6.

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interpreting such legal instruments may constitute an additional aid for the construction of the terms used in the definition of royalties. By way of example, some of the relevant private law instruments that may be referred to in order to interpret the terms used in the definition of royalties provided for in article 2(b) of the I&R Directive are:16 – the directive on the harmonisation of certain aspects of copyright and related rights in the information society of 22 May 2001;17 – the directive on rental right and lending right and on certain rights related to copyright in the field of intellectual property of 12 December 2006;18 – the directive on the resale right for the benefit of the author of an original work of art of 27 September 2001;19 – the directive on the coordination of certain rules concerning copyright and rights related to copyright applicable to satellite broadcasting and cable retransmission of 27 September 1993;20 – the directive on the legal protection of computer programs of 23 April 2009;21 – the directive on the enforcement of intellectual property right of 29 April 2004;22 – the directive on the legal protection of databases of 11 March 1996;23 – the directive on the term of protection of copyright and certain related rights of 12 December 2006;24 16. Some international treaties, which might be relevant for the purpose of interpreting the definition of royalties under the I&R Directive, are still not in force (e.g. the Beijing Treaty on Audiovisual Performances adopted on 24 June 2012). 17. Directive 2001/29/EC of the European Parliament and of the Council of 22 May 2001 on the harmonisation of certain aspects of copyright and related rights in the information society. 18. Directive 2006/115/EC of the European Parliament and of the Council of 12 December 2006 on rental right and lending right and on certain rights related to copyright in the field of intellectual property. 19. Directive 2001/84/EC of the European Parliament and of the Council of 27 September 2001 on the resale right for the benefit of the author of an original work of art. 20. Council Directive 93/83/EEC of 27 September 1993 on the coordination of certain rules concerning copyright and rights related to copyright applicable to satellite broadcasting and cable retransmission. 21. Directive 2009/24/EC of the European Parliament and of the Council of 23 April 2009 on the legal protection of computer programs. 22. Directive 2004/48/EC of the European Parliament and of the Council of 29 April 2004 on the enforcement of intellectual property rights. 23. Directive 96/9/EC of the European Parliament and of the Council of 11 March 1996 on the legal protection of databases. 24. Directive 2006/116/EC of the European Parliament and of the Council of 12 December 2006 on the term of protection of copyright and certain related rights (as

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– the directive on certain permitted uses of orphan works of 25 October 2012;25 – the directive on collective management of copyright and related rights and multi-territorial licensing of rights in musical works for online use in the internal market of 26 February 2014;26 – the regulation on cross-border portability of online content services in the internal market of 14 June 2017;27 – the directive on the protection of undisclosed know-how and business information of 8 June 2016;28 – the directive on the approximation of the laws on trade marks of 16 December 2015;29 – the regulation on the EU trade mark of 14 June 2017;30 – the regulation on the supplementary protection certificate for medicinal products of 6 May 2009;31 – the directive on the Community code relating to veterinary medicinal products of 6 November 2001;32 – the directive on the Legal Protection of biotechnological inventions of 6 July 1998;33 – the regulation on Community Plant Variety Rights of 27 July 1994;34

amended by Directive 2011/77/EU of the European Parliament and of the Council of 27 September 2011). 25. Directive 2012/28/EU of the European Parliament and of the Council of 25 October 2012 on certain permitted uses of orphan works. 26. Directive 2014/26/EU of the European Parliament and of the Council of 26 February 2014 on collective management of copyright and related rights and multi-territorial licensing of rights in musical works for online use in the internal market. 27. Regulation (EU) 2017/1128 of the European Parliament and of the Council of 14 June 2017 on cross-border portability of online content services in the internal market. 28. Directive (EU) 2016/943 of the European Parliament and of the Council of 8 June 2016 on the protection of undisclosed know-how and business information (trade secrets) against their unlawful acquisition, use and disclosure. 29. Directive (EU) No. 2015/2436 of the European Parliament and of the Council of 16 December 2015 to approximate the laws of the Member States relating to trade marks. 30. Regulation (EU) 2017/1001 of the European Parliament and of the Council of 14 June 2017 on the European Union trade mark. 31. Regulation (EC) No. 469/2009 of the European Parliament and of the Council of 6 May 2009 concerning the supplementary protection certificate for medicinal products. 32. Directive 2001/82/EC of the European Parliament and of the Council of 6 November 2001 on the Community code relating to veterinary medicinal products. 33. Directive 98/44/EC of the European Parliament and of the Council of 6 July 1998 on the Legal Protection of biotechnological inventions. 34. Council Regulation (EC) No. 2100/94 of 27 July 1994 on Community Plant Variety Rights, as amended by Council Regulation (EC) No. 2506/95 of 25 October 1995.

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– the regulation of the Council on supplementary protection certificate for plant protection products of 23 July 1996;35 – the directive on the legal protection of designs of 13 October 1998;36 – the regulation on Community designs of 12 December 2001;37 – the Berne Convention for the Protection of Literary and Artistic Works, as resulting from the Paris Act of 24 July 1971;38 – the Rome Convention for the Protection of Performers, Producers of Phonograms and Broadcasting Organizations;39 – the World Trade Organization (WTO) TRIPS Agreement of 15 April 1994;40 – the World Intellectual Property Organization (WIPO) Copyright Treaty of 20 December 1996; – the WIPO Performances and Phonograms Treaty of 20 December 1996; and – the European Patent Convention of 5 October 1973.41

4.2.4. Using the OECD Model Commentary As previously mentioned, Article 12 of the OECD Model clearly represented the main source of inspiration for the EU legislature when drafting the definition of “royalties” to be included in the Directive. This is confirmed by the Commentary to the 1998 Proposal, where the Commission stated that the “term ‘royalties’ as used for the purposes of this Directive denotes in general all payments made as consideration made for the use of, or the entitlement to use copyright, work, patents, etc. as included in Article 12 of the 1996 OECD Model Tax Convention”.42 The relevance of the OECD documents for the purpose of the definition of “royalties” was also highlighted by the European Economic and Social Committee, which, in the Opinion issued in connection with the 1998 Proposal, made reference 35. Regulation (EC) No. 1610/96 of the European Parliament and of the Council of 23 July 1996 concerning the creation of a supplementary protection certificate for plant protection products. 36. Directive No. 98/71/EC of the European Parliament and of the Council of 13 October 1998 on the legal protection of designs. 37. Council Regulation (EC) No. 6/2002 of 12 December 2001 on Community designs. 38. As amended on 28 September 1979. 39. International Convention for the Protection of Performers, Producers of Phonograms and Broadcasting Organizations (26 Oct. 1961). 40. Agreement on Trade-Related Aspects of Intellectual Property Rights, Annex 1C to the Marrakesh Agreement Establishing the World Trade Organization. 41. Convention on the Grant of European Patents (European Patent Convention) (5 Oct. 1973). 42. See 1998 Proposal, supra n. 14, at p. 6.

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to the work of the OECD Committee for Fiscal Affairs in order to interpret the definition included in that Proposal.43 Although the ECJ is (obviously) not bound by the OECD Commentary when interpreting the I&R Directive, there is case law confirming its willingness to follow non-legally binding instruments, which are not part of the EU legal order, for the purposes of construing EU secondary legislation. Among non-tax decisions, it is worth recalling the judgment in Verwertungsgesellschaft Rundfunk (Case C-641/15),44 concerning the interpretation of article 8(3) of Directive 2006/115/EC on rental right and lending right and on certain rights related to copyright. More specifically, in such a case the Court had to construe the expression “places accessible to the public against payment of an entrance fee” employed in that directive. The ECJ started its analysis by noting that both Recital 7 of Directive 2006/115/EC and its travaux préparatoires gave evidence of the intention of the EU legislature to follow and not to conflict with the 1961 Rome International Convention for the Protection of Performers, Producers of Phonograms and Broadcasting Organizations.45 On this basis, the Court 43. See the Opinion of the Economic and Social Committee on the Proposal for a Council Directive on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (98/C 284/09), para. 7.3, where it was stated that “[t]he OECD Fiscal Affairs Committee has clearly stated that no withholding tax should be levied on payments that do not represent royalties but result from agreements on contribution to a group’s central expenditure”. 44. AT: ECJ, 16 Feb. 2017, Case C-641/15, Verwertungsgesellschaft Rundfunk GmbH v. Hettegger Hotel Edelweiss GmbH, ECLI:EU:C:2017:131. 45. See id., at paras. 21 and 22, which read as follows: “21. As regards interpreting the concept of ‘places accessible to the public against payment of an entrance fee’, it is apparent from recital 7 of Directive 2006/115 that it seeks to approximate the legislation of the Member States in such a way as not to conflict, in particular, with the Rome Convention. Accordingly, although that convention does not form part of the legal order of the European Union, concepts appearing in Directive 2006/15 must be interpreted in particular in the light of that convention, in such a way that they are compatible with the equivalent concepts contained in that convention, taking account also of the context in which those concepts are found and the purpose of the relevant provisions of the convention (see, to that effect, judgment of 15 March 2012, SCT, C‑135/10, EU:C:2012:140, paragraphs 53 to 56). 22. In the present case, the scope of the right of communication to the public laid down in Article 8(3) of Directive 2006/115 is equivalent to that of the right provided for in Article 13(d) of the Rome Convention, which, in accordance with the wording of Article 8(3), limits it to ‘places accessible to the public against payment of an entrance fee’ (see, to that effect, judgment of 4 September 2014, Commission v Council, C‑114/12, EU:C:2014:2151, paragraphs 94 to 96). The intention of the EU legislature was – as confirmed by the amended proposal for a directive, of 30 April 1992 (COM(92) 159 final, p. 12), which led to the adoption of Council Directive 92/100/EEC of 19 November 1992 on rental right and lending right and on certain rights related to copyright in the field of intellectual property (OJ 1992 L 346, p. 61), which was repealed

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concluded that although the Rome Convention did not form part of the legal order of the European Union, the concepts appearing in Directive 2006/15 had to be interpreted in the light of the equivalent concepts employed in that convention.46 Then, in order to interpret the relevant provision of the Rome Convention, it made reference to the Guide to the Rome Convention and to the Phonograms Convention, a non-legally binding document prepared by the WIPO, which provides explanations as to the origin, purpose, nature and scope of the Rome Convention. As a result, the ECJ construed article 8(3) of Directive 2006/115/EC in accordance with the interpretation of the Rome Convention put forward in the aforementioned non-legally binding Guide.47 Somehow similarly, in Internetportal und Marketing (Case C-569/08),48 the Court interpreted Commission Regulation (EC) No 874/2004, on the implementation and functions of the .eu Top Level Domain, in light of the nonlegally binding 1999 Final Report of the First WIPO Internet Domain Name Process. Also, in this case, the ECJ attributed relevance to the assumed intention of the EU legislature, which was derived from Recital 16 of the Regulation, according to which the Registry of the Domain must take into account the international best practices and, in particular, the relevant WIPO recommendations.49 In respect of tax cases,50 the Advocate General’s Opinion in Scheuten Solar (Case C-397/09)51 supported the conclusion that the I&R Directive is concerned solely with international juridical double taxation and not with international economic double taxation, by recalling that the 1998 Proposal “was and codified by Directive 2006/115 – to follow to a large extent the provisions of the Rome Convention introducing minimum protection in order to achieve uniform minimum protection in the European Union and, by modelling Article 6a(3) of the proposed Directive on Article 13(d) of the Rome Convention, to provide for an exclusive right to communicate television broadcasts to the public under the conditions set out in that convention.” 46. Id., para. 21. 47. Id., para. 23. 48. AT: ECJ, 3 June 2010, Case C‑569/08, Internetportal und Marketing GmbH v. Richard Schlicht, 2010 I-04871. 49. Id., para. 38. 50. There are several references to the OECD Model and Commentary in the case law of the ECJ and in the Advocates General’s opinions, in addition to those expressly quoted hereafter. See, among the most well-known, DE: ECJ, 14 Feb. 1995, Case C‑279/93, Finanzamt Köln-Altstadt v. Roland Schumacker, para. 32, ECJ Case Law IBFD; NL: ECJ, 7 Sept. 2006, Case C‑470/04, N v. Inspecteur van de Belastingdienst Oost/kantoor Almelo, paras. 45-46 and the case law cited therein, ECJ Case Law IBFD; EE: Opinion of Advocate General Jääskinen, 24 Nov. 2011, Case C-39/10, European Commission v. Republic of Estonia, para. 77 et seq. and, in particular, n. 35, ECJ Case Law IBFD. 51. DE: Opinion of Advocate General Sharpston, 12 May 2011, Case C-397/09, Scheuten Solar Technology GmbH v. Finanzamt Gelsenkirchen-Süd, ECJ Case Law IBFD.

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influenced by the OECD Model Tax Convention, the main purpose of which is to set out a means of dealing, on a uniform basis, with the most common problems that arise in the context of international juridical double taxation”.52 More significantly, in Berlioz (Case C-682/15),53 the Grand Chamber of the ECJ relied on the Commentary on Article 26 of the OECD Model in order to interpret the term “foreseeably relevant” employed in article 1(1) of Directive 2011/16/EU on administrative cooperation in tax matters.54 The Court recognized that the concept of “foreseeable relevance”, as used in the Directive, reflects that used in article 26 of the OECD Model, “both because of the similarity between the concepts used and given the reference to OECD conventions in the explanatory memorandum to the proposal for a Council Directive COM(2009) 29 final of 2 February 2009 on administrative cooperation in the field of taxation, which led to the adoption of Directive 2011/16.”55 Thus, the Court attributed relevance to (i) the similarity between the terms used, (ii) the overlapping of the object and purpose of the instruments and (iii) the intention of the EU legislator, as resulting from the preparatory works of the directive (including the Commission’s proposals). On such bases, the ECJ interpreted the term “foreseeable relevance” in accordance with the 2012 Commentary on Article 26 of the OECD Model, which was approved by the OECD Council on 17 July 2012, i.e. almost 1 year and a half after the adoption of Directive 2011/16/EU. In this respect, one may argue that the Court considered the 2012 update to the OECD Commentary as merely clarifying the concept of “foreseeable relevance”,56 which was introduced in the OECD Model back in 2005, and therefore that the 2012 update could be regarded as a relevant aid for the purpose of interpreting the provisions of the earlier directive. Similarly, AG Wathelet based his opinion also on the 2014 OECD Commentary, “by which the EU legislature was itself inspired”.57 According to the Advocate General, the 52. Id., para. 66. 53. LU: ECJ, 16 May 2017, Case C-682/15, Berlioz Investment Fund SA v. Directeur de l’administration des Contributions directes, ECJ Case Law IBFD. 54. Council Directive 2011/16/EU, of 15 February 2011, on administrative cooperation in the field of taxation and repealing Directive 77/799/EEC. 55. Berlioz (C-682/15), para. 67. 56. New para. 4.4 OECD Model: Commentary on Article 26 (2017) provides that the “Commentary was expanded to develop the interpretation of the standard of ‘foreseeable relevance’ and the term ‘fishing expeditions’ through the addition of: general clarifications …, language in respect of the identification of the taxpayer under examination or investigation …, language in respect of requests in relation to a group of taxpayers … and new examples… [emphasis added].” 57. LU: Opinion of Advocate General Wathelet, 10 Jan. 2017, Case C-682/15, Berlioz Investment Fund SA v. Directeur de l’administration des Contributions directes, para. 102, ECJ Case Law IBFD.

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Court “has already held that the Member States are entitled to be guided by an OECD Model Treaty”.58 Based on the above, it seems reasonable that definition of the term “royalties” provided for in article 2(b) of the I&R Directive should be construed as far as possible in the light of the Commentary on Article 12 of the OECD Model. The reference to the OECD Commentary would be particularly helpful when tackling interpretative issues concerning the tax characterization of the payments received, which are not dealt with in the IP law instruments referred to in the previous section, such as the distinction between letting and alienation,59 the qualification of payments made for exclusivity60 and exclusive distribution rights,61 the application of the definition to payments made under roaming and spectrum license agreements,62 the distinction between royalties and service fees, as well as between know-how contracts and service contracts,63 and the characterization of payments made in transactions involving the transfer of computer software.64

4.3. The subject-to-tax requirement 4.3.1. A “subjective” or an “objective” requirement? Under article 3(a)(iii) of the I&R Directive, a “Company of a Member State” is any company which is subject to one of the listed taxes without being exempt. The wording employed is substantially the same as that used in the Parent-Subsidiary Directive,65 except for fact that the latter also excludes companies having “the possibility of an option”. The requirement of being subject to tax without being exempt has been recently scrutinized by the ECJ in Wereldhave (Case C-448/15),66 where

58. Id., n. 46. 59. Para. 8.2 OECD Model: Commentary on Article 12 (2017). 60. Id., para. 8.5. 61. Id., para. 10.1. 62. Id., paras. 9.2 and 9.3. 63. Id., paras. 10.2 through 11.6. 64. Id., para. 12 et seq. 65. Council Directive 2011/96/EU, of 30 November 2011, on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States. 66. BE: ECJ, 8 Mar. 2017, Case C-448/15, Belgische Staat v. Wereldhave Belgium Comm. VA and Others, ECJ Case Law IBFD.

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the Court held67 that “Article 2(c) of [the Parent-Subsidiary Directive] lays down a positive criterion for qualifying, that is to say, being subject to the tax in question, and a negative criterion, that is to say, not being exempt from that tax”,68 which entails that “the condition laid down in Article 2(c) of the directive does not merely require that a company should fall within the scope of the tax in question, but also seeks to exclude situations involving the possibility that, despite being subject to that tax, the company is not actually liable to pay that tax”.69 Although the Court took a position only in respect of subjective (full) exemptions due to the specific facts of the main proceedings, the impression is that both the Court and the Advocate General construed the subject-to-tax requirement as a subjective requirement, under which a company otherwise qualifying for the application of the Directive is excluded therefrom only if it benefits from a domestic law-based subjective full exemption.70 On the contrary, partial objective exemptions would not disqualify a company from being regarded as a company of a Member State for the purpose of the Parent-Subsidiary Directive. In particular, according to the Advocate General, “exemption” within the meaning of article 2(1)(c) of Directive 90/435 (Parent-Subsidiary Directive) entails that “no payment of the relevant tax is required as the legislature has deemed fit to release a particular class of companies from the obligation to pay the tax”,71 which is true when, “by means of an express legal provision”, a Member State “establishes permanently and in advance [a complete absence of tax] for a certain class of bodies, irrespective of the profits received”.72 The construction of the subject-to-tax requirement in the Parent-Subsidiary Directive as a subjective requirement is also upheld by scholars, based on the literal, systematic and teleological interpretation of that directive.73 67. See, similarly, BE: Opinion of Advocate General Campos Sánchez-Bordona, 26 Oct. 2016, Case C-448/15, Belgische Staat v. Wereldhave Belgium Comm. VA and Others, paras. 43-44, ECJ Case Law IBFD. 68. Id., para. 31. 69. Id., para. 32. 70. See, in particular, Wereldhave (C-448/15), paras. 32-33: the Directive “also seeks to exclude situations involving the possibility that, despite being subject to that tax, the company is not actually liable to pay that tax” and “[a]lthough, formally, a company which is subject to tax at a zero rate, provided that all of its profits are paid to its shareholders, is not exempt from that tax, it is, in practical terms, in the same situation as the one which Article 2(c) of Directive 90/435 seeks to exclude, that is to say, a situation in which it is not liable to pay that tax [emphasis added].” 71. AG Opinion in Wereldhave (C-448/15), para. 42. 72. Id., para. 44. 73. See, for instance, W. Wijnen et al., Survey of the Implementation of the EC Corporate Tax Directives p. 374 (IBFD 1995); G. Maisto, Il regime tributario dei dividendi nei rapporti tra “società madri” e “società figlie” pp. 27-29 (Giuffré editore 1996); P. Arginelli,

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One may wonder whether any reason exists to take a different stand in respect of the interpretation of the subject-to-tax requirement encompassed in article 3(a)(iii) of the I&R Directive. From a literal and a systematic perspective, this does not seem the case. As previously mentioned, the wording adopted in the I&R Directive is almost the same as the one employed in the (previous) Parent-Subsidiary Directive and, in both cases, the subject-to-tax requirement is used for the purpose of defining the personal scope of application of the directives74 and not, more generally, to single out cases where the existence of specific exemptions makes their benefits inapplicable. On the other hand, from a teleological perspective, the objective exemption of the dividends received by the parent company, in the context of the ParentSubsidiary Directive, and the objective exemption of the royalties received by the IP company, in the context of the I&R Directive, are not comparable. While, in the first case, the exemption enhances the elimination of the economic double taxation of the profits distributed, thus contributing to the achievement of the goal of the directive, in the second case it generally leads to an instance of deduction without inclusion (double exemption), a result which certainly does not represent the goal of the I&R Directive and which might arguably be regarded as contrary to the object and purpose thereof. This last argument has been, indeed, put forward by some Member States, which have implemented the subject-to-tax requirement in the domestic legislations as an “objective” requirement.75 To this end, they also relied upon recital (3) of the I&R Directive, according to which, “[i]t is necessary to ensure that interest and royalty payments are subject to tax once in a Member State”, which they read as requiring royalties to be taxed at least once in either the Member State of the payer or in the Member State of the payee.76 An additional argument that is relied upon in order to support the construction of the subject-to-tax requirement as an objective requirement is based The Subject-to-Tax Requirement in the EU Parent-Subsidiary Directive (2011/96), 57 Eur. Taxn. 8, pp. 338-339 (2017), and further references therein, Journals IBFD. 74. I.e. in the definition of “Company of a Member State”. 75. See, in particular, for Italy art; 26-quater(4)(b) of Decree 600/1973 (as commented in Circular Letter no. 47/E of 2 Nov. 2005, see Chap. 17 in this volume) and for France see art. 119 quater of the French Tax Code (see Chap. 15 of this volume). 76. The “Statements for entry in the minutes of the Council”, when the Directive was adopted, contain the following passage: “The Council and the Commission agree that the benefits of the Interest and Royalty Directive should not accrue to companies that are exempt from tax on income covered by this Directive. The Council invites the Commission to propose any necessary amendments to this Directive in due time” (see para. 3 of the Explanatory Memorandum to COM(2003) 841 final).

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on the comparison with article 1(5)(b) of the I&R Directive, under which a permanent establishment (PE) shall be treated as the beneficial owner of royalties “if the royalty payments represent income in respect of which that permanent establishment is subject in the Member State in which it is situated to one of the taxes mentioned in Article 3(a)(iii)”. The argument goes as such: since putting an objective subject-to-tax requirement only on PEs (and not on companies) would determine an unlawful discrimination of PEs as compared to companies, it is necessary to read the subject-to-tax requirement encompassed in article 3(a)(iii) of the I&R Directive as an objective requirement in order to avoid such discrimination. From the author’s perspective, neither of these two arguments is convincing. Starting with recital (3), when that is read in its context, it appears clear that the expression “subject to tax once in a Member State” was intended to mean that royalty payments should not be taxed more than once in the European Union, i.e. by no more than one Member State, rather than prescribing such payments to be taxed at least once. Indeed, recitals (1) and (2) highlight that, in the Single Market, transactions between companies of different Member States should not be subject to less favourable tax conditions than those applicable to the same transactions carried out between companies of the same Member State and that such requirement was not met – before the approval of the I&R Directive – as regards intra-EU interest and royalty payments, which were often subject to double taxation and more burdensome administrative formalities and cash-flow problems. This, obviously, would require the elimination of the multiple layers of taxation within the Single Market in order to get rid of such issues, which seems to be what recital (3) is aimed at affirming. Subsequent recital (4) closes the reasoning by pointing out that the abolition of taxation on royalty payments in the Member State where they arise is the most appropriate means of eliminating the aforementioned formalities and problems, and of ensuring the equality of tax treatment as between national and cross-border transactions. There is nothing in the context of such recitals suggesting that the primary focus of the EU legislature was to ensure that the royalties were taxed at least once in a Member State. The only, more limited, inference that may be drawn therefrom is that the intention of the EU legislature was primarily to eliminate double taxation and certainly not to trigger double non-taxation on a systematic basis. With regard to the argument based on article 1(5)(b) of the I&R Directive, it is interesting to compare it with its twin article 1(3), under which a PE shall be treated as the payer of the royalty payment only to the extent that the latter represents a tax-deductible expense for the PE in the Member 65

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State where it is situated. It is at least doubtful that article 1(3) should be construed as requiring the royalty payments to be actually deducted for tax purposes by the PE in order to make the Directive applicable in the Member State where that PE is situated. Indeed, this interpretation would lead to the absurd result that the latter state could both disallow the deduction of the royalty payment for the purpose of computing the taxable profits of the PE and tax such payment in the hands of the recipient, while, where allowing the deduction of the payment, it would be bound not to tax it in the hands of the recipient pursuant to the Directive. In this respect, it would seem more reasonable to read article 1(3) as merely requiring that the royalty payment must be genuinely connected to the paying PE. The proposal for the amendment of the Directive issued by the Commission in 2011 (hereafter the “2011 Proposal”)77 moved in the same direction, providing that article 1(3) should be interpreted as not requiring any actual deduction. The same teleological and systematic-oriented interpretation could (and should) apply also to article 1(5)(b) of the I&R Directive, which would consequently be construed as merely requiring that the royalties received are part of business profits of the PE, in respect of which its Member State applies one of the taxes mentioned in article 3(a)(iii). This construction would make the first postulate of the advocated argument (i.e. that royalties must be effectively subject to tax in the hands of the PE in order for the Directive to apply) false, thus making the entire argument untenable.

4.3.2. Attempts to modify the “subject-to-tax” requirement The previous section demonstrates that there is (or might be) a friction between the desire of some Member States to make the application of the I&R Directive subject to the requirement that the royalty payments are effectively subject to tax in the recipient’s Member State and the orthodox interpretation of the Directive. In order to eliminate this (potential) conflict,

77. COM(2011)714 final, Proposal for a Council Directive on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States, p. 6: “Article 1 (3) clarifies that a permanent establishment is considered to be making a payment when it represents a tax-deductible expense. The Commission’s report on the Directive mentioned that it is clear from the context that the purpose of the ‘tax-deductibility’ requirement is to ensure that the benefits of the Directive accrue only in respect of those payments that represent expenses which are attributable to the permanent establishment. However, in its current wording the provision would also apply to cases where deduction is denied on other grounds. The recast amends this paragraph to make it clear that the Directive applies when the payment is linked to the activities carried out by the permanent establishment.”

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there have been in the course of years many attempts to amend the subjectto-tax requirement in the Directive. The first one came only a few months after the approval of the Directive. On 20  December  2003, the Commission presented Communication COM(2003)841 final (hereinafter “2003 Proposal”),78 where it acknowledged that, notwithstanding the fact that the Council and the Commission agreed on that “the benefits of the Interest and Royalty Directive should not accrue to companies that are exempt from tax on income covered by this Directive”, the wording of the Directive should be modified in order to achieve that result.79 In this respect, recital (1) of the proposed directive highlighted that: Directive 2003/49/EC does not contain any explicit requirement that the beneficial owner of an interest or royalty payment be effectively subject to tax in relation to that payment. To ensure that the objectives of that Directive are met, it is necessary to introduce such a requirement in order to exclude from the benefits of Directive 2003/49/EC any case where the interest or royalty payment received is not subject to tax.

To that end, the Commission proposed to amend article 1(1) to read as follows: Interest or royalty payments arising in a Member State shall be exempt from any taxes imposed on those payments in that State … provided that the beneficial owner … is effectively subject to tax on the interest or royalty payments in that other Member State [emphasis added].

The European Parliament80 and the European Economic and Social Committee81 approved the 2003 Proposal, which, however, was never 78. Commission, COM(2003) 841 final, Proposal for a Council Directive amending Directive 2003/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. 79. Para. 3 of the Explanatory Memorandum to COM(2003) 841 final. Indeed, already in 2006, a survey carried out by the IBFD showed that all Member States, except for Italy and France, either implemented the subject to tax requirement as a “subjective” requirement or did not implement that requirement at all (see IBFD, Survey on the Implementation of the EC Interest and Royalty Directive p. 7 and Table 4 at pp. 18-19 (IBFD Publications 2006). 80. Final A5-0150/2004, European Parliament, Report on the proposal for a Council directive amending Directive 2003/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (COM(2003) 841 – C5-0054/2004 – 2003/0331(CNS)) (16 Mar. 2004). 81. C_112/113, Opinion of the European Economic and Social Committee on the ‘proposal for a Council Directive amending Directive 2003/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States’ (COM(2003) 841 final – 2003/0331 (CNS)), OJ 20 Apr. 2004.

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adopted by the Council due to the lack of political agreement. The Commission withdrew the 2003 Proposal in 2010.82 A second attempt was made with the 2011 Proposal, which included at article 1(1) a wording analogous to that of the 2003 Proposal. The Explanatory Memorandum highlighted that the proposal: [A]dd[ed] a new requirement for the tax exemption: the recipient has to be subject to corporate tax in the Member State of its establishment on the income derived from the interest or royalty payment. This condition seeks to ensure that the tax relief is not granted when the corresponding income is not subject to tax and thus close a loophole that could be used by tax evaders.83

The 2011 Proposal was approved by the European Economic and Social Committee.84 The European Parliament approved it with amendments and suggested to substitute the following text for article 1(1) of the 2011 Proposal:85 Interest or royalty payments arising in a Member State shall be exempt from any taxes imposed on those payments in that State … provided that the beneficial owner … is effectively subject to tax on the income … at a rate not lower than 70% of the average statutory corporate tax rate applicable in the Member States, without there being the possibility of exemption or a substitution or replacement by payment of another tax. Interest or royalty payments shall not be exempted in the Member State in which they arise if the payment is not taxable according to the national tax law to which the beneficial owner is subject due to a different qualification of the payment (hybrid instruments) or a different qualification of the payer and recipient (hybrid entities) [emphasis added].

This was the first hint of an ongoing shift of the focus from a pure objective subject-to-tax requirement towards a minimum effective tax (MET) requirement, which was also triggered by the introduction by several Member States of preferential tax regimes granting reduced (although not zero) taxation to royalty income (IP box regimes).86

82. C_252/7, Withdrawal of obsolete Commission proposals, OJ 18 Sept. 2010, p. 11. 83. See also the commentary on the amended arts. (2011 Proposal, p. 5). 84. C_143/46, Opinion of the European Economic and Social Committee on the ‘Proposal for a Council Directive on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (recast)’ (COM(2011) 714 final — 2011/0314 (CNS)), OJ 22 May 2012. 85. Legislative resolution of 11 Sept. 2012- P7_TA(2012)0318. 86. See P. Arginelli, Innovation through R&D Tax Incentives: Some Ideas for a Fair and Transparent Tax Policy, 7 World Tax J., sec. 4.2. and further references therein (2015), Journals IBFD.

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Because of the inability to find a political agreement on either proposal (the objective subject-to-tax requirement and the MET), the Dutch Presidency put forward in 2016 a compromise solution87 based on a modified MET, aimed at balancing (i) the need to avoid exemption of royalties at source in cases where they are not taxed, or taxed at a very low effective tax rate, in the state of the recipient and (ii) the willingness to preserve the ability of Member States to design their own tax policy with a view to stimulate business activities and investments (also by means of IP box regimes). In a nutshell, the Dutch compromise solution made the benefits of the Directive subject to a MET requirement, with a carve-out for cases where the low effective tax rate was due to the application, in the state of the recipient, of a BEPS-compliant IP box regime. The proposal rephrased article 1(1) of the I&R Directive as follows: 1. Interest or royalty payments arising in a Member State shall be exempt from any taxes imposed on those payments in that Member State … provided that: (a) … (b) the income deriving from the royalty or interest payments is subject to an effective tax rate of at least 10% in the Member State of the beneficial owner … 1b. Where the condition … above is not fulfilled, royalty payments arising in a Member State shall however be exempt … to the extent that – the [lower effective tax rate is the result of an IP box regime compliant with the OECD Nexus Approach] (I alternative); and – the effective tax rate is at least equal to X% (II alternative).

The 2016 Dutch proposal, however, did not lead to any political agreement within the Council. A working paper transmitted by the Maltese Presidency to the Working Party on Tax Questions (Direct Taxation) on 19 April 2017 made clear that:88 Divergent views remain between Member States on whether the MET clause as a principle should be introduced. A substantial number of Member States are reluctant or negative on the principle to introduce a MET clause, particularly if this is contemplated in isolation. On the other hand, some Member States continue to argue that a “dry/mechanical MET” clause is required by which, when the effective taxation would be lower than the minimum tax rate threshold, the right to apply withholding taxes on an interest and royalty payment would remain at the level of the source Member State. In their view, the application of the MET ought to cover beyond mere cases of abuse; and it is for this reason that the insertion of a [targeted anti-avoidance rule, modelled

87. See Room Document 2, Working Party on Tax Questions (Direct Taxation), Interest and Royalties Directive (16 Feb. 2016). 88. WK 4478/2017 INIT.

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on the one introduced in the Parent-Subsidiary Directive and on the general anti-abuse rule (GAAR) of the Anti-Tax Avoidance Directive (ATAD)] would not suffice in their view.89

The ongoing discussion at the Presidency level shows how the subject-totax and the MET requirements are seen by a significant number of Member States as disproportionate anti-avoidance rules, while others regard them as tax policy tools necessary to achieve a balanced allocation of taxing rights. On this basis, the Maltese Presidency put forward that a possible compromise package could be built upon the following three intermingled pillars:90 (1) The insertion of an objective subject-to-tax clause in article 1(1). (2) The inclusion in article 5 of a specific anti-avoidance rule (SAAR) modelled on the one introduced in the Parent-Subsidiary Directive and on the GAAR of the ATAD. (3) The amendment of article 4(1), allowing the source state not to apply the I&R Directive to payments going into preferential tax regimes in the state of the recipient.91 Later, the June 2017 ECOFIN Report to the European Council on tax issues highlighted that several Member States could not agree on the April 2017 Maltese Presidency proposal. In particular, their delegations insisted that non-harmful preferential regimes should not be excluded from the scope of the I&R Directive.92 As a result, on 30 May 2017, the Maltese Presidency proposed an updated compromise, under which the planned amendment of article 4(1) was reformulated with a view of targeting intra-EU payments indirectly remitted to a third country included in the EU list of non-cooperative jurisdictions. However, no agreement was found on this solution either.93 Finally, in the latter part of 2017 the Estonian Presidency put forward a further compromise text, still under discussion, based on the following cornerstones: 89. Id., p. 2. 90. Id., p. 4. 91. According to the Maltese proposal, for the purpose of further discussions, a preferential tax regime could initially be defined as one providing for a significantly lower effective level of taxation, including zero taxation, than those levels which generally apply in the Member State in question (see WK 4478/2017 INIT, p. 4). 92. ECOFIN Report to the European Council on tax issues of 16 June 2017 (10397/17, FISC 141, ECOFIN 551), p. 10. 93. Id., p. 11.

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(1) The insertion of an objective subject-to-tax clause in article 1(1). (2) The inclusion in article 5 of a SAAR modelled on the one introduced in the Parent-Subsidiary Directive and on the GAAR of the ATAD. (3) The exclusion of a MET requirement. (4) The addition of a declaration by Member States emphasizing the need to have a separate and full discussion on how to avoid non-taxation in bona fide situations (i.e. not aimed at tax avoidance) on all appropriate levels of the Council bodies and, if appropriate, in Code of Conduct (Business Taxation).94

4.4. Beneficial ownership and abuse 4.4.1. Interpretation of the term “beneficial owner” Article 1(1) of the I&R Directive makes the benefits of the Directive subject to the condition that the beneficial owner of the royalties is a company of another Member State or a PE situated in another Member State of a company of a Member State. In this respect, article 1(4) provides that a “company of a Member State shall be treated as the beneficial owner of … royalties only if it receives those payments for its own benefit and not as an intermediary, such as an agent, trustee or authorised signatory, for some other person”.95 This definition of the term “beneficial owner” is similar to the one included in the Commission 1998 Proposal,96 which made reference to any company holding “those payments for its own benefit and not as an agent, trustee or nominee for some other person”. The major changes are the introduction, in the 2003 definition, of a general reference to “intermediary”, of which the

94. ECOFIN Report to the European Council on tax issues of 24 November 2017 (14790/17, FISC 302, ECOFIN 1001), p. 11. 95. The additional requirements for a PE to be regarded as the beneficial owner of the payments, which are provided for in art. 1(5), are not relevant for the purpose of the analysis carried out in this section and therefore will not be discussed further. 96. COM (1998) 67 final, Proposal for a Council Directive on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States, art. 3(1)(c).

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agent, the trustee and the authorized signatory are only specific instances, and the substitution of the term “nominee” with “authorised signatory”. The similarity with the “beneficial owner” definition included in the 1977 Commentary on Article 12 of the OECD Model is also striking. That Commentary, on which both the 1998 Proposal definition and the I&R Directive definition are clearly based, provided that “the exemption from tax in the State of source is not available when an intermediary, as an agent or nominee, is interposed between the beneficiary and the payer”. The main differences between this definition and the one employed in the Directive are the use of the term “nominee” instead of “authorised signatory” (as for the 1998 Proposal) and the absence of an explicit reference to trustees, although the presence of such a reference in the I&R Directive definition should be read in its context, i.e. not referring to any trustee, but only to those acting as intermediaries, so that trustees of discretionary trusts would typically qualify as beneficial owners under both the OECD Model (1977) and the Directive. On the basis of the analysis carried out in section 4.2.4., it would be reasonable to conclude that the 1977 OECD Commentary on Article 12 should be regarded as a relevant source of interpretation for the purpose of construing the definition of “beneficial owner” included in the Directive.97 One may question, however, whether the same may be said in respect of the 2003 and 2014 amendments to the OECD Commentary. With regard to the 2003 amendments, it is worth observing that the 2003 OECD Commentary was adopted by the OECD Council some 5 months before the adoption of the I&R Directive by the Council, i.e. on 28 January 2003. This may be relied upon to argue that the (previous) 2003 OECD Commentary should be taken into account for interpreting the I&R Directive, as Member States knew its content when they adopted the Directive and did not explicitly reject it, in particular, with regard to its clarification on the application of the “beneficial owner” requirement in the case of conduit companies. Moreover, the 2003 amendments did nothing more than formally include in the Commentary the OECD position on the matter, which had been already agreed upon in 97. Advocate General Kokott, in her recent Opinion in N Luxembourg 1 (DK: Opinion of Advocate General Kokott, 1 Mar. 2018, Case C-115/16, N Luxembourg 1 v. Skatteministeriet, para. 52, ECJ Case Law IBFD), stated in a somewhat ambiguous manner that “the commentaries on the OECD MTC cannot have a direct effect on the interpretation of an EU directive, even if the terms used are identical”, although, “should it transpire from the wording and history of the directive that the EU legislature was guided by the wording of an OECD Model Tax Convention and the commentaries (available at the time) on that OECD Model Tax Convention, a similar interpretation might be appropriate”.

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the 1986 Conduit Companies Report.98 This conclusion appears all the more reasonable if one regards the 2003 amendments as being clarifications of the meaning of the term “intermediary”, which was already employed in the 1977 Commentary within the definition of term “beneficial owner”.99 It might also be argued that such a conclusion in further upheld by the fact that 22 of 28 (current) EU Member States are also OECD member countries and that the European Union takes part in the works of the OECD under the Supplementary Protocol No. 1 to the OECD Model, in particular in the works of WP 1 on tax treaties. On the other hand, the fact that the 2003 OECD Model was adopted before the Directive and that the latter did not expressly include any of the 2003 amendments to the Commentary on Article 12 of that Model could be relied upon to support the argument that the intention of the EU legislature was to reject such changes and to stick to a very narrow interpretation of the term “intermediary”, which did not include conduit companies that, though the formal owners of the royalties, had, as a practical matter, very narrow powers on the income. The author, however, does not have great sympathy for the latter argument, which appears extremely formalistic and does not take full account of the actual dynamics for reaching compromise agreements within the Council, which often make it inappropriate to seek last-minute changes in the text of the directives. The author would be similarly inclined to rely also on the 2014 amendments to the Commentary on Article 12 of the OECD Model for the purpose of interpreting the definition of “beneficial owner” of the I&R Directive. In fact, although such amendments are posterior to the Directive, they appear to be eminently of a clarifying nature. Indeed, the main purpose of the 2014 amendments is to elucidate the meaning of the term “intermediary”, as used in the 1977 OECD Commentary, which should be regarded as denoting all direct recipients whose “right to use and enjoy the royalties is constrained by a contractual or legal obligation to pass on the payment received to another person”.100 As the term “intermediary” in also the key term of the definition of “beneficial owner” provided for in the I&R Directive, there is no valid reason to exclude a priori the use of the 2014 OECD Commentary to elucidate the meaning of that definition. The fact that, as previously mentioned, 22 of 28 EU Member States are also OECD member countries and that the European Union takes part in the works of the OECD under the

98. OECD, Double Taxation Conventions and the Use of Conduit Companies, p. 8 (1986). 99. This is the position of the author. 100. Para. 4.3 OECD Model: Commentary on Article 12 (2014).

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Supplementary Protocol No. 1 to the OECD Convention, in particular in the works of WP 1 on tax treaties, further supports this conclusion.101 The questions analysed in this section will soon receive a qualified answer by the ECJ, as some Danish tribunals have referred preliminary questions to the Court dealing, inter alia, with the interpretation of the definition of “beneficial owner” employed in the I&R Directive and the relevance of the OECD Commentary for the purpose of such interpretation.102

4.4.2. Means to tackle abuses of the Directive Although, from a tax treaty perspective, the beneficial owner clause should rather be regarded as an objective requirement for the application of treaty benefits103 than as an anti-avoidance tool,104 it certainly may have an anti-

101. The use of later Commentary of the OECD Model for the purpose of construing the I&R Directive seems to be outright excluded by Advocate General Kokott, who, however, recognized that her interpretation of the “beneficial owner” definition included in the I&R Directive is, “[i]n the final analysis,… similar to the approach taken in the more recent commentaries on the OECD MTC” (AG Opinion in N Luxembourg 1 (C-115/16), paras. 53-54). 102. See, for instance, the Request for a preliminary ruling from the Østre Landsret (High Court of Eastern Denmark), DK: ECJ, 25 Feb.2016, Case C-115/16, N Luxembourg 1, ECJ Case Law IBFD (see the AG Opinion in N Luxembourg 1 and particularly questions 1.1 and 1.2: “[1.1] Is the concept ‘beneficial owner’ in Article 1(1) of Directive 2003/49, read in conjunction with Article 1(4) thereof, to be interpreted in accordance with the corresponding concept in Article 11 of the OECD 1977 Model Tax Convention? [1.2] If Question 1.1 is answered in the affirmative, should the concept then be interpreted solely in the light of the commentary on Article 11 of the 1977 Model Tax Convention (paragraph 8), or can subsequent commentaries be incorporated into the interpretation, including the additions made in 2003 regarding ‘conduit companies’ (paragraph 8.1, now paragraph 10.1), and the additions made in 2014 regarding ‘contractual or legal obligations’ (paragraph 10.2)?”). 103. In the tax treaty context, the characterization of the beneficial owner clause as an objective requirement for the application of tax treaty benefits begs the question of the interaction between such clause and the principal purpose test (PPT) included in new art. 29 of the OECD Model (2017). It is the author’s view that there may be cases, where no abuse is at stake, in respect of which the beneficial owner requirement nonetheless precludes the application of tax treaty benefits. Example E provided for in para. 187 of the Commentary on Article 29 of the OECD Model (2017) is a good instance of such cases. Although the Commentary concludes that the group structure described in the Example E is not abusive for the purpose of the PPT, it seems apparent that the IP intermediate holding company (RCO) in the example could not be regarded as the beneficial owner of the royalty payments and therefore that the benefits of the treaty between the source state and the state of residence of such company should not apply. 104. See, concurrent, AG Opinion in N Luxembourg 1 (C-115/16), para. 60.

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avoidance (and evasion) effect.105 The author does not see any reason why this characterization of the beneficial owner clause should not apply in the domain of the I&R Directive, as its structure and (some of its) main goals are derived from the international tax treaty practice and the OECD Model in particular. Not all types of abuse, however, may be tackled by relying on the beneficial owner clause. This is the case, for example, with regard to certain base company structures, diverted management functions, non-arm’s length cost contribution arrangements and cost sharing agreements, as well as, in more general terms, other (non-conduit) artificial arrangement aimed at circumventing the Directive. In order to counteract such instances of abuse, EU law provides Member States with a well-equipped arsenal. First, under article 5(1) of the I&R Directive, Member States may apply domestic or agreement-based (i.e. in general terms, included in tax treaties) provisions required for the prevention of fraud or abuse. This norm puts on the Member States two major limitations: on the one hand, the anti-avoidance (evasion) norms must be proportionate and not rely on a general presumption of abuse;106 on the other hand, they must exist and be in force in the relevant national tax system, either in the form written tax provisions or as unwritten principles relied upon by the judiciary.107 Second, article 5(2) of the I&R Directive provides that Member States may, in the case of transactions for which the principal motive or one of the principal motives is tax evasion, tax avoidance or abuse, withdraw the benefits 105. See the author’s perspective in P. Arginelli et al., The Royal Bank of Scotland case: More Controversy on the Interpretation of the Term “Beneficial Owner”, in A Decade of Case Law: Essays in Honour of the 10th Anniversary of the Leiden Adv LLM in International Tax Law p. 215 et seq. (R. (Raffaele) Russo & R. Fontana eds., IBFD 2008). 106. This principle has been repeatedly affirmed by the ECJ with regard to both the Parent-Subsidiary Directive (FR: ECJ, 7 Sept. 2017, Case C-6/16, Eqiom SAS, formerly Holcim France SAS, Enka SA v. Ministre des Finances et des Comptes publics, paras. 3132, ECJ Case Law IBFD; DE: ECJ, 20 Dec. 2017, Case C-504/16, Deister Holding, paras. 61-62, ECJ Case Law IBFD) and the Merger Directive (NL: ECJ, 17 July 1997, Case C-28/95, A. Leur-Bloem v. Inspecteur der Belastingdienst/Ondernemingen Amsterdam 2, paras. 41-44, ECJ Case Law IBFD; DK: ECJ, 5 July 2007, Case C-321/05, Hans Markus Kofoed v. Skatteministeriet, para. 37, ECJ Case Law IBFD; FR: ECJ, 8 Mar. 2017, Case C-14/16, Euro Park Service, paras. 55-56, ECJ Case Law IBFD; PT: ECJ, 10 Nov. 2011, Case C-126/10, Foggia – Sociedade Gestora de Participações Sociais SA v. Secretário de Estado dos Assuntos Fiscais, para. 37, ECJ Case Law IBFD). 107. Kofoed (C-321/05), para. 44-46; IE: ECJ, 22 Nov. 2017, Case C-251/16, Edward Cussens, John Jennings, Vincent Kingston v. T.G. Brosnan, paras. 28-32, ECJ Case Law IBFD.

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of the Directive or refuse to apply it. Even in this case, however, the tax authorities of the relevant Member State must rely on “domestic provision or general principle prohibiting abuse of rights or other provisions on tax avoidance which might be interpreted in accordance with”108 article 5(2) of the I&R Directive. Thus, article 5(2) is not self-executing, but relies on domestic norms and principles, which may be construed and applied as transposing that article of the Directive in the national legal system. Third, it should not be lightly excluded that article 6 of the ATAD109 might apply to the above-mentioned cases.110 That general anti-abuse provision is relevant “[f]or the purposes of calculating the corporate tax liability”. However, the ATAD does not give a definition of the term “corporate tax liability” and there is room to argue that withholding taxes applied by Member States in order to tax non-resident corporations may fall with the concept of “corporate tax”, particularly where (i) a strong integration exists under the domestic tax systems of such Member States between withholding taxes and corporate income taxes111 and (ii) the anti-abuse purpose of the Directive is taken into account. Fourth, recent case law of the ECJ restates the possibility for Member States to invoke the general EU principle that abusive practices are prohibited also in the field of EU secondary legislation. In Cussens (Case C-251/16),112 for instance, the Court affirmed that while the provisions of a directive cannot of themselves impose obligations without being transposed into national law,113 the norm that abusive practices are prohibited is an inherent prin108. Kofoed (C-321/05), para. 46. The case dealt with the right of a Member State to tackle abusive practices pursuant to art. 11(1)(a) of the Merger Directive, which is similar to art. 5(2) of the I&R Directive: “A Member State may refuse to apply or withdraw the benefit of [the Directive] where it appears that the merger, division, transfer of assets or exchange of shares … has as its principal objective or as one of its principal objectives tax evasion or tax avoidance.” 109. Council Directive (EU) 2016/1164, of 12 July 2016, laying down rules against tax avoidance practices that directly affect the functioning of the internal market. 110. See, inter alia, C. Brokelind, Anti-Directive Shopping on Outbound Dividends in Light of the Pending Decision in Holcim France (Case C-6/16), 56 Eur. Taxn. 9 (2016), Journals IBFD, who takes the position (see sec. 5.) that art. 6 of the ATAD should apply also to abuses of domestic law implementing the Parent Subsidiary Directive; C. Docclo, The European Union’s Ambition to Harmonize Rules to Counter the Abuse of Member States’ Disparate Tax Legislations, 71 Bull. Intl. Taxn. 7 (2017), Journals IBFD. 111. E.g. the reduction (credit) of the corporate income tax for the withholding taxes paid at source on certain categories of income; the use of withholding taxes as substitute for the corporate income tax where the non-resident taxpayers receive payments from resident persons and the income is not connected to assets situated in the state territory. 112. Cussens (C-251/16). 113. Id., para. 26.

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ciple based on settled case law114 that applies to the rights and advantages provided for by EU law irrespective of whether those rights and advantages have their basis in the Treaties, in a regulation or in a directive.115 As such, the principle that abusive practices are prohibited may be relied on against a taxable person to refuse him the advantages stemming from a directive even in the absence of provisions of national law providing for such refusal.116 Although, in Cussens, the Court carried out this analysis in the framework of the VAT Directive, it appears from the latitude of that analysis that it might similarly apply in respect of other EU tax directives, including the I&R Directive.117 Indeed, the Court highlighted118 that the case law affirming the principle that abusive practices are prohibited has been formulated

114. Id., para. 27. 115. Id., para. 30. 116. Id., para. 33. 117. See, however, the contrary conclusion of Advocate General Kokott in N Luxembourg 1 (AG Opinion in N Luxembourg 1 (C-115/16)), who maintained that the Cussens case “referred exclusively to value added tax (VAT), which differs from the subject matter at issue here [i.e. the application of the I&R Directive]. First, VAT is much more harmonised under EU law and, as it is coupled to the funding of the Union, has far more of an impact on interests under EU law than national income tax. Second, EU law (Article 325(1) and (2) TFEU) requires the Member States to take (effective) measures to collect VAT, whereas the same does not apply under income tax law. Moreover, VAT law is particularly susceptible to fraud; therefore particularly effective enforcement of tax claims is required” (paras. 106-107). Advocate General Kokott concluded that “[t]herefore, direct application of Article 5 of Directive 2003/49 to the detriment of the taxable person is out of the question” (para. 107). However, the arguments put forward by the Advocate General are not fully convincing. First, the Court has applied the principle that abusive practices are prohibited also in areas where the level of harmonization is limited and where no direct economic interest of the Union is at stake (such as company law; see infra n. 119 et seq.). Second, the Court has never draw a distinction, for the purpose of applying the principle that abusive practices are prohibited, between different areas of law on the basis of their intrinsic susceptibility to be abused. On the contrary, it has applied that principle across the board to the entire spectrum of EU law (concurrent, inter alia, P. Schammo, Arbitrage and Abuse of Rights in EC Legal System, European Law J., p. 359 (2008)). Third, the issue does not concern the direct application of art. 5 of the I&R Directive in the absence of a norm implementing it in the legal system of the relevant EU Member State, but rather the direct application of the general principle that abusive practices may not rely on EU law. The argument, if any, could be raised that where a directive includes a specific antiabuse provision, the general principle that abuses are prohibited might not apply to the subject matter covered by that specific provision, as the latter would pre-empt it (Advocate General Kokott seems to consider this argument when stating that “the Court itself drew a distinction in a recent judgment between VAT law and secondary EU law, which contains an express authority to prevent abuse” (see AG Opinion in N Luxembourg 1 (C-115/16), para. 107). This argument, however, also does not appear persuasive, as it leads to an effective reduction of the safeguards for Member States against abuses precisely in areas where the fear of abusive practices was so significant to lead Member States to include specific anti-abuse provisions in the relevant directives. 118. Cussens (C-251/16), para. 29.

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in various areas of EU law,119 such as company law,120 common agricultural policy121 and VAT,122 and that the “refusal of a right or an advantage on account of abusive or fraudulent acts is simply the consequence of the finding that, in the event of fraud or abuse of rights, the objective conditions required in order to obtain the advantage sought are not, in fact, met, and accordingly such a refusal does not require a specific legal basis”.123 Moreover, the Court highlighted that its conclusions in Cussens do not conflict with its decision in Kofoed (Case C-321/05),124 where the Court stated that national tax authorities must rely, in order to withdraw the benefits of the Merger Directive, on “domestic provision or general principle prohibiting abuse of rights or other provisions on tax avoidance which might be 119. As Advocate General Bobek affirmed in his Opinion in Cussens (C-251/16) (para. 48), “the prohibition of ‘abusive practices’ or ‘abuse of rights’ has been applied by the Court since the 1970s in a wide range of substantive areas and in terms not specific to those areas. That broad use of the notion serves to confirm its ‘general, comprehensive character which is naturally inherent in general principles of law’.” In addition to the decisions cited by the Court in Cussens (issued in the areas of company law, common agricultural policy and VAT), the principle that abusive practices are prohibited has been affirmed also with regard to EU fundamental freedoms (e.g. in respect of the free movement of goods: FR: ECJ, 10 Jan. 1985, Case 229/83, Leclerc, para. 27, ECLI:EU:C:1985:1; in respect of the freedom of establishment: NL: ECJ, 7 Feb. 1979, Case 115/78, Knoors, para. 25, ECLI:EU:C:1979:31; DK: ECJ, 9 Mar. 1999, Case C-212/97, Centros Ltd v. Erhvervs- og Selskabsstyrelsen, para. 24, ECJ Case Law IBFD; in respect of the freedom to provide services: NL: ECJ, 3 Dec. 1974, Case 33/74, Johannes Henricus Maria van Binsbergen v. Bestuur van de Bedrijfsvereniging voor de Metaalnijverheid, para. 13, ECJ Case Law IBFD; NL: ECJ, 3 Feb. 1993, Case C-148/91, Veronica, para. 12, ECLI:EU:C:1993:45; in respect of the free movement of workers: DE: ECJ, 21 June 1988, Case 39/86, Lair, para. 43, ECLI:EU:C:1988:322) and other areas of EU law, such as maritime cabotage (e.g. IT: ECJ, 6 Apr. 2006, Case C-456/04, Agip Petroli, ECLI:EU:C:2006:241). 120. GR: ECJ, 12 May 1998, Case C-367/96, Alexandros Kefalas and Others v. Elliniko Dimosio (Greek State) and Organismos Oikonomikis Anasygkrotisis Epicheiriseon AE (OAE), ECJ Case Law IBFD; GR: ECJ, 23 Mar. 2000, Case C-373/97, Dionysios Diamantis v. Elliniko Dimosio (Greek State) and Organismos Ikonomikis Anasygkrotisis Epicheiriseon AE (OAE), ECJ Case Law IBFD. 121. DE: ECJ, 11 Oct. 1977, Case 125/76, Cremer, ECLI:EU:C:1977:148; DE: ECJ, 3 Mar. 1993, Case C-8/92, General Milk Products GmbH v. Hauptzollamt Hamburg-Jonas, ECJ Case Law IBFD; DE: ECJ, 14 Dec. 2000, Case C-110/99, Emsland-Stärke GmbH v. Hauptzollamt Hamburg-Jonas, ECJ Case Law IBFD. 122. DK: ECJ, 3 Mar. 2005, Case C-32/03, I/S Fini H v Skatteministeriet, ECJ Case Law IBFD; UK: ECJ, 21 Feb. 2006, Case C-255/02, Halifax plc, Leeds Permanent Development Services Ltd, County Wide Property Investments Ltd v. Commissioners of Customs & Excise, BUPA Hospitals Ltd, Goldsborough Developments Ltd v. Commissioners of Customs and Excise and University of Huddersfield Higher Education Corporation v. Commissioners of Customs and Excise, ECJ Case Law IBFD. 123. Cussens (C-251/16), para. 32, referring to previous case law (e.g. Emsland-Stärke (C-110/99), para. 56; Halifax (C-255/02), para. 93; IT: ECJ, 4 June 2009, Case C-158/08, Agenzia Dogane Ufficio delle Dogane di Trieste v Pometon SpA, para. 28, ECJ Case Law IBFD. 124. Kofoed (C-321/05), para. 38 et seq.

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interpreted in accordance with”125 article 11(1)(a) of that directive. In the view of the Court, the decision in Kofoed only concerned the conditions for the application, by the tax authorities of a Member State, of a specific antiavoidance provision contained in a directive and did not have any bearing on the direct application of the general EU principle that abusive practices are prohibited to subject matters regulated by EU directives.126

4.4.3. The “minimum holding period” requirement A specific anti-avoidance provision, which Member States may adopt when transposing the I&R Directive into national law, is enshrined in article 1(10) thereof, providing that: A Member State shall have the option of not applying this Directive to a company of another Member State or to a permanent establishment of a company of another Member State in circumstances where the conditions set out in Article 3(b) [namely the minimum-holding requirements] have not been maintained for an uninterrupted period of at least two years [emphasis added].

A similar provision is contained in article 3(2)(b) of the Parent-Subsidiary Directive, the scope of which was clarified by the ECJ in Denkavit International (Case C-283/94),127 where the Court was faced with the question whether the minimum holding period requirement had to be met at the time of the profits distribution or whether it was sufficient for it to be met after the distribution. The Court concluded that the minimum holding period requirement could be met after the distribution and supported its decision on the basis of the following arguments: (i) the Parent-Subsidiary Directive uses of the present tense, in article 3(2)(b), in almost all languages;128 (ii) that interpretation is confirmed by the purpose of the Parent-Subsidiary Directive, which is to facilitate the tax arrangements governing cross-border cooperation;129 (iii) article 3(2)(b) must be interpreted strictly, since it constitutes a derogation from the principle of exemption from withholding tax of profits distributions provided for in article 5;130 (iv) article 3(2)(b) is aimed at counteracting abuse whereby holdings are taken in the capital of companies for the sole purpose of benefiting from the Directive and are not 125. Id., para. 46. 126. Cussens (C-251/16), para. 38. 127. DE: ECJ, 17 Oct. 1996, Case C-283/94, Denkavit Internationaal BV, VITIC Amsterdam BV and Voormeer BV v. Bundesamt für Finanzen, ECJ Case Law IBFD. 128. Id., para. 25. 129. Id., para. 26. 130. Id., para. 27.

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intended to be lasting; this goal is effectively achieved even where article 3(2)(b) is interpreted as allowing the minimum holding period requirement to be met after the distribution has taken place131 and (v) the Directive does not require Member States to grant the withholding tax exemption before the end of the minimum holding period, without being certain of having the concrete possibility to recover the tax at a later stage; therefore the right of Member States to effectively collect the taxes due is safeguarded.132 If the five-pronged analysis developed by the Court in Denkavit International is applied, by analogy, to article 1(10) of the I&R Directive, the results tend to support the conclusion that also in the framework of the I&R Directive the minimum holding period requirement may be met after the royalty payment has occurred.133 With regard to the wording used in the various official language texts of the Directive, it appears that the vast majority of the language versions employ the past tense, instead of the present tense as in the Parent-Subsidiary Directive. Table 4.1. provides a sample of the most widely spoken languages in the European Union (plus Portuguese).134

131. Id., paras. 31 and 32. 132. Id., para. 33. 133. See, concurring, D. Hristov, VI - The Interest and Royalty Directive, in Introduction to European Tax Law on Direct Taxation pp. 183-184 (M. Lang et al. eds., Linde 2012); D. Weber, European Direct Taxation pp. 478-479 (Wolters Kluwer 2011); J. Müller, The Interest & Royalty Directive, 7 Tax Planning International European Union Focus 4, pp. 13-14 (2005); J.L. Rodriguez, Chapter 8: Commentary on the Interest and Royalties Directive, in EC Corporate Tax Law para. 74 (O. Thömmes & E. Fuks eds., IBFD 2004); M. Distaso & R. (Raffaele) Russo, The EC Interest and Royalties Directive - A Comment, in 44 Eur. Taxn. 4, p. 151 (2004), Journals IBFD; COM(2009) 179 final, Report from the Commission to the Council in accordance with Article 8 of Council Directive 2003/49/ EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States, p. 5. 134. Portuguese is a widely spoken language and is the official language of a state (Portugal) that was already a Member State at the time of the approval of the I&R Directive.

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Table 4.1.  Most widely spoken languages in the EU (plus Portuguese) I&R Directive Art. 1(10) English

French

German

“A Member State shall have the option of not applying this Directive to a company of another Member State or to a permanent establishment of a company of another Member State in circumstances where the conditions set out in Article 3(b) have not been maintained for an uninterrupted period of at least two years” “Un État membre a la faculté de ne pas appliquer la présente directive à une société d’un autre État membre ou à un établissement stable d’une société d’un autre État membre lorsque les conditions prévues à l’article 3, point b), n’ont pas été remplies pendant une période ininterrompue d’au moins deux ans” “Es steht den Mitgliedstaaten frei, diese Richtlinie nicht auf ein Unternehmen eines anderen Mitgliedstaats oder die Betriebsstätte eines Unternehmens eines anderen Mitgliedstaats anzuwenden, wenn die in Artikel 3 Buchstabe b) genannten Voraussetzungen während eines ununterbrochenen Zeitraums von mindestens zwei Jahren nicht erfüllt waren”

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Parent-Subsidiary Directive Art. 3(2)(b) “By way of derogation from paragraph 1, Member States shall have the option of: (b) not applying this Directive to companies of that Member State, which do not maintain for an uninterrupted period of at least 2 years holdings qualifying them as parent companies, or to those of their companies in which a company of another Member State does not maintain such a holding for an uninterrupted period of at least 2 years.” “Par dérogation au paragraphe 1, les États membres ont la faculté : b) de ne pas appliquer la présente directive à celles de leurs sociétés qui ne conservent pas, pendant ne période ininterrompue d’au moins deux ans, une participation donnant droit à la qualité de société mère, ni aux sociétés dans lesquelles une société d’un autre État membre ne conserve pas, pendant une période ininterrompue d’au moins deux ans, une telle participation.” Abweichend von Absatz 1 haben die Mitgliedstaaten die Möglichkeit, b) von dieser Richtlinie ihre Gesellschaften auszunehmen, die nicht während eines ununterbrochenen Zeitraums von mindestens zwei Jahren im Besitz einer Beteiligung bleiben, aufgrund deren sie als Muttergesellschaften gelten, oder an denen eine Gesellschaft eines anderen Mitgliedstaats nicht während eines ununterbrochenen Zeitraums von mindestens zwei Jahren eine solche Beteiligung hält.

Chapter 4 - Open Issues in the Application of the Interest and Royalty Directive to Royalty Payments

I&R Directive Art. 1(10) Italian

“Uno Stato membro ha la facoltà di non applicare la presente direttiva a una società di un altro Stato membro o ad una stabile organizzazione di una società di un altro Stato membro, qualora le condizioni di cui all’articolo 3, lettera b), non abbiamo persistito per un periodo ininterrotto di almeno due anni”.

Portuguese “Um Estado-Membro pode optar por não aplicar a presente directiva a uma sociedade de outro Estado-Membro ou a um estabelecimento permanente de uma sociedade de outro Estado-Membro, caso as condições enunciadas na alínea b) do artigo 3.o se não tenham verificado por um período ininterrupto de pelo menos dois anos.” Spanish

“Un Estado miembro tendrá la posibilidad de no aplicar la presente Directiva a una sociedad de otro Estado miembro o a un establecimiento permanente de una sociedad de otro Estado miembro en aquellos casos en que no se cumplan los requisitos establecidos en la letra b) del artículo 3 durante un período ininterrumpido de, como mínimo, dos años”

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Parent-Subsidiary Directive Art. 3(2)(b) “In deroga al paragrafo 1, gli Stati membri hanno la facoltà: a) di sostituire, mediante accordo bilaterale, il criterio di partecipazione al capitale con quello dei diritti di voto; b) di non applicare la presente direttiva a quelle società di tale Stato membro che non conservino, per un periodo ininterrotto di almeno due anni, una partecipazione che dia diritto alla qualità di società madre o alle società nelle quali una società di un altro Stato membro non conservi, per un periodo ininterrotto di almeno due anni, siffatta partecipazione.” Em derrogação do n.o 1, os Estados-Membros têm a faculdade de: b) Não aplicar a presente directiva às suas sociedades que não conservem durante um período ininterrupto de pelo menos dois anos uma participação que dê direito à qualidade de sociedademãe, ou às suas sociedades nas quais uma sociedade de outro Estado-Membro não conserve essa participação durante um período ininterrupto de pelo menos dois anos. No obstante lo dispuesto en el apartado 1, los Estados miembros tendrán la facultad: b) de no aplicar la presente Directiva a aquellas de sus sociedades que no conserven, durante un período ininterrumpido de por lo menos dos años, una participación que dé derecho a la calidad de sociedad matriz, ni a las sociedades en las cuales una sociedad de otro Estado miembro no conserve, durante un período ininterrumpido de por lo menos dos años, una participación semejante.

Beneficial ownership and abuse

The parallel reading shows that while all six versions of the ParentSubsidiary Directive use the present tense, five of the six versions of the I&R Directive use the past tense, the exception being the Spanish text. This evidence may be used to support the argument that, after the ECJ’s decision in Denkavit International, Member States wanted to be sure to be entitled to levy their final withholding taxes (without any obligation to reimburse them) whenever the holding period requirement had not been met at the date of the payment. The switch from the present to the past tense was the means to achieve that result.135 Although this argument has its merits, it does not seem conclusive. First, the use of the past tense might be due to the different structure of article 1(10) of the I&R Directive (passive form and focus on the conditions, rather than on the behaviour of the recipient company), as compared to article 3(2)(b) of the Parent-Subsidiary Directive (active form and focus on the behaviour of the parent company). Second, it may be argued that if Member States had really been willing to revert the result of the interpretation upheld by the Court in Denkavit International, they could have referred to the “time of the payment” as the moment at which the minimum holding period requirement had to be met, like they did in the context of article 1(11) with regard to the attestation. These two counter-arguments make the textual analysis less conclusive than it may appear at first glance. On the other hand, the systematic and teleological arguments relied upon by the Court in Denkavit International may be applied by analogy to the minimum holding period requirement of the I&R Directive. Indeed, the latter Directive has the purpose to facilitate the tax arrangements governing cross-border cooperation (argument no. (ii)); there is a need to interpret article 1(10) of the I&R Directive strictly, as it constitutes a derogation from the principle of exempting royalties from withholding tax (argument no. (iii)) and the goal of article 1(10), i.e. counteracting abuse whereby holdings are taken in the capital of companies for the sole purpose of benefiting from the Directive and are not intended to be lasting, may be effectively achieved even where that article is interpreted as allowing the minimum holding period requirement to be met after the royalty payments have taken place (argument no. (iv)).

135. M. Helminen, Chapter 3: Corporate Tax Directives in EU Tax Law - Direct Taxation p. 30 (IBFD 2017); B.J.M. Terra & P.J. Wattel, European Tax Law pp. 771-772 (Kluwer 2012); R. Schneider, Austria - Implementation of the Interest and Royalty Directive, 7 Derivs. & Fin. Instrums. 1, p. 37 (2005), Journals IBFD.

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Finally, EU law provides Member States with various tools for ensuring the effective collection of source taxation on royalties. First, article 1(11) of the Directive allows Member States to demand that the fulfilment of the requirements for the application of the Directive be substantiated at the time of payment by an attestation. In the absence of a timely and complete attestation, Member States are entitled to require deduction of tax at source, a reimbursement of which may be claimed later by the recipient company if all the requirements for the application of the Directive are met. Second, where Member States do not provide under their domestic law for the issuing of an attestation at the time of the payment, they might certainly rely on the Tax Recovery Directive136 for the purpose of collecting ex post the withholding taxes due on the royalty payments in cases where the minimum holding period requirement had not been met, neither at the time of the payment nor subsequently. Finally, one may argue that, as the Court stated in Denkavit International (argument no. (v) above), Member States are allowed in any case to withhold the tax at the time of the payment (or to ask for an equivalent guarantee) if the minimum holding period requirement is not met at that moment, subject to the right of the recipient to claim its reimbursement where the requirement is satisfied at a later stage.137

136. Council Directive 2010/24/EU, of 16 March 2010, concerning mutual assistance for the recovery of claims relating to taxes, duties and other measures. 137. This possibility could appear disproportionate, since Member States may currently rely on the above-mentioned Tax Recovery Directive, contrary to the situation current at the time of the Denkavit International case, when the relevant directive on the administrative cooperation in the field of recovery of claim (Directive 76/308/EEC) did not extend to income taxes. In this respect, although with regard to the different case of exit taxation, the Court has recently affirmed that when EU law imposes the postponement of the tax collection, Member States are entitled to ask for a guarantee only in cases of actual risk of non-recovery, to be assessed on a case-by-case basis, since the guarantee (and, a fortiori, the payment) determines a restrictive effect (DE: ECJ, 23 Jan. 2014, Case C-164/12, DMC Beteiligungsgesellschaft mbH v. Finanzamt Hamburg-Mitte, paras. 66-69, ECJ Case Law IBFD; for previous cases concerning individuals, see FR: ECJ, 11 Mar. 2004, Case C-9/02, Hughes de Lasteyrie du Saillant v. Ministère de l’Économie, des Finances et de l’Industrie, para. 47, ECJ Case Law IBFD; NL: ECJ, 7 Sept. 2006, Case C-470/04, N. v. Inspecteur van de Belastingdienst Oost/kantoor Almelo, para. 36, ECJ Case Law IBFD). However, art. 1(11) appears to support the thesis that Member States are entitled to levy their withholding taxes where the holding period requirement is not satisfied at the time of the payment, subject to the right of the recipient to ask for the subsequent reimbursement thereof.

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Procedural issues

4.5. Procedural issues 4.5.1. Formal requirements introduced by Member States As previously mentioned, the I&R Directive not only aims at eliminating the juridical double taxation on intra-EU royalty and interest payments, but also at removing the burdensome administrative formalities and cash-flow disadvantages associated to such payments.138 The most suitable means to achieve that result is the abolition of any taxation on interest and royalty payments in the Member State where they arise, whether collected by deduction at source or by assessment.139 This immediate and outright exemption might be detrimental to the legitimate right of Member States to verify whether the conditions for the application of the Directive are satisfied and, for this reason, the very same Directive allows Member States to impose certain (proportionate) formalities on the taxpayers in order for them to benefit from the exemption. More specifically, under article 1(11), Member States may require that the fulfilment of the substantive requirements laid down by articles 1 and 3 of the Directive be substantiated at the time of payment by an attestation.140 In cases where the fulfilment of those requirements has not been attested at the time of payment, Member States are entitled to require deduction of tax at source. Alternatively, under article 1(12), Member States may subordinate the exemption to the condition that they have issued a (positive) decision on

138. See I&R Directive, recital (2). 139. See id., recital (4). 140. According to art. 1(13) of the Directive, the attestation shall, in respect of each contract for the payment, be valid for at least 1 year, but for not more than 3 years, from the date of issue and shall contain the following information: (a) proof of the receiving company’s residence for tax purposes and, where necessary, the existence of a PE certified by the tax authority of the Member State in which the receiving company is resident for tax purposes or in which the PE is situated; (b) beneficial ownership by the receiving company in accordance with para. 4 or the existence of conditions in accordance with para. 5 where a PE is the recipient of the payment; (c) fulfilment of the requirements in accordance with art. 3(a)(iii) in the case of the receiving company; (d) a minimum holding or the criterion of a minimum holding of voting rights in accordance with art. 3(b) and (e) the period for which the holding referred to in (d) has existed. Member States may request in addition the legal justification for the payments under the contract (e.g. loan agreement or licensing contract).

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the basis of an attestation certifying the fulfilment of the substantive requirements laid down by articles 1 and 3 of the Directive.141 These formal requirements have been transposed by several Member States into their national legislation.142 By way of example, Italy,143 Ireland,144 Austria,145 Belgium146 and France147 require an attestation at the time of payment, while Germany148 and the Czech Republic149 make the exemption subject to the condition that they have issued a decision. On the contrary, some Member States, such as Cyprus,150 Estonia,151 Finland152 and Slovakia,153 have decided to impose no formal requirement under their domestic laws. If for any reason (including the case of the absence of an attestation and/or decision at the time of the payment), the payer has withheld tax at source, article 1(15) allows a claim to be made for repayment if all the substantive requirements for exemption are met. In such a case, the Member State may subordinate the reimbursement to the provision of the same information that might be required in the attestation. Article 1(16) establishes that the taxes must be repaid within 1 year from the due receipt of the application and 141. According to art. 1(12) of the Directive, a decision on exemption shall be given within 3 months at most after the attestation and such supporting information as the source state may reasonably ask for having been provided and shall be valid for a period of at least 1 year after it has been issued. 142. For a comparative analysis, see IBFD, supra n. 79 and particularly, Table 7 Procedure and anti-abuse measures, and/or the Country specific annexes (available at https://ec.europa.eu/taxation_customs/sites/taxation/files/docs/body/survey_ir_dir.pdf or https://ec.europa.eu/taxation_customs/publications/studies-made-commission/archives/ survey-implementation-ec-interest-royalty-directive_en (last accessed 27 Mar. 2018)). For a more recent comparative analysis, see L. Cerioni, The European Union and Direct Taxation: A Solution for a Difficult Relationship p 80 (Routledge 2015). 143. See Chap. 16 in this volume; IBFD, id., sec. 3.2.1. p. 365; Cerioni, id. 144. See IBFD, id., sec. 3.2. p. 333; Cerioni, id. 145. See IBFD, id., sec. 3.2. p. 48; Cerioni, id.; M. Jann, J. Schuch & G. Toifl, Austria Corporate Taxation secs. 7.3.4.2., 7.3.4.3. and 7.3.4.5., Country Analyses IBFD. 146. See IBFD, id., secs. 3.2.- 3.3. p. 85; Cerioni, id. 147. See Chap. 14 in this volume; IBFD, id., sec. 3.2. p. 249; Cerioni, id. 148. See Chap. 15 in this volume; IBFD, id., secs. 3.2.-3.3. pp. 285-286; Cerioni, id. 149. See IBFD, id., secs. 3.2.-3.3. pp. 136-137; Cerioni, id.; T. Mkrtchyan, Czech Republic Corporate Taxation secs. 7.3.4.2., 7.3.4.3. and 7.3.4.5., Country Analyses IBFD. 150. See IBFD, id. sec. 3. p. 108; Cerioni, id.; A. Taliotis, Cyprus - Corporate Taxation secs. 7.3.4.2., 7.3.4.3. and 7.3.4.5., Country Analyses IBFD. 151. See IBFD, id., secs. 3.2.-3.3. p. 189; Cerioni, id.; M. Herm, Estonia - Corporate Taxation secs. 7.3.4.2., 7.3.4.3. and 7.3.4.5., Country Analyses IBFD. 152. See IBFD, id., sec. 3. p. 215; Cerioni, id.; K. Hiltunen, Finland - Corporate Taxation secs. 7.3.4.2., 7.3.4.3. and 7.3.4.5., Country Analyses IBFD. 153. See, IBFD, id., secs. 3.2. and 3.3. p. 446; Cerioni, id.; L. Dumitrescu et al., Slovak Republic - Corporate Taxation secs. 7.3.4.2., 7.3.4.3. and 7.3.4.5., Country Analyses IBFD.

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the relevant supporting information. After 1 year, the taxpayer is entitled to interest at a rate corresponding to the national interest rate to be applied in comparable cases under the domestic law of the source state.

4.5.2. Exemption applied in the absence of attestation or decision at the time of the payment Where the Member State of the payer makes the exemption subject to the prior issue of an attestation (article 1(12)) or a decision (article 1(13)), a first issue that may arise concerns the possible legal consequences in cases where the payer applies the exemption in the absence of such attestation or decision at the time of the payment. In order to ensure the effectiveness of the obligation for the withholding agent to obtain an attestation or a decision before exempting the payments, Member States should be entitled to apply appropriate penalties and interest charges in this case. With regard to the payment of the tax, however, it seems that where the tax audit shows that the substantive requirements are met, no recovery should occur, as the recipient would have had in any case the right to claim the tax reimbursement under article 1(15) of the Directive. The collection of the tax and its subsequent repayment appear to constitute a non-efficient and superfluous procedure in this case, as the legitimate interest of the Member States to apply the exemption only where all the substantive requirements of the Directive are satisfied is safeguarded by the tax audit carried out.154

4.5.3. Recovery of the tax in the case of abuse A second issue that is worth analysing concerns the recovery of the tax in cases of abuse or where the beneficial owner requirement appears nonsatisfied on the basis of the evidence collected in the course of the tax audit. 154. As far as Italian case law is concerned, see, inter alia, IT: Tax Court of Milan, 17 Nov. 2015, Decision no. 9819; IT: Tax Court of Milan, 3 Nov. 2016, Decision no. 8303, which affirmed that the mere fact that the attestation was issued after the payment of the royalties did not justify the denial of the benefits of the I&R Directive (see Chap. 16 in this volume). Contra, BE: Court of Appeal of Ghent, 18 Mar. 2014, case 2010/AR/2449, critically analysed in F. Mortier, Interest and Royalties Directive (2003/49): Court of Appeal Denies Withholding Tax Refund on Interest Due to Lack of Attestation at Time of Payment, 54 Eur. Taxn. 9, secs. 1.-4.2. (2014), Journals IBFD.

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More specifically, the question arises whether the tax collection may be carried out at the level of the paying company or exclusively at the level of the payee. While the practice of several Member States is that the tax collection almost invariably occurs at the level of the paying company, it seems that such a practice is unlawful in some cases. In particular, where the provisions transposing the Directive into national law impose no formal requirement on the payer or where a formally correct attestation or a decision have been provided thereto, it seems that no penalty should be charged and no tax recovery should occur at the level of the paying company, unless tax authorities prove that the latter company was aware, or could have been reasonably aware, of the abuse or of the fact that the recipient was not the beneficial owner of the payment. This conclusion is grounded on multiple arguments. First, the case law of the ECJ in the VAT area has reached similar conclusions. Specifically, the Court found that (i) it is incompatible with the VAT Directive to refuse the exercise of a right on a taxable person who did not know, and could not have known, that the transaction concerned was connected with fraud; (ii) the tax authorities cannot, as a general rule, require the taxable person wishing to exercise its rights to fulfil its own investigative tasks; it is for the tax authorities to carry out the necessary inspections in order to detect VAT irregularities and fraud, and (iii) the establishment of a system of strict liability (système de responsabilité sans faute) would go beyond what is necessary to preserve the rights of the Member State concerned.155 In the field of the I&R Directive such principles should be applied even more strictly, as the paying company is not exercising a right, such as the right of deduction in the VAT framework, but is under an obligation to exempt the royalty payments under article 1(1) of the Directive and the corresponding domestic provisions. The interest of the Member States to the effective collection of the taxes due is sufficiently secured by the possibility for them, on the one hand, to make 155. See, inter alia, BE: ECJ, 6 July 2006, Case C-439/04, Axel Kittel v. État belge and État belge v Recolta Recycling SPRL, para. 52, ECJ Case Law IBFD; BG: ECJ, 6 Dec. 2012, Case C-285/11, Bonik EOOD v. Direktor na Direktsia ‘Obzhalvane i upravlenie na izpalnenieto’, Varna, paras. 40-42, ECJ Case Law IBFD; HU: ECJ, 21 June 2012, Case C-80/11, Mahagében Kft v. Nemzeti Adó- és Vámhivatal Dél-dunántúli Regionális Adó Főigazgatósága and Péter Dávid v. Nemzeti Adó- és Vámhivatal Észak-alföldi Regionális Adó Főigazgatósága, para. 61 et seq., ECJ Case Law IBFD.

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the exemption subject to the prior issue of a decision under article 1(13) and, on the other hand, to be assisted by other Member States in the recovery of the tax claim pursuant to the Tax Recovery Directive. Once the Member State autonomously decides not to make use of such tools, it is precluded from preserving the effectiveness of its tax collection by recovering the tax due from the paying company, which was compelled to apply the exemption at the moment of the payment and which no longer shows any ability to pay taxes in respect of the amount of money that it has transferred to the payee as royalties.

4.6. Policy perspective 4.6.1. The missing external dimension From a policy perspective, the I&R Directive is just half of what a coherent system of taxation of royalty (and interest) payments within the European Union should have been. When it was decided to set up a European Economic Community based on the four freedoms and, in particular, on the free movement of goods, the funding states agreed to create a custom union “comprising both the prohibition, as between Member States, of customs duties on importation and exportation and all charges with equivalent effect and the adoption of a common customs tariff in their relations with third countries”.156 The reason why the elimination of intra-EU custom duties and charges with equivalent effect was combined with the adoption of a common custom tariff vis-à-vis third countries is that in the absence of such common tariff, the elimination of the intra-EU custom duties would have created an incentive to channel importation within the European Union and exportation towards third countries through the Member States with the most attractive tariffs, even in the absence of substantial economic reason justifying such flows of goods. Thus, the creation of a custom union based on both internal and external dimensions was due to the necessity to avoid artificial transactions and conduit situations. Unfortunately, when Member States decided to adopt the I&R Directive, they did not supplement it with its natural complement, i.e. a “common [withholding] tariff in their relations with third countries”. The system was, and is still, lacking of its necessary external dimension. This has led to 156. The Treaty of Rome art. 9(1) (25 Mar. 1957).

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well-anticipated phenomenon157 of the I&R Directive shopping by multinational groups with ramifications outside the European Union and put a significant pressure on both the taxpayers and the tax authorities engaged with the day-to-day application of the Directive. This situation is further exacerbated by the fact that royalty payments are deducible from the corporate tax base of the payer, generally without any limitations comparable to those applicable in the case of interest payments (such as thin-cap rules or earnings before interest, taxes, depreciation and amortization (EBITDA) rules).

4.6.2. A possible solution: The ATRiD In order to fix this broken regime (and other direct tax issues within the European Union), the author has recommended, some 2 years ago, the adoption of a Directive on the Allocation of Taxing Rights (ATRiD).158 The ATRiD would apply to income derived by individuals and entities, both resident and non-resident of EU Member States and would mainly shape the taxing rights and obligations of EU Member States in respect of cross-border income. The ATRiD would supersede the existing tax treaties between Member States and would render their further amendment and conclusion superfluous. With regard to the allocation of taxing rights, the directive would identify the source of income through ad hoc definitions. In respect of passive income sourced in EU Member States, it would oblige such states to tax the income by applying a minimum tax rate (ideally between 25% and 30%) to the gross amount of outbound dividends, interest and royalties and to the net amount of capital gains derived by persons resident of third countries. This would help counteracting phenomena of directive and tax treaty shopping, aimed at channelling income flows through specific Member States for the 157. See the seminal article by F. Vanistendael, Impact of European Tax Law on Tax Treaties with Third Countries, 8 EC Tax Rev. 3, p. 163-170, in particular at 169-170 (1999). 158. See the proposal presented by the author in the course of the 11th GREIT Conference, held in Ischia on 9 and 10 Sept. 2016 (http://greit-tax.eu/pdf-s/2016-09-06-greit-11-brochure. pdf); P. Arginelli, A proposal for harmonizing the rules on the allocation of taxing rights within the EU and in the relations between Member States and third countries: ATRiD and EU tax treaties, Kluwer International Tax Blog (http://kluwertaxblog.com/2017/08/09/ proposal-harmonizing-rules-allocation-taxing-rights-within-eu-relations-member-statesthird-countries-atrid-eu-tax-treaties/); P. Arginelli, A Proposal for Harmonizing the Rules on the Allocation of Taxing Rights within the EU and in the Relations with Third Countries, in European Tax Integration: Law, Policy and Politics (P. Pistone ed., IBFD, forthcoming).

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purpose of avoiding or substantially reducing the tax to be paid in the EU Member State of source. On the other hand, all intra-EU royalty (interest and dividend) payments would be taxed exclusively in the Member State of residence (or of the PE receiving the payment). This solution, based on reciprocity, would streamline the taxation of intra-EU income, ensuring a more efficient system of fair taxation thereof. Furthermore, this solution would be in line with the regime in force under the I&R Directive (and the Parent-Subsidiary Directive).

4.6.3. The EU external competence to conclude tax treaties Once the rules on the allocation of taxing rights were harmonized, with regard to income taxes, per effect of the ATRiD, it would become questionable whether bilateral tax treaties would continue to represent a proper and legitimate tool to regulate the allocation of taxing rights in the relationship between EU Member States and third countries. Indeed, article 216 of the TFEU grants to the European Union the competence to conclude, inter alia, any international agreement that “is likely to affect common rules or alter their scope”. Moreover, article 3(2) of the TFEU states that the competence of the European Union to conclude such agreements is exclusive.159 The above provisions of the TFEU are aimed at codifying the principles developed by the ECJ in its case law on the external competence of the Union in respect of the conclusion of treaties with third countries. That case law has grown around the seminal judgment delivered in the AETR case,160 where the Court asserted that, when the European Union, “with a view to implementing a common policy envisaged by the Treaty, adopts provisions laying down common rules, whatever form these may take, the Member States no longer have the right, acting individually or even collectively, to undertake obligations with third countries which affect those rules”.161 Thus, according to the ECJ: 159. Art. 3(2) of the TFEU provides that “[t]he Union shall also have exclusive competence for the conclusion of an international agreement when its conclusion is provided for in a legislative act of the Union or is necessary to enable the Union to exercise its internal competence, or in so far as its conclusion may affect common rules or alter their scope” [emphasis added]. 160. ECJ, 31 Mar. 1971, Case 22/70, Commission v. Council [AETR case], ECLI:EU:C:1971:32. 161. Id., p. 17.

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As and when such common rules come into being, the [Union] alone is in a position to assume and carry out contractual obligations towards third countries affecting the whole sphere of application of the [EU] legal system. With regard to the implementation of the provisions of the Treaty the system of internal [EU] measures may not therefore be separated from that of external relations.162

These principles, and particularly the rule in foro interno, in foro externo, have been further developed by the Court in its subsequent decisions163 and finally codified in the TFEU by the Lisbon Treaty, which has introduced the current wording of articles 3(2) and 216 of the TFEU. The ATRiD, as well as the other direct tax directives,164 lay down common rules purported at ensuring the well-functioning of the internal market, which, in turn, represents one of the common policies of the Union. As a consequence, the provisions of the ATRiD and the other direct tax directives certainly represent common rules that may be theoretically affected or altered by the conclusion of international agreements between Member States and third countries. In order to conclude if, after the adoption of the ATRiD, the conclusion of tax treaties with third countries falls within the exclusive competence of the Union, it is therefore necessary to answer the question whether there is an actual risk that the provisions of such tax treaties may affect the common rules laid down by the ATRiD and the other direct tax directives or alter their scope. According to the ECJ’s settled case law, this risk exists where the provisions of a (tax) treaty fall within the scope of the common rules.165 Moreover, the finding that such risk exists does not presuppose that the scope of the (tax) 162. Id., pp. 18-19. 163. See, inter alia, ECJ, 26 Apr. 1977, Opinion 1/76, Agreement on the establishment of a European Laying-up Fund for Inland Waterway Vessels; ECJ, 19 Mar. 1993, Opinion 2/91, Convention no. 170 of the International Labour Organization concerning safety in the use of chemicals at work; ECJ, 15 Nov. 1994, Opinion 1/94, Competence of the Community to conclude international agreements concerning services and the protection of intellectual property; ECJ, 7 Feb. 2006, Opinion 1/03, New Lugano Convention; as well as the group of decisions collectively known as the Open Skies judgments (e.g. ECJ, 5 Nov. 2002, Case C‑467/98, Commission v. Denmark, ECLI:EU:C:2002:625). 164. The term “direct tax directives” is used here to denote, in addition to the ATRiD, the Parent-Subsidiary Directive, the I&R Directive, the Merger Directive and the ATAD (I and II). 165. See, inter alia, ECJ, 4 Sept. 2014, Case C‑114/12, Commission v. Council, p. 68, ECLI:EU:C:2014:2151; ECJ, 14 Oct. 2014, Opinion 1/13, Accession of third States to the Hague Convention, p. 71; ECJ, 26 Nov. 2014, Case C‑66/13, Green Network, p. 29, ECLI:EU:C:2014:2388; ECJ, 14 Feb. 2017, Opinion 3/15, Marrakesh Treaty on access to published works, p. 105; ECJ, 16 May 2017, Opinion 2/15, Free Trade Agreement between the European Union and the Republic of Singapore, p. 180.

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treaty rules and that of the EU common rules coincide fully. The scope of the common rules may also be affected or altered by the (tax) treaty provisions where the latter fall within an area that is already covered to a large extent by those rules.166 Finally, a (tax) treaty must be regarded as capable of affecting or altering the scope of the EU common rules where the (tax) treaty provides for the application, to the international relations covered by that treaty, of rules that overlap to a large extent with the common EU rules applicable to intra-EU situations. In this respect, the meaning, scope and effectiveness of the EU common rules may be affected despite there being no contradiction between such common rules and the (tax) treaty provisions.167 Leaving aside the articles providing for definitions, which are inherently auxiliary to normative articles and thus follow their qualification and treatment, it appears that most of the substantive rules of tax treaties with third countries (hereafter “external tax treaties”) qualify as provisions that risk to affect the common rules laid down by the ATRiD or alter their scope. This is certainly the case in respect of the treaty distributive rules, i.e. the treaty rules that allocate the taxing rights between EU member States and the third country, as their scope almost fully coincide with that of the ATRiD rules. The same holds true with regard to the treaty rules for the elimination of double taxation,168 which fall within an area that would be fully covered by the ATRiD. Moreover, the possibility that external tax treaty rules may affect the functioning or alter the scope of the EU common rules exists, by definition, in respect of those rules that might be specifically included in future external tax treaties for the purpose of regulating the interaction between the tax treaty and certain ATAD rules.169 After the adoption of the ATRiD, the competence to conclude, with a third country, a tax treaty providing for such substantive rules would therefore be vested exclusively in the European Union. On the other hand, the competence would be shared between the European Union and the Member States with respect to (i) certain non-discrimination provisions, (ii) rules on exchange of information and assistance in the

166. See, inter alia, Opinion 1/03, supra n. 163, at p. 126; Commission v. Council (C114/12), pp. 69 and 70; Opinion 1/13, id., pp. 72 and 73; Opinion 3/15, id., pp. 106 and 107; Opinion 2/15, id., p. 181. 167. See, inter alia, Opinion 1/03, supra n. 163, at pp. 143 and 151-153; Opinion 1/13, supra n. 165, at pp. 84-90; Green Network (C-66/13), pp. 48 and 49; Opinion 2/15, supra n. 165, at p. 201. 168. Corresponding to art. 23 of the OECD Model. 169. E.g. arts. 5, 7 and 8 of the ATAD.

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collection of taxes going beyond the mere application of substantive treaty rules and (iii) compulsory arbitration clauses.170 That would imply the need for the European Union to negotiate and conclude tax treaties with third counties (hereafter “EU tax treaties”), subject to the requirement to ensure the involvement of Member States in relation to matters for which the external competence is shared. Finally, with regard to the substantive content of the EU tax treaties provisions dealing with the taxation of royalties, the latter should include a minimum-tax clause, under which source tax exemption or reduction would be granted subject to the condition that the relevant item of income were actually included in the taxable base of the taxpayer in the contracting state of residence. In any case, no exemption or reduced taxation at source should be granted where the relevant item of income was subject to no or low taxation in the latter state. The EU tax treaty should establish the level of “low taxation” and the methods to compute foreign taxation, for the purpose of establishing whether the “low taxation” threshold is met. The minimum-tax clause should not apply where the no, or low, taxation in the state of residence were due to preferential tax regimes aimed at promoting legitimate economic policy objectives, such as BEPS-compliant IP box regimes. The EU Commission should be given mandate to publish and regularly update a list of types of tax incentives qualifying for the nonapplication of the minimum-tax clause, on the basis of the work performed by the Forum on Harmful Tax Practices and the Code of Conduct Group on Business Taxation.

170. For further details, see Arginelli, supra n. 158.

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Part Three

Tax Treaty Issues of Intellectual Property

Chapter 5 Source vs Residence Taxation of Royalties: A Historical Perspective by Jacques Sasseville1

5.1. Introduction One of the most significant differences between the OECD and the UN models is the fact that article 12 of the OECD Model provides for the exclusive residence taxation of royalties whereas article 12 of the UN Model allows for limited source taxation of such income. This chapter focusses on the history of that specific aspect of article 12 of the current OECD and UN models. It shows that the early models of the League of Nations and the subsequent work of the Organisation for European Economic Cooperation (OEEC) did not firmly endorse the conclusion that royalties should exclusively be taxed in the state of residence and that while the first published model of the OECD adopted the principle of exclusive residence taxation of royalties, this was a compromise solution that was far from reflecting the unanimous view of the OECD members.

5.2. The work of the League of Nations The early treaty reports of the League of Nations did not include specific references to income from intellectual property (IP) (patents, copyrights, etc.). That type of income was not dealt with expressly in either the 1923 Four Economists’ Report, the 1925 Technical Experts Report or the 1927 Draft Convention. Under the general rules proposed therein, it seems that royalties would have been exclusively taxable in the state of residence but that result was neither discussed nor stated expressly in any of these reports.

1. Interregional Adviser, DESA/FfDo Capacity Development Unit, United Nations. This chapter reflects the personal views of the author, which should not be attributed to the United Nations.

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The 1928 Draft Model Conventions2 followed these earlier examples and did not include any express references to royalties. The Committee of Experts that developed these model conventions, however, recognized the need to develop a specific rule concerning income derived from IP in order to prevent double taxation of such income and decided that work should be undertaken on that topic.3 That work began with an analysis of the responses to a country questionnaire on the domestic treatment of such income in the countries that were represented on the Fiscal Committee that was set up after the 1928 meeting of the Committee of Experts. Based on that analysis, the Fiscal Committee reached the conclusion, at its second meeting held in 1930, that “income from authors’ rights or patents, which is characteristically such and does not fall into the class of industrial or commercial income, should always be taxed by the state in which the intitulee [the person having the right to receive the income] is domiciled”.4 During the same meeting, a subcommittee was appointed to “submit at the next meeting … a draft multilateral convention based upon the following general proposals: … Proposal 1. — That the following classes of income shall be taxable only in the State of fiscal domicile of the recipient or creditor of such income: a) … (b) Authors’ royalties or rights….”5

2. Draft Conventions No. 1a), 1b) and 1c) in League of Nations: General Meeting of Government Experts on Double Taxation and Tax Evasion Double Taxation and Tax Evasion, Report Presented by the General Meeting of Government Experts on Double Taxation and Tax Evasion, Document C.562.M.178.1928.II, Geneva, 1928, p.34 (all League of Nations documents referred to in this chapter are reproduced in the section “Classic Texts in Australian and International Taxation Law” of the SETIS database of the University of Sydney, available at http://adc.library.usyd.edu.au/index.jsp?database=ozlaw&page=home (last accessed 10 Feb. 2018)). 3. “The Meeting holds that, in addition to the work suggested by the Committee of Technical Experts, the latter might deal with all questions connected with the study of fiscal problems—in particular, methods for the prevention of double taxation in the matter of income derived from patents and authors’ rights…”, p. 34. 4. Sec. C “Study of the Principles involved in the Avoidance of the Double Taxation of Authors’ Rights and Patents”, in League of Nations Fiscal Committee: Report to the Council on the Work of the Second Session of the Committee, Document C.340.M.140.1930.II., Geneva, 1930, at p.7. The country replies to the questionnaire are reproduced in Appendix III of that report. 5. P. 8.

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The draft multilateral convention that was ultimately produced and presented by that subcommittee at the 1931 meeting of the Fiscal Committee included the following provision:6 Article 8. Authors’ rights and income from patents shall be taxable only in the State of fiscal domicile of beneficiaries. If, however, they are collected by persons to whom these rights have been assigned for a consideration, or fall on any other grounds into the category of industrial or commercial income, they shall be taxable as such under the conditions laid down in Article 4.7

The discussion of that draft convention, however, led the Fiscal Committee to identify certain problems related to the drafting of a single multilateral convention. It therefore proposed two alternative drafts and indicated that: [a] certain number of countries would be able to accept the first draft, others the second, others again Model Convention Ia of 1928. Even if the proposals led to no other result, it would be a step in the direction of avoiding double taxation. There is some hope, however, that certain countries will be able to sign two plurilateral conventions of different types simultaneously. In this way double taxation will be eliminated to an increasing extent, even though a single plurilateral convention may appear impracticable at present.

Having thus concluded that the idea of a single multilateral convention “appeared impracticable” at that time, the Fiscal Committee nevertheless undertook, at its subsequent meeting, to recommend the conclusion of another multilateral convention, albeit one that dealt exclusively with the allocation of business profits.8 While that “limited” multilateral convention, which was never signed, did not deal directly with the taxation of royalties, it included a definition of the term “business income” that expressly excluded “rentals and royalties” described as follows: Rentals or royalties arising from leasing personal property or from any interest in such property, including rentals or royalties for the use of, or for the privilege of using, patents, copyrights, secret processes and formulae, goodwill, trade marks, trade brands, franchises and other like property, provided the enterprise is not engaged in dealing in such property.9

6. League of Nations Fiscal Committee: Report to the Council on the Work of the Third Session of the Committee, Document C.415.M.171.1931.II.A, Geneva, 1931. 7. P. 11. 8. League of Nations Fiscal Committee: Report to the Council on the Fourth Session of the Committee, Document C.399.M.204. 1933.II.A., Geneva, 1933, p. 2. 9. P. 4. That description includes many elements of what is now the definition of royalties in art. 12 of the OECD and UN Models.

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The last two models that were subsequently adopted by the Fiscal Committee of the League of Nations in 1946,10 however, indicated that there was no longer a consensus with respect to exclusive residence taxation of royalties. The 1943 Mexico Model departed from the approach proposed in the 1930 report and the 1931 draft multilateral convention and stated that royalties, other than those for the use of certain cultural or scientific work, should be taxable only in the state where intellectual rights were exploited:11 Article X … 2. Royalties and amounts received as a consideration for the right to use a patent, a secret process or formula, a trademark or other analogous right shall be taxable only in the State where such right is exploited. 3. Royalties derived from one of the contracting States by an individual, corporation or other entity of the other contracting State, in consideration for the right to use a musical, artistic, literary, scientific or other cultural work or publication shall not be taxable in the former State.

The 1946 London Model, however, adopted the opposite approach, according to which royalties were exclusively taxable in the state of residence, with the exception of royalties paid to associated companies which could be taxed in the state of source without any rate limitation: Article X … 2. Royalties derived from one of the contracting States by an individual, corporation or other entity of the other contracting State in consideration for the right to use a patent, a secret process or formula, a trade-mark or other analogous right, shall not be taxable in the former State. 3. If, however, royalties are paid by an enterprise of one contracting State to another enterprise of the other contracting State which has a dominant participation in its management or capital, or vice versa, or when both enterprises are owned or controlled by the same interests, the royalties shall be subject to taxation in the State where the right in consideration of which they are paid is exploited, subject to deduction from the gross amount of such royalties of all expenses and charges, including depreciation, relative to such rights and royalties. 4. Royalties derived from one of the contracting States by an individual, corporation or other entity of the other contracting State, in consideration for the right to use an artistic, scientific or other cultural work or publication shall not be taxable in the former State.12

10. League of Nations Fiscal Committee: Report on the Work of the Tenth Session of the Committee, Document C.37.M.37.1946.II.A, Geneva, 1946. 11. League of Nations Fiscal Committee, London and Mexico Model Tax Conventions Commentary and Text, Document C.88.M.88.1946.II.A, Geneva, 1946, p. 64. 12. P. 65. While para. 3 of that provision seems to be the prototype of the excessive royalty provision included in art. 12(4) of the OECD Model/art. 12(6) of the UN Model,

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The Commentary on the Mexico and London Models explained the diverging provisions of the two models in the following words: The second paragraph of Article X refers to royalties from scientific, industrial and commercial property, such as patents, secret processes and formulæ, trade-marks and trade-names. The Mexico Convention, applying the principle of immediate economic origin, placed them under a single rule according to which the royalties are taxable in the country where the patent or other similar right to which they correspond is exploited. As a result, the returns of patents and similar rights always remained taxable in the country where the rights were used, whether the proprietor exploited them himself or through a lessee. Following a similar line of reasoning to that which inspired the new wording of Articles VIII and IX of the London draft, royalties from patents and similar rights are made taxable in the new version of paragraph 2 of the article under consideration exclusively in the country to which the grantor belongs. A restriction to that principle is, however, made by the new paragraph 3 in case the concession has taken place between inter-related enterprises. In that case, the royalties become taxable in the country where the rights are exploited subject to deduction of “all expenses and charges including depreciation relative to such rights”. The fourth paragraph of Article X in the London draft is identical with the third paragraph of the Mexico version. Copyright royalties from artistic and scientific productions, wherever earned, remain exclusively taxable in the country where the recipient has his fiscal domicile or permanent establishment. The specific purpose of this rule is to facilitate cultural exchanges.

The final guidance of the League of Nations concerning the taxation of cross-border royalties was therefore a neutral position recognizing two possible approaches: exclusive source taxation or exclusive residence taxation (except in the case of what the Commentary described as “copyright royalties from artistic and scientific productions”, royalties paid to related enterprises and natural resource royalties).

5.3. The work of the OEEC13 The work of the OEEC (to which the OECD succeeded in 1961) on the tax treaty treatment of royalties began when, at its fourth session of its scope was considerably wider as it allowed source taxation of any royalties paid to a related enterprise, whether the amount paid was arm’s length or not. 13. All documents of the OEEC and OECD referred to in this chapter are available on the “History of Tax Treaties” website at http://www.taxtreatieshistory.org (last accessed 10 Feb. 2018).

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4-7 June 1957, the Fiscal Committee of the OEEC set up Working Party (WP) 8, consisting of representatives from Germany and Luxembourg, to study the “direct taxation of royalties”.14 The first report of WP8, dated 12 February 1958, clarified that the object of that study was “to draft a provision to settle the taxation of such payments, for inclusion in a Convention for the avoidance of double taxation”.15 The draft article on the tax treaty treatment of royalties that was included in that report provided for the exclusive taxation of royalties by the state of residence (except where the royalties exceeded an “adequate consideration” or were derived from a permanent establishment (PE) or fixed base situated in the state of source).16 The report did not put forward compelling arguments in support of its recommendation that royalties should only be taxable in the state of residence of the recipient. After recalling that the 1928 Draft Model Conventions17 did not deal expressly with royalties, which were therefore taxable only in the state of residence under the general default rule included in these Model Conventions, and that the Mexico (1943) and London (1946) models had reached diametrically opposed conclusions on that issue, the report merely noted that the draft article was prepared on the basis of a study of the most recent conventions, which revealed that:18 [T]he principles set forth in the London draft have been adopted by most O.E.E.C. countries: (a) the right to tax patent royalties and similar payments is conferred in principle, therefore, on the State of domicile of the grantor … (b) where patent royalties and similar payments are derived through a permanent establishment situated in one of the States and forming part of an industrial or commercial enterprise in the other State carried on by the grantor, or are derived in connection with professional services performed by the grantor in one of the States and the grantor is a resident of the other State, then they are treated in accordance with the rules applicable

14. Fiscal Committee, Minutes of the 4th Session, held on 4-7 June 1957, document FC/M(57)2 (3 July 1957), p. 8. 15. Working Party 8, Report on the Direct Taxation of Patent Royalties and Similar Payments, document FC/WP8(58)1 (12 Feb. 1958), p. 1. 16. P. 2. The draft article also extended the application of that rule “to amounts received as consideration for the sale or disposal of any property”, which reflected the fact that when the report was produced, the Fiscal Committee had not yet begun its consideration of a specific article on capital gains. 17. See supra n. 2. 18. Pp. 4-5.

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under the Convention to income derived from an industrial or commercial enterprise or to income from the performance of professional services respectively.

The surprising part of the first report of WP8 was the following “reservation” from Luxembourg, one of the two members of WP8: IV. Reservations In preparing the draft, the Luxemburg Delegation was guided by the consideration that the aim of the O.E.E.C. is to lay the foundations of a multilateral Convention. It is only for the sake of this aim that the Luxemburg Delegation has consented to withdraw its objections to a solution which, for a country in the position of Luxemburg, means the unilateral relinquishment of the right to tax. The Luxemburg Delegation would, in principle, have preferred to give the right to tax to the country where the patent, copyright or other right is used. It considers that this solution would certainly not be inconsistent with economic realities. Accordingly, the Delegate for Luxemburg believes that so long as the question of double taxation is governed by bilateral conventions, the Draft Article should contain a provision that two countries may agree that a certain right to tax should be reserved to the country where the rights in question are used.

That reservation is not only surprising because it originates from a country that contemporary readers would not associate with the principle of the source taxation of royalties, but also because one would not expect a report by a subcommittee of two countries to include a proposal for a new article with a such a strong reservation by one of the two countries. What Luxembourg basically indicated is that it could only agree to the exclusive residence taxation of royalties in the context of a multilateral convention; in the context of bilateral treaties, however, it considered that the draft article should provide “that two countries may agree that a certain right to tax should be reserved to the country where the rights in question are used”. That reservation was to become more important as it gradually became clearer that the end-result of the work of WP8 would be a draft article to be used as a model for bilateral conventions. The report of WP8 was discussed at the 8th session of the Fiscal Committee, which took place on 5-7 May 1958. The minutes of that meeting19 reveal that the Delegate for Austria expressed the view that royalties paid by a subsidiary to its parent should be subject to source taxation (as was provided in

19.

Document FC/M(58)3 (16 June 1958).

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the London Model)20 and that the Delegate for Belgium supported the reservation made by Luxembourg concerning the source taxation of royalties.21 At the end of the discussion, the Chair of the Fiscal Committee invited WP8 to submit a revised report at the next session of the Committee. Like the initial draft article, the revised article included in the second report of WP8, dated 3 September 1958,22 followed the principle of exclusive residence taxation of royalties. That second report also expressly rejected the Austrian proposal that source taxation should be allowed in the case of royalties paid by a subsidiary to its parent:23 The proposal by the Austrian Delegation to confer on the State of source a certain right to tax in respect of industrial and commercial royalties paid by subsidiaries to their parent companies, or vice versa, was found inacceptable by the Working Party. Such an exception would constitute a fundamental derogation from the clauses adopted up to now by almost all the Member countries of the O.E.E.C. […] The adoption of the proposal would mean that a company established abroad would have to be taxed differently according as it received royalties from its subsidiary or from an enterprise in which it owned no interest. Furthermore, the principle would be called in question of treating subsidiaries as separate entities for taxation purposes, which principle was recognised in the discussions on the concept of permanent establishment.

The report also addressed the question, raised by the United Kingdom, of whether the state of source should be allowed to tax royalties if the state of residence did not tax them:24 The Working Party does not propose to rule on this question which pertains to the general economy of the Convention - must the Convention prevent virtual or actual double taxation? - and is therefore outside the scope of the present Draft Article.

The second report of WP8 was discussed at the 9th session of the Fiscal Committee on 22-25 September 1958.25 It became obvious during that 20. See supra n. 12. 21. P. 9. The minutes also include the intervention of the Delegate for Luxembourg who “pointed out that the International Chamber of Commerce supported the principle of taxation in the country of source”. The position of the International Chamber of Commerce, however, seems to have changed shortly after: see infra n. 38. 22. Document FC/WP8(58)2. 23. P. 2. 24. P. 3. 25. See the minutes of that meeting in document FC/M(58)4 (31 Oct. 1958).

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meeting that a number of member countries were opposed to the principle of exclusive residence taxation of royalties which was recommended in the first two draft articles prepared by WP8. The Delegates for Luxembourg, Austria and Belgium repeated their arguments in favour of source taxation. They were joined by the Delegates for Portugal and Italy, the latter indicating that “he preferred the principle of taxation by the state of source, but could accept taxation by the State of residence so far as the enterprise did not have a permanent establishment in the State of source”.26 The Delegate for Greece reserved its position on the issue and the Delegate for France, while agreeing to the principle of taxation by the state of residence, considered that this should not be the absolute rule. The Delegates for Germany, Switzerland, Sweden, Norway, Denmark, the United Kingdom and the Netherlands expressed their support for exclusive taxation of royalties in the state of residence (subject to the exception applicable to royalties attributable to a PE or fixed base in the other state). The Delegate for the United Kingdom also repeated his subject-to-tax suggestion, asking “that it should be made clear that in the bilateral agreements the right to tax could be given to the State of source if the State of residence did not levy taxes”.27 Given the different views expressed on the issue of source versus residence taxation of royalties, the Committee ultimately decided that delegates who supported the source taxation of royalties should send their arguments in writing to WP8 “which would seek a compromise formula”. The Delegate for Luxembourg also invited these delegates to indicate “whether the questions raised should be dealt with in the draft Article or in the Commentary and how the right to tax should be limited (percentage, basis, rate, restriction to the level of tax on capital)”.28 In a short “supplementary memorandum” submitted a few weeks later,29 WP8 announced that based on the written submissions received from delegates, it now proposed that source taxation limited to 5% of the gross amount of royalties be allowed “when this is justified by special conditions”:30 26. P. 8. 27. P. 9. 28. P. 9. 29. Working Party No. 8, Supplementary Memorandum to the Second Report on the Direct Taxation of Patent Royalties and Similar Payments, document FC/WP8(58)3 (10 Nov. 1958). 30. Pp. 1-2. The supplementary memorandum also briefly addressed Switzerland’s earlier suggestion to add to the article a provision that would ensure that royalties would be deductible in determining the payer’s tax. The Working Party rejected that suggestion,

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(1) The Working Party is still of opinion that in a multilateral Convention the right to tax royalties should be conferred exclusively on the State of which the recipient is a resident. (2) But so long as such a multilateral Convention does not exist and double taxation is prevented by means of bilateral Conventions, it would be for the Contracting States concerned to confer a limited right to tax on the State of source when this is justified by special conditions. Such conditions are present when in view of the economic relations between the two Contracting States it would hardly be proper to deprive the State of source of all right to tax royalties. (3) The tax levied by the State of source should not exceed 5 per cent of the gross amount of the royalties. In limiting the right to tax of the State of source in this way, the Working Party has been guided by the consideration that to levy a tax in the State of source of the royalties of up to 5 per cent of the gross receipts would amount to only a minor derogation from the principle that the State of residence should have the exclusive right to tax. The limitation of the right to tax of the State of source would apply irrespective of the manner in which the tax is levied, only the tax must not exceed the limit specified above.

This new proposal was discussed a few days later at the 10th session of the Fiscal Committee.31 As must have been expected, there was substantial opposition to the proposed compromise. While the Delegate for Luxembourg logically supported it together with the Delegate for Austria, opposition came from two different sides. On the one hand, the Delegates for Sweden, Switzerland and the United Kingdom made it clear that they did not support any source taxation of royalties. On the other hand, the Delegate for Portugal argued that there should not be any restriction on the right of the source state to tax royalties and the Delegate for Italy continued to argue in favour of an unrestricted right to tax by the state of source if the Committee would not agree to its “force-of-attraction” principle (according to which royalties would be taxable in the state of source whenever the recipient had a PE in that state). Given the deadlock, the discussion was adjourned to the next meeting of the Committee and WP8 was asked to prepare a document that would include the original draft article as well as either a new draft article or a list of questions that would be based on its recent “supplementary memorandum” and

concluding that “[t]he Working Party does not consider it expedient to depart in regard to royalties from the practices hitherto followed, particularly as the question might also arise in connection with other categories of income, e.g. interest” (at p. 3). 31. Fiscal Committee, Minutes of the 10th Session, held on 18-21 Nov. 1958, document FC/M(58)5 (16 Dec. 1958).

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on the various views expressed during the meeting concerning the source taxation of royalties.32 Four weeks later, WP8 dutifully complied and produced a document entitled “Aide-Mémoire on the Direct Taxation of Patent Royalties and Similar Payments”.33 That note first indicated that Denmark, Germany, the Netherlands, Norway, Sweden, Switzerland and the United Kingdom supported the principle of exclusive taxation in the state of residence. France also supported that principle but was prepared to allow a limited right to tax to the state of source. As regards states that advocated taxation by the state of source, the note distinguished the position of: – Portugal, which wanted exclusive source taxation of royalties; – Greece, which wanted some source taxation but also did not agree to include payments for the use of industrial and commercial equipment if the article provided for exclusive residence taxation; – Italy, which was in favour of taxation by the state of source when there was a PE in that state, regardless of whether or not the royalties were attributable to the PE; and – Austria, Belgium and Luxembourg, which could agree with a limited right to tax for the state of source (Austria would then abandon its proposal that royalty payments between subsidiaries and parent companies be taxable in the state of source).34 Based on these different views, the Working Party did not consider that it would be useful to revise the draft article that it had presented earlier and preferred to ask the Committee “for precise instructions on the points not yet settled, with a view to the preparation of a final draft Article”. It then summarized these points as follows:35 As, on one side, there seem to be too many Delegations opposed to granting an exclusive right to tax to the State of source, and as it appears extremely difficult to reach agreement on the basis of any of the above-mentioned proposals by the Austrian, Greek or Italian Delegations, the Committee will have to decide between the two solutions under mentioned: A. giving an exclusive right to tax to the State of the recipient’s residence, and

32. Pp. 9-10. During the meeting, the UK Delegate also repeated his prior intervention to the effect that “film rents” should be excluded from the scope of the article on royalties. 33. Document FC/WP8(58)4 (19 Dec. 1958). 34. Pp. 1-2. 35. Pp. 3-4.

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B. giving a right to tax to the State of the recipient’s residence, combined with a limited right to tax for the State of source, with the proviso that credit would be given against the tax payable in the State of residence for the tax paid in the State of source. Should the second solution be adopted, the Committee will have to: (a) decide whether the solution would hold good for a multilateral Convention or should be limited to bilateral Conventions, and (b) fix a maximum for the right to tax given to the State of source. There might be a maximum rate on the gross royalty, or a fraction of the gross royalty might be taxed at the normal rate. The two methods could even be combined, in that a maximum rate (which in this case, however, would have to be higher than under the first method) would be applied to a fraction of the gross royalty.

The note then went on to describe the following additional issues that would need to be addressed by the Fiscal Committee: – the UK suggestion to exclude “film rents” from the scope of the article on royalties; – the Swiss earlier proposal to include a provision that would ensure the deductibility of royalties; and – whether the article should include an express provision on payments that exceeded an adequate consideration. Given the lack of consensus on the issue of source versus residence taxation of royalties, it is not surprising that the Fiscal Committee was in no hurry to discuss the questions raised in the December 1958 aide-memoire prepared by WP8. These questions were put aside for the next 15 months and were not discussed at any of the six sessions of the Fiscal Committee which took place during that period.36 The Fiscal Committee finally resumed its discussion of the article on royalties at its 17th session held at the end of March 1960.37 During the meeting, the Chair invited all delegates to describe their country’s domestic tax treatment of royalties paid to non-residents and express their views on the

36. These were the 11th session held on 20-23 Jan. 1959, the 12th session held on 17-20 Mar. 1959, the 13th session held on 9-12 June 1959, the 14th session held on 2124 Sept. 1959, the 15th session held on 8-11 Dec. 1959 and the 16th session held on 2-5 Feb. 1960. 37. Fiscal Committee, Minutes of the 17th Session, held on 28 Mar.-1 Apr. 1960, document FC/M(60)2 (28 Apr. 1960).

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issue of source versus residence taxation of royalties. That consultation revealed that:38 – seven countries (Denmark, Germany, the Netherlands, Norway, Sweden, Switzerland and the United Kingdom) favoured exclusive residence taxation of royalties with no possibility for source taxation; – two countries (Portugal and Spain) favoured exclusive source taxation of royalties; and – nine countries (Austria, Belgium, France, Greece, Ireland, Italy, Luxembourg, Turkey and the United States) “could, as a compromise, agree to limited taxation in the country of source, although the Delegates for France, Ireland and the United States were in favour of taxation by the country of residence”. There were, however, differences between these countries as regards the maximum rate of source taxation that should be allowed: Turkey wanted 15%; Austria, France, Ireland and the United States were willing to accept 10%; Belgium, Italy and Luxembourg were prepared to agree to 5% and Greece reserved its position. The Chair interpreted these results as meaning “that in fact ten countries favoured taxation in the country of residence”. Noting that these countries had already conceded a right to tax at source in the case of dividends and interest, he suggested that “the Article on royalties should be based on taxation in the country of residence and that the Commentary should concede a limited right to tax to the country of source up to a ceiling of 5 per cent”.39 He then invited WP8 to submit two alternative texts for decision at the next meeting of the Committee. The other questions raised in the 1958 aidememoire prepared by WP8 were not discussed during the meeting. WP8 complied with that request a few weeks after the meeting. The short document that it submitted in May 196040 included a new draft article as well as the description of three additional issues previously identified by the Working Party but still unresolved by the Committee. The new draft article differed in a very significant way from the previous drafts proposed by the Working Party: for the first time, the draft article 38. P. 16. The Chair also noted that “the International Chamber of Commerce had up to now been in favour of taxation by the country of source, but its Commission on Taxation had the previous week adopted a Resolution whereby the country of source was defined as the country in which the centre of activities of the owner of the right was situated”. 39. Id. 40. Fiscal Committee, Second Aide-Mémoire on the Taxation of Royalties, document FC/WP8(60)1 (3 May 1960).

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allowed for the source taxation of royalties, that tax being limited to 5% of the gross amount of the royalties. Paragraph 2 of the article read as follows: 2. Paragraph 1 shall not preclude the right of the other Contracting State to tax such royalties and other payments arising in its territory. Nevertheless, the tax may not exceed 5 per cent of the gross amount of the royalties or other payments.

There was no discussion of the article on royalties at the 18th and 19th sessions of the Fiscal Committee held respectively on 10-13 May and 28 June 1960. In August of that year, WP8 proposed a slightly modified version of the draft article in which paragraph 2 read as follows:41 2. A Contracting State in which royalties arise to a resident of the other Contracting State shall retain the right to tax such royalties. However, the rate of the tax may not exceed 5 per cent of the gross amount of the royalties. The administrative authorities of the two States shall by mutual agreement settle the mode of application of such limitation.

The discussion of the article on royalties resumed at the 20th session of the Fiscal Committee held on 6-9 September 1960.42 During that meeting, the Committee did not expressly address the issue of source versus residence taxation, preferring to focus on two of the three additional questions that had been raised by WP8. In doing so, it first rejected the UK proposal concerning the exclusion of “film rents” and then agreed to further examine Switzerland’s proposal concerning a provision requiring the deductibility of royalties on the basis of a note to be provided later.43 The Fiscal Committee finally resumed its discussion of the issue of source versus residence taxation of royalties at its 21st session in December 1960.44 That discussion, however, did not get the Committee any closer to a resolution of that issue. After the Committee agreed to make a few minor edits to the paragraph that provided for the source taxation of royalties limited to 5%, it was suggested that regardless of the article, countries should be able to agree bilaterally on the taxation by the state of source or taxation by the state of residence. That triggered a discussion as to what would be the nature of the OEEC Council Recommendation that would include the article, in particular, as regards the 5% limit, and as to whether the article should 41. Working Party 8, Article on the Taxation of Royalties, document FC/WP8(60)2 (18 Aug. 1960). 42. Fiscal Committee, Minutes of the 20th Session, document FC/M(60)5 (12 Oct. 1960). 43. That note was subsequently distributed as document TFD/FC/102 (5 Oct. 1960). 44. Fiscal Committee, Minutes of the 21st Session, held on 25-28 Oct. 1960, document FC/M(60)6 (23 Dec. 1960).

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provide a fixed 5% rate or should allow the rate to be determined bilaterally between 0% and 5%. After a number of delegates expressed a preference for a single uniform rate, the discussion shifted back to the issue of residence versus source taxation, a few delegates simply repeating the position that they expressed when the issue was last discussed by the Committee. It is at the 22nd session of the Fiscal Committee, held on 17-20 January 1961, that the deadlock was broken and a compromise solution adopted. The minutes of that meeting45 indicate that after the Delegate for Luxembourg invited the Committee to reach a final position on the proposal for a maximum 5% rate of source taxation on royalties, the Swiss Delegate suggested that each country that favoured the exclusive residence taxation of royalties express its position. While a majority of delegates indicated support for the compromise solution proposed by Working Party 8, a number of these delegates also indicated that their countries preferred or could agree bilaterally (that was the position expressed by Luxembourg) to the exclusive residence taxation of royalties. Focusing on the latter aspect of these interventions rather on than on the former, the Swiss Delegate indicated that since only Austria, Greece, Portugal, Spain and Turkey would insist on the source taxation of royalties, the article proposed by WP8 should be redrafted to provide for the exclusive residence taxation of royalties. Although the Delegate for Sweden supported that proposal, he suggested that the Commentary should provide that countries that would find it difficult to agree to that solution would be granted the right to levy a tax at the maximum rate of 5%. Quite understandably, the Delegate for Luxembourg did not agree with that turn of event and expressed the wish for an “alternative text” that would apply to countries wishing to retain the right to tax royalties at source. The discussion then shifted to how the position of the countries that supported the source taxation of royalties would be reflected if the Committee adopted the Swiss proposal of a new version of the article that would ­provide for the exclusive residence taxation of royalties.

45.

Document FC/M(61)1 (17 Feb. 1961).

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The Chair of the Committee first suggested that the “alternative test” suggested by the Delegate for Luxembourg “should be included in the Recommendation that the [OEEC] Council would make to Member countries in the same way as the reservations of Member countries who stated that they could not apply a particular provision of the Article”. The Delegates for Germany and Switzerland, however, thought that the countries that supported the source taxation of royalties should simply make reservations that would appear in the Fiscal Committee’s report and that the Recommendation of the Council should merely refer to these reservations. Other countries, however, suggested that the position of these countries should be given a higher status. The Delegate for France suggested that the Recommendation of the Council “should take official note of the reservations since they implied that the parties concerned retained their freedom of action in relation to one another”. The Delegate for Sweden proposed “a joint declaration which would allow countries with a special taxation system to maintain a tax at the source at a maximum rate of 5 per cent” and added that “there would then be no need for such countries to enter reservations on the draft Article. The declaration could either refer to these countries in general terms or mention them by name if they so desired.” The Delegate for Luxembourg queried what would be the effect of such a declaration on countries that favoured exclusive residence taxation since the draft article would only be a recommendation. At the end of the discussion, the Chair invited the delegates to express their views on the proposal which he described as follows, thereby responding to the Delegate for Luxembourg: [O]n the one hand, an Article giving the exclusive right to tax royalties to the country of residence of the recipient and, on the other hand, a separate Declaration according to which certain countries would have the right to levy a tax at the source at the maximum rate of 5 per cent. This declaration could either include a general formula referring to “countries in a special position with regard to royalties” and then name the countries concerned, or simply give a list of these countries. The Article and the Declaration would be included in a Recommendation of the Council of the O.E.E.C. By adopting this Recommendation, countries in favour of exclusive taxation by the country of residence would acknowledge the right of the countries listed in the Declaration to levy a tax at the source of 5 per cent. The Declaration would have the same legal value as the rest of the Recommendation and would carry, as it were, the same moral obligation.

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The nine countries that previously supported the exclusive residence taxation of royalties (Denmark, Germany, Ireland, Italy, the Netherlands, Norway, Sweden, Switzerland and the United Kingdom) all supported that proposal while the eight countries that has supported some form of source taxation of royalties either opposed the proposal (Belgium and Luxembourg) or abstained (Austria, France, Greece, Portugal, Spain and Turkey). It is therefore by a majority of only one country that the principle of exclusive taxation of royalties by the state of residence was adopted but, as the Chair indicated, that decision was conditional on the adoption of a: Declaration according to which countries in favour of taxation of royalties exclusively by the country of residence of the recipient would commit themselves to grant, upon request, the right to levy a tax at the source of 5 per cent to countries which are recognized as having a special position in the matter.46

The “declaration” was included in a recommendation that the OEEC Council adopted on 7 July 1961. That recommendation added the following sub-paragraph to the Recommendation Concerning the Avoidance of Double Taxation which the Council had previously adopted:47 Notwithstanding the provisions relating to royalties in the Annex to this Recommendation, the other Member countries declare that they are prepared in bilateral Conventions and subject to reciprocity to concede to Greece, Luxembourg, Portugal and Spain a right to impose tax at 5 per cent on the gross amount of royalties, to which rate these four countries declare that they are prepared in such Conventions to limit their tax at the source where the recipient of the royalties has not in their respective territories a permanent establishment with which the right or property giving rise to the royalties is effectively connected.

That amended recommendation of the OEEC was replaced when, on 30 July 1963, the Council of the OECD (which succeeded the OEEC in 1961) adopted the Draft Convention on Income and Capital.48 Unlike the previous OEEC recommendation, however, the new recommendation by the OECD did not include the above declaration. In its place, it included the following “special derogation”, which was inserted in the Commentary on Article 12 of the 1963 Draft Convention:

46. Id., p. 11. 47. See the Appendix to the Report, The Elimination of Double Taxation – Fourth Report of the Fiscal Committee 1961, OEEC, Paris, 1961, at p. 81. 48. Reproduced in the Appendix to the 1963 Draft Convention.

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SPECIAL DEROGATION IN FAVOUR OF CERTAIN COUNTRIES 25. The following Member countries, Greece, Luxembourg, Portugal and Spain consider that they are unable to relinquish all taxation at the source as regards royalties arising in their territories and paid to residents of another State. They are prepared, however, to limit their tax at the source on such royalties to a maximum of 5 per cent of the gross amount of the royalties. 26. The other Member countries, for their part, declare that they are prepared to allow such States, by bilateral Conventions and subject to reciprocity, a limited right to tax as described above. 27. Whenever use is made of the above derogation in a bilateral Convention, the Contracting States are recommended to model the special clause giving a limited right to tax to the State of source on the formulas employed in paragraphs 1 and 2 of the Article on the taxation of interest. In such a case it will also be necessary to define the State of source. For this purpose, the formula employed in paragraph 5 of the Article on the taxation of interest will serve as a model

While the wording of that “Special Derogation” is very similar to that of the “Declaration” that was added in 1961 to the OEEC Recommendation Concerning the Avoidance of Double Taxation, the fact that these words were taken out of the Council Recommendation and included in the Commentary on Article 12 seemed to reduce the status of the positions expressed in that Council Recommendation. That status was reduced even more dramatically when the OECD Model was subsequently revised.

5.4. The 1977 OECD Model and after The “Special Derogation” was still present in the revised version of the Commentary on Article 12 that was approved at the 36th session of the Fiscal Committee held on 1 December 1970.49 At some point in time between 1971 and the final adoption of the 1977 OECD Model, however, that “Special Derogation” was deleted and replaced by a list of reservations by 12 of the 2450 member countries of the OECD (i.e. 50% of the OECD members) which indicated that these countries wanted some form of source taxation or royalties.

49. See pp. 17 and 18 of note FC(71)1 (14 Jan. 1971). 50. For the reservations from Australia, Austria, Canada, Finland, France, Greece, Japan, Luxembourg, New Zealand, Portugal, Spain and Turkey, see OECD Income and Capital Model Convention and Commentary art. 12, Reservations on the Article, paras. 23-29 (11 Apr. 1977), IBFD Models.

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The 1992 OECD Model no longer included reservations from Finland and Luxembourg, although it included a new similar reservation by Italy. Subsequent versions of the OECD Model saw a gradual decline in the proportion of OECD member countries that reserved the right to tax royalties at source. The latest version of the OECD Model, published in December 2017, indicates that 15 of the 35 OECD member countries reserve the right to tax royalties at source. If, however, one takes into account the positions expressed by the 33 non-member countries or jurisdictions that have officially stated their positions on the OECD Model, the picture is very different: since 30 of these 33 countries or jurisdictions reserve the right to tax royalties at source, this shows that as many as 66% of the members and non-members that have registered their views on the OECD Model support the source taxation of royalties and do not therefore endorse the current wording of article 12 of the OECD Model.

5.5. Conclusion The discussions of the reports of Working Party 8 in the Fiscal Committee of the OEEC and the final outcome of these discussions, which was reflected in the “Special Derogation” and reservations that were included in the Commentary on Article 12 of the 1963 OECD Draft Convention, reveal that the principle of exclusive residence taxation of royalties was far from being generally accepted by the OECD countries when the 1963 Draft Convention was adopted and published. That became even more obvious when, at the time of the publication of the 1977 OECD Model, half of the OECD member countries expressed a preference for some form of source taxation of royalties. At a time when the OECD is paying more attention to the tax treaties concluded by non-member countries and is inviting them to sign the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting and to join the Inclusive Framework, one could argue that since two thirds of the countries and jurisdictions that have expressed their views on the 2017 OECD Model have indicated their support for the source taxation of royalties, it may be time to review the compromise that resulted in the current wording of article 12 of the OECD Model.

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Chapter 6 Article 12 OECD/UN Models: Definition of Royalties and “Overlapping” between Articles 7, 12 and 13 by Adolfo Martín Jiménez1

6.1. Introduction Conflicts of classification2 with regard to the royalty concept in tax treaties are very common in the international arena. The overlapping and conflict usually takes place between the royalty article, on the one hand, and the business profits or capital gains articles, on the other, in tax treaties where royalties are taxed at source. This chapter explores the reasons for this overlapping in section 6.2., which can be summarized by the fact that the royalty article in tax treaties usually applies to categories of income often derived by enterprises (individuals or companies), i.e. to items of income that are often characterized as business profits in domestic law or even in treaties if it were not because the royalty article exists. The historical evolution of the concept of royalties, 1. Professor of Tax Law, Jean Monnet Chair, University of Cádiz, Spain. Some of the main ideas of this work were presented on 7 September 2015 at the seminar “Duets on International Taxation”, organized by IBFD in Amsterdam, with the title The Mutable Concept of Royalties in Tax Treaties, which were also published in A. Martín Jiménez, El “cambiante” concepto de cánones / regalías en los convenios para la eliminación de la doble imposición in Nueva Fiscalidad: Estudios en Homenaje a Jacques Malherbe (Hoyos Jiménez, García Novoa & Fernández eds., ICDT 2017). Both the Amsterdam presentation and the article cited are also based on ideas further developed in A. Martín Jiménez, Article 12: Royalties secs. 1. and 5., Global Tax Treaty Commentaries IBFD. See also in this respect B. Arnold & A. Martín Jiménez, Protecting the Tax Base of Developing Countries Against Base Eroding Payments: Rents and Royalties (United Nations 2017), available at http://www.un.org/esa/ffd/wp-content/uploads/2017/05/PP_Rents-Royalties. pdf (last accessed 20 Dec. 2017). This chapter, however, puts more emphasis on conflicts of classification and overlapping of the royalty article than all the others. 2. For purposes of this chapter, the expression “conflicts of classification” is used with the same meaning as “conflicts of characterization” or “qualification”. In international private law all of these have the same meaning, “conflicts of qualification” is the preferred expression in continental Europe whereas in Anglo-American law “conflicts of characterization or classification” is more commonly used; see the classic article by E. Lorenzen, The Qualification, Classification or Characterization Problem in the Conflict of Laws, 50 Yale L.J., p. 43 et seq. (1941), available at http://digitalcommons.law.yale. edu/cgi/viewcontent.cgi?article=5593&context=fss_papers, and the literature there cited (last accessed 20 Dec. 2017).

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which is briefly explained in section 6.3., also illustrates that the conflicts and overlapping are closely connected with economics and politics: the fight between states that are exporters and importers of technology, developed and developing countries, for tax bases. This is the reason why the Commentary on Article 12 of the OECD Model has evolved since 1963 until 2017 to accommodate different trends and interpretations of the royalty concept that are not always compatible and are often a major source of conflicts of classification and overlapping, in part also because international acceptance of the Commentary on Article 12 of the OECD Model (19632017), or how it has evolved, is less popular than may appear at first sight. These statements and the problems of overlapping and conflicts of classification are explained in this work with several examples in sections 6.4. and 6.5. First, article 12 of the OECD Model and its Commentary (1963-2017), and, in particular, the concept of royalties, do not have an easy relationship with domestic law, especially of source countries. Second, in an attempt to overcome the problems of interaction of the tax treaty concept of royalties with domestic law, the Commentary on Article 12 of the OECD Model (1963-2017) has evolved towards a contextual meaning of the terms used in the royalty definition, but this evolution has been resisted by countries wishing to apply withholding taxes to royalties, since it seems that the solution to problems of overlapping and the contextual attempt to define royalties always had the same effect of carving out the scope of the royalty definition, a trend several countries have resisted. Section 6.5. explores two examples of this trend towards the elaboration of a (not always accepted) context in the Commentary on Article 12 of the OECD Model that are of major importance to understand conflicts of classification: the concept of “use” as an inherent feature of the royalty definition in article 12(2) of the OECD Model and the notion of payments for the supply of know-how as one of the categories of income included in that article. The conclusions of these sections (6.4. and 6.5.) are that overlapping between the royalty article and the business profits and capital gains articles is facilitated by the state of the Commentary on Article 12 of the OECD Model (2017), the historical evolution of the royalty concept through the Commentary and the politics behind it. Moreover, section 6.6. points out how overlapping and conflicts of classification may be aggravated by the new OECD BEPS context where the consideration of intangibles for transfer pricing purposes and the economic/ value creation approach to attribution of income from intangibles in the OECD Transfer Pricing Guidelines 2017 will originate new problems of attribution/classification of royalty income. In addition, the new and 118

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proposed Commentary on Article 12 of the UN Model (2017) plus the new technical services article 12A of the UN Model (2017) offer another alternative context to the OECD Model that, on the one hand, can also contribute to exacerbate conflicts of classification, but, on the other hand, may also solve some of the problems of the OECD Model and the royalty definition, as explained in section 6.7. The conclusion of this chapter is that conflicts of classification or overlapping rather than being eliminated will probably proliferate in future unless action is taken to somehow “clean up the mess” with royalties and technical services or a sounder basis for the taxation of royalties and services is established.3 In this direction, the new “UN alternative context” and the role it can have in the taxation of the digital economy is considered in sections 6.7. and 6.8.

6.2. The reasons for overlapping between the royalty definition and the concept of business profits/capital gains in the OECD and UN Models Article 12(2) of the OECD Model and article 12(3) of the UN Models have several differences but both share a closed definition of royalties.4 In view of this closed definition, it might be thought that overlapping with other articles may be strange since there is no room to apply domestic source or residence state domestic legislation. However, if there is an article where conflicts of classification are common and difficult to solve, that is article 12 of the OECD/UN Models. There are mainly two reasons for the overlapping of article 12 OECD/UN Models with the business profits and capital gains articles (articles 7 and 13 of the OECD/UN Models). First, article 12 of the OECD/UN Models includes within its scope business profits, with the consequence that both article 7 and 12 (as well as article 13) will apply to income derived from the

3. The expression is borrowed from the seminal article by B. Arnold, The Taxation of Income from Services under Tax Treaties: Cleaning Up the Mess, 65 Bull. Intl. Taxn. 2 (2011), Journals IBFD, which had a direct impact on new art. 12A of the UN Model (2017). 4. E.g. art. 12(3) of the UN Model includes within the royalty definition the use of industrial, commercial and scientific equipment and payments for use or right to use films or tapes used for radio or TV broadcasting.

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source state by an enterprise.5 When, as it happens with article 12 of the UN Model, tax treaties permit the source country to tax royalties, the outcome is that the tax treaty has two different thresholds for the taxation of business profits: the permanent establishment (PE) principle, which requires some presence in the source state (through a fixed place of business or an agent), and the withholding taxes for royalties which do not require any presence in the source state to tax the profits of an enterprise (business profits).6 These two different thresholds for the same type of income (profits derived by an enterprise) have the consequence that source countries will have an interest in expanding the effects of the royalty article, whereas residence countries will tend to characterize income as business profits in article 7 (or capital gains of article 13) to avoid taxation in the source state for their enterprises if they have no PE in the source country. Indeed, article 12 of the OECD/UN Models does include within its scope “passive” income that is not derived in the course of business activities and it only affects business profits which fall within the royalty definition, but the categories of business profits and enterprises included within the scope of article 12 are very broad and relevant in a traditional or digital economy context (e.g. licences for patents, copyrights, software, know-how, etc.). Second, it might be thought that due to the closed definition of royalties in article 12 of the OECD/UN Models, the overlapping is less serious than it may appear at first sight. However, as will be shown below, the royalty definition is less closed and the concept of royalties more “volatile” or “mutable” than it appears. To explain why the concept of royalties, despite being closed, has changed over the years, is not interpreted equally in different countries and there is overlapping with other articles, notably articles 7 and 13 of the OECD/UN Models, it is necessary to explore in more detail some elements of the evolution of the concept of royalties and why this article was included in the OECD Model. Unless the historical evolution is known, article 12 of the OECD Model may be regarded as irrelevant because it 5. OECD Model Tax Convention on Income and on Capital: Commentary on Article 12 para. 1 (1963-2017) has always recognized that it applies to royalties derived by an enterprise. See also UN Model Double Taxation Convention between Developed and Developing Countries: Commentary on Article 12 para. 3 (2011 and 2017), which also accepted para. 1 OECD Model: Commentary on Article 12 as being relevant for the purposes of the UN Model. 6. See, on this issue, more generally, S. Wilkie, The character and purpose of Article 12 with reference to “industrial, commercial and scientific equipment” and software-payment related issues, Discussion paper prepared for the 11th Session of the UN Committee of Experts on International Taxation, Geneva, 11-23 Oct. 2015, E/C.18/2015/CRP.6, available at http://www.un.org/esa/ffd/wp-content/uploads/2015/10/11STM_CRP6_Article12_Royalties. pdf (last accessed 20 Dec. 2017).

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does not establish any different threshold for source country taxation from article 5 of the OECD Model. As a consequence, its function and problems (especially the overlapping with other articles in the OECD Model) are better understood if its history is explained. As will also be explained in the following sections, the history of article 12 of the UN Model is largely a reaction to the evolution of article 12 of the OECD Model.

6.3. Historical evolution of article 12 OECD Model and the “unfinished job” in defining royalties7 6.3.1. Why is there a royalty article in the OECD Model?8 The answer to this question can only be derived from a historical study of the evolution of royalties since the 1920s. In the first Model Treaties of 1928 in the context of the League of Nations, it was not clear if royalties were included within the scope of those models, but the aspiration of the time, especially in the Report of the Four Economists, of attributing tax bases to residence states made it necessary to conclude that this type of income was covered by the 1928 Models in order to make sure that the source states will not apply withholding taxes upon payments characterized or classified as royalties. Because of that, although royalties were not a specific type of income mentioned in the 1928 Models, in subsequent years it was defended that they were included within the categories of income to which they applied. The effect of that position was that the jurisdiction to tax royalties by the state of the payer was limited since the taxation of royalties was attributed to the state of residence. In the 1950s, when the work of the Organisation for European Economic Co-operation (OEEC) (the precursor of the OECD) started, the principle of taxation of royalties exclusively in the state of residence was not easily 7. On the history of art. 12 of the OECD Model, see Chap. 5 in this volume or R. Vann, The History of Royalties in Tax Treaties 1921-1961: Why?, in Comparative Perspectives on Revenue Law: Essays in Honour of John Tiley (J. Avery Jones, P. Harris & D. Oliver eds., Cambridge U. Press 2008); K. Szücs-Hidvégi, Article 12 – Royalties, in History of Tax Treaties pp. 473-507 (M. Lang, T. Ecker & G. Ressler eds., Linde 2011); B. Wells & C. Lowell, Tax Base Erosion and Homeless Income: Collection at Source is the Linchpin, 65 Tax L. Rev., pp. 535-617 (2011); or Martín Jiménez, Chapter 12: Royalties, supra n. 1, at sec. 1.2. 8. For full reference to historical documents and a more detailed explanation on the evolution of art. 12 of the OECD Model, see Chap. 5 in this volume or Martín Jiménez, id. Footnotes to the specific historical documents are omitted in this section but can be found in those two works.

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accepted, especially by capital- and technology-importing countries. As a result, the issue was controversial in the preparatory works of the 1963 Draft OECD Model. In fact, article 12 of the 1963 OECD Draft Model represented a compromise that admitted (i) the taxation of royalties in the state of residence as a principle and (ii) an exception for some countries that could apply withholding taxes at source for royalties at a rate of 5%. In that compromise, capital and technology exporters tried to restrict as much as possible the royalty concept as a form of limiting the impact of withholding taxes when applied by source countries. Two tools were used to achieve that purpose: (i) the concept of royalties was turned into a closed definition by eliminating the reference to “similar properties or rights” included within the concept of royalties (this open formulation is still used in some tax treaties) and (ii) excluding “sales” from the royalty definition through the inclusion of a specific article (later article 13 of the OECD Model) on taxation of capital gains that applied the PE threshold to capital gains linked with the activities of an enterprise (originally the proceeds from the sale of assets included within the royalty definition could be regarded as a royalty). In this context of preparation of the 1963 Draft OECD Model, article 12 had the function of protecting the interest of exporters of technology and capital (residence states) since, with the exception of derogations for some source states, it ensured that royalties received by their companies would not be subject to tax at source. It was thought also that conflicts of classification were avoided since article 12 made clear that the type of income covered by the article was only taxable in the state of residence unless there was a PE in the state of source to which the income could be attributed. However, in this period, the different aspirations of importers and exporters of technology (source and residence states) revealed that consensus on the taxation of royalties was not easy to achieve. When the definition of royalties became a closed one in the preparatory works of the 1963 Draft OECD Model, the battlefield moved to the Commentary on Article 12 of the OECD Model and the interpretation of the royalty definition. In this context, it is curious that an article that was included in the Models to protect residence states from source country taxation and conflicts of classification (it made clear that certain types of income were only taxable in the state of residence), has been the main cause of concern in terms of also creating conflicts of classification: capital and technology exporters have tended to narrow down the definition of royalties because they are aware of the fact that some countries want to tax royalties at source and capital importers have tried to apply withholding taxes upon royalties and also expand the royalty definition so that more income (especially business profits) is captured by 122

Historicalevolutionofarticle12OECDModelandthe“unfinishedjob”indefiningroyalties

their withholding taxes (also to minimize the effects of royalties as deductible payments in the source state since the highest volume of payments is often made by source state enterprises). After 1963, the royalty concept in article 12 of the OECD Model changed only once in 1992 to exclude payments for the leasing of industrial, commercial and scientific equipment from the royalty definition, another move that was not easily accepted by developing countries (article 12 of the UN Model still includes those payments within the royalty definition), but even if the concept has not formally changed, the evolution of the Commentary of the OECD Model has brought substantial alterations in the meaning of the royalty concept over time.

6.3.2. The evolution of the Commentary on Article 12 OECD Model in the period 1963-2017: An unfinished royalty definition with strong potential for overlapping with other articles As mentioned in the preceding section, after 1963 the changes in the royalty concept took place at the level of the Commentary on Article 12 of the OECD Model. They always went in the same direction of narrowing down the scope of the concept of royalties in favour of the business profits and capital gains articles (articles 7 and 13).9 They were sometimes relatively unimportant, but often they had a very crucial impact in shrinking the royalty concept. Therefore, without formally changing the royalty definition, the Commentary on Article 12 of the OECD Model (1963-2017) has reduced its scope more and more through the years. However, the changes of this period were not peacefully accepted by all countries, as shown, for instance, by the observations and reservations, or the positions of nonmember countries in the OECD Model. In this period too, the evolution of the UN Model until 2011 has been mainly reactive, to accept or reject the changes to the Commentary on Article 12 of the OECD Model, until 2017, where very significant changes took place.10 Therefore, from this quick historical overview, it can be inferred that if changes in the Commentary on Article 12 of the OECD Model (1963-1977) were not always peacefully accepted and the UN Model has added very relevant nuances in this regard, conflicts of classification and overlapping 9. For a detailed explanation of the changes in the Commentary on Article 12(2) of the OECD Model, see Martín Jiménez, Article 12: Royalties, supra n. 1, at sec. 5. 10. On the evolution of the concept of royalties in the UN Model, see Martín Jiménez, id., at sec. 1.2.3. and infra sec. 6.7.

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between the concepts of business profits, royalties and capital gains in a treaty context will be frequent. In fact, as a consequence of the evolution of the royalty article succinctly explained, the concept of royalties in article 12(2) of the OECD Model and its Commentary has the following features: (1) It has changed over the years (it is a “mutable concept”) despite limited changes in the definition of royalties in article 12(2) of the OECD Model (1963-2017). (2) It is not accepted by or given the same meaning in all countries (especially if the Commentary on Article 12 of the OECD Model that tries to explain the meaning of the terms used and concepts included within the royalty definition of article 12(2) is taken into account). (3) It is not interpreted in a uniform manner in all countries. (4) It presents contractions since the Commentary permits countries to defend different positions. (5) It looks like an unfinished definition or work in progress that needs to be complemented. With those features, it is normal that overlapping will occur between articles 7, 12 and 13 of the OECD Model (the same conclusion can be extended to the UN context, although with some nuances after 2017 as explained in section 6.7.). It is paradoxical that an article whose history very much shows that it intended to make clear that certain items of income were only taxable in the state of residence and avoiding conflicts of classification ends up often producing the same types of problems it tried to eradicate. The problems are more visible in article 12 of the UN Model since, in the end, this article permits source country taxation and, in this context, and the treaties that subject royalties to source taxation, the application of the business profits/ capital gains or royalty article is not indifferent. The main problems of article 12 of the OECD Model, as described in the preceding paragraphs, can be illustrated with two cases explained in the following sections: (i) the relationship of the royalty concept with domestic legislation (section 6.4.) and (ii) the attempts to build a contextual meaning of the concept of royalties through changes in the Commentary on Article 12 of the OECD Model (section 6.5.).

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The concept of royalties in article 12 OECD Model and domestic law

6.4. The concept of royalties in article 12 OECD Model and domestic law The fact that the concept of royalties is a closed one in article 12 of the OECD Model does not mean that the relationship of that concept, when used in the tax treaties of a country, with domestic law always produces the same outcomes in all countries. As commented above, the closed definition of royalties in article 12 of the OECD Model sought to avoid the application of domestic law, especially the law of the source state. However, the meaning of the terms and categories used in the royalty definition that are crucial to understand such a concept (e.g. “copyrights”, “work”, “patent”, “trade mark”, “design or model”, “plan”, “secret formula or process” or “information concerning industrial, commercial or scientific property”) is not defined in article 12 of the OECD Model or the Commentary to such an article. Although international treaties (under the auspices of the World Intellectual Property Organization (WIPO) or the TRIPS Agreement of the World Trade Organization (WTO) system) and EU directives within the European Union have contributed to harmonize differences in intellectual property (IP) law, there are substantial divergences depending on the system that countries use. For instance, from an IP law perspective, there are very relevant differences in the understanding and protection of “copyrights” or “related rights” in different systems and between civil and common law countries (in the former the author is protected more strongly whereas in the latter the holder of commercial rights deserves a protection that is almost equal to that of the author). In view of these differences, it is not always clear whereas the holder of related rights, which are recognized to those that are not authors of a relevant IP work, is included within the scope of the reference to copyrights in article 12 of the OECD Model or not since, depending on the domestic system, the outcome can be one or another. That is to say, depending on the IP law tradition, the meaning of “copyright” in article 12 can be broader or narrower with the result that broadcasters, producers, performers, etc., can be included or not within the reach of the article when they permit third parties to reproduce the works upon which they have rights. This happens with other categories of rights or assets identified in the article too since, for instance, in most countries but not in all, software is assimilated to copyrights, or some countries do not admit sales of know-how (e.g. for a long time sales of know-how were not recognized in Spain) whereas in others “use” or “sale” of know-how is possible, so depending on the system in which article 12 of the OECD Model applies, payments for the use of software or know-how may be classified as royalties or as business profits or sales.

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In line with those ideas, paragraph 18 of the Commentary on Article 12 of the OECD Model emphasized the relevance of domestic law and contracts to conclude if there is “use” of a copyright (royalty) or, instead, provision of a service. The reference to the “relevant copyright law and the terms of the contracts” in such a paragraph recognized that, depending on the law applicable in the specific case, there can be a royalty or a service. Such a reference to the relevant law and contract is directly linked with the Boulez case,11 where after the US competent authority had defended that the renowned conductor provided services to CBS Records, a US company, and the German one that the payments were royalties, the US Tax Court concluded that, based on the applicable law (the law of the United States at the time of signing the contract), the conductor did not have any right upon the recordings and therefore was providing a service. The US Tax Court recognized that based on the contract and the applicable law, the payments were services and could not be characterized as royalties. After this case, the reference to “relevant copyright law and contracts” was introduced in 2003 in the Commentary on Article 12 of the OECD Model in paragraph 18. But paragraph 18 of the Commentary on Article 12 of the OECD Model does not precise if the “relevant law” is that of the source state, the law of the residence state or a third state to which the contract may be subject (a similar reference to domestic law can be found in paragraphs 8.2 or 12.2 of the Commentary on Article 12 of the OECD Model). Depending on the applicable law, the consequences can be one or another and conflicts of classification can arise. Therefore, paragraph 18 explains something that is natural – rights and obligations depend on the applicable law – and makes clear how to approach some issues and resolve conflicts of classification or, rather, conflicts regarding the appreciation of the facts that produce conflicts of classification (in the end, the Boulez case was about whether the conductor had any copyright in the recordings). However, source countries have a natural tendency to apply their domestic law to define whether there is “a copyright”, “use of a copyright” (and royalties in general) or services and tax scholars quite often tend to (wrongly, in this author’s view) resort automatically to article 3(2) of the OECD Model in order to conclude that the law of the source state applies to define the terms and categories in the royalty concept. If article 12 of the OECD Model exists at all, that is to resist the attempts of source states to tax some types of income at source, so it would be illogical 11. US: US Tax Court (USTC), 16 Oct. 1984, Boulez v. Commissioner, 83 T.C. 584 (1984).

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to admit that the law of the source state is the one that always controls in determining whether there is an IP right that is being used in the source country or a service. It can therefore be concluded that this is a case where “context otherwise requires” and the law to which the contract is subject – which may or may not be the law of source state – should apply. As the Boulez case showed, different views on which law is relevant may lead again to conflicts of characterization or classification or overlapping of the royalty and business profits/capital gains articles in the specific treaty. In fact, it is often the case that contracts involving payments that source countries classify as royalties are subject to the legislation of the country of residence of the person receiving the payment or the legislation of a third country, but very rarely the source country will verify if the outcome with the residence country legislation is payment of a royalty or a service because the tax authorities of the source country will tend in most cases to resort to source country legislation (especially if the source country has a definition of royalties for tax purposes that is autonomous from IP law). This approach often ends up with conflicts of classification in which a country defends that certain payments should be classified as services and another one that they are royalties. The clarity of the closed definition of royalties in article 12 of the OECD Model (this also applies to article 12 of the UN Model) is therefore darkened when it is connected with specific legal systems and the legislation and practice of the states that have entered into a double tax treaty. Most naturally, source country tax administrations and courts will tend to apply domestic legislation to determine if there is a royalty, a sale or a service, but that outcome may not correspond to what the taxpayers intended or the state of residence recognizes. Probably because of this uneasy relationship between the concept of royalties in article 12 of the OECD/UN Models and domestic law, the Commentary on Article 12 of the OECD Model has evolved, not without problems, as explained in section 6.5., to define some of the most relevant terms of the royalty definition independently from domestic law in a contextual manner (the trend has also been followed in the UN context).

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6.5. The “contextual definition” of royalties in the Commentary on Article 12 OECD Model 6.5.1. The move towards a “contextual definition” of royalties In the period between 1977-2017, especially since 1992, the Commentary on Article 12 of the OECD Model has gradually tried to introduce contextual elements to clarify the definition of royalties, probably with the goal of avoiding the conflicts of classification of income or overlapping between articles 7, 12 and 13 of the OECD Model that derive from the possibility to resort to domestic law to attribute a meaning to the undefined terms used in the royalty definition. The move has always gone in the direction of narrowing down the royalty definition so as to avoid the impact of withholding taxes when they are applied to royalties and therefore has expanded the scope of articles 7 or 13 of the OECD Model. This trend has not only worked in favour of states that are capital exporters of technology (the narrower scope of the royalty article, the less withholding taxes will their companies pay in the source country) but has also shown companies of those countries how to plan their business in the state of source in order to avoid paying taxes there with the simple use of the Commentary on Article 12 of the OECD Model. It is therefore natural that source countries have resisted this trend either by not accepting the changes in the Commentary on Article 12 of the OECD Model (through reservations, observations or positions of nonmember countries) or have tried to reduce their effects by interpreting the royalty definition broadly or trying to recharacterize transactions in order to give effect to withholding taxes at source on royalties. Once again, conflicts of classification will arise as the natural consequence of divergent views on whether the Commentary on Article 12 of the OECD Model, as added from time to time, has effect or not upon the tax treaties of a country. Two examples in the Commentary on Article 12 can be used to illustrate these ideas: (i) the concept of “use” and “sale”, and (ii) the concept of know-how and technical assistance.

6.5.2. The contextual definition of “use” and “sale” in the Commentary on Article 12 OECD Model The concept of “use” is a fundamental feature of the royalty definition in article 12 of the OECD Model since, if there is a sale of one of the assets

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or rights referred to in that article, the transaction would fall within the scope of article 13 and not article 12 of the OECD Model. A first move to reduce the scope of article 12 in the preparatory works of the 1963 OECD Draft Model was to remove sales from the scope of the article to include them within the capital gains article. From that moment, it was crucial to differentiate between grant of a licence (“use”) and sale of assets or rights included in the royalty definition. If the definition of the concept of “use” is left to domestic law, there can be problems of classification because the same transaction (e.g. a leasing contract if the royalty definition includes payments for use of equipment, a software licence, a supply of know-how) can be regarded as “use” by a country and “sale” by another one. Since 1977, there is a trend in the direction of defining the concept of “use” regardless of what domestic law does. In 1977, paragraph 9 of the Commentary on Article 12 of the OECD Model included a definition of use that relied on the substance of the transaction and the real intention of the parties. The real will of the parties had to be inferred from the circumstances of the transaction to deduct whether they intended a “lease” (royalty) or a “sale”/“finance lease” of equipment (business profits or capital gains). Although that paragraph was deleted from the Commentary on Article 12 when payments for use of equipment were removed from the royalty definition in 1992, the definition of “use” by taking into account the “essential features” of the transaction was transferred, also in 1992, to the Commentary on Article 12 on “software payments” in order to differentiate “licences of software” that could be assimilated to sales from those that really granted to the licensee the use and right to exploit software. Later on, in 2000 and 2008, this definition of use in the Commentary on Article 12 was extended to any transaction. As a consequence, nowadays there is a “contextual definition” of “use” in the Commentary on Article 12 of the OECD Model that has a general application, takes into account the substance of the contracts and the real intention of the parties as well as the rights and obligations they assume. The name of the contract (e.g. “licence”) is irrelevant since the Commentary prefers to pay attention to the essence of the transaction, not to its name or form (paragraph 8.2 in general, paragraphs 12-17 for software and paragraphs 17.2-17.4 for digital products). In addition, “use” has also been attributed another very relevant feature in the changes to the Commentary on Article 12 of the OECD Model in 1992. After the 1992 software commentaries, “use” was identified with acquisition of the right to commercially exploit the rights granted to the licensee, not only with use of the intangible as such in, for instance, business activities of the licensee. This means that the granting of a licence for non-commercial 129

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exploitation or self-consumption (as a consumer or as an enterprise that uses the licence for business purposes) will not generate a royalty but only business profits (paragraphs 12.2 and 14 of the Commentary on Article 12 of the OECD Model, which was added in 1992, as a consequence of the OECD’s Software Report,12 although paragraph 14 was modified in 2000). Therefore, the definition of “use” in the Commentary on Article 12 of the OECD Model (“contextual definition of use”) has two features: the essence of the transaction (and not its form) is crucial and “use” is identified with the acquisition of the right to commercially exploit the intangible whose use was granted to the licensee. The contextual definition of use in the Commentary on Article 12 of the OECD Model sought two effects. First, it permits the interpreter to avoid resorting to domestic law to define whether there is “use” or “sale”. Since a number of states do not permit in their legal order the sale of certain rights (e.g. copyrights, know-how, software) and only admit licences, the contextual definition provokes the exclusion of domestic law to characterize the payments. The concept of use is therefore independent from domestic law classifications: regardless of domestic law, if the essential features are those of a sale, the payment must be classified as business profits or capital gains, not as a royalty, and the other way round, if the material features of the transaction are those of “use”, there will be a royalty and not a sale, no matter what the consequences of applying domestic law are. Second the contextual definition of use severely limits the scope of the royalty concept and the rights of source countries where withholding taxes apply since, in the end, (full or partial) material sales are included within the scope of articles 7 or 13 of the OECD Model and therefore excluded from the scope of the royalty article. The main consequence is that regardless of domestic law, “material sales” should avoid withholding taxes when the source country applies them in its tax treaties (if, of course, the source country accepts the OECD Commentary as a relevant source of interpretation of its tax treaties). The effect of these changes for states that are importers of technology were really important: most of the software licences/digital transactions were removed from the scope of the royalty article. Therefore, as long as the “seller” of the licence did not have any presence in the source state, there would not be taxation there for the non-resident, but still the tax base of the country could be eroded by deductible payments made by enterprises 12. OECD, The Tax Treatment of Software (1992).

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(individuals or companies) “purchasing” licences from foreign companies. Since the Commentary also admitted that partial sales of rights (e.g. exclusive granting of all rights on IP for a limited period or in a limited geographical area) will not be regarded as royalties, this facilitated enormously the work of tax planners in the cases that the specific tax treaty provided for taxation of royalties at source: regardless of domestic law, it was enough to organize a transaction as having the features of a full or partial sale in order to avoid the application of the royalty withholding taxes. This explains why some countries do not accept the Commentary on partial sales and tend to characterize those transactions as giving rise to use and therefore to royalties. The evolution towards a contextual definition of “use” and “sale”, however, coexists with paragraphs 8.2, 12.2 and 18, which still attribute importance to domestic IP law. Therefore, the Commentary on Article 12 of the OECD Model seems to accept two different (and, to a certain extent, contradictory) approaches to define whether there is use or sale since, in the end, the move towards a definition of use in view of the essential features of the transaction cannot be easily accommodated with the references in the Commentary on Article 12 of the OECD Model to domestic law. This “contradiction”, together with the fact that many states did not accept the most controversial changes to the OECD Commentary (e.g. the 1992 software commentaries or the possibility of partial sales of rights over property or assets mentioned in article 12(2) of the OECD Model), permits conflicts of classification and overlapping to arise quite easily: countries and companies wishing to avoid the application of source country withholding taxes upon royalties will always tend to resort to the contextual definition of use, whereas source countries will be more comfortable with using the paragraphs of the Commentary on Article 12 that permit them to apply domestic law (apart from the many observations and reservations to the OECD Commentary on the most controversial aspects of the changes of 1992, 2000 and 2008). It can be added that developing countries have learnt the lesson and the impact that commentaries to treaty models can have and, for instance, in the UN context, there is work going on to try to reintegrate some software payments to the royalty article by changing and differentiating the Commentary on Article 12 of the UN Model from those of the OECD (see section 6.7.). As can be easily inferred from the above, the current situation (coexistence of different approaches or intrinsic “contradictions” in the Commentary on Article 12 of the OECD Model between contextual and domestic law approaches, not universal acceptance of the changes to the Commentary on Article 12 of the OECD Model and the, still timid, emergence of an 131

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alternative context in the UN Model) is a breeding ground for conflicts of classification and overlapping between articles 7, 12 and 13 of the OECD/ UN Models. These conflicts will not be easily resolved in mutual agreement procedures (MAPs) or even the kind of arbitration promoted by article 25 of the OECD Model (2017) or part VI of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI). Although those conflicts can affect any company, they are especially problematic with regard to digital transactions (e.g. software as an application, infrastructure or storing, software distribution, access to databases) since, in the end, the software/digital transactions Commentary on Article 12 of the OECD Model is the least accepted by countries applying withholding taxes at source for royalties, as shown by the fact that in the UN context there seems to be a will to create an alternative context with regard to software payments (see section 6.7.).

6.5.3. The contextual definition of “know-how” and the problems of technical assistance The evolution of know-how in the Commentary on Article 12 of the OECD Model also illustrates the origins and causes of conflicts of classification with regard to royalties/services and why they are so frequent. In the preparatory works leading to the 1963 OECD Draft Model, Working Party 8 of the, by then, OEEC defined royalties in February 1958 as payments for (i) patents, designs and processes, trademarks or similar rights or manufacturing processes and (ii) supply of information concerning industrial and commercial experience (the reference to scientific experience was added later).13 In the negotiation process with the representatives of different countries, the reference to “formulas or secret processes” was added.14 In this evolution, the expression “supply of information” intended to cover technical assistance, show-how and probably, some technical services. Know-how was included under other references and, especially, that to secret formula, which, as mentioned, was added later in 1958. In this first stage, the royalty concept therefore included payments for know-how and technical assistance (show-how). 13. WP 8’s Report of 12 February 1958, OEEC, Report on the direct taxation of patent royalties and similar payments, FC/WP8(58)1 (12 Feb. 1958), p. 2., available at http:// taxtreatieshistory.org/data/html/FC-WP8(58)1E.html (last accessed 20 Dec. 2017). 14. Minutes of the 8th Session of the Fiscal Committee, 6-7 May 1958, FC/14(58)3, pp. 8-9. On this issue, see Vann, supra n. 7, at pp. 194-195 and Szücs-Hidvégi, supra n. 7, at p. 497.

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However, in 1977, the Commentary on Article 12(2) of the OECD Model linked the concept of know-how with the reference to “information concerning industrial, commercial or scientific experience” and adopted a restricted definition of know-how that excluded technical assistance from the royalty concept. As a consequence, payments for technical assistance were transferred to article 7 of the OECD Model and the scope of the reference in the royalty definition to “information concerning industrial, commercial or scientific experience” was dramatically reduced with the 1977 changes to the Commentary. That change was completed, also in 1977, with the (then) new drafting regarding mixed contracts, which reinforced the expansive force of article 7 vis-à-vis article 12 of the OECD Model to make clear that technical assistance would only fall within the scope of article 12(2) if it was “ancillary or largely unimportant” in connection with the payments that could be regarded as royalties. This new inclusion was also an open invitation to tax planners to break down contracts into different parts when there were withholding taxes for royalties in the source country since, if it could be defended that technical assistance linked with patents, know-how, etc. was relevant (not ancillary or unimportant), the payment for technical assistance would be business income and not royalties, therefore avoiding withholding taxes where they applied to royalties. Needless to say, this move again facilitated tax planning and benefited the states that are net exporters of technology. Later on, the changes in 2003 and 2008 also reinforced the trend of reducing the scope of article 12 of the OECD Model (e.g. when it was made clear that article 12 could only apply to pre-existing know-how). The preparatory works of the 1980 UN Model as well as the Commentary on Article 12 of that Model showed that the OECD’s position in 1977 on know-how, technical assistance or even technical services was not going to be readily accepted by developing countries or countries that taxed royalties at source. In fact, the UN works of 1980 reflected that some countries preferred to stick to the more traditional position, as derived from the Draft 1963 OECD Model, that article 12 of the OECD Model could apply to technical assistance, or even some technical services (e.g. the “make available” provisions in the tax treaties of India is a clarification that the 1977 changes to the Commentary on Article 12 of the OECD Model are not accepted by that country, which prefers to attribute to the royalty definition a broader scope than that recognized by the 1977 changes to the OECD Model). Even some developed countries (e.g. Australia and the United States) have not fully accepted the 1977 modifications and tend to include some types of technical assistance within the royalty definition of their tax treaties.

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Once again, the evolution of the Commentary to define know-how (or rather, supply of information) narrowly for the purposes of article 12 of the OECD Model has had the effect of eroding the royalty definition. But more importantly, since this “cut” in the royalty definition has not been peacefully accepted by especially (although not exclusively) developing countries, there is a lot of potential for classification conflicts in the context of tax treaties. In fact, the controversy on whether payments for technical assistance and some technical services, especially when linked with licences of patents or know-how, are royalties or services is one of the most frequent conflicts of classification that can be found internationally. Moreover, in this context, not all countries apply equally the Commentary on Article 12 of the OECD Model on mixed contracts and therefore aggregation or disaggregation of transactions also contributes to cause more problems of classification.

6.5.4. Conclusions Overlapping between royalties (article 12), on the one hand, and business profits (article 7) and capital gains (article 13) articles of tax treaties, on the other, is directly connected with the evolution of the Commentary on Article 12 of the OECD Model and the fact that it has adopted two different approaches to classification of transactions. First, it admits the relevance of domestic law to find whether there is one of the assets or rights of article 12 of the OECD Model and if it is being used, second, it has evolved towards a contextual definition of some terms of the royalty concept to avoid the problems of resorting to domestic law. The former approach causes problems since, depending on the applicable law, the outcome can be one or another and the same transaction can be viewed differently by the source or the residence state. The latter approach (contextual definition of some terms) is the result of an evolution of the Commentary that has always operated in one direction, the reduction of the scope of the royalty definition, and has not always been accepted by all countries, especially those having the policy of taxing royalties at source, with the consequence again that conflicts of classification and overlapping between articles 7, 12 and 13 of the OECD Model have become common. The treatment of royalties in the OECD Model (no withholding tax for royalties, progressive reduction of the scope of that concept that permits avoiding source withholding taxes where they exist) has also facilitated avoidance of taxation in source countries or base erosion and profit shifting. If no PE exists in the source state, payments of royalties or for concepts excluded from the royalty definition through changes in the Commentary on 134

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Article 12 of the OECD Model will very often entail deductible expenses for the payer that are not matched by corresponding withholding taxation in treaties that follow the OECD Model (in cases of payments by consumers, there will only be no taxation in the source state). Even where withholding taxes for royalties are applied, the contextual definition of “use”, the recognition of partial alienation or rights as “sales”, the concept of know-how admitted in the Commentary, the exclusion of technical assistance from the concept of royalties and the principles applicable to “mixed contracts” enormously facilitate by-passing the royalty concept and reduce its effect for source countries. As a matter of fact, for companies in, for instance, the audiovisual, Internet, software sectors, it is easy to structure value chains where a non-resident entity without a PE will “sale” products to final consumers (either private individuals or companies) in the market state. That is to say, the definition of sale that takes into account the essence of the transaction regardless of the source country legislation and the orientation of the royalty concept to payments for acquisition of the right to exploit an asset or right included within the royalty concept (to which the Commentary of the OECD Model on distributors, paragraphs 10.1 and 14.4 could be added) make it possible that all transactions in a country with end-consumers could escape from any taxation there (provided, of course, there is no PE in that country and disregarding VAT issues). In those cases where physical presence in a country is necessary (e.g. with a subsidiary of the MNL group), the Commentary on Article 12 of the OECD Model also offers some advice on how to avoid source country taxation for royalties: once that paragraph 8.2 (after 2008) admitted partial sales of rights that are limited geographically or for a period, it would be enough to structure the grant of a licence as a partial sale to reduce the exposure to withholding taxes for royalties. A similar effect occurs with the rules on mixed contracts (paragraph 11.6 of the Commentary) that permit to treat differently, from a source country perspective, parts of a contract that are not ancillary or largely unimportant and that are an invitation to disaggregate contracts to reduce exposure to withholding taxes at source for royalties. It will be difficult to attack those behaviours that try to reduce withholding taxes at source for royalties since, in the end, they are legitimized by and find support in the Commentary on Article 12 of the OECD Model. In this context, the attempts of some countries to react via expansive interpretations of the royalty concept will produce conflicts of classification and more overlapping.

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It is natural, in view of that evolution, that source countries either do not accept the most controversial changes to the Commentary on Article 12 of the OECD Model or simply try to stick to the relevance of domestic law, which is also admitted in the Commentary, and to interpret broadly the royalty definition. The natural consequence of this situation is overlapping and conflicts of classification between royalty, business profits and capital gains articles.

6.6. BEPS and overlapping of articles 7, 12 and 13 OECD Model In view of what has been explained in section 6.5., it is surprising that BEPS has not dealt with the problems of base erosion and profit shifting connected with royalty payments (with the exception of the special tax regime provisions in Action 6 BEPS)15 and has even admitted that royalty payments can be taxed nowhere, permitting double non-taxation or low taxation of this type of income. This is the consequence of the joint effect of article 12 of the OECD Model and BEPS Actions 5 (with the patent boxes regimes that permit no taxation of royalties), 6 (with a limited concept of abuse that is subsidiary to the application of transfer pricing rules) and 8-10 (with their over attribution of corporate profits to intangibles and risk management). It can even be said that BEPS may have the effect of facilitating BEPS for royalty income.16 Regardless of the fact that “BEPS may potentiate BEPS” behaviours in connection with royalties, it may also create other problems in terms of overlapping between articles 7, 12 and 13 of the OECD Model. As known, Actions 8-10 of BEPS follow an economic approach to intangibles so that income from intangibles should accrue to the parties that perform development, enhancement, maintenance, protection and exploitation (DEMPE) functions with regard to those intangibles, who bear the risks of intangibles associated with the DEMPE functions and have the capacity to bear those risks, or parties who provide assets and funds for the development of the intangibles. The (new) transfer pricing principles derived from Actions 8-10 15. See OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 Final Report (2015), paras. 79-81. The special tax regime proposals were not included within the MLI. 16. On this issue, see this author’s work, Tax Avoidance and Aggressive Tax Planning as an International Standard – BEPS and the “New” Standards of (Legal and Illegal) Tax Avoidance, in Tax Avoidance Revisited in the EU BEPS Context (A.P. Dourado ed., EATLP and IBFD 2017).

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of BEPS and now enshrined in chapter 6 of the OECD Transfer Pricing Guidelines 2017 have the potential of creating conflicts between different countries since transfer pricing rules, as derived from Chapter 1 of the OECD Transfer Pricing Guidelines 2017, not only permit corrections on the amount of royalties but also on the entitlement to royalties and the nature of the transaction (delineation of transactions and non-recognition principles of Chapter 1 of the OECD Transfer Pricing Guidelines 2017, as derived from Actions 8-10 of BEPS). However, unlike the transfer pricing approach to intangibles, article 12 of the OECD Model is still based on a legal approach to the entitlement of royalties with the corrections that may be derived from the concept of beneficial ownership or domestic or treaty anti-avoidance rules. The different approaches between transfer pricing rules and article 12 of the OECD Model are admitted by the OECD in Chapter 6 of the OECD Transfer Priding Guidelines 2017, paragraph 6.13, but, in reality, there is less independence between article 12 and transfer pricing “delineations”/“recharacterizations” than it may be thought at first sight and the OECD seems to assume. For the purposes of this chapter, these two different approaches (economic transfer pricing approach to intangibles versus the legal approach of article 12 of the OECD Model subject to the corrections of the beneficial ownership test and general anti-avoidance rules (GAARs) or specific anti-avoidance rules (SAARs)) have the potential of also creating conflicts of allocation of income and overlapping if the same transaction is perceived differently by all the countries involved. There is probably a need of reconciling both approaches since simply saying that transfer pricing rules and article 12 of the OECD Model are independent rather than being the solution is the cause of the problem.17 It is true that the concept of intangible for transfer pricing purposes and the definition of royalties in article 12 of the OECD Model have very relevant differences, but it is also no less certain that royalties in article 12 and for transfer pricing purposes, in cases where the payments fall within the royalty definition and take place between associated companies, should be approached by using the same techniques in order to avoid asymmetric outcomes and conflicts of classification. For the OECD, in a context where article 12 does not provide for withholding taxes, conflicts may be irrelevant but that will not be the case when tax treaties provide for withholding taxes at source for royalties. The idea of giving priority to 17. Para. 6.13 of the OECD Transfer Pricing Guidelines 2017 explains that “the manner in which a transaction is characterized for transfer pricing purposes has no relevance to the question whether a particular payment constitutes a royalty or may be subject to withholding tax under Article 12”.

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transfer pricing rules in the new BEPS context as anti-avoidance devices should also give pre-eminence to transfer pricing in resolving disputes and applying article 12 of the OECD Model, but not all the states may see it the same way (also because the value added chain analysis and the DEMPE functions approach to intangibles and how to apply them is difficult, admits discretion, there is little guidance on how to do it and is open to different interpretations).

6.7. Building blocks? Conflicts of classification and the emergence of an “alternative UN context” for the taxation of royalties Dissatisfaction with the evolution of thresholds for source taxation in the context of the OECD Model (particularly with regard to the PE concept and royalties) but also with the BEPS outcomes have moved countries and the United Nations to propose alternative systems. In this regard, the UN’s move towards more source country taxation stands out. The changes to the UN Model in 2017 or currently being studied in the UN may solve some of the problems of classification and overlapping in the OECD Model, but they may also create new ones, and, in addition, may also have an impact on the effects of the Commentary on Article 12 of the OECD Model. Before 2017 there were already very relevant differences between article 12 of the OECD and UN Models and their Commentaries since some relevant parts of the evolution of the Commentary on Article 12 of the OECD Model were not accepted in the UN context, but this contribution will focus on the new issues that emerge with the new 2017 UN Model.18 First, the 2017 UN Model has a new article 12A that deals with taxation of technical services. This article permits the source country to tax payments for technical services provided by non-residents without a PE in the country of the payer on a gross basis.19 From a tax policy standpoint, it resembles, although it is not completely equal to, article 12 (royalties) of the UN Model. Like article 12 of the UN Model, article 12A does not fix a withholding tax rate. 18. For a detailed explanation of the differences between art. 12 of the OECD and UN Models, see, in general, Martín Jiménez, Article 12: Royalties, supra n. 1, especially secs. 3.1.2. and 5. 19. The fact that a treaty permits a country to tax payments on a gross basis does not impede domestic legislation to permit deduction of expenses that are directly connected with that income or to provide for specific incentives for certain types of royalties. See Martín Jiménez, Article 12: Royalties, supra n. 1, secs. 1.1.2.1. and 1.1.2.4.

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Building blocks? Conflicts of classification and the emergence of an “alternative UN context” for the taxation of royalties

If the royalty and technical services articles of a tax treaty have the same withholding tax rates, the effect of the new article 12A (technical services) of the UN Model will be that the problems of overlapping of the OECD Model will be reduced in the UN Model context, as well as possibilities of organizing transactions to avoid withholding tax at source for royalties (e.g. by breaking down contracts into two parts, one on royalties and another that refers to technical assistance or services connected with royalties). In that context, it will be irrelevant to classify a payment as royalties or technical services since, in the end, the same withholding tax rates will apply. However, other problems of classification may emerge since, in tax treaties that include both a royalty and a technical services article, it will be necessary to differentiate between services captured by the new article that have a “technical nature” (as defined by the new article 12A, services of a managerial, technical or consultancy nature that involve the application by the service provider of specialized knowledge, skills or expertise) and nontechnical services. The distinction between general and specific services is not very clear.20 In this regard, the idea that technical services are not routine services may help,21 but is not completely self-evident: it is not that simple to differentiate when, for instance, a database, a hosting contract or any other case of contracts involving software as application is general or specific. The experience of countries like Spain that tried to differentiate for the purposes of article 12 of the OECD and UN Models between “general” and “specific” software or databases is not very promising since there have been endless disputes on whether a software or database is general or specific. Recently, also Germany, for instance, abandoned the controversial distinction between standard and specific software and databases in the circular released on 2 November 2017 to accept the principle recognized in the Commentary on Article 12 of the OECD Model (1992-2017) that there will be royalties only where payments refer to the acquisition of the right to exploit or commercialize the software or database.22 The broad nature of the technical services definition, however, may make disputes less likely 20. See, for instance, A. Baez, The Taxation of Technical Services under the United Nations Model Double Taxation Convention: A Rushed – Yet Appropriate – Proposal for (Developing) Countries?, 7 World Tax J. 3, sec. 3.2.1.2.2. (2015) Journals IBFD. The present author also referred to that problem in Martín Jiménez, Article 12: Royalties, supra n. 1, at sec. 5.1.8.5.4., where it was held that even some of the examples added in the Commentary to the technical services article (by then in draft model at the time of writing) were confusing. 21. B. Arnold, The New Article on Fees for Technical Services, in ITP@20: 1996-2016 p. 170 (H.D. Rosenbloom ed., NY University School of Law 2016). 22. See PwC, German tax authorities release circular on non-resident taxation of royalties for software and databases, available at https://www.pwc.com/us/en/tax-services/ publications/insights/german-tax-authorities-release-circular-on-taxation-of-royalties.html (last accessed 20 Dec. 2017).

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than in the case of differentiating between services and royalties (as well as the proposed changes to article 12 of the UN Model on software payments commented below). If, however, different withholding tax rates are used in the royalty and technical services article, the problems of conflicts of classification will not only resurface but will dramatically increase in this context: there will be overlapping not only between articles 7, 12 and 13 (and 14) but also with the new article 12A of the UN Model. This is probably the worst scenario. Additionally, the new (and proposed) changes to the Commentary on Article 12 of the UN Model (2017) may also contribute to exacerbate overlapping and problems of classification in a global context. First, the new definition in the Commentary on Article 12 of the UN Model (2017) of “use” of equipment may reflect the fact that “use”, for some countries (not only developing countries, i.e. Germany), does not involve physical possession of the equipment, which may produce the outcome of giving countries that follow article 12 of the UN Model and defend that position the right to tax payments connected with use of satellite capacity, cables, pipelines, networks, etc. that the payer does not operate.23 In the OECD context (paragraphs 9.1 through 9.3 of the Commentary on Article 12 of the OECD Model, added in 2010) it is clear that payments for use of equipment will only be included within the pre-1992 definition of royalties when the payer operates the equipment, but not when the provider of the services has the physical possession of it.24 Second, although they have not yet been accepted, there have been proposals to modify the Commentary on Article 12 of the UN Model in order to include within the scope of the royalty definition any payment for use of software, therefore departing from the OECD’s consensus and broadening the scope of the royalty definition.25 These proposals are mainly justified 23. At the time of writing, the final version of the UN Model (2017) had not yet been published, in connection with options to tax payments for use of equipment which is not in the possession of the payer, see the UN document Possible Amendments to the Commentary on Article 12 (Royalties) (Note by the Coordinator, Ms Pragya Saksena), E/C.18/2016/ CRP.8 (5 Oct. 2016). The concept of “use” will also be clarified to differentiate between “use” and “sale” of equipment in a similar form as in para. 9 of the Commentary on Article 12 of the OECD Model, although with a bit more precision and in line with IAS 17. 24. The changes on the definition of industrial, commercial or scientific equipment or on how to determine from the outset in a transaction whether there is a sale or lease are less relevant for the purposes of this chapter. 25. See the UN document, supra n. 23 or the document Software Payments as Royalties under Article 12, E/C.18/2017/CRP.25 (5 Oct. 2017).

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Conclusions

by the fact that enterprises, as commented above, have an increased ability to directly interact with customers through the Internet and there is virtually no longer any need to transfer to source country distributors the rights to copy and distribute software. If the Commentary of the UN Model is finally expanded to cover any payment for software (or only base-eroding payments or a more limited formula), this would be a significant departure of the OECD consensus and, depending on whether the specific country defends the OECD’s position on software payments or the (proposed) UN position, there can be conflicts of classification/overlapping between the business profits, capital gains articles and the royalty article. As a consequence of the changes in the UN Model in 2017 (article 12A) and the Commentary on Article 12 (those already accepted or proposed), it seems that the UN is addressing the problem of base erosion with more withholding taxes for some types of services and a broadened concept of royalties that also reinforces the position of source countries. Due to the failure (so far) of Action 1 of BEPS on the digital economy, the new UN context may be a (partial) solution to the problems of no taxation at source of digital economy companies, at least with regard to royalties and the most important types of remote (technical) services. But more importantly from the perspective of this work, the new context for tax treaties represented by the UN Model may have a strong impact on conflicts of classification since, if treaties adopt the new article 12A or countries decide to abandon the OECD consensus and adopt the new positions in the UN Model on royalties (on “use” of equipment or, if finally adopted, on “software”), those conflicts may even be more common and problematic than they are nowadays. The new UN Model (2017) therefore represents an alternative position to the OECD’s view and the UN concept on royalties plus the new provision on technical services now supports more strongly the position of source countries that try to define royalties in a broader manner, with the consequence that conflicts of classification will not be easy to resolve either in MAPs or in arbitration (if that possibility is available) if one country accepts the new UN’s context and the other one sticks to the OECD’s consensus.

6.8. Conclusions Overlapping between articles 7, 12 and 13 of the OECD Model is directly connected with the “fight for tax bases” between exporters and importers of technology (developed versus developing countries) and the controversial evolution of article 12 of the OECD Model and particularly its Commentary over the years. This evolution has left a Commentary on Article 12 that has 141

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always operated in the direction of protecting residence states in a constant move of reduction of the scope of the royalty concept that was seeking to have a relevant impact upon the withholding taxes for royalties that some states apply. It is therefore natural that the latter have resisted that evolution and tried to interpret the concept of royalties differently either with express reservations, observations in the OECD Model or simply in domestic decisions or trying to have their positions recognized in the UN context. As a consequence, the Commentary on Article 12 of the OECD Model very much resembles an unfinished job where it is not clear when domestic law or which domestic law (source, residence or third state) should apply or when to use contextual meanings that have been developed mainly since 1977 to overcome the problems of referring to domestic law. Overlapping and conflicts of classification are therefore common in view of the (i) clash of interest between different states in the royalty context and (ii) the current state of the Commentary on Article 12 of the OECD Model. In the OECD context at least, some revision of the Commentary on Article 12 may be needed if only to make clear when and how to apply domestic law or when and how context displaces it. It is evident that immaterial rights, to which article 12 of the OECD Model refers, are sons of legal systems and that depending on the one applied, the outcome may be one or another; these ideas and which domestic law controls a transaction or when a contextual definition that excludes domestic law should apply should be more prominent in the Commentary on Article 12 of the OECD Model. Some sorting out or consideration of changes in the Commentary on Article 12 may therefore be convenient even if that may involve opening a Pandora’s box. It is presumed that harmonization between the OECD and the new UN context is more difficult, but the current context of revision of taxation of the digital economy may be a good opportunity for a broader consensus. In parallel to the OECD Model, article 12 of the UN Model and its Commentary have picked up some of the claims of “importers of technology” and their disagreement with the evolution of the OECD Model. But, more importantly, with the 2017 changes to the UN Model, they probably represent a new and completely different scenario or context. The new article 12A of the UN Model for technical services and the changes to the Commentary on Article 12 of the UN Model can be presented as a new international standard that may resolve some of the overlapping in the OECD context (only if technical services and royalties are applied the same withholding tax rates) but may create other problems of classification (the distinction between royalties and technical services on the one hand and general services on the other). This new standard offers good grounds 142

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to some states not to use the Commentary on Article 12 of the OECD Model because the UN Commentary may be more supportive of their positions. In view of the evolution of the OECD and UN Models, it appears that conflicts of classification and overlapping between the business profits, royalty and capital gains articles in those models are likely to increase in future rather than being reduced unless some action is taken. It is curious in this context that the current international debate on taxation of the digital economy in the OECD (Action 1 of BEPS and its aftermath) or the European Union is focusing on completely new solutions and does not pay attention to how to “sort out the mess” with regard to the taxation of royalties, business profits and capital gains and whether more source country recognition of rights for royalties and services along the lines proposed by the UN will not be enough for source countries without turning the international tax order upside down with new radical initiatives. It is common to hear nowadays that a reduction of the PE threshold for business profits is needed, but not much attention is paid to the fact that article 12 of the UN Model, now complemented by brand new article 12A, already represents a substantial lowering of the PE threshold of the OECD Model. Rather than new solutions outside the current structure of the international tax system, exploring the potential and effects of the UN Model (2017) thresholds for taxing business profits, probably complemented by some not so radical changes in transfer pricing, will not only contribute to resolve problems of classification and overlapping explored in this contribution but also to preserve the long-standing structure of the current international system and approximate again the UN and OECD Models while at the same time giving an answer to the legitimate claims of source countries.26 26. There is evidence that Action 7 of BEPS changes to art. 5 of the OECD Model, together with Actions 8-10 of BEPS, have pushed companies to change “commissionaire agreements” into buy-resell/distributor models (see OECD/G-20, Tax Challenges Arising from Digitalisation – Interim Report 2018, paras. 253, 262, 273 and 309, or S. Soong Johnston, Facebook Restructures Amid Digital Economy Tax Debate, 88 Tax Notes Intl., pp. 1169-1170 (2017)), an outcome that the present author already pointed out in Martín Jiménez, Chapter VII: Preventing avoidance of permanent establishment status, in UN Handbook on Selected Issues in Protecting the Tax Base of Developing Countries secs. 4.2. and 6.5. (A. Trepelkov, H. Tonino & D. Halka eds., 2nd edn, UN 2017). As the UK and Australian diverted profit taxes show, unless the reduction in PE thresholds is coupled with measures that affect royalties (as well as services), there will not be effective protection of the source state tax base. Art. 12A plus the royalty withholding taxes of art. 12 of the UN Model can probably represent a fair solution if also complemented with a more balanced approach to transfer pricing. For an overview and criticism of the most relevant new radical solutions that try to resolve the problems of taxation of the digital economy companies, see W. Schön, Ten Questions about Why and How to Tax the Digitalized Economy, Max Planck Institute for Tax Law and Public Finance Working Paper 2017, 11.

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Part Four

International Developments

Chapter 7 Royalties in the Context of the Multilateral Instrument, the Principal Purpose Test and the Limitation on Benefits Provision by Sophie Chatel1

7.1. Introduction With the globalization of the economy and the increasing mobility of certain assets, such as intangible property, tax administrations around the world are facing sophisticated tax strategies designed to reduce the corporate tax paid by multinational enterprises and to “mine” the benefits set forth in tax treaties. Historically, national tax systems emerged to finance social programmes and national priorities. Today, multinationals are using tax avoidance strategies, such as “treaty shopping”, that exploit gaps and mismatches in tax rules to artificially shift profits to low- or no-tax locations. Treaty shopping is not a defined term but it generally refers to strategies by which a person takes advantage of a tax treaty between two countries (not being a resident of either country themselves) by establishing an entity in one of the countries for the purpose of obtaining treaty benefits from the other country in a way that was not intended.2 Allowing persons who are not directly entitled to treaty benefits (such as the reduction or elimination of withholding taxes on dividends, interest or royalties) to obtain these benefits indirectly through treaty shopping would frustrate the bilateral and reciprocal nature of tax treaties. The consequences of treaty shopping remained subtle for many years, but the G20/OECD Base Erosion and Profit Shifting (BEPS) project highlighted how this practice had been an important cause and facilitator of BEPS. At the same time, some countries had become more aggressive in attracting foreign capital through, for example, preferential regimes and extensive

1. Head of the Tax Treaty Unit, Centre for Tax Policy and Administration, OECD, Paris. 2. See OECD Income and Capital Model Convention and Commentary: Commentary on Article 29 para. 4 (21 Nov. 2017), Models IBFD.

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and generous tax treaty networks, accelerating the steady erosion of the tax base in many countries. The BEPS Project was an international effort to address this global problem. It marked an important step towards an ideal international tax system under which national governments unite in a concerted effort to level the playing field, reduce discrepancies between national tax systems and nudge them towards a common and sustainable standard. But the international political scene remains divided and therefore any progress is to be applauded. Over the last few years, more than 100 countries have set aside their divisions and united to create new standards to address the problem of base erosion and profits shifting. The Action Plan on BEPS identified 15 actions to address BEPS in a comprehensive manner. In October 2015, the G20 Finance Ministers endorsed the BEPS Package, which included a report on Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances). This report proposes a new standard to deal with the problem of treaty shopping and other aggressive tax strategies. These new standards are being implemented in the laws of countries in a cohesive and harmonized way. Today, over 78 countries and jurisdictions are in the process of implementing these standards through the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (Multilateral Instrument). The Multilateral Instrument will update over 1,200 tax treaties to introduce new standards that will restore the integrity and balance to bilateral tax treaties. This chapter will examine, through a real-life example of treaty shopping, how seemingly small changes such as the modification of the preamble to treaties and the addition of an anti-abuse provision could have a significant impact, not only by protecting the tax base from being eroded, but also in terms of how the international community can work efficiently together to find common solutions to worldwide problems.

7.2. The BEPS Project and Action 6 (prevention of tax treaty abuse) The Report on Action 6 identifies treaty abuse, and in particular treaty shopping, as one of the most important sources of BEPS concerns. The minimum standard on treaty shopping included in the Report on Action 6 is one of the four BEPS minimum standards. Each of these minimum standards is subject to a peer review to ensure timely and accurate implementation and thus 148

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safeguard the level playing field. All members of the Inclusive Framework on BEPS have committed to implementing the Action 6 minimum standard and to participating in the peer review on an equal footing. The minimum standard on treaty shopping described in the Report on Action 6 first commits countries to include in their treaties an express statement that the common intention of the parties to the treaty is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements. This should generally be done by amending the preamble of the tax treaties. Second, the Action 6 minimum standard requires that countries amend their tax treaties to include treaty provisions to prevent treaty shopping. Countries also agreed that some flexibility in the implementation of this minimum standard is required as these provisions need to be adapted to each country’s specificities and to the circumstances of the negotiation of bilateral tax treaties. The Action 6 Report therefore allows countries to implement the minimum standard by adopting one of the following three provisions: (i) the principal purpose test (PPT) rule together with either the simplified or the detailed version of the limitation-on-benefits (LOB) rule that appears in paragraph 25 of the Report, as subsequently modified; (ii) the PPT rule on its own or (iii) the detailed version of the LOB rule together with a mechanism (such as a treaty rule that might take the form of a PPT rule restricted to conduit arrangements or domestic anti-abuse rules or judicial doctrines that would achieve a similar result) that would deal with conduit arrangements not already dealt with in tax treaties.

7.3. Implementation of the Action 6 minimum standard to prevent tax treaty abuse 7.3.1. Title and preamble of tax treaties As the title and preamble form part of the context of the tax treaty and constitute a general statement of its object and purpose, they play an important role in the interpretation of its provisions.3 According to the general rule of treaty interpretation contained in article 31(1) of the Vienna Convention on the Law of Treaties, “[a] treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose.”

3.

Para. 16.2 Introduction OECD Model (2017).

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As a result of the BEPS Project, the title and preamble4 of the OECD Model (2017) now include a reference to the elimination of double taxation and the prevention of fiscal evasion or avoidance. Paragraph 1 of the Introduction to the Model defines juridical double taxation as “the imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same subject matter and for identical periods”. Paragraph 5 of the Commentary on Article 9 of the Model defines economic double taxation as the “taxation of the same income in the hands of different persons”. These changes expressly recognize that the purpose of tax treaties is not just the elimination of double taxation and that countries do not intend the provisions of their tax treaties to create opportunities for non-taxation or reduced taxation through tax evasion and avoidance. Given the particular BEPS concerns arising from treaty shopping arrangements, it was also decided to refer expressly to such arrangements as one example of tax avoidance that should not result from tax treaties, it being understood that this was only one example of tax avoidance that the contracting states intended to prevent.5 In the context of royalties, instances of low taxation or reduced taxation often involve countries that have enacted preferential regimes (patent boxes) or countries that do not have a comprehensive corporate income tax system. This does not mean, however, that if the income is not subject to tax in a country, the provision of tax treaty benefits would necessarily be against the treaty’s object and purpose. There are situations where tax treaty benefits apply while the particular item of income is not subject to taxation, such as when it is received by governments, pension funds, not-for-profit organizations or companies having deductible losses. The preamble indicates, however, that tax treaties should not create such opportunities through tax evasion and avoidance.

7.3.2. Principal purpose test Having in mind the object and purpose of tax treaties, tax administrations, taxpayers and perhaps courts6 will soon have to look at taxpayers’ transactions and tax treaty benefits in thanks to the introduction of the PPT. 4. Formerly, the Model foresaw the existence of a preamble, but no language was suggested. 5. Para. 16.1 Introduction OECD Model (2017). 6. It is interesting to note that although a “main purpose” test appeared in tax treaty practice in the 1990s, it has not given rise to a known mutual agreement procedure (MAP) or court case.

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Since 2003, the Commentary on Article 1 of the OECD Model has contemplated the inclusion of a general anti-abuse rule to specific types of income in the form of a “main purpose test”.7 This approach denies treaty benefits on dividends, interest and royalties (and other income) in cases where the main purpose or one of the main purposes of any person concerned with the creation or assignment of an interest in property (e.g. shares, debt-claims or rights) is to take advantage of the treaty provision by means of that creation or assignment. Several countries have included this general rule in some or even most of their more modern tax treaties (a provision of this sort is currently found in over 300 tax treaties). The PPT is now found, for the first time, in article 29(9) of the OECD Model (2017). As stated in paragraph 169 of the 2017 OECD Commentary on Article 29, the PPT mirrors the guidance in pre-existing OECD Commentary on Article 1. According to that guidance, the benefits of a tax treaty should not be available where one of the principal purposes of certain transactions or arrangements is to secure a benefit under a tax treaty and obtaining that benefit in these circumstances would be contrary to the object and purpose of the relevant provisions of the tax convention. The PPT incorporates the principles underlying the pre-existing OECD Commentary on Article 1 in order to allow countries to address cases of improper use of their tax treaties. The PPT (article 29(9) of the OECD Model (2017) reads as follows: 9. Notwithstanding the other provisions of this Convention, a benefit under this Convention shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this Convention.

The 2017 OECD Commentary on Article 29 is extensive and explains each of the elements of the PPT, from the concept of “tax benefit” to circumstances under which it would be reasonable to conclude that granting that benefit would be in accordance with the object and purpose of the relevant provisions of a tax treaty.

7.

See para. 21.4 OECD Model: Commentary on Article 1 (2003).

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7.3.3. The LOB provision and its interaction with the PPT As contemplated by the Report on Action 6, some countries may prefer not to use the PPT to prevent treaty abuse, but to adopt instead the detailed LOB provision, which they would supplement by a mechanism to address conduit arrangements not otherwise dealt with by the LOB provision. Or they may prefer to include in their treaty a PPT together with any variation of the LOB provision. Those two variations of the LOB are described in detail in the 2017 OECD Commentary on Article 29. Generally speaking, the provisions of the LOB seek to deny treaty benefits in the case of structures that typically result in the indirect granting of treaty benefits to persons that are not directly entitled to these benefits while recognizing that, in some cases, persons who are not residents of a country may establish an entity in that country for legitimate business reasons. Although these provisions apply regardless of whether a particular structure was adopted for treaty shopping purposes, the LOB allows the competent authority of a country to grant treaty benefits where the other provisions of the LOB would otherwise deny these benefits but the competent authority determines that the structure did not have as one of its principal purposes the obtaining of benefits under the tax treaty. As stated the Report on Action 6, the LOB does not address all forms of treaty abuse; it also does not address certain forms of treaty shopping, such as conduit arrangements through which a resident of country that would otherwise qualify for treaty benefits is used as an intermediary by persons who are not entitled to these benefits.8 Another way to look at the objective of the LOB is to understand that it intends to identify persons that, structurally speaking, are less likely to use a tax treaty for tax avoidance purposes (such as individuals, governments, pension funds, publicly traded companies or actively traded companies). In the case of Bank of Scotland,9 for example, the taxpayer, a publicly traded bank and active business (and therefore a qualified person under an LOB), entered into an arrangement to artificially obtain (and pass on to a US company) benefits provided under the France-United Kingdom tax treaty on dividends. The French Supreme Court (Conseil d’État) had to apply the concept of fraude à la loi (a concept similar to a general anti-avoidance rule) in the context of treaty shopping. The Court denied the benefits of the tax treaty, considering that the 8. See OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 – 2015 Final Report para. 20 (5 Oct. 2015). 9. FR: Conseil d’État (CE) (Supreme Administrative Court), 29 Dec. 2006, Société Bank of Scotland, No. 283314.

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transactions were objectively contrary to the intent of the tax treaty and solely tax motivated. The PPT does not apply to a treaty benefit that has already been denied under the LOB: once a taxpayer has failed to meet any of the tests in the LOB, the door to treaty benefits is closed.10 Conversely, when a taxpayer satisfies the LOB provisions, the benefit provided under the tax treaty is available subject to considering whether, under the PPT, it would be appropriate to grant that benefit. As stated in paragraph 173 of the 2017 OECD Commentary on Article 29, the fact that a company is a qualified person under the LOB does not mean that benefits could not be denied under the PPT for reasons that are unrelated to the ownership of the shares of that company. Also, the guidance provided in the OECD Commentary on the PPT should not be used to interpret the LOB and vice-versa.

7.3.4. The Multilateral Instrument and anti-abuse measures Developed by over 100 countries and jurisdictions, the Multilateral Instrument and its accompanying Explanatory Statement is a groundbreaking tool, allowing countries to rapidly amend their bilateral tax treaty network with a single instrument. The Multilateral Instrument now covers 78 jurisdictions. More jurisdictions are expected to join the Multilateral Instrument in the coming period. But based on the current signatures, it will modify more than 1,200 existing tax treaties. The Multilateral Instrument reflects the treaty-related minimum standards that were agreed as part of the BEPS Package and to which all countries and jurisdictions in the Inclusive Framework on BEPS have committed. These standards relate to the prevention of treaty abuse (Action 6) and the improvement of dispute resolution (Action 14). The Multilateral Instrument further enables signatories to implement virtually all the other tax treaty measures developed in the BEPS Project that are not minimum standards. These include, inter alia, measures on dual-resident companies and fiscally transparent entities, measures to make mutual agreement procedures (MAPs) more effective, including a mandatory binding MAP arbitration provisions (which so far 28 jurisdictions have committed to implement) 10. Technically speaking, a benefit that is denied in accordance with the LOB provision is not a “benefit under the Convention” when looking at the application of the PPT. See para. 171 OECD Model: Commentary on Article 29 (2017).

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and measures to prevent the artificial avoidance of permanent establishment (PE) status. Recognizing the need to accommodate a variety of tax policies, the Multilateral Instrument is a flexible yet robust instrument that provides the possibility to apply optional and/or alternative provisions where there are multiple ways to address BEPS, while not diverging from the BEPS minimum standards. Furthermore, given the importance of countering treaty abuse and improving dispute resolution, some signatories prioritize the implementation of the minimum standard measures, while planning to opt in for other provisions at a later stage. The jurisdictions that have signed the Multilateral Instrument are now preparing for its ratification in accordance with their domestic processes. For the modifications made by the Multilateral Instrument to have effect with respect to an existing bilateral tax treaty, both parties to the tax treaty will have to ratify the Multilateral Instrument in accordance with their domestic procedures, for which the timing will vary between countries. It is anticipated that the first modifications may enter into effect in 2018. The Multilateral Instrument is therefore expected to allow jurisdictions to swiftly implement the treaty-related measures of the BEPS Project and, in particular, the agreed minimum standards under Action 6 to counter treaty abuse, i.e. as discussed earlier, the new preamble and the PPT. In addition, for a few jurisdictions, it will introduce a simplified LOB. The United States is not a signatory to the Multilateral Instrument but has been a frontrunner in the countering of treaty abuse and, over the last 20 years, has included in all of its tax treaties a comprehensive LOB provision and has developed domestic anti-conduit rules.

7.4. Application of the Action 6 anti-abuse standard to cross-border payment of royalties The transfer of intellectual property (IP) and the payment of significant amount of royalties were identified by countries as one of the most important sources of BEPS concerns. To understand those concerns, it is helpful to look at a real-life example of transfer of intangibles and at the

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resulting cross-border payment of royalties. The case of Velcro Canada Inc. v. Canada11 has often been cited as such an example.12 Velcro Canada was in the business of manufacturing and selling fastening products mainly for the auto industry. Velcro’s technology was famously developed by a Swiss engineer and inventor, George de Mestral. He was intrigued by the burdock burrs that kept sticking to his dog’s fur as they hiked in the woods and wondered if it could be turned into something useful. After years of research Mestral translated its affixing and fastening functions into textiles, creating what we now know as “hook-and-loop”. The invention was formally patented in the United States in 1952 (US Patent 2,717,437 filed on 15 October 1952). The Velcro ® Brand fasteners evolved extensively since de Mestral’s invention and even accompanied the first man on the Moon, securing components of Neil Armstrong’s space suite on his famous 1969 trip. According to publicly available information, Velcro companies have a library of more than 450 patents worldwide. Today, they are featured in automobiles and medical devices, as well as personal care, apparel and consumer packaging. Velcro’s Innovation Technology Center is located in Manchester (New Hampshire, US). Velcro Canada paid royalties under a licence agreement to Velcro Industries in the Netherlands for the use of Velcro Brands Technology. In 1995, Velcro Industries changed its residence from the Netherlands to the Netherlands Antilles. Canada did not have a tax treaty with the Netherlands Antilles and therefore any royalties paid by Velcro Canada to Velcro Industries would have been subject to a withholding tax of 25%. Velcro Industries immediately assigned the licence agreement to Velcro Holdings, a subsidiary resident of the Netherlands, while retaining ownership of the Velcro Brand. Under the licence and assignment agreements, 11. CA: Tax Court of Canada (TCC), 24 Feb. 2012, 2012 DTC 1100. 12. Canada, Department of Finance, Consultation Paper on Treaty Shopping – The Problem and Possible Solutions (http://www.fin.gc.ca/activty/consult/ts-cf-eng.asp) (Ottawa: Department of Finance, 12 Aug. 2013) and related Department of Finance news release 2013-102 (http://www.fin.gc.ca /n13/13-102-eng.asp) (12 Aug. 2013); D.G. Duff, Chapter 1: Beneficial Ownership: Recent Trends in Beneficial Ownership: Recent Trends (M. Lang et al. eds., IBFD 2013), Online Books IBFD; B.J. Arnold, Chapter 3: The Concept of Beneficial Ownership under Canadian Tax Treaties in Beneficial Ownership: Recent Trends id.; D. Regan & P. Stepak, Canada, in Tax incentives on Research and Development (R&D) p. 213 (IFA Cahiers vol. 100A, 2015), Online Books IBFD; D.D. Hueppelsheuser & H. Joshi, Canada, in Assessing BEPS: origins, standards, and responses p. 206 (IFA Cahiers vol. 102A, 2017), Online Books IBFD; M. (Martha) O’Brien, Chapter 7: Canada in GAARs – A Key Element of Tax Systems in the Post-BEPS Tax World sec. 7.5.1. (M. Lang et al. eds., IBFD 2016), Online Books IBFD.

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Velcro Canada paid royalties to Velcro Holdings, which in turn paid approximately 90% of that amount over to Velcro Industries (10% corresponded to the withholding tax to be remitted to the Canadian government under the tax treaty). Under the Canada-Netherlands Income Tax Treaty (1986) the withholding tax rate on royalties was limited to 10%. Velcro Canada therefore withheld and remitted a tax of 10% on the royalties paid to Velcro Holdings. Velcro Holdings (Netherlands) regarded itself as the beneficial owner of the royalties, but the Canadian tax authority viewed the situation differently and considered that Velcro Industries (Netherlands Antilles) was the beneficial owner. Velcro Canada was reassessed on the basis that it should have withheld and remitted a tax of 25% of the royalties paid to Velcro Holdings. There was no PPT in the Canada-Netherlands Income Tax Treaty and the Canadian government had been unsuccessful with its general anti-avoidance rule (GAAR) in challenging treaty shopping cases.13 In Velcro, the Canadian tax authority argued that, under the licence agreement, Velcro Holdings was not the “beneficial owner” of the royalties, which was a condition to obtain the benefit of the reduced withholding tax on royalties under the Canada-Netherlands Income Tax Treaty. The Tax Court of Canada concluded that there were four elements to the notion of beneficial ownership: possession, use, risk and control. In the court’s opinion, Velcro Holdings had all of those attributes and was therefore the beneficial owner of the royalty payments. The Canadian courts were evidently reluctant to deny the benefit of tax treaty on the basis on an argument resting on the somewhat vague concept of beneficial owner. The court cited paragraph 7 of the 2003 OECD Commentary on Article 12 which discussed an example with facts similar to the case at bar (the beneficial owner of royalties arising in a contracting state is a company resident in the other contracting state; all or part of its capital is held by shareholders resident outside that other state and it enjoys preferential taxation treatment). The court highlighted the fact that the Commentary recommended, in such case, to negotiate a special provision to define the treatment applicable to such companies.14

13. CA: Federal Court of Appeal (FCA), 13 June 2007, Canada v. MIL (Investments) S.A., 2007 FCA 236; MIL (Investments) S.A. v. The Queen, 2006 TCC 460. 14. See para. 3 of the Velcro decision, supra n. 11.

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Velcro therefore illustrates the need for further guidance for both tax administrations and courts in the area of beneficial ownership and treaty shopping. The Model Commentary on beneficial ownership was significantly changed in 2014. But even if the Canadian court was correct in finding that the beneficial ownership test was satisfied, the way of approaching these cases has completely changed with the Action 6 of the BEPS Project and the introduction of a new preamble and anti-treaty abuse rules such as the PPT. Paragraphs 182 and 187 of the 2017 OECD Model Commentary on Article 29 provide several examples of treaty shopping. Paragraph 182 provides an example where the PPT would apply to deny tax treaty benefits where the right to receive an item of income is assigned to a resident of a tax treaty country: Example A: TCO, a company resident of State T, owns shares of SCO, a company listed on the stock exchange of State S. State T does not have a tax convention with State S and, therefore, any dividend paid by SCO to TCO is subject to a withholding tax on dividends of 25 per cent in accordance with the domestic law of State S. Under the State R-State S tax convention, however, there is no withholding tax on dividends paid by a company resident of a Contracting State and beneficially owned by a company resident of the other State. TCO enters into an agreement with RCO, an independent financial institution resident of State R, pursuant to which TCO assigns to RCO the right to the payment of dividends that have been declared but have not yet been paid by SCO. In this example, in the absence of other facts and circumstances showing otherwise, it would be reasonable to conclude that one of the principal purposes for the arrangement under which TCO assigned the right to the payment of dividends to RCO was for RCO to obtain the benefit of the exemption from source taxation of dividends provided for by the State R-State S tax convention and it would be contrary to the object and purpose of the tax convention to grant the benefit of that exemption under this treaty-shopping arrangement.

As stated in paragraph 182 of the OECD Commentary on Article 29, the examples included in paragraph 187 should also be considered when determining whether the PPT would apply in the case of conduit arrangements. Example C of paragraph 187 provides another example where the PPT would apply to deny the benefit of a tax treaty in a case of assignment of income: Example C: TCO, a company resident of State T, which does not have a tax treaty with State S, loans 1 000 000 to SCO, a company resident of State S that is a wholly-owned subsidiary of TCO, in exchange for a note issued by SCO. TCO later realises that it can avoid the withholding tax on interest levied by State S by assigning the note to its wholly-owned subsidiary RCO, a resident 157

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of State R (the treaty between States R and S does not allow source taxation of interest in certain circumstances). TCO therefore assigns the note to RCO in exchange for a note issued by RCO to TCO. The note issued by SCO pays interest at 7 per cent and the note issued by RCO pays interest at 6 per cent. The transaction through which RCO acquired the note issued by SCO constitutes a conduit arrangement because it was structured to eliminate the withholding tax that TCO would otherwise have paid to State S.

Other actions of the BEPS Action Plan should also help to prevent treaty shopping involving royalties. Preferential regimes continue to be a key pressure area and Action 5 of the BEPS Project (Countering Harmful Tax Practices) focusses on preferential regimes which can be used for artificial profit shifting and on the lack of transparency in connection with certain rulings. The Action 5 Report sets out an agreed methodology to assess whether there is substantial activity. In the context of IP regimes such as patent boxes, agreement was reached on the “nexus approach” which uses expenditure as a proxy for substantial activity and ensures that taxpayers can only benefit from IP regimes where they incurred actual expenditure on R&D. Also, the Actions 8-10 Report (Aligning Transfer Pricing Outcomes with Value Creation) contains revisions to the OECD Transfer Pricing Guidelines to align transfer pricing outcomes with value creation. One of the key areas of the report is transfer pricing issues relating to transactions involving intangibles.

7.5. Conclusion The implementation of the Action 6 minimum standard has been widespread. Countries have started to implement the necessary treaty changes either through the Multilateral Instrument or by updating their tax treaties through bilateral negotiations. The PPT, whether or not supplemented by an LOB, has been designed to stop aggressive tax strategies such as treaty shopping. Mere conduit arrangements that channel royalty income through intermediary companies in low-tax jurisdictions will fall foul of the new rules introduced by Action 6 and other components of the BEPS exercise. BEPS is only a symptom of a more fundamental development: the globalization of markets has allowed multinational corporations effectively to transcend the jurisdiction of tax authorities, whose sovereignty is largely at the national level. There is no comprehensive domestic remedy for problems that jump multiple national borders. Progress made by the G20 and the

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OECD with the BEPS Project shows that countries can come together to find and implement common solutions at the international level. Ensuring the effectiveness of any nation’s tax regime lies with establishing reforms at the international level. Globalization has made more urgent the need to harmonize divergent national corporate tax regimes and the wheels have been set in motion with the BEPS Project. Progress there has created momentum towards a broader agreement in other areas of international taxation. The OECD and the Inclusive Framework is the most logical forum for reaching such an international accord. However, for that vision to become a reality, countries have to realize the benefits of cooperation and the risks associated with inaction.

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8.1. Introduction The transfer of intangible property from a high-tax jurisdiction to a low-tax jurisdiction has been the Holy Grail of international tax planning for many years. The staff of the Joint Committee on Taxation of the US Congress, in explaining changes made by the Tax Reform Act of 1986, provided this succinct description of the economic considerations: There was a strong incentive for taxpayers to transfer intangibles to related foreign corporations … in a low tax jurisdiction, particularly when the intangible has a high value relative to manufacturing or assembly costs. Such transfers could result in indefinite tax deferral or effective tax exemption on the earnings, while retaining the value of the earnings in the related group.2

The success of the planning strategy depends on achieving appropriate tax treaty treatment of royalties or other amounts earned through exploitation of the intangible after the transfer occurs. The large number of reservations on article 12 of the OECD Model, and the issues addressed in other chapters of this volume, reflect the fact that the treatment of such royalties can be contentious. It is therefore surprising that relatively few tax treaties contain rules that directly address the transfer of the intangible itself. There are several possible explanations for this lacuna. First is what appears to be an accident of history (but may actually have been a concerted effort to achieve a desired result). Second is a tendency to trust transfer pricing rules and other anti-abuse rules to ensure that income does not escape taxation. However, it is necessary to rely on those rules only because of a fundamental reliance on legal fictions relating to the identity of taxpayers and 1. Director, Graduate Program in Taxation and Graduate Program in Taxation of Cross-Border Investment, University of Miami School of Law; previously (1997-2007), Deputy International Tax Counsel (Treaty Affairs), US Treasury Department, responsible for the coordination of the US tax treaty programme. 2. General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress; Public Law 99-514), prepared by the Staff of the Joint Committee on Taxation (4 May 1987) (the 1986 Blue Book), pp. 1013-1014.

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the effect of contracts. The result is that tax systems, including tax treaties, both recognize legal transfers that have little practical effect but also fail to tax other transfers that take place before legal rights have been created or have any ascertainable value.

8.2. The application of tax treaties to transfers of intangible property Neither the OECD Model nor the UN Model contains a specific provision dealing with the treatment of gains from the transfer of intangible property. Accordingly, the general provisions of articles 7, 13 and, in some cases, article 12 apply to such transfers. While it is common to refer to “transfers” of intangible property, that obviously is not the terminology that is used in tax treaties. Instead, the legal question is whether there has been an “alienation” of the intangible. If there has been such an alienation of the intangible, article 7 or article 13 generally would apply. Interestingly enough, neither the Commentary on Article 7 nor the Commentary on Article 13 provides guidance on what constitutes an “alienation” of intangible property. Instead, that guidance is found in the Commentary on Article 12. Because the discussion relates to article 12, it is couched in terms of what payments are in consideration “for the use of, or the right to use” the intangible property specified in article 12(2). That is, a payment cannot fall within article 12 “[w]here a payment is in consideration for the transfer of the full ownership of an element of [such property]”.3

8.2.1. Allocation of taxing rights under the OECD and UN Models Under treaties based on the OECD Model, gains from the transfer of most intangibles, whether by licence or through an alienation, in most cases will be taxable only in the state of residence of the transferor of the property, no matter which article of the treaty were to apply. Article 13 provides that gains from the alienation of most property (including, implicitly, intangible property) are taxable only in the state of residence of the person alienating the property. The major exceptions to this rule relate to gains from the alienation of real property (whether held directly or through a real property 3. OECD Income and Capital Model Convention and Commentary: Commentary on Article 12 para. 8.2 (21 Nov. 2017), Models IBFD.

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holding company) and movable property forming part of the business property of a permanent establishment (PE) located in the other contracting state. Of course, under article 12 of the OECD Model, royalties are taxable only in the state of residence of the beneficial owner, unless (i) the beneficial owner of the royalties carries on business in the other contracting state through a PE situated therein and the property giving rise to the royalty is effectively connected with such PE or (ii) the amount of the royalty is paid to a related party and exceeds the amount that could have been paid in the absence of that relationship. Finally, under article 7, business profits of an enterprise of a contracting state may be taxed in the other contracting state only if attributable to a PE of the enterprise situated in that other state. There may be slight differences in the standards set out in each of those rules. However, under treaties conforming to the OECD Model, questions regarding the boundaries between the various rules seldom arise because taxation generally is assigned exclusively to the residence state. On the other hand, under the UN Model, whether a particular item of income constitutes a royalty or a gain from the alienation of property can create real differences in treatment. While article 13(6) of the UN Model also provides for exclusive residence state taxation of gains, article 12 contemplates that the source state will be given a limited right to impose a gross basis withholding tax on royalties. Article 7 also provides for greater host state taxing rights than in the OECD Model. Article 7(1) allows the host state to tax not only business profits attributable to a PE, but also income from sales in that state of goods or merchandise that are the same or similar to those sold through the PE and from other business activities carried on in that state of the same or similar kind as those effected through the PE. Article 13(2), however, follows the OECD Model in limiting source state taxing rights to the alienation of movable property forming part of the business property of the PE (or, because the UN Model retains article 14, of movable property pertaining to a fixed base available to a resident for purposes of performing independent personal services).4 Accordingly, article 7(1) allows the host state of a PE of an enterprise of the other contracting state to tax income derived from property that is not part of the PE, but gains from the sale of such property would not be taxable in the host state. Few companies regularly alienate intangible assets as part of their on-going business; they are much more likely to be in the business of licensing them or exploiting them through manufacturing, etc. The obvious exception is 4. Art. 5 of the UN Model, of course, has a broader definition of “permanent establishment” than the OECD Model, particularly as it relates to the provision of services.

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mass-market software, profits from the sale of which (although structured as a licence) generally are treated as business profits.5 Article 7 also applies to persons who are providing services for someone else, where the resulting intangible property is owned by the person for whom the services were rendered.6 Accordingly, the following discussion focuses primarily on article 13 rather than article 7.

8.2.2. Treaty practice with respect to royalties and capital gains: Symmetry or cynicism? Treaty practice among the countries for which reports were submitted is mixed, with some countries pursuing a tax treaty policy of eliminating withholding taxes on royalties where possible and others preferring to maintain at least some source state taxing rights.7 However, even those countries that prefer to eliminate withholding tax at source on royalties frequently concede taxation rights to treaty partners and in most cases will themselves impose withholding taxes on royalties paid from sources in their state when the treaties allow them to do so, in order to maintain the principle of reciprocity.8 There are far fewer countries that change the residual rule of taxation for capital gains, even when their tax treaty policy is to maintain source state taxing rights with respect to royalties. 5. The number of observations relating to the treatment of software suggests that treatment as business profits is still not universal. See paras. 28, 30, 31 and 31.2 OECD Model: Commentary on Article 12, Observations on the Commentary (2017). Much of the heat around that issue seems to have dissipated as software companies must have adapted their structures in order to minimize the risk of double taxation that could result from countries taking those positions. For example, State R, the state of residence of a company selling mass-market software cross-border is likely to deny foreign tax credits for withholding taxes imposed on what State R considers to constitute business profits, but would be required to provide a foreign tax credit for withholding taxes imposed (at the treaty rate) on an actual royalty paid by a subsidiary to which the software was licensed and which itself made the mass-market sales. 6. The UK country report notes that in the United Kingdom, an employee will actually need to transfer the copyright to the employer. Despite the fact that this is clearly an alienation of property as a matter of law, it is treated as a payment for services for tax purposes. This presumably would be the case for purposes of UK tax treaties as well. 7. Spain recently withdrew its reservation with respect to art. 12(1) and has signed several agreements that will eliminate withholding taxes on royalties, including the pending protocol with the United States. 8. This is not generally true of the Netherlands and Switzerland as neither currently impose a withholding tax on royalties under their domestic law. See Chap. 17, sec. 17.2.1.; Chap. 19, sec. 19.2.3.

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It is not necessary here to describe the entire history of the development of the capital gains article, which has been recounted in detail elsewhere,9 but some background is helpful. The drafters of what became the 1963 OECD Draft Convention did not work on a complete text, but separate working groups, of one or two countries, developed individual articles which were then combined.10 Initially, two articles, dealing with immovable property and royalties, covered both income arising from property and gains from the disposal of the property under a single rule, ensuring symmetry of treatment.11 However, the other distributive articles did not cover capital gains. Eventually, the decision was made to have a separate capital gains article.12 Pijl argues that notwithstanding the decision to have a separate article on capital gains, the drafters still generally desired symmetrical treatment of taxation of the property (in the capital gains article), income arising from the property (in the relevant distributive article) and gains from the disposition of the property (in the capital gains article).13 This general position is supported by the following sentence, which remains in the Commentary: It is normal to give the right to tax capital gains on a property of a given kind to the State which under the Convention is entitled to tax both the property and the income derived therefrom.14

However, a review of country practice in negotiating actual tax treaties around this time provides a more nuanced picture. Very early treaties reserved taxing rights to the state of “fiscal domicile” of the taxpayer except with respect to relatively narrow categories of income or property. It was nearly universal practice for the source state to be given taxing rights with respect to all aspects of real property and business establishments located in its territory, as well as with respect to wages and pensions the state itself paid to its employees. Accordingly, when it was decided to segregate capital gains in a separate article, it was “logical” that the taxing rights over the gains from the alienation of such property be given to the state that already exercised taxing rights over the income and property 9. H. Pijl, Capital Gains: The History of the Principle of Symmetry, the Internal Order of Article 13 and the Dynamic Interpretation of the Changes in the 2010 Commentary on “Forming Part” and “Effectively Connected”, 5 World Tax J. (2013), Journals IBFD; R.J. Vann, Chapter 8: Transfer of Shares and Anti-Abuse under the OECD Model Tax Convention in Taxation of Companies on Capital Gains on Shares under Domestic Law, EU Law and Tax Treaties, (G. Maisto ed., IBFD 2013), Online Books IBFD. 10. Vann, id., at sec. 8.3.2. 11. Id., at sec. 8.3.2.2. 12. Id., at sec. 8.3.2.3. 13. Pijl, supra n. 9, at sec. 3.1. 14. Para. 4 OECD Model: Commentary on Article 13 (2017).

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to which the gains related.15 In many cases, the income was already being taxed on a net basis and it was likely that the gain would be so taxed as well. However, as treaties provided for source state taxing rights with respect to more types of income, the capital gains article, which generally reserved taxing rights to the state of residence, did not result in such symmetry. It appears from the history of treaties signed during this period that there was a clear intention for the treatment of income and gains to be asymmetrical. In a number of treaties negotiated in the 1950s and 1960s (some of which remain in force), royalties were taxable only in the state of residence of the recipient.16 Those treaties frequently included gains within the royalties article, ensuring that they also would be taxed only in the country of residence. However, as more treaties allowed taxation of royalties by the source state, there was a tendency to limit article 12 to current income, allowing gains upon the transfer of the intangible to be covered by article 13, thus maintaining exclusive resident state taxation of such gains.17 This was the backdrop against which the 1963 OECD Draft Model was developed. As described in Jacques Sasseville’s presentation on Article 12: Policy and History,18 the Working Group tasked with developing the royalties article consisted of Luxembourg and Germany. Luxembourg argued strongly for a source state taxing right. Although Germany (joined by Denmark, the Netherlands, Norway, Sweden and the United Kingdom) ultimately prevailed and the 1963 OECD Draft Model did not allow such source 15. See Vann, supra n. 9, at sec. 8.3.2.4. (citing the objection of the Netherlands to exclusive residence state taxation of gains from the alienation of shares in light of granting of limited source state taxing rights with respect to dividends). 16. See Convention and Protocol [between France and the Netherlands] for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and Property art. X (30 Dec. 1949); art. 8(1) Belg.-Fr. Income Tax Treaty (1964), Treaties IBFD; Tax Agreement between the Government of the French Republic and the Government of the Republic of the Upper Volta art. 20(2) (11 Aug. 1965); art. VIII(3) Ger.-Ir. Income and Capital Tax Treaty (1962), Treaties IBFD; art. VIII(5) Isr.-UK Income Tax Treaty (1962), Treaties IBFD; art. 9(1) and (4) Austria-Lux. Income and Capital Tax Treaty (1962), Treaties IBFD. 17. Cf. arts. XIII and XV Fr.-Switz. Income and Capital Tax Treaty (1966) (positive withholding tax on royalties, gains covered by capital gains article), Treaties IBFD, with art. 20 Fr.-Togo Income, Inheritance, Registration and Stamp Tax Treaty (1971) (gains from the alienation of most intangible property included in royalties article and taxed only in state of domicile), Treaties IBFD, with arts. 20 and 21 Fr.-Tun. Income, Inheritance, Registration and Stamp Tax Treaty (1973) (similar to Fr.-Switz. Income and Capital Tax Treaty (1966), Treaties IBFD. See also arts. 8 and 9 Jap.-UK Income Tax Treaty (1969), Treaties IBFD. 18. See Chap. 5, sec. 5.3. in this volume.

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state taxation, the OECD members no doubt could see the writing on the wall. Accordingly, shifting gains out of the royalties article was likely not intended to provide “symmetry” but to ensure continued exclusive residence state taxing rights. Some other treaties attempt to achieve symmetry only between royalties and contingent payments. The US Model Income Tax Convention, from the time it was first introduced in 1976, until the version that was issued in 2016, provided that lump-sum payments from the alienation of intangible property are taxable only in the state of residence of the alienator, while such gains that are contingent on future profits are included within the definition of “royalties”. The US Treasury Department has not yet issued a Model Technical Explanation of the 2016 Model, and the relatively short “Preamble” issued at the same time as the 2016 Model focused on explaining changes to various anti-abuse measures introduced in response to (or in sympathy with) the Base Erosion and Profit Shifting (BEPS) Project. Accordingly, there is no official explanation of this change to long-standing US tax treaty practice. Although a similar change was made in recent US agreements with Belgium, Spain and Vietnam, neither the Technical Explanations of those agreements nor the legislative history addresses the reasons for the change. The most likely explanation is that US treaty negotiators have simply realized that the more expansive source country taxation of payments for technology that is provided for in US domestic law should not drive US tax treaty policy, as the flows of payments for intangible property always favour the United States. That is, where the United States’ preferred policy of residence-only taxation of royalties is adopted in a tax treaty (such as in the 2006 treaty with Belgium and the 2013 protocol with Spain), the inclusion of the gains rule in the royalties article has no effect whatsoever. However, if the United States agrees to allow some source state taxation of royalties as a concession (such as in the treaty with Vietnam), revenue considerations would argue for narrowing as far as possible the types of income that would be subject to that source state taxation.19 The gains rule with respect to intangible property cut in the other direction and it is not surprising that the United States has decided to eliminate it going forward.

19. Similarly, the 1996 US Model included a definition of royalties that conformed to US domestic law, but that was broader than the definition in art. 12 of the OECD Model. Soon after that Model was issued, the United States started conforming to the OECD definition in its bilateral treaties, a change in policy that was reflected in the 2006 US Model.

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Accordingly, in most jurisdictions it will at least occasionally be necessary to draw a line between royalties and gains from the alienation of property because of a lack of symmetry in treatment between the potentially applicable articles.

8.2.3. Delineating the boundary between article 13 and article 12 The term “royalty” generally is defined in modern tax treaties as consideration “for the use of, or right to use” various types of intangible property. The terms “gains” and “alienation” are not defined in tax treaties and the introductory paragraphs of the Commentary on Article 13, which have changed relatively little over the years, generally refer back to the domestic law of the state of residence of the alienator of the property. The Commentary on Article 13 is therefore little help in distinguishing the types of income that may be subject to withholding tax as “royalties” and payments that are exempt from tax at source as gains subject to article 13. General guidance on delineating the boundary between articles 12 and 13 is in the Commentary on Article 12, Paragraph 8.2 of which states: Where a payment is in consideration for the transfer of the full ownership of an element of property referred to in the definition, the payment is not in consideration “for the use of, or the right to use” that property and cannot therefore represent a royalty … [D]ifficulties can arise in the case of a transfer of rights that could be considered to form part of an element of property referred to in the definition where these rights are transferred in a way that is presented as an alienation. For example, this could involve the exclusive granting of all rights to an intellectual property for a limited period or all rights to the property in a limited geographical area in a transaction structured as a sale. Each case will depend on its particular facts and will need to be examined in light of the national intellectual property law applicable to the relevant type of property and the national law rules as regards what constitutes an alienation but in general, if the payment is in consideration for the alienation of rights that constitute distinct and specific property (which is more likely in the case of geographicallylimited than time-limited rights), such payments are likely to be commercial income within Article 7 or a capital gains matter within Article 13 rather than royalties within Article 12.20

Few if any of the country reports refer to this paragraph of the Commentary, most likely because paragraph 8.2, like the Commentary on Article 13, 20.

Para. 8.2 OECD Model: Commentary on Article 12, added in 2008.

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largely defers to countries’ domestic laws because of the variety of ways that countries approach these issues. For example, from the country reports, Italy appears to be the most formalistic, relying on private law to determine the legal owner of the intellectual property (IP), without regard to effective alienation of the economic benefits.21 Because there is no domestic tax law definition, the private law definition also applies for tax purposes.22 The report gives the example of a licence that would be treated as a licence for private law (and therefore tax) purposes that: (i) includes an exclusive clause; (ii) grants the right to use such IP without any geographical limitation and until the expiration of the legally protected status or without any specified deadline; (iii) establishes the consideration in the form of a substantial lump sum or up-front payment.23 Many countries might view such an agreement as an alienation, the consideration for which should be taxable under article 13, not under article 12. There is therefore a theoretical risk of a conflict of qualification, with Italy seeking to impose withholding tax on the payments under such an agreement as royalties, while the other contracting state would not relieve double taxation with respect to the payment because it believes that the payment represents a gain, taxable only in the state of residence of the alienator. However, Italy’s reliance on formalism should make it relatively easy to avoid this trap by documenting the transfer of the IP as a sale, which should fall within article 13. Several country reports specifically note that the consideration paid for the IP does not affect whether the transfer is treated as a licence or a sale. In Germany, for example, the key question is whether the granting of the right is temporary – whether rights will revert to the transferor. If so, the transfer is a licence; if not, there an alienation.24 In the United Kingdom, the analysis may be complicated by the form of payment, but the country report suggests that the question may turn on whether the IP (a) will be exhausted

21. 22. 23. 24.

See Chap. 16, sec. 16.1.2. in this volume. Id., sec. 16.2.1. Id., sec. 16.1.2. See Chap. 15, sec. 15.2.1. in this volume.

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or diminished in value by the transaction or (b) will retain its value for the owner despite the transaction.25 By contrast, in Australia, periodic contingent amounts paid for what is clearly an “assignment” (rather than a licence) of IP will be treated as royalties under Australia’s domestic law. However, Australia does not seek in its tax treaties to retain taxing rights over such payments, so the exhaustive definition of “royalty” for treaty purposes captures amounts for the use or right to use IP, which would not include the periodic amounts paid for the assignment.26 That is, under most of Australia’s tax treaties, contingent periodic payments for the assignment (as opposed to the licence) of IP may not be taxed by the source state because they do not fall within the relevant treaty’s definition of royalties. The United States similarly imposes a withholding tax on contingent periodic payments from the transfer of IP when such payments are made to a non-resident alien. However, the payments are not treated as royalties under its domestic law. Instead, such payments are treated as gains27 and a specific provision of the Internal Revenue Code (IRC) imposes the withholding tax (even though the United States does not impose tax on most capital gains – other than real property gains – received by non-residents). The Australia-US Income Tax Treaty (1982) includes contingent payments for the transfer of IP rights within the definition of royalties,28 thereby giving both countries source state taxing rights over such payments, even though the US preference is to not allow for taxation of royalties or capital gains at source and Australia generally gives up its taxing rights over such payments.

8.3. Transfer of intangibles to a related party 8.3.1. Determining a price for the transfer of IP to a related party While the treaty framework generally is the same for transfers to a related party as to an unrelated party, the economics of the transaction are quite 25. See Chap. 20, sec. 20.2.2.1.1.1., n. 37 in this volume (referencing Jeffrey v. Rolls Royce LTD, [1962] 40 TC 443). 26. See Chap. 9, sec. 9.2.1. in this volume. 27. Accordingly, the contingent periodic payments should not be deductible to the payer for US tax purposes, but the purchased intangible itself may be amortized under sec. 197. 28. Art. 12(4)(c) Austrl.-US Income Tax Treaty (1982), Treaties IBFD.

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different. In the case of a sale to an unrelated party, the transferor taxpayer has an incentive to maximize the price charged. The interests of the taxpayer and its state of residence are essentially aligned. In the case of a transfer to a related party, the state of residence of the transferor still has an interest in maximizing the price charged, because the contracting state from which the intangible is transferred is losing the right to tax future business profits arising from the intangible. However, the taxpayer’s incentives are quite different, particularly if the related transferee is located in a low-tax jurisdiction (as would usually be the case). While the worlds of treaty interpretation and transfer pricing are generally quite separate these days, transfer pricing is so key to this issue that it is not possible to develop policy with respect to the tax treaty treatment of the transfer of intangibles without considering how well transfer pricing norms address countries’ concerns. In theory, it should make no difference whether a company keeps intangible property and exploits it itself or transfers the property to another entity which will exploit it. That is because the “right” price paid to the entity that is transferring the property should be equal to the net present value of the profits expected from the exploitation of the intangible property. As long as the compensation offered by the other entity exceeds what the original owner of the intangible expects to earn by exploiting the property itself, it is likely to accept the offer. However, if the offer is less than the original owner’s expected profits, then it should keep the intangible property. This dynamic is relatively straightforward in the case of unrelated parties, where each party to the transaction has economic incentives to make a very clear-eyed analysis of the potential future earnings. Most importantly, if the owner of the intangible property is going to give up all rights to future income, it will provide to the prospective purchaser projections of future earnings that will maximize the current value of the property. There is no incentive for the transferor to be conservative in its valuation. This, obviously, is not the case when transfers take place within a corporate group. The Joint Committee on Taxation of the US Congress described some of the difficulties relating to high-value intangibles: In many cases, firms that develop high profit-potential intangibles tend to retain their rights or transfer them to related parties in which they retain an equity interest in order to maximize their profits. The transferor may well be looking in part to the value of its direct or indirect equity interest in the related party

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transferee as part of the value to be received for the transfer, rather than to “arm’s length” factors. Industry norms for transfers to unrelated parties of less profitable intangibles frequently are not realistic comparables in these cases.29

Moreover, the arm’s length principle traditionally had to be applied using information available at the time the transfer was made. For the most important intangible property, it is unlikely that there would be any comparable property that could be used to establish a value. As a result, the best way to develop a price would be to calculate the expected future profits from the intangible. Because the intangible remains within the affiliated group, “[t]ransfers between related parties do not involve the same risks as transfers to unrelated parties”.30 That is, if the price charged by the transferor is too low, the benefit accrues not to an unrelated party but to another member of the related party group. As a result, the transferor in a high-tax jurisdiction no longer has an incentive to develop projections that will maximize the price paid by the person acquiring the intangible property, but the opposite, since a low price will shift most of the value of the intangible to the acquiring affiliate, usually located in a lower-tax jurisdiction. The remedy provided by the US Congress was the “commensurate with income” standard, added to section 482 of the IRC in 1986. This addition was, first, to make clear that “high profit potential” intangibles were to be compensated at higher than industry norms.31 This guidance from Congress seems completely consistent with the notion of the arm’s length standard. It was the next bit that was revolutionary at the time: Congress intended that consideration also be given to the actual profit experience realized as a consequence of the transfer. Thus, Congress intended to require that the payment made for the intangible be adjusted over time to reflect changes in the income attributable to the intangible … However, it will not be sufficient to consider only the evidence of value at the time of the transfer. Adjustments will be required when there are major variations in the annual amounts of revenue attributable to the intangible.32

For many critics, the requirement to make adjustments, to take into account information that was not available to the parties to the transfer at the time it took place, was completely inconsistent with the arm’s length method. 29. 30. 31. 32.

1986 Blue Book, p. 1015. 1986 Blue Book, p. 1015. 1986 Blue Book, pp. 1015-1016. 1986 Blue Book, p. 1016.

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The Treasury Department and the Internal Revenue Service initially tried valiantly to implement the commensurate with income standard in accordance with the Congressional purpose. However, over time, the United States adopted the view that it was more important to be able to argue that its transfer pricing rules were consistent with the arm’s length standard as articulated in the OECD Transfer Pricing Guidelines. As those Guidelines required the use only of information available to the parties at the time the transfer took place, the commensurate with income standard slowly faded from view.33 BEPS-related changes to the 2016 Transfer Pricing Guidelines provide significantly more detail regarding the way that prices for intangible property are to be established. In particular, they suggest that independent enterprises, faced with uncertainty regarding the value of intangibles, might enter into shorter-term agreements or write price adjustment clauses into the contract or provide for contingent (rather than lump-sum) payments.34 These changes are not unlike what was envisioned with respect to the commensurate with income standard, which was intended as a substantive rule to deal with the uncertainty that arises because intangibles must be priced at the time a transfer takes place (ex ante). In the BEPS expanded guidance on hard-to-value intangibles,35 information about actual results can be used to address a procedural problem arising from information asymmetry. That is, information about actual results can be used to conclude that the projections on which the taxpayer relied were incorrect. If the projections and assumptions were appropriate, then no adjustments to the transfer price can be made even if the actual results are wildly out of line with these projections. Because the business community was concerned that “ex post” adjustments change the balance of power between the tax authorities and business, the Guidelines include exemptions and safe harbours that, in particular, prevent adjustments for minor deviations between expectations and results.36 The

33. Y. Brauner, Value in the Eye of the Beholder: The Valuation of Intangibles for Transfer Pricing Purposes, 28 Va. Tax Rev. 79, pp. 100-102 (2008). 34. OECD – Transfer Pricing Guidelines for Multinationals and Tax Administrations (2017) para. 6.183, International Organizations’ Documentation IBFD [hereinafter Transfer Pricing Guidelines]. 35. See paras. 6.186-6.195 Transfer Pricing Guidelines. See also OECD, Base Erosion and Profit Shifting (BEPS) Public Discussion Draft on Implementation Guidance on Hard-to-Value Intangibles (23 May-30 June 2017), available at http://www.oecd.org/tax/ transfer-pricing/BEPS-implementation-guidance-on-hard-to-value-intangibles-discussiondraft.pdf (last accessed 21 Mar. 2018). 36. Para. 6.193 Transfer Pricing Guidelines.

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current transfer pricing framework therefore largely remains intact, but now with a new set of rules over which to litigate.

8.3.2. Issues relating to contributions to capital In the paradigmatic case of the “cash box” subsidiary in a low-tax jurisdiction, the cash actually comes from the parent company, of course. The parent can capitalize the subsidiary, which then “buys” the IP from the parent or other affiliated enterprise. Alternatively, the parent in the hightax jurisdiction may contribute the IP to the capital of the subsidiary in what would, if the transfer took place entirely within one country, be a taxdeferred reorganization. In the United States, a specific provision of the IRC,37 enacted at the same time as the “commensurate with income” standard, treats such a cross-border transfer as a sale of the IP. Moreover, the provision specifically requires that the compensation consist of annual payments contingent on the productivity use or disposition of the IP. Accordingly, for tax purposes what was intended to be an alienation of property is taxed in the same way as a licence, as the annual payments are taxed as ordinary income.38 As noted above, the Commentary on Article 13 is particularly hands-off regarding the way in which capital gains are taxed in the country of residence, so there appears to be no treaty issue regarding the US requirement regarding the form of compensation. Moreover, the United States famously includes the saving clause in its tax treaties, preserving its right to apply its domestic law to its citizens and residents without regard to the treaty, subject to specified exceptions. The United States does not list article 9(1) as one of those exceptions, so the United States’ right to impose domestic transfer pricing rules (of which the anti-off-shoring provision of section 367(d) is a part) is not constrained. However, if the subsidiary makes such payments and its state of residence were to take the position that the required payments were not consistent with the arm’s length principle,39 it could make an adjustment to the subsidiary’s income. If it does so, the US taxpayer arguably could claim the benefits of article 9(2), which generally is an exception to the saving clause. 37. Sec. 367(d) IRC. 38. See Chap. 21, sec. 21.2.2.5. in this volume. 39. The payment presumably will affect the calculation of net income in the other contracting state, either because the subsidiary has treated the payments as deductible royalties or is amortizing the purchase price of the intangible property.

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With some exceptions, the distributive rules of tax treaties generally limit the taxation by one state of income derived by residents of the other state. Accordingly, in the case of a transfer of intangible property, tax treaty experts would generally ensure that the state to which the IP was transferred did not attempt to tax the entity that had “alienated” the IP. However, practitioners structuring cross-border contribution transactions should be aware that there are situations in which the company receiving a contribution of IP may be subject to taxation.40 In most cases, the taxable transactions arise when the residence state of the subsidiary receiving the IP considers the IP to have been received in exchange for services. However, in some countries, a contribution to capital without the issuance of additional shares may result in the subsidiary being required to recognize a gain.41 Taxation of the recipient of property in a cross-border reorganization seems inconsistent with the intent of the treaty. In practice, it appears that taxation of such gain may be avoided by issuing even a single additional share, providing an easy way to sidestep the treaty issue.

8.3.3. Ignoring separate entities entirely One of the first things budding tax lawyers learn is to draw boxes, triangles and ovals – the universal language of tax planning. Every summer a roomful of law students takes basic federal income tax. They accept (mostly without question) various mysteries – income doesn’t include “gifts”, compensation for personal injuries is not taxable, but punitive damages are, and on and on. From year to year, their reactions to certain questions differ wildly. But, every class is brought up short by this case: Professional basketball player, B, enters into an employment contract with a basketball team. He then enters into another employment contract with a Panamanian firm which licenses its rights to a British Virgin Islands (BVI) limited liability company. He instructs the basketball team to pay his salary to the BVI firm. He claims that the income is taxable to the BVI and Panamanian companies, not to him.

These students, most of whom have completed only 1 year of basic law classes, without fail, have the same reaction – that can’t be. They do not

40. S.R. Lainoff & R.C. Vaish, General Report, in The taxation of income derived from the supply of technology pp. 39-40 (IFA Cahiers vol. 82a, 1997), Online Books IBFD. 41. See J. Bernstein & M. Guilbault, Canada, in The taxation of income derived from the supply of technology, id. p. 286; C. Emmeluth, Denmark, in id. p. 334.

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believe that it is possible to shift tax liabilities simply by interposing a corporation.42 When the same case is presented to tax lawyers, the reaction is much different. “Surely the company is engaged in a US trade or business.” “This must be subpart F income.” Even, occasionally, “Didn’t he have income when he transferred the contract to the Panamanian company?” However, the tax lawyers all accept the existence of the “box” – they believe in it and then try to apply anti-abuse measures to it. The idea that taxpayers can rely on the boxes they draw is stated quite baldly in comments submitted in connection with the BEPS Project. For example: A corollary of the arm’s length principle is that taxpayers are allowed to choose their business structure, and it generally cannot be imposed on them by tax authorities. The arm’s length principle does not require related parties to replicate the behavior of unrelated parties or to only enter into transactions which unrelated parties would have. It recognizes that, because of their common control and common interests, unrelated parties can and do enter into transactions which unrelated parties would or could not. It generally respects those transactions (as long as they have economic substance) and merely seeks to find the price unrelated parties dealing at arm’s length would have. Any work designed to prevent related parties from engaging in transactions which would not, or would only very rarely, occur between third parties is inconsistent with the arm’s length standard….43

The BEPS Monitoring Group, set up by civil society organizations focused on “tax justice”, is at the far opposite end of the spectrum in terms of policy, as it notes that: In the absence of acute economic duress or some very significant and identifiable business reason … an entity … developing intangible rights within its core business would virtually never transfer all or any portion of those rights to unrelated persons. These are most typically core products that would be considered “crown jewels”… While MNEs are very resourceful and creative in providing important business reasons for their tax structuring, the reality virtually always is that the sort of transfer [of partially developed pharmaceutical compounds

42. It turns out that in this particular case, the court did not accept the taxpayer’s assignment of income to the corporation. See US: US Tax Court, 7 June 1982, Johnson v. Commissioner, 78 T.C. 882, aff’d without opinion, 734 F.2d 20 (1984). 43. United States Council for International Business Comments on the OECD Revised Discussion Draft on Transfer Pricing Aspects of Intangibles (27 Sept. 2013), p. 2, available at http://www.oecd.org/ctp/transfer-pricing/uscib-intangibles.pdf (last accessed 21 Mar. 2018).

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described in the proposed guidance] has no purpose other than BEPS. Further, there are seldom any substantive operational changes that accompany such transfers.44

Despite their view that these transactions would not take place between unrelated parties, the BEPS Monitoring Group concedes that, because MNE groups have “full entity and contractual freedom,” the most the guidance can do is not legitimize such planning.45 Numerous calls to reform the international tax system argue that it is necessary to ignore separate entities and to allocate the global income of the multinational group on a formulary basis. Again, these arguments seem to accept that under tax treaties, it is all about pricing and nothing can be done about structure without upending the entire system. To the extent that is true, it is a result of treating the Transfer Pricing Guidelines as the rule, not as the means. It should not be necessary to change the international tax rules that govern millions of transactions every day in order to deal with entities that serve no purpose. There are more straightforward ways to address the particular problems of an entity that serves no purpose other than tax planning. When in the middle of a religious war (as between those who believe in the arm’s length standard and adherents to formulary apportionment), it may be helpful to re-read the sacred texts. Article 9(1) of the OECD Model states that where there are certain specified relationships: and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

In other words, there is no reference to price, only to conditions and profits. That is, Article 9 of the OECD Model does not refer to revenue, cost, price or similar concepts, and its role is not to determine the right price of anything but to 44. Comments of the BEPS Monitoring Group in Comments Received on Public Discussion Draft BEPS Action 8 Implementation Guidance on Hard-to-Value Intangibles (5 July 2017), available at http: //www.oecd.org/ctp/transfer-pricing/Public-comments-received-on-the-ImplementationGuidance-on-Hard-to-Value-Intangibles-2017.pdf, p. 21 (last accessed 21 Mar. 2018). 45. Id., p. 22.

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identify non-commercial outcomes arising from the exercise of control, in circumstances in which there is no adversity of interest. Consequently, article 9 of the OECD Model is concerned with the allocation of profit among associated enterprises free of any distortions to their own profit motives induced by the exercise of control. In short, article 9 of the OECD Model concerns the end, i.e. the amount of profit allocated to a jurisdiction, not the means.46

Accordingly, while paragraph 1.122 of the 2016 Transfer Pricing Guidelines includes language that seems to support the notion that a transaction between related parties may be appropriate even if a similar transaction “may not be seen between independent parties”, that is not the end of the story. Paragraph 1.128 of the Transfer Pricing Guidelines provides an example of an agreement regarding the transfer of intangibles between two related parties which will not be recognized for transfer pricing purposes because it is “commercially irrational”. The example in paragraph 1.128 is extreme (as the research company has accepted a lump-sum payment from a related party in exchange for unlimited rights to all future intangibles developed over the course of 20 years). No doubt the drafting of the example was a response to comments, like those set out above, that raised concerns about arbitrary recharacterizations of transactions by tax officials. It is also very likely that countries will use the principle established in these expanded paragraphs to attack more transfers of intangibles, even in circumstances that are not as extreme as in the example.

8.3.4. Does it matter? As noted in section 8.1., successfully transferring ownership of high-value intangibles out of high-tax jurisdictions to lower-tax jurisdictions has for decades been the goal of much international tax planning. The BEPS changes discussed above seek to ensure that the transferor is adequately compensated for unique, high-value intangibles. However, other BEPSrelated changes minimize the effect of legal ownership, thus calling into question whether there is any benefit to pursuing such a transfer at all. 46. E. Baistrocchi, Article 9: Associated Enterprises - Global Tax Treaty Commentaries sec. 4.1.1.3.1., Global Tax Treaty Commentaries IBFD (accessed 21 Mar. 2018), citing J. Li & S. Li, Location-Specific Advantages: A Rising Disruptive Factor in Transfer Pricing, 71 Bull. Intl. Taxn. 5, p. 259 (2017), Journals IBFD, who in turn cite J. Scott Wilkie, Transfer Pricing Aspects of Intangibles: The License Model, in Transfer Pricing in a Post-BEPS World pp. 61-96 (M. Lang, A. Storck & R. Petruzzi eds., Wolters Kluwer 2016).

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Paragraph 6.42 of the 2017 Transfer Pricing Guidelines includes the following statements: While determining legal ownership and contractual arrangements is an important first step in the analysis, these determinations are separate and distinct from the question of remuneration under the arm’s length principle. For transfer pricing purposes, legal ownership of intangibles, by itself, does not confer any right ultimately to retain returns derived by the MNE group from exploiting the intangible, even though such returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible … For example, in the case of an internally developed intangible, if the legal owner performs no relevant functions, uses no relevant assets, and assumes no relevant risks, but acts solely as a title holding entity, the legal owner will not ultimately be entitled to any portion of the return derived by the MNE group from the exploitation of the intangible other than arm’s length compensation, if any, for holding title.

Other members of the MNE group must be remunerated to the extent they contribute to the development, enhancement, maintenance, protection and exploitation of the intangibles.47 This focus on the functions performed, rather than legal ownership, is conceptually much closer to the authorized OECD approach to the attribution of profits to PEs than it is to prior incarnations of the Transfer Pricing Guidelines. The country reports for both Austria and China note that they already recognize economic ownership.48 As more countries adopt the approach permitted by the newest version of the Transfer Pricing Guidelines, the advantages of cross-border transfers may be greatly diminished. This is true, however, only if tax authorities can successfully attack structures that violate these principles. The Executive Summary of the BEPS Actions 8-10 Final Report49 suggest the transfer pricing changes are not a “silver bullet”. Rather, the summary boasts of the “holistic” approach to tackling “cash boxes”. “Holistic” medicine generally considers both physical and mental aspects of the patient to develop treatment targeted to the patient’s specific condition. The BEPS approach is the equivalent of throwing the entire – traditional and naturopathic – medicine chest at the patient 47. Para. 6.45 Transfer Pricing Guidelines. These principles are reflected in SAT Bulletin [2017] No. 6. See Chap. 13, sec. 13.2.4.2. in this volume. 48. See Chap. 9, sec. 9.2.2.7. and Chap. 13, sec. 13.1.2.2. in this volume. 49. OECD Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project p. 11 (2015), available at http://dx.doi.org/10.1787/9789264241244-en (last accessed 21 Mar. 2018).

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to see if anything works and hoping the patient doesn’t die from unexpected interactions of different treatments.

8.3.5. Transfers of “non-proprietary” intangibles The previous sections addressed how the focus on legal form can result in recognizing transactions that have no economic substance and BEPS measures intended to reduce income shifting that might result. It is also possible that a focus on legal form can result in failing to recognize transfers of intangible property. Imagine a business person, Ms B, an executive. She knows how to get things done. She is a US citizen but has no particular need to live in the United States. She knows someone, Mr I, who knows how to do something and, being a good manager, she knows how to make money from Mr I’s technical knowledge. She finds someone, Mr C, who needs what Mr I knows how to do, and Mr M, who is willing to put up the cash to fund the venture that Ms B is putting together. In most cases, Ms B probably would have just incorporated a Delaware corporation or maybe formed a Delaware LLC, before talking to tax counsel, and somewhere down the line some international tax planner would have told Ms B that she was going to have a hard time getting what had become very valuable intangibles out of the United States.50 However, maybe because Mr I, Mr C and Mr M are all non-US people, Ms B talks to some international tax professionals much earlier, all of whom tell her that she must set up a non-US company before any contracts are signed and that the contracts must be entered into by that company. Not surprisingly, Ms B pushes back. How can it be that signing the contract and then transferring it to a non-US company results in a big tax bill, while doing it in the opposite order avoids the bill? As a business person, Ms B just wants to do the deal, the economics of which are already established. It is the tax lawyer that is concerned about form. This focus on the creation of the company and the signing of the contract seems to fall within what Scott Wilkie describes as “‘legal lore’ that found 50. See Statement of Robert H. Perlman, Vice President, Tax, Licensing & Customs, Intel Corporation, before the Committee on Finance of the United States Senate, 11 Mar. 1999, S. 361-42, p. 11 (“Let me begin by stating that if Intel were to be founded today, I would strongly advise that the parent company be incorporated outside the United States.”).

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justification and solace in the unbridled adherence to legal constructions as dispositive determinants of fiscal consequences grounded in transfer pricing.”51 He questions why “‘corporations’ and ‘contracts’ have determinative fiscal significance even though they supply the means by which economic units organize themselves and conduct global business.”52 During the course of the revisions to the Transfer Pricing Guidelines as part of the BEPS Project, business interests sought to keep the concept of “intangible” narrowly focused on legal rights. The National Foreign Trade Council, for example, argued that the definition should be limited to “proprietary” information protected by law or contract because independent parties would be unlikely to pay for knowledge that is not legally protected.53 This narrow approach was explicitly rejected. The new guidance on identifying intangibles has this to say about the significance of legal protections: The availability and extent of legal, contractual, or other forms of protection may affect the value of an item and the returns that should be attributed to it. The existence of such protection is not, however, a necessary condition for an item to be characterised as an intangible for transfer pricing purposes.54

This seems right. Clearly there is something of value (Mr I’s technical knowledge and Ms B’s business acumen) for which someone (in this case, both Mr C and Mr M) are willing to pay. The “legal lore” that no intangible existed until the contract is signed by Mr C and the new company created a “cliff effect” whereby, if the contract was signed by a US company and then transferred, there was the transfer of intangible which needed to be compensated while, if a non-US company was formed and then signed the contract, no transfer took place and there was no need to compensate Ms B and/or Mr I for their know-how. The form therefore effected a significantly different allocation of tax revenue despite there being little if any economic difference between the two structures. The broad scope of what constitutes an intangible potentially eliminates the “cliff” because, under new paragraph 6.8, intangibles exist at a much earlier stage than “lore” would have it. As a result, practitioners should be 51. Scott Wilkie, supra n. 46, at p. 80. 52. Id. 53. National Foreign Trade Council, Comments on OECD Revised Discussion Draft on Transfer Pricing Aspects of Intangibles and White Paper on Transfer Pricing Documentation (30 Sept. 2013), available at: http://www.oecd.org/ctp/transfer-pricing/nftc.pdf (last accessed 21 Mar. 2018). 54. Para. 6.8 Transfer Pricing Guidelines.

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aware that compensation may be required in situations where previously few would have viewed a transfer as having taken place. Moreover, because the transfer takes place earlier in the intangible’s development, pricing may be even more uncertain. Some might say that it also calls into question whether the existence of the corporation should be recognized at all. In this case, however, there seems to be a legitimate reason for the existence of a corporation, as it brings together three people with distinct contributions – technical know-how, management experience and capital. This is a very different situation from the captive “cash boxes” described in the preceding sections.

8.4. Conclusion The current BEPS approach(es) to transfers of intangibles lacks the clarity displayed by those young law students who question why the tax law recognizes a company that has no purpose other than to shift income. For the most part, BEPS treats the “box” as real and then seeks to blunt the effect of that recognition. The wide range of “actions” to deal with the problem of cash boxes is necessary because they do not go to the heart of the problem. There is a significant difference between asserting that something doesn’t matter and saying that it didn’t happen. Until tax authorities are willing to say the latter – that the transfer of intangibles to the cash box didn’t happen – they are doomed to second-best results. At the same time, practitioners attempting to apply tax treaties to cross-border transfers of intangibles will be forced to spend some quality time with the Transfer Pricing Guidelines – a volume that many seek to avoid at all costs – to count the many ways their structure may fall afoul of the new rules.

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Part Five

Country Reports

Chapter 9 Australia by Celeste M. Black1 This chapter reviews the legal protections provided under Australia’s domestic law in relation to intellectual property (IP) as well as the application of Australia’s tax laws to both the assignment and licensing of IP under the domestic law and tax treaties, with particular emphasis on the characterization and tax treatment of payments as royalties.

9.1. Introduction on private law aspects of IP 9.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law Australia has a well-developed legal regime for the protection of IP rights at a national level that meets and exceeds the standards required under the Trade-Related Aspects of Intellectual Property Rights (TRIPS) Agreement. The traditional categories of IP are protected by way of specific statutory schemes while confidential information and know-how, which are not considered to be in the nature of property, are protected by common (courtdeveloped) law.2 The rights provided under the statutory schemes in relation to copyright, patents, trademarks and registered designs are all considered to be personal property of the owner or holder. Copyright arises automatically upon the creation of the work and provides rights with respect to reproduction and dissemination of the ideas or information expressed in the work.3 The Copyright Act 1968 provides the categories of works protected by copyright as literary, artistic, dramatic 1. Associate Professor, University of Sydney Law School, University of Sydney. 2. The information in this section is drawn primarily from the following two works: M.J. Davison, A.L. Monotti & L. Wiseman, Australian Intellectual Property Law (3rd edn, Cambridge University Press 2016) and R. Reynolds, N. Stoianoff & A. Roy, Intellectual Property: Text and Essential Cases (5th edn, The Federation Press 2015). 3. AU: Copyright Act 1968 (Cth), sec. 31.

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or musical works (so-called authored works),4 so-called entrepreneurial works (such as sound recordings, cinematographic films, sound and television broadcasts and published editions of works)5 and performer’s rights.6 Where the requisite connection with Australia is shown, the rights arise on creation of the work and have a duration of the life of the author plus 70 years.7 Authored works must be original and must exist in a material form, i.e. there must be a physical embodiment of the work. The concept of literary work includes a computer program8 and a computer game has been held to be both a literary work and a cinematograph film.9 A script for a cinematographic film is an example of a dramatic work10 while the film itself is an entrepreneurial work. An artistic work is defined to include a drawing, which is also defined to include a diagram, map, chart or plan.11 The standard of originality for entrepreneurial works is lower than authored works, where the subject matter must merely not have been copied (it must be a first publication),12 and the duration of these types of copyrights vary.13 The meaning given to cinematographic films has been the subject of a number of cases. This term is defined as follows: [T]he aggregate of the visual images embodied in an article or thing so as to be capable by the use of that article or thing: (a) of being shown as a moving picture; or (b) of being embodied in another article or thing by the use of which it can be so shown; and includes the aggregate of the sounds embodied in a sound-track associated with such visual images.14

In this context, a video game where the actions of the player dictated the game events was held to be a cinematographic film15 but the playing of the game through a games console, which required a portion of the game code to be temporarily stored in the RAM of the console, was held not to be a 4. Part III Copyright Act 1968. 5. Part IV Copyright Act 1968. 6. Part XIA Copyright Act 1968. 7. Sec. 33 Copyright Act 1968. 8. Sec. 10 Copyright Act 1968. 9. See AU: Full Federal Court (FFC), 2003, Kabushiki Kaisha Sony Computer Entertainment v. Stevens, [2003] FCAFC 157; (2003) 132 FCR 31. 10. Sec. 10 Copyright Act 1968. 11. Id. 12. Secs. 89-92 Copyright Act 1968. 13. The duration of copyright in sound recordings and cinematographic films is 70 years, television and sound broadcasts 50 years and published editions 25 years. Secs. 93-96 Copyright Act 1968. 14. Sec. 10 Copyright Act 1968. 15. AU: Federal Court of Australia (FCA), 1997, Galaxy Electronics Pty Ltd & Gottlieb Enterprises Pty Ltd v. Sega Enterprises Ltd, [1997] FCA 403; (1997) 75 FCR 8.

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reproduction (and therefore not a violation of copyright).16 Similarly, it has been held that playing a film embodied on a DVD disc, which would involve the temporary storage in the RAM, was not reproducing or copying the film in a material form by the DVD player or computer.17 Protection akin to copyright is provided with respect to the layout of integrated circuits under a separate piece of legislation.18 Another special regime provides artists with a right to royalties on the commercial resale of their art works.19 Patent protection is provided under the Patents Act 1990 through two mechanisms: the standard patent and the innovation patent. The standard patent is available for a novel, useful and inventive step in a process or product,20 but a mere scheme, abstract idea or intellectual information alone is not patentable. Computer software may be protected by a standard patent. The registration process for a standard patent is comprehensive and the exclusive protection extends for 20 years.21 An innovation patent is available for a novel, useful and innovative step.22 No substantive examination is undertaken prior to the granting of an innovation patent (this is done when a certification is needed, e.g. to support an infringement action) but the protection only extends for 8 years.23 A recent High Court of Australia decision held that an isolated gene sequence could not be patented.24 A separate regime has been established to protect the rights of plant breeders similar to patents.25 The registration system for trademarks under the Trade Marks Act 1995 applies to specific marks in relation to specific goods or services.26 The types of marks protected are standard, certification, collective and defensive marks and registered marks are protected for 10-year periods, with unlimited renewals. The system applies to “a sign used, or intended to be used, to distinguish goods or services dealt with or provided in the course of trade 16. AU: High Court of Australia (HCA), 2005, Stevens v. Kabushiki Kaisha Sony Computer Entertainment, [2005] HCA 58 at [79]; (2005) 224 CLR 193. 17. AU: FCA, 2001, Australian Video Retailers Association v. Warner Home Video Pty Ltd, [2001] FCA 1719 at [65]. 18. AU: Circuit Layouts Act 1989 (Cth). Because of this special regime, the layout of an integrated circuit is excluded from the meaning of the protected works under the Copyright Act 1968 and the Designs Act 2003 (Cth). 19. AU: Resale Royalty Right for Visual Artists Act 2009 (Cth). 20. AU: Patents Act 1990 (Cth), sec. 18(1). 21. Sec. 67 Patents Act 1990. 22. Sec. 18(1A) Patents Act 1990. 23. Sec. 68 Patents Act 1990. 24. AU: HCA, 2015, D’Arcy v. Myriad Genetics Inc, [2015] HCA 35. 25. AU: Plant Breeder’s Rights Act 1994 (Cth). 26. AU: Trade Marks Act 1995 (Cth), sec. 19.

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by a person from goods or services so dealt with or provided by any other person.”27 In comparison, the Designs Act 2003 protects for up to 10 years the way that a commercial or industrial product looks, the design being the overall appearance of the product that results from one or more visual features.28 The design must be new and distinctive in comparison to other designs already in the prior art base.29 The registration system is similar to innovative patents, with no substantial assessment on registration, but only when the owner seeks to enforce its rights. To resolve potential overlaps, if a design is registered or used to industrially manufacture 50 or more articles, the design is not protected as an artistic work under the Copyright Act 1968 but may be protected under the Designs Act 2003.30 The value of confidential information, trade secrets or know-how is in its secrecy, and Australian law recognizes three ways that an obligation to maintain confidentiality can arise: (i) by an express contractual term; (ii) by an implied contractual term and (iii) by the equitable obligation of confidentiality.31 These mechanisms are not based on treating the information as property,32 though it has been acknowledged that some information acquires a proprietary character by virtue of the protection provided,33 and there is no “owner” of the information but rather a party who can bring the action for breach of contract or breach of confidence. Confidential information may also be protected by the action for breach of fiduciary duty if the information has passed between parties where a fiduciary relationship already exists.34 An action for breach of the equitable obligation of confidence requires the following four elements: (i) the plaintiff must be able to identify with specificity, and not merely in global terms, that which is said to be the information in question, and must be able to show that (ii) the information has the necessary quality of confidentiality (and is not, for example, common or public knowledge), (iii) the information was 27. Sec. 17 Trade Marks Act 1995 (Cth). 28. AU: Designs Act 2003, sec. 5. 29. Sec. 15 Designs Act 2003. 30. Secs. 75 and 77 Copyright Act 1968. 31. AU: New South Wales Supreme Court (NSWSC), 2002, AG Australia Holdings Limited v. Burton, [2002] NSWSC 170 at [73]. 32. AU: HCA, 1984, Moorgate Tobacco Co Ltd v. Philip Morris Ltd (No 2), [1984] HCA 73; (1984) 156 CLR 414 at [28] and AU: HCA, 1943, FCT v. United Aircraft Corporation, [1943] HCA 50; (1943) 8 CLR 525 at [8]. 33. AU: HCA, 2007, Farah Constructions Pty Ltd v. Say-Dee Pty Ltd, [2007] HCA 22 at [118]. 34. AU: FCA, 1990, Smith Kline & French Laboratories (Australia) Ltd et al. v. Secretary, Department of Community Services and Health, [1990] FCA 151 at [50].

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received by the defendant in such circumstances as to import an obligation of confidence, and (iv) there is actual or threatened misuse of that information, without the consent of the plaintiff.35

Distinctions are drawn between confidential information, which would include trade secrets and which is protected in equity, and mere know-how that represents accumulated knowledge and experience (usually held by an employee). Trade secrets are perhaps the closest to property as the courts have acknowledged that they may be transferred, held in trust and charged.36 Confidential information has been found in a list of overseas suppliers and manufacturers who had been found to be reliable over time.37 In another case the list of suppliers alone was not confidential information but the identity and contact details of key persons within those organizations was protected.38 Customers lists may normally be confidential information but “such information is not necessarily confidential, or may be at a low order of confidentiality, depending on the particular circumstances”39 and, though it is not entirely clear, a former employee would be entitled to use information that is remembered but not recorded, though not as a result of deliberate memorization.40

9.1.2. Distinction under private law between alienation of IP and granting the right to use IP The alienation or disposal of IP is captured by the concept of assignment while the granting of a right to use IP is captured by the concept of licensing. In relation to each of the legally recognized forms of IP, the rights held by the owner are considered to be personal property capable of assignment and transmission by will or operation of law,41 and there are some specific rules in place in the respective statutes regarding exploitation of IP. 35. Smith Kline (1990) at [54]. 36. AU: HCA, 2007, Farah Constructions Pty Ltd v. Say-Dee Pty Ltd, [2007] HCA 22 at [118] citing with approval Smith Kline (1990) at [167]. 37. AU: Supreme Court of New South Wales Court of Appeal (NSWCA), 1991, Wright v. Gasweld Pty Ltd, (1991) 22 NSWLR 317 at 325. 38. AU: NSWSC, 2007, Orica Investments Pty Ltd v. McCartney, [2007] NSWSC 645 at [254]. 39. AU: NSWSC, 2000, Forkserve Pty Ltd v. Pacchiarotta, [2000] NSWSC 979 at [19]; (2000) 50 IPR 74. 40. AU: NSWSC, 2000, Weldon & Co Services Pty Ltd v. Harbinson, [2000] NSWSC 272 at [70] and Forkserve (2000) at [20]. 41. Sec. 196 Copyright Act 1968, sec. 13 Patents Act 1990, secs. 21 and 22 Trade Marks Act 1995, sec. 10 Designs Act 2003, sec. 45 Circuit Layouts Act 1989 and sec. 20 Plant Breeder’s Rights Act 1994.

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The owner of copyright has the exclusive rights in relation to the work that are dictated by the type of work in question. The Copyright Act 1968 contemplates total and partial assignments as well as licences.42 An assignment may be limited in any way, including as to place or duration of assignment as well as in relation to different rights such as film rights or paperback reprint rights.43 The holders of the various rights, such as those retained by the original owner and those assigned to the new owner in the case of a partial assignment, are each treated as an owner of the copyright who may pursue an action for infringement of the rights held.44 This reflects the nature of an assignment as being a transfer of property rather than the granting of contractual rights to exploit the copyright in a particular way, which would suggest merely a licence.45 The term “exclusive licence” is further defined to authorize the licensee, to the exclusion of all other persons, to do an act that the copyright owner would otherwise have the exclusive right to do,46 and in this regard an exclusive licensee is given rights under the Copyright Act 1968 in relation to enforcement proceedings and remedies equivalent to an assignee.47 A licence granted by the owner binds every successor in title to the copyright.48 A patent gives the patent holder the exclusive rights to exploit the patent or to authorize another person to do so.49 These rights are divisible and the legislation provides that a patent may be assigned for a place in or part of the patent area (a partial assignment).50 The assignee thereby becomes an owner of the patent rights so assigned. For the purposes of the legislation, a licence means a licence to exploit or to authorize the exploitation of a patented invention and an exclusive licence confers the right to exploit the patented invention throughout the patent area to the exclusion of the patentee and all other persons.51 Like the case of copyright, an action for infringement of patent rights may be commenced by the patentee or an exclusive licensee.52

42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52.

Sec. 16 Copyright Act 1968. Sec. 196(2) Copyright Act 1968. Sec. 30 Copyright Act 1968. Sec. 15 Copyright Act 1968. Sec. 10 Copyright Act 1968. Sec. 119 Copyright Act 1968. Sec. 196(4) Copyright Act 1968. Sec. 13 Patents Act 1968. Sec. 14 Patents Act 1968. Sch. 1 dictionary to Patents Act 1990. Sec. 120 Patents Act 1990.

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The registered owner of a trademark is empowered to deal with the mark as its absolute owner.53 Under the legislation, a registered trademark may be assigned or transmitted and such assignment or transmission may be partial as to apply only some of the goods or services in respect of which the mark is registered but may not be partial in relation to the use in a particular area, and such transfers do not need to accompany goodwill of business.54 The person to whom the trademark has been assigned or transmitted is then acknowledged as the owner of the trademark (with any relevant restrictions as to goods or services covered) in the register.55 Rather than licensing, the trademark legislation uses the terms authorized user and authorized use to reflect the fact that the owner of the trademark must retain control over the relevant goods or services if rights akin to a licence are granted, where this control can take the form or quality control or financial control.56 The registered owner of a registered design may assign all or part of its interest in the design and may limit the assignment to a specific place.57 Such an assignment effects a change of ownership that must be reflected on the register.58 The designs legislation does not specifically address the position of licensees except in relation to applications for compulsory licences.59 The treatment of confidential information and know-how is different due to the fact that under Australian domestic law, the protection of confidential information is based on principles of equity rather than property and therefore information cannot be assigned. As the Federal Court of Australia has confirmed: [W]hile commercial parties may deal in confidential information, it is clearly not an asset which is capable of being assigned. It is incapable of assignment because confidential information is not property.60

Although the relevant information is not acquired by but is rather imparted to the purchaser, it is suggested that the purchaser would obtain a right in 53. Sec. 22 Trade Marks Act 1995. 54. Sec. 106 Trade Marks Act 1995. Assignment is defined as an assignment whereas transmittal is used to refer to transmission by operation of law, devolution on the personal representative of a deceased person or any other kind of transfer except an assignment. Sec. 6 Trade Marks Act 1995. 55. Sec. 110 Trade Marks Act 1995. 56. Sec. 8 Trade Marks Act 1995. 57. Sec. 11 Designs Act 2003. 58. Sec. 114 Designs Act 2003. 59. Sec. 90 Designs Act 2003. 60. AU: FCA, 2003, TS & B Retail Systems Pty Ltd v. 3fold Resources Pty Ltd, [2003] FCA 371; (2003) 57 IPR 530 at [24].

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equity to enforce the obligation of the original holder to keep it secret.61 As a consequence, although confidential information is not property and therefore in itself is not recognized as a capital gains tax (CGT) asset for tax purposes, the equitable right in relation to information is a CGT asset.62 These issues are discussed below in section 9.2.

9.2. Taxation of IP under the domestic tax law 9.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP Australia’s domestic income tax law, comprising the Income Tax Assessment Act 1997 and the Income Tax Assessment Act 1936, utilizes the ordinary meaning of royalties for general income tax purposes and a specific statutory definition of royalties largely for the purposes of international tax measures. A receipt that is a royalty within the ordinary meaning of that term will often be assessable as “ordinary income” as it will display the indicia of income as ordinarily understood.63 However, an amount received “as or by way of royalty” within the ordinary meaning of that phrase, but which is not ordinary income, is also included in assessable income by a specific provision.64 This section will only operate where the royalty is not already assessable as ordinary income and therefore, in practice, has limited application. The structure of the Income Tax Assessment Act 1997 does not rely on a list of categories of “ordinary income” but rather this concept has been developed over time by the courts. Royalty income is a type of income from property, i.e. income flowing from or derived from property, and is to be contrasted with receipts derived from the transfer or disposal of the IP. Royalties under general concepts includes those receipts that are triggered by, or contingent on, the use or exploitation of rights in IP as well as natural 61. TS & B (2003) at [25]. 62. Australian Taxation Office (ATO), Taxation Determination TD 2014/26, Income tax: is bitcoin a ‘CGT asset’ for the purposes of subsection 108-5(1) of the Income Tax Assessment Act 1997? (released 17 Dec. 2014) at [13]. 63. AU: Income Tax Assessment Act 1997, sec. 6-5 [hereinafter ITAA 1997]. 64. Sec. 15-20 ITAA 1997. The previous version of this provision was sec. 26(f) of the Income Tax Assessment Act 1936 [hereinafter ITAA 1936]. Sec. 26(f) did not exclude from its reach ordinary income royalties. As a result, royalties that were ordinary income were picked up by both sec. 25 of the ITAA 1936 (the earlier version of sec. 6-5 of the ITA 1997) and sec. 26(j) of the ITAA 1936. See the opinion of Mason J in AU: HCA, 1997, Federal Commissioner of Taxation v. Sherritt Gordon Mines Ltd, (1977) 137 CLR 612 at [15].

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resource royalties. Consideration of the nature of royalty income by the High Court of Australia has largely been in the context of natural resources, but the basic principles regarding the nature of the receipts are equally applicable to IP.65 The key criterion for royalties from the cases is that “the payments should be made in respect of the particular exercise of the right”66 such that the amount of consideration payable is based on the use made of the right or a pre-estimate of such use. In the opinion of the High Court, “[i]n the case of patents a royalty is usually a fixed sum paid in respect of each article manufactured under a licence to manufacture a patented article. Similarly, the publisher of a work may agree to pay the author royalties in respect of each copy of the work sold.”67 More recently, the Full Federal Court of Australia stated that “[i]t is inherent in the concept of ‘royalty’ that a royalty payment is in respect of a licence or permission granted by the owner of a monopoly or other property right in respect of that property.”68 Payments in respect of know-how are not “royalties” in the ordinary sense of the term.69 In the Sherritt Gordon Mines case, the payments at issue were made in relation to the provision of technical assistance and information regarding a mining process and the amount payable was calculated by reference to the value of sales resulting from the process. The majority of the High Court concluded that this did not give rise to royalties under the ordinary meaning.70 However, receipts of this kind may still be assessable as income derived in the ordinary course of carrying on a business. Whether such receipts are characterized as income or capital receipts (and therefore potentially assessable under the CGT regime)71 is determined by an application of general tax principles. The only Australian judicial authority in relation to the tax treatment of receipts derived in relation to know-how is the decision of the Supreme Court of Queensland in Kwikspan Purlin 65. The two key cases are AU: HCA, 1955, Stanton v. Federal Commissioner of Taxation, [1955] HCA 56; (1955) 92 CLR 630, and AU: HCA, 1944, McCauley v. Federal Commissioner of Taxation, [1944] HCA 18; (1944) 69 CLR 235. 66. Stanton (1955) at [11]. 67. McCauley (1944). 68. AU: FFC, 2016, Federal Commissioner of Taxation v. Seven Network Limited, [2016] FCAFC 70 (application for leave to appeal to the High Court refused) at [94] with reference to Stanton (1955), 92 CLR 630 at 641-2; AU: HCA, 1968, Barrett v. Federal Commissioner of Taxation, (1968) 118 CLR 666 at 671; and AU: HCA, 1997, Sherritt Gordon Mines (1977) at 627. 69. See Sherritt Gordon Mines (1977) per Mason J, with reference and approval to United Aircraft (1943) and UK: House of Lords (HL), 1962, Rolls-Royce Ltd v. Inland Revenue Commissioners, (1962) 1 WLR 425. 70. Sherritt Gordon Mines (1977). The ITAA 1936 was amended in response to this case to ensure that payments received for providing mining information would be included in assessable income. See now sec. 15-40 of the ITAA 1997. 71. Part 3-1 ITAA 1997.

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System Pty Ltd v. Federal Commissioner of Taxation.72 The payments in question were lump sums paid for a number of exclusive licences that were each limited in geography in relation to the use of an industrial construction system, only some elements of which were protected by a patent. The agreements were described variously as licences, agreements or sales of knowhow. After an extensive discussion of a number of UK decisions, the court noted that the taxpayer was not in the business of dealing in patents (so this was not ordinary course business income) and concluded that the several exclusive licences for different places in Australia had the same effect as one licence granted for the whole of Australia. The Court therefore concluded that the receipts were not income from putting the know-how to use but effectively a disposal. Under the tax legislation now in force, such receipts would be taxable as capital gains (discussed in section 9.2.2.). Although not ordinary royalties, payments for the supply of know-how may be captured by the extended definition of “royalties” that is relevant for international tax purposes (see section 9.2.3.). In the context of know-how, the Federal Commissioner of Taxation (the Commissioner) has identified a number of criteria to consider in order to determine the extent to which a particular payment is for the supply of know-how or for the provision of services.73 If the contract provides for both the supply of know-how and services (other than ancillary services), the Commissioner’s view is that a reasonable apportionment is acceptable. A reasonable allocation provided under the contract would be accepted. Otherwise, the apportionment will be based on the features of the particular case and a suggested method is based on the transferor’s estimated cost of providing the services, which may be substantiated with an accountant’s certificate, plus a profit margin.74 Consideration for the assignment or transfer of IP may be characterized as ordinary income or a capital receipt for tax purposes depending on how the 72. AU: Queensland Supreme Court (QSC), 1984, Kwikspan Purlin System Pty Ltd v. Federal Commissioner of Taxation, (1984) 71 FLR 154; 15 ATR 531. 73. ATO, Taxation Ruling IT 2660, Income tax: definition of royalties (released 28 Nov. 1991) at [28]-[34]. 74. ATO, IT 2660 at [36]: “One way of apportioning the price in a contract that requires payments of an undivided sum would be to proceed on the basis of details of the “sale price” of each component obtained from the transferor company. It may be necessary to apportion the total contract price on the basis of the estimated cost of providing the services. For this purpose, an accountant’s certificate will generally be acceptable evidence of the estimated cost. It may be necessary in these cases to increase the estimated cost by the inclusion of a normal profit margin in order to arrive at the amount to be allocated for the ‘unassociated’ services to be performed.”

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consideration payable has been determined and the nature of the taxpayer’s business. If the consideration for the assignment is calculated be reference to the use of the assigned rights or the anticipated use, that consideration will be considered in the nature of royalties and therefore ordinary income.75 If a taxpayer holds and deals with IP as inventory, receipts from sales will be assessable as income, but as business income rather than royalties. If a taxpayer holds the IP as a capital asset and the consideration for the assignment is not linked to use, the profit so realized will be assessed by way of asset disposal rules. The Income Tax Assessment Act 1936 expands the notion of royalties beyond the income receipts described above by providing a definition of “royalties” for the purposes of the Income Tax Assessment Act 1936 and the Income Tax Assessment Act 1997.76 This definition is relevant when the term “royalty” or “royalties” is used in the relevant Act. However, it is not relevant for determining whether a particular receipt is assessable as ordinary income royalty as this is determined by case law rather than the legislation. As a result, this definition is effectively relevant for international tax purposes when, for example, source rules and withholding tax may be triggered. Section 6 of the Income Tax Assessment Act 1936 provides as follows: royalty or royalties includes any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for: (a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade mark, or other like property or right; (b) the use of, or the right to use, any industrial, commercial or scientific equipment; (c) the supply of scientific, technical, industrial or commercial knowledge or information; (d) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in paragraph (a), any such equipment as is mentioned in paragraph (b) or any such knowledge or information as is mentioned in paragraph (c); (da) the reception of, or the right to receive, visual images or sounds, or both, transmitted to the public by: (i) satellite; or 75. UK: Court of Appeal (CA), 1967, Murray (Inspector of Taxes) v. Imperial Chemical Industries Ltd, [1967] Ch 1038, cited with approval in Kwikspan Purlin (1984) at 158-159. 76. Sec. 6 ITAA 1936. For the purposes of the ITAA 1997, the term “royalty” is defined in sec. 995-1 of the ITAA 1997 by way of reference to the meaning given in sec. 6 of the ITAA 1936.

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(ii) cable, optic fibre or similar technology; (db) the use in connection with television broadcasting or radio broadcasting, or the right to use in connection with television broadcasting or radio broadcasting, visual images or sounds, or both, transmitted by: (i) satellite; or (ii) cable, optic fibre or similar technology; (dc) the use of, or the right to use, some or all of the part of the spectrum (within the meaning of the Radiocommunications Act 1992) specified in a spectrum licence issued under that Act; (e) the use of, or the right to use: (i) motion picture films; (ii) films or video tapes for use in connexion with television; or (iii) tapes for use in connexion with radio broadcasting; or (f) a total or partial forbearance in respect of: (i) the use of, or the granting of the right to use, any such property or right as is mentioned in paragraph (a) or any such equipment as is mentioned in paragraph (b); (ii) the supply of any such knowledge or information as is mentioned in paragraph (c) or of any such assistance as is mentioned in paragraph (d); (iia) the reception of, or the granting of the right to receive, any such visual images or sounds as are mentioned in paragraph (da); (iib) the use of, or the granting of the right to use, any such visual images or sounds as are mentioned in paragraph (db); (iic) the use of, or the granting of the right to use, some or all of such part of the spectrum specified in a spectrum licence as is mentioned in paragraph (dc); or (iii) the use of, or the granting of the right to use, any such property as is mentioned in paragraph (e).

In order to overcome the decision in the Aktiebolaget Volvo case,77 the original definition was amended in 1980 by replacing “paid” in the introductory clause with “paid or credited, however described or computed, and whether the payment or credit is periodical or not” and by adding paragraph (f) regarding payments for forbearance in respect of using or granting rights and supplying knowledge.78 Paragraphs (da) and (db) and the corresponding 77. AU: Supreme Court of Victoria (SCV), 1978, Aktiebolaget Volvo v. Federal Commissioner of Taxation, (1978) FLR 334. In that case, an annual payment based on sales and made to the parent company was held not to be a royalty under either the ordinary meaning or the statutory definition as it then stood since the payment was described as being for the parent company agreeing not to supply its products to anyone in Australia other than the subsidiary. In one of the years in question, the amount was accounted for as due and payable but had not yet been paid, and therefore the amount was not caught by the statutory definition. See Aktiebolaget Volvo (1978) at 345-346. 78. AU: Income Tax Assessment Amendment Act 1980 (Cth). See R.J. Vann & J.D.B. Oliver, The new Australia-UK tax treaty, 3 British Tax Rev. 194, p.223 n. 96 (2004).

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amendments to paragraph (f) were added to the definition in 199279 and paragraph (dc) was added in 1999 at the same time that a cost amortization regime was added to the legislation for spectrum licences80 (this regime has since been repealed as the general depreciation regime now applies to spectrum licences). Like the ordinary meaning of royalty, the statutory definition largely retains the requirement that the payment be for the use or the right to use the IP but, unlike the ordinary income test, the amount need not be calculated by reference to that use. Definitions of the specific types of IP are not provided in either the Income Tax Assessment Act 1936 or the Income Tax Assessment Act 1997 and therefore these terms take their ordinary meaning. The use of the ordinary meaning of terms thereby implicitly refers to the private law meaning as discussed in section 9.1. The Commissioner has considered the circumstances where payments in relation to computer software will be considered royalties under this definition given that software is recognized in the Copyright Act 1968 as a literary work. The Commissioner concluded that amounts for granting a licence to reproduce or modify the program as well as payments for know-how (such as for the supply of source code or algorithms of the program) would be royalties under paragraphs (a) and (c), respectively.81 However, payments for a licence for simple use only of the software (such as allowing the end user to run the software on a computer or network) are not considered to be royalties.82 In more recent rulings, the Commissioner commented more generally that the nature of hosted (cloud) access to proprietary software has not yet been judicially considered but “might be thought to be more akin to the provision of service rather than a licence,”83 and that copyright can also subsist in parts of a website as well as content available on a website.84 In a recent decision, Federal Commissioner of Taxation v. Seven Network Limited, the Full Federal Court considered whether payment for the international audiovisual signal (ITVR signal) for use in connection with broadcasting the 2002-2008 Olympics Games in Australia were royalties as defined 79. AU: Taxation Law Amendment Act (No 5) 1992 (Cth). 80. AU: Taxation Laws Amendment Act (No 6) 1999 (Cth). 81. ATO, Taxation Ruling 93/12, Income tax: computer software (released 13 May 1993) at [3]. 82. Id., at [4]. 83. ATO, Taxation Ruling 2014/1, Income tax: commercial software licencing and hosted agreements: derivation of income from agreements for the right to use proprietary software and the provision of related services (released 12 Mar. 2014) at [134]. 84. ATO, Taxation Ruling 2016/3, Income tax: deductibility of expenditure on a commercial website (released 14 Dec. 2016).

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under the Australia-Switzerland Income Tax Treaty (1980), specifically as either “consideration for the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade-mark, or other like property or right” or “for total or partial forbearance in respect of the use of [such] a property or right”.85 These phrases are in effect identical to those used in the statutory definition of royalty and therefore the court’s analysis is relevant here. At the relevant time, the Australia-Switzerland Income Tax Treaty (1980) did not contain the subsection (db) extension to broadcasting rights. The focus was initially on the meaning of “copyright” where the court referred to the Copyright Act 1986 for its meaning, with specific consideration given to the Commissioner’s argument that the ITVR signal was within the definition of a cinematographic film. The court rejected this characterization of the ITVR signal, a particular difficulty being that there was no fixation or material embodiment of the aggregation of images or sounds as required by the Copyright Act 1986.86 In the words of the Court, “[n]o cinematograph film was made because no first copy was made.”87 The court in the Seven Network case also considered the phrase in paragraph (a) that includes a payment for “other like property or right”. As an initial matter, the court agreed that the words in paragraph (a) enumerate classes of rights that relate, broadly, to IP and also includes trade secrets and other commercially confidential information, which has a proprietary character.88 The court further analysed these issues more specifically in relation to the relevant treaty, so these matters are discussed in section 9.4. One question that was not necessary to answer in the Seven Network case was whether the transaction would be caught by paragraph (db) of the domestic law definition. The Federal Court seemed to suggest that it might be.89 However, one commentator has suggested that a digital signal such as the ITVR signal would not be caught as it is not visual images or sounds as required by that subsection.90

85. Seven Network (2016). For a more detailed description of the facts and decision of the court, see M. Dirkis, Australia: Limitations on applying the royalties Article in a digital era in Tax Treaty Case Law around the Globe 2017 (M. Lang et al. eds., IBFD 2018), Online Books IBFD. 86. Seven Network (2016) at [75]. 87. Id. 88. Seven Network (2016) at [82]. 89. Seven Network (2016) at [88]. 90. R. Goodwin, Royalty withholding tax – Payments for Olympic Games broadcasting rights, 51 Taxation in Australia 5, p. 249 (2016).

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9.2.2. Qualification of income deriving from IP and applicable tax regimes Pursuant to Australian IP law, a distinction is drawn between the assignment or partial assignment of IP, where the legal right to enforce the IP is transferred to the assignee and can therefore be characterized as a disposal, and the granting of a licence over IP, which merely creates contractual rights between the licensor and the licensee and can be seen as granting the right to use the IP. However, this distinction is not clearly maintained for tax purposes. Where consideration is calculated by reference to the use of the IP, that consideration will be considered to be ordinary concepts royalties (and income) whether or not the nature of the transaction is an assignment or a licence. By way of example, if copyright is assigned but the consideration is payable periodically based on the number of copies of the work sold, the consideration will be considered ordinary concepts royalty income even though the IP asset (the copyright) has been disposed of by way of the assignment. Where the consideration for the assignment of IP is a capital sum, the profit will either be included in income or treated as a capital gain depending upon whether the IP is a “depreciating asset” or a “CGT asset”. The tax regimes dealing with these asset types are, for nearly all purposes, mutually exclusive.91 The concept of depreciating asset is limited by definition to certain categories of property assets and includes the traditional types of IP (except for trademarks) whereas the concept of CGT asset is broader, encompassing any kind of property as well as legal and equitable rights that are not property.92 As a result, since Australian law does not treat either confidential information or know-how as property, information cannot be a depreciating asset but dealings with such information can give rise to CGT consequences. The term “depreciating asset” is defined generally as an asset with a limited effective life that can reasonably be expected to decline in value over time as it is used93 but specifically includes only listed types of intangible property. The non-deductible costs associated with acquiring depreciating assets (such as patent lawyer and filing fees for new IP or amounts paid to acquire already registered IP) can be recovered over time and there are also special

91. Although a “depreciating asset” (sec. 40-30 ITAA 1997) would be a “CGT asset” (sec. 108-5 ITAA 1997), by virtue of sec. 118-24 of the ITAA 1997, any capital gain or loss realized in relation to a depreciating asset is disregarded. 92. Sec. 108-5 ITAA 1997. 93. Sec. 40-30 ITAA 1997.

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rules dealing with disposals of depreciating assets.94 Relevantly, the list of depreciable intangible property includes items of “intellectual property” (as defined), in-house software,95 IRUs,96 spectrum licences,97 datacasting transmitter licences98 and telecommunications site access rights.99 For these purposes, “intellectual property” is defined as the rights that an entity has under Australian or equivalent foreign law as a patentee of a patent, owner of a registered design, or owner of a copyright, or a licensee of a patent, registered design or copyright. This notion of IP excludes most notably trademarks, which therefore are not covered by the depreciation provisions. The capital allowance provisions allow deductions for the depreciation (decline in value) of a depreciating asset that is used to produce assessable income.100 Depreciation is usually calculated on either a straight-line or diminishing value basis, but only the straight-line method may be used for in-house software, intellectual property (as defined) except for copyright in a film, and transmission licences.101 The effective life of these specified intangibles is prescribed by the legislation, for example 20 years for a standard patent, 25 years for copyright, 15 years for registered designs and the term of the relevant licence for licences.102 Amendments currently pending in the Federal Parliament will allow taxpayers to self-assess a shorter effective life for these assets.103 The assignment (disposal) of an intangible depreciating asset (the IP) triggers the requirement to calculate a balancing adjustment. The proceeds from the assignment are compared to the written-down value of the asset: if the proceeds are less than the written-down value, an additional amount is deductible to reflect the actual depreciation in value that has not yet been claimed; and if the proceeds exceed the written-down value, this indicates 94. Div. 40 ITAA 1997. 95. Defined as computer software or a right to use computer software that you acquire, develop or have another entity develop that is mainly for you to use in performing the functions for which the software was developed. 96. Defined as an indefeasible right to use a telecommunications cable system, sec. 9951 ITAA 1997. 97. Meaning given by reference to sec. 5 of the Radiocommunications Act 1992 (Cth). 98. Meaning given by reference to sec. 5 of the Radiocommunications Act 1992. 99. Means a right except an IRU of a carrier to share a facility as defined in sec. 7 of the Telecommunications Act 1997. 100. Sec. 40-25 ITAA 1997. The costs that are recovered by way of this mechanism only include capital costs that are not otherwise deductible. Secs. 40-215 and 40-220 ITAA 1997. 101. Sec. 40-72(2) ITAA 1997. 102. Sec. 40-95(7) ITAA 1997. 103. AU: Treasury Laws Amendment (2017 Enterprise Incentives No 1) Bill 2017.

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that excess depreciation has been claimed that should now be recouped by including the excess in income.104 A partial assignment will also trigger a balancing adjustment and the depreciation rules treat such a transaction as the IP being split into two assets: those rights retained and the rights assigned.105 The written-down value is allocated to these two parts on a reasonable basis so that the balancing adjustment can be calculated with regard to the rights so assigned. A specific set of rules provide that the grant of a licence over depreciable IP is also treated as a part disposal of the IP (i.e. in the same way as a partial assignment) and the proceeds from the grant are compared to portion of the written-down value of the IP that is reasonable allocated to the rights granted under the licence.106 In relation to these various balancing adjustment events, the proceeds used to work out the balancing adjustment will exclude any amount already included in ordinary income or statutory income. This exclusion would be triggered, for example, if the consideration is ordinary concepts royalty income. The assignment of IP that is not a depreciating asset, such as a trademark, gives rise to a CGT event (it would be treated as a disposal) and the proceeds will be compared to the cost base to determine any gain or loss realized.107 Like the balancing adjustment, this capital gain will be reduced to the extent to which the gain is included in assessable income by another mechanism, such as royalty income if the consideration for the assignment is based on the use or exploitation of the IP.108 The net capital gain is included in assessable income.109 A partial assignment would be viewed as a part disposal of the IP, such that the proceeds would be reduced by the relevant proportion of the cost base in the trademark in working out the gain or loss. A special rule allows for roll-over treatment where a spectrum licence is assigned or resumed and replaced by one or more spectrum licences that cover the same rights.110 Where the CGT treatment differs to the depreciation rules is in relation to a licence. As noted above, if the IP is a depreciating asset, the grant of a licence triggers a balancing adjustment but the proceeds can be reduced by a portion of capital costs. In comparison, the grant of a right to an authorized user of a trademark would be treated as the creation of a new asset for CGT purposes rather than a part disposal, with the effect that the proceeds will only be reduced by any non-deductible incidental costs in 104. 105. 106. 107. 108. 109. 110.

Sec. 40-285 ITAA 1997. Sec. 40-205 ITAA 1997. Secs. 40-115 and 40-205 ITAA 1997. Sec. 104-10 ITAA 1997. Sec. 118-20 ITAA 1997. Sec. 102-5 ITAA 1997. Sec. 40-120 ITAA 1997.

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determining the capital gain, and there will be no offset for any portion of the cost base in the trademark.111 As noted in section 9.1., Australian law does not recognize confidential information as property (at best it has a proprietary nature) and payments made for the use of know-how are considered not to be royalties but can be assessable as ordinary business income. Where a capital sum is received in relation to confidential information or know-how, the CGT treatment will depend upon the characterization of the transaction. The Commissioner has concluded that “know-how is knowledge or information rather than a CGT asset” but a contractual right to require disclosure or non-disclosure of know-how can be a CGT asset.112 One consequence of this view is that the creation of contractual rights in relation to know-how will be treated as the creation of a new CGT asset rather than a dealing with a pre-existing asset and the assessable gain will be effectively the whole of the grant proceeds. Similarly, a more recent opinion of the Commissioner suggests that the equitable right in relation to confidential information, although not property, would also be a CGT asset in relation to which CGT event may occur.113 These asset regimes, depreciation and CGT, provide mechanisms for the recovery of costs incurred in relation to the creation or acquisition of IP that are not otherwise immediately deductible when incurred, such as patent application fees. Some expenses related to research and development (R&D) activities would be ordinarily deductible as business expenses where the nature of the business activities of the taxpayer includes R&D.114 Australia has a number of input incentives but does not have an output-based tax incentive such as an IP box. Tax incentives exist to provide additional deductions, such as the general R&D incentive and the software development project pools rules. Australia’s R&D incentive is in the form of an offset (credit) calculated as a percentage of eligible expenditure.115 Costs that are included in the cost of a depreciating asset are not eligible for the offset. An allowance is also available for costs associated with developing in-house software.116 One consequence of claiming this allowance is that consideration derived in relation to the software is included in assessable 111. Sec. 104-35 ITAA 1997. 112. ATO, Taxation Determination 2000/33, Income tax: is know-how a CGT asset? (released 13 Sept. 2000). 113. ATO, Taxation Determination 2014/26, supra n. 62, at [13]. 114. AU: FCA, 1991, Goodman Fielder Wattie Ltd v. Commissioner of Taxation, (1991) 29 FCR 376; [1991] FCA 206. 115. Div. 355 ITAA 1997. See sec. 73A ITAA 1936 for expenditure incurred prior to 1 July 1995. 116. Sec. 40-450 ITAA 1997 regarding software development pools.

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income regardless of its character.117 Another allowance is available in relation to capital expenditure incurred in seeking (but failing) to obtain a right to IP (as defined for tax purposes), as this would not otherwise be recoverable for tax purposes.118 A separate incentive regime operates with respect to Australian production expenditure on films, where three alternative refundable offsets are provided.119

9.2.3. Tax treatment of income from IP derived by nonresident taxpayers Australian tax legislation provides a statutory source rule specific to royalties derived by non-residents in section 6C of the Income Tax Assessment Act 1936 that operates along with the withholding tax.120 Under this provision, royalty income will be considered Australian sourced if it is paid or credited by an Australian government body or resident to a non-resident (unless it is wholly incurred in carrying on business at or through a PE of the resident payer outside of Australia) or if it is paid or credited to the non-resident by another non-resident and wholly or in part incurred by the non-resident payer in carrying on business at or through a PE of the payer in Australia. Apportionment rules operate where the royalty is only partly incurred in relation to a relevant PE, as the situation requires. Where the situation is outside of the circumstances described in the statutory source rule, it is possible that the royalty could still be Australian sourced based on the application of general source rules, where this is “a hard, practical matter of fact.”121 Factors that have been considered relevant include where the contract is entered into, where the amounts are payable, the currency in which the amounts are to be paid and where anything under the contract is to be done (such as providing the information) or performed (such as ancillary training with respect to know-how).122 If the IP is held by or through a PE in Australia, the income from the IP would be sourced in Australia due to its connection with the business activity being carried on by the PE.

117. Sec. 40-460 ITAA 1997. 118. Sec. 40-840(2)(d)(vi) ITAA 1997. 119. Div. 376 ITAA 1997. The three offsets are the producer offset, the location offset and the post, digital and visual effects production offset. 120. Sec. 6C(2) ITAA 1936. 121. AU: HCA, 1938, Tariff Reinsurances Ltd v. Commissioner of Taxes (Victoria), (1938) 59 CLR 194. 122. Aktiebolaget Volvo (1978) at 344 and United Aircraft (1943) at [18].

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Originally, the final gross withholding tax regime only applied in Australia to interest and dividends so that royalties that were Australian sourced under section 6C were taxed on a net assessment basis.123 A withholding tax for royalties was introduced in 1986 but it was not a final tax, allowing taxpayers to claim often significant expenses, such as those in relation to equipment leasing, through the assessment process.124 From the 1993/1994 income year, the final gross withholding tax on royalties came into effect125 and the withholding tax now operates via section 128B of the Income Tax Assessment Act 1936. A person who derives royalty income (under the statutory definition) that is caught by the terms of section 128B is liable to withholding tax by virtue of section 128B(5A) and, in many cases, as described in section 128D of the Income Tax Assessment Act 1936, this will operate as the exclusive mechanism for the taxation of royalties. The withholding tax is a final tax in relation to subsection 128B(2B) royalties, which are those derived by a non-resident and that are paid by an Australian resident (but not where the royalty is incurred by the resident payer in carrying on business in a foreign country at or through a PE of the payer in that country) or paid by a non-resident to another non-resident and incurred by the payer in carrying on a business in Australia at or through a PE.126 In this way the withholding tax operates on an origin basis. The exclusion from withholding tax of royalties paid by an Australian resident which are incurred in carrying on business in a foreign country through a PE therein was tested in the Unisys case involving a back-to-back arrangement. The decision of the court turned on the interpretation of “carrying on business” and what constitutes a PE for these purposes.127 In that case, although there was a business carried on in the United States, it was not carried on at or through a PE and therefore the court declined to issue a declaration that withholding tax was not payable under the circumstances (effectively the exclusion did not operate). The withholding tax operates but not as a final tax in relation to subsection 128B(2C) royalties, which are royalties derived (received) by an Australian resident in carrying on business outside Australia at or through 123. An earlier regime provided that royalties in relation to film and videotapes that were Australian sourced under sec. 6C would not be included in assessment income but would be taxed at a special rate. This regime was repealed with the introduction of royalty withholding tax. 124. Vann & Oliver, supra n. 78, at 222. 125. Div. 17 Taxation Law Amendment Act (No 5) 1992 (Cth). 126. Sec. 128B(2B) ITAA 1936. 127. AU: NSWSC, 2002, Unisys Corporation v. Federal Commissioner of Taxation, [2002] NSWSC 1115.

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a PE in that other country and the payer is either an Australian resident (but not where the royalty is incurred by the resident payer in relation to a foreign PE) or a non-resident where the royalty is incurred in relation to a PE in Australia.128 In this subsection (2C) situation, the legislation provides that any ordinary income tax payable on this income is in addition to the withholding tax and credit will not be allowed for the withholding tax paid.129 However, in many cases Australia’s foreign branch income exemption would operate130 and it would be likely the royalties would be taxed in the other country as profits attributable to the PE in that state and the Australian withholding tax would be creditable against the foreign tax on the PE’s profits. At the same time that subsection 128B(2C) was inserted into the legislation, the general anti-avoidance rule was strengthened to apply to the avoidance of withholding tax.131 The statute also provides further elaboration regarding the application of the subsection (2B) and (2C) requirements.132 As noted above, this withholding tax regime ordinarily applies in lieu of assessment to income tax by virtue of section 128D of the Income Tax Assessment Act 1936.133 The administrative obligations to withhold and pay the tax to the Commissioner are imposed on the payer separately under the tax administration legislation.134 A payer who fails to meet its withholding obligations is denied a deduction for the royalty payment,135 unless it pays an administrative penalty equal to the withholding tax it should have withheld.136 The standard withholding tax rate on royalties is 30% but this is

128. Sec. 128B(2C) ITAA 1936. 129. Secs. 128B(11) and 128D ITAA 1936. 130. Sec. 23AH ITAA 1936. 131. Sec 177CA ITAA 1936 inserted by Taxation Laws Amendment Act (No 2) 1997 (Cth). 132. Sec. 128B(9A) and (9B). 133. Sec. 128D ITAA 1936. The royalty income is non-assessable, non-exempt income for the purposes of income taxation, meaning that it is effectively disregarded for income tax purposes. 134. AU: Taxation Administration Act 1953, secs. 12-280 and 12-385, Sch. 1 [hereinafter TAA 1953]. Obligation to withhold imposed by sec. 12-280 of the TAA 1953 if payment made to a recipient who has an address outside Australia or the payer is authorized to pay the royalty at a place outside Australia. There is also a withholding obligation under sec. 12-285 of the TAA 1953 if the recipient is a person in Australia and a foreign resident is entitled to receive the royalty or have it credited or dealt with on its behalf. Sec. 16-5 of the TAA 1953 provides that this withholding must occur on the making of the payment. 135. Sec. 26-25 ITAA 1997. 136. Sec. 16-30 Sch. 1 TAA 1953 and sec. 26-25(3) ITAA 1997. See also ATO, ID 2007/188, Income tax: failure to withhold from a royalty payment to a non-resident and the effect on the payment’s deductibility (released 1 Oct. 2007).

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often reduced by treaty to 5%, 10% or 15%.137 However, if a tax treaty is in place and the meaning given to “royalty” in the treaty is narrower than the statutory definition (which is often the case), the withholding tax will not operate in relation to royalties outside the treaty definition paid to a resident of the other contracting state.138 The Commissioner provides an example of this in the case of a payment of royalties in relation to literary works (the example given being computer programs) by an Australian resident to a Singaporean resident, where such royalties fall outside the treaty definition.139 In the Commissioner’s opinion, the withholding tax does not apply but the statutory source rule (section 6C) would still operate, thereby giving Australia jurisdiction to tax on an assessment basis due to the Australian source. As another example, the statutory definition of royalty is inclusive and thereby including amounts that would be royalties within the ordinary meaning, such as periodic amounts paid for the assignment of IP which are calculated based on the exploitation of the IP, whereas the exhaustive definition of royalty for treaty purposes captures amounts for the use or right to use IP, which would not include the periodic amounts for the assignment. One issue that has been addressed by the Commissioner is whether withholding tax applies to partial assignments of copyright.140 As a general law matter, payments made in consideration of a grant of a licence clearly relate to use or the right to use (therefore royalties) but assignments or partial assignments of IP involve a transfer of legal rights to the assignee. However, the Commissioner does not accept this distinction as controlling whether the consideration payable in each case is within the statutory definition of royalties.141 Rather, in the opinion of the Commissioner, whether the assignment is more akin to an “outright sale” or a grant of a right to use will be determined by considering four criteria: 137. AU: Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 (Cth), sec. 7. Between 1977 and 1992, a special rate of 10% applied to film and video tape royalties. Income Tax (Film Royalties) Act 1977 (Cth) (repealed). 138. AU: International Tax Agreements Act 1953, sec. 17A(5). As a general matter, aside from the operation of the Part IVA general anti-avoidance rule, the International Tax Agreements Act (which includes the tax treaties by incorporation) prevails over the ITAA 1936 and ITAA 1997, see sec. 4(2). 139. ATO, ATO ID 2012/67, Income tax: Singaporean resident company receiving Australian sourced royalties (released 3 Aug. 2012). See also ATO, ATO ID 2006/282, Income tax: Singapore resident receiving Australian sourced excluded royalties (released 10 Aug. 2006). 140. ATO, Taxation Ruling 2008/7, Income Tax: Royalty withholding tax and the assignment of copyright (released 27 Aug. 2008). A similar view was expressed in a narrowed context in the earlier ATO, Taxation Determination 2006/10, Income tax: can a payment to a non-resident author for the use of his or her article be a royalty for the purposes of subsection 6(1) of the Income Tax Assessment Act 1936? (released 5 Apr. 2006). 141. ATO, TR 2008/7 at [15].

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– the duration of the assignment compared to the remaining legal life of the copyright; – the geographical extent of the assignment, with coverage of an entire country suggesting an assignment; – any limitation on the class of acts assigned, so an assignment of a whole class of acts indicates an assignment; and – whether the amount and timing of the payments are dependent on the exploitation of the copyright by the assignee.142 The Commissioner’s conclusion is that, at least in relation to copyright, the standard treaty definition denotes a class of payments broader than merely those for a licence to use copyright and would include payments for a partial assignment where in substance the payments are more akin to payments for use, and draws support for this conclusion from the OECD Commentary and Vogel.143 However, one commentator suggests that the bases for the Commissioner’s views in this instance are unsound and a partial assignment should be treated as a sale, therefore not subject to withholding tax.144 The Commissioner has also provided his opinion regarding the treatment of royalty withholding tax indemnity or gross-up clauses.145 A decision of the Full Federal Court of Australia has addressed the treatment of interest withholding tax gross-up payments and concluded that such were not in the nature of interest and therefore would not be subject to withholding tax.146 The Commissioner is of the view that this case is distinguishable from and not applicable to royalty withholding tax.147 Rather, the terms of the specific royalty agreement must be analysed to determine whether the additional gross-up payment is part of the consideration paid for the matters listed in the statutory royalty definition, where the presumption seems to be that this will often be the case and, as a result, royalty withholding tax would be payable on both the initial royalty and the gross-up amount.

142. Id., at [16]. 143. Referring to K. Vogel et al., Klaus Vogel on Double Tax Conventions, 3rd edn (Kluwer Law International 1997). 144. C. Peadon, Withholding Tax on Partial Assignments of Copyright, 15 Tax Specialist 2, pp. 88-92 (2011). 145. ATO, TR 2004/17, Income tax: indemnification of royalty withholding tax (released 15 Dec. 2004). 146. AU: FFC, 1998, Commissioner of Tax v. Century Yuasa Batteries Pty Ltd, (1998) 82 FCR 288. 147. TR 2004/17 at [65].

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9.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules Australia’s CFC rules operate to include the attributable percentage of the CFC’s attributable income in the assessable income of an attributable taxpayer.148 Whether the CFC has passed the active income test will determine how the attributable income is calculated. For the purpose of the active income test, the CFC’s “adjusted tainted income” must be determined149 where this includes “passive income”. Passive income is defined150 to include “tainted royalty income” as well as amounts derived from the assignment or partial assignment of copyright, patent, design, trademark or other like property or right. Tainted royalty income includes royalties generally (and therefore picks up the extended statutory definition) but does not include royalties received from unrelated persons in the course of carrying on a business where the CFC substantially develops or improves the property or right for which the royalty is paid (such as when the CFC develops software and licenses it to unrelated party).151 If the CFC fails the active income test, attributable income includes adjusted tainted income derived directly and indirectly by the CFC. If the CFC passes the active income test, attribution is much more limited. The determination of attributable income of the CFC is a calculation based on the application of a modified version of the taxation rules under the assumption that the CFC is a resident of Australia.152 This produces an amount referred to as “notional assessable income”153 against which notional allowable deductions will be applied. This notional income does not include amounts that have been taxed in full in Australia, and amounts will be treated as taxed in full if they have been included in a CFC’s (real) assessable income, such as income sourced in Australia derived by an Australian branch of the CFC.154 Australian-sourced royalty income derived 148. Sec. 456 ITAA 1936. For a detailed overview of the CFC rules as enacted, see L. Burns, Controlled Foreign Companies (Longman Professional 1992). 149. Sec. 386 ITAA 1936. 150. Sec. 446 ITAA 1936. 151. Sec. 317 ITAA 1936. These excluded royalties will also not be tainted services income. Sec. 448(6)(b)(ii) ITAA 1936. 152. Secs. 384 and 385 ITAA 1936. 153. Sec. 382 ITAA 1936. If the CFC is a resident of a so-called unlisted country, this is adjusted tainted income, which picks up passive income, tainted sales and tainted services (sec. 386). If resident of a listed country, only eligible designated concession income. 154. Sec. 402(2)(a) ITAA 1936. See also Explanatory Memorandum to Taxation Laws Amendment (Foreign Income) Bill 1990 that inserted the CFC rules. See Burns, supra n. 148, at pp. 142-143.

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by the CFC will normally have been subject to withholding tax and therefore treated as non-assessable non-exempt income (not assessable income) by virtue of section 128D. This royalty income has therefore not been taxed in full and may be included in attributable income. As a further point, section 128D is disregarded as one of the modifications to the general rules so that these amounts can be included in the notional assessable income even if withholding tax has been paid.155 The withholding tax that has been paid is then allowed as a deduction in determining the attributable income.156

9.3. Taxation of IP under EU law As Australia is not a Member State of the European Union, this section is not applicable.

9.4. Taxation of IP under tax treaties 9.4.1. Taxing rights over royalties assigned by article 12(1) Consistent with Australia’s reservation to article 12(1) of the OECD Model,157 all of Australia’s 44 comprehensive tax treaties contain a version of article 12 broadly consistent with the UN Model whereby the source state is granted limited taxing rights concurrent with the taxing rights of the residence state.158 The limited rate of tax is usually a single rate for all types of IP (only five Australian tax treaties contain different rates for different

155. Sec. 389 ITAA 1936. 156. Sec. 393 ITAA 1936. See also Explanatory Memorandum to Taxation Laws Amendment (Foreign Income) Bill 1990 that inserted the CFC rules. 157. OECD Model Tax Convention on Income and on Capital: Commentary on Article 12, Reservations on the Article para. 36 (2014). 158. See M. Dirkis & M. Birch, Chapter 9: Australia in Departures from the OECD Model and Commentaries: Reservations, observations and positions in EU Law and Tax Treaties pp. 187-229 (G. Maisto, ed., IBFD 2014), Online Books IBFD.

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types of IP)159 and varies between 5% and 20%, with the most common rate in recent treaties being 5%.160 The definitions of “royalties” for treaty purposes in article 12(3) of Australia’s tax treaties is broader than the OECD Model and is similar to the domestic tax law definition of royalties considered in section 9.2.161 By way of example, article 12 of the Australia-Switzerland Income Tax Treaty (2013) contains the following: 3. The term “royalties” as used in this Article means payments or credits, whether periodical or not, and however described or computed, to the extent to which they are made as consideration for: a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right; b) the supply of scientific, technical, industrial or commercial knowledge or information; c) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in subparagraph a) or any such knowledge or information as is mentioned in subparagraph b); d) the use of, or the right to use: (i) motion picture films;

159. Agreement between the Government of Australia and the Government of the Argentine Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, and Protocol, art.12 (27 Aug. 1999) [hereinafter Arg.-Austrl. Income Tax Treaty]; Convention between Australia and the Republic of Chile for the Avoidance of Double Taxation with Respect to Taxes on Income and Fringe Benefits and the Prevention of Fiscal Evasion, art. 12 (10 Mar. 2010) [hereinafter Austrl.-Chile Income Tax Treaty]; Agreement between the Government of Australia and the Government of the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art. 12 (25 July 1991, amending protocol 16 Dec. 2011) [hereinafter Austrl.-India Income Tax Treaty]; Agreement between the Government of Australia and the Government of the Republic of Indonesia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art.12 (22 Apr. 1992) [hereinafter Austrl.-Indon. Income Tax Treaty]; and Agreement between the Government of Australia and the Government of the Republic of the Philippines for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art. 12 (11 May 1979) [hereinafter Austrl.-Philip. Income Tax Treaty]. 160. The exceptions for treaties since 2003 being the Convention between the Government of Australia and the Government of the Republic of Turkey for the Avoidance of Double Taxation with respect to Taxes on Income and the Prevention of Fiscal Evasion, art. 12 (10% rate) (28 Apr. 2010) [hereinafter Austrl.-Turk. Income Tax Treaty] and Austrl.-Chile Tax Treaty (with 10% applying to all types of royalties except for payments for the use of equipment where the rate is 5%). 161. Australia reserved the right to amend the definition of royalties in this way, OECD Model: Commentary on Article 12, Reservations on the Article para. 39 (2014).

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(ii) films or audio or video tapes or disks, or any other means of image or sound reproduction or transmission for use in connection with television, radio or other broadcasting; or e) total or partial forbearance in respect of the use or supply of any property or right referred to in this paragraph.162

Unlike the closed definition in the OECD Model, Australia’s treaty practice is to include the phrase “other like property or right” at the end of paragraph (a). The more limited phrase “other like property” was included in the Australia-United Kingdom Income Tax Treaty (1946)163 and the fuller “other like property or right” has been included since the Australia-United Kingdom Income Tax Treaty (1967)164 and the Australia-Singapore Income Tax Treaty (1969).165 The meaning of this phrase was recently considered by the Full Federal Court in the Seven Network case, where it was held that it “was intended to embrace rights recognised as in the nature of intellectual property rights by the laws of the Contracting States” and thereby permits an ambulatory operation.166 The court agreed with the court in first instance that this phrase “extends the operation of a royalty to enable each country to enlarge or contract its protected intellectual property rights, so long as they fall within the genus of intellectual property”.167 However, the Full Federal Court stated further that “the historical material indicates that the phrase was not intended to extend the category beyond rights given legal protection under intellectual property laws.”168 There is some degree of variation in the treaty definition. Some of the newer treaties, including the Australia-Germany Income and Capital Tax Treaty (2015) as well as the Australia-New Zealand Income Tax Treaty (2009), also

162. Convention between Australia and the Swiss Confederation for the Avoidance of Double Taxation with respect to Taxes on Income, with Protocol, art. 12 (30 July 2013) [hereinafter Austrl.-Switz. Income Tax Treaty]. 163. Agreement between the Government of Australia and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art. VII(2) (29 Oct. 1946). 164. Agreement between the Government of the Commonwealth of Australia and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and Capital Gains, art. 10(5) (7 Dec. 1967). 165. Agreement between the Government of the Commonwealth of Australia and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art. 10(3)(a)(i) (11 Feb. 1969) [hereinafter Austrl.-Sing. Income Tax Treaty]. 166. Seven Network (2016) at [83]. 167. Seven Network (2016) at [86]. 168. Seven Network (2016) at [87].

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include payments in relation to spectrum licences.169 Under the AustraliaUnited States Income Tax Treaty (1982), profits on the sale of IP are also defined as royalties if the consideration is contingent on the productivity, use or further disposition of the IP.170 In all of the older Australian treaties, rental payments for equipment leasing are included171 (consistent with the Australian statutory definition and the OECD Model before 1992) but Australia’s treaty practice appears to have changed in this regard,172 with no treaties concluded after 2003 including such payments with the exception of the Australia-Chile Income Tax Treaty (2010)173 and the Australia-Turkey Income Tax Treaty (2010).174 The Australia-Singapore Income Tax Treaty (1969) specifically excludes from the meaning of “royalties” payments for the use of or right to use literary, dramatic, musical or artistic copyrights, as well as motion picture films, tapes for use in connection with radio broadcasting or films or video tapes for use in connection with television.175 In addition to payments for services ancillary to another listed matter, the Argentina-Australia Income Tax Treaty (1999) and Australia-India Income Tax Treaty (1991) include payments for other technical services176 and the Australia-Fiji Income Tax Treaty (1990) includes payments for management services.177 169. Agreement between Australia and the Federal Republic of Germany for the Elimination of Double Taxation with Respect to Taxes on Income and on Capital and the Prevention of Fiscal Evasion and Avoidance, art. 12(3)(e) (12 Nov. 2015) [hereinafter Austrl.-Ger. Income and Capital Tax Treaty] and Convention between Australia and New Zealand for the Avoidance of Double Taxation with Respect to Taxes on Income and Fringe Benefits and the Prevention of Fiscal Evasion, art. 12(3)(e) (26 June 2009) [hereinafter Austrl.-NZ Income Tax Treaty]. 170. Convention between the Government of Australia and the Government of the United State of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art. 12(4)(c) (6 Aug. 1982) [hereinafter Austrl.US Income Tax Treaty]. 171. For example, Agreement between the Government of Australia and the Government of the People’s Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art. 12(3)(b) (17 Nov. 1988), Convention between Australia and the Republic of Italy for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, and Protocol, art. 12(3) (14 Dec. 1982) and Convention between the Government of Australia and the Government of the Republic of Korea for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art. 12(c)(b) (12 July 1982). 172. Dirkis & Birch, supra n. 158, at p. 199. 173. Austrl.-Chile Income Tax Treaty, art. 12(3)(c). 174. Austrl.-Turk. Income Tax Treaty, art. 12(3)(b). 175. Austrl.-Sing. Income Tax Treaty, art. 10 (11 Feb. 1969, protocol 16 Oct. 1989). 176. Arg.-Austrl. Income Tax Treaty, art. 12(3)(e) and Austrl.-India Income Tax Treaty, art. 12(3)(g). 177. Agreement between Australia and Fiji for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, art.12(3)(f) (15 Oct. 1990).

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Australia has also reserved the right to provide a specific source rule in article 12 analogous to that provided for interest in article 11(5) of the OECD Model.178 Where included, the source rule in the Australian tax treaties follows article 11(5) of the OECD Model and provides that the royalties are deemed to arise in the payer’s state of residence, unless they are incurred in connection with a PE and the PE bears the royalties, in which case the royalties are deemed to arise where the PE is located.179 Australia’s tax treaty practice is to also include a general source of income article whereby income derived by a resident of one state that may be taxed in the other state shall be taken for domestic law purposes of the other state to be sourced in that other state.180 This has the effect of deeming royalties to be sourced in the state where they arise, either the payer’s residence state or the location of the relevant PE.

9.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 The Australian domestic law definition of royalties for withholding tax purposes has evolved and expanded over time such that in many, if not all, cases, that definition is broader than that provided in article 12. As noted above, Australian domestic law specifically provides that where an amount would be within the domestic law royalty definition but not within the relevant narrower treaty definition, withholding tax does not apply to the amount, such that the treaty definition prevails.181 Obvious inconsistencies may arise from older notions of royalties being retained in the domestic law but rarely included in modern treaties, where payments in relation to industrial, commercial or scientific equipment is the obvious example. Similarly, the domestic law has been extended to include new technologies, for example including the use of visual images and/or sounds transmitted by satellite, cable or optic fibre or similar technology in connection with television or radio broadcasting and spectrum licences, where such are not included in the older treaties. 178. OECD Model: Commentary on Article 12, Reservations on the Article para. 48 (2014). 179. E.g. see Austrl.-Ger. Income and Capital Tax Treaty, art. 12(5). 180. The source of income article appears in all of Australia’s tax treaties since 2003, usually as article 21 or 22, the only recent exception being the recent Austrl.-Ger. Income and Capital Tax Treaty where this rule appears in the protocol that was entered into at the same time as the treaty. 181. Sec. 17A(5) International Tax Agreements Act 1953 (Cth).

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Perhaps less obviously, as the domestic law statutory definition of “royalties” is inclusive, it picks up royalties as understood under the general law. As discussed above, under Australian law, a disposal or assignment of IP can give rise to ordinary royalty income where the consideration is calculated or payable by reference to the use or exploitation of the IP. Such royalties are included in the statutory definition and would be subject to withholding tax were it not for the override by the narrower treaty definition that only includes payments for use or the right to use IP. As a result, for treaty purposes, such payments will be characterized as a capital gain or a gain from the alienation of property and therefore subject to article 13. The one exception would be under the Australia-United States Income Tax Treaty (1982) that specifically includes these payments.182

9.4.2.1. Distinguishing royalties and payments for services or other rights The Commissioner has provided guidelines for distinguishing between payments for the provision of services and royalties, where this is seen to more often arise in the context of know-how but can be generalized to other types of IP.183 According to the Commissioner’s ruling, a contract for the supply of know-how (rather than services) will often exhibit the following three features: – the product, such as knowledge, information, process, plan, etc., already (or substantially) exists or has been developed; – the product is transferred or supplied for the use of the buyer; and – the property in the product remains with the seller and the seller may retain the right to use the product and also transfer it to others (akin to a non-exclusive licence).184 Therefore, in this case, there will generally be little additional work to be done by the supplier of the know-how and further expenditure will be relatively low.185 In comparison, a contract for services would display the following features: – the contractor must perform services which will result in the creation or development of the product; – the contractor will be using its own know-how or skills in developing the product; and 182. 183. 184. 185.

Art. 12(4)(c) Austrl.-US Income Tax Treaty. IT 2660 at [25]-[27]. IT 2660 at [28]. IT 2660 at [31].

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– the product so created may be used by the buyer but a “by-product” of performing the services may be the creation of a work protected by copyright (such as a plan or design) where such copyright is owned by the contractor and the buyer can only use the property for the purposes for which it was originally designed.186 As a result, there would be a much greater amount of work to be done and additional expenditure incurred when the contract is for services and the nature of this expenditure would likely be salary and wages for the development and testing.187 Where both know-how and services are provided, an apportionment will be necessary to determine the royalties.188 An apportionment approach was attempted in the International Business Machines (IBM) case,189 where the issue was whether the payments made under a Software Licence Agreement (the SLA) were wholly or only in part royalties for the purposes of article 12(4) (definitional provision) of the Australia-United States Income Tax Treaty (1982). IBM argued that the payments under the SLA related to the right to use, distribute and market computer programs such that part of these payments were for distribution rights rather than IP rights. The Commissioner argued that the intention of the agreement was to grant any and all IP rights necessary to allow IBM Australia (IBMA) to deal with the IBM programs (which involved patents, copyrights, mask work rights and trademarks) and therefore the payments were in their entirety royalties – they were payments for the use or right to use IP or other like property, consideration for the supply of commercial knowledge or information, and the supply of assistance of an ancillary and subsidiary nature. The decision ultimately turned on the construction of the contract. The court held that “the SLA grants to IBMA such IP rights as are necessary for distribution of the relevant products by IBMA. It is not a distribution agreement which confers distribution rights independently of the grant of IP rights. The detail of the SLA concerns the definition of IP and IP rights. There is no such detail with respect to distribution rights.”190 The payments were therefore held to be royalties in full.

186. 187. 188. 189. 190.

IT 2660 at [29]. IT 2660 at [31]-[32]. IT 2660 at [35]-[36]. AU: FCA, 2011, International Business Machines Corp v. C of T, [2011] FCA 335. International Business Machines (2011) at [52].

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A similar approach to characterization was taken in the Task Technology case.191 At issue was whether payments made by an Australian resident to a Canadian company were royalties, where the payments were described as being in relation to a licence to reproduce and sell computer software to end users, including the right to develop templates for customers that would go along with the software. In particular, the question was whether the payments were excluded by article 12(7) of the Australia-Canada Income Tax Treaty (1980) that was added by protocol in 2002, which provided: Without prejudice to whether or not such payments would be dealt with as royalties under this Article in the absence of this paragraph, the term “royalties” as used in this Article shall not include payments or credits made as consideration for the supply of, or the right to use, source code in a computer software program, provided that the right to use the source code is limited to such use as is necessary to enable effective operation of the program by the user.192

Based on a close and “careful read” of the terms of the agreement, the court found on appeal that the royalties were payable in relation to rights granted under a specific clause of the distribution agreement which did not refer to source code193 and did not include a grant of a supply of the source code or the right to use the source code.194 Under the terms of the agreement, the right to use the computer program did not constitute the right to use the source code,195 and so ultimately paragraph 7 did not operate to exclude the payments from article 12. According to Vann, the approach of the courts in this and the IBM case “seems not to accept (or maybe be aware of) the important distinction that underlies the OECD approach to software” and the concern over the type of use.196 In relation to software more generally, and as discussed above in relation to the domestic law meaning of royalties, the Commissioner has expressed the view that amounts paid for granting a licence to reproduce or modify a computer program as well as payments for associated know-how (such as source code or algorithms) would be royalties,197 but payments for a licence for simple use only of the software (such as allowing the end user to run 191. AU: FFC, 2014, Task Technology Pty Ltd v. Commissioner of Taxation, [2014] FCAFC 113. 192. Convention between Australia and Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, art 12(7) (21 May 1980, protocol 23 Jan. 2002) [hereinafter Austrl.-Can. Income Tax Treaty]. 193. Task Technology (2014) at [19]. 194. Task Technology (2014) at [33]. 195. Task Technology (2014) at [43]. 196. R. Vann, Tax Treaty Developments p. 21 (The Tax Institute (Australia) 2014). 197. Taxation Ruling 93/12 at [3].

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the software on a computer or network) are not considered to be royalties198 and so such payments would instead be business income (article 7 therefore being relevant). The Commissioner has also commented that the nature of hosted (cloud) access to proprietary software is more akin to the provision of service rather than a licence199 so, again, payment for cloud access may be seen as business income rather than royalties. In relation to digital products, the focus has been on the application of the goods and services tax to such products, with the law having recently been amended to apply to the inbound supply of digital products and certain services.200 The supply of a digital product would normally have the same limits as a single-use licence and, based on the opinion expressed by the Commissioner in relation to software, payments for such a supply should not be considered royalties.

9.4.2.2. Cross-border equipment leasing As noted above, the Australian domestic law and many of Australia’s tax treaties (particularly the older treaties) include within the meaning of “royalties” payments for the use of commercial, industrial or scientific (CIS) equipment. The Commissioner has considered whether royalty withholding tax applies in relation to leasing arrangements and draws the distinction between payments for the use of equipment, which would be royalties under article 12, and payments consisting of consideration for the sale of equipment, which would not be royalties, consistent with the Commentary to the 1977 OECD Model.201 The sale of equipment would give rise to business income or perhaps a capital gain. In the view of the Commissioner, where it is “clear from the outset” that the “paramount purpose” of the transaction is the purchase or repurchase of the equipment, the payments made would not be subject to royalty withholding tax.202 In the case of hire-purchase agreements, interest withholding may instead apply to any implicit interest component.203 However, where the main object of the contract is hire, even if there is an option to purchase, royalty withholding will apply, unless a relevant tax treaty does not treat such a payment as a royalty.204 Agreements 198. Taxation Ruling 93/12 at [4]. 199. Taxation Ruling 2014/1 at [134]. 200. AU: Treasury Laws Amendment (GST Low Value Goods) Act 2017 (Cth), applying to taxable importations of services and digital products from 1 July 2017. 201. ATO, Taxation Ruling 98/21, Income tax: withholding tax implications of cross border leasing arrangements (released 2 Dec. 1998) at [25], with reference to para. 9 OECD Model: Commentary on Article 12 (1977). 202. ATO, TR 98/21 at [7]. Factors to be considered are listed in para. [31]. 203. Sec. 128AC ITAA 1936. See TR 98/21 at [7]. 204. ATO, TR 98/21 at [8].

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characterized as instalment sales or “terms purchase” or where the lease is for all or substantially all of the effective life of the equipment and the incidents and risks of ownership are passed to the lessee are also effectively treated as sales and therefore not subject to royalty withholding tax.205 A related issue is the potential interaction of articles 7 and 12 under circumstances where the equipment leasing is potentially within the scope of both the PE definition in article 5 and the royalty definition in article 12. Australia’s domestic law deems a PE if the non-resident “has, is using or is installing” substantial equipment or machinery.206 Consistent with Australia’s reservation to article 12 of the OECD Model regarding royalties and payments for the use of CIS equipment, Australia similarly reserves the right to treat an enterprise as having a PE where it “operates substantial equipment … with a certain degree of continuity”207 where Australia’s treaties traditionally include such a clause and specify a minimum 6- (or 12-) month period in the year as the necessary continuity. The formulation of the activity in relation to the equipment varies in the treaties and includes terms such as “uses”, “operates” or “maintains”. Traditionally, Australia’s tax treaties also include payments for the use of CIS equipment in the definition of royalties, which therefore would trigger article 12 and withholding tax. However, reflecting a change in treaty practice post-2003, many of Australia’s modern tax treaties no longer include equipment royalties, the exceptions being the tax treaties with Chile and Turkey.208 Where the activities of the non-resident lessor providing or leasing substantial equipment to a resident lessee constitutes a PE under the treaty, the lease payments by the lessee to the non-resident lessor would, by virtue of article 12(4), generally be taxed on a net assessment basis if the property is effectively connected to the PE rather than being subject to final gross withholding tax. According to Vann and Oliver, following Australia’s extension of the final gross withholding tax to royalties in 1992, the Commissioner took a view broadly consistent with the Commentary on Article 7 of the OECD Model, that “the reference to payments for the use or right to use industrial, commercial or scientific equipment in the royalty definition impliedly qualified the substantial equipment PE language so that lessors did not have a PE.”209 However, when the Australia-United States Income Tax Treaty protocol 205. ATO, TR 98/21 at [9]-[10]. 206. Sec. 6(1) definition of permanent establishment subsec. (b) ITAA 1936. 207. OECD Model: Commentary on Article 5, Reservations on the Article para. 46 (2014). 208. Art. 12(4)(c) Austrl.-Chile Income Tax Treaty and art. 12(3)(b) Austrl-Turk. Income Tax Treaty. 209. Vann & Oliver, supra n. 78, at p. 222.

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(2001) and then the Australia-United Kingdom Income Tax Treaty (2003) removed equipment leasing from the royalties article, the Commissioner adjusted his view such that mere leasing would be sufficient to find a PE under treaties following the model of the US protocol but would continue to apply the royalties article (rather than article 7) to such transactions under other treaties.210 Vann and Oliver describe this as allowing the tax administration to “have its cake and eat it.”211 This approach was tested in the McDermott Industries case,212 where the Commissioner argued that mere passive leasing would not give rise to a PE under the Australia-Singapore Income Tax Treaty (1969) and, rather, the royalty article should operate. At issue in the McDermott Industries case was whether royalty withholding tax should have been paid with regard to payments to a Singaporean resident by an Australian resident to obtain the use of barges (agreed by the parties to be substantial equipment, not ships). It was also agreed by the parties that the payments for the bareboat charters were royalties under the treaty definition. The point of contention was whether the Singapore resident had a PE in Australia such that article 10(4) of the Australia-Singapore Income Tax Treaty (1969) would apply (equivalent to article 12(3) of the OECD Model), thereby relieving Australia from the limits of the royalties article and allowing for assessment-based taxation of the royalty income as profits of the PE. The PE definition in article 4 in the Australia-Singapore Income Tax Treaty (1969) defines the term PE to include where “substantial equipment is being used in that other State by, for or under contract with the enterprise” and the royalty definition includes payments for use of CIS equipment. It was accepted that the Singapore company had no business, office or staff in Australia. The Full Federal Court commented in relation to the PE definition that “the contemplated use must be a real use of the asset in Australia to gain income”213 and held that the barges were either used by the Singapore company itself or by the Australian company under contract with the Singapore company. A PE was therefore deemed to arise, such that withholding tax was not payable but rather that the profits of the PE were taxable on a net assessment basis.214 This would appear to be contrary the approach adopted by the Commissioner as described above. However, it should be recognized that the implications of this case may be limited to those treaties 210. Id. 211. Id. 212. AU: FFC, 2005, McDermott Industries (Aust) Pty Ltd v. Commissioner of Taxation, [2005] FCAFC 67. 213. McDermott Industries (2005) at [70]. 214. McDermott Industries (2005) at [71]. See also C. Birchall, The Taxation of Royalties and Equipment Leasing Income under Australia’s Tax Treaties with the UK and the US, 8 Tax Specialist 5, pp. 265-268 (2005).

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that have the old article 5 formulation that requires only that the equipment is “being used … for or under contract” and that in Australia’s more modern treaties the deemed equipment PE requires an arguably higher standard, that either the entity “maintains” the substantial equipment for rental or other purposes215 or “operates” such equipment. The Commissioner considered the implications of the McDermott Industries case in the more complex scenario that includes an additional non-resident sub-lessor.216 The transaction contemplated in the public ruling involves a non-resident head lessor leasing equipment to a non-resident sub-lessor which then sub-leases the equipment to an Australian resident that operates the equipment. Based on the decision in McDermott Industries, under the Australian domestic law, as a starting point, by sub-leasing the substantial equipment to another entity that operates it in Australia, the sub-lessor is considered to be using the equipment itself and so will have a deemed equipment PE in Australia under the Australian tax law definition, which merely requires that the non-resident “has, is using or is installing substantial equipment”.217 This conclusion would also apply where the relevant treaty describes the deemed equipment PE in this manner. However, the liability to tax will also depend upon whether the sub-lessor is carrying on business in Australia and, if so, whether such business is carried on at or through the PE.218 According to the Commissioner’s view, a sub-lessor of substantial equipment will almost always be carrying on a business through the deemed equipment PE,219 where this is also a necessary condition for the domestic withholding tax to be triggered in relation to payments between non-residents (in this case between the sub-lessor and the head lessor). However, if the treaty definition of royalties does not include such payments, this would override the domestic definition in any event, in which 215. The Commissioner provides a view as to the meaning of this test in relation to leases of aircraft and ships in ATO, TR 2007/10, Income tax: the treatment of shipping and aircraft leasing profits of United States and United Kingdom enterprises under the deemed substantial equipment permanent establishment provision of the respective Taxation Conventions (released 19 Dec. 2007) at [26]-[27]. 216. ATO, Taxation Ruling 2007/11, Income Tax: withholding tax and related implications for a non-resident head lessor or hire-purchase provider of substantial equipment where the equipment if obtained by another non-resident entity that subleases, sub-provides or leases it for use in Australia (released 19 Dec. 2007). The ruling also considers the implications of these arrangements where the transaction is a hire-purchase agreement rather than a lease, given that a hire-purchase agreement will give rise to a deemed interest amount that may be subject to withholding tax. This alternative structure is outside the scope of this chapter. 217. ATO, TR 2007/11 at [12]. Sec. 6(1) definition of permanent establishment subsec. (b) ITAA 1936. 218. These issues are explored in ATO, TR 2007/10 at [159]-[170]. 219. ATO, TR 2007/11 at [85].

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case the withholding tax would not operate. If the sub-lessor is not carrying on business at or through the equipment PE, the lease payments to the head lessor will not be incurred in relation to a business carried on in Australia through the PE and therefore will not trigger the domestic withholding tax.220 In relation to the head lessor, in the Commissioner’s view, the equipment is not considered to be “used” by the head lessor in Australia as a result of arrangements of this kind, so the head lessor would not have a deemed equipment PE in Australia merely by virtue of such an arrangement.221 The Commissioner asserts that the head lessor could alternatively be taxable on an assessment basis in the following manner: if the relevant treaty definition of royalties includes equipment lease payments, article 12 will consider them to arise where the sub-lessor’s deemed PE is located (in Australia), such that the source of income article will treat the payments as Australiansourced royalty income of the head lessor that may be liable to Australian tax on an assessment basis.222 However, the ruling does not consider any limitations on this taxing right by virtue of a tax treaty, such as the requirement that the head lessor has a PE in Australia and that the lease payments are effectively connected to that PE.

9.4.2.3. Payments for technical services and interaction of articles 7 and 12 The recent Tech Mahindra case223 considered whether payments for technical services were royalties under article 12 of the Australia-India Income Tax Treaty (1991) as well as the interaction of articles 7 and 12.224 It should be noted that the 1991 treaty at issue has since been amended by protocol in 2011,225 where this protocol had the effect of changing the terms of article 7 so that its current form no longer includes the limited force of 220. ATO, TR 2007/11 at [13] and [14]. 221. ATO, TR 2007/11 at [96]-[97]. 222. ATO, TR 2007/11 at [90]. 223. AU: FFC, 2016, Tech Mahindra Limited v. Federal Commissioner of Taxation, [2016] FCAFC 130 (application for leave to appeal to the High Court refused). See Dirkis, supra n. 85. 224. G.S. (Graeme) Cooper, Chapter 27: Australia: Royalties and Business Profits in the IT Sector in Tax Treaty Case Law around the Globe 2016 pp. 313-320 (E.C.C.M. Kemmeren et al. eds., IBFD 2017), Online Books, discussing Tech Mahindra at first instance: AU: FCA, 2015, Tech Mahindra Limited v. Federal Commissioner of Taxation, [2015] FCA 1082. 225. Protocol Amending the Agreement between the Government of Australia and the Government of the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, art. 3 (16 Dec. 2011).

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attraction clause. The taxpayer was a software company resident in India whose business activities included carrying out IT services for Australian customers both from its PE in Australia and by employees located in India. At issue was whether some or all of the income derived from the services provided from India were taxable in Australia as royalties under article 12. The parties had agreed that the profits referable to the Indian services were not attributable to the Australian PE under article 7(1)(a) and this arguably limits the relevance of the case, but the interaction of articles 7 and 12 was critical, as is seen below. The Commissioner argued that the payments for the Indian services were royalties and taxable under article 12 or, alternatively, were taxable under article 7(1)(b) (the limited force of attraction clause). The taxpayer submitted that the payments were not royalties, but if they were article 12(4) gave priority to article 7 and the amounts would be taxable only if the article 7 tests were met, which the taxpayer argued was not the case. The first substantive issue, the characterization of the payments, was resolved in the decision of first instance and was not considered further on appeal.226 In relation to characterizing the payments, article 12 of the Australia-India Income Tax Treaty (1991) includes the following in the definition of royalties: (g) the rendering of any services (including those of technical or other personnel) which make available technical knowledge, experience, skill, knowhow or processes or consist of the development and transfer of a technical plan or design.

Such payments would not be picked up by the meaning given to royalties under any other Australian tax treaties except for the Argentina-Australia Income Tax Treaty (1999).227 A consequence not discussed in the case is that such payments for technical services would not be within the definition of “royalties” for Australian domestic law purposes and so would not be subject to withholding tax (this is a rare example of a circumstance where the treaty royalty definition is broader than the domestic law meaning for withholding tax purposes). However, by virtue of the source rules of article 12(5) and article 23 (the source of income article), such treaty royalties paid by the Australian customers would be sourced in Australia and therefore taxable on an assessment basis to the Indian resident company, but subject to the article 12 cap of 15% of the gross amount as specified in article 12(2) (b). It was therefore critical to determine whether the right to tax under 226. Tech Mahindra (2015). 227. Art. 12(3)(e) Arg.-Austrl. Income Tax Treaty includes “the rendering of any technical assistance not included in subpara. 3(d)” [the ancillary assistance clause].

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article 12 was overridden by article 7, which would also require the necessary connection to the PE. The Federal Court in first instance considered that this paragraph had two separate limbs: services that make available technical knowledge, experience, etc. and services that consist of the development and transfer of a plan or design. The first limb therefore referred to payments for services that enabled the recipient to make use of the technical knowledge independently, something the Indian services clearly did not do. However, the second limb was held to apply to the following services that related to software design, testing and customization: – the development of new software applications for a customer on request; – the customization of existing software applications on request; – software fixing by amending the source code; – upgrading or enhancing source code for a customer’s applications; and – testing enhancements and new releases before being rolled out as ancillary to the above.228 The payments for other services such as monitoring the functionality of applications and problem solving (not involving writing new code) were outside the definition and therefore not royalties.229 The dispute at the Full Federal Court focused on how to resolve the interaction of articles 7 and 12 of the Australia-India Income Tax Treaty (1991) in relation to those payments that were royalties, given the inherent circularity of these rules.230 The focus was on article 7(7) of the Australia-India Income Tax Treaty (1991), which is equivalent to article 7(4) of the OECD Model, and article 12(4) of the Australia-India Income Tax Treaty (1991), broadly equivalent to article 12(3) of the OECD Model. The court reasoned as follows: Article 12(4) is to be construed in the context that Art 7(7) gives priority to Art 12 over Art 7. Without Article 12(4), royalties forming part of the business profits of an enterprise attributable to a permanent establishment in the source State would be taxable by the source State but subject to a limit on the amount of tax that may be charged … [T]he evident purpose of Art 12(4) is to relieve the source State from the limitation on taxing rights imposed under Art 12 by taxing such royalties under Art 7, not to disentitle the source State from any

228. Tech Mahindra (2015) at [114]-[133]. 229. Tech Mahindra (2015) at [127]. 230. For a more complete analysis, see Dirkis, supra n. 85.

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taxing rights where otherwise Art 7 would not give such taxing rights. Such a construction gives effect to the language of Art 12(4) and is consistent with the extrinsic materials.231

This analysis was considered to be consistent the extrinsic material consulted, being the Explanatory Memorandum that accompanied the bill making the treaty effective in Australian domestic law and the 1980 UN Commentary.232 The effect of article 12(4) was that article 7 would operate and article 12 would not apply to the royalties if the Indian services in respect of which the royalties were paid were effectively connected with the PE in Australia.233 For the purposes of resolving this question, the court held that the phrase effectively connected with the PE “is intended to encapsulate” the standard nexus rule under article 7(1)(a), and not the extended nexus rule under article 7(1)(b) (the force of attraction clause).234 The court stated: It is sufficiently clear that Art 7 and Art 12(4) have a coextensive operation, in that Art 7(7) contemplates that the business profits of an enterprise may include income covered by Art 12 as a royalty. Those royalties that may be taxed under Art 7 are the payments in respect of property, rights or services “effectively connected with” the permanent establishment of an enterprise in the source State and under Art 7(1)(a), profits that are “attributable to” that permanent establishment are taxable by the source State. This is not to base the construction of Art 12(4) upon an assumption that the purpose of Article 12(4) is to remove royalties from Article 12 only if the source State has the right to tax such royalties pursuant to Art 7(1)(a) but to give effect to the coextensive operation of the Articles.235

As these Indian services were not effectively connected to the Australian PE under the standard rule in article 7(1)(a) (because the parties agreed on this point in the case at first instance, it was not litigated or considered by the court), article 7 would not apply to the royalties, and article 12 would be reinvigorated. Whether the payments would have been caught by the force of attraction principle in article 7(1)(b) was not considered relevant. As a result, the payments for the Indian services were taxable in Australia by virtue of article 12 but subject to the limit as specified in that article. The rule that would seem to flow from the decision in this case is that, if payments that meet the definition of royalties for the purposes of article 12 are in relation to property, rights or services that are effectively connected to a 231. 232. 233. 234. 235.

Tech Mahindra (2016) at [31]. Tech Mahindra (2016) at [32]-[36]. Tech Mahindra (2016) at [43]. Tech Mahindra (2016) at [39]. Tech Mahindra (2016) at [37].

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PE, those royalties will be taxable as part of the profits attributable to the PE under article 7 and not subject to the limits of article 12. Where there is a PE but the effectively connected test is not met, such royalties are taxable under the principles and limits of article 12. In this way article 7 does not override article 12 but the two operate coextensively.

9.4.3. Beneficial ownership and royalties The concept of “beneficial ownership” or “beneficial entitlement” as it applies in the context of passive income such as royalties and withholding tax is not defined in Australia’s tax treaties so takes its meaning from the domestic law. A fundamental principle of Australian tax law is that income is assessable to the person who has beneficially derived it236 and this is reflected in the taxation of trust income, where an express, resulting or constructive trust would be effective to shift the tax liability from the trustee to the trust beneficiary.237 The Commissioner has expressed his view regarding the beneficial ownership of interest earned on bank accounts operated jointly and on behalf of children.238 In respect of the operation of this concept in the context of cross-border transactions, the Commissioner has examined the implications of the beneficial ownership concept in relation to the comparable case of interest.239 In concluding that partners of a New Zealand limited partnership (a fiscally transparent vehicle) would be the beneficial owners of the interest and therefore able to access treaty benefits under the Australia-New Zealand Income Tax Treaty (2009), the Commissioner relied on the Commentary on Article 11240 as well as the OECD partnership report.241 The more general principle expressed by the Commissioner was that in applying the test, the beneficial owners should align with the liability to tax.242 It should also be noted that the Australia-New Zealand Income Tax Treaty (2009) includes 236. AU: HCA, 1932, The Countess of Bective v. FCT, (1932) 47 CLR 417. See also R.W. Parsons, Income Taxation in Australia: Principles of Income, Deductibility and Tax Accounting Proposition 5 at [2.41]-[2.44] (Law Book 1985). 237. AU: FCA, 1986, MacFarlane v. FCT, (1986) 13 FCR 356 at 367. 238. ATO, Taxation Ruling 2017/11, Income tax: who should be assessed to interest on bank accounts? (released 26 Apr. 2017). 239. ATO, ATO ID 2011/13, Interest withholding tax: interest arising in Australia paid to a New Zealand Limited Partnership ‘beneficially owned’ (released 10 Feb. 2011). 240. Para. 9 OECD Model: Commentary on Article 11 (2010). 241. OECD, The Application of the OECD Model Tax Convention to Partnerships (1999) para. 61. 242. ATO ID 2011/13.

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a specific rule that for the purposes of article 12, the trustee is treated as the beneficial owner of royalties derived by or through a trust,243 but this rule does not appear in any other modern Australian tax treaty. The protocol accompanying the Australia-Switzerland Income Tax Treaty (2013) contains a special rule for royalties derived by or through a discretionary trust that will treat the beneficiary as the beneficial owner in certain circumstances.244

9.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state Australian treaty practice is to maintain the right to tax in the source state, but at a reduced rate, under article 12 regardless of the existence of a favourable regime in the residence state. The benefit of the reduced rate of tax may be denied by a limitation of benefits article in the relevant treaty. Australia is a signatory to the OECD Multilateral Instrument (MLI) and has nominated 43 of its 44 bilateral comprehensive tax treaties,245 the exception being the recent Australia-Germany Income and Capital Tax Treaty (2015) that already complies with the MLI and contains a limitation of benefits article.246 Australia has agreed to adopt article 7 and the principle purpose test (with a discretion not to apply the rule in certain circumstances), but has declined to adopt the simplified limitation on benefits rule.247 Australia has also recently strengthened its general anti-avoidance laws, with the introduction of a new multinational anti-avoidance law248 and a diverted profits tax.249

9.4.5. Time of taxation Under domestic law, royalties are generally assessable as income when received or applied as directed by the taxpayer (cash basis) but, if received 243. Art. 3(4) Austrl.-NZ Income Tax Treaty. 244. Protocol para. 8(b) Austrl.-Switz. Income Tax Treaty. 245. OECD Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (signed 7 June 2017). 246. Art. 23 Austrl.-Ger. Income and Capital Tax Treaty. 247. Australian Treasury, “Multilateral Instrument” available at https://treasury.gov.au/ tax-treaties/multilateral-instrument/ (accessed 3 Oct. 2017). 248. AU: Taxation Laws Amendment (Combating Multinational Tax Avoidance) Act 2015 (Cth) amending ITAA 1936 to insert new sec. 177DA, with effect from 1 Jan. 2016. 249. AU: Treasury Laws Amendment (Combating Multinational Tax Avoidance) Act 2017 (Cth) and Diverted Profits Tax Act 2017 (Cth), with effect from 1 July 2017.

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as part of business income, will be earned or derived on an accruals basis given that such a tax accounting method is usually applicable to businesses.250 The liability to withholding tax also operates based on having derived the income in the period,251 though the obligation of the payer to withhold is only triggered on payment.252 The withholding tax mechanism has a special rule to pick up constructive payments, where the amount is taken to be paid “when the first entity applies or deals with the amount in any way on the other’s behalf or as the other directs.”253 As was noted above, in response to the Aktiebolaget Volvo case,254 the original statutory definition of royalties, which is relevant for the operation of the withholding tax, was amended in 1980 to replace “paid” in the introductory clause with “paid or credited”.

9.4.6. Excessive royalty payments With regard to non-arm’s length transactions regarding IP, the concern of the government has generally been with the understating of royalties and therefore the avoidance or reduction in withholding tax, rather than excessive royalty payments. This is reflected, for example, in the transfer pricing legislation where a transfer pricing benefit includes a case where the amount of withholding tax payable in respect of royalties by the entity would have been greater under arm’s length conditions than the amount payable under the actual conditions, so this is directed at reducing the amount of withholding tax by reducing the royalty payable, not excess payments.255 In relation to non-arm’s length payments more generally, at a domestic level there is some case authority where “excess” interest outgoings were held to be non-deductible under the general deduction provision on the basis that the excess was not incurred to produce assessable income but for some

250. See ATO, Taxation Ruling TR 98/1, Income tax: determination of income; receipts versus earning (released 14 Jan. 1989) at [48]. 251. Sec. 128B(5A) ITAA 1936. 252. Sec. 12-280 Sch. 1 TAA 1953. 253. Sec. 11-5 Sch. 1 TAA 1953. 254. AU: SCV, 1978, Aktiebolaget Volvo v. Federal Commissioner of Taxation, (1978) FLR 334. In that case, an annual payment based on sales and made to the parent company was held not to be a royalty under either the ordinary meaning or the statutory definition as it then stood since the payment was described as being for the parent company agreeing not to supply its products to anyone in Australia other than the subsidiary. In one of the years in question, the amount was accounted for as due and payable but had not yet been paid, and therefore the amount was not caught by the statutory definition. See Aktiebolaget Volvo (1978) at 345-346. 255. Sec. 815-120(1)(c) ITAA 1997.

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other reason256 and the general anti-avoidance rule could operate to reverse a benefit obtained by virtue of excess deductions.257 Payments for intangibles including royalties for IP are obviously a significant concern in the transfer pricing context. The Commissioner has expressed some limited views specific to IP in his published rulings. For the purposes of identifying arm’s length conditions for a transfer pricing determination, the preference or “basic rule” is to examine the commercial or financial relations that actually exist. However, one exception to this rule is if the entities would have entered into commercial or financial relations that differ in substance from the actual conditions and the Commissioner has identified as an example of a contract that would not be commercially rational where, for a lump-sum payment, an entity sold, under a long-term contract, an unlimited entitlement to IP rights arising from future research over the contract term.258 In the transfer pricing context, the Commissioner has also provided analysis of cost contribution arrangements which may result in a participant being granted rights to exploit interests free of an obligation to pay royalties.259

256. AU: HCA, 1991, Fletcher v. Federal Commissioner of Taxation, [1991] HCA 42 and AU: FFC, 1981, Ure v. Federal Commissioner of Taxation, (1981) 50 FLR 219. 257. Sec. 177F ITAA 1936. 258. ATO, Taxation Ruling 2014/6, Income tax: transfer pricing – the application of section 815-130 of the Income Tax Assessment Act 1997 (released 12 Nov. 2014) at [55][57]. 259. ATO, Taxation Ruling 2004/1, Income tax: international transfer pricing – cost contribution arrangements (released 21 Jan. 2004).

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10.1. Introduction on private law aspects of intellectual property (IP) 10.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law Article 12(2) of the OECD Model defines royalties as follows: The term “royalties” as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.2

Although article 12 of the OECD Model provides this definition, it is necessary to further analyse and interpret the various terms used in the definition. Thus, pursuant to article 3(2) of the OECD Model reference could be made to a term’s meaning in domestic law. In fact, terms used in tax law could be based on the meaning they have in private law. Hence, the following section analyses the tax treaty relevant terms and their meaning in Austrian domestic law. There are different meanings for the terms used in article 12(2) of the OECD Model in Austrian private law.3 Under Austrian private law, intellectual creations of literary, artistic or scientific work including cinematograph films are protected by the Copyright Act 1968.4 The Act defines works 1. The authors are Research Associates at the Institute for Austrian and International Tax Law, WU (Vienna University of Economics and Business). 2. OECD Model Tax Convention on Income and on Capital art. 12(2) (15 July 2014). 3. D. Heinke & F. Rischka, Intellectual Property Law in Austria p. 27 (2nd edn, Wolter Kluwer 2014). 4. See AT: Urheberrechtsgesetz [Copyright Act 1968], Federal Law Gazette 1936/111, latest amendment I 2015/99.

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of literature as written work of any kind,5 speeches, lectures, talks and computer programs.6 In addition, the Copyright Act 1968 covers stage performances, works of fine arts such as photographs, adapted works, collection of works, free works, computer work and database work within its scope. Photographs, which are not beyond everyday pictures, do not qualify as a work of fine art. For those pictures, special ancillary rights are in place in the Copyright Act 1968. Thus, the law grants the producer of the picture the exclusive right to sell, reproduce or make the picture available to the public.7 Although various artistic performances are covered by the Copyright Act 1968, the law does not provide for a general definition of “artistic”.8 Moreover, phonogram rights for music recordings and rights for sound or pictures which were broadcasted are also protected by the Copyright Act 1968.9 Another central term of article 12 of the OECD Model is “patent”, which is regulated in Austria under the Patent Act 1970.10 A patent constitutes a legal title that allows the owner of the IP to exclude other persons from the use of the IP. The Patent Act 1970 can be applied to inventions, which have to be regarded as new and for which the inventor has made a registration in a patent register.11 A precondition for an invention to be patentable is that it has to be innovative, not state-of-the-art and for commercial purposes.12 The Copyright Act 1968 and the Patent Act 1970 are important for domestic tax law, as the Income Tax Act 198813 refers directly to them.14 Trademarks are protected under the Trademark Act 1970.15 According to section 1 of the Act, trademarks are any special signs16 (marks) which can

5. This definition includes scientific or educational work. 6. R. Diettrich, Österreichisches und Internationales Urheberrecht p. 68 (4th edn, Manz 2004). 7. See secs. 73-75 Copyright Act 1968; Heinke & Rischka, supra n. 3, at p. 35. 8. Heinke & Rischka, id., at p. 31. 9. Id., at p. 34. 10. AT: Patentgesetz 1970 [Patent Act 1970], Federal Law Gazette 1970/259, latest amendment I 201/71. 11. S. Fehringer, Übersicht über die einzelnen Arten von Immaterialgüterrechten in Verträge über Immaterialgüterrechte p. 53 (S. Fehringer ed., 1st edn, Linde 2010). 12. L. Wiltschek, Patentrecht, § 1 PatG, para. 1 ff (1st edn, 2006 Manz). 13. AT: Einkommensteuergesetz 1988 [Income Tax Act 1988], Federal Law Gazette 1988/400, latest amendment I 2017/125 [hereinafter ITA]. 14. See secs. 28(1)(3) and 38(1) ITA. 15. AT: Markenschutzgesetz 1970 [Trademark Act 1970] Federal Law Gazette 1970/260, latest amendment I 2016/71. 16. I.e. logos, particularly words, designs, letters, numerals, the shape of goods and packing; see also Heinke & Rischka, supra n. 3, at p. 130.

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be used to distinguish the products from one company of another company.17 Signs, graphics, particular words, designs, letters, numerals, the shape of the goods and their packing can constitute a protected trademark.18 A precondition for the creation of a trademark under the Trademark Act 1970 is that the trademark is listed in a trademark register.19 Under Austrian private law, designs are defined in the Design Protection Act 1990.20 Therein, the law subsumes models under the term design.21 The law defines designs as “the appearance of a product or a part of it which results of [sic] the characteristics of the lines, the contours, the colours, the figure, the surface texture, the materials of the products or its adornment”.22 Plans, secret formulas or a process are not defined in Austrian private law.23 Finally, the terms secret formula or process and information concerning industrial, commercial or scientific are also not defined in public law. For interpretation purposes, the terms secret formula or process as well as information concerning industrial, commercial or scientific can be subsumed under know-how or business secrets.24 Moreover, Austrian private law does not contain a legal definition for know-how or business secrets.25 Nevertheless, the Unfair Competition Act 1984 deals with the protection of business secrets.26 From the supplementary materials of the parliamentary procedure it can be derived that business secrets are essential for the company for which the secrecy has effectively been carried out. Furthermore, the company shall have an interest in keeping the information secret in the future and for which the secrecy is important.27 It is questionable if Austrian private law also accepts the qualification of IP based on foreign private law. As national definitions may diverge from each other, there is a potential risk of qualification conflicts. The domestic 17. G. Kucsko, Geistiges Eigentum p. 37 (1st edn, Manz 2003). 18. Heinke & Rischka, supra n. 3, at p. 130. 19. See sec. 2 Trademark Act 1970. 20. AT: Musterschutzgesetz 1990 [Design Protection Act 1990], Federal Law Gazette 1990/497, latest amendment I 2016/71. 21. Kucsko, supra n. 17, at p. 724. 22. See sec. 1(2) Design Protection Act 1990, translated by Heinke & Rischka, supra n. 3, at p. 162. 23. H.J. Aigner, G. Aigner & H. Buzanich, DBA-Kommentar, Art. 12 Lizenzgebühren, Art. 12, para. 64 (D. Aigner, G. Kofler & M. Tumpel eds., 1st edn, Linde 2016). 24. R. Pöllath & A. Lohbeck, Doppelbesteuerungsabkommen, Art. 12 para. 70f (K. Vogel & M. Lehner, 5th edn, Beck 2008). 25. Fehringer, supra n. 11, at p. 63. 26. See AT: Bundesgesetz gegen den unlauteren Wettbewerb 1984 – UWG [Unfair Competition Act 1984], sec. 11, Federal Law Gazette 1984/448, latest amendment I 2016/99. 27. ErläutRV in 464 BlgNR I. GP 12; see also Fehringer, supra n. 11, at p. 63.

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private law contains a special provision for such situations. Pursuant to section 34(1) of the Choice of Law Act 1978,28 the creation, content and cancellation of the IP right has to be assessed according to the right of the country in which the IP was used or infringement took place.29 Austrian tax law follows the private law unless the tax law contains a divergent rule. Therefore, it is possible that a qualification conflict in tax law may arise if another state applies a divergent qualification of IP in its domestic tax law. It is possible to argue that this conflict will be resolved through article 3(2) of the OECD Model, which clarifies that “any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that State”.30 According to that view of article 3(2) of the OECD Model, Austria would apply, pursuant to this provision, foreign definitions which may diverge from domestic definitions.31 In contrast, one could argue that double tax treaties shall be interpreted autonomously without a fallback to any state’s domestic tax law. Therefore, the context and the interpretation materials shall primarily be used for the interpretation of terms which are not explicitly defined in the treaty.32 In the past years, there were no fundamental revolutions and trends of IP rights that can be protected under Austrian private law.33 However, the intellectual and industrial property legislation in Austria is subject to harmonization at an EU level. Austria therefore needs to implement, for example, the Trade Marks Directive34 in the coming years.

28. AT: Internationales Privatrecht Gesetz [Choice of Law Act], Federal Law Gazette 1978/304, latest amendment I 2015/87. 29. M. Schwimann, Internationales Privatrecht p. 145 ff (3rd edn, Manz 2003); Kucsko, supra n. 17, at p. 834. 30. See art. 3(2) OECD Model (2014). 31. H. Loukota & H. Jirousek, Art. 23, para. 195 in Internationales Steuerrecht (H. Loukota, H. Jirousek & S. Schmidjell-Dommes eds., Manz 2016). 32. C. Strasser, Die Auslegung von Quellenstaatsregelungen in Doppelbesteuerungs­ abkommen, p. 75 (M. Lang ed., 1st edn, Linde 2005); M. Lang, Auslegungsgrundsätze für DBA: Art. 3 Abs. 2 OECD-MA und die Auslegung von Doppelbesteuerungs-Abkommen, 3 IWB 8, p. 287 (2011). 33. However, the Copyright Act 1968, Patent Act 1970 and Trademark Act 1970 were subject to minor changes in the past. Nevertheless, those changes do not reflect any new trend as they do not change the scope of the law substantially; see Federal Law Gazettes: I 2015/11, I 2015/99, I 2015/130, I 2016/71, I 2017/124. 34. Directive (EU) 2015/2436 of the European Parliament and of the Council of 16 December 2015 to approximate the laws of the Member States relating to trade marks.

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10.1.2. Distinction under private law between alienation of IP and granting the right to use IP The legal ownership of patents, trademarks and designs is transferable under private law in Austria. In order to transfer the legal ownership of those IP properties, an acquisition procedure is generally necessary, which requires a title (i.e. contract) and an actual transfer (handing over of the property).35 For this purpose it is required that the new owner must be listed in the underlying patent register which forms a constitutive requirement for the transfer of a patent. In contrast to that, the registration in the trademark register is not needed for the transfer of a trademark.36 It is also possible to grant licences which allow other persons to use the IP for a defined purpose.37 Such partial rights may be restricted to a specified territory or period of time. In contrast to that approach, according to the domestic Copyright Act 1968, copyrights are not transferable to another person.38 Nevertheless, it is possible to allow another person to use partial rights of the IP.39 Hence, the concept of economic ownership does not apply in private law. The Copyright Act 1968 distinguishes between two types of partial rights which are called “Werknutzungsrecht” (right to use and duplicate) and “Werknutzungsbewilligung”. A Werknutzungsbewilligung (permission to use) transfers only some rights, which means that the holder of the copyright allows another person to use the protected IP within a specified territory or time period. In contrast to that, a Werknutzungsrecht transfers all exclusive rights to another person, which means that this person becomes the exclusive holder of the utilization rights. The holder of the copyright can grant a Werknutzungsbewilligung to a variety of other persons and thereby allows them to use the protected IP. However, the holder of the copyright can use the copyright further on without limitation. On the other hand, a Werknutzungsrecht can only be granted to one person and allows an exclusive use of the IP, which means that even the holder of the IP is excluded from the use of the IP.40

35. H. Koziol & R. Welser, Grundriss des bürgerlichen Rechts Band I p. 310 (13th edn, Manz 2006). 36. S. Fehringer, Vertragliche Verfügungen über Immaterialgüterrechte und vertragliche Gestaltungen in Verträge über Immaterialgüterrechte, supra n. 11, at pp. 269 and 274. 37. See sec. 35 Patent Act 1970; sec. 14(2) Trademark Act 1970. 38. See sec. 10(2) Copyright Act 1968; Heinke & Rischka, supra n. 3, at p. 61. 39. Aigner, Aigner & Buzanich, supra n. 23, at Art. 12, para. 48. 40. Heinke & Rischka, supra n. 3, at p. 61.

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10.2. Taxation of IP under the domestic tax law 10.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP Austrian tax law refers in various sections to “royalties” or payments similar to royalties. The following section describes which definitions of the term “royalties” are relevant for domestic tax law and analyses if there are any differences within specific provisions of the tax law. Section 28(1)(3) of the Income Tax Act 198841 deals with income from renting, leasing and royalties. This provision is applicable for persons who are unlimitedly tax liable in Austria. Moreover, section 98(1)(6) of the Income Tax Act 1988, which also deals with the tax treatment of persons subject to limited tax liability, refers to income derived from the granting of property rights under section 28(1)(3) of the Income Tax Act 1988.42 The provision neither provides for a definition of royalties nor mentions “royalties” explicitly. It merely refers to income derived from the granting of property rights.43 Nevertheless, the provision mentions sources of income which fall in any case under the scope of this provision. Payments for a Werknutzungsrecht and Werknutzungsbewilligung, which are protected by the Copyright Act 1968, as well as payments from the assignment of industrial property right, patents and commercial experiences, fall under the scope of section 28(1) (3).44 The term “assignment of industrial property right” describes payments for property which are protected by the Industrial Property Right Acts. The term “commercial experiences” describes payments for address lists, recipes, plans and manufacturing processes.45 The alienation of rights does not fall under the scope of section 28(1)(3) of the Income Tax Act 1988.46

41. ITA, latest amendment I 2017/83. 42. T. Ehrke-Rabel in Die Einkommensteuer (EStG 1988), § 98 para. 89 (F. Hofstätter & K. Reichel eds., LexisNexis 2015). 43. The German form of sec. 28(1)(3) of the ITA is as follows: “Einkünfte aus der Überlassung von Rechten auf bestimmte oder unbestimmte Zeit oder aus der Gestattung der Verwertung von Rechten.” 44. S. Bernegger, Steuerliche Fragen des Technologietransfers in Verträge über Immaterialgüterrechte, supra n. 11, at p. 230. 45. S. Büsser in Die Einkommensteuer (EStG 1988), § 28, para. 13 (F. Hofstätter & K. Reichel eds., LexisNexis 2007). 46. M. Laudacher in Jakom Einkommensteuergesetz 2017 § 28, para. 85 (S. KanduthKristen et al. eds., 10th edn, Linde 2017).

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In section 38(2) of the Income Tax Act 1988 the Austrian legislator explicitly refers to the term “royalties”. Nevertheless, the provision does not contain an independent definition of royalties. But the provision cross-references to the Patent Act 1970. Basically, section 38 of the Income Tax Act 1988 provides a reduced tax rate47 for income from inventions protected by patent law in connection with the exploitation of the inventions to other persons.48 As a result, the term royalties, as used in section 38(2) of the Income Tax Act 1988, is to be defined more narrowly than the definition of royalties in article 12(2) of the OECD Model, as section 38(2) only refers to inventions which are protected by the Patent Act 1970. According to the Patent Act 1970, royalties are payments received by the inventor for the authorization to use the patent in the territory where the patent protection is still effective.49 However, the Income Tax Act 1988 contains an explicit definition of royalties under section 99a(1) that reflects the Austrian implementation of the Interest and Royalty Directive (I&R Directive).50 According to this provision, “royalty payments represent compensation of any kind that is paid for the use of or the right to use copyrights to literary, artistic or scientific works, including cinematographic films and software, patents, brands, samples and models, plans, secret formulas or processes or for the disclosure of commercial, business management or scientific experience as well as payments for the use of or the right to use commercial, business management or scientific equipment.”51 Furthermore, section 12(1)(10) of the Corporate Income Tax Act 1988,52 which provides for an anti-abuse rule for royalty payments, also refers to the royalty definition of section 99a(1) of the Income Tax Act 1988.53 Therefore, this definition is not only relevant for cases that are within the scope of the I&R Directive but also constitutes a relevant provision of Austrian tax law. 47. See sec. 10.2.2.5. regarding reduced tax rate for exploitation of patent rights. 48. Laudacher, supra n. 46, at § 38, para. 1. 49. L. Wiltschek, Patentrecht, § 38 PatG, para. 1 (1st edn, 2006 Manz). 50. Council Directive, 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. 51. See sec. 99a(1) ITA: “Als Lizenzgebühren gelten Vergütungen jeder Art, die für die Benutzung oder für das Recht auf Benutzung von Urheberrechten an literarischen, künstlerischen oder wissenschaftlichen Werken, einschließlich kinematografischer Filme und Software, von Patenten, Marken, Mustern oder Modellen, Plänen, geheimen Formeln oder Verfahren oder für die Mitteilung gewerblicher, kaufmännischer oder wissenschaftlicher Erfahrungen, sowie für die Benutzung oder das Recht auf Benutzung gewerblicher, kaufmännischer oder wissenschaftlicher Ausrüstungen gezahlt werden.” 52. AT: Corporate Income Tax Act 1988, Federal Law Gazette 1988/401, latest amendment I 2017/107. 53. P. Plansky & C. Marchgraber, Körperschaftsteuergesetz 2016, § 12 para. 201 (M. Lang et al. eds., 2nd edn, 2016 Linde).

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Technical assistance does not fall under the scope of the different definitions and provisions described above.54 It is questionable what happens if payments for technical assistance are connected to royalty payments. However, the impact of this answer for domestic tax law seems limited. This is because the distinction between royalties and technical assistance is of subordinate importance in domestic tax law as basically no special tax regime applies to royalties in which this question would be relevant.

10.2.2. Qualification of income deriving from IP and applicable tax regimes 10.2.2.1. Categories of income As there are no special tax regimes provided for royalty income in Austria, the general rules set forth in the Income Tax Act 1988 apply to income stemming from IP. The following sections aim at describing the categories of income under which revenue arising from IP can be subsumed and examines the tax regimes that are applicable. In general – pursuant to section 2(2) of the Income Tax Act 1988 – taxable income is the total amount of income aggregated from all seven categories of income. From this amount taxpayers can deduct certain personal expenses (section 18 of the Income Tax Act 1988) and extraordinary expenses (section 34 of the Income Tax Act 1988). The distinction between the seven types of income is important as there are significant differences in the procedure of tax computation. In principle, the categories of income in Austrian tax law can be divided into business and non-business income and main and ancillary categories of income. However, the application of the first three categories, which are forms of business income, have priority over forms of non-business income. Pursuant to section 23 of the Income Tax Act 1988, business income is defined as income from an independent, continuous activity which is undertaken with the intention to make a profit.55 The sum of all seven categories of income acts as a basis for the calculation of the amount of tax to be paid. Thus, the average tax rate cannot be derived directly from the law as Austria applies a progressive tax rate according to section 33 of the Income Tax Act 1988. However, it is important to mention that Austrian tax law provides a special tax regime for corporations (corporate income tax).

54. See secs. 28(1)(3), 38(2) and 99a(1) ITA. 55. K. Ubelhofer et al., Introduction to Austrian Tax Law p. 8 ff (1st edn, Facultas 2014).

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10.2.2.2. Income from renting, leasing and royalties Income arising from IP can fall under section 28 of the Income Tax Act 1988 as income from renting, leasing and royalties, which is a non-business subcategory of income. This category includes income from payments for a Werknutzungsrecht and Werknutzungsbewilligung, which are protected by the Copyright Act 1968, as well as payments from the assignment of industrial property rights, patents, and know-how. Moreover, the Supreme Administrative Court clarifies that, besides renting and leasing, any payments for usage authorization for property can be subsumed under section 28 of the Income Tax Act 1988.56 Section 28 is only applicable if the income is not derived from a business activity. Therefore, the income shall not result from an independent, continuous activity that is undertaken with the intention to make a profit.57 However, if these requirements are fulfilled, the income will be treated as business income. Thus, the provision’s scope is limited as it only covers passive royalty income which may not be linked to any kind of business activity. The guidelines provided for by the Ministry of Finance clarify that the provision’s main field of application is where a person is the legal successor58 of a holder of an IP and receives royalty income from the exploitation of the IP. Therefore, income received by an inventor or a holder of an IP itself generally constitutes a form of business income.59 As the activities described in section 28 of the Income Tax Act 1988 constitute non-business income, the taxable amount is determined as the surplus of receipts over expenditure.60 Therefore, actual expenditure incurred in relation to income derived, i.e. patent fees for the registration of the patent, is deductible and reduces the tax base accordingly. Income from renting, leasing and royalties will be taxed together with all other sources of income61 and is subject to a progressive tax rate. If income is qualified as non-business income, the alienation of IP rights is tax free as it does not constitute a taxable event. However, the alienation of IP may constitute speculative gains, which are taxable under section 31 ITA. Speculative gains are gains from the sale of property within a period of 1 year.62

56. AT: VwGH [Supreme Administrative Court], 21 Nov. 1958, 1321/56; Büsser, supra n. 45, at § 28 para. 13. 57. Ubelhofer et al., supra n. 55, at p. 11 ff. 58. For example, a person who inherits a property right by reason of death. 59. Ministry of Finance, Administrative Guidelines for the Income Tax Act 1988 2000, para. 6416. 60. C. Lenneis in Jakom Einkommensteuergesetz 2017, supra n. 46, at § 16, para. 1. 61. See sec. 2(3) ITA. 62. Laudacher, supra n. 46, at § 28, para. 85.

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10.2.2.3. Income from self-employment In Austria, there are three types of business income: (i) income from agriculture and forestry (section 21 of the Income Tax Act 1988); (ii) income from self-employment (section 22 of the Income Tax Act 1988) and (iii) income from commercial activities (section 23 of the Income Tax Act 1988). Income from royalties may also fall under the scope of sections 22 and 23 of the Income Tax Act 1988 if the payments are connected to a business activity.63 In order for income to be categorized as income from self-employment, the profession exercised by the taxpayer needs to be listed in section 22 of the Income Tax Act 1988, since this subcategory of income only applies to exhaustively listed activities. Income from self-employment includes, inter alia, income from scientific, artistic and literary activities which have to be exercised professionally by a person.64 Moreover, certain professions governed by statutory regulations such as medical doctors, attorneys and tax consultants fall under the scope of the provision. In all these professions, the work power of the self-employed person is of paramount importance65 Moreover, a self-employed individual earns his income through conducting profitable operations from a trade or business that he operates directly instead of receiving it from an employer.66 An exact delimitation is therefore necessary for the freelance services discussed in the previous paragraph as the scope of the provision is limited. Basically, the categorization of the professions follows the specific professional regulations. However, there are no professional regulations for scientists, artists and authors that may receive income from IP. As Austrian tax law does not provide for a precise definition of the aforementioned terms, their interpretation is largely dependent on several decisions rendered by the Supreme Administrative Court. In one of its rulings the court defined scientific work as an activity which exclusively or almost exclusively aims at generating new scientific findings and/or at teaching scientific knowledge to others for the purpose of expanding the scientific knowledge of the audience.67 Moreover, the Supreme Administrative Court clarifies that the Copyright Act 1968 cannot be used to interpret the term artistic work.68 Instead – according to the Court – artistic work can be defined as work 63. Ubelhofer et al., supra n. 55, at p. 9. 64. Only income that derives from professions which are listed in sec. 21 of the Income Tax Act 1988 fall under this income category; Bernegger, supra n. 44, at p. 229. 65. Büsser, supra n. 45, at § 22 para. 3. 66. Id. 67. AT: VwGH, 31.Mar. 2000, 95/15/0066; M. Vock in Jakom Einkommensteuergesetz 2017, supra n. 46, at § 108c, para. 11. 68. AT: VwGH, 21 July 1993, 91/13/0231; Ministry of Finance, supra n. 59, at para. 5243.

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that is created by the artist himself and which is characteristic of a specific kind of art.69 However, artistic work has to meet a certain quality standard notwithstanding its commercial performance.70 A person who publishes his own ideas in a written form and makes it available to the general public is considered producing literary work.71 The scientific or cultural value is not important for a work to be regarded as a literary work.72 Basically, all sources of income connected to self-employed work are subsumed under section 22 of the Income Tax Act 1988.73 This covers payments from the assignment of industrial property rights, patents and knowhow as well as payments for the alienation of IP rights. Therefore, if a scientist receives royalties for another person’s invention that is protected by a patent, the payment will be qualified as income from self-employment.74 If, however, an invention was made accidentally, i.e. without a professional background or the objective to make an invention, the income may not be qualified as income under section 22 of the Income Tax Act 1988 as the taxpayer lacks the necessary professional background.75 Furthermore, it is important to note that the income shall not be generated in connection with a commercial activity. Thus, the Supreme Administrative Court clarifies that if an invention is made in the course of a commercial activity under section 23 of the Income Tax Act 1988, royalty payments for the exploitation of the invention shall be regarded as income under that section.76 Taxpayers who receive income from self-employment are not obliged to determine their profit through a net equity comparison.77 If a taxpayer, who receives income pursuant to section 22 of the Income Tax Act 1988 and does not determine its profit through a net equity comparison on a voluntary basis, the simplified determination of business income pursuant to section 4(3) of the Income Tax Act 1988 applies. The profit will thereby be determined as the surplus of business profits over expenses.78 Income from self-employment will also be taxed through a progressive tax rate with all other sources of income. Thus, connected costs to IP can be deducted from 69. Vock, supra n. 67, at § 22, para. 11; AT: VwGH, 18 Mar. 1997, 95/14/0157; AT: VwGH, 12 Sept. 1996, 94/15/0079; AT: VwGH, 19 Oct. 2006, 2006/14/0109. 70. AT: VwGH, 23 Oct. 1984, 84/14/0083. 71. AT: VwGH, 29 Mar. 1989, 85/13/0163; AT: VwGH, 11 Aug. 1993, 91/13/0201. 72. Büsser, supra n. 45, at § 22 para. 31. 73. Ministry of Finance, supra n. 59, at para. 1001. 74. Id., at para. 5236. 75. AT: VwGH, 25 Nov. 1980, 2737/79; Büsser, supra n. 45, at § 22 para. 17. 76. Büsser, id., at § 22 para. 11. 77. Vock, supra n. 67, at § 22, para. 3. 78. Ubelhofer et al., supra n. 55, at p. 31.

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the income as business expenses if they are related to the business activity under section 4(4) of the Income Tax Act 1988.79 However, Austrian tax law also provides a simplified computation regime for income from self-employment. This simplified tax computation regime, “Betriebsausgabenpauschalierung”,80 may be applied voluntarily by taxpayers who receive income under section 22 of the Income Tax Act 1988 and do not generate sales revenue of more than EUR 220,000 per year. In this case, the taxpayer can deduct 6% (maximum EUR 13,200) from the turnover of its activity as business expenses without any further evidence. As a result, taxpayers who determine their taxable income through a Betriebsausgabenpauschale cannot deduct connected costs to IP-related income directly because they apply a “flat rate” for business expenses.81

10.2.2.4. Income from commercial activities Income derived from a trade or business that is considered neither as agricultural or forestry activity nor as self-employment is to be qualified as income from commercial activities under section 23 of the Income Tax Act 1988.82 In practice, the dividing-line between income under section 22 and under 23 of the Income Tax Act 1988 may be difficult to assess. Contrary to income from self-employment, income from commercial activities is not limited to specific professions. Instead, all kinds of activities can fall within the scope of the respective section, with the result that the provision’s scope is broader.83 If a taxpayer receives income from self-employment as well as income from commercial activity, the payments are basically treated separately from each other.84 However, if the activities are connected to each other (i.e. an inventor who also uses the invention in his commercial business) the categorization of the income primarily depends on which elements are paramount.85 In order to assess the income of a taxpayer who receives income under section 23 of the Income Tax Act 1988, it is important to know which payments may be qualified as business income. Austrian tax law does not explicitly define the term business income. However, according

79. N. Zorn in Die Einkommensteuer (EStG 1988), supra n. 45, at § 4 Abs 1 para. 1. 80. See sec. 17 ITA. The Betriebsausgabenpauschalierung has significant importance for certain freelance services. 81. Ministry of Finance, supra n. 59, at para. 4100 ff. 82. Büsser, supra n. 45, at § 23 para. 2. 83. Id., at § 23 para. 84. 84. AT: VwGH, 5 May 1989, 1894/68; AT: VwGH, 15 Sept. 1993, 91/13/0237. 85. Vock, supra 67, at § 22, para. 4.

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to a judgment rendered by the Supreme Administrative Court,86 income may be classified as business income if it is directly connected to a taxpayer’s business activity.87 Therefore, royalty payments or all other sources of income which are related to IP fall under the scope of section 23 of the Income Tax Act 1988 if the payments are connected to the business activity. Income from commercial activities, as part of business income, will basically be taxed with the progressive tax rate according to section 33 of the Income Tax Act 1988. In order to assess the amount of business income a profit determination is necessary, which means that all sources of business incomes and expenses have to be detected.88 The profit is determined through a simplified determination of business income pursuant to section 4(3) of the Income Tax Act 1988 as long as the taxpayer does not exceed an annual sales turnover of EUR 700,000.89 Taxpayers who exceed this amount are obliged to keep books.90 Connected costs to those royalties can be deducted as business expenses under section 4(4) of the Income Tax Act 1988. In addition, it is also possible to determine the profit through a flat rate of income tax under section 17 of the Income Tax Act 1988 if the sales revenue exceeds EUR 220,000 per year.91 Furthermore, the alienation of IP is considered to be business income under section 23 and will be included in the tax base.

10.2.2.5. Reduced tax rate for exploitation of patent rights Basically, income that is subsumed under sections 22, 23 and 28 of the Income Tax Act 1988 will be taxed with a progressive tax rate under section 33. However, section 38 of the Income Tax Act 1988 provides a reduced tax rate for income derived from royalty payments for a patented invention.92 Therefore, the invention has to be regarded as new and the inventor must have registered it in a patent register.93 Another requirement for the provision’s application is that the invention is effectively used by another person (i.e. a company that pays a royalty to the inventor for the utilization of the 86. AT: VwGH, 17 Jan. 1989, 88/14/0010. 87. Ministry of Finance, supra n. 59, at para. 1001. 88. Ubelhofer et al., supra n. 55, at p. 15. 89. AT: Unternehmensgesetzbuch [Commercial Code] sec. 189(1)(3), Federal Law Gazette I 1994, latest amendment I 2017/107 [hereinafter CC]. 90. Ubelhofer et al., supra n. 55, at p. 37. 91. Ministry of Finance, supra n. 59, at para. 4100 ff. 92. R. Damberger, Einkünfte aus der Verwertung patentrechtlich geschützter Erfindungen – Ort der Verwertung, Anwendung des Hälftesteuersatzes?, 28 ecolex, p. 891 (2017). 93. Fehringer, supra n. 11, at p. 53.

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IP for its business activity).94 Furthermore, this provision is also applicable if the inventor sells the patent to another person.95 Moreover, the person or company exploiting the patent must use the invention in a territory in which the patent protection is effective.96 If a company in Austria uses the patent, some sort of protection is necessary. If the patent is used in Germany, for example, it must be protected under German law. Nevertheless, it is also possible to apply this rule if the patent protection is only effective in Austria and it is utilized abroad.97 This rule only applies to the individual inventor and may not be transferred to another person. Thus, section 38 of the Income Tax Act 1988 is basically applicable to all types of income.98 Besides that, it is also possible to apply this rule, under certain conditions, to income from employment under section 25 of the Income Tax Act 1988. For example, if the invention is made in the course of an employment relationship and the employer grants the inventor a special remuneration for the invention, the rule described above will be applicable.99 For income derived from the exploitation of patent rights, the tax rate will be reduced by half the average tax rate.100 This means if a taxpayer applies, for example, an average tax rate of 30% to its whole income, the tax rate for the income for the exploitation of patent rights will be reduced to 15%.

10.2.2.6. Taxation of corporations So far, this chapter has only discussed the taxation of individuals. Just as individuals are subject to individual income tax, corporations are subject to corporate income tax in Austria.101 This regime is applicable to legal entities organized under private law, such as public and private limited companies. Moreover, foundations and associations with their own legal identity like private foundations and commercial enterprises operated by public entities are also covered by the scope of the Corporate Tax Act 1988.102 For those entities, all forms of income, including income from IP, are qualified as 94. J. Fuchs in Die Einkommensteuer (EStG 1988), supra n. 42, at § 38 para. 1. 95. Ministry of Finance, supra n. 59, at para. 7347. 96. M. Rauscher, EStG – Einkommensteuergesetz, § 38, para. 11 (W. Wiesner, R. Grabner & R. Wanke eds., online edn, Manz 2017). 97. Damberger, supra n. 92, at p. 892. 98. Ministry of Finance, supra n. 59, at para. 7345. 99. Kanduth-Kristen, supra n. 48, at § 38, para. 15. 100. Id., at § 38, para. 18. 101. AT: Körperschaftsteuergesetz 1988 [Corporate Tax Act 1988], Federal Law Gazette 1988/401, latest amendment I 2017/107 [hereinafter CTA]. 102. Ubelhofer et al., supra n. 55, at p. 46.

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income from commercial activities under section 23 of the Income Tax Act 1988.103 The Corporate Tax Act 1988 contains special tax regimes and provisions that are based on the principles developed by the Income Tax Act 1988 and they only apply to corporations. Nevertheless, the Corporate Tax Act 1988 does not contain any favourable treatment for income derived from royalties by corporations. As a result, the royalty income generated by entities under the Corporate Tax Act 1988 is subject to the generally applicable flat tax rate for corporations, which amounts to 25%.104 Corporations are obliged to determine the taxable income through a net equity comparison. According to the accounting standards set forth in commercial law, companies are thereby not allowed to capitalize self-created intangible assets.105 This covers R&D costs, personnel costs and material costs connected to the development of the IP. Hence, the costs in connection with self-created IP cannot be capitalized, with the result that the expenses incurred in connection with the creation of the IP reduce the tax base immediately after they occur. The expenses will therefore not be depreciated over the lifetime of the asset.106 Furthermore, a sale of those assets has a completely increasing effect of the profit as the asset is not capitalized in the balance sheet. In contrast, purchased IP right can be capitalized because this rule only applies to self-created IP. This principle is also applicable for taxpayers who are not obliged to fulfil the accounting standards set forth in commercial law standards but who have to determine their profit through a net equity comparison. This is due to the fact that section 4(1) of the Income Tax Act 1988 clarifies that intangible assets can only be activated if they were acquired.107 Moreover, the deduction of running costs connected with the IP as business expenses is also possible for corporations. The alienation of IP rights also constitutes a taxable event for corporations, as such entities generate income under section 23 of the Income Tax Act 1988.

10.2.2.7. Economic ownership concept in tax law Austrian tax law contains a special regime which applies to the allocation of an asset to a taxpayer. Assets will thereby not be allocated automatically to the owner of the IP under civil law because domestic tax law follows

103. 104. 105. 106. 107.

See sec. 7(3) CTA. Ubelhofer et al., supra n. 55, at p. 47. See sec. 197(2) CC. U. Troggler, UGB 2013, § 197, para. 1 (1st edn, Linde 2013). Id., at § 197, para. 4.

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the beneficial ownership concept108 according to section 24 of the Federal Fiscal Code (FFC).109 The beneficial owner of an IP needs to have the de facto power of disposal over the asset. This means that this person has the control of the asset and has the power to exclude others from its paramount utilization.110 Hence, Austrian tax law applies the principle of “substance over form”, which means that assets will be attributed according to actual rather than formal legal circumstances.111 The beneficial ownership concept is also applicable to the attribution of earnings and costs that are connected to an asset.112 As a result, royalties, sales revenues and costs that are connected to an IP will be allocated to the IP’s beneficial owner.

10.2.2.8. Tax premium for research activities There are no special tax regimes in Austria for income derived from IP, such as IP boxes or reduced tax rates for royalty income. However, section 108c of the Income Tax Act 1988 provides the “Forschungsprämie” (research premium), which is a special tax premium granted for research activities. The research premium was introduced in 2002 and serves as the sole tax incentive for R&D activities in Austria, which is applicable to all companies. Over the years, the premium has gained importance in domestic tax law and was subject to several increases by the legislator.113 A study on behalf of the Ministry of Finance comes to the conclusion that the premium is an effective instrument that helps to boost research activity in Austria.114 According to section 108c(1) of the Income Tax Act 1988, 12% of the expenses of in-house research activities or contract research will be reimbursed as a tax premium under certain conditions. In practice, the premium is deducted directly from the tax burden.115 If a taxpayer is subject to a tax 108. H. Koziol & R. Welser, Grundriss des bürgerlichen Rechts Band I, p. 281 (13th edn, Manz 2006). 109. AT: Bundesabgabenordnung [Federal Fiscal Code], Federal Law Gazette 1961/194, latest amendment I 2017/40 [hereinafter FFC]. 110. C. Ritz, BAO Bundesabgabenordnung § 24 BAO, para. 8 ff (5th edn, Linde 2014). 111. M. Tanzer & P. Unger, BAO 2016/2017 p. 56 ff (5th edn, LexisNexis 2017). 112. M. Tanzer, P. Unger & F. Althuber, BAO Handbuch § 24 BAO, p. 109 (1st edn, Lexis Nexis 2015). 113. B. Ecker et al., Evaluierung der Forschungsprämie gem. § 108c EStG, Projektbericht, p. 98 (2017, research paper on behalf of the Ministry of Finance). 114. WPZ Research, KMU Forschung Austria, Institute for Applied Science, a study on behalf of the Austrian Finance Ministry, Evaluierung der Forschungsprämie gem. § 108c EStG, Projektbericht p. 1 (2017); available at: https://www.bmf.gv.at/budget/aktuelleberichte/BMF_Evaluierung_der_Forschungspraemie_Endbericht.pdf?5wmav6 (accessed 18 Aug. 2017). 115. Ubelhofer et al., supra n. 55, at p. 39.

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burden of EUR 100,000 and he incurs expenses for in-house research activities amounting to EUR 200,000, EUR 24,000 can be deducted from the payable amount of taxes, assuming that the taxpayer applies the premium of 12% to the amount of EUR 200,000 (200,000 x 0.12 = 24,000). As a result, the tax burden of the taxpayer will be reduced to EUR 76,000. The premium is applicable to in-house research activities that are performed through scientific methods with the purpose of creating new knowledge. In order to be entitled to apply the premium it is important to know exactly how the Austrian legislator defines the term “research”.116 Besides the wording of section 108c of the Income Tax Act 1988, the legislator clarified that the definition of the term provided for in the OECD Frascati Manual shall be used for interpretation purposes.117 According to the OECD Frascati Manual, research is defined as “creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of knowledge to devise new applications”.118 The premium therefore applies to wages, direct and indirect costs, and finance expenses that are connected to the research activity.119 Furthermore, the research has to be done in a domestic company or in a domestic PE.120 Moreover, further formal requirements – including an expert opinion confirming that the activity creates new knowledge – have to be met in order to be entitled to apply the premium.121 According to section 108c(2)(2) of the Income Tax Act 1988, the premium is also applicable for a company if the research is carried out by another company through a contract research agreement. The contractor has to be a research institute or a research company that has its seat in the European Union.122 However, only expenses of a maximum of EUR 1 million can be claimed each year, which means that the premium is limited to EUR 120,000. The scope of the research premium for contract agreements overlaps with the scope of the premium for in-house research.123 In order to 116. Lenneis, supra n. 60, at § 108c, para. 5. 117. Anhang I, Verordnung der Bundesministerin für Finanzen über die Kriterien zur Festlegung förderbarer Forschungs- und Entwicklungsaufwendungen (-ausgaben), zur Forschungsbestätigung sowie über die Erstellung von Gutachten durch die Österreichische Forschungsförderungsgesellschaft mbH (Forschungsprämienverordnung), Federal Law Gazette II 2012/515. 118. OECD, Frascati Manual, p. 30, para. 63 (6th edn, OECD 2002). 119. Zorn, supra n. 79, at § 108c para. 6. 120. W. Pilgermair, T. Kühbacher & P. Pülzl, Forschungsförderung im Steuerrecht und in der Privatwirtschaftsverwaltung, ÖStZ-Spezial, p. 27 (1st edn, LexisNexis 2014). 121. Lenneis, supra n. 60, at § 108c, para. 6 ff. 122. Id., at § 108c, para. 20. 123. Zorn, supra n. 79, at § 108c para. 6/4.

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avoid a double utilization of the premium by the contractor and the client for the same research activity, the provision clarifies that the premium can only be claimed once.124

10.2.3. Tax treatment of income from IP derived by nonresident taxpayers Pursuant to section 1(3) of the Income Tax Act 1988, individuals who have neither their residence nor their habitual abode in Austria are subject to limited tax liability in Austria. Also, legal persons such as corporations are subject to limited tax liability in Austria if they have neither their legal seat nor their place of effective management in Austria. For persons who are only subject to limited tax liability in Austria, only specific sources of income are subject to taxation in Austria. Hence, domestic tax law provides – in section 98 of the Income Tax Act 1988 – an exhaustive catalogue of sources of income which will be taxed for these persons. Pursuant to section 98(1)(6) of the Income Tax Act 1988, income derived from leasing of property for the granting of property rights to use an immovable property that was situated in Austria (e.g. IP) is subject to tax for limited tax liable persons.125 Section 98(1)(6) refers to the same comprehension for the terms granting of property rights as section 28(1)(3) of the Income Tax Act 1988.126 Moreover, the Supreme Administrative Court clarifies that this understanding also includes payments for the right to produce or distribute phonograms,127 film distribution rights,128 royalties and unprotected know-how,129 and payments for the use of literature that is protected under the Copyright Act 1968.130 However, the scope of section 98(1)(6) of the Income Tax Act 1988 is narrower that the scope of 28(1)(3) because the property necessarily needs to be situated in Austria or listed in an Austrian register (i.e. patent register, trade register) or used in an Austrian PE. These requirements are set forth because the principle of territoriality requires a certain connection to Austria in order to tax a person that is only subject to

124. Lenneis, supra n. 60, at § 108c, para. 6 ff. 125. Ubelhofer et al., supra n. 55, at p. 121. 126. Bernegger, supra n. 44, at p. 230. 127. AT: VwGH, 28 Oct. 1954, 1487/52. 128. AT: VwGH, 23 Mar. 1956, 3475/53. 129. AT: VwGH, 25 Nov. 1965, 1477/64. 130. AT: VwGH, 21 Feb. 1964, 2007/63.

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limited tax liability in Austria.131 However, payments for the alienation of IP may not be subsumed under this provision.132 Royalties that fall within the scope of section 98(1)(6) of the Income Tax Act 1988 are subject to a so-called “tax deduction at source in special cases”, according to section 99(1)(3) of the Income Tax Act 1988, which means that they are – in practice – subject to a withholding tax. It is therefore irrelevant under which type of income the payment can be qualified.133 The withholding tax rate amounts to 20% of the gross royalty payment. However, if the recipient of the payments is a resident of a Member State of the European Union or the European Economic Area (EEA), the taxpayer has the possibility134 to deduct all expenses that are directly connected to the payment from the full amount of the royalties. The implementation of this special rule for EU/EEA residents is based on EU law requirements that require taxpayers to have the possibility to deduct directly connected costs from income in the course of withholding taxes.135 However, in this system of net-based taxation, the withholding tax amounts to 25%.136 Domestic tax law allows taxpayers who are subject to taxation under section 98(1)(6) of the Income Tax Act 1988 to request a tax assessment. Following a voluntary tax assessment, the taxpayer can deduct expenses from the taxable income to the extent that they are economically connected to the asset. In contrast to the net-based taxation of EU/EEA residents, the income will be taxed with the progressive tax rate foreseen in section 33 of the Income Tax Act 1988. However, an amount of EUR 9,000 has to be added to the income in order to calculate the tax. This may result in the situation that the applicable tax rate may be higher than the withholding tax that would be levied without a tax assessment.137 The tax assessment is therefore only beneficial if a taxpayer is subject to limited tax liability and generates low royalty income. For companies that are subject to the Corporate Tax Act 1988, a mandatory tax assessment is required and the final tax rate amounts to 25%.138 131. Ubelhofer et al., supra n. 55, at p. 120. 132. Kanduth-Kristen, supra n. 48, at § 98, para. 101. 133. K. Kufner in EStG – Einkommensteuergesetz, supra n. 96, at § 99, para. 10. 134. See sec. 99(2)(2) ITA. 135. DE: ECJ, 3 Oct. 2006, Case C-290/04, FKP Scorpio Konzertproduktionen GmbH v. Finanzamt Hamburg-Eimsbüttel, ECJ Case Law IBFD; J. Fuchs & T. Ehrke-Rabel in Die Einkommensteuer (EStG 1988), supra n. 42, at § 99 para. 1; Ubelhofer et al., supra n. 55, at p. 127. 136. Kanduth-Kristen, supra n. 48, at § 100, para. 2. 137. Ubelhofer et al., supra n. 55, at p. 128. 138. See sec. 24(1) CTA.

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Pursuant to section 99a of the Income Tax Act 1988, royalty payments between affiliated companies within the European Union are exempt from withholding taxes in Austria. Austria has thereby implemented the I&R Directive.139 In order to apply the exemption, it is necessary that the payer of the royalties is a corporation that is subject to unlimited tax liability in Austria or has a PE in Austria. The recipient of the royalty needs to be a corporation or a PE of a corporation that is located in another EU Member State.140 The taxation of royalty payments under section 99a of the Income Tax Act 1988 is analysed in more detail in section 10.3.4.3.

10.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 10.2.4.1. Switch-over for dividends stemming from low-tax jurisdictions Austrian tax law does not provide for CFC rules. However, the Corporate Tax Act 1988 contains a rule which is – to a certain extent – comparable to a CFC legislation. This rule is embedded in section 10 of the Corporate Tax Act 1988 through which Austria implemented the Parent-Subsidiary Directive.141 Basically, the rules of section 10 stipulate that dividend income is – under certain conditions – tax free for corporations. If, for example, an Austrian corporation holds a minimum participation requirement of 10% in a foreign corporation for at least 1 year, dividends are therefore exempt from taxation. Moreover, the foreign corporation needs to be comparable with an Austrian corporation or alternatively it needs to be listed in the Annex to the directive. However, section 10(4) of the Corporate Tax Act 1988 contains an anti-abuse rule which aims at avoiding the abusive utilization of the participation exemption rules.142 Section 10(4) of the Corporate Tax Act 1988 refuses to grant the tax exemption if the foreign company is not subject to a comparable corporate income tax (CIT) and its focus is on generating passive income. A foreign CIT is 139. Council Directive, 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. 140. Ubelhofer et al., supra n. 55, at p. 127. 141. Council Directive 2003/123/EC of 22 December 2003 amending Directive 90/435/ EEC on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States. 142. K. Fürnsinn & C. Massoner in Körperschaftsteuergesetz 2016, supra n. 42, at § 10 para. 142.

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considered to be not comparable to the Austrian CIT if the average tax burden does not exceed 15%.143 In such a case, Austria refuses to grant the tax exemption for the dividends concerned and instead taxes them. The taxes paid by the foreign subsidiary, however, may subsequently be credited against the Austrian tax.144 In section 10(5) of the Corporate Tax Act 1988, the Austrian legislator also provides for a comparable provision145 for portfolio dividends stemming from foreign corporations in which an Austrian corporation holds less than 10% of the shareholdings.146

10.2.4.2. Comparability of the Austrian rules to the ATAD In contrast to CFC rules, the Austrian rules in section 10 of the Corporate Tax Act 1988 do not avoid profit shifting to other countries as they are only applicable if the dividends are distributed to Austria because they only avoid the tax-free repatriation of the profit to Austria.147 The rules are therefore not applicable if the profit will not be distributed to Austria. In contrast to section 10(4) of the Corporate Tax Act 1988, the CFC rule of article 7(2)(a) of the EU Anti-Tax Avoidance Directive (ATAD) provides a different approach as it immediately attributes the subsidiary’s non-distributed income to the domestic parent company.148 As a result, the foreign income of a foreign subsidiary will be included in the domestic tax base. Since the Austrian legislator adopted a fundamentally different approach, the respective rules do not exactly correspond to each other.149 Besides the rules set forth in section 10(4) of the Corporate Tax Act 1988, Austrian tax law contains a general anti-abuse rule in section 22 of the FFC. Pursuant to section 22(1) of the FFC, a company’s tax liability cannot be evaded through abusive measures. It is therefore questionable whether the Austrian anti-abuse rule is compatible with article 7(2)(b) of the ATAD, 143. See. sec. 3(3) Verordnung – Internationale Schachtelbeteiligungen, Federal Law Gazette II 2004/295. 144. Ubelhofer et al., supra n. 55, at p. 110. 145. In contrast to sec. 10(4) CTA, it is not required that the focus of the company is on generating passive income. 146. E. Strimitzer & M. Vock, die Körperschaftsteuer (KStG 1998) § 10, para. 311 (LexisNexis 2015). 147. K. Haslinger, National Report Austria in CFC Legislation, Domestic Provisions, Tax Treaties and EC Law p. 75 (M. Lang et al. eds., 1st edn, Linde 2004). 148. S. Kirchmayr, Hinzurechnungsbesteuerung in Anti-BEPS-Richtlinie: Konzernsteuerrecht im Umbruch?, Hinzurechnungsbesteuerung p. 100 (S. Kirchmayr et al., eds., 1st edn, Linde 2017). 149. P. Orlet, Die Controlled Foreign Company Rule (Art 7 und 8 der Anti-Tax-AvoidanceRichtlinie) in Die Anti-Tax-Avoidance-Richtline p. 128 (M. Lang et al. eds., 1st edn, Linde 2017).

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which contains an alternative approach for a CFC rule that obtained nongenuine arrangements. However, an analysis by Orlet came to the conclusion that the Austrian anti-abuse rule does not comply with the second CFC approach taken in article 7(2)(b) of the ATAD.150 First of all, it remains unclear whether or not the terms “non-genuine arrangement” and “anti-abuse” have the same meaning. Moreover, the legal consequences of the rules discussed in the previous paragraph appear to be different. The CFC rule of article 7(2)(b) of the ATAD, for instance, regulates that the taxpayer shall include “the non-distributed income of the entity or permanent establishment arising from non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage”.151 Pursuant to this approach, taxes that were paid by the subsidiary will be credited. Section 22(2) of the FFC, however, stipulates that any income derived from an abusive source shall be treated as if the income was generated in an appropriate way. Foreign taxes will not be credited in such a situation, which is in clear breach of the principle described in the ATAD. Furthermore, the Austrian anti-abuse rule is a general rule that is not specifically designed to avoid profit shifting via foreign subsidiaries.152 Hence, section 10(4) of the Corporate Tax Act 1988 and section 22 of the FFC do not meet the minimum standard set forth in the ATAD. As a result, Austria will have to adopt the rules laid down in the directive by the end of 2018.153

10.2.4.3. Prohibition of royalty deduction in special cases In 2014,154 Austria introduced a special anti-abuse rule in section 12(1)(10) of the Corporate Tax Act 1988 that prohibits the deduction of interest or royalty payments made to affiliated companies under certain conditions. The purpose of this rule is to reduce tax benefits for corporations aiming at shifting their profits to low-tax countries.155 The Austrian legislator introduced this rule before the BEPS measures were published by the OECD.156 In practice, such payments will rarely be accepted as business expenses and 150. Id., at p. 125. 151. Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market, OJ L193 (2016). 152. Orlet, supra n. 149, at p. 122 ff. 153. Id., at p. 130. 154. Federal Law Gazette I 2014/13. 155. Plansky & Marchgraber, supra n. 53, at § 12 para. 151. 156. T. Bieber, A. Lehner & S. Bergmann, Körperschaftsteuergesetz - Update-Kommentar § 12 para. 132 (1st edn, 2015).

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will not reduce a domestic corporation’s tax base. The rule is applicable if the recipient of the royalty payments is either subject to no tax at all or if the nominal or effective tax rate is lower than 10% or if the effective tax rate is reduced to under 10% as a result of a tax reimbursement.157 Thus, royalty payments are, inter alia, not deductible in Austria if the receiver may apply a patent box regime resulting in an effective tax rate that is lower than 10%.158 For interpretation purposes, section 12(1)(10) of the Corporate Tax Act 1988 clarifies that the term royalty shall have the same meaning as under section 99a(1) of the Income Tax Act 1988.159 The recipient of the payments needs to be a corporation under section 1(2)(1) of the Corporate Tax Act 1988 (an entity organized under private law) or a foreign corporation that is comparable to an Austrian entity. The provision is especially designed to cover foreign affiliated companies that are located in low-tax jurisdictions. Besides that, according to the wording of the provision, it is possible that domestic corporations fall within the scope of this provision if they are subject to no tax.160 Furthermore, the provision follows the beneficial owner concept, which means that the rule is also applicable if the royalty is paid through an intermediate company. Thus, this approach shall avoid that in contrast to the beneficial owner, the direct recipient of the payments does not fall under the scope of the provision, with the result that the payment is not applicable.161 One requirement to fall under the scope of section 12(1) (10) of the Corporate Tax Act 1988 is that the recipient of the payment is an affiliated company. However, the legislator does not provide for a definition of the term. From the provision’s context, it can be derived that the affiliated company has to be subject to the company’s unified management or control.162

157. Id., at § 12 para. 197 ff. 158. Ministry of Finance, Administrative Guidelines for the KStR 2013 para. 1266bl. 159. See sec. 10.2.1. 160. Plansky & Marchgraber, supra n. 53, at § 12 para. 156. 161. Id., at § 12 para. 201. 162. Bieber, Lehner & Bergmann, supra n. 156, at § 12 para. 177; Ministry of Finance, supra n. 159, at para. 1266aw.

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10.3. Taxation of IP under EU law 10.3.1. Issues of compatibility of domestic law with EU law 10.3.1.1. Inbound royalties As Austria has not implemented a special rule concerning inbound royalties, there is no need to investigate whether a specific rule violates the principles established by the ECJ.

10.3.1.2. Outbound royalties This section examines whether the taxation of outbound royalties is in line with the principles established by the ECJ in the field of fundamental freedoms. Section 12(1)(10) of the Corporate Tax Act 1988, which was introduced in 2014, provides for the non-deductibility of intra-group interest and royalty payments if the recipient of the payments is a resident in a low-tax jurisdiction.163 Royalties are not paid for services; hence, the freedom of services is not applicable. The same holds true for the fundamental freedoms of free movement of workers and goods.164 Regarding the question whether the freedom of establishment or the free movement of capital is applicable, the purpose of the legislation must be taken into account165 and thus the term “konzernzugehörig” (part of the concern) needs to be defined.166 That is because due to the jurisdiction of the ECJ, a direct or indirect majority influence in another company is needed in order for the freedom of establishment to be applicable.167 If the term “konzernzugehörig” is defined in a more loose sense,168 it would lead to the applicability of the free movement 163. R., Jerabek & N. Neubauer, Is Sec. 12 Para. 1 No. 10 Corporate Income Tax Act 1988 in Conformity with European Union Law?, 32 SWI 8, p. 369 (2014). 164. C., Wimpissinger, Is the Non-Deductibility of Interest Payments and Royalties According to Sec. 12 of the Corporate Income Tax Act Contrary to Union Law?, 32 SWI 5, p. 220 (2014). 165. T., Kühbauer, Abzugsverbote für Zinsen und Lizenzgebühren im Licht des Unionrechts, 33 ÖStZ 7, p. 170 (2017). 166. R. Baiser, Schuldzinsenabzugsbeschränkungen im Licht des Unionsrechts: konsistente Einmalerfassung versus diskriminierende Doppelbesteuerung, 34 Rdw 4, p. 212. 167. HU: ECJ, 5 Dec. 2014, Case C-385/12, Hervis Sport- és Divatkereskedelmi Kft. v. Nemzeti Adó- és Vámhivatal Közép-dunántúli Regionális Adó Főigazgatósága, ECJ Case Law IBFD. 168. The Austrian tax administration argues that the term “konzernzugehörig” is to be defined in respect of sec. 15 of the Stock Corporation Act. As a result, a mutual management would be sufficient in order for the company to be qualified as part of the concern. The ECJ holds the view that this is not sufficient to have a majority influence. PT: ECJ,

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of capital. However, the ECJ is not consistent with this opinion. According to the Court, many cases that involved a legal person’s participation in a foreign company’s stock leading to a rise of its influence in the other person’s decision-making fall under the freedom of establishment.169 According to recent cases, the ECJ decided that 25% of stock is needed in order for the freedom of establishment to be applicable.170 In Itelcar and Kronos, the ECJ decided that 10% was not enough for the freedom of establishment to be applicable; hence, the freedom of capital would be applicable.171 However, section 12(1)(10) of the Corporate Tax Act 1988 does not specifically stipulate a certain amount of influence and it can be argued whether or not “konzernzugehörig” complies with the requirements set out by the ECJ in order for the freedom of establishment to be applicable. We take the view that these principles are met.172 Section 12(1)(10) of the Corporate Tax Act 1988 affects unilateral and bilateral interest and royalty payments. At first glance, one could argue that this rule does not violate the freedom of establishment. As only legal persons173 fall under section 12(1)(10), who are regularly taxed at a rate higher than 10% in the domestic scenario,174 it leads to an (indirect) discrimination against foreign affiliated group companies175 founded in a low-tax country, which is treated as a violation against the freedom of establishment by the ECJ.176 If the subsidiary is founded in Austria, the affiliated company 3 Oct. 2013, Case C-282/12, Fazenda Pública v. Itelcar - Automóveis de Aluguer, Lda, ECJ Case Law IBFD. 169. UK: ECJ, 13 Mar. 2007, Case C-524/04, Test Claimants in the Thin Cap Group Litigation v. Commissioners of Inland Revenue, ECJ Case Law IBFD; DE: ECJ 14 Oct. 2004, Case C-36/02, Omega; UK: ECJ, 12 Sept. 2009, Case C-196/04, Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd v. Commissioners of Inland Revenue, ECJ Case Law IBFD; DE: ECJ, 3 Oct. 2006, Case C-452/04, Fidium Finanz AG v. Bundesanstalt für Finanzdienstleistungsaufsicht, ECJ Case Law IBFD. 170. FR: ECJ, 7 Sept. 2017, Case C-6/16, Eqiom SAS, formerly Holcim France SAS, Enka SA v. Ministre des Finances et des Comptes publics, ECJ Case Law IBFD. 171. Itelcar (C‑282/12); DE: ECJ, 11 Sept. 2014, Case C‑47/12, Kronos International Inc. v. Finanzamt Leverkusen, ECJ Case Law IBFD. 172. Bieber, Lehner & Bergmann, supra n. 156, at § 12 para. 177; Ministry of Finance, supra n. 159, at para. 1125. The Administrative Guidelines stipulate that a dominant influence and control is needed in order to be part of the concern. Even though it does not mention a specific amount of influence, we take the view that more than 25% is needed to exercise a major influence on an affiliated company. 173. As defined under sec. 1(1) CTA. 174. Unless the company falls under the relief of sec. 5 CTA. 175. See Jerabek & Neubauer, supra n. 163, at p. 370. 176. BE: ECJ, 22 Mar. 2007, Case C-383/05, Raffaele Talotta v. Kingdom of Belgium, ECJ Case Law IBFD; DE: ECJ, 16 Sept. 1999, Case C-294/97, Eurowings Luftverkehrs AG v. Finanzamt Dortmund-Unna, ECJ Case Law IBFD; DE: ECJ, 12 Dec. 2002, Case C-324/00, Lankhorst-Hohorst GmbH v. Finanzamt Steinfurt, ECJ Case Law IBFD.

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benefits from the deductibility of the royalties, provided the corporation is not tax exempt under section 5 of the Corporate Tax Act 1988. This tax advantage cannot be denied by arguing that section 12(1)(10) aims to ensure a similar level of taxation in the low-tax country.177 The ECJ also decided that such a rule is not an adequate measure to balance the advantage of the low taxation in the foreign country in comparison with the Austrian nondeductibility.178 However, the freedom of establishment may be restricted due to reasons listed in article 52(1) of the Treaty on the Functioning of the European Union (TFEU) or an overriding reason related to public interest. Nevertheless, it is also necessary that the restriction is appropriate for ensuring the attainment of the objective in question and does not go beyond what is necessary to attain that objective.179 Possible reasons180 to justify section 12(1)(10) of the Corporate Tax Act 1988 would be the coherence of the Austrian tax law,181 the prevention of abuse182 and the protection of a balanced allocation to impose taxation.183

10.3.1.3. Research premium Section 108c of the Income Tax Act 1988 provides that a premium of 10% may be claimed for costs of R&D expended in a domestic place of business; however, comparable expenditure of a foreign PE is excluded from the research premium. Thus, domestic PEs are treated more favourably, which falls within the scope of the freedom of establishment. This differentiation, however, is permitted if foreign and domestic PEs carrying out R&D are 177. See H. Peyerl, Das neue Abzugsverbot für Zins- und Lizenzzahlungen im Konzern, 31 ÖStZ 9, p. 226 (2014); Cadbury Schweppes (C-196/04). 178. FR: ECJ, 28 Jan. 1986, Case 270/83, European Commission v. French Republic, ECJ Case Law IBFD; Eurowings (C-294/97); SE: ECJ, 26 June 2003, Case C-422/01, Försäkringsaktiebolaget Skandia (publ) and Ola Ramstedt v. Riksskatteverket, ECJ Case Law IBFD. 179. Itelcar (C-282/12). 180. Jerabek & Neubauer, supra n. 163, at p. 378. 181. BE: ECJ, 28 Jan. 1992, Case C-204/90, Hanns-Martin Bachmann v. Belgian State, ECJ Case Law IBFD. 182. Test Claimants in the Thin Cap Group Litigation (C-524/04); DE: ECJ, 17 Sept. 2009, Case C-182/08, Glaxo Welcome GmbH & Co. KG v. Finanzamt München II, ECJ Case Law IBFD. 183. BE: ECJ, 5 July 2012, Case C-318/10, Société d’investissement pour l’agriculture tropicale SA (SIAT) v. État Belge, ECJ Case Law IBFD; AT: ECJ, 10 Feb. 2011, Case C-436/08, Haribo Lakritzen Hans Riegel BetriebsgmbH and Österreichische Salinen AG v. Finanzamt Linz, ECJ Case Law IBFD; UK: ECJ, 13 Dec. 2005, Case C-446/03, Marks & Spencer plc v. Halsey (Her Majesty’s Inspector of Taxes), ECJ Case Law IBFD.

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not in a comparable situation.184 Kühbacher argues that if the foreign PE is situated in a country with which Austria stipulated the credit method, the situation is comparable.185 That is because Austria is allowed to tax the foreign PE. As a result, Austria would have to grant in this case the research premium, as Austria would not lose its right to tax. The premium is only granted if the PE is taxable. If the credit method is applied, the ECJ follows the view that the state of residence may not distinguish between domestic and foreign sources. If the exemption method is applied, however, the situation is not clear: Austria will not tax potential future income that is linked to the research. However, in Timac Agro, the ECJ decided that a German regime that allowed a German company to deduct losses incurred by its PE in Austria subject to recapture in certain circumstances is a comparable situation even though the exemption method was applied and, as a result, this restriction was not justified. This would mean Austria had to grant the research premium if the ECJ decided the situation would be comparable.186 In another relevant case, the ECJ decided that a research premium had to be granted as the rental income was taxable in Austria.187

10.3.2. Inbound and outbound royalty taxation with respect to third countries As mentioned earlier, section 12(1)(10) of the Corporate Tax Act 1988 may also violate the free movement of capital. A comparison between the domestic and the bilateral scenario determines whether there is a potential violation of the free movement of capital. Article 65(1)(a) of the TFEU allows Member States to treat taxpayers with a different place where the capital is invested differently. However, this does not grant Member States the right to discriminate arbitrarily.188 This discrimination could be justified189 if an (mandatory) exchange of information is not possible.190 Another reason 184. BE: ECJ, 22 Dec. 2008, Case C-282/07, Belgian State v. Truck Center SA, ECJ Case Law IBFD; UK: ECJ, 12 Dec. 2006, Case C-374/04, Test Claimants in Class IV of the ACT Group Litigation v. Commissioners of Inland Revenue, ECJ Case Law IBFD. 185. T. Kühbauer, Tax Premium (only) for Domestic R&D Expenditures?, 32 SWI 10, p. 482 (2014). 186. DE: ECJ, 17 Dec. 2015, Case C-388/14, Timac Agro Deutschland GmbH v. Finanzamt Sankt Augustin, ECJ Case Law IBFD. 187. AT: ECJ, 4 Dec. 2008, Case C-330/07, Jobra Vermögensverwaltungs-Gesellschaft mbH v. Finanzamt Amstetten Melk Scheibbs, ECJ Case Law IBFD. 188. N. Zorn, EG- Grundfreiheiten und dritte Länder p. 211 (P. Quantschnigg, W. Wiesner & G. Mayr eds., FS Nolz). 189. Jerabek & Neubauer, supra n. 163, at p. 380. 190. IT: ECJ, 19 Nov. 2009, Case C-540/07, Commission of the European Communities v. Italian Republic, ECJ Case Law IBFD.

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would again be the prevention of abuse.191 Lang argues that in cases where a company was influenced by another affiliated company; the ECJ tends to apply the freedom of establishment rather than the freedom of capital. As a result, section 12(1)(10) of the Corporate Tax Act 1988 would not be applicable in respect to third countries.192

10.3.3. Domestic tax regime and EU State aid rules Article 107(1) of the TFEU requires that State aid be “granted by the State or though State resources”.193 However, this does not also mean that a state can provide financial support indirectly.194 There is no rule in Austria which grants a direct aid concerning royalties for the taxpayer. It is also questionable whether any Austrian rule regarding royalties can be treated as an indirect State aid. Furthermore, it must be added that the State aid rules along with the fundamental freedoms can be applied to the same case,195 due to the fact that they both aim to guarantee free competition and economic trade among the Member States.196 If the criteria introduced in article 107 of the TFEU are not fully met, the European Commission is not allowed to check whether there is also a violation against the fundamental freedoms.197 The ECJ clarified that if not all the four criteria listed in article 107 of the TFEU (former article 87 of the EC treaty) are met, the rule in question cannot be qualified as a State aid.198 First, there must be an intervention by the state or through state resources, second, the intervention must be liable to affect trade between Member States, third, it must confer an advantage on the recipient and, fourth, it must distort or threaten to distort competition. If a measure constitutes State aid, it may be deemed by the Commission to be compatible with State aid rules under certain circumstances. In general, an 191. NL: ECJ, 20 May 2010, Case C-352/08, Modehuis A. Zwijnenburg BV v. Staatssecretaris van Financiën, ECJ Case Law IBFD. 192. M. Lang, Der Anwendungsbereich der Grundfreiheiten p. 521 (M. Lang & C. Weinzierl eds., Festschrift Rödler 2010). 193. Treaty on the Functioning of the European Union art. 107, OJ C326/47 (2012). 194. DE: ECJ, 22 Mar. 1977, Case 78/76, Steinike & Weinlig v. Federal Republic of Germany; FR: ECJ, 30 Jan. 1985, Case 290/83, Commission v. France; FR: ECJ, 16 Nov. 2000, Case C-279/98, Cascades v. Commission. 195. FR: ECJ, 7 May 1985, Case 18/84, Commission v. France; IT: ECJ, 20 Mar. 1990, Case C-21/88, Commission v. Italy. 196. IT: ECJ, 5 June 1986, Case 103/84, Commission v. Italy. 197. DE: ECJ, 19 Sept. 2000, Case C-156/98, Federal Republic of Germany v. Commission of the European Communities, ECJ Case Law IBFD; M. Lang, Seminar: Steuerrecht, Grundfreiheiten und Beihilfenverbot, 25 IStR 15, p. 570 (2010). 198. IT: ECJ, 17 Nov. 2009, Case C-169/08, Presidente del Consiglio dei Ministri v. Regione Sardegna, ECJ Case Law IBFD.

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aid measure is compatible if it is well defined, targeted at identified market failures and objectives of common interest, limited to the minimum amount necessary and creates an incentive effect.199 The question is whether the tax rulings confer a selective economic advantage on the companies concerned by lowering their tax liabilities in certain jurisdictions.200 However, there is no discussion in scientific journals if a rule regarding royalties violates EU State aid. It can be argued that the Austrian research premium is selective as it only affects Austrian PEs.201

10.3.4. Open issues in the interpretation of the I&R Directive 10.3.4.1. The notion of “royalties” included in article 2(b) of the I&R Directive In the course of the implementation of the I&R Directive the Austrian legislator decided to alter section 99(a)(1) of the Income Tax Act 1988 by incorporating the same definitions of interests and royalties found in the directive. The definition of royalties provided by article 2(b) of the directive mirrors that in article 12(2) of the OECD Model, subject to the two following important differences:202 – it includes the term “software”; and – contrary to the OECD Model (after 1992), payments for the use of industrial, commercial or scientific equipment fall under the definition of the directive.203 Considering that the I&R Directive mirrors the OECD Model (2003), it can be argued that the OECD Commentary offers an indication whether specific items of income fall within the definition of royalties. Exclusivity payments would therefore be treated as a royalty, as defined under paragraph 8(1) of the Commentary on Article 12 of the OECD Model (2003), as it should not 199. N. Robins, The Tax State Aid Investigations, and the Role of Economic and Financial Analysis, 19 Derivs. & Fin. Instrums. 5, p. 2 (2017), Journals IBFD. 200. K. Bacon, European Union Law of State Aid p. 2 (3rd edn, Oxford University Press 2017). 201. ES: ECJ, 21 Dec. 2016, Case C-20/15_P, European Commission v. World Duty Free Group and Others, ECJ Case Law IBFD. 202. M. Gusmeroli, Triangular Cases and the Interest and Royalties Directive: Untying the Gordian Knot? – Part 2, 45 Eur. Taxn. 2, sec. 5.1.3.2. (2005). 203. S.M. Fernandes et al., A Comprehensive Analysis of Proposals to Amend the Interest and Royalties Directive – Part 2, 51 Eur. Taxn. 11, sec. 3.3.2.2. (2011).

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make any difference if the payments were made due to separate contracts.204 As the directive itself does not mention the transfer of the right to use an IP – neither under a licence nor under a sub-licence agreement – payments made as a consideration for the transfer of the IP would be regarded as regular business income.

10.3.4.2. The introduction of a “minimum effective taxation clause” Austria does not have a minimum effective taxation clause; whereas in order to be eligible for the exemption of the source taxation, it is required for the other Member State to impose a tax, listed under article 3 of the I&R Directive.205 However, the Austrian legislator has concluded a minimum tax requirement under section 12(1)(10) of the Corporate Tax Act 1988, but it does not plan to implement a minimum effective taxation clause in the future.

10.3.4.3. Anti-abuse provisions and beneficial ownership clauses Section 99a(3) of the Income Tax Act 1988 implemented the I&R Directive by requiring that the affiliated foreign company is qualified as a beneficial owner if it receives those payments for its own benefit and not as an intermediary, such as an agent, trustee or authorized signatory, for some other person. Moreover, section 99a(3) requires that the company is a beneficial owner if the debt-claim, right or use of information in respect of which interest or royalty payments arise is effectively connected with the receiving company. This part cannot be found in the directive and it can be argued whether it is in accordance with the directive.206 Pöllath and Lohbeck argue that due to the wording of this paragraph, that a beneficial owner can only be a company that is able to dispose of the royalty-generating asset or of the use of the generated income can be regarded as the beneficial owner.207 Section 99a(4) of the Income Tax Act 1988 implemented article 1(4) of the I&R Directive literally and defines when a PE is treated as a beneficial owner. The wording is fairly similar to that of paragraph 3 but is split into 204. C. Bobbett et al., The Treaty Definition of Royalties, 60 Bull. Intl. Taxn. 1, sec. 3.2.3. (2006). 205. See sec. 99a(5) ITA. 206. A. Bayer, Beneficial Ownership According to Section 99a of the Austrian Income Tax Act, 29 SWI 1, p. 7 (2011). 207. Pöllath & Lohbeck, supra n. 24, at Art. 12 Lizenzgebühren para. 54.

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two sub-paragraphs. A PE is therefore the beneficial owner of the payment if the debt-claim, right or use of information in respect of which interest or royalty payments arise is effectively connected with the PE. Moreover, the PE needs to be located in a Member State listed in the directive.208 The anti-abuse provision of article 5 of the I&R Directive was implemented in section 99a(5) of the Income Tax Act 1988. Article 5(1) of the directive determines that the Member States may use their domestic abuse or agreement-based provisions. Section 22(1) of the FFC however, is in fact similar to the implemented provision that can be found under section 99a(9)(2) of the Income Tax Act 1988. Member States can therefore deny the exemption from taxation if the principal motive of the transaction is tax evasion. Section 22(1) of the FFC is therefore not applicable.209

10.3.4.4. Procedural issues Section 99a(8) of the Income Tax Act 1988 defines that if the requirements listed under paragraph 6 are not fulfilled for a whole year, the paying company is entitled to levy withholding tax. The receiving company or PE can demand a refund of a tax by the responsible Austrian tax office.210

10.4. Taxation of IP under tax treaties When it comes to Austria’s treaty practice, Austria tends to follow the international standards. Until 2009, Austria’s main goal was to ensure the quality of its business location in international competition and legal security by concluding as many double tax treaties as possible. From then on, the focus has shifted and Austria tries to follow the OECD standards precisely.211 Regarding business income, for example, Austria is willing to apply the OECD standard unconditionally.212 When the Ministry of Finance came up

208. G. Furherr & C. Nowotny, Uumsetzung der Zinsen-/Lizenzen-Richtlinie in § 99A EsTG Durch das Abgäg 2003, 2 GeS 5, p. 190 (2004). 209. C. Staringer & N. Tüchler, Die Quellensteuerfreiheit nach der Mutter-TochterRichtlinie und nach der Zinsen/Lizenzgebühren-Richtlinie und ihre Umsetzung in Österreich in Quellensteuern p. 281 (M. Lang, J. Schuch & C. Staringer eds., Linde 2010). 210. Furherr & Nowotny, supra n. 208, at p. 192. 211. H. Jirousek, Die österreichische Position beim Abschluss von DBA in Die österreichische DBA-Politik p. 21 (M. Lang, J. Schuch & C. Staringer eds., Linde 2013). 212. H. Jirousek, Die Umsetzung des OECD-Standards der Amtshilfe in Österreich – das neue Amtshilfe-Durchführungsgesetz, 19 SWI 10, p. 488 (2009).

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with the transfer pricing guidelines in 2010, the main source was the OECD Transfer Pricing Guidelines.213 Another goal concerning Austria’s treaty practice is to ensure the reduction or even the elimination of source taxation regarding interest and royalty payments and dividends.214 The purpose of this is the promotion of exports. Also, the Commentary on the OECD Model serves as the most important interpretation aid.215 This relevance of the Commentary is highlighted in the “Protokollbestimmungen” of Austria’s tax treaties.

10.4.1. Taxing rights over royalties assigned by article 12(1) As mentioned above, Austrian tax treaties reflect the goal to minimize source taxation. However, this used to be different: until 1997, Austria filed a reservation against the exemption of source taxation for royalties. This was given up, however, in favour of the aforementioned goal.216 In any case, the tax treaties that Austria has concluded in the past do not necessarily showcase this. In more than a half of the Austrian tax treaties, a withholding tax was stipulated. This can be explained by the fact that a majority of the tax treaties was concluded before 1997. In this case, a 10% withholding tax was agreed upon, as Austria wanted to present itself as an importer of technology.217 Nevertheless, even after 1997, 16 more tax treaties were concluded that included a withholding tax.218 That is because a relief of source taxation leads to a loss in the total tax revenue of Austria, which is why the Ministry of Finance decided to abandon this strategy with these countries.219 An analysis conducted by Pfeiffer in 2013 revealed that 19 tax treaties exempt royalties from source taxation. Two treaties include a 3% rate,220 15 treaties a

213. Jirousek, supra n. 211, at p. 21. 214. H. Loukota, Die aktuelle österreichische DBA-Politik, 48 ÖStZ 13, p. 249 (1995). 215. Jirousek, supra n. 211, at p. 22. 216. Loukota, supra n. 214, at p. 250. 217. Jirousek, supra n. 212, at p. 249. 218. Double tax treaties with Armenia, Bulgaria, Hong Kong, India, Iran, Cuba, Lithuania, Morocco, Mexico, Pakistan, Poland, Serbia, Singapore, the Czech Republic, Venezuela and Vietnam. 219. M. Lang, Überlegungen zur österreichischen DBA-Politik, 30 SWI 3, p. 117 (2012). 220. Double tax treaties with Hong Kong and Romania.

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5% rate,221 one treaty a 7% rate,222 one treaty an 8% rate,223 13 treaties a 10% rate224 and two treaties a 15% withholding tax.225 In other tax treaties, special rules were stipulated. In the Austria-Azerbaijan Income and Capital Tax Treaty (2000), the withholding tax will be reduced from 10% to 5% if the royalties are of a special kind.226 The Austria-Brazil Income and Capital Tax Treaty (1975) even has three different rates of withholding tax: 10% for the use of or the right to use specific copyrights, 15% for the use of or the right to use trademarks and for all other royalties 25%. The Austria-China (People’s Rep.) Income and Capital Tax Treaty (1991), on the other hand, allows for a reduction of the tax base to 60% of the gross amount of the royalties if they are connected with the use of or the right to use industrial, commercial or scientific equipment. There are also a couple of tax treaties that – unlike the I&R Directive – allow the source state to impose a 10%227 withholding tax on royalties if the royalties are paid to an affiliated company, but otherwise are tax free. However, due to the I&R Directive, these special provisions render them useless in EU Member States.228 After 2013, four more tax treaties were concluded. The AustriaChile Income and Capital Tax Treaty (signed 6 December 2012; effective 1 January 2016) also includes two different tax rates: 5% tax is withheld for the use of or the right to use industrial, commercial or scientific equipment, and 10%, on the other hand, for every other royalty. The Austria-Montenegro Income and Capital Tax Treaty (2014) is similar: 5% tax for copyrights for literary, artistic and scientific works, including cinematographic films and other media capture, used for television and radio or the like and the use or the transfer of software, and 10% tax for patents, trademarks and designs, plans, secret formulas or processes and information concerning industrial, commercial or scientific experience. The Austria-Turkmenistan Income and

221. Double tax treaties with Albania, Armenia, Belarus, Bosnia and Herzegovina, Moldavia, Poland, Qatar, Singapore, Slovenia, Spain, Uzbekistan and Venezuela. 222. Austria-Greece Income and Capital Tax Treaty (2007). 223. Austria-Taj. Income and Capital Tax Treaty (1981). 224. Double tax treaties with Australia, Indonesia, Japan, Kazakhstan, Kirgizstan, Kuwait, Morocco, Mexico, New Zealand, Pakistan, Saudi Arabia and Turkey. 225. S. Pfeiffer, Passive Einkünfte in der österreichischen DBA-Politik, in Die österreichische DBA-Politik, p. 180 (M. Lang, J. Schuch & C. Staringer eds., Linde 2014). 226. Namely, royalties for patents, trademarks, literary, scientific or artistic works, plans, secret formulas or processes and information concerning industrial, commercial or scientific experience. 227. The Austria-Port. Income and Capital Tax Treaty stipulates a 10% rate if the royalties are paid to a person owning more than 50% of the royalty-paying company. The rate is reduced to 5% in every other case. 228. Pfeiffer, supra n. 225, at p. 182.

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Capital Tax Treaty (2015) stipulates a 10% rate and the Austria-Iceland Income and Capital Tax Treaty (2016) stipulates a 5% rate.

10.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 As described before, the I&R Directive was the basis for Austria’s section 99a of the Income Tax Act 1988, which lists the definitions of royalties.229 The directive, however, was mainly inspired by article 12 of the OECD Model (2003). Due to this relationship, many overlapping definitions can be found. Under the OECD Model (2003), royalties were defined as any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.230 The directive simply added “commercial or scientific equipment shall be regarded as royalties”.231 Until the update of the OECD Model (1992), the use of or the right to use of industrial, commercial or scientific equipment were subsumed under the definition of royalties. The scientific community232 reasoned that if payments for the use of or the right to use industrial, commercial or scientific equipment is regarded as a royalty, leasing therefore has to also be subsumed under article 12. This renders no problem if the tax treaty follows the OECD Model, as the residence state is solely entitled to tax. However, there are a couple of examples in which Austria has concluded a double tax treaty where both countries agreed on a source taxation on royalties.233 In this case, it is possible that the term “royalties” is interpreted through a renvoi to domestic law according to article 3(2) of the OECD Model, as the term “leasing” does not occur in the tax treaties and it is questionable whether the term “the use of or the right to use” also implies leasing. If Austrian tax law were then applied, leasing would be regarded as a royalty.234 In more than half of its tax treaties, Austria has included this special provision.235 However, this was later changed by 229. Gusmeroli, supra n. 202, at sec. 5.1.3.2. 230. OECD Model Tax Convention on Income and on Capital art. 12 (28 Jan. 2003). 231. Art. 2(b) Interest and Royalty Directive (2003/49/EC). 232. Pöllath & Lohbeck, supra n. 24, at para. 54. 233. Pfeiffer, supra n. 225, at p. 180. 234. C. Ludwig in EStG, §99a EStG. Befreiung vom Steuerabzug para. 11 (W. Doralt et al. eds., Facultas 2011). 235. Pfeiffer, supra n. 225, at p. 180.

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the OECD and the term “the right to use of industrial, commercial or scientific equipment” was completely scrapped.236 Each case, however, will depend on its proper facts. In general, if the payment is made in consideration for the transfer of the rights that constitute a distinct and specific property, these payments are more likely to be subsumed under other articles.237 According to the Supreme Administrative Court, there needs to be a distinction made between the use and the alienation of IP.238 As already mentioned, according to section 28(1)(3) of the Income Tax Act 1988, the ownership of the IP needs to be interpreted as economical ownership rather than being based on civil law.239 As a result, Austria does not subsume the alienation of royalties under business profits (article 7); only the assignment and the use of rights are considered as royalties, as seen under section 28. Regarding the case of mixed agreements, the Supreme Administrative Court is very clear about that.240 The case concerned a company engaging in a credit card business that concluded a franchise agreement with a Swiss company. Nevertheless, they called it a license agreement and wanted to treat it as such. However, the Court decided that it would have to be categorized as a franchise agreement due to the fact that the franchisor advised the franchisee and also had control over it. On the other hand, the contract also had the characteristics of a license agreement in the sense that the credit card company provided its know-how. The Court then decided that this agreement would have to be considered as a mixed agreement according to the Commentary of the OECD Model.241 As a result, the price that corresponded to the franchising was treated as business profits under article 7 and the price that corresponded to the licensing was treated as royalties under article 12.242 The difference between the “granting” to use an IP and the “provisions of services” can be regarded as passive (granting) and active (provisions of services) income.243 If an IP is granted to another person just for the sake of using it, it is regarded as passive income and therefore falls within the scope 236. OECD, The Taxation of Income Derived from the Leasing of Industrial, Commercial or Scientific Equipment, 12 Intertax 1, p.6 (1984). 237. Para. 16 OECD Model: Commentary on Article 12 (2014). 238. AT: VwGH, 24 Nov. 1987, Case 87/14/0001. 239. AT: VwGH, 24 Nov. 1999, Case 94/13/0233. 240. Id. 241. Para. 17 OECD Model: Commentary on Article 12 (2014). 242. VwGH, Case 94/13/0233. 243. H. Loukota & H. Jirousek, Commentary on Article 12 concerning the Taxation of Royalties n. 12-074 (H. Loukota, H. Jirousek & S. Schmidjell-Dommes eds., Manz 2008).

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of article 12 of the OECD Model. On the other hand, active income can be described as a dependent or independent activity. These considerations would fall within the scope of article 7, 15 or 17 of the OECD Model.244 The following examples, in which the opinion of the Ministry of Finance is reflected, demonstrates these possible overlaps of IP income. These examples are to be found in the EAS (Express Antwort Service) where questions regarding international tax law are answered. If an author, for example, sends his manuscript to a publishing company and grants them the right to publish it, he receives license fees as defined by article 12 of the OECD Model.245 Studio recordings, for example, are considered in the eyes of the Ministry of Finance as an active artistic performance. They are therefore subsumed under article 17. This is based on a case in which a Dutch music company wanted to make records in a rented Austrian studio.246 Another case involved an Austrian foreign correspondent of the ORF (Austrian television). The Israeli tax administration considered his payment not as an allocation of copyrights, but rather as income from employment (article 15).247 Acting is also considered active income in Austria. It is not possible according to the Ministry of Finance to pay a royalty, because only the film production company can possess the licence.248 An artist that is performing live receives consideration according to article 17 of the OECD Model. On the other hand, if the performance is recorded and the artist signed a contract that grants him fees, those fees are considered royalties and fall within the scope of article 12.249 Models working for a photographer can receive either active or passive income. It depends on the contract they have signed. However, a high hourly rate might be an implication that the model not only receives active income, but also passive income for the exploitation rights. In this case, there would be a mixed agreement.250 A Chinese person who lives in Austria that receives remuneration from a Chinese publishing company is regarded as a royalty. However, if 244. 245. 246. 247. 248. 249. 250.

Id., at para. 75. EAS Ann. 2005-2557, 5 Jan. 2005. EAS Ann. 1995-610, 12 Apr. 1995. EAS Ann 1998-1255, 4 May 1998. EAS Ann 2007-2825, 2 Mar. 2007. AÖFV Ann. 1999-134, 1 Jan. 1999. EAS Ann. 1992-108, 26 Mar 1992.

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self-publishing takes place, he would no longer receive a royalty, but rather business income.251 Payments made as a consideration for securing exclusivity of information or for the exclusive use of property is treated as a royalty. There is no special guideline or case law to be found. As a result, we take the view that this consideration is part of the licensing agreement and thus falls within the scope of article 12 of the OECD Model. The treaty practice concerning payments for the use of industrial, commercial or scientific equipment has already been dealt with. In more than 50% of the tax treaties, this term is explicitly defined in the treaty.252 However, if an Austrian service station rents a Swiss car wash, Austria may tax due to the limited tax liability of the Liechtenstein company. Due to the double tax treaty, the tax may not be higher than 10%253 of the gross amount of the total rents. This is because the car wash can be seen as industrial equipment.254 If an Austrian software company produces a special software and delivers it to a Romanian client for its computer system, the received considerations are considered royalties under article 12. The Austria-Romania Income and Capital Tax Treaty (1976) was concluded before 1992.255 Payments made as a consideration for the transfer of the right to use an IP under a license agreement to a new licensee is not regarded as an alienation of the right in the sense of article 12(2) of the OECD Model, but rather as capital gains of article 13(5). This is due to the aforementioned case law.256 If an Austrian company, which was granted the know-how of producing special synthetic material, concludes with the Israeli licensee to sell the whole know-how, then it is still regarded as an alienation, even though the Austrian company was the beneficial owner of know-how itself. This is because the leaseholder is already in disposal of the asset. It is essential for 251. EAS Ann. 2045, 24 Apr 2002. 252. Pfeiffer, supra n. 226, at p. 180. 253. Convention between the Republic of Austria and the Principality of Liechtenstein for the Avoidance of Double Taxation with Respect to Taxes on income and Capital and Various Other Taxes, and for the Regulation of Other Questions relating to Taxation art. 12 (18 Sept. 1970). 254. EStR Ann. 2000-7984. 255. EAS Ann. 1999-149, 26 Sept. 1999. 256. AT: VwGH, 24 Nov. 1987, Case 87/14/0001.

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it to be an alienation that the licensee no longer has the possibility to dispose of its inventions.257 If an Austrian company sells a software product, which was invented by a German company, in a way that allows the Austrian client to download the software directly from the servers of the German company, is the price that is paid to the German company per sold unit the “purchase price” of the sold products? Just because this price that was paid to the software producer was called a license fee does not lead to it being classified as a royalty under article 12, but rather as a business profit under article 7.258 For payments made as a consideration for the transfer of the IP under a sub-licence agreement by the licensee to a sub-licensee, there is no specific case law or administrative guidelines. As a result, we take the view that the rules for licences also apply for sub-licences. When it comes to deemed payments, there are also no specific guidelines or case law. If a postponement of the payment is permitted, the claim as well as the debt fall within the definition of article 12. However, due to the so-called accounting rule “realization principle”, found in section 201(2) (4) of the FFC, the royalty payment is taxable every year, whereas for the payer, due to the deferred payment, the royalty payment only affects taxes in the year of the payment.259

10.4.3. Beneficial ownership and royalties Austria follows an economic approach in order to answer the question of who the beneficial owner is, as only the economic owner of the intellectual property is obliged to be the beneficial owner of the royalties. An entity entitled to intangible related returns must perform and control all of the functions related to all assets, including funding burdens and controls all of the risks related to the development, enhancement, maintenance, protection and exploitation of the intangible (DEMPE concept).260

257. EAS Ann. 1233, 23 Feb 1998. 258. EAS Ann. 2006-2740, 26 June 2006. 259. R. Beiser, Das Realisationsprinzip und die Besteuerung nach der Leistungsfähigkeit der Steuerpflichtigen, 11 SWK 26, p. 641 (2001). 260. H. Loukota & H. Jirousek, Commentary on Article 9 concerning the Taxation of Royalties n. 12-084 (H. Loukota, H. Jirousek & S. Schmidjell-Dommes eds., Manz 2015).

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Loukota and Jirousek offer an example in their commentary of article 9 of the OECD Model that showcases the economic ownership concept: the Austrian SOFTWARE AG (public limited company) belongs to a multinational enterprise and develops patentable technologies. Based on the concerning rules and an agreement, all patents are held by the Luxembourgian LUX plc, registered and being protected by lawyers against infringement. A new software developed by the SOFTWARE AG will then be transferred to the LUX plc and registered. But the Austrian SOFTWARE AG is entitled to the received royalties by the LUX plc. The legal owner of the patent is the LUX plc; the economic owner is still the SOFTWARE AG.261 The following cases showcase two example of administrative guidelines concerning beneficial ownership and royalties. According to article 12(2) of the Austria-United Kingdom Income Tax Treaty (1969), a 10% tax is withheld at the source if the receiving company holds directly or indirectly 50% of the stock of the paying company. In a case of 1997, a UK parent company had two subsidiaries: one located in Austria and one located in the United Kingdom. A license agreement was concluded between those two subsidiaries and the Austrian company had to pay royalties to the other sister company. The question arose whether this sister company is also regarded as an affiliated company and so source tax would have to be withheld. Based on the information service of the Ministry of Finance, the treaty has to be interpreted according to its wording.262 Thus, the sister company is not considered as an affiliated company and no tax has to be withheld. However, this is only the case if the sister company is the beneficial owner of the royalties, which means that the royalties have to be attributable for tax purposes. The Austrian Ministry of Finance applied (1997) sections 21-24 of the FCC263 in order to decide if the sister company is regarded as the beneficial owner. The ministry argued that if a UK parent company grants a licence to a UK subsidiary that should have been granted to the Austrian subsidiary, and, as a consequence, the UK subsidiary concludes a license agreement with the Austrian subsidiary, the UK subsidiary cannot therefore be seen as the beneficial owner. In this case, the parent company would be regarded as the beneficial owner. The Austrian subsidiary has to ensure that the UK subsidiary is not a letterbox company and that this agreement is not a sub-licensing in trust.264 This case is still relevant today: the same rules would be applied if the foreign subsidiary would not be located in 261. 262. 263. 264.

Id., at para. 266 EAS Ann. 1997-1040, 24 May 1997. This occurred 6 years before the directive was implemented. EAS Ann. 1997-1040.

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the United Kingdom but in a state outside the European Union with which Austria has concluded a double tax treaty. If the current rules were to be applied, there would no tax to be withheld due to the implemented I&R Directive. A sister company can therefore be considered as a beneficial owner according to section 99(a)(3) of the Income Tax Act 1988, if it does not act as an intermediary, an agent or a trustee.

10.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state Austria does not have a favourable tax regime applicable to the beneficial owner.

10.4.5. Time of taxation Until 2000,265 article 12(1) of the OECD Model included specifically the term “royalties paid”. The term “paid” has to be interpreted in accordance with the OECD Model and needs to be interpreted broadly.266 It comprises as well the arising of the claim as the fulfilling of the obligation.267 The time of payment is determined by the national law of the states applying the convention.268 It is therefore possible that the residence state and the source state apply a different definition of payment. In the Austrian treaty practice, the attribution of the taxation right to the residence state is bound to the moment of the (taxable) inflow of the payment to the licensor.269 It is possible, however, that the residence state and the source state apply different definitions of payment. The time of payment of the licensee determines the time of the taxing right, if the source state is granted a taxing right according to the double tax treaty.270 If an Austrian company has received royalties in the years X1 and X2 from a Romanian company, which may be taxed at 10% at the source according to the Austria-Romania Income and Capital Tax Treaty (2005), but the tax 265. 266. 267. 268. 269. 270.

Art. 12 OECD Model (2000). Pöllath & Lohbeck, supra n. 24, at para. 33. Loukota & Jirousek, supra n. 243, at para. 19. Pöllath & Lohbeck, supra n. 24, at para. 23. Loukota & Jirousek, supra n. 243, at para. 20. Id. at para. 21.

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was imposed in Romania in X3, the retained tax may be credited in Austria only in the years X1 and X2. This is because a foreign tax may only be credited against a domestic tax if both are based on the same revenue.271 The belated payment of the foreign tax is treated as an event with retroactive effects according to section 295(a) of the FFC.272 Regarding the Austrian Ministry of Finance, in the years X1 and X2 a provision for the unpaid tax has to be formed.273 If an Austrian company receives royalty payments in the amount of EUR 100 million in advance for a time period of 10 years from a Czech company, which will then lead accordingly to a taxable income of EUR 10 million per year, it is only possible to credit only one tenth of the total source taxation in the amount of EUR 5 million (5% source taxation due to article 12(2) of the Austria-Czech Republic Income and Capital Tax Treaty (2006) and not the whole EUR 5 million.274 This is because of the aforementioned required taxable inflow.275

10.4.6. Excessive royalty payments There are as yet no guidelines or case law concerning excessive royalty payments. However, it is likely that Austria will follow the OECD Commentary276 if such a case occurs. Loukota and Jirousek introduce in their commentary to the OECD Model a short example to showcase its implicit legal consequences. An Austrian subsidiary pays royalties to its parent company in the amount of EUR 100 million, of which 10% source tax is retained due to article 12 (2) of the Austria-Malta Income and Capital Tax Treaty (1978). However, after an audit by the fiscal authorities has been conducted, it was determined that only 60% of the royalties would have been appropriate. As a result, EUR 60 million will be attributed to the Austrian taxable profit. This amount does not fall within the scope of article 12; it rather comprises a hidden profit distribution according to section 8(2) of the Austrian Corporate Tax Act 1988. Moreover, the EUR 60 million may not be subject to source taxation according to section 94(a) of the Income Tax Act 1988. Despite the 271. 272. 273. 274. 275. 276.

EStR Ann. 2000-7586. EAS Ann. 1997-1120, 8 Aug. 1997. EAS Ann. 1996-888, 29 May 1996. EAS Ann. 1999-1497, 19 July 1997. Loukota & Jirousek, supra n. 243, at para. 21. Para. 23 OECD Model: Commentary on Article 12 (2014).

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fact that Austria would be eligible to retain source tax in the amount of 15% according to article 10 of the Corporate Tax Act 1988, Austria will not make use of this right due to the aforementioned provision. As a result, Austria is legally obligated to pay back the excessive source tax.277

10.5. Summary Austria did not introduce specific definitions of royalties into its national tax law. An exemption from source tax is to be found in section 99a of the Income Tax Act 1988, which provides the implementation of the I&R Directive. Basically, royalty income is taxed at the progressive tax rate for natural persons and at a flat rate for corporations. However, there is a rule in section 38 of the Income Tax Act 1988 that provides for a reduction to half of the average tax rate for payments derived from the patent of an invention. In that case, Austria also grants a premium for special kinds of research activities. An interesting fact, however, is that Austria chose against a CFC rule for royalty payments. The way it was chosen was different: instead of making the royalty payment taxable for the company, Austria decided to refuse the deductibility of the payment in section 12(1)(10) of the Corporate Tax Act 1988 if the other company is located in a low-tax country. It is possible to call this approach a “reverse CFC” rule. There is also no minimum effective taxation clause. In this report it could be showcased that the Austrian rules, when it comes to the taxation of IP, can be considered as not really special, as there is no such regime like a patent box system. It is also obvious that the Austrian legislator implemented the I&R Directive almost literally into Austrian law. However, two different rules may violate the principles of fundamental freedoms set out by the ECJ: the research premium and section 12(1)(10) of the Corporate Tax Act 1988. There still has not been a lot of case law when it comes to the taxation of IP and it will be interesting to see if the two rules that might violate EU law will ever be subject to being challenged at the ECJ. Austria usually follows the OECD guidelines and tries to avoid withholding tax for article 12 of the OECD Model. Despite that, Austria concluded in more than half of its tax treaties a withholding tax. Also, different examples were shown how the Ministry of Finance handles situations where an 277. Loukota & Jirousek, supra n. 243, para. 106.

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overlapping of treaty distributive rules occurs. In order to clarify which article is applicable, in Austria, the Ministry of Finance determines whether the income derived is regarded as active or passive income.

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Chapter 11 Brazil by Leonardo F. de Moraes e Castro1

11.1. Introduction on private law aspects of intellectual property (IP) 11.1.1. Private law meaning of terms used in tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the right protected under relevant private law 11.1.1.1. Brazilian private law on IP On 20 March 1975, through Decree 75.541/1975, the Convention of the World Intellectual Property Organization (Convention) was effectively introduced in Brazilian legislation, stating, for the first time, which rights would be comprehended within the scope of IP (section 2(VIII) of the Convention). Since then, the rights under the definition of IP can be summarized as follows: (i) scientific, artistic and literary work; (ii) performance of interpreters and artists; (iii) phonograms and broadcasting rights; (iv) inventions in all domains of human activity; (v) scientific discoveries; (vi) industrial designs; (vii) brands, as well as corporate names and forms; (viii) protection against unfair competition and (ix) all other rights inherent to the intellectual activity in industrial, scientific, literary and artistic fields. Thereby, IP could encompass copyrights, scientific discoveries and goods relating to industrial property.

1. PhD Candidate in International Taxation at Universiteit Leiden (Netherlands); LLM in Taxation at Georgetown University Law Center (US) – Graduate Tax Scholarship and Dean’s Certificate award; LLM in Economic, Financial and Tax Law at University of São Paulo (Brazil). Professor of International Tax Law in Brazil. Administrative Judge at São Paulo State Tax Court. Tax Partner of Costa e Tavares Paes Advogados in Brazil. The author can be contacted at [email protected].

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11.1.1.1.1.  Copyrights and scientific discoveries Copyrights are related to any right deriving from the relation between the creator/owner and its original work. Basically, this IP category consists of the authors’ right to always have their name bound to their work, to be protected against any modifications that may be imposed on it and to be provided with the freedom of transacting and benefiting from it. As for scientific discoveries, they involve any perception of a natural phenomenon that pre-exists to any human intervention. A scientific discovery has a speculative nature, since it is a revelation that results from the human investigation and observation on the physical world, in such a way that increases the human knowledge on such field (speculative intellect). 11.1.1.1.2.  Industrial property Industrial property is an IP category and consists of any invention, utility models, industrial designs, brands, geographical indications, as well as rules against unfair competition (section 2 of Law 9.279/1996). Invention is not a scientific discovery. Invention is the human act of creating from pre-existing elements another (new) element, different from those already pre-existing in the society, with the purpose of satisfying needs or solving problems of practical or technical order (practical intellect). Similarly, a utility model also results from a creative process, but the utility model does not aggregate any new knowledge, being limited to bring over an innovation that grants a better functioning, utility or convenience to a pre-existing good. It is therefore not a creation of new element, but a modification process of known goods that will critically result in their functional improvement. As for industrial design, according to section 95 of Law 9.279/1996, it consists of every esthetical creation that provides an innovative visual outcome to a given good and can be susceptible to an industrial production.

11.1.1.1.2.1. Corporate distinctive factors Brazilian IP law did not expressly include industrial secrets, natural resources (grains, animals, minerals, etc.), corporate names, domain names (Internet) and titles of establishment among the rights and goods that are

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under the specific protection of the industrial property legislation (Law 9.279/1996). Despite of the absence of legal provision in such way, this does not entirely remove corporate names, domain names (Internet) and titles of establishment from their status of belonging to rights that are under the protection of industrial property, since they are also results from the human creative process and, jointly with trademarks, consist of key factors able to identify (i.e. individualize) one corporate entity from another. A trademark is every distinctive sign, visually perceptible, that directly or indirectly identifies a product or a service. According to section 123 of Law 9.279/1996, the purpose of using a trademark can be framed in three categories: (i) a service or product trademark, used to distinguish one similar product or service from another (being both from different origins); (ii) certification trademark, used to certify consumers about the quality, nature, ingredients and methodology applied on the product; and (iii) collective trademark, used to identify when a product or service is being provided by one of the affiliated members of a given entity (i.e. for products that are collectively exploited by several members belonging to the same organization). Corporate names are also distinctive signs that reveal an individual or a legal entity carrying a specific business activity. Depending on the corporate form chosen (i.e. Eireli, Limitada, S.A.), the Brazilian legislation (i.e. Civil Code) allows that a firm name or a corporate name or even both be chosen by the legal entity, to the extent that some naming requirements are observed, such as, abbreviations, wording, etc. Similarly, titles of establishments are regarded as “word, numeric or figurative signs that identify traders carrying out their activities and through which they present themselves for the public in general”.2 According to this definition, signboards, labels and emblems are some examples of titles of establishment, since they indicate to the public the place where the entrepreneur carries out its activities. With respect to domain names (Internet), they correspond to systems whose main functions are to locate and identify the information that is available in the World Wide Web network (www.). Domain names have a similar 2.

W. Ferreira, Tratado de direito comercial vol. 6 p. 197 (Saraiva 1962).

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function to telephone numbers and postal codes, but instead of using numbers, these kinds of systems use names (e.g. http://www.receita.fazenda. gov.br). 11.1.1.1.2.2.  Biotechnology Under Brazilian legislation, biotechnology is also protected by the specific legislation concerning industrial property. Biotechnology can be defined as the form of applying scientific principles and technological knowledge in the processing of materials, by using biological organisms, systems and processes, in such a way that enables an industrial production of goods and services. However, only two categories of biotechnologies are regulated by Brazilian IP law, namely: (i) the genetically modified micro-organisms (Law 9.279/1996), consisting of microscopic organisms that have suffered modifications in their original composition due to human intervention; and (ii) the cultivars (section 3(IV) of Law 9.456/1997), which, despite having suffered modifications, are a biotechnology limited to the category of superior vegetal species (i.e. flowering plants, enhanced seeds, etc.). 11.1.1.1.3.  Integrated circuit topographies and geographical indications Integrated circuit topographies, pursuant with section  26 of Law 11.484/2007, are several interrelated, constructed and codified images under any kind of means or form, that represent a three-dimensional shape of layers that compose an integrated circuit, at any stage of its conception or manufacturing. In a simple way, an integrated circuit topography is a three-dimensional representation of a miniaturized electronic circuit (i.e. representation of a chip, commonly used in electronic devices). According to the Agreement on Trade-Related Aspects of Intellectual Property Rights (introduced in Brazilian legislation through Federal Decree 1.355/1994), geographical indications are generically defined as the indications that identify one product as originating from one location, when and if a given quality, reputation or other trait of the product is attached to that location (i.e. geographical origin).

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On this subject, Law 9.279/1996 foresees two categories of geographical indications: (i) indication of origin, which means the geographic name of the country, city, region or location, that has become known as the centre of extraction, production or manufacturing of a given product or the provision of a given service (section 177 of Law 9.279/1996), i.e. natural or human factors do not affect the indication of origin; and (ii) designation of origin, which means the geographical name of the country, city, region or location that designates products or services whose qualities or characteristics are exclusive or essentially attached to the geographic, human and natural factors (section 178 of Law 9.279/1996), i.e. natural or human factors affect the designation of origin. Finally, it is worth mentioning that rights related to a person’s name or image (rights of identity) and rights arising from contracts (contract law), despite being protected by other legal provisions of Brazilian law (i.e. Civil Code – Law 10,406/02), are not specifically covered under the definition provided by the IP law.

11.1.2. Distinction under private law between alienation of IP and granting the right to use IP 11.1.2.1. Forms of exploring patents To grant the protection of the rights attached to inventions, utility models, genetically modified micro-organisms, etc., its creators must require the registry (i.e. “patent”) before the competent public body (Brazilian Patent and Trademark Office - INPI). In other words, just as from the granting of the patent, the creator will be able to benefit from the exploitation of its creation. Once all the legal requirements set forth under Law 9.279/1996 are fulfilled, the patent can be granted. With the patent at hand, one becomes the owner/ holder of the patent (not of the creation per se), allowing its exploitation through two types of transactions: an assignment or a licence agreement. 11.1.2.1.1.  The assignment agreement Assignment has the purpose of changing the status of “patent holder” from one individual or legal entity to a third person, by granting to this latter all 277

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the rights attached to the assigned patent, including the rights inherent to the ownership (i.e. transfer of legal title), for a certain amount of time. The third person, by holding the patent, can partially or entirely exploit the rights inherent to the invention or utility model that has been assigned, depending on the terms and conditions of the agreement entered into with the original patent holder. When the assignment involves consideration, it will have the legal nature of a sale and purchase agreement. Otherwise, if the agreement is settled at no cost for the third person, it will take the form of a donation agreement.

11.1.2.1.2. The licence agreement Licensing is the act whereby the patent owner (licensor) safeguards its ownership but grants to a third person (licensee) the right to use the invention or utility model for a certain amount of time, under certain specific conditions. Therefore, differently from an assignment, in the licence agreement only some rights (i.e. “the right to use”) are detached from the owner’s legal title, who remains with the rights inherent of ownership. The economic ownership for exploitation purposes is transferred to the licensee. The licensee, by having the right to use the IP, can also economically exploit such right in a partial or full manner. This means, for instance, that the licensee can be authorized to exclusively manufacture a given patented product, but not to sell it, or even to be subject to territorial limitations (e.g. within Brazilian territory). It is important to highlight that in addition to the exploitation of the patent, other forms are also possible under a licence agreement (or in a separate agreement), such as, consideration for provision of technology and/or the know-how necessary for the correct use of the licence (ancillary consideration related to IP use/exploitation). When the licence entails consideration, it will have the legal nature of a lease agreement, but involving an intangible asset, instead of a tangible one. On the other hand, when there are no costs involved in the transaction, the licence will be legally qualified as a free lease agreement of an IP.

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11.2. Taxation of IP under the domestic tax law 11.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 11.2.1.1. Royalties definition and tax deductibility The definition of income derived from royalties is set forth in section 22 of Law 4,506/64, which reads as follows: Income of any type will be classified as royalties if derived from the use, enjoyment or exploitation of rights, such as: (1) the right to seize or extract vegetal resources, including forests; (2) the right to research and extract mineral resources; (3) the use or exploitation of inventions, manufacturing processes and formulas, and trademarks; (4) the exploitation of copyright, except when received by the author or creator of such asset or right.

Under section 355 of Decree 3,000/99 (Income Tax Code), the tax deductibility of royalties is subject to a maximum of 5% of the net sales revenue of the product in respect of which the royalties are used and/or applied. Section 355 of Decree 3,000/99 reads as follows: The amounts due related to royalties for the exploitation of patents or use of industrial or commercial trademarks and technical, scientific, administrative or similar assistance may be deducted as operating expenses up to a maximum of five percent of the net sales revenue of the product manufactured or sold (art. 280), except as provided in arts. 501 and 504, V: (1) The deduction percentages ratios shall be established and reviewed periodically by an ordinance of the Finance Minister, as referred in this section, considering the production or activities types, classified in groups, according to the level of essentiality.

In light of section 355(1) of Decree 3,000/99, the Ministry of Finance issued Ordinance MF 436/58 to regulate the minimum and maximum percentages allowed for corporate income tax (IRPJ) deduction purposes, i.e. the percentages deductible as business expenses in calculating the taxable bases of the IRPJ, with regard to payments of licences of intangibles. These percentages vary according to the different sectors of the economy. Specifically, the fixed percentages range from 1% to 5% of net sales revenue with regard to each of the industries listed in Ordinance MF 436/58. In most of the cases encountered by multinational groups that are not expressly listed under a certain industry in Ordinance MF 436/58 or in case 279

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of services industries, the applicable rate regarding the tax deductibility of royalties paid to the overseas licensor is normally 1%, as most types of services do not fit into any of the categories of the existing industries listed in Ordinance MF 436/58, which only lists older industries and/or sectors and has not been updated since the 1960s. Consequently, the general rule in item II of Ordinance MF 436/58, which imposes a limit of 1%, applies.3 In addition, in order to deduct the royalties at the 1% limit, it is necessary to record the contracts between the parties with the INPI, as a condition precedent, according to section 355(3) of Decree 3,000/99, as reproduced below: The amounts paid with regard to royalties related to the exploitation of patents, or use of trademarks, as well as the remuneration that involves a transfer of technology (technical, scientific, administrative or similar assistance, technical projects or specialized services), can be deducted only if the respective act or contract is recorded in the INPI, and the terms and conditions of registration and the provisions of Law No. 9,279/96 are complied with.

It is also required to register the licence or technical assistance service agreement with the Brazilian Central Bank (BACEN), as provided for by section 50 of Law 8,383/91, which reads as follows: The expenses related to line b of the sole paragraph of Section 52, and in item 2 of line “e” of the sole paragraph of Section 71, both of Law No. 4,506/64, arising from agreements executed after December 31 of 1991, recorded on the INPI and registered at BACEN, become deductible under the Actual Profit Regime calculation, provided the requirements and conditions established by legislation in force are complied with.

It is important to note that Decree 3,000/99 is a federal decree that consolidates all of the income tax laws in force up to 1999. As a result, section 355, as with all of the related sections of Decree 3,000/99, is derived from specific previously published tax laws. It is therefore crucial to examine the historical evolution of the laws that resulted in this provision to understand this tax deductibility limitation in force in Brazil for decades.

3. It should be noted that according to sec. “f” of Ordinance MF 436/58, as permitted by Decree 3,000/99, sec. 355(1), where the industry or economic sector into which a taxpayer falls is not listed in the types of industries set out in Ordinance MF 436/58, it is possible for a taxpayer to request inclusion and/or review of the existing percentage to which the taxpayer is subject, as regulated by Brazil (Ordinance MF 303/1959). Any such request should be filed together with sufficient proof before the Brazilian Federal Revenue Office, which should give its opinion regarding the issue to the Ministry of Finance, which is the body that finally decides the issue.

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Section 74 of Law 3,470/58 was the first rule establishing the maximum tax deductibility limit with regard to royalties derived from patents, trademarks and technical, scientific, administrative and similar assistance. This law set the limit at a maximum of 5% of the gross revenue derived from the relevant product. Originally, there was no reference to the application of this provision to payments made abroad, i.e. international remittances of royalties, or to Brazil, i.e. domestic remittances of royalties. It was therefore understood that the law applied to all royalties, regardless of where the beneficiary was located (domestic or international royalty payments). Subsequently, section 12 of Law 4,131/62 essentially reproduced the same rule previously set forth in section 74 of Law 3,470/58. This also set the maximum tax deductibility limit for royalties at 5% of the gross sales revenue derived from the relevant product. It is important to note that notwithstanding the fact that Law 4,131/62 did not state its scope, i.e. whether applicable to international or domestic transactions, the intention of the law was “to regulate the application of foreign capital and the remittances of amounts abroad”. This law is therefore commonly referred to as the “statute of foreign capital”. Two years later, section 71 of Law 4,506/64 extended the non-deductibility rules in respect of the payment of royalties to individuals4 who were shareholders or officers in the Brazilian companies paying the royalties and prohibited deductions in respect of royalties paid by a Brazilian branch or controlled company5 to its parent abroad. 4. It is still controversial as to whether the shareholders subject to this limit are only individuals or if legal entities are also included. There are court decisions in favour of both interpretations. For instance, the Administrative Council of Tax Appeals (Conselho Administrativo de Recursos Fiscais, CARF) in Brazil: CARF, 2014, Administrative Decisions No. 1102-001.182: CARF, 2011, Administrative Decision No. 02-33514; and: CARF, 1992, Administrative Decision No. 103-12.157 extend the prohibition to legal entities that are shareholders of Brazilian companies. There is, however, a judicial precedent, for example, the decision of Tribunal Regional Federal da 4ª Região (Regional Federal Court, TRF4) in TFR4, 30 Oct. 1990, Appeal No. 89.04.19593-4/RS, as well as the decisions of the Administrative Council of Tax Appeals (Conselho Administrativo de Recursos Fiscais, CARF) 2004, Administrative Decision No. 101-94.552; CARF, 2003, Administrative Decision No. 01-04.629; and: CARF, 1994, Administrative Decision No. 108-04.211, which state that the provision only applies to individuals. In the author’s opinion, the provision should apply only to individuals (not companies) who are shareholders in Brazilian legal entities. 5. Law 8,383/1991, sec. 50 authorized the tax deductibility of royalties paid by a Brazilian-controlled company to its controlling entity abroad and only required the recording and registering of the agreement with the INPI and the BACEN. The prohibition on tax deductibility relating to royalties paid by a Brazilian branch to its parent remains and currently only applies to royalties derived from patents and trademarks, even if the agreement is recorded with the INPI and registered with the BACEN.

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Finally, in 1979, section 6 of Decree-Law 1,730/79 amended the tax deductibility limit to 5% of the net sales revenue, in place of gross sales revenue, but maintained the 5% maximum rate, by stating the following: The maximum deductibility limitation, set forth in section 12 of Law No. 4,131 of September 3 of 1962, will be calculated over the net revenue from sales of the manufactured or sold product [emphasis added].

This is the legal framework that formed the basis for Decree 3,000/99, especially sections 352 to 355, which deal with tax deductibility limitation for royalty payments by Brazilian resident companies, either to Brazil (domestic transactions) or to abroad (international remittances). However, until the current times, there is still a legal discussion on whether the 5% net sales revenue limit for deductibility and the requirement to record the agreement with the INPI applies to royalties paid to a beneficiary located in Brazil or if this limit and the related requirement only apply to beneficiaries located abroad, i.e. to international remittances. Normative Opinion 139/75, which was issued by the federal tax authorities, stated that section 12 of Law 4,131/62 also applied to beneficiaries in Brazil as, in this respect, there was no express reference, therefore, section 74 of Law 3,470/58 should still apply to all transactions related to royalties, regardless where the licensee is located. Accordingly, Normative Instruction 5/74 states that given the absence of an express limitation saying that it is only applicable to beneficiaries located outside Brazil, the recording with the INPI is mandatory for the tax deductibility of royalties, regardless of where the beneficiary is located, thereby including royalties paid to a Brazilian resident within this requirement. As a result, the tax authorities apply both the 5% limit as well as the requirement to record the licence agreement with the INPI, for any payment of royalties to local beneficiaries in Brazil. However, this position has been questioned by Brazilian scholars, who understand that the 5% limit on tax deductibility of royalties and the need to record the corresponding agreement with the INPI are only applicable to beneficiaries located outside Brazil, i.e. only to international remittances.6

6. E. Santos Carrilho, Royalties - contratos relativos a patentes, assistência técnica, transferência de tecnologia e marcas – beneficiário com domicílio ou sede no Brasil inexistência de limites à dedutibilidade e desnecessidade de averbação no INPI, Resenha Tributária 7, p. 177 (1987) and L. Mélega, Contrato de prestação de assistência técnica, Revista de Direito Mercantil, Industrial, Econômico e Financeiro 19, pp. 61-70 (1975).

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The Brazilian jurisprudence reveals that these issues are still far from a final and unanimous position in both judicial and administrative courts. With regard to the 5% net sales revenue tax deductibility limit not applying to beneficiaries of royalties located in Brazil, there are both administrative7 and judicial decisions8 in this sense. Nevertheless, there are recent administrative9 and judicial decisions10 stating the exact contrary, which have concluded that the limit and the record requirement also apply to beneficiaries of royalties located in Brazil. It should be noted that the 5% net sales revenue limitation does not apply to payments in respect of copyright, as decided by an administrative decision, which held that copyright is subject to the general deductibility rule currently set out in section 299 of Decree 3,000/99.11 The same rationale applies to software licences without the transfer of technology, as software is protected and treated as copyright. This is again confirmed by administrative decisions.12 Providing services without the transfer of technology is also not subject to the 5% deductibility limit, as also decided by various administrative decisions.13 An additional tax deductibility requirement for IRPJ that applies to any expense is that payments of royalties by a Brazilian entity to its foreign related party are only tax deductible if the expense meets the general requirements of section 299 of Decree 3,000/99. According to section 299, in order to be tax deductible, payments must be a necessary and ordinary business expense, customary and/or usual to the primary core business activity of the entities incurring the payments,14 provided this is substantiated by reputable 7. See, for example, the decision CARF, 2004, Administrative Decision No. 10707.514 and CSRF, 2002, Decision No. 01-046. 8. See, for example, TFR, 1988, Appeal No. 109.899/SP. 9. See, for example, the decision of CARF, 2012, Administrative Decision No. 180301.287 and CSRF, 2007, Administrative Decision No. 01-05.700. 10. See, for example, the decisions BR: Supreme Federal Court (STF), 1992, Extraordinary Appeal No. 104.368/ SP and BR: Superior Court of Justice (STJ), 2006, Special Appeal No. 378.575/RS. 11. See, for example, the decision CARF, 1994, Administrative Decision No. 108-1.502. 12. See, for example, the decisions CARF, 1997, Administrative Decision No. 10511.943/97 and CARF, 2004, Administrative Decision No. 108-07.741. 13. See, for example, the decisions CARF, 1988, Administrative Decision No. 1052.773 and CARF, 1993, Decision No. 101-85.487. 14. From a practical perspective, this means that: (i) it is necessary to maintain the source of income of the entity that pays the royalties; (ii) the payment of the royalties is related to and regularly incurred in the ordinary course of business by the entity; (iii) the royalties are effectively incurred or paid, i.e. deemed or notional expenses are not allowed; and (iv) payment of the royalties is supported by sufficient reputable documentation. For a more detailed analysis on the concept of “business expenses” and a list of documentation

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documentation,15 e.g. a signed licence agreement, evidencing the expense. In this respect, section 299 of Decree 3,000/99 wording is the following: There will be considered as business expenses the ones not computed as costs, and that are necessary to the activity of the company and the maintenance of its source of production. (1) Paragraph 1. There are considered necessary the expenses paid or incurred to the performance of the transactions or operations required by the business activity of the company. (2) The operational expenses admitted are those that are usual or ordinary to the type of transaction, operation or activity of the company.

The Brazilian entity must comply with this four-part test to be able to deduct, for tax purposes, royalties and fees for technical assistance paid to a local or foreign party. When a Brazilian company is the licensee of intellectual or industrial property rights that are legally owned by a foreign entity, i.e. the licensor, this entails that the Brazilian entity imports the intangibles and therefore pays royalties to the foreign entity as remuneration for the import, i.e. exploitation, of the intangibles. In this scenario, the Brazilian entity, which is related to the foreign company, is the payer of the royalties. On cross-border remittances, this means that: (i) the payments must not exceed the percentage limits set out in Ordinance MF 436/58; (ii) the licence agreement must be recorded with the INPI; (iii) the licence agreement must be registered with the BACEN; and (iv) the requirements of section 299 of Decree 3,000/99 must be satisfied.

required by the Federal Revenue Office, see L.F. de Moraes e Castro, Taxation of CostSharing Contractual Arrangements in Brazil, 39 Intl. Tax J. 6, pp. 57-59 (Nov-Dec. 2013). 15. See, for example, the decision CARF, 2007, Administrative Decision No. 10196.082, which stated that: “IRPJ. EXPENSES. PROOF. In order to prove expenses, for deductibility purposes, it is not sufficient to prove that they were accrued and that there was financial disbursement. It is a necessary requirement for the deductibility to prove that the service was effectively rendered, supported by sufficient and reputable documentation. Duly proved with sufficient and reputable documentation, the expense effectively incurred, provided it is necessary and essential to the activity being carried out by the taxpayer and related to the source of production of the income, its deductibility from the taxable base of the IRPJ shall be observed.” See also, for example, the decision CARF, 1999, Administrative Decision No. 108-05.884, which expressly sets out the requirements in respect of “normality, necessity and customary” characteristics of expenses for these to be deductible for the purposes of the IRPJ and/or the CSLL.

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11.2.2. Qualification of income deriving from IP and applicable tax regimes 11.2.2.1. Consideration for the assignment and licensing of trademarks and patents 11.2.2.1.1.  Capital gains As previously mentioned in section 11.1., patents and trademarks are goods that belong to industrial property and they may be the subject matter of an assignment or a licence agreement. The consideration paid by the assignee for the permanent legal title of the IP that results in an increase of revenue for the assigning party, if deemed as a non-operational revenue, will be qualified as capital gain. The capital gain, according to section 138 of Decree 3,000/99, will be ascertained by the positive difference between the sale price and the cost acquisition price. Therefore, to the extent that an assignment/licence of a patent or trademark is negotiated at a price higher than the one by which it was acquired (i.e. “cost acquisition”), there will be a capital gain ascertained and subject to Brazilian income tax. It requires the “sale”, i.e. transfer of the legal title of the IP to the assignee, by the assignor. The capital gain income is levied at a combined rate of 34% income taxes – which is the current standard rates for corporate income taxes (25% of IRPJ and 9% of social contribution on net profits – CSLL) for legal entities resident in Brazil, regardless of where the source of payment/income is located. The capital gain income is not eligible to be included in the special income tax regimes existing in Brazil (to be further explained herein), being levied separately under the usual corporate income taxes rate, as already mentioned. As to resident individuals, the capital gain income is levied by a progressive rate starting on 15% but reaching a maximum of 22.5%, also regardless of where the source of payment/income is located.

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11.2.2.1.2.  Taxation of royalties paid for the exploitation of trademarks and patents The consideration for the granting of a “user’s licence”, i.e. the non-permanent use and exploitation of an IP, is defined as royalties under Brazilian legislation. According to section 22 of Law 4.506/64, royalty is the consideration paid for “any kind of use, fruition or exploitation of rights” (economic ownership of an IP). Hence, just as occurs with interest payments as consideration for the capital in financial instruments (i.e. loans) or rentals as consideration for leasing a real estate, the payments of royalties are deemed to be a consideration for the use (rent/lease) of trademarks and patents, i.e. IP. The payment of royalties for the exploitation (i.e. “license”) of trademarks and patents represents is subject to Brazilian income tax. In such cases, the taxable events must be studied from two perspectives (i.e. licensor and licensee) considering also different circumstances (i.e. resident or non-resident in Brazil). When the licensor is an individual, regardless if the payment was made to another individual or a legal entity, for having increased the assets of the licensor, the royalties will be taxed in accordance with graduated rates set forth in section 86 of Decree 3,000/99, with legal basis is section 21 of Law 9.532/1997. For Brazilian-resident individuals, the maximum income tax rate is levied at 27.5% over the difference that results from the sum of the taxable revenue earned during the calendar year (including the royalties), added to the revenue that has already been taxed at source (i.e. IRRF), as well as the legal deductions allowed, up to the amount that exceeds the exemption limit. There is no different basket or pool of passive income (royalties) for individuals (or companies) resident in Brazil. All income derived from royalties’ exploitation or licensing will be levied by the income tax as “general income”, without any different tax treatment, rates or incentives. In addition, according to section 106 of Decree 3,000//99, if the licensor is an individual resident in Brazil and he receives the royalties from a foreign licensee (i.e. foreign source of income), he must calculate and collect, on 286

Taxation of IP under the domestic tax law

each month, the individual income tax due (IRPF) through a voluntary tax voucher known as “Carne-Leão”, which must be declared in the Annual Individual Tax Return. By contrast, if a legal entity resident in Brazil is the one paying the royalties to the individual resident in Brazil, such payment shall be taxed at source (i.e. IRRF) pursuant with section 631 of RIR/99 and section 7(II) of Law 7.713/1988. Therefore, the tax withheld (IRRF) on such payments will be deemed as an anticipation/advance collection of the income tax that will be calculated and definitively due at the end of the calendar year when filing the annual corporate tax return, by the individual (licensor). In case a legal entity is the licensor resident in Brazil and receives the royalties paid for the exploitation of trademarks and patents, notwithstanding if the payment is made by an individual or a legal entity, it must tax them according to the rules of IRPJ, currently at 34% combined rate (25% of IRPJ and 9% of CSLL) for most companies (exception for banks, financial institutions, insurance companies, asset management, factoring and similar ones, which are subject to a higher CSLL of 20% instead of 9%). The royalties received by a legal entity resident in Brazil will be taxed according to different approaches, depending on under which method the taxpayer (i.e. the licensor) has chosen to tax the IRPJ and CSLL, namely: (a) actual profit method (APM) or (b) presumed profit method (PPM). The option for one method or the other will depend on whether the legal entity is legally bound to elect its IRPJ under the APM, as set forth in section 14 of Law 9.718/1998. For the legal entities that are not subject to any of the circumstances mentioned in items I to VII of section 14, the initial option for the PPM is possible, if they wish to do so. Under the APM, the royalties earned by a legal entity will be part of the net profit of the corresponding ascertainment period. The calculation of net profit precedes the taxable basis of IRPJ, which is the actual profit (section 6 of Decree Law 1.598/1977 and section 247 of RIR/99). Accordingly, for the legal entity to reach its actual profit (i.e. IRPJ taxable basis), Decree 3,000/99 sets forth that the net profit should be accrued with non-deductible additions and exclusions, as well as the offsetting of tax losses (NOL) from previous periods. Having reached the actual profit (including income from royalties) a tax rate at 15% (section 3 of Law 9.249/1996 and section 541 of Decree 3,000/99) plus a 10% surtax rate on 287

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the amount that exceeds BRL 20,000 per month, should apply (total 25% tax rate). The CSLL will be added at 9% for most types of legal entities in Brazil, totalizing the 34% standard corporate income tax burden under the APM. As for the legal entities subject to PPM, assuming they are not bound to the APM and that they do not exceed in the previous year an annual gross revenue of BRL 78 million, the revenue earned by them for the exploitation of patents and brands will be part of their gross revenue, upon which the IRPJ taxable basis will be calculated on a quarterly basis, by applying different statutory flat rates, under the law, depending on the type of business/ activity performed by the legal entity (section 15 of Law 9.249/1995 and sections 518 and 519 of Decree 3,000/99). Accordingly, over the taxable basis (i.e. gross revenue multiplied by the flat rate given by law) – to which the earnings from royalties must have been included – the standard tax rates of 15% plus the surtax of 10% for IRPJ on the amount that exceeds BRL 20.000,00 per month (total 25% tax rate) should then be applied. Also, the CSLL will be applied at 9% rate, on the amount considered as “income” based on the statutory rates applicable to the gross revenue of the legal entity, depending on the type of business it carries out.

11.2.3. Tax treatment of income from IP derived by nonresident taxpayers In regard to the cross-border payments to a non-resident beneficiary, the WHT applies on income “paid, credited, delivered, used or remitted” (whichever occurs first)16 abroad, by a Brazilian source (payer) to a nonresident person (individual or legal entity). Accordingly, the WHT taxpayer is the non-resident beneficiary of the income, who is taxed for the income generated in Brazilian territory (sourced in Brazil). Nevertheless, Brazilian legislation sets forth the Brazilian payer of the amounts as a “responsible agent”,17 imposing the liability for the collection of the WHT to the person remitting the amounts to abroad.

16. 17.

Sec. 685, Decree 3,000/99. Sec. 128, Brazilian National Tax Code and secs. 717 and 722 of the RIR/99.

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As per section 382(I) of Decree 3,000/99, the payment of royalties from a source located in Brazil to individuals or legal entities resident abroad, shall be taxed at source by the IRRF. In such situation, any payment of royalties is subject to IRRF at 15% tax rate (section 71018 of Decree 3,000/99), with the exception of payments made to beneficiaries resident in low-tax jurisdictions19 (LTJ) – tax havens – upon which an increased 25% WHT rate is applicable. Brazil introduced the concept of LTJ through the enactment of section 24 of Law 9.430/1996, which has defined low-tax jurisdictions as the jurisdictions that, alternatively, do not tax income or tax at a maximum rate lower than 20%. In addition to the concept of a LTJ, as from the enactment of Law 11.727/2008, Brazil included other jurisdictions that would be characterized as privileged tax regimes (PTR).20 For the characterization as a PTR, 18. Id., RIR/99 at sec. 710, which reads, “The amounts paid, credited, delivered, employed or remitted to abroad, related to royalties will be subject to withholding income tax, at [the] rate of 15%.” (author’s unofficial translation). 19. The LTJs are defined as “country or location that does not tax income or taxes it at a maximum rate of 20%; or countries and locations with legislation that does not allow access to information concerning the corporate structure of legal entities, their ownership, or identification of the beneficial owner” (sec. 24 Law 9,430/96). In practice, the LTJs are those blacklisted under sec. 1 of Normative Ruling RFB No. 1.037/10, amended by Normative Ruling RFB No. 1,045/10, Executive Declaratory Act No. 3/11 and Normative Ruling No. 1,474/14, and this includes the following: American Samoa, Andorra, Anguilla, Antigua and Barbuda, Netherlands Antilles, Aruba, Ascension Island, Bahamas, Bahrain, Barbados, Belize, Bermuda, Brunei, Campione d’Italia, Singapore, Cyprus, Costa Rica, Djibouti, Dominica, French Polynesia, Gibraltar, Granada, Cayman Islands, Cook Islands, Ireland, Island of Madeira (Portugal), Isle of Man, Pitcairn Islands, Qeshm Island, Channel Islands (Jersey, Guernsey, Alderney, Sark), Hong Kong, Kiribati, Marshall Islands, Samoa Islands, Solomon Islands, St Helena Island, Turks and Caicos Islands, British Virgin Islands, US Virgin Islands, Labuan, Lebanon, Liberia, Liechtenstein, Macau, Maldives, Mauritius, Monaco, Monserrat, Nauru, Niue, Norfolk, Oman, Panama, Saint Kitts and Nevis, Saint Lucia, Saint Pierre and Miquelon, Saint Vincent and Grenadines, San Marino, Seychelles, Swaziland, Tonga, Tristan da Cunha, Vanuatu and United Arab Emirates. 20. The PTRs are listed in sec. 2 of Normative Ruling RFB No. 1,037/10, with amendments, being the following: (i) Uruguay, regime applicable to the legal entities constituted under the form of Financial Institutions of Inversion (Safis) until 31 Dec. 2010; (ii) Denmark, regime applicable to the holding companies not exercising substantial economic activities in the country; (iii) the Netherlands, regime applicable to the holding companies not exercising substantial economic activities in the country; (iv) Iceland, regime applicable to the legal entities constituted under the form of International Trading Companies (ITC); (v) the United States, regime applicable to state limited liability companies (LLCs) owned by non-residents and not subject to the federal income tax in the United States; (vi) Malta, regime applicable to the legal entities constituted under the form of International Trading Companies (ITC) and International Holding Companies (IHC); (vii) Switzerland, regime applicable to the legal entities constituted under the form of holding companies,

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such jurisdictions, in addition to the absence of income taxation or a taxation at a maximum rate lower than 20%, need to meet other requirements, such as the granting of tax advantages to non-resident individuals or legal entities (i) without the requirement of substantial economic activity in the jurisdiction or (ii) conditioned to no performance of substantial economic activity in the jurisdiction. As to international payments of copyrights, according to section 709 of Decree 3,000/99,21 the applicable WHT rate is also 15%. Thus, section 709 deals with cross-border payments arising from the use or the right to use any IP derived from artistic, literary or scientific creation, i.e. copyright, or payments in respect of the consideration for the exploitation of patents, trademarks, designs or models, plans; secret formulas or processes, industrial, commercial or trade secrets and the transfer of technology or know-how. In case there are services fees included in addition to the remuneration of royalties under a contract, the general WHT rate for cross-border payments, according to section 685(I)(a) of the Income Tax Code (Decree 3,000/99) is 25%. However, such section only refers to “general services”, i.e. services that are not dealt with in another section of Decree 3,000/99, which in practice are the services that are not classified as “technical, technical assistance or administrative services”. Under case law, the Receita Federal do Brasil (RFB) has issued several decisions mentioning that commercial intermediation services, remunerated by commission, is a “general or pure service”, thus qualified under section 685(II)(a) of RIR/99.22 domiciliary company, auxiliary company, mixed company and administrative company, where the income is taxed at less than 20%, in accordance with the federal, cantonal and municipal law, as well as the regime applicable to other legal types of constitution of legal entities, due to the ruling issued by the tax authorities, which results in income tax taxed at less than 20%, in accordance with the federal, cantonal and municipal law; and (viii) Austria, regime applicable to the holding companies not exercising substantial economic activities in the country. 21. “Section 709. The amounts paid, credited, delivered, employed or remitted to abroad, for the acquisition or for the remuneration, [of] any nature, of any right, will be subject to withholding income tax, at [the] rate of 15%, including the transmission, by the means of radio or television, or any other form, of any movie or event, regardless if sports related, of which a Brazilian representative is part” (author’s unofficial translation). 22. Other cross-border payments levied at 25% WHT are the following: (i) movie activities (ADN 20/00); (ii) cultural activities (General Coordination of the Tax System of RFB (COSIT) Divergence Ruling 3 to 10/01); (iii) pensions and retirement; (iv) news, forecast and journalistic; and (v) others based on the RFB’s understanding (which are still debatable).

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Hence, specifically regarding the “technical services, technical assistance, administrative and similar services”, there is a specific provision – section 708 of RIR/99 – which establishes a 15% WHT rate.23 The exception is the payment made to a person resident in an LTJ, which is subject to a 25% WHT rate. Under Brazilian tax regulations, technical services are defined as those involving activities which execution relies on specialized technical knowledge rendered by professionals. In this sense, section 17(§1º)(II) of Normative Instruction RFB 1,455/1424 defines technical services as “those which execution relies on specialized technical knowledge or involving administrative assistance or consulting services performed by independent professionals or companies or relying on automated means with clear technological content”. Conversely, other services that are not classified under such definition should be treated as non-technical. The application of such provision to certain services is not entirely clear and may leave certain discretion to RFB for those services that are not clearly technical in nature. In practice, RFB tends to consider the majority of services as “technical services”, thus imposing a 15% WHT (and, consequently, additionally 10% of CIDE).

11.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules In Brazil, there is no attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules. According to Law 12,973/14, Brazilian companies are subject to IRPJ and CSLL on the income earned during the calendar year on a worldwide basis, which includes any profits generated within the Brazilian territory and the 23. Law 10,168/00, sec. 2-A, combined with sec. 3 of Provisional Measure 2.159-70/01 (and sec. 7 of Law 10.332/01), reduce the WHT rate to 15% in case of technical services and technical assistance, administrative and similar. In addition to the 15% WHT, the contribution on interference on the economic domain (referred as CIDE) is levied on cross-border payments for payments as consideration for technical services, technical assistance and administrative services, trademarks, patents and transfer of technology. The CIDE is levied at a rate of 10% on the gross fees paid to the non-resident beneficiary. Unlike the WHT, the taxpayer of the CIDE is the Brazilian payer and not the non-resident beneficiary; thus, the CIDE burden is a tax cost of the Brazilian party and not of the foreign beneficiary. In this sense, see, inter alia, Consultation proceeding N. 04/2004. 24. Previously defined in Normative Instruction No. 252/02, sec. 17(§)(1º)(II).

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profits earned abroad through its controlled or affiliated companies (CFC) rules. Therefore, profits of foreign controlled companies are deemed to be distributed every year on 31 December, irrespective of actual payment/distribution of funds to Brazil. In other words, with regard to controlled foreign companies, if profitable, the profits must be added to the taxable basis of the Brazilian controlling entity; if negative, losses may be offset against future profits of the same legal entity that gave rise to them, provided that the control of losses is reported to the Brazilian tax authorities under proper documentation. According to the Brazilian CFC rules, “active income” means the income directly earned by a CFC as a remuneration for the performance its own economic activity, excluding revenues deriving from: – royalties; – interest; – dividends; – rental; – capital gains; – financial investment; and – financial intermediation. Exceptionally, dividends paid by non-Brazilian subsidiaries to holding companies may be considered as active income in the active versus passive income test, provided that such subsidiaries have been acquired before 2013 and that their active income ratio is equal to or greater than 80% of the total income. In principle, income from affiliated companies may be considered in the active versus passive income test. Additionally, Brazil does not apply the permanent establishment (PE) concept in order to attract taxation as the source country, based on article 5 of most of the double tax treaties it has entered into with 33 other countries.25 25. There is little case law on PEs in Brazil. The most important are the following: (i) Administrative Decision No. 09/98 (which decided for the application of the PE article under the Braz.-Neth. Income Tax Treaty (1990) instead of the domestic PE rule equivalent to sec. 147(III) of RIR/99 at the time); (ii) Administrative Decision No. 01-967/89 (which applied the domestic PE equivalent to sec. 539 of RIR/99 at the time, to decide that it shall be proved that the agent or attorney in Brazil had powers to contractually bind the seller to the buyer located in Brazil in order to apply the “imputed income” rule for taxing purposes. The sole fact that the seller held 99.99% of the corporate interest of the agent or attorney in Brazil does not imply that the agent or attorney had power to contractually bind the principal in Brazilian territory); and (iii) Administrative Decision 2202-003.114 of January 2016 examining the application of the Braz.-Fr. Income Tax Treaty (1971),

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Instead, the government has historically chosen to tax the income paid from Brazil to foreign countries (i.e. non-residents) as passive income, such as income from royalties or import of services (depending on the case), levying the WHT at a 15% rate (or 25% if paid to tax havens or in case of certain types of services), according to domestic law. Since the overall domestic tax burden imposed by Brazil in cross-border payments for services in general is around 45% (overall tax burden on import of services, regardless of the withholding nature), it is easier and simpler for the Brazilian tax authorities to ignore any discussion involving the PE characterization under tax treaties and the net calculation of the PE’s profits in the country, and just apply its domestic tax treatment on such payments (levying the gross revenue and income). It is said that the federal government tends to prefer taxing the gross income of foreign entities doing business in Brazil by qualifying the activities carried out by non-residents without a permanent presence in the territory as import of services or royalties fees paid by Brazilian clients, rather than to impose a PE characterization and tax the net income after the deductions and offsets, since the first form of taxation usually leads to a higher tax revenue and less compliance and inspection costs for the government and the federal tax authorities. This has been the Brazilian tradition over the past decades. Thus, it is unlikely that a PE issue would emerge under a tax treaty, in order to attract the taxation of royalty’s income under a PE in Brazil; rather, the WHT taxation on the gross amount is the procedure related to IP income paid to a foreign enterprise.

which decided that due to the existence of a PE of the French enterprise in Brazil, the WHT of 15% would be applicable under the treaty on the gross amount to be remitted to France (this decision is clearly a misconception by the CARF regarding the taxation of PE – which should have been taxed as a Brazilian company on its net income – but that was, unfortunately, the outcome of this decision).

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11.3. Taxation of IP under tax treaties 11.3.1. Taxing rights over royalties assigned by article 12 Most of the Brazilian tax treaties26 currently in force (i.e. 28 out of the 33) were followed by a protocol agreed on by both contracting states intending to qualify “technical services” and/or “technical assistance services” as royalties (article 12). Under this premise, technical service fees should be qualified under article 12 of the tax treaty, which allows the source country (i.e. normally Brazil – the importer of technology, capital and services) to withhold the WHT on that income.27 Therefore, Brazil does not adopt the OECD Model wording for article 12, but instead the UN Model version, which allows the taxation at source by WHT (this is also true regarding article 21, Other Income of the Brazilian tax treaties). The wording of article 12(2) usually encountered in Brazilian tax treaties has the following language: 2. However, such royalties may also be taxed in the Contracting State in which it arises and according to the laws of that State, but the tax so charged shall not exceed: ….

Usually the WTH standard rates under most tax treaties is 15% (most cases) or 10% (fewer cases). In this sense, it is important to mention which countries will be entitled to a reduced rate of WHT on payment for royalties due to a tax treaty in force with Brazil: – South Africa: 10% (Ordinance MF 433/06); – Korea (Rep.): 10% (Interpretative Declaratory Act 17/06);28 – Spain: 10% (Interpretative Declaratory Act 04/06);29 – Israel: 10% (Ordinance MF 01/06); – Japan: 12.5% (due to wording of article 12 of the tax treaty itself); and 26. Namely, 28 out of the 33 tax treaties currently in force entered into by Brazil contain such protocol provision, with a few differences on the wording, depending on the specific tax treaty. 27. Art. 12 (Royalty) of the OECD Model sets forth the exclusive taxation of royalties’ income by the residence state, therefore denying the source state to levy WHT. The typical wording in the OECD Model is the following: “Royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State.” However, the tax treaties entered into by Brazil provide the cumulative taxation of royalty income both by the source and the residence state, with the limitation on the WHT rate by the source state (similarly to the systematic of the OECD Model applicable to dividends and interest). 28. Matching credit of 20%. 29. Matching credit of 25%.

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– Mexico: 10% (Interpretative Declaratory Act 01/07). Brazilian tax treaties that do not contain the protocol provision considering “technical services” as royalties are those entered into with: (i) Austria; (ii) Finland; (iii) France; (iv) Japan; and (v) Sweden. Thus, for those tax treaties, no WHT can be levied by Brazil, in case it is the source country. On the other hand, it is possible to conclude that in all the other 28 tax treaties in force, technical services and technical assistance services should be qualified under article 12 – as royalties – allowing the source country to levy WHT on payments made to the service provider (exception made for the five countries mentioned in the preceding paragraph). The main legal discussion, in this case, would be as to what can be considered technical services for purposes of applying article 12 of the tax treaties, as there is no definition under the treaties. Also, there is also the legal discussion on whether technical services and technical assistance services levied under article 12 must only be those with transfer of technology or know-how, i.e. in cases of no transfer of technology/know-how to the Brazilian service importer, Brazil would not be allowed to levy WHT on such types of technical services regardless of the protocol treating them as royalties.

11.3.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 The vast majority of Brazilian tax treaties essentially has similar wording regarding the main provisions, including articles 7, 12 and 13. Articles 7 and 13 (with a few suppressions) are based on the OECD Model and article 12 is based on UN Model. For Brazilian tax purposes, no discussion has ever arisen in relation to the overlapping of articles 7, 12 and 13, but rather the Brazilian tax authorities and judges have always debated the overlapping between article 7 (business profits), article 12 (royalties), article 14 (independent personal services) and article 21 (other income). In this sense, article 13 (capital gain) has not so far been linked to IP transactions under Brazilian case law. This, however, applies to technical services and technical assistance services, but not to actual royalties or copyrights, which are subject to article 12 of the tax treaties without much controversy by the tax authorities. 295

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As to the definition of “royalties” in the tax treaties, this is the most sensitive issue under Brazilian tax treaties, due to the existence of protocols treating income from technical services and technical assistance services as royalties for purposes of applying article 12 to such international payments and, hence, allowing Brazil to levy WHT in most of the cases. Moreover, Brazil has decided to retain including article 14 when negotiating its tax treaties, even after 2000, when it was deleted from the OECD Model. In this sense, differently from the OECD Model (which only allows the source state to tax the income from professional services if the relevant person has a fixed base in the source state), article 14 of the Brazilian tax treaties allows the source state to exercise its jurisdiction to tax and therefore to apply WHT upon payments made to the other contracting state, regardless of the presence of a fixed base in Brazil. Furthermore, the wording of article 14 in most of the Brazilian tax treaties30 defines the jurisdiction to tax based on the payment made by a Brazilian payer, and not only to individuals making such payments (which thus expands the taxing power of Brazil to include payments made by Brazilian companies to independent personal service providers). By maintaining article 14 in its tax treaties, the Brazilian tax authorities face the challenge to find a hermeneutical solution to distinguish it from article 7, struggling with the scope and reach of “business profits” under the tax treaty. In that sense, under the domestic law, section 966 of the Civil Code (Law 10,406/02) defines “business enterprise” as an activity carried out by a: Person professionally organized to develop an economic activity of manufacturing or sale of goods or rendering of services. Single paragraph: The concept of business person does not comprise persons who develop intellectual profession of scientific, artistic or literary nature, even with the employment of auxiliary personnel, except if its exercise constitutes element of a business.

By comparing the scope of article 7 and article 14 of the tax treaty with the domestic legislation, for illustrative purposes, it seems that article 7 30. Despite the fact that the OECD deleted art. 14 from its Model Convention, such provision – with the particularities of its wording – is still in force and in effect in all the 32 tax treaties entered into by Brazil, being fully applicable.

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is equivalent to section 966 of the Brazilian Civil Code (business enterprise) and article 14 is equivalent to the sole paragraph of section 966 of the Brazilian Civil Code (independent personal services). However, this specific discussion between application of article 7 (case in which Brazil is not entitled to levy WHT) or article 14 (case in which Brazil is entitled to levy the WHT) has not yet been dealt with at administrative or judicial courts. The qualification issue, regarding the overlapping between the provisions of a tax treaty dealing with income derived from IP in Brazil has been, historically, between article 7 or article 21, and, more recently, article 7 or article 12. Historically, Brazil had been habitually reluctant to apply article 7 of tax treaties to qualify income from services as “business profits” and therefore to acknowledge that no WHT should be levied upon payments of service fees to countries that have entered into a tax treaty with Brazil. For the purpose of applying the existing treaties, a payment for services qualified under article 7 should prevent the source country (i.e. Brazil) to impose WHT at the rates of 15% or 25%. However, RFB has been using the source-payment rule argument to apply WHT on virtually every payment originated from Brazil,31 arguing that the existence of a tax treaty does not necessarily repeal the levy of the WHT on remittances of service fee abroad. Aiming at ensuring that its position would prevail over taxpayers, RFB former understanding (i.e. before 2013) to levy WHT on service payments under the treaty basically relied upon the reasoning that article 7 was not the provision applicable to service income, but rather article 21 or 22 (depending on the tax treaty) which deals with “other income”. As already mentioned, the “other income” article in Brazilian tax treaties entitles both the source country (Brazil) and residence country to tax based on their domestic law, following the UN Model. As a consequence, many taxpayers sought judicial protection, submitted consultations32 (not always successfully) or paid taxes that otherwise would not be due if the RFB acknowledged the prevalence of the tax treaty 31. This approach differs from the vast majority of OECD member countries. In this sense, it is important to stress that Brazil is not a member country of the OECD. 32. E.g. Private Ruling No. 35/05, Private Ruling No 119/99 and Private Ruling No. 369/98.

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over domestic laws, which is clearly stated in section 98 of the Brazilian national tax code (CTN)33 as follows: Section 98. International treaties and conventions revoke or modify domestic tax legislation and shall be observed by supervening laws.

The exact same wording of section 98 of the CTN is reproduced in section 997 of Decree 3,000/99. In this sense, the prevalence of tax treaties over internal legislation was already favourably ruled by higher courts, such as by the STJ) in Special Appeal 426,94534 and the STF in Extraordinary Appeal 229,096-035. Therefore, the discussion on the tax treaties prevailing over domestic law in regard to the levy of taxes is essentially settled, being possible to affirm that tax treaties shall be observed by domestic tax legislation. The other line of argument historically used by tax authorities to misinterpret and wrongfully apply the tax treaty in order to levy WHT on crossborder payments of services was to simply deny application of article 7. Tax authorities claimed that the term “profits” used in article 7 refers to net income (after deductions of costs and expenses) whereas fees for technical services would constitute gross income. By this line of argument, article 7 of tax treaties would only apply in cases where the amounts remitted abroad are net of costs and expenses (characterized by the gross revenue less expenses/costs in Brazil), which would make article 7 virtually inapplicable, since the costs and expenses to be deducted from the gross revenue would only be calculated and applied at the residence country, and not in source country (i.e. Brazil). Based on this misconception, the General Coordination of the Tax System of RFB (COSIT) issued Normative Declaratory Act 01/00 (ADN 01/00). The specific wording of ADN 01/00 is the following: I – Remittances related to technical services or technical assistance services agreement with no transfer of technology are subject to taxation according to section 685, II, “a”, of Decree 3,000, of 1999. II – In Double Taxation Treaties signed by Brazil, this kind of income qualify under the Article referred to as “Other Revenue”, hence, are taxed according to Item I above, which will be so even if the Double Tax Treaty does not comprise the referred Article. 33. 34. 35.

Law 5,172/66. Justice Teori Albino Zavascki (22 June 2004). Justice Ilmar Galvão (16 Aug. 2007).

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III – For the purpose of Item I above, technical services or technical assistance services agreement with no transfer of technology is the ones that are not subject to registry with the Patent and Trademark Office and the Brazilian Central Bank [emphasis added].

The ADN 01/00 expressly determined that cross-border payments in consideration for technical services and technical assistance service are qualified as “Other Income” and therefore subject to WHT in Brazil, since “Other Income” provisions in Brazilian tax treaties (article 21 or 22, depending on the treaty) deviates from the OECD Model by allowing taxation also at the source level. In 2013, the Attorney General’s Office reviewed the position of RFB under ADN 01/00, motivated by a diplomatic impasse with Finland on how to apply the tax treaty between the two countries,36 and issued PGFN/CAT Formal Opinion 2,363/13. According to the understanding therein, whenever the tax treaty does not expressly qualify technical services and technical assistance as royalty, the corresponding payment should qualify under article 7 (Business Profits) and therefore would not be subject to WHT in Brazil. Consequently, PGFN/CAT Formal Opinion 2,363/13 recommends that RFB refrain from its former understanding that article 21 (Other Income) would be applicable to service payments from Brazil to the tax treaty country. Additionally, it recognizes that certain payments for technical services (without transfer of technology) made by Brazilian residents to the nonresidents (i.e. beneficiaries of jurisdictions with which Brazil has entered into a tax treaty) should not be subject to WHT. It also stated that the application of article 7 is limited to tax treaties in which the technical service payments are not qualified as royalty (i.e. those with Austria, France, Finland, Japan and Sweden). PGFN/CAT Formal Opinion 2,363/13 is important also because it confirms that the provisions of tax treaty provisions should prevail over domestic tax legislation. However, for service payments to residents where the tax treaty qualifies technical service payments as royalty (i.e. under article 12 of the 36. The Finnish government threatened to terminate the tax treaty with Brazil if Brazil kept the approach of “Other Income” previously mentioned herein in order to levy WHT on service payments, instead of applying the “Business Profits” provision and hence not taxing such income. The intention was manifested through a notification issued by the Finish Ministry of Finance on 27 Feb. 2013 and later analysed by the Coordination of International Relations (CORIN) through Memo 64/2013 of 19 Apr. 2013 and COSIT through Technical Note No. 23/2013 of Aug. 2013.

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tax treaty), the Opinion did not mention the exclusion of the WHT. Thus, at that point, the controversy regarding the 27 DTTs without protocol remains, with arguments in favour of the taxpayers in order to avoid the WHT in those cases as well. On 20 June 2014, following PGFN Formal Opinion 2,363/13, RFB enacted Interpretative Declaratory Act 5 (ADI 5/14), which stated the following: Section 1. Tax treatment to income paid, credited, handed or remitted by a Brazilian resident to a non-resident for the rendering of technical services or technical assistance services agreement with or without transfer of technology, based on Double Taxation Treaties will be the treatment set forth in the Double Tax Treaty: I – In the Royalties Article, where the respective protocol established that technical services or technical assistance services agreement should receive equal treatment, if the Double Tax Treaty allows for taxation in Brazil; II – In the Independent Profession Article, in case of a technical services or technical assistance services agreement related to the technical qualification of a person or group of persons, in case the Double Tax Treaty allows for taxation in Brazil; III – In the Business Profits Article, apart from Items I and II provisions.

As transcribed above, based on such ADI 5/14, the amounts remitted abroad as compensation for the provision of technical services and technical assistance, with or without transfer of technology, are subject to the provisions of the tax treaty, in the following order: Article 12 of the DTT, as “Royalties”, where such treatment is provided for in the protocol to the DTT deeming the technical service and technical assistance as royalties; Article 14 of the DTT, as “Professional or independent personal services”, where the providing of technical services and technical assistance are related to the technical qualification of a person or group of persons; Article 7 of the DTT, as “Business profits”, where none of the two cases described in items I and II above applies.

The publication of ADI 5/14 was relevant for the following reasons: firstly, because RFB expressly recognized that tax treaty provisions should prevail over domestic legislation, and secondly, because RFB made it clear that depending on the wording of the tax treaty, it is still feasible to apply the provisions of article 7 to scenarios connected to the remittance of service fees to a non-resident provider, thus avoiding the levy of the WHT.

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Additionally, ADI 5/14 revoked Normative Declaratory Act No. 01/2000, which represented RFB understanding over the years, until 2013. On 17 June 2015, the COSIT issued Ruling No. 153/2015 pursuant to a case where a Brazilian entity was remitting service fees to its French parent company, due to the provision of technical services or technical assistance by the French company to the Brazilian payer. Aligned with the terms of ADI 5/14, COSIT37 concluded that no WHT was due on payments from Brazil to France for technical services or technical assistance (with or without transfer of technology) because the payments qualify as business profits under article 7 of the Brazil-France Income Tax Treaty (1971), since there is no protocol qualifying the technical services/ technical assistance as royalties under the treaty. In other words, since the Brazil-France Income Tax Treaty (1971) does not qualify technical service/assistance as royalties or professional/independent personal services, payments due by a Brazilian entity to a French beneficiary should qualify as business profit, without triggering WHT in Brazil. This private ruling should be viewed as an additional favourable development in the discussions around the non-taxation of WHT on technical service and technical assistance fees payments from Brazil to a non-resident located in France (and in the other four countries that do not have a protocol qualifying such services under article 12 of the tax treaty), since it reinforces that no WHT should be due based on article 7 of the Brazil-France Income Tax Treaty (1971). In a similar conclusion, COSIT Private Ruling No. 109/2016 has also confirmed the position that amounts paid for technical services/assistance to a provider resident in Finland are not regarded as royalties, since the BrazilFinland Income Tax Treaty (1996) does not qualify the income from technical services and technical assistance service as royalties under article 12

37. Normative Rule 1,434/14, COSIT’s answers to Private Rulings and Divergence Solutions (based on the verification of a conflict among different Private Rulings) issued by COSIT have binding effect over RFB (i.e. erga omnes effect), regardless of whether other taxpayers have officially enquired RFB in the matter. For this reason, we believe that the position regarding the non-levy of WHT on payments for technical services and technical assistance due to the application of art. 7 of the tax treaty, under COSIT Private Ruling No. 153/2015, can be extended to the other tax treaties that do not contain a protocol qualifying the income from technical services and technical assistance service as royalties under art. 12, namely, Austria, Finland, Japan and Sweden.

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(due to the absence of a protocol in that sense), thus such income is qualified as business profits (article 7), which are not subject to WHT in Brazil.

11.3.2.1. Brazilian case law (judicial precedents) 11.3.2.1.1.  Superior Court of Justice (STJ) 11.3.2.1.1.1.  COPESUL case (2012) In June 2009, the Regional Federal Appellate Court38 issued a decision stating that service payments remitted to Canada (and before 2006 to Germany)39 were not subject to WHT in Brazil because the payments qualify as business profits (article 7) under the tax treaty. The decision was the first judicial court precedent on the matter. The RFB then appealed to the higher courts, but in 2012 the STJ also ruled in favour of the taxpayer,40 confirming the understanding of the lower court. The main legal ground on which the STJ based its decision (in addition to confirming that the provisions from the respective tax treaty should apply) was that the concept of “business profits” in article 7 includes income derived from rendering technical services without the transfer of technology. It is important to mention that even though the COPESUL case was a major milestone in tax treaty interpretation in Brazil, it refers to a dispute dating back to when the RFB argued that service income should be qualified under article 21 (as “other income”). As a consequence, other issues such as the existence of protocols in both treaties (Canada and Germany) determining that technical services are qualified as “royalties” for purposes of applying the treaty (article 12) were not discussed.41 Based on the language of both the above-mentioned protocols, technical service (including technical assistance) rendered by the German and Canadian companies in Brazil should fall within article 12 and consequently be subject to 15% WHT in Brazil. However, the analysis of the protocol or the 38. BR: Federal Regional Court of Appeal of 4th Circuit, Appeal No. 2002.71.00.0065305 (2009). 39. The Braz.-Ger. Income and Capital Tax Treaty (1975) was terminated by Germany in 2005, effective as of 1 Jan. 2006. 40. Special Appeal (REsp) No. 1.161.467-RS, Justice Castro Meira (17 May 2012). 41. Item 8 of the protocol of the Braz.-Can. Income Tax Treaty (1986) (Decree No. 92,318/86) and item 4 of the Braz.-Ger. Income and Capital Tax Treaty (1975) (Decree No. 76,988/76).

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examination of either article 12 or article 14 were not even mentioned in the COPESUL decision. It therefore seems not entirely safe to assume, based on the COPESUL case alone, that the STJ would still rule in the same direction (i.e. that services would be qualified under article 7) when faced with the current understanding of the RFB. Also, even if there were a discussion on the qualification of technical services as “royalty”, there would be legal grounds to support the position that only technical services with the transfer of technology or know-how are the ones subject to article 12 as “royalty”, according to the protocols, but not in cases where such services were rendered alone.42 Despite the COPESUL favourable precedent from the STJ, it is relevant to note that such decision is not binding to all taxpayers (i.e. it does not have erga omnes effect) and, at this point, there is no consolidation on the case law as to the matter. 11.3.2.1.1.2.  Iberdrola case (2015) The most recent development at the higher judicial courts level is the decision issued in November 2015 by STJ,43 in which Iberdrola – a Spanish company – argued that no WHT should be withheld in Brazil upon the remittance of service fees from Brazil to Spain. In view of the provisions of the Brazil-Spain Income Tax Treaty (1974), the STJ ruled that payments for services performed by the Spanish entity

42. In this sense, see COSIT Declaratory Normative Act No. 01/00; Consultation Proceeding No. 369/98 and Tax Ruling No. 10980.006598/97-78; see also A. Xavier, O Imposto de Renda na Fonte e os Serviços Internacionais – Análise de um Caso de Equivocada Interpretação dos arts. 7 e 21 dos Tratados in Revista Dialética de Direito Tributário 49, pp. 14-15 (Dialética 1999); A. Xavier, Direito Tributário Internacional do Brasil pp. 626-627 (Forense 2010); S.A. Rocha, Caso COPESUL: Tributação pelo IRRF da Prestação de Serviços, Antes e Depois do ADI RFB N. 5/14 in L.F. de Moraes e Castro, Tributação Internacional: Análise de Casos vol. 3, pp. 211-238 (MP 2015); R.P. Ribeiro & R.F. Vasconcellos, A Transferência Internacional de Tecnologia e sua Tributação, 6 Revista de Direito Tributário internacional, pp. 127-168 (2007); L.F. de Moraes e Castro, Parallel Treaties e a Interpretação dos Acordos para Evitar a Dupla Tributação: a Experiência Brasileira em face dos Artigos 7, 12 e 21 da Convenção Modelo OCDE in Tributação, Comércio e Solução de Controvérsias Internacionais pp. 159-183 (A.L. Moraes do Rêgo Monteiro et al. eds., Quartier Latin 2011). Stating the contrary, see Consultation Proceeding No. 199/99. 43. Special Appeal No. 1.272.897-PE, Justice Nunes Maia Filho (19 Nov. 2015).

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without a PE in Brazil are not subject to WHT. The main arguments supporting the STJ’s position were that: (i) the provisions of the tax treaty should prevail over Brazilian domestic rules (as per the already-mentioned section 98 of the National Tax Code) and should be interpreted in line with the OECD standards, even if Brazil is not a member of said organization; and (ii) the expression “profits of an enterprise” means the operational profits of the company that are derived from activities, including the income received from the rendering of services. Although the latest discussion on cross-border remittances of services fees were focused on the difference between technical and non-technical services, the STJ did not analyse the nature of the services (i.e. technical or non-technical). As a consequence, with regard to the 28 tax treaties which have bilateral protocols the issue remains as to which cases article 12 would apply. The Iberdrola case – even though it is not binding on taxpayers – represents an important and recent precedent on this matter, confirming the understanding that the WHT shall not be levied as service fees should be qualified under article 7 as “business profits”. Despite being a favourable precedent for taxpayers, the fact that the Iberdrola case (similarly to the COPESUL case of 2012) also failed to examine the application of article 12 and article 14 of the tax treaty prevents it from being a bullet-proof precedent for taxpayers. For that reason, even though the Iberdrola case is a relevant development on the issue, with regards to the application of article 7 of tax treaties, there are still additional aspects that need to be addressed, which can affect the outcome of the tax assessment of WHT by Brazil in technical service and technical assistance fees to countries like Spain. Finally, it has to be noted that the STF has already decided in the Extraordinary Appeal (RE) No. 450.239-PR (2010, Justice Dias Toffoli – known as the “Volvo case”44) that the STF has no jurisdiction to decide on disputes dealing with tax treaties, as there is no relevant constitutional 44. For a better understanding on the case, see L.F. de Moraes e Castro, R. Maito da Silveira & C.C. de Hildebrand Grisi Filho, Caso Volvo 1: Possibilidade de Aplicação do Art. 10 (Juros) do Tratado Brasil-Japão a Filial de Banco Japonês Sediada no Panamá in Tributação Internacional: Análise de Casos pp. 341-358 (1st edn, vol. 1, L.F. de Moraes e Castro ed., MP 2010).

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matter involved. Accordingly, it seems that the decisions on tax treaties held by the STJ shall be the ones prevailing in the end (res judicata), being unlikely to be overruled by the STF.45 Due to the fact that both STJ decisions in favour of the non-levy of the WHT on such technical services payments are not extended to all taxpayers (i.e. do not have erga omnes effect) but are only effective for the parties that reached for the judicial remedy (inter-parties effect), even though they represent an important development on this issue, they are not fully extendable to all Brazilian payers. 11.3.2.1.2.  Precedents from the lower federal courts 11.3.2.1.2.1.  Ambev case (2017) Recently, the 3rd Tax Circuit of the Federal Regional Court (TRF3) decided that no WHT should be withheld in Brazil upon the remittance of technical service fees from Brazil to Belgium, by reason of the application of article 7 of Decree 72.542/1973 (Brazil-Belgium Tax Treaty). According to the decision, there should be no IRRF on international payments for technical services, since the legal nature of such remittance should be qualified under article 7 (Business Profits) of the Brazil-Belgium Income Tax Treaty (1974) (Decree 72.542/1973) and therefore no IRRF should be imposed in Brazil. The exception to such rule would occur only if the Belgian company had a PE in Brazil, under the terms of article 5 of the tax treaty – which, pursuant to the decision, did not occur. The decision concluded that only if the Belgian company had a PE in Brazil (article 5) or if it were transferring technology to the Brazilian company, article 12 could apply, regardless if the tax treaty foresees a protocol that treats technical/assistance services as royalties for treaty purposes.

45. One exception shall be made to the decision held by STJ on Special Appeal (REsp) No. 426,945 of 22 June 2004, which deals with non-discrimination (art. 24 of the Braz.Swed. Income Tax Treaty (1975)). The case is currently waiting for a decision by the STF (Extraordinary Appeal 460,320). Since this case deals with the issue of the violation of equality principle under the Federal Constitution, in addition to the non-discrimination principle under the tax treaty, the STF may decide on the issue. Nevertheless, from a technical standpoint, it seems that the treaty issue may be left aside by the STF, which will probably analyse the constitutional principles, rather than the treaty provision in the case.

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The most important aspect of this decision relates to the analysis of the protocol of the tax treaty. When examining the protocol, the Federal Court concluded that such instrument does not aim at extending or modifying the concept of “royalties”, but at expressly including the provision of technical services under the scope of “royalties”, yet, without any mention that leads to a modification of the concept of royalties. Additionally, it has been said that the Brazilian tax authorities are not allowed to create a new tax-triggering event and the protocol item should be carefully analysed by the contracting states in such a way that they do not distort the agreement, under penalty of the treaty’s main effects falling apart. In such sense, the decision under analysis has adopted the position of many scholars in Brazil by having affirmed that the protocol should be understood only in very specific cases in which, despite of the contract be of provision of services, there must be a transfer of technology or know-how in some way. As this was not the case in Ambev, in which the Belgian company had only applied its knowledge for technical support, item 6 of the protocol would not apply (and consequently article 12 that allows the IRRF in Brazil), but rather article 7 that does not allow Brazil to impose IRRF on the payments. On this matter, the decision is unprecedented and is an important one for taxpayers, since 28 of the 33 tax treaties signed by Brazil and effective up to the current date have the protocol item that treats technical services as royalties, which, in principle, could cause the triggering of IRRF. As per the conclusion set by this recent decision under analysis, any payment of technical/assistance service fees made to a country with which Brazil has signed a tax treaty should not be subject to IRRF in Brazil even in the existence of a protocol to article 12. However, this decision was appealed to the STF which will, in the end, have the last word on this case. In addition to the relevant cases mentioned above, i.e. COPESUL, Iberdrola and Ambev, there are other precedents issued at the lower court level that have dealt with the scope of the application of article 7 in contrast to article 12, as summarized below: – Renault case (1997):46 The decision applied article 7 of the BrazilFrance Income Tax Treaty (1971) to qualify income from technical 46. BR: 9th Fiscal Region of Federal Revenue Office, Administrative Decision No. 9E97F007 (8 Oct. 1997).

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Taxation of IP under tax treaties

services (engineering services without transfer of technology) as business profits, thus preventing the WHT on such payments from Brazil to France. – Nestlé case (2012):47 The court held in favour of the applicability of article 7 of the Brazil-Canada Income Tax Treaty (1984), recognizing the non-levy of WHT, once the remittance of fees under a service agreement regarding know-how were regarded as a payment for services performed by a foreign company without a PE in Brazil. – Aracruz case (2013):48 The decision applied article 7 of the BrazilFinland Income Tax Treaty (1996) to qualify income from technical services (industrial drawing) as business profits, thus preventing the WHT on such payments from Brazil to Finland. – Alcatel case (2013):49 Rather than applying article 7 of the BrazilFrance Income Tax Treaty (1971), this precedent decided that the Brazilian company must collect the WHT on the amount remitted to France relating to a technical service agreement (construction and maintenance of underwater cables) since the payment was related to remuneration of services and not to business profits. – Veracel case (2013):50 This decision held that article 7 of the BrazilFinland Income Tax Treaty (1996) was applicable, since there was no PE of the entity in Brazil. Thus, no WHT was due by the Brazilian payer upon the international remittance. – Sodexo case (2013):51 This precedent applied article 7 of the BrazilFrance Income Tax Treaty (1971) to qualify income from services (administrative support) as business profits, thus preventing the WHT on such payments from Brazil to France.

47. BR: Regional Federal Court of 3rd Circuit (TRF3), 8 Nov. 2012, Appeal No. 000036189.2004.4.03.6100, reporting Judge C. Marcondes. 48. BR: Regional Federal Court of 2nd Circuit (TRF2), 6 Aug., 2013, Appeal No. 000890597.2001.4.02.5001, reporting Judge R. Perlingeiro. 49. BR: TRF2, 19 Feb. 2013, Appeal No. 0012788-28.2010.4.02.5101, reporting Judge J.F. Neves Neto. 50. BR: Regional Federal Court of 1st Circuit (TRF1), 15 July 2013, Appeal No. 2004.33.01.000026-1, reporting Judge R. Fonseca. 51. BR: TRF3, 16 May 2013, Appeal No. 0006803-34.2011.4.03.6130, reporting Judge R. Jeuken.

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Chapter 11 - Brazil

– Philips case (2013):52 The decision granted the applicability of article 7 of the Brazil-Netherlands Income Tax Treaty (1990) based on the grounds that the amount remitted to the company in the Netherlands was characterized as foreign business profits and could not be subjected to WHT, since there was no PE of the Dutch company in Brazil. – BMG case (2014):53 The decision granted the applicability of article 7 under the Brazil-Portugal Income Tax Treaty (2000), since the beneficiary of the income (i.e. payments of edification costs of a sport museum and rent of spaces for advertisement purposes) was located in Portugal and there was no PE located in Brazil. Thus, no WHT was due by the Brazilian payer upon the international remittance.

11.3.3. Beneficial ownership and royalties Brazil does not have any case law dealing with beneficial ownership and royalties.54 The only two cases dealing with the beneficial owner concept in tax treaties are related to interest and both involved the Brazil-Japan Income Tax Treaty (1979)55 (one administrative56 and one judicial).57 Moreover, there is no definition of beneficial owner in Brazilian domestic tax legislation. There is, however, a definition of “effective beneficial”, which is not related to tax treaties, under section 26 of Law 12,249/2010. This legal provision states that any amounts paid to an LTJ or a PTR are non-deductible expenses, unless the Brazilian taxpayer can comply with the following three cumulative requirements: (i) the effective foreign beneficiary can be identified; (ii) the operational capacity of the foreign individual or entity to undertake the relevant transaction can be demonstrated; and (iii) it can be demonstrated that the price has been effectively paid and that the 52. BR: TRF3, 19 July 2013, Appeal No. 0025200-76.2007.4.03.6100, reporting Judge R. Calixto. 53. BR: TRF1, 8 Apr. 2014, Appeal No. 0058303-05.2011.4.01.3800, reporting Judge L. Tolentino Amaral. 54. For a study on the concept of beneficial owner from a worldwide comparative case law perspective, see L.F. de Moraes e Castro, Concept of Beneficial Owner in Tax Treaties: Separating the Wheat from the Chaff Through Case Law Method Internationally, Intl. Tax J., pp. 25-44, July-August 2013. 55. For a detailed analysis of the beneficial owner concept in Brazilian case law, see L.F. de Moraes e Castro, Brazil’s Anti-Treaty Shopping Measures: Current and Future Developments regarding Beneficial Ownership and Limitation on Benefits Clauses in Tax Treaties, 65 Bull. Intl. Taxn. 12, sec. 5. (2011), Journals IBFD. 56. BR: CARF, 4 Feb. 2009, Administrative Decision 102-49.480, TIM Nordeste. 57. BR: STF, 30 Aug. 2010, Extraordinary Appeal 450239, Volvo.

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Taxation of IP under tax treaties

corresponding assets, rights or services have been effectively provided and/ or used. Out of the 33 tax treaties entered into by Brazil, the beneficial owner clause is included in 25 of them, being absent only in the treaties with Argentina, Austria, Denmark, Spain, France, Japan, Luxembourg and Sweden. From a practical perspective, Brazil has never required proof of the beneficial owner being resident in the other contracting state in order to apply the tax benefits of the treaties, particularly the reduced WHT of 10% for royalties for a few countries (as already mentioned herein). Nonetheless, Normative Instruction RFB 1,226/2011 has annexed forms that must be duly completed and submitted to the commercial bank responsible for remitting the funds from Brazil to the tax treaty country in order to claim the treaty benefits. Thus, since 2011 onwards, the beneficial owner statement is made by completing the applicable form with the information necessary to claim the treaty benefits in that specific case (such as type of income, country of residence, address, etc.).

11.3.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the resident state There is no regime equivalent or similar to this in Brazil. Therefore, there is no exemption in Brazil, as the source state, in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the resident state.

11.3.5. Time of taxation The taxation of income by the federal government is set forth by section 15(III) of the Federal Constitution of 1988, which allows the federal government to establish a tax on income, as follows: Section 153. The Federal Government is entitled to levy taxes on: [...] III income and earnings of any nature;….

309

Chapter 11 - Brazil

In this respect, it should be noted that the constitutional legislator is not entirely free to enact laws imposing the income taxes as it is necessary to respect the constitutional limitations, principles and individual guarantees granted to taxpayers. The secondary legislation that must be observed when taxing income under the Brazilian tax system is the National Tax Code (Código Tributário Nacional, CTN), specifically section 43, which reads as follows: Section 43. The tax that may be imposed by the Federal Government on income and earnings of any nature has as its taxable event the acquisition of economic or legal availability of: I - income, understood as the product of capital, work or the combination of both; II - earnings of any nature, understood as any surplus to the assets, not specifically [included] in the previous item.

According to the wording of sections 708 (technical services), 709 (copyright) and 710 (royalties) of Decree 3,000/99, the time of taxation of the WHT levied on cross-border payments of IP remuneration is the moment that the amounts are “paid, credited, delivered, employed or remitted to abroad”. Brazilian scholar Mariz de Oliveira defines each of the expressions used in such cases, as follows: “Payment” is the act that extinguishes the pre-existing obligation under civil law (section 304 of the Civil Code, approved by Law 10,406 of 10 January 2002) in a manner that there is only payment when the debt is past due; “Remittance”, “employment” and “delivery” are also types of payment that represent the occurrence of the triggering event and only occur when the obligation is fulfilled; “Remittance” consists in sending money to a beneficiary, being a term usually used for transfers of money overseas, where the beneficiary is located; “Employment” is the use of the proceeds from the payment in the interest of the beneficiary, wherein the paying source uses the money on behalf of the beneficiary; “Delivery” is the act of transferring the proceeds from the payment to the hands of the beneficiary, or someone authorized to receive the money;

310

Taxation of IP under tax treaties

“Credit” is the “quasi-payment” or “implied-in-law payment” of the due debt since the debtor makes it available to the respective creditor on his account, so that he receives the amount due when required. (author’s unofficial translation)58

In light of these six definitions, it is clear that in order to levy the WHT on amounts remitted abroad, the amounts must represent “income” in the transaction between the parties and that is considered to happen upon the crossborder remittance, payment or equivalent legal act that represents such. In this sense, it is important to point out that section 45 of the CTN states that the other parties are jointly and severally liable for the collection of income tax where they are connected to the taxable event. Notwithstanding the fact that the taxpayer in respect of IRRF is the foreign entity, i.e. the beneficiary of the income, sections 682 and 685 of the ITR (Decree 3,000/99) state that the Brazilian source, i.e. the payer, is jointly and severally liable for the payment of IRRF when income is paid, credited, delivered, employed or remitted to abroad. These sections read as follows: Section 682. According to the provisions on this Chapter, the income and earnings of any nature, when remitted from sources located in the country, will be subject to the withholding tax, when received: I - by individuals or legal entities resident or domiciled abroad; [...] Section 685. The income, capital gains and any kind of earnings paid, credited, delivered, employed or remitted by a source established in the country, to individuals or legal entities resident abroad, are subject to the withholding income tax.

Also, according to Circular 3,691/2013, issued by the BACEN, the financial institutions registered at BACEN must not only comply with the specificities of each exchange transaction, but also subject each closing of an exchange transaction to compliance with applicable legislation, including those issued by other governmental bodies.59 Additionally, as per the Notice of Exchange Department – DECAM No. 2,223/90, issued by the BACEN, the financial institutions registered at

58. R. Mariz de Oliveira, Os Importantes Conceitos de Pagamento, Crédito, Remessa, Entrega e Emprego da Renda (a propósito do imposto de renda na fonte e de lucros de controladas e coligadas no exterior), 22 Revista Fórum de Direito Tributário, pp. 39-76, (July-Aug. 2006). 59. Secs. 2 and 4, Circular BACEN 3,691/2013.

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Chapter 11 - Brazil

BACEN must demand proof of the payment of the WHT levied on international remittances from Brazil to abroad, as below transcribed: Except to the previous item, the closing of exchange agreements regarding the remittance of any funds from Brazil to abroad is conditioned to the proof of the collection of the withholding income tax or express statement of exemption, non-assessment or similar case regarding such tax, notwithstanding the fact that the transaction is carried out in the free rate exchange market referred in Resolution No. 1,690/90 or in the, floating rate exchange market referred in Resolution No. 1,552/88, both issued by the National Monetary Council.

Therefore, from a practical standpoint, the commercial bank/financial institution may not close the exchange agreement to remit funds to a non-resident service provider without proof of the collection of the WHT. Hence, the WHT collection by the Brazilian payer is in practice a condition precedent for the remittance of funds to another country.

11.3.6. Excessive royalty payments With regard to the regulatory limits in respect of cross-border payments of royalties from Brazil to abroad, the INPI and the BACEN apply the tax rules regarding deductibility to limit the international remittances of funds paid by a Brazilian entity to a foreign related party. In this regard, the INPI applies Ordinance MF 436/58 to limit the cross-border payment of royalties between related parties. Consequently, if the maximum percentage allowed for tax deduction purposes is 1% of the net sales revenue of the Brazilian subsidiary, the INPI only authorizes royalties to be paid up to 1% of the net sales revenue of the Brazilian subsidiary, and the BACEN only authorizes the remittance of funds up to the limit approved by the INPI when the licence agreement is registered. No additional payment of royalties is possible under an agreement recorded with the INPI, regardless of whether the price clause in an agreement sets a higher amount. Therefore, it is not possible to have excessive royalties’ payments from Brazil to abroad, either from a regulatory as to a tax deductibility purposes. It should be noted that, in theory, the legal basis for the regulatory limits as applied by the INPI and the BACEN is based on Law 4,131/62, which regulates the general rules regarding foreign capital. Specifically, section 28(3) of Law 4,131/6260 establishes that when there are reasons to envisage the 60. Law 4,131/62, sec. 28(3) reads as follows: “In the same cases of this section, the Council of the Superintendence of Currency and Credit can limit the remittances of amounts

312

Taxation of IP under tax treaties

economic distortion of payments from Brazil to another country, typically involving an international commercial transaction between related parties, the competent regulatory body, in this case the INPI (the BACEN, in practice, simply follows the information already registered with the INPI) can restrict the international transfer of such funds. With regard to royalties and fees for technical, scientific and administrative services, the limit is up to 5% of the annual gross revenue of the Brazilian payer, provided the relevant agreements have been registered with the INPI. This follows from the wording of sections 12 and 28(3) of Law 4,131/62. However, as section 6 of Decree-Law 1,730/79, which modified the income tax legislation, amended the limit to up to 5% of “net revenue”, rather than “gross revenue” as originally stated in section 12 of Law 4,131/62, from a practical perspective, the INPI normally applies the 5% maximum limit of net sales revenue. This is established by section 6 of Decree-Law 1,730/79, which is the current rule as set out in section 355 of Decree 3,000/99, not the gross sales revenue as contained in sections 12 and 28(3) of Law 4,131/62. In this respect, it should be noted that the latter is not tax legislation. As a result, cross-border remittances of royalties to a foreign related party in respect of most royalties from the newer economic sectors and fees for technical assistance services are limited to 1% of the net sales revenue, provided the business activities carried on by the Brazilian party are not expressly listed in Ordinance MF 436/58. If the licence agreement stipulates remuneration higher than 1% of net sales revenue, the INPI will most likely deny the recording of the licence agreement. This is because the remuneration is higher than that permitted under the tax legislation, which, as previously noted in this section, is adopted for regulatory purposes by the INPI and applied by the BACEN. Consequently, in such cases, it is not possible to remit the funds representing more than 1% of the net sales revenue of the Brazilian company abroad. This is because recording such an agreement with the INPI, which is a mandatory requirement for the BACEN to permit the international remittances of royalties and fees for technical assistance services, would most probably be denied, provided, of course, that the remuneration clause in the licence agreement is not amended by the parties to reflect the 1% limit. Royalties paid by a Brazilian company that are higher than 1% of net sales related to royalties and technical assistance payments until the accrued maximum limit of 5% (five percent) of the gross revenues of the company.”

313

Chapter 11 - Brazil

revenue are also not tax deductible, as recording an agreement with the INPI and its consequent registration with the BACEN are conditions that are required by the tax law. The percentages set out in Ordinance MF 436/58 have been criticized by taxpayers, especially as the industries and economic sectors covered by the Ordinance have generally not been updated. In this respect, it should be emphasized that the reasons for, and the historical background to, the tax and regulatory limit on foreign remittances are a matter of the protectionist policies adopted by Brazil with regard to technology in the past. In this context, it should be noted that the relevant tax deduction limit rules and the related regulations were enacted in a period in history when Brazil was economically closed and the government strictly limited the flow of money from Brazil abroad. During this period, Brazil was a military dictatorship and nationalism was the norm, so any payment made to foreign parties was not favourably regarded by the government. These rules and regulations have not been updated and therefore the same limits still apply. In recent years, several companies have tried to challenge the rules before the courts, but the rules have been held by the judiciary to be constitutional and legal. The primary arguments advanced by the government to retain the existing limits on the tax deductibility of cross-border remittances are essentially two: technological and fiscal. From a technological perspective, the INPI wishes to protect and provide incentives for Brazilian industry and stimulate development of technology and innovation nationally. For this reason, the INPI limits the amounts that can be paid to related companies to avoid the use of foreign capital by Brazilian residents to pay for foreign technology, instead of remunerating national industries and encouraging the development of similar Brazilian technology with foreign capital. For practical purposes, the INPI used the existing rules in the tax legislation, i.e. the 5% of net sales revenue limit, instead of applying the limits set out in the foreign capital law that regulates the related direct investments made in Brazil, i.e. the 5% of gross sales revenue limit. This makes the limitation policy even stricter, as the net amount of sales revenue is obviously less than the gross amount of sales revenue. From a fiscal perspective, the rules result in more tax being paid by companies based in Brazil, as tax deductions are restricted. This is convenient for the tax authorities, as the establishment of fixed percentages facilitates the work of the tax officials in auditing companies that claim deductions for

314

Taxation of IP under tax treaties

royalties with regard to corporate income taxes. This also reduces compliance costs and inspection times. It is again important to note that the regulatory limits in respect of the international remittance of funds do not apply to licence agreements involving cross-border payments for intangible fees that do not have to be recorded with the INPI.61 Such agreements include software licence agreements without the transfer of technology62 and several types of technical services agreements. In these cases, the treatment is similar to that for taxation as, with regard to such intangibles, the transfer pricing rules apply instead of the 5% net sales revenue limit. In this context, practice reveals that the regulatory limits and rules broadly follow the tax rules. These are applied together to harmonize tax deductibility and the regulatory rules regarding the remittance of funds from intangible income sourced in Brazil.

61. As per Resolution 54/2013 of the INPI’s Presidency, the following 14 types of contracts do not have to be recorded, as the INPI understands such contracts do not imply the transfer of technology: (1) services provided with regard to purchase agencies, including the provision of logistics services, i.e. boarding support, administrative tasks relating to customs release, etc; (2) services carried out abroad without the presence of technicians from the Brazilian company that do not result in the creation of any documents and/or reports, such as product processing; (3) product homologation and quality certification; (4) financial consulting; (5) commercial consulting; (6) legal consulting; (7) consulting involving participation in public tenders; (8) marketing services; (9) remote consulting services that do not result in the creation of documents; (10) services in respect of support, maintenance, installation, implementation, integration, customization, adaption, certification, migration, configuration, the setting of parameters and the translation or localization of software; (11) training services for the final user or other software training; (12) software use licences; (13) software distribution; and (14) the acquisition of a sole copy of software. 62. It should be noted that, typically, the maximum term permitted for agreements involving the transfer of technology that can be recorded with the INPI, i.e. the maximum period during which royalties may be paid from Brazil abroad, provided that the relevant contract is recorded with the INPI, varies depending on the intangible. With regard to licences involving the use of trademarks, patents and copyright, different terms apply under IP laws, generally ranging from 10 to 25 years. With regard to royalties that imply the transfer of technology, sec. 123 of Law 4,131/62 establishes that the deductibility of royalties, and other payments relating to intangibles, is only allowed for a period of 5 years but can be renewed for an additional 5 years on the submission of a motivated request in exceptional cases, thereby giving rise to a maximum period of deductibility of 10 years, at the discretion of the INPI.

315

Chapter 11 - Brazil

11.4. Practical issues on cross-border remittances of royalties As agreements concluded by the entities in multinational groups and their related parties abroad usually provide for different types of remuneration in respect of intangibles, it is important that the subject matter of each agreement is dealt with separately. This means that a specific agreement should be executed for each type of remuneration based on the relevant legal nature and the object, price, term, etc. should be separated as much as possible. The primary objective of the segregation of each type of remuneration is separate agreements. The reasons for this separation is that if all types of remuneration derived from intangibles are dealt with together in one agreement, i.e. bundles of rights, the federal tax authorities may requalify the agreement as a “pure” service agreement, i.e. an agreement to provide services as the main subject matter. If an agreement is treated as a pure service agreement, the tax rules that apply are those for the “import of services”, which entails the levying of the social integration programme (Programa de Integração Social – PISimport) and the social contribution for the financing of social securityimport (Contribuição para Financiamento da Seguridade – COFINSImport) at a total combined rate of 9.25%. This contrasts with the treatment of cross-border payments in respect of royalties and copyright, which are not subject to the PIS and COFINS-Import as no services are provided in these circumstances. Consequently, if each type of income is not segregated by the taxpayer, the federal tax authorities may levy PIS and COFINS-Import on the payments made by Brazilian entities to related parties abroad. The federal tax authorities have confirmed that this is their position in Tax Ruling 263 of 2011, which reads as follows: The payment or remittance of amounts to residents or those domiciled abroad, by simple trademark license or by way of royalties, does not characterize consideration for services from abroad, provided by an individual or legal entity resident or domiciled abroad; thus, there will be no levy of PIS/COFINSImport. However, if the license agreement provides technical services or technical assistance, beyond just the trademark license use, on these services, the PIS/COFINS-Import will be levied. In cases when the contract is not clear enough to distinguish these components, the total value should be considered for services and, therefore, suffer the levy of PIS/COFINS-Import.

316

Practical issues on cross-border remittances of royalties

In addition, if the licence agreement, as a result of a lack of proper and clear segregation of all types of remuneration and objects into different contracts, is deemed to be a payment for the import of services, the municipality in which the Brazilian entity is located may also levy the service tax (Imposto Sobre Services – ISS) at a minimum rate of 2% and a maximum rate of 5%, depending on the type of services provided and the municipality in which the entity is located. Consequently, where a licence agreement executed, or to be executed, by a Brazilian entity and its foreign related party includes technical services in addition to royalties and copyright, it is advisable that the multinational group separates each type of remuneration with regard to royalties, copyright and services into separate and individual agreements to avoid the imposition of the PIS and COFINS-Import and the ISS on all cross-border royalties.63 Finally, it is common for the tax authorities of the country in which the foreign related party is located to question the remittance of only 1% of the net sales revenue with regard to the Brazilian entity on the basis that such remuneration is too low under the arm’s length principle or with the intention to widen the corporate income tax base in the resident state. This is typically undertaken to argue that more income under that country’s transfer pricing or other domestic rules should have been paid as royalties based on the premise that a higher percentage of net sales revenue should have been paid. It is therefore recommended that a Brazilian entity always records the licence agreement with the INPI as including remuneration in respect of royalties higher than 1% in respect of the use of trademarks or 5% in other circumstances. Empirically, the INPI tends to deny the recording of such agreements and requires the Brazilian entity to comply with the legal limits set out in the relevant laws, i.e. by amending the remuneration clause to comply with the tax legislation. In such cases, the denial by the INPI results in an official document issued by the government that serves as proof to support the impossibility of remitting more than the 1% to 5% limit as established by Brazilian law. For regulatory purposes, the Brazilian entity cannot legally remit more than 5% on net sales revenue to the foreign country and, as a result, the foreign related party has additional proof to challenge any arm’s length or income adjustment with regard to the earnings and/or income by the resident state with regard to intangible property licensed to a related 63. For a more detailed analysis on the legal grounds on which to challenge any PIS and COFINS-Import and ISS tax assessment on cross-border (and domestic) payment of royalties, see L.F. de Moraes e Castro, The Service Tax on Royalties Conundrum in Brazil, 77 Tax Notes Intl. 13, pp. 1207-1210 (30 Mar. 2015).

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party in Brazil. It has been demonstrated that such actions can counter automatic income tax adjustments on the part of some OECD member countries.

11.5. Appendix: Taxation of WHT on IP payments from Brazil to tax treaty countries Contracting state

WHT on royalties (trademark) (%)

WHT on royalties (copyrights) (%)

Argentina Austria

Brazilian law 25

Brazilian law 10

WHT on royalties (other cases) (%) Brazilian law 15

Belgium

20

10

15

Canada

25

15

15

Chile

15

15

15

China (People’s Rep.) Czech Rep.

25

15

15

25

15

15

Denmark

25

15

15

Ecuador

25

15

15

Finland

25

10

15

France

25

10

15

Hungary

25

15

15

India

25

15

15

Israel

15

10

10

Italy

25

15

15

318

Brazilian tax credit

Technical services reference

Brazilian law

protocol 7

income tax paid abroad income tax paid abroad income tax paid abroad income tax paid abroad income tax paid abroad

no

income tax paid abroad income tax paid abroad 25% presumed tax credit income tax paid abroad income tax paid abroad income tax paid abroad 25% presumed tax credit income tax paid abroad income tax paid abroad

protocol 3

protocol 6 protocol 8 protocol 5 protocol 3

protocol 3 protocol 5

no no protocol 6 protocol 2

protocol 2 protocol 5

Appendix: Taxation of WHT on IP payments from Brazil to tax treaty countries

Contracting state

WHT on royalties (trademark) (%)

WHT on royalties (copyrights) (%)

Japan

25

12.5

WHT on royalties (other cases) (%) 12.5

Korea, South 25

10

10

Luxembourg 25

15

15

Mexico

15

10

10

Netherlands

25

15

15

Norway

25

15

15

Paraguay

15

15

15

Peru

15

15

15

Philippines

25

15

15

Portugal

15

15

15

Russia

25

15

15

Slovak Rep.

25

15

15

South Africa

15

15

10

Spain

15

10

10

Sweden

25

15

15

Trinidad & Tobago Turkey

15

15

15

15

10

10

Ukraine

15

15

15

319

Brazilian tax credit

Technical services reference

income tax paid abroad 20% presumed tax credit income tax paid abroad income tax paid abroad income tax paid abroad income tax paid abroad income tax paid abroad income tax paid abroad 25% presumed tax credit income tax paid abroad 25% presumed tax credit income tax paid abroad income tax paid abroad 25% presumed tax credit income tax paid abroad income tax paid abroad income tax paid abroad income tax paid abroad

no protocol 4

protocol 4 protocol 6 protocol 5 protocol 6 protocol 4 protocol 4 protocol 7

protocol 5 protocol 3

protocol 3 protocol 3 protocol 5

no protocol (c) protocol 3 protocol 2

Chapter 11 - Brazil

Contracting state

WHT on royalties (trademark) (%)

WHT on royalties (copyrights) (%)

Venezuela

15

15

320

WHT on royalties (other cases) (%) 15

Brazilian tax credit

Technical services reference

income tax paid abroad

protocol 3

Chapter 12 Canada by Joel Scheuerman1

12.1. Introduction to private law aspects of intellectual property (IP) 12.1.1. Private law meaning of terms used in the tax treaty definition of royalties Under Canadian private law, the principal legal categories of IP that have importance for tax purposes are: (i) copyrights;2 (ii) patents3 and (iii) trademarks.4 Canada also offers protection for “industrial designs”.5 Additionally, an often-difficult subject with respect to Canadian income tax treatment is the transfer of “know-how” on the sale of a business. However, this concept is not defined or regulated by Canadian private law in the same way as other categories of IP.6 Canada views patents, copyrights, trademarks and registered industrial designs as being part of a class of policy tools used to improve society’s “total information system” in sectors in which the production and distribution of knowledge might otherwise be inadequate.7 As such, they are incentive devices, designed to encourage knowledge creation, knowledge processing and learning.8

1. Associé/avocat en litige fiscal (Partner/Lawyer in tax litigation), BCF Avocats d’Affaires – BCF Business Law, Montréal. 2. CA: Copyright Act, R.S.C., 1985, ch. C-42. 3. CA: Patent Act, R.S.C., 1985, ch. P-4. 4. CA: Trade-marks Act R.S.C., 1985, ch. T-13. 5. CA: Industrial Design Act, R.S.C. 1985, ch. I-9. 6. Because the concept of “know-how” is not defined and regulated by any statutory regime, it will not be discussed in this section, but will be treated later as it pertains to its Canadian tax treatment. 7. Economic Council of Canada, Report on Intellectual and Industrial Property, ch. 3 (Ottawa: Industry Canada, 1971). 8. Id.

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As a general concept, a copyright will protect original artistic, literary, musical and dramatic products, as well as software.9 This extends to the specific expression of a work in its material form (such as in a play, poem, book, movie or musical composition) but does not extend to generalities such as ideas, methods or systems. Patents protect new and non-obvious inventions. This includes “any new and useful art, process, machine, manufacture or composition of matter, or any new and useful improvement in any art, process, machine, manufacture or composition of matter”. Trademarks protect the use of marks that serve to distinguish businesses, their products or their services in the marketplace. These marks can include symbols, words, phrases, names, slogans and distinguishing guises. As opposed to copyrights and patents, trademarks do not protect the underlying knowledge product, but instead protect against forms of unfair trading that are likely to have the effect of causing confusion or depreciating the goodwill generated by a business and its products and services, which may themselves be representations of new knowledge or learning. Industrial designs are the features of a product that appeal to the eye. They consist of the visual features of shape, configuration, pattern or ornament (or any combination of these features) applied to a finished article. Specific jurisdiction over IP law resides with the federal government of Canada. Canada is a federal state wherein its Constitution creates a division of powers between the ten Canadian provinces and the federal Parliament.10 Canada’s Constitution expressly grants the federal Parliament the right to regulate “Patents of Invention and Discovery”11 and copyrights.12 Additionally, the federal Parliament’s jurisdiction over trademarks was recognized by the Supreme Court of Canada (SCC).13 This jurisdiction over trademarks results from, as the SCC held, Parliament’s broad legislative jurisdiction over “The Regulation of Trade and Commerce,”14 under which trademarks fall. 9. Sec. 2, Copyright Act, definition of “literary work”: includes tables, computer programs and compilations of literary works. 10. CA: Constitution Act, 1867 (UK), 30 & 31 Vict, ch. 3, reprinted in R.S.C. 1985, Appendix II, No. 5. 11. Id., at sec. 91(22). 12. Id., at sec. 91 (23). 13. CA: Supreme Court of Canada (SCC), 11 Nov. 2005, Kirkbi AG v. Ritvik Holdings Inc./Gestions Ritvik Inc., 2005 SCC 65. 14. Appendix II, No 5, sec. 91(2) Constitution Act.

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12.1.1.1. Copyrights In Canadian law, copyrights exist purely as a result of statute, that being the Copyright Act.15 There is no recognized common law right to a copyright and, as such, copyrights do not fall under either property or tort law.16 Rather, Canadian law recognizes rights and obligations only on those terms and only in the circumstances set out in the statute.17 In other words, the rights and remedies provided by statute are exhaustive.18 The scope of protection granted by a copyright is limited to the expression of an idea. A copyright can only exist in the physical form of an idea (i.e. the work itself), such as a novel, an article, a theatrical production, a musical work or software, and not in the idea itself. Subsection 3(1) of the Copyright Act19 defines a copyright as the sole right: “1) to produce or reproduce the work or any substantial part thereof in any material form whatever; 2) to perform the work or any substantial part thereof in public; or 3) if the work is unpublished, to publish the work or any substantial part thereof.” The Copyright Act also defines in more detail the scope of the rights for specific types of work. To exist, a copyright must satisfy two requirements: (i) originality and (ii) fixation. There is no value judgement requirement in order to create a copyright in Canadian law since the Copyright Act contains no such requirement. In 2004, the SSC clarified the meaning of “originality” in Canadian law: For a work to be “original” within the meaning of the Copyright Act, it must be more than a mere copy of another work. At the same time, it need not be creative, in the sense of being novel or unique. What is required to attract copyright protection in the expression of an idea is an exercise of skill and judgment. By skill, I mean the use of one’s knowledge, developed aptitude or practised ability in producing the work. By judgment, I mean the use of one’s capacity for discernment or ability to form an opinion or evaluation by comparing different possible options in producing the work [emphasis added].20 15. Id., at ch. C-42. 16. CA: SCC, 2 Oct. 1979, Compo Co. Ltd. v. Blue Crest Music et al., [1980] 1 SCR 357, at 372. 17. Ch. C-42 Copyright Act. 18. B. Sookman, S. Mason & D. Glover, Intellectual Property Law in Canada: Cases and Commentary p. 65 (2nd edn, Thomson Reuters 2009). 19. Ch. C-42 Constitution Act. 20. CA: SCC, 4 Mar. 2004, CCH Canadian Ltd. v. Law Society of Upper Canada, 2004 SCC 13 at para. 16.

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As such, the exercise of both skill and judgement required to produce the work must not be so trivial that it could be characterized as a purely mechanical exercise.21 Moreover, while creative works will by definition be “original” and covered by copyright, creativity is not required to make a work original.22 In order to satisfy the “fixation” criterion, a work must exist at least for some period of time in some concrete, material, more or less permanent form.23 It must be capable of identification and having a more or less permanent endurance.24 Finally, for a copyright to subsist in a work, the work must fall into one of the enumerated categories of works protected under the Copyright Act.25 Section 5 of the Copyright Act provides that copyrights may cover “every original production in the literary, scientific or artistic domain, whatever may be the mode or form of its expression, such as compilations, books, pamphlets and other writings, lectures, dramatic or dramatico-musical works, musical works, translations, illustrations, sketches and plastic works relative to geography, topography, architecture or science.”26 12.1.1.1.1.  Scope of protection A copyright generally lasts for the life of the author and 50 years following the end of the calendar year in which the author dies.27 In the case of a work of joint authorship, copyright shall subsist during the life of the author who dies last.28 As explained above, copyright protection extends to expressions of an idea and not to ideas, operational methods and procedures, or mathematical 21. Id., at para. 25. 22. Id. 23. CA: Exchequer Court of Canada (until 1971) (Ex Ct Can), Canadian Admiral Corp. Ltd. v. Rediffusion Inc., [1954] Ex. C.R. 382 at para. 28; CA: SCC, 28 Mar. 2002, Théberge v. Galerie d’Art du Petit Champlain Inc., [2002] 2 SCR 336. 24. Canadian Admiral Corp. Ltd., id. 25. Ch. C-42, sec. 89 Constitution Act. 26. Sec. 2 Copyright Act; According to Sookman, Mason & Glover, supra n. 18, at 98, the list of words is similar from art. II of the Berne Convention signed at Rome on 2 June 1928. “Literary works” include computers programs and “cinematographic work” includes any work expressed by a process analogous to cinematography, whether or not accompanied by a soundtrack. 27. Sec. 6 Copyright Act. 28. Sec. 9(1) Copyright Act.

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insights.29 This is related to the concepts of originality and fixation. Only the originality of expression is protected, and not originality of idea, and the expression thereof results in its fixation. The distinction between an idea and the expression thereof is often referred to as the “idea-expression dichotomy”. This dichotomy is a recurring feature of disputes as to the existence of a copyright. Clearly, most plaintiffs wishing to assert copyright will seek to define the idea as narrowly as possible, while a defendant will wish to define the idea as broadly as possible. It is often difficult for parties and courts to determine the degree of detail to apply in distinguishing between the idea and the expression thereof, and the two tend to blur into each other.

12.1.1.2. Patents Patent protection rests on the concept of a bargain between the inventor and the public. A patent grants its owner the right to exclude the world from “practising” the invention, thus according the inventor a monopoly to exploit the invention for a limited time. In exchange for this right, the patentee discloses his invention to the public and “teaches” the reader how to practise it, thus allowing the public to exploit the invention after the expiry of the term of monopoly.30 In Canada, the duration of the patent is generally 20 years from the filing date of the patent application.31 To be eligible for patent protection in Canada, an invention must be something new (first in the world), useful (functional and operative) and inventive (meaning that it demonstrates ingenuity and is not obvious to someone of average skill working in the field of the invention).32 The invention must also not have been previously disclosed to the world. To obtain patent protection in Canada, the invention must be with respect to subject matter that is “patentable” as such concept is set out in section 2 of the Patent Act. This provision defines an invention as “any new and useful art, process, machine, manufacture or composition of matter, or any new 29. CA: Ontario Court of Appeal, 1 Mar. 2002, Delrina Corp. v. Triolet Systems Inc. (2002) 17 CPR (4th) 289; [2002] OJ No. 676. 30. CA: SCC, 15 Dec. 2000, Free World Trust v. Électro Sant Inc, [2000] 2 SCR 1024 at para. 13. 31. Ch. P-4, sec. 44 Patent Act. 32. Id., at sec. 2, definition of “invention”.

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and useful improvement in any art, machine, manufacture of composition of matter”. The Patent Act also sets out limitations to what may be patented: subsection 27(8) expressly provides that no patent shall be granted for “any mere scientific principle or abstract theorem”. A patent is not available for a mere discovery but is potentially available for a business method.33 To be valid, a patent must fulfil certain requirements. First, the applicant must demonstrate some utility for the invention.34 Canadian courts have held that this is a low threshold and does not require a patentee to demonstrate actual commercial use of the invention.35 Second, the invention must be novel.36 An invention is not novel if it can be anticipated, meaning that it can be derived from a single prior source. An invention can be anticipated if both: (i) there is a prior disclosure and (ii) that prior disclosure enables its anticipation, meaning that a person skilled in the art would have been able to perform the invention.37 Third, the invention must not be obvious. More specifically, the subject matter defined by a claim in an application for a patent in Canada must be subject matter that would not have been obvious on the claim date to a person skilled in the art or science to which it pertains, having regard to information that was available to the public, either in Canada or elsewhere in the world.38

12.1.1.3. Trademarks In Canada, trademarks are understood by the courts to be “a symbol of a connection between a source of a product and the product itself.”39 More specifically, section 2 of the Trade-marks Act40 defines a trademark as follows: 33. CA: Federal Court of Appeal (FCA), 24 Nov. 2011, Amazon.com Inc., Re, 2011 FCA 328. 34. Ch. P-4, sec. 2 Patent Act. 35. CA: SCC, 19 Mar. 1981, Consolboard Inc. v. MacMillan Bloedel (Sask.) Ltd, [1981] 1 SCR 504. 36. Ch. P-4, sec. 28.2(1) Patent Act. 37. CA: SCC, 6 Nov. 2008, Apotex Inc. v. Sanofi-Synthelabo Canada Inc., 2008 SCC 61 at para. 26. 38. Sec. 28.3 Patent Act. 39. Kirkbi AG (2005) at para. 39., CA: SCC, 2 June 2006, Mattel Inc. v. 3894207 Canada Inc., 2006 SCC 22 at para 24. 40. Ch. T-13 Patent Act.

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(a) a mark that is used by a person for the purpose of distinguishing or so as to distinguish goods or services manufactured, sold, leased, hired or performed by him from those manufactured, sold, leased, hired or performed by others, (b) a certification mark, (c) a distinguishing guise, or (d) a proposed trade-mark.

Unlike other IP rights that protect the substance of a product, trademarks only protect the word, name, slogan, symbol, distinguishing guise, get-up or other mark against certain forms of unfair trading that are likely to have the effect of depreciating the value of the goodwill attaching to the trader.41 A trademark must not be confused with the product covered by the trademark; rather, it is a symbol of a connection between the source of a product and the product itself. An essential element of a trademark is that it be distinctive; it is of the essence that it should indicate origin and be used as an indication of origin of the goods or services to which it is applied. It represents a connection in the course of trade between the goods and the proprietor of the mark. A trademark also functions as a guarantee of commercial origin.42 Unlike copyrights and patents, the owner of a trademark may acquire it via the common law and not solely via statutory law. This means that one does not have to register a trademark and the ownership and rights to a trademark may be acquired by using a mark for a certain length of time.43 However, claiming ownership of an unregistered trademark often results in lengthy litigation, as the factual record must be established and legal ownership of the trademark may be difficult to prove.

12.1.1.4. Industrial design Industrial designs are the features of a product that appeal to the eye.44 They consist of the visual features of shape, configuration, pattern or ornament (or any combination of these features) applied to a finished article. An industrial design must be original. More specifically, if the industrial design is not identical with or does not so closely resemble any other design

41. Sec. 22(1) Trade-marks Act. 42. Kirkbi AG (2005). 43. Id. 44. Ch. I-9, sec. 2 Industrial Design Act.

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already registered as to be confounded therewith, it will be eligible for registration.45 Once an industrial design is granted, it is protected for a period of 10 years, beginning on the date of registration.46

12.1.2. Distinction under private law between alienation of IP and granting the right to use IP Clearly, in order to determine the tax treatment of IP, one must first identify its owner (including whether it has been alienated or whether the mere right to use it has been granted). The owner of a copyright may assign the right or an interest in it, wholly or with limitations (such as territorial limitations), either for the whole term of the right or for any part of it.47 The provisions of the Copyright Act require that an assignment for an exclusive licence be made in writing and will otherwise be invalid. Trademarks can be either transferred or licensed. Section 50(1) and (2) of the Trade-marks Act allow the owner of a trademark to assign a licence under two conditions: (a) the owner must keep a direct or indirect control of the character or quality of the goods or services licensed; and (b) the owner must give public notice of the fact that the use of a trade-mark is a licensed use and of the identity of the owner.

The level of control needed to satisfy the first condition is that the original owner must have actual control of the quality of the products and services provided by the licensee rather than a “mere potential to control”.48 A trademark is transferable either in connection with or separately from the goodwill of the business.49

45. Id., sec. 6. 46. Id. 47. Sec. 13(4) Copyright Act. 48. CA: Federal Court (FC), Cheung Kong (Holdings) Ltd. v. Living Realty Inc., [2000] 2 FCR 501, paras. 44-45; see also D. Gervais & E.F. Judge, Le droit de la propriété intellectuelle p. 272 (Les Éditions Yvon Blais 2006). 49. Sec. 48(1) Trade-marks Act.

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Every patent issued for an invention is assignable in law, either as to the whole interest or as to any part thereof. The assignment must be made in writing and must be registered at the Patent Office of Canada.50

12.2. Taxation of IP under the domestic tax law 12.2.1. Meaning of royalties and qualification of income deriving from utilization of IP The concept of a “royalty” is not expressly defined in the Income Tax Act 1985.51 Moreover, the provisions of the ITA 1985, whereby royalties are to be included in a taxpayer’s income, are of no particular assistance in determining what constitutes a royalty for domestic tax purposes. Rather, under section 3 of the ITA 1985, a taxpayer must include in its income for the year all income from property. Subsection 9(1) of the ITA 1985 specifies that a taxpayer’s income for a taxation year from property is the taxpayer’s profit (meaning net income) from that property for the year. Additionally, paragraph 12(1)(g) of the ITA 1985 further specifies: There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property … any amount received by the taxpayer in the year that was dependent on the use of or production from property whether or not that amount was an instalment of the sale price of the property, except that an instalment of the sale price of agricultural land is not included by virtue of this paragraph [emphasis added].

As such, if a royalty were, for some reason, not considered to be “income from property” under section 3, it could fall under paragraph 12(1)(g), depending on how the disposition or licensing of the rights was structured. The ITA 1985 does provide, in the non-domestic context, some indication of what types of payments are included in the meaning of a “royalty” for tax purposes. For example, every non-resident of Canada must pay Canadian tax on every amount that a person resident in Canada pays or credits to him

50. 51.

Sec. 50(1) and (2) Patent Act. Ch. 1 (5th Supp.) Patent Act.

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as, on account or in lieu of payment of, or in satisfaction of “rents, royalties or similar payments”.52 As opposed to sections 3, 9 and 12 of the ITA 1985 there is a fairly significant body of jurisprudence interpreting the meaning of royalty in the context of this provision dealing with payments to non-residents. Some caution must be exercised in interpreting these decisions, however, since paragraph 212(1)(d) contains a significant number of specific inclusions and carve-outs regarding which payments to non-residents will attract withholding tax. As such, a court decision dealing with whether a particular payment was subject to withholding tax is not necessarily an indicator of whether such payment constituted a “royalty”, writ large. Nevertheless, some lessons can be gleaned.

12.2.1.1. R. v. Saint John Shipbuilding & Dry Dock Co. In an oft-cited decision dating from 1980, the court was faced with the following situation.53 Amounts were paid by a Canadian shipbuilding company pursuant to a contract under which another company supplied tapes containing technical information which, when combined with other input data on a specific ship’s hull, produced technical data for use in the construction of the hull. The items supplied also included user’s manuals and programmer’s manuals. The contract purported to be a grant of a non-exclusive licence to use the system in connection with the design and construction of the ships, the forming of sections of ships and for other industrial applications for which the system may be suitable. There was no reference in the contract to the ownership of the tapes or manuals so supplied nor was there any provision which the provider of the data any right in any circumstances to require that they be returned. The information so obtainable by the use of the system was not secret. It was information that could have been worked out by competent technical personnel, as had formerly been necessary, by more laborious efforts and with the expenditure of much more time. There was no contractual restriction on the shipbuilding company as to how many times or over what period of time the information might be obtained or preserved or used, and the 52. Id., at para. 212(1)(d). This provision is the subject of further analysis below. 53. CA: FCA, R. v. Saint John Shipbuilding & Dry Docks Co., [1981] 1 F.C. 334, [1980] C.T.C. 352.

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amounts of the payments were in no way related to the extent of such use, or to revenues or profits attributable thereto or to the period of such use. Faced with these circumstances, the Federal Court of Appeal (FCA) held that “Royalties”, though a broad term, when used in the sense of a payment for the use of property, connotes a payment calculated by reference to the use or to the production or revenue or profits from the use of the rights granted.54 Moreover, the court held that royalties do not include a lump sum payment “for the use of or for the privilege of using property indefinitely [emphasis added]”.55 The results of this case are somewhat contradicted by another decision of that same court, where a lump-sum payment for a trade name was found to fall within the meaning of a “rent, royalty, or a similar payment”.56 However, a payment for the exclusive right to buy and sell a pipe-bending machine was found, in the same case, to not fall within such meaning since, in the court’s view, this right did not include “the use or the right to use” the machine in question.57 This tension between the results in these cases remains unresolved by Canadian courts. Ultimately, the courts should probably be looking at the purpose for making the payment and the rights acquired rather than the form that the payment takes (i.e. lump sum versus recurring).

12.2.1.2. Is the payment for services rendered? In another decision, Zainul & Shazma Holdings v. R. this time rendered by the Tax Court of Canada (TCC), the court held that a one-time licence fee was not a royalty because it was, in the court’s view, an application fee paid before the grant of franchise, to compensate the franchisor for services performed in reviewing the franchisee’s qualifications.58 As the court stated: In other words considerable time and effort and presumably monies were expended in analyzing the situation of the applicant and only after that an analysis was conclusive of allowing the granting of a licence, was the licence actually granted and the on-going relationship [created]. The application fee was simply that, an application fee, an initial fee, definitely not a rent or royalty.59 54. Id., at para. 15. 55. Id. 56. CA: FCA, Farmparts Distributing, [1980] C.T.C. 205 at para 16. 57. Id., at para. 19. 58. CA: Tax Court of Canada (TCC), Zainul & Shazma Holdings Ltd. v. R. [2005] 3 C.T.C. 2140. 2004 TCC 527. 59. Id., at para. 6.

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Similarly, in Blais, payments by a reseller of satellite television for access to satellite channels were for services and could not be said to have been in the nature of or to have had the characteristics of a royalty or similar payment since “[t]hey were for [the reseller] to activate the descrambler units held by the [recipient’s] customers for the subscription period.”60

12.2.1.3. Is the payment actually business profit? In Grand Toys Ltd. v. M.N.R.,61 the Canadian tax authorities alleged that a Canadian taxpayer had paid to a non-resident person amounts on account of or in satisfaction of royalties or similar payments for the use of or for the right to use in Canada the “names, characters, symbols, designs, likenesses and visual representations” of certain dolls and failed to withhold and remit the amount of tax on behalf of the non-resident person. Pursuant to the “Exclusive Distribution Agreement” executed between the parties, a price schedule set out: Per unit, the sum of (i) the ex Hong Kong factory price, plus (ii) 3% of such ex Hong Kong factory price (to cover office overhead), plus (iii) a buying commission and royalty (the “Buying Commission and Royalty Amount”) of U.S. $0.52 [emphasis added].

While the tax authorities argued before the TCC that the “Buying and Royalty Amount” was a royalty for tax purposes, the taxpayer submitted that the payments constituted part of the purchase price of goods acquired for resale by the appellant and therefore were not royalties within the common use of that term nor within any legal definition of that term. The taxpayer further submitted that these payments were clearly quite different from royalties, as they were not based on production from use of the property acquired. Referring to a decision of the SCC dealing with oil and gas royalties, the TCC stated that “the use of the word ‘royalties’ in an agreement between two parties is an element to be considered in the determination of whether a payment is a royalty or not but it does not mean that a payment that is described as a royalty is necessarily a royalty [emphasis added].”62

60. CA: TCC, Blais v. R., [2011] 1 C.T.C. 2240, 2010 TCC 36 at para. 22. 61. CA: TCC, Grand Toys Ltd. v. M.N.R., [1990] 1 C.T.C. 2165, 90 D.T.C. 1059. 62. Id.

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This is essentially a restatement of the Canadian doctrine of seeking the true “legal reality” created by a document. As the SCC explained, it is permissible to recharacterize the legal reality of a document “if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect.”63 Holding that the payment was not a royalty, despite the label affixed to the payments in the agreement, the TCC reasoned: In the case at bar, the payments were the payee’s profits and were in no way related to the [Canadian taxpayer’s] profits nor were they related to the [Canadian taxpayer’s] gross sales of the units. Whether the appellant sold all the units or none of them, whether it made profits or not, did not influence the amount of money paid. There was no element of contingency in the payments in question and an element of contingency is the essence of a royalty payment [emphasis added].64

As such, Canadian courts will go beyond the labels affixed to payments in order to determine their true nature before accepting that they constitute royalties. Moreover, where a payment is simply an amount payable for every unit sold regardless of how many are sold, this will not be characterized as a royalty, since there is no element of contingency present.

12.2.1.4. The Canada Revenue Agency’s view While the above decisions indicate that Canadian law distinguishes payments for services and business profits from payments of royalties, the Canada Revenue Agency (CRA) nevertheless takes the position that certain payments may nevertheless constitute royalties even if they are described in a contract as being “for services”. The CRA states that “[w]hether a payment is labelled as a ‘franchise fee’ or a ‘service fee’ does not, in and of itself, change the non-resident withholding tax requirement on the payment, which is determined based on an analysis of the nature of the payment.”65 This is consistent with the decisions referred to above in Grand Toys Ltd. v. M.N.R.66 and Shell Canada Ltd. v. Canada.67 63. CA: SCC, Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622 at para. 39. 64. Grand Toys Ltd. (1990) at para. 18. 65. Canada Revenue Agency (CRA), 2007-0253321E5, Non-resident withholding tax (14 Nov. 2007). 66. Grand Toys Ltd. (1990). 67. Shell Canada Ltd. (1999).

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The CRA has stated its position that for motion picture films, payment for (or for an option to acquire) the rights to a script does not constitute a royalty because it is payment for the purchase of the property, not its use.68 The CRA also considers, following what is known as the “surrogatum principle”, that a payment by a Canadian corporation to a foreign corporation to settle an IP infringement action is a royalty for purposes of the ITA 1985 and the relevant tax treaty between Canada and a foreign country.69

12.2.2. Qualification of income deriving from IP and applicable tax regimes 12.2.2.1. Acquisition of IP The main difficulty with respect to the acquisition of IP is to determine, for the purposes of Canadian domestic tax law, whether the cost of its acquisition is a capital expenditure or a current expense. Obviously, IP can be developed, it can be acquired in an already existing form or an already existing IP can be exploited by a business. Generally, the most important question to be determined is whether the IP was acquired via transfer of ownership or whether it is merely a right that has been granted to exploit it, such as a licence. 12.2.2.1.1. Current expenses Salaries paid to employees in the course of their employment would normally constitute a current expense and thus be deductible against income earned in the year,70 since employee salaries are recurring expenditure incurred in the process of the operation of a profit-seeking entity.71 However, where employees dedicate “all or substantially all” (90% or more) of their time to “scientific research and experimental development” (SR&ED) during the year, their salary becomes eligible for specific tax 68. CRA, 2006-0179371I7, Part XIII withholding tax (14 June 2006). 69. CRA, 2004-0081521R3, Payment to settle patent infringement action (2004). 70. CA: Income Tax Act, R.S.C. 1985, ch. 1 (5th Supp.), subsect. 9(1) [hereinafter ITA 1985]. 71. See AU: High Court of Australia (HCA), 23 Dec. 1938, Sun Newspapers Ltd. et al. v. Federal Commissioner of Taxation (1938), 61 C.L.R. 337 at p. 359.

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treatment under Canada’s SR&ED regime. Under this regime, 100% of such employee’s salary becomes deductible against income in the year even if they might be treated as a capital expense for accounting purposes.72 Similarly, royalties paid in a year for the exploitation of IP would be deductible in the year as a current expense since they also are recurring and are an integral part of the operation of the enterprise. As with salaries paid to employees working to develop IP, they are deductible under general principles, being the meaning of the word “profit” as contained in the rule set out in subsection 9(1) of the ITA 1985 that “a taxpayer’s profit for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.” Canadian courts have long accepted that such “profit” is calculated in accordance with well-accepted principles of commercial trading, since the goal in ascertaining profit is to present “an accurate picture of the taxpayer’s profit for the given year”.73 With respect to the acquisition of licences for the utilization or exploitation of IP, one must look closely at the terms of the licence and its acquisition. Certain indicators will tend to reveal whether the cost of acquisition is a current or a capital expense. These include: (i) the duration of the licence; (ii) whether the licence grants exclusive rights; (iii) geographical limitations to its exploitation; and (iv) other conditions and restrictions; and rights to any further developments in the technology so licensed. For example, in Canadian General Electric Co. Ltd. v. R.,74 the FCA held that the sale of IP through a non-exclusive licence will not normally be considered a transaction on account of capital. In an oft-cited decision, the court was faced with the following situation: the taxpayer, in the course of bringing a new product to market, spent significant amounts on market research, industrial designs and advertising and, in addition, paid out an amount to a competitor in order to induce it to drop its opposition to the registration of the taxpayer’s trademark.75

72. Ch. 1 (5th Supp.), subsect. 37(1) ITA 1985. 73. CA: SCC, 12 Feb. 1998, Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147. One might argue that, in theory, salary paid to an employee who is involved solely in the creation of a capital asset should not be treated as a current expense but should be added to the cost base of said asset; however, no such cases ever seem to have been litigated in Canada. 74. CA: FCA, Canadian General Electric Co. Ltd. v. R., [1987] 1 C.T.C. 180, leave to appeal to SCC refused. 75. CA: Ex Ct Can, Canada Starch Co. v. Minister of National Revenue, [1968] C.T.C. 466, [1969] 1 Ex. C.R. 96.

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The question before the FCA was whether this latter amount was a current expense, as it was claimed by the taxpayer, or whether it was a non-deductible capital expenditure, as contended by the tax authorities. The court held that even though the expenditure paid to the competitor was a one-time outlay and not a recurring expense, the trademark was not actually acquired by the payment to the taxpayer’s competitors. Instead, only the competitor’s uncontested registration was secured by such payment. Indeed, the trademark was a capital asset that could only arise out of the current operation of the business.76 As such, the court held that the payment to the competitor was a current expense and not a capital expense, since the payment itself did not result in the acquisition of a capital asset. 12.2.2.1.2. Capital expenditure In general, any outlay or payment on account of capital is not deductible pursuant to paragraph 18(1)(b) of the ITA 1985. This would generally include any lump-sum amount expended to acquire IP. Canada, as is common, has a depreciable property regime and a regime governing “goodwill” (for 2016 and prior, this was the “eligible capital expenditure” regime), which permit deductions to be taken on an annual basis for depreciation (called “capital cost allowance”) of certain capital assets.77 Recent amendments to the ITA 1985 and the Income Tax Regulations (ITR), effective 1 January 2017, replaced the eligible capital expenditure regime with respect to certain assets (in which may be included such things as “know-how”) to a system creating the concept of “goodwill”, to which regular depreciable capital property treatment is applied.78 Henceforth, subsections 13(34)-(37) of the ITA 1985 provide rules for expenditure and receipts of a business that do not otherwise fall under the definition of “property”, as set out in subsection 248(1) of the ITA 1985.79

76. Id., at para. 15. 77. Ch. 1 (5th Supp.), subsect. 13(21), para. 21(1)(a) ITA 1985, and their associated regulations contained in the Income Tax Regulations (ITR), C.R.C., ch. 945 at part XI. 78. Ch. 1 (5th Supp.), subsect. 13(34) ITA 1985. 79. This provision of the ITA defines property as “property of any kind whatever whether real of personal, immovable or movable, tangible or intangible, or corporeal or incorporeal and, without restricting the generality of the foregoing, includes (a) a right of any kind whatever, a share or a chose in action….”

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Subsection 13(34) of the ITA 1985 treats every business as having a single goodwill property on which Class 14.1 capital cost allowance may be claimed, i.e. 5% depreciation annually on a declining balance basis. Patents qualify as depreciable property and are included in Class 14 or Class 44 under the ITR.80 Class 14 permits a straight-line depreciation over the life of the property and Class 44 permits a 25% declining balance depreciation for any “property that is a patent, or a right to use patented information for a limited or unlimited period.”81 Copyrights may qualify under Class 14 if granted for a limited time, and copyrights of computer software copyrights may be included in Class 12, providing for an immediate depreciation rate of 100%. The cost of purchasing a trademark that was an eligible capital expenditure prior to 1 January 2017 is now considered a depreciable capital property under Class 14.1, and a 5% capital allowance of the balance may be taken annually. However, a trademark licence for a limited time is considered to be a Class 14 property, being depreciable on a straight-line basis over the maximum duration of the IP. Patent, copyright and trademark application costs are deductible from income or on a 10-year straight-line basis.82 12.2.2.1.3. Know-how Because know-how does not fall under the definition of “property”, its acquisition can have different tax consequences. The line between payments for rights and payments for services rendered is narrow.83 As the FCA put it: [A]s far as I know, under no system of law in Canada does knowledge, skill or experience constitute property that can be the subject matter of a gift, grant or an assignment except to the extent, if any, that it can be a right or a part of right in respect of which there is property of the kind classified as industrial property.84 80. Ch. 945, sched. II ITR. 81. Id.; additionally, a taxpayer may elect to not include a property in Class 44: subsect. 1103(2h) such that the property would normally be included in Class 14. 82. Ch. 1 (5th Supp.), para. 20(1)(cc) and subsect. 20(9) ITA 1985. 83. See A. Rautenberg, Income Tax Aspects of Intellectual Property Transactions in Reports of Proceedings of the Fifty-Fifth Tax Conference para. 35:22 (Canadian Tax Foundation 2003). 84. CA: FCA, Rapistan Canada Ltd. v. M.N.R., 74 D.T.C. 6426.

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The modifications to the ITA 1985 effective 1 January 2017 require that where any taxpayer incurs an expense on account of capital for the purpose of gaining or producing income, and no portion of that amount is a cost of property, the taxpayer is deemed to have acquired goodwill with a cost equal to the cost of the outlay.85 The key question for taxpayers will therefore be whether the nature of the expenditure is a current expense for services or a capital expense giving rise to the acquisition of goodwill. This provision of the ITA 1985 has not yet been the subject of Canadian court decisions. 12.2.2.1.4. Expenses incurred in the pursuit of SR&ED While this chapter is not intended to provide an in-depth analysis of the tax treatment of research and development tax incentives in Canada, it must be noted that Canada has generous incentive programs for undertaking such work in Canada.86 There are criteria that work must meet to fit within the meaning of SR&ED for the purposes of the ITA 1985, these being: (i) Was there a technological risk or uncertainty? (ii) Did the person claiming to be doing SRED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty? (iii) Did the procedures adopted accord with established and objective principles of scientific method, characterized by trained and systematic observation, measurement and experiment, and the formulation, testing and modification of hypotheses? (iv) Was a detailed record of the hypotheses, tests and results kept as the work progressed?87

85. Ch. 1 (5th Supp.), subsect. 13(35) ITA 1985. 86. In 2011, it was determined in a study that the strength of Canada’s SR&ED subsidies to business ranked third out of 36 countries studied: C.D. Howe Institute, M. Parsons, Reward Innovation: Improving Federal Tax Support for Business R&D in Canada, C.D. Howe Institute Commentary, no. 335, Sept. 2011, available at www.cdhowe.org. However, reductions in the tax credit rates of the programme have likely since reduced this ranking. 87. CA: TCC, Northwest Hydraulic Consultants Ltd. v. Her Majesty The Queen, 98 D.T.C. 1839, [1998] 3 C.T.C. 2520.

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If the work meets these four criteria, the work with give rise to two main benefits: a deduction and a tax credit, which itself is taxable in the following year. The deduction applies for all documented SR&ED work, whether the work is current or capital in nature.88 Investment tax credits (ITCs) are earned in the year during which the SR&ED work is performed. ITCs may be carried back 3 years or carried forward 20 years. If the corporation is a “Canadian-controlled private corporation” that earned less than CAD 500,000 in the previous year, it earns ITCs at a rate of 35% of its SR&ED expenditure up to expenditure of up to CAD 3 million in any one taxation year,89 and this ITC is a refundable credit.90 All other corporations, i.e. large corporations, public corporations and non-resident controlled corporations, will earn ITCs at a rate of 15%.91 The combination of these two aspects gives rise to the following:9293 Company type Large, public or non-resident corporations Canadian-controlled private corporations

Federal tax savings93 16.3% 39.9%

12.2.2.2. Disposition of IP At times, the distinction between the disposition of IP and the granting of a licence can be subtle. Normally, the disposition of IP would give rise to a capital receipt. On the other hand, while revenues received from the granting of a licence would normally give rise to regular income, the granting of a licence may result in a capital receipt if it grants exclusive rights over a specific territory.

88. Ch. 1 (5th Supp.), subsect. 37(1) ITA 1985. 89. Ch. 1 (5th Supp.), subsect. 127(10.1) ITA 1985. This enhanced credit is phased out as taxable income increases from CAD 500,000 to CAD 800,000. It is also phased out as corporate group taxable capital employed in Canada increases from CAD 10 million to CAD 50 million. 90. Ch. 1 (5th Supp.), sec. 127.1 ITA 1985. 91. Ch. 1 (5th Supp.), subsect. 127(9) ITA 1985. 92. Source: E. Viner, Guide to the Taxation of R&D Expenses para. 1-12 (loose-leaf, Thomson Reuters Canada 2017). 93. There are additional provincial tax incentives which piggy-back onto the federal rules.

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The disposition of know-how may be treated as disposition of Class 14.1 capital property. This can give rise to a capital gain if the proceeds exceed its cost base.94 It may also result in “recapture”, meaning an inclusion in income, to the extent that the proceeds of disposition exceed the remaining undepreciated amount of the class. Of course, there may be situations, as discussed above, where it may be arguable that there was no disposition of a capital property, but rather the rendering of services.

12.2.3. Tax treatment of income from IP derived by nonresident taxpayers Every non-resident person must pay a tax of 25% on every amount, as set out below, that a person resident in Canada pays as: (d) rents, royalties, etc. rent, royalty or similar payment, including, but not so as to restrict the generality of the foregoing, any payment (i) for the use of or for the right to use in Canada any property, invention, trade-name, patent, trade-mark, design or model, plan, secret formula, process or other thing whatever, (ii) for information concerning industrial, commercial or scientific experience where the total amount payable as consideration for that information is dependent in whole or in part on (A) the use to be made of, or the benefit to be derived from, that information, (B) production or sales of goods or services, or (C) profits, (iii) for services of an industrial, commercial or scientific character performed by a non-resident person where the total amount payable as consideration for those services is dependent in whole or in part on (A) the use to be made of, or the benefit to be derived from, those services, (B) production or sales of goods or services, or (C) profits, but not including a payment made for services performed in connection with the sale of property or the negotiation of a contract, (iv) unless paragraph (i) applies to the amount, made pursuant to an agreement between a person resident in Canada and a non-resident person under which the non-resident person agrees not to use or not to permit any other person to use any thing referred to in subparagraph (i) or any information referred to in subparagraph (ii), or

94.

Ch. 1 (5th Supp.), para. 13(24)(c) ITA 1985.

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(v) that was dependent on the use of or production from property in Canada whether or not it was an instalment on the sale price of the property, but not including an instalment on the sale price of agricultural land, but not including (vi) a royalty or similar payment on or in respect of a copyright in respect of the production or reproduction of any literary, dramatic, musical or artistic work,…[emphasis added].95

This tax must be withheld and remitted to the tax authorities by the Canadian payer, failing which the Canadian resident will otherwise be personally liable for the tax, plus a penalty, on behalf on the non-resident.96

12.2.4. Attribution to resident taxpayers of IP income by non-resident entities under controlled foreign affiliate and similar rules 12.2.4.1. Foreign affiliate and controlled foreign affiliate basics The system in the ITA 1985 for taxing foreign indirect income is simple in terms of its policy objectives. Canadian tax law makes a distinction between foreign passive income and foreign active business income earned by foreign affiliates. If the underlying income earned through a foreign entity is portfolio or investment (i.e. passive) income, Canada will seek to tax it as though it were not earned in an intermediate entity – that is, on a current basis. This is so in order to combat erosion of the Canadian tax base. The ITR sets out an elaborate tax accounting regime, called “surplus accounts”.97 These surplus accounts are intended to track three categories of income earned: active business income (exempt surplus and taxable surplus, depending on whether the income was earned in a “designated treaty country”), passive business income (taxable surplus and foreign accrual property income (FAPI), again depending on where the income was earned), and gains from the disposition of assets (hybrid surplus and pre-acquisition surplus). If the income earned by the controlled foreign affiliate is income from an active business earned in a “designated treaty country” (essentially, a country with which Canada has a tax treaty or tax information exchange 95. 96. 97.

Ch. 1 (5th Supp.), subsect. 212(1) ITA 1985. Ch. 1 (5th Supp.), subsects. 215(1), 215(6) and 227(8) ITA 1985. Ch. 945, part LIX ITR.

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agreement),98 Canada’s policy is to allow it to be distributed to Canadian shareholders via a dividend from the foreign affiliate’s exempt surplus account.99 Such a dividend is included in the Canadian shareholder’s income, but an equivalent deduction may be taken to the extent that it was paid out of the foreign affiliate’s exempt surplus, thus rendering the dividend free of Canadian tax.100 In the case of a controlled foreign affiliate earning passive income, the Canadian shareholder will be taxed on the FAPI earned by the affiliate.101 Under the FAPI rules, a Canadian-resident shareholder must include in income the appropriate share of passive income earned by the controlled foreign affiliate each year.102 More specifically, the Canadian shareholder must, inter alia, include in its FAPI “the affiliate’s income for the year from property”.103 Income from property is defined to include income from an investment business104 and “investment business” is defined as follows: “investment business” of a foreign affiliate of a taxpayer means a business carried on by the foreign affiliate in a taxation year … the principal purpose of which is to derive income from property (including interest, dividends, rents, royalties or any similar returns or substitutes for such interest, dividends, rents, royalties or returns)… [emphasis added].105

Finally, even active business income can be included in FAPI if it is derived from a “non-qualifying business”.106 A business will be characterized as a non-qualifying business if: (i) it is carried on through a permanent establishment (PE) in a jurisdiction that is a “non-qualifying country” (essentially a country with which Canada has no tax treaty, no tax information exchange agreement and with which Canada has attempted to negotiate such a treaty or agreement); (ii) it is not an investment business; and (iii) it is not a “business other than an active business”. In other words, Canada does not grant the same benefits to active business income derived through a 98. Ch. 945, reg. 5907 ITR. 99. Ch. 1 (5th Supp.), para. 113(1)(a) ITA 1985. 100. Ch. 1 (5th Supp.), subsect. 113(1) ITA 1985. 101. Ch. 1 (5th Supp.), subsect. 91(1), secs. 92 and 95 et seq. ITA 1985. If the foreign affiliate is not a controlled foreign affiliate, and the ITA 1985 cannot therefore guarantee that information will be available, the Canadian taxpayer’s investment in the foreign affiliate will be taxed on an accrual basis. 102. If there is any foreign income tax paid in respect of the FAPI, the ITA 1985 provides relief for such foreign tax in a manner similar to a foreign tax credit: ch. 1 (5th Supp.), subsect. 91(4) ITA 1985. 103. Ch. 1 (5th Supp.), subsect. 95(1) “foreign accrual property income” ITA 1985. 104. Ch. 1 (5th Supp.), subsect. 95(1) “income from property” ITA 1985. 105. Ch. 1 (5th Supp.), subsect. 95(1) ITA 1985. 106. Id.

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PE of a foreign affiliate in a non-qualifying country that it does to the active business of a foreign affiliate derived through a PE of a qualifying country. The key question, then, is to determine whether royalties are received by the foreign affiliate as part of an active business (other than a non-qualifying business) or whether they are received as part of a business, the principal purpose of which is to derive income from property. In the 1990s, the CRA was asked to analyse certain specific situations in this regard and its comments are helpful. In one case, the question was whether royalty income from copyrighted music is active business income or income from property. The CRA commented as follows: Although royalty income is generally from a source that is property, where it can be established that the royalty income is related to an active business carried on by the recipient corporation in the year, or the recipient corporation is, in the year, in the business of originating property from which the royalties are received, such income will be considered to be income from an active business. Therefore, if a company is in the business of composing music, the income it earns with respect to its copyrighted music would generally be considered active business income. The fact that such income is in the form of royalties is not, in and by itself, sufficient to conclude that it is property income. Where the copyrighted music owned by the company was not produced directly by the company but rather relates to music composed by an individual who was not in the employ of the company at the time of its copyright, it is a question of fact whether the royalty income received by the company in any particular year is from a specified investment business or an active business carried on the company [emphasis added].107

With respect to whether income from a licensing agreement would be considered to be active business income, the CRA repeated that, [A]s a general rule, income from a licensing agreement would not be income from an active business because it would be income from a source that is property or income from a specified investment business. In a situation where it could be established that the licensing income is related to an active business carried on by the recipient corporation or the recipient corporation is in the

107. CRA Views, Tech Interp. 9722915, Royalty income as active business income (1997).

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business of dealing in or originating the property from which the licensing income is received, such income could be considered to be income from an active business [emphasis added].108

On the other hand, where a Canadian corporation asked the CRA whether the income earned by a controlled foreign affiliate on the sale of shrinkwrap software was a “royalty” or “similar return or substitute therefore” in the context of the definition of “investment business”, the CRA responded that “that CFA would be considered to derive its income from sale of tangible goods.” And that “[a]ccordingly, it would not be viewed as engaged in a business the principal purpose of which is to derive income from property for purposes of the ‘investment business’ definition’ in the Income Tax Act.”109

12.3. Taxation of IP under tax treaties 12.3.1. Taxing rights over royalties assigned by article 12(1) Article 12(1) of the OECD Model is not representative of Canada’s tax treaties, as Canada retains its right to tax royalties at the source. More representative of Canada’s tax treaties is article XII of the Canada-US Income and Capital Tax Treaty (1980) which states: 1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. 2. However, such royalties may also be taxed in the Contracting State in which they arise, and according to the laws of that State; but if a resident of the other Contracting State is the beneficial owner of such royalties, the tax so charged shall not exceed 10 per cent of the gross amount of the royalties. 3. Notwithstanding the provisions of paragraph 2, (a) copyright royalties and other like payments in respect of the production or reproduction of any literary, dramatic, musical or artistic work (other than payments in respect of motion pictures and works on film, videotape or other means of reproduction for use in connection with television); (b) payments for the use of, or the right to use, computer software;

108. CRA Views, 9507915, License agreement revenues (1995). Similar statements were made in CRA Views, 9507915, License agreement revenues (1995). 109. CRA Views, Tech Interp. (external), 2003-0016791E5, Shrink-wrap software; 95(1) “investment business”.

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(c) payments for the use of, or the right to use, any patent or any information concerning industrial, commercial or scientific experience (but not including any such information provided in connection with a rental or franchise agreement); and (d) payments with respect to broadcasting as may be agreed for the purposes of this paragraph in an exchange of notes between the Contracting States; arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State … [emphasis added].

Article XII(6) of the Canada-US Income and Capital Tax Treaty (1980) serves to determine the source of royalties paid. In essence, royalties are considered to have their source according to the following rules: (1) If the payer is a resident of Canada or the United States, then the royalties have their source in the state of residence of the payer; (2) If a permanent establishment bears the charge of the payment, then the royalties have their source in the state where that permanent establishment is located; and (3) If the above points do not apply, then the royalties are sourced in the state where the property that is the object of the royalties is used.

12.3.2. Meaning of royalties and overlapping between articles 7, 12 and 13 The overlap between article VII dealing with business profits and article XII dealing with royalties is mainly addressed by article XII(6) of the Canada-US Income and Capital Tax Treaty (1980), which sets out rules for the source of royalties: 6. For the purposes of this Article, (a) royalties shall be deemed to arise in a Contracting State when the payer is a resident of that State. Where, however, the person paying the royalties, whether he is a resident of a Contracting State or not, has in a State a permanent establishment or a fixed base in connection with which the obligation to pay the royalties was incurred, and such royalties are borne by such permanent establishment or fixed base, then such royalties shall be deemed to arise in the State in which the permanent establishment or fixed base is situated and not in any other State of which the payer is a resident; and (b) where subparagraph (a) does not operate to treat royalties as arising in either Contracting State and the royalties are for the use of, or the right to use, intangible property or tangible personal property in a Contracting State, then such royalties shall be deemed to arise in that State.

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Interpretative issues with respect to the distinction between royalties, business income, gains, etc. will generally be dealt with by Canadian courts by referring to: (i) the commentaries by the parties to tax treaties at the time they are entered into110 and (ii) their interpretation of these concepts as they have been interpreted in a domestic context.

12.3.3. Beneficial ownership and royalties With respect to the beneficial ownership of royalties, the FCA has held the following as comprising the current state of Canadian law: [T]he “beneficial owner” of dividends is the person who receives the dividends for his or her own use and enjoyment and assumes the risk and control of the dividend he or she received. The person who is beneficial owner of the dividend is the person who enjoys and assumes all the attributes of ownership. In short the dividend is for the owner’s own benefit and this person is not accountable to anyone for how he or she deals with the dividend income…. Where an agency or mandate exists or the property is in the name of a nominee, one looks to find on whose behalf the agent or mandatory is acting or for whom the nominee has lent his or her name. When corporate entities are concerned, one does not pierce the corporate veil unless the corporation is a conduit for another person and has absolutely no discretion as to the use or application of funds put through it as conduit, or has agreed to act on someone else’s behalf pursuant to that person’s instructions without any right to do other than what that person instructs it, for example, a stockbroker who is the registered owner of the shares it holds for clients.111

More recently, in Velcro Canada Inc.112 the TCC was asked to consider the beneficial owner of royalties paid from a Canadian company to companies in the Netherlands in the context of article XII of the Canada-Netherlands Income Tax Treaty (1986, as amended through 1997). Velcro Canada Inc. (VCI) was in the business of manufacturing and selling fastening products mainly for the auto industry. VCI paid royalties under a license agreement to Velcro Industries BV (VIBV), previously a resident of the Netherlands, for the use of Velcro Brands Technology. In 1995, VIBV became a resident of the Netherlands Antilles and in October, 1995 assigned the license agreement to Velcro Holdings BV (VHBV), a subsidiary resident of the Netherlands. Between 1996 and 2004, VCI paid royalties to VHBV which 110. See CA: TCC, 22 Apr. 2008, Prévost Car Inc. v. R., [2008] 5 C.T.C. 2306, 2008 TCC 231 (General Procedure]). 111. CA: FCA, 26 Feb. 2009, Prévost Car Inc. v. R., [2009] 3 C.T.C. 160, 2009 FCA 57, at para. 13. 112. CA: TCC, 24 Feb. 2012, Velcro Canada Inc. v. The Queen, 2012 TCC 57.

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in turn paid approximately 90% of that amount over to VIBV. Any royalties paid by VCI to VIBV would be subject to a withholding tax of 25%. Canada does not have a tax treaty with Netherlands Antilles. However, Canada does have a tax treaty with the Netherlands and under that treaty, VCI withheld and remitted a reduced rate of tax of 10% of the royalties paid to VHBV for the 1996 to 1998 taxation years and nil for 1999 and subsequent taxation years. VHBV is of the view that it is the beneficial owner of the royalties and the CRA took the opposite view: that VIBV is the beneficial owner and VCI therefore should have withheld and remitted a tax of 25% of the royalties paid to VHBV, as required by the Canada-Netherlands Convention.113 In determining whether VIBV or VHBV was the beneficial owner of the royalties, the TCC relied on the decision in Prevost Car and held that four criteria would determine the beneficial owner of the royalties: (a) possession; (b) use; (c) risk and (d) control.114 Essentially, these criteria, or their absence, would indicate a relationship of agency between the immediate recipient of the royalties and their beneficial owner. As such, a recipient of royalties will generally be accepted by Canadian courts as being the beneficial owner thereof if it is not acting as an agent or nominee on behalf of another person.

12.3.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state There is no federal “patent box” or “innovation box” regime in Canada or any other similar regime that reduces the normal corporate tax rate for income derived from patents and potentially other IP-derived income, but Canada’s SR&ED incentive programme is discussed above. While provincial incentives are beyond the scope of this paper, it should be noted that the provinces of both Saskatchewan and Québec recently introduced “patent box” type incentives for provincial income. Effective 31 December 2016, Québec introduced the “deduction for a qualifying innovative manufacturing corporation” (DIMC), which allows income from innovation to be taxed provincially at 4% instead of the 11.8% that 113. Id., at para. 1. 114. Id., at para. 29.

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would otherwise generally apply. The DIMC will enable such a corporation to reduce its taxable income for a taxation year by an amount equal to a portion of the value of a qualified patented part integrated into qualified property that the corporation sold, leased or rented that year.115 In the province of Saskatchewan, the government introduced the “Saskatchewan Commercial Innovation Incentive” in its 2017-2018 budget.116 This programme reduces the provincial corporate income tax rate for eligible corporations to 6% for a period of 10 years on taxable income earned from the commercialization of qualifying types of intellectual property in Saskatchewan such as patents, plant breeders’ rights, trade secrets and copyrights. Eligible corporations can extend the benefit period to 15 years if the majority of the related R&D was conducted in the province.

12.3.5. Time of taxation The terms “paid” and “payment” within the context of article XII of Canada’s tax treaties is not the source of much ambiguity in Canada. However, domestically, the ITA 1985 requires that withholding be made by Canadian payers when they pay or “credit” the amounts in question.117 The meaning of the verb “to credit” was the subject of debate before the TCC in the context of distributions having been declared (but not paid) to a non-resident beneficiary. The TCC (whose decision was upheld on appeal by the FCA) held that the meaning of “to credit” was “the unconditional placing of funds – on a practical level – at the disposal of the Beneficiary in fulfilment of the Trust’s obligation to pay.”118 This definition of the concept “to credit” should not give rise to a great deal of timing issues, as it is, practically speaking, similar to simple payment, although there may not be a payment of actual cash. 115. Revenu Québec, Creation of a Deduction for Innovative Manufacturing Corporations (11 May 2016), available at http://www.revenuquebec.ca/en/salle-de-presse/nouvellesfiscales/2016/2016-05-11.aspx. 116. Available at http://www.finance.gov.sk.ca/budget17-18/2017-18Budget.pdf. 117. Ch. 1 (5th Supp.), subsect. 212(1) ITA 1985. 118. CA: TCC, Lewin v. R., [2012] 3 C.T.C. 2024, 2011 TCC 476 [General Procedure], affirmed by 2012 FCA 279.

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12.3.6. Excessive royalty payments Canada has adopted the language of article 12(4) of the OECD Model. Domestically, Canada’s transfer pricing rules require related parties to determine the amount of royalties on an arm’s length basis.119 Where such payments were not made on arm’s length terms, the transfer pricing rules would permit the CRA to adjust the transactions to reflect arm’s length terms.

119. Ch. 1 (5th Supp.), subsect. 247(2) ITA 1985.

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Chapter 13 China (People’s Rep.) by Na Li1

13.1. Introduction on private law aspects of intellectual property (IP) 13.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law 13.1.1.1. Definition of the terms for or relating to “royalties” under Chinese private law There is no specific definition for the terms “intellectual properties” or “intangible properties” in Chinese private law. Thus, the author has to divide the properties covered in article 12(2) of the OECD and UN Models into four categories according to their separate applicable private laws in China. These four categories are: (i) copyright of literary, artistic or scientific work; (ii) patent, design or model; (iii) trademark; and (iv) plan, secret formula or process, information concerning industrial, commercial or scientific experience. 13.1.1.1.1.  Copyright of literary, artistic or scientific work The expression “copyright of literary, artistic or scientific work” is covered by the Copyright Law 1990,2 which defines the scope of “literary, artistic or scientific work” as broad as the works in the form of “literature, art, natural science, social science, engineering technology”,3 and also lists some forms of such work as examples, including: (i) written works; (ii) oral works; (iii) musical, dramatic, quyi, choreographic and acrobatic 1. Lecturer at East China University of Political Science and Law, Shanghai, China. The author can be contacted at [email protected]. 2. CN: Copyright Law of the People’s Republic of China, adopted by the 15th Session of the Standing Committee of the Seventh National People’s Congress on 7 September 1990, amended in 2001 and 2010 [hereinafter CL 1990]. 3. Art. 3 CL 1990.

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works: (iv) fine art and architectural works; (v) photographic works: (vi) cinematographic works and works created by means similar to cinematography; (vii) graphic works, including engineering design drawings, product design drawings, maps, schematic drawings, etc. as well as model works; (viii) computer software; and (ix) other forms of works as provided by Chinese laws and regulations. The copyright on these work(s) refers to both personal rights and property rights. As the personal rights should always remain with the author, the royalties or capital gains derived from copyright could only refer to the payment for transfer or license of the property right of these work(s). The details about categories of personal rights and property rights are addressed in section 13.1.2. 13.1.1.1.2.  Patent, design or model The terms “patent” and “design or model” are covered by the Patent Law 1984,4 which collectively refers to these as “patents”. The Patent Law 1984 further divided “patents” into three categories: (i) inventions; (ii) utility models; and (iii) design. The inventions are defined as “new technical solution proposed for a product, a process or the improvement thereof”; while the utility models are defined as “new technical solutions proposed for the shape and structure of a product, or the combination thereof, which are fit for practical applicability”; and lastly, the designs are defined as “new designs of the shape, pattern, the combination thereof, or the combination of the colour with shape and pattern, which create an aesthetic feeling and are fit for industrial application.”5 13.1.1.1.3.  Trademark The term “trademark” is covered by the Trademark Law 1982,6 which defines trademark in a narrow approach referring only to those registered trademarks that have been verified and approved by the China Trademark 4. CN: Patent Law of the People’s Republic of China, adopted at the Fourth Session of the Standing Committee of the Sixth National People’s Congress on 12 March 1984; amended in 1992, 2000, and 2008 [hereinafter PL 1984]. 5. Art. 2 PL 1984. 6. CN: Trademark Law of the People’s Republic of China, adopted at the 24th Session of the Standing Committee of the Fifth National People’s Congress on 23 August 1982; amended in 1993, 2001 and 2013.

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Office. In other words, trademarks which have not complied with such registration, verification and approval requirement, irrespective of what you call them, should not be recognized as trademarks in China. The registered trademarks in China consist of four types of marks: (i) commodity trademarks; (ii) service marks; (iii) collective marks; and (iv) certification marks. 13.1.1.1.4.  Plan, secret formula or process, information concerning industrial, commercial or scientific experience The terms “plan”, “secret formula or process” and “information concerning industrial, commercial or scientific experience” are covered in the AntiUnfair Competition Law 1993,7 as long as these properties cannot qualify as copyright works, patents or trademarks as stated in the above. The AntiUnfair Competition Law 1993 collectively named these as “trade secrets” through defining them as “any technology information or business operation information which is unknown to the public, can bring about economic benefits to the owner of such information, has practical utility and about which secrets the owner has adopted secret-keeping measures”.8 Clearly, the right for those “trade secrets” are not protected as an IP right but are covered within the scope of competition law in China. However, an overlapping situation for being both an infringement of trademark right and a harm on fair competition could occur when either of these four circumstances occur: (i) counterfeiting a registered trademark of another person; (ii) using for a commodity without authorization a unique name, package or decoration of another’s famous commodity, or using a name, package or decoration similar to that of another’s famous commodity, thereby confusing the commodity with that famous commodity and leading the purchasers to mistake the former for the latter; (iii) using without authorization the name of another enterprise or person, thereby leading people to mistake their commodities for those of the said enterprise or person; or (iv) forging or counterfeiting authentication marks, famous-and-excellent-product marks or other product quality marks on their commodities, forging the origin of their products or making false and misleading indications as to the quality of their commodities. For any of the above cases, the owner is eligible to choose to protect its rights under either the Trademark Law 1982 or the Anti-Unfair Competition Law 1993. 7. CN: Anti-Unfair Competition Law of the People’s Republic of China, adopted at the Third Meeting of the Standing Committee of the Eighth National People’s Congress of the People’s Republic of China on 2 September 1993 [hereinafter AUCL 1993]. 8. Art. 10 AUCL 1993.

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13.1.1.2. Whether qualification for private law purposes would have an impact on the qualification of the income from the IP for domestic tax and tax treaty purposes The above-described four private laws were enacted respectively in the 1980s and 1990s, which were later than the promulgation of the Individual Income Tax Law 1980 but earlier than the Enterprise Income Tax Law 2007. It seems from this time sequence that at least the Enterprise Income Tax Law 2007 should have incorporated some features as the definition for the above four categories of properties from their private laws. However, the fact does not prove this speculation, as there is no clue that the definition for “royalties” in the Enterprise Income Tax Law 2007 was transplanted from those private laws. This will be addressed in detail in section 13.2.1.1. Nevertheless, influences from private law, formally or informally, still exist in practice when determining the qualification of IP income for application of both domestic tax law and tax treaty purposes. One example is that for income qualifying for transferring or licensing a trademark, this trademark must be registered as one being provided in the Trademark Law 1982. The same registration requirement also applies to transfer or licence copyright and patents; but the difficult one would be for trade secrets which cannot be registered with any competent authorities. Thus, the Supreme People’s Court of China took another approach to test whether the owner of the secrets adopted secret-keeping measures for the properties, and this judicial interpretation is followed by all courts throughout China. If yes, then these properties could be treated as “trade secrets”, otherwise there would be some properties not being protected and/or recognized as “trade secrets” under the Anti-Unfair Competition Law 1993. The assessment for the secret-keeping measures is determined according to the features of the relevant information carrier, the confidentially willingness of the owner, the identifiability degree of the confidentiality measures, the difficulty for others to obtain it by justifiable means and other factors. The Court furthermore gave some examples that shall decide whether the owner has adopted the confidentiality measures: (i) limiting the access scope of the classified information and only notifying the contents to relevant persons that should have access to the information; (ii) locking up the carrier of the classified information or adopting any other preventive measure; (iii) indicating a confidentiality mark on the carrier of classified information; (iv) adopting passwords or codes on the classified information; (v) concluding a confidentiality agreement; (vi) limiting visitors to the classified machinery, factory, workshop or any other place or putting forward any confidentiality request;

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or (vii) adopting any other proper measure for guaranteeing the confidentiality of information.9

13.1.1.3. New trend and evolution of the rights which can be protected by IP or industrial property legislation No evidence shows that the scope of copyright, trademark or patents is on a trend of expansion under Chinese private laws. However, the scope of “plan”, “secret formula or process” and “information concerning industrial, commercial or scientific experience”, which are called “trade secrets” under the Anti-Unfair Competition Law 1993, is expanding through administrative interpretation and judicial interpretation. As early as in 1995, the State Administration for Industry and Commerce had issued a circular10 interpreting that a “trade secret” should consist of two types of secrets: i.e. information about technologies and information about business operations, which should include, but not limited to, designs, procedures, formula of products, manufacturing techniques and methods, management secrets, name list of customers, information about resources, production and sales strategies, bottom price of a bid and contents of a bidding document, etc. Comparing this administrative interpretation with the Anti-Unfair Competition Law 1993, one can find that this interpretation circular clearly added some business information such as management secrets, name list of customers and information about resources, etc. This was further affirmed by the Supreme People’s Court in 2007, which issued a judicial interpretation11 particularly providing that a customer list can be treated as one type of trade secrets if the customers’ name, address, contact information, trading habits, trading intent and trading contents consist of the specific customer’s information different from relevant public information. This means that income derived from a transfer or license of such customer list would be treated at least by the Anti-Unfair Competition Law 1993 as income derived from a license to use of the “trade secret”. But this expanding trend is shown only at private laws and no evidence yet shows the same expansion at a tax law perspective. 9. See CN: Supreme People’s Court of China (ZRF), 12 Jan. 2007, Interpretation of the Supreme People’s Court on Some Issues Concerning the Application of Law in the Trial of Civil Cases Involving Unfair Competition, which came into force on 1 February 2007. See also X. Zhou, Analysis of Luo shi MS Motorola (China) Electronics Corporation, Ltd., Dispute on Business Secret Appeal Case, Technology and Law 3 (2003). 10. State Administration for Industry and Commerce, Several Provisions on Prohibiting Infringements upon Trade Secrets (23 Nov. 1999, amended 3 Dec. 1998). 11. ZRF, supra n. 9.

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13.1.2. Distinction under private law between alienation of IP and granting the right to use IP 13.1.2.1. Domestic private law legislations governing (may result in applying different treaty provisions (article 12, 13 or 7)) All four Chinese private laws (as mentioned above) have clearly distinguished alienation of the ownership from the granting of use-right(s) for copyrights, patents, trademarks and trade secrets. Therefore, payments deriving from alienation of these rights should fall into tax provisions (article 13 of the OECD Model) different from tax provisions for the granting of the use-right(s) derived thereof (article 12 of the OECD Model) in China. However, the treatment of copyright is different from the treatment of other IPs. The fact is that although copyright refers to both personal rights and property rights, the Copyright Law 1990 does not allow to transfer or license the personal rights, which consist of the right of publication, right of authorship, right of alteration and right of integrity.12 In other words, payment can only derive from alienation of the property rights in whole or in part, or from granting the others with a right to the use of a particular category of property rights, which consist of 13 categories:13 (i) right of reproduction, i.e. the right to make one or more copies of a work by means of printing, photocopying, rubbing, sound recording, visual recording, duplicating a sound or visual recording, duplicating a photographic work, etc.; (ii) right of distribution, i.e. the right to make the original or reproduced version of a work available to the public by sale or donation; (iii) right of rental, i.e. the right to authorize others, on the basis of compensation, to temporarily use a cinematographic work, a work created by means similar to cinematography, or computer software, excluding circumstances under which the computer software is not the main subject matter under the lease; (iv) right of exhibition, i.e. the right to publicly display the original or reproduced version of a fine art or photographic work; (v) right of performance, i.e. the right to publicly perform a work and to publicly broadcast, via any medium, the performance of a work; (vi) right of projection, i.e. the right to publicly show, via film projectors, overhead projectors and other technologies and 12. The right of publication means the right to decide whether or not a work is to be made available to the public; the right of authorship means the right to indicate the identity of the author of a work by affixing the author’s name thereto; the right of alteration means the right to alter or authorize others to alter a work and the right of integrity means the right to protect a work from being distorted or falsified. 13. See art. 10 CL 1990.

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equipment, a fine art, photographic or cinematographic work, or a work created by means similar to cinematography; (vii) right of broadcasting, i.e. the right to publicly broadcast or disseminate a work through wireless transmission, to disseminate a broadcast work to the public through wire transmission or rebroadcast and to disseminate a broadcast work to the public through a loudspeaker or any other similar instrument used to transmit symbols, sounds or images; (viii) right of dissemination via an information network, i.e. the right to make a work available to the public by wire or wireless means, through which the public may access the work at times and places of their respective choices; (ix) right of cinematography, i.e. the right to fix a work in a medium by cinematographic or similar means; (x) right of adaptation, i.e. the right to alter a work so as to create a new original work; (xi) right of translation, i.e. the right to convert a work from one language to another; (xii) right of compilation, i.e. the right to make works, or segments thereof, into a newly compiled work through selection or arrangement; and (xiii) other rights to which a copyright owner shall be entitled. In comparison, with respect to patents,14 trademarks and trade secrets, there is no distinction on personal rights and property rights. All rights for or related to these could be licensed or transferred. And, in addition, for patents, the patent right itself can be transferred or licensed in the form of an exclusive licence,15 sole licence16 or non-exclusive licence,17 as well as even the right to apply for a patent can be transferred.

13.1.2.2. Whether the private law meaning of ownership of IP is based exclusively on legal ownership or if, in the context of certain transactions, it is recognized as the concept of economic ownership Chinese private laws do not distinguish legal ownership from economic ownership, as they generally provide that the rights of the relevant properties 14. Referring to all three categories of “patents” under the Patent Law 1984: inventions, utility models and designs. 15. Exclusive licence means that the owner licenses the patent to only one licensee within the agreed scope of licensed exploitation of the patent and the owner is not allowed to exploit such patent as agreed. 16. Sole licence means that the owner licenses the patent to only one licensee within the agreed scope of licensed exploitation of the patent and the owner is allowed to exploit such patent as agreed. 17. Non-exclusive licence means that the owner licenses the patent to others within the agreed scope of licensed exploitation of the patent and the owner is allowed to exploit such patent.

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should be enjoyed by “holders”.18 One may need to pay attention to this term of “holders”, which are not specified as “legal owners” or “economic owners” in practice. However, in terms of patents, the parties contributing economic factors to the creation of the patents may also qualify to be one of the “holders” for the patents rights because the Patent Law 1984 allows the contributors to the inventions to agree on being joint-holders for owning the right to apply for a patent when any inventions are accomplished by two or more organizations or individuals in collaboration, or an invention accomplished by an organization or individual under entrustment of other organizations or individual.19 Upon going through the registration, verification and approval process for application for a patent, all joint-holders will share the patents rights. However, more focus needs to be made to the “legal owners” of copyrights, trademarks and patents, as all these properties must be registered and approved with the competent Chinese authorities before they could be qualified as those properties governed under the relevant private laws. In other words, only those holders who have been legally registered (having a legal title on the properties) would be able to derive income from these properties. The difference might be made to “trade secrets”, which are not subject to any registration/approval requirements, thus those economic owners of such trade secrets might also argue for the income derived from these properties as long as they can prove their owning these trade secrets.

13.2. Taxation of IP under the domestic tax law 13.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP 13.2.1.1. Domestic tax law meaning (definition of “royalties”) The individual income tax (IIT) and enterprise income tax (EIT) in China are encoded into separate laws, therefore income from royalties derived by individual persons is governed by the Individual Income Tax Law 198020 while royalties’ income derived by enterprises is governed by the Enterprise 18. CN: General Provisions of the Civil Law of the People’s Republic of China, art. 123, promulgated at the 5th Session of the 12th National People’s Congress of the People’s Republic of China on 15 March 2017 and came into force on 1 October 2017. 19. Art. 8 PL 1984. 20. CN: Individual Income Tax Law of the People’s Republic of China, National Legislation IBFD [hereinafter IITL 1980].

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Income Tax Law 2007.21 However, neither the Individual Income Tax Law 1980 nor the Enterprise Income Tax Law 2007 provides a specific definition for “royalties”, although they both state that income from royalties should be subject to tax. One issue worthy of notice is that income derived by individuals from publication of their works in books and newspapers is not taxed as “royalties” but as a separate category of income called “remuneration to authors”.22 The Rules for Implementation of the Individual Income Tax Law (the IITL Implementation Rules) provide that “remuneration to authors” refers to the income derived from publishing or distributing works in the form of or via the media of a book, a newspaper or a periodical, although such a definition is similar with the one for the “right of reproduction” (i.e. income arising from licensing the others to right to make one or copies of the authors’ work) which is one of the 13 categories of the property rights of the copyright owners under the Copyright Law 1990. The reason to separate royalties and “remuneration to authors” into two separate categories of income is because the Individual Income Tax Law 1980 applies a schedular regime which calculates and taxes each category of income separately. In contrast, the Enterprise Income Tax Law 2007 does not make such a distinction and all IP- or intangible property-related income is included in the taxable income for calculation. Although not defined by the Individual Income Tax Law 1980 or the Enterprise Income Tax Law 2007, the term “royalties” is defined by the IITL Implementation Rules,23 which were enacted by the State Council for the purpose of providing detailed rules for implementing the Individual Income Tax Law 1980 in China. Thus, it is legitimate for the State Council to interpret the term “royalties” through making a definition in such Rules. This definition is as follows: “Income derived from royalties means income derived from providing and assigning patent rights, copyrights, rights to use proprietary technology and other rights; income derived from providing copyrights excludes remuneration to authors.”24 Such definition is not only inconsistent with the OECD Model and UN Model, but is also inconsistent with the definitions for copyrights and trade secrets as defined in the above-described Chinese private laws. Firstly, it excludes the “remuneration to authors” from the scope of royalties and, secondly, it used the term of 21. CN: Enterprise Income Tax Law of the People’s Republic of China, National Legislation IBFD [hereinafter EITL 2007]. 22. CN: Rules for Implementation of the Individual Income Tax Law, 1994 (amended 2005, 2008 and 2011), art 8(5), National Legislation IBFD [hereinafter IITL Implementation Rules]. 23. IITL Implementation Rules. 24. Id., art. 8(6).

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“proprietary technology,” which does not require any secret-keeping measures as required for trade secrets but limited only to “technologies”. Thus, it is also inconsistent with the term “trade secret” under the Anti-Unfair Competition Law 1993. No evidence shows where such a definition in the IITL Implementation Rules came from, but clearly it did not use the definitions of the private laws. Furthermore, it is difficult to see any impact of the private laws on such definition, although such Rules were enacted in 1994, which was earlier than the four private laws as described above. Even more surprising is that with respect to the EIT, the Implementation Rules of the Enterprise Income Tax Law (EITL Implementation Rules) do not provide a definition for “royalties” at all, although there is already an absence of such definition in the Enterprise Income Tax Law 2007. Furthermore, it is inappropriate for taxpayers and tax authorities to refer to the definition given by the IITL Implementation Rules, as the EIT and IIT are two separately encoded income taxes in China. The issue that is left to the taxpayers and tax authorities in calculating EIT is therefore uncertainty and the State Administration of Taxation (SAT), which is the highest level administrative authority in China, has to intervene through issuing several tax circulars as administrative interpretations trying to clear such uncertainty. So far, however, all the relevant SAT circulars are for or relating to the term “royalties” as provided in the tax treaties China has concluded, so the uncertainty still exists for purposes of calculating domestic EIT.

13.2.1.2. SAT’s interpretation for “royalties” used in Chinese tax treaty provisions The SAT’s first several circulars were issued piece by piece for one or certain specific issues in interpreting Chinese tax treaties. For example, in 2009 the SAT issued Circular 507,25 providing that “information concerning industrial, commercial or scientific experience” should be interpreted as technical know-how, which, however, are unknown to the public but are necessary for the production of a certain product or for the copy of the relevant working procedures.26 Furthermore, in 2010, the SAT issued Circular

25. China - Guo Shui Han [2009] No. 507, Notice of the State Administration of Taxation on Issues Concerning the Implementation of the Terms regarding Licensing Fee in Tax Agreements [unofficial translation] (issued on 14 Sept. 2009 and in force on 1 Oct. 2009), Tax Authorities’ Documentation IBFD. 26. This interpretation is consistent with the definition for “trade secrets” under the AUCL 1993.

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46,27 providing that technology service activities involved in the transfer of the right to use a proprietary technology should be subject to the royalty provisions of the tax treaty. The SAT changed such piece-by-piece approach in July 2010 through issuing Circular 75,28 where the SAT not only provides its administrative interpretation of each provision of the China-Singapore Income Tax Treaty (2007), but also states clearly that these interpretations shall also apply to all Chinese tax treaties. It is in Circular 75 that the SAT interprets the term “royalties” in an approach which is broader than the definitions under both the IITL Implementation Rules and that given by the Chinese private laws. Firstly, the SAT provides in Circular 75 that, The “royalties” shall firstly be related to the use of, or the right to use, the following rights: various forms of literature and art constituting rights and property, and intellectual property in the relevant text and information concerning industrial, commercial or scientific experience, regardless of whether these rights have been registered or must be registered at the specified departments. It shall also be noted that this definition includes not only the payments made under permission but also the payment of compensation made for tort.… The royalties shall also include the income from the use of, or the right to use, the information concerning industrial, commercial or scientific experiences. Such income shall be construed as arising from proprietary technology, which generally refers to the information or materials which are necessary for the production of certain products or process reproduction, and are unpublicized and have the character of proprietary technology. The royalties relevant to proprietary technology usually involves that the technology licensing party agrees to license its technology which is not disclosed to the other party, so the other party can freely use the technology, the technology licensing party usually does not personally participate in the specific application of the licensed technology by the technology alienee and does not guarantee the results of application. The licensed technology has been usually in existence already, but also includes the technology which is licensed for use after being researched upon the requirements of the technology alienee, and restriction on the use of which such as confidentiality is contained in the contract.

27. CN: China (People’s Rep.) - Circular No. 46 of 2010 Cai Shui [2010] Circular of the State Administration of Taxation on Issues Concerning Enforcement of Relevant Clauses of Tax Treaties, National Legislation IBFD. 28. SAT, Notice of the State Administration of Taxation on Issuing the Interpretation of the Articles of the Agreement between the Government of the People’s Republic of China and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and the Protocol Thereof (Circular No. 75 [2010]), issued and in force on 26 July 2010.

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One needs to notice the wording “regardless of whether these rights have been registered or must be registered at the specified departments” in the above paragraph, as it means that the SAT expanded the scope of copyright, trademark and patents to those which the Chinese private laws, as well as the IITL Implementation Rules, would not recognize. One more noticeable issue is that even the compensation for torts is also included within the scope of royalties. And furthermore, the SAT also includes the payment for the right to use “information concerning industrial, commercial or scientific experience” within the scope of royalties through being “construed as” arising from proprietary technologies. This term “construed as” means that the SAT agreed with the IITL Implementation Rules that such experience secrets are not the properties falling within the scope of royalties under the such Rules as they are not technically relevant properties. But the SAT is willing to include such secrets by deeming them as technology-relevant properties. Furthermore, the SAT continued in Circular 75 that, The royalties shall also include the income from the use of, or the right to use, industrial, commercial or scientific equipment, i.e., rental of equipment, but shall exclude the part regarded as interest for the payments involved in the relevant finance lease agreement in which the ownership of the equipment is ultimately alienated to the user; and also exclude the income from the use of immovable property, and Article 6 of the Agreement shall apply to such income.

This part of the interpretation is interesting since rental income from leasing industrial, commercial or scientific equipment is not treated as royalties for both IIT and EIT purposes in China. Furthermore, the Chinese private laws do not treat such right to the use of industrial, commercial or scientific equipment as IP, intangible property or trade secrets. This means the SAT’s interpretation for expanding the royalties’ scope of rental income actually has no legal basis in domestic laws, although most Chinese tax treaties do include such rental income in the definition of royalties in treaty provisions. The SAT’s interpretation approach triggered tax disputes on satellite income derived by a US company from China, which is addressed in detail in section 13.3.2.2.

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13.2.1.3. Whether technical assistance is treated or characterized as royalty, especially where technical assistance is connected with a licence of the relevant IP If, in a service contract, a service provider uses some expertise and technologies during the course of providing services but does not license the right to use these technologies, the SAT in Circular 75 interprets that the income deriving from providing such services should not be treated as royalties unless the outcome of such services falls within the scope of the works within the royalty provisions. In addition, the SAT lists several types of services as examples for such clarifications: (i) compensation for after-sale services under the trade of goods; (ii) compensation which the seller obtains from the provision of services to the buyer within the term of product warranty; (iii) the relevant service payments made to an institution or individual engaging in such professional services as engineering, management and consultation; and (iv) other similar compensations as decided by the SAT.

13.2.1.4. Whether domestic tax law rules or practice exist on aggregation and/or disaggregation of transactions that include both technical assistance and licensing of IP As for the circumstance that during the course of alienating or licensing the right to use the proprietary technology, the technology licensing party sends personnel to provide relevant support, guidance and other services for the application of such technology, and charges a service fee, the SAT interprets that such service fee shall be regarded as royalty regardless of whether it is charged separately or is included in the price of technology. However, if the services provided by the aforesaid personnel have constituted a permanent establishment (PE), the service income attributable to the PE shall be governed by the provisions on business profits of article 7 of the treaty and the personnel providing the service shall be governed by the provisions on dependent personal services in the treaty. The income from services which do not constitute a PE or the service income not attributable to the PE shall still be governed by the provisions on royalties.29

29. C. Qing-hui, On Taxation and Harmonization of Cross-border Royalty in the Context of E-Commerce and Capital Tax Conventions, 170 Journal of Xiamen University (Arts & Social Sciences) 4 (2015).

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13.2.2. Qualification of income deriving from IP and applicable tax regimes 13.2.2.1. Categories or subcategories of income As the Enterprise Income Tax Law 2007 and the Individual Income Tax Law 1980 do not provide any rule for distinguishing the payments for “the granting of right to use the IP” and the payments for “the transfer of the full ownership of the IP”, qualification of such income under tax treaties, again, has to be done according to the SAT’s administrative interpretations in Circular 75. Therefore, as a general rule, “the gains arising from the change in legal ownership of property, including the gains from the sale or exchange of property, and also the gains from partial alienation, requisition or sale of rights, etc.” should be categorized as “capital gains”, while the income derived as described in section 13.1.1.2. should be categorized as “royalties”. However, as described above, the “remuneration to authors” should be treated as a separate category of income under the Individual Income Tax Law 1980. For incomes that cannot fall into capital gains, royalties or remuneration to authors, they will still be taxed in the category of “other incomes” for IIT or EIT purposes.

13.2.2.2. Tax regimes applicable to IP income derived by resident taxpayers In terms of the EIT, the royalties, capital gains as well as other incomes should all be included in the gross income of the Chinese-tax-resident enterprise,30 but the income derived from “transferring technologies” could be fully exempted from ETI if the amount does not exceed RMB 5 million,31 as well as a half-exemption of the EIT for the portion of the amount exceeding RMB 5 million.32 This is a tax incentive measure encouraging resident enterprises to engage in developing technologies, but neither the Enterprise Income Tax Law 2007 or the EITL Implementation Rules provide any explanation for what kind of “technologies” could qualify this incentive and in what form the “transfer” should take place. Again, the SAT fills in 30. Chinese-tax-resident enterprise refers to an enterprise established in China or an enterprise that is established under the laws of a foreign country (or other tax region) but whose actual management or control is located in China. 31. I.e. approximately USD 750,000. 32. CN: China (People’s Rep.) - Implementation Rules of Enterprise Income Tax Law of the People’s Republic of China, art. 90, National Legislation IBFD [hereinafter EITL Implementation Rules].

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the gap through giving administrative interpretations in several circulars, which continue to expand the eligible scope for technologies and the forms of transfer. As of the end of August 2017, the “technologies” eligible for such incentives already include patents, computer software, IT circuit plans, new plants and bio-medicines, which are already much broader than the scope of patents as defined in the Patent Law 1984. But these technologies must be legally owned by the Chinese-tax-resident enterprise and should be subject to registration and verification by the competent Chinese authorities. As for the eligible forms of “transfer”, the SAT interprets this as including selling the ownership of the technologies and licensing the use-right of the technologies (irrespective of exclusive or non-exclusive) for no less than 5 years.33 The difference will be made to calculate the IIT when categorizing the relevant income into capital gains, royalties, remuneration to authors or other incomes, as they are separate categories of income in parallel within the total 11 categories that are subject to different tax rates and tax base for IIT purposes. For the income being categorized as “capital gains”, the applicable tax rate is 20%, while the tax base is the sales price deducting the “original value” of the IP and any reasonable expenses incurred during transfer. For royalties’ income, the applicable tax rate is also 20%, but the tax base is the total amount receivable being deducted with RMB 800 (when the amount receivable is less than RMB 4,000) or 80% of the total amount (when the amount receivable is more than RMB 4,000). For the income being categorized as remuneration to authors, the applicable tax rate is the same as the above two categories, being 20%, but an additional 30% tax credit is allowed on the tax base, which is the total amount receivable being deducted with RMB 800 (when the amount receivable is less than RMB 4,000) or 80% of the total amount (when the amount receivable is more than RMB 4,000). However, if the authors are professional writers, journalists or editors, the income received from their employers in respect of works published by their employers shall be consolidated with 33. SAT, Announcement on the Enterprise Income Taxes Issues for Licensing Use-right and Sale of Ownership, SAT Announcement [2015]82; Announcement on Exemption or Reducing the Enterprise Income Taxes for Licensing Use-right and Sale of Ownership, SAT Announcement [2013]62; Notice on Enterprise Income Taxes Issues for Resident Enterprises Transferring Technologies, Caishui [2010]111; and Notice on Exemption or Reducing the Enterprise Income Taxes for Transferring Technologies, Guoshuihan [2009]212.

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their wage or salary income and taxed under the category of “employment income” under the IITL, which is taxed at a progressive rate ranging from 5% to 45%. Lastly, for the other incomes that do not fall into any of the above categories, they are taxed at a rate of 20% and tax base shall be assessed case by case.

13.2.3. Tax treatment of income from IP derived by nonresident taxpayers 13.2.3.1. Rules applicable to non-resident taxpayers in general Distinguishing capital gains and royalties will make a difference when a non-Chinese-tax-resident enterprise derives such income from China.34 A non-resident enterprise shall be subject to income tax on its China-sourced income when it does not have an establishment in China or that has an establishment in China but whose income is not effectively connected with such an establishment. However, the tax rates for capital gains and royalties are different. Its capital gains income derived in China shall be subject to a standard rate of 20% on a tax base as the excess of the proceeds over the net value of the IP transferred, while its royalty income could be subject to a preferential tax rate of 10% (unless the tax treaties provide otherwise) on the full amount of the royalties. Another key factor is to determine whether the non-resident enterprise has sourced its capital gains or royalties in China, which should be assessed according to China’s source rule. The source of royalty income is determined in accordance with the place of the enterprise or establishment which bears or pays the income, or with the place of domicile of the individual who bears or pays the income. The source of capital gain is determined in accordance with the place of the non-resident enterprise that transfers the IP.

34. A “non-tax resident enterprise” as referred to in the Enterprise Income Tax Law 2007 is an enterprise that is established under the laws of a foreign country (or tax region) and whose actual management or control is located outside China but which has an establishment or place in China, or that does not have an establishment or place in China but derives income from sources within China.

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13.2.3.2. Tax exemption for non-resident taxpayers The old income tax law effective before 2008 provided full exemption of EIT for non-residents receiving royalty income, but the EITL abolished the old income tax law since 1 January 2008 and the only incentive now is a lower rate of 10%,35 compared to the standard EIT rate of 20%.

13.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 13.2.4.1. Taxation rules applicable to IP income derived by entities falling within the scope of CFC regulation The Enterprise Income Tax Law 2007 has a controlled foreign company (CFC) rule which governs an enterprise controlled by resident enterprises and/or individual residents of China and established in a jurisdiction where the effective tax rate is lower than 12.5%. When such enterprise either does not distribute profits or distributes profits lesser than it should, not because of reasonable operational needs, the portion of the above-mentioned profits attributed to the Chinese resident enterprises shall be included when computing the taxable income of the Chinese resident enterprise in the current period.36 Thus, the IP income of the CFC could fall within the scope of this CFC rule, unless the CFC could satisfy one of the following exemption situations: (i) the CFC is located in a non-low-tax rate jurisdiction designated by the SAT (i.e. white list jurisdictions);37 (ii) the CFC primarily derives income through active business activities; or (iii) the CFC’s annual profits do not exceed RMB 5 million.

35. Art. 91 EITL Implementation Rules. 36. Art. 45 EITL 2007. 37. The white list countries are Australia, Canada, France, Germany, India, Italy, Japan, New Zealand, Norway, South Africa, the United Kingdom and the United States, according to SAT Circular (Guoshuihan (2009) 37).

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13.2.4.2. Other domestic anti-abuse rule targeted on IP income sourced in/connected to tax havens or countries with privileged tax regimes The OECD BEPS Project has influenced the development of China’s antitax avoidance rules, in particular the transfer pricing rules. Payments of royalties or capital gains paid between related companies in China, especially the payment from Chinese payers to foreign receivers, are particularly the focus for Chinese tax authorizes applying China’s transfer pricing and general anti-avoidance rules. For example, the SAT has instructed its local branches to investigate whether excessive fees were being paid by the Chinese subsidiaries of multinational companies to their foreign affiliates in respect of interest, service charges, management and technical fees, and royalties.38 Furthermore, following China introducing the concept of “location specific advantages” (LSAs) from the UN Transfer Pricing Manual in 2013,39 the Chinese tax authorities have put more effort into investigating whether multinational companies have allocated “reasonable profits” to China, in particular for the outcome of their R&D centres located in China.40 In addition, in March 2017, the SAT issued the updated Bulletin on Administrative Measures for Special Tax Investigations and Adjustments and the Mutual Agreement Procedure (SAT Bulletin [2017] No. 6),41 which expressly reflects the result of the BEPS report that “the place where profit and economic activities occur matches the place of value creation”. It is in this new Bulletin (SAT Bulletin [2017] No. 6) that the SAT extended the definition of intangibles in China for tax purposes to include both application intangibles (e.g. local efforts to make technological improvements to the production process) and marketing intangibles (related to local marketing activities). The royalty received or paid by an enterprise in connection with the transfer of the right to use the intangible assets with its related party shall therefore be commensurate with the economic benefits brought by the intangible assets for the enterprise or its related party. Where the royalty 38. SAT, Notice on Conducting Anti-Tax Avoidance Investigation on Excessive Payment to Abroad (Circular 146 [2014]), issued on 29 July 2014 and SAT, Announcement on Issues concerning Enterprise Income Tax on Expenses Paid by Enterprises to Their Overseas Affiliates (Announcement No. 16 [2015]), enacted on 18 Mar. 2015. 39. UN, Practical Manual on Transfer Pricing for Developing Countries, ST/ESA/347 (UN 2013). 40. SAT, Jiangsu Provincial Office, 2016-2018 Compliance Plan on International Tax Administration (Suguoshuifa [2016] No. 125), published and with effect on 30 May 2016. 41. CN: China (People’s Rep.) - SAT Announcement Gong Gao (2017) No. 6 on Administrative Rules for Special Tax Investigation and Adjustment and Mutual Agreement Procedures (issued 28 Mar. 2017), National Legislation IBFD.

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involved is not commensurate with the economic benefits, resulting in the reduction of the taxable incomes or earnings of the enterprise or its related party, the tax authority shall make a special tax adjustment. Where no economic benefits have been brought in and the arm’s length principle is not complied with, the Chinese tax authority may make a special tax adjustment in the full amount according to the amount which has been deducted before tax. In the case that an enterprise pays the royalty to a related party that only owns the tangible assets, however, but does not make any contribution to the value thereof, which does not comply with the arm’s length principle, the tax authority may make a special tax adjustment in the full amount according to the amount which has been deducted before tax. Furthermore, this new Bulletin clarifies that for tax purposes, the legal ownership of intangibles alone no longer determines entitlement to a return on the intangible, thus having legal ownership alone on intangibles is disallowed to generate a right to all (or indeed any) of the return that is generated by the exploitation of the intangibles. When assessing the contribution by an enterprise and its related parties to the value of intangible assets and the corresponding distribution of benefits, the tax authority shall comprehensively analyse the global operation process of the enterprise group to which the enterprise belongs, taking into account the full value of the contribution made by all parties to the development of intangible assets, the value increment, maintenance, protection, application and promotion, the realization of the value of intangible assets and the interaction of intangible assets with other business functions, risks and assets within the enterprise group. If the enterprise possesses only the ownership of intangible assets and does not contribute to the value of intangible assets, it shall not participate in the distribution of proceeds of intangible assets. In the course of the formation and use of intangible assets, if the enterprise only provides funds, however, but does not actually perform the relevant functions or assume the corresponding risks, it should only be entitled to a reasonable return on capital. In other words, royalties’ payments must match the economic benefits brought by the intangible assets to the payer. In addition, this new Bulletin expressly provides that the Chinese tax authorities are empowered to make an adjustment on the amount of the royalties paid between affiliated parties if (i) there are fundamental changes in the value of the intangible assets, (ii) according to business common practice, there should be a royalty adjustment mechanism for comparable transactions between unrelated parties, (iii) there are changes to the functions performed, risks assumed or assets used by the enterprise and its related party during the utilization of the intangible assets, and (iv) the enterprise and its 369

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related party do not receive reasonable returns for their contribution to the intangible assets in terms of the subsequent development, value enhancement, maintenance, protection, application and promotion.

13.3. Taxation of IP under tax treaties 13.3.1. Taxing rights over royalties assigned by article 12(1) In all the tax treaties China has concluded with 106 jurisdictions, the taxing right on royalties has been allocated to both the residence state and the source state, and the maximum withholding tax rate that a source state may impose varies from 5% to 15%. Clearly, this is an approach adopted from the UN Model, given that China has been (and still is) the largest country for importing foreign direct investment (FDI), it is important for China to insist on the source state having the tax right over royalties. However, following China’s increasing outbound investment in recent years, it is changing from a source state to a residence state in terms of IP incomes, in particular with some less-developed countries. Thus, China’s treaty policy has clearly changed with regard to royalties’ income with two major changes: (i) the maximum withholding tax rates on royalties’ income are decreasing and (ii) the scope of the definition of royalties becomes narrower.

13.3.1.1. Maximum withholding tax rates on royalties are decreasing The maximum withholding tax rate in the 1980s was no less than 10% (even reaching 15% in the China-Malaysia Income Tax Treaty (1985)), which was due to the fact that China at that time was in the position of source state to attract both capital and technologies. This tax rate started to change at the end of the 1990s and early 2000s when China began to invest in other countries. For example, the ChinaLaos Income Tax Treaty (1999) provides a maximum rate of 5% in the case that Laos is the source state for the royalties,42 the China-Nigeria Income Tax Treaty (2002) provides a rate of 7.5% for royalties43 and the ChinaTajikistan Income and Capital Tax Treaty (2008) provides a rate of 8%.44 42. 43. 44.

Art. 12(2)(a) PRC-Laos Income Tax Treaty (1999), Treaties IBFD. Art. 12(2) PRC- Nig. Income Tax Treaty (2002), Treaties IBFD. Art. 12(2) PRC- Taj. Income and Capital Tax Treaty (2008), Treaties IBFD

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Looking at these treaty partners (as well as some others),45 one may find that China would in most cases be in the position of a residence state when receiving royalties’ income. Given that China taxes residents on a worldwide income basis, the less withholding taxes imposed at the source state, the more taxes China could collect when crediting the source-paid taxes.

13.3.1.2. Scope of royalties becomes narrower The scope of royalties, as provided in China’s tax treaties concluded in the 1980s, 1990s and 2000s, adopted the broad definition provided in the UN Model, which typically provides as follows: The term “royalties” as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films and films or tapes for radio or television broadcasting, any patent, know-how, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience.

One exception is that the China-India Income Tax Treaty (1994) specifically provides that payment for the provision of services of managerial, technical or consultancy nature should be taxed as the “fees for technical services” rather than “royalties”. The broad definition of the UN Model has one important feature: including the payment for “use or the right to use industrial, commercial and scientific equipment” as part of “royalties”. China’s tax treaties before 2005 insisted on having all its definitions for royalties including such payment, although taxing satellite-relevant payments did cause tax disputes in China (see section 13.3.2.2.). However, starting with the China-Georgia Income and Capital Tax Treaty (2005),46 the term that the payment for “use or the right to use industrial, commercial and scientific equipment” started to disappear from some of the Chinese tax treaties, in particular from those China concluded with less-developed countries, for example, Georgia (2005), Algeria (2006), Tajikistan (2008), Turkmenistan (2009), Botswana (2012), Zimbabwe (2015) and Cambodia (2016). The typical definition for royalties with these countries is as follows: The term “royalties” as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of 45. 46.

E.g. Botswana, Cuba, Ethiopia, Georgia, Zambia and Zimbabwe. PRC-Geor. Income and Capital Tax Treaty (2005), Treaties IBFD.

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literary, artistic or scientific work including cinematography films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.

Clearly, the above definition is more of the approach in the OECD Model, which is more in favour of a residence state. China, in terms of deriving IP-relevant income from the above-mentioned countries, is indeed in the position of a residence state. Thus, the narrower the scope of royalties, the less taxes paid at the source state, the more residence tax to be paid in China.

13.3.2. Meaning of “royalties” and overlapping between articles 7 and 12 13.3.2.1. Including rental income for “the use of, or the right to use industrial, commercial or scientific equipment” in “royalties” When breaking down the definition of the term “royalties” as used in most of the Chinese tax treaties into several parts, one may find that the definition in the treaty does not go beyond the domestic private laws or the tax laws, except for the payment for “the use of, or the right to use industrial, commercial or scientific equipment”. Such payment is not treated as a royalty in both the private laws and tax laws, although China has been persistent in including such payment in most of its tax treaties (see section 13.3.1.2.). In fact, such a payment should be categorized as “rental income” under both the Individual Income Tax Law 1980 and the Enterprise Income Tax Law 2007. However, the SAT in Circular 75 made an express statement that for tax treaty purposes, “income from the use of, or the right to use, industrial, commercial or scientific equipment, for example, rental of equipment should be characterized as royalties, unless such income is the interest for payments involved in financial leasing activities”. However, the legitimacy of the SAT’s such administrative interpretation is already questionable, as the source of Chinese tax laws are messy right now. The framework of Chinese domestic tax law stands like a pyramid with three tiers.47 On the top are the four tax laws promulgated by the National People’s Congress (NPC) and its Standing Committee, which are legislative

47. D. Qiu, Legal Interpretation of Tax Law: China, in Legal Interpretation of Tax Law p. 77 (R.F. van Brederode & R. Krever eds., Kluwer Law International BV 2014).

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organs in China.48 On the second tier are the approximately 30 tax regulations enacted by the State Council, which is the highest executive organ in China. The State Council obtained such legislation power partially from the Legislation Law49 and partially from the delegated legislative power from the NPC.50 At the bottom of the pyramid are the ministerial rules and circulars in an amount of more than 5,000 enacted by the Ministry of Finance and SAT under the legislative power re-delegated from the State Council to them. These ministerial rules and circulars provide detailed rules for how to interpret and apply tax treaties in China, and the most detailed circular is the Circular 75. The SAT, however, is also the highest-level tax authority in China supervising administration work of all Chinese tax authorities throughout the country. This means that, on one hand, the SAT enacts rules and circulars deciding how the treaties should be interpreted and implemented in China, and, on the other hand, the SAT supervises all Chinese tax authorities to apply the rules and circulars it enacted. Hence, as a consequence, the SAT plays a predominant role in interpretation and application of tax treaties in China.

13.3.2.2. A tax case for conflict of qualification between “royalties” and “business income” The conflict of qualification already arose in the 1990s with regard to a US resident receiving satellite-relevant income from China, where the 48. These four tax laws are the EITL 2007, the Law on the Levying and Collection of Taxes, the IITL 1980 and the Vehicle and Vessel Tax Law. 49. Legislation Law of the People’s Republic of China, promulgated at the third Session of the Ninth National People’s Congress on 15 March 2000, and amended at the 3rd Session of the Twelfth National People’s Congress on 15 March 2015. Article 9 of this law empowers the State Council to enact administrative regulations, rules and measures to implement the tax laws promulgated by the NPC and its Standing Committee, e.g. the Regulation on Implementing the EITL 2007, promulgated on 6 December 2007; Regulation on Implementing the IITL 1980, promulgated on 28 January 1994 and amended on 19 July 2011; and the Implementing Regulations of the Vehicle and Vessel Tax Law, promulgated on 23 November 2011 and effective on 1 January 2012. 50. Decision of the NPC Standing Committee to Authorize the State Council to Reform the System of Industrial and Commercial Taxes and Issue Relevant Draft Tax Regulations for Trial Application, issued by the NPC on 18 September 1984 and repealed on 27 June 2009; Decision of the NPC on Authorizing the State Council to Formulate Interim Provisions or Regulations Concerning Economic Structural Reform and Open Policy, issued by the NPC on 10 April 1985. The delegated legislative power from the NPC to the State Council was for the latter to enact provisional regulations before the NPC formally enacted them, e.g. Provisional Regulations on the Value-added Tax, promulgated by the State Council on 13 December 1993; Provisional Regulations on Business Tax, promulgated by the State Council on 13 December 1993; and Provisional Regulations on Consumption Tax, promulgated by the State Council on 13 December 1993.

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United States claimed to apply the business profit (article 7) provision but the Chinese tax authorities argued to apply the royalties provision (article 11) of the China-United States Income Tax Treaty (1984) on the basis of this phrase that payment for “the use of, or the right to use industrial, commercial or scientific equipment”. This dispute was later brought to Chinese courts and became one of the most well-known tax treaty cases in China, referred to as “the PanAmSat case”. The facts of the case were that PanAmSat International Systems Inc. (PanAmSat) was a US tax resident, which signed a Digital Compression Television Fulltime Satellite Transmission Services Agreement in 1996 with the China Central Television (CCTV). Under this agreement, PanAmSat operated its satellite located in outer space and its ground facilities located in the United States to “provide full-time, fixed-term and non-transferable (except in the situation of unilateral priority rights) compressed digital television satellite transmission services” to CCTV.51 PanAmSat first digitally encrypted the signals received from CCTV, compressed those signals and then transmitted them to the B and C transponders of its satellites. The B and C transponders then retransmitted the signals via its downlink services to its footprint in the targeted regions (Pacific, Africa, Indian Ocean and Latin America). PanAmSat argued that the payment it received from CCTV under this agreement should be characterized as business profits (article 7) under the ChinaUnited States Income Tax Treaty (1984), because PanAmSat owned and had been actively and constantly operating all of the satellites and ground facilities used in providing the transmission services, and it undertook all risks and liabilities for transmission interruptions. As PanAmSat had no PE in China, it argued that China had no taxing rights over such business profits according to article 7 of the China-United States Income Tax Treaty, then the United Sates as the residence state of PanAmSat shall have exclusive taxing right over such PanAmSat’s business profits. However, the No. 2 Office of the Foreign Taxation Branch of the Beijing Tax Bureau (the Foreign Tax Office), the Chinese tax authorities in charge of tax matters of CCTV, claimed that such payment should be characterized as royalties, on which China may impose a withholding tax according to article 11 of the China-United States Tax Treaty (1984), and then requested CCTV to withhold the withholding taxes applicable on royalties when CCTV made the payment to PanAmSat. PanAmSat disagreed with the Foreign Tax Office’s 51. 7 International Tax Law Reports, Re PanAmSat International Systems, Inc., 7 ITLR 419.

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characterization and brought the dispute to the entire legal remedy process in China – the administrative review, the trial and the appeal – during 1999 to 2000. PanAmSat lost this case during the entire process and its income was finally taxed in China as royalties under article 11 of the China-United States Income Tax Treaty (1984). The SAT issued a circular in 1998 regarding taxing foreign companies’ income derived from leasing satellites to Chinese tenants (Circular 201).52 Circular 201 stated that all income that foreign companies receive from Chinese entities for the use of their satellite facilities shall be characterized as rental income, which should be taxed in China according to article 6 of the Implementing Rules for the Foreign Enterprise Income Tax Law.53 SAT did not explain in Circular 201 why the use of foreign-owned satellites should be treated as a leasing activity, nor did it address how to distinguish a satellite lease from the satellite transmission service. As SAT has a mixed role of being both a legislative organ and the highest tax administration authority in China, Circular 201 could be interpreted either as a tax rule SAT enacted through excising its legislative power and it could also be interpreted as a guidance SAT gave to the local Chinese tax authorities through exercising its administrative power. Although SAT did not clarify which power it was exercising when it issued Circular 201, the Chinese tax authorities have used Circular 201 as a domestic law basis to characterize foreign satellite companies’ incomes as rental incomes derived from China. 52. Circular 201 was titled Taxing Foreign Enterprises’ Income from Leasing Satellite Communication Lines (Guoshuifa [1998] No. 201). 53. The Implementing Rule of Income Tax Law of the People’s Republic of China for Enterprises with Foreign Investment and Foreign Enterprises promulgated by the State Council on 30 June 1991 and abolished on 1 January 2008. Art. 6 of this Implementing Rule provided that a list of the incomes of foreign companies with no establishment or site set up in China should be taxed in China. Rentals on property leased to and used by lessees in China was on this list. The provisions of art. 6 were “‘Income derived from sources inside China’ mentioned in Article 3 of the Tax Law refers to: (1) income from production and business operations derived by enterprises with foreign investment and foreign enterprises which have establishments or places in China, as well as profits (dividends), interest, rents, royalties and other income arising within or outside China actually connected with establishments or sites established in China by enterprises with foreign investment or foreign enterprises; (2) the following income received by foreign enterprises which have no establishments or sites in China: (a) profits (dividends) earned by enterprises in China; (b) interest derived within China such as on deposits or loans, interest on bonds, interest on payments made provisionally for others, and deferred payments; (c) rentals on property leased to and used by lessees in China; (d) royalties such as those received from the provision of patents, proprietary technology, trademarks and copyrights for use in China; (e) gains from the transfer of property, such as houses, buildings, structures and attached facilities located in China and from the assignment of land-use rights within China; (f) other income derived from China and stipulated by the Ministry of Finance to be subject to tax” [emphasis added].

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The Foreign Tax Office’s characterization of PanAmSat’s income received from CCTV as rental income in 1999 was based on Circular 201. Furthermore, the Foreign Tax Office claimed that such rental income should be taxed in China according to article 11 (royalties) of the China-United States Income Tax Treaty (1984). Article 11(3) of the China-United States Income Tax Treaty (1984) defines royalties as the “payments of any kind received as consideration … for the use of, or the right to use, industrial commercial or scientific equipment....”. The Foreign Tax Office interpreted that the “rental income” PanAmSat received from CCTV corresponded to the term “for the use of, or the right to use, industrial commercial or scientific equipment” under article 11(3) of the tax treaty. This is not only the Foreign Tax Office’s opinion for such characterization. When PanAmSat, in accordance with China’s administrative procedural law, brought the case to the Foreign Taxation Branch of the Beijing Tax Bureau, i.e. the higherlevel tax administration supervising the Foreign Tax Office’s work, for an administrative review, the Foreign Taxation Branch of the Beijing Tax Bureau in 1999 also upheld the Foreign Tax Office’s characterization to tax PanAmSat’s income in China as royalties under article 11 (royalties) of the China-United States Income Tax Treaty (1984). In PanAmSat’s view, transfer of possession and the right to use the property should be the predominate feature of a lease activity. Therefore, PanAmSat argued that the royalties’ definition of “the use of, or the right to use, industrial commercial or scientific equipment” under the China-United States Income Tax Treaty (1984) should be understood to mean the equipment is actively and effectively used by the tenant. PanAmSat’s satellites and its transponders did not transfer to CCTV and all the facilities used in the digital transmission were wholly and exclusively under PanAmSat’s control and operation. Thus, PanAmSat argued that its income received from CCTV should not be characterized as royalties derived from China. Furthermore, PanAmSat argued that its income should instead be characterized as business profits under article 7 of the China-United States Income Tax Treaty (1984). PanAmSat argued that it had been actively and constantly operating its satellite and ground facilities to provide CCTV with the transmission services; it had staff operating PanAmSat’s Carrier Supervision System for 24 hours a day to monitor each of the on-air service carrier parameters and, most importantly, PanAmSat undertook all risks and liabilities for transmission interruptions. Furthermore, PanAmSat argued that as it had no PE in China, the Chinese tax authorities should not tax its business profits according to article 7 of the China-United States Income Tax Treaty (1984).

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However, the Chinese court – the Higher People’s Court of Beijing – interpreted this payment as a consideration for granting the right for CCTV to use certain bandwidth of PanAmSat’s satellite facilities, rather than for obtaining satellite transmission services from PanAmSat. This interpretation approach is opposite to the OECD’s view since 1992, as the OECD in 1992 already deleted the provision that the payment for “use, or the right to use, any industrial, commercial or scientific equipment” from its Model Convention for definitions of royalties and, in addition, the OECD in 2000 added a paragraph to the Commentary specifically stating that satellite service income should be characterized as business income, rather than as royalties. Although China as a non-member observer state of the OECD has engaged in various discussions on the revision work of the Commentary,54 it has made a reservation on the OECD’s change of position in 1992 through deleting the term of “payments of any kind received as consideration … for the use of, or the right to use, industrial commercial or scientific equipment” from the royalties’ definition.55 Hence, in the PanAmSat case, the Higher People’s Court of Beijing did not take into account the OECD’s opinion and ruled in favour of the Beijing tax authorities to tax PanAmSat in China under the royalty’s provision under the China-United States Income Tax Treaty (1984). As a result, the court in December 2002 supported the Beijing tax authorities’ argument of characterizing the income PanAmSat derived from China as royalties rather than business income.56

13.3.3. Beneficial ownership and royalties The royalties’ provisions in all Chinese tax treaties require that the receiver must be the beneficial owner for royalties, while the term “beneficial owner” in the tax circulars issued by the SAT57 is defined as a person who has the right to own and dispose of the income and the rights or properties generated 54. J. Li, The Great Fiscal Wall of China: Tax Treaties and Their Role in Defining and Defending China’s Tax Base, 66 Bull. Intl. Taxn. 9, sec. 2.3. (2012), Journals IBFD. 55. See OECD Model Tax Convention on Income and on Capital: Commentary on Article 12, Positions on the Article para. 8 (2012). China’s reservation is to keep “the right to include in the definition of royalties payments for the use of, or the right to use, industrial, commercial or scientific equipment”. 56. CN: First Intermediate People’s Court of Beijing (BFIPC), 20 Dec. 2001, PanAmSat International Systems, Inc. v. Second Department in the External Substation of the Beijing State Tax Authority at 168 and CN: Higher People’s Court of Beijing, 20 Dec. 2002, PanAmSat International Systems, Inc. v. Second Department in the External Substation of the Beijing State Tax Authority, Gaoxingzhongzi (2002) at 24. 57. CN: Notice of the State Administration of Taxation on How to Understand and Determine the “Beneficial Owners” in Tax Agreements (Letter No. 601 [2009]), issued by the SAT on 27 October 2009 and came into force on the same day.

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from the said income. Thus, the beneficial owner may be an individual, a company or any other organization which is usually engaged in substantial business operations. Furthermore, the SAT specifically provides that an agent or a conduit company is not a “beneficial owner”.58 When the receiver of a payment of royalties applies for being entitled to the lower rate as provided in the royalties’ provision of a tax treaty,59 the Chinese tax authority shall determine on a case-by-case basis whether the income receiver qualifies as a beneficial owner by applying the substanceover-form principle. As for royalties income, the SAT in its circulars made it clear that, among the other factors,60 the following factor will put the receiver of the royalties income in a disadvantageous position in the determination of its “beneficial owner” status: there is another contract between the applicant and the third party on the right to use or own a copyright, patent or technology apart from the contract on the transfer of the right to use or own a copyright or technology, from which the royalty is generated and under which the said royalty is paid. In determining the beneficial owner, special attention shall be paid to examining, in addition to the alienation contract on the right to use copyright, patent, technology, etc. for which royalties arise and are paid, whether there are alienation contracts in terms of the right to use or ownership of copyright, patent, technology, etc. between the applicant and a third party. If the taxpayer cannot prove it being the beneficial owner, then it shall not be 58. The term “conduit company” is defined in Circular 601 as a company which is usually established for purposes of dodging or reducing taxes and transferring or accumulating profits. Such a company is only registered in the country of domicile to satisfy the organizational form as required by law, but it does not engage in such substantial business operations as manufacturing, distribution and management. 59. CN: SAT, Announcement on Issuing the Measures for the Administration of NonResident Taxpayers’ Enjoyment of the Treatment under Tax Agreements ((No. 60 [2015]). 60. These factors include (i) the applicant is obliged to pay or distribute to residents of a third country (region) the total or most of the income (e.g. 60% or more) within the prescribed time limit (e.g. within 12 months after the income is received); (ii) except for holding properties or rights generated from the incomes, the applicant does not have or hardly carries out other business operations; (iii) the applicant is a company or any other entity, but it has very few assets, is small in scale or has very few employees which are difficult to match its amount of income; (iv) as to the income or the properties or rights generated from the said income, the applicant does not have or hardly has the right to control or dispose of, and it does not bear any risk or bears very little risk; (v) the other contracting country (region) does not impose any tax on or exempts tax from the relevant income, or imposes tax on the relevant income but the actual tax is extremely low; and (vi) there is another loan or deposit contract between the creditor and the third party, of which the amount, interest rate or contract conclusion time are nearly the same as those of the loan contract, from which the interest is generated and under which the said interest is paid.

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granted with application of the tax treaty. In that case, the domestic tax law of China shall apply.

13.3.4. Anti-tax avoidance There is as yet no switch-over provision in Chinese tax treaties, so the source state shall grant tax exemption according to its domestic laws, irrespective of the income tax treatment in the resident state of the recipient. However, all Chinese tax treaties have included several paragraphs in the royalties’ provisions to counter tax avoidance through using royalties’ provisions. The first provision included in all the tax treaties is an excessive royalties’ payment provision, which restricts the application of preferential clauses in the tax treaty in associated transactions. If the royalties are overpaid by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the excessive payments that should be paid according to the arm’s length price shall not enjoy the preference in the agreement. Furthermore, in the treaties concluded after 2008, most of these has included an anti-tax avoidance clause which provides that the preferential provisions of royalty clauses of the tax treaty shall not apply to the transactions or arrangements of which the main purpose is to obtain favourable tax status. If a taxpayer improperly enjoys the treatment in the tax agreements for such transaction or arrangement, the competent tax authority shall have the right to make adjustments. In other words, the relevant provisions on special tax adjustments in the domestic laws of China shall also apply in implementation of the tax treaties. In addition, following the implementation of the OECD BEPS project, China in recent years added new anti-treaty abuse provisions into its tax treaties. For example, in 2015, for the first time, a principle purpose test (PPT) and a limitation on benefits (LOB) clause were included in the Chile-China Income Tax Treaty (2015).61 It should be noted that the preamble to the Chile-China Income Tax Treaty (2015) expressly states that the purpose of the tax treaty includes the prevention of double non-taxation.62 An LOB clause is then also included in the ChileChina Income Tax Treaty (2015) to limit the entitlement of treaty benefits 61. Agreement between the Government of the People´s Republic of China and the Government of the Republic of Chile for the Elimination of Double Taxation and the Prevention of Tax Evasion and Avoidance with Respect to Taxes on Income (25 May 2015). 62. The preamble to the PRC-Chile Income Tax Treaty (2015) states that the tax treaty should not give rise to “opportunities for non-taxation or reduced taxation through tax

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solely to those “qualified persons”.63 In addition, a PPT provision is also included with the following wording to emphasize the fact that the burden of proof should lie with the taxpayer with regard to the principle purpose of given transactions: Notwithstanding the other provisions of this Agreement, a benefit under this Agreement shall not be granted in respect of an item of income if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of this Agreement.64

However, when China signed the OECD Multilateral Convention (2016) on 7 June 2017, it only committed to apply the PPT, rather than LOB, for preventing treaty abuse. This might still reflect China’s position as a source state intending to have more discretionary power in assessing whether an abusive arrangement exists.

13.3.5. Time of taxation There is no interpretation in Chinese domestic laws with regard to the terms “paid” and “payment” as included in article 12 of the OECD Model. While Chinese domestic tax laws provide an accrual basis for calculation of income, except for certain specified types of income, however, may be recognized periodically,65 which does not include IP incomes.

13.4. Conclusion There is no evidence showing that Chinese tax laws were impacted by Chinese private laws when defining the terms relating to IP as provided in the tax treaties; and clearly both the Enterprise Income Tax Law 2007 and the Individual Income Tax Law 1980 are not adequate in defining and categorizing IP incomes for those derived in domestic circumstances as well as those derived from cross-border circumstances. This results in a situation where the SAT has to issue administrative interpretations for the evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this Agreement for the indirect benefit of residents of third States)”. 63. See art. 26(2) PRC-Chile Income Tax Treaty (2015). 64. See art. 26(5) PRC-Chile Income Tax Treaty (2015). 65. Art. 23 Regulation on Implementing the EITL 2007.

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purpose of providing certainty, but this triggers debates on the legitimacy of such SAT’s interpretations as well as concerns on its discretionary power in implementing and interpreting tax treaty provisions. The provisions on royalties in Chinese tax treaties demonstrate a trend of China’s shifting to the position of residence state, at least in the treaties China signed in recent years with those less-developed countries. This might be an opportunity for the Chinese government to review and reconcile the concepts of the terms in its tax laws and tax treaties with the concepts of its private laws, e.g. the definition of IP.

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Chapter 14 France by Mathieu Daudé1

14.1. Introduction on private law aspects of intellectual property (IP) 14.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under French private law In accordance with the French Intellectual Property Code (IPC), IP rights are composed of two categories: (i) industrial property rights and (ii) artistic or literary rights.

14.1.1.1. Industrial property rights The IPC defines three main categories of industrial property rights: (i) patents; (ii) designs or models; and (iii) trademarks. 14.1.1.1.1.  Patents Patents protect technological innovations, i.e. products or processes that provide a solution to a given technical problem. The invention for which a patent may be obtained in France from the National Institute of Industrial Property (INPI) must also be new, involve an inventive step and be susceptible of industrial application. An invention is considered new if it is not state-of-the-art. The state-of-theart consists of “everything made available to the public before the filing date of application for a patent by a written or oral description, use or any other means”. Secondly, an invention is considered to involve an inventive step if, for a person skilled in the state-of-the-art (i.e. an expert), its solution does not arise in an obvious manner from the existing state-of-the-art. Finally, an 1.

Avocat, Of Counsel, CMS Francis Lefebvre Avocats, Paris.

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invention is considered as susceptible of industrial application if its object can be made or used in any kind of industry, including agriculture (article L.611-15 of the IPC). Article L611-2 of the IPC grants the protection of inventions for a period of 20 years from the filing date of application and an exclusive right of exploitation to its owner. Once this period has elapsed, the owner of the patent loses the rights of exclusivity on the exploitation of the invention. All acts or transfer must be in writing and they must be registered with the INPI in order to be enforceable against third parties. 14.1.1.1.2.  Designs or models Designs and models benefit from a dual protection, i.e. legal protection under copyright law and under industrial property law. Any industrial object characterized by a particular aesthetic, regardless of its use or artistic value, benefits from protection by copyright (droit d’auteur) without any registration, provided that the work is original. Such copyright requires no formality of filing; it is enough for the creator to prove the anteriority of his design. Among these means of proof, it is possible to use a “Soleau envelope” for the deposit of designs or models. The advantage of filing a design or model is to obtain this dual protection: copyright protection and industrial property protection. Industrial property protection may be claimed under the following conditions: – the design or model must be new, i.e. on the filing date of application for registration or on the date of any priority claimed, no identical design or model has been disclosed; and – new designs or models must have their own character, that is, must not create a feeling of déjà vu, compared to a design or model disclosed before the date of protection granted to your application. Designs and models are protected as industrial property rights by their registration in the national register of designs and models. This title provides the depositor with a certain date of creation, gives rise to the right of priority and creates a presumption of ownership. They are protected for an initial period of 5 years, renewable for a period of up to 25 years and give the holder an exclusive right of exploitation and right to bring an action for infringement.

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14.1.1.1.3.  Trademarks A trademark is a “sign” that makes it possible to distinguish precisely between the goods or services of a company and those of its competitors. The sign can be: – denominations in all forms such as, words, assemblages of words, surnames and geographical names, pseudonyms, letters, numbers, acronyms; – sound signs such as sounds or, musical phrases; or – figurative signs such as drawings, labels, seals, selvedges, reliefs, holograms, logos, computer-generated images; forms, in particular those of the product or its packaging or those characterizing a service, arrangements, combinations or shades of colour. It is usually advised to consult the trademark register before filing a new trademark, so as to avoid potential litigation with third parties (i.e. anteriority search). A trademark can be registered in France with the INPI and in Europe with the European Intellectual Property Office. For an international trademark, it is registered through the World Intellectual Property Organization. By filing his trademark with the INPI, the applicant obtains a monopoly of exploitation on French territory for 10 years, renewable indefinitely. Aside from these three categories of rights that are protected under the IPC, French case law had granted legal value to secret formulas or processes and “know-how”. These rights do not grant a monopoly but may be enforced in case of unfair competition. It should be noted that software is not subject to an industrial property regime but is protected like artistic or literary rights.

14.1.1.2. Artistic and literary rights The natural or legal person who has created artistic or literary work benefits, without any legal formalities or registration, from an exclusive property right. The creation may take the form of text, wording, music, image, drawing, photography, film, software, or even translations, transformations or arrangements of the previously mentioned works. The property right belongs to the author of the work during all his life, then to his heirs during 70 years. It implies the right to represent the work before the public and to provide copies of the work. These rights may be sold or licensed; however, the “personality” rights also attached to a “droit d’auteur” under French

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law may not be sold. Most authors are affiliated with an organization that acts as an intermediary to manage their property rights (e.g. the Sacem, the Scad or the Scam).

14.1.2. Distinction under private law between alienation of IP and granting the right to use IP A licence agreement is an agreement between the owner of intellectual property rights (licensor) and a third party (licensee) whereby the licensor authorizes the licensee to use those rights against payment of an agreed amount (royalty). A licence agreement may be exclusive or not. It may apply worldwide or be limited to certain geographical territories only. Theoretically, all IP rights may be licensed: patents, trademarks, know-how, copyrights, software, etc. A licence agreement may be part of a wider arrangement, such as a distribution agreement or a service agreement. A trademark licence agreement may provide for specific requirements imposed on the licensee who exploits the trademark: technically speaking, this does not constitute a franchise agreement.2 Finally, an IP right may be sub-licensed. A licence agreement (i.e. granting of the right to use an IP right) differs from the transfer of the full ownership of the right. The French civil Supreme Court has considered that a trademark licence does not imply a transfer of business or clientele, even though it is concluded for an unlimited period of time. Indeed, the Court considered that the licensor retained the ownership of the business going-concern and allowed the use of its trademark only subject to certain conditions. The licensor could terminate the contract unilaterally if the licensee did not respect these conditions.3 Moreover, French private law generally does not recognize economic ownership, but only legal ownership. The legal owner of an IP asset is the one registered with the INPI.4 Only this person may license the IP asset.

2. FR: Versailles Court of Appeal, 7 Mar. 2002, RJDA 7/02 no. 829. 3. FR: Cour de Cassation (CC), 12 Jan. 1993, Bull. civ. IV p. 4. 4. Certain IP assets do not have to be registered with the INPI in order to be protected. This is the case, for instance, of copyrights.

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14.2. Taxation of IP under the domestic tax law 14.2.1. Meaning of “royalties” and qualification of income derived from utilization of IP Under French law, there is no specific tax regime applicable to royalties per se. Therefore, there is no definition of “royalties” for tax purposes under domestic law. Broadly speaking, for corporate taxpayers, royalties are subject to corporate income tax at the standard rate of 33.33%. There is therefore no distinction between the tax regime applicable to fees paid for technical assistance and to royalties. Likewise, this distinction is not relevant for withholding tax purposes either (subject to tax treaties), since the withholding tax of article 182 B of the French Tax Code (FTC) has a very broad basis and applies to service fees as well as royalties. However, domestic tax provisions contain references to certain categories of IP, since specific derogatory regimes may apply to these categories.

14.2.1.1. Scope of IP rights eligible to the favourable regime of patents (article 39 terdecies of the FTC) A favourable regime applies to patents and patentable inventions, as well as to industrial processes that are inseparable from them. The French administrative guidelines state that the notion of patent is clearly defined by the French IPC.5 Patentable inventions are defined by reference to articles L. 611-10 et seq. of the IPC, i.e. (i) the invention must be new, (ii) it must imply an inventive activity and (iii) it can be used for industrial application. The French administrative guidelines precise that certain elements may not be considered as “patentable”, including notably mathematic methods, aesthetic creations, the mere presentation of information, financial or accounting models, etc.6 The IPC itself excludes the possibility to register a patent concerning certain categories such as certain surgical or therapeutic methods applied to humans or animals, the genetic constitution of the human body or of animals, or inventions that would be contrary to good morals and public order.7 5. 6. 7.

BOI-BIC-PVMV-20-20-20-20140414, no. 10. BOI-BIC-PVMV-20-20-20-20140414, no. 110. BOI-BIC-PVMV-20-20-20-20140414, no. 230.

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The French administrative guidelines (BOI-BIC-PVMV-20-20-20201404014) go to considerable length in explaining, by reference to private law, the notion of patentable invention. The guidelines also define the notion of industrial processes that are inseparable from the patentable invention. Industrial processes that are eligible to the favourable regime are inventions that do not meet the patentability criteria but: – must constitute the result of research operations; – must be necessary to the exploitation of the patent or the patentable invention; and – must be transferred or licensed simultaneously with the patent or patentable invention, subject to the same unique contract or agreement.8 The tax definition of patents therefore corresponds to the private law definition. The guidelines have stipulated that when a contract implies the transfer of a patent or patentable invention and the provision of technical services, the proportion corresponding to the price of the latter may not benefit from the favourable regime. In other words, there are no aggregation rules that allow technical services fees to benefit from the favourable regime. When a unique price covers both the transfer/licence of a patent, and the provision of technical services, the beneficiary must split the income according to objective criteria such as the intrinsic value of the transferred assets, the acquisition cost and the cost of the services provided. The administrative guidelines9 consider that the favourable regime may apply to foreign patents under the following conditions: – the regime applies to patents registered with the European Patent Office, since they meet the same “patentability” criteria; – the regime applies to patents registered with the patent office of a foreign country provided the same invention has also been registered in France; and – if the foreign patent has not been registered in France, the favourable regime applies provided the invention meets the patentability criteria set forth by French domestic private law.

8. 9.

BOI-BIC-PVMV-20-20-20-20140414, no. 430. BOI-BIC-PVMV-20-20-20-20140414, no. 20.

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14.2.2. Qualification of income deriving from IP and applicable tax regimes 14.2.2.1. Corporate taxpayers 14.2.2.1.1.  Ordinary regime 14.2.2.1.1.1. Taxation of IP income For entities subject to corporate income tax, royalties arising from IP products are subject to corporate income tax at standard rate, unless a specific regime applies. Most IP products are therefore taxed at the standard rate of 33.33%. IP assets are generally considered as a fixed asset. The holder of an IP asset may deduct amortization expenses if the asset is expected to have a maximum fixed-term duration. Acquired trademarks are generally not amortized, unless the holder can prove that he has a limited exploitation period, for instance, if the holder has concluded a forward sale agreement with respect to this trademark. The French Supreme Court considered that the rights of a producer on its produced films constitute fixed assets and may be amortized.10 Likewise, copyrights of books acquired by a company are considered as fixed assets as long as they are exclusive rights, as they may be exploited over a long period of time and their transferability is limited.11 14.2.2.1.1.2. Taxation of capital gains made on the disposal of an IP asset Capital gains are also subject to corporate income tax at standard rate unless a specific favourable regime applies. Capital gains are calculated by withdrawing the net book value from the sale price. Therefore, sold IP assets that were amortized over time will likely generate a higher capital gain. When the IP asset is not booked as a fixed asset in the seller’s balance sheet, the whole purchase price is taxable under standard conditions. 14.2.2.1.1.3. Deduction of royalties paid in connection with IP assets Royalties paid for the use of IP are generally deductible from the paying enterprise’s taxable income. However, the deduction of excessive royalties may be challenged by the French tax authorities under the transfer pricing 10. FR: Conseil d’Etat (CE), 3 Feb. 1989, no. 58260. 11. FR: CE, 19 Mar. 2003, no. 233004, Sté La Maison de Molière.

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rules, where applicable (article 57 of the FTC, see section 14.2.4.), or under the “abnormal management” theory, which may apply when an enterprise does not act in the interest of its corporate purpose in a domestic or international context. The French tax authorities may also challenge the deduction of royalties paid by an enterprise for the use of an IP asset, if they consider that the payments correspond to the price paid for the use of a fixed asset. According to extensive case law of the French Supreme Court, an IP licence must be considered as a fixed asset when three cumulative conditions are met: – the rights granted under the licence generate income; – the rights may be transferred to a third party;12 and – the rights have a long duration (e.g. 1 year or more). When these conditions are met, the royalties paid by the licensee are not deductible, but must be booked as a fixed asset. The royalties may be amortized from a tax standpoint if the licensing contract has a fixed term or when it is expected that the period during which the licensed asset will generate income is limited in time. Depreciations may be booked in order to take into account the loss of value of the IP rights. 14.2.2.1.1.4. Transfer taxes/registration duties The licence of an exploited IP asset must generally be registered with the French tax authorities. It is subject to a fixed duty of EUR 125. The sale 12. The condition of transferability is no longer required under French accounting principles in order to recognize certain IP rights as fixed assets. However, this new accounting regulation does not apply to trademark or patent licence agreements. Therefore, the French tax authorities consider that the transferability condition continues to apply in most cases. This has been confirmed recently by the Supreme Court (FR: Conseil d’Etat (CE), 15 June 2016, no. 375446, Société D Distribution). In this case, the Court considered that a right was transferable when the licence contract only provided for an information obligation of the licensee and the express agreement of the licensor. In the Pfizer case, the Court considered that a sub-licence agreement could not be regarded as a fixed asset based on the absence of transferability, since the agreement could be terminated by the licensor without any notice, indemnity and compensation (FR: CE, 16 Oct. 2009, no. 308494, Pfizer Holding France). An early termination clause subject to the sole discretion of the licensor usually excludes the qualification of fixed asset (FR: CE, 24 Sept. 2014, no. 348214, SAS Beauté Créateurs). However, the Court has disregarded the transferability condition in the past, under specific circumstances. For instance, in the Sife case (FR: CE, 21 Aug. 1996, no. 154488, SA Sife), the Court considered that trademark licences should be considered as fixed assets when they were granted for 10 years with exclusivity, and subject to tacit renewal, even though the licence was not transferrable to a third party.

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of an exploited patent follows the same treatment. However, transfers of patents are generally subject to VAT at the standard rate of 20%. Trademark licence agreements are generally not required to be registered with the French tax authorities and are therefore not subject to registration duties. However, royalties paid for a trademark licence are generally subject to VAT. The sale of an exploited trademark is generally considered as a transfer of clientele and is therefore subject to the registration duties applicable to transfers of business and going-concerns under article 719 of the FTC, which has a marginal rate of 5%. It is usually not subject to VAT. The sale of a trademark that is not exploited and that may not be assimilated with a sale of clientele is subject to a fixed EUR 125 duty and to VAT. 14.2.2.1.2.  Favourable regime applicable to patents and assimilated The favourable tax regime of article 39 terdecies of the FRC applies to certain specific patent income as described in section 14.2.1.1. It does not apply to other IP products (trademarks, literary or artistic copyrights, etc). Eligible IP products are subject to the reduced rate of 15%, instead of the standard corporate income tax rate of 33.33%. The favourable regime applies to income resulting from the sale, licence or sub-licence of eligible IP assets. The regime applies to the “net licensing income”, i.e. net of certain costs. The French administrative guidelines consider that in order to determine such “net income”: – expenses relating to the management of the licence are deductible: this includes notably the study and advisory fees paid for the search of a licensor, the fees incurred for the negotiation of the licence (staff expenses, travel expenses, etc.), the expenses paid for the conclusion of the licence (formality and publicity costs, translation, etc.), INPI and insurance fees, and where applicable, litigation and collection expenses; and – expenses relating to the research and the amortization of the patent are not deductible. The special regime does not apply to the sale of IP rights or assets when the parties are considered to be related for the purpose of article 39(12) of the FTC, i.e. when one party holds directly or indirectly the majority of the

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share capital of the other party; when a party exercises in fact the decisionmaking powers of the other party, or when both parties are under the common influence of a same third party. The special regime does not apply to the products or IP assets: – that are not booked as fixed assets in the financial statement of the beneficiary; or – when the IP rights are sub-licensed, unless the sub-licensor is the first company to benefit from the favourable regime (i.e. the licensor does not benefit itself from the favourable regime) and if it proves that the sub-licensing operations (i) do not constitute an artificial operation aimed at circumventing French law and (ii) create value added at the level of the sub-licensing company. When the royalties paid by the licensor to the patent holder are higher than the net income earned by the sub-licensor, the excess payments are deductible from the sub-licensor’s income only up to a 15/33.33 proportion. Furthermore, when the IP assets have been acquired, the favourable regime only applies if the assets have been included in the balance sheet of the seller for at least 2 years. However, when the IP assets were created by the seller or were acquired free of charge, the 2-year minimum holding period is not required. When the patent holder and the licensee are considered as related enterprises for the purpose of article 39(12) of the FTC, the royalties paid by the licensee are deductible only if the licensee proves that the operations (i) do not constitute an artificial operation aimed at circumventing French law and (ii) create value added at the level of the licensee. When these conditions are not met, the royalties are deductible from the licensee’s income only up to a 15/33.33 proportion.

14.2.2.2. Individual taxpayers 14.2.2.2.1.  Categories of personal income tax The FTC describes the tax regimes applicable to various types of IP income earned by individuals. Broadly speaking, personal income tax is composed of several categories, which may all have different rules regarding the computation of the taxable basis, the reporting obligations or even the tax rates. The main categories that may apply in the context of IP-related income are described in the following subsections.

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14.2.2.2.1.1. Wages Wages correspond to income received by an individual in compensation for a work contract, i.e. when the individual is in a subordinated position. Wages are subject to personal income tax at progressive rates, after a 10% flat rate deduction for professional expenses. Under certain conditions, the deduction of actual expenses is allowed. 14.2.2.2.1.2. Industrial or commercial profits This corresponds to income arising from a commercial or speculative activity (provisions of services, sale of goods, etc.). This regime is applicable to sole proprietorships. It also constitutes the basis for corporate income tax, subject to provisions specific to corporate income tax. The taxable income is determined by taking all profits (including capital gains), minus all deductible expenses. The net result is determined on an accrual basis. This tax regime implies accounting obligations. 14.2.2.2.1.3. Non-commercial profits This corresponds to lucrative activities that do present per se a commercial or speculative character. Certain IP products are specifically assigned to this category according to the FTC. Moreover, this category also comprises all types of income that no not correspond to another category. Contrary to commercial and industrial profits, the taxable income is determined on the basis of flows actually arising within the fiscal year and not on an accrual basis. This tax regime implies accounting obligations. 14.2.2.2.1.4. Professional capital gains Capital gains are considered to be professional when the sold item is considered to be booked as a professional asset. These gains are taxable under the industrial or commercial profits rules. A specific reduced rate of 16% applies to “long-term” capital gains. Broadly speaking, this reduced rate applies to assets that were held for at least 2 years, up to the amount that exceeds the amortizations deducted for tax purposes. 14.2.2.2.2.  Copyrights 14.2.2.2.2.1. Ordinary regime: Non-commercial profits According to article 92(2)(2°) of the FTC, copyright income (droits d’auteur) received by authors or composers, or by their heirs, is subject to personal income tax in the category of non-commercial profits. 393

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French case law has extended this definition to copyrights arising from other artistic activities such as sculpture, photography or cinema.13 Likewise, individuals who are authors of designs and models may be considered as earning non-commercial profits. The qualification of non-commercial profits implies the production of an original and personal work. On the other hand, the mere reproduction of an artistic work, in order to sell the copies for profit, constitutes industrial and commercial profits. The qualification of photographic work depends on the nature of the underlying activity. All photographs that constitute original and personal work fall into the scope of non-commercial profits, even if they do not present an artistic character.14 However, fashion photography may fall within the scope of industrial or commercial profits if the importance of the financial investments in this activity and of the means engaged, in terms of staff and material resources, show that it corresponds more to a speculative activity than to an artistic activity.15 The income arising from the production and realization of movies by an individual, using his own technique and processes, has been qualified as non-commercial profits.16 Regarding the profits made by the heirs of a deceased artist and arising from the sale of the work produced by the artist, French case law has established that such income constitutes: – non-commercial profits when the heirs manage the artistic work in the same way as the artist would have done himself; and – industrial and commercial profits when the heirs pursue a commercial or speculative management of the artistic work.17 14.2.2.2.2.2. Option for a smoothing mechanism Article 100 bis of the FTC provides that certain income arising from literary, scientific or artistic work as well as sportsmen’s income may be taxed on the average of their income of the current year, minus the average of their deductible expenses, for the past 2 or 4 years. This option leads to a 13. BOI-BNC-CHAMP-10-10-20-20. 14. BOI-BNC-CHAMP-10-10-20-40. 15. Id. 16. FR: Cour Administrative d’Appel (CAA) Lyon, 27 Jan. 2005, Tenacci. 17. FR: CE, 23 Mar. 1988, n°48131; BOI-BNC-CHAMP-10-10-20-20, no. 10.

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reduced effect of the progressivity of personal income tax. It may be particularly interesting for persons who earn variable income. However, the option should not be exercised when the income of the previous 3 or 5 years was exceptionally high. This option is only available to the persons producing the artistic or scientific work, to the exclusion of their heirs. This option is not available for income earned by inventors or patent holders, or to income arising from the development of software. Indeed, even though software benefits from the same legal protection as copyrights, it does not constitute literary, artistic or scientific work. 14.2.2.2.2.3. Taxation of authors and composer’s copyrights as wages When copyrights are entirely paid and declared by third parties, they fall within the scope of the wages category, unless a specific option for the noncommercial profits is exercised. The taxation as wages is compatible with the smoothing mechanism of article 100 bis of the FTC. Since 2011, the wages regime is applicable to all income arising from literary, scientific or artistic work, and not only to income of authors and composers. However, artists/interpreters, such as singers, are excluded from this regime.18 Finally, copyrights received by the heirs of the author or artist are not eligible to this regime and should therefore be taxed as non-commercial profits or industrial and commercial profits (see above). The wages regime applies to copyrights that are declared by third parties: in practice, this means copyrights paid by author or artists societies, such as the SACEM or the SCAM in France. The French administrative guidelines consider that copyrights paid by a similar foreign institution to a French tax resident may benefit from the wages regime.19 The wages regime is compatible with the flat rate 10% deduction for professional expenses, as well as the deduction of actual professional expenses. These expenses are those necessary to the artistic or scientific activity and incurred in connection with the income arising from this activity, such as

18. 19.

BOI-BNC-SECT-20-10-10-10, nos. 110 and 120. BOI-BNC-SECT-20-10-20, nos. 40 and 50.

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IP or artistic material, travel expenses, documentation and information expenses, etc. 14.2.2.2.3.  Patent or trademark licence income 14.2.2.2.3.1. Professional income taxed as industrial or commercial profits When an IP right is booked as a professional asset in the balance sheet of a sole owner, profits relating to this right fall into the category of industrial and commercial profits. Moreover, when the sale or licence of an IP right constitutes the extension of a commercial activity, the entire profits of the business are taxed as commercial or industrial profits. 14.2.2.2.3.2. Income received by inventors or their heirs According to article 92(2)(3°) of the FTC, income received by inventors in compensation for a patent licence or for the sale or licence of a trademark (marque de fabrique), formula or process, is taxable in the non-commercial profits category. This rule applies when the IP right is not booked as a professional asset of a commercial enterprise (sole proprietorship) and when the income benefits to the inventor or to its heirs. This rule does not apply to income or gains arising from trade names (marques de commerce), which are always taxed as industrial or commercial profits. Income derived by software developers or creators is considered as noncommercial income. Pursuant to article 93 quater I of the FTC, income arising from the sale of rights relating to an original software may benefit from the long-term gains reduced rate of 16%. Furthermore, according to article 93 quater I of the FTC, all products within the scope of article 39 terdecies of the FTC (patents and patentable inventions – see above) are taxed according to the long-term gains regime, i.e. they benefit from a reduced 16% rate, instead of being subject to personal income tax at progressive rates. This favourable regime applies subject to the conditions described in section 14.2.2.1.2.

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14.2.3. Tax treatment of income from IP derived by nonresident taxpayers In the absence of a tax treaty, royalties paid by a French entity are subject to a withholding tax in France when they accrue to non-residents who do not have a professional installation in that state (regardless of whether they are individuals, corporations or any other entities). More precisely, according to article 182 B of the FTC, the withholding tax may apply in France when: – the payer carries out an activity in France, even if he is neither domiciled nor established; and – the beneficiary does not have a permanent professional installation in France. The withholding tax has a very broad scope and does not only cover income deriving from IP. Therefore, the distinction between IP income and income deriving from services is not relevant for the purposes of French withholding tax. Indeed, it applies to: – amounts paid in compensation for an activity carried out in France in the framework of one of the professions mentioned at article 92 of the FTC, i.e. notably copyrights (droits d’auteur), income derived from the granting of the right to use patents, income derived from the alienation of or the right to use trademarks, formulas or processes; – all the products of industrial or IP and assimilated rights; – amounts paid in compensation for services of every nature provided or used on the French territory; and – amounts (including wages) paid in connection with sport performances and services provided or used in France.20 The withholding tax is equal to 33.33% of the gross amount of the sums paid. By exception, the rate is lowered to 15% for athletes carrying out sport performances in France. If the payer assumes responsibility for the withholding tax, the benefit obtained by the beneficiary is considered to be taxable. Therefore, the withholding tax may apply on a grossed-up basis, as the case may be.

20. Amounts paid in connection with artistic performances are subject to a specific withholding tax with a 15% rate pursuant to art. 182 A bis of the FTC.

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This withholding tax does not discharge the beneficiary’s tax liability; it constitutes only an advance payment on the income tax or corporate tax payable by the beneficiary in France. Since the standard withholding rate of 33.33% is equal to the French standard corporate income tax rate, corporate beneficiaries will generally not incur additional French tax. Individual beneficiaries, however, may incur additional French tax, since the marginal rate of personal income tax reaches 45%. According to the administrative guidelines, where the amount of the withholding tax is greater than the amount of the tax actually due, the excess tax withheld cannot be repaid.21 Payments made to a creditor established in a non-cooperative state or territory (NCST) are subject to a punitive 75% withholding. NCSTs are defined under article 238-0 A of the FTC as jurisdictions that: – are not members of the European Union; – do not meet certain standards in terms of transparency and information exchange; and – have not entered into a satisfactory administrative assistance treaty with France or with at least 12 other countries. The list of the NCSTs is established every year by a ministerial decree. The last list, published on 8 April 2016, includes Botswana, Brunei, Guatemala, the Marshall Islands, Nauru, Niue and Panama. However, a safe harbour clause is available when the payer proves that the payments correspond to the remuneration of actual services or operations that have not been motivated by the shifting of profits to such jurisdiction. Within the framework of the European Union, an exemption of the 33.33% withholding tax was introduced by Amending Finance Law 200322 on the common system applicable to interest and royalty payments between associated European companies.

21. BOI-IR-DOMIC-10-20-20-50-20170306, no. 120. 22. FR: Amending Finance Law 2003-1312 of 30 December 2003 transposing into national law the Directive of 3 June 2003.

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14.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules Under article 209 B of the FTC, resident taxpayers may be subject to tax in France on their share of profits derived by a controlled foreign company (CFC). The French CFC rules apply to French entities that directly or indirectly hold a participation of more than 50% in a foreign entity that is subject to a privileged tax regime. The participation includes shares in stock companies, interest shares in a partnership or similar entity, and financial rights or voting rights held in such entities. Article 209 B of the FTC also contains an anti-abuse rule that provides that the above-mentioned 50% threshold is lowered to 5% when over 50% of the shares of the foreign entity are held by (i) enterprises established in France or (ii) enterprises directly or indirectly controlled by the French company. The 50% thresholds may also take into account the participations held by third parties that have a “community of interest” with the French company (i.e. participations held by persons under the same control or influence, participations held by employees, etc.). The French CFC rules only apply if the foreign entity is subject to a privileged tax regime. In order to determine whether an entity is subject to a privileged tax regime, the amount of (corporate income or equivalent) tax paid locally on the foreign entity’s profits should be compared with the amount of tax that it would have paid if it were established in France. If the foreign income tax burden is by 50% lower than the theoretical French income tax, the foreign entity is in principle to be regarded as subject to a privileged tax regime. In other words, the assessment of the privileged tax regime is not a mere comparison of the tax rates in France and in the foreign jurisdiction at hand. It involves computing the amount of French tax that the foreign entity would have paid if it were established in France, taking into account all French tax rules in order to determine the taxable basis (e.g. French territoriality rules, rules applicable to the deductibility of expenses, etc.) and related tax burden. Though a jurisdiction may be deemed as having a privileged tax regime, there are some exceptions (safe harbour clauses): – The first exception applies when the CFC is established in an EU Member State. In this case, the CFC rules do not apply, unless the 399

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structure is purely artificial and its sole purpose is to avoid French tax. According to administrative guidelines, an “artificial structure” is defined according to the solution provided by the European Court of Justice (ECJ) in the Cadbury Schweppes case (Case C-196/04). – A general exception also provides that if the French company is able to demonstrate that the operations of the foreign entity do not have as their main object or effect to allocate the profits in the foreign jurisdiction where it is subject to a privileged tax regime. The burden of the proof lies in the hands of the French taxpayer. According to the law, such evidence is deemed brought where the foreign entity’s main activity consists in an industrial or commercial activity effectively carried out locally in the foreign jurisdiction. The administrative guidelines provide that (i) an activity is considered as industrial if it consists mainly in the production and transformation of goods and (ii) an activity is considered as commercial if its corresponds to the acquisition of goods for resale or to the provision of services, including bank and insurance services, that do not have a civil or liberal character under French law (BOI-IS-60-10-40, n°70 to 90). For instance, in the case of a foreign entity that is the mere legal owner of patents, the French tax authorities may argue that such entity does not have an industrial or commercial activity in its jurisdiction, especially if the foreign entity does not manage itself the patents (registration, legal protection, litigation, etc.). It should be noted that prior to Law 2012-958 of 16 August 2012, article 209 B provided that an entity would automatically fall within the scope of the CFC rules if more than 20% of its profits are derived from passive financial or IP income. The French authorities used to consider that income derived from the use of, or right to use, industrial, commercial or scientific equipment was not to be regarded as passive income. Even though this provision was amended in 2012, the French authorities still scrutinize foreign entities that earn IP income. Generally speaking, a taxpayer may rely on the safe harbour clause if the CFC has employees, resources, premises, etc. in its jurisdiction. Also, for the sake of completeness, note that the EU Directive on tax avoidance of 12 July 2016 contains a CFC provision. Attention should therefore be paid to the potential consequences of the transposition of such directive into French law, although at this stage, most commentators believe that the implementation of this directive should not require amendments to article 209 B of the FTC. 400

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14.3. Taxation of IP under EU law 14.3.1. Issues of compatibility of domestic tax law with EU law As described above, non-residents are subject to article 182 B withholding at the rate of 33.33% on a gross basis. Therefore, they are unable to deduct their professional expenses from the basis of the withholding tax. However, resident taxpayers who receive the same income are subject to corporate income tax on a net basis. In other words, from a French tax standpoint, non-residents taxpayers are treated in a less favourable way than resident taxpayers. The ECJ has considered that if the mechanism of a withholding tax on service fees is compatible with the principle of free movement of services, it is only the case where the professional expenses incurred directly in connection with these services may be deducted from the basis of the tax.23 This principle has been applied by the ECJ to the case of a withholding tax on interest paid by a Portuguese company to an Irish bank. The ECJ considered in this case that the deduction of professional expenses must be allowed under the same conditions as for resident taxpayers.24 The French tax authorities have not endorsed this approach and continue to apply article 182 B withholding on a gross basis. However, administrative guidelines regarding the tax treatment of outbound flows to Denmark, following the termination of the Denmark-France Income and Capital Tax Treaty (1957), state that article 182 B withholding applies on a net basis, after deduction of professional expenses.25 Although this has not been specifically judged by the French Supreme Court, we consider that valid arguments may lead to claim the application of the withholding tax on a net basis.

23. DE: ECJ, 3 Oct. 2006, Case C-290/04, FKP Scorpio Konzertproduktionen GmbH v. Finanzamt Hamburg-Eimsbüttel, ECJ Case Law IBFD. 24. PT: ECJ, 13 July 2016, Case C-18/15, Brisal – Auto Estradas do Litoral SA et KBC Finance Ireland v. Finanzamt Hamburg-Eimsbüttel, ECJ Case Law IBFD. 25. BOI-INT-CVB-DNK-20120912, no. 150.

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14.3.2. Open issues in the implementation of the Interest and Royalty Directive 14.3.2.1. The notion of “royalties” included in article 2(b) of the Interest and Royalty Directive The provisions of the EU Interest and Royalty Directive (hereinafter I&R Directive) have been transposed in article 182 B bis of the FTC, applicable to payments made as from 1 January 2004. Under article 182 B bis, royalties paid to an associated EU enterprise are exempt from withholding tax. Royalties are defined in article 182 B bis by reference to the I&R Directive, which itself is inspired from the OECD Model. Article 182 B bis applies to: Payments of any kind received as a consideration for the use of, or the right to use, any copyright [droit d’auteur in French text] of literary, artistic or scientific work, including cinematograph films and software, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience; payments for the use of, or the right to use, industrial, commercial or scientific equipment.

It should be noted that alienation of such IP rights or assets does not fall within the scope of the article 182 B bis exemption. Two companies are “associated companies” if (i) one of them has a direct minimum holding of 25% in the capital of the other or (ii) a third EU company has a direct minimum holding of 25% in the capital of the two companies. The relevant companies must have a legal form listed in the Annex of the I&R Directive and be subject to a corporate income tax. A minimum holding period of 2 years is required. The withholding exemption also applies to royalties paid to an associated enterprise established in Switzerland, in accordance with the EU-Switzerland agreement of 26 October 2004.

14.3.2.2. The introduction of a “minimum effective taxation clause” France has not introduced an actual “minimum effective taxation clause”. However, the exemption set forth by article 182 B bis of the FTC is subject to conditions provided at article 119 quater of the FTC. Pursuant to this article, the exemption may be granted if the beneficiary company is subject 402

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to corporate income tax on the royalties received in the Member State where its place of effective management is located, without being tax exempted. This wording implies that the beneficiary of the payment must be subject to corporate income tax in order for the exemption to apply. Therefore, taxexempt entities such as certain funds or charities should not fall within the scope of the withholding exemption. However, French law does not provide for any specific minimum tax rate. This “liability to tax” condition is not specifically commented by French administrative guidelines; to our knowledge, there is no case law in the context of the I&R Directive. However, the similar condition existing in the context of the Parent-Subsidiary Directive is commented in the French administrative guidelines, which stipulate that the beneficiary must be subject to corporate income tax, without benefitting from an exemption, but regardless of whether a reduced rate is applicable. The same guidelines provide for an indicative list of taxes in different EU Member States that are “equivalent to corporate income tax” (BOI-RPPM-RCM-30-30-20-10-20160607). Regarding the “liability to tax” condition set forth by most tax treaties which follow the OECD Model, the Supreme Court has ruled that this condition is not fulfilled when the foreign beneficiary is tax exempt because of its status or activities,26 or is only subject to very low flat-rate taxation.27

14.3.2.3. Anti-abuse provisions Article 182 B bis exemption does not apply when, by reason of a special relationship between the payer and the beneficial owner of interest or royalties, or between one of them and some other person, the amount of the interest or royalties exceeds the amount which would have been agreed by the payer and the beneficial owner in the absence of such a relationship. The exemption only applies to the portion of royalties that would be considered as deductible under French transfer pricing rules.

26. This has been decided by the Supreme Court regarding foreign pension funds that were exempt from corporate income tax in their country of residence: FR: CE, 9 Nov. 2015, no. 371132, Santander Pensiones SA EGFP; FR: CE, 9 Nov. 2015, no. 370054, Landesätrztekammer Hessen Versorgungswerk. 27. This has been decided by the Supreme Court regarding a Lebanese “offshore company” which was technically liable to tax in Lebanon, but only on a reduced, flat rate basis: FR: CE, 20 May 2016, no. 389994, Easyvista.

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Furthermore, article 182 B bis of the FTC contains a general anti-abuse clause, whereby the exemption does not apply when two cumulative elements are met: – the royalties benefit to an entity or a permanent establishment (PE) of an entity that is directly or indirectly controlled by one or several residents of a third state; and – the only or principal objective of the chain of participation is to benefit from the withholding tax exemption. To our knowledge, there is no Supreme Court case law on the anti-abuse provision of article 182 B bis of the FTC. However, the wording of this provision is very similar to the former wording of the anti-abuse provision concerning the withholding exemption on dividends paid to EU parent companies (Parent-Subsidiary Directive prior to amending Directive 2015/121 of 27 January 2015). The withholding tax exemption on dividends has been subject to increasing scrutiny from the French tax authorities, based on this anti-abuse clause and particularly on the principal purpose test. Existing case law on this anti-abuse clause is almost systematically in favour of the French tax authorities and tends to impose very strict conditions when the beneficiary of the payment is a holding company. Generally speaking, the French authorities deny the exemption when the beneficiary company does not have a sufficient level of substance in its own jurisdiction, i.e. when it is considered as part of an artificial arrangement designed to circumvent the application of the withholding tax. Taxpayers’ justifications concerning the non-tax motives of the interposition of an EU holding company are generally not accepted, for instance: grouping of two family shareholdings,28 confidentiality reasons29 and grouping the operational control of various EU subsidiaries in one single EU holding company.30 The objective of a family reorganization was not accepted in the case of a Luxembourg holding company which did not have any premises, equipment or staff in Luxembourg.31 The French Supreme Court has denied the exemption paid to a Luxembourg company held by a Uruguay resident, when the shares of the French distributing company were contributed to the Luxembourg holding company 12 days before the exempt distribution.32 In this case, the Court also 28. 29. 30. 31. 32.

FR: CAA Versailles, 18 Apr. 2013, no. 11VE02468, Ocotea Holdings. FR: CAA Paris, 26 Apr. 2012, no. 10PA04267, Euronutrisanté. FR: CAA Marseille, 21 Dec. 2012, SAS Cameron France. Ocotea Holdings (2013). FR: CE, 23 Nov. 2016, no. 383838, Société Eurotrade Juice.

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denied the application of the reduced withholding rate set forth by the France-Luxembourg Income and Capital Tax Treaty (1958) on the basis that the Luxembourg company was not the beneficial owner of the dividends. Finally, the FTA may apply the procedure known as “abuse of law”, which is codified at article L.64 of the Tax Procedures Code, which is a sort of general anti-abuse provision. Under this procedure, the French tax authorities may disregard an arrangement that is artificial or that is exclusively tax-motivated.

14.3.2.4. Procedural issues The benefit of the withholding exemption set forth by article 182 B bis of the FTC is subject to a declaration made by the beneficiary to the payer of the royalties and to the French tax authorities, stating that it meets the conditions to benefit from the withholding exemption (article 46 quater-0 FB of the FTC). If the payer receives this declaration before the payment date, it may apply the exemption directly. In theory, if the payer is not provided with this certificate before payment date, it must withhold part of the payment in accordance with article 182 B of the FTC (i.e. 33.33% withholding rate). The beneficiary may claim the reimbursement of the undue withholding tax following the standard tax claim procedure. The claim must be filed with the French tax authorities before 31 December of the year following the one when the undue withholding tax was paid. The payer of the royalties may also file a claim before the French tax authorities. In this case, the claim must be filed before 31 December of the second year following the one when the undue withholding tax was paid. The ECJ has considered that the existence of a withholding tax on outbound interest does not, by itself, hamper the principle of freedom of establishment set forth by article 49 of the Treaty on the Functioning of the European Union (TFEU).33 The Supreme Court has adopted the same reasoning, considering that the existence of a withholding tax does not contradict the

33. BE: ECJ, 22 Dec. 2008, Case C-282/07, Belgian State v. Truck Center SA, ECJ Case Law IBFD.

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principle of freedom of establishment34 and the principle of free movement of capital.35

14.4. Taxation of IP under tax treaties 14.4.1. Taxing rights over royalties assigned by article 12(1) The repartition of taxing rights under tax treaties signed by France is generally consistent with the OECD Model.

14.4.1.1. Sourcing rules A notable issue concerns sourcing rules applicable to royalties. Indeed, the OECD Model (2014)36 does not contain any sourcing rules with respect to article 12. France has issued a reservation to the OECD Commentary on Article 12, according to which it “reserves the right, in order to fill what it considers as a gap in the Article, to propose a provision defining the source of royalties by analogy with the provisions of paragraph 5 of Article 11, which deals with the same problem in the case of interest.” Therefore, certain tax treaties signed by France depart from the OECD Model and include a sourcing rule. For instance, article 12(5) of the FranceSpain Income and Capital Tax Treaty (1995) provides: Royalties shall be deemed to arise in a Contracting State when the payer is a resident of that State. Where, however, the person paying the royalties, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base with which the right or property in respect of which the royalties are paid is effectively connected, and such royalties are borne by such permanent establishment or fixed base, then such royalties shall be deemed to arise in the State in which the permanent establishment or fixed base is situated.

For instance, if a French company has a PE in Spain, which is using for its manufacturing activities a patent licensed by another French company, the royalties would be considered as Spanish source according to the tax treaty, even though the legal entity paying the royalties is a French resident. This 34. FR: CE, 4 June 2012, no. 330075, Sté Aggreko France; FR: CE, 4 June 2012, no. 330088, Sté Aqualon France BV. 35. FR: CE, 29 Oct. 2012, no. 352209, min.c/ SA Kermadec. 36. The OECD Model will always be that of 2014, unless indicated otherwise.

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is the case if the royalties paid under the patent are effectively connected to and borne by the Spanish PE. The cost of the royalties is considered to be borne by the Spanish PE if it pays the royalties directly (i.e. if the patent is booked as an asset in the Spanish PE’s accounts), or if the Spanish PE reimburses the French seat by paying headquarter expenses. These sourcing rules may be problematical in a triangular context. For instance, if the licensing company was a Belgian resident instead of a French resident, the royalties would still be considered as Spanish source in accordance with the France-Spain Income and Capital Tax Treaty (1995), even though the legal entity paying the royalties is a Belgian resident. However, if the tax treaty between Belgium and Spain gives Belgium the right to tax the royalties, as the country of residence of the payer, a conflict will arise. Such triangular conflicts are usually not dealt with by tax treaties and domestic provisions, and in most cases, may only be resolved by mutual agreement. In the absence of any specific sourcing rules in the tax treaty (which is the most frequent case), French domestic sourcing rules apply. According to article 182 B of the FTC, the withholding tax may apply in France when the payer “carries out an activity in France”. Therefore, according to a literal reading of French domestic law, it is possible that the withholding applies even though the payer is not a resident of France. To our knowledge, the French jurisdictions and the French tax administration have not expressly dealt with this issue. However, the Supreme Court has indirectly addressed this issue in the case of a French PE of a Belgian company, which used patents for its manufacturing activity licensed by a US company.37 The French tax authorities noted that the French PE paid fees to the Belgian seat as a percentage of the royalties and considered that these payments were constitutive of French-source royalties, subject to withholding tax in France. The Supreme Court considered that since it was not justified that the fees were effectively paid to the US licensor, the withholding tax could not be levied.38 Therefore, even though the Court was not specifically asked to rule on the source of the royalties, it seemed to consider that they were French source in the case at hand. It could be concluded that when a French PE actually pays the royalties, such royalties have their source in France, whereas when the French PE only pays headquarter fees to its foreign seat, such fees are not considered as French-source royalties.

37. FR: CE, 28 Apr. 1986, no. 45505. 38. This solution would probably not be valid today as the Fr.-US Income and Capital Tax Treaty (1994) considers that royalties are deemed to be paid when they are taken into account as expenses for tax purposes in the contracting state where they arise.

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This solution, however, is not clearly expressed by the Supreme Court and should therefore be expressly confirmed. Moreover, certain authors39 consider that this analysis is irrelevant, arguing that article 182 B of the FTC does not provide for sourcing rules. Instead, these authors believe that French tax law only contains one sourcing rule, provided at article 164 B of the FTC, which defines French-source income as regards the territoriality of personal income tax. Article 164 B(II)(b) of the FTC provides that income from the disposal or the granting of the use of industrial or IP assets are considered as French source when the payer “has its domicile or is established in France”. Therefore, the conditions seem to be stricter than those of article 182 B of the FTC, according to which the withholding applies when the payer “carries out an activity in France”. To our knowledge, this inconsistency has not been addressed by case law or by French administrative guidelines.

14.4.1.2. Division of taxing rights Most tax treaties signed by France provide for an exemption of withholding tax on royalties, in accordance with the OECD Model (e.g. tax treaties currently in force with Germany, Luxembourg and the Netherlands). Some tax treaties depart from the OECD Model and allow both the source and the residence state to tax royalties. Such tax treaties usually limit the maximum withholding rate which may be applied (e.g. 5% under the France-Spain Income and Capital Tax Treaty (1995), 10% under the FranceIndonesia Income and Capital Tax Treaty (1979) or 15% under the FrancePhilippines Income Tax Treaty (1976). Certain tax treaties provide for different withholding rates depending on the nature of the payments. For instance, the Brazil-France Income Tax Treaty (1971) provides for a maximum withholding rate of 25% for royalties arising from the use of a trademark, 10% for royalties arising from the use or the right to use literary, artistic, or scientific works, and 15% in all other cases. Likewise, in order to encourage cultural exchange between states, some tax treaties signed by France provide for a specific withholding rate applicable to royalties paid for the use or the right to use literary, artistic, or scientific works. This is the case, for instance, under the Canada-France 39. F. Le Mentec, JCL Fiscal Impôts Directs Traité Fasc. N°3580, Traitement Fiscal. – Redevances (LexisNexis 1 Nov. 2016). Le Mentec is a partner in a law firm based in Paris. He received his Master’s Degree in Business and Tax Law from the University of Lyon III and currently teaches international taxation at the University of Paris I – Sorbonne.

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Income and Capital Tax Treaty (1975), which provides for an exemption of certain film royalties, instead of the 10% regular rate, and under the France-Italy Income and Capital Tax Treaty (1989), which provides for an exemption of certain royalties paid for the use or right to use of a copyright of literary, artistic or scientific work, instead of the 5% regular rate. Certain tax treaties signed by France contain a most-favoured nation clause. For instance, the application of this clause in the France-India context has been addressed by Indian case law. An Indian company was paying management fees to its French parent for the use of marketing, communication, IT, legal and recruitment services, which are subject to a 20% maximum withholding rate under the France-India Income and Capital Tax Treaty (1992). However, the India-UK Income Tax Treaty (1993) provides for a maximum withholding rate of 10% or 15% applicable to fees for any technical or consultancy services, and a withholding exemption for other fees (such as management fees). In the case at hand, the Delhi High Court considered that the management fees paid to the French company were exempt from withholding tax on the basis of the most-favoured nation clause.40

14.4.1.3. Procedural issues Unless the applicable tax treaty provides otherwise, non-residents who receive French-source royalties must provide a certificate of residence known as form 5000 and an application for the reduction of withholding rate, known as form 5003. These documents must be signed by the tax authorities of their country of residence and must be provided to the payer before the first payment of royalties in order to benefit immediately from the reduced withholding rates (so-called “simplified procedure”). If such documents are not provided in time to the payer, the French company has to apply domestic withholding rates, but a claim for reimbursement can be made in order to benefit from treaty rates (so-called “normal procedure”).

14.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 Generally speaking, tax treaties signed by France contain characterization principles that are in line with the OECD Model. The interpretation of treaty articles has been addressed by very little case law. 40. IN: High Court of Delhi, 28 July 2016, W.P. (C) 4793/2014 & CM APPL. 9551/2014, Steria India Ltd.

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14.4.2.1. Alienation of IP assets or rights Certain tax treaties signed by France depart from the OECD Model by considering that gains arising from the alienation of IP (disposal of full ownership) constitute royalties. This is notably the case of the tax treaties currently in force with Belgium, Israel, Luxembourg and the United States. For instance, the tax treaty concluded with the United States includes in the definition of royalties that “gains derived from the alienation of any such right or property described in this paragraph that are contingent on the productivity, use, or further alienation thereof”. Other tax treaties, notably with African countries, make reference to the alienation of certain IP assets or rights. In the absence of such a provision, the alienation of IP rights would in general be subject to either article 7 (business profits) or article 13 (capital gains).

14.4.2.2. Use of industrial, commercial or scientific equipment Tax treaties signed by France may include payments for the use of industrial, commercial or scientific equipment. This is the case for certain tax treaties concluded after the 1992 revision to the OECD Model, which amended this qualification (e.g. the tax treaties currently in force with Israel or Spain). This is also the case for a number of tax treaties concluded before the 1992 revision to the OECD Model (e.g. the tax treaties concluded with Brazil, Greece or Mexico). The tax treaty signed with Bulgaria provides that payments for the use of, or the right to use, industrial, commercial and scientific equipment constitute royalties, “but only to the extent such payments are made in exchange for the transfer of know-how”. In the context of the Canada-France Income and Capital tax Treaty (1975), the French Supreme Court has considered that payments made for the use of, or the right to use, industrial, commercial or scientific equipment constitute royalties within the meaning of article 12, and not real estate income dealt with under article 6, even though the rented assets were qualified as immovable property by destination under French civil law.41 In the case at hand, a French subsidiary had rented industrial premises and industrial equipment from its Canadian parent under two separate leases. The French tax authorities considered that payments for the use of the industrial equipment constituted real estate income based on an analysis of the French Civil Code. The Supreme Court considered that the applicable tax treaty stated that the term “real estate” must be interpreted within the meaning of the 41.

FR: CE, 27 May 2002, no. 125959, Société Superseal Corporation.

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law of the contracting state where it is situated, and that this law refers in the case at hand to “French tax laws”. Therefore, the civil law qualification of immovable property by destination did not affect the qualification of the income as royalties for treaty purposes.

14.4.2.3. Information concerning know-how and secret processes or industrial, commercial or scientific equipment Generally speaking, information concerning know-how and secret processes is included in the scope of the definition of royalties. A notable decision rendered by the Paris Administrative Court of Appeal has considered that amounts paid by a company in payment for strategic advice and pharmaco-clinical studies or research could not be regarded as royalties for treaty purposes.42 The court considered that in spite of the confidential character of the services, these payments did not remunerate the use of an intellectual property right and therefore could not be regarded as royalties paid for “information concerning industrial, commercial or scientific experience”. In the absence of any French PE of the service providers, the tax treaties applicable at hand43 precluded the application of French tax.

14.4.2.4. Technical services Most tax treaties signed by France do not include technical services fees in the scope of the definition of royalties. Certain treaties expressly exclude this type of fees from the scope of royalties and refer instead to the articles concerning business profits or independent professions (e.g. protocol of the tax treaty signed with Italy). Conversely, other tax treaties apply the same tax treatment to technical services fees and to royalties (such as the France-India Income and Capital Tax Treaty (1992)) or consider such fees as royalties but provide for a different withholding rate (such as the FranceMadagascar Income Tax Treaty (1983)). Finally, some tax treaties contain a specific article dealing with technical services fees (e.g. the FranceMalaysia Income Tax Treaty (1975)). When the tax treaty does not contain any specific reference to technical services fees, such payments usually fall within the scope of the business profits article. 42. FR: CAA Paris, 13 Apr. 2005, no. 00-2801, Société Parke Davis. 43. The tax treaties applicable in the case at hand were the Fr.-Switz. Income and Capital Tax Treaty (1966), the Can.-Fr. Income and Capital Tax Treaty (1975), the Austrl.-Fr. Income Tax Treaty (1976), the Fr.-Italy Income and Capital Tax Treaty (1989) and the Fr.-US Income and Capital Tax Treaty (1994).

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14.4.2.5. Transfer of software Few tax treaties signed by France expressly refer to the notion of transfer of software. For instance, the France-Russia Income and Capital Tax Treaty (1996) provides that the payments for the use or right to use of software constitute royalties, which are taxable only in the state of residence of the beneficiary of the payment. The tax treaties currently in force with Canada, the United Kingdom and the United States also include the payments for the use or right to use of software in the scope of the royalties’ definition. In the absence of specific provisions, the French tax authorities tend to consider that when a software licence is granted by the author of the software, the payments made under the licence constitute copyrights.44 Conversely, when the operation is not realized by the author of the software, it is usually analysed in the following manner. When the transfer concerns merely the right to use the software, without granting the technique necessary to the manufacture and reproduction of the software, it is usually considered as the use of industrial equipment. Therefore, it will be treated as a royalty if the relevant tax treaty includes income from the use of industrial, technical or scientific equipment in the scope of the definition of royalties; otherwise, it will be treated as business income. If the operation also entails transfer of the technology or communication of technical knowledge that enables the buyer to reproduce or modify the software, it is usually treated as a licence of know-how and treated as a royalty.

14.4.2.6. Copyrights and similar rights The French version of the OECD Model qualifies as royalty payments of any nature for the use of “droits d’auteur sur une œuvre littéraire, artistique ou scientifique”, which corresponds to copyright of literary, artistic or scientific work in the English version. This wording is generally used in tax treaties signed by France. However, the notion of “droits d’auteur” within the meaning of French law does not exactly overlap with the notion of “copyright” from a common law standpoint. Indeed, under French law, the “droits d’auteur” necessarily belong to the author of the work and may not be transferred. On the other 44. This approach results from the French administrative guidelines regarding the 1984 amendment to the Fr.-US Income and Capital Tax Treaty (2010) (Instr. Adm., 21 Jan. 1987: BOI 14 B-1-87). However, this instruction is no longer binding upon the French tax authorities.

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hand, under most common law systems, copyrights are transferable rights and are not necessarily owned by the author of the work. From a civil law standpoint, the French legislator has granted similar rights to artists-performers, producers of video-grams and phonograms, and broadcasting and television organizations.45 Although these professionals do not fall within the scope of the “droits d’auteur”, the law has granted them similar moral and patrimonial rights. From a tax standpoint, the qualification of these “similar rights” may lead to conflicts. The OECD approach adopts a broad acceptation of the term “copyrights” and includes similar rights. However, this approach should not prevail from a French standpoint since similar rights do not constitute “droits d’auteur” from a legal standpoint. Therefore, similar rights should usually fall within the scope of the articles addressing artistes and sportsmen or business profits.

14.4.2.7. Royalties paid for the use of mines, quarries and natural resources Some tax treaties explicitly address these payments (usually tax treaties signed with African countries). For instance, the France-Morocco Income Tax Treaty (1970) provides that royalties paid for the working of mines, quarries or other natural resources shall be taxable only in the contracting state in which such property, mines, quarries or other natural resources are situated.

14.4.3. Beneficial ownership and royalties Most tax treaties signed by France contain a beneficial ownership clause. However, some tax treaties do not contain an express reference to beneficial ownership (most of them signed before the inclusion of this clause in the OECD Model – such as the France-Netherlands Income and Capital Tax Treaty (1973)). However, French jurisprudence tends to interpret constructively the terms “paid to a resident” contained in most treaties and may equate it to an implicit beneficial ownership clause.46 Administrative guidelines regarding beneficial ownership are extremely brief. The French tax authorities indicated in their comments (of a general 45. FR: Law 85-660 of 3 July 1985. 46. For instance, in the context of the Fr.-Neth. Income and Capital Tax Treaty, FR: CE, 13 Nov. 1999, no. 191191, Diebold Courtage.

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scope) on the Algeria-France Income and Capital Tax Treaty (1999) that an entity which would “solely act as an intermediary, such as an agent or proxy holder interposed between the debtor and the actual creditor of the revenues”47 could not be deemed to be the effective beneficiary of the corresponding income. Administrative guidelines regarding the FranceUzbekistan Income and Capital Tax Treaty (1996) more generally state that “the meaning of the word ‘effective beneficiary’ is not narrow and must be understood in light of the context and in light of the purpose and the objectives of the tax treaty”.48 In practice, in the relatively rare situations where the issue was raised and except when a clear agency situation exists, the French authorities seem to rely both on the level of substance of the foreign beneficiary and on the level of income paid by the foreign treaty resident to another (generally non-qualifying) entity. A few case law decisions have addressed the notion of beneficial owner of royalties. For instance, a relatively old judgement49 considered that the France-Switzerland Income and Capital Tax Treaty (1966) was applicable in the case of royalties paid by a French company to a Swiss company that was not even the legal owner of the IP rights (the Swiss company had unclear relationships with the US company that owned the trademark). In a case where a French company was paying royalties to a Dutch transparent entity (CV), the French tax authorities tried to challenge the application of the France-Netherlands Income and Capital Tax Treaty (1973), arguing that the Dutch company could not be considered as the beneficial owner since it paid 68% of the royalties received to a Swiss company. The Supreme Court dismissed this argument and considered that the France-Netherlands Tax Treaty was applicable in the case at hand since the partners of the CV were Dutch residents.50

47. BOI-INT-CVB-DZA-30-20120912, no. 90. 48. BOI-INT-CVB-UZB-20-20120912, no. 120, 12 Sept. 2012. 49. FR: CE, 13 Nov. 1985, no. 44535. 50. Diebold Courtage (1999), see above. In this case, the Supreme Court ruled that the CV could not be considered as a resident of the Netherlands due to its tax transparency and to the absence of legal personality. It considered, however, that since the partners of the CV were Dutch residents, the tax treaty with the Netherlands was applicable. In the case at hand, it considered that the mere fact that 68% of the royalties were passed on to a Swiss entity was not sufficient to demonstrate the absence of beneficial ownership, since the French tax administration did not establish that this amount was exaggerated or excessive taking into account the services rendered by the Swiss entity.

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14.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state Most tax treaties do not contain any provision regarding the denial of treaty benefits on the grounds that the beneficiary of the payment enjoys reduced rates or exemptions. Treaty benefits are therefore usually granted irrespective of the income tax treatment in the state of residence. Certain tax treaties contain an anti-avoidance rule which may target situations where the beneficiary of a payment is not subject to tax on the income (e.g. Andorra-France Income Tax Treaty (2013)). Treaty benefits may be denied altogether on the basis of a recent French case law, when the foreign beneficiary is tax exempt because of its status or activities51 or is only subject to very low flat-rate taxation.52 This case law is based on the fact that such foreign beneficiaries may not be considered as “residents” for treaty purposes so long as the treaty defines the term “residence” by reference to the “liability to tax”, which is the case of most tax treaties signed by France.53 Furthermore, from a domestic law standpoint, article 238 A of the FTC may limit the deductibility of royalties paid by a French entity to a foreign person if that foreign person is subject to a favourable tax regime. A person is considered as subject to a favourable tax regime if the foreign tax on their income is less than half of the French tax that would have been due had this person been established in France. In this case, the expenses are deemed non-deductible for tax purposes, unless the French company proves that the expenses correspond to genuine operations and that they do not have an exaggerated or abnormal character.

51. This has been decided by the Supreme Court regarding foreign pension funds that were exempt from corporate income tax in their country of residence: Santander Pensiones SA EGFP (2015); Landesätrztekammer Hessen Versorgungswerk (2015). 52. This has been decided by the Supreme Court regarding a Lebanese “offshore company” which was technically liable to tax in Lebanon, but only on a reduced, flat rate basis. The Court therefore considered that art. 182 B withholding could be applied regardless of the treaty provisions. In the case at hand, the income was a technical service fee and the taxpayer claimed the application of the article concerning business profits, which should lead to an exemption in the absence of any PE in France: Easyvista (2016). 53. For instance, the Fr.-Lux. Income and Capital Tax Treaty is one of the few treaties which does not define the residence of companies by reference to the liability to tax.

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Article 238 A of the FTC may apply when the payments are made to an entity which is established in a country where it is subject to a favourable tax regime or to an account opened in a financial institution that is established in such country. The scope of article 238 A is very broad: according to French administrative guidelines, it includes: royalties for the use or right to use of patents, trademarks, designs and formulas and other similar rights. The notion of royalties must be interpreted in its broadest meaning. It covers all kinds of expenses, regardless of their designation and of their payment mode, that remunerate the acquisition in full ownership or the right to use the industrial property assets that are enumerated by the law.54

Article 238 A of the FTC also targets payments for all kinds of services (which are within the scope of the French domestic withholding tax rules, subject to the provisions of the relevant tax treaty). As a notable difference from the transfer pricing rules, it should be noted that under article 238 A of the FTC, the burden of proof is with the taxpayer. Therefore, in an article 238 A reassessment, the taxpayer has to demonstrate that the payments (i) correspond to genuine operations and (ii) are not exaggerated or abnormal in their amount. The administrative guidelines have indicated that in the context of IP: [T]he effective use and the actual usefulness of the sold or licensed patent should be proven every time an industrial property asset is involved, as well as the originality of the technical knowledge transferred and the interest found in acquiring it.55

Regarding the amount of the royalties, the guidelines state that: The taxpayer has to prove that the arrangement, which is genuine, is also balanced. The taxpayer must therefore establish all elements and justifications on the actual importance of the advantages received in exchange for the payments and show that such payments are the adequate and fair remuneration of these advantages, taking into account the amounts usually paid for similar services.56

Generally speaking, such royalties may be requalified as deemed distributions in two cases: – when the taxable income of the reassessed company is positive; or – if the taxable income of the reassessed company remains negative after adding back the excess royalties, when the beneficiary of the payment is a shareholder of the French paying company. 54. 55. 56.

BOI-BIC-CHG-80-10-20120912, no. 40, 12 Sept. 2012. BOI-BIC-CHG-80-20-20150902, no. 110, 2 Sept. 2015. BOI-BIC-CHG-80-20-20150902, no. 120, 2 Sept. 2015.

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As in the case of an article 238 A reassessment, the deemed distribution may be subject to the withholding tax on dividends, subject to tax treaties.57

14.4.5. Time of taxation Tax treaties concluded by France usually follow the OECD Model and stipulate that the treaty provisions regarding royalties apply when royalties are “paid to a resident of the other Contracting State”. Therefore, the article generally does not apply to deemed payments. However, some tax treaties signed by France depart from the OECD Model. For instance, the 1994 France-US Income and Capital Tax Treaty (1994) provides that royalties are deemed to be paid when they are taken into account as expenses for tax purposes in the contracting state where they arise.

14.4.6. Excessive royalty payments Most tax treaties signed by France contain the principle stipulated by article 12(4) of the OECD Model. Generally, if by reason of a special relationship between the payer and the beneficial owner, the amount of the royalties paid exceeds the arm’s length amount, the provisions of the article apply only to the last-mentioned amount. In such case, the excess part of the payments remains taxable according to the laws of France, subject to the other provisions of the relevant tax treaty. From a French tax standpoint, the excessive royalties are added to the French paying company’s taxable income. Such royalties may be considered as deemed distributions and may therefore be subject to the withholding tax on dividends, subject to the provisions of the tax treaty. However, even if the tax treaty does not contain such provision, the French tax authorities may issue a reassessment on the basis of domestic law. Indeed, article 57 of the FTC provides for a general transfer pricing rule, according to which the tax authorities are entitled to add back to the taxable income of French companies (or French branches of foreign companies) any profits indirectly transferred to related companies (or head offices) situated abroad. This rule applies when the foreign enterprise is controlled by the French enterprise, or when the foreign enterprise controls the French 57.

BOI-BIC-CHG-80-20-20150902, no. 227, 2 Sept. 2015.

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enterprise. It also applies when the foreign enterprise is controlled by an enterprise or group which has itself control over the enterprise outside France. The transfer pricing provisions are therefore broad enough to cover virtually any transfer within a related group of companies or branches. The French administrative guidelines have expressly indicated that excessive royalties for the use of patents, trademarks, technical assistance, etc. may lead to a transfer pricing reassessment.58 The burden of proof regarding an indirect transfer of benefits abroad is on the tax authorities.59 Generally speaking, the excess royalties may be requalified as deemed distributions in three cases: – when the taxable income of the reassessed company is positive (before or after adding back the excess royalties); or – if the taxable income of the reassessed company remains negative after adding back the excess royalties, when the beneficiary of the payment is a shareholder of the French paying company; or – if the transfer of profits abroad constitutes a hidden distribution within the meaning of article 111 c of the FTC. If one of these conditions is met, the excess royalties may be subject to French withholding tax on dividends pursuant to article 119 bis 2 of the FTC, subject to tax treaties. Some tax treaties may not include deemed distributions in the scope of their article relating to dividends.60 If the wording of the relevant tax treaty allows the application of the French withholding tax, such tax is limited by treaty rates.61 It should be noted that a regularization procedure, codified under article L 62 A of the Tax Procedures Code, may prevent the application of the withholding tax. Moreover, regardless of the transfer pricing rules, article 238 A of the FTC may limit the deductibility of royalties paid by a French entity to a foreign person, if that foreign person is subject to a favourable tax regime (see section 14.4.4.). Under article 238 A, one of the conditions to be proven by the taxpayer is that the royalties are not excessive or abnormal in their amounts. Therefore, excessive royalty payments may also fall within the scope of article 238 A (with the burden of proof on the taxpayer). 58. For instance, BOI-IS-BASE-80-20-20150902, no. 170, 2 Sept. 2015. 59. FR: CAA, 25 June 2008, no. 06-2841, Société Novartis Groupe France SA. 60. For instance, the Supreme Court has considered that deemed distributions were not within the scope of art. 10 of the Fr.-Neth. Income and Capital Tax Treaty and therefore the French withholding tax on dividends could not be applied: FR: CE, 13 Oct. 1999, no. 190083, Banque Française de l’Orient. 61. BOI-BIC-BASE-80-20-20150902, no. 410, 2 Sept. 2015.

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Chapter 15 Germany by Florian Schmid1

15.1. Introduction on private law aspects of intellectual property (IP) Although there is a general term “intellectual property” used in German federal legislation,2 there is no common understanding of the term and its details and variations. In German private law there is a general distinction between copyrights and industrial property rights: copyrights are created simply by the act of creation whereas for protection of an industrial property right an administrative act is required, which can be granted after filing upon application.3 Since both categories of rights relate to different aspects of property, they can exist accumulatively in one protected object. For example, software can be regarded as a copyright under German copyright law and at the same time be protected under patent law as a technical implementation and solution.4

15.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law The term and the legal protection of copyrights are regulated by the Federal Act on Copyright and Related Rights of 9 September 1965. There is no comprehensive harmonization by EU law so far. The scope of German copyright law encompasses literary, scientific and artistic works.5 The legislation gives several typically protected works such as linguistic (written 1. Trainee Lawyer at an international law firm in Stuttgart; Master of Laws (LLM) at Queen Mary University London in international tax law. 2. DE: Gesetz gegen den unlauteren Wettbewerb (UWG) [Law Against Unfair Competition], sec. 5(1)(3). All legislation cited refers to the current stand of the respective provision as of Sept. 2017. 3. T. Bodewig, PatG, Einleitung, in BeckOK Patentrecht para. 102 (Fitzner/Lutz/ Bodewig eds., 5th edn, 2012). 4. Example taken from Bodewig, id. at 103. 5. DE: Urheberrechtsgesetz (UrhG) [Copyright Act], sec. 1.

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works, speeches and computer programs), musical works, works of fine art, photographic works and more.6 To be protected as a copyright such work needs to be a personal intellectual creation7 requiring a result of a human thought process in contrast to the results created solely by machines or chance. It is not necessary that the creation is novel or unique, but it must show some originality.8 Parts of a creation also benefit from legal protection but its title usually does not. In German private law, there is no “work made for hire” doctrine.9 Thus, the creator must be a natural person10 and the copyright originates for the creator not the person who orders it or the employer. Copyright law in Germany grants, inter alia, the exclusive right to exploit the work, including the right of reproduction and distribution, as well as the right to publish and exploit derivative works.11 The content or the information itself, however, is not protected.12 Protection is granted by law for the entire lifetime of the creator and an additional 70 years after the death of the longest surviving co-author.13 In the event of death, the right may be inherited.14 However, in contrast to many other jurisdictions, copyright law in Germany is based on the idea that works of authorship cannot be transferred by the creator like any other piece of property or in that regard like patents or trademarks. Rather, the creator can only grant certain rights to use and exploit a work, but the right itself remains with the creator.15 Copyright licences can be granted without formal requirements. Next to usual copyrights, German copyright law also protects “copyrightrelated rights” or “related rights”, i.e. artistic and entrepreneurial works such as performance, film production, photography, broadcasting, publishing and phonogram.16 Specific provisions grant a lower degree of

6. Sec. 2(1) UrhG. 7. Sec. 2(2) UrhG. 8. DE: Bundesgerichtshof (BGH) [Federal Court of Justice], 9 May 1985, I ZR 52/83, GRUR 1985, 1041 (1047). 9. A. Klett, M. Sonntag & S. Wilske, Intellectual Property Law in Germany, 2008, Part 1, ch. 3 Copyright. 10. Sec. 7 UrhG. 11. For more details, see Klett, Sonntag & Wilske, supra n. 9, at ch. 3 C. 12. Bodewig, supra n. 3, at 101. 13. Secs. 64 and 65 UrhG. 14. Sec. 28(1) UrhG. 15. Klett, Sonntag & Wilske, supra n. 9. 16. Secs. 70-87h UrhG.

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protection, e.g. a shorter term of protection.17 However, these works gain the full protection of copyrights if they represent a personal intellectual creation. German private law grants protection to works of Germans or citizens of an EU Member State.18 In specific circumstances other foreign citizens can receive similar protection if their works are brought within the scope of the German legislation.19 In addition, extensive international conventions exist that give similar protection as domestic creators as well as a minimum standard of copyright protection.20 On the other hand, patents refer to technical inventions, thus novel creation.21 It is required that such an invention can be used commercially or is utilizable of industrial application.22 Patents and other industrial property rights such as design rights, models or trademarks must be registered to receive legal protection. Various statutes exist to regulate these property rights. An invention is novel in the meaning of the statute if it is filed before any oral or written public disclosure of the invention is made.23 To receive legal protection the creator must file an application either at the German Patent and Trademark Office or at the European Patent Office. Applicants not resident or established in Germany must appoint a patent attorney or attorney-at-law in Germany as representative.24 Having received a patent by administrative act, the creator owns a private right as personal property. Contrary to copyrights, the owner may freely transfer the right laid down in the patent to others25 or grant licences.26 A patent gives right to use the invention exclusively for 20 years after filing27 – third parties are restricted from making products, offering products on the market or using a product or method that is the subject matter of the patent.28 Any 17. For example, images right regarding non-creative images are protected only for 50 years upon publishing, sec. 72 UrhG. 18. Sec. 120 (1) and (2) UrhG. 19. Sec. 121 UrhG. 20. Berne Convention for the Protection of Literary and Artistic Works (1886); Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPS) (1994); WIPO Copyright Treaty (1996) and WIPO Performances and Phonograms Treaty (1996). 21. DE: Patentgesetz (PatG) [Patent Law], sec. 1(1). 22. Sec. 1(1) PatG. 23. Sec. 3 PatG; Klett, Sonntag & Wilske, supra n. 9, at Part 1, ch. 1, B., II., 3., a). 24. Klett, Sonntag & Wilske, id., at Part 1, ch. 1, D., I., 3., a). 25. Sec. 15(1)(2) PatG. 26. Sec. 15(2) PatG. 27. Sec. 16 PatG. 28. Sec. 9 PatG.

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of these acts without consent of the patentee constitutes an infringement of the patent. However, there are some “privileged uses” of patents that are not prohibited. Such privileged use being notably private or non-commercial purposes.29 Also, under certain circumstances based on overriding public interest compulsory non-exclusive licensing may be granted by the Federal Patent Court upon request which, however, has almost never been granted.30 As with copyrights, Germany has signed international conventions regarding the international protection of patents that grant a similar level of protection to foreign patents under certain circumstances.31

15.1.2. Distinction under private law between alienation of IP and granting the right to use IP As mentioned above, German private law follows the idea that copyrights as such cannot be transferred except in case of inheritance. However, the entitled person may grant the right to use or exploit the copyright to others.32 In this regard, the statute is also strict on the term of ownership of a copyright: only the creator himself is regarded as the owner in the legal sense. This is particularly relevant in the case of a creation of an employee or hired work. Nevertheless, a solution is provided by law for specific creations by employees, notably software programs: in this case, the creator is still seen as the legal owner but the employer receives the exclusive right to exploit the program.33 Nevertheless, a sale of a copyright is not recognized under German private law. The owner of the copyright is free in the scope of granting rights or licences in his copyright. It is particularly possible to grant a right to use for a limited period of time, exclusive or non-exclusive rights or restricted or partial rights. Patentees on the other hand are allowed to transfer their right in the patent to transferees or license the right.34 In general, the patentee as a legal owner is free to transfer the entire right or mere parts of the right depending on the contractual terms. In case these terms are unclear, the Federal Court 29. Sec. 11 PatG. 30. Klett, Sonntag & Wilske, supra n. 9, at Part. 1, ch. 1, E., II. 31. Mainly, Paris Convention for the Protection of Industrial Property (1883), Patent Cooperation Treaty (1978) and TRIPS (1994). 32. Sec. 29(2) UrhG. 33. Sec. 69b UrhG. 34. Sec. 15 PatG.

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of Justice held that only as much of the right is transferred as necessary to fulfil the purpose of the contract.35 It is also possible to transfer a right in an invention that has not yet been given legal protection in the form of a patent. Regarding licensing, the patentee is also free in the scope of contractual terms: exclusive or restricted licences are possible. Licensees are protected in the event of a transfer of the patent to a third party in that the licence does not expire prematurely.36 Other industrial property rights, such as design rights and trademarks, may be transferred similarly to patents.37 There is no specific statute for knowhow, trade secrets and industrial secrets.38 However, it is recognized in German private law that know-how as such can be the subject of a transfer.39

15.2. Taxation of IP under the domestic tax law German domestic tax law did not follow the European trend to set up a preferential tax regime for IP income. Indeed, besides Estonia, Germany is the only state without a direct tax incentive for research and development (R&D).40 There has been a minor debate on this subject due to the potential economic uplift,41 but no proposed legislation. On the contrary, the German tax authority has been trying for years to defend the tax base against preferential regimes of other states, most prominently the United Kingdom’s “patent box”. In the course of the OECD Base Erosion and Profit Shifting (BEPS) Project, Germany reached a compromise with the United Kingdom, trying to set a level playing field for income derived from IP. On 11 November 2014, the governments of Germany and the United Kingdom released a joint statement on the subject.42 This compromise, the so-called “modified nexus approach”, was adopted by the

35. DE: BGH, 31 May 2012, I ZR 73/10, GRUR 2012, 1031. 36. Sec. 15(3) PatG. 37. DE: Designgesetz (DesignG) [Act on the Legal Protection of Designs], sec. 29(1); DE: Markengesetz (MarkenG) [Trademark Act], sec. 27(1). 38. See Klett, Sonntag & Wilske, supra n. 9, at Part 1, ch. 2, A. I. 39. Bodewig, supra n. 3, at § 15 PatG at 6. 40. J. Thiede, Besitzen Patentboxregime eine Zukunft? - Eine beihilferechtliche Untersuchung, IStR 2016, p. 283. 41. It has been stated that GlaxoSmithKline invested in the United Kingdom an additional GBP 500 million because of the UK patent box regime, A. Johnson, The Beginning of the End for the UK Patent Box, GRUR Int., p. 202 (2015). 42. Johnson, id., at 201.

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OECD for BEPS Action 5 on the topic “Countering Harmful Tax Practices More Effectively”. In addition to this political approach against harmful tax competition, Germany recently introduced unique unilateral domestic anti-abuse rules regarding costs incurred by payments on IP,43 which are explained in more detail in section 15.2.2.4.

15.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP German domestic income tax law only explicitly uses the term “royalties” (Lizenzgebühren) in the provision implementing the Interest and Royalty Directive (hereinafter I&R Directive), section 50g of the Einkommensteuergesetz 1934 [Income Tax Act] (EStG 1934), amended 2017. Section 50g(3)(4)(b) of the EStG 1934 defines royalty payments as: [C]ompensation of any kind paid for the use of or the right to use intellectual property rights to literary, artistic or scientific works, including cinematographic films and software, patents, trademarks, design rights and models, plans, secret formulas or processes, or paid for information concerning industrial, commercial or scientific experiences; payments for the use of or the right to use industrial, commercial or scientific equipment are regarded as royalty payments.

Furthermore, the law stipulates in section 21(1)(3) of the EStG 1934, as a taxable event for non-business income, any income derived from “temporary granting of rights, particularly literal, artistic and trading copyrights, trading experiences …” without explicitly using the term “royalty”. Similarly, section 50a(1)(3) of the EStG 1934 paraphrases royalties as “remuneration for providing the use of or the right to use rights, especially copyrights and industrial property rights as well as commercial, technical, scientific, or similar experience, knowledge and skills, such as plans, models and processes”. Regarding the meaning of the terms “copyright” and “industrial property rights”, including patents, design rights, trademarks and similar rights, for income tax purposes, section 73a of the Income Tax Ordinance 43. DE: Einkommensteuergesetz 1934 - EStG 1934 [Income Tax Act 1934] (amended 2017), sec. 4j.

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(Einkommensteuer-Durchführungsverordnung – EstDV) refers back to the definitions and meaning of German private law (as under section 15.1.1.) where a definition exists. Nevertheless, income from all kinds of immaterial property is taxable under section 21 of the EStG 1934 as a “royalty”. The term “granting the use of or the right to use” has a meaning of its own in domestic tax law. Sub-licences are included.44 The term encompasses all kinds of granting a right without a total relinquishment or transfer of the right itself. Hence, only the temporary granting of the right is meant.45 In particular, the temporary granting must be separated from a total buy-out or any other event in which a final transfer of the right occurs. In this regard a case-by-case examination applies whether the contractual terms give rise to a final transfer or whether the right should fall back to the licensor. The scope of examination is the contractual terms, later events are disregarded.46 The starting point of the examination is a legal point of view: the granting of the right is not seen as a final transfer simply because the licensee grants a right to another party. From a legal point of view, the basic contract still only gives rise to a temporary right to use.47As already mentioned, under German private law the final transfer of copyrights is not possible. Therefore, regarding copyrights, a total buy-out cannot exist, always leading to a temporary granting of the copyright.48 For industrial property rights, however, the examination also takes into account an economic point of view.49 Irrelevant are the payment procedure and the contractual terms of payment: a licence fee can be paid in a lump-sum payment and, on the other hand, a purchase price for a buy-out can be paid by instalments. However, from an economic perspective, a final transfer of a right can also be given where the right is fully consumed at the time the legal fallback to the owner takes place because, then, the temporary transfer is equivalent to a sale.50 This can be the case when exclusivity of an 44. M. Maßbaum, in EStG/KStG, 279, sec. 50a EStG, para 58 (Herrmann/Heuer/Raupach eds., edn, May 2017). 45. E. Kulosa, in EStG, sec. 21, para 57 (Schmidt ed., 36th edn, 2017); U. Schallmoser, in EStG/KStG/GewStG, sec. 21 EStG, para. 455 (Blümich ed., 137th edn, 2017); E. Reimer, in EStG/KStG/GewStG, id., at sec. 50a EStG, para. 38. 46. DE: Bundesfinanzhof (BFH) [Federal Tax Court], 23 Apr. 2003, IX R 57/99, BFH/ NV 2003, 1311. 47. Reimer, supra n. 45. 48. Bundesministerium der Finanzen (BMF) [Federal Ministry of Finance], IV C 3 2303/09/10002 (25 Nov. 2010), para. 23 [hereinafter BMF 2010]. 49. Reimer, supra n. 45, at 38, 39; BMF 2010, id. 50. Reimer, supra n. 45, at 39.

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event or premiere is one of the main purposes of a contract.51 The Federal Tax Court saw such an event in a contract for the right to advertise in sports fields – with time lapse of the match, the economic value vanquished.52 In cases where a time element is not laid down, so that the temporal aspect is uncertain, the Federal Tax Court held that a (temporary) granting of the right to use should be assumed instead of a final transfer.53 In German domestic income tax law, the provision of services is not qualified or treated as (part of the) royalty or licence.54 These terms merely encompass the granting of the right to use, but not services, even when they are combined in a contract.55 The requirement is that the services provided are of independent content next to the granting of rights.56 This is usually the case as rendering services is an active activity whereas the granting of rights a passive one. Nevertheless, this question has to be answered on a case-by-case base.57 So in cases where assistance is provided in connection to a licence of IP, remuneration for the service is not characterized as part of the royalty. Both parts of the remuneration have to be separated for tax law purposes.58 Thus, services might be taxed separately from income derived from IP. It could represent income from the course of business as trading or commercial income. The same should apply to technical services as well as to industrial, commercial or scientific equipment or other tangible assets provided in connection with a royalty. Payments for such services would not be included within the definition of royalty itself or characterized as royalty payment under German income tax law even if paid together. Only the payment for the right to use IP is regarded as a royalty or licence fee.

51. BMF 2010, supra n. 48. 52. DE: BFH, 16 May 2001, I R 64/99, IStR 2001, p. 780. 53. DE: BFH, 7 Dec. 1977, I R 54/75, BStBl. II 1978, p. 355; DE: BFH, 23 Apr. 2003, IX R 57/99, BFH/NV 2003, p. 1311. 54. Kulosa, supra n. 45, at 57. 55. DE: BFH, 28 Jan. 2004, I R 73/02, IStR 2004, p. 344. 56. Id., at p. 345. 57. H. Grams, Anmerkung zu BFH v. 19.12.2007, IStR 2008, p. 335. 58. DE: BFH, 19 Dec. 2007, I R 19/06, IStR 2008, p. 335.

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15.2.2. Qualification of income deriving from IP and applicable tax regimes For resident taxpayers, three categories of income are contemplated under German domestic law regarding revenue arising from IP: income from letting and (usufructury) leasing (see section 15.2.2.1.), business income (see section 15.2.2.2.) and self-employment income (see section 15.2.2.3.). Most importantly, although traditionally Germany is among the states with the highest output of innovations and IP,59 there is no special tax regime in German tax law like a “patent box” or “IP box”. There has been some discussion on whether to introduce such a preferential tax regime to hold up to other European countries in this regard,60 but there has not been a legislative procedure on the introduction as this would give rise to harmful tax competition and a race to the bottom.61 Besides, the benefit of such regimes over the reallocation of tax base as a disadvantage for other countries is doubtful.62 There are also no specific R&D input incentives. Thus, no ad hoc rules for the regulation between preferential regimes and incentives are needed. The usual tax rules (with some specifics) apply to IP income and costs. German tax law generally follows a quite generous approach on the deductibility of costs: except specific anti-abuse provisions like thin capitalization rules, all costs that are connected or derived from a taxable activity are deductible.63 However, the newly introduced section 4j of the EStG 1934 limits the deductibility of royalties unilaterally (see section 15.2.2.4.).

59. T. Creed, Steuergestaltung über Lizenz- bzw. Patentboxen - Ein Auslaufmodell?, GRUR-Prax 2014, p. 346. 60. For a statement of Finance Minister Schäuble on the introduction to create a fair level playing field, see D. Schanz & A. Feller, Wieso Deutschland (fast) keine Base Erosion and Profit Shifting-Bekämpfung braucht, BB 2015, p. 865, as well as a newspaper report (in German) available at https://www.welt.de/wirtschaft/article133480597/Neue-Attackegegen-Steuertricks-der-Grosskonzerne.html. 61. For example, T. Vogel, Niederländische Innovationsbox und britische Patentbox als Instrumente steuerlicher Förderung von Forschung und Entwicklung: Vorlage für Deutschland?, IStR 2014, p. 542. 62. Id, at 547. 63. Sec. 4(4) EStG 1934.

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15.2.2.1. Income from rental and leasing Income from rental and leasing is possible (but rather seldom) in connection to income derived from IP (section 21(1)(3) of the EStG 1934). Income in this category is “income derived from the temporary granting of rights, particularly literal, artistic and trading copyrights, trading experiences….” As already mentioned, these terms refer back to the meaning of copyright, patents, trademarks, etc. in German private law. Thus, if a right to use is granted in such a right, payments are taxable. A simple example would be income such as licence fees for the licence of a patent.64 From a German tax law perspective, standard software is not regarded as a case of section 21 of the EStG 1934 as such standard software is seen as comparable to an “item”.65 Thus, the lease of standard software is regarded as a purchase or final transfer but not as a royalty. The distinction has to be made on the basis of the question whether the software is provided or developed for a large range of maybe unknown customers. On the contrary, software is not standard software where it is developed specifically for the needs of a customer.66 This distinction is unclear, particularly for recent trends or applications such as software solutions in cars.67 However, section 21 of the EStG 1934 is subsidiary to business income.68 This is most often the case. Usually, income from letting and leasing is only applied in cases where an individual has acquired a right from the creator and subsequently licenses it to a third party.69 Where someone has made an invention or created a right himself and licenses it out, German fiscal courts usually qualify income as business income or self-employed income.70 Therefore, section 21(1)(3) is of relatively little importance.71 If section 21(1)(3) applies, computation of the taxable income takes place in the form of a cash basis accounting: The received income or royalty is taken into account into the overall income of the person. Costs incurred by or in 64. Schallmoser, supra n. 45, at 456. 65. BFH, 28. Oct. 2010, IX R 22/08; DStRE 2009, p. 130. 66. M. Maßbaum & D. Müller, Aktuelle Entwicklungen im Bereich der Abzugsteuer nach § 50a EStG bei Lizenzzahlungen und Anordnung des Steuerabzugs, BB 2015, p. 3033. 67. Id., at 3034. 68. Sec. 21(3) EStG 1934. 69. Kulosa, supra n. 45, at 57. 70. For example, BFH, 5 Jan. 1992, I R 41/92, DStR 1993, p. 680; BFH 6 Nov. 1991, XI R 12/87, DStR 1992, p. 353. 71. Schallmoser, supra n. 45, at 454.

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connection to the IP income can be deducted.72 The requirements for this connection are not too high: in general, any costs induced by the respective income are deductible. Since partnerships are treated as transparent entities under German tax law, the same applies for partnerships receiving income from leasing and letting under section 21(1)(3) of the EStG 1934, which is not qualified as business income. For this to apply, the partnership must not receive business income of other sources but must only manage assets. If this is the case, the income of the transparent partnership is computed on the level of the partnership but assigned to the partners depending on their participation in the partnership. The temporal separation must be regarded here as well: section 21(1)(3) of the EStG 1934 only applies if a temporal granting or licence is given. If a final transfer or total buy-out or sale of a right takes place, a taxable event under sections 22 and 23(1)(2) of the EStG 1934 might be given. Taxable under this provision are private sales of assets if less than a year has passed between acquisition and sale. If the taxpayer used the right as a source of income, the time period is extended to 10 years.73 Since section 23 of the EStG is subsidiary to business income,74 again, the provision is of little importance in practice. Income derived from such private sales is computed as the excess of the sale price over the acquisition costs.75 For income from both section 21(1)(3) and section 23(1)(2) of the EStG 1934, the individual tax rate76 applies after computing the profits and after the addition of other items of income from other categories of income.77 In addition, a 5.5% solidarity surcharge (Solidaritätszuschlag) is imposed on the result of the individual tax.

15.2.2.2. Business income The most important category of income regarding royalties and other income derived from IP is business income. This category applies to all items 72. Sec. 9 EStG 1934. 73. Sec. 23(1)(2)(3) EStG 1934. 74. Sec. 23(2) EStG 1934. 75. Sec. 23(3) EStG 1934. 76. Sec. 32a EStG 1934. 77. German income tax law does not apply a scheduler system except for income from capital.

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of income from business. Business is defined in section 15(2) of the EStG 1934 as “an independent enduring activity undertaken with a view to profits which is a participation in the general course of business and which is not regarded as agriculture, independent personal services or other independent work”. Income from IP is most often derived from the course of business. In practice, IP, particularly patents, is often developed in the context of businesses. In these cases, business income is a given. It is irrelevant for tax purposes whether there is an entitlement to use the respective right.78 Hence, taxable income can also lie in compensation or damage payments as a surrogate for an unlicensed use.79 The category of business income applies also in the case of a “company split-up” (Betriebsaufspaltung): if the inventor or creator licenses his invention or right to a corporation that he controls and where the right subsequently represents a key asset of this company, the royalty will be qualified as business income.80 By law, income of corporations is always regarded as business income.81 So in all cases where a royalty is received by a corporation, regardless whether the licensee is a resident or non-resident,82 it represents business income. There are two methods of computation: drawing up a balance sheet83 and computing the excess of income over expenditure on a cash basis.84 A balance sheet needs to be drawn up for tax purposes if an obligation for balancing exists under any (particularly commercial law) provision. As a rule, businesses that show an annual turnover of more than EUR 600,000 or annual profits of more than EUR 60,000 are obliged to draw up a balance sheet.85 Commercial partnerships and corporations are always obliged to draw up a balance sheet. 78. Maßbaum, supra n. 44, at 58. 79. H. Kube, in EStG sec. 50a C79 (Kirchhof/Söhn/Mellinghof eds., 223rd edn, Oct. 2011). 80. BFH, 6 Nov. 1991, XI R 12/87, DStR 1992, p. 353. 81. DE: Körperschaftsteuergesetz 1976 – KStG [Corporate Income Tax Act] (amended 2015), sec. 8(2) (hereinafter KStG 1976). 82. Unlimited taxation, i.e. taxation of worldwide income. 83. Secs. 4(1), 5(1) EStG 1934. 84. Sec. 4(3) EStG 1934. 85. See M. Krumm, in Blümich, EStG/KStG/GewStG sec. 5 EStG, para. 117 (137th edn, 2017).

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IP may only be capitalized in the balance sheet for tax purposes if it was acquired with a monetary value from a third person.86 This is due to the uncertainty that would be created if self-developed or created IP would be taken into the balance sheet without having any indication of an objective and reliable value.87 The acquisition and subsequent capitalization from another company of the same group is possible, however.88 Nevertheless, even if the IP was acquired, a capitalization is denied where the future consideration is unclear or vague.89 The consequence of this is that if IP was self-developed, the costs incurred by the IP will not be depreciated on the balance sheet but taken into account as business expenses on a year-byyear basis.90 Where a balance sheet does not have to been drawn up for tax purposes, the business income of a taxpayer is calculated on the basis of the excess of business income over the connected cost, i.e. cash accounting. For this easier method of computation, the restriction for capitalization and depreciation applies as well.91 Therefore, the calculation of taxable income is made on a year-by-year basis of the income from IP and expenses in relation to the IP. The excess (or minus) is added to other business income of that taxpayer. Sales of IP are regarded as business income in the course of business as well. In contrast to private sales (as under section 15.2.2.1.) for businesses, sales or equivalent final transfers of IP always constitute a taxable event. Time lapses for taxation do not exist. Hence, for taxpayers not drawing up a balance sheet or IP that is not taken into the balance sheet¨, income is calculated as the sales price minus the respective acquisition costs. For IP capitalized in a balance sheet (thus acquired IP), the taxable income is the sales price minus the value in the balance sheet (as depreciated). The tax regime applied to such business income depends on the category of taxpayer:

86. Sec. 5(2) EStG 1934 (amended 2017). 87. BFH, 8 Nov. 1979, IV R 145/77, BStBl. II 1980, p. 146; Krumm, supra n. 85, at 521. 88. Krumm, supra. n, 85 at 534. 89. BFH, 27 Feb. 1976, III R 64/74, BStBl. II 1976, p. 529. 90. BFH, 2 Mar. 2011, II R 5/09, BFH/NV 2011, p. 1147. 91. BFH, 8 Nov. 1979, IV R 145/77, BStBl. II 1980, p. 146.

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Individuals – either doing business directly or through a transparent partnership – are taxed on basis of their respective individual tax rate. A progressive tax rate applies up to 45%.92 A 5.5% solidarity surcharge is imposed upon the tax.93 In addition, trade tax (Gewerbesteuer) can apply at a rate of about 15% depending on the individual tax rate of the competent commune. This tax is imposed on the business itself not the person running the business.94 For the definition of business, section 15(2) of the EStG 1934 as described above applies. A further requirement for trade tax is a domestic permanent establishment (PE). The definition of a PE is similar under German tax law as in international tax treaties based on the OECD Model but not identical. Whether a business is run in the meaning of the provision and whether it is run through a PE must be examined on a case-by-case base. Corporations are taxed on the basis of the Körperschaftsteuergesetz 1976 (KStG) (Corporate Income Tax Act). Income is computed generally in the same way as for businesses under the EStG 1934 as already described.95 However, specific provisions apply, yet none in particular for IP. The tax rate under the KStG 1976 is a fixed 15% rate. Solidarity surcharge of 5.5% is imposed as well. Upon a payout of dividends, a second layer of tax is imposed on the recipient depending on his attributes. For trade tax purposes, corporations are always regarded as doing business, thus trade tax applies.96 For the computation of the trade tax, in general, the taxable amount computed under the EStG 1934 or the KStG 1976 applies.97 A speciality occurs, however, for licence fees and other payments for the right to use IP: in contrast to the general deductibility of expenses related to business activity and income for trade tax purposes, a quarter of these expenses cannot be deducted and are added back to the taxable business income.98 The provision applies to expenses on temporary licences and granting of the right to use. Exempt are only expenses for licences and other rights that merely give the right to grant a right therein to a third party, which is the case for

92. Sec. 32a EStG 1934. 93. DE: Solidaritätszuschlaggesetz 1995 - SolzG 1995 [Solidarity Surcharge Act], sec. 1(4). 94. DE: Gewerbesteuergesetz 1936 - GewStG 1936 [Trade Tax Act] (amended 2017), sec. 2(1) (hereinafter GewStG 1936). 95. Sec. 7(1) KStG 1976. 96. Sec. 2(2)(1) GewStG 1936. 97. Sec. 7 GewStG 1936. 98. Sec. 8(1)(f) GewStG 1936.

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Taxation of IP under the domestic tax law

distribution licences.99 Annual expenses up to the amount of EUR 100,000 are also exempt.

15.2.2.3. Self-employment income It is also possible that income derived from IP is qualified as self-employment income under section 18 of the EStG 1934. Innovation by an individual directly or through a partnership fall within the scope of section 18. These are typically cases of “inventors”. The Federal Tax Court held that an inventor’s income from licensing who is not employed should usually be regarded as income from self-employment in the form of scientific work.100 Inventors receive business income, on the other hand, after this judgement if their work is connected to a business of the inventor. Since inventions are mostly developed in the course of or in connection to a business, most often business income as in section 15 of the EStG 1934 will apply. Self-employed persons are not legally obliged to draw up a balance sheet but they can elect to do so.101 If they do not compute their taxable income by a balance sheet, they have to compute it by calculating the excess of self-employed income over the related expenses. The method is in both situations similar to the calculation for business income (as under section 15.2.2.2.). For both methods, the restriction to capitalize self-created IP applies as well.102

15.2.2.4. Section 4j EStG: Recently introduced limitation of the deductibility of expenses for the right to use IP With effect for taxable events after 31 December 2017, the legislator has newly introduced a unique measure to unilaterally prevent base erosion by capping the deductibility of royalties paid to a licensor if the royalty is subject to a preferable tax regime and if no substantial business activity is given. Thus, section 4j of the EStG 1934 is a unilateral introduction of an OECD BEPS Action 5-equivalent measure. The German legislator thereby

99. F. Hofmeister, in Blümich, EStG/KStG/GewStG, supra n. 85, at sec. 8 GewStG, para 290. 100. DE: BFH, 2 Mar. 2011, II R 5/09, BFH/NV 2011, p. 1147; similar: DE: BFH, 5 Nov. 1992, I R 41/92, DStR 1993, p. 680. 101. See Hutter, in Blümich, EStG/KStG/GewStG, supra n. 85, at sec. 18 EStG, para 52. 102. DE: BFH, 8 Nov. 1979, IV R 145/77, BStBl. II 1980, p. 146.

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respects the compromise on the so-called “nexus approach”103 found on an international law level. The provision applies to both taxation of residents and non-residents. Furthermore, by section 8(1) of the Gewerbesteuergesetz 1936 (GewStG) (Trade Tax Act), it is taken into account for trade tax purposes as well. However, it does not apply to income that falls under the German controlled foreign company (CFC) provisions to prevent double taxation.104 Expenses for the granting of the use or the right to use of rights, particularly copyrights and industrial property rights, are under the scope of the provision. The terms and scope are equivalent to section 50a of the EStG 1934105 so that it applies to all expenses on the temporary transfer of such rights but not to the final transfer or sale of such rights or cases of consummation. It is necessary for denying the deduction that the payment is made to a connected person or entity within the meaning of section 1(2) of the Außensteuergesetz 1972 (AStG, Foreign Tax Act), which requires a direct or indirect participation or control of 25% in the other party of the contract or that a third party has such a position in regard to both contracting parties. By section 1(1)(2) of the AStG 1972, partnerships and PEs can be regarded as connected as well. If parties are not connected in that meaning, there is no cap of deductibility as it is assumed that those transactions are at arm’s length. Deductibility is capped where a royalty is subject to a preferential tax regime in the hands of the licensor that leads to an effective tax rate of less than 25%. The law unfortunately does not provide a definition of “preferential regime” but it is assumed from the context that only regimes that are specifically rendered for IP are meant.106 The provision applies only where the low taxation is due to a specific IP regime; thus, where a low taxation occurs under regular taxation, it does not apply.107 Because of section 4j(2) (2) of the EStG 1934 (amended 2017) all tax provisions are to be taken into account for the examination of whether a tax rate of less than 25% is given, such as partial exemptions. Section 4j(1)(2) of the EStG 1934 (amended 2017) expands the scope on sub-licences and other potential by-passing constructions. 103. See https://www.oecd.org/ctp/beps-action-5-agreement-on-modified-nexus-ap proach-for-ip-regimes.pdf. 104. Sec. 4j(1)(5) EStG 1934. 105. X. Ditz & C. Quilitzsch, Gesetz gegen schädliche Steuerpraktiken im Zusammenhang mit Rechteüberlassungen - die Einführung einer Lizenzschranke in § 4j EStG, DStR 2017, p. 1562. 106. Id., at 1563. 107. M. Geurts & G. Staccioli, § 4j EStG-E - das neue Abzugsverbot für Lizenzaufwendungen, IStR 2017, p. 517.

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Taxation of IP under the domestic tax law

The provision’s core is laid down in section 4j(3) of the EStG 1934 (amended 2017) that gives a dynamic108 calculation method of how much of the royalty can be deducted for tax purposes, which relies on the effective tax rate that is applied to the royalty income of the receiver. Section 4j(1) (1) of the EStG 1934 (amended 2017) explicitly states that the provision constitutes a treaty override regarding deductibility.109 To align the unilateral approach with Germany’s international tax policy and the compromise within the OECD, the legislator provided for an exception for expenses that are in line with the “nexus approach as in the final report of Action 5” of BEPS.110 Thus, R&D expenses serve as a nexus for business activity. The provision itself refers explicitly and extraordinarily to the requirements and content of the final report of BEPS Action 5, although that report uses terms that are not part of German tax law, which creates uncertainty for taxpayers.111 Since the provision is recently introduced it is not possible yet to foresee how it will be applied by the tax authorities. However, most commentators criticized the new provision, particularly since the arm’s length principle is already utilized by transfer pricing rules, hidden distribution provisions and provisions equivalent to article 9 of the OECD Model in German double tax treaties.112 The introduction is also surprising in that BEPS Action 5 does not recommend unilateral methods but requires reforming existing IP boxes and similar regimes. Therefore, the scope of section 4j of the EStG 1934 is narrowed to regimes which will not be reformed or to existing regimes until they are updated to the BEPS outcome.113

108. Id., at 514. 109. Since art. 12 of the OECD Model (2014) does not refer to the deductibility, the treaty override means the non-discrimination article (art. 24), Geurts & Staccioli, supra n. 107, at 515. However, since art. 24(4) does not prevent indirect discrimination, a treaty override is not given, Ditz & Quilitzsch, supra n. 105, at 1567. 110. Sec. 4j(1)(4) EStG 1934. 111. See C. Jochimsen, T. Zinowsky & A. Schraud, Die Lizenzschranke nach § 4j EStG Ein Gesellenstück des deutschen Gesetzgebers, IStR 2017, p. 600. 112. Ditz & Quilitzsch, supra n. 105, at 1566; Jochimsen, Zinowsky & Schraud, id., at 593. 113. Already in the process of reform: Ireland, the Netherlands and Luxembourg, Geurts & Staccioli, supra n. 107, at 514.

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15.2.3. Tax treatment of income derived from IP by nonresident taxpayers Section 49(1) of the EStG 1934 stipulates the taxable events of non-resident taxpayers irrelevant whether individuals, partnerships or corporations. Sections 49(2)(a) and (f), 3, 6 and 9 of the EStG are of relevance for IP income of non-residents.

15.2.3.1. Section 49(1)(2)(a) EStG: Business income Section 49(1)(2)(a) of the EStG 1934 encompasses business income that is originated through a domestic PE or domestic dependent agent. Both terms are widely similar to the equivalent terms in international tax law as laid down by article 5 of the OECD Model. However, both terms have a general broader meaning in German domestic tax law.114 PEs are defined for domestic tax law purposes in section 12 of the Abgabenordnung (AO, Fiscal Code). There is no negative catalogue of activities deemed not to constitute a PE as in article 5(4) of the OECD Model. Thus, from a German domestic perspective, auxiliary or preparatory activities can constitute a PE and therefore a taxable nexus in Germany as well.115 However, in contrast to the OECD Model,116 the domestic term does not encompass the mere working in premises of the employer or customer.117 Section 13 of the AO defines the dependent agent under domestic law. Contrary to article 5(5) of the OECD Model (2014) it is not necessary that the agent acts with authority and habitually exercises it.118 The controversial question whether a server constitutes a PE is of particular importance for the taxation of income derived from IP. Royalties could be taxed in Germany if a non-resident uses a server established in Germany to grant the right to use. Unfortunately for this question, the differences between the domestic and the OECD Model definition show up: there is a 114. F. Loschelder, in Schmidt, EStG, supra n. 45, at sec. 49 para. 22,30. 115. O. Jacobs, D. Endres & C. Spengel, Internationale Unternehmensbesteuerung, Dritter Teil, 3. Kapitel, A.(I.)(2.)(a) (8th edn, 2016). 116. OECD Model Tax Convention on Income and on Capital: Commentary on Article 5, Observations on the Commentary, para. 45.7 (2014). 117. Jacobs, Endres & Spengel, supra. n. 115. 118. U. Koenig, in Abgabenordnung: AO sec. 13, para. 2 (U. Koenig et al. eds., 3rd edn 2014).

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Taxation of IP under the domestic tax law

conflict of qualification since the domestic German term does not exclude auxiliary or preparatory activities.119 Under German tax law, a server can constitute a PE where the following requirements are given cumulatively: The server must give rise to a physical presence within Germany. Only the physical component of a server can constitute such a presence, the used software or immaterial components are not regarded as a fixed place in the meaning of section 12 of the AO.120 A certain duration instead of a mere temporary arrangement is necessary. Since “cloud” servers are only a virtual projection, they do not fulfil the requirement of a fixed place unless the underlying hardware is based in Germany as well.121 Such virtual servers are comparable to websites, which are usually not seen as a fixed place due to the lack of being tangible and therefore do not give rise to a PE.122 Secondly, the server must be at the disposal of the non-resident taxpayer. This is fulfilled if the taxpayer legally owns the server and can also be regarded as the economic owner. However, if a taxpayer uses a server provided by a contractor/ISP company, the server is not at his disposal. There is an argument for assuming the disposal nevertheless in the unlikely situation that the non-resident taxpayer rents a specific server at a specific location. However, even in such a case the server itself is not at the disposal of the non-resident taxpayer.123 Furthermore, the server must serve the purpose of the non-resident’s business. The threshold is not very high for this requirement under domestic tax law – servers are usually part of the chain of economic value added, particularly if transactions or licences are rendered through such a server.124 In cases where a PE is not constituted, contracting a domestic ISP company and renting a server does not make the ISP company a dependent agent.125 If a taxable presence in the meaning of section 12 or 13 of the AO is given, a limited taxation of the income derived from the taxable presence takes place. 119. Para. 42.7 OECD Model: Commentary on Article 5 (2014). 120. Jacobs, Endres & Spengel, supra. n. 115, at Dritter Teil, 3. Kapitel, A.(II.)(4.)(b) (1)(a). 121. H. Tappe, Steuerliche Betriebsstätten in der „Cloud“ - Neuere technische Entwicklungen im Bereich des E-Commerce als Herausforderung für den ertragsteuerlichen Betriebsstättenbegriff, IStR 2011, 870. 122. Para. 42.3 OECD Model: Commentary on Article 5 (2014). 123. Jacobs, Endres & Spengel, supra. n. 115, at Dritter Teil, 3. Kapitel, A.(II.)(4.)(b) (1)(b). 124. Id., at Dritter Teil, 3. Kapitel, A.(II.)(4.)(b)(1)(c); different opinion: Regional Tax Authority Karlsruhe, which took into account the auxiliary exemption of article 5(4) of the OECD Model for the domestic interpretation also, IStR 1999, p. 439. 125. Jacobs, Endres & Spengel, id.

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The limited taxation encompasses royalties and the sale of IP as all business income derived from a PE falls under the provision. For individuals, the limited taxation is based on section 49 of the EStG 1934, for corporations on section 2(1) of the KStG 1976. Regarding partnerships, the partners are taxable if the partnership owns a taxable presence.126 The derived income is attributed to the partners proportionately. The taxable income is computed on the basis of the regular computation methods depending on whether accounting is mandatory under German domestic private law.127 However, specific provisions apply due to the complexity of attributing profits to the taxable presence.128 The deduction of expenses is limited to expenses connected to domestic income.129 Non-resident individuals are generally taxed on a progressive tax rate comparable to the tax rate of residents.130 For nonresident corporations, a tax rate of 15% plus solidarity surcharge applies.131 Taxation is performed on the basis of an assessment.132 Under section 50(3) of the EStG 1934, a tax credit is granted for foreign tax on the income derived from the taxable domestic presence unless the foreign tax is an unlimited taxation. The tax credit encompasses mostly income from third states in the form of dividends, interest or royalties.133 Losses of a taxable presence can be set off with other positive income or carried forward indefinitely or carried backward 1year.134

15.2.3.2. Section 49(1)(2)(f) EStG: Business income in the form of rental, leasing or sale Section 49(1)(2)(f) of the EStG 1934 constitutes a limited taxation for cases where business income is received by a non-resident but without a taxable presence in the meaning of section 49(2a) of the EStG 1934. Thus, section 49(2)(a) takes precedence over section 49(1)(2)(f). The same meaning of business applies.135 The licensing of rights as well as the sale of rights is taxable. The meaning of renting is the same as in section 21 of the EStG 1934 (see section 15.2.2.1.); the meaning of sale has the same meaning as in section 23 of the EStG (see section 15.2.2.1.). Thus, the provision covers 126. Loschelder, supra n. 114, at 28. 127. E. Wied & E. Reimer, in Blümich, EStG/KStG/GewStG, supra n. 85, at sec. 49, para. 43. 128. Id. 129. Sec. 50(1)(1) EStG 1934. 130. Sec. 50(1)(2) EStG 1934. 131. Sec. 23(1) KStG 1976. 132. Jacobs, Endres & Spengel, supra. n. 115, at Dritter Teil, 3. Kapitel, B.(I.)(1.)(a). 133. Id. 134. Sec. 10d EStG 1934. 135. Wied & Reimer, supra n. 127, at 132.

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remuneration for both the temporary and the final transfer of IP. Cases of a consuming transfer of rights from an economic perspective are regarded as a sale under the provision.136 A limited taxation under section 49(1)(2)(f) does not in itself create a PE for the non-resident taxpayer.137 The term “rights” encompasses all rights that fall under section 21(1)(1) (3) of the EStG 1934 (see section 15.2.2.1.), particularly copyrights and industrial property rights such as patents or trademarks, with the exclusion of standard software.138 However, an internal taxable nexus is required for the limited taxation: a nexus exists under the provision where the respective right is registered in Germany. This could be the case for patents, trademarks or design rights – a register exists for these rights.139 Copyrights, however, cannot be registered under German private law but come into existence by the mere act of creation (section 15.1.1.). Furthermore, the register must be domestic – foreign or international registers are not included. Hence, the European patent register does not create a taxable nexus.140 Alternatively, a taxable nexus is given if exploitation of a right is performed via a domestic PE of another person regardless of the taxation of that person.141 The Federal Tax Court held that it is sufficient that transferred formulas and their manufacturing was done in Germany.142 If a taxable nexus is given, royalties or other payments for the right to use or profits derived from the sale of a right are taxed under German tax law. Since section 49(1)(2)(f) of the EStG 1934 takes into account business income, the computation of such income generally follows domestic provisions for business income as described above (section 4(5) of the EStG 1934, see section 15.2.2.2.).143 If depreciation on the right has taken place, the depreciated amount lowers the asset costs in case of a sale, thus leading to a higher sales price and higher taxable amount.144 Section 49(1)(2) (f) of the EStG 1934 also regards as business income any profit of such a transfer of the right to use by a foreign corporation that is regarded as similar to domestic corporations (Typenvergleich). This becomes relevant

136. Loschelder, supra n. 114, at 56. 137. Id., at 54. 138. See sec. 15.2.2.1. 139. Wied & Reimer, supra n. 127, at 207; Loschelder, supra n. 114, at 109. 140. Wied & Reimer, id. 141. DE: BFH, 5 Nov. 1992, I R 41/92, DStR 1993, p. 660; Wied & Reimer, supra n. 127, at 208. 142. BFH, id. 143. Loschelder, supra n. 114, at 59. 144. Id.

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in cases where an activity does not constitute a business activity in itself but is requalified for tax purposes if performed by a comparable corporation. An important difference to section 49 of the EStG 1934 must be seen in that no assessment takes place but the tax due is withheld upon payment under the provision of section 50a(1)(3) of the EStG 1934 if the taxable event is the granting of the right to use for a certain time, thus for royalties or licence fees for a temporary transfer. The correct withholding of tax under section 50a of the EStG 1934 has lately become more relevant in audits.145 On the contrary, remuneration for the final transfer, sale of a right or total buy-out are not withheld, but an assessment takes place. For the withholding, the formal taxpayer remains the non-resident.146 The debtor of the royalty or fee must withhold 15% of the gross payment plus solidarity surcharge, thus in total 15.825%.147 Under certain restrictions, and only for licensors from the European Union or the European Economic Area (EEA), the licensee can deduct directly connected expenses for the foreign taxpayer. However, for individuals as licensees, a higher tax rate of 30% applies on the net amount.148 The payer is liable for the tax due. For uniform payments that consist of different payments based on different grounds, a separation has to take place – only the amount paid for the granting of the right has to be withheld.149 However, due to the I&R Directive the licensor can apply for an exemption of withholding tax on royalties paid from a domestic company or PE of an EU company to a company or PE in another Member State under section 50g of the EStG 1934. In an annex, the accepted companies for each Member State are laid out, such as, for example, the société anonyme in French law, the Italian società per azioni or any corporation incorporated in the United Kingdom.150 For taxable final transfers or sales, sec. 50g(1) (2) of the EStG 1934 provides an opportunity under the same requirements to regard the royalties of the taxation in the assessment as exempt. It is necessary, however, that both the payer and the receiver of the royalty are connected companies. This means that a share of at least 25% in the capital of the company must be held or that a third company in the European Union holds in both the paying and the receiving company at least 25%.151 145. 146. 147. 148. 149. 150. 151.

Maßbaum & Müller, supra n. 66, at 3031. Sec. 50a(5)(2) EStG 1934. Sec. 50a(2) EStG 1934. Sec. 50a(3) EStG 1934. Loschelder, in: Schmidt, EStG, supra n. 45, at sec. 50a, para. 10. Anlage 3 zu § 50g EStG 1934 (amended 2013). Sec. 50g(3)(5) EStG 1934.

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Further requirements and definitions in dependence to the directive apply: the receiving company must be tax resident of the respective Member State and subject to unlimited taxation, it must also be the beneficial owner of the royalty to prevent “directive shopping”152 and the main purpose of the payment must not be of a fraudulent nature or for tax avoidance.153 The term “royalty payments” is defined in section 50g(3)(4)(b) of the EStG 1934 as:154 [C]ompensation of any kind paid for the use or the right to use of intellectual property rights in literary, artistic or scientific works, including cinematographic films and software, patents, trademarks, design rights and models, plans, secret formulas or processes, or paid for information concerning industrial, commercial or scientific experiences; payments for the use or the right to use of industrial, commercial or scientific equipment are regarded as royalties.

In its core, the term is equivalent to the term in article 12 of the OECD Model.155 Thus, fees for the right to use any kind of IP are included. But in contrast to article 12 of the OECD Model, remunerations for the right to use computer software are also included in the domestic term.156 It is not necessary that the consideration is paid in money, any consideration with a value is sufficient. However, section 50g(2) of the EStG 1934 exempts from the meaning payments that are regarded by German tax law as the distribution of profits or that are derived from a right to participate in the profits of a company. As in section 50a of the EStG 1934, in section 50g only the right to use is stipulated, thus the temporary transfer is encompassed. However, regarding payments for information on commercial, trading or scientific experiences, a separation between temporary and final transfer is not needed, making the information available is decisive. Experience in this regard means not registered or protected knowledge that was gained by activity.157 The exemption is granted only if applied for and on receipt of a certificate of exemption. If tax was withheld although the requirements were fulfilled, the tax paid is reimbursed under section 50d(1)(2) of the EStG 1934. Interest on the reimbursement is granted in certain situations.158 For cases of assessment, the royalties are exempt without having to apply for exemption.159 152. K. Wagner, in Blümich, EStG/KStG/GewStG, supra n. 85 at sec. 50g EStG, para. 47. 153. Although worded differently, the requirement has the same meaning as the general anti-abuse provision in sec. 42(1) of the Fiscal Code (Abgabenordnung, AO) (1 Jan. 2015). 154. See sec. 15.2.1. 155. Wagner, supra n. 152, at 62. 156. Id., at 62, 66. 157. Id., at 67. 158. Sec. 50d(1a) EStG 1934. 159. Wagner, supra n. 152, at 85.

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Section 50d(3) of the EStG 1934 establishes a specific anti-abuse provision and section 50d(9) provides a switch-over clause (for both, see section 15.3.1.).

15.2.3.3. Section 49(1)(3) EStG: Independent personal services Section 49(1)(3) of the EStG 1934 states an equivalent limited taxation for income from independent personal services, i.e. self-employed work. This is relevant in cases of non-resident natural “inventors” that receive domestic royalties. Income that encompasses other remuneration has to be split up.160 As a nexus, the provision requires that the independent work has been performed or exploited in Germany. Furthermore, a fixed place or PE for the work is sufficient as a nexus. Performance in Germany requires a physical presence and personal services. Exploitation in this regard means any action by which the inventor gains financial benefits, particularly the commercialization through granting of a right to use.161 In one case, the Federal Tax Court regarded the mere utilization in Germany as sufficient.162 The sale of a right from the invention could be regarded as taxable under the same requirements. Hence, the granting of a licence in a self-developed right to a domestic person by a non-resident is regularly seen as a taxable event. As a consequence, section 50a of the EStG 1934 applies with the requirement to withhold tax in the case of a temporary granting and assessment in the case of a final transfer in the same way as already described. Upon request, an exemption under section 50g of the EStG 1934 is possible as well for royalties.

15.2.3.4. Section 49(1)(6) EStG: Rental and leasing Section 49(1)(6) of the EStG 1934 stipulates a limited taxation of royalties and payments for the temporary rental and leasing of rights in cases where no business income or self-employed income is given. The provision is equivalent to section 21 of the EStG 1934 for non-residents. It is subsidiary to section 49(1)(2)(a) of the EStG 1934, thus to business income. The provision requires as a domestic nexus that the IP in which a right to use is granted is registered in Germany or exploited via a domestic PE or another

160. Loschelder, supra n. 114, at 72. 161. DE: BFH, 4 Mar. 2009, I R 6/07, IStR 2009, p. 427; DE: BFH, 28 Oct. 2009, I R 99/08, IStR 2010, p. 98. 162. DE: BFH, 5 Nov 1992, I R 41/92, DStR 1993, p. 680.

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facility. In this regard, the requirements are almost identical to section 49(1) (2)(f) (see section 15.2.3.2.). Again, section 50a of the EStG 1934 – withholding – applies with the exemption of section 50g. Where a sale or final transfer of IP by a non-resident does not give rise to business income or income from self-employment, no taxable event is given. Section 49(1)(6) of the EStG 1934 only encompasses the temporary granting but not a final transfer.163 Cases of consumption that are economically equivalent to sales are therefore also not taxable if not business or self-employed income.

15.2.3.5. Section 49(1)(9) EStG: Know-how Lastly, section 49(1)(9) of the EStG 1934 provides a taxation right for the granting of “know-how” by non-residents. Know-how is defined as “commercial, technical, scientific or similar experiences, knowledge and skills, for example plans, models and processes”. Payments for the granting are taxable if these experiences or this know-how is or was used in Germany. Section 49(1)(9) of the EStG 1934 is subsidiary to all other relevant subsections of section 49 of the EStG. It represents a “catch-all element”. Both mere experiences and not (yet) protected inventions are encompassed by the broad term. However, the focus lies on the transfer of the right to use; the transfer of know-how in the course of the performance of services is not regarded as a taxable event under the provision.164 In contrast to sub-paragraph (6), a temporal element is not required but if the transfer represents a sale, it is not taxable under sub-paragraph (9). Section 50a of the EStG 1934 applies, so the tax is collected by withholding.

15.2.3.6. Recent draft paper concerning software and databases It is important to note that recently the Federal Ministry of Finance has sent a draft paper to stakeholders regarding a uniform application of sections 49 and 50a of the EStG 1934 concerning cross-border leases of software and databases. This is due to the constant uncertainty of limited taxation and

163. Loschelder, supra n. 114, at 113. 164. Wied & Reimer, supra n. 127, at 230.

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withholding tax. As this concerns as yet a mere draft, only the relevant possible changes will be laid out by this chapter. Under the draft version, only the granting of a comprehensive right to economically use software will be encompassed under section 49 of the EStG 1934, such as the right to duplicate, modify, distribute or publish.165 Not included, thus not subject to tax, is the mere intended use of the software. Furthermore, the draft abandons the distinction between standard software and individually customized software.166 In addition, it shall be irrelevant how the software is given to the customer, e.g. by download, as a physical copy or the right to use the software on a third party’s server.167 However, payments made by a third party that hosts software for customers to the grantor of the right itself are taxable and tax is withheld.168 Of practical importance is a passage in the draft about sub-licences in a group: although the granting of the right to sub-license usually constitutes a taxable event and not only the intended use of the software, where such sub-licences’ rights are granted to a parent company, it does not give rise to limited taxation since the grantor could contract with all group companies individually.169 Therefore, it is not necessary to withhold tax on payments. It has been criticized by commentators that the draft mentions mixed payments but does not really clarify. The preliminary understanding seems to be that services in regard to software such as training, hosting server capacity and maintenance can be taxed together with the granting of the right where they fulfil merely an auxiliary function. On the contrary, royalties are not taxed separately where they represent only 10% of the mixed payment. In other cases, the draft version seems to imply that the contract has to be split up into a service and a royalty part.170 For rights in databases, the same guidelines apply with the consequence that cross-border rights to read or print do not lead to taxable events. It remains to be seen how the draft version will be updated and what the final tax authorities’ opinion will encompass.

165. A. Schnitger & M. Oskamp, Der Entwurf des BMF-Schreibens zur beschränkten Steuerpflicht und Abzugsteuer nach § 50a EStG bei grenzüberschreitender Überlassung von Software und Datenbanken, IStR 2017, p. 618. 166. Id., at 619. 167. Id. 168. Id. 169. Id. 170. Id.

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15.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules German tax law provides various mechanisms to attribute IP income derived by non-resident entities to resident taxpayers in undesirable situations.

15.2.4.1. CFC rules First of all, sections 7 to 14 of the AStG 1972 establishes the German CFC rules. The CFC regime applies to passive income – thus royalties and other payments on IP are within the scope of the provisions. A personal requirement is that a domestic taxpayer liable to unlimited taxation owns the majority of shares in the share capital (or equivalent shareholding under foreign private law) of a non-resident corporation, association or independent property fund in the meaning of the KStG 1976. It is irrelevant, however, to what percentage a single shareholder owns shares as long as the overall control of resident shareholders is more than 50%.171 The relevant date of regarding the ownership is the end of the fiscal year of the respective foreign entity. A majority can also be given if the shareholders own a majority in the voting rights.172 Indirect ownership is taken into account proportionally as well as economic ownership.173 Examples are where a person only owns a profit-sharing right but no formal right in the entity itself, such as profit participation rights/jouissance rights, silent partnerships or profit participating loans. Usually in the cases where a right to grant back the valuta exists (profit participating loan), CFC rules do not apply. It is not clear what the opinion the tax authority is in that regard, but other profit participation rights are also mostly regarded as falling out of the scope of the provisions.174 As an objective requirement, the foreign entity must receive base income (Zwischeinkünfte) in the meaning of section 8 of the AStG 1972. For this, the income must be of a passive nature and must only be taxed at a tax rate of less than 25%, unless this is due to the setting off with negative income of other sources.175 There is a negative catalogue list in section 8(1) of the AStG 1972 that defines active income, particularly manufacturing, active 171. G. Vogt, in Blümich, supra n. 85, at sec. 8 AStG, para. 19. 172. DE: Außensteuergesetz 1972 – AstG 1972 [Foreign Tax Act], sec. 7(2)(1). 173. Sec. (7)(2)-(4) AStG 1972. 174. Vogt, supra n. 171, at 22. 175. Sec. 8(3) AStG 1972.

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trading, provision of certain services and more. Although rental and leasing is regarded as active by sub-paragraph (6) of the provision, an exception applies to the granting of rights to use and the granting of patterns, methods, experiences and knowledge, thus the granting of IP rights is seen as passive income unless the domestic taxpayer proves that the foreign entity merely evaluated or used results of own R&D that was gathered without support of a domestic shareholder. Under the scope of this sub-paragraph, are all temporary transfers for remuneration of copyrights, as well as patents and other protected IP.176 Furthermore, royalties from such rights that the foreign entity acquired are represented as well.177 There is a bona fide clause in section 8(2) of the AStG 1972 due to the European Court of Justice (ECJ) Cadbury Schweppes judgment.178 Under this clause, CFC taxation is prevented for EU or EEA entities upon showing that it actually carried on genuine economic activity. At first glance, it seems surprising that for CFC purposes a threshold of 25% taxation of the foreign entity applies on the passive income although German corporation tax applies a tax rate of 15%. However, since most companies in Germany are also liable to trade tax of around another 15%, the legislation regards less than 25% as a low taxation. Only the respective passive income is relevant, other income has to be separated. Furthermore, different sources of passive income have to be examined separately.179 The legal consequences of the CFC regimes are the following. An amount of the passive income computed under German domestic tax law equivalent to the capital ownership percentage is regarded as income of the respective domestic shareholder/taxpayer and taken into account for his tax assessment for the income tax and corporation tax as business income or income from capital.180 There is an ongoing debate on whether the amount has to be included in the taxable amount for the trade tax as well. Although the Federal Tax Court held that they are not to be included for trade tax purposes,181 the tax authorities do not apply the judgment but take into account CFC income in the trade tax assessment (Nichtanwendungserlass).182 Taxpayers therefore need to appeal their tax assessment in such cases. 176. Vogt, supra n. 171, at 67 177. Id. 178. UK: ECJ, 12 Sept. 2006, Case C-196/04, Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd v. Commissioners of Inland Revenue, DStR 2006, p. 1686. 179. Vogt, supra n. 171, at 184. 180. Sec. 7(1) AStG 1972. 181. DE: BFH, 11 Mar. 2015, I R 10/14, DStR 2015, p. 995. 182. BMF, Gleich lautende Ländererlasse v. 14.12.2015, BStBl. I 2015, 1090 [Consequences of the BFH judgment of 11 Mar. 2015, id.].

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Under CFC rules, the passive income is thus regarded as distributed. Real distributions that occur subsequently are disregarded for income tax purposes in order to avoid double taxation.183 In the aftermath to the OECD BEPS Project and the EU Anti-Tax Avoidance Directive (ATAD),184 it has been debated whether the German CFC rules fulfil the minimum standard of the ATAD. This is because the directive obliges legally – in contrast to the BEPS outcome – to amend national law if not compliant with the minimum standard. Generally, the German CFC rules are regarded as stricter than the requirements of the ATAD.185 Some commentators thus advise to soften the domestic regime on the level of the minimum standard.186 However, in some regards, there is a controversial debate on whether the German CFC rules are compliant with the ATAD. This is relevant for IP income, in particular, to the scope of passive income: the ATAD follows a tighter approach here than the existing German provisions in that it stipulates all royalties as passive income. Article 7(2)(a)(ii) of the ATAD stipulates as a category of income that must be included as CFC income “royalties or any other income generated from intellectual property”. Furthermore, the time of inclusion in the tax assessment of the controlling domestic taxpayer under section 10(2)(1) of the AStG 1972 might not be compliant with the ATAD.187

15.2.4.2. Transfer pricing rules Secondly, section 1 of the AStG 1972 provides tax authorities the right to correct transfer prices between connected parties (at least 25% control or similar position). Furthermore, section 1(1) of the AStG 1972 constitutes the “arm’s length principle” for German domestic tax law in the scope of foreign transactions.188 Although the OECD transfer pricing guidelines do

183. Sec. 3(41)(a) EStG 1934. 184. Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market. 185. A. Schnitger, D. Nitzschke & R. Gebhardt, Anmerkungen zu den Vorgaben für die Hinzurechnungsbesteuerung nach der sog. „Anti-BEPS-Richtlinie“, IStR 2016, p. 960; A. Linn, Die Anti-Tax-Avoidance-Richtlinie der EU - Anpassungsbedarf in der Hinzurechnungsbesteuerung, IStR 2016, p. 645; Vogt, supra n. 171, at 11. 186. Linn, id., at 645; Vogt, id., at 12. 187. Schnitger, Nitzschke & Gebhardt, supra n. 185, at 973. 188. For domestic transactions, the instrument of hidden distributions (verdeckte Gewinnausschüttung) under sec. 8(3) of the KStG 1976 applies.

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not apply directly, the German tax authority has released regulations that broadly follow the OECD guidelines.189 Of special interest regarding royalties are the following views. Where goods are manufactured using an intangible asset, their subsequent acquisition and use by the acquirer does not represent a use of the intangible asset itself, thus any royalty paid would be disregarded for tax purposes.190 It is also stated that where the appropriateness of a royalty cannot be sufficiently assessed by use of the comparable uncontrolled price (CUP) method, it must be assumed that a reasonable manager acting for a licensee would only pay royalties up to an amount which still leaves a reasonable operating profit. In exceptional cases, the cost-plus method might be used.191 A unique German special regime provides the right to tax mere future profit potentials by the transfer of functions (Funktionsverlagerung).192 In the context of royalties and IP, this is of special interest and importance and can lead to a reallocation of income under German domestic tax law. A typical case would be the outsourcing of manufacturing to a foreign entity under simultaneous transfer of the relevant IP such as patents. The provision can apply to all transfers of IP abroad if the transfer represents a reallocation of a function.193 Transfer prices for the IP and all transferred assets, including the mere potential as a whole package, have to be founded on the basis of a hypothetical arm’s length transaction – which is usually of high difficulty. Section 1(3)(11) of the AStG 1972 stipulates the right to make appropriate subsequent adjustments. In a recent statement, the Federal Finance Ministry has laid out under what circumstances the right to use a name of a brand or a group between connected companies gives rise to taxation or profit allocation under transfer pricing rules.194 The tax authority as a rule regards the right to use a name as a profitable event where, firstly, the group or the owner of the right to use the name can exclude others from the use. This is always the case where 189. Particularly, Grundsätze für die Prüfung der Einkunftsabgrenzung bei international verbundenen Unternehmen (Transfer Pricing Regulations 1983) and Grundsätze für die Prüfung der Einkunftsabgrenzung durch Umlageverträge zwischen international verbundenen Unternehmen (Principles for Cost Sharing Agreements 1999), both German texts and English translations in KPMG, Deutsches Außensteuerrecht/German International Taxation, 2010. 190. Transfer Pricing Regulations, para 3.1.2.3. 191. Transfer Pricing Regulations, paras. 5.2.3 and 5.2.4. 192. Sec. 1(3)(7) AStG 1972. 193. C. Pohl, in Blümich, supra n. 85, at sec. 1 AStG, para. 135. 194. BMF 2017, IV B 5 - S 1341/16/10003, IStR 2017, p. 373.

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a brand name is protected under section 4 of the Markengesetz (MarkenG, Trademark Act), thus for registered brands or notoriously known brand names.195 The second requirement for a profit allocation under transfer pricing rules is that the user of a brand name expects an economic benefit from the use of the name. However, this is not congruent with the arm’s length principle as it constitutes an ex ante view.196 The statement of the Federal Finance Ministry gives priority to the standard transfer pricing methods.

15.2.4.3. General anti-abuse rule (GAAR) Thirdly, under the domestic GAAR in section 42(2) of the AO, under certain circumstances foreign base companies can be disregarded completely for tax purposes. The requirement is that the foreign entity is connected and does not serve any business purpose of its own but was merely installed for tax reasons.197 The income is then regarded as income of the shareholders.198

15.3. Taxation of IP under EU law This section provides a summary of recent questions of compatibility of specific domestic provisions and the domestic implementation of the I&R Directive.

15.3.1. Issues of compatibility of domestic tax law with EU law Regarding the compatibility of domestic tax law with EU law, certain provisions give rise to discussion. From the perspective of the state of residence, domestic taxation on inbound royalties seems to be in line with the EU Treaty fundamental freedoms.

195. F. Beermann, Das neue BMF-Schreiben zur Namensnutzung im Konzern - Pflicht zur Lizenzierung?, BB 2017, 1431. 196. Id., at 1432. 197. DE: BFH, 27 Aug. 1997, I R 8/97, DStR 1998, p. 116; E. Ratschow, in Abgabenordnung: AO sec. 42, para. 137 (F. Klein ed., 13th edn 2016). 198. BFH, id.

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For outbound situations, the ECJ has held in Scheuten199 that the domestic assessment of the trade tax does not constitute a breach of EU law in the form of the I&R Directive. In particular, the adding back of payments for debts which have been deducted to the basis of assessment by section 8 of the GewStG 1936 was under examination. The ECJ held that article 1(1) of Directive 2003/49 does not preclude such a domestic provision as the directive lacks a provision governing the rules for calculating the basis of assessment of the payer of interest. Furthermore, the directive is limited in its scope to source taxation as it concerns solely the tax position of the interest creditor.200 The Federal Tax Court joined this opinion and clarified that there is also no breach of EU freedoms.201 These judgments can be applied to section 8(1)(f) of the GewStG 1936, which subjects a quarter of royalties to the basis of assessment under German trade tax even if Germany has no taxation rights under the respective double tax treaty. In a recourse to the ECJ’s judgment, this provision is regarded as compliant with EU law.202 From the perspective of both the state of residence for outbound payments of royalties and the source state it is doubtful whether section 4j of the EStG 1934, limiting the amount of deductibility of payments made for the granting of the right to use copyrights, patents and others, is compatible with EU law. This provision indirectly solely concerns cross-border payments made from Germany as it encompasses royalties which fall under a preferential regime in the hands of the payee, unless the regime is in line with the modified nexus approach because Germany does not have such a preferential regime itself. Hence, the provision indirectly discriminates certain outbound payments in the hands of the payer.203 Some commentators argue parallel to the judgment in Scheuten with the scope of the I&R Directive.204 However, this argument does not justify the indirect discrimination under the fundamental freedoms. The discrimination could be justified by the prevention of tax avoidance or fraud. However, the broad scope of the provision also applies to transactions and contracts in the regular course of business that do not give rise to fraud.205 Regarding the ECJ’s Cadbury Schweppes decision, the mere use of cross-border benefits cannot be regarded as fraudulent. 199. DE: ECJ, 21 July 2011, Case C-397/09, Scheuten Solar Technology GmbH v. Finanzamt Gelsenkirchen-Süd, ECJ Case Law IBFD. 200. Scheuten (C-397/09), para. 28. 201. DE: BFH, 7 Dec. 2011, I R 30/08, IStR 2012, p. 262. 202. Hofmeister, supra n. 99, at 31. 203. K. van Lück, Gesetzentwurf zur Einführung einer Lizenzschranke durch § 4j EStG Verfassungsrechtliche und europarechtliche Herausforderungen, IStR 2017, p. 391; Ditz & Quilitz, supra n. 105, at 1567. 204. Ditz & Quilitz, id. 205. Van Lück, supra n. 203.

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The coherence of the domestic tax system is also likely unable to justify the discrimination, particularly since the ECJ is restrictive in this regard. As the nexus approach does not give an immanent relation within the domestic tax system but an interstate relation, this justification most likely does not apply.206 As a consequence, section 4j of the EStG 1934 is likely to constitute a breach of EU law. In addition, the compatibility of section 1(3)(7) of the AStG 1972 – the taxation of future profit potentials in the context of a transfer of a function – is debatable.207 Most experts in German literature regard the provision as a breach of the freedom of establishment and the free movement of capital.208 Discrimination is given as the provision only applies in crossborder situations and is liable to hinder companies from engaging in crossborder activities or establishing foreign subsidiaries.209 Although regular adjustments under section 1(1) of the AStG 1972 in the context of transfer prices are justified since the arm’s length principle is in line with the EU freedoms,210 the hypothetical view of section 1(3) of the AStG 1972 is likely not justified. The allocation of taxing rights, coherence of the tax system and the effectiveness of the taxation do not justify the taxation of the mere profit potential.211 Other provisions in question are section 50d(3) and (9) of the EStG 1934 (amended 2013). Both provide anti-abuse rules for the exemption from withholding tax of (inter alia) royalties under double tax treaties and the I&R Directive. Section 50d(3) of the EStG 1934 intends to prevent treaty or directive shopping by restricting relief which would arise from a treaty or directive. Benefits are denied to the extent persons holding ownership interests in the company would not be entitled to a refund or exemption if they derived the income directly and where no economic or other valid reasons for the interposition of the foreign company are given or where the foreign company does not derive more than 10% of its gross earnings from own business activities. The purpose of preventing treaty benefits or EU law benefits is beyond question. Yet, the provision not only entails abusive structures, but 206. Id., at 392. 207. Pohl, supra n. 193, at 131. 208. T. Rolf, Europarechtswidrigkeit der Besteuerung von Funktionsverlagerungen gemäß § 1 Abs. 3 AStG, IStR 2009, p. 153. 209. J. Englisch, Einige Schlussfolgerungen zur Grundfreiheitskompatibilität des § 1 AStG - zugleich Anmerkung zum Urteil des EuGh in der Rs. SGI, IStR 2010, p. 139. 210. Id., at 141, taking recourse to the ECJ decision in SGI (C-311/08). 211. See Rolf, supra n. 208.

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seems to apply also to non-abusive, genuine cases.212 The Finanzgericht of Cologne (FG, Tax Court) shared the doubts and has submitted two cases to the ECJ.213 These cases are subject to an older version of the provision which has subsequently been changed to comply with EU law. However, most commentators still doubt the compatibility of the reformed provision as, for example, it does not comply with the requirement to allow taxpayers to give proof of genuine business activity.214 Section 50d(9) of the EStG 1934 constitutes a switch-over clause. The income exclusion based on a double tax treaty is denied if the other state applies the terms in a way that (partially) exempts the income or where such income is not taxed only because it is derived by a person that is not subject to tax as a resident. The provision does not apply where the other state generally does not subject that item of income to tax or where the income falls under the tax-free allowance.215 Taking into account the ECJ’s judgments regarding such clauses, this provision seems to comply with EU law.216

15.3.2. Open issues in the implementation of the I&R Directive The legislator has implemented the I&R Directive into domestic tax law in section 50g of the EStG 1934. The provision is of practical importance where double tax treaties allow source taxation of royalties.217 Section 50g(3)(4)(b) of the EStG lays out a definition of royalties for the provision (see section 15.2.1.). It reflects the definition of the directive almost identically. The German definition only differs in the use of the wording “Nutzung” instead of “Benutzung”, which does not give rise to a different interpretation but is merely a synonym.218

212. C. Biebinger & M. Hiller, Europarechtliche Zweifel an § 50d Abs. 3 EStG gemäß den EuGH-Vorlagen des FG Köln v. 08.07.2016 und v. 31.08.2016, IStR 2017, p. 299; G. Hahn-Joecks, in EStG 246, sec. 50d para. E 12 (Kirchhof/Söhn/Mellinghof eds., 2014). 213. DE: ECJ, 20 Dec. 2017, Case C-504/16, Deister Holding, ECJ Case Law IBFD, and DE: ECJ, 28 Nov. 2016, Case C-613/16, Juhler Holding A/S v Bundeszentralamt für Steuern, 2017/C 104/37 (pending), OJ, C104/25 (3 Apr. 2017) 214. Hahn-Joecks, supra n. 212. 215. DE: Finanzgericht (FG) Hamburg [Tax Court], 13 Apr. 2017, 6 K 195/16, IStR 2017, p. 791. 216. Hahn-Joecks, supra n. 212, at para. K 4. 217. Wagner, supra n. 152, at 7. 218. Id., at 62.

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There is no mismatch to other domestic income tax law in the distinction of granting the temporary right to use and final transfers or sales.219 There is no case law or discussion on whether payments for exclusivity fall under the provision or whether sub-licence payments are included. As the term has to be interpreted in a wide sense,220 at least sub-licence fees should fall under the definition. Fees for exclusivity rights should be regarded as royalty in cases where their transfer does not represent a sale but a temporal granting. In general, however, the terms should be interpreted as in the directive and thus article 12(2) of the OECD Model.221 The domestic definition encompasses – in contrast to the recent OECD Model but in compliance with the directive – payments for the use of industrial, commercial or scientific equipment. The domestic understanding gives rise to a broad interpretation: agricultural or artistic equipment should be included.222 German tax treaty practice varies significantly in regard to the respective royalty article, as will be shown in section 15.4. However, there are small differences between the German Model Convention (or basis for negotiation) and section 50g(3)(4) of the EStG 1934. The two differences between the negotiation basis and the domestic definition in section 50g(3)(4) are that the latter explicitly mentions software and includes payments for the use or the right to use equipment. German domestic tax law has not introduced a switch-over-clause for royalties under section 50g of the EStG 1934. There are as yet no plans to introduce such a clause in the aftermath of the OECD BEPS Project. Section 50g(4) of the EStG 1934 contains a domestic anti-abuse rule which, although differently worded, is interpreted in large part similar to the domestic general anti-abuse rule in section 42 of the AO.223 Under section 50g(4) of the EStG 1934, the benefits of the provision are denied where one of the principle purposes of a transaction is tax avoidance or tax abuse. This means that from an economic point of view an unreasonable structure must have been chosen and reasons beyond tax law must not be given for the choice of 219. Id., at 64. 220. L. Rehfeld, in EStG/KStG sec. 50g EStG, para. 13 (Herrmann/Heuer/Raupach eds., 279th edn 2017). 221. Hahn-Joecks, supra n. 212, at para. D 113. 222. Wagner, supra n. 152, at 65. 223. Id., at 79.

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such structure.224 It has been argued that the provision constituted a breach of EU law,225 but it does not seem to restrict the fundamental freedoms.226 .

Furthermore, section 50g(2)(2) of the EStG 1934 introduces the arm’s length principle in a provision similar to article 12(4) of the OECD Model. The provision is supplemented by section 90(2) of the AO, which requires taxpayers to document widely in accordance with EU law.227 Section 50g(3)(1) of the EStG 1934 restricts the provision by setting up the requirement that the receiving person must be the beneficial owner. In German literature, this term in section 50g of the EStG seems to be regarded as equivalent to the term under double tax treaties.228 Hence, the interpretation of the OECD Commentary, as well as judgments on the term under international tax law, can be consulted.229 There are as yet no domestic judgments verifying this opinion. The provision itself gives a definition with limited scope for section 50g of the EStG 1934. It stipulates that a company is beneficial owner if it attains the profits. This means the company must not only be a mere intermediary.230 A PE is beneficial owner where it is economic owner of the underlying right and where the payment is subject to a corporation tax in the state of its existence, as per a list in the annex to the provision. This list names the respective corporation taxes in every EU Member State, such as the “impôt sur les sociétés” in France or the “imposta sul reddito delle persone giuridiche” in Italy. Thus, this is not a general definition of beneficial ownership under domestic law but constitutes a subject-to-tax approach. As previously mentioned (see section 15.2.3.2.), the application gives rise to a refund procedure, section 50g(5) of the EStG 1934. Only where upon application a certificate of exemption has been granted, is a withholding tax not imposed. Where tax is withheld, it is refunded on application. The refunds are paid including interest under further requirements, section 50d(1a) of the EStG 1934. The refunding procedure requires a certificate of tax residence. There is no general requirement to give proof of the 224. Id. 225. H. Hahn, Zur Gemeinschaftsrechtskonformität der Missbrauchsklausel in § 50g Abs. 4 EStG - Zugleich ein Beitrag zur Auslegung der Zins-/ Lizenzgebühren-Richtline, IStR 2010, p. 638. 226. Wagner, supra n. 152, at 76. 227. Id., at 73. 228. Hahn-Joecks, supra n. 212, at para. D3. 229. Id. 230. Wagner, supra n. 152, at 48.

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underlying contracts; however, the competent tax authority may ask for respective documents.231

15.4. Taxation of IP under tax treaties Lastly, Germany’s double tax treaty practice shall be examined. The respective tax treaties can limit the taxation of non-resident taxpayers under domestic German tax law of section 49 of the EStG 1934 and reciprocally Germany has to give tax relief under article 23A or B for source taxation of royalties of resident taxpayers where a double tax treaty gives a taxing right to the respective source state. For example, Germany gives a tax credit for income from royalties under article 12 in article 23(2)(b)(bb) of the CanadaGermany Income and Capital Tax Treaty (2001).

15.4.1. Taxing rights over royalties assigned by article 12(1) All applied German double tax treaties contain a separate article regarding royalties.232 The German Model Tax Treaty or negotiation basis is identical – with smaller semantic differences in article 12(2) – to the OECD Model.233 However, in reality, existing double tax treaties vary significantly on the arrangement of article 12(1), thus the tax rate applied for source taxation.234 Some tax treaties – mostly with traditional exporters of IP such as the United States (2006) or Switzerland (1971) and many other European countries – do not assign any taxing rights to the source state unless the business profits article applies. Other treaties implement a fixed rate for the source state, e.g. the Germany-Japan Income Tax Treaty (2015) or the Australia-Germany Income and Capital Tax Treaty (2015) provide a 10% source taxing right. A third category of agreements contains different tax rates: the CanadaGermany Income and Capital Tax Treaty (2001) sees no source taxation rights for remuneration on copyrights or rights to use in software or certain patents but provides for a 10% tax rate for payments on other rights. Yet, in 231. Id., at 88. 232. R. Pöllath & A. Lohbeck, in DBA Art. 12, para. 80 (Vogel/Lehner eds., 6th edn, 2015). 233. See http://www.bundesfinanzministerium.de/Content/DE/Standardartikel/Themen/Steuern/ Internationales_Steuerrecht/Allgemeine_Informationen/2013-08-22-VerhandlungsgrundlageDoppelbesteuerungsabkommen-Steuern-vom-Einkommen-und-Vermoegen.html. 234. For an overview, see Pöllath & Lohbeck, supra n. 232, at 29; P. Dorfmueller, in DBA-Kommentar Art. 12 para. 24/1 (Gosch ed., 29th edn, 2016).

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this regard, German treaties are inconsistent: the Germany-Latvia Income and Capital Tax Treaty (1997) provides a reduced tax rate of 5% for the use of commercial or scientific equipment and a general 10% rate in other cases. The Egypt-Germany Income and Capital Tax Treaty (1987) and the Germany-Liberia Income and Capital Tax Treaty (1970) even provide tax rates under certain conditions of more than 15% (Egypt, up to 25%; Liberia, up to 20%). The Germany-United States Income and Capital Tax Treaty (1989) also encompasses in article 12(1) all royalties that a resident taxpayer receives as the beneficial owner, thus also royalties derived from a third state as well as royalties paid from the residence state to a PE in the other contracting state.235 The source tax is to be credited under article 23A or B in the residence state of the licensor. Usually, the tax rate is applied on the gross payment. The net amount is only relevant for the Germany-Luxembourg Income and Capital Tax Treaty (2012).236 Most German double tax treaties contain specific source rules equivalent to the source rules in the UN Model similar to article 11(5) of the OECD Model. Royalties are deemed to arise in a contracting state when the payer is a resident of that state. However, in case the royalty is borne by a PE, the royalty is deemed to arise in the contracting state in which the PE is situated. Such provisions exist in treaties that give a limited taxing right to the source state;237 but also, for example, in article 12(4) of the Germany-South Africa Income Tax Treaty (1973) or in article 12(4) of the Austria-Germany Income and Capital Tax Treaty (2000) (protocol 2010). However, in cases where sourcing rights are not laid out in a treaty, most commentators advocate application of article 11(5) of the OECD Model regarding sourcing rules.238 Some treaties contain specific anti-abuse provisions in article 12. By article 12(7) of the Germany-Mexico Income and Capital Tax Treaty (2008), article 12 as such does not apply if royalties were agreed on for the main purpose of treaty benefits. The Germany-Ghana Income and Capital Tax Treaty (2004) 235. 236. 237. 238.

Pöllath & Lohbeck, supra n. 232, at 30. DE: BFH, v. 20 Nov. 1974, I R 1/73. Pöllath & Lohbeck, supra n. 232, at 35. Id., at 29.

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and the Germany-Korea (Rep.) Income and Capital Tax Treaty (2000) only allow for a reduced tax rate where it has not been the main purpose of one of the contracting parties to profit from treaty benefits without economic substance. Also, the Germany-United Kingdom Income and Capital Tax Treaty (2010) contains a main purpose clause in article 12(5) which the United Kingdom wished to include.239 A special provision constitutes that a quarter of expenses on the right to use a right are taxed under domestic trade tax even if not taxable under the respective double tax treaty.240 It is under discussion whether this constitutes a treaty override.241

15.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 The meaning of royalties in all German tax treaties at least encompasses the core content of article 12(2) of the OECD Model.242 However, the definition of royalty various widely under different treaties. This is particularly relevant as many treaties implement a source withholding tax right, as mentioned above. Treaties define the term “royalty” autonomously243 and usually in a concluding manner.244 The only exception is the Germany-United States Income and Capital Tax Treaty (1989), which uses an open definition of royalty in article 12(2). Article 12 takes precedence over article 7 by article 7(4) of the OECD Model. As the meaning of royalty under tax treaties is autonomous, the interpretation and the separation of article 7 and article 12 cannot be based on the domestic German categories of business income or rental and leasing.245 Thus, article 12 of tax treaties – in contrast to the domestic provisions that give precedence to business income – is a general provision encompassing all kinds of licences as long as article 12(3) does not apply.

239. J. Bahns & U. Sommer, Neues DBA mit Großbritannien in Kraft getreten - ein Überblick, IStR 2011, p. 204. 240. Sec. 8(1)(f) GewStG 1936. 241. N. Häck, in DBA Deutschland-Schweiz Art. 12, para. 22 (Flick/Wassermeyer/ Kempermann eds., Aug. 2016). 242. Pöllath & Lohbeck, supra n. 232, at 81. 243. F. Wassermeyer, in DBA Kommentar Art. 12, para. 5 (F. Wassermeyer ed., July 2017). 244. Pöllath & Lohbeck, supra n. 232, at 82. 245. Id.; Wassermeyer, supra n. 243, at 5.

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Some – particularly older – treaties do not separate between the granting of the right to use and alienations or sales of IP. This is the case for the FranceGermany Income and Capital Tax Treaty (1959) and the Germany-Thailand Income and Capital Tax Treaty (1967). The term “royalty” in the GermanyUnited States Income and Capital Tax Treaty (1989) and the GermanyMexico Income and Capital Tax Treaty (2008) encompasses final transfers if the profit of the sale depends on the profitability, use or resale of the respective rights. For the rest of the German tax treaties where such a provision does not exist, final transfers or sales or any other granting which is not purely temporary fall under article 13 or article 7, depending on whether business income is derived through a PE.246 However, any remuneration made for the sharing of industrial, commercial or scientific knowledge and experience falls under article 12. Regarding the term of granting the right to use, some tax treaties have a slightly tighter meaning than the OECD Model term. The GermanyUnited States Income and Capital Tax Treaty (1989) and the GermanyGreece Income and Capital Tax Treaty (1966) (protocol 2000) exclude film licences, for instance. The Germany-United States Income and Capital Tax Treaty (1989) includes in article 12 cases where an artist who is resident of a contracting state records a performance and receives a right in the use of the performance for which he receives a payment. The requirement is that the artist receives a copyright. Therefore, this inclusion is not in contrast to the OECD Model.247 Recently introduced German treaties, however, include in contrast to the OECD Model explicitly remuneration for the use or the right to use names, pictures and other comparable personal rights.248 Examples are the Germany-Spain Income and Capital Tax Treaty (2011) and the Germany-Ireland Income and Capital Tax Treaty (2011). Without such an explicit statement such rights are not encompassed by articles based on article 12 of the OECD Model.249 Under domestic tax law such rights are subject to limited taxation under section 49(1)(2)(f)(aa) of the EStG 1934. In addition, the mentioned treaties encompass remuneration for the recording of events and performances of sportsmen and artists by television. This is a recharacterization for cases where the payments are made to a foreign presenter, as these would otherwise fall under article 7. The German tax authorities share this opinion.250

246. 247. 248. 249. 250.

Wassermeyer, id., at 11. Para. 18 OECD Model: Commentary on Article 12 (2014). Pöllath & Lohbeck, supra n. 232, at 91a. Id., at 66d. BMF1996, IV B4-S 2303-14/96.

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German literature regards it is a softening of the law that some double tax treaties include services and consulting in article 12, meaning that they are equivalent to royalties. This is the case particularly for treaties with developing countries, such as the Germany-Ghana Income and Capital Tax Treaty (2004), the Germany-Jamaica Income and Capital Tax Treaty (1974), the Germany-Malaysia Income Tax Treaty (2010), the Germany-Pakistan Income Tax Treaty(1994), the Germany-Zimbabwe Income and Capital Tax Treaty(1988) and the Germany-Vietnam Income and Capital Tax Treaty (1995).251 However, services and consulting also fall under article 12(3) of the treaty Australia-Germany Income and Capital Tax Treaty (2015), as well as the Germany-India Income and Capital Tax Treaty (1995). Article 12(3) of the Australia-Germany Income and Capital Tax Treaty (2015) is worded as follows: The term “royalties” as used in this Article means payments or credits, whether periodical or not, and however described or computed, to the extent to which they are made as consideration for: a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right; b) the supply of scientific, technical, industrial or commercial knowledge or information; c) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in subparagraph a) or any such knowledge or information as is mentioned in subparagraph b); […].

In contrast, the older Germany-New Zealand Income and Capital Tax Treaty (1978) explicitly excludes services from article 12. As the Australian tax treaty is one of Germany’s most recent treaties, it is not yet clear whether this is a new standard in Germany’s treaty practice. For now, the treaty practice is inconsistent, which is due to various economical means of treaties. A similar situation can be found in regard to technical services and support. These usually do not represent a temporary granting of a right, thus no royalty in the meaning of article 12.252 They are explicitly excluded from the royalty article of the Estonia-Germany Income and Capital Tax Treaty (1996) as well as the Germany-Lithuania Income and Capital Tax Treaty (1997) and treated as falling under either article 7 or article 14. The same applies to the Costa Rica-Germany Income and Capital Tax Treaty (2014) 251. Pöllath & Lohbeck, supra n. 232, at 83. 252. Wassermeyer,  supra n. 243, at 86a.

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(protocol 2014) in regard to technical support as well as scientific or technical studies or plans and consulting or monitoring. Another regime is laid down in the Germany-Indonesia Income and Capital Tax Treaty (1990) and the Germany-Vietnam Income and Capital Tax Treaty (1995) that apply the royalty article to technical support but stipulate a different tax rate (Indonesia, regular royalty rate 15%, rate on technical services 7.5%; Vietnam, regular rate 10%, rate for technical services 7.5%). The Germany-India Income and Capital Tax Treaty (1995) is relevant as it provides a definition of technical services in article 12(4) with the following wording: [P]ayments of any amount in consideration for the services of managerial, technical or consultancy nature, including the provision of services by technical or other personnel, but does not include payments for services mentioned in Article 15 [Dependent Personal Services]….

This is important as the Indian tax authorities often assign taxing rights to India excessively,253 which is a risk for German companies investing in Indian projects, although India is the second biggest market for technics in Asia for German businesses.254 In general, the term “technical services” is seen as any services other than granting a right to use, letting of equipment or mere sharing of knowledge and know-how.255 For cases of sending personnel abroad to instruct on technical equipment or to provide technical services, some treaties constitute a PE after a certain time spent abroad.256 Thus, the inclusion of technical services in article 12 prevents the problematic separation of royalties and services but creates a problematic classification of royalties and business income. In other cases, article 12 does not encompass fees for technical or consulting services.257 Due to the fact that the OECD Models of 1963 and 1977 regarded payments for the use of commercial or scientific equipment as part of the royalty article, a multitude of German tax treaties still contain equivalent provisions. 253. For an overview of judgments of Indian courts, see R. Gandhi & V. Palwe, India’s Tax Treaties and the Restricted Scope for Taxation of Technical Services, Tax Notes Intl., p. 595 (2011). 254. S. Bendlinger, M. Reinhold & D. Sennewald, Das deutsch-indische DBA und dessen Anwendung auf den deutschen Maschinen- und Anlagenbau, IStR 2013, p. 453. 255. Pöllath & Lohbeck, supra n. 232, at 85. 256. M. Görl, in Vogel/Lehner, supra n. 232, at Art.12, para. 81. 257. Dorfmueller, supra n. 234, at 96.

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However, many recent treaties also include such payments in article 12, e.g. the Germany-Spain Income and Capital Tax Treaty (2011) or the China (People’s Rep.)-Germany Income and Capital Tax Treaty (2014). Some treaties differ in the applied tax rate: the Germany-Indonesia Income and Capital Tax Treaty (1990) applies 10% instead of 15%, the China (People’s Rep.)-Germany Income and Capital Tax Treaty (2014) applies 10% on 60% of the gross amount instead of 10% on the whole gross amount. The term is not used in domestic tax law. For treaty purposes, equipment means any kind of material property, such as ships, planes, tools, pipelines and machines.258 The mere instruction on equipment by sent personnel is encompassed, too, the operation of such equipment must be seen as services, however, with the consequence that uniform payments must be split.259 Regarding software, German literature sees copyright in software as scientific work under article 12, thus in line with the Commentary of the OECD Model.260 Therefore, the royalty article is usually applied. German practice generally applies the OECD Model Commentary’s classification with the consequence that final transfers of software are not encompassed by article 12 but by article 7 or article 13,261 similar to the domestic situation where the final transfer needs to be separated from the temporary granting. From a German perspective, payments for standard software are seen as a final transfer or sale as well, thus not falling under article 12 as they represent a sale and not the granting of a right to use.262 German treaty practice is aligned with the OECD’s view in this regard.263 Some treaties explicitly include the granting of the right to use software in the respective royalty article. Examples are the Germany-Romania Income and Capital Tax Treaty (2001) or the Germany- Korea (Rep.) Income and Capital Tax Treaty (2000) under certain restrictions. In respect of payments for exclusivity, the Federal Tax Court decided in a single case regarding an exclusive distribution right for the domestic provision of section 49 of the EStG 1934 that such right is an autonomous 258. Pöllath & Lohbeck, supra n. 232, at 88. 259. Id., at 85. 260. Para. 12.2 OECD Model: Commentary on Article 12 (2014); W. Kessler, Qualifikation der Einkünfte aus dem Online-Vertrieb von Standardsoftware nach nationalem und DBARecht (Teil II), IStR 2000, p. 98; Pöllath & Lohbeck, supra n. 232, at 63; Wassermeyer, supra n. 243, at 63. 261. Pöllath & Lohbeck, id., at 64a. 262. Kessler, supra n. 260, at 100; Dorfmueller, supra n. 234, at 58. 263. Para. 15 OECD Model: Commentary on Article 12 (2014).

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immaterial right and that payments do not represent a royalty where the granting is not temporary.264

15.4.3. Beneficial ownership and royalties The concept of beneficial ownership is not a common principle under German tax law.265 However, in the course of the implementation of the I&R Directive, the legislator introduced the term into section 50g(3)(1)(1) of the EStG 1934but only for cases of connected companies within the EU and respective PEs. However, for the interpretation of German tax treaties this is fruitless: the meaning of the term cannot be taken from domestic law under article 3(2) since domestic tax law does not know the concept of beneficial ownership and does not provide a definition besides the limited section 50g of the EStG 1934, the scope of which is restricted in comparison to the concept in tax treaties.266 Thus, the meaning has to be interpreted autonomously for the respective agreement. Almost all tax treaties concluded by Germany after the OECD Model (1977) – in which the concept of beneficial ownership was introduced – incorporate the term. Recent development tends to show a generalization of the use for the entire treaty and not only for articles 10 to 12: the Germany-Mauritius Income and Capital Tax Treaty (2011) (article 22(2)) and the Germany-Spain Income and Capital Tax Treaty (2011) (article 28(2)) use the term “beneficial ownership” as a kind of limitation-of-benefits (LOB) clause even though Germany does not usually use LOB clauses. Some German tax treaties provide a definition of beneficial ownership, which varies, however. Under the Germany-Italy Income and Capital Tax Treaty (1989) (protocol (1989), paragraph 9) and the Germany-Norway Income Tax Treaty (1991, as amended through 2013) (protocol as amended through 2013, paragraph 4), a recipient is a beneficial owner if he is entitled to the underlying right and if he is entitled to the income under the tax law of both contracting states. Thus, where one state does not regard the recipient to be entitled for the payments, the treaty benefits would be denied.267 A 264. DE: BFH, 27 July 1988, I R 130/84, BStBl. II 1989, p. 101. 265. Grützner, in Gosch, supra n. 234, at Art. 10-12 OECD, para. 13; Pöllath & Lohbeck, supra n. 232, at Art. 10 bis (12), para. 14. 266. Pöllath & Lohbeck, id., at para. 15. 267. Id., at para. 27.

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slightly different wording was used in article 12(3) of the German-Sweden Income, Capital, Inheritance and Gift Tax Treaty (1992), which, for denying treaty benefits, requires the person beneficially entitled not to be resident in the state of the recipient. The older Australia-Germany Income and Capital Tax Treaty (1972) (terminated) distinguished in protocol (1972), paragraph 7 that German recipients were regarded as beneficial owners if the person beneficially entitled was resident in Germany; Australian recipients, however, were beneficial owners if they were economically owners of the underlying assets or property. However, the new Australia-Germany Income and Capital Tax Treaty (2015) no longer provides such a definition, although already putting in place some of the central ideas of the OECD BEPS Project.268 A similar situation applies in the relation to the GermanyUnited States Income and Capital Tax Treaty (1989): the protocol (1989) provided a definition of beneficial ownership, whereas the newer protocol (2006) no longer provides such a definition. All other German tax treaties do not provide a definition. The meaning then has to be determined by the domestic tax law of the state of residence of the paying company.269 This is generally the case where the payee has the right to dispose of the payment freely.270 Older tax German treaties do not introduce the concept at all. But in these cases, it can be applied, nevertheless. The introduction of the term only clarifies what has already been the case before:271 the Federal Tax Court denied treaty benefits regarding an older Germany-Switzerland Income and Capital Tax Treaty (1971) – although the beneficial ownership requirement was not introduced – based on the concept of treaty misuse.272 The Federal Tax Court does not deny treaty benefits by the mere fact that an intermediary is used.273 However, where an intermediary is solely a base company without substance, the Court would likely deny the treaty benefits for the intermediary and regard the shareholder behind as the real beneficial

268. See A. Becker, Die Umsetzung des BEPS-Projektes der OECD in einem Doppelbesteuerungsabkommen: Das neue DBA zwischen Deutschland und Australien im Überblick, IStR 2016, p. 621. 269. DE: BFH, 2 Aug. 2008, I R 39/07, DStRE 2009, p. 152. Of different opinion: Grützner, supra n. 265, at 13/2. 270. Grützner, id., at 15/2. 271. Pöllath & Lohbeck, supra n. 232, at Art. 10 bis (12), para. 27. 272. DE: BFH, 5 Mar. 1986, I R 201/82, DStR 1986, p. 440. 273. See DE: BFH, 15 Dec. 1999, I R 29/97, DStR 2000, p. 462.

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owner in accordance with the domestic principle of abuse in section 42 of the AO.274

15.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state German tax treaties do not contain specific provisions in case of favourable IP tax regimes. However, recent tax treaties mostly included a general subject-to-tax clause.275 Examples are the Bulgaria-Germany Income and Capital Tax Treaty (2010), the Germany-Ireland Income and Capital Tax Treaty (2011), the Germany-Hungary Income and Capital Tax Treaty (2011) and the Germany-United Kingdom Income and Capital Tax Treaty (2010). This seems to represent a change of system in German tax treaty police where exemption still remains a core element but the prevention of double non-taxation becomes central as well.276 As an example, article 23(1)(a) of the Germany-United Kingdom Income and Capital Tax Treaty (2010) exempts any item of income from the assessment basis of the German tax arising in the United Kingdom that is “effectively taxed in the United Kingdom”. Under article 12(1) of the treaty, royalties are exempt in the source state. The government’s explanations lay out that income is not effectively taxed where it is not subject to tax, is tax exempt or where a taxation for other reasons has not taken place in practice.277 However, since royalty income is usually not entirely tax exempt in the United Kingdom, even if under the scope of the IP box or patent box regime, article 23(1)(a) would not apply. Other restrictions on the German exemption as source state in case of a favourable tax regime are not in place and not yet planned. Germany’s approach to prevent tax base erosion by applicable IP tax regimes lies in tax policy attempts such as the compromise with the United Kingdom and 274. Wassermeyer,  supra n. 243, at 33. 275. For the application, see BMF, 20 June 2013, DStR 2013, p. 1894. Of particular interest is the example in para. 2.3 regarding licences under the Germany-US double tax treaties, where licences that are not subject to tax in the United States due to a different qualification will not be exempt from German tax under the treaty. 276. J. Holthaus, Systemwechsel in der Abkommenspolitik - tatsächliche Besteuerung im Quellenstaat Voraussetzung für Freistellungen nach den neuen DBA, IStR 2012, p. 537. 277. See Deutscher Bundestag, 21 June 2010, Drucksache 17/2254, p. 38.

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the unilateral limitation of deductibility of royalty payments by sec. 4j of the EStG 1934 (see section 15.2.2.4.).

15.4.5. Time of taxation Articles based on article 12 of the OECD Model leave the time of taxation to the domestic tax law of the contracting states. Where a treaty limits a state’s taxation rights, this limitation must be regarded when, by the domestic law, a taxable event is given.278 This is the case for the activation in the balance sheet where necessary or when the payment is received in all other cases.279 The term “paid” as used in German tax treaties concluded before 2000 is interpreted in a broad way: all settlements of the royalty claim are sufficient.280 In compliance with the OECD Model interpretation, the term does not have a temporal aspect, so for the time of payment the domestic law of the applying state is decisive. Particularly, the activation of a claim in the balance sheet is sufficient for the term “paid” under article 12 of the tax treaties.281 The German Model Tax Treaty uses the wording “payments of any kind” in article 12(2). Article 12 leaves the procedural aspects to the contracting states. It does not preclude source states from subjecting royalties to withholding tax in first instance and giving relief subsequently. By section 50a(1)(3) of the EStG 1934, royalties paid to a non-resident taxpayer must be withheld in the amount of 15% by the payer. Non-resident taxpayers can get relief by reimbursement under section 50d(1) of the EStG 1934 where the treaty tax rate is less than 15%. It is also possible for the beneficial owner to receive a certificate of exemption before payment with the consequence that the royalties are not subject to withholding tax. However, section 50d(3) of the EStG 1934 constitutes a domestic special substance requirement both for the reimbursement under section 50a(1) and the exemption under sec. 50d(2). Where a non-resident company is the taxpayer, relief is only granted where no persons are participating who could not obtain relief if they received the royalties themselves and where the payments made are not derived from an own business activity and where no

278. Dorfmueller, supra n. 234, at 28; Pöllath & Lohbeck, supra n. 232, at 25. 279. Wassermeyer,  supra n. 243, at 40. 280. Pöllath & Lohbeck, supra n. 232, at 23. 281. Id.

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economic reasons are given for intervening the foreign company or where this company does not have a substantial business itself.282

15.4.6. Excessive royalty payments Most German tax treaties contain a provision worded as article 12(4) of the OECD Model regarding excessive royalty payments. The France-Germany Income and Capital Tax Treaty (1959), the Germany-Israel Income and Capital Tax Treaty (2014) (protocol 2014) and the Germany-Luxembourg Income and Capital Tax Treaty (2012) do not contain such a provision. However, German literature nevertheless wants to exclude exceeding parts of a royalty from treaty benefits.283 Under article 12(6) of the BelgiumGermany Income and Capital Tax Treaty (1967) only “ordinary” royalties fall under the treaty benefits. It stipulates the use of the cost-plus method to determine whether a royalty is ordinary when paid between connected parties. It is also possible that royalty payments are understated in value. Under German practice it is possible that these are adjusted if Germany is the resident state with the consequence that the adjusted profits fall within the scope of article 9.284 The regional Tax Court of Cologne held in a case regarding the GermanyUnited States Income and Capital Tax Treaty (1989) that the term “special relationship” has a very broad meaning as any interdependence of an economical or personal kind.285 A special relationship can also be based on a dominant market position.286 To determine whether a royalty is at arm’s length, a comparison to the custom in a particular trade is necessary.287 Where a royalty is regarded as excessive, the excess payment does not fall under article 12(1), or (2) but under the respective other articles of the treaty. The most important case is the recharacterization of the excess payment as dividend in the form of a hidden distribution where an excessive payment is 282. 283. 284. 285. 286. 287.

Jacobs, Endres & Spengel, supra. n. 115, at Erster Teil, 5. Kapitel A.(II). Pöllath & Lohbeck, supra n. 232, at 108. Id., at 100. DE: FG Köln, 24 Oct. 2002, 2 K 6626/96, EFG 2003, p. 233. Pöllath & Lohbeck, supra n. 232, at 101. FG Köln, supra n. 285; Pöllath & Lohbeck, id.

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made due to a dominant position of one or more shareholders. The hidden distribution is taxed as a dividend under domestic tax law and article 10 of a treaty. Accordingly, it must not be deducted since it is a distribution but not business costs.288 Thus, the recharacterization leads to a higher profit.289

288. Pöllath & Lohbeck, supra n. 232, at Art. 10, para. 23 (for the similar situation of an excess payment in interest) and Art. 11. 289. DE: BFH, 27 Sept. 1967, I 63/64, BStBl. II 1968, p. 50.

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16.1. Introduction on private law aspects of intellectual property (IP) 16.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law Italian private law does not provide for a wholly comprehensive definition of the terms “intangible properties” or “intellectual properties”. Different laws regulate various categories of intangibles. In particular, under Italian private law there is a general distinction between: – copyrights (diritti d’autore), which protect intellectual works (opere dell’ingegno), which are regulated by articles 2575-2583 of the Civil Code, and by special regulations provided in the Copyright Act;2 and – industrial property rights (diritti della proprietà industriale), which encompass three different categories of rights: (i) patents for industrial inventions (invenzioni industriali) and registration for design and model, regulated by articles 2584-2594 of the Civil Code and by special regulations provided in the Industrial Property Code;3 (ii) distinctive signs (segni distintivi), which cover, inter alia, trademarks, regulated by articles 2363-2574 of the Civil Code and by the Industrial Property Code; and

1. Associate, Maisto e Associati, Milan. The author can be contacted at a.brazzalotto@ maisto.it. 2. IT: Legge sulla protezione del diritto d’autore e di altri diritti connessi al suo esercizio, Law 633 of 22 April 1941 [Copyright Act for the Protection of Copyright and Related Rights] (as amended by Law No. 208 of 28 December 2015 and Legislative Decree No. 8 of 15 January 2016) [hereinafter Copyright Act]. The Copyright Act also incorporates the principles laid down in the Berne Convention for the Protection of Literary and Artistic Works (9 Sept. 1886) (Berne Convention). 3. IT: Codice della proprietà industriale, Legislative Decree No. 30 of 10 February 2005 (Industrial Property Code).

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(iii) protection granted by the Industrial Property Code to non-registered industrial property (e.g. know-how). The first category of IP mentioned in article 12(2) of the OECD Model (2017) (i.e. copyright of literary, artistic or scientific work including cinematograph films) falls within the scope of the rights protected by the Copyright Act. In general, copyright is acquired by the author with the creation of a work resulting from an intellectual effort, which pertains to the field of sciences, literature, music, figurative arts, architecture, theatre and cinematography.4 No registration is required to benefit from copyright protection, which is thus automatically granted.5 The conditions for intellectual works for being protected are: (i) creativity; (ii) novelty; (iii) degree of externalization; and (iv) degree of affiliation to art or culture. 4. See IT: Codice civile [Civil Code] (approved by Royal Decree No. 262 of 16 March 1942 and amended up to Decree No. 291 of 7 December 2016), art. 2575 and art. 1 Copyright Act. There is no specific definition of the meaning of works protected by copyright. Case law, with reference to the qualification of an “opera dell’ingegno” (intellectual works), has specified that the object of the legal protection is not the internal intellectual content of the intellectual work, but its external realization and representation as it is characterized by the originality and personality of its author. According to scholars, the common element of intellectual works is that they are work creations of the human intellect with a requirement of creativity (see P. Marchetti & L.C. Ubertazzi, Commentario breve alle leggi su proprietà intellettuale e concorrenza p. 1462 (2016). Such a theory seems to be in line with some recent decisions of the European Court of Justice (ECJ) that have outlined an autonomous definition of “intellectual property” protected by EU law. See, for example, with reference to photography, AT: ECJ, 1 Dec. 2011, Case C-145/10, EvaMaria Painer v. Standard Verlags GmbH and others, concerning photos protected by copyright: “In that regard … an intellectual creation is an author’s own if it reflects the author’s personality. That is the case if the author was able to express his creative abilities in the production of the work by making free and creative choices.” ECJ Press Release No 132/11 (1 Dec. 2011). 5. The author of an original work is granted a moral right to be acknowledged as the author of the original work (this right is imprescriptible, inalienable and unassignable) and an economic right of exploitation of the work (this right is alienable/assignable, wholly or partially, and limited in time up to the 70th year after the death of the author). As to the economic rights of the author, the latter has the exclusive right to: (i) publish the work and utilize it in any economic way; (ii) reproduce and make copies of the work; (iii) transcribe the work (if oral); (iv) perform, represent and show the work to the public; (v) broadcast and telecast the work by any means, including cable or satellite transmissions; (vi) distribute the original work or copies thereof among the public by any means; (vii) translate the work in any language; and (viii) rent or transfer for use the original or copies of the work for a limited period of time and with the aim to benefit directly or indirectly, economically or commercially, the user. All these rights are independent from each other and the exercise of one of them does not preclude the exercise of the others. These rights cover the entire work and any part of it and are transferable (see Copyright Act, Ch. II – Transmission of right of utilization, arts. 107 to 155). As to the author’s moral right, this stays with the author even if he has transferred in whole or in part the economic rights on the work.

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Article 2 of the Copyright Act identifies ten protected categories of works:6 (i) literary, theatrical, scientific, educational and religious works (whether in written or oral form); (ii) musical works; (iii) choreographic or pantomimic works; (iv) works of sculpture, paintings, drawings, engravings and other similar forms of figurative arts; (v) drawings and architectural works; (vi) cinematographic works;7 (vii) photographic works; (viii) software programs however expressed, provided they are original works resulting from an intellectual effort of the author; (ix) databases, which for choice or organization of the content constitute an author’s intellectual creation;8 and (x) works of industrial design that present creative character and artistic value.9 The expression “design or model, plan” employed by the OECD Model definition of royalties in article 12(2) refers to categories of IP which could be both protected by copyright and registered as design or utility models in the industrial field (see below). Specific rules are also set forth for collective works (i.e. magazines, encyclopaedias, etc.), according to which the publisher has the right to economically exploit the whole work, but the copyright in the single contributions remains with the respective authors.10 In addition to copyrights, which recognize the author with the exclusive right to exploit his work, Italian private law also protects rights connected with the use of copyrights (so-called “neighbouring rights”) within the scope of Chapter II of the Copyright Act.11 This category includes rights with different content and object, which are “connected” in different ways to copyright.12 The typical example of neighbouring rights are those granted to categories of right holders (other than authors) who, in the course of an artistic activity or entrepreneurial activity, use the work of a different person 6. It is a non-exhaustive list so there may be other works protected by copyright (e.g. TV formats can be protected by copyright even if such work does not fall under the enumerated categories; see IT: Corte Suprema di Cassazione (Supreme Court, CSC), 27 July 2017, Decision no. 18633. 7. The author of the subject, the author of the screenplay, the composer of the music and the director shall be considered joint authors of a cinematographic work (art. 44 Copyright Act). 8. The protection of databases does not extend to their content. 9. In addition, industrial design can also be protected by design registration. 10. See arts. 3 and 38 Copyright Act). 11. The chapter is entitled “Disposizioni sui diritti connessi all’esercizio del diritto d’autore” (“Provisions on rights related to the exercise of copyright”). 12. In particular, scholars highlight the heterogeneous nature of the neighbouring rights: see P. Auteri, Diritti connessi al diritto d’autore, in Diritto industriale: proprietà intellettuale e concorrenza p. 675 (5th edn, 2016).

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(e.g. the Copyright Act protects artists, performers or executors, who have recorded their performances on a phonogram or on an audiovisual work or similar). For instance, the phonogram producer shall be entitled to a remuneration for the public communication and diffusion of music recordings, including public diffusion by radio or TV (broadcasting) and public diffusion in discotheques and other public places (public performance).13 According to scholars and case law, the interpretation and execution of a work or composition by an interpreter or performer do not constitute an intellectual work protected by an autonomous copyright, but only a “connected right”, which presupposes the use of an intellectual work.14 The category of neighbouring rights includes also rights covering works similar to those protected by the copyrights but that technically do not presupposes the use of an underlying copyright (e.g. image rights). Industrial properties encompass “patents”, “trademarks”, “design or models” and “information concerning industrial, commercial or scientific experience”. On this regard, article 1 of the Industrial Property Code reads as follows: For the purposes of this Code [the Industrial Property Code], the expression “industrial property” includes trademarks and other distinctive marks, geographical indications, designations of origin, designs and models, inventions, utility models, topographies of semiconductor products, confidential business information and new plant varieties.

Industrial property rights are acquired through patenting, registration or the other methods set forth by the law. In particular, inventions, utility models and new plant varieties are eligible to be patented.15 A patent constitutes a legal title that confers an exclusive right to exclude other persons from 13. See art. 73 and 73-bis Copyright Law 1941 (amended 2010). 14. See also IT: CSC, 29 Sept. 2006, Decision No. 21220, dealing with the inclusion of the rights related to copyrights within the definition of royalties under article 12 of the It.-US Income Tax Treaty (1999), where the Court stated that “under Italian law such rights could not be regarded as identical to copyrights”. See V. de Sanctis, Artisti ed esecutori, in Enciclopedia del diritto (1958), according to which “the performance of the executor that regards an intellectual creation should be considered as an artistic activity of intermediation between the author and the public, aimed at giving acknowledgement among the public of an intellectual creation already formed in the essential elements. … The interpretation activity (by means of voice, instruments, stage performance) does not give rise to an autonomous intellectual work covered by copyright.” See also De Sanctis, I soggetti del diritto d’autore 197 (2000); M. Fabiani, Diritto d’autore e diritto degli artisti interpreti ed esecutori 206 (2004), according to which the difference between the author and the artist is that the first give rise to an intellectual creation while the second performs an already existing creation. The function of the artist is to provide knowledge of the author’s message, by means of his personal interpretation. 15. See art. 2 Industrial Property Code.

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producing, marketing, importing or otherwise utilizing the invention without the patent owner’s permission.16 Patents may be granted for inventions, in all technical sectors, which are lawful, new, characterized by an inventive activity and suitable for industrial application.17 Patent protection lasts for 20 years from the filing date.18 Patents may be granted also to utility models apt to provide particular efficacy or convenience of application or use for machines, or parts thereof, instruments, tools or functional objects in general, such as new models consisting of particular conformations, arrangements, configurations or combinations of parts. Utility model patent protection lasts for 10 years from the filing date. Trademarks, designs and models, and topographies of semiconductor products may be registered.19 According to article 7 of the Industrial Property Code, a trademark may consist of any signs capable of being represented graphically, and in particular words, including personal names, designs, letters, numerals, sounds, the shape of goods or of their packaging, the colour combinations or tones, provided that such signs are capable of distinguishing the goods or services of an enterprise from those of other enterprises.20 In order to be registered, a trademark must be novel, lawful and have a distinctive character.21 Designs and models are new ideas aimed at improving the appearance (shape, colours, lines, contours, texture) of products.22 Industrial designs having an inherent creative feature and artistic value are also protected under the Copyright Act. Therefore, design related to the appearance and the aesthetic of an industrial product may be registered, whereas utility models with technical features may be patented. 16. See art. 66(2) Industrial Property Code. The inventor is also entitled to personal rights (so-called authorship right), i.e. the right to be acknowledged the authorship of the invention. This right is imprescriptible, inalienable and unassignable. 17. See art. 45 Industrial Property Code. 18. Three effective patent protection schemes are available in Italy: national patents, European patents and international patents under the Patent Cooperation Treaty (PCT) (1970). 19. See art. 2 Industrial Property Code. 20. In addition, persons whose function is to guarantee the origin, nature or quality of specific goods or services, may obtain the registration for specific collective trademark (so-called “machio collettivo”) and may grant the use of the marks to producers or traders. 21. Trade mark protection lasts for 10 years from the filing date and can be renewed indefinitely for 10-year periods. 22. Design protection lasts for 5 years from the date of submission of the request for registration and is renewable for periods of 5 years up to a maximum of 25 years.

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Paragraph 11 of the Commentary on Article 12(2) of the OECD Model (2017) identified “information concerning industrial, commercial or scientific experience” with know-how. Under Italian private law know-how or, more in general, information covered by the industrial secret enjoys a specific protection granted by articles 98 and 99 of the Industrial Property Code. In this category may be encompassed all knowledge and expertise of an industrial, commercial or scientific nature, whether patentable or not, if certain conditions are met. In particular, business information and technical, industrial and commercial experience are protected by domestic private law to the extent that such information: (i) is confidential in the sense that it is not generally well known or easily accessible by experts and operators in the field; (ii) has an economic value, as it is confidential; and (iii) is subject to adequate security measures, which are implemented to keep the information secret.23,24 Marketing information concerning useful data for commercial activity (e.g. customer list) falls within the protection granted to confidential information, to the extent that the above-mentioned requirements are met. The expression “secret formula or process”, also contained in the OECD Model definition of royalties, should be covered by the wide definition of know-how provided for by domestic private law. With reference to image rights, the legal status of the right of image in Italy is found in article 10 of the Civil Code and article 96 of the Copyright Law. In particular, article 10 of the Civil Code stipulates that whenever the image of an individual or one of his relatives is showed or published (i) in a circumstance that it is not foreseen by a disposition of law or, in any case, (ii) with the effect of harming the dignity or reputation of the individuals, the judicial authorities, upon request of the individuals involved, may order the termination of the image (ab)use and the indemnification of damages occurred. On the other hand, article 96 of the Copyright Law stipulates that the image (or, with the same meaning, the portrait) of an individual cannot be shown, reproduced or otherwise commercialized without the previous 23. See art. 98 Industrial Property Code. Protection shall also be granted to data relating to tests or other confidential data, whose processing entails a considerable effort and whose presentation is conditional upon the marketing authorization of chemical, pharmaceutical or agricultural products implying the use of new chemical substances. 24. Also relevant, for this purpose, is the definition of know-how provided for by Commission Regulation (EU) No. 316/2014 of 21 March 2014 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of technology transfer agreements, according to which “‘know-how’ means a package of practical information, resulting from experience and testing, which is: (i) secret, that is to say, not generally known or easily accessible, (ii) substantial, that is to say, significant and useful for the production of the contract products, and (iii) identified, that is to say, described in a sufficiently comprehensive manner so as to make it possible to verify that it fulfils the criteria of secrecy and substantiality.”

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consent of the individual. Literature and case law25 tend to emphasize the economic aspects of the right of image and consider it as a right with an autonomous patrimonial content. Consequently, civil law scholars have included image rights under the category of neighbouring rights. The image of a famous individual could be also registered as a trademark. It is worth noting that the industrial property legislation in Italy is constantly subject to EU harmonization (for instance, EU Directive 2015/2436 of 16 December 2015 relating to the harmonization of domestic legislation on trademarks should be implemented by 14 January 2019).26 Moreover, Italy ratified most of the international treaties on copyrights and industrial property rights, ensuring equal protection to both Italian and foreign works within the Italian territory, and recognizing the fundamental principles of foreign law and mutual rights protections.27 The private law meaning of the above-illustrated categories of intangible properties is relevant for both the purpose of interpreting and applying article 12(2) of the tax treaties concluded by Italy, which generally follow the OECD Model, and the qualification of income deriving from utilization of IP under domestic tax law. Neither article 12(2) of the OECD Model 25. There are several decisions that confirmed such a view: see ex plurimis IT: CSC, 2 May 1991, Decision No. 4785, in Foro Italiano 1992, I, column 831, with comment of M. Chirolla, Alla scoperta dell’America, ovvero: dal diritto al nome ed all’immagine al “right of publicity”; IT: CSC, 10 June 1997, Decision No. 5175; CSC, 11 Oct. 1997, Decision No. 9880, with comment of D. Ancienti, Lo sfruttamento pubblicitario della notorietà tra concessione di vendita e contratto di sponsorizzazione, in Giust. Civ., 1998, p. 1067 et seq. See also S. Gatti, Il “diritto” alla utilizzazione economica della propria popolarità, Riv. Dir. Comm., p. 355 et seq. (1988); A.M. Toni, Il “right of publicity” nell’esperienza nordamericana, Contratto e impresa, p. 82 et seq. (1996). The patrimonial nature of the image right has also found regulatory consecration in the context of social security contribution, under art. 43(3) of Law No. 289 of 27 Dec. 2002. The Italian tax authorities in Ruling No. 255/E of 2 Oct. 2009, which dealt with the case of an artist that disposed its image right in favour of a resident company, shared the view that in the case of a famous person in the world of entertainment, the image constitutes a good both in a legal and economic sense, susceptible to exploitation. 26. On 1 Oct. 2017, the second part of the European legislative reform on trademarks came into force. A first part of the provisions of Regulation (EU) 2015/2424 of the European Parliament and of the Council amending the EU trademark entered into force on 23 Mar. 2016. 27. However, note that IP is subject to the territoriality principle according to which IP rights are acquired on a territorial basis (i.e. on a country-by-country basis). Hence, an invention patented under the law of a foreign state is not generally protected under the law of another state, unless the patent protection has also been extended under the law of the other state. For instance, Italian private law does not automatically recognize the effects in Italy (and the enforcement cannot be granted) of a patent granted under the law of the United States, unless the same patent has also been protected under the Italian law.

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(2017) nor domestic income tax law provide for an autonomous definition of IP. Although domestic tax provisions concerning the taxation of income deriving from IP do not include any express reference to private law (i.e. domestic tax law does not explicitly refer to payments for the use of certain IP rights as defined or covered by private law), the interpretation of the undefined legal jargon terms employed by Italian tax provisions generally rely on private law meanings.28 As a consequence, tax treaty terms not defined within article 12(2) shall also be interpreted by reference to the meaning they have for the purpose of the domestic private law under article 3(2) of the OECD Model (2017).29 This issue is addressed in detail in section 16.2.1.

16.1.2. Distinction under private law between alienation of IP and granting the right to use IP Under Italian private law, the identification of the owner of an IP is based on a very formal approach driven by the concept of legal ownership, as departures from legal title (such as economic ownership) are not generally recognized. Conversely, from a tax perspective, the relevance of the economic ownership seems to be accepted (and in some circumstances to be preferred) by the Italian tax system, which generally privileges a substance-over-form approach (see section 16.2.2.1.3.1. with reference to the eligibility of the licensee as the economic owner of the licensed IP to elect for the patent box regime if he contributes to the development of the IP carrying out qualifying 28. However, it may be that domestic tax law attributes a specific meaning to the same categories of IP but in a different context and for the purposes of the application of a special tax regime (e.g. Ministerial Decree of 28 Nov. 2017, which enacted the optional patent box regime, provides for a more detailed list of the qualifying IP that fall within the scope of the patent box regime). In such a case, it would seem reasonable to apply the meaning that is attributed to those terms for the purpose of the tax law provision that appears to be the most closely connected to, or relevant for, the tax treaty provision to be interpreted. Therefore, a construction in good faith of the tax treaty does not seem to preclude the interpreter from attributing to a treaty term the meaning that it has under a domestic field of law other than tax law, where the non-tax law meaning appears to be more appropriate than the tax law meaning employed in a context far removed from the context where the term is used in the tax treaty. See P. Arginelli, The Interpretation of Multilingual Tax Treaties p. 487 (Leiden University Press 2013). 29. This principle has been expressly recalled by the Italian tax authorities within Ruling no. 143/E of 22 Nov. 2017, dealing with the interpretation of “copyright of artistic work” for the purpose of art. 12(3) of the Fr.-It. Income and Capital Tax Treaty (1989), according to which royalty payments arising from the use of, or the right to use, a copyright of literary, artistic or scientific work are exempted in the source state. In particular, the reference to Italian private law and case law has been required in order to understand when industrial design may be protected under Copyright Act or by design registration.

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research and development (R&D) activities). A special regime for the ownership of inventions made by employees is provided for under article 2590 of the Civil Code: in general terms, the employee would be granted the moral right (i.e. the authorship right on the invention) while economic rights (including right to patent) would typically be attributed to the employer.30 This being said, the IP legal owner has an exclusive right to use and dispose of the economic rights connected to such IP.31 In general, IP may be (partially or totally) either transferred or licensed. A transfer agreement takes place whenever there is a definitive assignment of the legal ownership of an IP in favour of the transferee.32 For instance, trademarks are normally transferable: the holder (transferor) may definitively assign the trademark to a third party (transferee), in whole or in part (e.g. only for use of some of the products or services for which it has been registered).33 With reference to copyrights, each economic right34 granted to the author in connection with the intellectual work may be transferred autonomously or in combination with each other. Under a licence agreement,35 the IP owner (the licensor), without waiving the legal ownership, grants to another person (the licensee) the right to exploit the IP, usually against remuneration. The sub-licensing of IP is also allowed within the limits of the rights granted to the licensee under the 30. See art. 2590 Civil Code and art. 64 Industrial Property Code. A special regime is also available for inventions made by researchers at universities and public research entities (see art. 65 Industrial Property Code). 31. In terms of formalities, there are no particular legal requirements for the validity or evidence of the relevant agreements between parties. Arts. 138 and 139 of the Industrial Property Code, however, require the registration of agreements concerning “registered” IP with the Italian Patents and Trademarks Office registry, as a condition for obtaining protection against third parties. The transfer of the right to use a copyright has to be evidenced in writing. 32. The alienation of the ownership may be realized through several types of agreements (sale, barter, donation, contribution, merger, etc.) and, generally, by means of any legal instrument capable of definitively transferring the legal ownership. 33. See art. 2573 Civil Code and art. 23(1) Industrial Property Code. Before 1992, trademarks were transferable only in connection with a business (or a part thereof). 34. As previously stated, right to copy, right to display to the public, right to disseminate with any means including cable and satellite, right to distribute and sell, right to translate and right to lease or lend. 35. As to the content of the licence agreement, this type of contract is not expressly contemplated by Italian private law (so-called “contratto atipico”), therefore its terms are fixed by agreement of the parties. Authoritative scholars agree that it should be assimilated to a lease agreement (see, F. Galgano, La cultura giuridica italiana di fronte ai problemi informatici, in I contratti di informatica p. 379 et seq. (G. Alpa & V. Zeno-Zencovich eds., (1987) and F. Marabini, Licenza di brevetto, in I Contratti p. 514 et seq. (V. Cuffaro ed. (2005).

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licence agreement. IP may be licensed on an exclusive or non-exclusive basis.36 The licence can cover the whole national territory or be limited to a part of it.37 With reference to know-how (i.e. secret information regarding industrial, commercial and technical experience), the agreements for the transfer of secret information have been recognized by case law,38 scholars39 and EU law.40 They are generally defined as a contract by which an entrepreneur (grantor), against consideration, puts another entrepreneur (grantee) in the condition of knowing and using the grantor’s expertise or inventions (which are not patented or not patentable but covered by the industrial secret).41 Such agreements may be characterized as either a sale or a licence agreement. Under a sale arrangement, the owner permanently transfers his knowhow to a third person and usually waives any right to exploit the know-how and to use the information. The transferee’s rights should not have any restrictions and consist of complete rights in the underlying secret information, since know-how is not subject to the territoriality principle and does not constitute a separate and autonomous right in the different jurisdictions (rights on patent and trademarks may instead be geographically limited). Conversely, under a licence agreement, the grantor may keep the right to use the know-how and the grantee’s rights may be subjected to any limitation in terms of time, geographical area and object. It was questionable among the scholars the admissibility of a licence agreement dealing with know-how since once that information is unveiled, the transaction might be deemed as equivalent to a definitive transfer, so it is not materially possible to only “make use of information”. It has been argued that the fact the grantee may retain and continue to use the information even after the expiration of the 36. Under an exclusive licence the licensor waives the right to use the IP and undertakes not to license the IP to others. 37. As for the assignment, the licence of a trademark may refer only to some of the products/services for which the trademark is registered. 38. The leading case is IT: CSC, 20 Jan. 1992, Decision no. 659. The principles enshrined under this decision have been expressly recalled by the Italian tax authorities within Ruling no. 5/E of 10 January 2002, dealing with a so-called “mixed contract” pursuant to which an Italian resident company, owner of the technology, licensed a patent and the know-how necessary to exploit the patent to a non-resident company. 39. See A. Vanzetti & V. Di Cataldo, Manuale di diritto industriale p. 501 (2012); A. Blandini, item Know-How, in Enciclopedia del diritto, Aggiornamento, I, 1997, p. 736 et seq.; A. Frignani, Know-How, in Digesto delle discipline privatistiche, Sezione Commerciale p. 98 (1992). 40. See (EU) No. 316/2014 of 21 March 2014, supra n. 24. On this subject, see L. Zagato, Il contratto comunitario di licenza di know-how p. 158 et seq. (1996). 41. With regard, for instance, to manufacturing know-how, the owner is required to prove that such procedures or formulae are secret, i.e. not available to the public, are kept confidential with adequate measures, are unique and possess an economic value.

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licence agreement it is inconsistent with the nature of the licence agreement. The grantee can be restricted on the use of such information under a specific obligation included in the agreement (non facere obligation). In this respect, the licence agreement dealing with know-how has been considered valid, regardless the impossibility to “restitute” the properties to the grantor.42 Finally, with reference to the distinction between sale and licence agreements, difficulties may arise in the context of certain transactions. Take into account, for instance, a licence agreement of an IP that (i) includes an exclusive clause, (ii) grants the right to use such IP without any geographical limitation and until the expiration of the legally protectable status or without any specified deadline and (iii) establishes the consideration in the form of a substantial lump sum or up-front payment. In such a case, it could be argued that this arrangement substantially entails the transfer of the economic ownership on the IP to the licensee, being the legal owner completely deprived of any rights on it. However, as outlined above, the characterization of a transaction under domestic private law is based solely on a formalistic notion of alienation, which refers exclusively to the final transfer of properties, while the concept of economic ownership is not recognized. Consequently, under Italian private law, a transaction involving the transfer of IP shall be qualified on the basis of whether the transfer of legal ownership occurred. It is also worth mentioning that the essential character of the transaction as an alienation or licence is not altered by the form of the consideration (lump sum, instalments, royalties, etc.).43

16.2. Taxation of IP under the domestic tax law 16.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP Under Italian income tax law there are a number of provisions concerning (explicitly or implicitly) IP. In particular, such provisions concern the characterization and source of income arising in IP transactions, as well as the application of withholding taxes on outbound royalties. Articles 53(2)(b) and 67(1)(g) of Presidential Decree 917 of 22 December 1986 (hereinafter the Income Tax Code, ITC), which qualify the income deriving from IP either as self-employment income 42. 43.

See, in particular, Frignani, supra n. 39, at p. 89. See M. Scuffi & M. Franzosi, Diritto industriale italiano p. 965 (2014).

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or miscellaneous income, make reference to: “Income derived from the economic utilization … of intellectual properties, patents and processes, formulas or information related to experiences acquired in the industrial, commercial or scientific field….” Article 23(2)(c) of the ITC, which provides the sourcing rules for income received by non-resident persons, states that the following items of income shall be regarded as Italian-source income if the payer is the Italian State, an Italian resident person or an Italian permanent establishment (PE) of a nonresident person: “compensation for the utilization of intellectual property, patents and trademarks as well as processes, formulas and information relating to the experience acquired in industrial, commercial or scientific field”. Article 26-quater(3)(a) of Presidential Decree no. 600 of 29 September 1973 (hereinafter Decree 600/1973), which implemented Council Directive 2003/49/EC (commonly referred to as the Interest and Royalties Directive, hereinafter I&R Directive),44 which provides for an exemption from withholding tax, explicitly defines “royalties” as: [P]ayments of any kind received as a consideration for the use of, or the right to use: 1) copyright of literary, artistic or scientific work, including cinematograph films and software; 2) patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience; 3) industrial, commercial or scientific equipment.45

From the analysis of the above-mentioned provisions it is clear that under domestic income tax law there is no unique and uniform definition of royalties.46 For instance, domestic distributive rules (articles 53(2)(b) and 67(1) (g) of the ITC) do not formally include trademarks among the categories of IP whose economic utilization generates either self-employment or

44. Directive 2003/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. 45. The quoted definition of “royalties” resembles that set forth by art. 2 of the I&R Directive. 46. M. Greggi, Profili fiscali della proprietà intellettuale nelle imposte sui redditi p. 33 et seq. (2009). The author points out that the different tax regimes applicable to income from IP under domestic tax law complicates the qualification income within a cross-border context, considering that both tax treaties and the I&R Directive employ an autonomous meaning of royalties. Conflicts of qualification may then easily arise. G. Tabet, Il diritto d’autore nella normativa tributaria, Rass. Trib., p. 57 (1988) notes that despite a “fragmented” approach of the Italian tax system, it is possible to argue that the tax regime applicable to proceeds deriving from IP constitutes a “mini-system” within the ITC.

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Taxation of IP under the domestic tax law

miscellaneous income,47 whereas trademarks are included, together with the other categories of IP, within the sourcing rule (article 23(2)(c) of the ITC). Moreover, only for the purpose of the application of the exemption from withholding tax on outbound royalties (article 26-quater(3)(a) Decree 600/1973), do payments for the use of, or the right to use, industrial, commercial or scientific equipment fall within the definition of royalties. Conversely, income deriving from the use of industrial, commercial or scientific equipment is not generally characterized as royalty payment (i.e. it is not included among the items of income stemming from the utilization of IP) under the domestic distributive and sourcing rules.48 The definition of royalties contained in article 26-quater(3)(a) of Decree 600/1973 expressly also includes payments for the use of, or the right to use, software, while the other mentioned provisions refer to the general category of IP. The departures of such a provision from the others included in the Italian tax system is due to the fact that it merely reproduces the definition of “royalties” contained in article 2 of the I&R Directive.49 As indicated in section 16.1.1., domestic income tax law does not provide for autonomous IP definitions. In order to interpret the undefined terms used in the tax provisions making reference to various types of IP, it is therefore necessary to make implicit reference to the corresponding notions provided for under Italian private law (in accordance with the interpretation of civil law court decisions and scholars).50 The relevance of private law concepts 47. The list of intangibles provided by art. 53(2)(b) of the ITC should be considered exhaustive and cannot be extended by analogy to other categories of intangibles. See E. Gulmanelli, Beni immateriali (diritto tributario), in Enc. Giur. Treccani, 1993. According to the author, “the enumeration of intangibles [provided by art. 53(2)(b) ITC] is exhaustive and cannot be extended by analogy to other categories of intangibles. This is due to the elimination of the phrase ‘et similia’ from the original provision of article 49(3)(b) of the Presidential decree 29 September 1973, no. 597 (‘incomes deriving from the economic exploitation of trademarks, intellectual property, industrial invention et similia, …’) aimed at including incomes derived from any kind of intangibles” [unofficial translation]. 48. In fact, as described in sec. 17.2.2.3., the income deriving from the use of equipment falls within the category of miscellaneous income (if the recipient does not carry on a business activity) and, precisely, under art. 67(1)(h) of the ITC which dealt with income deriving from the lease, rental, charter or of permission to use of vehicles, machinery or other tangible property. Such a characterization influences the application of the proper source rule: income deriving from the use of equipment is deemed to be Italian-source income if deriving from activities carried on in Italy or from assets located in Italy (art. 20(1) (f) ITC). 49. See sec. 16.3.2. 50. See C. Sacchetto, I redditi di lavoro autonomo p. 131 (1984); N. D’amati, Manuale della tassazione dei redditi di lavoro p. 235 (1996); Tabet, supra n. 46, at p. 56. In particular, with regard to the definition of “copyrights” for VAT purposes, the same reference to the private law and special regulations is made by Ministerial Resolution no. 143/E of 19 June 1997. Note also that it is a general principle of Italian tax law that implies

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for tax law purposes is expressly confirmed by the special rules that have been enacted for the Italian patent box regime. In particular, article 6(2) of Ministerial Decree of 28 November 2017 provides that:51 For the definition of the above-mentioned intangibles [the intangibles to which the Italian patent box regime applies] and requirements for their existence and protection it shall be referred to the domestic, European Union and international provisions and those contained in European Union regulations, international conventions on industrial and intellectual property applicable in the relevant territory of protection.52

In Circular Letter no. 42 of 12 December 1981, the Italian tax authorities (ITA) provided some guidelines for identifying the categories of IP included in the source rule concerning income from IP derived by non-resident taxpayers.53 In particular, the ITA adopted a definition of know-how including: [T]he undivulged technical information, whether capable of being patented or not, that is necessary for the industrial reproduction of a product or process,

referring to definitions provided for by other branches of domestic law for interpreting the meaning of terms undefined for tax purposes, in consideration of the presumption of consistency and unity of the Italian legal system. See, G. Falsitta, Manuale di diritto tributario p. 172 (2003); Greggi, supra n. 46, at p. 20; F. Bosello, La formulazione della norma tributaria e le categorie giuridiche civilistiche, Dir. prat. trib. I, p. 1433 et seq. (1981); G. Melis, L’interpretazione nel diritto tributario p. 143 et seq. (2003). See also the above- mentioned CSC Decision no. 21220 of 29 Sept. 2006, which refers to the Copyright Act in order to interpret the meaning of rights connected to copyrights and Ruling no. 143/E of 22 Nov. 2017, supra n. 29. 51. The following intangible assets fall within the scope of the patent box: patents (registered or in the process of being registered), copyrighted software, processes, formulas, designs and models that can be legally protected, trademarks (registered or in the process of being registered) and any other kind of know-how that can be legally protected. 52. The ITA have provided some administrative guidelines on the paten box regime in Circular Letter no. 11 of 7 Apr. 2016. With reference to the identification of qualifying intangibles, it has been confirmed that the definitions and requirements for obtaining the protection rely on private law. Nevertheless, the Circular Letter for each category of IP provides useful clarification for detecting the properties eligible to generate qualifying income for the purposes of the patent box regime (as described below there is an express reference to the Industrial Property Code for identifying the qualifying know-how). These guidelines represent certainly the most important interpretation of the meaning of the specific categories of IP provided by the ITA. 53. In particular, Circular Letter no. 42 of 12 Dec. 1981 commented the introduction by art. 31 of Presidential Decree no 897 of 30 Dec. 1980 of a new specific source rule applicable to the income related to the use of IP and tangible properties. The new provision inserted within art. 19(1)(9) of Presidential Decree no. 597 of 29 Dec. 1973 was replaced by art. 20(2)(c) of the ITC in 1986 and subsequently by art. 23(2)(c) of the ITC currently in force.

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Taxation of IP under the domestic tax law

directly and under the same conditions; inasmuch as it is derived from experience, know-how represents what a manufacturer cannot know from mere examination of the product and mere knowledge of the progress of technique.54

Recently, the ITA clarified in Circular Letter no. 11 of 7 April 2016 that for the purposes of the patent box regime, business information and technical-industrial know-how that can be legally protected, including those commercially or scientifically protected as secret information, refer to the scope of the protection granted to confidential business information, as laid down in article 39 of the Agreement on the Trade-Related Aspects of Intellectual Property Rights (TRIPS Agreement) and in articles 98 and 99 of the Industrial Property Code in connection with the protection granted for the information concerning industrial, commercial or scientific experience. Italian domestic law contains neither a definition of “technical assistance” nor of “technical services”.55 First of all, it should be borne in mind that according to the domestic tax legislation, income from services rendered in the carrying on of a business activity falls within the category of business profits (in the same way as royalties deriving from the exploitation of an IP in the course of a business activity).56 Should the services be rendered outside a business activity, the relevant income may be considered either self-employment or miscellaneous income. Payments for services are not included within the definition of royalty under Italian income tax law. Only the payment for the right to use an IP is regarded as royalty. The characterization of the income impacts on the application of sourcing rules in the case of services rendered by non-resident suppliers.57 This being said, income deriving from the supply of technical services should not fall under the scope of the different definitions of royalties and provisions described above and should not be considered income from IP under domestic tax law. However, the distinction in some circumstances between the transfer of know-how and the supply of services embodying a technical content is far 54. The definition coincides with that given by the Association des Bureaux pour la Protection de la Propriété Industrielle in the Commentary of the OECD Model (OECD 1977). 55. Reference could be made to the definition afforded by the OECD Technical Advisory Group on characterization of electronic commerce payments released in February 2001 in paras. 36 et seq. The meaning usually contained in the treaties including technical service fees within the scope of the royalty definition and endorsed by the OECD is: “The term ‘technical fees’ as used in this Article means payments of any kind to any person, other than to an employee of the person making the payments, in consideration of any service of a technical, managerial or consultancy nature.” 56. See sec. 16.2.2. 57. Analysis of the sourcing rules applicable to the different categories of income is addressed in sec. 16.2.3.

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less clear-cut. The separation of the royalties paid for the licensing of knowhow from the payments related to the provision of technical services could be even more difficult in the case of “mixed” contracts or bundled contracts whereby technical assistance is combined with the licensing of know-how.58 The characterization of the respective income as either royalties or business profits59 is particularly relevant in cases involving cross-border transactions. These issues are addressed in more detail in section 16.4.2. From a domestic tax perspective, it can be observed that where Italy is the state of residence of the beneficiary of a service supplied by a non-resident person (thus, from a bilateral perspective Italy is the state of source of that income), there is a tendency by the ITA to aggregate transactions that include both technical assistance and licensing of IP and to characterize as licensing of know-how the supply of any information having a technical content (regardless of whether it had the main features of know-how).60 This approach may affect the characterization of the income as royalties and imply the application of the domestic withholding tax on outbound payments. In the author’s opinion, this particular issue should be resolved on a case-by-case base. However, even for domestic tax purposes, reference should be made to the distinction between technology-intensive services and supply of know-how

58. See, for instance, the franchising agreement which combines payments for the right to use the name and know-how of the franchisor and also payments for further services (i.e. technical assistance) provided by the franchisor to the franchisee. 59. The issue regarding the distinction between the two concepts arises where royalties are subject to withholding tax at source. 60. As an example, Ruling of the Ministry of Finance no. 8/118 of 14 Feb. 1979 in which the ITA characterized as a transfer of know-how the supply of scientific material as well as of technical assistance. This rigorous position seems to be overruled by Ruling no. 99 of 30 Apr. 1997 that made a clear distinction between the tax ramifications of payments for services (including technical advice) rendered by a non-resident taxpayer without a PE in Italy (not subject to withholding tax in Italy) and payments as a consideration for the use of a trademark and know-how (subject to withholding tax in Italy). Case law also faced the issue about the recharacterization of the payments for technical services as royalties. See IT: Provincial Tax Court of Milan, 16 June 2011, Decision no. 261, where the court confirmed the view of the ITA and concluded that in the presence of a bundled agreement which covers both the right to use IP and the provision of technical assistance (such as a franchising contract), the remuneration falls into the scope of art. 12 of the OECD Model and therefore the withholding tax should have been applied. In such a case, neither the information contained within the underlying agreement nor the evidences provided by the defence were able to make a reasonable apportionment of the stipulated consideration, so that the court ruled that the part of remuneration for the service should have been taxed with the same regime of the royalties considered as the principal part of the agreement. See also IT: Regional Tax Court of Rome, 9 Nov. 2011, Decision no. 687, which excluded the recharacterization made by the ITA of various services (treasury and technical assistance) into a transfer of know-how to be subjected to withholding tax.

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as set forth in paragraph 11 of the Commentary on Article 12 of the OECD Model (2017).61

16.2.2. Qualification of income and applicable tax regimes The Italian tax system does not contain a coherent and comprehensive regime regarding the taxation of IP.62 Thus, the tax ramifications of royalties rely on the ordinary tax rules set forth under domestic tax law. The qualification of income stemming from IP varies according to a number of elements, such as (i) the residence status of the parties involved in the transaction,63 (ii) the characteristics of the person granting the right (e.g. the author or another person who is entitled to exploit the right) and (iii) the connection of the income with the business activity of an enterprise. The different qualification of the IP income has an impact on the application of the relevant tax regimes and sourcing rules. This section focuses on the analysis of the categories of income under which revenues arising from IP can be subsumed and it examines the tax regimes that are applicable to resident taxpayers (acting either individually or in connection with a business activity), while tax rules regarding IP income derived by non-resident taxpayers will be examined in section 16.2.3. The different tax treatment of income deriving from neighbouring rights (i.e. rights connected to IP) and from industrial, commercial or scientific equipment will also be discussed, where relevant. Under the Italian tax system, income tax on resident taxpayers is generally levied in accordance with the worldwide tax principle.64 Income derived 61. See C. Galli, Taxation of income derived from electronic commerce, Italian Report at the Congress of the International Fiscal Association, 2001. 62. Greggi, supra n. 46, at p. 33 et seq. 63. Where the income from IP is derived by non-resident persons is deemed to be sourced in Italy when paid by Italian persons, regardless of the connection of the income with the business activity of an enterprise. 64. Note that as from calendar year 2017, a new optional substitute tax regime for individuals that transfer their tax residence to Italy has been introduced (see art. 24-bis ITC). In a nutshell, such regime provides for the payment of a substitute tax of EUR 100,000 per year in lieu of ordinary taxation on (almost) all foreign-source income and assets. In order to be eligible for the regime, an individual must move his tax residence to Italy without having been resident therein for the previous 9 out of 10 years. The option may be exercised with or without the presentation of an advance ruling request to the ITA. The regime is available for a maximum of 15 years. During the period of validity, no income tax, wealth tax and inheritance tax would be due on foreign assets and income (Italian-source income remains subject to ordinary taxation). With reference to IP income, the royalties earned by the Italian-resident IP owner (under the new special regime) will

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by resident taxpayers from foreign sources is therefore subject to tax in Italy with a possibility for the taxpayer to claim domestic relief (tax credit) for taxes paid in the foreign jurisdiction. Individuals are subject to ordinary income tax (Imposta sul reddito delle persone fisiche, IRPEF),65 whereas companies and other legal entities66 are liable to corporate income tax (Imposta sul reddito delle società, IRES).67 Individuals, companies and other entities engaged in a business activity or in the provision of independent personal services are subject to regional tax (IRAP).68 The taxable base for individuals who do not carry on a business activity comprises only those items which fall into one of the six categories of income set forth under article 6 of the ITC69 (so-called scheduler system). Conversely, all income derived by companies that carry on business activities is considered business income (article 81 of the ITC). The qualification for domestic tax purposes of income derived from IP therefore firstly depends on the connection of the income with the business activity of an enterprise. Where the resident IP holder is a company that carries on business activities, the income qualifies as business income (see section 16.2.2.1.3.). If the resident IP holder does not carry on a business activity, the income may alternatively be qualified as either income assimilated to self-employment income or miscellaneous income (see sections 16.2.2.1.1. and 16.2.2.1.2.).

16.2.2.1. Tax treatment of IP 16.2.2.1.1.  Income assimilated to self-employment income As indicated above, article 53(2)(b) of the ITC provides that “income deriving from the economic utilization” by the author or the inventor of IP, patents and processes, formulas or information concerning experience acquired in the industrial, commercial and scientific field, if such income is

be regarded as foreign-source income and therefore covered by the substitute tax of EUR 100,000 if such royalties are paid by a non-Italian-resident licensee. 65. Progressive tax rates are applicable ranging from 23% to 43%. A further 3% surcharge is applicable to the total taxable income exceeding EUR 300,000. In addition, local surcharges are due: their amount depends on the municipality of residence. 66. Partnerships are fiscally transparent and are not liable to corporate income tax. The partners are taxed on their share of the partnership’s profits. 67. The corporate income tax rate is 24%. It was 27.5% until the fiscal year that was current on 31 Dec. 2016 (i.e. until 31 Dec. 2016 for taxpayers that choose the calendar year as the fiscal year). 68. The standard rate is 3.9%. 69. Income from immovable property, income from capital, employment income, selfemployment income, business income or miscellaneous income.

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Taxation of IP under the domestic tax law

not produced in the carrying on a business activity,70 shall constitute income assimilated to self-employment income. This characterization is therefore subject to the circumstance that such income is generated by an Italianresident author or inventor. Where the income from an IP is derived by an Italian-resident person, other than the author or the inventor, the income shall be qualified as miscellaneous income (see section 16.2.2.1.2.). Both the proceeds from the sale of an IP and the royalties received for the use of the intangible fall within the scope of the application of such a rule (the expression “income deriving from the economic utilization” employed in the above-mentioned article is wide enough to also include the alienation of an IP and the indemnities for the abusive use of an IP).71 As mentioned above (see section 16.2.1.), trademarks are not included among the categories of IP enumerated in article 53(2)(b) of the ITC (and in article 67(1)(g) concerning miscellaneous income). In this respect, it has been stated that income deriving from the use of trademarks might not be included in self-employment income and miscellaneous income since trademarks could be used only within a business activity and trademarks were transferable only in connection with the transfer of a going concern.72 This conclusion, however, seems to be outdated since the transfer of a trademark no longer depends upon the transfer of a business.73 The tax treatment applicable, for instance, to the royalties perceived by an Italian-resident individual who grants (out of the scope of a business activity) the use of his own name registered as trademark therefore remains unclear. Such royalties could fall within the category of miscellaneous income, in particular, as income derived from the assumption of “obligations to permit” under article 67(1)(l) of the ITC.74 However, in such a case the taxable basis would be calculated by deducting all the costs specifically connected to the income (article 71(2) of the ITC), while for the other categories of IP only a forfeit 70. This sentence is aimed at remarking that if the author or the inventor of the IP carries on business activities, the income qualifies as business income. 71. See M. Leo, Le imposte sui redditi nel Testo Unico, Tomo I p. 874 (2016); Greggi, supra n. 46, at pp. 36-37. The ITA have endorsed this interpretation in an unpublished ruling mentioned by Opinion no. 32 of 4 Oct. 2006 issued by the Coordination Committee of Tax Inspector (Servizio centrale degli ispettori tributar, SECIT). 72. Prior to amendment made by article 83 of Legislative Decree no. 480 of 4 Dec. 1992, art. 2573 of the Civil Code provided that trademarks were transferable only in connection with a business (or a part thereof). See in this sense Ruling no. 359/E of 14 Nov. 2002, which characterized as business activity the licensing of a distinctive sign by an entity whose main business purpose was the conduct of non-business activities. See also Gulmanelli, supra n. 47, at p. 2. 73. See Greggi, supra n. 46, at p. 38; M. Piazza, Guida alla fiscalità internazionale p. 808 (2004). 74. Piazza, id., at pp. 808-809; Greggi, id., at p. 81 et seq.

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deduction is allowed (see below). Alternatively, although trademarks are not expressly mentioned in article 53(2)(b) of the ITC, by virtue of an analogical application of that provision, income deriving from the use of the own name registered as a trademark may be qualified as income assimilated to self-employment income and taxed accordingly. Article 54(8) of the ITC indeed provides that income falling within article 53(2)(b) of the ITC is computed as the difference between the amount received in the tax period either in cash or in kind (also in the form of a participation to profits) and a forfeit deduction of 25% as a flat-rate deduction of costs, regardless of the expenses effectively incurred (the deduction increases to 40% if the author or inventor of the IP is younger than 35 years). The income is taxed on a cash basis, i.e. the income is taxed in the calendar year in which the author or inventor materially receives the payment of the remuneration. In the view of ITA, such forfeit regime of computation specifically provided for income from IP (rather than the analytical determination ordinarily applicable in case of self-employment income) is due to the special nature of this type of income, in particular, to the objective difficulties which the author or inventor of an IP would meet to keep an accurate and timely documentation of all the expenditure connected to the IP.75 In cases where the Italian-resident author or inventor has “created” an IP in the context of his habitual professional or artistic activity, it is far less clear-cut whether the income deriving from the use of such IP continues to be qualified as income assimilated to self-employment income or falls within the “ordinary” self-employment income (article 53(1) of the ITC) on the assumption that in such cases the royalties represent the remuneration of an habitual activity which is intrinsically of a self-employment nature (e.g. musician, writer, etc.).76 This distinction has a relevant impact in terms of the computation of the taxable base: self-employment income is determined on a net basis, i.e. the income is computed as the difference between the consideration received in the fiscal year and all the expenses incurred in the same tax period which are related to the activity. According to a first view, the distinction between the two subcategories of income (“ordinary” selfemployment income or income assimilated to self-employment income)

75. See Ruling No. 1207 of 23 Dec. 1977. 76. The definition of self-employment income relies on the following conditions: (i) the independent nature of the activity; (ii) the lack of an entrepreneurial organization, which would otherwise trigger the existence of a business activity; and (iii) the habitual nature of the activity.

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Taxation of IP under the domestic tax law

relies on the nature of the activity.77 In case of occasional activities, the IP income will be characterized as income assimilated to self-employment income; where the artist or the inventor is deemed to provide IP in the context of his artistic and professional activity on a habitual basis, the income from IP will be characterized as self-employment income. A second view invokes the substantial autonomy of the two subcategories of income and maintains that income from IP earned by an artist or inventor may exclusively fall only within the scope of article 53(2)(b) (income assimilated to self-employment income), as the creative work of an author – due to its nature – cannot be performed professionally and therefore can qualify as income assimilated to self-employment income.78 16.2.2.1.2.  Miscellaneous income Where the income from the economic utilization of an IP is derived by an Italian-resident person other than the author or inventor, the income will be qualified as miscellaneous income (article 67(1)(g) of the ITC).79 This is the case of income derived by the heirs of an author/inventor or by any person who acquired by an author/inventor the right to use an IP.80 According to article 71(1) of the ITC, such income is taxable on a cash basis: (i) for the full amount, if the IP has been acquired on a gratuitous basis (by succession or donation); and (ii) for 75% of the amount, if the IP has been acquired upon consideration. 16.2.2.1.3.  Business income This section focuses on the analysis of the specific aspects concerning the tax regime applicable to IP income derived by Italian-resident companies and, in particular, the analysis of the Italian patent box regime.81

77. See Gulmanelli, supra n. 47, at p. 2; Sacchetto, supra n. 50, at p. 129 et seq. 78. Tabet, supra n. 46, at p. 60. See also Greggi, supra n. 46, at p. 54, who pointed out that this controversial issue could be resolved by referring to the contractual framework adopted by the author or the inventor when he commits himself to realize an IP or when he realizes such IP in the framework of an independent service relationship. 79. The wording of art. 67(1)(g) of the ITC is almost the same as art. 53(2)(b). Thus, see sec. 16.2.2.1.1., with reference to the categories of IP included within the scope of the rule and to the meaning of “economic utilization”. 80. Clearly, where the person carries on business activities, the income qualifies as business income. 81. General principles and ordinary rules applicable for the determination of business income will not be addressed in this chapter. The tax treatment of R&D expenditure and depreciation rules applicable to IP will also not be deeply analysed.

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Chapter 16 - Italy

As already observed, under Italian domestic tax law, all items of income derived by Italian-resident companies that carry on business activities qualify as business income and are taxed accordingly.82 Therefore, any proceeds related to an IP derived by an Italian-resident company qualifies as business income. In particular, the disposal of IP may alternatively give rise to revenues or capital gains depending upon the nature of the asset that has been alienated.83 The consideration for the sale of IP whose production or exchange constitutes the company’s business activity represents revenues and is included in taxable income on an accrual basis.84 The consideration for the disposal of IP held as capital assets may give rise to capital gains85 or capital losses.86 A taxpayer may choose to (i) include realized capital gains in the taxable income of the fiscal year when they are realized or (ii) spread them in equal instalments over that year and (up to) the following 4 years. The option under (ii) is only available in the case of disposal of assets held for at least 3 years.87 Likewise, royalties from the licensing of IP derived by Italian-resident companies are considered as business income and taxed on accrual basis. In general, the flows of royalties deriving from the IP are subject to income tax in Italy regardless of the fact that such flows arise in the country where the IP is actually used by the licensee and that the activities connected to 82. Income accruing to companies (società per azioni, società a responsabilità limitata, società in accomandita per azioni), cooperatives (società cooperative), mutual insurance companies (società di mutua assicurazione), commercial entities (public and private resident entities, other than companies, including trusts having as their exclusive or main purpose the conduct of a business activity) and commercial partnerships (società in accomandita semplice and società in nome collettivo) is deemed to be, iuris et de iure, business income (see arts. 6(3) and 81 ITC). For the purposes of this chapter, all these entities will be hereinafter defined as “companies”. 83. Such a distinction was already clear before the ITC came into force. See Circular Letter no. 32 of 22 Sept. 1980, whereby the ITA confirmed that the alienation of an IP – save the case where the IP forms part of the main activity carried on by the enterprise – gives rise to capital gains. 84. See art. 85 ITC. 85. A capital gain or loss is equal to the difference between (i) the sale price or the indemnity received, reduced by the costs directly attributable to the sale or the indemnity, and (ii) the asset’s adjusted tax basis. If the company assigns a capital asset to the shareholders or uses it for purposes other than business, the capital gain is equal to the difference between (i) the asset’s normal value and (ii) the asset’s adjusted tax basis (see art. 86 ITC). In Ruling no. 9/661 of 10 Aug. 1991, the ITA clarified that the IP (the case dealt with a trademark) that is not recorded in the financial statements (as it may have been self-produced) may also be eligible to determine a taxable capital gain. 86. Capital losses are fully deductible and must be taken into account in the computation of business income (see art. 101(1) ITC). Write-downs of capital assets do not give rise to deductible capital losses. 87. See art; 86(4) ITC.

490

Taxation of IP under the domestic tax law

the management and improvement of the IP may be performed in the latter country.88 As a general principle, costs and expenses may be deducted only if they are incurred for the production of business income. Royalties paid for IP are thus generally deductible on accrual basis. If, under a licence contract, a lump-sum payment is agreed upon, this shall be capitalized and deducted in proportion to the duration of utilization established by the contract.89 Royalties paid to non-resident affiliated companies for the use of the IP are deductible to the extent they are paid on an arm’s length basis. R&D expenses relating to more than one fiscal year are deductible to the extent they are booked in the profit and loss of the relevant fiscal year. For depreciation purposes, the recovery cost of assets deriving from the R&D must be reduced by the amount already deducted in the fiscal years of development of the asset.90 As far as depreciation rules are concerned, trademarks may be amortized up to one eighteenth of their cost for each fiscal year. Patents and other IP may be amortized up to one half of their cost.91 It is worth mentioning an interesting case of the Supreme Court (Decision no. 20911 of 3 October 2014) dealing with a case of an Italian company that was part of a group contribution agreement, according to which the Italian company paid R&D contributions in return of the right to use some IP. The Court, confirming the decision of the Court of Appeal, recharacterized as royalties the R&D contribution paid under such arrangement because the Italian company cannot be regarded as the legal ownership of the IP (that circumstance was proved by the fact the cost contribution agreement did not provide for compensation upon the Italian company exiting from the 88. A foreign tax credit may be granted. 89. See art. 103(2) ITC. 90. See art. 108(1) and (3) ITC. 91. See art. 103(1) ITC. Art. 103(2) of the ITC provides that amortization allowances of the cost of concession rights and of other rights recorded in the balance sheet are deductible in an amount corresponding to the duration of their utilization established by the contract or by the law. The ITA have argued that the Italian accounting principles (n. 24) do not properly distinguish between the ownership of an IP and the right to use an IP under a licence agreement and inferred that such a classification is also relevant for tax purposes. For this reason, the ITA have maintained that the cost for the acquisition of licence rights on cinematographic works is deductible pursuant to art. 103(1) of the ITC and not under 103(2). This conclusion is based on the substantial equivalence of the period of economic utilization of the IP held by the owner or by the licensee. The ITA therefore concluded that if the economic life of the IP is shorter than the duration of the licence or the period of legal protection, the IP must be depreciated as if it had been purchased rather than being depreciated through the duration of the licence; consequently, the amortization process has to be made in accordance with art. 103(1) of the ITC (see Ruling no. 35/E of 13 Feb. 2003; accordingly, Ruling no. 5 of 10 Jan. 2002).

491

Chapter 16 - Italy

group). The Court also stated that such royalties could not in any event be equal to the amount of the R&D contributions paid by the Italian company and, therefore, redetermined the amount of deduction much lower compared to the payment made by the Italian company in compliance with the cost contribution agreement (no withholding tax issues were raised). This decision diverges from the position of the OECD Transfer Pricing Guidelines which recognize an economic concept of ownership. As far as tax incentives directly or indirectly connected to IP are concerned, taxpayers could benefit from both a tax credit for the R&D activities carried out and the patent box regime in the same fiscal year. In a nutshell, the patent box regime is a tax measure that allows an exemption of part of the income related to qualifying IP, while the R&D tax credit amounts to 50% of the R&D expenditure incurred in excess of the average R&D expenditure that the enterprise had incurred in the previous 3 years.92 The patent box regime introduced in the Italian tax system by the 2015 Finance Bill is succinctly described below.93 16.2.2.1.3.1.  Italian patent box regime The Italian patent box regime, substantially in line with the OECD nexus approach,94 is effective from fiscal year 2015 and aims at (i) encouraging the repatriation of the IP currently held abroad, (ii) preventing the transfer abroad of Italian IP and (iii) increasing R&D in Italy. All persons earning business income (e.g. resident companies, Italian commercial partnerships and resident sole proprietors) may elect for the application of the patent box regime. Non-resident persons are eligible for the patent box regime only if they are resident of a country that has a tax treaty in force with Italy and that allows an effective exchange of information. Taxpayers who do not legally own the IP but are entitled to the economic exploitation thereof (e.g. the licensee as the economic owner of the IP) can also opt for its application. The election lasts for 5 fiscal years (during which it cannot be revoked) and may be renewed at the end of the 5-year term.

92. The analysis of the R&D tax credit regime will not be addressed in this chapter. See G. Mameli, Italy, in Tax incentives on Research and Development (R&D) (IFA Cahiers vol. 100A, 2015), Online Books IBFD. 93. Art. 1(37-45) of Law No. 190 of 23 Dec. 2014, as subsequently amended. 94. See OECD, Harmful Tax Practices - 2017 Progress Report on Preferential Regimes: Inclusive Framework on BEPS: Action 5, OECD/G20 Base Erosion and Profit Shifting Project (2017).

492

Taxation of IP under the domestic tax law

Only taxpayers that carry out qualifying R&D activities aimed at developing, maintaining and improving the IP may access the special regime. In particular, R&D activities: – could be performed in-house or outsourced (to the extent that not all of the R&D activity is outsourced to related parties); – are not required to be exercised in the tax year in which the income arising from the IP benefits from the exemption; – may be carried out in Italy or abroad; and – must relate to separately identified IP. The following categories of IP fall within the scope of the patent box regime: patents (registered or in the process of being registered), copyrighted software, processes, formulas, designs and models that can be legally protected and any other kind of know-how that can be legally protected.95 As from 2017 onwards, a 50% exemption applies (for both IRES and IRAP purposes) on the income arising from:96 – licensing of the qualifying IP vis-à-vis third parties and related parties (royalties);97 and

95. Trademarks (registered or in the process of being registered) initially included among the eligible IP have been definitively removed from the scope of the patent box by art. 56(1) of Legislative Decree no. 50 of 24 Apr. 2017 in order to align the Italian regime with the conclusions of the OECD in the context of BEPS (see Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5 2015 Final Report according to which “marketing-related IP assets such as trademarks can never qualify under an IP regime”). For taxpayers (whose fiscal year coincides with the calendar year) the new rule applies to the elections exercised after 31 Dec. 2016. The elections, including also trademarks made before 31 Dec. 2016, remain valid for 5 years but are, for the part relating to trademarks, non-renewable. For taxpayers whose fiscal year does not coincide with the calendar year the election including trademarks is valid if it has been made in the first two tax periods following the one in progress as at 31 Dec. 2014 and it lasts for 5 years or, if the period is lower, until 30 June 2021. See art. 13(1) of Ministerial Decree 28 Nov. 2017. Nevertheless, note that countries that were not compliant with BEPS (like Italy) should be allowed to grandfather existing regimes for a period not longer than 5 years if the option was made by 30 June 2016 (and not by 31 Dec. 2016 or by a later date in case of taxpayers whose fiscal year does not coincide with the calendar year). The OECD stated that the Italian patent box regime is “Not harmful except for the extension to new entrants for trademarks between 1 July 2016 and 31 December 2016, which is harmful” (see OECD, Harmful Tax Practices, supra n. 94). 96. The exemption is limited to 30% in 2015 and 40% in 2016 and shall apply at the standard 50% rate from 2017 onwards. 97. In case of licensing agreement between related parties, an optional ruling may be submitted to ITA for determining the income and costs related to the qualifying IP.

493

Chapter 16 - Italy

– direct use of the qualifying IP (i.e. the value of the IP is embedded in the price of the goods or services sold); a mandatory ruling for determining the income and costs related to the qualifying IP is required.98 The election can be made on an IP-by-IP basis. In other words, it is not necessary to apply for the patent box with respect to all the eligible IP held by the taxpayer (i.e. “cherry-picking” approach). Hence, the taxpayer may elect to apply the patent box only for the highly profitable IP assets. The taxpayer is required to track the relevant IP income and expenditure connected to each single IP starting from the first year of application of the patent box. As a general rule the amount of the IP income qualifying for the exemption is determined as follows:99 Qualifying income = [income deriving from IP100 – IP-related expenditure101] × Nexus ratio102

This formula applies separately to each qualifying IP for which the patent box election has been made. The nexus ratio is calculated as follows: Nexus ratio = Qualifying R&D expenditure ÷ Overall R&D expenditure

Qualifying R&D expenditure is the expenditure related to R&D activities: – carried out by the eligible taxpayer; – outsourced to universities or other similar entities; – outsourced to unrelated parties; and 98. The ruling procedure guarantees the determination, in advance, of the exact criteria for the identification of patent box benefits. See ITA instructions issued on 1 December 2015 (Commissioner’s Regulation 2015/154278). 99. The specific rules for the determination of relevant IP income and the definition of the qualifying R&D expenditure has been enacted through Ministerial Decree of 30 July 2015 that has been replaced by Ministerial Decree 28 Nov. 2017. 100. If the taxpayer directly uses the qualifying IP the computation of the qualifying IP income must be made on the basis of methods and criteria in line with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017, OECD Publishing (hereinafter OECD Transfer Pricing Guidelines) as revised by the Guidance on Transfer Pricing Aspects of Intangibles (BEPS Action 8 2014 deliverable) released by the OECD on 16 September 2014. 101. I.e. direct and indirect costs related to the IP relevant for tax purposes in the year of application of the regime. 102. The nexus ratio consists of qualifying and overall expenditure related to R&D activities at the time they are incurred, regardless of their treatment for accounting or other tax purposes. The principle underlying the nexus ratio is that qualifying income fully benefits from the patent box only to the extent that (i) the taxpayer itself incurred the R&D expenditure that contributed to that IP or outsourced the R&D activities to unrelated parties and (ii) no acquisition costs for IP have been incurred.

494

Taxation of IP under the domestic tax law

– carried out by unrelated parties in accordance with an agreement with a related party that recharges the cost to the eligible taxpayer (without any markup). Overall R&D expenditure is the sum of the qualifying R&D expenditure plus the expenditure for R&D activities outsourced to related parties and IP acquisition costs (which includes the amount of royalties paid to the licensor in case the election for the patent box has been made by the licensee). Finally, qualifying R&D expenditure may be increased by 30%, up to the amount of the overall R&D expenditure. Gains arising from the sale of the qualifying IP are fully exempted to the extent that at least 90% of the proceeds is reinvested in the maintenance or development of other qualifying IP within the two fiscal years following the disposal. A ruling may be submitted to the ITA for the determination of the capital gain in case the transaction has been made between related parties. The ITA clarified that operations and arrangements aimed at transferring the ownership of the IP to an Italian-resident company of the group, whose activity mainly consists of the management and improvement of such IP, which will be then licensed back to the original Italian owner or licensor, are not regarded as abusive.103 In this regard, as the IP income consists of the royalties (less the direct and indirect costs connected to the IP) the licensor would not be required to submit a mandatory ruling for benefit from the patent box regime. In particular, the ITA concluded that to the extent that the new licensor carries on a substantial R&D activity, such arrangements are not abusive even if exclusively aimed at avoiding the mandatory ruling.

16.2.2.2. Tax treatment of neighbouring rights As observed in section 16.1.1., under Italian private law neighbouring rights are not fully assimilated to copyrights. The tax regime of the income from the use (and sale) of neighbouring rights is indeed uncertain, as Italian tax law does not provide specific provisions in this respect.104 It should be excluded that such items of income fall within the scope of articles 53(2) (b) (income assimilated to self-employment income) and 67(1)(g) of the ITC (miscellaneous income) as such provisions relate to the exploitation of well-identified IP, which do not literally include neighbouring rights (intellectual properties, patents and processes, formulas and information related 103. See Circular Letter no. 36/E of 1 Dec. 2015. 104. The issue has rarely been addressed by the ITA or by cases dealing with tax law.

495

Chapter 16 - Italy

to experiences in industrial, commercial or scientific).105 In the author’s opinion, income derived by the utilization of neighbouring rights (if such income is not produced in the carrying on of a business activity) should be classified as miscellaneous income, in particular, as income derived from the assumption of obligations “to permit” under article 67(1)(l) of the ITC.106 The taxable basis is calculated by deducting all the costs specifically connected to the income (article 71(2) of the ITC).

16.2.2.3. Tax treatment of income from industrial, commercial or scientific equipment Income deriving from the use of equipment falls within the category of miscellaneous income (if the recipient does not carry on a business activity) and, precisely, under article 67(1)(h) of the ITC, which dealt with income deriving from the lease, rental, charter or of permission to use of vehicles, machinery or other tangible property. The taxable basis is calculated by deducting all the costs specifically connected to the income (article 71(2) of the ITC). As indicated in section 16.2.1., for the purposes of the 105. According to a different opinion, the income from neighbouring rights should fall within either art. 53(2)(b) of the ITC or art. 67(1)(g) of the ITC as the ITA in Ruling no. 12/E of 9 Feb. 2004 regarded neighbouring rights as rights to be included within the definition of copyrights for the purposes of the application of the tax treaty between Italy and Germany (this ruling dealt with the case of royalties paid to a German resident artist for shows broadcasted on Italian television). However, the interpretation of the ITA is focused on the possibility to include within the scope of art. 12 of the tax treaty also income from neighbouring rights. The positive answer of the ITA is substantially based on the indications provided by para. 18 of the OECD Commentary on Art. 12. Therefore, such autonomous interpretation of the meaning of royalties under tax treaty law should not be extended to domestic tax law. In addition, the difficulty of characterizing income from neighbouring rights as income from the use of IP derives also from the evolution of the law, as with the introduction of the ITC, the expression “and similar” previously contained in art. 49(3)(b) of Presidential Decree 597/93 (“income derived from the economic use of trademarks and trade and the economic use of intellectual works, industrial inventions and similar”) was eliminated. The conclusion is further comforted by Ruling no. 143/E of 19 June 1997, which excluded assimilation of the connected rights to copyright for VAT purposes. 106. With particular reference to image rights, see M. Tenore, Chapter 19: Italy in Taxation of Entertainers and Sportspersons Performing Abroad sec. 19.3.4.1.1.3. (G. Maisto ed., IBFD 2016), Online Books IBFD. Income from image rights should also fall within the scope of art. 67(1)(l) of the ITC where the image of a famous individual is registered as a trademark (see sec. 16.2.2.1.1.). Where the image rights are exploited by an individual performing as an independent professional, income from self-employment includes income from the disposal of image rights pursuant to art. 54(1-quater) of the ITC. The amount of the consideration received upon the disposal of image rights is subject to IRPEF, as confirmed by Ruling no. 255/E of 2 Oct. 2009 (this ruling dealt with the case of an artist who disposed its image rights).

496

Taxation of IP under the domestic tax law

application of the exemption from withholding tax on outbound royalties (article 26-quater(3)(a) of Decree 600/1973), payments for the use of, or the right to use, industrial, commercial or scientific equipment fall within the definition of royalties.

16.2.3. Tax treatment of income from IP derived by nonresident taxpayers 16.2.3.1. Sourcing rules In general, income of non-resident persons is subject to tax in Italy to the extent that it is deemed to be sourced in the Italian territory. The source of income is to be determined separately for each category of income; this implies that the qualification of the relevant item of income is ordinarily the basis for identifying the applicable sourcing rules. As indicated in section 16.2.2., income derived from IP may be qualified as either (i) income assimilated to self-employment income, (ii) miscellaneous income or (iii) business income. Based on the above, the following source rules should be taken into account: – self-employment income is deemed to be sourced in Italy if the relevant professional activities are performed within the Italian territory (article 23(1)(d) of the ITC); – miscellaneous income is deemed to be sourced in Italy if derived from properties situated in Italy or activities carried out in Italy (article 23(1) (f) of the ITC); and – business income is deemed to be sourced in Italy if derived through a PE in Italy (article 23(1)(e) of the ITC). In addition, pursuant to article 23(2)(c) of the ITC, payments for the use of IP, patents and trademarks, as well as processes, formulas and information relating to the experience acquired in industrial, commercial or scientific field, are deemed to be sourced in Italy when paid by the Italian State, an Italian resident person or an Italian PE of a non-resident person.107 Royalties paid to non-resident taxpayers are thus taxed in Italy regardless 107. This provision was firstly included by art. 31 of Presidential Decree no. 897 of 30 Dec. 1980 within art. 19(1)(9) of Presidential Decree no. 597 of 29 Dec. 1973, introduced in order to definitively put an end to an issue long debated whether royalties paid to a nonresident person without a PE in Italy should have been taxed in Italy. See G. Marongiu, Royalties e imprese estere, in Dir. e prat. trib., p. 179 et seq. (1980); C. Garbarino, Regime impositivo delle royalties corrisposte a soggetti non residenti, in Dir. e prat. trib., p. 318 et seq. (1991). See also Circular Letter no. 47/E of 2 Nov. 2005.

497

Chapter 16 - Italy

of (i) the characterization of the income, (ii) the characteristics of the nonresident IP owner granting the right (the author/inventor or another person entitled to use the IP) and (iii) the connection of the income with the business activity of an enterprise.108 Income tax is levied exclusively based on (i) the objective requirement given by the qualification of the income as arising from the use of the categories of IP mentioned under the provision and (ii) the subjective requirement given by the status of the payer. The wording of “payments for the utilization” of IP employed by article 23(2)(c) of the ITC differs significantly from the expression “income from the economic utilization” of IP employed by articles 53(2)(b) and 67(1)(g) of the ITC, which, as indicated in section 16.2.2.1.1., includes also income from the alienation of IP. This implies that the income stemming from the sale of the full ownership of an IP by a non-resident taxpayer to a resident taxpayer should not be regarded as sourced in Italy under article 23(2)(c) of the ITC.109 Other territoriality rules may apply, however. This interpretation has been acknowledged in Circular Letter no. 12/227 of 13 March 1981 in which the ITA stated that where a patent is acquired under a sale agreement providing for a consideration reflecting exclusively the value of the patent, with the exclusion of any other claim by the foreign enterprise relating to the utilization of the rights that are being transferred to the resident person, the consideration for the acquisition of the patent reflects a mere commercial transaction and royalties payments are not involved. In addition, the ITA clarified that if the payment incorporates a licence fee (even if capitalized), the corresponding remuneration should be considered as royalties. There are no administrative guidelines or case law that clarify whether article 23(2) (c) of the ITC applies in cases of partial alienations of rights (e.g. transfer of rights involving exclusive right to use an IP during a specific period or in limited geographical area, or transfer of single economic rights in connection to the intellectual work covered by the copyright). In the author’s opinion, each case will depend on its particular facts but, in general, if the payment is in consideration for a transfer of rights that constitute a distinct and specific property under private law (e.g. in case of geographically limited rather than time-limited rights), such payments can likely be qualified as proceeds for the sale of an IP rather than as royalties.110 108. See Circular Letter no. 42 of 12 Dec. 1981. See also E. Gulmanelli, Royalties (dir. trib.), in Enc. Giur. Treccani p. 3, 1993. 109. See Piazza, supra n. 73, at p. 765. 110. Another case might consist in the transfer of the full ownership of one of the economic rights connected to an intellectual work covered by the copyright. For instance, the author might decide to transfer only the right of broadcasting, not including those entailing its distribution on a physical support. This might happen, for instance, with regards to cinematographic works, where the IP can be exploited through both broadcasting and

498

Taxation of IP under the domestic tax law

For the sake of completeness, income from industrial, commercial or scientific equipment,111 as miscellaneous income, is deemed to be sourced in Italy if derived from properties situated in Italy (article 23(1)(f) of the ITC).112 The same territoriality rule should also apply to income from neighbouring rights, to the extent that it is qualified as income derived from the assumption of obligations “to permit” for domestic tax purposes.113 Where neighbouring rights should instead be regarded as assimilated to copyrights and consequently the related income qualified as royalties, all the payment made by Italian-resident persons would be deemed as sourced in Italy under article 23(2)(c) of the ITC. Finally, income from the supply of services is regarded as Italian-source income if (i) earned through an Italian PE where qualified as business income or (ii) derived from activities physically performed in Italy, if characterized as income from independent personal services.114

16.2.3.2. Taxing rules According to article 25(4) of Decree 600/1973, payments referred to under article 23(2)(c) of the ITC are subject to a 30% final withholding tax if the Italian payer qualifies as a “withholding agent” according to article 23 of Decree 600/1973 (e.g. it is an Italian resident or an Italian PE of a nonresident person).115 The taxable base is equal to 75% of the gross amount distribution of DVDs. Each of these economic rights should be considered as an autonomous IP. Consequently, the sale of the full ownership of one of these rights should be considered as a sale of an IP and taxed accordingly. The ITA shared the view to consider as an autonomous IP the economic rights connected to the copyright with reference to the application of certain benefits under investment premiums (see Circular no 51/E, para. 5.4, 20 Mar. 2000; Circular no. 90/E, para. 3.6, 17 Oct. 2001; among scholars, see Piazza, supra n. 73, at p. 767). 111. The expression “industrial, commercial or scientific equipment” include assets destined to carry on a business activity (e.g. machines, containers and vehicles for the transport of goods and persons on land, air and sea, etc.) (see Circular no. 47/E, 2 Nov. 2005). 112. Circular no. 42 of 12 Dec. 1981 adopted as an ordinary criterion for determining the presence of a property in the territory of the state “the identification of the place where there is prevalent use of the good. In essence, if the good is used mainly abroad it is possible to conclude the source rule is not met and therefore that the related consideration is not taxable in Italy; on the other hand, the entire consideration for use of the property prevalently within the Italian territory is taxable in Italy”. Appropriate documentation must be kept to document the place of use of the properties. 113. Income deriving from the assumption of obligation “to permit” should be regarded as sourced in Italy to the extent that such income is derived from activities carried on in Italy, i.e. the show is broadcast or interpreted within the Italian territory. 114. On the other hand, income derived from the transfer of know-how, since it falls within the scope of art. 23(2)(c) of the ITC, is always regarded as Italian-source income if paid by an Italian taxpayer. 115. Non-resident taxpayers are required to file a tax return if the consideration for the use of an IP is not paid by an Italian withholding agent (e.g. an individual who does not

499

Chapter 16 - Italy

considering the 25% flat deduction allowed by articles 54(8) and 71(1) of the ITC.116 Non-resident taxpayers who have been subject to such final withholding tax are not required to file a tax return in Italy to declare its Italiansourced income. The withholding tax is not levied if the royalties are paid to an Italian PE of a non-resident company. Article 25(4) of Decree 600/1973 also provides that if the payer qualifies as a “withholding agent”, the same 30% final withholding tax applies on payments for the use of, or the right to use, industrial, commercial or scientific equipment that are located in Italy. The withholding tax in such a case applies on the gross amount (i.e. without deduction of expenses). There is no withholding tax if the I&R Directive applies (see section 16.3.2.2.). The withholding tax may be reduced (or in some cases excluded) if the applicable tax treaty limits the taxing rights of the source state (see section 16.4.1.)

16.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules In principle, Italian tax law contains several rules which would allow the taxation of IP income derived by non-resident entities in the hands of a resident taxpayer; for instance, either controlled foreign company (CFC) rules or rules on fictitious interposition of entities may apply. These rules may be specifically analysed for transactions aimed at delocalizing the IP and flow of royalties to another tax jurisdiction. Both sets of rules are described in the following subsections.

16.2.4.1. CFC legislation (article 167 ITC) Italian CFC legislation is contained in article 167 of the ITC, in particular: – under article 167(1) and (4), CFC income is attributable to a person resident in Italy if the latter holds directly or indirectly the control of a

carry on business activity or independent professional services). Although it is not so common that a licensee pays royalties for the use of an IP outside a business activity, in such a case the non-Italian resident licensor would be subject to IRPEF, with progressive tax rates applicable on its Italian-source income, or to IRES. 116. See R. Baggio, Sub Articolo 25, D.P.R. 29 settembre 1973, N. 600, in Commentario breve alle leggi tributarie p. 87 (G. Falsitta et al. eds., Cedam 2011).

500

Taxation of IP under the domestic tax law

company resident of a non-EU Member State that benefits from a lowtax regime; and – under article 167(8-bis), CFC income is attributable to a person resident in Italy if the latter holds directly or indirectly the control of a company resident in any foreign state to the extent that the controlled entity meets both of the following two tests: – the “effective tax rate test”, i.e. the foreign entity is subject to an effective taxation in its state of residence that is lower than half the tax that would have applied if the foreign entity had been a resident of Italy (i.e. the “virtual domestic tax rate”); and – the “passive income test”, i.e. the foreign entity derives more than 50% of the company’s income from the carrying out of passive activities (holding of shares and enjoyment of IP is expressly listed among such activities). According to article 167(6) of the ITC, the CFC profits are imputed to the Italian resident person who controls the CFC. The profits so imputed are computed by applying the rules on business income (with few exceptions) and are taxed in the hands of the controlling person on a separate basis at the taxpayer average rate. If, in a later year, the CFC distributes dividends to the resident shareholder, these dividends are not included in the shareholder’s income and, as a consequence, they are not taxed in Italy up to the amount that has already been taxed under the Italian CFC rules. CFC rules may thus be applicable in the case of an Italian-resident taxpayer controlling a foreign entity deriving IP income. The existence of optional tax regimes for IP income (e.g. patent box regime) in the foreign state often triggers application of the CFC rules. Indeed, under 167(8-bis) of the ITC, both the above-mentioned tests are commonly met, as (i) royalties fall within the concept of passive income and (ii) the preferential tax regime which may be granted to IP income often reduces the foreign effective tax rate below the threshold for the application of the CFC rule. In addition, the ITA has expressly excluded the relevance of Italian optional tax regimes, to which the foreign entity could have acceded if it had been resident of Italy, for the purpose of determining the virtual domestic tax rate.117 Hence, patent box regimes appear relevant for the purpose of determining the foreign effective tax rate and irrelevant for determining the virtual domestic tax rate. This incoherent result is at variance with the object and purpose of the Italian CFC rules. In any case, article 167(8-ter) of the ITC provides the resident taxpayer with the possibility to prove that the foreign CFC is not a 117. See IT: Act of the Director of the ITA, 16 Sept. 2016.

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Chapter 16 - Italy

wholly artificial arrangement and, as a consequence, to be exempted from being taxed on the CFC profits. With regards to the application of article 167(1)-(4) of the ITC, the ITA has not specifically addressed the issue whether optional patent box regimes could qualify as low-tax regimes. In particular, the ITA indicated that a foreign special tax regime qualifies as a low-tax regime if it meets both of the following requirements:118 – it applies to all taxpayers that fulfil the requirements set forth by the statute enacting the regime (however, somewhat inconsistently, the ITA states that special regimes obtained through specific ruling procedures may also fall within the definition of a low-tax regime); and – it determines a decrease of the applicable tax rates or, even if it does not directly and formally affect the rates, provides for exemptions or other reductions of the taxable base that in fact substantially lower the nominal taxation. The ITA also provide some examples of potential foreign low-tax regimes, including, inter alia, foreign tax regimes that provide broad exemptions for foreign-source income, notional deductions from the taxable base, tax holidays for start-up enterprises or newly formed companies, or tax-free zones. It is therefore up to the resident taxpayer to determine whether a foreign patent box regime could be regarded as a special regime for the application of CFC legislation (article 167(1) of the ITC). In conclusion, Italian CFC rules seem to comply with the minimum standard set by the CFC legislation contained in the Anti-Tax Avoidance Directive (ATAD). Hence, no relevant amendments are expected to that extent. Some features of the domestic legislation seem to be stricter than those provided for in the ATAD (which is allowed under article 3 thereof). Indeed, the Italian CFC rules provide for a broader scope of application due to the expansive definition of control, which also includes de facto control or contractual control119 and the adoption of an “entity approach” (unlike the transactional approach” adopted by the ATAD) for the determination of the income to be attributed in the hands of the controlling taxpayer.120 118. See Circular no. 35/E, 4 Aug. 2016. 119. According to the ATAD, control is considered to exist where an entity has a participation of more than 50% of the voting rights, owns more than 50% of the capital or is entitled to receive more than 50% of the profits of the CFC. 120. See D. Gutmann et al., The Impact of the ATAD on Domestic Systems: A Comparative Survey, 57 Eur. Taxn. 1, sec. 2.5. (2017), Journals IBFD. It should be noted that authoritative literature encourages the adoption by the Italian CFC legislation of the “transactional approach” (see Assonime, Circular no. 17, 28 June 2017).

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16.2.4.2. Rules on fictitious interposition of entities (article 37(3) Decree 600/1973) Article 37(3) of Decree 600/1973 stipulates that “income apparently accrued to another party can be imputed to a taxpayer, provided that it can be proven, also by means of material, precise and concurring items of evidence, that such taxpayer is the real owner of the said income through the first-mentioned taxpayer”. According to Italian case law, article 37(3) applies (i) to sham transactions, i.e. transactions where one party is fictitiously interposed (e.g. the interposition has been envisaged in cases where the legal owner of the income was a mere letter-box, totally lacking any organizational structure and any economic purpose) or (ii) also to transactions where no party is fictitiously interposed but where the interposition of a person (e.g. a company instead of the individual shareholder) is mainly (or exclusively) aimed at obtaining an (otherwise undue) tax saving (interposizione reale). This being said, application of article 37(3) of Decree 600/1973 has been claimed by the ITA in cases regarding the stipulation of an agreement between Italian football or basketball teams and non-resident companies that acquired the right to exploit the image of the football or basketball players who were playing for the teams. A similar case has been addressed in a decision of the Supreme Court (no. 4737 of 26 February 2010), which decided in favour of the ITA in respect of the interposition of a foreign vehicle (tax-resident in Ireland) set up for the purpose of acquiring and managing the image rights of various sportsmen resident in Italy for tax purposes.121

16.3.  Taxation of IP under EU law 16.3.1. Issues of compatibility of domestic law with EU law 16.3.1.1. Inbound royalties From the perspective of the state of residence, no special provisions concerning inbound royalties have been implemented in the Italian tax system. Royalties derived by Italian-resident companies are treated alike, regardless of the state of residence of the payer. Thus, domestic taxation on inbound royalties seems to be in line with the EU fundamental freedoms. 121. See also IT: Provincial Tax Court of Milan, 28 June 2016, Decision no. 5646.

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16.3.1.2. Outbound royalties As commented in section 16.2.3.2., outbound royalties paid by an Italian payer qualifying as an “withholding agent” are subject to a 30% final withholding tax. The tax basis of such levy consists of the 75% of the gross amount of the payments unless the payment is a consideration for the use of or the right to use, industrial, commercial or scientific equipment, in which case, the withholding tax is levied on 100% of the payment. The application of such a withholding tax determines a difference of treatment vis-à-vis the tax treatment of royalties paid to a payee resident in Italy. Indeed, tax-resident corporate payees are subject to corporate income tax at a 24% rate on a tax basis that is net of the costs directly related to such income. One may wonder whether this difference of treatment amounts to discrimination in breach of an EU fundamental freedom. Indeed, it seems that non-resident companies may be subject to a more burdensome tax treatment because (i) they are subject to tax at a higher rate (30% compared to 24%) and (ii) they are not allowed to deduct the expenses (for an amount exceeding 25% of the outbound payments) directly related to such income.122 The difference of treatment in point (i) is in most cases neutralized by application of the tax treaty signed with the Member State of residence of the payee. With reference to point (ii), recent case law of the ECJ confirmed that gross taxation of non-resident taxpayers compared to net taxation of resident taxpayers determines an infringement of the EU fundamental freedoms.123 Widening the scope of application of the principle of “net taxation” set forth 122. The judgment in PT: ECJ, 13 July 2016, Case C-18/15, Brisal – Auto Estradas do Litoral SA, KBC Finance Ireland v. Fazenda Pública, ECJ Case Law IBFD, seems to support the view that for the purposes of determining whether there is a restriction of a fundamental freedom, those two elements of the difference of treatment (tax rate and determination of the tax base) should be assessed separately. Indeed, in this judgment, the Court held that an unfavourable tax treatment (taxation on a gross basis vis-à-vis taxation on a net basis) cannot be regarded as compatible with EU law because of the potential existence of other advantages (application of a lower tax rate) (see para. 32 of the decision). Based on the same line of reasoning, the fact that a comparable resident company would be subject also to IRAP on the royalty payments should not bear any consequences in the assessment of whether outbound royalty payments suffered discriminatory tax treatment because of the higher tax rate applied. 123. Brisal (C-18/15). Concerning application of this decision to outbound royalty payments, see M. Manca, Domestic Double Deduction of Costs and the ECJ Decision in Brisal and KBC Finance Ireland (Case C-18/15): Tax Collection in Respect of Cross-Border IP Investments, 57 Eur. Taxn. 2/3 (2017), Journals IBFD. The principle of “net taxation” was already enshrined by the ECJ in previous rulings, such as DE: ECJ, 12 June 2003, Case C-234/01, Arnoud Gerritse v. Finanzamt Neukölln-Nord, ECJ Case Law IBFD, and DE:

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in the Brisal case to the IP cross-border IP investments, the Italian domestic tax provisions might give rise to incompatibility issues. For instance, taxation of the payments in consideration for the use of or the right to use, industrial, commercial or scientific equipment located in the territory of the state, which may be qualified, if not derived from a business activity, as miscellaneous income pursuant to article 67(1)(h) of the ITC, might be incompatible. The tax base of such income, according to article 71(2) of the ITC, is calculated as “the difference between the amount received during the relevant fiscal year and the expenses specifically connected to the generation of said income”. This rule, however, is only applicable to resident recipients. On the other hand, if the recipient is not an Italian resident, the withholding tax is levied at a 30% rate on the gross amount of the revenue, reduced by a 25% lump-sum deduction, pursuant to article 25(4) of Decree 600/1973.124 As far as royalty payments are concerned, it is necessary to draw a distinction: taxpayers that do not carry out business activity are equally treated irrespective of whether they are resident, since both of these categories will operate a flat deduction in the amount of 25%. However, resident companies will compute the royalties in their business income, with the possibility of deducting the inherent expenses on an analytic basis (not following a lumpsum approach). Royalties collected by non-resident companies without a PE in Italy will not benefit from this option, thus being only able to claim the above-mentioned 25% lump-sum deduction. By virtue of the ECJ principles, if the difference of treatment taking into consideration both the tax rate (point (i) above) and the computation of the tax base (point (ii) above) determines a more burdensome tax treatment of the non-resident taxpayer, it could be maintained that the above-mentioned domestic tax provisions do not comply with EU law.125 The existence of discrimination could be ruled out to the extent that between Italy and the state of residence of the recipient a tax treaty is in force that obliges such state to grant a credit for the withholding tax levied in Italy. However, the ECJ, 3 Oct. 2006, Case C-290/04, FKP Scorpio Konzertproduktionen GmbH v. Finanzamt Hamburg-Eimsbüttel, ECJ Case Law IBFD. 124. Moving from the principles already established by the ECJ in Scorpio (C-290/04), some scholars pointed out that the tax regime applicable to outbound payments for the use of or right to use equipment might reasonably constitute a restriction on the freedom to provide services (see Grilli & R.A. Papotti, Considerazioni critiche in merito al recepimento in Italia della c.d. Direttiva “Interessi e Royalties”, Riv. Dir. Trib., p. 72 et seq. (2009)). 125. For a comprehensive analysis, see G. Beretta, La Corte di Giustizia sancisce il principio della tassazione “al netto” dei costi degli interessi percepiti da soggetti non residenti privi di stabile organizzazione, Rassegna Tributaria, p. 883 et seq. (2017).

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tax credit granted by the state of residence should be as to fully credit the tax levied in Italy.126

16.3.1.3. Domestic tax regime and EU State aid rules As mentioned in section 16.2.2.1.3., Italy introduced a patent box regime in 2015 that basically grants a 50% exemption on income stemming from qualifying IP and to the extent that qualifying R&D activities have been performed by the taxpayer. The question arises whether this tax measure is in compliance with article 107 of the Treaty on the Functioning of the European Union (TFEU). In other words, the issue is to determine whether this reduction of the taxable base for IP income could be regarded as State Aid. The key question, in this respect, is whether the patent box scheme should be regarded as a general or selective measure.127 In this regard, if the access to the patent box regime is influenced by the discretionary power of the tax authorities, the analysis of the selectivity of the measure plays an even more relevant role.128 As already explained above, in case of income arising from direct use of qualifying IP, in order to opt for the Italian patent box regime, taxpayers are required to complete a mandatory ruling procedure with the ITA, which entails the presence of a certain degree of discretional evaluation by the competent tax authorities. The regime could be deemed as selective if the ruling procedure carried on by the ITA is affected by subjective criteria. This being said, in order to avoid a violation of article 107 of the TFEU, the ITA have adopted the following criteria (expressly stated in the administrative practice on the patent box) to be addressed in a ruling procedure:

126. See NL: ECJ, 17 Sept. 2015, Case C-10/14, Miljoen, X, Société Générale SA v. Staatssecretaris van Financiën, paras. 79, 80 and 86, ECJ Case Law IBFD. See also P. Arginelli & A. Zaimaj, La Corte di Giustizia dell’Unione Europea sancisce il principio della cd. “tassazione netta” anche per gli interessi intra-UE corrisposti a soggetti non residenti, in Riv. Dir. Trib., online supplement, 9 Aug. 2016; M. Emma, Ritenute sugli interessi intra-UE applicabili al netto dei Costi - “bocciate” dalla corte ue le ritenute “al lordo” dei Costi: possibili effetti della sentenza “Brisal”, GT - Rivista di Giurisprudenza Tributaria, p. 927 et seq. (2016). 127. For a comprehensive analysis of the compatibility of IP box regimes with EU law, see F. Mang, The (In)Compatibility of IP Box Regimes with EU Law, the Code of Conduct and the BEPS Initiatives, 55 Eur. Taxn. 2/3, sec. 3. (2015), Journals IBFD; C. Micheau & G.C. De la Brousse, Case Studies of Tax Issues on Selectivity: Analysis of the Patent Box Scheme and the Reduced Taxation of Foreign-Source Interest Income, in State Aid and Tax Law p. 153 et seq. (A. Rust & C. Micheau eds., Wolters Kluwer 2013). 128. See the recent decisions of the EU Commission to open formal proceedings in the well-known transfer pricing cases (Apple, Amazon, FCA and Starbucks).

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– OECD guidelines and methodology shall be the exclusive means to determine the arm’s length price of dealings between non-independent parties and the use of evaluation methods shall be minimized (in compliance with chapter 6 of the OECD Transfer Pricing Guidelines); – if the residual profit split method is applied, IP that does not qualify for the patent box regime should not influence the allocation of profits related to the beneficial regime itself; – if the residual profit split method is applied, objective and homogeneous criteria should be established to allow exclusion from the residual income of the profits that are not related to the IP included in the patent box regime; and – the processes leading to the determination of income qualifying for the patent box regime shall be as transparent as possible. As long as these principles are respected by the ITA during the ruling proceedings, no compatibility issues between the Italian patent box regime and State Aid or other EU law principles should arise.129 Apart from the cases where an advance ruling procedure is required by law, the Italian patent box regime might be regarded as selective as it is applicable only in respect of certain categories of income, thus derogating from the general application of the income tax system.130 However, it seems that such a conclusion is not supported by current European Commission practice.131 Furthermore, a measure such as a patent box could be considered compatible with the internal market under article 107(3)(c) of the TFEU 129. Note that the recent OECD report Harmful Tax Practices - 2017 Progress Report on Preferential Regimes has qualified the Italian patent box regime as “Not harmful”, except for the extension to new entrants for trademarks between 1 July 2016 and 31 December 2016. 130. As clarified by the European Commission in Commission Notice on the notion of State aid as referred to in Article 107(1) of the Treaty on the Functioning of the European Union (2016/C 262/01) of 19 July 2016, the determination of whether a certain measure that mitigates the normal charges of undertakings (such as a partial tax exemption) constitutes a selective measure requires a three-step analysis: (i) identification of the system of reference; (ii) assessment of whether the measure derogates from such system of reference; and (iii) whether the measure is justified by the nature or the general scheme of the reference system (see para. 128). Within such a framework, the qualification of a patent box as a selective measure could be supported by the recent ECJ judgment ES: ECJ, 21 Dec. 2016, Case C‑20/15_P, European Commission v. World Duty Free Group and Others, paras. 92-94, where the Court seemed to have qualified the general Spanish tax system as the relevant system of reference. 131. Indeed, in the decision of 13 February 2008, C(2008)467 final, the European Commission concluded that the Spanish patent box regime could not be considered a State Aid because it did not grant its beneficiaries a selective advantage. Such position has been endorsed also by the EFTA Surveillance Authority in respect of the Liechtenstein regime of tax deductions in respect of IP rights (see Decision No. 177/11/COL of 1 June 2011).

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as an “aid to facilitate the development of certain economic activities” and the European Commission Communication “Framework for state aid for research and development and innovation” (C(2014) 3282, 21 May 2014).

16.3.2. Open issues in the interpretation of the I&R Directive 16.3.2.1. The notion of “royalties” included in article 2(b) of the I&R Directive As indicated in section 16.2.1., article 26-quater(3)(a) of Decree 600/1973 introduced under the Italian tax system the same definition of royalties set forth under the I&R Directive.132 This definition resembles that contained in article 12 of the OECD Model (2017), even if article 2(b) of the I&R Directive departs from the OECD Model to the extent that: (i) unlike the OECD Model, the definition of royalties expressly includes payments for the use of, or the right to use, software; and (ii) payments for the use of, or the right to use, industrial, commercial or scientific equipment are encompassed in the definition of royalties of the I&R Directive133 (as from 1992 such payments are no longer covered by article 12 OECD Model and fall within the scope of article 7 of the OECD Model). The circumstance that the meaning of royalties laid down by the I&R Directive is drafted along the lines of the OECD Model support the view that the definitions of the I&R Directive should be interpreted in accordance with the Commentary on Article 12 of the OECD Model (2017).134 For 132. The I&R Directive was implemented by Legislative Decree no. 143 of 30 May 2005, which introduced article 26-quater. The ITA has commented such provisions in Circular Letter no. 47/E of 2 Nov. 2005. 133. In this respect, the ITA has clarified that lacking any definition under domestic law, the word “equipment” shall include “assets instrumental to the business activity (industrial, commercial or of services)” and in particular it refers to “movable properties such as machinery for the manufacturing activity (for example, industrial robot), containers, equipment for building activity (for example, cranes and cement mixers), agricultural equipment (for example, tractors and threshing machines) and vehicles for the land, air or sea transportation of goods and persons (for example, cars, trains, airplanes and ships)” (see Circular no. 47/E, id., at para. 2.1.1.). 134. See D. Weber, The Proposed EC Interest and Royalty Directive, 9 EC Tax Rev. 1, p. 24 (2000); B. Terra & P. Wattel, European Tax Law p. 773 (6th edn, Kluwer Law International 2012). See also N. Saccardo, Selected Issues on the EU Definitions of Interest and Royalties, Tax Notes International, p. 974 (2004), who observed that the relevance of the Commentary should also be grounded on the reference, which has been made in the Explanatory Memorandum to the 1998 Proposal, to the 1996 OECD Model. Such reference

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instance, payments made as consideration for securing exclusivity of information would therefore be treated as a royalty, in accordance with paragraph 8.5 of the Commentary on Article 12 OECD Model (2017), if the payment to secure exclusivity is ancillary to a payment for the use of property or assets included within the definition of royalties (e.g. exclusivity in the use of a trademark), it will be treated in the same way as the main payment. Moreover, as the I&R Directive does not mention the transfer of the right to use an IP, payments made as a consideration for the transfer of the IP would not be treated as a royalty. Therefore, in order to identify the items of income that fall within the meaning of royalties under the I&R Directive, reference should be made to the Italian treaty practice on article 12 and to the Italian case law and administrative practice on the interpretation of article 12 (see section 16.4.2.).135

16.3.2.2. Introduction of a “minimum effective taxation clause” Italy did not introduce a specific minimum effective taxation clause upon implementation of the I&R Directive. With reference to the subject-to-tax requirement, pursuant to article 26-quater(4)(a) of Decree 600/1973, the withholding tax exemption is granted to the extent that the non-resident recipient is subject to one of the listed taxes, without being exempted, or to a tax which is identical or substantially similar of those listed taxes. This double requirement has been interpreted as a subjective subject-to-tax requirement and should exclude from the scope of application of the I&R Directive companies that are not actually liable to pay one of the listed taxes due to full exemptions granted by the law.136 In addition, article highlights the intention of the drafters of the 1998 Proposal to follow the definitions of interest and royalties set forth by the OECD Model, as interpreted by its Commentary. 135. In any case, the ECJ interprets the EU directives by attributing an autonomous meaning to terms indicated in EU directives. Note that in AT: ECJ, 12 Sept. 2017, Case C- 648/15, Republic of Austria v. Federal Republic of Germany, the Court confirmed that it has jurisdiction over a dispute between Austria and Germany regarding the interpretation of a double tax convention entered into between the two Member States. The dispute concerned the interpretation of the phrase “income from … debt-claims with participation in profits” within the meaning of art. 11(2) of the Austria-Ger. Income and Capital Tax Treaty (2000). 136. Consequently, possible objective exemptions regarding specific items of income in favour of the foreign recipient company should not affect the benefits of the I&R Directive. This approach appears to be confirmed by the governmental report on Legislative Decree no. 143 of 30 May 2005, which states that “those taxpayers that are in general liable to tax, even though they enjoy a beneficial regime that is compatible with the EU rules are also entitled to the benefits of article 26-quater”. In this sense, see Grilli & Papotti, supra n. 124, at p. 103; K. Bourhan, La direttiva interessi royalties: alcune problematiche di carattere operativo, Dir. Prat. Inter, p. 984 (2007). Also, in the context of the domestic rules

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26-quater(4)(b) of Decree 600/1973 also includes an objective subject-totax requirement (concerning only certain items of income): royalties paid to the non-resident recipient need to be subject to one of the listed taxes.137 That said, in Circular Letter 47/E of 2005, commenting on the provisions implementing the I&R Directive, the ITA took the view that the exemption can be granted only if the royalties are effectively subject to one of the taxes listed in Annex B of the I&R Directive. The ITA further clarified that tax rates of the levies listed in the directive are deemed to be appropriate and therefore there is no need to verify the adequacy of the foreign taxation. The question arises as to whether an Italian company pays royalties to a company which opted (in its state of residence) for a regime that grants a (partial or full) objective exemption on inbound royalties (e.g. a domestic IP box regime). This scenario has not yet been specifically addressed by the ITA. However, note that the ITA pointed out that “Obviously, interest and royalties must not benefit from specific exemption regimes in the [recipient’s state of residence].”138 One may wonder if, by virtue of this clarification, the ITA intended to also cover partial exemption regimes, as well as regimes of tax base reduction that may lead to results akin to partial exemption. In Ruling No. 93/E of 10 May 2007 the ITA took the position that the “subject-to-tax” condition in order for application of the exemption from withholding tax is met only to the extent that the Swiss-resident shareholder does not benefit from any form of exemption of direct taxation at any level in Switzerland (i.e. federal, cantonal or communal level). Moreover, the implementing the Parent-Subsidiary Directive (both Directive 90/435/EEC and Directive 2011/96/EU), the subject-to-tax clause has been interpreted in the sense that companies must qualify as taxable persons and the eventual presence of objective exemptions should not affect access to the benefits granted by the Parent-Subsidiary Directive. The same cannot be inferred in case of subjective exemptions which fully exclude taxation in the hands of the recipient entity; see G. Maisto, Il regime tributario dei dividendi nei rapporti tra “società madri” e “società figlie”, p. 26 et seq. (1996). Recently, in BE: ECJ, 8 Mar 2017, Case C-448/15, Belgische Staat v. Wereldhave Belgium Comm. VA and Others, dealing with the interpretation of the subject-to-tax requirement provided for application of the Parent-Subsidiary Directive, the Court withdrew the benefit of the directive in a case where the Member State of the parent company exempted under its domestic law the dividends received (see P. Arginelli, The Subject-to-Tax Requirement in the EU ParentSubsidiary Directive (2011/96), 57 Eur. Taxn. 8, (2017), Journals IBFD). 137. The I&R Directive does not contain such a requirement. This is clearly supported by two proposals of the EU Commission aimed at including a more stringent “subjectto-tax” clause, whereby “Member States have to grant the benefits of the Directive only where the interest or royalty payment concerned is not exempt from corporate taxation in the hands of the beneficial owner in the Member State where it is established [by virtue of] special tax scheme exempting foreign interest or royalty payments received” (see proposal of 11 November 2011, COM(2011) 714 final). 138. See Circular Letter no. 47/E of 2 Nov. 2005, para. 2.3.1.

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question arises as to whether, for the purpose of this objective subject-to-tax test, the fact that the foreign exemption regime may be considered compatible with the EU legal order (e.g. because it does not constitute a State aid measure or represent a State aid measure compatible with the internal market) plays any decisive role.

16.3.2.3. Anti-abuse provisions Article 26-quater (4)(c)(1) of Decree 600/1973 introduced within the Italian tax system the EU law concept of beneficial owner by requiring that a company is regarded as the beneficial owner of royalties “if it receives those payments as final beneficiary and not as an intermediary, such as an agent, trustee or authorized signatory, for some other person”. In the context of the I&R Directive, the interpretation of the meaning of beneficial ownership provided by the ITA follows a substance-over-form approach. In particular, the ITA, commenting article 26-quater (4)(c)(1), specified139 that the recipient company may be regarded as the beneficial owner of the royalty only if “it derives an economic benefit from the transaction” and if it has the right to dispose of such income.140 This requires that taxpayers have a sufficient level of autonomy as to the decision on how to use the income and be unconstrained by a contractual or legal obligation to pass on the payments received. The ITA reiterated such substantial approach in subsequent guidelines concerning beneficial ownership of interest payments, where it specified that in order to assess whether the direct recipient is the beneficial owner of the payment, reference shall be made to the economic and contractual features of the transaction as well as to the existence of a proper structure and risk management capability.141 The same principles were also confirmed in a few decisions of lower-tier tax courts that also put particular emphasis on the existence of a proper organizational structure as a requirement142 and the effective power and discretion to decide how to 139. Id., at para. 2.3.2. 140. Such approach has also been confirmed in Circular Letter no. 41/E of 5 Aug. 2011, where, in determining the existence of an economic benefit and of the right to dispose of the income, relevance was given to the contractual terms of the transaction and also to the existence of an adequate structure and risks in the hands of the company receiving the payment. 141. See Circular Letter no. 41/E, id.; similar statements were subsequently also made in the more recent Circular Letter no. 4/E of 6 Mar. 2013. 142. E.g. see IT: Regional Tax Court of Piedmont, 12 Mar. 2012, Decision no. 15/06/12, where the court affirmed that “no doubt exists that the Luxembourg company is a fully operational company in Luxembourg, with its own sales, personnel and permanent organization, and is perfectly compliant with the requirements for the withholding tax exemption under Article 26-quater Presidential Decree 600/73 as well as, therefore, and

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use the income143 for the recipient of the income to qualify as the beneficial owner thereof. In addition, a specific anti-abuse provision concerns the exclusion of nonarm’s length payments. Indeed, the exemption from source taxation does not apply where the amount of the royalties exceeds the amount that would have been agreed by the payer and the beneficial owner in the absence of a special relationship between them. Pursuant to article 26-quater(5) of Decree 600/73, if the paying company is either directly or indirectly controlled by the beneficial owner of the royalties and the amount of royalties exceeds the arm’s length amount, the exemption will be applied only to the latter.144 The excess royalties are reintegrated into the tax base of the paying companies and taxed accordingly. There are no administrative guidelines dealing with the specific tax treatment of the payments that exceed the arm’s length value, in particular, whether they may be recharacterized as dividend distribution or as repayment of subscribed capital. Finally, source tax exemption may be denied by virtue of the general antiabuse rule (GAAR) (article 10-bis of Law no 212 of 27 July 2000), recently introduced by Legislative Decree no. 128 of 5 August 2015, which provides for a new statutory definition of “abuse of law”. Under the new definition, abuse of law exists when a transaction lacks any economic substance and, although formally consistent with tax law, is aimed at obtaining undue tax advantages. The new definition specifies that: – transactions are regarded as lacking any economic substance when they consist of facts, contracts, deeds, even interconnected, that are not suitable for creating significant effects other than tax saving; – undue tax advantages consist of tax benefits, even if achieved only in a long-term period, obtained in contrast with the purpose of the tax rules or with the principles of the tax legal system; – a transaction is not considered to be abusive when it is justified by sound and non-marginal non-tax reasons, including managerial or organizational reasons aimed at improving the structure or functionality of the taxpayer’s business or professional activity;

a fortiori, with the requirements of the Convention recalled by the tax authorities that reduce the withholding tax on the royalties, which were properly recognized in its own financial statements and were not passed on to third parties”. 143. E.g. see IT: Provincial Tax Court of Milan, 26 June 2017, Decision no. 4401, which denied application of the I&R Directive, as the recipient of the royalties used such sums to reimburse a non-interest-bearing loan granted by the original owner of the IP. 144. See Bourhan, supra n. 136, at p. 1001.

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– the taxpayer is always free to choose between different optional tax regimes provided by the law or between different transactions leading to different tax burdens; and – the tax authorities can resort to the statutory GAAR only if the tax benefits cannot be challenged based on other specific tax provisions (e.g. specific anti-avoidance rules).145

16.3.2.4. Procedural issues The exemption for royalty payments arising in a Member State provided by the I&R Directive might be achieved by non-resident recipients either directly (non-application of the withholding tax at source) or indirectly (the beneficial owners of the royalties may claim the refund of the domestic withholding tax to the ITA).146 The request for application of the exemption regime must be substantiated by (i) a certificate of residence issued by the tax authorities of the beneficial owner’s residence state and (ii) an affidavit of the beneficial owner regarding the fulfilment of the legal form and subject-to-tax requirements. Such documentation is valid for 1 year from the date of issue and shall be provided to the Italian payer acting as withholding agent before the royalty payment date. In this regard, note that the ITA tend to adopt a formalistic approach and to withdraw the benefit of the I&R Directive whenever the withholding agent is not able to prove the collection of the relevant documentation before the payment of royalties. However, the prevailing case law147 arising from several assessments issued by the ITA has recognized the possibility to claim the exemption even when the relevant certification is submitted after the payment date to the extent that the substantial requirements for the application of the I&R Directive are fulfilled. Another relevant issue concerns the responsibility of the resident withholding agent in respect of the substantial fulfilment of the conditions required for application of the source exemption (in particular, the beneficial 145. Taxpayers may file an advance tax ruling application to ascertain whether certain transactions constitute abuse of law under art. 11 of L212/2000. 146. According to art. 38 of Presidential Decree no. 602 of 29 Sept. 1973, the withholding tax must be refunded within 1 year after the date of the application for refund or within 1 year after the date on which the ITA acquired all the requested information. 147. See, inter alia, IT: Provincial Tax Court of Milan, 17 Nov. 2015, Decision no. 9819 and 3 Nov. 2016, Decision no. 8303, which clearly stated the mere fact that the certification issued by the competent tax authorities is dated after the payment of royalties cannot be an argument to deny the application of the I&R Directive.

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ownership status): it seems disproportionate to require the withholding agent to carry out extensive due diligence to ascertain the truthfulness of the evidence provided by the non-resident recipient. In this respect, note that according to the view of a number of judgments, certificates issued by foreign competent tax authorities have a binding probative value.148 Hence, the withholding agent can simply collect the affidavit and the tax certificates issued by the tax authorities of the state of residence of the recipient, as valid evidence of the fulfilment of the I&R Directive (or tax treaty) requirements by the non-resident person, including beneficial ownership.149 On the contrary, the withholding agent may not be requested to demonstrate that the recipient is not constrained by a contractual or legal obligation to pass on the payment received to other persons (hence, the burden of proof should lie with the ITA).150 Consequently, no penalties for the omitted application of withholding taxes should apply to a withholding agent that diligently collected appropriate certificates issued by the tax authorities of the state of residence of the direct recipient and made the royalty payments on the basis of a regular contract (and to the extent that the withholding agent was not aware of any agreements in place between the direct recipient and the real beneficial owner).151

16.4. Taxation of IP under tax treaties When concluding its tax treaties, Italy generally follows the 1977 OECD Model. The most recurrent departures from the OECD Model regarding royalties are examined in the following sections.

148. See IT: Regional Tax Court of Abruzzo, 22 Dec. 2010, Decision no. 228 and 30 June 2009, Decision no. 154. 149. See F. Avella, Recent Tax Jurisprudence on the Concept of Beneficial Ownership for Tax Treaty Purposes, 55 Eur. Taxn. 2/3, sec. 2 (2015), Journals IBFD. See also IT: Regional Tax Court of Piedmont, 4 May 2012, Decision no. 28. 150. See IT: Provincial Tax Court of Milan, 3 Nov. 2016, Decision no. 8303; IT: Regional Tax Court of Lombardy, 29 Jan. 2015, Decision no. 2897; IT: Regional Tax Court of Piedmont, 12 Mar. 2012, Decision no. 15/06/12. 151. In this sense, see IT: Provincial Tax Court of Milan, 1 Feb. 2013, Decision no. 66, which stated that: “As regards the application of penalties, the withholding agent, having concluded a contract for the payment of royalties to the Swiss company as the owner of the intangibles, could well believe that that company actually was the beneficial owner of the payments. Moreover, the tax office has not proven that the withholding agent was aware of the nature, content and magnitude of the agreement in place between the Swiss recipient and the ultimate parent company, therefore, this appears to be an excusable mistake.” See also Avella, supra n. 149, at sec. 2.

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16.4.1. Taxing rights over royalties assigned by article 12(1) Source taxation over royalties may be regarded as the most relevant deviation from article 12 of the OECD Model. In almost all its treaties,152 Italy preserves (limited) source taxation on outbound royalties, in accordance with the reservation recorded to article 12(1) of the OECD Model since 1992.153 This reservation presumably reflects the fact that Italy (still) regards itself as a net importer of technology. In addition, most treaties concluded in the 1960s and 1970s do not formally encompass a beneficial owner clause, although the practice of the ITA and the case law of Italian courts regard such condition as implicit in the relevant tax treaty provisions (generally article 12(2)). The maximum withholding tax allowed under article 12 varies between 5% and 20% of the gross amount of the royalties paid, except for ItalyPakistan Income Tax Treaty (1984) and the Italy-Philippines Income Tax Treaty (1980), which limit the taxation at source to a rate of, respectively, 30% and 25% (for certain categories of IP). Some treaties provide for different withholding tax rates (as well as exemptions from withholding tax) for different types of royalties. This praxis appears in line with the reservation recorded in the OECD Commentary, according to which Italy has reserved its right to grant favourable tax treatment to certain categories of royalties, such as those paid in connection with copyrights (with the exclusion of payments for the use of software rights that may be subject to a different treatment from that of copyrights).154 For instance, in the France-Italy Income and Capital Tax Treaty (1989) royalty payments arising from the use of, or the right to use, a copyright of literary, artistic or scientific work (excluding royalties for computer programs, cinematograph films and other sound or visual recordings) are exempted in the source state.155 Similarly, the ItalySpain Income Tax Treaty (1977) provides for a 4% tax rate on royalties arising from the use of, or the right to use, copyright of literary, dramatic, musical or artistic work (excluding royalties referring to motion picture 152. At time of writing (29 Oct. 2017) 92 double tax treaties are in force between Italy and other countries. 153. See OECD Capital and Income Model: Commentary on Article 12 (2017), Reservations on the Article, para. 37, Models IBFD. 154. Id. 155. See also the Can.-It. Income Tax Treaty (2002), which provides for the exemption for copyright royalties and similar payments in respect of the production or reproduction of any literary, dramatic, musical or other artistic work (but not including royalties in respect of computer software, royalties in respect of motion picture films nor royalties in respect of works on film or videotape or other means of reproduction for use in connection with television broadcasting).

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films and to films or video tapes to be used in connection with television) and a 8% tax rate in all other cases. No taxation in the source state on outbound royalties is generally provided for in Italy’s tax treaties156 with Cyprus (1974), Georgia (2000), Ireland (1971), Lebanon (2000), Macedonia (1996), Russia (1996), Hungary (1977) and the Soviet Union (1985).157 A number of treaties158 contain a most-favoured-nation clause according to which, had the other contracting state agreed with a third country on a narrower taxation on royalty payments after the conclusion of the relevant Italian tax treaty, Italy is entitled to require the application of such more favourable source taxation whenever the royalties sourced in the other contracting state are beneficially owned by its residents.159 The Austria-Italy Income and Capital Tax Treaty (1981) grants limited taxing rights to the source state exclusively in the case of royalties paid to a person holding, directly or indirectly, more than 50% of the capital of the company paying the royalties.160 In addition, some treaties make the application of reduced source taxation subject to the fulfilment of a number of formal requirements. For instance, the Argentina-Italy Income and Capital Tax Treaty (1979) specifies that the reduced sourced taxation only applies for Argentina to the extent that the contracts from which those payments arise have been approved by the competent authorities of Argentina in accordance with the law on the transfer of technology.

156. Also, the It.-Kenya Income Tax Treaty (as amended by the protocol of 1997) assigns exclusive taxing rights to the state of residence. Although the treaty was signed in 1979, the instruments of ratifications have not yet been exchanged. 157. The treaty with the Soviet Union still applies in relations with Kyrgyzstan and with Tajikistan. 158. See the tax treaties with Argentina (1979), Estonia (1997), Ethiopia (2003), Latvia (1997), Lithuania (1996), Pakistan (1984) and the Philippines (1980). In the tax treaties with Mauritius (1990) and Singapore (1977), the most-favoured-nation clause does not apply automatically but requires a consultation among Italy and the other contracting state in order to extend the same treatment on a reciprocal basis. 159. These clauses are usually added by treaty partners that wish to reduce rates for royalties at source when states which commonly negotiate high tax rates lower them in tax treaties with other states (e.g. see the It.-Pak. Income Tax Treaty (1984) under which Pakistan has the right to apply a tax rate up to 30%). 160. This confirms the policy of Austria to limit or eliminate source taxation in order to promote exports. See Ch. 10, Austria, supra at sec. 10.4.

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The tax treaties with Ireland (1971) and Switzerland (1976) provide for a deviation from the PE proviso of article 12(3) of the OECD Model, according to which the source state is entitled to tax the royalties without any limitation, under article 7, whenever the receiving company has a PE in Italy, i.e. even in cases where the IP giving rise to the income is not effectively connected to such PE. As for the taxing method, the withholding tax limitation provided for in the tax treaties is usually computed on the gross amount of the royalties. As indicated in section 16.2.3.2., the 30% domestic withholding tax on outbound royalties is instead applied on a taxable base reduced by a 25% lump-sum deduction pursuant to article 25(4) of Decree 600/1973. Where the combination of the domestic withholding tax rate with the reduced taxable base is more favourable than the treaty limit applied to gross income, the withholding agent shall apply the more limited domestic taxation.161 In this respect, paragraph (e)(1) of the 1986 protocol to the China (People’s Rep.)-Italy Income Tax Treaty (1986) provides that in the case of payments derived from the use of, or the right to use, industrial, commercial or scientific equipment, the maximum tax that may be levied at source (10%) must be computed on 70% of the gross amount of the royalty. Lastly, some Italian tax treaties contain a specific tax sparing (and sometimes matching credit) provisions. The main purpose of these provisions is to allow taxpayers to obtain a foreign tax credit for the taxes that have been “spared” under the incentive programmes of the source state.162 For instance, article 12(2) of the Argentina-Italy Income and Capital Tax Treaty (1979) provides for a tax rate of 10% for any copyright of literary, artistic or scientific work and a tax rate of 18% in all other cases. In order to eliminate double taxation under article 24(4), when a resident of Italy derives income taxable in Argentina, the tax levied in Argentina on royalties defined in article 12(3) shall always be deemed as paid at a rate of 20%.163 161. According to art. 169 of the ITC, Italian income tax legislation prevails over tax treaties when more favourable for the taxpayer. The same principle is enshrined in art. 75 of Decree 600/1973. 162. When the state of residence of a foreign investor applies the credit method, the benefit of the incentive granted by a state of source may be reduced to the extent that the state of residence, when taxing income that has benefited from the incentive, will allow a deduction only for the tax actually paid in the state of source (see para. 72 OECD Model: Commentary on Articles 23 A and 23 B (2017)). 163. Specific tax sparing clauses concerning royalties are also contained in Italy’s tax treaties with Brazil (1978), China (People’s Rep.) (1986), Ethiopia (1997), Malaysia (1984), Malta (1981), the Philippines (1980), Singapore (1977), Sri Lanka (1984), Tanzania (1973) and Turkey (1990).

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16.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 16.4.2.1. Definition of “royalties” under article 12 OECD Model and in Italy’s treaty practice Article 12(2) of the OECD Model (2017) provides for an autonomous definition of the term “royalties”.164 As indicated in section 16.1.1., neither article 12(2) of the OECD Model nor domestic income tax law provide for an autonomous definition of the specific types of IP included in the definition of royalties. As a consequence, tax treaty terms not defined within article 12(2) shall be interpreted by reference to the meaning they have for the purpose of the domestic private law under article 3(2) of the OECD Model (2017).165 It is therefore possible that a qualification conflict arises if the contracting states of a tax treaty have divergent IP definitions in their respective domestic legislations, which could potentially result in double taxation. For instance, the qualification of neighbouring rights as copyrights (or not as copyrights) within the scope of the tax treaty definition of royalties (on the basis of the definition of copyright under the domestic law of a contracting state) may lead to a conflict of qualification, where the relevant treaty rules provide for the application of different withholding tax rates for “copyrights” and for “other rights”, and the “related rights” are regarded as “copyrights” under the law of one contracting state and not as “copyrights” under the law of the other contacting state. This was the issue dealt with by the Supreme Court in its decision no. 21220 of 29 September 2006 regarding the application of article 12 of the Italy-United States Income Tax Treaty

164. See M. Valta, Article 12. Income from Royalties, in Klaus Vogel on Double Taxation Conventions p. 992 (4th edn, E. Reimer & A. Rust eds., Kluwer Law International 2015); C. Garbarino, Manuale di tassazione internazionale p. 502 (IPSOA 2008). Note that the OECD Transfer Pricing Guidelines have clarified that “the manner in which a transaction is characterized for transfer pricing purposes has no relevance to the question of whether a particular payment constitutes a royalty or may be subjected to withholding tax under Article 12. The concept of intangibles for transfer pricing purposes and the definition of royalties for purposes of Article 12 of the OECD Model Tax Convention are two different notions that do not need to be aligned” (see para. 6.13). 165. See sec. 16.1.1., where it has been clarified that the private law meaning of the IP is relevant for both the purpose of interpreting and applying article 12(2) of the tax treaties concluded by Italy and the qualification of income deriving from utilization of IP under domestic tax law. See also Ruling no. 143/E of 22 Nov. 2017, dealing with the interpretation of “copyright of artistic work” for the purpose of art. 12(3) of the Fr.-It. Income and Capital Tax Treaty (1989), supra n. 29.

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(1999).166 The Court observed that under Italian private law, neighbouring rights could not be regarded as identical to copyrights, whereas in the US and Canadian legislation they tend to be assimilated to “copyrights”. The Court also observed that payments covered by article 12(2)(c) of the treaty – i.e. royalty payments made “in all other cases”, i.e. payments not for the use of copyrights, motion pictures, films, tapes and the like – should be regarded as including payments made in connection with neighbouring rights. As a result, the royalties at issue were subject in Italy to the withholding tax rate provided for in article 12(2)(c), i.e. 10%, while the United States (as state of residence) granted a foreign tax credit limited to the tax rate of 5% provided for “copyrights” under article 12(2)(a). According to the Court, this partial double taxation was not the result of a wrong interpretation of the treaty, but rather the consequence of the right that each contracting state had under the treaty to interpret undefined terms according to its own domestic legislation. ITA’s Ruling no. 12/E of 9 February 2004 also dealt with the qualification of income from neighbouring rights under the Italy-Germany Income and Capital Tax Treaty (1989). In particular, the case concerned the royalties paid to a German resident artist for shows broadcast on Italian television. Article 12(3) of the tax treaty excludes taxation at source for royalties paid for the use of copyrights and for “other similar payments” in respect of the production or reproduction of any literary, dramatic, musical or artistic work. The ITA concluded that income from neighbouring rights falls within the scope of article 12(3). The ITA grounded such conclusion by also referring to paragraph 18 of the OECD Commentary on Article 12, which recognizes that the payment made to a musical performer for recording a musical performance should be regarded as royalty.167 Note that under domestic tax law, income from neighbouring rights should not be assimilated to royalties arising from copyrights, as domestic provisions (both distributive and sourcing rules) relate to the exploitation of well-identified IP, which do not 166. See C. Garbarino, Chapter 10 Legal Interpretation of Tax Law: Italy, in Legal Interpretation of Tax Law, Second Edition p. 242 (R.F. van Brederode & R. Krever eds., Kluwer Law International 2017); F. Avella, La qualificazione dei redditi nelle Convenzioni bilaterali contro le doppie imposizioni stipulate dall’Italia, Riv. Dir. Trib., p. 63 (2010). 167. Where, however, the copyright in a sound recording, because of either the relevant copyright law or the terms of contract, belongs to a person with whom the artist has contractually agreed to provide his services (i.e. a musical performance during the recording), or to a third party, the payments made under such a contract fall under art. 7 (e.g. if the performance takes place outside the state of source of the payment) or art. 17 rather than under art. 12, even if these payments are contingent on the sale of the recordings (see para. 18 OECD Model: Commentary on article 12 (2017)). Thus, the contract and the applicable legislation may also be decisive in ascertaining whether there is a royalty, a service or a performance fee.

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literally include neighbouring rights. Hence, from a domestic tax perspective, income from neighbouring rights derived by a non-resident person is regarded as miscellaneous income to be sourced in Italy if derived from activities or properties situated in Italy (article 23(1)(f) of the ITC).168 On the contrary, if the qualification of income from neighbouring rights as royalties endorsed by the ITA in the Ruling no. 12/E of 9 February 2004 in the context of tax treaty implies that income from neighbouring rights is treated as royalties also under domestic tax law, such income will be regarded as sourced in Italy whenever paid by an Italian-resident person. Clearly, the presence of different rates for royalties at source as well as reference to “other like property or right” in the definition of royalties increases the risk of interpretative issues and qualification conflicts.169 For instance, as indicated in section 16.1.1., under Italian private law computer programs (generally “software”) are a form of IP protected by the Copyright Act, which assimilates software programs to literary works. In the tax treaties where taxing rights are assigned to the source state at a different rate depending of the category of IP involved, it might be debatable in which of such categories royalties paid in respect of software programs should be included. In particular, a conflict of qualification may arise if, according to the source state’s domestic legislation, software cannot be assimilated to copyrights on literary or scientific work and, consequently, the use of software could be considered as “other” royalties in that state.170 In order to avoid such interpretative issue, a number of tax treaties concluded by Italy have expressly included the use of software in the definition of royalties.171 As far as the definition of royalties contained in Italy’s tax treaty practice is concerned, the following deviations from the definition laid down by article 12(2) of the OECD Model (2017) appear relevant. All tax treaties172 signed 168. See secs. 16.2.2.2. and 16.2.3.2. 169. Unlike the closed definition in the OECD Model, Italy’s tax treaty practice is to include expressions such as “other like property or right” within the definition of royalties (see art. 12(4) It.-US Income Tax Treaty (1999)) or with reference to a specific type of IP (e.g. see art. 12(3) of the It.-Ger. Income and Capital Tax Treaty (1989), which includes “other similar payment” in connection with copyrights). 170. In this sense, see Ruling no. 43121 of 14 Oct. 1996 of the Regional Tax Office of Emilia Romagna, which, under the previous treaty with the United States (1984), confirmed that since software is explicitly assimilated to literary or scientific work according to Italian copyright law, Italian withholding tax at the rate of 5% shall apply. 171. See Italy’s tax treaties with Armenia (2002), Azerbaijan (2004), Canada (2002), Chile (2015), Hong Kong (2013), Iceland (2002), Qatar (2002), Romania (2015) San Marino (2002), Saudi Arabia (2007) and the United States (1999). 172. The It.-Thai. Income Tax Treaty (1977) does not explicitly include in the definition of royalties the use of industrial, commercial or scientific equipment. However, the ITA

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by Italy include income derived from the leasing of industrial, commercial or scientific equipment in the definition of royalties, even if, as from 1992, such payments are no longer covered by article 12 of the OECD Model and fall into the scope of article 7 of the OECD Model.173 Indeed, Italy has expressed its disagreement with the amendments to article 12 of the OECD Model made in 1992 and reserved its right to continue to include income derived from the leasing of industrial, commercial or scientific equipment and of containers in the definition of “royalties” as provided for in article 12(2) of the OECD Model (1977). As a consequence, leasing payments made by an Italian lessee would be characterized as Italian-source income (except for those treaties which grant exclusive taxing rights to the state of residence).174 However, pursuant to the domestic sourcing rule, income from industrial, commercial or scientific equipment is regarded as sourced in Italy only if the relevant assets are prevalently used within the Italian territory (article 23(1)(f) of the ITC).175

16.4.2.2. Overlapping between articles 12 and 13 OECD Model In connection with the definition of the term “royalty”, it is also relevant to discuss the distinction between “use” and “alienation” of IP, which determines the alternative application of article 12 (royalties) or article 13 (capital gains). The expression “the use of, or the right to use” is not autonomously defined under article 12 of the OECD Model (2017) or the Commentary on Article 12.176 In order to establish whether a contract determines the alienation of an IP or merely the right for a third party to use it, reference should be made to the domestic law of the source state on the basis of article 3(2) of the OECD Model (2017). As observed in section 16.1.2., under Italian private law a transaction involving the transfer of IP shall qualify as alienation has maintained that even if a treaty does not contain an explicit reference to the use of industrial, commercial or scientific equipment, art. 12 still applies based on the circumstance that Italy’s treaty practice is to assimilate such items of income to royalties (see Circular no. 42, 12 Dec. 1981). 173. For the reasons of the elimination, see the OECD Reports The Taxation of Income Derived from the Leasing of Industrial, Commercial or Scientific Equipment and The Taxation of Income Derived from the Leasing of Containers, both adopted by the OECD Council on 13 Sept. 1983. 174. Italy’s tax treaties with Chile (2015), Estonia (1997), Indonesia (1990), Latvia (1997), Lithuania (1996) and United States (1999) provide for a specific rate for the use of equipment. 175. See Circular no. 42 of 12 Dec. 1981. For a general overview on income tax implications of leasing arrangements under both Italian tax law and tax treaty law, see P. Flora & M. Messi, Tax Treatment of Leasing Agreements, 9 Derivs. & Fin. Instrums. 5, pp. 162-167 (2007), Journals IBFD. 176. Valta, supra n. 164, at p. 995.

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of IP only where the transfer of the legal ownership occurs (partial alienations of rights are also admitted). Paragraphs 8.2, 15 and 16 of the OECD Commentary on Article 12 (2017) provide some useful principles in order to distinguish the consideration paid for the transfer of the full ownership of an IP from the payment of a royalty, recognizing that difficulties may arise where the right to use is not transferred permanently and exclusively177 (e.g. in the case of an exclusive granting of a right for a limited period of time or a specific geographical location). In this respect, Italy has recorded the following observation: Italy [and Spain] do not adhere to the interpretation in paragraph 8.2. They hold the view that payments in consideration for the transfer of the ownership of an element referred to in the definition of royalties fall within the scope of this Article where less than the full ownership is transferred. Italy also takes that view with respect to paragraphs 15 and 16.178

In particular, Italy holds that payments made for the transfer of less than the full ownership of elements included in the definition of royalties shall always be taxed under the provisions of article 12. Such a view seems to be in line with the aforementioned Circular Letter no. 12/227 of 13 March 1981, where the ITA stated that: If the acquisition of the intangible is carried out through a contract which entails the transfer of ownership against a payment that takes into account solely the value of the patent, thus excluding any other claim related to the use of the rights transferred to the Italian entity by the foreign enterprise, the payments should not be qualified as royalties, but as a mere commercial transaction.

There are no administrative guidelines, nor case law, clarifying the scope of this observation and its relation with the Italian domestic rules concerning the qualification and source of such income (in particular, article 23(2) (c) of the ITC). In any case, as the goal of such observation appears to be that to qualify as royalties, all payments made for the transfer of less than the full ownership of an IP, one would expect the domestic sourcing rules to treat such payments as royalties sourced in Italy whenever made by an Italian-resident person or PE. In any case, the observation begs the question 177. See A. Martín Jiménez, Article 12: Royalties - Global Tax Treaty Commentaries, IBFD, 2017, par. 5.1.3.1.3, the author maintains that the Commentary (as amended over the years) seems, in some parts, to emphasize an autonomous qualification of the nature of the transaction: “[T]he … Commentary on Article 12(2), especially in paragraphs 8.2. and 16, seems to prefer a contextual approach to distinguishing between ‘use’ and ‘sale’, in which the essence of the transaction and the rights and obligations of the parties, regardless of domestic law, should be the controlling criterion.” 178. See OECD Model: Commentary on Article 12 (2017), Observations on the Article, para. 27.

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whether the sale of geographically limited rights, or the transfer of specific economic rights in connection with an intellectual work covered by copyright, should be regarded as autonomous IP for the purpose of article 12. Where domestic private law recognizes the autonomous alienation of such less-than-full rights,179 one could argue that payments made for the alienation of those rights should fall within article 7 or article 13, rather than under article 12. Note also that article 12(4) of the Italy-Mexico Income Tax Treaty (1991) states: “The term ‘royalties’ also includes gains derived from the alienation of any such right or property referred to in this paragraph to the extent that the sum received with respect to that alienation is contingent on the productivity or use thereof.” On a different issue, paragraph (e)(2) of the 1986 protocol to the China (People’s Rep.)-Italy Income Tax Treaty (1986) specifies that where a mixed contract includes the supply of technical know-how, as well as the sale of equipment or machinery, only the payments for the know-how fall within the scope of article 12.

16.4.2.3. Overlapping between articles 12 and 7 OECD Model As far as transactions involving the transfer of computer software are concerned, prior to the amendments to the Commentary on Article 12 approved by the OECD Council on 18 July 2008, the ITA’s view on the qualification of payments related to software programs was basically aligned with the principles expressed in the Commentary. In particular, already from the 1990s, ITA’s practice was that payments made for the sole right to use software programs had to be treated as business profits.180 Subsequently, in ruling no. 128/E of 3 April 2008, the ITA

179. A. Prampolini, Disciplina tributaria dei compensi corrisposti ad artista cinematografico o televisivo non residente per diritti connessi all’esercizio del diritto d’autore relativi ad opere ritrasmesse televisivamente sul territorio italiano, Riv. Dir. Trib. 3, pp. 134-136 (2015). 180. See Ruling no. 169/E of 30 July 1997, where the ITA specified that “if the purchase of the software is aimed solely at the personal and commercial utilization of the software, not including the right to reproduce or market the software, the consideration paid represents business profits … and not royalties”.

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stated that payments made as a consideration for obtaining the right to distribute the copies of the software qualify as royalties for treaty purposes.181 The amendments to the Commentary on Article 12 made by the OECD in 2008 clarified that when a person acquires the right to distribute copies of a software (and the rights related to the underlying copyright that are strictly necessary for marketing the copies), but without the right to reproduce them, the payments for the acquisition of this right do not represent royalties, but instead business profits for treaty purposes.182 In this respect, Italy recorded an observation to the new Commentary, stating that it did not consider that the interpretation given by the OECD in paragraph 14.4 of the Commentary applied in all cases of distribution of software copies. According to the Italian government, a case-by-case approach must be preferred, taking into account all relevant facts and circumstances, including analysis of the rights granted in relation to the acts of distribution.183 In the author’s opinion, the Italian observation to the Commentary proves a contrario that the Italian government is open to accept the OECD interpretation in some cases. This reading has been confirmed by the ITA in an unpublished ruling of the Regional Directorate of Lombardy of 13 April 2012 (protocol no. 39171) where it was clarified that based on paragraph 14.4 of the Commentary and the related observation recorded by Italy, payments made for the sole right to distribute software copies fall outside the scope of article 12 and must be regarded as business profits under article 7 OECD Model. As a consequence, no Italian tax should apply to such payments, unless the recipient carries on a business activity in Italy through a PE located therein. The same issue has been recently addressed by some Italian tax courts, which confirmed that where an Italian distributor only acts as commercial intermediary, without enjoying any significant right in the underlying copyright, payments to acquire and distribute software copies qualify as business profits under article 7 and not as royalties under article 12.184 181. The question concerned an Italian company that marketed and distributed in Italy the software programs designed and produced by a company that was resident in France for tax purposes. The ITA stated that the remuneration paid to the French company constituted royalties since the Italian company paid such remuneration for the right to distribute the software to the public in Italy and this commercialization, in the absence of an agreement with the French company, would represent a copyright violation. The resolution did not make any distinctions on the basis of whether the rights acquired by the Italian distributor were limited to the distribution of the software or included other rights protected by copyright legislation. 182. See, in particular, para. 14.4 OECD Model: Commentary on Article 12 (2017). 183. See para. 31.2 OECD Model: Commentary on Article 12 (2017). 184. See IT: Regional Tax Court of Lombardy, 18 Jan. 2017, Decision no. 60 and IT: Regional Tax Court of Lombardy, section of Brescia, 26 May 2016, Decision no. 3223.

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Nevertheless, the ITA continues to recharacterize such (and similar) transactions as mixed agreements, in which part of the remuneration paid is qualified as the price for the purchase of goods (falling under article 7) and part as the royalty for the right to use the IP (falling under article 12). In particular, there are cases, other than those dealing with software, where the ITA maintained that if an Italian distributor acquires the exclusive right to commercialize tangible goods incorporating IP (such as know-how or trademarks), the purchase price also includes the remuneration for the right to use such IP. Consequently, according to the ITA, Italian withholding taxes should apply to the part of payment that represents the embedded royalties.185 In addition, if the transaction takes place between associated enterprises, the remuneration must respect the arm’s length principle. In the author’s opinion, the guidelines set forth in the OECD Commentary on Article 12186 should apply to such transactions: hence, if the distributor does not acquire any distinct rights in the IP embedded in the goods, no royalty within the meaning of article 12(2) of the OECD Model should be regarded as being paid.187 Similar issues should be resolved on a case-by-case base,188 also taking into account that as regards payments made as consideration for exclusive distribution rights,189 the ITA consider that where exclusive distribution rights are provided in connection with rights referred to in the definition of royalties, the part of the payment made for the exclusive distribution rights may be covered, depending on the circumstances, by article 12.190 Another controversial issue regarding the definition of royalties is whether payments for provision of services, particularly technical services, may be covered by article 12. It is worth noting that neither Italian domestic law nor the OECD Model provide for a definition of services in general or technical services/assistance, in particular (the Commentary on Article 12 deals with the distinction between payments for the supply of know-how and payments for the provision of services). In line with article 12(2) of the OECD Model (2017), the definition of royalties of most of Italian tax treaties does 185. In certain cases, which are still pending before the Italian tax courts, the ITA challenged the failure to apply withholding taxes on the part of payment that represents the embedded royalties for the right to use trademarks in the context of distribution agreements (see IT: Provincial Tax Court of Milan, 27 Dec. 2017, Decision no. 7134 and IT: Provincial Tax Court of Milan, 20 Feb. 2017, Decision no. 779). 186. See para. 10.1, for exclusive distribution rights, and para. 14.4, for software, OECD Model: Commentary on article 12 (2017). 187. See paras. 6.105-6.106 OECD Transfer Pricing Guidelines. 188. If the distribution agreement of a product “hides” the use of or right to use an IP included within art. 12, there indeed will be a royalty. This could occur when the distributor manufactures the product under a trademark of the foreign company. 189. See, on this issue, para. 10.1 OECD Model: Commentary on Article 12 (2017). 190. See para. 27.1 OECD Model: Commentary on Article 12 (2017).

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not generally include technical service fees. There are some exceptions, however. Indeed, some treaties provides for the taxation at source of fees for technical services or assistance. For instance, article 13 (Royalties and fees for technical services) of the India-Italy Income Tax Treaty (1993) assigns taxing rights at source also for “fees for technical services” and defines them as “payments of any amount to any person other than payments to an employee of the person making payments, in consideration for the services of a managerial, technical or consultancy nature, including the provisions of technical services or of other personnel”.191 Similarly, under article 5 of the 1978 protocol attached to the Brazil-Italy Income Tax Treaty (1978), income derived from the rendering of technical assistance and technical services are regarded as covered by the expression “information concerning industrial, commercial or scientific experience” mentioned in article 12(4).192 Moreover, article 12(3) of the Argentina-Italy Income and Capital Tax Treaty (1979) widens the definition of royalties by including remunerations for “studies or research of a scientific or technical nature and concerning industrial, commercial or administrative methods or processes”.193 Also, article 12(3) of the Australia-Italy Income Tax Treaty (1982) broadens the definition of royalties by including certain specific types of services, namely the assistance of an ancillary and subsidiary nature furnished as a means of enabling the application or enjoyment of the knowledge, information, property or right to which the same article 12 applies. The Italy-Soviet Union Income Tax Treaty (1985) specifies that the rule concerning royalty payments (article 5(3)) shall also apply to payments in respect of technical 191. The same provision is included in art. 12 of the It.-Oman Income Tax Treaty (1998) and the It.-Viet. Income Tax Treaty (1996). Likewise, the Ghana-It. Income Tax Treaty (2004) and the It.-Ugan. Income Tax Treaty (2000) dedicate a specific provision to service fees, which includes “payments of any kind to any person, other than to an employee of the person making the payments, in consideration for any services of a managerial, technical or consultancy nature” (art. 13). Also, the It.-Trin. & Tob. Income Tax Treaty (1971) provides for a specific provision for management and other personal, professional and technical services. 192. See para. 5 of the 1978 protocol to the Braz.-It. Income Tax Treaty (1978). The wording of the OECD Commentary on Article 12 (see para. 11.3) clarifies that the definition of know-how does not include the provision of services, in which the content of the transfer is represented by the activity performed by the provider rather than by the information transferred. Para. 5 of the 1978 protocol to the treaty widens such definition, including certain specific types of services, namely “technical assistance and technical services”, thus deviating from the treaty regime of services provided under art. 7 and granting the state of source taxing rights on the relevant income even in the absence of a PE. 193. Also, the It.-Spain Income Tax Treaty (1977) and the It.-Tun. Income Tax Treaty (1979) include in the definition of royalties, respectively, “consideration for technical and economic research of an industrial or commercial nature” (letter (c) of the protocol of the treaty with Spain) and technical and economic studies of an industrial or commercial character (letter (c) of the protocol of the treaty with Tunisia).

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services connected with the sale, use of or right to use industrial, commercial or scientific equipment. On the other hand, there are also treaties that contain specific provisions aimed at clarifying that income from services is not covered by article 12. For instance, article 7 of the 1989 protocol of the France-Italy Income and Capital Tax Treaty (1989) makes it clear that remuneration for technical services, including the analyses or studies of a scientific, geological or technical nature, for engineering work including plans pertaining thereto, or for consultation or supervisory services shall be considered profits of an enterprise to which the provisions of article 7 shall apply, or as income from an independent profession to which the provisions of article 14 shall apply, as the case may be.194 Conversely, where no special rules dealing with services are provided for by the relevant treaty, given the lack of an autonomous definition of the terms “technical assistance” and “technical service”, conflicts of qualification between the contracting states may arise. Although the Commentary on Article 12 provides for some guidelines to distinguish between income from know-how and income derived from the provision of services, as observed in section 16.2.1., the separation of the royalties paid for the licensing of know-how from the payments related to the provision of technical services is not always easy and it often turns out to be extremely difficult in the case of “mixed” contracts, or bundled contracts, whereby technical assistance is combined with the licensing of know-how. In particular, there is a tendency by the ITA to aggregate transactions that include both technical assistance and licensing of IP and to characterize as licensing of know-how the supply of any information having a technical content (regardless of whether it had the main features of know-how).195 In this respect, in the event of a contractual agreement regulating both the provision of IP and advisory services, missing any specification in the agreement on how to split the remuneration paid, the ITA claimed the application of the withholding tax on the entire amount of the consideration (ruling no. 183/E of 24 September 2003). The ITA stated that in the absence of a specific contractual provision intended to clearly identify the different components of the license agreement, one must rely on the “prevailing content of the contractual agreement”. Hence, in absence of a specific identification of the consideration of the individual components in the agreement, the taxpayer

194. Also, the It.-Kuwait Income Tax Treaty (1987) specifically excludes technical services (more precisely “consultancy and technical assistance services connected to the above properties and activities”) from the definition of royalties (art. 12(3)). 195. See supra n. 60.

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should apply the withholding rate provided for the main component of the consideration.196 Another relevant issue is whether payments for R&D contributions and cost-sharing agreements (CSAs) might fall under the scope of the definition of royalties. In this respect, the ITA tends to qualify such contributions as royalty payments to the extent that the agreements attribute to Italian companies the right to use the relevant IP resulting from the R&D activities.197 In other situations, the ITA even challenged the payment of royalties for the use of an IP, where the licensee had already contributed to the expenses for the R&D carried out in respect of the same IP under a CSA. As a result, the ITA denied the deduction for corporate income tax purposes of the royalties paid, based on the argument that such payments represented a duplication of costs already incurred under the CSA.198 Finally, if payments made as a consideration for the transfer of the right to use an IP under a sub-licensing agreement by the sub-licensee to the licensee should usually qualify as royalties under article 12 (even if the issue whether the royalties are beneficially owned by the licensee may arise),199 payments made as a consideration for the transfer of the right to use an IP under a licensing agreement by a licensee to a new licensee should not, as a general rule, qualify as royalties. There is no specific case law or administrative guidelines dealing with such a case. Under Italian private law, however, the transfer of a licensing agreement qualifies as a transfer of a contract 196. See also IT: Provincial Tax Court of Treviso, 4 Sept. 2001, Decision no. 64, where the court recharacterized the commission fee paid by an Italian company to a French company into a mixed contract whereby part of the payment had to be referred to use of a trademark and, consequently, subject to the withholding tax at source. 197. See, for instance, IT: Regional Court of Puglia, 28 Jan. 2013, Decision no. 6 and 23 July 2014, Decision no. 1709 dealing with a case in which the ITA had challenged the omitted application of withholding taxes on payments arising from a cost contribution agreement (CCA) in which the licensing administrator granted the protection and further development of IP to the Italian contributor who only benefitted from a non-exclusive, non-transferrable licence to use the asset. The ITA also relied on the former para. 8.23 of the Transfer Pricing Guidelines, which indicated that “No part of a contribution in respect of a CCA would constitute a royalty for the use of intangible property, except to the extent that the contribution entitles the contributor to obtain only a right to use intangible property belonging to a participant (or a third party) and the contributor does not also obtain a beneficial interest in the intangible property itself.” See also the above-mentioned CSC Decision no. 20911 of 3 Oct. 2014, dealing with a case of recharacterization as royalties of R&D contributions. Although this decision does not regard withholding taxes, it clearly states that recharges of costs under a CCA must be accounted as royalties by the payer if the payer does not obtain any legal ownership of the underlying intangible. 198. See IT: Regional Court of Lombardy, 16 Feb. 2017, Decision no. 604. 199. See sec. 16.4.3.

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pursuant to article 1406 of the Civil Code, which entails a full transfer of the entirety of rights and obligations stemming from the contract involving both of the parties (the licensee and the new licensee). As a consequence, in the author’s opinion, any payments received by the licensee for the transfer of the licensing agreement should be regarded as a consideration for the disposal of a property (in such a case the rights provided under the contract) and not as royalties for the use of or the right to use an IP.200

16.4.3. Beneficial ownership and royalties Most of the Italian tax treaties follow the 1977 OECD Model and therefore the application of the treaty benefits under article 12 is explicitly subject to the requirement that the beneficial owner of the royalties is a resident of the other contracting state.201 The concept of beneficial ownership is generally not defined in Italian tax treaties,202 except for the treaty with Germany (1989), which, at paragraph 9 of the protocol, provides as follows: The recipient of the dividends, interest and royalties is the beneficial owner within the meaning of Articles 10, 11 and 12 if he is entitled to the right upon which the payments are based and the income derived therefrom is attributable to him under the tax laws of both States.203 200. There may be cases where the licensing agreement is disposed to a new licensee immediately after the conclusion of the agreement and the payment of a lump-sum royalty. In such cases, payments (or part of these) deriving from the transfer of the licensing agreement could be considered royalties as aimed at compensating the first licensee of the up-front royalty payments made in favour of the licensor. 201. See sec. 16.4.1. 202. See para. V of the 1990 protocol to the It.-Turk. Income Tax Treaty (1990) specifying that a resident of Italy or Turkey must always be considered the beneficial owner of the income: “It is understood that the ‘beneficial owner’ clause should be interpreted in the meaning that a third country resident will not be allowed to get benefits from the Tax Agreement with regard to dividends, interest and royalties derived from Turkey or Italy, but this restriction shall in no case be applied to residents of a Contracting State.” 203. The definition drawn under para. 9 of the 1989 protocol to the It.-Ger. Income and Capital Tax Treaty (1989) influenced the interpretation of beneficial owner initially held by the ITA, according to which the recipient of an item of income is the beneficial owner thereof if such item of income is attributable to it for income tax purposes under the law of its state of residence. In particular, in Ruling no. 86/E of 12 July 2006, the ITA examined the case of an agreement whereby IP was granted by various licensors to a USresident company (the licensing administrator) for the sub-licensing of the same rights by the latter to final clients resident in various states, including Italy. In such a case, the ITA stated that the licensing administrator did not qualify as beneficial owner of the royalties on the basis of the assumption that the royalties were not included in its taxable income under the applicable US tax rules, as well as of an analysis of the actual relationships in place between the licensing administrator and the licensor. In this latter respect, the ITA emphasized, in particular, that the licensing administrator (i) acted solely as intermediary

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Note that a general definition of beneficial ownership does not exist in domestic law.204 Italy therefore refers to the Commentary of the OECD Model and to the guidance provided by both the ITA and case law, which makes it clear that the beneficial owner provision is a specific anti-avoidance rule.205 The ITA applies an economic-driven, substance-over-form approach on the beneficial owner concept. The ITA has repeatedly clarified how the term “beneficial owner” should be interpreted for the purpose of the I&R Directive and Italian tax treaties.206 Moreover, in the recent Circular Letter no. 6/E of 30 March 2016, the ITA took the view that the application of tax treaties as well as EU directives may be denied in cases of intermediate entities that are pure conduit companies and/or have a “light” organizational structure. In other words, if such entities are wholly artificial arrangements created for the main purpose to exploit a tax treaty or the EU directives, the tax benefits possibly achieved should be recaptured. In this respect, however, recent case law of the Supreme Court supports a partially diverging view, according to which, as long as the recipient effectively controls and enjoys the income, the fact that it does not have a significant business structure in terms of tangible assets and employments, as well as the fact that it is controlled by entities not resident of the same contracting state, does not preclude entitlement to the benefits of the treaty.207 Consequently, holding companies are regarded as the beneficial owners of the dividends as long as they maintain a sufficient degree of autonomy in the management of the assets held and if they retain control of the income received (instead of passing it on to the controlling entity on a regular basis).208 in the licensing of the IP rights but did not exploit the licensed rights for its own benefit, (ii) was not entitled to negotiate the sub-licensing agreement with the final clients, but had to comply with the instructions from the licensors and (iii) did not have the right to dispose of the royalty amount since it was required to deposit it in an account for the benefit of the licensors. 204. A specific definition of the term was introduced upon implementation of the I&R Directive (see sec. 16.3.2.3.). 205. See IT: CSC, 16 Dec.2015, Decision no. 25281, 25 May 2016, Decision no. 10792, and 28 Dec. 2016, Decision no. 27113, according to which beneficial ownership is a general clause of the international tax system, which is applicable even if the treaty is silent about it. See, in this respect, P. Arginelli, Spunti ricostruttivi della nozione di beneficiario effettivo ai fini delle convenzioni bilaterali per evitare le doppie imposizioni concluse dall’Italia, Riv. Dir. Trib., sec. V, p. 29 et seq. (2017). 206. See the administrative practice mentioned in sec. 16.3.2.3. 207. See IT: CSC, 28 Dec. 2016, Decisions nos. 27112, 27113, 27115 and 27116. See also IT: Provincial Tax Court of Milan, 24 July 2017, Decision no. 5052 and Arginelli, supra n. 205, at pp. 33-35. 208. The ITA also appears to have changed its approach to holding companies. See, in this sense, Ruling no. 69/E of Aug. 2016, where the ITA considered that a “mere” holding

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Lower-tier courts have put particular emphasis on the following circumstances in order for the recipient of the income to be qualified as the beneficial owner thereof: (i) the existence of an adequate organizational structure in terms of assets and personnel;209 (ii) the functions performed by the recipient of the payment and its decision-making process;210 (iii) the income received was not actually passed on to another group company by way of dividends211 or through contractual obligations:212 and (iv) the effective power and discretion to dispose of the income.213 Moreover, both the ITA and Italian courts appear to recognize the possibility to apply the treaty between Italy and the state of residence of the ultimate beneficial owner where the first recipient of the income may not be regarded as the beneficial owner thereof (look-through approach).214 Treaty benefits may be also denied by a specific anti-avoidance rule in the relevant treaty. See, for instance, article 12(7) of the Italy-Romania Income Tax Treaty (2015), according to which: The provisions of this Article shall not apply if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the rights in respect of which the royalties are paid to take advantage of this Article by means of that creation or assignment.215

Treaty benefits may also be denied on the basis of the beneficial owner clause, a limitation of benefits (LOB) article or the domestic GAAR (see section 16.3.2.3.).216

company is a company engaged in an economic activity. 209. See IT: Provincial Tax Court of Torino, 19 Oct.2010, Decision no 124; IT: Regional Tax Court of Milan, 5 Aug. 2016, Decision no. 4417. 210. See IT: Provincial Tax Court of Torino, 11 Feb. 2010, Decision no. 14. 211. See IT: Provincial Tax Court of Torino, 8 May 2013, Decision no. 93-8-13. 212. See IT: Provincial Tax Court of Milan, 1 Feb. 2013, Decision no. 66, whereby a company that sub-licenses trademarks and has a legal obligation to transfer to the owner of the intangible assets 90% of the royalties collected, does not qualify as beneficial owner for the purpose of the application of a treaty. 213. See IT: Provincial Tax Court of Milan, 19 June 2013, Decision no. 188. 214. With reference to the ITA, see Ruling no. 431 of 7 May 1987 and no. 86/E of 12 July 2006, as well as Circular Letter No. 6/E of 30 Mar. 2016. With reference to case law, see IT: Provincial Tax Court of Torino, 11 Feb. 2010, Decision no. 14; IT: Regional Tax Court of Milan, 22 Mar. 2017, Decision no. 1254. 215. A similar provision is also contained in the tax treaties with Ghana (2004) and the United States (1999). 216. The Barb.-It. Income Tax Treaty (2015) provides a general provision whereby “The benefits of this Convention shall not apply to a person entitled to a tax benefit under a special tax regime in either Contracting State” (art. 29).

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16.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state In general, Italy’s tax treaty practice is to maintain the reduced right to tax (or the exemption if applicable) in the source state under article 12 regardless of the existence of a favourable regime in the residence state.217 Note that a recent judgment of the Regional Tax Court of Milan has confirmed that application of the treaty with Switzerland to a beneficial owner who is a Swiss-resident holding company exempted from the municipal and cantonal taxes by virtue of a ruling concluded with the Swiss tax authorities.218 On the other hand, note also that with reference to the application of article 15 of the EU-Switzerland Agreement of 26 October 2004 (under which the measures equivalent to the provisions contained in the EU Parent-Subsidiary Directive on dividends and in the I&R Directive on interest and royalties were extended to Switzerland), the ITA took the position that the “subjectto-tax” condition in order for application of the exemption from withholding tax is met only to the extent that the Swiss-resident shareholder does not benefit from any form of exemption of direct taxation at any level in Switzerland (i.e. federal, cantonal or communal level).219

16.4.5. Time of taxation Article 12(2) of the OECD Model (2017), when defining the meaning of the term “royalties”, refers to “payment”, but does not deal with the precise moment of realization of the taxable event. This is commonly regarded as a question regulated by domestic law.220 From the residence state’s perspective, under domestic tax law royalties are included in the taxable income on an accrual basis (if received by an Italian-resident company) or on a cash basis (if received by an Italian-resident individual). From the source state’s perspective, pursuant to article 25 of Decree 600/1973, the withholding tax 217. The It.-Neth. Income and Capital Tax Treaty (1990) specifies that in determining the withholding tax rates as provided for in article 12(2), “it has been taken into account that the Netherlands does not levy a special withholding tax on … royalties paid to nonresidents”. 218. IT: Regional Tax Court of Milan, 22 Mar. 2017, Decision no. 1254. 219. Ruling No. 93/E of 10 May 2007. 220. Martín Jiménez, supra n. 177.

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is applicable on royalties on a cash basis, i.e. at the time of the payment. The concept of payment includes both actual payments and any other situation where the obligation to pay is extinguished, such as “set-off”, a merger with the debtor, etc. According to the ITA, the waiver of the receivable also qualifies as a payment. In particular, the ITA assimilated to an interest payment the waiver to the credit for accrued interest in Circular Letter no 73/E of 27 May 1994 (paragraph 3.20), specifying that: [T]he waiver of credits related to income that is taxed on a cash basis (such as, for example … interest related to financings from the shareholders) implies the deemed payment [incasso giuridico] of the credit and therefore the obligation to tax its amount, even through the application of final withholding taxes.221

Although no circular letters or ruling of the ITA address the issue regarding the application of the deemed payment principle to cases in which royalties are only accrued, by virtue of the concept of deemed payment, the ITA might challenge the omitted payment of the withholding tax at the time of the accrual of the royalties (such a risk increases if the licensee postpones for an extended period the payment of royalties).222 However, such position of the ITA – which is not explicitly regulated by any written provision – has been criticized by many Italian scholars. The protocol to the Australia-Italy Income Tax Treaty (1982) specifies that “The term ‘payments’ includes credits or any amount credited and a reference to royalties paid includes royalties credited.” This provision has been included in the Australian treaty network in response to the Aktiebolaget Volvo case in order for tax authorities to have the right to tax the amount of royalties accounted for as due and payable, but not yet paid.223 The protocol to the Italy-Portugal Income Tax Treaty (1980) also includes a specific provision regarding timing issues: “With reference to Articles 10,

221. A similar interpretation was also held in a few case law precedents relating, in particular, to the settlement of the credit by confusion following the merger between the debtor and the creditor (IT: CSC, Tax Chamber, 19 Oct. 2001, Decision No. 12793), the novation of the credit as a consequence of its conversion into a shareholders’ loan (IT: CSC, Tax Chamber, 20 Feb. 2013, Decision No. 4164) and the release of debts (IT: Provincial Tax Court of Vicenza, Decision no. 241/2008). 222. There is a tendency of the ITA to consider the capitalization of interest as a taxable event and claim the application of withholding taxes to the interest accrued at the date of the capitalization. 223. See Chap. 9, sec. 9.2.1., n. 77 in this volume.

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11 and 12, the term ‘paid’ may be construed as including dividends, interest and royalties attributed to a resident of the other Contracting State.”

16.4.6. Excessive royalty payments All the tax treaties concluded by Italy contain a specific anti-abuse provision that denies treaty benefits in cases where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the royalties paid exceeds the amount which would have been agreed upon by the payer and the beneficial owner had they stipulated at arm’s length.224 There are no administrative guidelines dealing with the specific tax treatment of excessive royalty payments, in particular, whether they may be recharacterized as constructive dividend distributions, as a loan or as a capital contribution.225 In general, the ITA scrutinize excessive royalty payments in the context of tax audits concerning transfer pricing matters by challenging their deduction for corporate income tax purposes and applying 30% domestic withholding tax.226

224. Art. 12(4) of the It.-Mor. Income Tax Treaty (1972) does not refer to a special relationship, as it specifies that “Where any royalty exceeds a fair and reasonable consideration in respect of rights for which it is paid, the provisions of paragraphs 1 and 2 shall only apply to so much of that royalty as represents such fair and reasonable consideration.” 225. Note the decision of the Provincial Tax Court of Ravenna no. 387 of 19 June 1998, which regarded the exceeding amount of royalty payment as a deemed distribution of dividends. 226. See, in this sense, IT: CSC, 27 Feb. 2013, Decision no. 4927.

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Chapter 17 Netherlands by Zoya Zalmai1

17.1. Introduction on private law aspects of intellectual property (IP) 17.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law The term “intellectual property” in its broad sense has not always existed in the Netherlands.2 Under that term was mainly understood “copyright”, while patent law, trademark law, trade name right, plant breeders’ right and design and model were regarded as “industrial property rights”. Since its foundation in 1967, the World Organization for Intellectual Property (WIPO) introduced the term “intellectual property” as a broad definition that includes these rights.3 “Intellectual property” is a term that covers more than just patents. IP refers to creations of the mind: inventions; literary and artistic works; and symbols, names and images used in commerce. IP is divided into two categories:

1. Tax advisor, PwC Amsterdam (EU Direct Tax Group). The text reflects the views of the author. Where original Dutch language texts have been quoted, the author has provided an informal translation into English. 2. The Kingdom of the Netherlands consists of the Netherlands, Aruba, the BES Islands (Bonaire, St. Eustatius and Saba), Curaçao and St. Maarten. The BES Islands have (as of 10 October 2010) the status of a special Dutch municipality while Curaçao, St. Maarten and Aruba have a partially separate status. As all parts of the Kingdom have their own taxation jurisdiction, Dutch tax law is not applicable in the other parts of the Kingdom. Tax treaties concluded by the Netherlands do not automatically apply to Aruba, Curaçao and St. Maarten. The BES Islands may, depending on the outcome of the treaty negotiations between the Netherlands and a (new) treaty partner, also be covered by that treaty. 3. C. Gielen et al., Kort Begrip Van Het Intellectuele Eigendomsrecht p. 1 (A.C.M. Alkema et al. eds., Wolters Kluwer 2017).

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(1) Industrial property, which includes next to patents, trademarks, industrial designs and geographical indication. (2) Copyright, which includes literary works (such as novels, poems and plays), films, music, artistic works (e.g. drawings, paintings, photographs and sculptures) and architectural design. Copyrights include those of performing artists in their performances, producers of programmes in their recordings, and broadcasters in their radio and television programmes. IP rights are like any other property right that allow creators or owners to benefit from their own work or investment in a creation. These rights are outlined in article 27 of the Universal Declaration of Human Rights, which outlines the right to benefit from the protection of moral and material interests resulting from authorship of scientific, literary or artistic productions.4 The importance of IP was first recognized in the Paris Convention for the Protection of Industrial Property (1883) and the Berne Convention for the Protection of Literary and Artistic Works (1886). For the purpose of this chapter, the important categories of IP rights used in the Netherlands (also in connection with the Dutch IP regime) will be discussed in more detail, namely patents, plant breeders’ right, copyrights, trademarks and design or model.

17.1.1.1. Patents In 600 BC, patents were granted for culinary dishes – which must have been delicious dishes – in the Greek colony of Sybaris, in the south of Italy. An organized grant procedure did not take place until 1474. At that time, the city of Venice had a decree that promised a 10-year privilege to “all inventors of new arts and machines”.5 From 1589 onwards, “patents for inventions” were being granted and recorded in the deed books of the States General of the United Provinces of the Netherlands. Patents for trademarks and manufacturers’ trademarks

4. Available at www.rvo.nl (last accessed 7 Oct. 2017); see also wipo.int (last accessed 7 Oct. 2017). 5. Gielen et al., supra n. 3, at p. 15. See also www.rvo.nl, id.

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also existed, such as the right to sell brooches on a green piece of paper with the image of an angel.6 The word “patent” originates from the Latin patere, which means “to lay open” (i.e. to make available for public inspection).7 The term “patent” (octrooi), which originally denoted a royal decree, means “open for public reading” or “granting exclusive rights to a person”. In modern usage, the term “patent” usually refers to the right granted to anyone who has invented a new, useful and non-obvious process or product. It is a legal instrument that grants an exclusive right to an invention which allows you to forbid someone else from using the invention for commercial purposes for a limited period of time within a specific jurisdiction.8 Patent protection in the Netherlands is regulated by law in the Patent Act 1995 and the Implementation Decree 1995 (Implementation Decree), which came into force on 1 April 1995. Until that time, the Patent Act 1910 was in force. Various international treaties9 regulate aspects within the patent system and these treaties have determined a significant part of the content of the current Patent Act 1995. Patent protection means an invention cannot be commercially made, used, distributed or sold without the patent owner’s consent. In order to be eligible for a patent in the Netherlands, a technical invention – a product or operating procedure in any technological field – should comply with three material conditions:10 (i) The invention is new11 Novelty: The product or process may not have been made public anywhere in the world before the date of submitting the patent application, not even through the activities of the inventor himself (e.g. by means of a company brochure or a presentation at a trade fair). 6. See www.rvo.nl. 7. B. Sas et al., Intellectual Property and Assessing its financial Value (Elsevier 2014). 8. See also OECD Transfer Pricing Guidelines, sec. 6.19. 9. Paris Convention (implemented in the Patent Act 1995), WIPO Treaty, Strasbourg Treaty (implemented in the Patent Act 1995), Strasbourg Agreement, Community Patent Convention (has not yet entered into force), Cooperation Treaty (PCT), European Patent Convention (EPC), London Agreement re. EPC (Translations Protocol) (implemented in the Patent Act 1995), Agreement on Trade-Related Aspects of International Property Rights (TRIPS), Directive for biotechnological inventions (implemented in the Patent Act 1995), Regulation relating to the granting of supplementary protection certificates (SPCs), Treaty of Budapest, Enforcement guideline. 10. NL: Rijksoctrooiwet 1995 (Patent Act 1995), art. 1(2). 11. Gielen et al., supra n. 3, at pp. 23 and 30-34.

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(ii) It involves an inventive step Inventive step: The invention may not be obvious to a professional. (iii) It is susceptible of industrial application Industrial application: The invention should relate to a technically demonstrable functioning product or production process. An invention shall be considered susceptible of industrial application if the subject of that invention can be made or used in any field of industry, including agriculture.12 Patents are only granted for inventions of a technical nature. Technology is therefore an essential feature of patent law. Each patent is valid in one or more countries and for a limited period of time (i.e. 20 years). After a patent has expired, the technique is available for use by everyone. The following are explicitly not regarded as “inventions”:13 (a) discoveries, as well as scientific theories and mathematical methods; (b) aesthetic creations; (c) schemes, rules and methods for performing mental acts, playing games or doing business, as well as computer programs; and (d) presentations of information. In order to be entitled to the patent, an application should be filed and a patent should be granted. The Netherlands Patent Office (Octrooicentrum Nederland), a department of the Netherlands Enterprise Agency, is the patent agency for the Dutch territory and has been charged with implementing the Patent Acts and other duties imposed under or by virtue of the law or binding international obligations.14 Since 1912, it has been granting Dutch patents in accordance with the terms and conditions formulated within the Patent Acts.15 In addition, the European Patent Office, a body of the European Patent Organisation, which is an intergovernmental organization that was set up in 1977, offers inventors a uniform application procedure on the basis of the European Patent Convention (EPC).

12. 13. 14. 15.

Art. 7(1) Patent Act 1995. See also Gielen et al., id., at p. 25. Art. 2(2) Patent Act 1995. Art. 15 Patent Act 1995. A patent can also be filed in English.

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17.1.1.2. Plant breeders’ right In the Netherlands, the Seeds and Planting Materials Act 2005 governs the approval of varieties of plants, the marketing of propagating material and the granting of plant breeders’ rights. Plant breeders’ rights may be applied for in the case of cultivation material and varieties of plants. A “variety” is a group of plants within a single botanical taxon of the lowest known rank, which group can be: – defined on the basis of the expression of the characteristics resulting from a certain genotype or a combination of genotypes; – distinguished from all other plant groups on the basis of the expression of at least one of the said characteristics; and – considered as a unit with regard to its suitability for being propagated unchanged.16 According to the Seeds and Planting Materials Act 2005, a plant breeder’s right can be obtained for varieties of all plants belonging to the plant kingdom in so far as the varieties concerned are:17 (i) New: A variety is deemed to be new if, 1 year prior to the date (outside the Netherlands: 4 years/6 years in the case of trees or vines) of submission of the application for a breeder’s right, no propagating material or harvested material of the variety has been sold or otherwise provided to others for purposes of exploitation of the variety. (ii) Distinguishable: A variety is deemed to be distinct if it is clearly distinguishable from any other variety whose existence is a matter of common knowledge at the time of the submission of the application. A variety is in any case considered to be a matter of common knowledge if an application for the granting of a breeder’s right has been submitted (in any country) and provided that the application leads to the granting of a breeder’s right. (iii) Uniform: A variety is considered uniform if, disregarding the variation that may be expected from the particular features of its propagation, it is sufficiently uniform as regards its significant characteristics.18

16. NL: Zaaizaad- en plantgoedwet 2005 (Seeds and Planting Materials Act 2005), sec. 1(c). 17. Sec. 49(1) Seeds and Planting Materials Act 2005. 18. Sec. 49(5), referring to sec. 35(3), Seeds and Planting Materials Act 2005.

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(iv) Stable: A variety is considered stable if its significant characteristics remain unchanged after repeated propagation or, in the case of a particular cycle of propagation, at the end of each cycle.19 The duration of the breeder’s right is 25 years.20

17.1.1.3. Copyright Copyright is the exclusive right of the maker of a literary, scientific or artistic work or his successors in title to make the work public and to reproduce it, subject to the limitations laid down by law.21 Communicating a work to the public is as such one of the exclusive rights of the maker. Another exclusive right of the maker is the right to reproduce the work. This means that nobody else is allowed to print, copy or download the work without permission of the copyright owner. Based on article 10 of the Copyright Act 1912, examples of protected works that are regarded as literary, scientific or artistic work are books, musical works, plays, films, paintings, photos and computer programs.22 The economic rights relating to copyright are of limited duration. The main rule is that copyright expires after 70 years, counting from the first of January of the year following the year of the maker’s death.23

19. Sec. 49(6), referring to sec. 35(4), Seeds and Planting Materials Act 2005. 20. Sec. 72 Seeds and Planting Materials Act 2005. 21. NL: Auteurswet 1912 (Copyright Act 1912) (amended 2015), art. 1. 22. For the purposes of this Act, literary, scientific or artistic works are: (1) books, brochures, newspapers, periodicals and all other writings; (2) dramatic and dramaticomusical works; (3) recitations; (4) choreographic works and entertainments in dumb show; (5) musical works, with or without words; (6) drawings, paintings, works of architecture and sculpture, lithographs, engravings and other graphic works; (7) geographical maps; (8) plans, sketches and three-dimensional works relating to architecture, geography, topo­ graphy or other sciences; (9) photographic works; (10) film works; (11) works of applied art and industrial designs and models; (12) computer programs and preparatory materials; and generally any creation in the literary, scientific or artistic domain, regardless of the manner or form in which it has been expressed. 23. Art. 37(1) Copyright Act 1912 (amended 2015). See also arts. 38-42 Copyright Act 1912 (amended 2015).

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17.1.1.4. Trademarks “Trade mark rights are, it should be noted, an essential element in the system of undistorted competition which the Treaty seeks to establish and maintain.”24 Trademark protection ensures that the owners of marks have the exclusive right to use them to identify goods or services, or to authorize others to use them in return for payment. Currently, trademark rights in the Netherlands are regulated by the Benelux Convention on Intellectual Property (Trademarks and Designs) of 25 February 2005 (Benelux Convention). Trademarks are identification tools. They give products an identification by way of a word or an image, a sound or a smell. In literature, identification and communication are regarded as the main functions of trademarks.25 Signs capable of constituting Benelux trademarks are names, designs, stamps, seals, letters, figures, shapes of products or packaging and all other signs able to be represented graphically and used to distinguish the goods or services of a company.26 In order for a trademark to be protected in the Netherlands it has to be registered at the Benelux Trademark Office. The registration is valid for a period of 10 years – with effect from the date of filing – after which the registration can be renewed.27

17.1.1.5. Design or model A definition of the term “design” in the Netherlands is provided by the Benelux Convention. Based on article 3.1 of the Benelux Convention, the appearance of a product or a part of a product shall be regarded as a design and is only protected in so far as the design is novel and has an individual character:

24. DE: ECJ, 17 Oct. 1990, Case C-10/89, Hag II, ECLI:EU:C:1990:359. 25. Gielen et al., supra n. 3, at p. 243. 26. Benelux Convention on Intellectual Property (Trademarks and Designs) (25 Feb. 2005) [Benelux Convention], art. 2.1. 27. Art. 2.9 Benelux Convention.

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(i) Novel: A design is regarded as novel if, on the filing or priority date, no identical design has been disclosed to the public. Designs are regarded as being identical if their characteristics differ only in terms of insignificant details.28 (ii) Individual character: A design is regarded as having an individual character if the overall impression which the design produces on the informed user differs from the design that has been disclosed to the public prior to the filing. In order to evaluate individual character, the creator’s degree of freedom in preparing the design shall be taken into account.29 In order to assess novelty and individual character, a design is deemed to have been disclosed to the public if it has been published (i.e. after registration or otherwise) or exhibited, used in trade or made public in any other way. The appearance of a product is imparted, in particular, through the characteristics of the lines, contours, colours, shape, texture or materials of the product itself or of its ornamentation. Within the meaning of the Benelux Convention, a product means any industrial or craft article including, inter alia, parts designed to be assembled into a complex product, packaging, presentation, graphic symbol or typographic character. Computer programs are not regarded as a product.

17.1.2. Distinction under private law between alienation of IP and granting the right to use IP IP rights in the Netherlands are considered as “property” (goederen), pursuant to article 3:1 of the Dutch Civil Code (Burgerlijk Wetboek) (DCC), which provides: “‘Property’ (or ‘assets’) comprises of all things and all other property rights.” More specifically, the form an IP right takes following from the definition of “property” is that of a “property right”. Article 3:6 of the DCC provides for a definition of “property right”: “Property rights are those which, either separately or together with another right, are transferable, or rights which are intended to procure a material benefit to their holder, or rights which have been acquired in exchange for actual or expected material benefit.” 28. 29.

Art. 3.3(1) Benelux Convention. Art. 3.3(2) Benelux Convention.

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Pursuant to the general rules of the Dutch property law embodied in article 3:84 of the DCC, the transfer of an IP requires (i) delivery (levering) by a person (i.e. legal owner of the IP) who has (ii) the right to dispose the asset (beschikkingsbevoegd) pursuant to (iii) a valid title (i.e. sale). Based on article 3:83 of the DCC, ownership rights are transferrable unless their nature or the law opposes to this. The transfer of an IP should be distinguished from the contractual law permission to grant the right to use an IP (i.e. the granting of a licence). When granting a licence, the holder of the IP (licensor) concludes, under certain conditions, an agreement based on which the licensor has the obligation to assign – in whole or in part – the IP rights. One of the main conditions under which a licence is granted is the payment of a fee – royalty – and a description of the rights in respect of the IP the licensee receives. For licence agreements – other than exclusive licences – there are no form requirements and such licences can also be granted implicitly.30 A copyright is the exclusive right of the maker. As mentioned above, the transfer of the copyright (goederenrechtelijke overdracht) should be distinguished from the contractual law permission the copyright holder can grant to a third party to perform exclusive activities. From a legal perspective, there are significant differences between transfer of the legal ownership of an IP and assignment of an IP by way of granting a licence. The transfer of an IP provides the person to whom the IP is transferred an own and independent right to exploitation. The original copyright holder in principle cannot “terminate” this right. In the case of a licence, on the other hand, where the rights of a licensee are not exclusive, the agreement can be terminated. Where the legal owner of the IP has an absolute right to maintain the IP independently of third parties, the licensee is dependent on the licensor, who remains the owner of the IP rights. Licence agreements generally contain provisions that stipulate the rights and obligations of the licensee (and the licensor). The differences mentioned are relative to the fact that they all can be almost offset by making agreements on the basis of the transfer of the right or in connection with the licensing. A legal owner of the IP is able to transfer his rights to a third person, while a licensee is not always able to do so (article 3:83 of the DCC, the nature of the licence can be countered). Moreover, transfer under the licence agreement is often excluded. These differences are relative in such a way that they can be 30. Gielen et al., supra n. 3, at p. 497. See also NL: Gerechtshof (Hof) (Court of Appeal of Amsterdam), 17 Feb. 1994, AMI 1995, 14.

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neutralized by making agreements in the context of transfer of the right or in the context of licensing.31 A plant breeder’s right and an entitlement to the granting of a breeder’s right, both as regards the entire right or a part of it, can be assignable or otherwise transferable. The explanatory memorandum mentions, for example, the transfer of the plant variety right, only as far as propagating material of the breed is concerned, while the remaining parts remain with the holder of the plant breeder’s right.32 The transfer required to assign a plant breeder’s right or the right arising from an application for the granting of a breeder’s right should be effectuated by means of a deed. If any proviso regarding the assignment is made, this should be specified in said deed. The transfer shall not take effect in respect of third parties until the deed has been registered in the Register of Varieties (Nederlands rassenregister).33 The holder of a patent has an exclusive right (article 3:6 of the DCC) and may enforce his patent towards any party who performs any of the following acts without being entitled to do so: (a) to make, use, put on the market or resell, hire out or deliver the patented product, or otherwise deal in it in or for his business, or to offer, import or stock it for any of those purposes, and (b) to use the patented process in or for his business or to use, put on the market, or resell, hire out or deliver the product obtained directly as a result of the use of the patented process, or otherwise deal in it in or for his business, or to offer, import or stock it for any of those purposes.34 The patent and the right to obtain a patent shall be assignable or otherwise transferable in full or joint ownership.35 The transfer required for the assignment of the patent or the rights arising from a patent application should be effected by means of a deed containing a declaration by the patent holder that he assigns the patent or the rights arising from the patent application to the assignee and a declaration by the assignee that he accepts the assignment. According to Dutch case law, this requirement is only met if the deed contains an explicit declaration of the transferor and the acquirer.36 If any reservation relating to the assignment is made, this should be specified in the deed. The

31. Gielen et al., id., at p. 498. 32. Kamerstukken II 2003/04, 29 650, no. 3, p. 63 (parliamentary documents, Dutch Lower House). 33. Art. 65 Seeds and Planting Materials Act 2005, referring to art. 3:95 DCC. 34. Art. 70, referring to art. 53 Patent Act 1995. 35. Art. 64 Patent Act 1995. 36. NL: Court of Overijssel, 31 Mar. 2015, IER 2015/32. NL: Court of The Hague, 10 Mar. 1993, BIE 1995, 294 (Halbertsma/De Groot). See also Gielen et al., supra n. 3, at p. 106.

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assignment shall only take effect towards third parties after an entry has been made concerning the deed in the patent register.37 Without prejudice to the right of priority provided for by the Paris Convention or the right of priority resulting from the Agreement on TradeRelated Aspects of Intellectual Property Rights, the exclusive right in a trademark shall be acquired by registration of the trademark through filing in Benelux territory (Benelux filing) or resulting from registration with the International Bureau (international filing).38

17.2. Taxation of income from IP under the domestic law 17.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP Dutch tax law does not contain a statutory definition of the term “royalties”. In its tax treaties – although the definition of royalties is not always the same – the Netherlands usually follows the definition of the OECD Model and Memorandum on Dutch Tax Treaty Policy 2011 (Notitie Algemeen Nederlands Verdragsbeleid) (Dutch Tax Treaty Policy), in which the term “royalties” is defined as: Payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.

A royalty will often include a periodic payment, the amount of which depends on the extent of use. However, this periodic character is not essential; a single payment – provided that it is for the use of the IP and not for its acquisition – is also considered a royalty.39 The Netherlands has concluded tax treaties with a large number of countries in order to avoid the double taxation of income. If the Netherlands has not concluded a tax treaty with a certain country, double taxation relief may nevertheless be available based on the unilateral Decree for the Avoidance 37. Art. 65 Patent Act 1995. 38. Art. 2.2 Benelux Convention. 39. C. van Raad et al., Cursus Belastingrecht – Internationaal Belastingrecht p. 355 (Wolters Kluwer 2017).

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of Double Taxation (Besluit voorkoming dubbele belasting 2001, Decree 2001). Article 5(c) of Decree 2001 also provides for a definition of the term “royalties”. This is in principle in line with the above-described definition of the OECD Model and the Dutch Tax Treaty Policy. However, under article 5(c) (4˚), an additional provision with respect to technical services provided in certain developing countries is included.40 In certain countries the fees for technical services are considered a royalty payment. In situations where technical services are provided in a developing country – and there is no tax treaty on avoidance of double taxation between the Netherlands and that particular developing country – the Netherlands considers the fees for technical services as a royalty payment (and grants a credit for the withholding taxes paid). Tax treaties that were concluded by the Netherlands before 1987 are largely based on the OECD Model. As from 1987, the Netherlands’ own model convention (Nederlands Standaardverdrag, NSV) was published, which is largely in line with the OECD Model.41 The Netherlands uses the OECD Model as a guideline in negotiations on the conclusion of bilateral tax treaties. When applying the tax treaties that are based on the OECD Model, the OECD Model Commentary is considered to be a valuable tool to determine the object and purpose of the treaty. The significance of the OECD Model is recognized in the Netherlands. However, as also previously discussed, IP is also defined in Dutch civil law, which is in line with international and EU law. Dutch tax law does not provide for a definition of the specific categories of IP. When it comes to application of the innovation box, one may fall back on the definition of the qualifying IP under the Dutch civil law and the definitions provided and agreed under the tax treaties concluded by the Netherlands. The OECD Model is considered to be the joint opinion of the parties if the contracting parties are OECD member countries. Royalties received in the Netherlands are generally treated as ordinary business income that are currently taxed at the statutory tax rate of 25% (or 20% for profits up to EUR 200,000), unless the royalty income qualifies for the innovation box (see section 17.2.2.). The Netherlands does not (yet) levy a 40. Developing countries within the meaning of the OECD’s Development Assistance Committee (DAC) List of Official Development Assistance (ODA) Recipients. 41. E. Jansen & E. van Kasteren, Hybrid Financial Instruments, 10 Derivs. & Fin. Instrums. 5, sec. 8 (2008), Journals IBFD.

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withholding tax on royalty payments.42 The Dutch policy of no withholding taxes for intra-group royalties is in line with EU policy. As the Netherlands does not levy a withholding tax on royalties, the definition of the Interest and Royalty Directive (I&R Directive)43 was not implemented into Dutch law. In light of the above, it should be mentioned that on 10 October 2017, the new Dutch coalition published an agreement (Coalition agreement) in which they announced plans for several tax measures. One of the measures proposed is to introduce a new withholding tax on outgoing royalty payments in specific cases of abuse. Among others, this may be the case if interest or royalty payments are made to certain low-tax jurisdictions.

17.2.2. Qualification of income deriving from IP and applicable tax regimes Under the Corporate Income Tax Act 1969 (CITA), the Netherlands levies a corporate income tax from the following resident entities: public companies (NV) and private companies (BV), cooperatives, associations and foundations, as well as the so-called “open limited partnerships” (i.e. the limited partners can dispose of their share without the permission of all other limited and general partners).44 The Netherlands applies the incorporation theory in company law. Entities governed by Dutch company law are therefore considered resident entities, regardless of their place of management or registration.45 Netherlands-resident entities are subject to taxation on their worldwide income. Non-resident entities are only subject to Dutch corporate income tax in case they derive certain types of Dutch-sourced income (e.g. via a permanent establishment (PE)).46

42. P.T.F. Schrievers & J. Voge, The Netherlands Has Not Turned a Blind Eye towards the International Debate Regarding Tax Planning, 54 Eur. Taxn. 5, sec. 1. (2014), Journals IBFD. 43. Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. 44. Wet op de vennootschapsbelasting 1969 (Corporate Income Tax Act 1969, CITA) art.2 (1). 45. P. Vlas, Rechtspersonen p. 22 (Maklu Uitgevers NV 2009). 46. A. Beek-Van Doremaele & N. Smetsers, Netherlands, in Tax incentives on Research & Development (R&D), sec. 1.2. (IFA Cahiers vol. 100A, 2015), Online Books IBFD.

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Corporate income tax is levied at the following rates (2017): 20% (EUR 0 to 200,000) and 25% (EUR 200,000 and more). Provided that certain requirements are met, corporate tax payers may elect a special optional effective tax rate of 7% (as of 1 January 2018) – instead of the top rate of 25% – for income attributable to qualifying intangible assets: the innovation box. In 2007, the original version of the current Dutch innovation box – which was then called “patent box” – was introduced. The objective of the patent box was to promote innovation and high-quality employment and to foster the innovative power of the Dutch economy.47 This patent box originally had a rather restrictive scope limited only to income from intangible assets that were protected by registered patents and only four times the development cost of the intangible asset could be regarded as profit that was eligible to benefit from the patent box. The patent box rules resulted in an effective corporate income tax rate on qualifying income of 10%. Due to the relative ineffectiveness of the patent box, in 2007, the government widened the scope of the patent box per 1 January 2008. As of 2008, the patent box was also applicable to non-patented intangible assets resulting from R&D activities for which an R&D certificate was received. However, for the latter, a cap of EUR 400,000 applied.48 R&D activities for which an R&D certificate is received involve technical innovation in processes, products and software, which do not necessarily lead to a patent application, but where the research or development activity is new to the taxpayer applying for the approval. Once approval is obtained, there is a wage tax credit available for R&D personnel on the Dutch payroll working on the project. This R&D incentive for R&D salary expenses has been available in the Netherlands since 1994 (WBSO). In 2010, significant changes came into effect. The effective tax rate was reduced from 10% to 5% and the name was changed to “innovation box”, as the scope had expanded to encompass more IP-related income than merely income from patented intangible assets. As of 2010, non-patented intangible assets for which an R&D certificate is received can also benefit from the regime under equal terms as patented IP, without a limit to the absolute amount of intangible asset income. Moreover, certain changes and 47. Kamerstukken II 2005/06, 30572, no. 3, p. 10; Kamerstukken II 2005/06, 30572, no. 8, pp. 25-26. 48. Letter of the State Secretary of Finance, 5 Nov. 2009, AFP/2009/0699 U, Kamerstukken II 2009/10, 32 128, no. 16, p. 11.

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improvements were introduced in 2011 and 2012 that effectively entailed less restrictions. As per 1 January 2017, the Dutch innovation box regime has been amended in light of the initiatives of the OECD in the field of base erosion and profit shifting (BEPS).49 Following the Netherlands’ commitment to the OECD’s BEPS Project (and particularly Action 5 on harmful tax practices), the Netherlands implemented as per 1 January 2017 the so-called “nexus approach”. The revised Dutch innovation box regime is included in articles 12b-12bg of the CITA. A transitional regime has been introduced in article 34 of the CITA on the basis of which existing arrangements will continue to apply to qualifying assets for a maximum period of 5 years, provided that the assets already existed and qualified on 30 June 2016. In such case, the old and the new regime will co-exist. Following the 2018 Dutch Tax Package, the effective tax rate of the Dutch innovation box has been increased from 5% to 7% as per 1 January 2018. Article 12b of the CITA provides: Qualifying benefits arising from a qualifying intangible asset generated by the taxpayer itself, shall, if he so chooses in his tax return, for that year, be taxed on 5/H. H stands for the percentage of the highest rate specified in article 22 CITA, applicable in the year in which the benefit was received. The first sentence shall only apply if the balance of benefits is positive.

The net income from qualifying intangible assets is taxed at the reduced rate of 7% rate. However, the way this has been incorporated in the Dutch tax law is not by creating a separate income box with a separate tax rate. Instead, the legislator has chosen to only include 7/H of the net income from a qualifying intangible asset to be taxable at the regular statutory tax rate (20% for taxable profits up to EUR 200,000 and 25% for profits in excess of EUR 200,000). In the fraction, H stands for the highest corporate tax rate in the Netherlands, currently being 25%. Consequently, 7/25 of the net income from a qualifying intangible asset is included in the taxable base. This portion is being taxed at the regular statutory tax rate, resulting in an effective tax rate of 7%. In order to be able to gain entry into the innovation box, a number of requirements should be met: (i) intangible asset (owned by the taxpayer); 49.

The revised innovation box regime is included in arts. 2b-12bg of the CITA.

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(ii) self-developed (development by the taxpayer); and (iii) R&D asset and/or patent.

17.2.2.1. Intangible asset As the first requirement in order to apply for the innovation box, the taxpayer should own an intangible asset. The rules on the innovation box, which are contained in the CITA, do not include a definition of what constitutes an intangible asset, nor does the parliamentary history. In the parliamentary history, it is only mentioned that an intangible asset must have the character of a business asset.50 The Decree on innovation box of the State Secretary of Finance of 1 September 201451 (Innovation Box Decree), which refers to literature from business economics and civil law, provides that there are certain common elements which are characteristic to an intangible asset, such as (i) separability, (ii) identifiability, (iii) transferability and (iv) repeatability.52 Ultimately, the relevant facts and circumstances are decisive. The Innovation Box Decree only provides that the innovation box is not applicable to income attributable to other types of intangible assets, such as trademarks, know-how and logos.53 Book 2 of the DCC, which contains provisions on, inter alia, annual accounting and annual report, distinguishes fixed and current assets depending on whether they are intended to be used sustainably in the performance of the operations of the legal person.54 Intangible assets are regarded as fixed assets. Sustainability is obviously an essential feature of intangible assets.55 Article 2:365 of the DCC distinguishes the following categories of intangible assets (author’s translation, emphasis added): (a) costs connected with the incorporation (formation of the legal person) and the issuance of shares; (b) costs of R&D; (c) costs of acquisition in respect of concessions, governmental permits (licences) and IP rights; (d) costs of goodwill acquired from a third party; and 50. 51. 52. 53. 54. 55.

Kamerstukken II 2006/2007, 30 572, no. 24, p. 2. Decree of the State Secretary of Finance, 1 Sept. 2014, No. BLKB2014/1054M. The decree is a not binding poly rule. Decree of the State Secretary of Finance, supra n. 51, at para. 4.1. Art. 2:364 DCC. M.L.B. van der Lande, Innovatiebox en RDA p. 17 (Wolters Kluwer 2012).

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(e) advanced payments on intangible fixed assets. According to the Dutch Guidelines for the Annual Report (Guidelines AR), the assets on the balance sheet are divided into fixed and current assets. Intangible assets are included in the fixed assets. In that sense, the Guidelines AR are in line with the DCC provisions. However, the Guidelines AR – RJ 210.104 – provide some further clarification and define an intangible asset as: “An intangible fixed asset is an identifiable non-monetary asset without physical form used for production, delivery of goods or services, for thirdparty rental or for administrative purposes.”56 The Guidelines AR – RJ 210.201 – require to only include an intangible asset in the balance sheet if: (a) it is likely that in the future economic benefits associated with the assets will flow to the company; and (b) the asset has a cost price that can be reliably measured. In summary, the Guidelines AR set three cumulative requirements:57 (i) The identifiability (i.e. the independence) of the asset: An asset is identifiable if it can exist independently of the business. An intangible asset is regarded independent if the legal person is able to rent, sell, exchange or distribute the specific economic benefits of the asset, apart from the future economic benefits associated with other assets.58 (ii) The likelihood of future benefits: The RJ require that it is likely that the company will generate future benefits from the asset. Examples are the sales proceeds of goods, savings, licence fees, rental income or other benefits which are the result of the use of the asset. With respect to a self-developed intangible asset, it is more difficult to assess whether this condition is met. In this regard, a distinction is made between the research phase and the development phase. During the research phase, the activities performed aim at obtaining new scientific or technical knowledge and insights.59 The development phase focuses on the application of the results of research into a plan or design for new or substantially improved products, processes, systems or services.60

56. Guidelines AR, RJ 2009, Hoofdstuk (Chap.) 940, p. 1235. 57. S. Böhmer et al., EY Handboek Jaarrekening 2016 (Wolters Kluwer 2016); see also Van der Lande, supra n. 55, at pp. 17-19. 58. Guidelines AR, RJ 210.109-111. 59. Guidelines AR, RJ 210.223. 60. Guidelines AR, RJ 210.224.

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(iii) The determinability of the cost price: The cost of internally generated intangible assets can usually be determined based on internal cost records relating to personnel costs, licensing costs, development costs of software, etc. In addition to the DCC and the Guidelines AR, the International Financial Reporting Standards (IFRS) also provide for a definition of the term “intangible assets”. International Accounting Standard (IAS) 38 sets out the criteria for recognizing and measuring intangible assets and requires disclosures about them. The definition of an intangible asset provided by the IFRS is: “An intangible asset is an identifiable non-monetary asset without physical substance.” Based on this definition of the term “intangible asset”, the following characteristics are of importance: – the intangible asset must be identifiable; – the intangible asset must be non-monetary; and – the intangible asset must not have a physical shape. Such an intangible asset is identifiable when it is separable or when it arises from contractual or other legal rights. Separable intangible assets can be sold, transferred, licensed, etc. Intangible assets are non-physical assets which can be categorized by the kind of activity that led to their creation.

17.2.2.2. Self-developed Most European countries allow acquired intangible assets to benefit from their IP regimes.61 However, in order to be eligible for the benefits of the innovation box in the Netherlands, the intangible asset needs to be either self-developed or developed for the risk and account of the taxpayer. The term intangible asset includes self-developed intangible assets within the meaning of IAS 38 in the taxpayer’s commercial accounts.62 Profits resulting from contract research may also be eligible for the innovation box if the research has been carried out by an unrelated party (third party) and for the risk and account of the taxpayer.63 The innovation box can only be applied if the taxpayer has obtained an R&D certificate 61. L.K. Evers, Intellectual Property (IP) Box Regimes (Tax Planning, Effective Tax Burdens and Tax Policy Options), PhD Thesis, Mannheim University (2014), p. 58. 62. Kamerstukken II 2005/06, 30572, no. 8, p. 95. 63. Id., at p. 96.

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(S&O-verklaring) within the meaning of the Act on Reduction of Wage Tax and National Insurance Contributions 1995 (Wet vermindering afdracht loonbelasting en premie voor de volksverzekeringen 1995, WVA) in respect of the research. In case of contract research, this results in a problem because the intangible assets are not solely developed by employees of the taxpayer, but also by employees of the third party (the research institute). In such a case, the profits can nevertheless be eligible for the innovation box if the employees of the taxpayer have developed the intangible asset for at least 50%. This is not a quantitative but rather a qualitative test.64 The Innovation Box Decree65 provides that if 50% or more of the R&D activities are outsourced, these activities can be considered self-developed in the meaning of the innovation box, provided the R&D activities for which an R&D certificate is obtained involves coordination of the R&D activities (i.e. employees who conduct research themselves and supervise or lead such R&D activities). In line with EU law, it is not required that the (contracted) R&D activities take place in the Netherlands.66 Under the innovation box, it is also possible to outsource part of the R&D activities to unrelated parties and can be carried out anywhere in the world. The activities, however, should be performed for the risk and account of the taxpayer, e.g. based on a service contract.67 In respect of outsourcing, the so-called “nexus approach” allows all outsourcing fees paid to an unrelated service provider to be included in the qualifying expenses, while all outsourcing fees paid to related service providers are excluded.68 This restriction, however, does not apply to fees paid related to service providers with a Dutch fiscal unity. Under the Dutch fiscal unity regime (article 15 of the CITA), in short, a Netherlands-resident parent company and its Netherlands-resident subsidiaries (if the parent owns at least 95% of the shares) may, under certain conditions, file a tax return as one entity. Within a fiscal unity, it is possible to offset profits of one company against losses of another company. Furthermore, intercompany transactions are eliminated. The fiscal unity regime is available for companies having their place of effective

64. Kamerstukken II 2009/10, 32128 no. 16, p. 12; Kamerstukken II 2009/10, 32128 no. 52, p. 7. 65. Decree of the State Secretary of Finance, supra n. 51, at para. 4.2.2. 66. Beek-Van Doremaele & Smetsers, supra n. 46, at sec. 1.5.5. 67. Id., at p. 495. See also Kamerstukken II 2005/06, 30572, no. 8, p. 96. 68. Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5 – Final Report, OECD/G20 Base Erosion and Profit Shifting Project, paras. 39-41 and 49-51 (OECD 2015).

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management in the Netherlands, both for Dutch and treaty purposes. A cross-border fiscal unity is not possible. In principle, the innovation box does not apply to acquired intangible assets. During the parliamentary discussion on the innovation box, it was noticed that – depending on the facts and circumstances – in certain cases, an acquired intangible asset that will be further developed by the taxpayer may become part of a new (larger) self-developed intangible asset eligible for the innovation box. In order to avoid the situation where both transferor and transferee can benefit from the innovation box, the transferee can only apply the innovation box to the proceeds of the further-developed intangible asset to the extent that the acquisition price is exceeded (threshold amount).69

17.2.2.3. R&D asset and/or patent In order to assess whether the taxpayer has a qualifying intangible asset, the Netherlands (as of 1 January 2017) makes a distinction between “small taxpayers” and taxpayers who do not qualify as small taxpayers (i.e. large taxpayer). Small taxpayers can apply for the innovation box if their income is attributable to an intangible asset that has been derived from R&D activities in respect of which the taxpayer has obtained an R&D certificate. Article 12ba(2) of the CITA provides a definition of a small taxpayer: (a) its gross revenue taken over a 5-year period from all intangible assets covered by an R&D certificate is less than EUR 37.5 million, calculated at the level of the taxpayer; and (b) the net turnover (on a global group basis if the taxpayer is part of a group) taken over a 5-year period is less than EUR 250 million.70 Large taxpayers should meet a combined entrance ticket. This requirement is in line with the OECD’s recommendation in BEPS Action 5.71 Large taxpayers are deemed to have a qualifying intangible asset only if (i) an R&D certificate has been granted for the activities that led to the development of the intangible asset and (ii):

69. 70. 71.

Beek-Van Doremaele & Smetsers, supra n. 46, at p. 490. The definition of a group will be in line with IAS. Action 5 – Final Report, supra n. 68, at p. 26, para. 37.

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Taxation of income from IP under the domestic law

– the intangible asset is covered by a patent or a plant breeder’s right that has been obtained;72 – an application for a patent or a plant breeder’s right has been filed; – it concerns software; – the intangible asset is formed by a licence to distribute medication for human or animal application; – a supplementary Protection Certificate has been issued by the Netherlands Patent Office; – a registered utility model has been granted for the purpose of the protection of the innovation; or – the intangible asset is formed by an exclusive licence obtained for the limited use of the intangible asset.73 17.2.2.3.1.  R&D certificate In order to be able to apply for the innovation box, an R&D certificate should be obtained. R&D certificates in the Netherlands are issued by the Netherlands Enterprise Agency (Rijksdienst voor Ondernemend Nederland, RVO), an agency of the Ministry of Economic Affairs.74 The RVO is a public body that operates independently from the Dutch tax authorities and is responsible for several Dutch subsidies and incentives, and encourages entrepreneurs in sustainable, agrarian, innovative and international business. The RVO assesses whether the necessary requirements have been fulfilled. Against a decision of the RVO, it is possible to lodge an appeal by submitting a notice of objection, with reasons (relevante artikelen). If the decision on the notice of objection is not in favour of the taxpayer, an appeal can be lodged with the Trade and Industry Appeals Tribunal. Article 1(p) of the WVA – based on which an R&D certificate can be applied for – and the Regulation on Delimitation of Research and Development 1997 (Afbakeningsregeling speur- en ontwikkelingswerk 1997) define the innovative activities or R&D activities for which an R&D certificate can be obtained. The R&D activities have to be systematically organized and performed in an EU Member State in one of the following areas: 72. The parliamentary history provides that foreign plant breeders’ rights which are comparable to Dutch plant breeders’ rights also qualify for the innovation box. See Kamerstukken II, 30 572, no. 9. 73. D. Oosterhoff & B. De Nies, Evaluation of the Innovation Box, 23 Intl. Transfer Pricing J. 6, sec 3.1. (2016), Journals IBFD. 74. NL: Wet vermindering afdracht loonbelasting en premie voor de volksverzekeringen 1995 (WVA) (Act on Reduction of Wage Tax and National Insurance Contributions 1995), art. 23.

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– conducting technical scientific research; – development of (parts of) physical products, processes or software; – conducting scientific technological research aimed at generating technological knowledge; – analyses of the technical feasibility of R&D; or – technological research aimed at the improvement of production processes or software used in the own business. Both self-employed individuals and taxable bodies – as listed in article 2 (1) of the CITA – who qualify as entrepreneurs can be eligible taxpayers. Selfemployed individuals are eligible to R&D input incentives (Wet bevordering Speur en ontwikkelwerk (Law Promoting Research and Development) (WBSO), while corporate tax payers are eligible to both R&D input incentives and R&D output incentives (innovation box). In both cases, the R&D has to be performed by persons who are “employees” within the meaning of article 2 of the Dutch Wage Tax Act 1964 (Wet op de loonbelasting 1964). 17.2.2.3.2.  Patents As regards patents, a patent must be granted for the intangible asset. This patent may be granted by the Netherlands Patent Office or by an international patent office. In order to access the innovation box, the expected benefits of the intangible asset must be directly attributable to patent(s).75 This criterion is aimed at preventing that relatively unimportant patents are used as a cover to bring an intangible asset under the innovation box.76 The term intangible asset includes self-developed intangible assets within the meaning of IAS 38 in the taxpayer’s commercial accounts.77 As mentioned above, for large taxpayers, possession of a patent is not sufficient for the intangible asset to enter into the innovation box. 17.2.2.3.3.  Definition of income The term “income” that qualifies for the innovation box is analogous to the term used in article 3.8 of the Dutch Personal Income Tax Act 2001 (which, through article 8 of the CITA, also applies to corporate taxpayers), which states: “[t]he profit from a business enterprise is the amount of the aggregate 75. M. Schellekens, The Netherlands as an Innovation Hub: An Appraisal of the Innovation Box Regime, 53 Eur. Taxn. 10, sec. 3.3.1.1. (2013), Journals IBFD. 76. Kamerstukken II 2005/06, 30572, no. 8, p. 96. 77. Id., at p. 95.

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Taxation of income from IP under the domestic law

benefits that, under whatever name and in whichever form, are derived form a business enterprise”. Income encompasses both positive and negative income derived from the qualifying intangible asset. In order for an income to be included in the profit, there should be a business connection. The business connection can be determined in different ways: – based on a causal link between an activity and the profit; – based on the purpose or motive of a particular activity; or – based on the environment in which the activity takes place.78 If there is no business connection, the income is not attributable to the company. In order to determine the income from an intangible asset, there should be a causal link.79 With respect to income eligible for the innovation box, two possible interpretations of income can be distinguished: a broad and a restrictive interpretation.80 Broad interpretation includes all income – meaning gross margin – derived from a qualifying intangible asset. The restrictive approach, however, limits the income to compensation for the purely intellectual factor. In this approach, the gross margin should be divided between the other production factors, such as marketing, strong market position, competent personnel, etc. In practice, the Dutch tax authorities apply the restrictive interpretation. This means that the benefits of an intangible asset will be less than, for example, the royalty income from that same intangible asset, as it is also attributable to other factors of the production (i.e. effective marketing through which the royalty agreement has been concluded).81 Income eligible for innovation box purposes includes royalty income, capital gains and sales income from the resulting product. The attribution of proceeds and expenses to intangible assets to a large extent depends of the facts and circumstances of individual cases.

78. NL: Hoge Raad (HR) (Dutch Supreme Court), 1 Dec. 2006, no. 41 985, BNB 2007/81. 79. M.L.M. van Kempen et al., Cursus Belastingrecht – Vennootschapsbelasting p. 821 (Wolters Kluwer 2017). 80. M.L.B. van der Lande, De octrooibox: een inventarisatie van discussiepunten, WFR 2007/527. 81. Van Kempen et al., supra n. 79, at p. 822.

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Chapter 17 - Netherlands

It has been acknowledged by the legislature that the question of which proceeds and expenses can be attributed to intangible asset will not be easy to answer.82 The attribution of proceeds and expenses to intangible assets to a large extent depends of the facts and circumstances of individual cases; it lends itself for consultation with the Dutch tax authorities and practical agreements.83 The principles developed under the arm’s length standard and OECD transfer pricing methods should be the starting point for this attribution. Indeed, an economical approach should be leading for the attribution of expenses and proceeds to an intangible asset. This economical approach is not purely mathematical but rather qualitative.84 The general practice as applied by the Dutch tax authorities has been described in the Innovation Box Decree. The general principles of how to determine the taxable profits attributable to qualifying intangible assets are described in this decree. A few general methods are described in more detail, but it is explicitly mentioned that a fixed calculation method or percentage of profit is not used: depending on the facts and circumstances of each individual case, a customized calculation method will be applied. The most commonly applied method in practice is the residual profit split method (afpelmethode). The residual profit split method takes the earnings before interest and tax (EBIT) which relates to the R&D function as basis. This method is typically applied where R&D is a key value driver for the business and as a result of that can be deemed to contribute to a substantial part of the “residual” profit or losses of the business. This requires carrying out a functional analysis, which is to some extent similar to the functional analysis set out in the transfer pricing methods as described by the OECD guidelines.85 This functional analysis identifies the “core functions” – functions which are essential to achieve the objective of the business – of the taxpayer and then determines the value of the contribution of each core function as percentage shares. Entrepreneurship (so-called “het onder­ nemerschap” or “corporate excellence”) and R&D are considered such core functions.86 Depending on the business model, production, marketing and sales, logistics and other functions either constitute core functions or other supporting functions.87

82. 83. 84. 85. 86. 87.

Kamerstukken II 2005/06, 30572, no. 3, p. 10. Id., at no. 8, pp. 96-97. Id., at p. 96. Van der Lande, supra n. 55, at p. 74. Id., at p. 75. Id., at p. 77.

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Taxation of income from IP under the domestic law

First, the “routine functions” are remunerated via generally accepted transfer pricing methods, typically transactional net margin method (TNMM) cost-plus or TNMM return on sales, and deducted from EBIT, resulting in the “residual profit”. Subsequently, the residual profit is split over the “core functions” in proportion to their contribution. This proportional split is typically based on a functional analysis, where appropriate also taking into account cost and effort put into each key value driver. The Innovation Box Decree mentions that it is highly unlikely that in such an analysis R&D can be considered the only key value driver.88 Within the scope of the residual profit split method, the income from qualifying intangible assets for the purposes of the innovation box is calculated on the basis of certain models of the Dutch tax authorities. Two of these models that the Dutch Tax Authorities are using for the attribution of expenses and proceeds have been published in the weekly Dutch tax journal V-N 2011/9.11. This is illustrated by an example (see Table 17.1.).89

88. Decree of the State Secretary of Finance, supra n. 51. 89. Praktische toepassing innovatiebox. Modellen belastingdienst, V-N 2011/9.11 (11 Mar. 2010).

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Table 17.1.  Example Year of assessment 2014 2015 2016 2017 2018 EBIT (EUR) 30,000 20,000 28,000 30,000 36,000 EBIT is divided into “routine functions” and “core functions” Minus return to production1 (EUR) 6,000 7,000 6,000 7,000 7,500 Minus return to routine R&D 625 750 750 875 925 activities2 (EUR) 23,375 12,250 21,250 22,125 27,575 EBIT related to core functions (EUR) Entrepreneurship function3 (%) 20 20 20 20 20 Sales function4 (%) 40 40 40 40 40 R&D function5 (%) 40 40 40 40 40 Expenses With respect to expenses, an IP regime can follow either a gross or a net approach. Under the gross approach, expenses are deductible from non-IP income, which is taxed at the regular corporate income tax rate. The net approach determines that the expenses have to be allocated to IP income and are thereby deducted at the lower IP regime rate.90 In the Netherlands, R&D expenses are immediately deductible, i.e. in the year in which they are incurred. However, a recapture for future years exists. The innovation box does not apply directly to losses from the innovative activity, which means that these are deductible at the regular tax rate of 25%. However, the 7% rate will only apply to the innovative profit in later years after recovery of those losses. 1. 2. 3. 4. 5.

Cost-plus + 10. R&D not associated with qualifying intangible asset. Taxed against regular tax rate. Taxed against regular tax rate. Innovation box tax base.

17.2.2.3.4.  The nexus approach90 The nexus approach as described in BEPS Action 5 aims to develop substance criteria for preferential IP regimes. The purpose of this approach is to grant benefits only to income that arises from an intangible asset where the actual R&D activity is undertaken by the taxpayer itself: “The nexus approach is intended to ensure that, in order for a significant proportion of income from an intangible asset to qualify for benefits, a significant proportion of the actual R&D activities must have been undertaken by the qualifying taxpayer itself.”91

90. Evers, supra n. 61, at p. 68. 91. Action 5 – Final Report, supra n. 68, at para. 49.

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Taxation of income from IP under the domestic law

The nexus approach has the objective to prevent companies from benefitting from the innovation box regime without having substantial economic activity in the Netherlands. This objective is achieved by applying the so-called “nexus fraction’’ for determining the benefits from qualifying intangible assets that are eligible for the Dutch innovation box. The nexus approach works as follows. First, the nexus fraction is calculated by multiplying the “qualifying expenditure” (kwalificerende uitgaven) of a taxpayer with a factor 1.3 (30% uplift) and dividing this number by the total expenditure of the taxpayer relating to the development of a qualifying intangible asset. The qualifying benefits, in turn, are calculated by multiplying the outcome of the nexus fraction with the total benefits derived from a qualifying IP. The formula can be depicted as follows: Qualifying benefits = [ Qualifying expenditure × 1.3 ÷ Total expenditure] × Total benefits qualifying intangible assets

(Total) expenditure (denominator of nexus fraction) The Dutch innovation box only provides a beneficial regime for self-developed intangible assets (in brief: an intangible asset that is developed for the risk and account of the taxpayer). As such, only expenditure that relate to self-developed intangible assets may be taken into account when calculating the nexus fraction. The denominator of the nexus fraction consists of the total expenditure. Article 12bb(7) of the CITA defines the total expenditure as all expenditure of a taxpayer relating to R&D activities for the purpose of developing an IP. The total expenditure comprises both expenditure incurred in the current as well as previous years.92 Based on article 12bb(8) of the CITA, however, expenditure not directly related to R&D activities for the purpose of developing IP, housing expenditure and debt-related expenditure may not be taken into account. In other words, there needs to be a sufficient relation between the expenditure and the development of IP. Whether expenditure sufficiently relate to the R&D activities should be assessed on a case-bycase basis. Qualifying expenditure (numerator of nexus fraction) Based on the definition provided by article 12bb(5) of the CITA, (i) the expenditure should be incurred by the taxpayer itself and (ii) the R&D 92.

Kamerstukken II 2016-2017, 34 552, no. 3 (explanatory memorandum), p. 67.

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activities (a) should be performed by the taxpayer itself or (b) may be outsourced, provided that the R&D activities are outsourced to a third party. Expenditure relating to the outsourcing of R&D activities to a related party of the taxpayer cannot be taken into account as qualifying expenditure in the nexus fraction. However, due to the 30% uplift (i.e. the 1.3 multiplication) in the numerator of the nexus fraction, limited outsourcing to related parties is possible without the nexus calculations negatively impacting innovation box benefits. The outcome of the nexus fraction, however, cannot exceed 100% as a cap applies to the mathematical formula.93 Expenditure of a foreign PE In light of the above, the question arises whether expenditure of a foreign PE of a Dutch taxpayer may be taken into account as expenditure for the purpose of the nexus fraction. In the parliamentary proceedings, the State Secretary of Finance has explicitly confirmed that expenditure incurred by a foreign PE should be taken into account as expenditure of the Dutch taxpayer in the nexus fraction (unofficial translation):94 The qualifying expenditure consist of two categories. First of all, this concerns expenditure incurred by the taxpayer in connection with research and development carried out by the taxpayer itself in order to develop qualifying intangible assets.… This includes expenditure incurred by permanent establishments of the taxpayer.

This means that to the extent that the criteria of the innovation box are met (e.g. in so far as the expenditure relate to R&D activities for the purpose of developing IP), the expenditure of a foreign PE should be taken into account as “total expenditure” in the denominator of the nexus fraction and can be taken into account as “qualifying expenditure” in the numerator of the nexus fraction. 17.2.2.3.5. WBSO Under the WBSO, which provides for an incentive on salary costs related to R&D activities, the R&D certificate is granted to the so-called “withholder” (inhoudingsplichtige) if more than 500 hours are performed per year on R&D activities. The withholder is the (legal) person liable to withhold the 93. 94.

Based on art. 12bb(1) of the CITA and Kamerstukken II, id. Kamerstukken II, supra n. 92, at p. 69.

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Taxation of income from IP under the domestic law

Dutch wage tax, social security contributions and other such contributions. Generally, this would be the employer of the persons engaged in the actual R&D activities. An R&D certificate is only granted if the R&D activities are performed by an employer that is a resident of the Netherlands or by a non-resident employer with a PE in the Netherlands. In both cases, the R&D has to be performed by persons who are “employees” within the meaning of article 2 of the Wages Tax Act 1964 (Wet op de loonbelasting 1964). Under the WBSO, the benefit is awarded in the form of a wage tax reduction which amounts to 32% of the first EUR 350,000 of R&D costs (both salary and other costs and expenses). For start-ups, this amounts to 40%. For the excess, the reduction amounts to 16%. Taxpayers eligible for the R&D tax incentives are those who qualify as entrepreneurs. Both self-employed individuals or taxable bodies as defined in the CITA (regardless of size) can be entrepreneurs. For self-employed individuals, the WBSO allows for a deduction of EUR 12,623 (2018) from their taxable base if they spend more than 500 hours per year on R&D activities. For self-employed individuals who commenced a new business less than 5 years ago and have not yet claimed this deduction more than twice, the deduction is increased by EUR 6,315 (2018), provided the company has not been converted into a sole proprietorship or partnership.95

17.2.3. Tax treatment of income from IP derived by nonresident taxpayers The rules for non-resident taxpayers in the Netherlands are largely the same as the rules for resident taxpayers. The main difference is the scope of the tax liability: resident taxpayers are in essence subject to tax on their worldwide income, whereas non-resident taxpayers are only subject to tax for certain specific categories of income from a Dutch source. The Netherlands levies corporate income tax on entities recognized as taxpayers under the CITA (i.e. public companies and private companies, as well as open limited partnerships). As previously mentioned, the Netherlands applies the incorporation theory in company law.96 Entities that are estab95. See also www.rvo.nl (last accessed 21 Oct. 2017). 96. Vlas, supra n. 45, at p. 22.

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Chapter 17 - Netherlands

lished in the Netherlands – under Dutch company law – are deemed to be resident in the Netherlands, regardless of their place of management or registration. These entities are deemed to conduct business activities by means of their total asset base and are liable to tax on their entire worldwide income. Entities (worldwide) that are not established under Dutch company law are for Dutch tax purposes treated as resident or non-resident taxpayers. To determine this status, the “(factual) circumstances” are decisive.97 However, from Dutch case law it can be concluded that the effective management of an entity is the most decisive factor in determining its location.98 To determine whether an entity is considered as Dutch resident, it is generally required that the place of effective management of the entity is in the Netherlands. Whether a foreign entity can be classified as a taxable entity (i.e. the entity is regarded as either transparent or opaque), the legal characteristics of the entity should be compared with those of the resident entities that are treated as transparent or opaque for Dutch tax purposes. The Dutch innovation box applies to both residents of the Netherlands and non-residents with a PE in the Netherlands, and provided that the R&D activities are attributable to this PE.

17.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules The domestic tax law of the Netherlands does not currently contain specific controlled foreign company (CFC) legislation and there is no definition of what a CFC is.99 However, article 13a of the CITA provides for a “CFClike” legislation based on which the exemption method is switched to a credit method. Provided the conditions for the participation exemption (article 13 of the CITA) are met, all benefits (dividends, other profit distributions, capital 97. NL: Algemene wet inzake rijksbelastingen (General Tax Act), art. 4(1). 98. NL: HR, 1 July 1987, No, 23.877, BNB 1978/306; NL: HR, 27 Apr. 1988, No. 24.252, BNB 1988/181. 99. Although in the Dutch literature there is no agreement with the position that the Netherlands does not have CFC legislation. See J. Müller, The Netherlands in International Tax Planning sec. 14.6. (IBFD 2005), Online Books IBFD, and P.J.F. Snel, Deelnemingsvrijstelling: goede bedoelingen, weinig visie en nog enkele knelpunten, WFR, para. 3.4 (2006/787).

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Taxation of income from IP under the domestic law

gains and foreign exchange rate results) derived from a qualifying participation are exempt from Dutch corporate income tax. Based on article 13a of the CITA, a company holding (alone or in combination with a related company) 25% or more of the shares in a company whose assets consist of at least 90% passive assets (not immovable property), and is taxed at a rate less than 10%, has an obligation to annually reassess these shares at fair market value, without an exemption applying. The increase or decrease of the value of the shares will annually be included in the taxable base of the Dutch company as income from a participation. The Dutch participation exemption rules will not apply to this profit (i.e. gain or loss). Although the provision of article 13a of the CITA, strictly speaking, applies to both domestic and foreign subsidiaries, in domestic settings taxpayers will typically meet the subject-to-tax test (effective tax rate of 10%). The de facto application of this article is therefore primarily limited to crossborder situations. Provided that a Dutch company holds 25% or more of the shares in a (foreign) company whose assets consist of at least 90% passive assets (i.e. IP) and that is taxed at a rate less than 10% – according to Dutch standards, has an obligation to annually reassess these shares at fair market value. In this regard the application of article 13a of the CITA can be avoided by mixing passive and active subsidiaries or assets. The EU-28 Finance Ministers reached a political agreement on 21 June 2016 on the Anti-Tax Avoidance Directive (ATAD), which is part of the AntiTax Avoidance Package originally presented by the Commission on 28 January 2016. The ATAD contains a number of minimum standard legally binding anti-abuse measures, largely implementing BEPS outcomes, which all EU Member States should apply against common forms of aggressive tax planning. Member States should implement and apply these measures for the most part as from 1 January 2019. As part of this obligation, the government released a consultation document on 10 June 2017 that contained a draft bill and an explanatory memorandum on the implementation of, inter alia, CFC rules of the ATAD into Dutch legislation. The government uses a consultation document to give taxpayers and other interested parties the opportunity to voice any concerns they may have and identify any potential flaws in the drafting of the bill at an early stage. The document was open for public comments up to 21 August 2017.

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Chapter 17 - Netherlands

The final bill is expected to be submitted to the Dutch parliament (Staten Generaal) in June 2018. The ATAD provides for two options for implementing the CFC rules: model A, which essentially involves CFC rules on the income approach, while model B essentially revolves around the transaction approach. In line with the preference of the Dutch parliament, model A is included in the consultation document. Under the proposed CFC rules, specified types of so-called tainted income (such as interest, royalties, dividends, financial lease benefits, insurance and banking benefits, and benefits from certain billing activities) of a CFC – a company in which the taxpayer has a direct or indirect interest of at least 50% – are included in the Dutch corporate income tax base of a corporate taxpayer. The tainted income is only included to the extent the income has not been distributed to the corporate taxpayer at the end of the financial year and the income is not subject to tax at the level of the CFC, which is (according to Dutch standards) considered being reasonable. Losses are not included in the Dutch corporate income tax base of the taxpayer but are instead carried forward for a period of up to 9 years to be offset against positive tainted income of subsequent years. The CFC rules are not applicable to the extent that the CFC in relation to which tainted income is included in the Dutch corporate income tax base carries out a fundamental economic activity, supported by personnel, equipment, assets and buildings.100 Another exception is made in situations where the income of the CFC at least predominantly (70% or more) exists of non-tainted income or if the company is a financial undertaking (as referred to in article 2(5) of the ATAD) and the tainted income is predominantly (70% or more) derived from other than the taxpayer or affiliated companies or affiliated individuals.101 Local profit tax paid at the level of the CFC can in principle be credited against Dutch corporate income tax due. On 23 February 2018, the State Secretary of Finance published a letter outlining the policy objectives of the government’s tax measures to curtail the 100. Consultation document, art. 15ba(4). 101. Consultation document, art. 15ba(3).

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Taxation of IP under EU law

role of the Netherlands in international tax planning structures aimed at base erosion and to protect the Dutch taxable base (Letter).102 The Letter confirms that the Netherlands wishes to introduce CFC rules on the basis of model A for CFCs in either low-taxed jurisdictions or in jurisdictions that are on the “EU list of non-cooperative jurisdictions for tax purposes”.

17.3. Taxation of IP under EU law 17.3.1. Issues of compatibility of domestic tax law with EU law 17.3.1.1. Compatibility with fundamental freedoms IP regimes within the European Union are also subject to the restrictions of the Treaty on the Functioning of the European Union (TFEU), in particular, the freedom of establishment and the freedom to provide services. The first step in determining compatibility of the IP regimes with EU law is to determine if there is a restriction of a particular freedom. The European Court of Justice (ECJ) ruled that regimes that did not extend benefits, such as deductions or tax credits for expenditure incurred in other Member States, when such benefits were given for domestic expenditure are considered to infringe the freedom of establishment. So far there have been three cases of the ECJ regarding the (in)consistency of R&D tax incentives with the fundamental freedoms. All of them concern input tax incentives rather than IP regimes.103 Baxter (Case C-254/97) concerned a special levy in France on revenue arising from the exploitation of proprietary medicinal products, which allowed for a deduction of R&D expenses only if the relevant research activities were carried out in France. The Court ruled that such a territorial restriction is considered to infringe the freedom of establishment, since it puts a non-resident company whose headquarters were located in another Member 102. Letter of State Secretary of Finance (23 Feb.2018). 103. FR: ECJ, 8 July 1999, Case C-254/97, Société Baxter, B. Braun Médical SA, Société Fresenius France and Laboratoires Bristol-Myers-Squibb SA v. Premier Ministre, Ministère du Travail et des Affaires sociales, Ministère de l’Economie et des Finances and Ministère de l’Agriculture, de la Pêche et de l’Alimentation, ECJ Case Law IBFD; FR: ECJ, 10 Mar. 2005, Case C-39/04, Laboratoires Fournier SA v. Direction des vérifications nationales et internationales, ECJ Case Law IBFD; and ES: ECJ, 13 Mar. 2008, Case C-248/06, Commission v. Spain, ECJ Case Law IBFD.

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State at a disadvantage in relation to pharmaceutical undertakings whose principal places of business were located in France. Such a violation could not be justified on the basis of preserving the effectiveness of fiscal supervision.104 Similarly, Laboratoires Fournier (Case C-39/04) concerned the French domestic law which granted a tax credit for R&D activities carried out in France, while disallowing such a credit if the relevant activities were subcontracted to a foreign entity. According to the ECJ, such a distinction was contrary to the freedom to provide services and could not be justified by the principle of territoriality, the coherence of the tax system or the effectiveness of fiscal supervision. The French government also put forward that the restriction was justified by the objective of promoting R&D activity, but the ECJ rejected this as disallowing a tax credit in respect of R&D activities carried out in other Member States was “directly contrary to the objective of the Community policy on research and technological development which, according to Article 163(1) EC [now article 179 TFEU] is, inter alia, ‘strengthening the scientific and technological bases of Community industry and encouraging it to become more competitive at international level’”.105 The Netherlands, as an EU Member State, must comply with the fundamental freedoms codified in the TFEU. In order to do so, the Netherlands does not restrict the R&D tax incentives to domestic R&D investments.106 Territorial restrictions, such as restriction of R&D incentives solely for domestic activities, would be an infringement of the freedom of establishment. For patents, the situation is relatively straightforward. Entry into the innovation box regime requires that a patent is granted to the taxpayer for an intangible asset. For the innovation box, both foreign patents as well as Dutch patents qualify as an entry ticket for the innovation box. With respect to the innovation box, part of the R&D activities can be outsourced to unrelated parties and be carried out anywhere in the world, as long as the activities are performed for the risk and account of the taxpayer.

104. See Baxter (C-354/97) paras. 18-20. See also C. Shi, IP Boxes in Light of the BEPS Project and EU Law – Part I, 56 Eur. Taxn. 8 (2016), Journals IBFD, and C. HJI Panayi, The Compatibility of the OECD/G20 Base Erosion and Profit Shifting Proposals with EU Law, 70 Bull. Intl. Taxn. 1/2 (2016), Journals IBFD. 105. See Laboratoires Fournier (C-39/04) paras. 5, 17-25. 106. Evers, supra n. 61, at p. 14.

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The Dutch innovation box does not distinguish between the place where R&D activities are performed and where costs are incurred.107 Article 49(1) of the TFEU prohibits restrictions on the freedom of establishment of nationals of a Member State in the territory of another Member State. The same prohibition also applies to restrictions on the setting up of branches or subsidiaries by nationals of any Member State established in the territory of any other Member State, which is usually referred to as the secondary establishment. The freedom of establishment is not only aimed at ensuring that foreign nationals and companies are treated in the host Member State in the same way as nationals of that Member State, but also prohibits the resident Member State from hindering its nationals and companies from establishing themselves in another Member State.108 This applies to an establishment in the form of a PE. Under the nexus approach qualifying taxpayers includes (i) resident companies, (ii) domestic PEs of foreign companies and (iii) foreign PEs of resident companies that are subject to tax in the jurisdiction providing benefits. As previously mentioned, the Netherlands implemented the nexus approach as such that expenditure incurred by the foreign PE of a Dutch company in connection with R&D activities – irrespective of where the research activities are located – are considered qualifying expenditure and can as such be taken into account.109 This means that to the extent that the criteria of the innovation box are met (e.g. in so far as the expenditure relate to R&D activities for the purpose of developing IP), the expenditure of a foreign PE should be taken into account as “total expenditure” in the denominator of the nexus fraction and can be taken into account as “qualifying expenditure” in the numerator of the nexus fraction. Based on the above, the Netherlands does not put resident companies investing in other Member States (or third countries) through a PE in a less favourable situation compared with those only investing in the Netherlands (resident state). Accordingly, there is no disadvantageous treatment – which would make it less attractive for a resident company to invest abroad – in cross-border situations which could constitute a restriction on the freedom

107. Beek-Van Doremaele & Smetsers, supra n. 46, at p. 495. 108. DE: ECJ, 21 Sept. 1999, Case C-307/97, Compagnie de Saint-Gobain, Zweigniederlassung Deutschland v. Finanzamt Aachen-Innenstadt, para. 35, ECJ Case Law IBFD. 109. Kamerstukken II 2016-2017, 34 552, no. 3 (explanatory memorandum), p. 69.

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of establishment.110 Consequently, there is no discrimination under this scenario. 17.3.1.1.1.  Outbound investment through a PE vs outbound investment through a subsidiary Under the nexus approach, the Dutch parent company is not able to take R&D expenditure incurred – i.e. outsourcing of the R&D activities – by its foreign subsidiary (or any related company) into account. This generates a difference in treatment between outbound investment through a subsidiary as opposed to a PE. In the latter case, the R&D expenditure incurred by the foreign PE can be taken into account when calculating the tax benefit for the company in the Netherlands. It should be pointed out that from the perspective of the origin state, PEs and non-resident subsidiaries are not comparable.111 Non-resident subsidiaries and PEs become comparable if the origin state defines its taxing jurisdiction on the basis of territoriality – i.e. excluding PE results altogether from the tax base of its resident companies (base exemption).112 As previously mentioned, under Dutch tax law, a taxpayer is in principle subject to Dutch corporate income tax on the basis of its worldwide income (i.e. including income that is attributable to a foreign PE).113 Provided that certain conditions are met, the profit of the Dutch taxpayer, however is reduced with certain foreign-sourced income based on article 15e of the CITA (“object exemption”). In this respect, article 15e of the CITA stipulates that (inter alia) income that is attributable to a foreign PE should be eliminated from the Dutch taxable base, provided that (to the extent relevant) the Netherlands is obliged to provide an exemption for such income on the basis of an applicable tax treaty. During the parliamentary proceedings, it has been explicitly confirmed that the income that is attributable to a foreign PE should be determined according to Dutch standards.114

110. DE: ECJ, 15 May 2008, Case C-414/06, Lidl Belgium GmbH & Co. KG v. Finanzamt Heilbronn, paras. 19-20, ECJ Case Law IBFD. 111. DE: ECJ, 6 Dec. 2007, Case C-298/05, Columbus Container Services B.V.B.A. & Co. v. Finanzamt Bielefeld-Innenstadt, ECJ Case Law IBFD, and NL: ECJ, 25 Feb. 2010, Case C-337/08, X Holding BV v. Staatssecretaris van Financiën, ECJ Case Law IBFD. 112. B.J.M. Terra & P.J. Wattel, European Tax Law p. 541 (Kluwer 2012). 113. Art. 8 of the CITA, referring to arts. 3.8 and 3.25 of the Personal Income Tax Act 2001. 114. Kamerstukken II 2011-2012, 33 003, no. 3, pp. 92-93.

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The Dutch object exemption is designed as a tax base adjustment rather than a “real” exemption. In this respect, there are arguments to take the position that it is illustrative that, on the one hand, losses of a foreign PE cannot be offset against the profits of the general enterprise, while, on the other hand, foreign exchange movements attributable to a foreign PE are still included in the Dutch taxable base and a transfer of assets from a Dutch company to its foreign PE is not subject to exit taxation.115 Provided that the Dutch base exemption is not considered a real exemption and there are arguments to take the position that a foreign PE of a Dutch company is subject to tax in the Netherlands, the refusal to extend the IP box regime to activities conducted by a foreign subsidiary will probably not lead to an infringement of the freedom of establishment. 17.3.1.1.2.  Investment through a domestic subsidiary vs investment through a foreign subsidiary As previously mentioned, under the nexus approach, qualifying expenditure include all expenditure related to the R&D performed by the taxpayer to develop the qualifying intangible asset, which also include the expenditure related to the direct or indirect outsourcing of R&D to a non-related party. However, expenditure relating to the outsourcing of R&D activities to a related party of the taxpayer cannot be taken into account as qualifying expenditure in the nexus fraction. In order to ensure compliance of the nexus approach with the EU fundamental freedoms, it is intended to move from a territorial to a personal nexus requirement. Under this line of reasoning, expenses related to outsourcing of R&D activities a foreign related party are not denied because these functions are carried out abroad but rather because they are not performed by the taxpayer itself. Although this rule, strictly speaking, applies to both domestic and foreign subsidiaries, in a purely domestic situation, this does not have to be a problem because the group can elect these companies to be treated as one single taxpayer (Dutch fiscal unity, article 15 of the CITA). Consequently, this expenditure is not excluded as expenditure of a related party. The same goes for the indirect outsourcing (to a third party via a related party). As a cross-border fiscal unity is not possible and as such the expenses related to fees paid to non-resident related services providers are excluded, the

115. F.P.G. Pötgens & J.W. Bellingwout, Objectvrijstelling voor vaste inrichtingen: Much Ado About Nothing?, WFR 2012/654.

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question arises whether this distinction is compatible with the freedom of establishment.116 A further point which needs to be examined is reflected by the various territorial restrictions in the application of the innovation box to an intangible asset for which an R&D certificate can be obtained. The innovation box is not available if the research is performed by persons who cannot be qualified as “employees” within the meaning of article 2 of the Wage Tax Act. This is the case if these persons do not live and work in the Netherlands. If these persons work at a PE of the taxpayer in another EU/EEA Member State, the innovation box is not available. This seems to constitute a prohibited restriction on the freedom of establishment.117 Also, in respect of a non-resident taxpayer that has a PE in the Netherlands, the innovation box is not available if there are no Dutch “employees” who have developed the intangible assets.

17.3.1.2. Compatibility of the Dutch innovation box with State aid rules Under article 107(1) of the TFEU, the following applies: Save as otherwise provided in the Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.

In order to fall within the scope of article 107(1) of the TFEU a measure must satisfy all the following requirements: – an economic advantage must be granted to an undertaking; – the aid must be provided by a Member State and financed through state resources; – the aid distorts or threatens to distort competition and affects EU trade; and – it favours certain undertakings or the production of certain goods ­(“selectivity”).

116. R.J. Danon, General Report, in Tax incentives on research & development (R&D) p. 49 (IFA Cahiers vol. 100A, 2015), Online Books IBFD. 117. M.L.B. van der Lande, Innovatiebox: de ongelijke behandeling van speur- en ontwikkelingswerk, NTFR 2009/2602.

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Measures satisfying the above-mentioned requirements in principle constitute unlawful State aid, unless one of the exceptions under article 107(2) or (3) of the TFEU applies.118 It is solely the competence of the Commission to decide whether this is the case. 17.3.1.2.1.  An economic advantage must be granted to an undertaking The concept of “aid” is not as such defined in the TFEU. However, it is generally understood to mean an intervention by a state or through state resources encompassing a financial burden borne by the state that results in an advantage for an undertaking by mitigating the charges which are normally included in its budget.119 As article 107(1) of the TFEU applies to aid granted “in any form whatsoever”, the ECJ has consistently held that the concept of aid is wider than that of a subsidy: [B]ecause it embraces not only positive benefits, such as subsidies themselves, but also interventions which, in various forms, mitigate the charges which are normally included in the budget of an undertaking and which, without, therefore, being subsidies in the strict meaning of the word, are similar in character.

In tax matters, an economic advantage could, inter alia, be a reduction of the tax base, e.g. where a tax measure results in an “extraordinary relief”,120 through special deductions, special or accelerated depreciation arrangements or the entering of reserves on the balance sheet, or a total or partial reduction in the amount of tax otherwise due, e.g. through a tax credit, or a delay in the payment of such amount.121 As such, there can be no doubt that tax measures can in principle also result in the provision of State aid.122

118. Art. 107(2) of the TFEU specifies certain types of aid which shall be compatible with the internal market. This includes (a) aid having a social character, (b) aid to make good damages caused by natural disasters and (c) aid granted to certain areas of the Federal Republic of Germany. Art. 107(3) of the TFEU provides a number of categories of aid which may be considered compatible with the internal market. 119. C. Quigley, European State Aid Law and Policy p. 12 (Hart Publishing 2015). 120. See, inter alia, P. Rossi-Maccanico, Community Review of Direct Business Tax Measures: Selectivity, Discrimination and Restrictions, European State Aid Q. 4, p. 491 (2009). 121. 1998 European Commission Notice, para. 9. 122. This is confirmed in Commission Notice on the application of State aid rules to measures relating to direct business taxation, OJ 98/C 384/03, para. 8.

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Moreover, the aid should be granted to undertakings,123 meaning every legal entity engaged in an economic activity regardless of its form or the way with which it is financed.124 Any activity consisting in offering goods or services on a given market is regarded as an economic activity.125 Notably, the ECJ has held that the mere acquisition and passive holding of shares in a company does not constitute an economic activity for purposes of State aid assessment.126 Aid granted directly to individuals, acting in their private capacity, rather than as entrepreneurs, cannot be classified as State aid, unless in reality the aid indirectly economically benefits a company.127 Finally, the ECJ concluded in a judgment that a company could still be regarded as receiving aid even where there was an argument that the benefit had been passed on to customers.128 17.3.1.2.2.  The aid is provided by a Member State and financed through state resources In order to meet this requirement, the advantage must be (i) imputable to the Member State (either at a national or local governmental level) and (ii) the advantage must be financed through state resources by reducing directly or indirectly the resources of the public sector. These conditions are to be interpreted cumulatively, rather than alternatively.129 A contrario, aid granted in compliance with an EU obligation or emanating from EU resources (e.g. where a state is obliged to introduce a measure transposing EU provisions, such as directives, in national law) is not State aid within the meaning of article 107(1) of the TFEU.

123. For simplification purposes, hereinafter, the term “company” will be used instead of “undertaking”. 124. DE: ECJ, 23 Apr. 1991, Case C-41/90, Klaus Höfner and Fritz Elser v. Macrotron GmbH, ECLI:EU:C:1991:161, para. 21. 125. IT: ECJ, Case, 18 June 1998, C-35/96, Commission of the European Communities v. Italian Republic, para. 36, ECJ Case Law IBFD. 126. NL: ECJ, 6 Feb. 1997, Case C-80/95, Harnas & Helm CV v. Staatssecretaris van Financiën, para. 15, ECJ Case Law IBFD. 127. DE: ECJ, 19 Sept. 2000, Case C-156/98, Germany v. Commission, ECJ Case Law IBFD; DE: ECJ, 1 July 2004, Case T-308/00, Salzgitter v. Commission, ECR 2004 p. II-1933) ECLI:EU:T:2004:199; IT: ECJ, 28 July 2011, Case C 403/10 P, Mediaset SpA v. European Commission, ECLI:EU:C:2011:533. 128. IE: ECJ, 21 Dec. 2016, Joined Cases C-164/15 P and C-165/15 P, Commission v. Aer Lingus Ltd, Ryanair Designated Activity Company and Ireland. 129. DE: ECJ, 13 Mar. 2001, Case C- 379/98, PreussenElektra AG v. Schleswag AG, paras. 58-62.

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In tax matters, this criterion is typically met for every economic advantage (e.g. tax exemption, deduction, credit) provided by a tax provision, tax ruling or tax settlement. 17.3.1.2.3.  The aid potentially distorts competition and affects EU trade The ECJ has consistently held that an aid intended to relieve a company of the expenses, which it would normally have had to bear in its day-today management or its usual activities, in principle distorts the conditions of competition existing within the EU internal market.130 Furthermore, the aid affects trade between Member States if the relevant markets are open to international competition. Given that article 107(1) of the TFEU uses the wording “threatens to distort competition”, the ECJ has concluded that no actual effects on competition and trade have to be demonstrated; it is adequate that a measure is likely to impact competition and trade. Thus, especially in tax matters, the threshold for proof of an effect on competition and trade is considered relatively low in the sense that no detailed evidence is required. However, the Court in its recent judgment in the Spanish tax lease case ruled that the Commission did not give sufficient reasons for its finding that the regime was likely to distort competition and affect trade between Member States.131 Notably, an appeal of the judgment before the ECJ is currently pending. 17.3.1.2.4.  It favours certain undertakings or the production of certain goods (“selectivity”) In cases concerning the innovation box (meaning all available IP regimes in the Member State such as innovation box, patent box), the most controversial condition is “selectivity”.132 The predominant way for assessing selectivity has been set out by the ECJ, which has consistently held that selectivity is a three-step test: (i) identification of the reference system; (ii) assess and determine whether the

130. IT: ECJ, 30 Apr. 2009, Case C-494/06, Commission of the European Communities v. Italian Republic and Wam SpA. 131. ES: ECJ, 17 Dec. 2015, Joined Cases T-515/13, Spain v. Commission and T-719/13, Lico Leasing, SA and Pequeños y Medianos Astilleros Sociedad de Reconversión, SA v. Commission, paras. 181-208. 132. C. Micheau & G.C. de la Brousse, Case Studies of Tax Issues on Selectivity: Analysis of the Patent Box Scheme and the Reduced Taxation of Foreign-Source Interest Income, in State Aid and Tax Law p. 156 (A. Rust & C. Micheau eds., Kluwers 2013).

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measure derogates from the preference system; and (iii) assess and determine whether the derogation from the reference system is justified.133 First, it is necessary to begin by identifying the reference system, which is composed of a consistent set of rules that generally apply – on the basis of objective criteria – to all taxpayers falling within its scope as defined by its objective. In tax matters, corporation tax should often be regarded as the tax regime of reference for the purposes of determining whether the measure at issue may be selective. Second, once the reference system is established, it should be assessed whether a given measure – in the underlying case, article 12b of the CITA – introduces a derogation from that system which has the effect of differentiating between companies that are in a comparable legal and factual situation in light of the objective of the measure viewed in the context of the reference system as a whole (“prima facie selectivity”).134 Measures which apply to all companies that are in a comparable legal and factual situation cannot be regarded as selective and as such will not constitute State aid (“general measures”). This is due to the fact that the application of State aid law is without prejudice to the power of the Member States to decide on their economic policy and therefore on the tax system which they consider the most appropriate.135 Nevertheless, measures that are formulated in general and objective terms may still be considered as de facto selective, if their structure is such that their effects significantly favour a particular group of companies.136 The ECJ judgment on the Spanish measure allowing for amortization of the goodwill arising from the acquisition of shareholdings solely in foreign companies, and not in Spanish companies, addressed the requirement

133. IT: ECJ, 8 Sept. 2011, Joined cases C-78/08 to C-80/08, Ministero dell’Economia e delle Finanze and Agenzia delle Entrate v. Paint Graphos Soc. coop. arl (C-78/08), Adige Carni Soc. coop. arl, in liquidation v. Agenzia delle Entrate and Ministero dell’Economia e delle Finanze (C-79/08) and Ministero delle Finanze v. Michele Franchetto (C-80/08). 134. See AT: ECJ, Case C-143/99, Adria-Wien Pipeline GmbH and Wietersdorfer & Peggauer Zementwerke GmbH v. Finanzlandesdirektion für Kärnten, para. 41, ECJ Case Law IBFD. 135. UK: ECJ, 18 Dec. 2008, Joined Cases T-211/04 and T-215/04, Government of Gibraltar (T-211/04) and United Kingdom of Great Britain and Northern Ireland (T215/04) v. Commission of the European Communities, para. 146. 136. ES: ECJ, 15 Nov. 2011, Case C-106/09_P, European Commission and Kingdom of Spain v. Government of Gibraltar and United Kingdom of Great Britain and Northern Ireland, paras. 73, 106, 107, ECJ Case Law IBFD.

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of selectivity (Autogrill).137 Without elaborating on what is the reference system in the case at hand, the ECJ ruled that the appropriate criterion for establishing the selectivity of the Spanish measure consists in determining whether it introduces, between undertakings that are, in the light of the objective pursued by the tax system concerned, in a comparable factual and legal situation, a distinction that is not justified by the nature and structure of that system.138 The ECJ clearly endorsed an approach based on discrimination in this judgment. The ECJ stated that the supplementary requirement that the General Court introduced in its earlier judgment on this case, i.e. that in order for a measure to be selective, a particular category of undertakings benefitting from it has to be identified, is incorrect, as it does not derive from the previous ECJ jurisprudence.139 The ECJ has now referred the case back to the General Court, which will have to decide the case on the basis of the ECJ’s guidance. In particular, the General Court will need to determine whether foreign and domestic acquisitions are comparable and if they are, whether a difference in treatment can be justified (discussed further below). The judgment in Autogrill was handed down by the ECJ’s Grand Chamber and may therefore be highly influential for future courts. Finally, it must be assessed whether the derogation from the preference system is justified by the nature or general scheme of the tax system. A measure that creates an exception to the application of the common regime may be justified if it results directly from the basic or guiding principles of that tax system.140 The progressive rate of income or profit taxation,141 the need to avoid double taxation,142 the sectoral tax differentiation143 and the

137. ES: ECJ, 21 Dec. 2016, Case C-20/15_P, European Commission v. World Duty Free Group and Others [Autogrill], ECJ Case Law IBFD. 138. Id., at para. 60. 139. Id., at para. 71. 140. IT: ECJ, 8 Sept. 2011, Case C-78/08, Amministrazione delle Finanze, Agenzia delle Entrate v. Paint Graphos Scarl; Adige Carni Scrl, in liquidation v. Ministero dell’ Economia e delle Finanze, Agenzia delle Entrate; Ministero delle Finanze v. Michele Franchetto, ECJ Case Law IBFD. 141. 1998 European Commission Notice, para. 24. In a recent decision the European Commission found that the progressive tax rates of a tax on turnover (instead of profit) derived from publication of advertisements in Hungary were selective and could not be justified by the ability to pay principle. The Commission considered that the turnover of a group of companies is not a good proxy for the assessment of taxpayers’ ability to pay nor could the pattern of progressivity of the tax be justified by the nature and general scheme of the tax system. SA.39235 Hungarian advertisement tax. 142. Paint Graphos (C-78/08). 143. C54a/2000 CR54/A/2000 Mesures fiscales pour les banques et les fondations bancaires. Furthermore, in N (C-482/2001), the ECJ approved a Danish measure allowing credit institutions to make provisions for losses inherent in credit risks.

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principle of tax neutrality are justifications that have been accepted by the ECJ or the Commission. 17.3.1.2.5. Review of the Dutch innovation box under article 107(1) TFEU There are two categories of R&D tax incentives: (i) input tax incentives that focus on stimulating R&D through lowering companies’ initial costs (e.g. R&D tax credits, accelerated depreciation or enhanced allowances) and (ii) output tax incentives that aim at promoting commercialization of innovation. The most characteristic form of output tax incentives are patent boxes, which exempt or tax at a lower rate income derived from successful R&D projects, being usually patents or trademarks and trade and marketing intangibles. Both input and output tax incentives are subject to State aid scrutiny as they may create distortion of competition by attracting investments which would otherwise not have been made. In the 1998 European Commission Notice, the Commission took the position that input R&D tax incentives could amount to a general measure (and thus not constitute State aid), provided they pursued general economic policy objectives through the reduction of the tax burden related to R&D costs, and they were open to all undertakings operating within a Member State.144 This has been reiterated on many occasions.145 In the 2016 Notice,146 however, this statement has been taken out. In 2008, the Commission reviewed the IP regime in Spain.147 The Commission considered that: The privileged treatment of income from intangible assets is a derogation from the ordinary corporate taxation rules. It is an advantage, since it mitigates the charges the companies would have to bear without the existence of the measure. However, the scheme is open to any undertaking subject to corporate taxation

144. Commission Notice on the application of the State aid rules to measures relating to direct business taxation, OJ 98/C384/03, para. 13. 145. Reference is made to Commission Decision of 11 December 2007, C(2007) 6042 def. (State Aid N507/2007; Italy – R&D Tax credit), with further references to case practice. 146. Notice from the European Commission on the notion of State aid as referred to in Article 107(1) of the Treaty on the Functioning of the European Union, 2016/C262/01. 147. Commission Decision of 13 February 2008, No. C2008) 467 final (State Aid N480/2007, Spain – Reduction of tax from intangible assets), para. 11.

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in Spain that develops intangible assets. Indeed, any corporate tax payer, independently from its size, legal structure and sector in which it operates can be the beneficiary.148

While it was “true that some undertakings may profit from the measure more than others”, that did “not necessarily make the measure selective.” Also, the fact that the advantage was limited to six times the costs of self-developing the asset is “not a sign of selectivity in itself”.149 The Commission also verified the preparatory legislative materials which preceded the introduction of the measure. There was “nothing in these materials … that may suggest that the objective of the measure was to make it restricted de facto to a particular group or sectors of undertakings.”150 The anti-abuse measures were justified by the logic of the Spanish tax system.151 In this light, the Commission considered that the measure did not provide a selective advantage. For largely the same reasons, the EFTA Surveillance Authority decided in June 2011 that the Liechtenstein patent box allowing for a special deduction of 80% of income from intellectual property rights, i.e. patent rights, trademarks, designs and utility models, did not amount to State aid.152 However, since June 2013, the IP regimes of various Member States have attracted the Commission’s attention. The Commission has received indications that special tax regimes seem to mainly benefit highly mobile businesses and do not trigger significant additional R&D activity. The Commission is therefore gathering information to assess whether the IP regimes grant a selective advantage to a particular group of companies, in breach of EU State aid rules. The Commission has requested information about IP regimes from the ten Member States with such an IP regime (Belgium, Cyprus, France, Hungary, Luxembourg, Malta, the Netherlands, Portugal, Spain and the United Kingdom).153 The Commission has not yet announced any information on whether the IP regimes of the above-mentioned countries provide State aid within the meaning of article 107(1) of the TFEU. During an interview in June 2016, Valère Moutarlier, Director of the European Commission’s Directorate General for Taxation and Customs

148. Id., at para. 14. 149. Id., at para. 17. 150. Id., at para. 18. 151. Id., at para. 19. 152. 177/11/COL, EFTA Surveillance Authority Decision of 1 June 2011 on tax deductions in respect of intellectual property rights. 153. See European Commission Press Release IP/14/2742.

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Union, said that the Commission is currently reviewing each Member State’s IP regime.154 In the light of the judgement in Autogrill,155 it could be argued that the privileged tax treatment under the innovation box, mitigating corporate income tax charges undertakings would otherwise have to bear, introduces a derogation from the reference system, in that case being the Dutch corporate income tax system. This derogation could be seen as favouring certain undertakings over other undertakings which are in comparable factual and legal situations – having regard to the general objective pursued by the corporate income tax system (i.e. the taxation of the corporate profits) – and is therefore prima facie selective. Difference in treatment, however, is not selective when companies engaged in R&D activities are not in a comparable legal and factual situation with other corporate entities in light of a specific objective of the corporate income tax system, such as the promotion of R&D. Even though this is not a tax-related objective, one could take the view that it is still a legitimate objective for State aid purposes, taking into account that the same is pursued by the European Union within the meaning of article 179(1) of the TFEU. The latter hails R&D promotion as a common interest of the EU and the Europe 2020 strategy,156 which puts R&D at its heart by setting a target of overall R&D spending of 3% of gross domestic product could be a legitimate aim that can be pursued through the tax system.157 In addition, in October 2016, the European Commission relaunched the Common Consolidated Corporate Tax Base (CCCTB) in which strong incentives to R&D are provided. The CCCTB includes a new super-deduction for companies that invest in R&D spending, given the importance of such investment for growth and jobs. On the basis of the foregoing, there are arguments to take the position that the difference in treatment could not be selective as the objective to promote R&D is a legitimate aim pursued by the tax system. In the light of this objective, undertakings which, respectively, do and do not engage in R&D 154. Available at http://taxinsights.ey.com/archive/archive-articles/interview--eu-taxofficial-assesses-beps-progress.aspx (last accessed 1 Oct. 2017). 155. Autogrill (C-20/15 P). 156. Communication from the Commission of 3 March 2010 – Europe 2020. A strategy for smart, sustainable and inclusive growth, COM(2010) 2020 final. 157. See also B. Perez-Bernabeu, R&D&I Tax Incentives in the European Union and State Aid Rules, 54 Eur. Taxn. 5 (2014), Journals IBFD.

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should in principle not be regarded as legally and factually comparable. As a consequence, the effective tax rate of 7% (innovation box) should not as such be selective.158 The requirement that the innovation box only applies in case of a patent or R&D certificate and not in case of other types of IP reflects an objective criterion which does not in itself render the measure selective.159 This limitation is aimed at stimulation of true R&D instead of the development of, for instance, logos and brands. Also, this limitation should keep the measure practicable and controllable from a budgetary point of view. Thus, the measure reflects legitimate objectives that are capable of distinguishing taxpayers with patents from taxpayers with other types of intellectual property, which is also shown by the decision in respect of the Spanish system discussed above and approved by the Commission (the Spanish regime was restricted to patents, designs and models, plans and secret formulas or processes). It also appears that the limitations on the maximum amount that can be taxed under the effective tax rate of the patent box are not in themselves selective. IP regimes may also fall foul of the harmful tax competition rules established by the EU Code of Conduct for Business Taxation.160 An example is the UK patent box, which provided for a lower UK corporate income tax rate for profits associated with UK and EU patented inventions. In 2013, the Commission opined that the regime was potentially a harmful tax practice, given that it was granting tax benefits for intangibles developed in other Member States. Notably, the classification of a measure as harmful under the Code of Conduct does not automatically mean that it will also be regarded as State aid, because the criteria do not always necessarily overlap. 158. This conclusion is shared by F.A. Engelen & P.C. van der Vegt, De octrooi- en rentebox: dispariteit, distorsie of steunmaatregel?, WFR 2006/1181, R.H.C. Luja, Boxen, belegginginstellingen en staatssteun, WFR 2006/819 and Q.W.J.C.H. Kok & J.C.M. van Sonderen, Octrooibox, groepsrentebox, en aftrekbeperkingen, TFO 2006, pp. 155-168, and M.L.B. van der Lande, Innovatiebox pp. 9-10 (Kluwer 2010). See also Kamerstukken 2005/06, 30572, no. 3, p. 10, and Kamerstukken 2005/06, 30572, no. 8, pp. 29-30. 159. Autogrill (C-20/15 P), para. 59. 160. The Code of Conduct for Business Taxation has no binding force and only operates through agreement. It aims at reducing distortions of competition in the internal market and prevents excessive losses of tax revenue resulting from relocating businesses to Member States offering tax benefits. In assessing whether a measure is harmful under the Code of Conduct rules, the group takes into account the following rules: (i) whether a measure benefits only non-residents (offshore companies); (ii) if it erodes the tax base of neighbouring states while protecting the domestic one (ring-fencing); (iii) if an advantage is granted despite the fact that there is no real economic activity and presence (substance test); (iv) whether the rules depart from internationally agreed standards (e.g. OECD arm’s length principle) and (v) whether a measure lacks transparency (e.g. unpublished APAs).

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However, the preliminary assessment based on the Code of Conduct rules could influence the Commission’s decision to open a State aid investigation into a measure. As previously mentioned, the Netherlands revised its innovation box regime in order to align the Dutch regime with the reached agreements based on BEPS Action 5. In 2015, in its Communication on “A Fair and Efficient Corporate Tax System in the European Union”,161 the Commission embraced the nexus approach and announced to propose binding legislative measures if it appears that Member States do not apply this approach consistently within a timeframe of 1 year. According to the Commission, “certain preferential tax regimes are perceived to facilitate tax avoidance rather than genuinely encouraging the economic activities for which the tax benefit is offered”. In order to address this problem, the Code of Conduct group agreed that preferential regimes, such as IP regimes, should be based on the nexus approach.162 The Commission also stated that it will continue to provide guidance to Member States on how to implement IP regimes in line with the new approach to ensure that they are not harmful and will carefully monitor this implementation. The Council of the European Union (Council) asked the Code of Conduct group to monitor this implementation process. The Code of Conduct group mainly deals with assessing tax measures in order to determine whether they fall within the scope of the Code of Conduct. Although, the Code of Conduct is not a legally binding instrument, its adoption requires the commitment of member states to (i) abolish existing tax measures that constitute harmful tax competition and (ii) refrain from introducing new ones in the future. In the meantime, the Commission has informally indicated that – pending the review – it will not pursue its State aid investigations but will first await the outcome of the review. The Code of Conduct group together with the Forum on Harmful Tax Practices of the OECD (FHTP) have performed a formal review of the revised Dutch innovation box rules in order to assess whether (i) it is implemented in line with BEPS Action 5 and (ii) whether the regime can be regarded as harmful under the Code of Conduct. The outcome of their formal review was announced by the Dutch Ministry of Finance on 28 June 2017. The FHTP and the Code of Conduct group considered the

161. European Commission, COM(2015) 302 final. 162. Action 5 – Final Report, supra n. 68.

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Dutch innovation box to be consistent with BEPS Action 5 and found the regime not harmful under the Code of Conduct. The above being said, the question arises whether the classification of a measure as not being harmful under the Code of Conduct automatically means that the measure also does not constitute State aid. The starting point is that although the two procedures pursue, to a certain extent, the same goal of reducing distortions of competition within the internal market, they are not identical. The key element for the Code of Conduct evaluation is to prevent harmful tax competition between Member States, while the purpose of State aid is to prevent situations where competition and trade between companies in the EU internal market are affected. These two procedures thus have different criteria and a measure which is considered not to be harmful under the Code of Conduct could still constitute State aid and vice versa. The European Commission has not yet formally announced whether the IP regimes of the above-mentioned Member States – after complying with the nexus approach – will still be subject to State aid scrutiny.

17.3.2. Open issues in the implementation of the I&R Directive Directive 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States was implemented in the Netherlands by the law of 18 December 2003. As the Netherlands does not levy a withholding tax on interest and royalties,163 it did not have to implement most of the provisions of the I&R Directive. Consequently, only two specific provisions in domestic law were amended to implement the directive. These concerned a provision on the avoidance of dual residence of companies and the corporate income tax provision on debt-claims, which a foreign company has on a Netherlands company in which it holds a substantial shareholding. There are no open issues in the implementation of the directive.

163. The Coalition agreement provides that a new withholding tax on royalty payments will be introduced in specific cases of abuse.

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17.4. Taxation of IP under tax treaties 17.4.1. Taxing rights over royalties assigned by article 12(1) The Netherlands has a far-reaching tax treaty network. It has tax treaties with all other EU Member States except Cyprus. All the tax treaties cover royalties. As the Netherlands does not levy a withholding tax on interest and royalties, the Netherlands’ treaty policy is to include no or very low withholding tax rates in its tax treaties. Most of the tax treaties concluded by the Netherlands allocate the taxation power of royalties to the resident state. The Dutch Tax Treaty Policy memo provides that on request of the treaty partner, the Netherlands is willing to consider reasonable anti-abuse provisions.164 In some tax treaties concluded by the Netherlands, taxation power of royalties is also allocated to the source state. However, as the Netherlands does not levy withholding taxes on outgoing royalty payments, this allocation to the Netherlands as a source state would hardly have any relevance. This will could change, however – as stated in the Coalition agreement – once a new withholding tax on royalty payments is introduced in specific cases of abuse.165 As previously mentioned, the Netherlands usually follows the definition of the OECD Model and Dutch Tax Treaty Policy, under which payments for the use or the right to use of a broad number of IPs are considered royalties. In its tax treaties, the definition of royalties is not always the same. In the China (People’s Rep.)-Netherlands Income Tax Treaty (2013), the term “royalties” as used in article 12 means: a) payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, or films or tapes for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information (know-how) concerning industrial, commercial or scientific experience; and b) payments of any kind received as a consideration for the use of, or the right to use, industrial, commercial, or scientific equipment.

In the case of royalties referred to in sub-paragraph a), such royalties may be taxed at 10% of the gross amount of the royalties. As it regards royalty referred to in sub-paragraph b), such royalties may be taxed at 10% of the 164. Memorandum on Dutch Tax Treaty Policy 2011, para. 2.8.2. 165. Vakstudie Nieuws, 19 Oct. 2017, 50.3, p. 20.

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adjusted amount of the royalties, meaning 60% of the gross amount of the royalties. This consequently results in an effective withholding tax rate of 6%. Such differences in withholding tax rates on royalty payments are agreed in several tax treaties concluded by the Netherlands. The Argentina-Netherlands Income and Capital Tax Treaty (1996) provides that a 3% rate is applicable to news-related royalties, a 5% rate to copyright royalties (other than royalties related to films, etc.) and a 10% rate to patents, trademarks, know-how, certain lease-related royalties and technical assistance. In the Azerbaijan-Netherlands Income and Capital Tax Treaty (2008), a lower rate of 5% applies to royalties for patents and know-how that are not older than 3 years. A 10% rate applies in all other cases. Such distinction in rates between different types of IP are also made in the tax treaties the Netherlands has concluded with Barbados,166 Belarus,167 Brazil,168 Canada,169 Estonia,170 Greece,171 Israel,172 Korea,173 Malta,174 Pakistan,175 Suriname,176 Thailand,177 Ukraine,178 Venezuela179 and Vietnam.180,181

166. 0%/5%: the lower rate applies to copyright royalties, including films, etc. 167. 3%/5%/10%: the 3% rate applies to royalties for patents, trademarks, etc.; the 5% rate to equipment leasing; the 10% rate to copyright royalties, including films, etc. 168. 15%/25%: the higher rate applies to trademarks. 169. 0%/10%: the lower rate applies to computer software, patent royalties and knowhow. 170. 5%/10%: the rates under the treaty are 5% (royalties paid for the use of industrial, commercial or scientific equipment) and 10% in all other cases. 171. 5%/7%: the lower rate applies to copyright royalties, including films, etc. 172. 5%/10%: the higher rate applies to royalties for films, etc. 173. 10%/15%: the higher rate applies to copyright royalties, including films, etc. 174. 0%/10%: the higher rate applies to copyright royalties, including films, etc. 175. 5%/15%: the lower rate applies to copyright royalties, excluding films etc. 176. 5%/10%: the higher rate applies to royalties for films, etc. 177. 5%/15%: the lower rate applies to copyright royalties, excluding films etc. 178. 0%/10%: the lower rate applies to industrial royalties in general. 179. 5%/7%/10%: the 5% rate applies to royalties for patents, leasing of equipment and know-how; the 7% rate to trademark royalties; the 10% rate to copyright royalties, including films, etc. 180. 10%/15%: the rate under the treaty is 5% for royalties for the use of, or the right to use, any patent, design or model, plan, secret formula or process and industrial or scientific information; 10% applies to the use of, or the right to use, a trademark or commercial information and 15% in all other cases. 181. For more details, see the IBFD Treaties database.

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Royalty income in the Netherlands is taxed at the statutory tax rate of 25% (or 20% for profits up to EUR 200,000), unless the royalty income qualifies for the innovation box. The Netherlands does not levy withholding taxes on outgoing royalty payments. The Dutch policy of zero withholding taxes for intra-group royalty payments is also in line with policy of the European Union.182 A tax credit is generally available for foreign withholding tax on royalty receipts (if any) under the Netherlands’ tax treaties. If there is no tax treaty, a credit is only available where royalty income is received from certain developing countries listed in Decree 2001. As previously stated, article 5(c) (4˚) provides that if technical services are provided in a developing country – and there is no tax treaty on avoidance of double taxation between the Netherlands and that particular developing country – the Netherlands grants a credit for the withholding taxes paid. The credit is granted only if the income is derived from developing countries listed in Decree 2001 (which conforms to the OECD’s DAC List of ODA Recipients).183 Article 36(1) of Decree 2001 intends to grant double taxation relief for withholding taxes on, inter alia, royalties that are included in the Dutch tax base (tax base requirement) to the amount of withholding taxes actually withheld, but in any case, to no more than the Dutch corporate income tax levied on the (net) royalties. If, under the innovation box, the income from the asset will be derived in the form of royalties paid by users of (for example) the patent in another country, such payments may be subject to withholding tax in that other country. It is then up to the Netherlands to what extent the Netherlands will provide a credit for the tax withheld. As previously mentioned, under the Dutch innovation box, 7/25 of the net income from a qualifying intangible asset – including royalty income – is included in the taxable base, resulting in an effective tax rate of 7%. Given the fact that only part of the income is included in the tax base for purposes of the innovation box regime, this would limit the credit available for such foreign taxes paid (as these are generally levied on the full amount of the royalties). In order to avoid an undesired outcome of article 36 of Decree 2001, article 36a of the decree was introduced.184 This article basically provides that the tax credit will be

182. I&R Directive. 183. Developing countries within the meaning of the OECD’s Development Assistance Committee (DAC) List of Official Development Assistance (ODA) Recipients. 184. Kamerstukken II, 30,572, NV II, no. 8, pp. 85-86.

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the lesser of (i) the actual tax paid on the relevant foreign income and (ii) 7% of the amount of the royalties (qualifying for the innovation box regime). Based on article 36a of Decree 2001, the royalty is not included in the Dutch taxable base but requires that article 12b of the CITA applies to the received royalty.185

17.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 There are different domestic methods to determine interpretation of bilateral treaties, e.g. the linguistic, historic, systematic and teleological methods. In domestic law as well as in treaty law, a provision should be interpreted in good faith in accordance with the ordinary meaning that is given to these provisions considering their context and in the light of their object and purpose. Based on article 3(2) of the OECD Model – which provision is included in a large number of tax treaties concluded by the Netherlands – the term “context” is considered important in the interpretation of the treaty. Under this article, the contracting states may fall back on their domestic definitions if the context of the treaty does not provide a solution. Several judgments of the Supreme Court refer explicitly to this article and subsequently consult domestic legislation.186 In the latter case, the Court established that a term (i.e. income) is not defined in the tax treaty. Referring to article 3(2) of the treaty, it concluded that this term has the meaning that it has under Dutch law. The Court attempts to infer the intention of the contracting states from the text of the treaty. Only if there are strong indications to the contrary, does it deviate from this. In this context, not only explanatory memoranda of both states and the Commentary of the OECD Model, but sometimes even the Dutch Tax Treaty Policy can be relevant.187 The Dutch government uses the OECD Model as a guideline in negotiations on the conclusion of bilateral tax treaties, irrespective whether the negotiations are conducted with states that are not members of the OECD. The OECD Commentary is considered to be a valuable tool to determine the object and purpose of the treaty. The significance of OECD Model is 185. Schellekens, supra n. 75, at sec. 2. 186. NL: HR, 28 Oct. 1998, BNB 1999/347. 187. M. Lang, Tax Treaty Interpretation p. 259 (Linde Verlag 2009).

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also recognized in the literature. The OECD Model is considered to be the joint opinion of the parties if the contracting parties are OECD members and the provisions of the treaty are in accordance with an article of the OECD Model.188 Until 1992, the OECD definition of royalty also included fees for the (right of) use of industrial, commercial or scientific equipment. Lease contracts are based on the separation of the ownership of an asset and its usage. The contract legally establishes that the owner of the asset in question is the lessor (leasing company) and the user is the lessee.189 Rental income relating to business assets (including operating lease payments) were thus excluded from the scope of article 7 (business profits) which had no effect, as both articles oblige the state of source to give up taxing rights (apart from the situations where royalties are attributable to a PE. However, if the treaty allows the source state to withhold tax on royalty payments, it would make a difference whether it is regarded as royalty or as business rental income. Tax treaties concluded in accordance with the OECD Model that applied until 1992 may include lease payments as royalties. In this regard, operational lease payments must be distinguished from financial lease payments. The difference is linked to the economic ownership of the asset. If this is with the lessor, it is considered an operational lease. The remuneration paid by the lessee to the lessor will, in the case of real estate, fall under the application of article 6 NSV (Income from real estate). However, if it concerns a movable property, article 12 applies, as is the case in a number of Dutch tax treaties, provided that the treaty is concluded before 1992.190 That definition until then included “payments … for the use, or the right to use, industrial, commercial or scientific equipment”. The Netherlands applies this definition, for example, in its tax treaties with Belarus, Estonia and Venezuela. The Netherlands and the United Kingdom signed the new treaty in 2008, which no longer covers compensation for the use or the right to use industrial, commercial or scientific equipment. This remuneration is, under the new treaty, governed by article 7 (business profits) and therefore exemption in the source state in absence of a PE is continued.

188. Id., at pp. 244-245. Tieskens, De betekenis van het OESO-modelverdrag voro de interpretatie van belastingverdragen, WFR 1999/6368, p. 1757. 189. T. Bender & R. Hamers, Verrekening van bronbelasting op octrooiboxroyaltys, WFR 2009/57. 190. OECD Model Tax Convention on Income and on Capital: Commentary on Article 12 para. 1 (2015).

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Under the current definition of royalties, such fees fall under article 7 if they are attributable to business profits and otherwise under article 21 (other income). In cases where the economic ownership is with the lessee, it is considered as financing and as such the payment is regarded as interest within the meaning of article 11 (interest). The provision of article 12(3) of the OECD Model for the taxation of royalties, which should be allocated to a PE in the other treaty state, applies only with respect to royalties derived from that other treaty state. This provision therefore does not apply to royalties derived from third states. Based on article 7 (business profits), royalties received from third states are taxable in the state of the PE.191

17.4.3. Beneficial ownership and royalties The term “beneficial owner” appears in articles 10, 11 and 12 of the OECD Model. In article 12(1), “beneficial owner” is the condition under which the residence state has the exclusive right of taxation. Given the fact that it is the source state which grants the benefit, this state decides whether the condition has been met. The requirement of beneficial ownership was introduced in article 12(1) in order to clarify how this article applies in relation to payments made to intermediaries. It provides that the fact that the income was paid direct to a resident of a state with which the state of source had concluded a convention does not merely oblige the state of source to give up taxing rights over royalty income. The term “beneficial owner” is therefore not used in a narrow technical sense, rather, it should be understood in its context and in light of the object and purposes of the treaty, including avoiding double taxation and the prevention of fiscal evasion and avoidance. For these reasons, the report from the Committee on Fiscal Affairs entitled Double Taxation Conventions and the Use of Conduit Companies192 provides that a conduit company cannot normally be regarded as the beneficial owner. Also, agents and nominees who are the direct recipient of the royalties are not considered the beneficial owners as that recipient’s right to use and enjoy the royalties is usually constrained by a contractual or legal obligation to pass on the payment received to another person.193 The above explanations concerning the meaning of beneficial owner provided by the OECD Commentary make it clear that the meaning given to 191. Van Raad et al., supra n. 39, at pp. 354-356. 192. Reproduced in vol. II at p. R(6)-1. 193. Para. 1 OECD Model: Commentary on Article 12 (2015).

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this term is only in the context of article 12 and should be distinguished from the different meaning that has been given to that term in the context of other instruments. Given the fact that the OECD Model does not define beneficial owner, its meaning must be established in conformity with article 3(2) of the OECD Model, which provides that in the absence of a definition in the OECD Model, the term must be given the meaning it has under domestic law. In the Netherlands, the term “beneficial owner” has not been introduced for royalty payments as the Netherlands does not levy withholding tax on royalty payments. The term “beneficial owner” – in particular, with respect to dividend distributions – has been clarified to some extent. During the parliamentary discussion on the Korea (Rep.)-Netherlands Income Tax Treaty (1978), attention was paid to this term: The purpose of introducing the term “beneficial owner” is to establish that not every recipient of the income mentioned is entitled to the agreed upon reduction of the tax levied at source by the State in which the debtor is resident, but only the beneficial owner resident in the other Contracting State.194

This statement, however, does not provide a definition.195 During the parliamentary discussion on the Memorandum on Dutch Tax Treaty Policy (1987), which is a second source, the Netherlands took the position that the interested party cannot be considered to be the beneficial owner if, for instance, there is a contractual obligation committed to pay a major part of the income received to third parties.196 The Netherlands applies an economic approach, without any factual/legal restriction, when dealing with the term “beneficial owner”. Consequently, neither a person nor an intermediary can be the “beneficial owner” if the income (or a major part of it) accrues to a third party. Whether the application 194. Nota naar aanleiding van het Verslag (Note on the Report), NRIB, II.B. Verdrag met Korea (Treaty with Korea). During the oral examination of the treaty in the parliament, the Vice-Minister stated: “This term is meant to express the view that the reduction of source tax as provided for in the treaty has to be granted only to residents of the Contracting States who are the beneficial owners of the income concerned” (Nederlandse Regelingen van internationaal belastingrecht (NRIB), II.B. Verdrag met Korea (Treaty with Korea), at 37). This statement, however, does not help much to clarify the term. 195. H. Pijl, The Definition of “Beneficial Owner” under Dutch Law, 54 Bull. Intl, Fiscal Docn. 6, p. 256 (2000). 196. Nota naar aanleiding van het Verslag, supra n. 189, at 123 (question no. 51).

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of the tax treaty is correctly claimed should be assessed on the basis of all facts and circumstances of the case concerned.197 In other words, substance takes precedence over form. As previously mentioned, the Netherlands did not implement a special provision also in view of the I&R Directive with respect to a definition of beneficial ownership. Article 16 of Decree 2001 provides that no credit shall be granted if the taxable person is not the beneficial owner of the dividends, interest or royalties. This article provides who cannot be regarded the beneficial owner: A taxpayer who paid consideration in connection with the received proceeds which forms part of a combination of transactions whereby it is likely that; – an individual or legal entity, directly or indirectly, benefited from part or all of the proceeds and that this individual or legal entity is itself entitled to a less favourable reduction of the Dutch taxes than the recipient of the proceeds; and – this individual or legal entity, directly or indirectly, retains or acquires a position in the shares, profit rights, or comparable with its position in similar rights prior to the occurrence of the combination of transactions.

In Dutch tax literature, there also appears to be a consensus that the application of the beneficial ownership provision should be restricted to “agency” and “nominee” situations. The definition of beneficial ownership in Dutch case law198 – with respect to dividends – is in line with its interpretation by both the OECD Commentary and Dutch tax literature.199

17.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state The Netherlands does not levy withholding taxes on outgoing royalty payments. Therefore, for the Netherlands as a source country, the topic of favourable tax regimes applicable in the resident state of the beneficial owner of the royalties has hardly any relevance. However, as previously mentioned, there is an agreement which provides that a new withholding

197. Id., at 122 (question no. 51). 198. NL: HR, 6 Apr. 1994, BNB 1994/217. 199. E. de Gunst & J.K. Weststrate, Anti-Dividend-Stripping Proposal, 4 Derivs. & Fin. Instrums. 1 (2002), Journals IBFD.

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tax on royalty payments will be introduced in specific cases of abuse (i.e. royalty payments are made to certain low-tax jurisdictions).

17.4.5. Time of taxation When it comes to the question as to when the result is taxable, the way the taxable profit is calculated in the Netherlands, is not the same as how the accounting profit is calculated. Where the latter is calculated under Dutch generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), taxable income is calculated according to the so-called “sound business practice” (goedkoopmansgebruik). Sound business practice is an open norm which implies that there are not a lot of detailed rules. It is up to the tax courts to fill in the norm. The Supreme Court has ruled that what is acceptable for accounting purposes typically should be acceptable for tax purposes (the sound business practice), unless the result would not be in line with a specific provision of the tax legislation or the purpose or a general principle of the tax legislation.200 As regards the terms “paid” and “payment” under article 12(1), the Netherlands considers the OECD Commentary to be a valuable tool. With respect to royalty – as far as known – no further clarification of these terms has been provided by Dutch law or Dutch case law. In the Decree for the Avoidance of Double Taxation under the application of the tax treaties of 2008 (Decree 2008),201 some guidelines are provided for situations as to the moment in which foreign royalties in the Netherlands are included in the taxable base and the moment when taxes are withheld on royalty payments in the other (foreign) country. This situation results in different taxable moments. Decree 2008 provides that this situation occurs if, according to sound business practice, income is taken into account in the Netherlands, whereas the actual payment is carried out later. In such cases, the foreign withholding tax can be credited in the year in which the deemed payment is taken into account in the Netherlands.

200. NL: HR, 8 May 1957, BNB 1957/208. 201. Decree of the State Secretary of Finance, 18 July 2008, no. CPP2007/664M, no. 151.

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17.4.6. Excessive royalty payments Excessive royalties that are not compatible with the arm’s length principle fall under the general Dutch transfer pricing rules. In certain cases, excessive royalties may be reclassified as a constructive dividend. Royalty payments made by a Dutch company or a Dutch PE of a foreign company to a related resident or non-resident company that are not at arm’s length may be recharacterized as a hidden profit distribution or constructive dividend (verkapt dividend). Constructive dividends are regarded as dividend distributions in the hands of the receiving shareholder. This means that if the shareholder is a non-resident company, the distribution is subject to dividend withholding tax, unless the requirements of the (Dutch domestic implementation of the) EU Parent-Subsidiary Directive are met.202

202. M. Schellekens, Netherlands - Corporate Taxation sec. 6.3. et seq., Country Surveys IBFD.

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Chapter 18 Spain by Elizabeth Gil García1

18.1. Introduction on private law aspects of intellectual property (IP) This section identifies private law aspects of IP that are relevant for tax purposes. It is organized into two subsections.

18.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under relevant private law The terms used in the definition of royalties in article 12(2) of the OECD Model have been incorporated in Spain’s domestic tax law and their meaning is based on IP law. It should be noted that IP law encompasses two large IP rights blocks: (i) copyright of literary, artistic or scientific work (so-called “propiedad intelectual”); and (ii) patent, trademark, design or model, plan, secret formula or process, know-how (so-called “propiedad industrial”). Thus, in Spain, under the term “intellectual property”, we distinguish “derechos de propiedad intelectual” and “derechos de propiedad industrial” – both regulated under private law. The terms used in article 12(2) of the OECD Model are therefore employed under domestic private law. Indeed, there is a reference to private law in the tax legislation. As mentioned below (see sections 18.2. and 18.3.), the domestic tax law defines royalties in similar terms as the Directive 2003/49/EC2 in article 13(1)(f) of the Non-Residents Income Tax Law (Ley

1. Assistant Professor, PhD, LLM, Tax Law Department, University of Alicante. The author can be contacted at: [email protected] 2. Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (hereinafter I&R Directive).

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del Impuesto sobre la Renta de no Residentes, LIRNR).3 This provision expressly refers to payments for the use of (or the right to use) rights covered under the Copyright Law (Ley de Propiedad Intelectual, LPI),4 the Patent Law (Ley de Patentes, LP)5 and the Trademark Law (Ley de Marcas, LM).6 In particular, IP rights contained in article 12(2) of the OECD Model can be classified, from the Spanish perspective, as (i) propiedad intelectual and (ii) propiedad industrial.7 On the one hand, the Copyright Law (Ley de Propiedad Intelectual, LPI) is set out in four parts. The first part deals with copyright defined in article 10 as: “all literary, artistic or scientific original creations expressed in any manner or medium, whether tangible or intangible, currently known or which may be invented in the future”.8 This first part of the LPI refers also to cinematographic films (articles 86-94) and computer programs (articles 95-104) as rights protected under copyright. Secondly, under part “De los otros derechos de propiedad intelectual y de la protección ‘sui generis’ de las bases de datos”, some copyright-related rights are included in the LPI (articles 105-137), i.e. phonogram and film producers, broadcasters and databases, among others. On the other hand, propiedad industrial involves patent, trademark, design or model, plan, secret formula or process and know-how. Intangibles such as (a) marks and trade names,9 (b) industrial inventions (including patents and utility models),10 (c) industrial designs (including drawings and

3. ES: Real Decreto Legislativo 5/2004, de 5 de marzo, por el que se aprueba e l texto refundido de la Ley del Impuesto sobre la Renta de no Residentes (Non-Residents Income Tax Law, LIRNR). 4. ES: Real Decreto Legislativo 1/1996, de 12 de abril, por el que se aprueba el texto refundido de la Ley de Propiedad Intelectual, regularizando, aclarando y armonizando las disposiciones legales vigentes sobre la materia (Copyright Law, LPI). 5. ES: Ley 24/2015, de 24 de julio, de Patentes (Patent Law, LP). This Law entered into force on 1 April 2017. 6. ES: Ley 17/2001, de 7 de diciembre, de Marcas (Trademark Law, LM). 7. This classification is relevant for tax purposes as propiedad intelectual is excluded from tax benefits of the Spanish patent box regime (see sec. 18.2.2.). 8. All quotations of Spanish law and regulations are author’s unofficial translations. 9. According to the Spanish Patent and Trademark Office (SPTO), a trademark is a title giving exclusive rights to the use of a name or mark identifying a product or service on the market. On the other side, a trade name is a title that grants the exclusive right to use any mark or name to identify a company involved in trading activity. 10. According to art. 4 of the LP, all inventions can be patented provided they are new as well as they have an inventive step and industrial application, including all fields of technology.

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models)11 and (d) topographies of semiconductor products12 have a specific legal regulation13 as well as access to public registers when certain requirements are met.14 Regarding this type of intangible, the rights awarded by the Spanish Patent and Trademark Office (SPTO)15 have effects in the whole national territory. Furthermore, some intangible assets do not have a specific legal regulation, such as plans, know-how and secret formulas or process. This legal gap could lead to a lower degree of legal certainty. In the case of know-how, it is, in our view, closely linked to patents, as it permits the development of an industrial process with commercial undisclosed information and precisely this use makes the process more valuable in terms of innovation. In Spain, in meeting some requirements, inventions can be patented (article 4 of the LP), but other types of inventions cannot be patented per se or there is no interest in patenting such invention from the perspective of the undertaking company. The problem in relation to know-how is therefore, on the one hand, the lack of a legal definition in the Spanish system and, on the other hand, the difficulties of distinguishing know-how from technical services. Nevertheless, a concept and some protection can be drawn from the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS Agreement). Accordingly, article 39 of the TRIPS Agreement stipulates the protection of undisclosed information (or know-how) when such information (i) is secret, (ii) has a commercial value and (iii) has been subject to reasonable steps to keep it secret. Moreover, for tax purposes, the definition of know-how given by paragraph 11 of the Commentary on Article 12(2) of the OECD Model (2017) applies. Concerning image rights, it should be taken into account that article 18 of the Spanish Constitution has enshrined the personal portrayal as a fundamental

11. The SPTO awards industrial designs that provide legal protection for the creative aspects of innovations. 12. According to the SPTO, rights protecting topographies of semiconductor products are the most recently introduced industrial property category and concern integrated electronic circuits. 13. ES: Ley 20/2003, de 7 de julio, de Protección Jurídica del Diseño Industrial (Law 20/2003, of 7 July 2003, on the Legal Protection of Industrial Design) Design Law) and Ley 11/1988, de 3 de mayo, de protección jurídica de las topografías de los productos semiconductores (Law 11/1988, of 3 May 1988, on the legal protection of topographies of semiconductor products), in addition to the LM and the LP. 14. Access or not to public registers is independent for the eligibility of the incentive according to the administrative practice (see sec. 18.2.2.). 15. SPTO’s official website available at https://www.oepm.es/en/index.html (last accessed 16 Feb. 2018).

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right. Consequently, it has a specific and reinforced legal protection,16 but no specific reference to image rights is contained in the LPI. An image may be registered as a trademark as Article 4(2)(b) of the LM states that trademarks can be, inter alia, pictures, figures, symbols and drawings.

18.1.2. Distinction under private law between alienation of IP and granting the right to use IP In the author’s opinion, the promotion of research and development (R&D) and innovation (together, R&D&I) is not only important, but also the encouragement of knowledge transfer. It is essential that scientific activities carried out by research operators “go beyond the walls of the laboratory” and benefit the society as a whole. Traditionally, the activity of transfer has been related to IP rights, i.e. the transfer of technology.17 According to the judgement of the Supreme Court (Tribunal Supremo, TS) of 21 June 2007, technology can be introduced through different ways, such as the transfer of patented knowledge, the transfer of non-patented knowledge related to industrial activities (i.e. know-how), the provision of technical assistance, agreements on R&D expenses and the transfer of technology by means of global agreements. In the view of the decision of the Central Economic Administrative Court (Tribunal Económico Administrativo Central, TEAC) of 23 October 1998, this type of operations implies a remuneration, i.e. a single payment or periodic payments. In general terms, such transfer will take the form of a licence contract (royalties) or of a transfer (or assignment) contract (capital gains). It should be noted that the Spanish tax legislation differs from terms used by the private law. The term “cesión de uso” (granting of the right to use the IP) is used instead of “licencia” (licence), and “transmisión” is used when referring to the transfer of the full ownership of the IP.18

16. ES: Ley Orgánica 1/1982, de 5 de mayo, sobre protección civil del derecho al honor, a la intimidad personal y familiar y a la propia imagen (Organic Law 1/1982, of 5 May 1982, on civil protection of the right to honour, personal and family privacy and to one’s own image). 17. There is no doubt of the relevance of IP; however, technology is not the only field of knowledge for which transfer is considered important in terms of the social, economic and cultural development. There are other useful forms of transfer than those requiring strong IP protection. 18. A. Navarro Faure, Los contratos de licencia de patentes: Aspectos tributarios, in Contratos Civiles, Mercantiles, Públicos, Laborales e Internacionales, con sus implicaciones tributarias p. 195 (vol. XIII, Y. Tolsada ed., Thomson Reuters 2014).

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Patents (article 82(1) of the LP), trademarks (article 46(2) of the LM) and industrial designs (article 59(1) of the Design Law) may be transferred and can be a matter for other rights in rem, licences, other legal transactions, etc. Spanish private law therefore recognizes both the IP alienation and the IP licence.19 The granting of the right to use the IP has specific provisions in the industrial property legislation. In case of the licence (total/partial and exclusive/non-exclusive based on article 83 of the LP), the licensor (the owner of the patent right) authorizes a third person (the licensee) to exploit the patent (or the patent request), receiving a remuneration (licence fee). In similar terms, article 48 of the LM stipulates that the licensing of a trademark – and of the trademark request – may be granted for the whole or partial national territory. Licences may be exclusive or non-exclusive. Finally, the licensing of an industrial design – and its request – may apply in the whole or partial national territory, for all or some of the powers involving the exclusive right, and for all or part of its applications (article 60(1) of the Design Law). Licences may be exclusive or non-exclusive (article 60(2) of the Design Law). As mentioned above, certain intangibles, such as plans, know-how and secret formulas or processes do not have a specific legislation. However, these intangibles, which are considered industrial property, may also be transferred. Indeed, the Supreme Court has established the possibility to transfer non-patented knowledge related to industrial activities. In these cases, circumstances for the alienation or licence will be based on the agreements reached among the contract parties. A priori, the private meaning of ownership of IP is based on legal ownership. Indeed, the ownership of patents, trademarks and industrial designs is based on the registration. Thus, the person holding the right awarded by the corresponding office (i.e. the SPTO) may exercise all legal actions related to the IP.

18.2. Taxation of IP under the domestic tax law This part focuses on the application of income tax to profits arising from the exploitation of IP in the light of the Spanish tax legislation. Section 18.2.1. refers to the definition of royalties under the Spanish domestic tax legislation. Section 18.2.2. focuses on the qualification of income deriving 19. The terms and conditions for the transfer of technology will obviously depend on the type of intangible.

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from IP (section 18.2.2.1.) and tax regimes applicable to IP income (section 18.2.2.2.). Section 18.2.3. examines tax rules regarding IP income derived by non-resident taxpayers. Lastly, section 18.2.4. deals with the attribution of IP income to taxpayers under controlled foreign company (CFC) legislation. It should be noted that IP in Spain does not have a specific tax regulation. In consequence, an analysis of the entire Spanish tax system is required.20

18.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP The domestic tax law definition of royalties is mainly contained in the LIRNR, which refers to income obtained in Spain as source state. In particular, article 13(1) (f) of the LIRNR states that “royalties” means: [P]ayments of any kind received as a consideration for the use of, or the right to use: any copyright of literary, artistic or scientific work including cinematograph films; patents, trademarks, drawings or models, plans, secret formula or processes; computer software; information concerning industrial, commercial or scientific experience; personal rights such as image rights; industrial, commercial or scientific equipment; any similar right.

The definition of royalties is in general terms in line with article 2(b) of the Interest and Royalty Directive (I&R Directive). Unlike the definition provided in article 12(2) of the OECD Model, Spanish tax legislation has extended the term “royalties” to payments for the use of, or the right to use, software, on the one hand, and industrial, commercial or scientific equipment, on the other hand.21 As stated in section 18.1.1., Spanish domestic tax law does not provide an autonomous concept of IP categories covered under the royalties concept. Article 13(1)(f) of the LIRNR explicitly refers to the private law meanings, i.e. LPI, LP or LM.

20. M. Nuñez Grañón, Los contratos de cesión de patentes: Aspectos tributarios, in Contratos Civiles, Mercantiles, Públicos, Laborales e Internacionales, supra n. 18, at p. 152. Previously in A. Navarro Faure, Los gastos deducibles derivados de la propiedad intelectual e industrial, Crónica Tributaria: Boletín de Actualidad. 6 (2012) and in A. Navarro Faure, El régimen jurídico-tributario de la propiedad industrial en España, Revista Técnica Tributaria 58 (2002). 21. The former LIRNR (ES: Ley 46/2002, de 18 de diciembre) did not include such reference under the meaning of royalties.

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18.2.2. Qualification of income deriving from IP and applicable tax regimes This section is divided into two parts: section 18.2.2.1. refers to the qualification of income deriving from IP; section 18.2.2.2. analyses the IP box regime introduced in Spain in 2007.

18.2.2.1. Qualification of income deriving from IP Income arising from IP may qualify under different income categories in regard of diverse elements. At the individual tax level, IP income qualifies as (i) employment income, (ii) business income or (iii) investment income. Indeed, royalties fall under income from capital when the taxpayer is not the author of the underlying intellectual or industrial work (article 25(4)(a) of the Individual Income Tax Law (Ley del Impuesto sobre la Renta de las Personas Físicas, LIRPF).22 It should be noted, however, that if the taxpayer is the author of the IP, the royalties received are treated as business income and must then be reported and computed under this category (article 27 et seq. of the LIRPF). However, if the rights of exploitation of the IP are assigned to a third party, the remuneration received is deemed to be employment income (article 17(2)(d) of the LIRPF). On the one hand, income from employment comprises any emoluments, consideration or benefits in cash or in kind which arise directly or indirectly from the rendering of dependent services by the taxpayer and which do not constitute business or professional income (article 17(1) of the LIRPF). Article 17(2)(d) of the LIRPF enumerates certain items which qualify as employment income: “Income derived from literary, artistic or scientific work provided that the right of exploitation has been assigned.” For example, a researcher in EU tax law has written a book on State aid rules. He has assigned the rights of exploitation of this scientific work (which is covered under the LPI) to the publisher ABC, so the income received under the royalties concept will be included as employment income in his tax return.

22. ES: Ley 35/2006, de 28 de noviembre, del Impuesto sobre la Renta de las Personas Físicas (Individual Income Tax Law, LIRPF).

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On the other hand, business income (which encompasses both income from entrepreneurial activities and income from professional activities) is defined as the result of the economic activities of a taxpayer aimed directly at the production or distribution of goods or services (article 27(1) of the LIRPF). In particular, it includes, inter alia, the exercise of professional and independent artistic or athletic activities. According to article 95(2)(b) of the Individual Income Tax Regulation (Reglamento del Impuesto sobre la Renta de las Personas Físicas, RIRPF),23 income from professional activities comprises income obtained by “[t]he authors or translators of works resulting from intellectual or industrial property. In case the author or the translator directly publishes the work, the remuneration received is deemed to be income from entrepreneurial activities.” In this regard, the General Directorate of Taxes (DGT) states that in the case of a taxpayer involved in the performance of their own documentary films, the remuneration received falls under business and professional income (DGT ruling No. V1199-07). The DGT deals with the qualification of income deriving from IP in the case of a taxpayer who has published a novel. The DGT explains that the assignment of copyright, as profits arising from the IP, may be regarded either as employment income or as business and professional income for individual tax purposes. That is to say, the author may include the remuneration received as employment income (based on article 17(2) (d) of the LIRPF) or as business/professional income (based on article 95(2) (b) of the RIRPF) in his tax return. However, it should be noted that article 17(3) of the LIRPF highlights that if income referred to in article 17(2)(d) of the LIRPF arises from an economic activity of the taxpayer aimed directly at the production or distribution of goods or services, it will be regarded as business/professional income. Thus, the DGT states that the remuneration the author of the novel receives will qualify as employment income unless the literary work had been developed in the frame of a professional activity, being therefore considered as business/professional income (DGT ruling No. V1300-17). Obviously, the different qualification of income deriving from IP implies a diverse treatment for individual tax purposes. In case IP income qualifies 23. ES: Real Decreto 439/2007, de 30 de marzo, por el que se aprueba el Reglamento del Impuesto sobre la Renta de las Personas Físicas y se modifica el Reglamento de Planes y Fondos de Pensiones, aprobado por Real Decreto 304/2004, de 20 de febrero (Individual Income Tax Regulation, RIRPF).

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as employment income, article 17 et seq. of the LIRPF sets out the rules for computation. In case IP income qualifies as business/professional income, it is computed according to the rules that apply to entities (i.e. corporate income tax legislation). In practice, there are different methods for income computation: (i) normal direct method (article 30 of the LIRPF); (ii) simplified direct method (article 30 of the LIRPF) and (iii) special computation regime or “a forfait” method (article 31 of the LIRPF). Lastly, article 25 of the LIRPF refers to income from movable capital (i.e. investment income). Income from movable capital comprises any returns or consideration arising directly or indirectly from assets, property or rights which are held by the taxpayer and which are not part of the taxpayer’s business or professional activity. In case the full ownership of such assets, property or rights is transferred, the income received will qualify as capital gains (or losses) (article 33 et seq. of the LIRPF). Article 25(4) of the LIRPF enumerates certain items regarded as “other income from movable capital”. In particular, (a) income derived from intellectual property [i.e. copyright of literary, artistic or scientific work] when the taxpayer is not the author and income derived from industrial property [i.e. patent, industrial design] where not attached to the exercise of an economic activity; (b) income resulting from technical assistance unless the service is rendered by an entrepreneur in the course of business; (c) income from the leasing of movable property, business and mines where not attached to the exercise of an economic activity; and (d) income from the assignment of the right to use the image unless such the image is assigned in the frame of an economic activity. Accordingly, royalties attached to intellectual or industrial works if the taxpayer is not the author qualify as investment income (article 25(4)(a) of the LIRPF). As mentioned, if the full ownership of the IP is transferred, the income will qualify as capital gains (or losses). Royalty income – as income from movable capital – is subject to a 19% withholding (standard) tax. On the other side, income derived under article 25(4)(b) and (c) of the LIRPF is also taxed at 19% (article 101(9) of the LIRPF), while income from the assignment of the right to use the image is taxed at 24% (article 101(10) of the LIRPF) (see Table 18.1.).

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Table 18.1.  Qualification of individual income derived from IP Income category

Regulation

Qualification of IP income

Employment income

Arts. 17-20 LIRPF

The remuneration the author of the IP receives for the assignment of the rights of exploitation of the IP (i.e. a third party carries out the economic activity) Royalty income derived General income from IP when the taxpayer is not the author The fee the author of the IP General income receives when carrying out an economic activity (i.e. direct exploitation of the IP)

Income from Arts. 25-26 movable capital LIRPF Business and professional income

Arts. 27-32 LIRPF

Kind of income: general/savings income General income

At the corporate tax level, the qualification of income deriving from IP is based on the distinction between payments for the granting of the right to use the IP (licence fee or royalty income) and payments for the transfer of the full ownership of the IP (transfer fee or capital gains). Actually, this difference is made in article 23 of the Corporate Income Tax Law (Ley del Impuesto sobre Sociedades, LIS)24 when defining the IP box regime (see section 18.2.2.2.). Royalties are subject to a 19% withholding (general) tax (article 128(6)(a) of the LIS). Income derived from the use or exploitation of image rights is subject to a 24% rate (article 128(6)(b) of the LIS). Capital gains are generally treated as ordinary income subject to the 25% (standard) rate.

18.2.2.2. Tax regime applicable to IP income In 2007, Spain introduced a patent box regime under the formula of an allowance in the corporate tax base, taking full effect in January 2008.25 The introduction of such regime in article 23 of the LIS26 interacts with the traditional research, development and innovation (R&D&I) tax credits. 24. ES: Ley 27/2014, de 27 de noviembre, del Impuesto sobre Sociedades (Corporate Income Tax Law, LIS). 25. ES: Ley 16/2007, de 4 de julio, de reforma y adaptación de la legislación mercantil en materia contable para su armonización internacional con base en la normativa de la Unión Europea. 26. In this context, it should be noted that in Spain, together with the common system of the corporate income tax, there are certain regions, i.e. Guipúzcoa, Vizcaya, Álava and

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Taxation of IP under the domestic tax law

Thus, tax incentives not only apply to R&D&I activities (input) but also benefit R&D&I results (output). In other words, tax expenditure is extended to R&D&I intangibles, covering the whole R&D&I process (“from the idea to the market”).27 The regime was introduced with the purpose to foster innovative activities within the business sector, to promote the internationalization of firms and to reduce the technological dependency of enterprises. With the purpose to turn the regime into a more attractive scheme for innovation, the Encourage Entrepreneurs Law changed its design in September 2013.28 Finally, the General State Budget for 2016 (Law 48/2015 of 29 October 2015) amended the patent box regime in order to be in line with the agreements adopted within the European Union and the OECD. This new regime takes full effect since July 2016. For the purpose of analysing the Spanish patent box regime, this section is organized into three parts: (i) qualifying taxpayers, (ii) eligible IP assets and (iii) the IP box base. 18.2.2.2.1.  Qualifying taxpayers for the patent box regime All types of companies in Spain may apply for the patent box regime. Indeed, article 23 of the LIS regulates a tax allowance open to all firms that fulfil certain conditions established in such provision. Thus, it is an “open access” incentive as all taxpayers who are subject to the LIS may have access to the regime. This preferential tax treatment implies a deviation from the general rules of corporate taxation. However, this tax advantage does not have the consideration of a selective measure as all corporate taxpayers may benefit from this incentive, regardless of the size, legal form or business sector. The European Commission thereby considered that the Navarra, with their own regional “fueros” (laws). In effect, these regions have their own corporate income tax and therefore their own IP box regimes. 27. This broad scope could be debatable in light of the tax fairness principles enshrined in art. 31 of the Constitution. The existence of input and output incentives implies an additional motivation for the firm to invest in R&D&I, as well as to exploit IP rights, but it may lead to a loss of public revenue. 28. ES: Ley 14/2013, de 27 de septiembre, de apoyo a los emprendedores y su internacionalización; particularly, art. 26 of this Law amended art. 23 of the LIS. No IP box regime is granted to individual taxpayers. The Encourage Entrepreneurs Law with the purpose to foster the so-called “business angels” or private investors, has established special measures at the IRPF level. In particular, art. 68(1) of the LIRPF grants a tax deduction for investing in new firms and art. 38(2) of the LIRPF exempts capital gains when reinvesting. For further information in this regard, see Y. Martínez Muñoz, El tratamiento fiscal del crowdfunding, Quincena Fiscal 14, pp. 78-83 (2015) and A. Ribes, Reflexiones críticas sobre el tratamiento fiscal de los inversores de proximidad o Business Angels, Quincena Fiscal 14 (2014).

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Spanish patent box does not fall into the scope of article 107(1) of the Treaty on the Functioning of the European Union (TFEU).29 Additionally, also taken into account are non-resident entities obtaining income in Spain through a permanent establishment (PE) (article 5 of the LIRNR) whose tax base is determined following the rules of the LIS. Moreover, the patent box regime applies to group companies. In this line, the Encourage Entrepreneurs Law introduced in article 23(4) of the former LIS30 the obligation for entities in a tax consolidation system to document all the transactions associated with the application of the IP box regime (according to transfer pricing rules). However, the current LIS has abolished such provision. Thus, the question is whether this obligation is abolished or is implicitly required. Qualifying taxpayers of the Spanish patent box regime are in line with the guidelines stated in the Final Report of BEPS Action 5. Nevertheless, in terms of an equal treatment, self-employed workers do not apply in practice to the IP box. Indeed, they do not have the consideration of taxpayers for corporate tax purposes, unless they carry out their economic activities under the scheme of a legal entity. Hence, individual entrepreneurs are subject to the IRPF (individual income tax) and, without the condition of corporate taxpayers, they are not able to benefit from the regime of article 23 of the LIS. However, the LIRPF states that individual entrepreneurs may apply to the “estimación directa” method, instead of the “a forfait” method, for the calculation of the tax base (article 30 of the LIRPF).31 This means that the amount of net profits will be calculated according to the provisions of the LIS. Thus, in that case, self-employed workers may have access to the patent box regime. 29. According to the Ninth Additional Provision of the LIS, the effective application of the patent box was subordinated to its compatibility with EU law. The Commission agreed its compatibility in February 2008: European Commission, State Aid Cases: N 480/2007 The reduction of tax from intangible assets (Brussels, 13 Feb. 2008), OJ C80 (2008); the EC’s decision is available at http://ec.europa.eu/competition/state_aid/ cases/221657/221657_784713_9_1.pdf (last accessed 16 Feb. 2018). 30. ES: Real Decreto Legislativo 4/2004, de 5 de marzo, por el que se aprueba el Texto Refundido de la Ley del Impuesto sobre Sociedades. 31. According to art. 30.1 of the LIRPF, in general terms, the method for the calculation of the tax base in regard of the net business income is the “estimación directa” method. Art. 31 of the LIRPF provides with “a forfait” method in regard of certain types of activities. In practice, a high number of individual entrepreneurs apply this method. The criteria for applying one or another method depends on the trade volume and the kind of activities performed. Hence, the “estimación directa” method is compulsory for those individual entrepreneurs who cannot apply the “a forfait” method or for those who, fulfilling the requirements, opt for it.

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Consequently, article 23 of the LIS provides for a tax allowance that is open to all taxpayers that meet four requirements. First, the assignee or the recipient of the IP asset must use the asset or the IP rights in the development of an economic activity. The results of this use must not involve the delivery of goods of the provision of services that implies deductible expenses for the assignor entity, when both are related parties. Second, the assignee or the recipient of the IP asset must not be resident in a tax haven, unless such residence is located in the European Union and the user can demonstrate that there are valid economic reasons underlying the transaction. Third, if the licence contract includes the provision of other services, i.e. technical services, it is necessary to differentiate between such services and the main transaction. Lastly, it is necessary to maintain accounting records that permit the determination of the relevant income and expenses from the licence or transfer of the IP asset.32 18.2.2.2.2.  Eligible IP assets for the patent box regime Article 23 of the LIS defines the scope of IP in respect of the patent box regime from a positive and a negative perspective. That is, the law not only refers to the eligible IP assets, but also expressly excludes those assets which, in spite of their high creative value, do not benefit from the patent box regime. From a positive perspective, the patent box regime is available in respect of patents, industrial designs (including drawings or models) and plans33 (article 23(1) of the LIS). This kind of IP assets may have access to public registers and its protection is covered by different IP laws.34 However, such access is independent for the eligibility of the incentive according to the administrative practice (DGT ruling No. V1881-12). Article 23(1) of the LIS, in fine, refers to “secret formulas or processes” and “undisclosed information with industrial, commercial or scientific value”, i.e. know-how, as forming part of the scope of IP for the patent box regime. The issue related to know-how is, as mentioned (see section 18.1.1.), the lack of a legal definition in the Spanish system as well as the difficulties of distinguishing know-how from technical services. Contracts of technical services are not covered by article 23 of the LIS (DGT ruling No. 32. Together with these conditions, the former patent box regime also required that, at least, the undertaking had created the assets or the IP rights in respect of 25% of the cost. This requirement has been abolished in respect of the new patent box regime. 33. Plans are not covered by any specific legislation. Plans may be covered under the LPI, but it should be noted that according to art. 23(5) of the LIS, copyright of literary, artistic or scientific work are not eligible for the patent box regime. 34. See sec. 18.1.1.

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V0532-14). In fact, article 23(1)(d) of the LIS states that it is necessary to differentiate between such services (i.e. technical assistance) and the main transaction (i.e. the know-how). A relevant point in the light of the legal certainty is the different levels of clarity depending on every eligible IP asset. The fact that patents and industrial designs have their own legal system and scope of protection provided by specific IP laws provides taxpayers with more certainty for applying the patent box of article 23 of the LIS. On the other side, the lack of specific regulation and even the absence of a concept in the Spanish system for know-how imply that taxpayers are placed in an area of uncertainty in regards of whether the commercial undisclosed information may be eligible for the patent box regime. Plans, which do not either have a specific regulation, can be classified as know-how if certain requirements are met. Such uncertainty is in evidence when the more recent tax rulings issued by the DGT tackle the application of article 23 of the LIS to know-how.35 According to the DGT, as there is no concept of intangibles for tax purposes, the criteria for accounting purposes are applicable (DGT rulings No. V171413, No. V1153-14 and No. V0522-15). Therefore, if formulas, designs and know-how fulfil such criteria, they are eligible for the patent box regime (DGT rulings No. V1714-13 and No. V0522-15). Spanish administrative practice has also accepted, inter alia, the following three items as falling within the scope of IP: (i) algorithms created by a company in undertaking the R&D&I process; (ii) related know-how and (iii) a new treatment in respect of an illness. From a negative perspective, article 23(5) of the LIS explicitly excludes the following six items from the application of the patent box regarding the transfer or licence of: (i) trademarks; (ii) literary, artistic or scientific works; (iii) industrial equipment; (iv) image rights; (v) computer programs and (vi) other items not included in article 23(1) of the LIS. In this way, the tax benefits of the patent box regime are not conferred to income resulting from the use of trademarks, trade names and other signs, and the manufacturing and provision of franchisee goods (DGT ruling No. V0510-15). Income derived from moulds can neither enjoy the IP box regime as they are considered as tangible fixed assets (DGT ruling No. V3309-13). According to article 23(5) of the LIS, software is also excluded from the regime unless it can be considered as know-how. In this sense, the DGT analyses the case where an 35. See, inter alia, the tax rulings issued by the DGT: No. V2788-15 (25 Sept. 2015); No. V2002-15 (26 June 2015); No. V1368-15 (29 Apr. 2015); No. V0522-15 (9 Feb. 2015); No. V0510-15 (9 Feb. 2015).

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entity has developed a technological tool for reducing the cost of the management of information and communication technology (ICT) systems as well as for increasing the capability of technology management. The DGT takes into account the concept of know-how given by the Supreme Court and, in particular, by paragraph 14(3) of the Commentary on Article 12(2) of the OECD Model (2017). Accordingly: [I]nformation about the ideas and principles underlying the program, such as logic, algorithms or programming languages or techniques … may be characterised as royalties to the extent that they represent consideration for the use of, or the right to use, secret formulas or for information concerning industrial, commercial or scientific experience which cannot be separately copyrighted.

The DGT therefore considers that such IP may enjoy the tax benefits granted by article 23 of the LIS if it is based on the “ideas and principles underlying the program” (DGT ruling No. V1080-16). On the other hand, in regard to pre-existing IP, article 23 of the LIS does not make any reference to such category. The author agrees with Alonso Murillo that pre-existing IP is not excluded from the regime, and not even the gradual implementation of the tax incentive was established.36 As a result, the scope of IP in respect of the patent box regime can be regarded as having adopted a “narrow approach”, as it covers trade intangibles and expressly excludes marketing intangibles. Administrative practice also indicates certain other kinds of categories, i.e. algorithms, that, even though they are not specifically patents or similar IP assets, are “functionally equivalent” to patents in terms of their effect on innovation, i.e. technical improvements in industrial processes, social benefits, etc. Moreover, this a priori narrow approach scope is broadened, in some cases, due to the interpretations made by the administrative practice, i.e. the consideration of software – which, in principle, is excluded – as know-how when certain requirements are met. In the opinion of Sanz Gadea, the scope of IP in respect of the patent box regime is broader than IP assets created in undertaking R&D&I activities in terms of the R&D&I tax credits of article 35 of the LIS. At the same time, the scope is narrower than that set out in article 12 of the OECD Model (2017).37

36. F. Alonso Murillo, Spain, in Tax incentives on Research and Development (R&D) p. 695 (IFA Cahiers vol. 100A, 2015), Online Books IBFD. 37. E. Sanz Gadea, El impuesto sobre sociedades en 2013 (III), Incentivos Fiscales, Revista Contabilidad y Tributación 375, p. 10 (2014).

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The selection of the eligible IP categories may be relevant to EU law. If the set of IP assets and kinds of income that are eligible for the IP box regime were too narrow, the tax benefit would be at risk of qualifying as unlawful State aid,38 as the incentive would exclude certain businesses or economic activities. Despite this consideration, in our view, the objective scope of the regime should be restricted to those R&D&I intangibles that imply a scientific improvement and a benefit for the society as a whole (i.e. patents and other similar rights), being this narrow approach justified in the nonfiscal goal pursued. Indeed, in Spain, the R&D&I promotion is considered a constitutional value enshrined in article 44 of the Constitution. 18.2.2.2.3.  Calculation of the IP box base As mentioned earlier, Spain introduced a patent box regime in 2007 by way of an allowance in the corporate tax base, with full effect from January 2008. In September 2013, the patent box regime was extended to encompass income derived from the transfer (or assignment) of IP. Consequently, both royalties arising from the IP licence and capital gains derived from the sale of intangibles may qualify for the patent box regime of article 23 of the LIS. In this respect, it should be noted that, in both cases, the income to be included in the base for the patent box regime is the net income and not the gross income (article 23(3) of the LIS). On the one hand, royalties do not include “embedded royalties”.39 On the other hand, the benefits of the patent box regime apply to income derived from the transfer of the IP when a transaction is not between related parties. In this way, capital gains derived from a contract in respect of the sale of a patent between related entities do not benefit from the patent box regime. In contrast, with regard to a licence contract between related parties, royalties resulting from such transaction qualify for the patent box regime. Despite this, the Spanish transfer pricing rules may apply in cases where the income is received from related parties. It should be noted that in these cases, i.e. IP licences between companies of the same group, there is a similar scenario to “embedded royalties”. For example, Company A1 licenses a patent to Company A2, being related parties within the same business group. Company A1 may apply the patent box regime in regard of the royalties paid by Company A2 for the direct use of the patent. 38. R. Sanz-Gómez, The OECD’s Nexus Approach to IP Boxes: A European Union Law Perspective, WU International Taxation Research Paper Series, No. 12, p. 14 (2015). 39. Alonso Murillo points that the Spanish patent box regime “has never been applicable to ‘embedded royalties’, and the current legal regime does not subject it to a quantitative limit” (Alonso Murillo, supra n. 36, at p. 694).

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Taxation of IP under the domestic tax law

With regard to the determination of the base for the patent box regime, income generated by the IP benefits from a tax allowance at the tax base level. The following formula applies: 60% × Direct expenditure related to creation of IP (increased by 30%) ÷ Overall expenditure related to creation of IP

In the same vein as the Final Report of BEPS Action 5,40 under this formula, the numerator is integrated with regard to the qualifying expenditure, which is defined as the expenditure directly related to the creation of the IP. In particular, this includes R&D&I expenditure incurred by a taxpayer itself and expenditure in respect of unrelated-party outsourcing. In contrast, the denominator is integrated with regard to the overall expenditure, which includes both of the categories previously referred to, as well as acquisition costs and expenditure in respect of related-party outsourcing. In no circumstances can financial expenses, depreciation in respect of fixed assets and other expenses that are not associated with the creation of the IP be included in the formula. As a result, taxpayers can only benefit from the patent box regime to the extent that they themselves have incurred the qualifying R&D&I expenditure in respect of deriving the IP income. With regard to qualifying expenditure in the formula, i.e. the numerator, the Spanish legislator has decided in favour of increasing qualifying expenditure up to 30% where such expenditure does not exceed the overall expenditure. Following the OECD’s nexus approach, the Spanish formula is intended to benefit taxpayers that undertake R&D&I activities themselves, but do not penalize taxpayers excessively for acquiring the IP or outsourcing R&D&I activities to related parties (see Table 18.2.). This is probably because such taxpayers may themselves still be responsible for much of the value-creation activities. Obviously, the tax benefit would not have been as generous had the taxpayer itself undertaken the R&D&I. Table 18.2.  The IP box base Factor Qualifying expenditure (× 1.3) Related-party outsourcing Acquisition costs Overall expenditure Ratio (%)

Company 1 200 (260) 70 30 300 86.67

Company 2 100 (130) 100 20 220 59.09

40. OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, p. 24 et seq. (2015).

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Factor Allowance (%) IP income (receiving benefits) Base incentive

Company 1 52.00 500 260

Company 2 35.45 500 177.25

Concerning the application of the patent box regime, agreements between taxpayers and tax authorities may have relevance for determining significant aspects of the regime. These agreements, i.e. advance pricing agreements (APAs), may lead to legal certainty as the taxpayer will know the terms for applying the regime, but they may also have influence on elusive tax practices. This type of agreement may imply the conferment of an economic advantage which may fall into the scope of article 107 of the TFEU (ex. article 87 of the EC Treaty). That is to say, the conferment of tax benefits granted by an IP regime may severely distort competition within the internal market and contravene State aid rules. In contrast, if they only confirm the application of the law, there is no risk of tax elusive practice.41 Therefore, the automatic exchange of this type of agreement (proposed in the Final Report of BEPS Action 5) is essential for monitoring agreements (or ­rulings) which may distort competition. The relevant legislation of the Spanish IP box includes a mention regarding the different ways to provide undertakings with legal certainty. Since the amendments introduced by the Encourage Entrepreneurs Law into the patent box regime, the legal certainty is guaranteed by the possibility to request an APA from the tax administration relating to the income earned in respect of the licence or the transfer of the IP, and to the expenses so generated. According to article 23(6) of the LIS, the request should be accompanied by “a proposed valuation, based on the market value”. The request form should include a description of the corresponding IP asset (article 39(2) of the Regulation of the Corporate Income Tax (RIS).42 Once the application is submitted, the tax authorities will examine it and they can request, inter alia, data, reports and receipts related to the proposed valuation (article 40(1) of the RIS). During the procedure, a reasoned report to the DGT in regard of the assessment of the IP will be requested. An opinion of the Ministry of 41. In our view, rulings are not per se an issue under State aid rules if they are restricted to confirm the application of the law. The decision of the Commission to classify this type of individual rulings (i.e. FIAT case, Starbucks case, Apple case, McDonald’s case, among others) under State aid rules is based on the objective of protecting free competition in the internal market. Nevertheless, it should be highlighted that tax rulings are intended to provide transactions with legal certainty. Given the investigation, these transactions might now need to be altered. 42. ES: Real Decreto 634/2015, de 10 de julio, por el que se aprueba el Reglamento del Impuesto sobre Sociedades (Regulation of the Corporate Income Tax, RIS).

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Taxation of IP under the domestic tax law

Economy may also be requested (article 40(2) of the RIS). The procedure should end within a period of 6 months (article 41(6) of the RIS). The resulting APA will have binding effect during its period of validity. Moreover, according to article 88 of the General Tax Act (LGT),43 taxpayers (i.e. those performing innovative processes) may request tax consultations or tax rulings regarding the interpretation and application of the tax legislation, i.e. the patent box regime. Such consultations or rulings have binding effect on the tax administration (article 89 of the LGT). The tax ruling has only informative character (article 89(4) of the LGT),44 but if taxpayer follows that ruling, he will not be subject to any penalty according to article 179 of the LGT. This extends to other taxpayers, because all tax rulings are binding not only for the one requesting the ruling, but also for other taxpayers in the same factual situation. The Spanish patent box is therefore compliant with international standards and is even more restrictive than the OECD’s nexus approach because it limits the IP scope and ratio. It does raise the question, however, as to whether this is the best regime for Spanish companies in terms of competitiveness.

18.2.3. Tax treatment of income from IP derived by nonresident taxpayers As explained in section 18.2.1., the LIRNR refers to income obtained in Spain as source state. For determining the non-resident’s income, the law distinguishes whether income has been obtained through a PE. In case income is obtained by a Spanish PE of a non-resident entity (articles 16-23 of the LIRNR), some tax provisions of the LIS should be taken into account. In regards to income obtained by non-residents without a PE (articles 24-33 of the LIRNR), some tax provisions of the LIRPF should be taken into account. Article 25 of the LIRNR provides the withholding tax rates. Accordingly, royalties paid to a non-resident (whether a company or an individual) are subject to a 24% withholding (standard) tax, unless the rate is reduced under 43. ES: Ley 58/2003, de 17 de diciembre, General Tributaria (General Tax Act, LGT). 44. Arts. 88 and 89 of the LGT allow taxpayers to request tax rulings (consultas tributarias) from the tax administration about the application of tax law in regards of the regime, the classification or the tax category. Hence, in this sense, tax rulings are a taxpayer’s instrument to be provided by tax authorities with the necessary assistance and information to fulfil their tax obligations. Consequently, the tax ruling is not an agreement between the tax administration and a taxpayer, being published on the “open access” database of the DGT. This means that the taxpayer cannot negotiate with tax authorities the conferment of a preferential tax treatment.

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a tax treaty or royalties qualify for an exemption under the I&R Directive (see section 18.3.2.). Moreover, a 19% withholding tax rate applies if the recipient is a resident in the European Union or European Economic Area (EEA) and if the country of residence of the recipient effectively exchanges tax information with Spain.

18.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules CFC rules are regulated in article 100 of the LIS with the purpose to include certain items of income in the tax base of the Spanish parent company where the following two conditions are met: (i) in case of the Spanish entity, the taxpayer itself, or together with its related parties, holds a direct or indirect participation of more than 50% of the capital, own funds, results or voting rights of the non-resident entity at the end of the financial year (of such non-resident entity) and (ii) the actual corporate tax paid on its profits by the non-resident entity is lower than 75% of the corporate tax that would have been charged on such entity under the LIS. CFC legislation distinguishes two levels for the purpose of determining the income that should be attributed. In the first level, the taxpayer will include in the tax base the total amount of the CFC income unless the non-resident entity has employees and facilities for earning the actual income. Thus, the CFC regime does not apply when the taxpayer proves that (i) the activities and transactions are carried out with the employees and facilities of the non-resident entity or (ii) there is a valid economic reason underlying the creation and business running of the entity. In the second level, CFC income will be included in the tax base of the parent company if conditions of the first level are not met. This second level is associated with certain categories of income.45 Article 100(3)(d) of the LIS provides that income arising from IP, technical assistance, movable property, image rights and leasing (or subleasing) of business or mines will be included in the tax base. As a matter of fact, not all CFC income should be attributed under CFC rules. In some cases, the establishing of non-resident affiliates can be based on business reasons, i.e. the availability of employees, nature resources, etc. Consequently, income that arises from economic and value-creating 45. In the corporate tax reform implemented at the end of 2014, cases of income attributed under the CFC legislation have increased following the recommendations of BEPS Action 3; thus, no amendments are expected in this regard.

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Taxation of IP under the domestic tax law

activities should be excluded from the scope of CFC rules. Royalties and IP income could be used to transfer purely passive income, i.e. income that does not arise from any substantial economic activity. However, IP-derived income does not always address base erosion and profit shifting concerns. In this regard, BEPS Action 3 provides a specific option for IP provisions related to the different ways that a jurisdiction may design a substance analysis. In this way, the IP income earned by a CFC that satisfied the requirements of the nexus approach would not be attributed as CFC income. Thus, if the taxpayer can demonstrate that income would qualify for benefits under a nexus-compliant IP regime in the CFC jurisdiction, such IP income should not be attributed or subject to the CFC rules. Article 100 of the LIS was amended in the 2014 corporate tax reform to be in line with BEPS Action 3. The new CFC regime has been extended to cover the benefits generated by the exploitation of the IP (article 100(3)(d) of the LIS). This is intended to attract R&D&I centres to Spain.46 Consequently, IP income generated by a Spanish subsidiary, i.e. the controlled party, located in a low-tax jurisdiction is taxed in Spain under CFC rules. According to this scenario, the IP income generated by a company located in Spain benefits from the patent box regime if it fulfils the requirements set out in article 23 of the LIS, but the IP income generated by a Spanish company under a preferential tax treatment abroad is penalized as it is included in the CFC regime. Nonetheless, it should be noted that with regard to these considerations, when CFC income arises from economic and value-creating activities, it should not be attributed under the CFC legislation. As BEPS Action 3 states, in respect of IP income, compliance with a nexus-compliant IP regime should be taken into account.47 As a result, if a Spanish company has a 46. F. Serrano Antón, La influencia del Plan de Acción BEPS en la tributación española: impacto en la normativa, incremento de la litigiosidad y el papel de los tribunales, Revista de Contabilidad y Tributación 391, p. 104 (2015). 47. Dourado states that due to the complex coordination among anti-BEPS measures, it is possible that based on BEPS Action 3, CFC rules apply even if there is a compliant IP box regime (A.P. Dourado, May You Live in Interesting Times, 44 Intertax 1, p. 5 (2016)). Even if hierarchy and coordination among measures contained in Final Reports of BEPS project are not clear, in this regard, Action 3 has provided specific provisions for IP matters. Thus, CFC rules should not apply when income is eligible for a patent box in line with the nexus approach. In this regard, see E. Gil García, Los Incentivos Fiscales a la I+D+I pp. 257-262 (Tirant lo Blanch 2017). In a similar vein, Soler Roch states that the substantial activity standard mentioned in BEPS Action 3 “seems to be coherent in order to preserve genuine activities and moreover, the consistency with the line drawn between bad and good preferential tax regimes; in other words, the consistency between Actions 3 and 5”. Indeed, we agree with Soler Roch that if royalty income eligible for a compliant

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controlled party in a jurisdiction granting a nexus-compliant IP regime, the IP income derived from the CFC should not be attributed under the Spanish CFC regime, unless the income does not qualify for the IP regime. In conclusion, CFC legislation should never apply to patent boxes that are in line with the nexus approach. Compliant IP boxes imply that they only grant a special tax treatment to IP income generated by genuine activities. As a result, the risk of profit shifting is removed.48 On the other hand, it is important to note that the nexus approach is compulsory, while BEPS Action 3 regarding CFC rules only contains recommendations for strengthening such mechanisms.49 Article 100 of the LIS is in line with the CFC legislation contained in the Anti-Tax Avoidance Directive (ATAD). Hence, no relevant amendments are expected to that extent. However, it is possible some changes are made in regard of the income description attributed under CFC rules in order to be fully in line with the ATAD. For instance, the inclusion, among income categories, of income from financial leasing or income from invoicing companies that earn sales and services income from goods and services purchased from and sold to associated enterprises and add no or little economic value. Nevertheless, currently, no amendment has been announced in this sense.

18.3. Taxation of IP under EU law This part deals with IP issues in the light of EU law. In this regard, the work is organized in two sections. Firstly, the compatibility of domestic tax provisions with the EU law; secondly, an analysis of open issues related to the I&R Directive.

patent box regime qualifies as CFC income, the tax incentive could be jeopardized (see M.T. Soler Roch, Consistency and Hierarchy among the BEPS Actions, in Tax Avoidance Revisited in the EU BEPS Context p. 114 (A.P. Dourado ed., vol. 15 EATLP International Tax Series 2017). 48. Obviously, the compliance of IP boxes with the nexus approach does not automatically mean that IP regimes are a good practice in terms of promoting R&D&I activities. It only implies there is an underlying R&D&I activity behind the IP income receiving tax benefits. 49. E. Gil García, The Effect of Anti-Avoidance Provisions Regarding the Promotion of Innovation: Considerations from a Tax Policy Perspective, 70 Bull. Intl. Taxn. 10, pp. 589-582 (2016).

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Taxation of IP under EU law

18.3.1. Issues of compatibility of domestic tax law with EU law Inbound and outbound royalties should be treated on an equal footing, i.e. in the light of tax neutrality. With respect to the state of residence perspective, domestic income derived by companies resident or established in Spain is subject to withholding of corporate income tax (article 128 of the LIS). Accordingly, royalties (paid to resident companies) are subject to a 19% withholding tax.50 From the state of source perspective, royalties paid to a non-resident (whether a company or an individual) are subject to a 24% withholding (standard) tax, unless the rate is reduced under a tax treaty or royalties qualify for an exemption under the I&R Directive. Moreover, a 19% withholding tax rate applies if the recipient is a resident in the EU or in the EEA and if the country of residence of the recipient effectively exchanges tax information with Spain (article 25 of the LIRNR). A reduced withholding tax rate (19%) therefore applies if the recipient is resident in the EU or EEA and if the country of residence of the recipient effectively exchanges tax information with Spain. Additionally, the tax exemption under the Spanish implementation of the I&R Directive should be considered (see section 18.3.2.). Concerning the compatibility of R&D&I tax incentives with EU fundamental freedoms, the European Court of Justice (ECJ), in Commission v. Spain (C-248/06), declared article 35 of the LIS contrary to EU law because the deduction of costs relating to R&D and innovation were less favourable in respect of costs incurred abroad than costs incurred in Spain. Particularly, the provision allowed a deduction for R&D&I costs relating to activities carried out abroad provided that the main R&D&I activity was performed in Spain and it did not exceed 25% of the total amount invested. Moreover, the deduction was not available in case of R&D&I outsourcing with nonresident entities. There was also an additional 20% deduction for expenditure associated with R&D projects contracted with universities, public research organizations or centres for innovation and technology, recognized and registered in accordance with Spanish legislation. Direct taxation implies a true competition among Member States, but, as the Court states, such competition should be exercise in line with EU law. The Court considered that a tax incentive restricted to expenditure incurred in 50. In the case of royalty payments resulting from the assignment of rights or use of an image, the withholding tax is 24%.

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the territory of a Member State contravenes the freedom of establishment. In this case, the provision dissuaded Spanish companies from the performance of R&D&I expenditure in non-resident entities, on the one hand, and dissuaded foreign companies from the establishment of secondary entities in Spain, on the other hand. Moreover, the Court recognized that the additional 20% deduction did not require the research centres and universities were established in Spain. However, for these research institutes to obtain the “recognition” was “necessary that the activity is carried out in Spain and such activity can benefit any entity or company performing activities in Spain” (paragraph 23 of the decision). Thus, there is a different tax treatment based on the place where services are provided. As previously mentioned (see section 18.2.2.2.), Spain introduced a patent box regime in 2007. The European Commission, in its Decision of February 2008, considered that the Spanish patent box does not fall into the scope of article 107(1) of the TFEU.51 Accordingly, this regime is an advantage as it mitigates the charges the companies would have to bear without the existence of the measure, but any corporate taxpayer, independently from its size, legal structure and sector in which it operates, can be the beneficiary. Thus, it is an “open access” incentive as all taxpayers who are subject to the LIS may access the regime. Concerning eligible R&D&I intangibles, a narrow IP scope may lead to selectivity as the incentive may exclude some businesses or economic activities. The European Commission considered that even if it is true that some undertakings may profit from the regime more than others, this does not necessarily make the regime selective. In our opinion, the Spanish IP box regime has been set up under a narrow approach as it is limited to trade intangibles. However, some IP categories, i.e. secret formulas or processes as well as know-how, are so wide and horizontal in nature that it does not result in favouring specific undertakings or certain businesses. Therefore, the a priori narrow IP regime is sometimes broadened allowing the access of an indefinite number of sectors (i.e. DGT ruling No. V1080-16).

18.3.2. Open issues in the implementation of the I&R Directive The I&R Directive is designed to eliminate withholding tax obstacles in respect of cross-border interest and royalty payments within a group of 51.

See supra n. 29.

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Taxation of IP under EU law

companies by abolishing withholding taxes on royalty and interest payments arising in a Member State. For this purpose, the meaning of “royalties” implies: [P]ayments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films and software, any patent, trade mark, design or model, plan, secret formula or process or for information concerning industrial, commercial or scientific experience; payments for the use of, or the right to use, industrial, commercial or scientific equipment shall be regarded as royalties.

As already mentioned (see section 18.2.1.), the domestic tax definition of royalties (article 13(1)(f) of the LIRNR) has been aligned to the notion of royalties of article 2(b) of the I&R Directive, i.e. it has been introduced to the definition to the reference to “industrial, commercial or scientific equipment”. There are, however, few differences because the directive does not refer to image rights that have been included in the LIRNR through Law 46/2002. Moreover, the domestic tax law meaning refers, at the end, to “any similar right” which is a generic formula. According to article 14(1)(m) of the LIRNR, royalties paid by a resident entity or by a PE located in Spain of a non-resident entity to an entity or PE resident in another EU Member State are tax exempt if the following conditions are met: (i) both entities should be subject to tax according to article 3 of the I&R Directive; (ii) both entities have taken one of the legal forms established in the annex of the I&R Directive; (iii) both entities are resident in the territory of the European Union and, for the purpose of a double taxation convention (DTC) signed with a third country, they are not considered resident of that third state; (iv) both entities are related parties;52 (v) the amount is, in the event, tax-deductible for the PE paying royalties and (vi) the recipient of the royalty payments is using them for its own benefit (it is not a simple intermediary) and in case of a PE, the amount received is related to its activity and it is income for calculating the tax base.53 The LIRNR provides that the royalties exemption of article 14(1)(m) does not apply if the majority of voting rights of the recipient entity are direct 52. For that purpose, they are associated companies when an entity holds at least 25% of the capital of the other company or a third party participates directly in at least 25% of the capital of both entities. 53. According to art. 10 of the Non-Residents Income Tax Regulation (Reglamento del Impuesto sobre la Renta de no Residentes, RIRNR), the way to prove the right to apply exemptions is through supporting documents with the fulfilment of the requirements. Moreover, art. 31(4)(a) of the LIRNR stipulates that no withholding tax applies in regard of tax exemptions of art. 14 of the LIRNR.

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or indirectly held by individuals or entities which are non-residents in EU Member States, unless the entity proves that there are valid economic reasons under the constitution and the performance of business activities. In June 2015, the Commission launched its Communication on A Fair and Efficient Corporate Tax System in the European Union: 5 Key Areas for Action. The Commission recognizes that the I&R Directive was adopted with the purpose to prevent tax obstacles which could hamper the development of the single market, i.e. double taxation.54 However, this type of provision, i.e. article 3 of the I&R Directive, may unintentionally lead to double non-taxation or double deductions scenarios. For example, Subsidiary Co. A1, which is a resident entity in an EU Member State, pays a licence fee to Parent Co. A, which is a resident firm in Spain, for the use of a patent. Royalties received by the Parent Co. A benefit from the Spanish patent box regime while no withholding tax is levied to Subsidiary Co. A1 as the I&R Directive applies. According to this EU Action Plan, the I&R Directive should be amended so that Member States are not required to give beneficial treatment to interest and royalty payments if there is no effective taxation elsewhere in the European Union.55 Nevertheless, it should be mentioned that Member States are not actually obliged to exempt royalties from taxation. Indeed, the I&R Directive (article 5) grants the possibility to Member States to deny unilaterally the application of the directive: “in the case of transactions for which the principal motive or one of the principal motives is tax evasion, tax avoidance or abuse”. Moreover, the directive “shall not preclude the application of domestic or agreement-based provisions required for the prevention of fraud or abuse”. Thus, Member States may introduce unilateral measures addressed to prevent tax elusive practices.56 In our opinion, even if the I&R Directive cov54. See European Commission, A Fair and Efficient Corporate Tax System in the European Union: 5 Key Areas for Action, COM(2015) 302 final p. 3 (17 June 2015). 55. Id., at p. 9. 56. In this sense, ECJ case law has repeatedly stated that effectiveness of fiscal supervision constitutes an overriding requirement of general interest capable of justifying a restriction on the exercise of fundamental freedoms (see, inter alia, Baxter (C-254/97) para. 18). For example, in France, art. 11 of the Loi de Finances pour 2012 (Finance Act 2012) restricts the conditions for deducting licensing royalties where the licensor and the licensee are related entities. In Austria, as from March 2014, royalties paid by an Austrian firm to a foreign recipient are not deductible when the royalties are exempt or subject to an effective tax rate (ETR) of less than 10% in the hands of the recipient; see K. Mitterlehner  & M. Mitterlehner, Austria in Tax Incentives on Research and Development (R&D pp. 142144 (IFA Cahiers vol. 100A, 2015), Online Books IBFD. It would appear that the new

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Taxation of IP under EU law

ers the introduction of such type of measures, the link of preferential tax regimes with the place where the underlying R&D&I activity is created requires the implementation of a standard approach instead of unilateral measures – which are dispersed within the single market. Moreover, it should be reminded that the ultimate aim is that all income is taxed only once in the European Union, which could consequently be contradicted. Freedman considers that specific anti-avoidance rules (SAARs) and other specific clauses may produce more litigation and more uncertainty.57 In the same vein, the Commission considers that unilateral actions by Member States would not adequately tackle the problem of aggressive tax planning and would create (other) issues. In a single market founded on free movement of goods, persons, services and capital, uncoordinated measures against profit shifting “can do more harm than good”, and non-coordination can bring uncertainty and administrative burdens for businesses.58 Following the EC 2015 Communication, the Working Party on Tax Questions – Direct Taxation of 16 February 2016 considered that the minimum effective tax rate (ETR) should be 10%. That is, any interest and royalty payment would be exempted from taxes in the Member State where they arise when the ETR resulting from the tax regime applying to those payments in the Member State of the beneficial owner is at least 10% – which is the lowest tax rate in the European Union, particularly the tax rate of Bulgaria. In other words, any interest and royalty payments would be exempt from tax in the source state when the ETR resulting from the tax regime for such payments in the residence state is at least 10%.59 In consequence, according to the IP box base calculated in Table 18.2., the ETR of royalty income is determined as follows: rules are designed to target patent box regimes; see R.J. Danon, General Report, in Tax Incentives on Research and Development (R&D), id., at. p. 53. It is important to note that for the time being, Austria has not implemented a patent box regime, but that indirect effects may arise in its territory from such measures. In this respect, see J. Loeprick, Indirect Access to Intellectual Property Regimes: Effects on Austrian and German Affiliates, WU International Taxation. Research Paper Series No. 13 (2015). 57. J. Freedman, Defining Taxpayer Responsibility: In Support of a General AntiAvoidance Principle, British Tax Rev. 4, p. 352 (2004). 58. Communication from the Commission to the European Parliament and the Council: Anti-Tax Avoidance Package: Next Steps towards delivering effective taxation and greater tax transparency in the EU, COM(2016) 23/2 p. 3. 59. Concerning the MET clause, see E. Gil García, Una nota sobre la propuesta de modificación de la Directiva de Intereses y Cánones, Boletín de Actualidad 1 (2016); E. Gil García, La pendiente modificación de la Directiva de intereses y cánones y su posterior incorporación a los ordenamientos nacionales, in Conflictos actuales en Derecho Tributario. Homenaje a la Profesora Doctora Manuela Fernández Junquera (Aranzadi (2017).

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Table 18.3.  The ETR calculation Factor Net income (EUR) Tax base (allowance) (EUR) Tax rate (%) Tax burden (EUR) ETR (tax burden/net income)

Company 1 500 240 60 60/500 = 12%

Company 2 500 322.75 25 80.69 80.69/500 = 16,14%

As was shown in Table 18.2., Company 1 has enjoyed a tax allowance of 52% which allows a reduction in the tax base because of the application of the IP box regime. This company has obtained a favourable tax treatment related to royalty income as it has self-contributed to the IP creation. Even with the great percentage of reduction, the ETR of royalty income is over the 10% threshold. On the other hand, Company 2 has benefited from a tax allowance of 32.45% ETR as it has incurred low-qualifying expenditure. In this case, there is a 16.14% ETR; therefore, the ETR is lower when the self-contribution to the IP creation is highest. For instance, in Ireland, the knowledge development box (KDB) provides with a 6.25% tax rate for eligible IP income, while the standard corporate tax rate is 12.5%. This special tax rate for IP income is thus below the minimum effective taxation (MET) clause. As patent box regimes may allow royalty payments to benefit from a lower tax rate than 10%, it is expected to consider the compliance of the regime with the nexus approach or the establishment of an additional threshold (lower than 10%) for nexus-compliant IP regimes. Therefore, if the MET clause is the only criterion, income benefiting from the Irish regime would not have access to the I&R Directive. However, if the MET clause is combined with the nexus approach, access to the directive will require to be in line with the additional threshold or just the mere alignment with the nexus approach. The proposed amendment is, in fact, a SAAR, which strengthens the effective taxation of interest and royalty payments in the state of residence. The work on the MET clause will probably take into consideration the nexuscompliant IP regimes as Member States may retain the possibility to provide entities with effective tax incentives to invest in genuine R&D (and innovation) in the European Union. As a result, a balance between the promotion of R&D (and innovation) and a minimum level of effective taxation should be maintained. For the time being, no amendments in this regard are expected in Spain.

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Taxation of IP under tax treaties

18.4. Taxation of IP under tax treaties This part is structured in five sections dealing with different tax treaty issues. At the present time, 102 tax treaties have been signed by Spain. Some of are still in working progress and others, e.g. the Spain-United Kingdom Income and Capital Tax Treaty (2013), have been renegotiated or amended by protocol.60

18.4.1. Taxing rights over royalties assigned by article 12(1) According to article 12(1) of the OECD Model (2017), royalties are only taxable in the country of residence of the taxpayer. Since July 2010, this is also the position of Spain. Indeed, Spain included a reservation to tax royalties at source until the OECD Model (2010)61 Due to the Spanish reservation, a high number of treaties signed by Spain combine the residence and source taxation, including limited taxing rights to the country of source. Among Spanish treaties, few tax royalties only at residence, i.e. Albania (2010), Barbados (2010), Bulgaria (1990), Germany (2011), the United Arab Emirates (2006) and the United Kingdom (2013). In the case of the Spain-United States Income Tax Treaty (1990), royalties are taxed at residence, but they may also be taxed at source at the rate of 5%, 8% or 10%. Nevertheless, this provision is aimed to be amended when the protocol (signed 14 January 2013) enters into force. Accordingly, royalties would be taxable only at residence. The tax treaty with Ecuador (1991) allows the taxation of royalties at source with a limited (10%) taxing right (article 12(2)). However, in case of royalty payments arising from copyright of literary, drama, musical or artistic work (except cinematographic films) the tax levied in the source state cannot exceed 5% rate (article 12(3)). The tax treaty with the Philippines (1989) provides a different withholding tax rate (20%) on cinematographic films, which is higher than the tax rate applied to royalties in all other cases. The tax treaty with Latvia (2003) provides a different withholding tax rate (5%)

60. Information on the Spanish tax treaty network is available online at the official website of the Ministry of Finance, http://www.minhafp.gob.es (updated Dec. 2017). 61. On 22 July 2010, the list of countries making such reservation changed, deleting Japan and Spain.

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on the gross amount of the royalties paid for the use of industrial, commercial or scientific equipment.62 On the other hand, the Cuba-Spain Income Tax Treaty (1999) allows the taxation at source granting limited taxing rights. Nevertheless, royalty payments arising from copyright of literary, drama, musical or artistic work (except cinematographic films) shall be taxable only in the residence state (article 12(3)).63 The tax treaty with Serbia (2009) provides a 5% withholding tax rate on copyright of literary, artistic or scientific work (including cinematographic films) and, a 10% withholding tax rate on patents, trademarks, designs or models, plans, secret formulas or processes and computer software, industrial, commercial or scientific equipment and information concerning industrial, commercial or scientific experience. The tax treaty with Argentina (2013) provides four different withholding tax rates on different types of IP (3%, 5%, 10% or 15%). As a result, it could be affirmed that Spain’s treaty practice combines (until now) the residence and source taxation, although it follows the criterion of article 12(1) of the OECD Model (2017) (see section 18.5.).

18.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 The meaning of “royalties” defined in article 12(2) of the OECD Model (2017) is generally followed by tax treaties signed by Spain and the term “royalties” is part of article 12 of those treaties. However, it should be highlighted that there are two relevant differences between such concept and the domestic tax law meaning. Thus, Spain’s tax legislation has extended the term “royalties” to payments for the use of, or the right to use, computer software, on the one hand, and industrial, commercial or scientific equipment, on the other hand (see section 18.2.1.). For instance, article 12(3) of the tax treaty with Singapore (2011) includes payments for the use of, or the right to use “any computer software”.64 On the other hand, article 12(3)

62. The Chile-Spain Income and Capital Tax Treaty (2003) also provides a 5% withholding tax rate on industrial, commercial or scientific equipment. 63. This is also the case of the tax treaties with, inter alia, the Czech Republic (1980), France (1995) and Poland (1979). 64. This is also the case of Spain’s tax treaties with, inter alia, Algeria (2002), Kazakhstan (2009) and Serbia (2009).

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of the tax treaty with Finland (1967)65 includes payments for the use of, or the right to use industrial, commercial or scientific equipment under the term “royalties”.66 The meaning of “royalties” implies the “payment of any kind received as a consideration for the use of, or the right to use”. However, the tax treaty with the United States (1990) covers, under the term “royalties”, capital gains derived from the alienation of IP rights (Article 12(3) in fine). As already mentioned, this provision is to be amended when the 2013 protocol enters into force,67 i.e. the new article 12 will not include capital gains derived from IP as part of the scope of this provision. According to paragraph 27 of Observations on the Article of the Commentary on Article 12 of the OECD Model (2017): “Spain hold[s] the view that payments in consideration for the transfer of the ownership of an element referred to in the definition of royalties fall within the scope of this Article where less than the full ownership is transferred.” Moreover, paragraph 28 of the same Observations states that: Spain hold[s] the view that payments relating to software fall within the scope of the Article where less than the full rights to software are transferred either if the payments are in consideration for the right to use a copyright on software for commercial exploitation … or if they relate to software acquired for the business use of the purchaser, when, in this last case, the software is not absolutely standardised but somehow adapted to the purchaser.

Concerning the relationship between article 7 and article 12 of the OECD Model (2017), when an exclusive distribution right exists and no payment for using the trademark is made, the payment will be regarded as a business profit.68 On the other hand, the Kuwait-Spain Income and Capital Tax 65. This treaty has been renegotiated (2015), but the new tax treaty has not yet entered into force. 66. This is also the case of Spain’s tax treaties with, inter alia, Argentina (2013), China (People’s Rep.) (1990), France (1995), India (1993), Latvia (2003), Senegal (2006), Serbia (2009) and the United Arab Emirates (2007). The tax treaty with Denmark (1972, terminated 1 January 1974) includes also transport equipment. 67. The former US Model (2006) included capital gains derived from the alienation of any IP right or intangible. This reference has been eliminated in the new US Model (2016). 68. In this regard, the Coca-Cola case decided by the Central Economic Administrative Court (Tribunal Económico Administrativo Central, TEAC) in October 2013 can be highlighted. In this case, Company X, resident in Spain, could use the trademarks owned by Company ABCD C, resident in United States, in order to manufacture, package, distribute and sell products (beverages) in a specific territorial scope under such trademarks. Moreover,

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Treaty (2008) has included in article 7(1), “payments of any kind received as consideration for the use of, or the right to use, industrial, commercial or scientific equipment” as profits of an enterprise to which the provisions of article 7 shall apply. The Serbia-Spain Income and Capital Tax Treaty (2009) (as well as other tax treaties signed by Spain) provides in article 12(4) that in case the beneficial owner of the royalties carries on business in the source state through a PE situated therein, article 7 shall apply.69 The tax treatment of image rights is especially complicated in some cases. Where image rights are not included in the tax treaty under the term “royalties”, such payments may be regarded as a business profit (article 7) or as other income (article 21). Some DTCs of the Spanish treaty network have included payments arising from image rights in the scope of article 12. Under the expression “other means of image or sound reproduction”, Spain’s tax treaties with Chile (2003), the United Arab Emirates (2006) and the United States (1990) include image rights in the scope of article 12. As regards artistic performance, i.e. a concert or recital, where the payment also includes simultaneous broadcasting, the tax treatment of artists’ income (article 17) shall prevail over article 12. In this vein, the Supreme Court considers article 17 has a vis attractiva. Accordingly, image rights derived from artistic or sporting performances are not covered by article 12.

Company X could use the trademark held by Company W, resident in Switzerland, for the manufacture, packaging, distribution and sale of products (beverages) identified by such trademark. In both cases, parties agreed that the use of trademarks, labels, designs, packaging and other IP assets can be used for free, i.e. excluding the payment of licence fees or royalties. Company X was obliged to acquire certain “concentrates” to manufacture the beverages, on the one hand, to the US company and, on the other hand, to the Swiss company. The Spanish tax administration considered that the right to use the trademarks granted to Company X was not for free but paid as a royalty within the sales contract of the “concentrated”. Thus, the Spanish tax authorities considered income paid to the US company and to the Swiss company qualified as royalties which, according to arts. 13 and 25 of the LIRNR, are subject to a withholding tax rate of 24%. With the aim to determine the amount paid as “royalties” (from the total amount paid for the “concentrated”), the tax inspector required certain reports and information. The court stated that the right to a defence was handicapped because of the inspector’s action. Regarding the valuation of transfer transactions in the framework of the Spanish IS, the inspector presented the details of other companies without any explanation to the taxpayer regarding the identity, the criteria for that choice or the product that they manufacture. The use of this kind of confidential data in a procedure of valuation makes it difficult for the taxpayer to mount an appropriate defence against the valuation made by the tax administration, in effect, leaving the taxpayer without any defence at all. The decision of the TEAC was in favour of the taxpayer (Company X). 69. This is also the case of Spain’s tax treaties with, inter alia, France (1995), Kuwait (2008) and the United Arab Emirates (2006).

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The DGT dealt in 2001 with the taxation in Spain of payments arising from copyright of literary, artistic or scientific work. Article 12(2)(a) of the tax treaty with France (1995) grants limited (5%) taxing rights to the source state, while article 12(2)(b) stipulates that royalties arising from copyright of literary or artistic work (except cinematographic films and audiovisual recording) shall be taxable only in the residence state. Even if the payment arising from the artistic performance should be covered by the regime of article 17, when, according to the contract, the artistic performance is recorded and the artist receives profits (i.e. royalty payments) derived from the sale or public display of the artistic work medium, article 12(2) (a) of the tax treaty shall apply. The term “recorded” refers to visual or audio works (or both of them) regardless of the kind of medium, which allows its visual, audio or audiovisual reproduction. In consequence, royalties from the assignment of the reproduction and distribution rights of audiovisual recordings are taxed in the source state at a 5% tax rate. However, royalties arising from the public communication (i.e. on stage or live) shall be taxable only in the residence state (DGT ruling No. V0015-01). More recently, the DGT has analysed the interaction between articles 7, 12 and 17. A Spanish company involved in audiovisual content for television and cinema intended to produce an advertisement for television. For this purpose, several technicians, actors, models and extras with no residence in Spain will participate. According to the Commentary on Article 17 of the OECD Model (2017), this provision also applies to “income from other activities which are usually regarded as of an entertainment character”, other provisions being applicable “whenever there is no close connection between the income and the performance of activities in the country concerned”. On the other side, paragraph 18 of the Commentary on Article 12(2) of the OECD Model (2017) states that: Where, however, the copyright in a sound recording, because of either the relevant copyright law or the terms of contract, belongs to a person with whom the artist has contractually agreed to provide his services … or to a third party, the payments made under such a contract fall under Articles 7….

Accordingly, as the services carried out by technicians, actors, models and extras are restricted to shoot the TV advertisement (being shown on a delayed basis) and none of them is presumably retaining copyright on the future TV advertisement reproductions, such services cannot be considered in the light of articles 12 or 17 but in the light of article 7 (DGT ruling No. V1454-14).

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In its judgment of 18 July 2007, the Audiencia Nacional (National Court) analysed the qualification as royalties of income derived from image rights of certain football players. When the facts occurred (1991), Law 46/2002, which introduced image rights to the domestic tax law meaning of “royalties”, was not in force. In the light of article 12 of the Netherlands-Spain Income and Capital Tax Treaty (1971), the court states that the qualification of image rights as royalties made by the Spanish tax authorities corresponds neither to the letter nor the spirit of the convention. Moreover, the court considered that article 7 (business profits) and article 18 (artists and sportspersons) cannot be applied to this case as article 7 requires the existence of a PE situated in the source state (Spain) and article 18 refers to income of artists and sportspersons from their personal activities (i.e. sporting performance). In its judgment of 26 September 2013, the Audiencia Nacional stated that for IRNR purposes, since Law 46/2002 is in force, “image rights qualify clearly as royalties and it affects the interpretation of the meaning of ‘royalties’ included in the Netherlands-Spain DTC”. The court added that in regard of its judgment of 2008, “image rights were not royalties, for the purposes of withholding tax rates”, but the legal regime has changed (due to the Law 46/2002) and “as a result, the Netherlands-Spain DTC should integrate such reference in the sense of Article 3.2 of the convention”. In our view, the meaning of “royalties” of article 12 of the Netherlands-Spain Tax Treaty should be interpreted in the light of the spirit of the convention, which has not been amended, so there is no reference to image rights in the scope of its article 12. In 1995, Company VHSA organized a tour of concerts of an artist resident in Miami. Two contracts were signed: one with the artist regarding the musical performance; the other with Company IBV (resident in the Netherlands), which holds the artist’s image rights regarding the assignment of image rights. The Supreme Court, in its judgment of 11 June 2008, addressed whether, in this case, the payments Company IBV received for the assignment of image rights to Company VHSA are subject to tax in Spain according to the Netherland-Spain Tax Treaty. The Court considered that both contracts are paying for the performance of the concert in Spain and the use of the artist’s image rights connected to the artistic performance. That is, Company VHSA is paying for the use of the artist’s image for advertising purposes as it is in charge of organizing the tour. Therefore, the Court concluded that such royalty payments should be taxable in Spain as artist income.

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Taxation of IP under tax treaties

The majority trend in tax treaties is to exclude technical services from the meaning of “royalties” as they are based on an “obligation to provide” instead of an “obligation to assign”. As mentioned in section 18.2.2.2., technical services are not eligible for the patent box regime of article 23 of the LIS. Nevertheless, some Spanish tax treaties have included such type of services in the scope of article 12. For instance, article 12(3) in fine of the Spain-Sweden Tax Treaty (1976) includes payments derived from technical assistance under the meaning of “royalties”. In regard of this convention, the TEAC, in its judgment of 23 October 1998, qualified as technical assistance the following services: (i) market investigation; (ii) feasibility study; (iii) strategic design; (iv) search and selection of potential partners and (v) training and education of the managing director. Therefore, the TEAC rejected the consideration of these services as independent personal services (article 14 of the Spain-Sweden Tax Treaty) and considered them as royalties which should be taxable in Spain at 10%. In a similar vein, article 12(3)(d) of the Australia-Spain Tax Treaty includes under the term “royalties”, the provision of assistance with auxiliary character for allowing the application or use of intangibles, IP rights, industrial, commercial or scientific equipment and information concerning industrial, commercial or scientific experience. Moreover, this tax treaty refers to the full or partial renunciation to the use of, or the right to use, intangibles or IP rights.70 In addition, article 13 of the India-Spain Tax Treaty (1993) refers not only to royalties, but also to fees for technical services. article 13(4) of the treaty states that the term “fees for technical services” means: Payments of any kind to any person other than payments to an employee of the person making the payments and to any individual for independent personal services mentioned in Article 15 (Independent Personal Services), in consideration for the services of a technical or consultancy nature, including the provision of services of technical or other personnel.71

Article 13 of the Netherlands-Spain Tax Treaty provides a limitation related to articles 10, 11 and 12 of the treaty. In particular, this provision states that reductions or exemptions of articles 10, 11 and 12 are not granted to international organizations and to their bodies and civil servants, as well as to diplomat personnel, when income of such articles obtained in the other state are not subject to tax in the first state. 70. In similar terms, the Lux.-Spain Income and Capital Tax Treaty (1986). 71. Concerning the meaning of “technical assistance” in India, see S. Rodríguez Losada, La particular concepción de la administración tributaria de la India en relación con el concepto y el régimen jurídico tributario de los servicios de asistencia técnica, Crónica Tributaria: Boletín de Actualidad 4 (2014).

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18.4.3. Beneficial ownership and royalties As is commonly held, the “beneficial ownership” clause was introduced in the OECD Model in regard of articles 10, 11 and 12 with the purpose to avoid that persons or entities benefit from the limited taxing rights to the source state. In terms of royalties, exemption in the source country is made conditional on the beneficial owner of the royalty being a resident of the residence state.72 There are some treaties signed by Spain that do not include any explicit reference to this clause, e.g. those with Austria (1966),73 Brazil (1974), the Netherlands (1971) and Sweden (1976). The definition of beneficial ownership envisaged in tax treaties is not often used by the Spanish tax administration since, when the intention is to combat certain tax elusive practices, recourse has been made to Spanish antiabuse legislation based on simulation or abuse of law.74 The decision taken on 28 September 2009 by the TEAC on the application of the “beneficial ownership” clause stated that this provision is restricted to cases where the recipient of the income acts as an intermediary, agent or person who immediately receives the income of another person, the real recipient. For instance, article 12(4) of the Ecuador-Spain Tax Treaty expressly stipulates that the provisions of paragraphs (2) and (3) will only apply if the recipient of royalty payments is the beneficial owner. The DGT analysed whether the main purpose of a company concerned with the assignment of some trademarks is to take advantage of article 12 in the light of article 12(5) of the United Arab Emirates-Spain Tax Treaty. A Spanish company holds trademarks that will be transferred to a newly set up company in the United Arab Emirates. The latest company will grant the right to use the trademark to other Spanish company. The DGT affirms that if the IP right had been assigned to another Spanish company, income derived from the transaction would be taxable in Spain. However, as the right has been assigned to the Arabian entity, royalty income is taxable 72. A.J. Martín Jiménez, Article 12: Royalties - Global Tax Treaty Commentaries, Global Tax Treaty Commentaries IBFD. 73. The 1995 protocol amending the Austria-Spain Income and Capital Tax Treaty (1966) has not incorporated the beneficial ownership clause. 74. E. Cencerrado Millan, Chapter 20: Spain in Taxation of Intercompany Dividends under Tax Treaties and EU Law sec. 20.7.4. (G. Maisto ed., IBFD 2012), Online Books IBFD. According to Trejo Gabriel Y Galán, the beneficial ownership clause has been analysed in but few cases by Spanish case law (M.J. Trejo Gabriel y Galán, La cláusula de beneficiario efectivo en el Modelo Convenio de la OCDE p. 177 (Instituto de Estudios Fiscales 2010). No relevant case law and administrative practice to that extent have been found.

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only in the United Arab Emirates (article 12(1) of the treaty). The Arabian entity is intended to finance its activity of distribution, commercialization and marketing mainly with the royalty income. Thus, if royalty income is the main source of income and a lower taxation is reached, it seems that the purpose of the assignments is to take advantage of article 12 of the tax treaty (DGT ruling No. V2519-13).75

18.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of royalties in the residence state Article 12(1) of the OECD Model (2017) does not specify whether the exemption in the state of source should be conditional upon the royalties are taxed in the residence state. As paragraph 6 of the Commentary on Article 12 of the OECD Model states, this issue can be settled by bilateral negotiations. In this sense, the tax treaties signed by Spain with Canada (1976, amended 2014), Poland (1979) and Tunisia (1982) have included subject-to-tax rules. Under the formula “if royalties are subject to tax in the first Contracting State”, the exemption in the state of source is conditional upon the royalties being subject to tax in the state of residence. Concerning favourable tax regimes, BEPS Action 6 proposes new provisions regarding article 11 (interest), article 12 (royalties) and article 21 (other income).76 In accordance with the new proposed provision, article 12 of the OECD Model would read: Royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State may be taxed in the first-mentioned Contracting State in accordance with domestic law if such resident is subject to a special tax regime….

The new provision would permit the taxation in the source state where there is a preferential tax regime in the residence state and this is defined in the relevant tax treaty. In accordance with this proposal, a “special tax regime” would mean:

75. The DGT has considered this case requires a factual analysis whose realization is not a competence of the DGT. 76. OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - Final Report 2015 pp. 96-98 (2015). In this regard, see Gil García, supra n. 49, at p. 586; Gil García, supra n. 47, at pp. 241-245.

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[A]ny legislation, regulation or administrative practice that provides a preferential effective rate of taxation to such income or profit, including through reductions in the tax rate or the tax base ... However, the term shall not include any legislation, regulation or administrative practice [whose application] does not disproportionately benefit interest, royalties or other income, or any combination thereof [or] that satisfies a substantial activity requirement.

The definition excludes from the term “special tax regime”, first, a provision if the application of such provision implies a proportional benefit and, second, cases where is evidenced a substantial economic activity. Such an exception is probably intended to take into account those IP box regimes that, following Action 5 of the OECD BEPS initiative, have adopted a nexus approach. It is not clear from the wording of BEPS Action 6 whether tax credits (or deductions) are included in the definition of “special tax regime” (“through reductions in the tax rate or the tax base”). Therefore, the Final Report of BEPS Action 6 includes an exception as regards royalties when the provision is designed to encourage, and de facto requires, substantial activities in the residence state. Hence, if the residence state introduces a provision that grants a preferential tax treatment to IP income, such provision is not regarded as a “special tax regime” when the tax benefit is restricted to income closely linked with the underlying R&D&I activity carried out in the residence state. Concerning the interpretation of the substantial requirement, we should take into account the guidance of the Forum on Harmful Tax Practices (FHTP) whose recommendations are included in the Final Report of BEPS Action 5. Given the “proportional benefit” as an exception, this raises the question as to how to interpret this expression. In general terms, the justification for introducing a special tax regime is based on the existence of constitutional values or other public interest, i.e. extra fiscal objectives. Thus, tax benefits should be in accordance with the proportionality principle and, in any case, cannot be based on arbitrary decisions.77 In this way, the requirements of a valid different tax treatment in comparable situations are (i) an objective and reasonable justification, i.e. constitutional values and (ii) the proportionality of the measure. With regard to the proportionality requirement, a special provision in respect of R&D&I is considered to be proportional only if the same result could not have been arrived at by a less distortive measure. In particular, the amount and intensity of the aid must be limited to the minimum needed for the aided R&D&I activity to take 77. M.A. Gutiérrez Bengoechea, Algunas notas sobre la extrafiscalidad y su desarrollo en el derecho tributario”, Revista Técnica Tributaria 107, p. 153 (2014).

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place.78 Consequently, such a special provision would be proportional, and reasonable, if it retained a fair balance between the effectiveness in reaching the objective, i.e. encouraging R&D&I activities, and its effect on public resources. Similarly, the United States has introduced into its new US Model provisions on special tax regimes in order to prevent double non-taxation when the taxpayer uses provisions of the treaty, combined with special regimes, to reach a low- or non-taxation in the contracting states.79 Thus, article 11 (interest), article 12 (royalties) and article 21 (other income) of the US Model allow taxation at source if the beneficial owner applies a preferential tax regime in his residence state. Article 3(1)(l) of the US Model does not refer to the disproportionately benefit nor to a substantial activity requirement; the provision defines “special tax regime” as “any statute, regulation or administrative practices” that meet a set of conditions. In particular, article 3(1)(l) refers to a preferential rate of taxation or permanent reduction in the tax base “for companies that do not engage in the active conduct of a trade or business”. This provision only applies when the recipient and the payer are connected persons according to the definition of article 3(1)(m) of the US Model.80 It could be said that proposals of the Final Report of BEPS Action 6 – as well as provisions of the US Model – are a type of subject-to-tax rule in regard to interest, royalties and other income. In such a way, the position of the European Commission (in EC Recommendation of 6 December 2012 on aggressive tax planning), which encourages Member States to introduce a subject-to-tax rule in their tax treaties, may be reinforced by the proposal of BEPS Action 6. These new provisions are more specific than the EC Recommendation, because they allow taxation in the source state when there is a preferential tax regime (in the residence state of the beneficial owner) and such regime is defined in the convention. Thus, BEPS Action 6 78. Community Framework for State aid for research and development and innovation, sec. 1.3.5 (30 Dec. 2006). 79. In this regard, see F.A. Vega Borrego, The Special Tax Regimes Clause in the 2016 U.S. Model Income Tax Convention, 45 Intertax 4 (2017). 80. Previously, a draft version of the US Model was subject to public consultation in May 2015. The draft model included a definition of “special tax regime” in similar terms of the Final Report of BEPS Action 6, i.e. excluded from such term was any legislation, regulation or administrative practice whose benefit is not disproportionately or, in regard of royalties, satisfies a substantial activity requirement. In such a way, there was an alignment with one of the key points of the OECD Action Plan: “to reinforce substantial requirements in the existing international standards” and, in particular, with the nexus approach of the Final Report of BEPS Action 5.

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does not base the subject-to-tax at source when there is no taxation in the residence state. In our opinion, this formula is more suitable and closer to the reality of IP box regimes.

18.4.5. Time of taxation Tax treaties do not deal with the temporal dimension of taxable events. This is a question regulated by domestic law, which governs when a tax claim may arise.81 The temporal issues related to the IRNR are stated in article 20 of the LIRNR. Accordingly, the tax period corresponds with the financial year and it cannot exceed 12 months. Thus, Spanish-source income is taxed the last day of the fiscal year (accrual). Article 12(2) of the OECD Model, when defining the meaning of “royalties”, refers to “payment”. In Martín Jiménez’s view, the terms “paid” or “payment” do not form part of the definition of taxing rights either for the residence state or for the source state, at least from a temporal perspective of those rights. This basically means that the residence state can tax royalties either paid, accrued or deemed.82 Concerning the Spanish tax treaty practice, treaties signed by Spain refer to the expression “any amount paid for the use, or the right to use”,83 i.e. Andorra-Spain Tax Treaty (2015) or Germany-Spain Tax Treaty (2011). The Albania-Spain Tax Treaty has three language versions (i.e. Spanish, Albanian and English), all being equally authentic. While the Spanish version of the tax treaty refers to the abovementioned expression, the English version refers to “payment”. In our opinion, this different use of “paid” or “payment” should not affect taxing rights of both jurisdictions. For instance, under a licence agreement, a Spanish company may use knowhow and trademark held by a US entity. Accordingly, the Spanish company will make three different payments. The DGT states that the three payments qualify as royalties in the light of the Spain-United States Tax Treaty regardless of “the moment the payment should be made or the calculation for each of them”, being subject to a 10% withholding tax rate at source (DGT ruling No. V0005-02). Thus, taxing rights of both countries are not affected by the moment the royalty payment is made.84 81. Martín Jiménez, supra n. 72, at sec. 2.1.1.2.2.3. 82. Id., at sec. 2.1.1.2.2.1. 83. This is an author’s unofficial translation (“cantidades de cualquier clase pagadas”). 84. No specific issues regarding the time of taxation have been found in the administrative practice. Martín Jiménez refers to some situations where rights of the state of

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Annex

18.5. Annex Table 18.4.  Taxing rights over royalties in the Spanish treaty network85 DTC

Year 2011 2005 2015 2014 2012 1992 19681 2011 2003 1998 2010

Residence taxation X X X X X X X X X X X

Source taxation – X X X X X X – X X X

Limited taxing rights at source (%) – 7 14 5 15 10 3 5 5 10 10 5 – 5 15 7

Albania Algeria Andorra Argentina Armenia Australia Austria Barbados Belgium Bolivia BosniaHerzegovina Brazil Bulgaria Canada Chile China Colombia Costa Rica Croatia Cuba Cyprus Czech Rep. Denmark Dominican Rep. Ecuador Egypt El Salvador Estonia Finland France Georgia

1975 1991 19812 2004 1992 2008 2011 2006 2001 2014 1981 19743 2014

X X X X X X X X X X X X X

X – X X X X X X X – X X X

10 – 10 5 10 10 10 8 5 – 5 6 10

15

1993 2006 2009 2005 1968 1997 2011

X X X X X X X

X X X X X X –

5 12 10 5 5 5 –

10

10

10

residence may be affected by art. 12 of the OECD Model; see Martín Jiménez, supra n. 72, at sec. 2.1.1.1. 85. This Annex includes tax treaties signed by Spain and been published in the Official Spanish Gazette (Boletín Oficial del Estado), i.e. are in force.

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DTC

Year

Germany Greece Holland Hong Kong Hungary Iceland India Indonesia Iran Ireland Israel Italy Jamaica Japan Kazakhstan Korea Kuwait Latvia Lithuania Luxembourg Macedonia Malaysia Malta Mexico Moldavia Morocco New Zealand Nigeria Norway Oman Pakistan Panama Poland Portugal Rumania Russia Saudi Arabia Senegal Serbia

2012 2002 1972 2012 1987 2002 1995 2000 2006 1994 2001 1980 2009 1974 2011 1994 2013 2005 2004 19874 2006 2008 2006 19945 2009 1985 2006 2015 2001 2015 2011 2011 1982 1995 1980 2000 2008 2014 2010

Residence taxation X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X

Source taxation – X X X – X X X X X X X X X X X X X X X X X – X X X X X X X X X X X X X X X X

636

Limited taxing rights at source (%) – 6 6 5 – 5 10 20 10 5 5 8 10 5 7 4 8 10 10 10 10 5 5 10 5 10 10 5 5 7 – 10 8 5 10 10 3.75 7.50 5 8 7.50 5 10 5 10 5 8 10 5 10

Annex

DTC

Year

Singapore Slovakia Slovenia South Africa Sweden Switzerland Thailand Philippines Trinidad & Tobago Tunisia Turkey United Arab Emirates United Kingdom United States Uruguay Uzbekistan Venezuela Vietnam 1. 2. 3. 4. 5. 6.

2012 1981 2002 2008 1977 19676 1998 1994 2009

Residence taxation X X X X X X X X X

Source taxation X X X X X X X X X

Limited taxing rights at source (%) 5 5 5 5 10 5 5 8 15 10 15 20 5

1987 2004 2007

X X X

X X –

10 10 –

2014

X

–

–

1990 2011 2015 2004 2006

X X X X X

X X X X X

5 5 5 5 10

Amended,1995 protocol. Amended, 2015 protocol. Amended, 2000 protocol. Amended, 2010 protocol. Amended, 2017 protocol. Amended, 2007 and 2013 protocol.

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8

10 10

Chapter 19 Switzerland by Peter Hongler1 and Livia Schlegel2

19.1. Introduction on private law aspects of intellectual property (IP) 19.1.1. Private law meaning of terms used in article 12 Article 12(2) of the OECD Model (2017) mentions the following terms, which will be discussed in the next sections with reference to their private law meaning in Switzerland: – copyright of literary, artistic or scientific work including cinematograph films; – patent; – trademark; – design or model; – plan; – secret formula or process; and – information concerning industrial, commercial or scientific experience.

19.1.1.1. Patents Patents are registered (exclusive) rights for inventions that are new and non-obvious according to current technology standards.3 In order to create a patent, an invention is required, which means that a certain creative idea is mandatory. A mere discovery of something existing is not sufficient. The invention must be a novelty and a technical one. The current technology standard is further defined in article 7 of the Patents Act. It refers to what was publicly accessible through a written or oral description.4 A patent

1. Dr. iur., Certified Tax Expert; Counsel, Walder Wyss Ltd.; Lecturer, University of Zurich, Executive Director LL.M. Programme International Tax Law; Adjunct Research Fellow, IBFD. 2. MLaw (University of Zurich); Legal Trainee, Walder Wyss Ltd. 3. CH: Federal Act on Patents for Inventions (Patents Act, PatA), art. 1(1) and (2), SR 232.14, 1954 (amended 2017). 4. Art. 7(2) PatA.

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registration is not possible regarding certain morally delicate inventions in relation to the human body or animals.5 The owner of the patent is granted the exclusive right to use the invention commercially. The owner may grant the right to use the patent to third parties through licences.6 This allows the patent holder to market his invention.7

19.1.1.2. Copyrights In Switzerland, copyrights are governed by the Federal Act on Copyright and Related Rights.8 According to article 1(a), the Act governs “the protection of authors of literacy and artistic works”. Article 2(1) defines works as “literary and artistic intellectual creations with an individual character, irrespective of their value or purpose”. These include, in particular, the following: – literary, scientific and other linguistic works; – musical works and other acoustic works; – works of art, in particular, paintings, sculptures and graphic works; – works with scientific or technical content such as drawings, plans, maps or three-dimensional representations; – works of architecture; – works of applied art; – photographic, cinematographic and other visual or audio-visual works; and – choreographic works and works of mime.9 These examples are not exhaustive.10 For instance, computer programs explicitly qualify as works also.11 And, even drafts, titles and parts of works,

5. See art. 2 PatA. 6. Art. 34(1) PatA. 7. See R.M. Hilty, Lizenzvertragsrecht, Systematisierung und Typisierung aus schutzund schuldrechtlicher Sicht p. 5 et seq. (Stämpfli Verlag AG 2001). 8. CH: Federal Act on Copyright and Related Rights (Copyright Act, CopA), SR 231.1, 1992 (amended 2017). 9. Art. 2(2) CopA. 10. R. von Büren, E. Marbach & P. Ducrey, Immaterialgüter- und Wettbewerbsrecht, para. 242 (Stämpfli Verlag AG 2008). 11. Art. 2(3) CopA. The fact that software is not mentioned in art. 2 triggers the application of certain special rules, as outlined by von Büren, Marbach & Ducrey, id., at para. 265.

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in so far as they are intellectual creations with an individual character, are protected.12 In more general terms, copyright protection is possible in case of a creation that is recognizable and which has an individual character.13 Importantly, copyrights are transferrable according to article 16(1) of the Copyright Act, except for certain copyrights attached to a specific person (Urheberpersönlichkeitsrechte). Switzerland does not have a copyright register. Moreover, the copyright itself does not protect the underlying ideas but only the concrete form, e.g. of a software.14

19.1.1.3. Trademarks According to article 1 of the Trademark Protection Act, a trademark is a sign which is capable of distinguishing goods and services of one enterprise from goods and services of another enterprise.15 Trademarks “may, in particular, be words, letters, numerals, figurative representations, three-dimensional shapes or combinations of such elements with each other or with colours.”16 There are some exceptions of signs which cannot receive a trademark protection such as misleading signs17 and shapes that constitute the nature of a good itself.18 According to article 13(1) of the Trademark Protection Act, the owner has the exclusive right “to use the trade mark to identify the goods or services for which it is claimed and to dispose of it”. The trademark right belongs to the person who registered it first.19 However, the owner of the trademark may allow others the use of the trademark for goods or services. Moreover, a trademark may be subject to a usufruct, pledge or compulsory enforcement measures.20

12. Art. 2(4) CopA. 13. For more details, see von Büren, Marbach & Ducrey, supra n. 10, at para. 230 et seq. 14. See W. Straub, Softwareschutz, Urheberrecht, Patentrecht, Open Source p. 156 (Dike 2011). 15. CH: Federal Act on the Protection of Trade Marks and Indications of Source (Trade Mark Protection Act, TmPA), SR 232.11, 1992 (amended 2017). 16. Art. 1(2) TmPA. 17. Art. 2(c) TmPA. 18. Art. 2(b) TmPA. 19. Art. 6 TmPA. 20. Art. 19 TmPA.

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19.1.1.4. Design or model A design may be protected to the extent it is new and has an individual character.21 There is currently no legal distinction between a design and a model.22 The Designs Act protects the graphical design of certain products or parts of products. In particular, lines, surfaces, contours, colours or material used are protected.23 The legal protection of a design is achieved by registering it in the design register.24 It is not the abstract design concept that is protected, but the concrete application of a specific product or part of a product.25 Design protection is not possible if the elements of a design only exist due to the technical function of the product or of parts of a product. However, if there is an alternative, a technical design can still be protected.26 Regarding the scope of a design protection, an international exhaustion applies.27 The owner of the design is in general allowed “to prohibit others from using the design for commercial purposes. Use includes, in particular, manufacturing, storing, offering, placing on the market, importing, exporting and carrying in transit, as well as possession for any of these purposes.”28 There is an explicit provision in article 15 of the Designs Act regarding licensing of designs. It is stated that “[t]he right holder may permit third parties to use the design right or individual rights conferred by the design right either exclusively or non-exclusively.”

19.1.1.5. Plan The Swiss IP acts contain no specific legal protection measures concerning “plans”. Certain plans, however, might be protected as copyrights according to the Copyright Act29 if there is place for creative freedom.30 For other plans, protection is possible by patent law according to the European 21. CH: Federal Act on the Protection of Designs (Designs Act, DesA), art. 2, SR 232.12, 2001 (amended 2017). 22. Von Büren, Marbach & Ducrey, supra n. 10, at para. 427. 23. Art. 1 DesA. 24. Art. 5(1) DesA. 25. Von Büren, Marbach & Ducrey, supra n. 10, at para. 425 et seq. 26. Id., at para. 468 et seq. 27. Id., at para. 534. 28. Art. 9(1) DesA. 29. See sec. 19.1.1.2. 30. CH: Bundesgericht (Federal Supreme Court) (Bger), 25 Nov. 1977, 103 Ib 324, cons. 3.

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Patent Convention (EPC),31 provided the plan has technical applications.32 Furthermore, a plan can constitute a manufacturing or trade secret according to the Swiss Criminal Code33 or the Federal Law on Unfair Competition34 if it concerns, for example, a construction plan for machines.35

19.1.1.6. Secret formula or processes There is no specific private law protection of secret formulas or processes. However, the term “secret” is defined by case law and scholars as any particular knowledge that is not commonly known, is not easily accessible, which a manufacturer or trader has a legitimate interest in retaining the exclusivity and which he does not intend to disclose.36 Swiss criminal law and rules against unfair competition distinguish between manufacturing and trade secrets.37 Manufacturing secrets mean technical knowledge (see section 19.1.1.5.), whereas trade secrets include all information that is otherwise relevant to a company (e.g. organization).38 The original “process” of a machine which is not known or accessible to anyone and that the holder does not want to disclose because of justified interest, constitutes a manufacturing secret.39 Secret formula or processes are manufacturing secrets and can therefore be defined as technical knowledge required for the manufacture of products.

19.1.1.7. Information concerning industrial, commercial or scientific experience According to the Commentary on Article 12 of the OECD Model (2017), the expression “information concerning industrial, commercial or scientific

31. European Patent Convention (16th edn June 2016) art. 52(2)(c). 32. P. Heinrich, PatG/EPÜ, Kommentar in synoptischer Darstellung, Art. 1 cons. 25 et seq. (Stämpfli Verlag AG 2010). 33. CH: Strafgesetzbuch (Swiss Criminal Code), art. 162, SR 311.0, 1937 (amended 2017). 34. CH: Bundesgesetz über den unlauteren Wettbewerb (Federal Law on Unfair Competition), arts. 4(c) and 6, SR 241, 1986 (amended 2016). 35. CH: Bger, 1 July 1977, 103 IV 283, cons. 2c. 36. Id., at cons. 2b; CH: Bger, 22 Jan. 1954, 80 IV 22, cons. 2a; G. Stratenwerth & W. Wohlers, Schweizerisches Strafgesetzbuch Handkommentar, Art. 162, para. 3 (Stämpfli Verlag AG 2013). 37. Von Büren, Marbach & Ducrey, supra n. 10, at para. 1224. 38. Id., at para. 1226. 39. CH: Bger, 10 Sept. 1962, 88 II 319, cons. 1; CH: Bger, 22 Jan. 1954, 80 IV 22, cons. 2a.

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experience” refers to “know-how”.40 Pursuant to scholars, know-how means all technical, commercial and administrative knowledge and experience required for the production and distribution of goods or the provision of services.41 Know-how is unpatented knowledge that is directly applicable for the production and distribution of goods or the provision of services, is independent of its owner and therefore transferable.42 In contrast to secret formula or processes, know-how does not have to be secret, as long as the knowledge is difficult to access for competitors.43

19.1.2. Distinction between sale and licensing of IP rights Through the licence agreement the licensor commits to transfer TO the licensee an intangible asset for use and exploitation, usually against payment of a licence fee.44 The licence agreement is typically a contract about the paid transfer for use that enables the licensor to market an intangible asset which he is exclusively entitled to by allowing the licensee to use it for economic purposes and commercialization for a certain period of time.45 If an exclusive licence is granted, only the licensor and the licensee can use the intangible asset; if it is only a simple licence, the licensor can grant licences to others as well.46 Some special laws expressly provide for the granting of a licence,47 but the legislator has not created independent statutory provisions covering the licence agreement. A licence agreement generally does not cover the sale of an intangible asset, but solely its use and exploitation.48 However, if an intangible asset is sold, the transaction might partly fall under the Swiss rules on sales contracts.49 For the distinction 40. OECD Model Tax Convention on Income and on Capital: Commentary on Article 12 para. 11 (21 Nov. 2017). 41. R. Hausmann, P. Roth & O. Krummenacher, Lizenzbox als alternatives Steuermodell zur gemischten Gesellschaft, ST 1-2, p. 87 et seq. at 88 (2012); R. Schlosser, Der KnowHow Vertrag, sic!, p. 269 et seq. at 269 (1998). 42. Schlosser, id., at 270. 43. Id. 44. M. Amstutz, A. Morin & W.R. Schluep, Einführung zu Artikeln 184 ff., in Basler Kommentar, Obligationenrecht I, para. 238 (H. Honsell, N.P. Vogt & W. Wiegand eds., Helbing & Lichtenhahn 2011). 45. T. Probst, Der Lizenzvertrag: Grundlagen und Einzelfragen, Jusletter, p. 3 (2 Sept. 2013). 46. Id., at p. 7. 47. E.g. PatG, DesA. 48. Probst, supra n. 45, at 11; M.M. Pedrazzini, Patent- und Lizenzvertragsrecht p. 126 (Stämpfli 1987). 49. K. Troller, Précis du droit suisse des biens immatériels p. 283 (Helbing & Lichtenhahn 2006).

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between a sale and a licence agreement it is decisive whether there is a purchase of rights and whether the intangible asset is transferred to the purchaser definitely.50 The application of the Swiss rules on sales contracts (articles 184 et seq. of the Code of Obligations, CO)51 – including its warranty law – apply only if there is a one-time exchange ratio and not a continuing obligation.52

19.2. Taxation of income from IP under domestic tax law 19.2.1. Income and corporate income tax treatment 19.2.1.1. Income tax From an (individual) income tax perspective, all income is in general taxable according to article 16(1) of the Federal Direct Tax Act (DBG).53 Switzerland does not follow a scheduler approach in defining the taxable income streams. The different income streams such as employment income or income from movable assets, however, are further outlined in article 17 et seq. of the DBG. There is a specific clause stating that income from IP property is taxable.54 IP not only includes assets protected by IP law, but also legally non-protected assets such as unpatented inventions and processes.55 The qualification changes if the intellectual property belongs to the business activity of an individual. In this case the IP income would be qualified as general business income.56 Importantly, Switzerland has an income tax exemption for capital gains on private assets. The distinction between capital gains and taxable income is therefore important in practice. A qualification as a private capital gain requires in general that an asset is alienated to another person.57 This 50. R. von Büren, Der Übergang von Immaterialgüterrechten, in SIWR I/1 p. 265 (R. von Büren & L. David eds., Helbing & Lichtenhahn 2002). 51. CH: Federal Act on the Amendment of the Swiss Civil Code (Part Five: The Code of Obligations), SR 220, 1911 (amended 2017). 52. CH: Bger, 27 Aug. 1998, 124 III 456, cons. 4b, bb. 53. CH: Bundesgesetz über die direkte Bundessteuer (Federal Direct Tax Act) (DBG), SR 642.11, 1990 (amended 2017). 54. Art. 20(1)(f) DBG. 55. M. Reich & M. Weidmann, Artikel 20, in Kommentar zum Bundesgesetz über die direkte Bundessteuer para. 123 et seq. (M. Zweifel & M. Beusch eds., Helbing & Lichtenhahn 2017). 56. See art. 18 DBG. 57. Reich & Weidmann, supra n. 55, at Artikel 16, para. 50 et seq.

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means that if a person receives income in relation to an IP right and the taxpayer does not transfer the right itself, the capital gain exemption would not be applicable.

19.2.1.2. Corporate income tax From a corporate income tax perspective, income from royalties is in general treated as any other income and therefore subject to corporate income taxation in line with the authoritative principle (Massgeblichkeitsprinzip). Following this principle, the net profit according to the financials for accounting purposes is taxable (i.e. considering IP income).58 According to Swiss accounting rules, a royalty is accounted for at the moment it is realized by the taxpayer. This means at the moment it is certain.59 This is true for capital gains triggered by a sale of an IP right but also regarding ordinary income from IP rights such as royalties. The distinction between income and capital gain has no impact for corporate income tax purposes. Of course, if an IP right is sold, the taxable gain might be lower if the sold IP is still accounted for in the balance sheet of the seller. In this respect, it should be noted that IP rights shall be capitalized if the enterprise can dispose over them based on the past experience, if revenue is likely and if the value of the IP can reliably be measured.60 The enterprise, however, be capable of financing the remaining research and development (R&D) phase until marketization.61 A capitalization is not possible in case of base research with no specific product development.62 If an IP right is capitalized, a depreciation period of 5 years is recommended, in justified cases even up to 20 years.63 From a tax perspective, the depreciation should in general not exceed 20% following a straight-line depreciation method.64

58. See art. 58 et seq. DBG. 59. M. Reich, Steuerrecht p. 391 et seq. (Schulthess 2012). 60. HWP, Schweizer Handbuch für Wirtschaftsprüfung, Band “Buchführung und Rechnungslegung” p. 200 (EXPERTsuisse 2014), with reference to art. 959(2) of the CO. 61. Id., at p. 201. 62. Id., at p. 200. 63. Id., at p. 201. 64. See Merkblatt A 1995 – Geschäftliche Betriebe, Abschreibungen auf dem Anlagevermögen geschäftlicher Betriebe (Eidgenössische Steuerverwaltung ESTV).

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19.2.2. Qualification of income deriving from IP and applicable tax regimes 19.2.2.1. IP box regime (Tax Proposal 17): Overview Switzerland will likely introduce an IP box from 1 January 2020 or 1 January 2021.65 The introduction of such IP box was first intended through the so-called Corporate Tax Reform III. However, a public referendum on the Corporate Tax Reform III led to a negative vote in February 2017 and certain changes to the proposal were necessary. The main argument against the Corporate Tax Reform III was that it was not well-balanced as it presumably would have led to lower corporate income taxes by not implementing sufficient distributive elements such as higher dividend taxation or the introduction of a capital gains tax on the alienation of private assets. In September 2017, an amended proposal was published and renamed as Tax Proposal 17 (Steuervorlage 17). The rules provided therein are the focus of the following analysis. In particular, the intended introduction of an IP box regime will be outlined. According to article 24b of the Draft of the Tax Harmonization Act (E-StHG),66 the net profit from patents and similar rights can benefit from a tax base reduction of up to 90% on a cantonal and communal level. Following the modified nexus approach, the exact reduction depends on the R&D in Switzerland.67 The cantons are free to implement such an IP box regime; there is no such regime available at a federal level.68 As mentioned, the Corporate Tax Reform III proposal already contained an IP box regime. However, the proposed legal drafts did not yet contain a detailed definition of royalty income that would benefit from the IP box regime. It was only stated that “revenue from patents and similar rights” is subject to beneficial treatment, i.e. it falls into the box for corporate income tax purposes.69 The 65. So far, only the Canton of Nidwalden has introduced an IP box (see CH: Vollzugsverordnung zum Gesetz über die Steuern des Kantons und der Gemeinden (Steuerverordnung) (Implementation Ordinance to the Law on Taxes of the Canton and the Municipalities (Tax Ordinance), art. 57a, 521.11, 2000 (amended 2011)). 66. CH: Bundesgesetz über die Steuervorlage 17 (Draft of the Tax Harmonization Act), 12 Sept. 2017, BBl 2017 5875, E-StHG 1990 (amended 2017). 67. See Vernehmlassungsverfahren zur Steuervorlage 17, Erläuternder Bericht (Vernehmlassungsbericht) (Consultation Procedure on the Tax Bill (Explanatory Report) (Consultation Report), pp. 9 and 31 (EFD 6 Sept. 2017). 68. This is the reason why the provision regarding the IP box regime is included in the E-StHG and not in the DBG. 69. See CH: Bundesgesetz über steuerliche Massnahmen zur Stärkung der Wettbewerbsfähigkeit des Unternehmensstandorts Schweiz, 17 June 2016, BBl 2015 4937 (4941), Bundesgesetz

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Tax Proposal 17, however, contains a more detailed definition of which patents qualify for the IP box regime. Article 24a of the E-StHG stipulates that patents are: (a) patents according to the EPC, according to its amended version as of 29 November 2000; (b) patents according to the Patents Act; and (c) foreign patents corresponding to the patents mentioned in (a) and (b). Moreover, similar rights are included. This means: (a) supplementary protection certificates according to the Patents Act; (b) semiconductor topography rights; (c) varieties of plants protected by the Varieties Protection Act; (d) certain documents protected according to the Federal Act on Medicinal Products and Medical Devices; and (e) foreign rights corresponding to the rights mentioned in (a)-(d). Some of these terms do not need further description as we have outlined above, for instance, what patents are according to the Patents Act.70 Some terms, however, do need further explanation, as provided in the following subsections. At the outset it should be noted that the IP box covers both income from patents, such as royalties, and gains from the alienation of patents.71

19.2.2.2. Patents according to the EPC Switzerland is part of the EPC, which allows enterprises to receive protection in several states by registering with one authority. An important distinction between the domestic and the European patent protection is that no detailed research is triggered in Switzerland through the filing request.72 As a consequence, Swiss domestic patent registration is in general cheaper compared to European protection.

über die Harmonisierung der direkten Steuern der Kantone und Gemeinden (E-StHG), art. 24a(1), SR 642.14, 1990 (amended 2017). 70. See sec. 19.1.1.1. 71. Vernehmlassungsbericht, supra n. 67, at 10. 72. Cf. art.59(4) PatA.

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19.2.2.3. Foreign patents corresponding to the patents mentioned in (a) and (b) Explicitly not covered by the IP box is software, as software is in general outside the scope of patent protection in Switzerland. Regarding software, however, it is stated in the accompanying report to the draft legislation that if software is a part of an invention, it can be patented (invention implemented through computers). The Federal Council is of the opinion that such patent-protected software should also qualify for the IP box.73 Moreover, even software protected as a patent abroad may benefit from the IP box.

19.2.2.4. Supplementary protection certificates according to the Patents Act The supplementary protection certificates were introduced as an economic compensation as there is often a long duration between patent registration and admission to the market of medicinal products.74 The protection of a supplementary protection certificate is no longer than 5 years.75 Supplementary protection certificates are only available for “active ingredients or combination of active ingredients of medical products”.76 This of course requires an analysis of what “active ingredients” and “combination of active ingredients” mean.77

19.2.2.5. Semiconductor topography rights Switzerland has a specific law on the protection of topographies.78 However, since the implementation only very few topographies have been registered. One of the reasons is that certain elements of a topography can be protected as patents if these fulfil the requirements of a patent. Nevertheless, for the sake of completeness, the semiconductor topography rights were included within the scope of the IP box.

73. Vernehmlassungsbericht, supra n. 67, at 10. 74. With further references, see S. Kohler & L. Friedli, Ergänzende Schutzzertifikate für Arzneimittel, Aktueller Stand der Praxis in der Schweiz, sic!, p. 92 et seq. at 92 (2011). 75. Art. 140e(2) PatA. 76. Art. 140a(1) PatA. 77. For further details, see Kohler & Friedli, supra n. 74, at 93 et seq. 78. CH: Bundesgesetz über den Schutz von Topographien von Halbleiterzeugnissen (Topographiengesetz, ToG) (Federal Act on the Protection of Topographies of SemiFinished Products) (Topography Act)), SR 231.2, 1992 (amended 2017).

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19.2.2.6. Varieties of plants protected by the Varieties Protection Act The Swiss Varieties Protection Act implements the International Convention for the Protection of New Varieties of Plants (1961).79 According to the Patents Act, plant varieties are excluded from patentability.80 With the varieties protection, patent-like protection is granted to the breeder with regard to the propagation material of a variety.81

19.2.2.7. Certain documents protected according to the Federal Act on Medicinal Products and Medical Devices In order to place medicinal products on the market, they must be authorized by the Swiss Agency for Therapeutic Products.82 The Act on Medicinal Products and Medical Devices contains a non-exhaustive list of documents necessary to assess an application for such a marketing authorization. These are: (i) the brand name of the medicinal product; (ii) the names of the manufacturer and the distribution company; (iii) the manufacturing process, i.e. composition, quality and stability; (iv) the therapeutic effects and adverse events; (v) the labelling, i.e. medical information and the dispensing and application method; and (vi) the results of (physical, etc.) tests and clinical trials.83 The documentation is specified in the medicinal product authorization regulation. For new active substances, a complete authorization dossier has to be filed. The marketing authorization is based on a comprehensive review of the medicinal product.

79. See CH: Bundesgesetz über den Schutz von Pflanzenzüchtungen (Sortenschutzgesetz) (Federal Act on the Protection of New Varieties of Plants (Plant Variety Protection Act)), art. 1, SR 232.16, 1975 (amended 2011). 80. Art. 2(2)(b) PatA. 81. M.M. Pedrazzini & C. Hilti, Europäisches und schweizerisches Patent- und Patentprozessrecht p. 184 (Stämpfli Verlag AG 2008). 82. CH: Bundesgesetz über Arzneimittel und Medizinprodukte (Heilmittelgesetz, TPA) (Federal Act on Medicinal Products and Medical Devices (Therapeutic Products Act), art. 9(1), SR 812.21, 2000 (amended 2014). 83. Art. 11(1) TPA.

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19.2.3. Tax treatment of income from IP derived by nonresident taxpayers Unless royalties can be attributed to a permanent establishment (PE), a nonresident person will not be taxed on royalty income sourced in Switzerland.84 There are, in particular, no withholding taxes on royalties and, moreover, there are no qualification difficulties regarding withholding taxes in relation to IP rights. However, excessive royalty payments qualify as deemed dividend distribution triggering 35% withholding taxes in Switzerland.85

19.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules Switzerland has not implemented controlled foreign company (CFC) legislation and, currently, there is no political intention to do so.

19.3. Taxation of income from IP under EU law 19.3.1. Compatibility with the fundamental freedoms As Switzerland is not part of the European Union, the case law of the European Court of Justice on the fundamental freedoms does not limit the taxing rights of Switzerland in relation to IP income.

19.3.2. Taxation of royalties according to the Savings Agreement According to article 9(2) of the Savings Agreement, the source state shall not tax royalties between related parties.86 There is no further definition of royalties in article 9 of the Savings Agreement. As Switzerland does not levy a withholding tax on royalties, the definition of royalties has not triggered any difficulties in Switzerland in relation to the Savings Agreement, at least on outbound payments from a Swiss source to a recipient in an EU

84. See arts. 5 and 51 DBG. 85. See sec. 19.4.6. 86. Taxation of Savings Agreement between Switzerland and the European Union of 1 July 2005.

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Member State. Moreover, there is also not an intense discussion on what royalties mean according to article 9 of the Savings Agreement.87

19.4. Taxation of income from IP under tax treaties 19.4.1. Taxing rights over royalties assigned by article 12(1) The Swiss treaty negotiators in general aim at reducing the residual rate to 0% in the respective article 12 of the tax treaties.88 Many of the Swiss tax treaties therefore follow the OECD Model and provide for a 0% residual withholding tax rate.89 In some treaties, the residual rate, however, is between 3%90 and 15%.91 A few Swiss tax treaties even contain split rates for specific parts of the royalty definition. For instance, the treaty with Lithuania distinguishes between royalties for the use of industrial, commercial or scientific equipment and all other royalties by using the following wording: 2. However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the royalties is a resident of the other Contracting State, the tax so charged shall not exceed: (a) 5 per cent of the gross amount of the royalties paid for the use of industrial, commercial or scientific equipment; (b) 10 per cent of the gross amount of the royalties in all other cases.92

The treaty with Belarus even splits the royalties into three categories and uses different rates: 2. However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the recipient is the beneficial owner of the royalties, the tax so charged shall not exceed: 87. Winzap & Oesterhelt, for instance, argue that for the purpose of interpreting the term “royalty”, the definition according to art. 2(b) of the EU Interest and Royalty Directive should be decisive. See M. Winzap & S. Oesterhelt, Quellensteuerbefreiung von Dividenden, Zinsen und Lizenzen durch Art. 15 Zinsbesteuerungsabkommen (ZBstA), 74 ASA 8, p. 449 et seq. at 490 (2005/2006). 88. See, in general, R. Matteotti & J. Giraudi, Schweizerische DBA-Politik, in Die österreichische DBA-Politik - Das “österreichische Musterabkommen” p. 55 et seq. (M. Lang, J. Schuch & C. Staringer eds., Linde 2013). 89. For an overview, see A. Müller & T. Linder, Artikel 12, in Kommentar Internationales Steuerrecht para. 51 (M. Zweifel, M. Beusch & R. Matteotti eds., Helbing & Lichtenhahn 2015). 90. E.g. art. 12(2) HK-Switz. Income Tax Agreement (2011). 91. E.g. art. 12(2) Philip.-Switz. Income Tax Treaty (1990). 92. Art. 12(2) Lith-Switz. Income and Capital Tax Treaty (2002).

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(a) 3 per cent of the gross amount of the royalties, if the royalties have been received as a consideration for the use of, or the right to use, any patent, secret formula or process, or for information concerning industrial, commercial or scientific experience; (b) 5 per cent of the gross amount of the royalties, if the royalties have been received as a consideration for the use of, or the right to use, industrial, commercial or scientific equipment including transport vehicles; (c) 10 per cent of the gross amount of the royalties in all other cases.93

Or for instance, article 12(2) and (3) of the treaty with Malaysia has the following wording: 2. However, such royalties may be taxed in the Contracting State in which they arise, and according to the law of that Contracting State, but the tax so charged shall not exceed 10% of the gross amount of the royalties. 3. Notwithstanding the provisions of paragraph 2 of this Article, royalties arising in Malaysia and paid to a resident of Switzerland shall be exempt from Malaysian tax if the royalties are approved by the competent authority of Malaysia.

Some treaties contain specific provisions in their protocol leading to a lower residual rate if Switzerland does not levy withholding taxes on royalties, which is currently the case.94

19.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 As mentioned, Switzerland does not levy withholding taxes on royalties. Therefore, there is not an intense discussion about the exact interpretation of the term “royalties” according to double tax treaties signed by Switzerland.95 This is why there is no evidence of whether the Swiss authorities understand article 12 of the OECD Model with reference to domestic law or autonomously. It is, moreover, unclear as to whether the authorities would extensively refer to the Commentary while interpreting article 12(2) of the OECD Model.96 Because of the lack of source taxation on royalties there

93. Art. 12(2) Belr.-Switz. Income and Capital Tax Treaty (1999). 94. Müller & Linder, supra n. 89, para. 54, mention Bulgaria, Kuwait, Mongolia, Romania, Serbia, Slovakia, Thailand, the Czech Republic and Uruguay. 95. Id., at para. 59 et seq. 96. In general, there is no clear practice with respect to the use of the Commentary for interpretation purposes both by the authorities and the Federal Supreme Court (S. Oesterhelt, Bedeutung des OECD-Kommentars für die Auslegung von Doppelbesteuerungsabkommen,

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are also no disputes of whether part of the price for a product qualifies as a royalty for treaty purposes. Another question is whether income qualifies as a capital gain (i.e. article 13 of the OECD Model). Certain Swiss authors argue that a capital gain is at hand if, as a decisive factor, the ownership changes.97 However, again, as Switzerland has not implemented a source tax on royalties, it is indeed not disputed from a tax perspective whether an income is a capital gain or a royalty from a Swiss treaty perspective. In more general terms, however, the Swiss authorities are rather reluctant to apply an autonomous understanding of capital gains. For instance, regarding the distinction between capital gains and dividends, the Swiss authorities deem certain transactions as dividends based on a domestic understanding instead of searching for an autonomous understanding.98

19.4.3. Beneficial ownership and royalties Several older Swiss tax treaties do not contain the beneficial ownership requirement in the respective royalty article. However, it reflects the case law of the Federal Supreme Court that there is an inherent beneficial ownership requirement in all treaties. So far, the Court decided that in relation to dividends but not yet with respect to royalties.99 But considering the argumentation of the Court, it seems that the conclusion of an inherent beneficial ownership requirement is also true for purposes of the royalty article.100 At least the argumentation does not contain explicit statements that the conclusions of the Court are only valid for the purpose of applying the dividend article.101 Contrary to a decision of the Court, there have been both Swiss and international scholars arguing that articles 10-12 do not contain an implicit beneficial ownership requirement, i.e. contrary to the case law of the Federal Supreme Court.102 80 ASA 6/7, p. 373 et seq. (2011/2012); P. Hongler, Hybride Finanzierunginstrumente im nationalen und internationalem Steuerrecht der Schweiz (Schulthess 2012)). 97. E.g. Müller & Linder, supra n. 89, at para. 69. 98. E.g. the gains from the sale of a shelf company or the buy-back of shares for the purpose of capital reduction qualify as dividends without a potential analysis of whether a capital gain could be at hand. 99. See CH: Bger, 5 May 2015, 2C_364/2012, 2C_377/2012, cons. 4.4. 100. This seems to be the opinion of M. Bauer-Balmelli & M.E. Vock, Vor Art. 10-12, in Kommentar Internationales Steuerrecht, supra n. 89, at para. 17. 101. Bger, 2C_364/2012, 2C_377/2012, cons. 4.4. 102. E.g. B. Baumgartner, Das Konzept des beneficial owner im internationalen Steuerrecht der Schweiz: unter besonderer Berücksichtigung der Weiterleitung von abkommensbegünstigten Dividenden- und Zinseinkünften p. 199 et seq. (Schriften zum Steuerrecht 2010).

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19.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state Switzerland does not levy withholding taxes on royalties. It does, moreover, grant an unconditional source tax exemption. Therefore, it does not rely on the treatment in the recipient state for its exemption. In other words, royalties are according to domestic law exempt from withholding tax even in case these are paid to a company applying a special tax regime. However, Switzerland has a general anti-abuse rule (GAAR) since the 1930s, which could mean, for instance, that the tax authorities would deny the deduction because of a royalty payment if the transaction or the structure is artificial and not justified by any business reasons.103

19.4.5. Time of taxation As Switzerland does not levy withholding taxes on royalties, the timing question in case of outbound royalty payments is irrelevant. Nevertheless, it should briefly be outlined how royalties are treated in inbound situations. As Swiss corporate income tax follows the authoritative principle, it is decisive when a certain item of income is accounted for in the financials of corporations. In this respect, Switzerland follows the principle of prudence, which means that income is only accounted for if it is realized.104

19.4.6. Excessive royalty payments As mentioned,105 excessive royalty payments are subject to withholding tax of 35%. Moreover, such excessive payments are not deductible for corporate income tax purposes according to article 58(1)(b) of the DBG. However, excessive royalty payments require related-party circumstances. It is important to note that for the purposes of withholding tax refund, the relation between the payer and the recipient is decisive. This means, for instance, that in case an excessive royalty payment is made to a sister company, an intra-group relief of withholding taxes is not possible as the sister 103. For a more detailed and precise definition of when the GAAR applies, see P. Hongler, Chapter 35: Switzerland in GAARs – A Key Element of Tax Systems in the Post-BEPS Tax World (M. Lang et al. eds., IBFD 2016), Online Books IBFD. 104. See sec. 19.2.1.2. 105. See sec. 19.2.3.

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company does not own a participation of more than 20% according to article 10(2) of the OECD Model or the respective Swiss tax treaties.

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20.1. Introduction on private law aspects of intellectual property (IP) 20.1.1. Private law meaning of terms used in the tax treaty definition of royalties (article 12 OECD and UN Models) and the evolution of the rights protected under the relevant private law 20.1.1.1. Meaning of terms: Overview The tax treaty definition of royalties provides that “royalties” means payment of any kind relating to any “copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience”.2

20.1.1.2. UK domestic law definitions of terms used in article 12(2): General 20.1.1.2.1.  Copyright According to UK domestic law “copyright” is: [A] property right which subsists … in the following descriptions of work: (a) original literary, dramatic, musical or artistic works, (b) sound recordings, films or broadcasts (known as “derivative rights” as they are generally derived from other copyright works), and (c) the typographical arrangement of published editions.3

1. 2. 3.

MA (Oxon), Barrister – Temple Tax Chambers, London. OECD Income and Capital Model Convention (2017), art. 12(2). UK: the Copyright, Designs and Patents Act 1988 (CDPA 1988), sec. 1.

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There is no statutory system of registration of copyright in the United Kingdom. The right arises automatically when the work is recorded, subject to various qualifications. A “literary work” means: [A]ny work, other than a dramatic or musical work, which is written, spoken or sung, and accordingly includes: (a) a table or compilation other than a database, (b) a computer program, (c) preparatory design material for a computer program and (d) a database; “dramatic work” includes a work of dance or mime; and “musical work” means a work consisting of music, exclusive of any words or action intended to be sung, spoken or performed with the music.4

“Artistic work” means: (a) a graphic work, photograph, sculpture or collage, irrespective of artistic quality, (b) a work of architecture being a building or a model for a building, or (c) a work of artistic craftsmanship.5

20.1.1.2.2.  Scope of copyright Copyright does not subsist in a work unless the statutory requirements are met with respect to qualification for copyright protection as regards the author, the country in which the work was first published or, in the case of a broadcast, the country from which the broadcast was made. The author must be a qualifying person at the material time in order to create a UK copyright. The author must be linked to the United Kingdom by being British or by residing in the United Kingdom.6 The country in which the work was first published, or the first broadcast made, must have been the United Kingdom or another specified country.7 Reciprocal protection may also be granted to works from other countries where those countries protect UK works.

4. 5. 6. 7.

Sec. 3 of CDPA 1988. Sec. 4 of CDPA 1988. Sec. 154 of CDPA 1988. Secs.155 and 159 of CDPA 1988.

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Note, however, that copyright “does not subsist in a literary, dramatic or musical work unless and until it is recorded, in writing or otherwise”.8 That is, the subject matter must be expressed in a permanent form such as writing, film, broadcast or a recording before it can be protected as copyright under UK domestic law. The requirement that a work be “original” for copyright to subsist in that work means that the work must have originated from the skill and labour of the author, and that a non-trivial amount of effort was involved in creating the work. It does not mean that the work be original in the sense of being novel in the marketplace, although the work must not be a copy of existing material. Although UK law does not specifically refer to “scientific work” as an element of copyright, the definition of a “literary work” means that a written scientific work is not precluded from being protected as copyright and the definition of literary work specifically includes computer programs and databases. Accordingly, the absence of the term “scientific work” from UK domestic law interpretations of the term “copyright” should not lead to a conflict between states as to whether withholding tax should apply. The United Kingdom does not include performance rights within the scope of copyright; such rights are separately protected.9 In the United Kingdom, performance rights are separate unregistered rights which protect a performer’s live or recorded performances from having unauthorized recordings or broadcasts made of them, and from other unauthorized dealings in such performances. They are distinguished from a copyright owner’s right to perform copyright-protected works in public, which is protected as part of copyright.10 To the extent that copyright in another state therefore includes performance rights, there could be a conflict between states as to the interpretation of “copyright” for the purposes of determining whether withholding tax should apply to payments for such rights. Finally, in an area that has been subject to a degree of scrutiny in recent years, the United Kingdom has no free-standing image rights or rights of personality which celebrities can invoke to protect their likeness. However, unauthorized use of the image of a well-known person could involve 8. 9. 10.

Sec. 3 of CDPA 1988. Pt. II of CDPA 1988. Sec. 16(1)(c) of CDPA 1988.

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copyright infringement in respect of (for example) the use of a photograph containing that person’s image.11 20.1.1.2.3.  Patent A patent in the United Kingdom is a registered right. A patent can only be granted in respect of: [A]n invention in respect of which the following conditions are satisfied … (a) the invention is new (that is, does not form part of the state of the art); (b) it involves an inventive step (that is, is not obvious); (c) it is capable of industrial application; (d) the grant of a patent for it is not excluded by the legislation (generally, is not morally objectionable; and is not a method of treatment or diagnosis).12

The United Kingdom departs from a number of countries in not, generally speaking, granting patents over business processes and methods,13 or over software, unless the business process, method or software results in a physical manifestation of the invention which goes beyond merely providing a computer program or implementing the process or method.14 Accordingly, to the extent that another state protects business processes, methods and software within patents to a greater extent than the United Kingdom, a conflict may arise between the states as to the interpretation of “patent” for the purposes of determining whether withholding tax should apply to payments for such rights. 20.1.1.2.4.  Trade mark “Trade mark” is “any sign capable of being represented graphically which is capable of distinguishing goods or services of one undertaking from those of other undertakings”.15

11. See, for example, UK: High Court of Justice (Chancery Division), 31 July 2013, Robyn Rihanna Fenty v. Arcadia Group Brands, [2013] EWCA Civ 3. 12. UK: the Patents Act 1977 (PA 1977), sec. 1. 13. Sec.1(2) of PA 1977, which specifically excludes “schemes, rules or methods for performing mental acts or doing business” from being considered as inventions. 14. See, for example, UK: Court of Appeal of England and Wales (Civil Division) (EWHC Ch), 27 Oct. 2006, Aerotel Ltd v. Telco Holdings Ltd and others, and Neal William Macrossan’s application, [2006] EWCA Civ 1371, [2007] IP & T 158. 15. UK: the Trade Marks Act 1994 (TMA 1994), sec.1(1).

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The UK interpretation of the term is rather broad, such that there should be limited conflict with the interpretation of the term in other states. It should be noted, however, that (as above for copyright) unauthorized use of a mark could involve trade mark infringement proceedings in the United Kingdom in circumstances where other jurisdictions may regard such right being an image right. In such circumstances, a conflict may arise between the states as to the qualification of the right for the purposes of determining whether withholding tax should apply to payments for such rights. 20.1.1.2.5.  Design “Design” is “the design of any aspect of the shape or configuration (whether internal or external) of the whole or part of an article”16 but excludes: (a) a method or principle of construction, (b) features of shape or configuration of an article which— (i) enable the article to be connected to, or placed in, around or against, another article so that either article may perform its function, or (ii) are dependent upon the appearance of another article of which the article is intended by the designer to form an integral part, or (c) surface decoration.17

For the purposes of registered designs, a “design” is specifically the “appearance of the whole or a part of a product resulting from the features of, in particular, the lines, contours, colours, shape, texture or materials of the product or its ornamentation”,18 in respect of which “product” means “any industrial or handicraft item other than a computer program; and, in particular, includes packaging, get-up, graphic symbols, typographic type-faces and parts intended to be assembled into a complex product”.19 The definition of “design” is relatively broad and, as such, may cover material which could cover matters not protected by other forms of IP rights. In the past, for example, certain aspects of industrial design rights in the United Kingdom were regarded as protected by copyright law. Where, in the present, both copyright and design rights may apply to something, copyright protection will take precedence under UK law,20 although both may be pleaded in the alternative in proceedings. In contrast, there is nothing in

16. Sec. 213(2) of CDPA 1988. 17. Id. 18. UK: the Registered Designs Act 1949 (RDA 1949), sec. 1(2). 19. Sec.1(3) of RDA 1949. 20. Sec. 51 of CDPA 1988.

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UK law which prevents something that could be protected as a design from being registered as a trade mark (where it meets the criteria). Other states may take a different approach to matters which could be regarded as protected by either a design right or another form of IP, such that a conflict could arise where, for example, the United Kingdom requires that copyright take precedence as the right to be relied upon where the matter in question could also be regarded as being within the scope of design rights and the other state takes a different view. 20.1.1.2.6.  Model, plan, etc. UK domestic law does not specifically define “model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience” and the United Kingdom presently has no statutory protection for trade secrets or other technical information. Such rights could be protected by the common law covering confidential information, where appropriate. To the extent that the plan, formula or information is recorded in writing, that written material could be protected by copyright (and may be referred to as “know-how”, although that is not a specific separate IP right in the United Kingdom).

20.1.2. Distinction under private law between alienation of IP and granting the right to use IP Under UK domestic law, alienation of IP is undertaken by assignment. An assignment transfers ownership of IP from one entity to another, so that the assignor is no longer the owner of it and therefore cannot use the IP unless the assignee grants a licence back to the assignor. Granting of the right to use IP is undertaken by licence. A licence is the grant of permission to do an otherwise unlawful act; the specific nature of the unlawful act will depend on the nature of the IP. A licence can be exclusive, sole or non-exclusive. In practical terms, there may be little distinction between an exclusive licence and an assignment where the exclusive licence is for a term that is broadly equivalent to the remaining term of protection under law of the IP (where such IP has a limited term). Broadly, the United Kingdom is likely

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to regard the grant of an exclusive licence as at least a part-alienation of the relevant IP right. Where it is difficult to determine whether a licence or an assignment has been granted it will always be a matter of construction and dependent on the facts. Interpretation of the documents and facts is usually left to the courts rather than being set out in domestic law. For example, where UK domestic law contains specific provisions for the assignment of IP, the question of whether a purported assignment amounts to alienation of the patent rather than the granting of an exclusive licence over the patent will depend upon the facts, as for other forms of IP.21 The terms of the documents are not always conclusive: for example, in a case where the parties were described as licensor and licensee and the grant given in consideration of a royalty, the House of Lords (as the UK Supreme Court was known at the time) found that an assignment had been granted.22 The nature of the payment is not always conclusive either: an exclusive licence was held to have been granted rather than an assignment where the payment for the grant was the payment to the author of royalties or a share of the profits rather than a lump sum.23

20.1.3. How is ownership determined? Under UK domestic law, IP is generally regarded as being owned by the person or persons who, without the consent of the others, can carry on activities that would otherwise amount to an infringement of the IP concerned. For registered rights, such as patents and registered trademarks and design rights, this will be the person or persons listed on the register as the owners of the IP. The United Kingdom does not generally recognize a person who has paid for the creation of IP rights as having ownership interest in those rights under domestic law; such rights would generally arise under contract law. For example, the commissioner of a copyright work does not own the copyright in that work unless the contract in respect of the commission specifically assigns the copyright to the commissioner. In the absence of such a contractual provision, the copyright remains with the author. 21. 22. 23.

Sec. 90 of CDPA 1988; sec. 30 of PA 1977. UK: House of Lords (UKHL), Messager v. British Broadcasting, [1929] AC 151. UK: EWHC Ch, Hole v. Bradbury, (1879) 12 Ch.D. 886.

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20.2. Taxation of income from IP under the domestic law 20.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP There is no comprehensive definition of a royalty for the purposes of UK tax, although HM Revenue & Customs (HMRC) guidance states that “a royalty is paid to the originator of a work when someone other than that person uses or exploits IP”,24 but this is clearly intended as an introductory description rather than a comprehensive definition of the term. For withholding tax purposes, a “royalty” echoes the guidance referred to above, as the requirement to withhold tax applies to “payment [of] a royalty, or a payment of any other kind, for the use of, or the right to use” IP.25 Accordingly, the UK definition of a “royalty” for these purposes does not include a payment for the full transfer of ownership. UK tax law generally refers to “royalties and other income” when considering receipts of IP26 rather than referring, for example, to payment for use of IP specifically. In part, this is because UK tax law distinguishes primarily between income receipts and capital receipts for tax purposes. There are few distinctions between different types of income receipt; the tax distinctions for income receipts focus primarily on the nature of recipient (business or non-business) rather than the nature of the income. The United Kingdom accordingly does not automatically characterize payments for technical assistance as being “royalties” or income derived from IP; the characterization would depend primarily on how the technical assistance was delivered and is primarily of importance where withholding taxes are being considered. Where written material is provided, the payment may be capable of being regarded being paid for the use of copyright material which could be a royalty for withholding tax purposes. Where the technical assistance is provided in person, the payment is more likely to be regarded as a payment for services. Where a payment made by a UK business consists of a mixture of royalties and other payments, UK tax law would generally require that the payment be split on a “just and reasonable” basis in order to determine the withholding tax treatment of the different types of payment. 24. HMRC Manual INTM342510. 25. UK: the Income Tax Act 2007 (ITA 2007), sec. 906. 26. See, for example, UK: the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005), sec.579(1).

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Any payment received for technical assistance by a UK business would likely be regarded as income of the business providing the assistance for non-withholding tax purposes, and it would make no specific difference whether the payment was received as a royalty in respect of copyright (or otherwise) or as income from the provision of services. Any tax withheld at source by the payer would likely be deductible under unilateral relief if treaty relief is not available,27 regardless whether the United Kingdom would characterize the payment as a royalty. The definition of royalties in article 2 of the Interest and Royalty Directive (hereinafter I&R Directive) was referred to in implementing provisions in UK law,28 but those implementing provisions did not provide any additional interpretation, nor does guidance29 on the provisions provide any interpretation. The meaning of “copyright royalty” was considered in IRC v. Longmans Green & Co Ltd, (1932) 17 TC 272, where it was held that a lump-sum advance payment for the right of translation and publication of a fixed number of copies of a book by a non-resident French author was a royalty within the meaning of what is now section 906 of the Income Tax Act 2007. Periodical payments and also lump sums, if they are advances or compositions for payments of the nature of royalties, are therefore also treated as royalties for tax purposes. However, lump-sum payments for the outright purchase of a copyright, or any part of a copyright (e.g. the serial rights) will not be treated as a royalty.30

20.2.1.1. Definition of “intellectual property” for UK domestic tax law purposes UK tax law does not provide a very detailed definition of the term “intellectual property” for general purposes or for the specific purpose of withholding tax. For general tax purposes, “intellectual property” is defined as: (a) any patent, trade mark, registered design, copyright, design right, performer’s right or plant breeder’s right, (b) any rights under the law of any part of the United Kingdom which are similar to rights within paragraph (a), 27. UK: the Taxation (International and Other Provisions) Act 2010 (TIOPA 2010), sec. 9. 28. Sec. 766 of ITTOIA 2005. 29. HMRC Manual INTM367040. 30. HMRC Manual INTM342530.

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(c) any rights under the law of any territory outside the United Kingdom which correspond or are similar to rights within paragraph (a), and (d) any idea, information or technique not protected by a right within paragraph (a), (b) or (c).31

The inclusion of subsection (c) makes it clear that the terms in paragraph (a), which include a number of the terms within article 12, are not to be interpreted as having only their UK law meanings for UK tax purposes. Although UK tax law does not specifically include “model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience” as IP, such aspects would seem to be included within the general sweep-up provision in subsection (d) as an “idea, information or technique” not otherwise protected. For withholding tax purposes, the definition of “intellectual property” is relatively broad32 and, for payments made on or after 28 June 2016, is: (a) copyright of literary, artistic or scientific work (other than a cinematographic film or video recording, or the soundtrack of a film or video recording, unless separately exploited); (b) any patent; (c) any trade mark (registered or unregistered); (d) any design (registered or unregistered); (e) any model, plan, or secret formula or process; (f) any information concerning industrial, commercial or scientific experience; or (g) public lending right in respect of a book. This definition of “intellectual property” reproduces the terms in the definition of “royalty” in article 12(2) of the OECD Model and the terms are not constrained to any specific UK law meaning, save that “copyright” excludes recordings of cinematographic films or videos and the soundtrack of a cinematographic film or video recording, except so far as the soundtrack is separately exploited. These limited exclusions applied to copyright for the purposes of royalties are historic exclusions which continued to be reproduced when the definition of ‘intellectual property” for withholding tax purposes was broadened. Accordingly, in interpreting the tax treaty definition of “royalties”, UK domestic law does not explicitly exclude items from the definition of the 31. 32.

Sec. 579(2) of ITTOIA 2005. Sec. 907 of ITA 2007.

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terms by which “royalties” are defined for tax treaty purposes in article 12(2) beyond the minor exclusion from the definition of “copyright” of cinematographic and video recordings, and soundtrack recordings which are not separately exploited.

20.2.2. Qualification of income deriving from IP and applicable tax regimes 20.2.2.1. Qualification of income deriving from utilization of IP Under UK domestic law, a UK resident is taxable on their worldwide income and gains, with unilateral relief from foreign taxes paid or withheld being given against UK tax (and only up to the amount of UK tax) to the extent that treaty relief is not available against such foreign taxes. 20.2.2.1.1.  Income derived from IP used directly by the owner Income derived by a UK-resident taxpayer from direct use of IP in a trade, manufacturing or services will be treated as income from the sale of manufactured goods or from the supply of services and will therefore be taxed as business income and subject to the general rules on taxation of profits derived from a business.33 Income derived from the direct use of IP outside the scope of business (e.g. payments received for a book written or contributed to by a person who is not an author by profession) will be taxed as miscellaneous income from IP when received by a UK-resident taxpayer.34 The distinction between business profits and miscellaneous income for tax purposes lies primarily with the ability to deduct expenditure from the income in calculating profits. In general, revenue expenditure can be deducted from business income where it is incurred wholly and exclusively for the purposes of the business;35 in contrast, such expenditure can only be deducted from non-business income where specifically permitted by statute.36 33. Pt. 2 of ITTOIA 2005. 34. Sec. 579 of ITTOIA 2005. 35. Sec. 34 of ITA 2007. 36. E.g. see sec.600 of ITA 2007 in respect of expenses relating to patents incurred by inventors.

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20.2.2.1.1.1. Licensing: Distinguishing between grant of right to use and transfer of ownership A distinction also needs to be made between the alienation of IP (generally subject to capital gains tax in the United Kingdom) and the granting of a licence (generally subject to income tax in the United Kingdom) in respect of that IP should be straightforward. In practice, however, the distinction can be complicated, particularly when dealing with licences where the consideration mechanisms can include a number of different elements, e.g. a one-off lump-sum payment, milestone payments on reaching certain further development criteria and ongoing royalties for the use of the IP on a percentage or per-item basis. The difficulty of ascribing an overall value to the IP asset, especially where it has not already been used for the purposes of a trade, means that consideration can often involve participation in the success (or otherwise) of the use of that IP by the licensee in order to produce a more equitable form of consideration for both parties. Accordingly, the tax treatment may depend on whether the IP (a) will be exhausted or diminished in value by the transaction or (b) will retain its value for the owner despite the transaction.37 Where the copyright will be diminished in value, HMRC are more likely to accept that the transaction is capital. In this case, the accounts may assist where the IP has been recognized on the balance sheet (generally, where it has been acquired by the business): if the balance sheet shows a reduction in value of the IP (full or partial), it is likely that a disposal or part-disposal of the asset has occurred for tax purposes. Where the exploitation limits the rights of the owner of the relevant IP – for example, on the sale of the film rights to a novel or on the grant of an exclusive licence in respect of software – the receipts are more likely to be capital because the licensor is giving up the rights to exploit within a territory.38 Although such exploitation will allow the owner of the IP to retain overall ownership of that IP, such a sale is regarded for UK tax purposes as effectively a part-disposal of the IP. 37. See, for example, Lord Reid’s judgment in UK: UKHL, 1 Mar. 1962, Jeffrey v. Rolls-Royce Ltd, [1962] 40 TC 443. 38. UK: UKHL, 4 Dec. 1957, Evans Medical Supplies Ltd v. Moriarty, (1957) 37 TC 540.

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20.2.2.1.1.2. Licensing income: Whether business income or nonbusiness income Where IP is regularly exploited by licensing to others, the owner will be assessed on profits from the exploitation of the IP rights as income of a business,39 even if a particular receipt is a one-off payment.40 In contrast, if the transaction is an isolated occurrence, receipts are less likely to be revenue.41 Whether a business is carrying on a trade in exploiting IP will be a question of fact, although there are a number of key areas that are taken into account when considering the question of whether a trade is being carried on. Where the business retains patents with the intention of exploiting those patents by granting licences, this will generally be regarded as a trading activity.42 In contrast, a one-off license of IP to a connected company was not regarded as a trading activity.43 If a payment is made retrospectively – and so relates primarily to the past use of an IP right – it is likely to be considered to be income where the owner of the IP has retained that asset.44 However, where a one-off payment is made for the future use of IP, it is more likely to be treated as capital where it also precludes the owner from using the asset.45 In this case, the transaction is closer to a part-disposal of the IP. 20.2.2.1.1.3. Patent income derived by an individual Finally, it should be noted that receipts from patents received by an individual in the United Kingdom (whether in the course of business or otherwise) 39. Pt. 2 of ITTOIA 2005 for individuals and, for pre-1 Apr. 2002 IP of companies, UK: the Corporate Tax Act 2009 (CTA2009), pt. 3. 40. This was supported in a know-how case, UK: EWCA Civ, British Dyestuffs Corp (Blackley) Ltd v. CIR, [1924] 12 TC 586, which related to an exchange of know-how for which the UK taxpayer was entitled to receive a sum of GBP 25,000 each year for 10 years. The Court of Appeal held that the receipt was revenue and not capital and that the test to apply was to identify whether the taxpayer was parting with any of its property for a purchase price or whether it was “a method of trading by which it acquires this particular sum of money as part of the profits and gains of that trade”. 41. E.g. see Upjohn LJ’s comments in Jeffrey (1962), supra n. 37. 42. UK: EWHC Ch, Noddy Subsidiary Rights Co Ltd v. IRC, (1966) 43 TC 458. 43. UK: High Court of Justice of England and Wales (King’s Bench Division) (EWHC KBD), Sangster, [1920] 1 KB 557. 44. UK: UKHL, Constantiesco v. R, (1927) 11 TC 730. 45. UK: UKHL, Desoutter Bros Ltd v. J E Hanger & Co Ltd and Artificial Limb Makers Ltd, (1936) 15 ATC 49.

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are always subject to income tax, either as profits from a business under the general rules or under the provisions relating to miscellaneous income.46 This is the case even where the ownership of the patent has been transferred outright.

20.2.2.2. Tax regimes applying to income from IP Different tax regimes apply to (a) income derived by a company from IP created or acquired on or after 1 April 2002, which is dealt with by a specific set of tax rules,47 and (b) income derived from companies in respect of older assets and income derived by non-corporate businesses, which is dealt with under general tax rules. 20.2.2.2.1.  Corporate rules The distinction between the rules is primarily in the way that the profits subject to tax are calculated: in the case of income derived by a company under (a) above, the profits are calculated in accordance with the accounts of the company and therefore income and expenses are recognized in accordance with accounting rules.48 This is somewhat unusual in UK tax law; the income derived by a noncorporate business, or in respect of older IP assets of a business (under (b) above), is dealt with under general tax rules, which take the accounts only as a starting point in assessing the income and expenses of the business for the purposes of calculating taxable profits from IP. 20.2.2.2.2. General rules Under the general rules, income is generally assessable on an arising basis. There are spreading provisions in respect of income derived by individuals from patents allowing for the income from the sale of patent rights to be spread over 6 years and therefore potentially providing that the income is not all taxed at the highest rate of tax.49

46. Sec. 579 of ITTOIA 2005. 47. Pt. 8 of CTA 2009. 48. Assuming that such accounts comply with the UK generally accepted accounting principles (GAAP) or International Accounting Standards (IAS). 49. Currently 45% for individuals. This spreading provision is of most use to investors who only sell patents occasionally and otherwise have relatively low levels of income.

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Taxation of income from IP under the domestic law

The deduction of expenses in relation to IP depends on the nature of such expenses: revenue expenses incurred by a business are deductible if they are incurred wholly and exclusively for the purposes of the business50 and, in the case of companies, may also benefit from the research and development (R&D) tax reliefs provided by UK domestic law. In contrast, capital expenditure can only be deducted where specifically permitted by law: in the case of acquisitions of IP, the capital cost of acquiring the IP is generally only deductible when the IP is later sold, expires or has negligible value.51 There are special rules allowing for accelerated deductions (over a number of years) for the capital cost of acquisition of patents and know-how.52 Capital expenditure on physical assets used to create IP may be deducted under the capital allowance rules if the asset meets certain criteria. These rules provide deductions for the cost of the asset over time (up to 30 years) where the expenditure exceeds an annual allowance.53 Costs within the annual allowance can be deducted in full when incurred. Where such physical assets are used for R&D that qualifies for relief under the R&D tax reliefs for revenue expenditure, an accelerated deduction is available which allows for the cost to be deducted in the year of expenditure even where the annual allowance has been utilized.54 A special elective tax regime, i.e. the patent box,55 applies in respect of income derived by a company from patents. The patent box provides a deduction from taxable profits for income derived by the company from patents, adjusted to remove the effect of a routine return (profits derived from overheads, arguably) and marketing assets. The effect of the deduction on the corporation tax payable by the company is equivalent to taxing the qualifying profits from patents at 10% instead of the present corporation tax rate in the United Kingdom of 19%.

50. 51. 52. 53. 54. 55.

Sec. 34 of ITA 2007. UK: the Taxation of Chargeable Gains Act 1992 (TCGA 1992), sec. 38. UK: the Capital Allowances Act 2001 (CAA 2001), pts. 7 and 8. Pt. 2 of CAA 2001. Pt. 6 of CAA 2001. Pt. 8A of CTA 2009.

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20.2.3. Tax treatment of income from IP derived by nonresident taxpayers 20.2.3.1. Determining non-residence For individuals, the United Kingdom defines non-residence by means of a statutory residence test,56 based on physical presence in the United Kingdom and, in certain circumstances, social and economic ties to the United Kingdom. In contrast, a company will be regarded as resident in the United Kingdom under UK domestic law if it is incorporated in the United Kingdom57 or its place of central management and control is in the United Kingdom.58 A UK-incorporated company may claim to be treaty non-resident if it is also regarded as resident in another jurisdiction (where, of course, an applicable treaty exists between that jurisdiction and the United Kingdom) but the company will be regarded as UK resident for tax purposes until such treaty claim is made. 20.2.3.1.1.  Permanent establishment (PE) of a non-resident company A company which is neither incorporated in the United Kingdom nor managed and controlled there and so is prima facie non-resident may still be regarded as subject to UK corporation tax on an element of its profits, including those relating to IP, if it has a PE in the United Kingdom.59 The UK domestic definition of a PE is similar to that used in tax treaties, but applies in a domestic law context.60 Where a tax treaty also applies, the provisions of that tax treaty will take precedence in determining whether there is a UK PE.

20.2.3.2. Taxation of non-residents: Overview The United Kingdom applies tax to income from IP earned by non-residents primarily through withholding.

56. UK: the Finance Act 2013 (FA 2013), sched. 45. 57. Sec. 14 of CTA 2009. 58. The “case law rule” of residence; see, for example, UK: UKHL, 30 July 1906, De Beers Consolidated Mines Ltd v. Howe, [1906] AC 455. 59. Sec. 5(2)(b) of CTA 2009. 60. Sec. 1141 of CTA 2009.

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Taxation of income from IP under the domestic law

Firstly, the United Kingdom applies a general withholding tax to payments of royalties in respect of IP from the United Kingdom to a non-resident recipient. The tax is withheld from the payment at the basic rate of income tax and accounted for to the tax authority by the UK payer. This withholding tax may also apply to a PE of a non-resident company where the nonresident entity pays royalties to another non-resident in respect of IP used by the PE. A non-UK resident may also be subject to tax on the proceeds of sale of a UK patent (i.e. those registered in the United Kingdom under the PA 1977).61 This tax is also generally collected through withholding.62

20.2.3.3. Payments of royalties from the UK: Tax withholding Substantial changes were made to the rules relating to withholding taxes on royalties in the United Kingdom in 2016. The changes were not particularly surprising in context, although they had not been consulted on beforehand. The effect of the rules was to substantially broaden the scope of UK withholding tax on royalties so that tax will be withheld on any payment that is a “royalty, or a payment of any other kind, for the use of, or the right to use”63 IP (as defined above) where the usual abode of the owner is abroad without any need for the payment to be an annual payment. 20.2.3.3.1.  Pre-2016 approach to withholding tax on royalties The United Kingdom’s approach to withholding tax in domestic law has been rather haphazard historically: withholding tax has been applied only to certain limited types of IP and to certain types of IP payments – the rules were inconsistent and not particularly intelligible. In particular, UK withholding tax rules applied only to royalties paid from the United Kingdom in respect of specific IP, principally: (a) patents; (b) copyright (but not film or video recording copyright); (c) design rights (registered or unregistered); (d) public lending rights in respect of a book; and 61. 62. 63.

Sec. 587 of ITTOIA 2005; sec. 912 of CTA 2009. Sec. 910 of ITA 2007. Sec. 906 of ITA 2007.

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(e) in limited cases, payments in respect of other IP rights that met strict criteria as to the nature of the payment rather than the IP right itself;64 in all cases where the usual abode of the owner of the royalties was outside the United Kingdom. The situs of the IP itself was not specifically relevant, only the habitual place of abode of the owner and the type of IP.65 The result of this rather chaotic collection of rules was that there had always been quite a wide range of IP to which no UK tax applied under UK domestic law when royalties were paid to non-residents. In particular, it would have been unusual to have to withhold tax on royalty payments for trademarks or for know-how. 20.2.3.3.2.  Present approach to withholding tax on royalties With effect for payments made on or after 28 June 2016, a UK payer of royalties in respect of IP owned by a person whose “usual place of abode” is outside the United Kingdom, as defined in UK tax legislation, has been required to withhold tax at the basic rate of income tax66 in force in the tax year of payment on such payments and account for the tax withheld to HMRC.67 It is not possible to contract out of the requirement to withhold tax on royalties.68 The payment must be in respect of the IP itself, rather than in respect of copies of works or articles produced from IP.69 The range of IP on which tax must be withheld under domestic law widened with effect from 28 June 2016 and now includes: (a) copyright of literary, artistic or scientific work (other than a film or video recording, or the soundtrack of a film or video recording, unless separately exploited); (b) any patent; (c) any trade mark (registered or unregistered); (d) any design (registered or unregistered); (e) any model, plan, or secret formula or process; 64. These had to be “qualifying annual payments”, the details of which is considered to be outside the scope of this report as it is no longer relevant when considering the UK tax treatment of royalties. 65. With the exception of withholding tax on payments made by a UK resident in respect of the acquisition of patent rights from a non-UK resident, which only applied where the patent was a UK patent (sec. 910 of ITA 2007). 66. Currently 20%. 67. Sec. 906 of ITA 2007. 68. Sec. 909(2) of ITA 2007. 69. Sec. 906(4) of ITA 2007.

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Taxation of income from IP under the domestic law

(f) any information concerning industrial, commercial or scientific experience; or (g) public lending right in respect of a book. In contrast to the position before 28 June 2016, this specifically includes trademarks and know-how, neither of which would usually have been subject to withholding tax. There is no situs requirement in respect of the IP itself;70 there is no distinction made between UK trademarks and foreign trademarks, for example. 20.2.3.3.3.  Withholding compliance: Payment via agents Where royalties are paid through a UK-resident agent (who is entitled to deduct a sum for commission), tax withheld is calculated on the net payment as reduced by the agent’s commission. Where the payer either does not know that commission is payable or does not know how much is payable, the tax withheld must be calculated on the total amount of the payment.71 If the person making the payment is a UK-resident company, income tax equivalent to the sum deducted from the payment is collected under part 15, sections 945-962 of ITA 2007. If the person making the payment is not a UK-resident company, that person must account to HMRC for the payment under part 15, chapter 16, sections 963-963A of ITA 2007. An officer of HMRC may then issue an assessment on that person for income tax equivalent to the sum required to be deducted. 20.2.3.3.4.  PEs of non-resident companies: Withholding tax Further changes in 2016 also brought into the scope of UK tax payments of royalties made in respect of IP that is used by a UK PE where the payment is made between non-residents. The type of scenario to which these rules72 apply is that where, for example, company A makes a royalty payment to company B in respect of a piece of IP. Neither company A nor company B is in the United Kingdom, but the IP for which the royalty is paid is used by company A’s UK PE. 70. With the exception of withholding tax on payments made by a UK resident in respect of the acquisition of patent rights from a non-UK resident, which continues to apply where the patent is a UK patent (sec. 910 of ITA 2007). 71. Sec. 908 of ITA 2007. 72. Sec. 577A of ITTOIA 2005, inserted by sec. 42 of FA 2016.

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These rules mean that UK withholding tax will be required to be accounted for in the United Kingdom, generally by the UK PE. The same rules will apply where a non-resident company has an “avoided” UK PE under the United Kingdom’s diverted profits tax rules, to ensure that such deemed PEs are treated in the same way as actual UK PEs.

20.2.3.4. Domestic law exceptions to the requirement to withhold tax 20.2.3.4.1.  Creative professionals: Payments Payments to professional authors and other creative professionals for work created in the ordinary course of their business are generally regarded as a payment for professional services,73 rather than royalties in respect of copyright and therefore tax would not generally be withheld from such payments.74 20.2.3.4.2.  Limited software licences Similarly, payments in respect of a licence over computer software which provides only a limited right to copy it to facilitate its use are not regarded as being subject to withholding. However, if the purchaser has a right to copy the software for exploitation purposes, the payment will be within the scope of UK withholding tax if the usual abode of the owner of the software copyright is outside the United Kingdom.75 20.2.3.4.3.  Copies of works Withholding taxes are not applied if the payment is made in respect of copies of works, or articles, which have been exported from the United Kingdom for distribution outside the United Kingdom, even if the payment includes an element of licensing of the IP relating to the works or articles.

73. E.g. UK: UKHL, 25 Nov. 1958, Carson (HM Inspector of Taxes) v. Cheyney’s Executor, 38 TC 240. 74. Despite this, HMRC apparently still requires a payer to make a claim not to have to withhold tax: HMRC Manual INTM342590. 75. HMRC Manual INTM342630.

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Taxation of income from IP under the domestic law

20.2.3.4.4.  Payments to associated EU companies UK companies (and UK PEs of non-resident companies) are not required to withhold tax on royalties paid to associated EU companies76 if the company has a reasonable belief that the recipient meets the conditions for gross payment.77 Where the belief turns out to be mistaken, HMRC can recover the tax that should have been deducted and impose penalties where the belief could not have been reasonable. The amount of the royalty that can be paid without withholding is limited to arm’s length royalties where a special relationship exists between the payer and recipient.78 20.2.3.4.5.  Payments to recipients in treaty countries UK companies (and UK PEs of non-resident companies) are not required to withhold tax on royalties paid to a recipient if the company has a reasonable belief that the recipient is entitled to relief from the withholding tax under a tax treaty.79 There is no clearance procedure for exemption from withholding tax, although companies are advised to be able to show that their belief was reasonable and, if in doubt, should ask the recipient to complete treaty relief forms.80 Where the belief turns out to be mistaken, HMRC can recover the tax that should have been deducted and impose penalties where the belief could not have been reasonable. 20.2.3.4.6.  Anti-treaty shopping rules Relief will not be available under a tax treaty in respect of UK withholding tax on royalties where “it is reasonable to conclude that the main purpose or one of the main purposes of the arrangements was to obtain a tax advantage by virtue of any provisions of a double taxation arrangement and obtaining that tax advantage is contrary to the object and purpose of those provisions” and the payment is between connected persons.81 Although these changes in outline follow the OECD BEPS framework proposal for an anti-abuse test in treaty limitation of benefits (LOB) provisions 76. Sec. 758 of ITTOIA 2005. 77. Sec. 924 of ITA 2007. 78. Sec. 917 of ITA 2007. 79. Sec. 911 of ITA 2007. 80. Form DT-Company or Form DT-Individual, available from https://www.gov.uk/gov ernment/collections/international-tax-forms and https://www.gov.uk/government/uploads/ system/uploads/attachment_data/file/452997/dtindividual.pdf (last accessed 23 Feb. 2018). 81. Sec. 917A of ITA 2007, applying to payments made on or after 17 Mar. 2016.

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(the principal purpose test, PPT),82 the BEPS framework has it applying more generally and not only to withholding tax on royalties. The breadth of the UK provision raises questions as to the extent to which sub-licensing arrangements may have an avoidance motive; there is no direct provision for a “substance” or similar defence. As the test was only introduced in June 2016, it is still too early to see how this test will be implemented in practice. Future arguments about what is “reasonable to conclude” in particular circumstances seem inevitable.

20.2.3.5. Sales of IP: Patents only The gain on sale of a UK-registered patent83 by a non-UK resident will be subject to income tax in the United Kingdom under domestic law, even if the transferor is otherwise entirely outside the scope of UK tax.84 This is because income and gains from a UK patent are treated as having a UK source, regardless of where the patent is actually used. This tax treatment applies only to patents registered in the United Kingdom; under UK domestic legislation, there is no equivalent for sales of foreign-registered patents nor for other forms of IP. In the first instance, tax is required to be withheld from the payment by the purchaser.85 This withholding is subject to any tax treaty reliefs available to the transferor. Where the transferor is in a country with which the United Kingdom has a tax treaty and that tax treaty gives primary taxing rights in respect of gains on sale to the country of residence, the transferee will not have to withhold tax on the payment if it receives the appropriate treaty claim from the transferee. Tax is charged on the net proceeds of sale of the patent, i.e. after the capital cost of the patent is deducted, together with any applicable expenses.86 As tax must be withheld from the gross payment by the payer, if the transferor has a capital cost or expenses to deduct that will reduce the UK tax due, the transferor will have to submit a tax return to HMRC claiming a repayment of part of the tax withheld. 82. Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 – Final Report, OECD/G20 Base Erosion and Profit Shifting Project (OECD 2015). 83. I.e. a patent registered under the PA 1977 in the United Kingdom. 84. Sec. 912 of CTA 2009, for corporate vendors; sec. 587 of ITA 2007 for individual vendors. 85. Sec. 910 of ITA 2007, unless the beneficial owner of the payment is a UK PE of a non-resident company, secs. 930 and 934 of ITA 2007. 86. Sec. 913 of ITA 2007.

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Taxation of income from IP under the domestic law

These rules apply only to non-UK transferors with no taxable presence in the United Kingdom. Where the proceeds of sale are taxable in the United Kingdom as trading income,87 these rules do not apply. There is no requirement to withhold tax on payments in respect of transfers of IP other than UK patents.

20.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules 20.2.4.1. Companies In order to reduce the risk of companies diverting profits overseas without good commercial reason, UK companies are subject to tax on the profits of their “controlled foreign companies” (CFCs). These rules do not apply to non-corporate entities. A CFC is one which is resident outside the United Kingdom, controlled by persons resident in the United Kingdom. “Control” is determined by considering the rights of the UK residents with an interest in the company, together with any rights held by persons connected with the UK resident. Broadly, a person will have control if they have power to secure that the affairs of the company are conducted in accordance with their wishes, where that power arises through shareholdings, voting power or by the documents governing the non-UK company.88 Where an entity is capable of being a CFC, the profits have to pass a gateway test in order to be capable of being caught by the rules. For an IP holding company, the relevant gateway test89 relates primarily to where the risks and assets of the entity are managed and does not specifically relate to IP. Where the gateway test cannot be met, so that the profits of the CFC could fall within the CFC charge for a UK shareholder company, the profits that would potentially be taxed in the United Kingdom must be calculated using UK corporation tax rules as if the CFC were a PE of the UK corporate shareholder.90 87. E.g. where the non-UK-resident transferor has a PE in the United Kingdom that will be taxed on the proceeds of sale. 88. Sec. 371RB of TIOPA 2010. 89. Sec. 371CA of TIOPA 2010. 90. I.e. using the normal UK corporate tax rules.

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The starting point is the profits derived from UK significant people functions in respect of risks and assets relating to the CFC. Excluded from those profits are profits from relevant trading income, which will include IP profits unless the profits come from IP that was transferred to the United Kingdom within the accounting period in question or in the 6 years preceding that accounting period.91 There is no bona fide commercial exclusion, so it is questionable whether this meets EU law requirements;92 however, in practice it means that profits from non-UK connected IP will be outside the scope of a CFC tax charge on the UK shareholder. If the CFC fails the gateway test and cannot exclude the IP profits, there are still a number of exemptions available, including a low profits exemption,93 an exemption for CFCs in particular named territories94 and an exemption for CFCs in higher-tax jurisdictions.95 Any IP-related profits (and indeed other profits) of the CFC that cannot be excluded will be treated as taxable profits of the UK corporate shareholder,96 subject to UK corporation tax with a credit given for any tax paid by the CFC on those profits.97 20.2.4.1.1.  Transfer pricing The United Kingdom is a member of the OECD and broadly follows the OECD Guidelines in relation to its transfer pricing rules;98 these domestic rules are also written to be consistent with article 9 of the OECD Model, even in respect of transactions with non-treaty countries. 91. Sec. 371DB et seq. of TIOPA 2010. 92. Following NL: ECJ, 29 Nov. 2011, Case C-371/10, National Grid Indus BV v. Inspecteur van de Belastingdienst Rijnmond/kantoor Rotterdam, ECJ Case Law IBFD. 93. The profits of a CFC with accounting profits (or assumed UK-equivalent taxable profits) of less than GBP 500,000 and non-trading profits of less than GBP 50,000 will be exempt from the charge (sec. 371LB of TIOPA 2010). 94. This exemption is subject to the same test for IP income as the taxable profits exclusion: the profits must not be derived from IP transferred by related parties from the United Kingdom in the accounting period or the 6 years before that, although this condition is relaxed for a number of favoured trading partners: Australia, Canada, France, Germany, Japan and the United States. CFCs in these countries can still come within the excluded territories exemption where it has IP income from IP transferred from the United Kingdom within the previous 6 years (sec. 371KB of TIOPA 2010). 95. I.e. those in which the local tax charge (ignoring designer tax rates) is at least 75% of the corresponding UK tax charge (sec 371NB of TIOPA 2010). 96. In the same proportion as that corporate shareholder’s shareholding in the CFC. 97. Sec. 371BC of TIOPA 2010. 98. Pt. 4 of TIOPA 2010.

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Taxation of income from IP under the domestic law

The basic transfer pricing rule, which applies to IP transactions in the same way as other transactions, requires the adjustment of profits or losses in the UK corporation tax return where a provision exists between two or more affected persons (the UK person must be a company; the other must be an enterprise), by means of a transaction or series of transactions, which does not follow the arm’s length standard; and that provision creates a potential UK tax advantage for one or both of those persons. The rule only applies if at the time of the making or imposition of the actual provision one of the affected persons was directly or indirectly involved in the management, control or capital of the other; or the same person was directly or indirectly involved in the management, control or capital of each of the affected persons. 20.2.4.1.2.  Diverted profits tax The United Kingdom is a member of the OECD BEPS Project;99 however, it has chosen not to implement Action 7 (Preventing the Artificial Avoidance of Permanent Establishment Status) of the October 2015 BEPS Report by way of changes to tax treaties under the Multilateral Instrument,100 but has instead implemented its own rules, known as the “diverted profits tax”. For IP assets, the tax is most likely to apply on the taxable diverted profits of a company for an accounting period where a large UK-tax-resident company creates a tax advantage by involving entities or transactions that lack “economic substance”.101 The type of arrangement caught would be, for example, that where a UK company transfers IP to a related entity in a low-tax jurisdiction and then pays a UK tax-deductible royalty to such related entity. The overseas entity does not have the technical and management capacity to develop, maintain and exploit such IP and the transfer is only being undertaken for tax purposes. There are other structures which can be caught by the diverted profits tax, but this is the most likely scenario in relation to IP. Where the charge applies, the UK company will be subject to a 25% tax charge on the profits that are regarded as having been diverted from the United Kingdom (in comparison to the 19% corporation tax rate which normally applies to UK profits of a company). 99. Base Erosion and Profit Shifting, available at http://www.oecd.org/tax/beps/bepsabout.htm (last accessed 23 Feb. 2018). 100. Available at http://www.oecd.org/tax/treaties/multilateral-instrument-for-beps-taxtreaty-measures-the-ad-hoc-group.htm (last accessed 23 Feb. 2018). 101. As set out in the Annex to Commission Recommendation 2003/361/EC of 6 May 2003.

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Unusually, the charge is not self-assessed. Companies which consider that they are potentially within the scope of the charge must notify HMRC, which will make the assessment.

20.2.4.2. Individuals and other non-corporates The CFC rules described above do not apply to individuals and other noncorporate entities. However, there are certain UK tax rules which may apply, with the aim of reducing the risk of tax being diverted from the United Kingdom. UK-resident individuals (and corporate entities, in some cases) may be subject to capital gains tax on gains made by closely held foreign companies in which they are shareholders.102 Accordingly, if a UK individual is a shareholder in an overseas company which is closely held and that company disposes of IP rights at a gain, the gain may be attributed to a UK-resident shareholder in proportion to that shareholder’s shareholding. There is an exemption for assets used for the purpose of a trade carried on wholly outside the United Kingdom or for the purposes of “economically significant activities” carried on wholly or mainly outside the United Kingdom, and for transactions which are not undertaken for the purposes of avoiding UK tax.103 UK-resident individuals may also be subject to income tax if they transfer assets (including IP or funds with which IP is acquired) abroad and, as a result, an overseas person (individual or otherwise) obtains income or gains that can be enjoyed by the UK resident or a person connected with them. There are exceptions for genuine commercial transactions that are not intended to avoid UK tax.104

102. I.e. controlled by five or fewer participators or any number of directors (sec. 439 of CTA 2010). 103. Sec. 13 of TCGA 1993. 104. Sec. 714 of ITA 2007.

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Taxation of income from IP under EU law

20.3. Taxation of income from IP under EU law 20.3.1. Issues of compatibility of domestic tax law with EU law 20.3.1.1. Income received by UK residents Royalties received by UK residents are generally subject to tax under UK domestic law in the same way regardless of the origin of the payment (both as to the source country of the payment and the jurisdiction in which the relevant IP originates). UK tax law provisions rarely distinguish between income sources in EU Member States and those in other countries outside the European Union; UK-tax residents are subject on their worldwide income and gains, and tax relief is available for tax withheld in the country of source (such relief being limited to the amount of UK tax payable on the royalty received). The exception would be receipt of a royalty outside the United Kingdom by a person whose domicile105 is outside the United Kingdom where the payment is also made by a person outside the United Kingdom: such a payment may not be subject to tax in the United Kingdom unless and until the payment is received in the United Kingdom. Although this provision applies a different tax regime and may prima facie appear to be incompatible with EU law, it is generally considered that the regime for non-domiciled individuals is not incompatible as it is not based on residence of the individual nor on the location of the asset in general. Accordingly, it is generally accepted that these provisions do not infringe on the free movement of capital. As noted above, it is questionable whether the “genuine commercial activity” exclusions in the United Kingdom’s attribution of gains and transfer of assets abroad rules are wholly compatible with EU law, following National Grid Indus (C-371/10). The rules were changed in 2012 in order to comply with a formal request from the European Commission,106 which considered that the rules could infringe upon the freedom of establishment and the free movement of capital as they could result in higher taxation for nonUK investments. The United Kingdom did not attempt to challenge the request on the basis of the rules being a proportionate response to preventing

105. As defined for UK tax purposes; broadly, where the permanent ties of that individual s are outside the United Kingdom. 106. See EC press release IP/11/158.

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anti-avoidance but, instead, added provisions to slightly broaden the concept of genuine commercial activity where undertaken in the European Union. Nevertheless, it remains the case that investment activity may not be regarded as genuine commercial activity under the revised rules; the EU freedoms, in contrast, do not distinguish between business and investment activities. 20.3.1.1.1.  Payments made from the UK Royalties paid from the United Kingdom are, under domestic law in the first instance, subject to withholding tax on the gross royalty when paid to a person whose “usual place of abode” is outside the United Kingdom. The nationality of the recipient is not relevant, nor is their actual location at the time of payment. No such withholding applies on payments of royalties from one UK entity to another except in relation to patent royalties.107 UK tax treaties may operate to reduce withholding taxes on payments to residents in treaty countries and, where those provisions have not removed a withholding obligation, UK legislation will also operate to remove a withholding obligation on EU entities that are entitled to receive payments gross in accordance with applicable EU directives. However, where tax is withheld by a UK taxpayer, it must be withheld on the gross payment. Recent European Court of Justice (ECJ) case law suggests that this may not be wholly compatible with EU law. In July 2016, the ECJ considered the position of withholding tax on interest in the case of Brisal - Auto Estradas do Litoral SA, KBC Finance Ireland v. Fazenda Pública (C-18/15). The Court held that withholding tax at source in one Member State on interest received in another Member State is contrary to the freedom to provide services where a resident recipient of interest would be entitled to deduct business expenses directly related to the activity giving rise to the interest, but the non-resident recipient of interest is not entitled to make such deductions.

107. Sec. 903 of ITA 2007. There is also an exception to this for UK-source payments of royalties in respect of other types of IP which meet the criteria to be a “qualifying annual payment” under secs. 900 and 901 of ITA 2007. A qualifying annual payment is one which is pure income profit and so will not apply to royalties relating to IP that is registered, as there will be fees which will be deductible from the income received so that it would not be pure income profit. In practice, the main type of IP that could result in qualifying annual payments is copyright.

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Taxation of income from IP under EU law

The analogy to royalties is clear: a UK-resident business licensing IP would be taxed on receipts after deduction of expenses, but a non-UK-resident EU business licensing IP to a UK licensee could suffer withholding tax on a gross basis.108 Even where UK withholding tax applies to a payment to a UK recipient (as in the case of patent royalties, for example) that UK recipient will be assessed on net receipts with a credit for tax withheld. There seems no reason why the taxation of royalties in this context should not be as contrary to EU law as the taxation of interest in Brisal. Indeed, the widening of UK withholding tax on royalties in the Finance Act 2016 could make such a challenge more likely.109

20.3.1.2. State aid The UK R&D for small and medium-sized enterprises is a notified State aid, permitted by the European Commission.110 The UK patent box incentive111 has been modified to match the provisions set down in the OECD BEPS Action 5 Report and so is not considered to be State aid.

20.3.2. Open issues in the implementation of the I&R Directive 20.3.2.1. The notion of “royalties” included in article 2(b) of the I&R Directive (2003/49/EC) The concept of royalties for UK tax purposes in this context is defined by reference to article 2(b) of the I&R Directive, such that no issues in implementation arise in this respect. For general tax purposes, the United Kingdom does not specifically define “royalties” but instead refers to “royalties and other income” relating to IP. 108. Where the UK treaty with the licensor’s country of residence does not have a withholding tax rate of 0% and there is insufficient connection between the payer and recipient for the I&R Directive to apply. 109. Although the appetite for challenging UK tax law at the ECJ may be constrained by art. 50 of the Treaty on the Functioning of the European Union (TFEU) process (Brexit) currently underway. 110. Pt. 13 of CTA 2009. 111. Pt. 8A of CTA 2010.

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With specific regard to withholding taxes, the UK tax applies to “payment [of] a royalty, or a payment of any other kind, for the use of, or the right to use” IP. There is a difference therefore between the definition of royalties for the purposes of the directive under UK domestic law and the definition of royalties for the purposes of domestic withholding taxes, as the definition of “royalty” in article 2(b) includes “payments for the use of, or the right to use, industrial, commercial or scientific equipment”. This part of the definition is incorporated into the UK definition for the purpose of the directive alone, although a number of UK tax treaties also include such payments within the definition of royalties. 20.3.2.1.1.  Minimum effective taxation clause The United Kingdom does not impose a minimum effective taxation requirement in order for entities to benefit from the I&R Directive under UK domestic law and does not propose to impose such a requirement. The United Kingdom relies upon anti-abuse provisions to ensure that the provisions of the directive are not improperly used to circumvent minimum taxation. 20.3.2.1.2.  Anti-abuse provisions The United Kingdom has a specific anti-abuse provision (entitled an “antiavoidance provision”, in line with UK terminology) which provides that the exemption from withholding shall not apply where the “main purpose or one of the main purposes of any person concerned with the creation or assignment of the right in respect of which the royalty is paid” is to obtain the exemption “by means of that creation or assignment”.112 This is in line with article 5(2) of the I&R Directive, which permits Members States to withdraw the benefit of the directive where one of the principal motives is tax evasion, avoidance or abuse. 20.3.2.1.3.  Procedural issues The UK provisions give UK companies the power to make payments gross where they “reasonably believe” that the payment is exempt from tax in

112. Sec. 765(b) of ITTOIA 2005.

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accordance with the I&R Directive (as implemented into UK law)113 without obtaining specific permission or undertaking any specific procedural requirements. A company would need to be able to show why its belief that the provisions applied was reasonable if HMRC were to query the recipient’s entitlement to the exemption: it would be appropriate114 for the company to retain evidence why the conclusion had been reached that the exemption was available, where the position is not clear on the face of the matter. No particular evidence is proscribed for these purposes: it is for the company to assess what may be appropriate in the circumstances. Such evidence would assist in reducing the risk of penalties applying to the payer for making a payment without withholding where the exemption was later shown not to be available.

20.4. Taxation of income from IP under tax treaties 20.4.1. Taxing rights over royalties assigned by article 12(1) The United Kingdom has effective tax treaties with over 130 countries; the majority of these are based on the OECD Model, although the United Kingdom does have a number of treaties with former Commonwealth countries that do not follow the OECD Model. The focus for withholding purposes is generally on the residence of the payer and the recipient rather than the jurisdiction where the royalties may arise. The United Kingdom does not insist on a clause determining where a royalty arises for withholding tax purposes, although it will accept such a clause where the counterparty state requires it.115 In those treaties which follow the OECD Model, the United Kingdom is willing to accept zero rates of withholding tax on interest and royalty payments if the treaty partner is prepared to offer reciprocal treatment of payments to UK residents. Although UK domestic law takes the position that royalties should be taxed on the basis of their source, the UK initial position in negotiating treaties is therefore that royalties are to be taxed on the basis of residence rather than on the basis of the source of the payment. 113. Sec. 914(1)(a) of ITA 2007. 114. Under UK general rules requiring companies to provide evidence as to entitlement to the use of tax provisions. 115. E.g. see art. 12(5) of the Austrl.-UK Income Tax Treaty (2003).

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Accordingly, any withholding tax under the royalties article in UK tax treaties116 that follow the OECD Model is generally the result of the counterparty state’s requirements in negotiation.

20.4.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 The United Kingdom follows domestic law in determining whether a payment will be a royalty or business profits; a tax treaty can only reduce or remove a tax charge imposed by domestic law, it cannot recategorize the payment giving rise to the tax charge nor can it increase the tax charge. In interpreting tax treaties, the UK approach is to consider first whether there is a clear meaning to the relevant provision, taking a purposive approach rather than a literal approach. Where a term is not defined in the treaty, the United Kingdom would apply the UK domestic law definition; UK definitions in respect of “royalty” and “intellectual property” are broadly intended to follow the terms in the OECD Model. Where there is any ambiguity in the meaning of a treaty, purposive construction is further considered. If the ambiguity remains, the Commentary of the OECD Model would be used as an aid to interpretation, although this would only be persuasive rather than determinative. However, with regard to “royalties” in particular, as the UK domestic definition is intended to follow the definition in article 12 of the OECD Model,117 the United Kingdom would generally consider the relevant Commentary to be more persuasive than might otherwise be the case. Decisions of foreign courts in relation to the particular question of interpretation would also be regarded as persuasive. In line with the OECD Model, the United Kingdom considers a “royalty” to be a “payment … for the use of, or the right to use” IP,118 rather than a payment related to IP generally. The definition of a “royalty” does not, accordingly, include a payment relating to the alienation of IP. While UK domestic law requires a UK payer to withhold tax on the payment for the purchase of a UK patent from a non-UK resident, that payment is not characterized as a 116. E.g. see art. 12 of the Austrl.-UK Income Tax Treaty (2003). 117. See HMRC Technical Note of 27 June 2016. 118. Sec. 906 of ITA 2007.

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royalty119 and so the provisions of article 12 of the OECD Model would not apply to such withholding tax; instead, the provisions of article 22 (Capital) may apply to determine the taxing rights in respect of the gain, depending on the terms of the specific treaty. Similarly, payments made to a licensor for the transfer or novation of a licence agreement would not be characterized as a royalty. However, a payment made for the right to grant a sub-licence of licensed IP could fall within the definition of a royalty for UK tax purposes, as the sub-licensing activity could be regarded as a use of the IP and a payment for that specific use would seem likely to fall within the scope of the UK domestic definition of a royalty.120 Similarly, payments for the use of technical and scientific equipment or for services using such equipment are regarded under UK domestic law as payments of business profits and the United Kingdom does not impose any withholding tax on such payments. In some treaties the United Kingdom has accepted that payments for the use of, or the right to use, industrial, commercial or scientific equipment can be included in the definition where the counterparty state has requested this. Such inclusion in the treaty does not mean, however, that the United Kingdom will interpret a payment from the United Kingdom in respect of equipment use to be a royalty for the purposes of UK withholding tax. Payments for services are also considered to be payments of business profits under UK domestic law; this would include technical services provided in conjunction with licences of IP. The definition of IP, for the purposes of withholding tax, is focussed on whether something is an “idea, information or technique”.121 The communication of non-documented IP (such as know-how or trade secrets) may be required in order for the IP to be used by the licensee – such communication to enable use would not be regarded as a technical service for UK purposes and a payment for the communication of the information for its subsequent use would be regarded as a payment for the use of IP, and hence a royalty.122 119. Sec. 910 of ITA 2007. 120. The point has not been specifically addressed in UK guidance, nor has it been subject to litigation in the United Kingdom. 121. Sec. 907 of ITA 2007. 122. E.g. see UK: EWHC KBD, Paterson Engineering Co Ltd v. Duff, (1943) 25 TC 43 – in this case, the payments relating to patents which were not payments for the “user of a patent”; there was a suggestion that where payments included “incidental rights” to advice or assistance as to how best to use the patent, that such payments might be payments for the “user of a patent”. However, such suggestion has not been confirmed in later litigation.

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Where a licence does include technical assistance beyond the communication of undocumented IP, an apportionment of the licence fees would generally be required for UK tax purposes (on a just and reasonable basis) to determine the amount to be treated as a royalty and the amount to be treated as business profits. Payments to professional authors and other creative professionals for work created in the ordinary course of their business are also regarded as a payment for services,123 rather than royalties in respect of copyright, so tax would not generally be withheld from such payments. Despite this, HMRC apparently still requires a UK payer to make a claim not to have to withhold tax on payments to creative professionals.124 Payments to foreign performers for appearances in the United Kingdom are not treated as royalties in the United Kingdom; these are considered to be payments for services provided by the foreign performer. UK domestic law requires tax to be withheld from such payments,125 but the relevant provisions are different to those applying to royalties. The taxing rights in respect of such payments are dealt with under the terms of the specific treaty, generally derived from article 17 of the OECD Model. However, where, and to the extent that, a payment to a foreign performer includes a payment in respect of copyright, the relevant proportion of the payment (on a just and reasonable basis) would be regarded as payment of a royalty and so subject to domestic and treaty provisions in relation to withholding.126 Where a counterparty state has required a transfer pricing adjustment which may be regarded as a deemed royalty, the United Kingdom does not automatically permit a deduction of such a deemed royalty for UK tax purposes. The position would be considered on the basis of the merits of the claim for deduction, subject to the arm’s length principle. Where a deduction for such a deemed royalty is permitted, however, UK domestic tax provisions would apply to the deemed royalty as if it were a royalty within the scope of the definition in UK tax law and, hence, within the scope of the definition in 123. E.g. see Cheyney’s Executor, supra n. 73. 124. HMRC Manual INTM342590. 125. Under the IT (Entertainers and Sportsmen) Regulations, SI 1987/530. 126. See https://www.gov.uk/guidance/pay-tax-on-payments-to-foreign-performers (last accessed 23 Feb. 2018) – the point is not particularly clear in this edition of the guidance. It was more clearly stated in earlier editions, such as the version of FEU50 to be found at https://www.makingmusic.org.uk/sites/makingmusic.org.uk/files/pictures/Payer%27s%20 Guide.pdf (last accessed 23 Feb. 2018).

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article 12. The United Kingdom does not otherwise generally include provisions that would give rise to deemed royalties for tax purposes.

20.4.3. Beneficial ownership and royalties The concept beneficial ownership is generally not defined in UK treaties. As such, interpretation of the term has fallen to the UK courts when considering its meaning. The leading case on the point in the United Kingdom is Indofood,127 in which the UK Court of Appeal found that beneficial ownership “should be understood in its context and in light of the object and purposes of the [OECD Model] Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance” and that tests of the legal structure, and of the commercial and practical substance of the scheme, should be used to determine beneficial ownership. In Indofood, the conclusion was that the beneficial owner was the person with “the full privilege to directly benefit from the income”, which HMRC has interpreted as meaning “the sole and unfettered right to use enjoy or dispose of the asset or income in question”.128 Beneficial ownership will not exist where the recipient “does not have the full right to directly benefit from income because of an obligation to pass it on to another person”.129 Indofood related to interest rather than royalties (and related to transactions that did not involve the United Kingdom, but to which UK law applied as a result of the contract), but HMRC takes the view that the principles apply in the same way to beneficial ownership of royalties for the purposes of UK withholding tax and treaties.130

20.4.4. Exemption in the source state in cases of favourable tax regimes applicable to the beneficial owner of the royalties in the residence state The United Kingdom does not have a “subject to tax” provision in its domestic law in relation to withholding tax, nor does it insist on such a 127. UK: EWCA Civ, 2 Mar. 2006, Indofood International Finance Ltd v. JP Morgan Chase Bank NA, [2006] EWCA Civ 158. 128. HMRC Manual INTM332010. 129. HMRC Manual INTM504030. 130. HMRC Manual INTM332050.

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provision in its tax treaties. Instead, the United Kingdom prefers to rely on anti-avoidance provisions. These do not specifically refer to tax rates but, in practice, HMRC are more likely to query arrangements with low-tax jurisdictions or where there is a specific tax incentive reducing the rate of tax on royalties to a rate that is low in comparison with that which would apply in the United Kingdom. Under domestic law, relief is not available under a tax treaty in respect of UK withholding tax on royalties where “it is reasonable to conclude that the main purpose or one of the main purposes of the arrangements was to obtain a tax advantage by virtue of any provisions of a double taxation arrangement and obtaining that tax advantage is contrary to the object and purpose of those provisions” and the payment is between connected persons.131 Although these changes are based on the OECD BEPS framework proposal for an anti-abuse test,132 the United Kingdom has made no direct provision for a “substance” or similar defence. Future arguments about what is “reasonable to conclude” in particular circumstances seem inevitable. The royalties article in UK tax treaties mirrors the domestic provisions, as this usually includes an additional paragraph providing that the provisions of the respective article do not apply if the IP giving rise to the royalties was created or assigned mainly for the purpose of taking advantage of those articles and not for bona fide commercial reasons.

20.4.5. Time of taxation The United Kingdom does not have any specific interpretation of the meaning of the words “paid” or “payment” for treaty purposes. Under domestic law, a payment is generally regarded as being made (i.e. recognized for tax purposes) on an arising basis, when the date on which the legal obligation to make that payment first exists. However, for the purposes of determining whether a withholding tax obligation arises, it is the date of actual payment that applies.133 131. Sec. 917A of ITA 2007. 132. The United Kingdom has opted for the “principal purpose” test in enacting the proposals in BEPS Action 6, rather than the limitation of benefits provisions. 133. E.g. see UK: UKHL, 1 Mar. 1935, Rye and Eyre v. Inland Revenue, [1935] 19 TC 164, where a payment on account of royalties was paid in advance of the royalties becoming due. The payment on account was agreed to be subject to withholding tax provisions, although the legal obligation to pay the royalties had not yet arisen. Furthermore, sec. 909 of ITA 2007 provides that a royalty “is treated for all income and corporation tax purposes as made when it is made by the first person who makes it” and also notes that

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This can give rise to temporary double taxation in the United Kingdom where a UK recipient of royalties that have been subject to withholding tax receives the payment in an accounting period after that in which the payment is recognized as having been made for UK tax purposes, so that the foreign tax is withheld in the later accounting period. However, the credit for foreign tax paid can be claimed up to 4 years after the end of the tax year in which the relevant UK tax was charged or, if later, by 31 January following the end of the tax year in which the foreign tax is paid.134

20.4.6. Excessive royalty payments 20.4.6.1. Special relationships The United Kingdom has included domestic provisions such that the special relationship clause in a treaty is construed as taking account of all factors, including:135 (a) whether the agreement under which the royalties are payable would have been made at all in the absence of the special relationship; and (b) whether the royalty rate or amount of the royalty and other terms would have been agreed in the absence of the special relationship. Where there has been a previous transfer of the IP rights between associated parties, further factors, including the amounts paid under previous transactions, are considered in determining the extent to which the special relationship rule applies and so the extent to which the royalty may be regarded being excessive under that rule. In cases where it is doubtful that the arrangements under which the royalties are paid would have been entered into at all absent the special relationship,136 HMRC states that they have always interpreted the special relationship clause in most of the UK’s treaties as allowing for the royalty rate to be set at nil so that the full amount of the royalty being regarded as excessive.137

the withholding tax provision in sec. 906 of ITA 2007 applies to “payments on account of royalties as it applies to payments of royalties”. 134. Sec. 19 of TIOPA 2010. 135. Sec. 132 of TIOPA 2010. 136. Such as arrangements involving fragmentation. 137. HMRC Manual INTM440180.

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Where the excessive royalty provisions are applied, the UK payer will be required to account for withholding tax at the full rate rather than at the relevant treaty rate,138 to the extent that the royalty is regarded as excessive. Where a royalty is regarded as excessive for treaty purposes it is likely that HMRC will also regard the payment as excessive under UK domestic transfer pricing provisions and reduce the domestic deduction for the payer in calculating their profits accordingly.139 Where royalty payments made to a UK entity from overseas are regarded by the tax authority in the jurisdiction of payment as excessive, there is generally no domestic tax adjustment in the United Kingdom: there is no provision for automatic secondary adjustments in respect of transfer pricing or in relation to special relationship treaty provisions in the United Kingdom. Unilateral relief may be available in the United Kingdom for the additional foreign withholding tax paid.

138. Currently 20%. 139. Pt. 4 of TIOPA 2010.

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Chapter 21 United States by Larissa B. Neumann,1 Julia Ushakova-Stein,2 David N. de Ruig,3 Michael D. Knobler4 and Sean P. McElroy5

21.1. Introduction to private law aspects of intellectual property (IP) 21.1.1. Private law meaning of terms used in tax treaty definition of royalties and evolution of rights developed under relevant private law IP law in the United States has evolved from its modern origins in the US Constitution.6 The domestic law that dictates the treatment of IP in the United States, and which creates and enforces rights associated with such property, is relevant in several regards to understanding how IP is taxed under US law. Since US treaty law generally looks to domestic tax law to define terms that are not defined in treaties,7 an understanding of how US law categorizes and characterizes property rights for different types of IP is required as a primer to understanding the international taxation of IP under US law.

21.1.1.1. Taxation of IP centres on the taxation of royalties US bilateral tax treaties vary in their definition of “royalties” and some treaties do not define the term.8 As will be discussed in greater detail in section 21.2.1., royalties generally entail payments for the use of, or the right to use, copyrights, patents, trademarks, secret formulae and processes, 1. Partner, Fenwick & West LLP, Mountain View, CA. 2. Associate, Fenwick & West LLP, Mountain View, CA. 3. Associate, Fenwick & West LLP, Mountain View, CA. 4. Associate, Fenwick & West LLP, Mountain View, CA. 5. Associate, Fenwick & West LLP, Mountain View, CA. 6. See US Constitution, art. I(8)(8). 7. See United States Model Income Tax Convention - Technical Explanation to the 2006 United States Model Income Tax Convention art. 12(2) (2006), Models IBFD [hereinafter 2006 Model Technical Explanation]. 8. E.g. see US Model Income Tax Convention (17 Feb. 2016) art. 12(4) (2016), Models IBFD [hereinafter US Model (2016)].

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and information relating to industrial, commercial or scientific experience.9 While patent and copyright law have existed in the United States since the late 18th century, the terminology has evolved and shifted over time. For example, the various types of property that give rise to royalties are now encompassed by the term “intellectual property,” a term that only emerged in the 20th century.10 Under US law, a copyright grants the creator of an original work exclusive rights for its use and distribution for a limited time, over a particular territory. This right originates in the Copyright Clause of the US Constitution, which authorized Congress to create copyright law.11 Today, US copyright law is governed by the Copyright Act of 1976.12 US law allows copyrights to be obtained for any literary, musical, dramatic, pantomime, choreographic, architectural and audiovisual works, as well as for software, sound recordings, derivative works, and compilations.13 Under US law, a patent is the right granted to an inventor of a new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, so long as what is created is both novel and non-obvious.14 The novelty requirement prevents patenting any technology that is already “patented, described in a printed publication, or in public use, or otherwise available to the public”.15 Furthermore, for a technology to be patentable, it must be non-obvious, meaning that a person having ordinary skill in the relevant field would have not found the invention or improvement obvious prior to the application date.16 The application process runs through a federal agency, the US Patent and Trademark office (USPTO) and a patent generally takes around 2 to 3 years to be fully processed and approved by the USPTO.17

9. E.g. see art 12(4) US Model (2016). 10. M. Lemley, Property, Intellectual Property, and Free Riding, 83 Tex. L. Rev. 4, p. 1033 and n.4 (2005). 11. See art. I(8)(8) US Const. 12. US: Copyright Law of 1976, Pub. L. no. 94-553, 90 Stat. 2541 (1976). 13. 17 US Code (USC) § 102. 14. See 35 USC § 101 (discussing patentable subject matter); 35 USC § 102 (discussing novelty); 35 USC § 103 (discussing obviousness). 15. 35 USC § 102. 16. 35 USC § 103. 17. See generally US Patent and Trademark Office, Patent Process Overview (last updated 9 June 2017), available at https://www.uspto.gov/patents-getting-started/patentprocess-overview (last accessed 8 Mar. 2018).

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A trademark, under US law, is the IP behind a word, phrase or logo that identifies the source of goods or services.18 Thus, a trademark offers governmental protection of the IP behind the mark of a commercial brand. The primary source of law for trademarks is the federal Lanham Act, passed by the US Congress in the 1940s.19 Like patents, the application process for registering trademarks is run by the federal government, also through the USPTO. There are other varieties of IP that are referenced in tax treaties and in the Code.20 For example, while in general US tax treaties’ definitions of royalties – discussed in detail in section 21.3. et seq. –­ do not mention the concept of “trade secrets,” the Code provides royalty treatment for payments on trade secrets, e.g. the right to use a “secret process or formula,” or “knowhow”.21 Thus, IP does not need to be registered to be IP that can generate royalties for US federal income tax purposes; unregistered IP can, when proprietary, be included within the definition of royalties”.22

21.1.2. Distinction under private law between alienation of IP and granting the right to use IP Domestic IP law in the United States generally makes a distinction between the sale of the IP and the granting of a right to use that IP.23 However – given the complexities that have emerged in delineating IP rights associated with new technologies – this remains an unsettled and contentious area of law.24 A full discussion of this topic is well beyond the scope of this chapter, but the following examples of how domestic law distinguishes between a sale of IP and the right to use IP can provide a general illustration. 18. 15 USC § 1051. 19. US: Lanham Act, Pub. L. 79-489, 60 Stat. 427 (1946) (codified at 15 USC. § 1051 et seq.). 20. Except as specified otherwise, all references to the “Code” refer to the US Internal Revenue Code of 1986, as amended (IRC) and the Treasury Regulations (Treas. Reg.) promulgated thereunder. 21. Art. 12(2) 2006 Model Technical Explanation; see also IRC § 351; IRC § 367; IRS Rev. Rul. 55-17, 1955-1 C.B. 388; IRS Rev. Rul. 64-56, 1964-1 C.B. 133; IRS Rev. Proc. 69-19, 1969-2 C.B. 301. 22. See sec. 21.3.2. 23. E.g. see US: US Court of Appeals for the Federal Circuit 9th Cir. (CAFC), Vernor v. Autodesk, Inc., (2010) 621 F.3d 1102, 1103-04 (holding this licensee/owner dichotomy exists in the context of copyright law). 24. See C. Asay, Kirtsaeng and the First-Sale Doctrine’s Digital Problem, 66 Stan. L. Rev., pp. 17 and 19 (2013), available at http://www.stanfordlawreview.org/wp-content/uploads/ sites/3/2013/05/Kirtsaeng.pdf (challenging this distinction) (last accessed 8 Mar. 2018).

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For example, there is no clear test for distinguishing between a sale and a licence under US copyright law; different federal courts have established different tests for this distinction. For example, the US Court of Appeals for the Ninth Circuit looks to three key factors: (i) whether the copyright holder labels the agreement with the purchaser a licence agreement; (ii) whether the copyright holder imposes significant restrictions on the recipient’s ability to transfer the copyrighted work and (iii) other notable use restrictions.25 Since, the sale/licence distinction delineates the parties’ rights, the classification of a sale or licence is important for IP law purposes. One area where this distinction has had particular potency of late is the law of patent exhaustion. This doctrine holds that once a patentee has sold an item, it has enjoyed all the rights secured by its limited monopoly on that item provided by the patent law.26 In 2017, the US Supreme Court in Impression Products, Inc. v. Lexmark International, Inc.27 considered a product lawfully sold outside the United States to another entity, which then imported the product into the United States. The Court held that the patent holder cannot sue the importer for patent infringement because an authorized sale outside the United States exhausts all rights under the Patent Act.28 The sale transfers the right to use, sell or import because those are the rights that are associated with the ownership of property.29 However, the Court noted that unlike in the case of a sale, a patentee can impose restrictions on licensees.30

21.2. Taxation of IP under US tax law 21.2.1. Meaning of “royalties” and qualification of income deriving from utilization of IP Although there is no single definition of “royalties”,31 US common law has defined a royalty as “a payment or interest reserved by an owner in return for permission to use the property loaned and usually payable in proportion to 25. See id., pp. 18-19 (citing Vernor, 621 F.3d at 1110, 1111 and n.11). 26. US: United States Supreme Court (USSC), Keeler v. Standard Folding Bed Co., (1895) 157 US 659, 661. 27. US: USSC, No. 15-1189 (30 May 2017). 28. Id. at 11. 29. Id. at 10. 30. Id. at 11. For a thorough discussion of the tax consequences of this distinction, see sec. 21.2. 31. See sec. 21.3.2.2.

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use”.32 A key distinction between royalties and rents is that rents are fixed periodic payments regardless of the extent to which the property is used, whereas royalties are typically based on the extent to which the property is used.33 Typically, but not always, US tax law reserves the term “royalty” for payments pursuant to a licence rather than a sale.34 This chapter follows that convention. The US Treasury Regulations promulgated under the Code (Treasury Regulations) define “royalties” in one context as amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and other like property.35 This US regulatory definition of “royalties” is similar to the definition in article 12 of the OECD Model and the UN Model.36 However, unlike the US

32. US: US Bd. Tax App., 1942, US Universal Joints Co. v. Comm’r, 46 B.T.A. 111, 116, acq., 1942-1 C.B. 17. 33. See US: CAFC 3d Cir., 1941, Logan Coal & Timber Assn. v. Helvering, 122 F.2d 848, 850. 34. Cf. IRS Rev. Rul. 60-226, 1960-1 C.B. 26 (referring to interests “resembling royalties” when discussing a transfer that may qualify as a sale) with US: US Tax Court (USTC), 1957, Coplan v. Comm’r, 28 T.C. 1189, 1192 (holding that a sale of a patent occurred but describing as “royalties” the payments calculated as a percentage of the transferee’s net sales of the patented items). 35. Treas. Reg. § 1.543-1(b)(3) (defining royalties in the context of a statute defining “personal holding company income” to include, inter alia, royalties). Provision of information related to computer software generates royalty income when it is treated as the provision of know-how, which occurs only if: the information transferred relates to computer programming techniques; the information is furnished under conditions preventing unauthorized disclosure, specifically contracted for between the parties; and the information is subject to trade secret protection. Treas. Reg. § 1.861-18(e). “Intangible property” is defined in § 936(h)(3)(B) to mean patent, invention, formula, process, design, pattern or know-how; copyright, literary, musical or artistic composition; trademark, trade name or brand name; franchise, license or contract; method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list or technical data; or any similar item which has substantial value independent of the services of any individual. In addition, for purposes of sec. 865 of the Code, source rules for personal property sales, “intangible” means any patent, copyright, secret process or formula, goodwill, trademark, trade brand, franchise or other like property. 36. Art. 12(2) of the OECD Model (2017) defines “royalties” as payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience. The UN Model definition of “royalties” is almost identical to the OECD Model definition. Art. 12(3) of the UN Model (2011) defines “royalties” as payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, or films or tapes used for radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial

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regulatory definition, goodwill and franchises are not included in the OECD Model and UN Model definitions. The Code and the Treasury Regulations define some of the specific IP categories used in the definition of “royalties.” The term “patent” means a patent granted under US law or any foreign patent granting similar rights – the right to exclude others from making, using or selling the invention, and the right to prevent others from importing the invention.37 The Code defines the term “copyright royalties” to mean compensation for the use of, or the right to use, copyrights in works protected under US or foreign copyright laws.38 The Code establishes copyright protection in original works of authorship fixed in any tangible medium of expression, now known or later developed, from which they can be perceived, reproduced or otherwise communicated, either directly or with the aid of a machine or device.39 Although neither the Code nor the Treasury Regulations define trademark or tradename, Treasury Regulations proposed in the 1970s, but since withdrawn, did define those terms.40 “Trademark” included any word, name, symbol, or device, or any combination thereof, adopted and used by a manufacturer or merchant to identify goods and distinguish them from those manufactured or sold by others. “Trade name” included any name used by a manufacturer or merchant to identify or designate a particular trade or business, or the name or title lawfully adopted and used by a person or organization engaged in a trade or business. Transfers of trademarks and trade names are governed for US tax purposes by the same statute that governs or scientific equipment or for information concerning industrial, commercial or scientific experience. 37. Treas. Reg. § 1.1235-2(a). For the purposes of US tax law governing the character of income from the sale or exchange of a patent by an individual, the term “patent” includes patent rights to an invention even if the patent or patent application are not in existence. Id. 38. IRC § 543(a)(4) (defining copyright royalties as “compensation, however designated, for the use of, or the right to use, copyrights in works protected by copyright issued under Title 17 of the United States Code and to which copyright protection is also extended by the laws of any country other than the United States of America by virtue of any international treaty, convention, or agreement, or interests in any such copyrighted works, and includes payments from any person for performing rights in any such copyrighted work and payments (other than produced film rents …) received for the use of, or right to use, films”). 39. US: The Copyright Act of 1976, Pub. L. No. 94-553, § 102 (codified at 17 USC. § 102). 40. Former Prop. Treas. Reg. § 1.1253-2 (issued 15 July 1971 and subsequently withdrawn).

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Taxation of IP under US tax law

the transfer of a franchise.41 A franchise is defined to include an agreement that gives one of the parties to the agreement the right to distribute, sell or provide goods, services, or facilities, within a specified area.42 The term “know-how” also is not defined in the Code or the Treasury Regulations. The Internal Revenue Service (IRS) has defined know-how as a secret process, formula, or other secret information that is original, unique, and novel and which the owner has taken adequate safeguards to protect against unauthorized disclosure.43 Know-how not known to the trade generally is a capital asset, even if it is simple and easily discoverable through reverse engineering.44 The Tax Court has stated that “unpatented technology such as know-how can be the subject of a sale [and] technical data is treated for tax purposes in a manner similar to patents”.45 Payments for services that are merely ancillary to a transfer of know-how are treated as payments for property – the know-how – rather than services.46 Similarly, a patent transferor may render ancillary and subsidiary services in connection with the sale and transfer of a patent without affecting the capital nature of the total sale proceeds.47 In Ruge v. Commissioner,48 the sale of a patent was accompanied by an agreement that the transferors would (i) furnish up to 60 days of consulting services per year to assist the buyer in the “establishment, or subsequent control, of its manufacturing operations” and (ii) give their “best efforts and thoughts for promoting” the business. The consulting services were held to be ancillary and subsidiary to the patent assignments; the provision of promotional efforts and thoughts was characterized as a service that was not ancillary and subsidiary to the sale. Payment for technical assistance generally is not treated or characterized as a royalty. When a person’s labour or services result in the production or creation of IP, payment for the labour or services is not considered a royalty unless the person performing the services owns the rights to the IP. Thus, 41. IRC § 1253. 42. IRC § 1253(b)(1). 43. See IRS Rev. Rul. 69-19, 1969-2 C.B. 301, amplified by IRS Rev. Proc. 74-36, 1974-2 C.B. 491. 44. US: USTC, 1969, US Mineral Prods. Co. v. Comm’r, 52 T.C. 177, 197, 198. 45. US: USTC, 1971, Taylor-Winfield Corp. v. Comm’r, 57 T.C. 205, 213. 46. See IRS Rev. Rul. 64-56, 1964-1 C.B. 133. 47. US: USTC, 2010, Farris v. Comm’r, 100 T.C.M. (CCH) 325; see also former Treas. Reg. § 1.482-2(b)(8) (providing that where “ancillary and subsidiary” performances were performed in connection with a transfer of tangible or intangible property, the transfer pricing rules applicable to the property transfer applied, and no separate allocation was needed for the services) (withdrawn in 2009). 48. US: USTC, 1956, 26 T.C. 138.

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in Boulez v. Commissioner, payments to a conductor for making musical recordings were treated as compensation for services rather than royalties – even though the agreement referred to the payments as “royalties” and the payments were based on a percentage of the recordings’ sales – because the conductor did not have any property rights in the recordings.49 In contrast, in Commissioner v. Wodehouse, a lump-sum payment received in advance by a British author for book rights was a royalty for the use of copyrights in the United States.50 When both technical assistance and the privilege of using IP are provided together under the same agreement, the two components generally are disaggregated and treated as being transferred in separate transactions.51 If disaggregation is impossible, the predominant character of a transaction determines the type of income.52

21.2.2. Qualification of income deriving from IP and applicable tax regimes The sale or exchange of IP generally produces capital gain, whereas royalties from a licence for the use of IP generally are treated as ordinary income. The mere fact that payments are made periodically over a period coterminous with the transferee’s use of a patent or are contingent on the productivity, use or disposition of a transferred patent does not necessarily preclude capital gains treatment.53 US individuals are taxed at a reduced rate for long-term capital gains; the highest nominal rate for long-term capital gains is 20%,54 compared with a highest nominal marginal rate of 37% for ordinary income.55 Corporations are taxed at the same rate – a nominal rate of 21% – on capital gains and ordinary income.56 The use of capital 49. US: USTC, 1984, Boulez v. Comm’r, 83 T.C. 584. See also US: USTC, 1950, Hopag S.A. Holding de Participation et de Gestion de Brevets Industriels v. Comm’r, 14 T.C. 38 (holding that the taxpayer did not receive a royalty when it shared in income derived from a patent in which it had no ownership interest), acq. in result, 1953-1 C.B. 4. 50. US: USSC, 1949, Comm’r v. Wodehouse, 337 US 369. 51. See Treas. Reg. § 1.954-1(e)(2). 52. See Treas. Reg. § 1.954-1(e)(3). 53. IRC § 1235; US: CAFC 2nd Cir., 1942, Comm’r v. Hopkinson, 126 F.2d 406; US: USTC, 1957, Carroll Pressure Roller Corp. v. Comm’r, 28 T.C. 1288. 54. IRC § 1(h). In addition, a net investment income tax of 3.8% may apply to an individual’s capital gain attributable to the disposition of certain property. IRC § 1411. 55. IRC § 1(i). In addition, a net investment income tax of 3.8% may apply to an individual’s income from interest, dividends, annuities, royalties, rents and certain other passive income. IRC § 1411. 56. IRC § 11.

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Taxation of IP under US tax law

losses and capital loss carryovers is limited.57 Subject to certain wage and capital limitations, an individual is allowed a deduction equal to 20% of the individual’s qualified business income (which, by definition, must be effectively connected with a US trade or business), resulting in a top tax rate of 29.6% for income earned by many sole proprietors or passed through to individuals through partnerships or S corporations.58 In general, a transfer of “all substantial rights” to IP is treated as a sale or exchange taxed as capital gain or loss, whereas a transfer of less than all substantial rights to IP is treated as a licence taxed as ordinary income. In general, a transfer of all substantial rights occurs when the transfer is exclusive within a particular territory for the remaining useful life of the transferred property.59 A particular territory may be one or more countries to which the transferred rights extend.60 For example, the IRS ruled that no sale occurred in connection with a grant of exclusive rights to import, make, use, sell and sublicense patents to a chemical compound in a country because the licence agreement allowed the patent owner to also sell the chemical compound in the same country.61 The IRS ruling concluded that “all substantial rights” were not transferred because in substance “the transaction constituted a grant of a nonexclusive license and not a sale”. In Bell Intercontinental Corp. v. United States,62 the US Court of Claims held that no sale occurred because the transferor retained the right to terminate the grant at its own discretion before the patent expired. Similarly, in Oak Manufacturing Co. v. United States,63 a US appellate court held that no 57. IRC § 1211; IRC § 1212. 58. IRC § 199A. 59. US: USSC, 1891, Waterman v. MacKenzie, 138 US 252, 256; US: CAFC 3rd Cir., 1970, E.I. Du Pont De Nemours & Co. v. United States, 432 F.2d 1052, 1055; US: US Court of Claims (Ct. Cl.), 1967, Bell Intercontinental Corporation v. United States, 381 F.2d 1004, 1016, 1021; US: USTC, 1963, McDermott v. Comm’r, 41 T.C. 50, 59; IRS Rev. Rul. 84-78, 1984-1 C.B. 173; IRS Rev. Rul. 64-56, 1964-1 C.B. 133; IRS Rev. Rul. 60-226, 1960-1 C.B. 26; see Treas. Reg. § 1.1235-2(b)(1)(ii). 60. IRS Rev. Rul. 64-56, 1964-1 C.B. 133 (finding that the transfer will qualify under sec. 351 if the transferred rights extend to all of the territory of one or more countries and consist of all substantial rights therein, the transfer being clearly limited to such territory, notwithstanding that rights are retained as to some other country’s territory); IRS Rev. Rul. 79-288, 1979-2 C.B. 139 (stating that for purposes of sec. 351 the rights to use a trade name in a country, goodwill associated with the name and goodwill existing independently of the name in that country were all a transfer of property). 61. IRS Rev. Rul. 69-156, 1969-1 C.B. 101, modifying IRS Rev. Rul. 57-317, C.B. 19572, 909. 62. US: Ct. Cl., 1967, 381 F.2d 1004 (“[A] transfer limited in duration to a period less than the remaining life of the patent . . . will ordinarily constitute a licensing arrangement rather than a sale….”). 63. US: CAFC 7th Cir., 1962, Oak Mfg. Co. v. United States, 301 F.2d 259.

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sale had occurred where an agreement’s term was 15 years, 2 years shorter than the then-current life of a US patent. However, the fact that a contract is terminable at the option of the transferee64 or on the occurrence of a condition subsequent that is outside the control of the transferor – such as non-payment65 or failure of the transferee to exert best efforts to exploit the invention66 – will not prevent a transfer from being treated as a sale. Whether a payment qualifies as a royalty under US tax law generally depends on the substance of the related transaction rather than its form.67 Non-US law is not controlling, other than to the extent that it governs the rights transferred.68 In general, a payment under an arrangement documented as a licence – and treated as a licence under US IP law – will nevertheless be a purchase rather than a licence for US tax purposes if the transaction results in the transfer of “all substantial rights” to the property.69 This is true even if the payments are contingent.70 For example, a licence agreement transferring all substantial rights to a patent pursuant to a cost sharing agreement is a sale of a capital asset, with any income being taxed under the long-term capital gains rates if the IP was held for more than 1 year, regardless of whether payments are payable periodically or contingent on the productivity, use or disposition of the transferred property.71 Additionally, when IP is transferred, each transferred intangible generally is analysed separately to determine whether it was sold or licensed. The court in US Mineral Products Co. v. Commissioner72 analysed each intangible separately, first by type – patents, trademarks and know-how – and then by individual asset within each category when the intangibles were transferred as part of the transfer of a single going business of the US corporation to a related foreign subsidiary.73 This asset-by-asset analysis mirrors the US tax treatment of intangibles in other contexts. For example, under section 197(a) taxpayers are “entitled to an amortization deduction with respect

64. See US: USTC, 1947, Kimble Glass Co. v. Comm’r, 9 T.C. 183, 190. 65. See US: CAFC 3rd Cir., 1958, Merck & Co. v. Smith, 261 F.2d 162. 66. See US: USTC, Rouverol v. Comm’r, 42 T.C. 186, 194 (1964). 67. E.g. see Treas. Reg. § 1.954-1(e)(1); Treas. Reg. § 1.861-18(g)(1). 68. E.g. see Treas. Reg. § 1.954-1(e)(1); Treas. Reg. § 1.861-18(g)(1); see also 63 Fed. Reg. 52,971, 52,973 (2 Oct. 1998) (explaining that non-US law is applicable to the characterization of a computer software transaction only to the extent that non-US law determines the rights conveyed). 69. See US: CAFC 7th Cir., 1962, Oak Mfg. Co. v. United States, 301 F.2d 259. 70. See IRS Rev. Rul. 60-226, 1960-1 C.B. 26. 71. IRC § 1235. 72. US: USTC, 1969, U.S. Mineral Products Co. v. Comm’r, 52 T.C. 177. 73. Id. at 193.

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Taxation of IP under US tax law

to any amortizable section 197 intangible [emphasis added]”74 and under section 1060 the transferee’s basis in acquired assets and the transferor’s gain or loss with respect to the transfer are established by allocating the consideration asset by asset. Furthermore, the Supreme Court in Newark Morning Ledger Co. v. United States75 held that an intangible can be separately identified if it meets the two-pronged test of (i) having an ascertainable value and (ii) having a limited life that is amortizable.76 Thus, under this two-pronged test an intangible can be separately identified even if it fits within the traditional definition of goodwill. For example, in Private Letter Ruling (PLR) 201016053, the taxpayer had sufficient records to identify separate pools of acquired customer relationships and self-created customer relationships, each with reasonably ascertainable value and reasonably determinable life. The IRS in this PLR treated the self-created customer relationships as a severable and distinct asset from acquired customer relationships.

21.2.2.1. Copyrights A copyright transfer can be treated as a sale provided the transferee receives the exclusive right to exploit the copyrighted work within the scope of the grant for the remaining useful life of the property.77 The US Tax Court in Weimer v. Commissioner78 stated, “There is nothing inherent in the nature of a copyright which precludes the separate sale of the several parts which make up a whole. However, all substantial rights in a separate and distinct medium of publication must be transferred for a transaction to be treated as a sale of a portion of a copyright.” For example, the transfer of motion picture rights to a copyright is a sale even if the book publishing rights have previously been sold to another buyer.79 On the other hand, in Cory v. Commissioner,80 a US appellate court held that a transfer of publishing rights was a licence rather than a sale where the transferor retained

74. IRC § 197(a). 75. US: USSC, 1993, Newark Morning Ledger Co. v. United States, 507 US 546, 56465. 76. Id.; see also US: Ct. Cl., 1968, Meredith Broad. Co. v. United States, 405 F.2d 1214, 1224 (finding the total intangible value of a going business, representing goodwill in its broad sense, is divisible into identifiable constituent assets which, if they have an ascertainable useful life, may be separately valued). 77. IRS Rev. Rul. 60-226, 1960-1 C.B. 26. 78. US: USTC, 1987, Weimer v. Comm’r, T.C. Memo. 1987-390. 79. US: Ct. Cl., 1952, Herwig v. United States, 105 F.  Supp. 384. 80. US: CAFC 2nd Cir., 1956, Cory v. Comm’r, 230 F.2d 941.

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serial publication rights and the consideration for the transferred rights was indeterminable at the time of the transfer. A transfer of the exclusive right to exploit the copyrighted work in a single medium of publication with reservation to the transferor of rights in other media still constitutes a sale even if the consideration is received in the form of annual payments. In TeLinde v. Commissioner,81 the taxpayer transferred the entire bundle of rights in a copyright for a price to be fixed by reference to the future profits, which resulted in a sale, even though the price was indeterminable at the time of transfer. A sale of a self-developed copyright results in ordinary, rather than capital, income;82 thus there appears to be no tax rate benefit to selling a selfdeveloped copyright instead of licensing it. When the transferee is not a US taxpayer, one benefit of a copyright sale with a lump-sum payment, rather than a sale with payments contingent on the use of the property or a licence, may be that such lump-sum payments from US sources are not subject to a 30% withholding tax.83 In addition, the withholding rate may be lower under a US bilateral income tax treaty.84 Special regulatory rules apply to determine the treatment of transactions involving copyrighted computer software.85 Under US copyright law, a copyright consists of six rights: (i) to reproduce the copyright work in copies or phonorecords; (ii) to prepare derivative works based upon the copyrighted work; (iii) to distribute copies or phonorecords of the copyrighted work to the public by sale or other transfer of ownership, or by rental, lease or lending; (iv) to perform the copyrighted work publicly; (v) to display the copyrighted work publicly and (vi) to perform the copyrighted work publicly by means of a digital audio transmission.86 However, when analysing whether a transaction conveys a computer software copyright, the right to make copies of the copyrighted work and the right to distribute copies of the copyrighted work to the public are treated as a single right that is not conveyed unless both components are conveyed.87 Thus, an agreement allowing a computer software user to make copies of the software does not 81. US: USTC, 1952, TeLinde v. Comm’r, 18 T.C. 91. 82. IRC § 1221(a)(3). 83. IRC §§ 871(a)(1)(D); 881(a)(4). 84. Note the definition of royalty in US bilateral income tax treaties sometimes excludes and sometimes includes gain derived from alienation of royalty-producing property if it is contingent on its productivity or use. See sec. 21.1.1. 85. Treas. Reg. § 1.861-18. 86. US: Copyright Act of 1976, Pub. L. No. 94-553, § 106. 87. Treas. Reg. § 1.861-18.

706

Taxation of IP under US tax law

convey the copyright right unless it also allows the user to distribute those copies to the public. An example in the Treasury Regulations describes the sale of a computer program that is used to create new computer programs and that contains libraries of reusable software components, none of which is a significant component of any new program.88 The “licence” agreement allows the buyer to distribute copies of the libraries with any program developed using the purchased program. Because the right to distribute the libraries in conjunction with the newly created programs is a de minimis component of the transaction and the buyer does not have a right to distribute copies of the purchased program, the transaction is treated as the purchase of a copyrighted article rather than the lease of a copyright.

21.2.2.2. Patents US tax treatment of a transfer of patent rights is governed by different rules depending on whether the transfer is from an individual or a corporation. Section 1235 of the Code governs transfer by individual patent holders; case law governs transfers by others, including corporations. Where the transferor is an individual patent holder, capital gains treatment is available on the transfer of all substantial rights to a patent.89 All substantial rights will not be considered transferred if: (i) the transfer is limited geographically within the country of issuance; (ii) the transfer is limited in duration to a period less than the remaining life of the patent; (iii) the transfer grants rights to the grantee, in fields of use within trades or industries, which are less than all the rights covered by the patent, which exist and have value at the time of the grant; or (iv) the transfer grants to the grantee less than all the claims or inventions covered by the patent which exist and have value at the time of the grant.90 The “all substantial rights” analysis under section 1235 is governed by substance rather than form. Thus, retention of legal title is not considered retention of a substantial right when the retention is for the purpose of securing performance or payment by the transferee in a transaction involving transfer

88. 89. 90.

Treas. Reg. § 1.861-18(h), ex. 17. IRC § 1235. Treas. Reg. § 1.1235-2(b)(1).

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Chapter 21 - United States

of an exclusive licence to manufacture, use and sell for the life of the patent.91 Retention of the following rights may or may not be substantial, depending on the circumstances of the whole transaction in which patent rights are transferred: an absolute right to prohibit sub-licensing or sub-assignment by the transferee, or the right to use or sell the patent property.92 The right to terminate the transfer at will is a significant right.93 Transfers of patents by corporations are governed by common law that, like the statutory provisions governing transfers by individuals, looks to the rights transferred and the rights retained. The rights transferred generally must be the exclusive rights to make, use and sell within the United States or a specified area of the United States, or an undivided part or share in that exclusive right,94 and the right to sue infringers,95 and the right must be transferred for the remaining useful life of the patent. Generally, a transfer which is not exclusive, or is limited (other than territorially), is a licence and not an assignment.96 Rights under a patent may be disregarded if they are of no value to the seller of the patent. For example, in Hooker Chemicals and Plastics Corp. v. United States,97 Hooker Chemicals was held to have sold a patent with respect to which it retained the right to import products; since the retained right to import was commercially infeasible to exercise and had no value, it was disregarded. The income from an assignment of a patent is taxable as long-term capital gain, providing the invention is a capital asset and has been held for more than a year. Anything less is a licence. Generally, whether payment is made in a lump sum or over a period of time is immaterial.

91. Treas. Reg. § 1.1235-2(b)(2). A vendor’s lien or a provision for forfeiture on account of non-performance also will not be considered the retention of significant rights. Id. 92. Treas. Reg. § 1.1235-2(b)(3). 93. Treas. Reg. § 1.1235-2(b)(4). 94. US: USSC, 1891, Waterman v. MacKenzie, 138 US 252; see US: CAFC 9th Cir., 1959, Schmitt v. Comm’r, 271 F.2d 301; US: USTC, 1956, Champayne v. Comm’r, 26 T.C. 634; IRS CCA 201121020. 95. See US: Ct. Cl., 1961, E.I. Du Pont de Nemours & Co. v. United States, 288 F.2d 904, 911. 96. See supra n. 88. 97. US: Ct. Cl., 1979, Hooker Chemicals and Plastics Corp. v. United States, 591 F.2d 652.

708

Taxation of IP under US tax law

One US appellate court has held that patent rights may be “divisible between different industries and different industrial products”.98 The US Court of Appeals for the Third Circuit has held that a transfer of a patent limited to its use in the manufacture of nylon99 and a transfer of a patent limited to its use with respect to one chemical compound100 were sales.

21.2.2.3. Trademarks, trade names and franchises The rules regarding transfers of trademarks, trade names and franchises are conceptually similar but different from the rules regarding transfers of patents. Under section 1253 of the Code, a transfer of a trademark, trade name or franchise is not treated as a sale or exchange of a capital asset if the transferor retains any significant power, right or continuing interest with respect to the subject matter of the trademark, trade name or franchise.101 A “significant power, right, or continuing interest” includes, but is not limited to, the following rights: – The right to disapprove any assignment, or any part thereof. – The right to terminate at will. – The right to prescribe the standards of quality of products used or sold, or of services furnished, and of the equipment and facilities used to promote such products or services. – The right to require that the transferee sell or advertise only products or services of the transferor. – The right to require that the transferee purchase substantially all supplies and equipment from the transferor. – The right to payments contingent on the productivity, use or disposition, if such payments constitute a substantial element under the transfer agreement.102 98. US: CAFC 3rd Cir., 1970, E.I. duPont de Nemours and Co. v. Comm’r, 432 F.2d 1052, 1057. 99. Id. 100. US: CAFC 3rd Cir., 1958, Merck & Co. v. Smith, 261 F.2d 162, 165 (holding that “[a] single patent may issue for two or more separate inventions” and a single invention may be sold separately from other inventions covered by the same patent). 101. IRC § 1253(a). 102. IRC § 1253(b)(2).

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Chapter 21 - United States

Prior to enactment of section 1253, the law was somewhat uncertain. In Conde Nast Publications, Inc. v. United States,103 a Second Circuit case, Conde Nast conducted a dress pattern business and published fashion magazines, both under the Vogue trademark and trade name. The case turned on whether certain instalment payments received by Conde Nast in connection with the sale of its dress pattern business and the transfer of the right to use the trademark “Vogue” in the dress pattern business were payments of royalties for a licence, taxed as ordinary income, or were instalment payments on the purchase price for the sale of a capital asset, taxed as long-term capital gains. The parties entered into a licence agreement, which stated that the taxpayer granted the buyer “the sole and exclusive right and license to use the trademark ‘Vogue’” in various countries in connection with its dress pattern business. After the transfer, Conde Nast itself continued the magazine business, with both Conde Nast and the buyer using the Vogue trade name and trademarks for their respective businesses. In its analysis, the court looked to IRS Revenue Ruling 60-226, which states that a transfer will be a sale only if it grants “the exclusive right to exploit the copyright work in a medium of publication”. The court stated that a transfer of the exclusive right to exploit the copyrighted work in a single medium of publication with reservation to the transferor of rights in other media would still constitute a sale even if the consideration was received in the form of annual payments. As a result, the right of exploitation within each of the separate and distinct media would be treated as an entire “cluster of rights” for purposes of deciding whether a sale had been made. Thus, although Conde Nast had a right to terminate the agreement if the buyer did not make a payment or if it was no longer engaged in the business and the buyer had to seek consent from Conde Nast to assign the licence or grant sub-licences, which could not be unreasonably denied, the court found that these rights were not significant and that Conde Nast sold the Vogue trademark and tradename for use exclusively in the dress pattern business.

21.2.2.4. Costs of IP creation Costs to create intangibles must generally be capitalized.104 However, until the first taxable year beginning after 31 December 2021, a taxpayer may receive a deduction for “research or experimental expenditures” that are paid or incurred by the taxpayer during a taxable year in connection with the taxpayer’s trade or business. In taxable years beginning after 103. US: CAFC 2nd Cir., 1978, Conde Nast Publ’ns, Inc. v. United States, 575 F.2d 400. 104. See IRC § 263(a)(1).

710

Taxation of IP under US tax law

31 December 2021, a taxpayer may amortize such research or experimental expenditure over a 5-year period if it is attributable to domestic research and over a 15-year period if it is attributable to foreign research.105 In addition, increases in research and development (R&D) expenditure paid or incurred in carrying on any trade or business of the taxpayer may be eligible for a credit equal to 20% of the excess of such research expenses over a base amount reflecting the taxpayer’s past R&D expenditure.106 To be eligible for the credit, the expenses must be paid or incurred before the beginning of commercial production of a business component.107 Internal use software is eligible for the credit only if it is innovative, involves significant economic risk and is not commercially available for use by the taxpayer.108 A credit also is available for 20% of certain payments to perform basic research.109 On the other hand, the cost of acquired IP used in a business generally may be amortized over 15 years.110

21.2.2.5. Offshoring US IP Special rules govern certain transfers of IP by a US person to a non-US corporation in transactions that would otherwise not result in the recognition of income.111 In general, such transfers – including transfers pursuant to a reorganization or by a parent to a subsidiary in which the parent owns at least 80% of the stock by vote and value – are treated as a sale of the IP in exchange for annual payments that are contingent upon the productivity, use or disposition of the IP. The deemed annual payments are treated as ordinary income of the transferor.

21.2.2.6. Deduction for foreign-derived intangible income US corporations are allowed a 37.5% deduction, resulting in a 13.125% effective tax rate before other deductions and credits, on “foreign-derived 105. IRC § 174; IRC § 263(a)(1)(B) (stating that sec. 174 is an exception to the normal capitalization rule). 106. IRC § 41(a)(1). 107. IRC § 41(d)(4)(A). 108. Treas. Reg. § 1.41-4(c)(6). 109. IRC § 41(a)(2). 110. See IRC § 197. Amortization of computer software is allowed only if the software is acquired in the purchase of a trade or business. Treas. Reg. § 1.197-2(c)(4). 111. See IRC § 367(d).

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Chapter 21 - United States

intangible income”, which is the US corporation’s aggregate foreign market income to the extent it exceeds a fixed return on tangible assets.112 The deduction is scheduled to be reduced from 37.5% to 21.875% in taxable years beginning after 31 December 2025.113 To qualify as foreign market income, the income must be earned through the sale, exchange, lease or licensing of property to foreign persons for a foreign use, or from services provided to foreign persons or with respect to foreign property.114 Special rules apply in the case of sales or services provided to intermediaries, including related parties.115

21.2.2.7. Transfer of IP vs transfer of an article Regulations governing the transfer of computer software provide that transfers generally are classified in one of four categories: a sale or a licence of a copyright right or a sale or lease of a copyrighted article.116

21.2.3. Tax treatment of income from IP derived by nonresident taxpayers Non-resident individuals and corporations with income that is effectively connected with the conduct of a US trade or business generally are subject to US taxation at graduated rates for individuals and, generally, a 21% nominal rate for corporations.117 Non-US individuals and non-US corporations that are not engaged in a US trade or business and thus do not have effectively connected income are subject to a 30% tax on the gross amount of US-source royalty income.118 This 30% tax also applies to amounts received from sources within the United States that constitute gains from the sale or exchange of patents, copyrights and other IP, to the extent such gains are contingent on the productivity, use or disposition of the property or interest sold or exchanged, if the amount received is not effectively connected with the conduct of a US trade or business.119 In addition, payments in consideration for the sale of goodwill 112. 113. 114. 115. 116. 117. 118. 119.

IRC § 250. IRC § 250(a)(3). IRC § 250(b). IRC. § 250(b)(5)(C), (D). Treas. Reg. § 1.861-18(a)(2). IRC § 871(b); IRC § 882(a). IRC § 871(a); IRC § 881(a). IRC § 871(a); IRC § 881(a); IRC § 865(d).

712

Taxation of IP under US tax law

are sourced to the United States if the goodwill was generated in the United States.120 Generally, the person paying the US-source royalty is required to withhold a 30% tax from the payment.121 Royalties that are not effectively connected with the conduct of a US trade or business and not US-source income are not subject to US tax. Royalties are US-source income if they are received for the use or for the privilege of using IP in the United States.122 Royalties are foreign-source income if they are received for the use or for the privilege of using IP outside the United States.123 However, if a licence covers the use of IP both in the United States and in another jurisdiction, and the taxpayer is unable to demonstrate a basis for apportioning the royalties between the United States and the other jurisdiction, all royalties may be treated as from US sources.124 US tax law generally sources income from sales of personal property based on where title passes, or if the transferor retains bare title, where beneficial ownership and risk of loss pass.125 This rule applies to sales of software that constitutes inventory property; parties may agree in the commercial documents where title passes or where beneficial ownership and risk of loss pass.126 Where the transferred property is intangible, like a downloaded computer program, the documentation can provide that delivery is complete and risk of loss and title with respect to the copyrighted article pass when it is received at the end user’s location.127

21.2.4. Attribution to resident taxpayers of IP income derived by non-resident entities under CFC and similar rules A US taxpayer generally must include in taxable income its pro rata share of “Subpart F” income earned by a controlled foreign corporation (CFC) 120. IRC § 865(d)(3). 121. IRC § 1441(a); IRC § 1442(a). 122. IRC § 861(a)(4). For purposes of sec. 861(a)(4), IP means patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises and other like property. 123. IRC § 862(a)(4). 124. US: CAFC 2nd Cir., 1951, Misbourne Pictures, Ltd. v. Johnson, 189 F.2d 774; US: USSC, 1949, Comm’r v. Wodehouse, 337 US 369. 125. Treas. Reg. § 1.861-7(c). 126. See 63 Fed. Reg. 52,971, 52,973 (1998) (preamble to software regulations) (stating that the general sourcing rules for inventory property will apply to income from electronic transfers of computer programs that constitute inventory property and are classified as sales of copyrighted articles). 127. See Treas. Reg. § 1.861-7(c).

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Chapter 21 - United States

when the US taxpayer owns, directly or indirectly, at least 10% of the total combined voting power or value of the CFC.128 A CFC is defined as a nonUS corporation in which more than 50% of the stock, by vote or value, is owned, directly, indirectly or by attribution by “United States shareholders,” defined as US citizens or residents, partnerships, corporations, estates or trusts that own, directly, indirectly or by attribution, (i) at least 10% of the voting stock of the foreign corporation or (ii) at least 10% of the total value of all classes of stock of the foreign corporation.129 The Subpart F rules were first enacted as part of the Revenue Act of 1962. Since then, they have been amended numerous times. In particular, the Tax Reform Act of 1986 significantly expanded the coverage of Subpart F. Recently, the Tax Cuts and Jobs Act of 2017130 added to the Subpart F rules by introducing a new tax regime under which such “United States shareholders” must include in gross income their “global intangible lowtaxed income” (GILTI).131 GILTI means all net income of all CFCs, excluding Subpart F income and certain other types of income, over and above a deemed fixed return on all CFCs’ tangible assets. US corporations are eligible for a deduction equal to 50% of the GILTI inclusion and the resulting 10.5% effective tax rate can be further reduced by up to 80% of the foreign tax credits on the CFCs’ underlying income.132 GILTI is included in income only once; it can be repatriated without further tax, subject to foreign exchange gain or loss.133

21.2.4.1. Royalties Subject to certain exceptions, royalties received by CFCs are foreign personal holding company income, a subcategory of Subpart F income.134 The relevant exceptions to royalties being treated as Subpart F income are the active licensing exception, the same-country exception and the lookthrough exception.135 In addition, profits attributable to IP embedded in a CFC’s sales or services income generally are not foreign personal holding 128. IRC § 951(a), (b) (with “value” applicable for taxable years beginning in 2018). 129. IRC § 957(a), (c); see also IRC § 951(b) (defining “United States shareholder”). 130. US: Pub. L. No. 115-97, introduced as the Tax Cuts and Jobs Act and enacted on 22 Dec. 2017 (officially, “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018”). 131. IRC § 951A. 132. IRC § 960(d). 133. IRC § 951A(f). 134. IRC § 954(c)(1)(A). 135. IRC § 954(c)(2)(A), (c)(3), (c)(6).

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company income.136 Although royalties may not be Subpart F income in certain circumstances, such income may still result in GILTI inclusions to the United States shareholders. Under the active licensing exception, royalties derived in the active conduct of a trade or business and received from an unrelated person are not foreign personal holding company income.137 A person is related to a CFC for this purpose if the person controls the CFC, the CFC controls the person or they are both controlled by the same person or persons.138 “Control” of a corporation means ownership of more than 50% of its stock, by vote or value.139 Royalties are considered to be derived in the active conduct of a trade or business if the CFC: (i) (a) through its own officers or employees, developed, created or produced the IP, or (b) acquired the property and, through its own officers or employees, added substantial value to the IP, and (ii) is regularly engaged in the development, creation or production of, or in the acquisition of and addition of substantial value to, IP of a similar kind.140 However, activities undertaken by another party to a cost sharing agreement are not considered to be undertaken by a licensor’s own officers or employees.141 In addition, royalties are generally considered to be derived in the active conduct of a trade or business if the CFC licenses the IP as a result of the performance of marketing functions by the CFC through its own officers or employees located outside the United States. To fit under this exception, the licensor must maintain and operate an organization through its officers or employees, either in the non-US country or countries (collectively), that is regularly engaged in the business of marketing the licensed IP and that is substantial in relation to the amount of royalties derived from the licensing of this IP.142 Note that although marketing function under this provision must be performed by officers or employees located in a country other than the United States, they need not be located in the CFC’s country of incorporation and the IP need not be used in either the CFC’s country of incorporation or the country in which the officers or employees performed the marketing function. As stated above, activities undertaken by another 136. Such profits, however, may be Subpart F income if they fall within the definitions of foreign base company sales income or foreign base company services income, two additional subcategories of Subpart F income. 137. IRC § 954(c)(2)(A). 138. See IRC § 954(d)(3). 139. Id. 140. Treas. Reg. § 1.954-2(d)(1)(i), (d)(3) ex. 1. 141. Treas. Reg. § 1.954-2(d)(2)(v). 142. Treas. Reg. § 1.954-2(d)(1)(ii).

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party to a cost sharing agreement are not considered to be undertaken by a licensor’s own officers or employees.143 The same-country exception excludes from a CFC’s foreign personal holding company income any royalties received for the use of, or for the privilege of using, IP in the same country under the laws of which the CFC was incorporated.144 The same-country exception does not apply to royalties received from partnerships (unless they have validly elected to be treated as corporations for US tax purposes), trusts or individuals, because royalties are treated as paid by any corporate partners to the extent they result in a deduction that is allocable to the corporate partner or to the extent that the corporate partner is allocated the payment under the partnership agreement.145 In addition, the same-country exception is inapplicable to the extent that a royalty payment reduces the Subpart F income of the payer as a result of a deduction, for example, or the Subpart F income of another CFC.146 Under the “look-through rule,” in § 954(c)(6), royalty income derived by one CFC from a related CFC is excluded from foreign personal holding company income to the extent such royalty income is attributable or properly allocable to income of the related CFC that is neither Subpart F income nor effectively connected with the conduct of a US trade or business.147 The look-through rule was enacted in 2005 with a sunset provision and has been extended by Congress numerous times, with the most recent being through 31 December 2019.148 Royalties are eligible for the look-through rule even if the CFC payer’s deductions exceed its gross income in the year the royalty is paid or accrued.149 However, similar to the limitation on the same-country exception, the look-through rule does not apply if a royalty creates or increases a deficit that may reduce the Subpart F income of the payer or another CFC.150

143. Treas. Reg. § 1.954-2(d)(2)(v). 144. IRC § 954(c)(3)(A)(ii). 145. Treas. Reg. § 1.954-2(b)(4)(i)(B). 146. IRC § 954(c)(3)(B). 147. IRC § 954(c)(6). 148. US: Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. no. 109-222 § 103(b)(1); US: Protecting Americans from Tax Hikes Act of 2015, Pub. L. no. 114-113, § 144(a). 149. See IRS Notice 2007-9, 2007-5 I.R.B. 401. 150. IRC § 954(c)(6)(B).

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Taxation of IP under US tax law

21.2.4.2. Sale of IP Foreign personal holding company income includes gains from the sale of certain property that does not give rise to income and property that produces, inter alia, royalties.151 However, the sale of IP that produces active royalty income152 does not produce gain that is characterized as foreign personal holding company income.153 Property that does not give rise to income does not include IP, goodwill or going concern value to the extent used or held for use in the CFC’s trade or business.154 This is a different standard than the active licensing exception, which requires “active” conduct of a trade or business and the use of the entity’s own employees to conduct the trade or business.155 The Subpart F regulations do not provide guidance on what it means for a CFC to carry on a trade or business. In addition, although income from the sale of IP may not be Subpart F income in certain circumstances, such income may still result in GILTI inclusions to the US shareholders. If a CFC sells IP that, in part, gives rise to royalties and, in part, does not give rise to any income, such IP is considered dual character property.156 Dual character property must be treated as two separate properties and will give rise to gain or loss that in part must be included in and in part that must be excluded from its foreign personal holding company income. In certain circumstances, the sale of IP can result in foreign base company sales income,157 another type of Subpart F income. Foreign base company sales income is defined to mean income derived in connection with (i) the purchase of personal property from a related person or from any person on behalf of a related person, and its sale to any person, or (ii) the purchase of personal property from any person and its sale to a related person or to any person on behalf of a related person, where the purchased personal property is both manufactured, produced, grown or extracted outside of the CFC’s country of incorporation and sold for use outside the CFC’s country of incorporation. Importantly, a purchase and sale are required in each circumstance. Gain on the sale of self-developed intangible property should 151. IRC § 954(c)(1)(B)(iii). 152. See Treas. Reg. § 1.954-2(d). 153. Treas. Reg. §§ 1.954-2(e)(1)(ii)(C); Treas. Reg. § 1.954-2(e)(2)(i). 154. Treas. Reg. § 1.954-2(e)(3)(iv). 155. See Treas. Reg. § 1.954-2(c)(1); Treas. Reg. § 1.954-2(d); Treas. Reg. § 1.954-2(e) (1)(ii)(C); Treas. Reg. § 1.954--2(e)(2)(i). 156. Treas. Reg. § 1.954-2(e)(1)(iv). 157. IRC § 954(d)(1).

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therefore not result in foreign base company sales income, although it could result in foreign personal holding company income, as discussed above. If a single item of income meets the definition of both foreign personal holding company income and foreign base company sales income, the item is treated as foreign personal holding company income.158

21.2.4.3. Investment in US property In addition to the current taxation of Subpart F income described above, a 10% US shareholder of a CFC is also taxed on a CFC’s earnings invested in certain US property pursuant to section 956 of the Code. In general, section 956 US property includes any right to use IP in the United States that is acquired or developed by the CFC for use in the United States.159 Whether an intangible property right has been acquired or developed for use in the United States is determined from all of the facts and circumstances of each case.160 In addition, for purposes of section 956, IP is defined as a patent or copyright, an invention, model or design (whether or not patented), a secret formula or process, or any other similar property right.161 There is no mention in section 956 of marketing intangibles such as trademarks, trade names and brand names, or general intangible property rights, such as goodwill and going concern values. Code sections with similar language indicate that the phrase “any other similar property right” in section 956 should be interpreted as IP similar to the production type IP specifically listed in section 956 rather than as marketing intangibles, goodwill and going concern value.162 Section 956 earnings are determined as the lesser of (i) the US shareholder’s pro-rata share of the average of the “amount of US property” held (directly or indirectly) by the CFC as of the close of each quarter of the taxable year, less the amount of undistributed earnings and profits included in the US shareholder’s income under section 956 in prior years (or which would have been included in the US shareholder’s income under section 956 if such earnings and profits had not been previously taxed as Subpart F income), or

158. Treas. Reg. § 1.954-1(e)(4)(i)(D). 159. IRC § 956(c)(1)(D). 160. Treas. Reg. § 1.956-2(a)(1). 161. IRC § 956(c)(1). 162. See K. Brewer & B. Reynolds, Some Intangibles May be Untouched by US Internal Revenue Code Section 956, 21 Tax Notes Intl., p. 1791 (2000).

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(ii) the US shareholder’s pro rata share of the CFC’s earnings.163 The amount taken into account under (i) with respect to any US property is its adjusted basis reduced by any liabilities to which the property is subject.164 Thus, there must be basis in the IP to have an issue under section 956. In addition, if a CFC has previously taxed Subpart F income, section 956 amounts exclude such previously taxed income.165

21.3. Taxation of IP under tax treaties 21.3.1. Taxing rights over royalties assigned by article 12(1) 21.3.1.1. Overview and 2016 Model Tax Treaty Article 12 of the US Model (2016) discusses the treatment of royalties.166 The US Model is intended to act as the Treasury Department’s starting point when negotiating bilateral tax treaties.167 While US model tax treaties are not law, they provide a generalized example of a US tax treaty and are reflective of the United States’ tax treaty policy.168 Thus, each treaty must be separately analysed, based on its specific language. There are significant additions and changes to article 12 in the US Model (2016) as compared to the US Model (2006). These additions and changes are intended to “eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance”.169 The 2016 Model also makes technical changes to reflect developments in bilateral treaty negotiations.170 There were no changes to the main royalty provision in the US Model (2016). It provides that “[r]oyalties arising in a [source state] and beneficially 163. IRC § 956(a). 164. Id. 165. IRC § 959(a). 166. Art. 12 US Model (2016). 167. See id. 168. See generally B. Wells & C.H. Lowell, Income Tax Treaty Policy in the 21st Century, 5 Colum. J. Tax L. 1, p. 1 (2013). 169. See Press Release, Treasury Announces Release of US Model Tax Treaty (17 Feb. 2016), available at https://www.treasury.gov/press-center/press-releases/Pages/jl0356.aspx (quoting Bob Stack, US Assistant Secretary of the Treasury for Tax Policy) (last accessed 8 Mar. 2018). 170. Id. While the Treasury Department stated that the accompanying Technical Explanation to the 2016 Model Treaty would be released shortly after its publication, the Technical Explanation is yet to be published as of the date of this writing.

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owned by a resident of the other Contracting State shall be taxable only in that other Contracting State” (i.e. a zero rate of withholding).171 US treaty policy is to provide that taxation of royalties that are not attributable to a permanent establishment (PE) may only occur in the state of residence of the beneficial owner. In this regard, royalties attributable to a PE are not subject to the rules of article 12 and instead are subject to the provisions of article 7 of the US Model, which provides for the taxation of a PE’s profits.172 Both the 2016 and 2006 US Models provide that “royalties” include payments received as consideration for the use of, or the right to use, any copyright of literary, artistic, scientific or other work (including cinematographic films); any patent, trademark, design or model, plan, secret formula or process; or for information concerning industrial, commercial or scientific experience.173 The 2006 US Model’s Technical Explanation states that “royalties” does not include income from leasing personal property.174 The US policy is that terms used in the treaty definitions of “royalty” that are not specifically defined in the treaty “may be defined under domestic tax law”.175 One change in the 2016 US Model is that the term “royalty” no longer includes “gain derived from the alienation of any [royalty-producing property], to the extent that such gain is contingent on the productivity, use, or disposition of the property”.176 US bilateral treaties vary as to whether they include this provision. Some treaties include it within the definition of “royalties,”177 while other treaties do not include it within their definition.178 171. Art. 12(1) US Model (2016). 172. Art. 12(5) US Model (2016); see also sec. 21.3.2.3. 173. See art. 12(4) US Model (2016); art. XII(2) US Model (2006). 174. Art. 12(2) US Model (2006). While there is not yet (at the time of writing) a published Technical Explanation for the US Model (2016), the Technical Explanation does address some of these terms in greater detail and possible interpretations of this information. For example, it states that “with respect to any subsequent technological advances in the field of radio or television broadcasting, consideration received for the use of such technology will also be included in the definition of royalties”. Id. at 42. 175. See art. 12(2) US Model (2006). For example, the Technical Explanation provides that “the term ‘secret process or formulas’ is found in the Code, and its meaning has been elaborated in the context of sections 351 and 367.” Id. (citing IRS Rev. Rul. 55-17, 1955-1 C.B. 388; IRS Rev. Rul. 64-56, 1964-1 C.B. 133; IRS Rev. Proc. 69-19, 1969-2 C.B. 301. 176. Cf. art. 12(4) US Model (2016) with art. 12(2)(b) US Model (2006). 177. E.g. see art. 12(2)(b) Fr.-US Income and Capital Tax Treaty (1994); art. 12(2) Ger.-US Income and Capital Tax Treaty (1989). 178. E.g. see art. 12(2)(b) Belg.-US Income Tax Treaty (1970), although it is included in art. 12(2) Belg.-US Income Tax Treaty (2006).

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Taxation of IP under tax treaties

21.3.1.2. Royalty withholding rates Many US treaties follow the US Model and therefore do not provide for the taxation of royalties by the source state.179 Thus, most US treaties provide a zero rate of withholding for royalties. Some US treaties, however, do retain withholding tax rights for the source state; for those treaties, the withholding rate is generally between 5% and 15%.180 Among those US treaties that do allow for withholding of royalties by the source state, some treaties apply different rates to different types of royalties. Generally speaking, such treaties distinguish between royalties for the right to use or reproduce literary, dramatic, musical or artistic works (collectively, “cultural royalties”) and royalties for the right to use patents, trademarks, designs, secret formulae and know-how (collectively, “technical royalties”).181 Generally speaking, cultural royalties are subject to taxation by the source state at a lower rate than royalties for patents, trademarks, designs, secret formulae and know-how.182

21.3.1.3. Royalty sourcing rules As a general rule, the United States sources royalties in the United States to the extent the payments are received for the use of, or the privilege of using, IP in the United States.183 While US taxpayers are subject to worldwide taxation on income from all sources, non-US taxpayers are generally subject to taxation in the United States only on their income from sources within the United States, unless reduced by an applicable income tax treaty. Most US tax treaties provide specific sourcing rules that align with the US rules,

179. See art. 12 US Model (2016) (lacking a distinction between withholding rates for different types or categories of IP); art. 12 US Model (2006) (same). 180. E.g. see art. 12(2) Thai.-US Income Tax Treaty (1996) (allowing taxation at variable rate between 5% and 15%); art. 12(2) Czech Rep.-US Income and Capital Tax Treaty (1993) (allowing withholding tax on patents, trademarks, etc. at a rate of 10%. 181. E.g. see art. 12(3) Czech Rep.-US Income and Capital Tax Treaty (1993); art. 12(2) It.-US Income Tax Treaty (1999); art. 12(2) Spain-US Income Tax Treaty (1990); see also Nauheim & Scott, 938-1st, US Income Tax Treaties – Income Not Attributable to a Permanent Establishment, VI.D.2 nn. 659 and 660 (2017) (listing treaties that distinguish withholding rates and using the terms “cultural royalties” and “technical royalties”). 182. E.g. see art. 12(2) Thai.-US Income Tax Treaty (1996). But see art. 12(2) It.-US Income Tax Treaty (1999) (providing a 5% withholding rate for certain uses of software and an 8% withholding rate for all other types of royalties). 183. IRC § 861(a)(4).

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sourcing royalties to the place of use.184 Some treaties do not contain any specific sourcing rules and thus the US statutory rules govern.185 Some US tax treaties, however, provide special rules for the sourcing of royalties.186 Among these are treaties that contain rules that deal with particular situations – e.g. the US tax treaties with France and Italy source royalties first to the country of use and then, if the country of use is outside the treaty countries, to the PE of the licensee, even if not a resident of either treaty state.187 Other treaties follow the model of the Spain-US Tax Treaty, which sources royalties first to the licensee’s place of residence, then to the licensee’s PE, if applicable, and only finally to the place of use.188 However, under US constitutional law, a tax treaty can only lower the US taxes owed by a person, a treaty cannot increase the taxes one must pay.189

21.3.2. Meaning of “royalties” and overlapping between articles 7, 12 and 13 21.3.2.1. Definition of “royalties” under article 12 Almost all US tax treaties contain a definition of “royalties”.190 The US Model (2016) defines “royalties” as payments of any kind received as consideration for the use of, or the right to use, any copyright of literary, artistic, scientific or other work (including cinematographic films); any patent, trademark, design or model, plan, secret formula or process; or for information concerning industrial, commercial or scientific experience.191 184. E.g. see art. 12(6) Austria-US Income Tax Treaty (1996); art. 14(7)-(9) Jap.-US Income Tax Treaty (2003). 185. E.g. see art. 13 Neth.-US Income Tax Treaty (1992). 186. See generally Nauheim & Scott, supra n. 181, at VI.F.9 (discussing various special sourcing rules under US bilateral treaties). 187. E.g. see art. 12(6) Fr.-US Income and Capital Tax Treaty (1994); art. 12(5) It.-US Income Tax Treaty (1999). 188. E.g. see art. 12(5) Spain-US Income Tax Treaty (1990). 189. See art. I(7)(1) US Const. (providing that “[a]ll Bills for raising Revenue shall originate in the House of Representatives”); art. II(2)(2) US Const. (giving the US Senate the sole authority to approve Treaties negotiated by the President). But see R.M. Kysar, On the Constitutionality of Tax Treaties, 38 Yale J. Int’l L. 38, p. 21 (2013) (noting that while income tax treaties typically cannot, by their own terms, increase a taxpayer’s US tax liability, US tax treaties can in some cases indirectly increase revenue for the United States, which raises potential constitutional issues). 190. E.g. see art. 12(2) Ger.-US Income and Capital Tax Treaty (1989) (defining “royalties”); art. 12(4) Fr.-US Income and Capital Tax Treaty (1994) (same). 191. See art. 12(4) US Model (2016).

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Taxation of IP under tax treaties

21.3.2.2. Comparison of treaty definition of “royalties” with US tax law definition of “royalties” There is no single definition of “royalties” under US tax law.192 However, US tax law addresses the treatment of “royalties” in different contexts, most of which align with the definition provided in the US Model (2016). For example, under the sourcing rules of section 861 of the Code: “royalties for the use of or for the privilege of using in the United States patents, copyrights, secret processes and formulas, goodwill, trade-marks, trade brands, franchises, and other like property” are sourced in the United States.193 There is a corresponding rule for royalties from property located without the United States.194 Those royalties are foreign-source income.195

21.3.2.3. Treaty interpretation issues and considerations One area of interpretive difficulty is the treatment of software, i.e. when and to what extent revenue generated from software should qualify as a royalty. Some US tax treaties explicitly provide in their definition of “royalties” that consideration for the use of computer software qualifies as a royalty.196 However, many US tax treaties,197 as well as the 2016 and 2006 US Models,198 do not explicitly include computer software within their definition of “royalties”. The Technical Explanation to the 2006 Model Treaty provides guidance as to how the United States will treat computer software under article 12: “Computer software generally is protected by copyright laws around the world. Under the Convention, consideration received for the use, or the right to use, computer software is treated either as royalties or as business profits, depending on the facts and circumstances of the transaction.”199 Furthermore, the main factor in determining whether consideration received for the use or the right to use computer software will be treated as royalties or as business profits is the “nature of the rights transferred”.200 192. See sec. 21.2.1. 193. See IRC § 861(a)(4). 194. See IRC § 862(a)(4). 195. See id. 196. E.g. see art. 12(2)(a) Den.-US Income Tax Treaty (1999); art. 12(2)(a) Fr.-US Income and Capital Tax Treaty (1994); art. 12(2)(a) SA-US Income Tax Treaty (1997). 197. E.g. see art. 12(2) Ger.-US Income and Capital Tax Treaty (1989). 198. See art. 12(4) US Model (2016); art. 12(2) US Model (2006). 199. See art. 12(2) 2006 Model Technical Explanation. 200. Id. (citing Treas. Reg. § 1.861-18).

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The Technical Explanation, using the principles of Treas. Reg. § 1.86118, provides that a transaction’s characterization as a licence under the principles of copyright law is not dipositive.201 In addition, the means by which the computer software is transferred is not relevant.202 The § 1.86118 Regulations provide four categories involving computer programs: (i) transfer of a copyright right to the program;203 (ii) a transfer of a copy of the computer program;204 (iii) the provision of services relating to development or modification of a computer program205 or (iv) the provision of know-how relating to computer programming techniques.206 Only transfers of computer software that fall under Category 1 or Category 4 could create royalty income; a Category 2 transaction would generate sales income, while a Category 3 transaction would generate services income. So long as a sale of the IP does not occur – which is defined by the 1.861-18 Regulations as a transfer “of all substantial rights” to the IP207 – the partial transfer of a copyright right to the program or a partial transfer of know-how relating to computer programs may, in some circumstances, generate royalties under US tax principles.208 Another important interpretive issue is whether artistic performances or public displays of art should be considered services income (and thus sourced to the place of performance) or instead ought to be considered royalties income (which would be sourced to the place of use). It is the US position that if an artist who is resident in one treaty state records a performance in the other treaty state, retains a copyrighted interest in a recording, and receives payments for the right to use the recording based on the sale or public playing of the recording, the right of the other state to tax those payments is governed by article 12.209

201. Id. (“For example, a typical retail sale of ‘shrink wrap’ software generally will not be considered to give rise to royalty income, even though for copyright purposes it may be characterized as a license.”); see also Treas. Reg. § 1.861-18(g)(1). 202. Art. 12(2) 2006 Model Technical Explanation; see also Treas. Reg. § 1.861-18(g) (2). 203. Treas. Reg. § 1.861-18(b)(1)(i); Treas. Reg. § 1.861-18(c)(1)-(c)(2). 204. Treas. Reg. § 1.861-18(b)(1)(ii); Treas. Reg. § 1.861-18(c)(3). 205. Treas. Reg. § 1.861-18(b)(1)(iii); Treas. Reg. § 1.861-18(d). 206. Treas. Reg. § 1.861-18(b)(1)(iv) Treas. Reg. § 1.861-18(e). 207. See Treas. Reg. § 1.861-18(f)(1). 208. But see supra nn. 68-70 and accompanying text (discussing partial transfers of copyrights). 209. E.g. see US: USTC, 1984, Boulez v. Comm’r, 83 T.C. 584, aff’d D.C. Cir., 1986, 810 F.2d 209, cert. denied 484 US 896; S.D.N.Y., 1931, Ingram v. Bowers, 47 F.2d 925; see also art. 12(2) 2006 Model Technical Explanation (discussing Boulez).

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Taxation of IP under tax treaties

21.3.2.3.1.  Beneficial ownership and royalties The concept of beneficial ownership is an important requirement for claiming tax treaty benefits under US tax treaties.210 In general, only the “beneficial owner” of an item of income, including a royalty, is entitled to a reduced or zero rate of withholding.211 Although this requirement has long been a cornerstone of US tax treaty policy, US tax treaties generally contain no definition of the term “beneficial owner.”212 In the absence of a definition for a specific term, US tax treaties generally apply the internal law of the source country.213 Thus, for purposes of determining the beneficial owner of US-source royalties, it is necessary to apply principles of US federal tax law. Under US federal tax law, the determination of the “beneficial owner” of an item of income, including a royalty, depends on the underlying facts and circumstances, taking into account the substance of the transaction, rather than its mere form.214 In this regard, US courts have explained that “the true owner of income-producing property is the one with beneficial ownership, rather than mere legal title”, i.e. “[i]t is the ability to command the property, or enjoy its economic benefit, that marks a true owner”.215 210. 65 Fed. Reg. 40994 (3 July 2000). 211. See art. 12(1) 2016 US Model Tax Treaty; art. 12(1) US Model (2006). 212. See generally US Model (2006), US Model (2016); see also art. 42 2006 Model Technical Explanation (“The term ‘beneficial owner’ is not defined in the Convention, and is, therefore, defined under the internal law of the State of source.”). But see art. 3(1) Lux.-US Income and Capital Tax Treaty (1996) (containing a limited definition of the term “beneficial owner” in the case of an item of income received by a pass-through entity). 213. See art. 3(2) US Model (2016) (providing that “unless the context otherwise requires”, any undefined term will “have the meaning that it has at that time under the law of that Contracting State for the purposes of the taxes to which this Convention applies”); see also US Model (2006) (providing that “unless the context otherwise requires”, any undefined term will “have the meaning which it has at that time under the law of that State for the purposes of the taxes to which the Convention applies”); see also art. 12(1) 2006 Model Technical Explanation (“The term ‘beneficial owner’ is not defined in the Convention, and is, therefore, defined under the internal laws of the State of source.”). 214. E.g. see US: CAFC 8th Cir., 1965, Schoenberg v. Comm’r, 302 F.2d 416; see also US: USSC, 1945, Comm’r v. Court Holding Co., 324 US 331. 215. US: CAFC 5th Cir., 2014, Salty Brine I, Ltd. v. Comm’r, 761 F.3d 484, 492 (holding that the purported transfer of certain royalty interests was an invalid assignment of income) (internal citations and quotations omitted); see also US: USTC, 1996, Chu v. Comm’r, 72 T.C. Memo. 1519) (“The true owner of income-producing property … is the one with beneficial ownership, rather than mere legal title. It is the ability to command the property, or enjoy its economic benefits, that marks the true owner.”) (citations omitted). The determination of tax ownership often arises in the context of income that is assigned to another party, but the relevant underlying property giving rise to such income is not treated as transferred for US federal income tax purposes. See also US: USSC, 1948, Comm’r v. Sunnen, 333 US 591, 604 (“The crucial question [is] whether the assignor retains sufficient power and control over the assigned property or over receipt of the

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Chapter 21 - United States

Consistent with US tax principles governing the determination of beneficial ownership, the Technical Explanation to the US Model (2006) provides that the “beneficial owner of the royalty for purposes of Article 12 is the person to which the income is attributable under the laws of the source State”.216 Thus, where a royalty arising in the source country is received by a nominee or agent that is a resident of the other country (under an applicable income tax treaty) on behalf of another person that is not a resident of the other country, the royalty is generally not entitled to the benefits of article 12.217

income to make it reasonable to treat him as the recipient of the income for tax purposes.”). In addition to case law, the Treasury Department and IRS have issued administrative guidance addressing the concept of beneficial ownership. The Treasury Department and IRS first issued proposed regulations in 1996 defining the term “beneficial owner” for purposes of income tax withholding under secs. 1441 and 1442 of the Code, as amended, on certain US-source income (including royalties) paid to foreign persons. See 61 Fed. Reg. 17614 (22 Apr. 1996). As proposed, the term “beneficial owner” was defined as the “person required under US tax principles to include the amount in gross income under section 61,” without regard to any applicable exclusions or exceptions. Id. at 17636. In the treaty context, however, the proposed regulations would have applied foreign tax principles, rather than US tax principles, to identify the beneficial owner of income for which a claim of a reduced rate of withholding is made based upon a tax treaty. Id. at 17621, 17636. Ultimately, the proposed definition of a “beneficial owner” specifically excluded applications for cases involving a reduced rate of withholding being claimed under an income tax treaty. See T.D. 8734, 62 Fed. Reg. 53387, 53393 (14 Oct. 1997); T.D. 8881, 65 Fed. Reg. 32152, 32155 (22 May 2000) (“This change has been made to clarify that a person who is a beneficial owner of an item for purposes of those regulations would not necessarily beneficially own the item of income for purposes of an income tax treaty.”). The Treasury Department and IRS issued temporary and final regulations under sec. 894 of the Code for the purpose of determining whether US-source income paid to certain entities is eligible for a reduced rate of US tax under an income tax treaty. While these rules do not expressly contain a definition of “beneficial owner” for purposes of US tax treaties, they confirm the Treasury Department’s and IRS’s positions that as used in US tax treaties, the term “beneficial owner” is intended to “address ‘conduit,’ ‘nominee’ and comparable situations in which the person receives the payment in form (and may even be taxed on that income in the jurisdiction in which it resides), but is nevertheless not treated as beneficially owning the income for purposes of a particular treaty because, under the rules of the source country, the income is deemed to belong to another person who is determined to have a stronger economic nexus to the income”. See T.D. 8722, 62 Fed. Reg. 35673, 35676 (2 July 1997); T.D. 8889, 65 Fed. Reg. 40993 (3 July 2000). The sec. 894 rules also confirm that the “anti-conduit” regulations in Treas. Reg. § 1.881-3 issued under section 7701(l) of the Code are incorporated into the US determination of beneficial ownership. 65 Fed. Reg. 40993, 40994. 216. Art. 12(1) US Model (2006). 217. See id.

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Taxation of IP under tax treaties

21.3.3. Exemption in source state in cases of favourable tax regimes applicable to the beneficial owner of royalties in the state of residence While other countries have supported investment by establishing special tax regimes for IP – e.g. a so-called “patent box”218 – the United States lacks any such special tax regime for IP.219 However, the US tax system does subsidize research activities through its tax law; it offers a credit for certain qualified research expenditure and allows research expenditure to be expensed rather than amortized over time.220

21.3.4. Time of taxation Article 12 of the 2016 and 2006 US Models does not specifically define or otherwise provide guidance as to the definition of the term “payment”, nor does it provide any specific guidance regarding the treatment of accrued, but unpaid, royalties.221 However, under Treasury Regulations governing withholding with respect to US-source payments to non-US persons, a “payment” is defined in terms of income realization, not in terms of the receipt or transfer of property or cash.222 218. Joint Committee on Taxation, Background and Selected Policy Issues on International Tax Reform (28 Sept. 2017). at 36-37 [hereinafter JCT Report]. The US Joint Committee on Taxation identifies three key design features of patent boxes: (i) a definition of the type of IP that qualifies for the special tax regime; (ii) a required nexus between the IP and the country with the special tax regime and (iii) a description of income that qualifies for the special tax regime and the preferential tax treat given to such income. Id. at 37. 219. Countries that have enacted such preferential tax regimes since 2000 include Belgium, Cyprus, France, Hungary, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Spain, Turkey and the United Kingdom. JCT Report at 37. 220. JCT Report at 37. 221. In the absence of a definition, the term is generally given the “meaning that it has at that time under the law of that Contracting State” (art. 3(2) US Model (2016)). See also art. 3(2) 2006 Model Technical Explanation (“The reference in paragraph 2 to the internal law of a Contracting State means the law in effect at the time the treaty is being applied, not the law as in effect at the time the treaty was signed.”). 222. Treas. Reg. § 1.1441-2(e). For example, under Treasury Regulations, a “payment is considered made when the amount would be includible in the income of the beneficial owner under the US tax principles governing the cash basis method of accounting” and a “payment is considered made whether it is made directly to the beneficial owner or to another person for the benefit of the beneficial owner (e.g., to the agent of the beneficial owner).” See id.; see also US: USTC, 2002, Framatome Connectors USA, Inc. v. Comm’r, 118 T.C. 32, 72-74 (holding that a constructive dividend, for which there was no actual cash payment, was subject to tax by the French shareholder under the then operative France-US Tax Treaty, although the treaty limited the source country’s right to tax a dividend to 5% “of the amount actually distributed”).

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Chapter 21 - United States

21.3.5. Excessive royalty payments Royalty payments are generally deductible under US tax law, provided such payments are properly treated as ordinary and necessary business expenses incurred during the taxable year in carrying on the taxpayer’s trade or business.223 Deductions for royalties reduce taxable income. Thus, tax authorities are often concerned that taxpayers under common control may be incentivized to charge excessive, or above-market, royalties.224 To prevent related taxpayers from charging excessive royalty payments, US tax treaties generally limit application of the reduced rate of withholding only to the portion of the royalty that is arm’s length.225 In this regard, article 12(7) of the US Model (2016) addresses the treatment of royalties among taxpayers with a “special relationship,” a term that is not defined in the 2016 or 2006 US Models, but which the United States generally views as akin to “controlled” parties for purposes of section 482 of the Code:226 223. IRC § 162(a), Treas. Reg. § 1.162-1(a). To the extent that royalties are incurred by an individual not engaged in a trade or business, but rather for the production or collection of income or for the management, conservation or maintenance of investments, such payments may be deductible, in whole or in part. See IRC § 212. 224. Generally, no deduction is allowed for the non-arm’s length or above-market portion of a royalty. See IRS Rev. Rul. 69-513, 1969-2 C.B. 29 (holding that payments by a corporation to its majority stockholder for the use of a patent were deductible, but that the portion of any payment in excess of a “reasonable amount” would be treated as a distribution by the corporation and not deductible); US: USTC, 1998, Podd v. Comm’r, T.C. Memo. 1998-231 (holding, in relevant part, that the portion of a royalty in excess of an arm’s-length rate was not an ordinary and necessary business expense, but rather a non-deductible expenditure in the form of a constructive dividend); US: USTC, 1996, Medieval Attractions N.V. v. Comm’r, T.C. Memo. 1996-455, at 41 (“The ‘arm’s-length’ test commonly associated with section 482 is equally applicable in ascertaining the ‘ordinary and necessary’ character of a payment to a related party that is deductible under section 162(a)”); see also IRS FSA 200019026 (12 May 2000) (“A controlled-party royalty that satisfies the arm’s length standard under section 482 by definition also constitutes an ‘ordinary and necessary’ expense for purposes of section 162(a). In the event that a particular expense item between controlled parties, such as a royalty, does not satisfy the arm’s length standard, courts generally prefer an allocation of income pursuant to section 482 to a complete disallowance of the deduction pursuant to section 162”) (citations omitted). 225. E.g. see art. 12(7) US Model (2016); art. 12(4) US Model (2006). Art. 12(7) of the US Model (2016) addresses the treatment of non-arm’s length royalties among taxpayers with a “special relationship”, a term that is not defined in the 2016 or 2006 US Models, but which the United States views as akin to “controlled” parties for purposes of sec. 482 of the Code. The Technical Explanation to the US Model (2006) explains that the “United States considers the term to include the relationships described in Article 9 [Associated Enterprises], which in turn correspondences to the definition of ‘control’ for purposes of section 482 of the Code”. Art. 11(5) 2006 Model Technical Explanation. 226. The Technical Explanation to the 2006 US Model Tax Treaty explains that the “United States considers the term to include the relationships described in Article 9 [Associated

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Taxation of IP under tax treaties

Where, by reason of a special relationship between the payor and the beneficial owner or between both of them and some other person, the amount of the royalties, having regard to the use, right, or information for which they are paid, exceeds the amount that would have been agreed upon by the payor and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount.227

The Technical Explanation to the 2006 US Model Treaty further provides that if, for example, “the excess amount is treated as a distribution of corporate profits under domestic law, such excess amount will be taxed as a dividend rather than as royalties, but the tax imposed on the dividend payment will be subject to the rate limitations of paragraph 2 of Article 10 (Dividends).”228

Enterprises], which in turn corresponds to the definition of ‘control’ for purposes of section 482 of the Code”. Art. 11(5) 2006 Model Technical Explanation. 227. Art. 12(7) US Model (2016). By contrast, art. 12(7) of the US Model (2016) provides that the portion of the royalty that exceeds an arm’s-length royalty, i.e. the portion that is above-market, may be taxable by the United States and its treaty counterparty, unless some other provision in the relevant tax treaty applies. Id. (“In such case the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention.”). 228. Art. 12(4) 2006 Model Technical Explanation. Notably, neither the US Model (2016) nor the US Model (2006) address the treatment of a below-market royalty. Presumably, such payments may be addressed in other portions of the tax treaty, including the savings clause, which generally permits a country to apply its own taxing rules, subject to certain exceptions.

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Contributors Paolo Arginelli is Professor of European Union Tax Law and Corporate Tax Law at the Università Cattolica del Sacro Cuore, Italy and an Adjunct Postdoctoral Research Fellow at IBFD. He is Of Counsel with Maisto e Associati in Milan and can be contacted at [email protected]. Celeste M. Black is an Associate Professor at the University of Sydney Law School, University of Sydney, Australia. Alberto Brazzalotto is an Associate with Maisto e Associati in Milan. He can be contacted at [email protected]. Patricia A. Brown is the Director of the Graduate Program in Taxation and Graduate Program in Taxation of Cross-Border Investment at the University of Miami School of Law. From 1997 through 2006, Ms Brown was the Deputy International Tax Counsel (Treaty Affairs) at the US Treasury Department, where she was responsible for the coordination of the US tax treaty programme. Sophie Chatel is the Head of the Tax Treaty Unit at the OECD in Paris. Previously, Sophie worked at Canada’s Department of Finance and at the Canada Revenue Agency where she played a key role in the international tax policy work of the Canadian government. Earlier in her career she worked as a tax advisor in the private sector. Sophie holds a law degree from the University of Montreal and a master’s degree in taxation from the University of Sherbrooke. She is also a member of the Chartered Professional Accountants of Canada. Robin Damberger holds an MSc degree from the WU (Vienna University of Economics and Business), where he is currently a Research Associate at the Institute for Austrian and International Tax Law. Robert J. Danon is Professor of Swiss and International Tax Law at the University of Lausanne, where he heads its Tax Policy Center. He is a founding Partner of the tax firm Danon & Salome, Lausanne, Switzerland and Chairman of the Permanent Scientific Committee of the International Fiscal Association (IFA). He holds a PhD in Tax Law from the University of Geneva and an LLM in International Taxation from the University of Leiden.

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Mathieu Daudé is an Avocat and Of Counsel with CMS Francis Lefebvre Avocats in Paris. David N. de Ruig is an Associate with Fenwick & West LLP in Mountain View, California. Sjoerd Douma is a Professor at the Amsterdam Centre for Tax Law, University of Amsterdam and a Partner with Lubbers, Boer & Douma. Anne Fairpo holds an MA (Oxon) degree and is a Barrister at Temple Tax Chambers in London. Elizabeth Gil García is an Assistant Professor in the Tax Law Department of the University of Alicante, Spain. She holds PhD and LLM degrees and can be contacted at [email protected]. Hans-Peter Gradwohl holds an MSc degree from the WU (Vienna University of Economics and Business), where he is currently a Research Associate at the Institute for Austrian and International Tax Law. Peter Hongler, Dr. iur., is a Certified Tax Expert and Counsel with Walder Wyss Ltd in Zurich. He is a Lecturer at the University of Zurich and Executive Director of the University’s LLM Programme in International Tax Law, and an Adjunct Research Fellow at IBFD, Amsterdam. Michael D. Knobler is an Associate with Fenwick & West LLP in Mountain View, California. Na Li is a Lecturer at the East China University of Political Science and Law in Shanghai, China. She can be contacted at [email protected]. Sean P. McElroy is an Associate with Fenwick & West LLP in Mountain View, California. Adolfo Martín Jiménez is Professor of Tax Law, Jean Monnet Chair, at the University of Cádiz, Spain. Leonardo F. de Moraes e Castro is a PhD Candidate in International Taxation at the Universiteit Leiden (Netherlands) and in Economic, Financial and Tax Law at University of São Paulo (Brazil). He holds an LLM in Taxation from Georgetown University Law Center (US) – Graduate Tax Scholarship and Dean’s Certificate award and an LLM in Economic, 732

Contributors

Financial and Tax Law from the University of São Paulo (Brazil). He is a Professor of International Tax Law in Brazil and an Administrative Judge at the São Paulo State Tax Court. A Tax Partner of Costa e Tavares Paes Advogados in Brazil, he can be contacted at [email protected]. Larissa B. Neumann is a Partner with Fenwick & West LLP in Mountain View, California. Jacques Sasseville is Interregional Adviser in the Capacity Development Unit, FfDO/DESA, at the United Nations, New York. His work focusses primarily on assistance programs and training related to the negotiation, application and interpretation of tax treaties. From 1995 to 2016, he was Head of the Tax Treaty Unit at the OECD in Paris, where he also previously worked from 1990 to 1993, when he was Principal Administrator and subsequently Deputy Head of the Fiscal Affairs Division, as well as with the Federal Government of Canada as Counsel in the Tax Counsel Division (Department of Justice) and as Chief, Tax Treaties (Department of Finance). He has lectured and written extensively on international taxation and is a guest lecturer at the international taxation programs of the University of Leiden (Netherlands) and the Vienna University of Economics and Business Administration (Austria). Joel Scheuerman is an Associé/avocat en litige fiscal (Partner/Lawyer in tax litigation) with BCF Avocats d’Affaires – BCF Business Law in Montréal. Livia Schlegel holds an MLaw degree from the University of Zurich and is a Legal Trainee with Walder Wyss Ltd in Zurich. Florian Schmid is a Trainee Lawyer at an international law firm in Stuttgart and holds a Master of Laws (LLM) degree from Queen Mary University London in international tax law. Julia Ushakova-Stein is an Associate with Fenwick & West LLP in Mountain View, California. Matthias Valta, Dr. jur., is Professor for Public Law and Tax Law at the Heinrich Heine University Düsseldorf, Germany. Zoya Zalmai is a Tax Advisor with PwC Amsterdam (EU Direct Tax Group).

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Other titles in this series Vol. 1 – Multilingual Texts and Interpretation of Tax Treaties and EC Tax Law Vol. 2 – Tax Treaties and Domestic Law Vol. 3 – Courts and Tax Treaty Law Vol. 4 – International and EC Tax Aspects of Groups of Companies Vol. 5 – Residence of Companies under Tax Treaties and EC Law Vol. 6 – Residence of Individuals under Tax Treaties and EC Law Vol. 7 – The Meaning of “Enterprise”, “Business”, and “Business Profits” under Tax Treaties and EU Tax Law Vol. 8 – Taxation of Intercompany Dividends under Tax Treaties and EU Law Vol. 9 – EU Income Tax Law: Issues for the Years Ahead Vol. 10 – Taxation of Companies on Capital Gains on Shares under Domestic Law, EU Law and Tax Treaties Vol. 11 – Departures from the OECD Model and Commentaries Vol. 12 – Immovable Property under Domestic Law, EU Law and Tax Treaties Vol. 13 – Taxation of Entertainers and Sportspersons Performing Abroad Vol. 14 – Non-Discrimination in Tax Treaties: Selected Issues from a Global Perspective Vol. 15 – Taxation of Shipping and Air Transport in Domestic Law, EU Law and Tax Treaties