Tax Treaty Series

ITQ T-

051

July 24, 2020

Question

ACo, a company resident in A, owns a patent which is registered in B.

BCo, a company resident in B, wants to use that patent to manufacture certain goods in B.

ACo and BCo are related parties.

ACo sells the patent to BCo, in consideration for an annual fee which is set at 5% of BCo's annual revenue from sale of the goods manufactured by using the patent. The contractual obligation to pay the annual fee is for 10 years. The sale contract calls the annual fee a "royalty".

Under B tax law:

BCo is able to claim tax depreciation on the 10 years aggregate of the annual fee (which is initially estimated, and then "trued up" each year)
Outbound royalties are subject to 20% royalty withholding tax on gross (final tax)

The A/B treaty is identical to the 2017 OECD model treaty, except that the source country tax in Article 12 is limited to 10% on gross.

ACo is in an excess foreign tax credit position in A, which means that it cannot obtain an effective credit for the B withholding tax.

Does the A/B treaty permit B to impose tax on the annual fee payments?

Answer

1. Art. 12

i. The key issue is whether the annual fee payments fall within the definition of "royalties" in Art. 12(2): "consideration for the use of, or the right to use, any…patent”

ii. The answer is no. The annual fee payments are consideration for the acquisition of the patent, not for its use: see OECD Comm., para. 8.2 (first sentence). The form of consideration (i.e., a percentage of annual sales revenue for 10 years) and the name given to the consideration (i.e., "royalties") are irrelevant.

iii. Note, however, that some bilateral and model treaties include in the definition of "royalties" in Art. 12, gains on the disposal of IP where the consideration is contingent on the use of the IP – for example, see the 2006 US model treaty.

2. Art. 13

i. The gain derived by ACo on the sale of the patent should be exempt from B tax under Art. 13(5) – subject to Art. 29(9) (see below). The fact that the patent is registered in B is irrelevant.

ii. If Art. 12 applies (see 1(iii) above), then an interesting conflict would arise between Art. 12 (which would allow B tax of 10% on the gross annual fee payments) and Art. 13(5) (which would exempt the gain from B tax).

3. Art. 11

It is conceivable that B domestic law "carves out" implicit interest from the series of annual fee payments – despite the fact that the quantum of each annual fee payment is uncertain at the start. If it does so, the B tax authorities might claim that that interest is taxable in accordance with Art. 11. The OECD Comm. probably supports that approach: see "conflicts of qualification" in regard to Art. 23A/B.

4. Art. 29(9)

i. Based on the facts (in particular, that ACo is in an excess foreign tax credit position), it is conceivable that Art. 29(9) (the PPT) could be triggered by this transaction.

ii. Art. 29(9) would probably not apply if this were merely a "plain vanilla" sale of the patent to BCo for a lump sum price – it’s the contingent consideration which makes the transaction unusual and therefore raises the risk that, viewed objectively, the avoidance of B withholding tax under Art. 12 is seen to be a dominant purpose. Nevertheless, no B tax advantage seems to be achieved from structuring the consideration in contingent form, rather than a lump sum.

iii. On balance, IMHO: Art. 29(9) should not apply.

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