Tax Treaty Series

ITQ T-

073

January 22, 2021

Question

XCo 1, a company resident in X, owns some IP.

XCo 1 licenses the IP to XCo 2, a related company also resident in X, for arm's length royalties.

The IP is registered in many countries throughout the world, including Y.

XCo 1 and XCo 2 do not have any assets or employees in Y.

Under the Y domestic law, royalties which are paid for the licence of IP which is registered in Y, are deemed to be sourced in Y. This means that such royalties are subject to a final Y withholding tax of 25% of the gross amount of royalties.

The X/Y treaty is identical to the 2017 UN model, with the rate in Art. 12(2) being 10%.

Does the X/Y treaty permit Y to impose withholding tax on the royalties paid by XCo 2 to XCo 1? If so, at what rate?

Answer

Y is modeled on Germany.
Art. 12(2) will not apply to permit (and limit) the Y tax, as the royalties do not "arise" in Y (as defined in Art. 12(5)) – regardless of the fact that the royalties are sourced in Y under Y domestic law.
Some folks might then consider Art. 21:
1. Art. 21(3) uses the term, "arising". According to the UN Comm., that term should take its meaning under domestic law. This would mean that the royalties "arise" in Y for the purposes of Art. 21(3), due to the deemed source in Y under Y domestic law (and regardless of the conclusion under Art. 12(5)).
2. If Art. 21(3) applies, the treaty would permit Y to impose tax on the royalties, without limitation – i.e. Y tax of 25% would apply.
However, Art. 7 should generally apply in this situation. As XCo 1 has no PE in Y, Art. 7(1) would provide an exemption. Art. 21(3) would not apply, as the royalties would be "dealt with" in Art. 7 – i.e., no Y tax would apply.
If XCo 1 is a passive IP holding company, and is not considered to carry on an "enterprise" (as defined in Art. 3(1)), then the Y tax authorities might take the view that Art. 7 does not apply to the royalties – in which case, Art. 21(3) should apply (see above).

ITQ Disclaimer

This International Tax Quiz (ITQ) contains general information only, and none of International Insights Pte Ltd, its employees or directors is, by means of this ITQ, rendering professional advice or services. You use the content of this ITQ strictly at your own risk. You should not rely on all or any part of the content of this ITQ in making decisions to take action (including inaction) in regard to tax or other matters. Before making any decision or taking any action (including inaction) that may affect your tax position, your finances or your business, you should consult a qualified professional advisor. None of International Insights Pte Ltd, its employees or directors shall be responsible for any loss whatsoever sustained by any person who relies on the content of this ITQ.