Tax Treaty Series

ITQ T-

093

July 2, 2021

Question

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

Some years ago, XCo licensed the IP to YCo (a related company resident in Y), for use in Y.

The royalties paid by YCo to XCo are (1) tax deductible to YCo, (2) subject to 10% Y royalty withholding tax (in accordance with the X/Y treaty), and (3) taxable to XCo under X income tax law (with a foreign tax credit for the Y royalty withholding tax). However, due to the calculation of credits under X law (i.e., allocation of deductions), XCo does not obtain a full credit for the Y withholding tax.

YCo entered into a unilateral APA with the Y tax authorities. Under the APA, the royalty rate was reduced. Also, the APA was "rolled back" for 2 years.

YCo has filed amended Y income tax returns covering the last 2 years, to reflect reduced deductions for royalties, as agreed in the APA.

The APA does not cover the Y royalty withholding tax which has been incurred by XCo – and, being unilateral, it also does not cover XCo's X income tax liability on the royalty income.

The X/Y treaty is identical to the 2017 OECD model treaty, with Art. 23B – except that Art. 12 permits 10% source country tax on royalties.

What steps can be taken to properly adjust XCo's tax position (in both X and Y), to reflect the APA's reduced royalty rate for the last 2 years?

Answer

(1) XCo's tax position in Y:

Although the reduction in YCo's royalty deductions ("excess royalties") is pursuant to Art. 9(1), XCo cannot claim the benefit of Art. 9(2), which is directed at the X tax authorities making a corresponding adjustment (see below).

However, Art. 12(4) should apply, with the result that the 10% Y tax does not apply to the excess royalties. Instead, under the 2nd sentence in Art. 12(4), the excess royalties "shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention". If the Y tax law does not allow secondary TP adjustments, then the excess royalties should be exempt from Y tax under Art. 7 or 21 (assuming that XCo does not have a PE in Y). However, if the Y tax law does allow secondary TP adjustments, then the excess royalties might be treated as a deemed dividend to YCo's shareholder, or as a deemed interest-bearing loan to XCo – both of which might cause further Y tax (wholly or partly compensating for the 10% royalty withholding tax on the excess royalties).

If the net result would be an amount of reduced Y tax for XCo, XCo could institute the MAP process under Art. 25 to try to secure the reduction. Alternatively, the Y domestic law might allow XCo to secure the reduction.

(2) XCo's tax position in X:

Threshold issue: The X tax authorities are not required to make any corresponding adjustment except to the extent that they agree with the primary adjustment made by the Y tax authorities in the APA.

Assuming they do fully agree with the primary adjustment…

Art. 9(2) requires the X tax authorities to "make an appropriate adjustment to the amount of the tax charged" on XCo’s profits. Art. 9(2) and the OECD Comm. do not mandate the form of that adjustment – but a common way would be for XCo’s royalty income from YCo to be reduced. XCo could institute the MAP process under Art. 25 to try to secure the consequential reduction in X tax.

The amount (if any) of the reduction in X tax should take into account the amended Y withholding tax position. Also, as XCo is not entitled to a full foreign tax credit, the impact on XCo's credit position would need to be calculated.

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