Tax Treaty Series

ITQ T-

110

November 26, 2021

Question

ACo, a company resident in A, owns a valuable trade mark.

ACo licenses the trade mark to BCo, a related company resident in B, in return for annual royalties which are set at 93% of the gross amount of royalty income to which BCo is contractually entitled to receive from sub-licensing the trade mark. However, BCo's contractual obligation to pay the royalties to ACo is not dependent on BCo actually receiving the royalty income from sub-licensing.

BCo sub-licenses the trade mark to CCo, an unrelated company resident in C, in return for annual royalties which are calculated as a percentage of CCo’s gross revenue from using the trade mark in its business.

These 2 transactions are the only transactions which are entered into by BCo. BCo has no other operations, assets, liabilities or employees. BCo pays royalties to ACo 3 days after receiving royalties from CCo.

BCo uses its 7% "spread" to pay its administrative expenses and B income tax on its taxable profits, and the balance is paid as a dividend to the group parent company.

Withholding tax rates on outbound royalties under domestic law are: 0% (B) and 20% (C).

The B/C treaty is identical to the 2014 OECD model treaty, and was signed and entered into in 2016. The MLI does not apply to the B/C treaty.

The A/C treaty is identical to the 2011 UN model treaty, with a 10% rate specified in Art. 12(2). The MLI (including the PPT) applies to the A/C treaty.

There is no A/B treaty.

After applying all treaty benefits, what rate of withholding tax (if any) should apply to the royalties paid by CCo to BCo?

Answer

B/C treaty: beneficial ownership

To qualify for the 0% rate under Art. 12(1) of the B/C treaty, BCo must be the beneficial owner (B.O.) of the royalties. The 2014 OECD Comm. narrowed the circumstances in which a conduit company would fail the B.O. condition: BCo would fail the condition, only if its "right to use and enjoy the royalties is constrained by a contractual or legal obligation to pass on the payment received to another person [, provided the] contractual or legal obligation [is] dependent on the receipt of the payment by the direct recipient …".

As BCo's contractual obligation to pay royalties to ACo is not contingent on BCo actually receiving royalties from CCo, it might be thought that BCo satisfies this narrowed B.O. condition. However, the 2014 OECD Comm. states that the contractual or legal obligation "will normally derive from relevant legal documents but may also be found to exist on the basis of facts and circumstances showing that, in substance, the recipient clearly does not have the right to use and enjoy the royalties unconstrained by a contractual or legal obligation to pass on the payment received to another person."

BCo's only source of funds to pay the royalties to ACo is the actual receipt of royalties from CCo. Thus, it can be argued that BCo’s contractual obligation to pay royalties to ACo is contingent, in substance, on BCo actually receiving royalties from CCo.

If this argument is accepted, BCo would fail the B.O condition.

B/C treaty: abuse

Even if BCo passes the B.O. condition, it is possible that a C court would take the view that the conduit arrangement was an abuse of the B/C treaty (based on the 2014 OECD Comm. on Art. 1), and deny the treaty benefit for that reason

A/C treaty: beneficial ownership

If BCo fails the B.O. condition, can ACo claim the benefit of the 10% rate under Art. 12(2) of the A/C treaty?

The UN Comm. on Art. 12 allows a “look through” to the B.O. "when an intermediary, such as an agent or nominee, is interposed between the beneficiary and the payer". However, there is no reference to an interposed conduit company. Also, Art. 12(2) applies to "such royalties" – i.e., the royalties referred to in Art. 12(1). Art. 12(1) refers to royalties "arising in a Contracting State [C] and paid to a resident of the other Contracting State [A]". In our case, there are 2 different royalty streams, neither of which satisfies the 2 conditions in Art. 12(1).

IMHO: ACo is not entitled to the 10% rate.

Conclusion

If BCo fails the B.O. condition or if the Art. 1 "abuse" rule is applied by a C court, then the 0% rate would be unavailable.

And, IMHO, ACo is not entitled to the 10% rate, even if BCo fails the B.O. condition.

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.