Transfer pricing: Types of transactions: intangibles: royalties
What is a royalty?
A royalty is a payment for the use of, or the right to use, something that does not belong to the payer. This may well concern the right to use intangible property.
The Royalties Article, Article 12 of the July 2008 edition of the OECD Model Convention on Income and on Capital, defines the term for the purposes of the Article at 12(2):
“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.”
Although useful, this definition applies solely for the purposes of Article 12 (and impacts on withholding tax rights under treaties incorporating the Article) but has no direct relevance for transfer pricing purposes.
A payment described by the parties as a royalty might also be used to compensate for an underpayment elsewhere between them. For example, an affiliate might buy goods at cost from another affiliate and the supplier may charge the profit element that would be paid at arm’s length separately as a royalty. More simply, a royalty might be the payment for the right to distribute, akin to a licence fee.
Perhaps the more common case is where a royalty is paid in return for the use of intangible property. This is probably the most common type of transaction seen involving intangible property. There are plenty of commercial instances where this happens. In such a case, consider how the intangible property had been valued and whether both parties benefit appropriately from the arrangements. This is discussed in more detail at INTM485120. Examine very closely what is received in return for the payments. Would an independent actually pay to use this property?
Always consider whether the UK business is paying for something it has helped create in the first place. This is particularly relevant where a company pays a royalty for a trade mark legally owned by a connected person, when the trade mark has value in the UK largely because of the efforts of the UK licensee in the first place. There may well be other transactions that have to be considered - is the UK providing some service to the licensor that needs to be rewarded? See INTM440100 for an example of this.
When looking at a royalty, always keep in mind the reason why it is being paid and how each party benefits from the transaction. In essence the royalty divides the profits from the overall trade between those parties who play the various roles in the trade. After the royalty has been paid, do those profits accrue between the parties as they would do at arm’s length, according to the functions carried out and the risks borne?
The payment of royalties under a licence agreement can be a powerful tool, helping the tax-efficient movement of profits around the world. Royalties may be paid between two connected persons in circumstances where it is doubtful whether the underlying intangible property is particularly valuable, an arrangement that would not be put in place if the two parties were independent.
The grant of a licence agreement is a transaction between two parties. The payment of a royalty under that licence is a provision imposed by means of that transaction. When applying TIOPA10/Part 4 to royalties, all provisions resulting from the transaction should be considered. As well as the royalty rate, consider the length of the licence agreement and the terms under which the royalties are paid.
Treaties and TIOPA10/S132
As well as transfer pricing, there is a related compliance issue to deal with when considering cases involving royalties.
A royalty has to be paid under deduction of income tax if ITA07/S903 applies to the payment. This is taxation at source.
However if a double taxation agreement (‘DTA’) exists between the UK and the country of residence of the receiver of the royalties, then the recipient might be able to receive the royalty at a more beneficial treaty rate - in most cases gross. Most of the UK DTAs have an article dealing with the payment of royalties. In each case, check the wording of the royalty article of the particular DTA in question to establish the extent to which the UK is prepared to give up its taxing rights (which are given effect by ITA07/S903). For payments on or after 1 October 2002, ITA07/S911 allows the payer of royalties to apply the treaty rate of deduction (which may be nil) where they have a reasonable belief that the recipient is entitled to treaty benefits - seeCTM35270. Prior to this, it was necessary for the recipient to lodge a claim under the treaty with HMRC.
For payments of royalties to certain associated companies in other EU Member States (or their EU permanent establishments) the rules were further modified from 1 January 2004 by the implementation of the EU Interest and Royalties Directive at what is now ITTOIA05/S758 onwards. This provides an exemption from income tax for the overseas recipient of royalties. The exemption does not need to be claimed in advance, but the payer can make payments gross if they hold a reasonable belief that the conditions for exemption are satisfied.
Double taxation agreements and anti-avoidance provisions
Article 12 of the OECD Model Tax Convention (‘MTC’) deals with the taxation of royalties, and states that royalties shall only be taxed in the country where the beneficial owner resides, i.e. where the UK is the licensee, the overseas country has the taxing rights. Some of the UK’s DTAs retain some taxing rights over royalties, in which case payment is allowed subject to a reduced rate of tax. Article 12 of the OECD MTC contains an anti-avoidance clause that denies the benefit of the treaty to any excessive royalties. While the majority of the UK’s DTAs are based on the OECD MTC, generally the royalty articles concluded contain an anti-avoidance clause that is broader in its scope than that of the MTC.
The anti-avoidance clauses under both the OECD MTC’s Royalty Article and the UK’s DTAs refer to instances where the payment of royalties is excessive by reason of a special relationship between the payer and the beneficial owner, or between both of them and some other person.
The term ‘’ is not defined, but some guide to interpretation is given in the commentaries to the OECD MTC. As well as cases such as a 51% controlling interest, the term ‘also covers relationship by blood or marriage and, in general, any community of interests as distinct from the legal relationship giving rise to the payment of the royalty’. A small shareholding or inter-dependent trading relationship might constitute a special relationship. CSTD Business, Assets & International, Tax Treaty team considers the practical application of tax treaties in this respect and should be referred to where necessary.
The OECD MTC Royalty Article refers to ‘the amount of the royalties, having regard to the use, right or information for which they are paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship’.
Many of the UK’s DTA Royalty Articles, however, deny the benefit of the treaty where the amount of the royalties paid exceeds (“for whatever reason”) the amount that would have been agreed by the payer and beneficial owner in the absence of the special relationship. It is this additional wording, which is permitted under paragraph 22 of the OECD commentary on Article 12 of its MTC, which broadens the scope of those UK DTA’s which contain it.
If the issue is the rate of royalty, then it is generally accepted that the special relationship clause applies to the excessive amount. For example, if a royalty was paid at 15%, and it was agreed that absent the special relationship, the rate would be 10%, the special relationship clause would apply to the excessive amount, the difference between 15% and 10%.
In some instances, particularly those involving fragmentation (see INTM440130), it is doubtful that the arrangements under which the royalties are paid would have been entered into absent the special relationship. In these cases HMRC has always interpreted the special relationship clause in most of the UK’s DTAs as allowing for the royalty rate to be set at nil (with the full amount of the royalty being regarded as excessive). TIOPA10/S132(3) makes the position clear.
The special relationship and TIOPA10/S132
TIOPA10/S132 applies for accounting periods ending on or after 1 April 2010 and for income tax years 2010-11 onwards (the previous legislation which applied to royalties payable on or after 28 July 2000 was at ICTA88/S808B). It states that the special relationship clause in a DTA shall be construed as taking account of all factors, including
- Whether the agreement under which the royalties are payable would have been made in the absence of the special relationship.
- The royalty rate and other terms that would have been agreed absent the special relationship.
Where the royalties broadly derive from an asset that was owned by the UK company (or an associated enterprise), or the asset was owned by a business that is now undertaken by the UK company (or an associated company), consider
- The amounts paid in respect of the transaction or series of transactions leading the transfer of the asset
- The amounts that would have been paid absent the special relationship
- Whether the transaction or series of transactions would have taken place absent the special relationship.
Where appropriate this provides an opening to argue that the arrangements leading to the payment of the royalties (perhaps the sale of valuable intangible property to an overseas associated enterprise, followed by the payment of royalties to the new owner) would not have taken place at all and that the benefit of the treaty would not apply.
The legislation places the onus on the UK company to demonstrate that the special relationship does not apply in any given situation.
Claiming the benefit of a double taxation treaty
From 1 October 2002 a UK company has been able to pay royalties gross (or at the reduced rate of deduction under the DTA) without making a formal claim, where the company has a reasonable belief that the beneficial owner of the royalties is entitled to relief under the DTA. This scheme is explained in more detail in the Company Tax Manual atCTM35270. For royalty payments to which the exemption provided under the EU Interest and Royalties Directive applies (see above), a similar reasonable belief scheme is used, and the guidance at CTM35270 and CTM35215 applies, with appropriate modification.
Is there a domestic charge on the royalties?
Domestic charging rights have to exist under ITA07/S903 before taxation at source can take place.
Royalties payable to low tax territories
Payment of royalties to connected persons in low tax territories should be examined critically to see if ITA07/S903 applies. In some instances, the facts might indicate that transactions have been structured to avoid this legislation or to take advantage of a treaty network. For a more detailed discussion on treaty shopping please see INTM504000.
Interaction of transfer pricing and withholding tax in respect of royalties
The transfer pricing provisions and ITA07/S903 are not mutually exclusive. If excessive royalties are paid the deduction claimed in the CTSA return may be reduced under TIOPA10/Part 4, and income tax charged on the excessive payments under ITA07/S903. Generally groups will refrain from paying royalties until it is established the extent to which the benefit of a DTA can apply.