intensive study course on dtaa...case studies passive income - royalties and case studies on...

Passive Income – Royalties and case studies on royalties

Paresh Parekh

20 December 2014

Intensive Study Course on DTAA

http://www.google.co.in/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=Hien1BRkzrZiIM&tbnid=9SdV67Sb9L3h6M:&ved=0CAUQjRw&url=http://www.bcasonline.org/policy/advertise_website_soli.asp&ei=LIWqUuu-MsfOiAeRz4GYCA&psig=AFQjCNFFKbS3bgg7jY0MvfxVmlb0rwJPAA&ust=1386993301306846

20 December 2014

Contents

► Royalty : Some basics

► UN / OECD Model

► Some important concepts

► Variations under tax treaties

► Royalties under the Act

► Impact of amendments by FA 2012

► Effective connection with PE

► Basis of taxation under treaties and ITA

► Case studies

Passive Income - Royalties and Case Studies on Royalties

20 December 2014

Basics


20 December 2014

Royalty : rewarding the creator

► Payment reserved by the grantor of a patent or similar right, and

payable proportionately to the use made of the right by the grantee

► Payment to a person who has right for allowing another to make use

in respect of thing which can be:

► Physical / tangible (e.g. equipment, mining)

► Intellectual Property Rights (IPRs) / Intangibles


20 December 2014

Scintillating IPRs

―A person approaches the General Electric‘s Chairman, and proposes to buy the

entire GE enterprise. As for the cost, the chairman puts it at about $50 million.

After a week the prospect comes back again, and this time instead proposes to

just buy the GE label and asks for the price. The chairman pauses, ponders

and replies, $500 million, perhaps.”


20 December 2014

Rationale for Insulating Inventors

► Importance of copyright by Anthony Trollope:

“Take away from English authors their copyright and you would very

soon take away from England her authors.

► Trade Chief of the European Union on caution to Chinese culture of

IPRs infringement:

“Tolerating Intellectual property theft is a dead end for China. If China

continues to look the other way, this will come back and bite the

Chinese.”


20 December 2014

Increasing Royalty Outflow: emerging concerns

► UN Practical Manual on Transfer Pricing for Developing Countries at pg 396:

“The pace of growth of the intangible economy has opened new challenges to the

arm’s length principle. 75 per cent of all private R&D expenditure worldwide is

accounted for by MNEs. World royalty and license fee receipts that were just US

$29 Billion in the year 1990 has increased to US $191 Billion in 2010.”

► The Economic Times dt. 22 December 2013:

“Worried over "excessive" outflow of foreign exchange as royalty and fees for

technology transfer and use of brand names, the government is considering to re-

introduce restrictions on such payments by foreign companies to their parent

entities. …….The increase in outflow of these payments started after the government

liberalised the FDI policy in 2009. It had removed the cap and permitted Indian

companies to pay royalty to their technical collaborators without seeking prior

government approval.”

► The Economic Times dt. 23 December 2013:

“This has now led to a sharp increase in royalty payments - 18% of FDI inflows in

2012-13 from 13% in 2009-10 - according to data compiled by the ministry”

► Business Standard dt. 18 January 2014:

“In five years, royalty payments have grown 31.1% yearly, much faster than rise in

revenue and profit”


http://economictimes.indiatimes.com/topic/FDI

20 December 2014

UN / OECD Model on Royalties


20 December 2014

UN definition dissected

Consideration for the use

of, or the right to use

diverse IPRs

Consideration for use or

right to use

Consideration for

a) Copyright of literary,

artistic, scientific work.

Industrial, commercial or

scientific equipment. (ICS

Equipment)

Information concerning

industrial, commercial or

scientific experience

(popularly called undivulged

know-how)

b)Copyright of

cinematograph films or

films or tapes used for

radio or television

broadcasting

c) Patent, trademark, design,

model, plan, secret

formula, process

► OECD Model provides for exclusive taxation to Country of Residence (‗COR‘) : UN

Model permits source taxation

► UN model definition

Underlined portion is only in UN Model, not in OECD Model


20 December 2014


Consideration for the use of, or the

right to use diverse IPRs

a) Copyright of literary, artistic, scientific

work

b) Copyright of cinematograph films or

films or tapes used for radio or

television broadcasting

c) Patent, trademark, design, model, plan

d) Secret formula or process


http://www.google.co.in/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&docid=dDNyA9539wcuQM&tbnid=pb07cprzeXJ8TM:&ved=0CAUQjRw&url=http%3A%2F%2Fwww.twi-global.com%2Ftechnical-knowledge%2Fpublished-papers%2Fapplication-of-friction-stir-welding-for-the-manufacture-of-aluminium-ferries-may-2000%2F&ei=uhThUqW3I8mS2AW6mYCIBQ&psig=AFQjCNHR6K_iP7Q7Ll0x56GBnV0adqtpnA&ust=1390568843818824

20 December 2014


Consideration for use of or right to use Consideration for

Industrial, commercial or scientific

equipment (ICS Equipment)

Information concerning industrial,

commercial or scientific experience

(popularly called undivulged know-how)


20 December 2014

Inherent Features of IPR Grant

► IPR is result of owner‘s skill, effort, exertion, intellect and/or suffering

(at times may be aborted)

► Owner‘s possession; usually, constitutes his tool of trade

► May or may not be registered / protected

► Grantee / Payer is permitted to do what otherwise would be

infringement

► Enabled to do what owner could have done

► Can commercialise the product

► Generally, not in public domain; possessed secretly


20 December 2014

Certain aspects of relevance

► Covers user under licences as also compensation for infringement

► Covers broadly intangible – though, ICS equipment likely to be

tangible

► Covers protected as also unprotected IPRs

► Payee need not be owner / creator of IPR

► Could be legal heir

► Includes authorised licencee / assignee

► But for authorized permission, user guilty of infringement

► Providing use of intellectual right for commercial exploitation gives rise

to royalty


20 December 2014

Certain aspects of relevance

► Purchase of product embedding / based on intellectual property right

is not for use of IP

► ‗Pre-dominant purpose test‘ applies

► Identify the element for which payment is essentially made

► Incidental factors not to affect characterisation

► If mixed contracts, fair allocation to different components


20 December 2014

Product V/S. Underlying IPR

Product Embedded IPR content

What does Licencee of IPR expect?

What does Purchaser of product

get?

Medicines /

DrugsPatent

Licence to

manufactureOwnership of drugs

Books Copyright

Publishing house

wants right of

reproduction

Ownership of book

Packaged

drinking waterTrademark

Franchisee wants right

to manufacture and

sell under trademark

Ownership of

product

Receipt constitutes

price

Receipt constitutes

Royalty


20 December 2014

Consideration for use v/s transfer

► Royalty is consideration for ‗use or right to use‘ IP

► Consideration for use ≠ transfer

► Consideration for ‗transfer of property‘ is not covered by this Article

► Transfer = alienation of ownership rights,

► Transfer can be by way of exclusive license

► Alienation could be partial or total

► Alienation can be geographically limited

► Certain treaties cover consideration for alienation within scope of royalty (E.g.

Singapore). Treaties like USA covers gains derived from the alienation of IPR which are

contingent on the productivity, use, etc.

► Under ITL capital gains income is excluded


20 December 2014

Use of equipment v/s. Service

► Consideration for ‗use‘ or ‗right to use‘ industrial, commercial or scientific (ICS) equipment

Am I acquiring use of

Equipment

V/s

Am I availing service?

► Possession, custody and

control of property with user.

► Significant economic or

possessory interest

► Equipment at user disposal

► No concurrent use by others

► Risk of operation is with the

User.

► Guaranteed service level of

desired specification

► Fees linked to right of user

► Obligation on service

provider to ensure security,

back ups, firewalls, etc.

► Generally offered by many to

many

Certain Indian treaties do not include ICS equipment in

royalty definition (E.g. Netherlands)


20 December 2014

Information concerning ICS experience

► Corresponds to undivulged information arising from previous

experience

► Information that is not publicly available and cannot be known from

mere examination of product and mere knowledge of the process and

technique

► Experience giving rise to some form of intellectual property rights

► Supply of logic, algorithms or programming techniques or languages

of computer program may get covered

► One‘s own experience v/s compilation of data relating to experience

of others


20 December 2014

Database subscription

► ACo subscribes to ‗database‘ which is located

outside India and which contains financial and

economic information including fundamental data of

a large number of companies worldwide.

► F Co collects and collates the information / data

available in public domain and puts them all in one

place in a proper format.

► Rights of subscriber:

► Right to view and make use of the data for internal

purpose.

► No right to distribute the data downloaded by it or

provide access to others.

► Not right to reproduce or adapt the work.

Database Co

Subscription

charges

Whether payment for database

subscription amounts to royalty?

Data

accessed


20 December 2014

Information concerning ICS experience

► Exclusive domain with no one

else privy (i.e. confidential /

protected)

► Compilation of someone else‘s

experience

► Perpetual / Extended use

► Arising from previous

experience. Accumulated fund

of knowledge acquired by

years of observation, search

experimentation and

experience

► Limited ―owners‖ and limited

permitted ―licencees‖

► General report / data

compilation / collation of user

for use by many

► Statistical analysis to help

someone take decision

► Need for constant updation

► Most up to date is a virtue

► Standard product / services by

many for many

V/S.


20 December 2014

Know-how v/s. Service

► Imparting of past

knowledge and experience.

Know-how exists

► Past exertion and creativity

► Involves imparting of skill

► Generally, know-how

belongs to licensor (payee)

► Using skill to perform work

for the others

► Deployment of resources

for creation/ rendition

► No imparting of skill of the

provider

► Generally, the product of

service belongs to the

service availer / payer

ServiceKnow-how

V/S.


20 December 2014

Design : Alternative formats

`

`

`

Product

Design which facilitates installation /

use / maintenance of equipment

`Ready Design /

Design manual

Basic design which was inbuilt

know-how

Customized designs FTS / FIS

Part of equipment

Royalty

―What are the “goods” in a sales transaction, therefore, remains primarily a matter of

contract and intention. The seller and such purchaser would have to be idem as to the

subject-matter of sale or purchase. The Court would have to arrive at the conclusion as to

what the parties had intended when they entered into a particular transaction of sale, as

being the subject-matter of sale or purchase. In arriving at a conclusion the Court would

have to approach the matter from the point of view of a reasonable person of

average intelligence.” (SC in BSNL case)


20 December 2014

Royalty under the Act


20 December 2014

Royalty – Explanation 2 to S. 9(1)(vi)

Consideration (incl. lumpsum consideration) for:

Transfer of all or any rights (including license) in respect of

Patent, invention, model

Design, secret formula or process or trademark, or similar property

(IPRs)

Copyright, literary, artistic or scientific work including films or video

tapes/tapes for use in TV/radio broadcasting

Rendering of any services in connection with each element included


20 December 2014

Royalty – Explanation 2 to S. 9(1)(vi)

Consideration (incl. lumpsum consideration) for:

Imparting of any information

concerningUse of

The working of or use of IPRs

Technical, industrial, commercial or

scientific knowledge, experience or

skill

Any IPRs

or right to use any industrial,

commercial or scientific equipment

(other than those referred to in

S. 44BB)


20 December 2014

Exclusions from royalty

► Consideration chargeable under the head ―Capital gains‖

► Consideration for the sale, distribution or exhibition of

cinematographic films

► Consideration for use / right to use ICS equipment referred to in S.

44BB


20 December 2014

Software payments


20 December 2014

ITA provisions

Amendment vide Finance Act 2012 - Explanation 4 to section 9(1)(vi)

(effective 1.4.76)

► “For the removal of doubts, it is hereby clarified that the transfer of all or any rights in

respect of any right, property or information includes and has always included transfer

of all or any right for use or right to use a computer software (including granting of a

licence) irrespective of the medium through which such right is transferred”

► Computer software as defined in Explanation 3

“For the purposes of this clause, “computer software” means any computer programme

recorded on any disc, tape, perforated media or other information storage device and

includes any such programme or any customized electronic data”

Treaties like Morocco, Namibia, Russia cover ―computer software

programme/ computer programme‖ within the term ―royalty‖


20 December 2014

Illustrative Rights of Copyright Holder

► Literary work protected under the Indian Copyright Act [ICA].

► Literary work includes computer programme [Section 2(o)of ICA].

► Exclusive rights of ―copyright‖ holder [section 14 of ICA] :

► To reproduce work.

► To issue copies to the public.

► To make translation.

► To make adaptation.

► To sell or offer for sale

► Specific provisions permitting copying for intended use,

archival purpose


20 December 2014

Scenario 1: “Shrink Wrapped” license

Key features

► Foreign Company (FCo) owns the copyright in the computer

program (Program S)

► Program S is loaded on disks and sold in boxes

► End user permitted to operate Program S, but cannot exploit

the copyright in Program S

► End user enters into an end user license agreement (EULA)

with FCo (copyright owner)

Analysis

► No copyright right (to commercially exploit software)

transferred

► Payment likely to be for copyright article under OECD

approach, even if end user allowed to make back-up/ archival

copy

► Mode of delivery, nature of software not determinative

Payment for a

single copy

Delivery of a

single copy of

shrink wrapped

software

Overseas

India

Delivery of software

Payment of software

Foreign Co

End user


20 December 2014

Samsung Ruling*: a game changer!!

► Grant of license to use ―off the shelf‖ software involves use of

copyright

► But for license, to copy software into computer, would be infringement of

CA

► Even copying for authorized purpose/archival pre-supposes grant of

license

► Price is paid for 3 component : CD, software & license

► But for license, dumb CD not useful to the end user

► Computer software differs from copyright in respect of books, pre-

recorded music CD

► Even ICA treats software separately from other literacy works like books

► Consideration is royalty under ITA and DTAA__________________

*(345 ITR 494) (Kar)


20 December 2014

Transponder payments


20 December 2014

Taxation of Satellite/ Transponders payments –Mechanics

Transponder

hire charges

Uplinking of

signal

Satellite CoBroadcasting

Co.

Outside India India

Outer Space

Direct to home

Cable

operator

End

User


20 December 2014

OECD Point of View

► Following are not royalty :

► Transponder leasing agreements under which the satellite operator

allows the customer to transmit over large geographical areas is not for

use of secret process / ICS equipment

► Payments by a telecommunications network operator to another network

operator under a typical ―roaming‖ agreement

► Specific treaty illustration:

► India-Hungary DTAA covers transmission by satellite as part of royalty

► Protocol to India Mexico treaty : Royalty covers consideration for receipt of

voice / images for transmission to public


20 December 2014

Source Rule


20 December 2014

Section 9(1)(vi) – ambit of source rule

Status of Payer Coverage

The Government No exception In all cases

Resident of India Excluded

only if

► Utilised for business /

profession of resident

outside India (or)

For source of income

outside India

Non-resident

Included

only if

► Utilised for business /

profession of NR in

India (or)

For source of income

in India


20 December 2014

India-UK DTAA

Article 13(1) & 13(2) on Royalties and fees for technical services:

“1. Royalties and fees for technical services arising in a Contracting State and paid to a resident of the other

Contracting State may be taxed in that other State.

2. However, such royalties and fees for technical services may also be taxed in the Contracting State in

which they arise and according to the law of that State; but if the beneficial owner of the royalties or fees for

technical services is a resident of the other Contracting State, the tax so charged shall not exceed:

(a) in the case of royalties within paragraph 3(a) of this Articles, and fees for technical services within

paragraphs 4(a) and (c) of this Article,—

(i) during the first five years for which this Convention has effect;

(aa) 15 per cent of the gross amount of such royalties or fees for technical services when the payer of the

royalties or fees for technical services is the Government of the first-mentioned Contracting State or a

political sub-division of that State, and

(bb) 20 per cent of the gross amount of such royalties or fees for technical services in all other cases; and

(ii) during subsequent years, 15 per cent of the gross amount of such royalties or fees for technical

services; and

(b) in the case of royalties within paragraph 3(b) of this Article and fees for technical services defined in

paragraph 4(b) of this Article, 10 per cent of the gross amount of such royalties and fees for technical

services.”


20 December 2014

Some Fundamentals

► Anchors of treaty entitlement:

► Treaty residence

► Beneficial ownership

► Impact of LOB [E.g.: Dubai, USA]

► TRC requirement under ITA

► Anti avoidance rule specific to royalty article: Excessive payment to

be assessed under ITL @ 25%?

► Payment to nominee / agent does not impact treaty entitlement

of BO

► GAAR to be evaluated after 1 April 2015


20 December 2014

Excessive royalty or FTS payment

F Co

I Co

Licence Royalty

---- Ownership Linkage

Royalty - 100

ALP - 80

How is 20 to be taxed?


20 December 2014


► Conscious excess payment mistakenly

conceived by enterprises as a cash

repatriation mechanism

► Concessional rate under DTAA

applicable only with regard to equivalent

of ALP1

► Liability in excess of ALP retains its

character, to be taxed as per domestic

law

► Risk of liability @25% u/s.115A and risk

of TDS related defaults and

consequences21 Refer Art. 12(4) of OECD Model 2 Refer K&S Doc.id 20025

F Co

I Co

Licence Royalty

---- Ownership Linkage

Royalty - 100

ALP - 80

How is 20 to be taxed?


20 December 2014


Article 12(8) of India-Singapore DTAA

► Where, by reason of a special relationship between the payer and the

beneficial owner or between both of them and some other person, the amount

of royalties or fees for technical services paid exceeds the amount which

would have been paid in the absence of such relationship, the provisions

of this Article shall apply only to the last-mentioned amount. In such case,

the excess part of the payments shall remain taxable according to the

laws of each Contracting State, due regard being had to the other

provisions of this Agreement.


20 December 2014

Section 9(1)(vi)- ambit of source rule

► Royalty taxable in India regardless of:

► Residential status of recipient

► Situs and mode of rendition of services

► Purpose whether personal or non personal

► Situs and currency of receipt

► Situs of conclusion of contract

Cont….


20 December 2014

Scope of 9(1)(vi) Deeming Fiction : Exclusion qua Resident

Is Mr. Lee to pay tax in India? - No

For use in ICO‘s branch at China


Treaty, if applicable to Mr. Lee is unlikely to avoid source tax in India; Treaty source rule wider than ITL

20 December 2014

Scope of 9(1)(vi) Deeming Fiction : Inclusion qua NR

Is Mr. Lee to pay tax in India?

Payment towards licence fees

Licence


20 December 2014

„Source‟ of FTS paid in connection with export activity

► An Indian company (ICo), exports its

products to UK.

► FCo has granted know-how to ICo.

► ICo uses know-how to manufacture

goods which are sold locally as also

exports.

► Export contracts concluded in India ,

goods manufactured and exported

from India

► ICO claims royalty payment to the

extent it relates to exports being

source of income outside India

FCO

India Co

(I Co)

UK

India

Grant of

Know-how

Payments

made


20 December 2014

Effective connection


20 December 2014

Basis of taxation under treaty- OECD model

► Article 7(4)

“Where profits include items of income which are dealt with separately in

other Articles of this Convention, then the provisions of those Articles shall

not be affected by the provisions of this Article.

► Article 12(3)

“The provisions of paragraph… shall not apply if the beneficial owner of

the royalties, being a resident of a Contracting State, carries on business

in the other Contracting State in which the royalties arise through a

permanent establishment situated therein and the right or property in

respect of which the royalties are paid is effectively connected with such

permanent establishment. In such case the provisions of Article 7 shall

apply.


20 December 2014

Interplay of Article 7 and Article 12

Business income in

the nature of royalty?No PE – No Taxation

Effectively connected

with PE ?

Net taxation at full rate to

the extent attributable to

operations in India

Gross basis of Taxation

under Royalty Article

No

Yes

Yes

No

Go to Royalty

Article


20 December 2014

Factors influencing effective connection

► Mere existence of PE in source state is not enough

► Effective connection is equivalent of integral nexus, something really and

intimately connected and not merely legally connected

► Set up, functions, purpose and duration of PE relevant in determining

‗effective connection‘

► Economic ownership of right / property in respect of which royalty is paid

should be allocated to PE

► Economic ownership to be judged having regard to fiction of ‗separate

enterprise‘

► PE should be exposed to gain or losses related to the property

► PE should have the ability to exploit IPRs in its own right

► E.g. IPRs resulting from activities of PE


20 December 2014

Case study : “Effective connection”

FCO1

FCO2

► FCo1 has branch in India

► Branch of FCo1 has developed software over

years with the help of its personnel

► FCo1 enters into licence agreement with

FCo2 outside India

► FCo1 wants to pay tax on gross basis

► FCo1 claims income not effectively

connected with PE in India as royalty is

earned pursuant to offshore contract

► Please advise

Branch develops

software

Licence

Agreement

Licence granted


20 December 2014

Case study : “Effective connection”

− F Co and I Co enter into contracts for

supply and installation of machine; grant

of process knowhow

− Installation triggers construction PE for F

Co

− Know how represents existing know-how

of F Co

− F Co is to impart know-how in the form of

ready manuals; ICO personnel to visit F

Co overseas factories etc.

− F Co apprehends that know-how receipt

may be treated as effectively connected

with PE

− Please advise

Construction PE

India

Outside India

FCo

ICo

Plant set up

contract


Thank You

―This Presentation is intended to provide certain general information existing as at the time of

production. This Presentation does not purport to identify all the issues or developments. This

presentation should neither be regarded as comprehensive nor sufficient for the purposes of decision-

making. The presenter does not take any responsibility for accuracy of contents. The presenter does

not undertake any legal liability for any of the contents in this presentation. The information provided is

not, nor is it intended to be an advice on any matter and should not be relied on as such. Professional

advice should be sought before taking action on any of the information contained in it. Without prior

permission of the presenter, this document may not be quoted in whole or in part or otherwise.‖

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