Friday, October 14, 2011

Royalty in Double Taxation Convention Models Between Developing and Industrialised Countries

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Royalty in Double Tax Convention Models


Between Developing and Industrialised Countries


Indra Muliawan


Introduction


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Commerce and Technology are major forces that influence the process of global transformation. In order to keep up with the pace of such transformation, a Developing Country (“DC”), must consequently be aware of new technologies emerging from, most of the times and very likely from, Industrialised Countries (“IC”). Researches conducted on their own would never match those of the more developed ICs, thus leaving only little possibilities for keeping up, one which is by way of technology transfer. One way in effecting such transfer in the commercial world would be by a conferring of right to use certain technologies with a sum of remuneration attached (royalty), and together with it, technical advises from owners of the respected technology.


Given the discrepancy of conditions between DCs and ICs, the convention between these nations shall have its own particular clauses, in the terms of the technology itself, or other matters such as the sharing of tax claims, Definitions, merits, and other clauses, mostly in the light of attracting foreign investment and in the same time to fill in the state’s budget, in comparison with conventions between ICs. Therefore, this paper would approach the problems of Double Tax Conventions (“DTC”) betweent DCs and ICs, in the light of comparison between the OECD model convention (“OECD MC”), and the UN Model (“UN MC”), which is supposedly in favour of DCs, and also some reference shall be made to the practice in Indonesia as a DC. Furthermore, due to the large area of discussion regarding the international taxation rule of Royalty, it should be noted that this paper will discuss, instead all problems in the respected area of international tax law, only some particular matters in the abovementioned area of Royalty in conventions between DCs and ICs.


DCs have indeed different needs and concerns compared with ICs. This may give rise to problems in drafting conventions between the two countries using the OECD model tax convention, that the drafters of this model designed it to accommodate the needs and concerned of ICs, particularly members of the OECD. The UN model which was published in 180 was meant to be an alternative to the OECD Model Taxation Convention which puts most emphasis on residence based taxation. This pattern may not be appropriate in treaties between DCs and ICs, because income flows are largely from DCs to ICs and the revenue sacrifice would be one sided. That is to say, although developing countries adopted the principle of taxing worldwide income, they had, as typical source countries, only the sacrifices arising from the signing of conventions, without deriving any real compensation for these sacrifices from the corresponding sacrifices imposed, in form rather than in reality, on the othern contracting state. DCs are aware that they are negotiating away the right to tax income generated under their jurisdiction by investments undertaken by developed countries.


Matters to be Discussed by DCs in drafting DTC on Royalty With ICs





Royalty, in this sense, as in Merriam Webster Dictionary 000 is


“a share of the product or profit of property reserved by the owner when the property is sold, leased, or used or a payment (as a percentage of the amount of property used) to the owner for permitting another to exploit, use, or market such property (as natural resources, patents, or copyrights) which is often subject to depletion in use”.


Although laymen would refer to it as remunerations in accordance of usage of intangible properties. In the framework of International Tax Law, surely, in the viewpoint of country there are two kinds of Definitions regarding royalty, namely the one in a DTC on the one hand, and the one in the domestic tax law on the other. In accordance to DTC, the following are, inter alia, the concerns mostly thought of and fought about in negotiating a DTC by DCs


a. Sharing of Tax Claim


It is of a public knowledge, that in the matter of Royalty, most DCs, that do not have the time nor the resources to conduct researches and consequently produce properties that are sell-able, lease-able, all in all which would then be the base for receiving remuneration on royalty, would then be instead the party paying the remuneration for the royalty from ICs which are in posession of such kind of property/base. Hence, in most cases, the flow of payment would come to DCs to ICs, or in other words, DCs shall play the part of State of Source (“SS”), and IC shall be the State of Residence (“SR”). Article 1 paragraph 1 of the OECD MC stipulates


“ Royalties arising in a Contracting State and paid to a resident of the other Contracting State shall be taxable only in that other state if such resident is the beneficial owner of the royalties”.


By the the wording of “only in”, this article is therefore bestowing exclusive title to the SR to tax such royalty, leaving none to the SS. Advocation of this logic by the majority of the OECD was inter alia, that the SR has forfeited tax by having had to allow as a deduction the costs of developing the rights, etc, in respect of which the royalties were paid. This, However, is regarded as a “subjective way of thinking” of the OECD members by DCs, which, in their own subjectivity, think that as the SS, they should be entitled to tax the remuneration that it is within their border the usage of the royalty is conducted.


Article 1 of the UN MC offers a better-accepted clauses in paragraph one that stipulates that “Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other state.” A slight different wording here has given rise to a significant different effect in comparison with the OECD MC. “may be taxed”, implies that the SR has only bestowed primary right, instead of exclusive right, to tax royalties. A contrario, this article also bestows some right to the SR for taxing the royalty. Consequently, paragraph of the UN MC stipulates that


“ However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the recipient is the beneficial owner of the royalties, the tax so charged shall not exceed … percent (the percentage is to be established through bilateral negotiations) of the gross amount of the royalties. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of this limitation.”


This paragraph implies that the SR shall be entitled to tax the royalty up to a certain percentage of the gross amount of the royalties, with shall be further negotiated in a mutual agreement.


As most of the time, the position of a DC does not provide a sound bargaining power compared with ICs. Therefore, DCs would not get an adequate percentage of the gross amount in the negotiation. However, adding a fixed percentage in the UN MC would also not seemed to be fair, that this area concerns minute details which differ between each country and its treaty. Another problem that lies, is what constitutes “gross amount”? The OECD commentary stipulates that ” the refund of costs accruing to the licensor and capable of being openly passed on to the licensee … may have to be treated as if it were a royalty.” However, there is no exact stipulation of which kind of costs that are accountable, or in what degree of connection shall these costs be? Shall it be right in the adjacent area of the royalty only, or it also covers indirect costs? German tax authorities however, accept that even refunded travelling expenses on technical assistance may be of particular significance and particularly clearly attributable. Some writers suggest that the costs should be costs that are deductable from the tax base in calculating domestic income tax. Some others suggest that the costs are those considered normal in everyday’s commercial practice. The former suggestion shall then have to rely to the exchange of information between the contracting states, while the latter shall have to undergo further scrutinisation. As aforementioned, the needs and con


cerns of ICs and DCs are somewhat different, as it is also the case with their inhabitants, which in turn regards differently on what is “normal in everyday’s commercial practice”. These different standards shall then have to be harmonised by further negotiations between the contracting states.


b. Definition of Royalty


Apart from other problems imposed by article 1 of the definition of Royalty, such as defining software and its adjacent area, in the viewpoint of DCs, the advance of Information Technology confers the possibility that activities which previously have to be conducted with the presence of a permanent establishment (“PE”) in the SS, can now be conducted directly from the SR, particularly in terms of Broadcasting and advertisements. This way, SS would lose the chance to tax these activities without the presence of the respected PE. However, as endeavoured by Indonesia in some of its treaties, in order to still be able to tax these activities, broadcasting and advertisements are negotiated to be included in the definition of royalty of the article 1 paragraph of the OECD/UN MC.


Another way of taxing broadcasting or advertisement or other activities in the light of novel technologies are if they were conducting through the internet. Two possibilities exist in this matter. Firstly, it may be necessary to accommodate the definition of PE into these new technologies. Article 7 of the OECD provides that


“The profits of an enterprise of a Conracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them is attributable to that permanent establishment.”


Several test are available to regard something to be constructed as a PE, namely ,


1. Place of Business test


A website would definitely not satisfy to fulfil the definition of “Place”, being merely programmed electronic process within a computer, and not a physical object. However, the server is aphysical object, hence if it is substantial it may qualify as PE-constituting “machinery of equipment”. However so, portable equipment does not qualifiy as a “place of business.


. Location test


The place of business must to some extent be linked to a specific geographical point in the source state. The location test excludes places of business that are mobile. However, in accordance with the above point A, , the room or office in which the server is located would qualify for this purpose.


. Personal Presence test


The presence of a server, without the personal presence of a human being in the country which the business is conducted may be regarded as a PE. Judicial and administrative practice and subsequently also in the commentary to the OECD Model Tax Convention is that a PE does not require the presence of human beings, thus the enterprise may be present in the country by means of the right to use a server.


4. Right of use test


A strict definition used to be incorporated by german courts are that the taxpayer has alegal position to the extent that he cannot be removed from the place of business without his own consent. The mere actual use of a place of business is not sufficient. However, recent decisions seem to indicate modifications in the right of use test even in Germany. Therefore the right of use test in the respect of a server, should normally be present. Other countries, athough not agreeing with a reasonable interpretation of the wording of the Commentary apply the actual use test. Thus the placing of a website on a server would mean that the place of business is at the tax payer’s disposal in those countries.


5. Permanence test


Permanence test usually constitutes a certain duration of time. A duration of six months seems to be sufficient in many countries. Intended perpetuity will also be sufficient for the constitution of a PE. In the case of electronic commerce, it seems to be fairly easy to move the web site from a server in one country to another server in another country with the effect that the existence of a right of use to a place of business is terminated. This is still an unresolved problem of tax avoidance, yet.


c. Technical Assistance


Article 1 paragraph stipulates


“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 infomation concerning industrial commercial or scientific experience.”


Before commencing the discussion regarding technical assistance, it should be noted that royalty in this sense as stipulated in the abovementioned paragraph, covers a considerably large area, inter alia, copy right, patent, trade mark, industrial design, model, and plan.


In the conduct of conferring copy right, patent, trade mark, industrial design, et cetera, sometimes the grantee may not be able to operate such right without further assistance by the grantor. There are kinds of these assistance, namely;


a. know how


Know how is generally described as unpublicised and unpatented knowledge obtained by the owner without further research, mostly from his/her own experience. The owner of the Know-how is not included in applicating the formula, and shall not be responsible regarding to the result. It is also regarded as an intangible fixed capital asset, if the owner retained the “Know-How” for himself. It also has the peculiar quality that it can be communicated to or shared with others outside the manufacturer’s own business without in any sense destryoing its value to him. However, the selling of such property changes its status into service.


Whenever the term royalties relates to payments in respect of experience (“know how”), the condition for applying article 1 is that the remuneration is being paid for imparting such know-how. Where there is a mixed agreement, such as one licensing a patent in connection with imparting know-how, the patented knowledge must be let in the above described sense, whilst know how need only be imparted. Where the imparting of experience is of a mere ancillary character under a patent licence, there need not be any separate characterisation at all.


b. Technical assistance


Technical assistance, although has not been clearly defined, is generally described as services provided in relation with sui generis knowledge, industry and or commerce. The provider of the service is included in the application, and therefore obtaining responsibility with regard to the overall result. It is usually the case in DCs, that ICs provide Technical assistance in conducting some projects, for example to operate machineries common to the IC, however uncommon to the DC. Therefore, Technical assistance has a somewhat different character in comparison with know how, that amongst others, Technical assistance is a form of service, therefore unrelated with royalty, and hence can only be taxed by SS if it derives from a PE existing in the respected SS. Consequently, several tests must be fulfilled in order to determine the existence of a PE as mentioned in pages 4 and 5, supra.


The concerns of DCs, are as usual, how to impose as much as taxation on these activities. In this particular case, is how to tax Technical assistance in the absence of a PE. Some DCs, one of which is Indonesia, endeavoured that Technical assistance shall be incorporated under the definition of royalty, which may be done by expanding the definition of know-how to include technical assistance. An argument in favour of this kind of logic would be that by the inclusion of technical assistance into royalty, the need to distinguish between such assistance and licences shall perish. However, on the other hand, there shall be the need to distinguish royalties and payments for assistance rendered and payments connected with business activities or independent personal services. This, we shall leave to negotiations between the contracting state, and perhaps, further case law.


d. Definition on Source of Income


As mentioned above, in paragraph one article 1 of the OECD or the UN MC, “Royalties arising in a Contracting state … “, and further, in paragraph of the said article “… arise through a permanent establishment …”. However, the OECD MC fails to provide a treaty definition of the term “arising”. However, the word “arising” used in the english text might be interpreted to indicate the place where the royalties should be treated as a claim (and correspondingly as a liability or expense in the hands of the licensee). Should “arising” means that the point of time to tax is at the rise of the liability? Article 1 also fails to settle the question as to the point of time at which royalties may be taxed.


A question then stands. Should the point of time in imposing the tax be at the rise of the liability, or shall it be at the time of payment? Both of this problem, would have to be scrutinised in the light of which accounting system, namely the cash basis or the accrual basis, prevails. Negotiation then must take place between the contracting parties in settling this matter, due to the fact that the contracting parties may not have the same accounting basis in its domestic tax law. Accrual accounting basis shall favour the use of the time the liability rises, and cash basis shall favour otherwise. However, if this view is taken, another question may emerge, that is, in the case if a negotiation result put the time of payment to be the time of tax imposition, but on the other hand still prefer the accrual basis. An accrual payment, as in the account payable of the ledger, as may be possible in certain accounting regime,is set off with another account receivable, writing off each other, thus leaving nothing to display on the ledger. Would, in this case, in the standpoint of the accrual basis, the accrued payment ceases to exist, or to the contrary, it retain its existence thus allowing the imposition of tax? This I should say shall be put in the hands of the tax authorities of each contracting parties to arrive at a mutual agreement in solving this matter, or perhaps, some alteration to the models.


Conclusion


This paper, as many other papers, would only arrive at a clich� conclusion all around, that there are some problems with the OECD and UN MC that needs to be solved. It is as already well known, that as a model convention, both model would only stand as guidance rather than being imperative. Therefore, alterations of its articles are possible as long as agreed between the contracting parties who would negotiate under their own spesific conditions, also in accordance with the fact that the both MCs may never be able to accommodate all the needs of each country in the world, having different needs and concerns. All I can say is that as the the world is undergoing constant changes, it is advisable to always revise and search new meanings and possible implementation of the MCs.


Currently an LL.M. student in Groningen Rijksuniversiteit, the Netherlands.


For Example, a Technology may be obsolete in an Industrialised Country, however that may not the case


in a Developing Country, that it may be regarded as a completely new one.


Van Der Bruggen, Edwin, “A Preliminary Look at the New UN Model Tax Convention”, British Tax


Review, 00, page 11.


Figuero, A.H., “Comprehensive Tax Treaties”, Seminar paper in 44th congress of the International Fiscal


Association, Stockholm, 10, page 1.


Rahayu, Ning, “Treatment of Income Tax on Royalty in Indonesia”, Seminar paper in intern discussion at


Indonesia University, Faculty of Economics, July 00, page .


In this case, the Treaty shall take the position of the Lex Specialis of the Domestic Tax Law (in the viewpoint of a country’s tax authority).


Kadir, Ali, “Negotiation of DTCs on Royalty between DCs and ICs”, PrimeTax Review 001, page 56.


Vogel, Klaus, “Commentary on OECD Model Tax Convention”, page 77.


Kadir, Ali, loc.cit, page 64.


Vogel, Klaus, loc.cit. page 770


Many bilateral treaties within the OECD maintain a limited rate of tax at source on ryalties. See OECD, Committee of Fiscal Affairs,b”the Taxation of Income Derived from the Leasing of Industrial, Commercial or Scientific Equipment”, Intertax 184/1, page . see also, the concept of “economic allegiance”, Vogel, Klaus, “Which Method Should the European Community Adopt for the Avoidance of Double Taxation?”, Bulletin-Tax Treaty Monitor, January 00, page .


Average percentage for Indonesia’s treaties is 10%. See Sunardi, Untung, “Indonesia’s Tax Treaties”, Paper for the seminar of “Tax treaties of Indonesia what are needed?”, held in Jakarta September 001, page .


Vogel, Klaus, loc.cit. page 780


Ibid.


Kadir, Ali, loc.cit. page 68.


Sunardi, Untung, loc.cit., page .


Skaar, Arvid Aage, “Erosion of the Concept of Permanent Establishment Electronic Commerce”, paper based partly on a paper presented and discussed at the New Delhi IFA Congress 17.


Ibid.


Ibid.


Ibid.


Rahayu, Ning, op.cit. page .


Vogel, Klaus, op.cit., pages 75-80.


Crystal, John, “The Curious Nature of Know How”, taken from an article bundle at Makarim & Taira Law Firm Jakarta, origin of the bulletin or review is not known, pages -4.


Vogel, Klaus, op.cit., page 70.


Ibid, page 801.


Rahayu, Ning, op.cit.


Vogel, Klaus, op.cit., pages 75-80.


Vogel, Klaus, op.cit, page 776.


Ibid., page 777.


Kadir, Ali, op.cit., page 60.


However, this kind of accounting treatment, according to the international accounting standard, (GAAP) which is widely incorporated as the accounting standard of many countries, is not allowed. This accounting regime is also incorporated in the indonesian accounting standard, “PSAK”, therefore sharing the view of the GAAP. On the other hand, this kind of “accrual account set off” is abundant in Indonesia’s accounting practice, thus the usage of an accrual regime in relation with the time of tax imposition of royalties, in the midst of this “illegal” accounting practice, will not be effective, that an audit of book keeping would unlikely to unveil this practice. Also, in the viewpoint of the company, since the set off materially erase its right and liability, that for the purpose of simplification and perhaps tax evasion, displaying the accounts would not be beneficial.


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