Post on 30-May-2020
Passive Income – Royalties and case studies on royalties
Paresh Parekh
20 December 2014
Intensive Study Course on DTAA
Page 2 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
Page 3 20 December 2014
Basics
Passive Income - Royalties and Case Studies on Royalties
Page 4 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
Passive Income - Royalties and Case Studies on Royalties
Page 5 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.”
Passive Income - Royalties and Case Studies on Royalties
Page 6 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.”
Passive Income - Royalties and Case Studies on Royalties
Page 7 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”
Passive Income - Royalties and Case Studies on Royalties
Page 8 20 December 2014
UN / OECD Model on Royalties
Passive Income - Royalties and Case Studies on Royalties
Page 9 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
Passive Income - Royalties and Case Studies on Royalties
Page 10 20 December 2014
UN definition dissected
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
Passive Income - Royalties and Case Studies on Royalties
Page 11 20 December 2014
UN definition dissected
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)
Passive Income - Royalties and Case Studies on Royalties
Page 12 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
Passive Income - Royalties and Case Studies on Royalties
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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
Passive Income - Royalties and Case Studies on Royalties
Page 14 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
Passive Income - Royalties and Case Studies on Royalties
Page 15 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
Passive Income - Royalties and Case Studies on Royalties
Page 16 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
Passive Income - Royalties and Case Studies on Royalties
Page 17 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)
Passive Income - Royalties and Case Studies on Royalties
Page 18 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
Passive Income - Royalties and Case Studies on Royalties
Page 19 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
Passive Income - Royalties and Case Studies on Royalties
Page 20 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.
Passive Income - Royalties and Case Studies on Royalties
Page 21 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.
Passive Income - Royalties and Case Studies on Royalties
Page 22 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)
Passive Income - Royalties and Case Studies on Royalties
Page 23 20 December 2014
Royalty under the Act
Passive Income - Royalties and Case Studies on Royalties
Page 24 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
Passive Income - Royalties and Case Studies on Royalties
Page 25 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)
Passive Income - Royalties and Case Studies on Royalties
Page 26 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
Passive Income - Royalties and Case Studies on Royalties
Page 27 20 December 2014
Software payments
Passive Income - Royalties and Case Studies on Royalties
Page 28 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‖
Passive Income - Royalties and Case Studies on Royalties
Page 29 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
Passive Income - Royalties and Case Studies on Royalties
Page 30 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
Passive Income - Royalties and Case Studies on Royalties
Page 31 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)
Passive Income - Royalties and Case Studies on Royalties
Page 32 20 December 2014
Transponder payments
Passive Income - Royalties and Case Studies on Royalties
Page 33 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
Passive Income - Royalties and Case Studies on Royalties
Page 34 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
Passive Income - Royalties and Case Studies on Royalties
Page 35 20 December 2014
Source Rule
Passive Income - Royalties and Case Studies on Royalties
Page 36 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
Passive Income - Royalties and Case Studies on Royalties
Page 37 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.”
Passive Income - Royalties and Case Studies on Royalties
Page 38 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
Passive Income - Royalties and Case Studies on Royalties
Page 39 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?
Passive Income - Royalties and Case Studies on Royalties
Page 40 20 December 2014
Excessive royalty or FTS payment
► 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?
Passive Income - Royalties and Case Studies on Royalties
Page 41 20 December 2014
Excessive royalty or FTS payment
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.
Passive Income - Royalties and Case Studies on Royalties
Page 42 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….
Passive Income - Royalties and Case Studies on Royalties
Page 43 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
Passive Income - Royalties and Case Studies on Royalties
Treaty, if applicable to Mr. Lee is unlikely to avoid source tax in India; Treaty source rule wider than ITL
Page 44 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
Passive Income - Royalties and Case Studies on Royalties
Page 45 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
Passive Income - Royalties and Case Studies on Royalties
Page 46 20 December 2014
Effective connection
Passive Income - Royalties and Case Studies on Royalties
Page 47 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.
Passive Income - Royalties and Case Studies on Royalties
Page 48 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
Passive Income - Royalties and Case Studies on Royalties
Page 49 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
Passive Income - Royalties and Case Studies on Royalties
Page 50 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
Passive Income - Royalties and Case Studies on Royalties
Page 51 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
Passive Income - Royalties and Case Studies on Royalties
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-
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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.‖