TAXATION of royalties has been one of the most contentious issues between different countries. Where lies the source of royalty?

Is it in the country where research and development takes place, or in the country where the payer resides, or in the country where the technology is put to use or in the country where the recipient resides; these are the questions which are answered differently by different countries, depending on its respective jurisprudence on the subject.

This often leads to double taxation and since in most countries, royalties are subject to a very high level of withholding tax on gross basis, the tax payers often end up paying much more in taxes than the actual income earned by them.

Taxation in India: Indian income-tax law is amongst the strictest in terms of taxing royalties. The definition of `royalty' is very wide, which includes consideration for transfer of all or any rights in an intellectual property.

This may be one of the reasons why the high powered committee set up for ‘Taxation of E-commerce' has characterized (though questionably) most e-commerce payments as ‘royalty' under the Income-Tax Act, 1961 (I-T Act).

Further, Section 9 of the I-T Act, which deems certain incomes to be taxable in India includes royalties which are paid outside India by one non-resident to another non-resident, where the payment is made in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on in India.

This provision would bring most offshore royalty payments within the Indian tax net where the payer has some business connection in India, unless the tax treaties provide for some concession.

For example, certain tax treaties restrict the taxability of second-tier royalty in the country of source, unless the recipient has a Permanent Establishment and the royalty is borne by such PE.

India has effectively used provisions of Section 9 to tax second-tier royalties. Some advance rulings have touched upon this issue in detail. One such case was that of White Consolidated Industries (AAR No 250 of 1995).

In this case, it was held that the royalty paid by one US company to another US company for the use of trademark, which was, in turn, also used by its Indian subsidiary, was held to be taxable in India and subject to a withholding tax on gross basis.

In another ruling in the case of Bechtel France SA (228 ITR 487B), a similar view was taken, though the outcome was different as the India-France treaty provided some relief.

According to the treaty, these royalties could be taxable in India only if the payer had a PE in India and these royalties were borne by such PE. The provisions of the India-US treaty are not as beneficial and have an additional provision as regards taxability in India ,even in the absence of PE, where the intellectual property in respect of which such royalties are paid, is put to use in India.

Taxation in the US: There were some rulings in the US in support of taxation of second-tier royalty. However, a recent court decision has overturned the past rulings and set the record straight in terms of avoidance of multiple taxation of the same income.

It seems that the IRS has also withdrawn its appeal against this decision and hence, this would remain settled law for now.It would be interesting to see how royalty payments are structured by multinationals in order to achieve maximum tax efficiency. The facts of the case are.

Ownership structure: The parent of the group is SDI, a Bermudan company, which has a wholly owned subsidiary in Bermuda called SDI Bermuda. SDI Bermuda has a wholly owned subsidiary in Netherlands Antilles called SDI Antilles, which in turn, has a WOS in Netherlands called SDI Netherlands.

SDI BV has several marketing WOS' in USA, Germany, France and UK.

Royalty structure: There is a Bermuda License Agreement between SDI Bermuda and SDI BV, whereby SDI BV has a non-exclusive license to use or market the use of, on a worldwide basis, all of the software and any and all intellectual property rights of SDI/SDI Bermuda, for payment of a royalty.

It included a right to sub-license any of the above rights.

The royalty payable was 93 per cent of the net (after-tax) amount of all of the royalties due to BV by all persons, entities and institutions. This percentage could increase upto 98 per cent, depending on the quantum of royalties received by SDI BV

SDI BV had an exclusive US license agreement with SDI US. SDI US was responsible for direct marketing and sales of the software in the US. This license included right to sublicense the use and lease of software to others and to provide for exclusive maintenance, servicing and repair of the software within the US.

The royalty payable was 50 per cent of the annual gross revenues of SDI US from leasing and sublicensing of software. The taxability in question was in relation to the two payments,royalty paid by SDI to SDI BV, royalty paid by SDI BV to SDI Bermuda.

Royalty payable by SDI to SDI BV was taxable in the US, though tax-exempt by virtue of the then prevailing US-Netherlands tax treaty. IRS raised notice of deficiency to SDI BV to question why no tax was withheld on royalty paid by SDI BV to SDI Bermuda.

According to Section 881(a) of the Internal Revenue Code, payment of royalty received by a foreign corporation from sources within the US is subject to a withholding tax of 30 per cent in the US.

Royalties included in US source income includes rentals or royalties from property located in the US or from any interest in such property, including rentals or royalties for the use of or for the privilege of using in the US, any patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and other like property (Section 861(a)(4) of IRC).

All persons, having the control, receipt, custody, disposal or payment of any taxable royalty of any non-resident, is liable to deduct and withhold tax at the rate of 30 per cent (Section 144(1)(a) of IRC).

SDI BV argued that the royalty received by SDI Bermuda was not taxable in the US as SDI Bermuda did not have any active trade or business in the US. It further argued that royalties received by SDI BV from SDI got merged with royalties received by it from its other (non-US) sub-licensees and lost its character as US source income.

Several cases and rulings were referred to, relied on or distinguished from in the course of delivery of this judgement. The court held that both the license agreements had separate distinct terms and that SDI BV had an independent role as the licensee from SDI Bermuda and the licensor of the other entities, including but not limited to SDI US.

The court also commented that if IRS' view was upheld, that it be allowed to tax the second-tier payment as it had not actually collected any tax on the first-tier royalty, law could cause a cascading royalty problem, whereby multiple withholding taxes could be levied on the same royalty payment as it is transferred up a chain of licensors.

It was finally held that the payments by SDI BV to SDI Bermuda were not “received from sources within the US” and hence not taxable in US.

A similar argument could be applied to India. If Section 9 is applied as it is, almost all tiers of royalty payments, made in any part of the world, could be taxable in India so long as any part of the intellectual property was put to use in India.

Since royalties are taxed at the rate of 20 per cent on gross basis, the ultimate tax liability, up the entire chain, could be in excess of any comprehensible amount.

It is time India started taking a more pragmatic view on taxation of foreign companies.

Indian revenue authorities should look beyond the immediate objective of collecting maximum possible tax revenues and vouch to do more justice to international principles of tax and revenue sharing in a just and fair manner and interpret the same in the true spirit, such that businesses worldwide do not suffer multiple taxation of the same income.