IN198 - Royalty Planning

In the absence of careful planning, owners of intellectual property can find their profits seriously eroded by both taxes on profits and by withholding taxes.

1. Traditional Planning for the Holding of Intellectual Property

Traditional royalty tax planning has involved transferring intellectual property (IP) to a company in a jurisdiction that imposes low tax or no tax on profits. However countries from where royalties are paid generally levy a withholding tax that can be as high as 35%.

It is important to take into account that if IP is transferred after it has become valuable, it likely that there will be capital gains tax implications on the disposal of the IP to the low tax company. It is therefore preferable to aim to transfer the IP to the intellectual property holding company while it is at a low value, or, alternatively, to ensure that the IP is developed by the company that is to ultimately own it.


In the example shown above, ownership of the IP is held in an offshore jurisdiction where the tax rate on profits is zero. The offshore jurisdiction grants a sub licence to an intermediate royalty holding company in a tax treaty jurisdiction such as Malta or Madeira, which, in turn, licences the IP to a third party.

The Importance of Double Taxation Treaties

If a double taxation treaty exists between two jurisdictions, when royalties are paid the withholding tax rate will be no greater than the rate specified in the tax treaty between the tax treaty jurisdiction and the country paying the royalty. This rate is generally significantly lower than the standard withholding tax rate.

Intermediate Royalty Holding Company Location

The jurisdiction for the location of an intermediate royalty holding company should offer the following beneficial features:

• Access to a large network of double taxation treaties
• Low corporate tax rate liability on royalties received
• The ability to pay-on royalties without withholding tax
• The eligibility of royalty payments as a deductible expense against royalty receipts
• The ability to get tax rulings on the margin to be retained in the intermediate company

Possible Problems with the Traditional Tax Planning Approach

In order for the withholding tax benefits contained within double taxation treaties to be applied, the company receiving the royalty must own the intellectual property “beneficially”.

Tax authorities in certain countries, for example Germany, argue that a conduit company, such as the one detailed in the traditional royalty planning structure, fails the test of beneficial ownership. In addition, some double taxation treaties include specific anti-avoidance provisions, such as anti-conduit rules.

The way to solve the problem of anti-conduit rules is to choose a jurisdiction with a good network of double taxation treaties and with low rates of tax on the royalty income. The IP can then be held in the treaty jurisdiction company without a back to back agreement with an offshore jurisdiction.

The jurisdiction of Malta and the jurisdiction of Madeira each offer this combination of benefits.

2. An Alternative Approach to Traditional Royalty Planning


The diagram above illustrates royalties being paid from operating companies with reduced withholding taxes, due to the application of Malta’s double tax treaties.

Although the royalty is taxed in Malta at 35%, the net Malta tax is between 5% and 10% due to the tax refunds available to the parent on payment of dividends.

On receipt of the dividend the parent company can claim back 6/7ths of the tax paid by the company on income used to pay the dividend, if the royalties are regarded as trading income, and 5/7ths if the royalties are regarded as passive income. Where double tax relief has been claimed, 2/3rds of the Malta tax paid can be claimed back.

The example below illustrates a Maltese company that receives a royalty after withholding tax of €100. The company can claim a flat rate foreign tax credit of 25%.

The cash flows are as follows:


The net Malta tax paid is 6.25% of the net foreign royalty income received.

Malta companies have access to an extensive range of double taxation treaties and the EU Directive on Interest and Royalties. Further details regarding Malta companies and Malta double taxation treaties can be found in Article 190.

If the parent company does not want to receive the tax refund, an alternative option is for the Malta intellectual property company to be held by a Malta holding company. The dividend received by the Malta holding company would then not be taxed. The Malta holding company could claim the tax refund and pay the dividend received plus the tax refund to the ultimate parent as a dividend. There is no withholding tax on dividends paid by Maltese companies. 

The diagram above illustrates royalty income being paid to a Madeira company using the reduced withholding taxes as detailed in Portugal’s double tax treaties. The royalty income will then be taxed at a rate of 4% in 2012 and then 5% until December 2020.  Dividends can be paid to the parent without deduction of any withholding tax.

Madeira is a region of Portugal and therefore has access to the majority of Portugal’s double tax treaties and the EU Directive on Interest and Royalties. Any taxation withheld on royalty payments to Madeira can be used as a credit against Madeira tax effectively reducing the tax of the Madeira company level to nil.

Payments of dividends by Portuguese companies including those in the Free Zone of Madeira are subject to Portuguese withholding tax. The Madeira Royalty Company is therefore owned by a Malta Holding Company. Dividends paid from the Madeira company to its Malta parent will be paid without deduction of a withholding tax by virtue of the EU Parent Subsidiary Directive. The dividend received by the Malta company will not be taxed. There will also be no withholding tax on the payment of dividends on from Malta.

Further details regarding Madeira companies and Portugal’s double taxation treaties can be found in the Articles Section of the Dixcart website at www.dixcart.com, Information Note 167, and Jurisdiction Note C respectively.

Summary

A case by case approach to tax planning for royalty routing needs to be adopted. Anti-avoidance provisions in the jurisdiction of the paying company must be taken into account. 

In certain circumstances, the more traditional conduit approach may work.  However, in other situations different solutions will be required.  The jurisdictions of Malta and Madeira are definitely worth consideration.

Dixcart has offices in both Madeira and Malta and therefore a complete solution can be provided by one organisation.

Lists of respective Malta and Portuguese Double Taxation Treaties can be provided by your usual Dixcart contact.

Additional Information

For additional information on this topic, please speak to Laurence Binge in the Dixcart office in the UK, Robert Homem at our Madeira office or Sean Dowden at the Dixcart office in Malta or contact us.