Should Royalty Withholding Tax Apply? Taxpayer Alert TA 2018/2
The Commissioner issued Taxpayer Alert TA 2018/2 on 20 November 2018. This alert raises his concerns with arrangements involving the supply of tangible goods and/or services which are connected with the use of intellectual property owned by an offshore supplier or its offshore associate. We also query whether the Commissioner’s approach in TA 2018/2 will apply to all arrangements involving intangible assets in cross-border supply contracts based on the current definitions of a royalty under the tax law.
TA 2018/2 addresses the potential existence of a royalty payment embedded in the consideration paid for the tangible good or service but represented in supply contracts as consideration solely for the supply of goods and/or services.
Importers and distributors of products sourced from related and unrelated offshore suppliers should review their current arrangements, as TA 2018/2 could potentially apply to them resulting in either transfer pricing adjustments being made (in the case of related parties), or the imposition of Australian royalty withholding tax on payments made to foreign suppliers where there is currently no withholding made.
The article below is a summary of the key points from TA 2018/2.
What is the ATO concerned about?
The ATO’s concern arises in two (2) contexts:
- arrangements between related parties which raise the issue of whether the following amounts are in accordance with the arm’s length principle under the transfer pricing provisions:
- the amount of the deduction claimed by the Australian recipient; and
- the amount of the Australian recipient is compensated for based on functions performed, assets used and risks assumed by the Australian entity, in connection with the arrangement;
- in respect of related and unrelated party supply arrangements, whether part of the payment made under the supply arrangement is a royalty attracting royalty withholding tax.
Which IP does this apply to?
The intangible assets to which TA 2018/2 applies are those defined as such in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 at Chapter IV: Intangibles and include trademarks, copyright, designs, know how, patents, secret formulas or processes or similar property or rights.
These are assets which are:
… property, assets and rights that are not physical assets or financial assets, which are capable of being controlled for use in commercial activities..
Which royalties does TA 2018/2 apply to?
TA 2018/2 applies to royalties which meet the definition of ‘royalty’ under subsection 6(1) of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act) or under any applicable Australian tax treaty.
The definition of ‘royalty’ under subsection 6(1) of the 1936 Act is an expanded definition and includes, among other things, the use of industrial commercial or scientific equipment.
Which arrangements is TA 2018/2 directed to?
The Commissioner states that arrangements which involve related parties exhibit the following features:
- intangible assets are developed and owned by a related entity in a foreign jurisdiction (the IP Entity);
- the Australian entity enters into an arrangement to undertake an activity or a combination of activities;
- the Australian entity requires the use of relevant intangible assets in order to undertake these activities;
- the Australian entity purchases goods or acquires services from the IP Entity or from its associate;
- the consideration paid by the Australian entity is for the supply of tangible goods and/or service and no part of the consideration is recognised as for the use of the intangible asset.
Which arrangements do not fall within TA 2018/2?
Arrangements which involve the supply of finished goods to an Australian entity and the use of an intangible asset is incidental to that supply.
The Commissioner states:
For example, this Alert does not apply to resellers of finished tangible goods where the activity of reselling the goods involves an incidental use of a brand name that appears on the goods and the related packaging. Whether a use is incidental in this sense will depend on an analysis of the true relationship and activities of the parties. The fact that an arrangement fails to expressly provide for the use of an intangible asset does not, in itself, determine that a use is incidental.
It would appear that in the context of distributors of imported finished goods, whereby the Australian distributor is permitted to use the foreign supplier trademark in the sale of the good, no embedded royalty will be found. Therefore, no Australian withholding tax liability should arise. This is provided that no separate intellectual property right is conferred on the Australian distributor for which a separate payment is made – whether under the global supply agreement, or under a separate licence agreement.
Which arrangements does TA 2018/2 potentially apply to?
TA 2018/2 contains two (2) examples.
Example 1 involves the following facts:
- An Australian company (AustCo) enters into an agreement with a foreign company (ForCo) which provides:
- the right to manufacture, market and distribute certain products in the territory of Australia
- manufacturing know how, including secret formulas or processes
- a right to use trademarks
- tangible goods such as raw materials used in the manufacturing process.
- AustCo applies the intangible assets under the agreement as follows:
- Applies the manufacturing know how and tangible goods in the process of manufacturing the product;
- Uses the trademarks in marketing and distributing the finished product in Australia.
- AustCo pays ForCo a single undivided amount of consideration which is stated to be solely for tangible goods.
- Accordingly, no amount of the consideration is stated to be for the use of ForCo’s intangible assets.
- AustCo does not pay any royalty withholding tax on any part of the consideration paid to ForCo.
The Commissioner states that:
This characterisation may not appropriately recognise the exploitation of relevant intangible assets or the functions performed and the risks assumed in connection with those intangible assets.
Example 2 involves the following facts:
- AustCo enters into an agreement with ForCo, a related foreign company and under the agreement AustCo:
- is granted the right to manufacture, market and distribute products within Australia;
- is obliged to do these things in accordance with the directions of ForCo;
- agrees to purchase tangible goods from another foreign company (SupplyCo) which may not be related to ForCo and this might be under a separate contract as between AustCo and SupplyCo
- ForCo provides management services to AustCo to assist with the manufacturing, marketing and distributing the products within Australia.
- ForCo owns the intangible assets which it permits AustCo to use in respect of manufacturing, marketing and distributing the products within Australia.
- The agreement between ForCo and AustCo specifically states:
- that AustCo is not granted the right to use the intangible assets;
- the consideration paid is a single undivided amount of consideration for the provision of management services only.
- ForCo grants another entity, IPCo, which is not a resident of Australia, exclusive use of the relevant intangible assets in the territory of Australia.
- pays SupplyCo an amount for the tangible goods, this amount is determined by ForCo;
- applies the intangible assets, exclusively licensed to IPCo, in the process of manufacturing the goods;
- uses the intangible assets exclusively licensed to IPCo in the marketing and distribution of the finished products in Australia.
- IPCo does not enter into an agreement for the use of the intangible assets with AustCo.
- There is, however, implicit in AustCo’s activities and dealings with ForCo and SupplyCo, an ‘in substance’ right conferred on AustCo to use the intangible assets.
- ForCo and SupplyCo do not recognise any part of the payments they receive from AustCo as a royalty payment.
- AustCo does not pay any royalty withholding tax on any part of the consideration paid to ForCo or SupplyCo.
The Commissioner has the same concerns as in Example 1.
What are the Commissioner’s concerns in more detail?
The Commissioner’s concerns arise in three (3) ways:
- The first is the non-recognition of a royalty payment and therefore the failure to comply with the Australian royalty withholding tax obligation under Subdivision 12-F of Schedule 1 of the Taxation Administration Act 1953 (Cth) (the TAA). Failure to withhold then brings the deduction for the payment representing the royalty into question under section 26-25 of the Income Tax Assessment Act 1997 (or at least part of the payment made under supply contracts);
- The second is the potential for a transfer pricing benefit to be obtained. This arises because of the mischaracterisation of the functions performed, assets used and risks assumed by the Australian entity. The Commissioner would be seeking to apply Division 815 of the 1997 Act to negate these benefits.
- The third is whether these arrangements are entered into for the dominant or principal purpose of obtaining a tax benefit and therefore may attract the operation of Part IVA of the 1936 Act or the operation of the diverted profits tax in sections 177H to 177R of the 1936 Act.
The question as to whether intangible assets are being used and in circumstances where there should be a royalty payment is a complex one. It requires not only an analysis from a tax perspective, but a very clear and comprehensive understanding of the nature of the arrangements themselves – and whether intangible assets are in fact being used in a way that warrants a separate royalty payment.
For supply arrangements whereby the supplier seeks to place restrictions and burdens on the Australian recipient as a means of protecting their intangible assets rather than to confer on the Australian recipient positive rights of use of intangible assets, these arrangements should attract a different characterisation to that which TA 2018/2 gives. These arrangements may well properly fall outside the royalty withholding tax regime on the basis that there is no such use of intellectual property under the relevant definitions contained in the tax law.
Australian distributors and manufacturers should therefore carefully review their cross-border supply arrangements to determine the risk of TA 2018/2 applying to their arrangements.