|
Academic Activities
Research Student Meeting
IBFD Tax Day
|
Table of contents
A complaint has been lodged by Pearonia with the newly constituted International Taxation Court in Amsterdam, alleging that Appalaria has acted in breach of the double taxation agreement between the two countries. The two countries have selected the CompuTV case as a representative case in this dispute, although there are many more cases in which the same or similar issues arise. The dispute centres on two questions:
- The proper interpretation of the definitions of royalties and technical services fees in the treaty; and
- The date on which the relevant treaty provision is to be applied.
Securobits is a company resident in Pearonia that specialises in developing advanced security systems for private homes. The security systems monitor the homes of the private clients continuously, and are linked to a central system that calls the emergency services when appropriate. The central system also collects information about security problems in customers' homes, analyses it and produces suggestions for improvement of the systems on a continuous basis. For example, the system learns about the changing tactics of burglars and produces recommendations to pass to customers if it perceives a new trend.
Securobits has a well-established brand name all over the world. In some countries it supplies its systems directly to private customers, but in many countries it works in cooperation with a local provider that deals with the private client and installs the system in the client's home. There is a separate central system in each country where Securobits systems are supplied. In countries where Securobits supplies private clients directly, the central system is operated by Securobits. In countries where Securobits works with a local supplier, however, it is the local supplier that builds and operates the central system because the precise specifications require local knowledge.
CompuTV is a company resident in Appalaria. It sells interactive televisions and sound systems combined with powerful computers that perform many different functions. CompuTV approaches Securobits with a view to purchasing security systems that can be incorporated into the sound systems and televisions.
In 2000, Securobits and CompuTV started negotiating an agreement to co-operate on creating a system combining the CompuTV and the Securobits technologies. After three years of negotiation, the companies came to the following agreement:
- Securobits will supply CompuTV with the chips for the security programmes, sensors and other apparatus that have to be installed in the customer's home;
- Securobits will train the high-level technical staff of CompuTV in the technology used for the system so that they are able to build, operate and maintain the central system for Appalaria;
- Securobits will also train the employees of CompuTV in the installation of the security systems, and will train the sales force of CompuTV to instruct customers properly in the use of the systems;
- Securobits will supply the hardware and software for a central control unit to be operated by CompuTV that will perform the function of collecting and analysing information from the customers of CompuTV, thereby building up a database of information about the Appalarian market. The information collected will be available to both companies;
- CompuTV will start a marketing campaign in Appalaria advertising that its sound systems and televisions can now be bought with a built-in security system from Securobits. Given the nature of this market, it is extremely important that potential customers are approached in the right way. Securobits will assist CompuTV with the design of the campaign, and at the same time ensure that the campaign is consistent with the image that Securobits wishes to portray of itself. CompuTV is therefore obliged to follow certain guidelines from Securobits concerning the design of the campaign. The campaign is to last five years, and a plan is agreed in advance specifying the different phases of the campaign, together with the obligations of the two parties during the various phases;
- In addition to assistance with the marketing campaign, Securobits will supply CompuTV with lists of potential customers. The lists are to be drawn up by Securobits using both information it has gathered itself and information supplied by CompuTV about its own customer lists. The selection of names is to be made by Securobits using the knowledge it has built up over the years from its own marketing efforts and its combined marketing efforts with local suppliers in other countries. Different lists will be given to CompuTV at different stages of the marketing campaign, but Securobits will not divulge to CompuTV the basis on which the selection of names is made.
The agreement is divided into two separate contracts:
Sales agreement:
- The chips, sensors and other apparatus will be provided at specified unit prices. The prices are fixed for 2003, but will be re-determined each year according to inflation, the currency exchange rate and the price of raw materials on the world market. Securobits is to be ensured of a gross profit margin of at least 30% on each unit. The unit price will then be discounted in correlation with the number of sales each year;
- CompuTV will pay for the use of the Securobits brand name on the products made by CompuTV and the incorporation of the Securobits logo in the televisions and sound systems. This payment will be based on the number of sales;
- CompuTV will pay for the lists of potential customers on the basis of a fixed amount for each sale to a customer if the sale is made after the customer's name appears on a list given to CompuTV, regardless of whether CompuTV actually used the list to make a sale to that particular customer.
Service agreement:
- The training programme provided by Securobits will be remunerated on the basis of the number of days for which training is given and the number of CompuTV employees who follow the training;
- If any technical problems arise due to a failure of CompuTV to apply the standard procedure as set out in the manual and training sessions given by Securobits, the additional services rendered by Securobits to solve the technical problems will be charged to CompuTV with a cost-plus mark up for Securobits;
- The assistance with the marketing campaign to be provided by Securobits will be remunerated on the basis of lump-sum amounts; a different lump sum will be paid by CompuTV for each phase of the five-year marketing campaign.
General terms of the contract:
- The contract between the two companies is expressed to have a duration of five years. If either company wishes to terminate the agreement within that period, a large compensation payment ($ 15 million) will become due.
- The confidentiality clause is very extensive (five pages) and covers all aspects of the transaction. The penalty for breach of confidentiality is very high (twice the total amount of the contract for the five-year period). In addition, any dispute about a breach of confidentiality must be resolved before the CCI in Paris under the arbitration clause.
- The contract provides that payment for all goods and services supplied to CompuTV in a calendar year is to be paid within three months of the end of the year. Accordingly, on 20 March 2004 CompuTV paid for all the supplies, training and marketing assistance provided in 2003.
Chapter X of the Appalarian Income Tax Act 1987 (AITA) is devoted to withholding taxes. The relevant sections of the chapter are Sec. 111 and 112. The entire chapter is headed "Withholding of Tax", but the individual sections do not have headings.
Sec. 111 imposes withholding tax of 25% on payments of the following types of income to non-residents:
- payments for the use of, or the right to use, any copyright of literary, artistic or scientific work, including cinematographic films, photographs and sound recordings;
- payments for the use of, or right to use, any patent, trademark, design, model, plan, secret formula or process;
- payments for information concerning industrial, commercial or scientific experience.
Sec. 112 imposes withholding tax of 20% on payments of the following types of income to non-residents:
- payments, other than payments to an employee of the person making the payment, for services of a managerial, technical or consultancy nature, including the provision of services of technical or other personnel;
- payments for the rendering of any services (including those of technical or other personnel) which make available technical knowledge, experience, skill, know-how or processes;
- payments for the development and transfer of a technical plan or design.
Both these sections are subject to Section 115 AITA, which provides that where a treaty with another country is applicable, the rates mentioned in those sections are to be read as being subject to the provisions of that treaty. Sec. 57 AITA states that, in the computation of profits subject to income tax in Appalaria, no deduction is allowed for payments subject to withholding tax according to the provisions of Chapter X, unless the correct amount of tax has been withheld.
In 2002 the Appalarian tax authorities issued a circular letter explaining their understanding of how these provisions applied to certain types of income, stating that uncertainties had arisen in this respect. The circular letter includes the following text:
"The growing importance of intellectual property as a business asset means that the tax authority is confronted with an increasing number of cases in which disputes arise as to the proper interpretation of the types of income subject to the withholding of tax under the provisions of Secs. 111 and 112.
Given the variety of ways in which business is carried on, it is impossible to make a perfect distinction between these two categories of income, and it is conceivable that some borderline types of payment could fall under both Sections. As the category of income subject to Sec. 111 is the more specific of the two, this Section should be applied. Only if a payment does not fall under Sec. 111 is it necessary to determine whether or not it falls under Sec. 112.
Sec. 111 applies to the types of income commonly referred to as royalties. The common feature of these types of income is that they are paid for the use of, or the entitlement to use, a right of a kind mentioned in the Section. These rights are all forms of intellectual property that give the owner the right to legal protection against copying or unauthorised use. Most of the rights mentioned require registration in a public register in order to enjoy such protection. Registration is, however, not an essential feature of this type of property. Information concerning industrial, commercial or scientific experience (commonly referred to as know-how) is often not capable of being encapsulated in such a way as to make it capable of registration, yet its owner has the right to legal protection in this country, and in most other countries of the world.....
..... The precise extent of the concept "know-how" is one of the issues that has given rise to disputes with the tax authority. Know-how comprises three types of information for the purposes of this definition; industrial; commercial; and scientific. Unlike the first two categories of income subject to Sec. 111, this third category does not require the payment to be for "the use of, or the right to use" the intangible property, but only that the payment is "for" the information. Thus, payments fall within the third category of Sec. 111 if they are made for any supply of know-how, whether the know-how is transferred directly to the customer or included within a larger package of services.
Information concerning industrial experience is the technical information necessary for the industrial reproduction of a product or process that is not divulged to the general public. This type of know-how could be, for example, the special knowledge of the person who devised the product or process, but it also includes the experience and knowledge of a person who is familiar with a product or process.
Information concerning commercial experience is the special body of knowledge built up over the years by a company that has experience of marketing a certain product or service. Such a company has, for example, particular expertise in finding the customers for the product or service, advertising the product or service, approaching customers and presenting the product or service in a manner that is appealing to potential customers.
As regards information concerning scientific experience, ..."
Pearonian domestic law imposes tax on the worldwide income of resident companies. Section 88 of the Pearonian Income Tax Act (PITA) allows a credit for tax withheld from foreign-source income, but if the income is from a country with which there is a treaty the creditable tax is limited to the amount properly levied under the treaty.
In 1995 Appalaria and Pearonia signed a tax treaty with each other for the first time. The treaty was ratified in 1996 and took effect in 1997. It includes the following provisions:
Article 3(2)
As regards the application of the Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State.
Article 12
- Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.
- 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 beneficial owner of the royalties is a resident of the other Contracting State, the tax so charged shall not exceed 15 per cent of the gross amount of the royalties.
- 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 information concerning industrial, commercial or scientific experience.
Article 13
- 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.
- However, such fees for technical services may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the fees for technical services is a resident of the other Contracting State, the tax so charged shall not exceed 10 per cent of the gross amount of the fees for technical services.
- The term "fees for technical services" as used in this Article means payments of any kind received as a consideration for services of a technical or consultancy nature, including the provision of services by technical or other personnel.
Article 23
- Subject to the provisions of the law of Appalaria from time to time in force which relate to the allowance of a credit against Appalarian tax of tax paid in a country outside Appalaria (which shall not affect the general principle hereof), Pearonian tax paid under the law of Pearonia and in accordance with this Agreement, whether directly or by deduction, in respect of income derived by a person who is a resident of Appalaria from sources in Pearonia shall be allowed as a credit against Appalarian tax payable in respect of that income.
- In the case of Pearonia, the amount of Appalarian tax paid under the laws of Appalaria and in accordance with the provisions of this Agreement, whether directly or by deduction, by a resident of Pearonia in respect of income from sources within Appalaria which has been subjected to tax both in Pearonia and Appalaria shall be allowed as a credit against the Pearonian tax payable in respect of such income but in an amount not exceeding that proportion of Pearonian tax which such income bears to the entire income chargeable to Pearonian tax.
- Where a resident of one the Contracting States derives income which, in accordance with the provisions of this Agreement shall be taxable only in the other Contracting State, the first-mentioned State may take that income into account in calculating the amount of its tax payable on the remaining income of that resident.
Article 29
If after the signature of this Convention under a Convention or Agreement between Pearonia and a third State which is a Member of the OECD Pearonia should limit its taxation at source on dividends, interest, royalties, fees for technical services or payments for the use of equipment to a rate lower or a scope more restricted than the rate or scope provided for in this Convention on the said items of income, then, as from the date on which the relevant Pearonia Convention or Agreement enters into force the same rate or scope as provided for in that Convention or Agreement on the said items of income shall also apply under this Convention.
Article 30
This Agreement shall enter into force on the latter of the dates on which the respective Governments notify each other in writing through diplomatic channels that the formalities constitutionally required in their respective States for the entry into force of this Agreement have been complied with.
This Agreement shall have effect:
- in respect of tax withheld at the source, to income derived on or after 1st of January in the year next following that in which the Agreement enters into force; and
- in respect of other taxes on income, for taxable years beginning on or after 1st of January in the year next following that in which the Agreement enters into force.
When the treaty was published by Pearonia in its official gazette it was accompanied, as is usual in Pearonia, by an official press release reporting on the content of the treaty. This press release contains the following text:
"The treaty contains separate articles applying to royalties and technical service fees (Arts. 12 and 13, respectively), which allow taxation in the source state of up to 15% on royalties and 10% on technical service fees. After some discussion it was agreed to follow the definition of royalties suggested in the OECD Model Convention and to follow the definition of technical service fees that has been used in some earlier conventions signed by both countries."
Both Appalaria and Pearonia are signatories to the Vienna Convention on the Law of treaties. Appalaria is a member of the OECD, but Pearonia is not.
In 2002 Pearonia concluded a treaty with the Tangerine Republic (an OECD member), which limits source country taxation of royalties to 5 % and has no specific article on technical service fees allowing source state taxation. This treaty was ratified in 2003 and entered into force and took effect on 1 January 2004.
When CompuTV paid Securobits in March 2004 for the goods and services supplied in 2003, it withheld tax at 5% from the payments for use of the Securobits brand name and the use of the Securobits logo on the sound systems and televisions sold by CompuTV. It made the following payments without any withholding of tax:
- the payments for the lists of potential customers;
- the payment for the training provided by Securobits to the employees of CompuTV;
- the payment for assistance with the marketing campaign.
Appalaria reassessed CompuTV in a deficiency notice. According to the Appalarian tax administration, CompuTV as paying agent should have withheld tax at 15% withholding tax on all the payments except the payments for the chips, sensors and other security apparatus. Appalarian tax law required CompuTV to pay the difference between the two rates and an extra charge on behalf of Securobits. Securobits reimbursed CompuTV for the difference, but the Pearonian tax authorities limited the foreign tax credit to the amounts originally withheld by CompuTV.
Securobits asked Pearonia to initiate a MAP procedure with Appalaria to resolve the issue of double taxation, but the two tax authorities failed to reach an agreement. Many other Pearonian taxpayers have asked Pearonia to initiate a MAP with Appalaria regarding the same issue. If this issue is not resolved, Pearonia expects to lose revenue of $ 5 billion in the next 10 years.
Complaint before the court Pearonia has lodged a complaint against Appalaria with the newly established International Taxation Court, alleging that Appalaria has acted in breach of the treaty between the two countries. The complaint is based on the CompuTV case, and has two components:
- Pearonia asserts that the circular issued by the tax authorities of Appalaria goes beyond mere interpretation of the treaty, and amounts to treaty override;
- Pearonia further asserts that Appalaria is acting manifestly in breach of the treaty by requiring that tax be withheld from the amounts paid to CompuTV at the rate applicable in 2003, as the relevant treaty articles (whichever applies) clearly refer to the payment of such amounts.
There is no dispute that this case is appropriate to be brought before the International Taxation Court.
|
Contact the Academic Council
IBFD
H.J.E. Wenckebachweg 210
1096 AS Amsterdam
The Netherlands
Tel.: +31-20-554 0100
Fax: +31-20-622 8658
E-mail: Academic Council
|
