Usage of Royalty as a BEPS Instrumen

BEPS (an acronym for Base Erosion and Profit Shifting) typically refers to strategies adopted by large MNE groups, present in multiple jurisdictions, that exploit gaps and mismatches in tax rules¹, in order to artificially deflate profits in higher tax jurisdictions, for to avoid paying legitimate and possibly higher taxes as a group. As would be, these higher tax jurisdictions are mostly located in source jurisdictions and consequently have a claim over taxes on profits legitimately generated. The OECD estimates that such strategies cost countries $100 – $240 billion annually².

The OECD and the United Nations models have more or less the same definition of royalty³,⁴ after the most recent amendment in 2017. For the OECD model, Article 12(2) defines royalty whereas the same is embodied in Article 12(3) of the United Nations Model. The major difference between the two being the UN model encapsulates equipment royalty and cinematographic and other forms of artwork too. Apparently, the UN model has a higher threshold for the definition of royalty. The US model⁵ aligns itself with the OECD model and does not include equipment royalty and artwork into its definition. Colloquially, a better definition has been provided by the Gujarat High Court “In each of these agreements, the word “royalty” has been defined to mean any royalty or the like amount received as consideration for the right to use copyright, models or artistic designs, plans, secret processes, formulae and other like property. Thus, the modern international usage in the commercial field also accepts this very meaning of the word “royalty” in the sense of consideration paid from time to time or, may be, even outright, for the exploitation of the rights, inter alia, to the knowledge regarding secret processes, patents, registered trademarks, etc., and also the right to market the products as a result of those exploitations. It must be pointed out that it was in the field of taxation law and in the fields connected with taxation that these agreements were arrived at and the word “royalty” was thus understood by the contracting parties, namely, the respective countries.”⁶

For the sake of this report we would be using the OECD definition of royalty as outlined in the Article 12(3) of the United Nations model convention which defines Royalty as “The Term “royalties” as used in this article, means payments of any kind received as consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematographic films, or films or tapes used for radio or television broadcasting, any patent, trademark, design or model, plan or secret formula or process, or for the use of , or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience.”. For the limited purpose of this report, royalty and Intellectual property/assets have been used interchangeably according to the context.

What makes royalties important in terms of BEPS is the sheer quantity of profits transferred from source jurisdictions to residence jurisdictions or low or nil tax jurisdictions, and the taxes avoided on the same. For example, the US had an estimated inbound royalty revenue of $43.3 Billion, EU inbounds were $236 billion combined and the UK had $ 18 Billion of inbound revenue on account of royalty, and the worldwide royalty profit shifting was approximately $433.62 Billion on account of royalty in 2021⁷. Interestingly, Ireland, a country with not much commercial substance, tops the royalty charts with $133 Billion on account of incoming royalty⁸ during the same period.

It should be borne in mind that royalty is a cost in market jurisdictions and an income in residence jurisdictions and thus a profit shifting strategy. The tax implications of such strategies can be enormous to the source country. For example: in 2017 Facebook paid just GBP 15.8 millions of taxes on GBP 1.3 billion of British sales, making the taxes to hover around just 1% of turnover, whereas the global profits of Facebook were in excess of 50% of its turnover⁹. For highly digitized businesses, it is a fair assumption that profits the world over were almost at the same level. In another report reference has been made to Amazon¹⁰ halving its tax payment despite profits being doubled at their highest levels. The glaring gap between profits generated and profits attributed has concerned all market jurisdictions. In fact, it would not be wrong to say that almost every multinational is stripping income out of market economies and shifting them to tax haven holding companies, by use of tools such as royalty¹¹. India had on its part voiced deep concerns about the prevalent situation of base eroding payments especially royalty before the UN¹².

According to Graetz and Doud, and Brauner, some characteristics¹³ of any royalty arrangement make it an ideal paradigm for base erosion and profit shifting

Firstly, it has no physical presence as opposed to PE or underlying economic base, and transfers to tax eroding jurisdictions can be made just by concluding paperwork at any location in the world.
Secondly, whatever said about uniformity, fact remains that almost all royalty arrangements, involve use of a Hard To Value Intangible (HTVI) which has no exact comparables and whose value would be almost impossible to arrive correctly at, and thus gives leeway to MNE’s to arrive at values most suited to their economic interests. For example, if Google were to transfer its patents to maybe the IFSC regime in Ireland, then what could be a possible fair value to ascribe to such an IP? Same holds true for Apple.
Existence of an extensive network of tax treaties within the jurisdiction owning the patent to which the royalty must flow.
Existence of a favorable tax regime in the host nation favorable to such practices, including and not restricted to Advance Pricing Arrangements et al.

At this juncture it becomes imperative that some of the popular tools used for base erosion using royalty be examined

The most popular BEPS tools used by MNE’s :

Double Irish Arrangement: Under this strategy, the “Double Irish Dutch Sandwich” involves two entities Irish Entities, one IP-Holding Company and one Operational Company. The Irish IP- Holding Company is a direct first level subsidiary of the US Parent Company and it holds the entire voting power of the Irish Operating Company and the Dutch Conduit Company. The Irish IP- Holding company is controlled & managed in Bermuda and therefore considered resident in Bermuda in accordance with Irish Tax laws. The United States, on the contrary, treats the company as an Irish corporation according to US tax law. Revenue is earned by the operational company and profits therefrom are shifted to the IP-Holding company, thereby eroding the tax base of the revenue generated. In the initial days this was used in congruence with a “Dutch Sandwich”¹⁴ as Ireland tax rules mandated withholding taxes on non-EU payments @20%, and Dutch transparent companies had no withholding rules. The effective tax rate for MNE’s under this arrangement was microscopic, till the tune of about 0.005%¹⁵. This strategy alongwith the Dutch Sandwich strategy was very much in vogue till the Irish administration introduced the TP rules in 2010 and made the Dutch Sandwich irrelevant. Also the EU Watchdog was not much in favor of the same¹⁶. In its independent form, it still continued till 2018.
Single Malt : This is a variation of the double Irish arrangement aforementioned, with a Maltese company instead of a Bermuda based company at the helm of control and Management. This was also closed down in 2018, with majority of Single Malt users moving to the Capital Allowances for Intangible Assets schemes. Surprisingly it was revealed in 2021 that Abbot Labs was still using the Single Malt to shield profits of its Covid-19 products¹⁷. Interestingly Ireland had initially opted out of the Action Plan 12¹⁸ (Require taxpayers to disclose their aggressive tax planning arrangements), and Malta had opted out of Action Plan 4¹⁹ (Limit Base erosion via interest deductions and other financial payments) of the 15 BEPS Action plans.
Capital Allowances for Intangible Assets: Irish TP and tax rules were amended in 2018 to bring the effective tax rates between 2.5% to 0%. Effectively the Irish tax rules mandated that instead of royalties the difference between Market Capitalization and Tangible assets could be mandated to be Intangible assets and that there could be Capital Allowances under the same. While not exactly a royalty-based regime for exploitation of IP, this scheme is being used by tech giants like Apple to get double benefits on both Capital Allowances and Interest inversion alike²⁰.
Black Holes : Royalty Funds remitted to tax havens like Caymans and Bermuda were remitted back to the residence jurisdiction guised as loans.

Recognizing the availability of both resources and skills for the aforementioned BEPS arrangements, a report submitted to the UN Committee of Experts on International Cooperation in Tax Matters by the BEPS monitoring Group in 2021²¹ mentions “Furthermore, multinational enterprises (MNEs) particularly in the business software sector, can route these revenues through conduits in countries where they are subject to low or no tax, so generating untaxed income. Hence, depriving countries of the right to tax royalty payments to non-residents causes both direct losses of tax revenues for these source countries, and enables significant overall global tax losses from avoidance (base erosion and profit shifting).” It is an accepted fact that in such cases of artificial profit shifting and that too at such a large scale, the previously mentioned BEPS strategies alonwith a host of others are exploited over a longer range of time, thus causing significant base erosion.

The OECD FHTP (Forum on Harmful Tax Practices) started its work on harmful tax practices in 1998 post the Ottawa Conference, the scope which had been expanded to all Inclusive Framework members (and jurisdictions of relevance). The FHTP has, since the start of the OECD/G20 BEPS Project, engaged in the review of over 250 regimes under 70 jurisdictions for the purpose of evaluation of misuse of royalty in order to artificially divert profits from source jurisdictions. Keeping in mind the above the OECD introduced the BEPS package in 2015 and had set certain minimum standards in order to target artificial base erosion and profit shifting including on the account of royalty and had in September 2022 come out with a progress report on the same²². The author notes the following from the report:

The Forum on Harmful Tax Practices (FHTP) reviewed the compliance of no or only nominal tax jurisdictions with the substantial activities’ requirement associated with royalty, reported that out of the almost 131 jurisdictions covered, 95 are fully compliant with best practices, and the rest approximately 36 jurisdictions have received at least one recommendation on improvement of their information exchange network at least.
Under the April 2022 review the FHTP concluded under the monitoring of effectiveness in practice of the substantial activities’ requirements associated with royalty in no or only nominal tax jurisdictions, that minor adjustments were required with respect to the identified twelve²³ jurisdictions, and 4 of them were almost compliant with the requirements.
In accordance with the BEPS Action 5 minimum standard, further strict requirements for economically substantial activities were mandated, by way of introduction of the nexus approach for royalty remittances. At that moment in time, none of the existing IP regimes of OECD members and G20 countries were compliant with the nexus approach, which is a key feature of the Action 5 standard. One of the most important revisions as mandated under Action 5 was the As of 2019 June, at the time of presentation of the Report to G20 Finance Ministers and Central Bank Governors, all of the IP regimes were either abolished or made compliant with the nexus doctrine, both for the G20 members as well as those of the OECD inclusive framework. Any new IP regimes by any jurisdictions have to be compliant with the nexus approach both for the G20 members as well as the members of the inclusive framework.²⁴
In accordance with the BEPS Action plan 6, prevention of Treaty Abuse, which again is a minimum standard mandated by the BEPS project, the amendment to the intention of the treaty by way of amendment of the preamble has the support of an approximate 99 members of the Inclusive Framework, and it is estimated that about 2300 of the 2400 existing treaties would be covered under the minimum standards. Thus, the expectation of royalty being linked to substance is going up.

It’s important to consider the changes the MLI regime brings to BEPS strategies and how jurisdictions aim to address them. Although it is understood that even with the MLI it would only be the articles agreed to be modified under CTA’s which the jurisdictions agree on, but anti-abuse under Article 6 is mandatory, and a brief discussion would be in order. Under the BEPS framework royalty was a particular area targeted by the Inclusive Framework, in particular post the MLI. Prior to the MLI the basic requirement was a Tax Residency Certificate and Form 10F and a beneficial ownership requirement. However, under the MLI this scope of enquiry has been expanded to additional questions like

What would be the principal purpose of
entering into the royalty agreement?
What would be the activities of the people purporting to represent the payee in India?
Would royalty be attributable to the
expanded definition of PE?
Is royalty attributable to a split-up contract made with the sole purpose of avoidance of PE?
Is the payment being made to a conduit entity or a branch entity?

In case of any abuse being found under the treaty, then benefits from the treaty could be denied with recourse to Article 7.

It is apparent that the BEPS scenario with regards to royalty is a dynamically changing one and countries are trying to adapt fast. However, how much relief would MLI bring or the BEPS 1.0 would bring to the source jurisdictions is a question that remains in the future ahead. With courts still engaged in the pre-BEPS era litigations, it would still take some time before the stamp of judicial approval is gained on the administrative anti-abuse procedures.

OECD at https://www.oecd.org/tax/beps/about/ 
OECD at https://www.oecd.org/tax/beps/about/ </a >
OECD at https://www.oecd.org/ctp/treaties/articles-model-tax-convention-2017.pdf </a >
United Nations at https://www.un.org/esa/ffd/wp-content/uploads/2018/05/MDT_2017.pdf </a >
US Treasury at https://home.treasury.gov/system/files/131/Treaty-US-Model-2016_1.pdf</a >
Commissioner of Income-tax v. Ahmedabad Manufacturing & Calico Printing Co. [1983] 139 ITR 806 (Gujarat)[07-08- 1980] 
World Bank Data at https://data.worldbank.org/indicator/BX.GSR.ROYL.CD?type=shaded&view=map </a >
World Bank Data at https://data.worldbank.org/indicator/BX.GSR.ROYL.CD?type=shaded&view=map </a >
Facebook’s UK tax bill rises to £15.8m – but it is still just 1% of sales (https://www.theguardian.com/technology/2018/ oct/08/facebook-uk-tax-bill-sales-margaret-hodge ) 
Amazon halved corporation tax bill despite UK profits tripling https://www.theguardian.com/technology/2018/aug/02/amazon-halved-uk-corporation-tax-bill-to-45m-last-year </a >
Lee A. Sheppard, Is Transfer Pricing Worth Salvaging?, 136 TAX NOTES 467, 470 (2012) 
United Nations at https://www.un.org/esa/ffd/wp-content/uploads/2014/10/ta-BEPS-CommentsIndia.pdf </a >
Michael J. Graetz & Rachael Doud, Technological Innovation, International Competition, and the Challenges of International Income Taxation, 113 COLUM. L. REV. 347 (2013); Omri Marian, Jurisdiction to Tax Corporations, 54 B.C. L. REV. 1613 (2013), Yariv Brauner, Value in the Eye of the Beholder: The Valuation of Intangibles for Transfer Pricing Purposes, 28 VA. TAX REV. 79, 88 (2008).
Bloomberg at https://www.bloomberg.com/news/articles/2013-10-28/man-making-ireland-tax-avoidance-hub-globally-proves-local-hero </a >
European commission at https://ec.europa.eu/commission/presscorner/detail/en/IP_16_2923 </a >
Financial times at https://www.ft.com/content/ba95cff0-4fcd-11e4-a0a4-00144feab7de </a >
Irish Times at https://www.irishtimes.com/business/economy/how-abbott-labs-devised-its-formula-for-single-malt-taxation-1.4674058 </a >
Irish Times at https://www.irishtimes.com/news/ireland/irish-news/ireland-resists-closing-corporation-tax-loophole-1.3286199 </a >
Irish Times https://www.irishtimes.com/business/economy/ireland-s-single-malt-still-aiding-tax-avoidance-1.3640062</a >
Martin Brehm Christensen and Emma Clancy For European Parliamentary Group at https://src.bna.com/zNy </a >
United Nations at https://www.un.org/development/desa/financing/sites/www.un.org.development.desa.financing/ files/2021-04/BEPS Monitoring Group (BMG) comments on the discussion draft on the inclusion of software payments in the definition of royalties.pdf </a >
OECD at https://www.oecd.org/tax/beps/oecd-g20-inclusive-framework-on-beps-progress-report-september-2021- september-2022.pdf </a >
Anguilla, Bahamas, Bahrain, Barbados, Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man, Jersey, Turks and Caicos Islands, United Arab Emirates
OECD Secretary General Report, Fukoka , June 2021 at https://www.oecd.org/tax/oecd-secretary-general-tax-reportg20-finance-ministers-june-2019.pdf</a >