US-AU DTA: Article 12 – Royalties
This week we will be taking a closer look at how royalties are dealt with in terms of the US/AUS DTA.
Royalties earned outside of your resident state are generally taxed by the source state on a withholding basis. Under domestic law, a state can require a person to withhold tax on making a payment to another person.
Royalties that are effectively connected with a permanent establishment are taxed either in terms of Article 7 which deals with business profits or Article 14 which deals with Independent Personal Services.
The US/AUS DTA Protocol amended the treatment of royalties to:
- reduce the general rate of source country tax on royalties from 10% to 5%;
- exclude from the scope of Article12(4) payments for the use of industrial, commercial, or scientific equipment, and
- extend the royalties definition to cover additional types of broadcasting media (Article 12(4)(a)(iii)).
INTERPRETING ARTICLE 12 OF THE DTA – ROYALTIES
The purpose of Article 12 is to limit the tax that the source country may impose on royalty payments to beneficial owners in the other country to 5%, however, this limit only applies if the payments are at arm’s length.
Article 12(1) states that royalties may be taxed in the country of residence of the beneficial owner even though derived from sources in the other Contracting State. This confirms Article 1(3) of the DTA that preserves the right of each country to tax its residents.
Article 12(2) stipulates those royalties may also be taxed by the source country but limits the tax to 5% of the gross amount of the royalties.
Article 12, however, does not apply to natural resource royalties, which are taxable in the country of source in terms of Article 6 of the DTA.
Article 12(3) sets out the exclusions and that the reduced withholding tax rate does not apply in the following cases:
- the beneficial owner has a permanent establishment in the source country;
- or performs personal services in an independent capacity through a fixed base in the source country, and the property giving rise to the royalties is effectively connected with the permanent establishment or fixed base.
In that event, the royalties will either be taxed as business profits (Article 7) or income from the performance of independent personal services (Article 14).
Article 12(4) is important as it defines the word royalties for purposes of the treaty. The definition of royalty in Art 12(4) comprises of the following three components:
Component 1 – Intellectual property
Article 12(4)(a) includes payments or credits of any kind to the extent that they are considered for the use or right to use any:
(i) copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right
(ii) motion picture films, or
(iii) films or audio or videotapes or disks, or any other means of image or sound reproduction or transmission for use in connection with television, radio, or other broadcasting.
Due to the technological advances made since the DTA was signed, the protocol was amended to reflect these advances more accurately.
For example, due to the Protocol, Article 12(4)(a)(iii) will apply to a payment made by an Australian broadcaster to a US company for the right to transmit a live feed of an entertainment program through satellite or the Internet.
However, on the other hand, Article 12(4)(a)(iii) will not apply to payments made by a retail customer who has subscribed to a satellite television service provided by a US company.
Component 2 – Scientific, technical, industrial, or commercial knowledge or information
Article 12(4)(b)(i) states that royalties include payments or credits for scientific, technical, industrial, or commercial knowledge or information (“know-how”) owned by any person.
The specific reference to knowledge or information owned is meant to indicate that the term royalties imply a property right as distinguished from personal services.
This is a very important distinction to understand, so let’s use an example –
An IT specialist who prepares or designs a website for a customer will be considered to perform personal services and the remuneration received will be taxable in terms of either Article 14 (Independent personal services) or Article 15 (Dependent personal services).
However, should the IT specialist supply a pre-existing design to a customer, this will be considered the furnishing of knowledge (know-how) or information and taxed in terms of Article 12?
Article 12(4)(b)(ii) provides that consideration for any assistance of an ancillary and subsidiary nature that enables the application or enjoyment of know-how is also a royalty payment. However, if the service is supplied in connection with the sale of property, Article 12 will not apply.
Article 12(4)(b)(iii) contains a special rule to deal with the situation of a disguised lease of a property right of the type covered Article 12(4)(b).
Component 3 – Disposition of property that is contingent
Article 12(4)(c) provides that, to the extent that income from the disposition of any property or right described in this paragraph is contingent on the productivity or use or further disposition of such property or right, it is a royalty.
Article 12(5) applies where there is a special relationship between the payer of the royalties and the person beneficially entitled to the royalties or between both of them and some other person.
Where this requirement is satisfied, the 5% limitation will only apply to the extent that the royalties do not exceed the amount that might be expected to be agreed upon by independent persons acting at arm’s length. The excess amount will therefore be taxable according to the law of each contracting state but subject to any other provisions of the DTA.
The term special relationship is significantly wider than the term associated enterprise contained in Article 9 and should be read in conjunction with Article 12(5).
Article 12(6) lastly provides special source rules for royalties. In general, a royalty is considered to have its source in a country if paid by the Government, or a resident of that country, or by a company that under domestic law is a resident of that country.
The US Treasury Department explained that a royalty paid by a dual resident company may be eligible for the reduced rate provided in Article 12(2), although a royalty beneficially owned by such a company is not.
It is important to take note that a mere accounting entry may be sufficient to attract royalty withholding tax as the definition refers to payments or credits.
To determine whether a payment is a royalty subject to Article 12 or a payment for services within the scope of Article 7, will depend on the purpose of the payment and circumstances of the arrangement been the parties.
The interpretation of Article 12 is going to take center stage in the near future. Due to the pandemic, numerous people across the world started new business ventures based on models that enable them to generate global income while rendering services remotely. The DTA and Protocol were drafted long before anyone knew the pandemic so neither the US nor Australia took this into consideration when the DTA bilateral instrument was agreed upon.
Make sure you understand how Article 12 can impact your new start-up, as you do not want to have non-compliance issues, penalties, or additional tax just due to not understanding Article 12.