In its Budget on 16 March 2016, the UK Government announced significant changes to the UK tax treatment of royalty payments for IP rights and, following the publication of a revised Technical Note on 27 June 2016, full draft legislation is now available. It was always clear that certain of the changes would have immediate effect from 16 March 2016, but it has now been confirmed that the remaining changes will have effect from 28 June 2016. These changes have the potential to create UK withholding tax costs for licensors and/or licensees of IP that did not previously exist. This briefing summarises the changes and their potential impact.
If they have not already done so, businesses which are party to licences of IP (whether on an intra-group or third party basis) should be reviewing their licensing arrangements as a matter of priority to confirm whether any of these changes could impact on the imposition of withholding taxes on royalty payments and where the cost of such withholding falls as a contractual matter.
Where businesses are adversely affected, there may be scope for extending the reasoning in the ECJ’s recent decision in Brisal to argue that aspects of these rules are contrary to EU law so far as they relate to payments to other EU member states.
Under the UK’s existing withholding taxes rules relating to IP royalties, unless royalty payments are “annual payments”, UK withholding tax only needs to be withheld from royalties relating to certain IP rights (patents, most copyright, design rights and public lending rights in respect of books), but not from royalties relating to other IP rights, including trademarks and trade names and copyright in film and video recordings.
Even where IP royalties are potentially subject to UK withholding tax, it will often be the case that no requirement to withhold exists. For example, where the recipient is resident in a jurisdiction which has a double tax treaty with the UK which provides for full relief from withholding tax on royalties (or the EU Interest and Royalties Directive applies), a payer that is a company can pay without withholding if they reasonably believe that relief is available; there is no requirement for the recipient to obtain prior treaty clearance.
The UK’s wide treaty network has provided opportunities for multi-national groups to achieve a tax advantage by avoiding UK tax on IP royalties, whilst potentially paying little or no tax in the jurisdiction where the IP is ultimately held. At its simplest level, this planning could involve a “conduit” arrangement whereby IP is held in a no tax jurisdiction and licensed to the UK via an interposed company in a jurisdiction with a suitable double tax treaty. To the extent that this planning is successful, the UK is denied taxing rights over the royalty which arises in the UK.
A key purpose of the changes announced on 16 March 2016 is to combat tax motivated structuring of IP ownership that exploits the UK’s tax treaties to avoid UK taxation of royalties arising in the UK.
There are three aspects to the changes, which are summarised below.
Targeted domestic anti-abuse rule
First, the UK is introducing a targeted domestic anti-abuse rule which will apply to royalty payments between connected parties. For these purposes, the question whether parties are connected looks to the same tests as apply to determine whether parties are related for the purposes of the UK’s transfer pricing legislation.
Where the rule applies, it will effectively override any applicable tax treaty - the payer will be required to deduct UK withholding tax from the royalty, notwithstanding the existence of a treaty providing for taxation only in the recipient’s state of residence. So for affected royalties, there will now be a UK withholding tax cost where one previously did not exist. The effect will be felt immediately - this aspect of the changes applies to payments made on or after 17 March 2016, irrespective of when the arrangements were entered into.
The new rule will apply to arrangements where it is reasonable to conclude that the main purpose, or one of the main purposes of the arrangements is to obtain a tax advantage (widely defined) by virtue of any provisions of a double taxation arrangement and obtaining that tax advantage is contrary to the object and purpose of those arrangements.
As a purpose based test, whether the rule will apply will involve weighing up the particular facts and circumstances. It will be for the payer of the royalty to form a view as to whether or not the rule applies - if tax should have been withheld and was not, the payer is assessable for that tax. In an intra-group context, it is to be expected that the payer will be in a position to make this judgement. If certainty is required, consideration could be given to the recipient applying to HM Revenue & Customs (HMRC) for a treaty clearance to receive royalties without withholding, although this would clearly need to be done with full disclosure of relevant facts and circumstances.
Extension of categories of IP royalties subject to UK withholding tax
The categories of IP royalties which are not “annual payments” from which UK withholding tax is required to be deducted will be substantially extended. When originally announced on 16 March 2016, the proposal had been to adopt a wide definition of intellectual property based on an existing definition used for income tax purposes. In its 27 June 2016 Technical Note HMRC clarified that the new definition would instead follow the definition of royalties used by the OECD model tax treaty, with limited changes - by and large aligning the withholding tax rules with the UK’s taxing rights in relation to royalties under its double tax treaties. As such, in determining whether a royalty payment is one to which a deduction of tax applies, the UK will look to the relevant commentary to the OECD model tax treaty.
Broadly, withholding now potentially applies to virtually all types of payment, notably bringing within the scope of withholding royalties paid in respect of trademarks and knowhow. Limited existing exclusions for certain payments in respect of copyright (copyright in cinematographic film or video recordings or separately exploited sound tracks) will be retained.
This change has effect for payments made on or after 28 June 2016, but with anti-forestalling arrangements to counteract arrangements whose purpose is to avoid the changes (e.g. by accelerating payments which would otherwise be due on or after 28 June 2016).
Extension of circumstances in which IP royalties arise in the UK
The UK only subjects IP royalties arising to non-residents to withholding tax where the royalties comprise income “arising in the UK” ie royalties which have a UK “source”. Unfortunately, “source” is a difficult concept and has no statutory definition.
The UK Government is clearly concerned that a non-resident may exploit IP in the UK, yet the royalties paid by the non-resident to access that IP escape UK tax because it is not clear they have a UK source. To address this concern, legislation will be implemented with effect from 28 June 2016 which expressly provides that royalties paid by a non-UK resident will always have a UK source where: (1) the non-resident carries on a trade in the UK through a permanent establishment (eg branch or agent) in the UK; and (2) the payment (or part of the payment) is made “in connection” with the trade of the non-resident carried on through that UK permanent establishment. There are two aspects of particular difficulty with this change.
First, HMRC appear to interpret the requirement that the payment is made “in connection” with the trade carried on through the UK permanent establishment (PE) widely, which is not the same test as whether the royalty is deductible in computing the profits of the PE for UK corporation tax purposes. HMRC have indicated that this would cover where UK personnel conclude sales of goods and services which exploit the relevant IP. However, in HMRC’s view it could also catch activities with a far less direct contribution to the making of a sale, such as where the sales process is automated and the contract concluded online, but it is the activities of UK personnel which have contributed to that customer entering into the online contract, or where UK personnel market goods or services, or manage client relationships.
Second, where the relevant IP is not exclusively used by the non-resident in connection with the activities of the UK PE, in arriving at the part of the royalty which is UK source (and so potentially subject to withholding tax), it will be necessary to calculate on a just and reasonable basis the proportion of the non-resident’s total income compared to the total income which arises in connection with the part of the trade carried on through the UK PE. HMRC’s Technical Note leaves open a number of important points, eg how the non-resident should deal with the likelihood of this proportion changing over time and how often this calculation should be revisited.
This change applies irrespective of the relationship between the payer and recipient of the royalty, so equally to intra-group and to arm’s length licensing. Given that the obligation to withhold tax lies with the payer and the payer can be assessed for tax if it fails to withhold the correct amount of tax, the difficult questions of judgement clearly create potential risks for a payer. A prudent non-resident licensee in an arm’s length situation would surely be advised to seek an indemnity to cover the costs of being assessed by HMRC for underaccounting for withholding tax.
An anti-avoidance rule will be included to combat arrangements (whenever implemented) which have a main purpose of avoiding these changes, eg through accelerating payments. In addition, where the licensor and licensee are connected persons in different non-UK jurisdictions and a main purpose of the licensing arrangements is to exploit the provisions of a double tax treaty between two non-UK territories (or the EU Interest and Royalty Directive), the royalty will be deemed to fall foul of the new anti-abuse rule referred to above and so cannot escape UK withholding tax on the UK source component.
Finally, as a related change, the UK’s diverted profits tax (DPT), introduced last year, will be amended so that royalties arising in connection with the activities of a UK "avoided PE" which are UK source on a similar basis will be included within the computation of the profits of the avoided PE and, therefore, within the scope of the DPT.
Could aspects of these changes be contrary to EU law?
On 13 July 2016, the Court of Justice of the European Union in Brisal - Auto Estradas do Litoral SA, KBC Finance Ireland v Fazenda Pública (C-18/15) held that the levying of withholding tax at source by a Member State of the EU on interest received by a financial institution resident in another Member States is contrary to the freedom to provide services where a resident financial institution is entitled to deduct business expenses directly related to the activity in question, but the non-resident financial institution is not.
It appears straightforward to extend similar reasoning to, for example, the position of a company which carries on a trade of developing and licensing intellectual property. Since a UK resident licensor carrying on that trade would be taxed on a net basis, the fact that a non-UK resident, EU licensor could suffer withholding tax on a gross basis seems equally prone to challenge as contrary to EU law.
The changes announced on 16 March 2016 arguably make it more likely that such a challenge could be brought. Most obviously, this is because, in extending the categories of royalty which are subject to withholding tax even when not annual payments (so not ‘pure income profit’), they have extended the possibility of gross taxation to royalties which could be trading profit, taxed on a net basis, in the hands of the UK resident recipient. An important caveat is that the UK’s relationship with the EU post-Brexit could be such as to preclude Brisal being relied on in relation to post-Brexit payments.
Following the 16 March 2016 announcement, businesses which are party to licences of IP (whether intra-group or arm’s length) should already have been reviewing their licensing arrangements as a matter of priority to confirm whether any of these changes impact on the imposition of UK withholding taxes on royalty payments. Confirmation of 28 June 2016 as the effective date for the remaining measures which were not immediately effective from 16 March 2016 makes this review all the more urgent, if not already been completed or underway.
Businesses with the greatest potential to be effected are:
- parties to intra-group IP licences where a double tax treaty with the UK is currently relied on to avoid UK withholding tax on royalty payments
- parties to IP licences which include IP rights (eg trademarks or knowhow) which, before these changes, were not subject to UK withholding tax, but will now be within scope of withholding, and
- parties to IP licences where the licensee is a non-UK resident but has sales/client relationship/marketing activities in the UK which require the licensed IP rights.
Key issues to address will be:
- Identifying which royalties will now be subject to withholding, and for royalties paid by a non-residents with a UK PE, which part of the royalty, so that withholding obligations can be complied with in a timely fashion.
- Who bears the cost of withholding under the relevant licences, in particular, whether there is a withholding tax gross up which effectively leaves the cost of the withholding with the payer.
- Where there is such a gross up, licensees could find themselves having to increase royalty payments by 25%.
- Going forward, ensuring that the UK withholding tax position is fully understood when negotiations of licence agreements take place so that contractual allocation of withholding tax risks is agreed with eyes open.
- Taking legal advice as to whether the ECJ’s decision in Brisal could be used as a basis for continuing not to withhold on royalties paid within the EU in appropriate cases, or withholding, but immediately filing a refund.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.