Tax aspects of pricing in IP transactions
Price is an important element of all contracts, and IP transactions are no exception. Due to the unique character of most transferable IP assets, it is vital to define the contractual price clearly as, in case of disagreement, it is difficult to apply civil mechanisms to determine it.
The terms of contractual pricing are particularly important in relation to taxation matters. This report considers issues surrounding the determination of prices in licence and assignment agreements under Russian law and in Russia. However, the recommendations on certain global issues, such as double taxation treaties, transfer pricing rules and the inclusion of royalties in customs values, may also apply in other countries in accordance with national law.
VAT aspects of licence and assignment agreements
According to Russian tax law, value added tax (VAT) applies to the price of goods, works, services and property rights sold in Russia. The place of sale for property rights under cross-border transactions is determined by the location of the customer. In general, if the assignee of the exclusive rights or the licensee is located in Russia, the price of the property rights is subject to VAT. If the licence or assignment is granted by the Russian rights holder to a foreign party, VAT is not levied in Russia. These rules apply to situations where the assignor or the licensor is a foreign legal entity. If the payment from Russia is made in favour of a natural person, it is not subject to VAT.
Russian tax law also provides a VAT exemption with respect to assignments of exclusive rights to inventions, utility models, industrial designs, computer programs, databases, integrated circuit topographies and trade secrets, as well as the rights to use these based on a licence agreement. This list excludes trademark rights and other means of individualising legal entities, as well as rights to copyrighted works (other than those mentioned above). Consequently, the assignment of rights to means of individualisation and rights to copyrighted objects are subject to VAT.
The VAT exemption applies only if the taxpayer exercises the separate accounting of taxable and non-taxable objects. Accordingly, if the prices of taxable and non-taxable objects are not specified in the contract separately, the taxpayer cannot provide separate accounting.
Thus, if the transfer of different IP rights is to be priced in a single contract, the price must be specified separately for taxable and non-taxable objects. For example, if a franchise agreement involves the transfer to a franchisee of the rights to a trademark, computer programs, know-how and techniques identified as works of copyright, the price structure may be specified as follows:
- The objects should be divided into two groups – VAT taxable objects (trademarks and copyright objects) and objects that are exempt from VAT (computer programs and know-how).
- There should be a separate royalty rate for each group (regardless of whether it is a percentage of a certain index or a fixed amount) indicating either that the tax is included in the price or it should be charged on top of the price.
- If the contract provides that the payment should be processed with relevant documents (eg, invoices or certificates of services rendered), these should also be separated – that is, the invoices and certificates related to VAT taxable objects should be issued separately from the same documents related to the objects that are exempt from VAT.
- The rights holder must issue an invoice in respect of VAT taxable operations. The remuneration paid to the foreign company is subject to withholding tax in Russia, thus the Russian assignee or licensee should issue an invoice and transfer the corresponding withheld tax to the Russian state.
Meeting all these requirements will allow the assignee or licensee to organise separate accounting for the taxable and non-taxable operations, and therefore confirm the right to a VAT exemption in relation to the corresponding objects.
Double taxation treaties
Double taxation treaties affect the taxation of international transactions. The majority of double taxation treaties are based on the Organisation for Economic Cooperation and Development Model Convention, and accordingly contain a special article on the procedure for avoiding the double taxation of royalties.
Further, according to the corresponding double taxation treaties, taxes on royalty income may be charged in either the country of the licensor or (fully or partially) the country of the licensee. In the latter case, the treaty fixes a tax rate in the country of the licensee and contains a mechanism for the avoidance of double taxation by offsetting the amount paid in the country of the licensee as part of the tax obligations of the licensor on presentation of the appropriate documents.
This double tax treaty aspect must be taken into account by the parties to a licence agreement, otherwise it may cause serious uncertainty in the relationship. There will be no problems if the double taxation treaty provides full payment of tax in the country of the licensor (as in the treaties concluded between Russia and the United States, the United Kingdom, Germany, France and Switzerland). However, Russian double taxation treaties with a large number of countries (including China, India, Japan, Spain and South Korea) provide for the possibility of levying tax on royalties in the country of the licensee at a rate of between 5%-15%. In most of these countries, including Russia, the collection of this tax is performed by withholding it at the source of payment. Therefore, in this case the licensee should withhold tax at the appropriate rate and transfer it to its own country's tax authority. This can lead to the situation where the amount received by the licensor is less than the amount specified in the contract. Thus, if the parties do not settle this issue in the contract, it could lead to conflict.
In some cases parties have tried to solve this problem by including in the agreement a provision that all taxes in connection with the payment of royalties should be paid by the licensee above the agreed price of the contract and at its own expense. With regard to Russian tax law, this wording is incorrect and may cause significant risks for the licensee as the tax agent is not entitled to pay the tax from its own funds. Thus, if a Russian licensee pays the tax for the foreign licensor at its own expense, the tax authorities may apply penalties.
If the payment from Russia to the foreign rights holder is subject to withholding tax, the most appropriate method is to raise the amount of royalties agreed in the contract by the amount of the withholding tax. It must be borne in mind that according to double taxation treaties, the licensor would be able to offset the withholding tax paid by the licensee in Russia towards payment of the corresponding profit or income tax in the state of the licensor. Therefore, it is necessary to set out in the contract the licensee’s obligation to receive from the Russian tax authorities a corresponding certificate for the amount of tax withheld and provide it to the licensor in the contract.
Tax aspects of royalty-free licences
Sometimes the parties to a licence agreement indicate that the corresponding rights are transferred to the licensee without consideration. This can results in tax risks for the Russian licensee. Under Russian law, property rights received without consideration are considered to be non-operating income for tax purposes.
In practice, the use of intellectual property may not also be arranged through a paid licence agreement. Further, intellectual property transferred through a paid licence agreement for a certain period may be used by the licensee without payment of royalties. The tax authorities may deem these cases to constitute obtaining IP rights without consideration, which results in the company's non-operating income being estimated as the market price of the received property rights, with corresponding profit taxation and related fines and penalties.
In this regard, a number of points should be noted.
The company's non-operating income in the form of property rights received without consideration appears only if there is evidence of the transfer or receipt of IP rights. This can be confirmed by establishing the will of the rights holder to transfer the property rights, which may be expressed in a licence agreement or other form (eg, written permission from the rights holder to use a trademark). In addition, this expression of will may not be supported by documentary evidence and may follow from an existing business relationship between the parties, including interdependence (eg, when one party to the licence agreement has a direct or indirect participation in the capital of another). For example, a trademark may be used without written permission or an agreement from the rights holder, but under its control. According to court practice, for the purpose of calculating taxes, the use of trademarks under the rights holder's control proves the transfer of the right to use the trademark to the taxpayer.
It is important to draw a distinction between the will of the rights holder to transfer IP rights and its will to market the products containing the intellectual property. In the latter case, the company does not derive non-operating income in the form of IP rights received without consideration. For example, the trademark owner may give written authorisation to a company to sell goods bearing its trademark, without giving that company the right to use the trademark independently and directly. The company can sell only the goods labelled by the trademark owner and cannot apply the trademark to the goods itself.
According to court practice, a written authorisation from the trademark owner for the sales of goods bearing its trademarks does not mean the transfer of the rights to the trademark itself, and therefore does not cause the tax risks associated with the deriving of non-operating income in the form of trademark rights received without consideration. In this regard, failing to use the trademark as an independent object of civil rights means there is no non-operating income.
Another essential element for the emergence of non-operating income is the use of an IP right without consideration. In this regard, in order to avoid the tax risk of the non-operating income the parties should provide in the contract for the non-gratuitous use of the transferred IP object through the corresponding consideration for the acquisition of relevant property rights. The consideration may be arranged in either cash or another form (eg, by performance by the rights holder of certain works or the provision of certain services, such as the licensee's obligation to place the rights holder's marks in advertisements). This consideration should be provided directly for the acquisition of relevant IP rights. However, even with non-gratuitous licence agreement, the parties may agree that for a certain period of time the licensee can use the IP right coverd by the contract without paying royalties. For example, this occurs when a taxpayer has concluded a non-gratuitous licence agreement, but before the state registration of the mark is used on goods without payment of consideration to the rights holder. Thus, the tax authority may conclude that in this period, the taxpayer used the trademark without consideration, and thus there is non-operating income. In order to avoid this tax risk, the parties to a non-gratuitous licence agreement should include a retrospective clause that its provisions (including the provision for payment of consideration) should be applied to the relations between the parties from the moment of signing the agreement, establishing separate consideration for use of the trademark before the corresponding state registration, which should subsequently be paid by the licensee.
Further, the contract may allow the licensee to use temporarily the intellectual property without the payment of royalties to the rights holder in order to give it time to establish and develop a business. In this situation, the tax authority also may conclude that in this period, the taxpayer used the trademark without consideration, which results in non-operating income. In such case, in order to mitigate these tax risks the contract should provide for the licensee's obligation to make royalty payments during the formation of its business.
Therefore, the use by the licensee of intellectual property during a certain period without the payment of royalties under the non-gratuitous licence agreement does not result in non-operating income provided that non-gratuitous relationships were extended by the parties for the period for which the licensee later paid royalties.
Royalties adjustment under transfer pricing rules
The parties to a licence agreement may try to circumvent the risks of gratuitous use by the licensee of the appropriate rights and set the formal price for such rights (eg, $1 a year). If the business of the licensee related to the use of the rights transferred to it under a licence agreement is substantial, the tax authorities may consider such formal contract price to be a non-market price. In certain cases stipulated by Russian law, the tax authorities can check whether the royalties established by the parties in the contract correspond to the market price level. If they differ from the market price level, the contract prices may be recalculated with a corresponding surcharge of additional taxes. The basic method for determining the market price of goods, works or services is the comparable market price method, according to which the calculation of a market price is made on the basis of transactions with similar goods, works or services made at the time of sale of the licensed goods and under comparable conditions. According to existing court practice, in order to establish the market price level the tax authorities often ask experts to examine the market and, based on relevant reports by independent appraisers, adjust the royalties provided by the parties in the contract and charge additional taxes, penalties and fines.
In some cases the examination of the market price does not fully conform with the Russian Tax Code's provisions on the methods for determining the market value of royalties. This results in the court rejecting the report as inadmissible evidence. The courts recognise the following violations:
- failure of an independent appraiser to use the methods of determination of market price provided by the Tax Code, without proving that they could not be used;
- use of information about royalty rates which did not refer to the audited period;
- use of foreign reviews of royalty rates without proving that information on the average royalty rates for the Russian market could not be used.
Thus, in tax disputes arising in connection with the royalty adjustment produced by tax authorities, the courts first examine the application of methods for the determination of market prices provided by the Tax Code. In this regard, royalties in IP transactions should be set by the parties using those methods. Certain royalty amounts may be determined either by the company or through an independent examination of the market value of royalties. The court will accept these results only if the examination is based on the use of the methods or there is proof that that could not be used.
Inclusion of royalties in customs value of imported goods
The Agreement on the Determination of the Customs Value of Goods Transported through the Customs Border of the Customs Union (January 25 2008) between the governments of Russia, Belarus and Kazakhstan provides that for the determination of the customs value of imported goods, the price actually paid or payable for the goods should include licence and other similar payments for the use of the IP rights (including payments for patents, trademarks, copyrights) in the imported goods and which were directly or indirectly affected by the buyer as a condition of sale of the imported goods. Since the establishment of the Eurasian Economic Union (EAEU), the agreement applies to the import of goods into the EAEU member states (Russia, Belarus, Kazakhstan, Armenia and Kyrgyzstan).
In case of import into the EAEU of goods marked with corresponding trademarks by a licensee which has entered into a licence agreement with the trademark owner, the price of imported products should include the royalties paid under the licence agreement. The Russian customs authorities receive information on licence agreements from the Russian Patent Office; if they discover that a licence agreement provides for royalties not included in the customs value of imported goods, the authorities will adjust the customs value of the consignment.
The inclusion of royalties in the customs value of imported goods is particularly difficult where the royalties in the licence agreement are established as a fixed amount for a certain period. The declarant may not know in advance how many goods will be imported in the period. Major problems can be caused by licene agreements in which the royalty rate is determined as a percentage of sales. When importing the goods the declarant may not know the final sales price, and therefore may not know the exact amount of royalties. In Russia, the situation is aggravated by the absence in the customs legislation of a clear mechanism for levying customs duties on deferred customs value (ie, in a situation where the final sale price of the imported goods is not known on the date of import). In this regard, the declarant usually includes in the supply contracts a provision that the price of the supplied goods includes royalties for the right to use the trademarks placed on the imported goods. If the Russian customs authorities ask whether royalties for trademarks were included in the customs value of the imported goods, the declarant usually responds in the affirmative with reference to the price structure of the supply contract.
However, such amendment of the supply contract will result in avoiding the inclusion of royalties paid under the licence agreement in the customs value of the imported goods only if there are subsequent changes in the licence agreement.
The methods of trademark use provided by the Civil Code include the import of goods into Russia. Thus, if a trademark licence agreement specifies the import of goods into Russia as an authorised method of trademark use, the royalties payable under the licence agreement will be recognised as related to the imported goods. In this case, no matter what the supply contract states, the Russian customs authorities have grounds to demand the inclusion of royalties under the licence agreement in the customs value of the imported goods.
In order to resolve this issue, the supply contract should include a provision on the inclusion of royalties for the use of trademarks in the price of goods. The licence agreement should specify the methods of the trademark use other than the import of goods (eg, the use of trademarks on documentation related to the commercialisation of goods, proposals for the sale of goods, announcements, signs, advertising and on the Internet, including in domain names).
Thus, the royalties paid as part of the price of the imported goods will be charged for the import and sale of imported goods in Russia. Royalties for other methods of trademark use will be paid under the licence agreement. This solution allows the parties to exclude royalties under the licence agreement in the customs value of imported goods.
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