Article 12.3 Explanation & Interpretation of Article XII Under U.S. Law
12.3.1 U.S. Taxation of Outbound Royalty Payments
12.3.1[a] Definition of Royalties
The Code generally defines the term “royalty” by enumerating the kinds of property that generate royalty income. For Example, the sourcing rules in the Code refer to income for the use or privilege of using “patents, copyrights, secret processes or formulas, good will, trade-marks, trade brands, franchises, or other like property.”
12.3.1[b] Characterization Issues
In addition to considering the definition of royalties, as a precursor to performing analysis under the U.S. domestic rules, or the Treaty, due regard should also be given to the proper characterization of the transaction giving rise to the income. Often it is not possible to discern whether or not a transaction should be characterized as a sale or as a lease until one has reviewed and applied detailed rules and case law and administrative rulings to the transaction may produce income subject to withholding under the U.S. domestic rules, and act as a further guide to the applicable provisions in the Treaty.
12.3.1[c] Source of Royalties
Sections 861(a)(4) and 862(a)(4) employ a “place of use” test in determining the source of income. Because of the significant role that government protection plays with respect to intellectual property, the question of where property is used often leads to the issue of the scope and geographic range of the government protection.
12.3.1[d] Taxation of U.S. Source Royalties Generally
Under section 871(a), a tax of 30 percent (reduced by treaty) is imposed on the gross amount of FDAP received from sources within the U.S. by a foreign person, but only to the extent not effectively connected with a U.S. by a foreign person, but only to the extent not effectively connected with a U.S. trade or business. Sections 871 and 881 generally impose a 30 percent tax on FDAP income of an NRA, foreign corporation, or foreign partnership, from U.S. sources withheld at source under sections 1441 and 1442. No withholding is required for income that is effectively connected with a U.S. trade or business.
12.3.1[e] Anti-hybrid Provisions
U.S. domestic tax rules may deny treaty benefits under certain circumstances. Sections 894[c] denies treaty benefits for income paid to hybrid entities (i.e, entities treated as fiscally transparent for U.S. income tax purposes, but as fiscally non-transparent for purposes of the tax laws of the taxpayer’s jurisdiction of residence).
12.3.1[f] Non-arm’s Length Payments
Section 482 is one of the most complex and important provisions concerning the transfer of intellectual property between related parties. Its chief purpose is to ensure that related party transactions reflect arm’s length consideration, and thus to ensure that income and expense derived in related party transactions are neither overstated nor understated in any jurisdiction. In a nutshell, section 482 allows the Service to make appropriate allocations to reflect an arm’s length consideration for the use of property where intangible property is transferred between controlled entities. The arm’s length standard also applies to consumer intangibles (like trademarks), and to the provision of services between related parties. In addition, the regulations recognize that services can have significant intangible components.
References:
Advisor’s Guide to Canada – U.S. Tax Treaty
By: Vitaly Timokhov, Raymond Montero, David Kerzner
Published by: Thomson Carswell
