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It is frequently important to distinguish between royalties and payments for services for the purposes of determining whether withholding tax applies. This is important not only for the SP, but also for any person who may be obliged to withhold tax. Even where the definition of royalties does not include payments for services, there may be difficulties in characterising certain payments for income tax purposes. For example, in contracts that provide both for the transfer or licensing of property and the provision of services, such as knowhow contracts that include a service element, it may be very difficult to determine where the exact border lies between the two elements of the contract. Contracts for the transfer of both intangible property and services are especially common where transfers of technology are involved.

Many countries distinguish between royalties for supply of knowhow and payments for services involving the application of knowhow in the way suggested in the OECD Commentary. However, in some countries, fees for technical sendees that involve the application of knowhow by the SP (without a transfer of such knowhow) are treated as royalties.

The most common approach is to disaggregate the contract, unless by far the most significant part is one or the other (as per the OECD Commentary). In some countries, disaggregation is not important, since the same tax treatment applies regardless of whether the income is from services or constitutes royalties.

For transfer pricing purposes, enterprises may be tempted to exploit uncertainties around that border in order to minimise tax. For example, where income from the supply of knowhow is treated as royalties, and subject to withholding tax under the domestic law of the source jurisdiction or under a treaty, enterprises may seek to attribute a greater amount to the service element of the contract, the income from which is likely to be taxed on a net basis, or not at all, in the source jurisdiction.

Conversely, tax administrations may take an aggressive approach to determining the amount attributable to the royalties element of the contract if they are concerned that erosion of their tax base might otherwise result (i.e. because the payments, if characterised as being for the provision of services, would generally be deductible in that jurisdiction, but may not be taxable therein).

The 2010 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations discuss in paragraphs 3.9 to 3.12 of Chapter III the difficulties for transfer pricing purposes where contracts involve different elements such as a mixed transfer of services and property. It is noted at paragraph 3.9 of Chapter III that

“Ideally, in order to arrive at the most precise approximation of arm’s length conditions, the arm’s length principle should be applied on a transaction-by- transaction basis. However, there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis.”


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