Royalty payment to non-resident is considered to be one of the most risky and complex business operations in terms of possible adverse tax consequences. Considering the recently enacted changes to the Tax Code of Ukraine, and those that will become effective in 2022, as well as complexity of the qualification of royalty payment, it is essential to accurately consider whether the payment in question falls under the definition of royalties and what taxes shall be paid.
What payments shall be qualified as royalties?
The Tax Code defines royalties as any payments received as compensations for using the rights of intellectual, industrial property and other similar property rights.
Even though this definition may seem all-embracing, there are a number of peculiarities that shall be considered, depending on the object of intellectual property for which payment is made. For example, payments for the use of software are rather complex and do not always meet the criteria to be qualified royalty payment for tax purposes.
In particular, the Tax Code provides a list of exempt operations, payments for which may not be regarded as royalties. For example, the fee for the use of software is not recognized as royalties if such software is used by the company for its own business needs (like the end user). It is important to qualify whether the payment is, in essence, a royalty payment or payment for supply of software products, as it will be definitive for WHT and VAT tax consequences.
In particular, royalty payment is not subject to VAT but is subject to WHT, as will be described in detail below. On the contrary, payments for the use of software products are temporary exempt from VAT, but there are also specific rules for application of this exemption.
This issue becomes even more relevant in present days with the popularity of SAP usage in business operation.
Does withholding tax apply to royalties?
The Tax Code directly provides that royalties paid by a resident of Ukraine to non-resident is subject to 15% WHT, which may be reduced under the relevant Double Tax Treaty (“Tax treaty”).
In order to apply for the benefits under the DTT, the following conditions shall be met:
- Royalties are paid to a beneficial owner of such royalties or to a person authorized to receive such royalty payment on behalf of the beneficial owner;
- The principle purpose test is met;
- The business purpose test is fulfilled (applicable starting from 1 January, 2022).
Aside from that, a non-resident shall provide a special certificate confirming its residency status in a State with which Ukraine has a Tax treaty in force.
We will review each of these criteria for application of a reduced tax rate under a Tax treaty more closely below.
Beneficial owner status
The Tax Code defines the beneficial owner of income (in this case – royalty income) as a person authorized to receive and to dispose of income received. There is no single document which confirms the beneficial owner status of royalties. However, under the established court practice it is evident that the following facts may be analyzed by the court to define whether the income recipient is the beneficial owner of income:
- Full rights to receive, use, and dispose of income;
- Absence of obligations before the third parties to transmit the received income;
- Sufficient assets to perform an operation and to bear the risks connected with the received income;
- Ability to perform functions necessary to receive, maintain and use the assets received.
All of these criteria shall be satisfied cumulatively. Hence, the non-resident recipient to be qualified a beneficial owner of income (in particular, royalties) with the source in Ukraine shall have sufficient substance in the country of residence, as well as properly formalized rights to receive and to dispose of such income.
Most commonly the question whether the royalties recipient shall be qualified as the beneficial owner of such royalties arises under the sub-license agreements. Currently, the Ukrainian court practice is inconsistent in question whether the royalties receiver under a sub-license agreement shall be considered as received by the beneficial owner and be entitled for the respective tax exemptions. Hence, for royalties paid under sub-license agreement, particular attention shall be paid to the terms of such license agreement (i.e whether such sub-license is permitted), as well as to the functions performed by the sublicensee, to ensure that a reduced WHT rate/exemption under the Tax treaty may be applied).
Principle Purpose Test and Royalties
The Principle Purpose Test means that the benefits under the Tax treaty (reduced WHT rate or exemption) shall not be granted if the only or one of the main reasons to perform a transaction was to obtain the benefits under the Tax treaty. This test applies only if it is foreseen under the relevant Tax treaty.
In order to substantiate that an operation meets the Principle Purpose Test, it is strongly advisable to prepare in advance a special report, which may contain the following information:
- Economic substance of the operation, contract provisions on which such operation shall be performed and economic/business reasoning behind such operation;
- Description of the nature of business of a non-resident, confirmation that such non-resident meets substance requirements in its country of residence, etc;
- Comparison between business and tax benefits which the transaction/operation will bring to the Ukrainian company, which pays income to a non-resident.
Recently the Ukrainian court adopted one of the first decisions on the application of Principle Purpose Test. The court analyzed in detail economic substance of the operation, and closely considered the report provided by the Ukrainian company. The court supported the position of the claimant and confirmed that an operation meets the Principle Purpose Test, taking into account all the business and economic benefits presented by the claimant (the ruling of Kyiv District Administrative court dated 01.03.2021, case no. 640/3584/19.
Business purpose test and royalties
The business purpose test previously applied only to evaluate the eligibility of an operation for VAT credit, but starting from 1 January 2021 it started to apply also to operations subject to transfer pricing rules. Starting from 2022, this test will also apply to all operation of royalty payment to non-residents of Ukraine.
Under this rule, the Ukrainian company will have to apply a specific adjustment and increase its taxable base for corporate income tax purposes by the amount of expenses carried in connection with royalty payment. Under the Tax Code, absence of “business purpose” means that a taxpayer has no intention to make profit as a result of the business operation or to create the conditions for the profit receipt in the future.
To substantiate the economic substance of an operation, it is advisable to prepare another report evidencing the economic effect of a transaction. In this report, the taxpayer may indicate the following:
- The general overview of the business operation, the contracting parties, description of the essential terms of the transaction.
- Economic effect of the operation. This section shall include both direct and indirect economic effect, including income increase, reduction of cots or expenses, value growth of the end product, etc.
- Analyses of the alternative options. In this section of the report all the alternative options to perform an operation shall be analyzed, and it shall provide substantiation for the choice of a particular product, service, or counterparty, and explanation why the chosen option will, supposedly, be the most efficient for business of a taxpayer.
The current version of the Tax Code provides for an ability to apply a look-through approach while determining who if the beneficial owner of the received income. The Look-through approach means that if the recipient of royalties is not the beneficial owner of such royalties, but is merely an intermediary or an agent which will further transfer the funds received to a real beneficial owner, it is possible to apply the Tax treaty between Ukraine and the country in which such a real beneficial owner is a resident.
This approach to some extent helps to mitigate the risks connected with denial of benefits under the Tax treaty for failing the “beneficial owner test”. For example, if the royalty payment is made from a Ukrainian resident to a non-resident sublicensee, who will further remunerate all or major part of the received royalties to the beneficial owner, a safe option would be to apply the ax treatydirectly with the license holder. To do this both paying party and non-resident the recipients of the income must file the respective applications to the tax office in Ukraine.
However, the “look-through approach” may put the past periods under the risk of a tax audit and denial of Tax treaty benefits for the past periods. In particular, if the Ukrainian company repeatedly during several last years paid royalties to a non-resident sublicensee and applied reduced tax rate under the Tax treaty, but than suddenly in 2021 opted to apply “look-through approach” directly with the license owner, the tax authority may scrutinize the application of a reduced tax exemption in the past periods.