pwc
In brief
Recently, a Dutch Court1 (“the Court”) ruled in a case where a Dutch taxpayer (“the taxpayer”), engaged in manufacture and sales of cleaning agents and anti rust agents (“chemicals”), had paid royalty for many years to a group company (based in a tax haven in Europe, i.e., Liechtenstein) for the use of recipes and know-how to manufacture the chemicals. Although the Dutch tax administration had not adjusted the royalties in prior tax audits, now it disallowed the royalties as deductible expenses as, in their view, the royalties did not meet the arm's length standard.
The taxpayer took this plea that royalty was accepted in prior tax audits and since the facts have remained unchanged, there was no mala fide intent. Moreover the acceptance in the prior tax audits had assured the taxpayer of it being an irrefutable deduction. Further, the taxpayer also submitted the license agreement in
1 District Court of Breda (Netherlands) – 2009 / 02639
respect of royalty in order to substantiate the economic substance of the payments.
However, in response, the Dutch tax administration argued that no commercial meaning can be attached to the license agreement, which was superfluous, and under the pretext of license costs, substantial sums of money were being transferred to the group company when there was actually no consideration being received from it that would justify the payment of royalty.
The taxpayer objected to the disallowance and filed an appeal before the Dutch Court.
Ruling of the Dutch Court
The Dutch Court upheld the decision of the tax administration. Further, as per the Court, the burden of proof vests with the taxpayer, and in the opinion of the Court, the economic substance of the license payments was not proved, for which the Court cited the following reasons:
Royalty payouts to pass the test of economic and commercial substance so as to meet arm’s length standard Tax & Regulatory Services
News Alert
20 August, 2010
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• Apart from the license agreement there was no other documentation between the parties or other evidence from which it could be deduced that the recipes of the cleaning agents actually contain commercial value.
• There was no evidence that these recipes originated from the group company.
• There was no proof of the group company being the owner of any intangible asset:
- as it was not plausible that the board or other employees of the group company had specific knowledge regarding the exploitation thereof, and - there were no indications that any research and development activities relating
to the recipes had taken place.
• An active role by the group company concerning the provisions which were included in the agreement could not be derived, as would have been expected in commercial relationships.
• The group company did not actually deliver license rights, know-how or any other performances to the taxpayer.
In view of the above, the Court was of the opinion that the arm’s length character of the license agreement, and the arm’s length character of the consequent license fees, was not established.
Also, the Court observed that the license agreement could be considered as a cover for payments made to the group company to which the taxpayer was actually not obliged. Accordingly, the Court held that the taxpayer had intentionally filed incorrect tax returns for multiple years by knowingly and wilfully deducting unjust license fees.
Therefore, the taxpayer had acted in bad faith.
Consequently, the additional tax imposed by the Dutch tax administration was sustained and the appeal of the taxpayer was rejected.
Conclusion
Cross border transactions involving intangibles have been observed to be on the rise, and it is not uncommon for tax administrations to challenge royalty payouts as their valuation has been a perennial issue. However, increasingly tax administrations are realising that besides valuation, the very genuineness of these transactions needs scrutiny because either income associated with intangible assets is being inappropriately shifted to low-tax jurisdictions, or payouts related to intangibles were being used as a mechanism to inappropriately shift income out of a jurisdiction - both resulting in significant erosion of tax base.
Pending the enactment of the General Anti Avoidance Rules laid down in the soon to be implemented Direct Tax Code, the concept of substance over form does not yet find mention in the Indian legislation. However, this concept is commonly found in OECD’s publications including OECD’s Transfer Pricing Guidelines, OECD’s Report on the Transfer Pricing Aspects of Business Restructurings, and OECD’s Report on the Attribution of Profits to Permanent Establishments. Also, the US legislation specifically provides for the “Doctrine of Economic Substance”, which states that a transaction must have an economic purpose aside from reduction of tax liability in order to be considered valid. This doctrine is used to determine whether tax shelters, or strategies used to reduce tax liability, are considered "abusive" by the Internal Revenue Service of the US.
Besides the emphasis on economic substance, the importance of this case is that it provides clear guidance to taxpayers with respect to evidence required to be maintained and furnished in order to prove arms’ length nature of royalty payouts. The guidance provided, can be helpful in respect of other intangible related payouts as well such as management fees, fees for other technical / consulting services, etc. Tax authorities are more than likely to question first the need for the services underlying a payout, the actual delivery of the service, and then the benefit derived by the taxpayer. Therefore, it is expected that the existence of underlying economic substance becomes a critical condition while establishing arms’ length nature particularly of intangible related transactions. It is also expected that tax authorities will apply similar tests as have been applied in this ruling to such payouts by taxpayers to their group companies.
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