The rationale behind the structure of international taxation agreements is to encourage and facilitate international trade and this feature is evident in the form of the Model Article on royalties.
Paragraph 1 outlines the basic position that royalty payments should be taxed only in the country where the recipient resides. In this respect Article 12 stands apart from Article 10 (Dividends) and 11 (Interest) which do provide that a withholding tax may be levied. It should be noted that a number of countries have expressed reservations about the Article (Australia, Greece, Luxembourg, Canada, Finland, France, Italy, Japan, Mexico, New Zealand, Poland, Portugal, Spain, the Czech Republic, Korea and Turkey) to the effect that they maintain the right to tax royalty payments made from their country to a beneficiary in another contracting state. The reservations of Finland, France and Luxembourg do not however appear in the 1992 or 2002 Commentaries.
The OECD Model does at least resolve a question on which no clear view was afforded by the League of Nations drafts. The Mexico draft allowed exemption in the source country for literary royalties, but not for patent royalties: the London draft favoured exemption for both classes, but allowed the source country to tax patent royalties where the recipient had a "dominant participation" in the enterprise paying the royalties.
The UN model permits the use of a withholding tax provided that the rate has been agreed between the states in their bilateral treaty.
The US Treasury model allows for taxation in the beneficiary country only, but this has not consistently been followed in its treaties.
It is noteworthy that the OECD Model adopted the general position that taxes on royalties should only be levied in the beneficiary country in view of the fact this has proved unacceptable to many countries. In the commentary on Article 11, the OECD decided against recommending that interest be taxed only in the beneficiary country owing to the fact this would not be generally acceptable.
Paragraph 2 discusses what should constitute a "royalty" payment. The general view is that a royalty payment is made in respect of the supply of an item of which there is a monopoly - for instance a patent or a copyright. Most rental payments can be understood as constituting royalties but not where a series of payments are being made for what is effectively the sale of the property on a credit basis. The OECD Article long differed from the US Treasury's model in that the USA until recently regarded rentals for cinematograph films as falling under the heading of business receipts. and as thus appropriately dealt with under Article 7. The 1996 US model royalties article however follows the OECD Model in this matter. The 1992 OECD Model Article 12 (in contrast with the 1977 and UN Articles) follows the US Model in effectively treating payments for industrial, commercial or scientific equipment (including containers) as business receipts, and hence as taxable in the source country, if at all, under the rules of Articles 5 and 7 - ie only if the recipient carries on a trade or business in the country through a permanent establishment situated therein. (Several countries have however reserved the right to treat them as royalties.) This topic is considered in more detail below.
Computer software The rapid expansion of computer technology has given added importance to the question whether or not one should classify as royalties payments which are made in consideration for computer software. (By software is understood programs which contain instructions for a computer.) This question was studied in the 1992 OECD publication "Model Tax Convention: Four Related Studies" and the Commentary on Article 12 of the Model was expanded in consequence.
In essence the conclusions recorded in the Commentary were that, although rights in computer software are a form of intellectual property, transfers of such rights can occur in so many different ways and the consideration for such transfers can take so many different forms that it may often be difficult to determine where the boundary lies between software payments which are properly to be regarded as royalties and those which are other types of payment.
Software is commonly acquired for the personal or business use of the acquirer, on terms which make the acquisition one of less than full rights in the software - the owner still preserving copyright protection and restricting the acquirer's use of the software. In such cases, the Commentary suggests, the purchase payment is properly regarded as commercial income of an enterprise or of an independent professional, and to be dealt with under Articles 7 or 14 (as a sale of goods or provision of services) as the case may be. Payment for a partial transfer of rights could nevertheless be a royalty, for example where the owner of the software places part of the rights at someone else's disposal to enable him to develop and distribute the software itself commercially. Even then there could be a problem in applying Article 12 since the software payment might not fall squarely within the definition of royalty in the Model Article, being most probably not a payment for a literary or artistic copyright and only doubtfully a payment for a copyright of scientific work. Some countries may in fact feel a need to refer specifically to software payments in this context.
Where consideration is paid for transfer of the full ownership of the rights, the Commentary indicates that it is properly treated as commercial income within Articles 7 or 14 or as an alienation of capital in respect of which Article 13 might be appropriate but not Article 12. Portugal has however reserved the right to tax as royalties all software income that is not derived from a total transfer of the rights attached to the software.
Where software payments are made under mixed contracts (eg as part of a packaged or bundled scheme of payments for computer operated machinery) then it would probably be necessary to break the payments down into their constituent elements and treat part perhaps as royalty and part as business receipts or as a payment of capital.
It seems likely that these problems will become more insistent as time goes by and that tax treaties may have to be elaborated and complicated to deal more satisfactorily with them.
It should further be noted that payments made for the working of mineral deposits and natural resources are governed by Article 6 (Income from immovable property).
Paragraph 3 outlines a basic exception to the rule that royalties should only be taxable in the country in which the beneficiary resides. Where the royalties receivable arise through assets which are owned by a "permanent establishment" or "fixed base" in the other state, then they will be taxed as part of its "attributable profits", but only when there is a direct connection between the two. This is similar to the provisions contained in Articles 10 and 11. Italy again felt unable to accept this, and reserves the right to tax royalties as part of the profits of the "permanent establishment" even though they may not be directly attributable to it. It should be noted that the language of the US/Swiss treaty made in 1951 was similar to many provisions in older treaties which were modified unilaterally by later domestic legislation generally limiting the force of attraction. On the question of "permanent establishments", the UN model (only) has a paragraph 5 for this Article (similar to paragraph 4 of Article 10 and paragraph 5 of Article 11 in the OECD Model) which provides that where royalty payments are directly connected to a "permanent establishment" or fixed base (even one belonging to an enterprise of a third country) then such amounts should be deemed to arise in the State where the permanent establishment or fixed base is located.
Paragraph 4 provides that the OECD provisions should apply only to royalties which have been negotiated on an arm's length basis. Excess amounts (in order to re-allocate profits) would not be covered and would be taxed according to the laws of the member states and other Articles. Some countries would treat the excess as a "distribution" and subject it to withholding tax.
Entrepreneurs have probably always recognised that in some circumstances it is more convenient to rent industrial, commercial or scientific equipment than to purchase it outright. The leasing of such equipment has however expanded very considerably in the last twenty years or so and has now assumed a much greater importance internationally than in the days when the OECD Model treaty was first constructed. The use of leased containers for sea transport has particularly expanded.
The OECD recognised in its 1985 publication "Trends in International Taxation" that there was a need to give these matters more detailed consideration than had been thought necessary when the Model tax treaty was published in 1977.
The 1977 OECD Model treaty itself is fairly clear that Article 12 of the Model applies to income from the leasing of industrial, commercial and scientific equipment (ICSE). So is the UN Model which in this matter uses the same words in defining "royalties" for the purposes of its rather different Article 12. Article 12 of both Models defines "royalties" as including payments for the use of, or the right to use industrial, commercial or scientific equipment. This gives rise to no serious problems if, in a bilateral treaty, the contracting states are content to follow the OECD Model and exempt these payments, like other payments described as royalties, from tax in the source country.
However, since a number of OECD Member countries have expressed reservations about the complete exemption of royalties from source country taxation and the UN Model in principle assumes that some source country tax will be charged on royalties, it is not surprising to find that a considerable number of bilateral treaties do in fact accept that tax will be withheld, though possibly at a reduced rate, from payments falling within the definition of royalty provided by the Model articles.
If, as has usually been the case, ICSE are included in the definition of royalties there is the possibility (more so, probably, than with some other classes of royalty) that the withholding tax deducted at source from the gross amount will represent a very high rate of tax on the net return from the leasing after the expenses of the lessor have been taken into account. Consequently the source country tax charged could exceed what would be charged if the income was taxable as income of a permanent establishment of the lessor in the source country.
A large majority of the OECD's Committee on Fiscal Affairs (including members from some countries which ordinarily reserve their right to withhold tax from royalties generally) agreed in fact in 1985 that it was inappropriate to treat income derived from leasing ICSE in this manner, and the Committee accordingly recommended that such income should not be treated as royalties in bilateral conventions. It would then fall to be treated, normally, as business income under the equivalent of Article 7 of the Model and either exempted if there was no permanent establishment in the source country or taxed there on a net basis if there was a permanent establishment.
In the 1992 Model Convention the definition of the term "royalties" was accordingly revised to leave out the words "or for the use of, or the right to use, industrial, commercial or scientific equipment". The Commentary on the article was expanded to take in the gist of the 1985 discussion. However several countries have expressed reservations in the Commentary, preserving their right to continue to subject such payments to withholding tax at source as a royalty.
In practice not many treaties, as yet, contain the revised definition of royalties.
The leasing of containers is from most points of view essentially a sub-division of the leasing of ICSE. The majority of the members of the OECD committee producing the 1985 "Trends in International Taxation" took this view in fact and accordingly agreed that what they had said about the leasing of ICSE applied just as much to the leasing of containers. Members who reserved their right to apply withholding taxes to income from leasing ICSE accordingly maintained the same reservation in relation to the leasing of containers. Those who did not regard it as appropriate to apply withholding taxes to payments for leasing ICSE could thus be expected ordinarily, under a bilateral treaty, to seek either to exempt such payments (including payments for leasing containers) under an article on the lines of Article 12 of the OECD Model or, if they accepted some deduction of withholding tax from royalty payments, to exclude income from leasing ICSE (including containers) from the definition of royalties, and thus to apply to such income an Article on the lines of Article 7 of the Model, taxing the payments on a net basis if they were attributable to a permanent establishment and otherwise not at all.
Container leasing is however a very varied and complicated business. The lessor may in some circumstances merely be financing what technically is perhaps a sub-letting operation. or he may be closely concerned with the actual details of managing the leasing of a large stock of individual containers. There is a wide variety of different forms of possible lease, depending on to what kind of use the lessee wants to put the container. The containers are, of their very nature, continually being moved about and the operation of a container leasing business consequently depends on a worldwide network of depots where the containers can be collected and stored, from which they can be despatched, and where they can be inspected and repaired, and physically managed and controlled on behalf of or by the leasing enterprise. The purpose for which the depots are used, the amount of use made of each one of them and the business relationship between the depots and the container leasing enterprises making use of them will vary enormously from case to case. It must often therefore be a matter for question whether a container leasing enterprise has a permanent establishment in any particular country, and, if it has, what profit can be attributed to the establishment.
In the chapter in "Trends in International Taxation" which deals specially with container leasing, the OECD has in fact provided some basic guidelines for deciding in what circumstances a container leasing enterprise could be said to have a permanent establishment in a country which is acting as a host in one way or another to its containers, and for deciding on the profit attributable to such a permanent establishment in various circumstances.
Another complication peculiar to containers however arises from the fact that they are a means by which the shipping industry carries on its business of sea transport. Much of the argument for confining the right to tax the profits derived from the operation of international shipping to the country where the effective management of the enterprise carrying the trade is situated can thus be applied to the profits of container leasing operations. It is for this reason, no doubt, that the commentary on Article 8 of the OECD Model says firmly that "profits derived by an enterprise engaged in international transport from the lease of containers which is supplementary or incidental to its international operation of ships or aircraft fall within the scope" of Article 8. In 1985 however the OECD concluded nevertheless that it was not appropriate to recommend that income from container leasing should in principle be treated as income from shipping under Article 8 of the Model, although they did not wholly close the door on the notion and in fact commented that it might be looked at again and that meanwhile "countries which favour submitting income from container leasing to the rules of Article 8 are free to suggest this solution when entering into bilateral negotiations". One may expect to find therefore that such income is in fact assimilated to shipping in some bilateral treaties.
It is clear that there is a substantial body of opinion among the tax authorities of OECD Member countries that income from the leasing of ICSE (including income from container leasing) is properly either exempted as a royalty from source country tax, or excluded from the definition of royalty and treated as a business receipt (thus being effectively exempted from source country tax if it is not attributable to a permanent establishment). The treatment of such payments is likely to vary considerably from one bilateral treaty to another.
Sometimes in bilateral treaties the definition of royalties includes income derived from the rendering of technical services and the provision of technical assistance (though such payments are also sometimes the subject of a separate article). This does not follow either the OECD or the UN Model. Usually when it occurs it is a feature of a treaty between a developed and a developing country.
The overall picture of the extent to which countries follow the Model is shown in the Model Article 12 Summary.