Subsections

• Paragraph 1
• Paragraph 2
• Paragraph 3
• Paragraph 4
• Paragraph 5
• Paragraph 6
• Relation to Other Articles

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ARTICLE 12 -- Royalties

Article 12 provides rules for source and residence country taxation of royalties. Generally, the Article provides for full residence country taxation of royalties and for a limited source State right to tax such income.

Paragraph 1

The right of a beneficial owner's country of residence to tax royalties arising in the other Contracting State is preserved by paragraph 1. For royalties from any other source paid to a resident, Article 22 (Other Income) grants the residence country exclusive taxing jurisdiction (other than for royalties attributable to a permanent establishment or fixed base in the other State).

Paragraph 2

Paragraph 2 grants to the source State the right to tax royalty payments but limits the rate of source State tax if the royalties are beneficially owned by a resident of the other Contracting State. The maximum rate of tax allowed by the source State varies depending upon the nature of the payment. The maximum rate of source country tax is 5 percent if the royalty payment is received for the rental of industrial, commercial or scientific equipment. All other royalties are subject to tax at a maximum rate of 10 percent under subparagraph 2(b).

The term ``beneficial owner'' is not defined in the Convention, and is, therefore, defined as under the internal law of the country imposing tax (i.e., the source country). The beneficial owner of royalties for purposes of Article 12 is the person to which the royalty income is attributable for tax purposes under the laws of the source State. Thus, if royalties arising in one of the States is received by a nominee or agent that is a resident of the other State on behalf of a person that is not a resident of that other State, the royalties are not entitled to the benefits of this Article. However, royalties received by a nominee on behalf of a resident of that other State would be entitled to benefits. These limitations are confirmed by paragraph 4 of the OECD Commentaries to Article 12. See also, paragraph 24 of the OECD Commentaries to Article 1 (General Scope).

Paragraph 3

Paragraph 3 defines the term ``royalties'' for purposes of the Article. The term means payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work including computer software, cinematographic films and films or tapes and other means of image or sound reproduction for radio and television broadcasting; for the use of, or the right to use, any patent, trademark, design or model, plan, secret formula or process or other like right or property; or for information concerning industrial, commercial, or scientific experience; for the use of, or the right to use information concerning industrial, commercial or scientific experience. In deviation from the OECD Model and from most U.S. treaties, ``royalties'' also includes payments of any kind received as a consideration for the use of, or the right to use industrial, commercial or scientific equipment. As noted above in the explanation to Paragraph 2, such royalties are taxed at the lower 5 percent rate.

The term ``royalties'' also includes gain derived from the alienation of any right or property that would give rise to royalties, to the extent the gain is contingent on the productivity, use, or further alienation thereof. As a consequence, such amounts may be taxed in accordance with this Article. Gains that are not so contingent are dealt with under Article 13 (Gains).

The term royalties is defined in the Convention and therefore is generally independent of domestic law. Certain terms used in the definition are not defined in the Convention, but these may be defined under domestic tax law. For example, the term ``secret process or formulas'' is found in the Code, and its meaning has been elaborated in the context of sections 351 and 367. See Rev. Rul. 55-17, 1955-1 C.B. 388; Rev. Rul. 64-56, 1964-1 C.B. 133; Rev. Proc. 69-19, 1969-2 C.B. 301.

Consideration for the use or right to use cinematographic films, or works on film, tape, or other means of reproduction in radio or television broadcasting is specifically included in the definition of royalties. The reference to ``other means of reproduction'' as it relates to cinematographic films, or works on file and tape makes clear that future technological advances in the field of radio and television broadcasting will not affect the inclusion of payments relating to the use of such means of reproduction within the definition of royalties.

If an artist who is resident in one Contracting State records a performance in the other Contracting State, retains a copyrighted interest in a recording, and receives payments for the right to use the recording based on the sale or public playing of the recording, then the right of such other Contracting State to tax those payments is governed by Article 12. See Boulez v. Commissioner, 83 T.C. 584 (1984), aff'd, 810 F.2d 209 (D.C. Cir. 1986).

Computer software generally is protected by copyright laws around the world. Under the Convention, consideration received for the use, or the right to use, computer software is treated either as royalties or as business profits, depending on the facts and circumstances of the transaction giving rise to the payment.

The primary factor in determining whether consideration received for the use, or the right to use, computer software is treated as royalties or as business profits, is the nature of the rights transferred. See Treas. Reg. section 1.861-18. The fact that the transaction is characterized as a license for copyright law purposes is not dispositive. For example, as was discussed and understood among the negotiators, a typical retail sale of ``shrink wrap'' software generally will not be considered to give rise to royalty income, even though for copyright law purposes it may be characterized as a license.

The means by which the computer software is transferred are not relevant for purposes of the analysis. Consequently, if software is electronically transferred but the rights obtained by the transferee are substantially equivalent to rights in a program copy, the payment will be considered business profits.

The term ``industrial, commercial, or scientific experience'' (sometimes referred to as ``know-how'') has the meaning ascribed to it in paragraph 11 of the Commentary to Article 12 of the OECD Model Convention. Consistent with that meaning, the term may include information that is ancillary to a right otherwise giving rise to royalties, such as a patent or secret process.

Know-how also may include, in limited cases, technical information that is conveyed through technical or consultancy services. It does not include general educational training of the user's employees, nor does it include information developed especially for the user, for example, a technical plan or design developed according to the user's specifications. Thus, as provided in paragraph 11 of the Commentaries to Article 12 of the OECD Model, the term ``royalties'' does not include payments received as consideration for after-sales service, for services rendered by a seller to a purchaser under a guarantee, or for pure technical assistance.

The term ``royalties'' also does not include payments for professional services (such as architectural, engineering, legal, managerial, medical, software development services). For example, income from the design of a refinery by an engineer (even if the engineer employed know-how in the process of rendering the design) or the production of a legal brief by a lawyer is not income from the transfer of know-how taxable under Article 12, but is income from services taxable under either Article 14 (Independent Personal Services) or Article 15 (Dependent Personal Services). Professional services may be embodied in property that gives rise to royalties, however. Thus, if a professional contracts to develop patentable property and retains rights in the resulting property under the development contract, subsequent license payments made for those rights would be royalties.

Paragraph 4

This paragraph provides an exception to the rules of paragraph 2 that limit the rate of source country taxation of royalties. This paragraph applies in cases where the beneficial owner of the royalties carries on business through a permanent establishment in the state of source or performs independent personal services from a fixed base situated in that state and the royalties are attributable to that permanent establishment or fixed base. In such cases the provisions of Article 7 (Business Profits) or Article 14 (Independent Personal Services) will apply.

The provisions of paragraph 9 of Article 7 (Business Profits) apply to this paragraph. For example, royalty income that is attributable to a permanent establishment or a fixed base and that accrues during the existence of the permanent establishment or fixed base, but is received after the permanent establishment or fixed base no longer exists, remains taxable under the provisions of Articles 7 (Business Profits) or 14 (Independent Personal Services), respectively, and not under this Article.

Paragraph 5

Paragraph 5 provides that in cases involving special relationships between the payor and beneficial owner of royalties, Article 12 applies only to the extent the royalties would have been paid absent such special relationships (i.e., an arm' length royalty). Any excess amount of royalties paid remains taxable according to the laws of the two Contracting States with due regard to the other provisions of the Convention. If, for example, the excess amount is treated as a distribution of corporate profits under domestic law, such excess amount will be taxed as a dividend rather than as royalties, but the tax imposed on the dividend payment will be subject to the rate limitations of paragraph 2 of Article 10 (Dividends).

Paragraph 6

Subparagraphs 6(a) and 6 (b) provide rules for determining the source of royalty payments. Subparagraph 6(c) provides rules for determining the source of payments received as consideration for the use of containers.

Under subparagraph 6(a), royalties are generally deemed to arise in a Contracting State if paid by a resident of that State. However, if the obligation to pay the royalties was incurred in connection with a permanent establishment or a fixed base in one of the Contracting States, and the royalties are borne by that permanent establishment or fixed base, the royalties are deemed to arise in that State, regardless of whether the payor is resident in one of the Contracting States. In general, royalties are considered borne by a permanent establishment or fixed base if deductible in computing the taxable income of that permanent establishment or fixed base. Under subparagraph 6(b), if royalties are neither paid by a resident of one of the Contracting States nor borne by a permanent establishment or fixed base in either State, so that they are not covered by subparagraph 6(a), but they relate to the use of a right or property in one of the Contracting States, they will be deemed to arise in the State where the right or property is used. For example, if a Latvian resident were to grant franchise rights to a resident of Mexico for use in the United States, the royalty paid by the Mexican resident to the Latvian resident for those rights would be U.S. source income under this Article, subject to U.S. withholding at the 10 percent rate provided in paragraph 2.

The rules of this Article differ from those provided under U.S. domestic law. Under U.S. domestic law, a royalty is considered to be from U.S. sources if it is paid for the use of, or the privilege of using, an intangible within the United States; the residence of the payor is irrelevant. If paid to a nonresident alien individual or other foreign person, a U.S. source royalty is generally subject to withholding tax at a rate of 30 percent under U.S. domestic law. By reason of paragraph 2 of Article 1 (Personal Scope), a Latvian resident would be permitted to apply the rules of U.S. domestic law to its royalty income if those rules produced a more favorable result in its case than those of this Article. However, under a basic principle of tax treaty interpretation, the prohibition against so-called ``cherry-picking'', the Latvian resident would be precluded from claiming selected benefits under the Convention (e.g., the tax rates only) and other benefits under U.S. domestic law (e.g., the source rules only) with respect to its royalties. See, e.g., Rev. Rul. 84-17, 1984-1 C.B. 308. For example, if a Latvian company granted franchise rights to a resident of the United States for use 50 percent in the United States and 50 percent in Mexico, the Convention would permit the Latvian company to treat all of its royalty income from that single transaction as U.S. source income entitled to the withholding tax reduction under paragraph 2. U.S. domestic law would permit the Latvian company to treat 50 percent of its royalty income as U.S. source income subject to a 30 percent withholding tax and the other 50 percent as foreign source income exempt from U.S. tax. The Latvian company could choose to apply either the provisions of U.S. domestic law or the provisions of the Convention to the transaction, but would not be permitted to claim both the U.S. domestic law exemption for 50 percent of the income and the Convention's reduced withholding rate for the remainder of the income.

Subparagraph 6(c) provides a rule that applies only to payments received as consideration for the use of containers (including trailers, barges, and related equipment for the transport of containers) used in transportation of passengers or property (other than transportation solely between places within a Contracting State) not dealt with in Article 8 (Shipping and Air Transport). Such payments not included in Article 8 are those received as consideration for the non-incidental rental of containers. Such payments are deemed to arise in neither Contracting State, and thus, do not fall under the taxing rules of Article 12, since as noted in paragraph 1 of Article 12, Article 12 only applies to payments of royalties that arise in a Contracting State. Non-incidental container leasing is not included as Royalties in Article 12 nor as profits from the operation of ships and aircraft in international traffic in Article 8 and thus falls under Other Income in Article 22. Other income beneficially owned by a resident of a Contracting State is only taxable by that resident's State. Thus, non-incidental container leasing is taxed in the same way in both this Convention and the U.S. model.

Relation to Other Articles

Notwithstanding the foregoing limitations on source country taxation of royalties, the saving clause of paragraph 4 of Article 1 (General Scope) permits the United States to tax its residents and citizens as if the Convention had not come into force.

As with other benefits of the Convention, the benefits of reduced source state taxation of royalties under paragraph 2 of Article 12 are available to a resident of the other State only if that resident is entitled to those benefits under Article 23 (Limitation on Benefits).