Large companies and financial industrial groups have always been interested in royalty as a tool for optimisation of the income tax. At present, when royalty is used as such a tool, attention shall be paid to the following aspects as to inclusion of royalty into the expenditures reducing the income taxable item:
- Procedure for inclusion of royalty into the expenditures reducing the taxable item;
- Restrictions as to inclusion of royalty into the expenditures: the need in increasing the financial result (taxable item) by the “differences in taxes”;
- Opportunities given by the differences in definition of royalty for the purposes of accounting and taxation records;
- Opportunities given by the definition of the regular price in royalty transactions.
Let’s consider each aspect in more detail.
Procedure for Inclusion of Royalty into the Expenditures Reducing the Taxable Item
According to Paragraph 1 Subclause 14.1.225 of the Tax Code of Ukraine (hereinafter the “TCU”), royalty is any payment received as remuneration for exercising or provision of the right to use the intellectual property, namely, any literature works, works of art or science, including computer programmes, other records on data carriers, video or audio cassettes, cinema movies or films for radio or television broadcasting, other audio-visual works, any patented rights, any registered trademarks (brand and service marks), intellectual property rights to design, secret drawings, models, formulas, processes, intellectual property rights to the information as to industrial, commercial or scientific experience (know-how).
The same definition is given in Clause 4 of the Accounting Provisions (Standard) 15: “Income”.
According to Subclause 134.1.1 of the TCU in the version effective since January 01, 2015, the taxable item shall include income originating from and outside Ukraine which is estimated be adjustment of (increase or decrease in) the financial result before tax (profit or loss) specified in the financial reports of the company according to national accounting provisions (standards) or international financial reporting standards by the differences arising according to the provisions of Section III of the Code.
Therefore, the accounting rules shall be applied to define the income taxable item.
According to Clause 7 of the Accounting Provisions (Standard) 16:“Expenditures”, expenditures shall be the ones during a certain period simultaneously with recognition of income receipt of which they have been incurred for.
The expenditures which may not be directly connected with the certain-period income shall be accounted within the expenditures of the reporting period when they were incurred.
Therefore, the expenditures for royalty payment shall be included into the expenditures during the period when they were incurred.
Restrictions as to Inclusion of Royalty into the Expenditures
According to Subclause 140.5.7 of the TCU, the financial result of the tax (reporting) period shall be increased by the amount of expenditures for royalty charging in full if the royalty is calculated for the benefit of:
1) a non-resident registered in the states (within the territories) specified in Subclause 22.214.171.124 Clause 39.2 Article 39 of the Code;
2) a non-resident which is not a beneficiary (actual) recipient (owner) of the royalty, except for cases when the beneficiary (actual owner) has granted the right to receive the royalty to other persons;
3) a non-resident as to the items intellectual property rights to which have been first received by a resident of Ukraine;
4) a non-resident which is not subject to taxation as to the royalty in the state resident of which it is;
5) a person paying the tax as a part of other taxes, except for natural persons taxed as prescribed by Section IV of the Code;
6) a legal entity which is exempted from payment of this tax according to this Code or pays this tax at the rate other than the one established by Clause 136/1 Article 136 of the Code.
Therefore, the tax benefit from inclusion of royalty into the expenditures is downplayed by “differences in taxes” in case the royalty is paid for the benefit of non-residents or residents according to the criteria specified in Subclause 140.5.7 of the TCU.
Opportunities Given by the Differences in Definition of Royalty for the Purposes of Accounting and Taxation Records
Thus, according to Paragraphs 2-6 Subclause 14.1.225 of the TCU, the following payments shall not be considered to be royalty:
- the ones received as remuneration for use of the computer programme if use conditions are restricted to the functional use of such programme, and its reproduction is limited to the number of copies necessary for such use (use by the “end consumer”);
- for purchase of copies of intellectual property items in electronic form for functional use by end consumers;
- for purchase of items (including data carriers) embodying or including intellectual property items defined in Paragraph 1 of this Subclause, to be used, held and/or disposed of by a person;
- for transfer of intellectual property rights provided that, according to the conditions of transfer of intellectual property rights, the person receiving such rights is entitled to sell or otherwise alienate intellectual property rights or publish (disclose) secret drawings, models, formulas, processes, intellectual property rights to the information as to industrial, commercial or scientific experience (know how), except for cases when such publication (disclosure) is compulsory according to the laws of Ukraine.
In its letter No. 21647/10/28-10-06-11 dated 09.09.2015, the State Fiscal Service of Ukraine stipulates that “the opinion whether a payment for use of the computer programme falls within the definition of royalty for the tax purposes may be made on the basis of analysis of the terms and conditions of the agreement, namely, whether the conditions of use of such programme are restricted to its functional use, and whether the conditions of transfer of the intellectual property rights provide for the rights as to sale, publication of individual types of intellectual property items.
Moreover, actual use of the purchased computer programme shall be taken into account for tax purposes: for functional use or another purpose (for development of other programmes on the basis thereof, sale to another consumer).
Consequently, if the remuneration is paid for functional use of a copy of the compute programme by the end consumer, such remuneration shall not be royalty for the tax purposes”.
In its letter No. 22907/6/99-99-19-02-02-15 dated 29.10.2015, the State Fiscal Service of Ukraine stated that “if the company makes payments which are deemed to be royalty according to the accounting rules and, therefore, are included into the expenditures whereas such payments are not considered to be royalty for the income tax purposes, the company shall not form the difference for adjustment of the financial result before income tax according to Subclauses 140.5.5 – 140.5.7 Clause 140.5 Article 140 of the Code”.
Therefore, payments for use of computer programmes by end consumers shall be recognised to be royalty according to the accounting rules and shall not be considered to be royalty for the tax purposes, so they reduce the taxable item without increase by “differences in taxes”.
Opportunities Given by the Definition of the Regular Price in Royalty Transactions
Subclause 140.5.7 of the TCU provides for not reducing the financial result before tax by “differences in taxes” as to royalty if:
- the transaction is controlled, and the royalty amount conforms to the level of regular prices, which is substantiated in the report on controlled transactions and respective documents submitted according to Article 39 of this Code;
- the transaction is uncontrolled, and the royalty amount is confirmed by the tax payer according to the regular price rules according to the procedure established by Article 39 of this Code, yet without submission of the report.
Therefore, definition of the regular price within royalty transactions according to Article 39 of the TCU (with or without submission of the report on controlled transactions) enables avoiding increase in the financial result (taxable item) by “differences in taxes”.
According to Article 39 of the TCU, the scope of the taxable income receive by the tax payer participating in one or more controlled transactions shall be deemed to be compliant with the arm’s length principle if the conditions of these transactions are not different from the conditions applied between the unaffiliated persons in comparable uncontrolled transactions.
It applies to all methods for determination of compliance of the conditions of the controlled transaction under the arm’s length principle (conformance of the price level in the controlled transaction to the market value).
Therefore, the principal problem in determination of the regular price at the arm’s length principle is sources of information on equivalent transactions.
In its letter No. 22908/6/99-99-19-02-02-15 dated 29.10.2015 the State Fiscal Service of Ukraine stated that “commercial databases, namely, databases of Bureau Van Dijk (Orbis, Amadeus, RUSLANA), Interfax (Spark), ThomsonReuters, Bloomberg, contain information on financial data of companies, royalty rates, interest rates under financial instruments etc.
As these data are not confidential, secret or proprietary information and may not constitute commercial secret, information from these databases is open (in public domain).
Therefore, commercial databases of these companies may be used as public sources of information on mortgage transactions and persons in order to define compliance of the conditions of the controlled transaction with the arm’s length principle according to Paragraph b Subclause 126.96.36.199 of the TCU.”
From our point of view, as Paragraph b Subclause 188.8.131.52 of the TCU provides for use of any information sources which are in public domain and provide information or equivalent transactions and persons in order to define compliance of the conditions of the controlled transaction to the arm’s length principle, with account of the provisions of the Law of Ukraine “On Information”, in order to confirm the regular price, the data of the independent expert evaluation of the market value of royalty according to National Standard No. 4 “Evaluation of Intellectual Property Rights” approved by resolution of the Cabinet of Ministers of Ukraine No. 1185 dated 03.10.2007 may be used, even with account of the fact that in this case such evaluation is not compulsory.
To sum up, it shall be noted that the version of the TCU in effect since January 01, 2015 enables reducing the income taxable item by the royalty amounts, but, for such expenditures to be used with no adjustment by “differences in taxes”, the market level of payments shall be substantiated, which is currently quite possible, or they shall be payments for use of computer programmes by end consumers.
Volodymyr Rak, Counsellor of MORIS GROUP LAW COMPANY