In this post, we discuss the differences between paying for services and paying for the use of intellectual property (“IP”). The latter is generally considered a royalty payment, which results in a very different transaction from the tax perspective. We discuss this from the South African (“SA”) context today, but this issue is relevant across the board.
For SA purposes, IP is defined as any patent, design, trademark, copyright, property, right. Or knowledge connected to the use of such patent, design, trademark, copyright, property, or right. Each of these types of IP is defined further in the relevant legislation.
Now, what is a service in the context of group companies? To prove that intercompany services have been provided, there should be an activity that provides one entity with some sort of economic or commercial value. It could be something that either the entity would have to perform itself. Or something that they would pay for externally. It should be beneficial. Typically, in a group context we deal with management, administrative, and technical services.
So why is there confusion?
Often the provision of services involves the use of IP, hence a payment purportedly for services rendered may actually be a royalty “in disguise”. Take for example, a payment to a Microsoft systems engineer for sorting out Windows for you. On the one hand, you are seemingly paying the engineer for her services. However, it could be argued that you are actually paying for the use of knowledge connected to the Microsoft patents, designs, and trademarks. It can be very hard to distinguish between the two.
Why is this important?
The difference between the two has significant tax consequences when the payment is cross-border, mainly because of withholding taxes.
SA imposes a 15% withholding tax (“WHT”) on royalty payments made to a non-resident. Unlike other African countries, SA levies nothing on payments for services rendered by a non-resident. Whereas African countries often have a lower WHT or royalties than services.
In SA, the royalty WHT applies to royalties from a SA source. Royalties are regarded as arising from a SA source if:
- An SA tax resident is the user of the IP regardless of where in the world it is used; or
- IP is used in SA regardless of whether the user is an SA tax resident or not.
The royalty must be withheld by the user of the IP and paid over to the South African Revenue Service (“SARS”). The applicable Double Taxation Agreement (“DTA”) should always be consulted to confirm if the WHT rate can be reduced.
The good news is that royalty payments are deductible for SA tax purposes.
Transfer Pricing royalty issues
It is important to note that if IP is held by a person connected to you, the amount of the royalty must be determined on an arm’s length basis for SA transfer pricing purposes.
The pricing of royalties and IP transactions in general is a highly complex area, particularly from a transfer pricing perspective. To establish an arm’s length royalty, the Organisation for Economic Co-operation and Development has produced many hundreds of pages of scintillating documents. Including how to ascertain where value lies by using the so-called DEMPE concept. Looking at the location for each composite part of the IP value chain as follows: development, enhancement, maintenance, protection, and exploitation of the IP.
Don’t forget royalty exchange control
Exchange control approval is generally required for both overseas service payments and royalties, but the latter is usually much more cumbersome.
It is important to know and decide where IP is being maintained and developed. IP must be registered within the SA Reserve Bank for regulatory reasons. Exchange control approval is generally required to transfer IP offshore. Obtaining exchange control approval for the transfer of IP is a time-consuming and complex procedure. Hence if it is intended for IP to be moved offshore at any stage, we recommend it should be done at the beginning.
It is always necessary to perform a detailed analysis of whether any IP or intangibles have been or will be developed in your business. You should consider who would own such intangibles and who would be compensated for the creation of value for such intangibles. Or whether simply, services are being provided.
Please contact us to discuss further or click here to arrange a call with one of our team.
How can we help?
How you structure your business is a critical question as you expand globally. The right structure will protect your assets, improve your currency position, support your business operations, facilitate future business expansion and changes, and optimise your overall tax rate. Trying to unscramble a sub-optimal structure entered into in haste or without full consideration of relevant facts is complex and expensive, so it’s important to plan upfront.
Structuring an international business is both a science and an art – this is our specialist area of expertise. Regan van Rooy is an international tax and structuring advisory firm focussing on Africa. We have offices in South Africa, Mauritius and Ireland and we can help you with any international tax or structuring query.