Claiming deductionsfor royalty payments? Beware any "Tainted IP": A rude surprise awaits
If you're a South African taxpayer, and you pay any royalty fees for the right to use intellectual property ("IP"), then you're probably claiming a tax deduction for that expenditure. IP includes any patent, design, trade mark, copyright, or know how associated with any of these.
For many taxpayers, the party's now over. With effect from 1 January 2009, SARS has put severe limitations on this deduction in cases where the license relates to "tainted IP". These limitations are found in the new Section 23I of the Income Tax Act.
What is "tainted IP"? Will this affect every royalty payment and every license?
No – only those licenses in which the IP is 'tainted" will be affected. Section 23I is essentially an anti-avoidance provision against what is known as an "IP arbitrage". It targets IP sale-and-leaseback arrangements where certain players are located outside of SARS's tax net. At its most basic level, IP will be "tainted" in situations where:
• IP is created in South Africa;
• and then sold to someone who doesn't pay tax in South Africa (typically: a foreigner or a tax-exempt entity);
• the IP is then licensed back to the South African creator, or certain other South African end users;
• who pay royalty fees for the right to use the IP, and then claim a tax deduction for that expenditure.
So, when IP is sold to, and leased-back from, another South African taxpayer, Section 23I won't not apply. In this scenario, you would be entitled to continue to claim the deduction, as before.
Examples of cases where Section 23I would apply
Section 23I is not limited to particular types of transactions or commercial arrangements only – it addresses the underlying arbitrage itself, and not the mere transaction.
The most common example, at the simplest level, is where South African Company X develops a computer program or a trade mark and sells this to its foreign parent company Y in Europe. Y then licenses X to use that computer program or trade mark in South Africa, in return for a regular royalty payment, and X claims a tax deduction for each royalty payment made to Y. In this example, the IP is tainted and Section 23I would apply, meaning that the deduction claimed by X would need to be limited. The extent of that limitation will depend on whether the royalty payments were subject to withholding taxes and, if so, at what rate.
There are countless other examples where Section 23I will be triggered. These grow increasingly more complicated and technical, and are not discussed in detail in this article. However, in transactions involving any of these arrangements, there is a strong possibility that Section 23I might apply:
• where an intermediary is interposed between the seller and purchaser of tainted IP (eg: in the example given above, if Company X sold the IP to
Company Z that then on-sells the IP to Company Y; Y then licenses X to use the IP); OR
• instead of a royalty payment, the agreement between companies involves:
- a credit default swap arrangement;
- a securitisation transaction; or
- linked loans;
• licensing arrangements involving controlled foreign companies; OR
• a sale of business including licensing arrangements.
Connected Party Transactions
Section 23I is also triggered in cases where the end user of tainted IP (together with any taxable connected person) holds participation rights in a non-taxable licensor of the IP. This may be relevant, for example, where the tainted IP is sub-licensed in South Africa. In these cases, the licensee and sub-licensee will likely have different tax liabilities.
To complicate matters further, the threshold for "connected parties" is lower in Section 23I than for other sections in the Income Tax Act.
What is the effect on my tax position?
If you pay royalties under a contract that contains any of these provisions, and Section 23I applies, then one of three things will happen:
• worst-case scenario: your deduction for tainted royalty payments will be excluded completely – zero deduction allowed; OR
• you'll be entitled to a deduction, but limited to 10% of the usual amount; OR
• best-case scenario: you'll be entitled to a deduction, but limited to 33?% of the usual amount.
Which one of these scenarios will apply depends on other, technical issues that are specific to each arrangement. Unfortunately, getting to the answer isn't always an easy process.
What should you be doing?
If you think that Section 23I might affect you, then you're potentially at risk of overstating your permissible tax deductions. That may mean deductions being disallowed, interest & penalties being imposed against you.
Section 23I is also one of the most technically demanding provisions ever promulgated under the Income Tax Act. It requires expertise in both IP and tax law to be understood and applied properly. If in doubt, consult the experts – the need for skilled professional advice can't be overstated. It's the prudent thing to do.
If we can be of assistance, you're very welcome to to contact us.