IP licensing arbitrage tax section 23I
A new tax provision came into force as from 1 January 2009, which will change the landscape of many international licensing arrangements. The provision aims to tackle licences that generate a tax arbitrage considered abusive by Treasury.
The section received vociferous resistance along the way. Some of it justified. In response, Treasury effected various amendments to sharpen this anti‐avoidance tool and limit collateral damage. Since various disparate drafts of this section have been released, it is best to ignore all prior bills and commentaries as they only serve to confuse the current situation.
Generally speaking, the provision acts to remove tax arbitrage associated with the following licensing scenarios:
- Exported intellectual property: Where (i) a South African taxpayer (resident) licenses patents, designs, trademarks or copyright (intellectual property) from a tax exempt person or a foreigner, and (ii) the intellectual property was developed by the licensee or a person “connected” to the licensee (e.g. 20% common shareholding).
- Bare dominium structures: Where (i) a resident licenses intellectual property, (ii) the intellectual property is owned by a taxable resident, and (iii) the royalties are paid to a tax exempt person or a foreigner.
This arrangement would generally flow from what is known as "a bare dominium structure" wherein ownership in an asset is divorced from use rights therein.
- Sale of business as a going concern: Where (i) a resident’s business is sold by the sale of assets of the seller generally to another resident (purchaser) while transferring the intellectual property to a tax exempt person or a foreigner, and (ii) the purchaser licenses the intellectual property. Furthermore, any resident that subsequently acquires the business from the purchaser and licenses the intellectual property from the tax exempt person or foreigner will similarly be caught within this provision.
- R&D structure: Where: (i) R&D that gave rise to intellectual property was performed by a resident within South Africa, (ii) the intellectual property is licensed to the resident or to another "connected" resident, (iii) the licensor is a tax exempt person or a foreigner, and (iv) the licensee and resident "connected" persons in relation to the licensee own at least 20% shares in the licensor.
- Controlled Foreign Companies (CFCs): Where royalties are paid by a resident to a CFC (i.e. a company in which South Africans hold a majority shareholding), royalties paid to the CFC are captured in the section to the extent that shares in the CFC are held by foreigners.
- Synthetic arrangements: Any arrangement that attempts synthetically to achieve the same tax result as any of the arrangements described in 1‐5. For example, where a resident licenses intellectual property from a taxable resident and the licensor concludes a back‐to back arrangement whereby the royalty receipts are diverted to a tax exempt person or foreigner in another form (such as payments in terms of a credit default swap, promissory note, or securitized bond).
Where a transaction falls within any of the above categories, the licensee is denied tax deductions for royalties paid. However, if royalty payments to a foreigner triggers withholdings tax of at least 10%, the licensee is allowed to deduct a third of the royalties for tax.
Accordingly, when licences involve a foreigner or tax exempt person (either directly or indirectly), one must audit the chain of ownership of the intellectual property licensed. Generally, this is easily done by reviewing the register form at the Patent Office, which is available online. However, where transactions are concluded at arm’s length between unrelated parties, one may merely gloss over this section. For example, where a South African conducts R&D on behalf of a foreigner, despite the fact that the resultant intellectual property is exported, this section will likely never be triggered.
Although this provision should limit abusive arrangements to which our tax net may be exposed following expatriation of South African registered intellectual property (e.g. a patent registered in South Africa), it does not deal with avoidance flowing from expatriation of foreign registered intellectual property (e.g. a trademark registered in the US). At present, the only effective tools available to our Regulators to restrict tax arbitrage resulting from expatriation of foreign registered intellectual property are the transfer pricing provisions in our Income Tax Act.