BECHTEL SAYS TO DISTINGUISH BETWEEN ROYALTY INCOME AND SERVICE INCOME.

SUMMARY: M.E. Lawson of Bechtel Corp., San Francisco, Calif., has urged that any tax treaty with Taiwan distinguish between true royalties for the use of patented or copyrighted property or processes and business income from unique services, such as engineering-related services, technical assistance, and consulting services. These latter fees, says Lawson, should be classified as business income or personal services income.

The following comments and suggestions are submitted with respect to the proposed tax treaty negotiations with the Government of the Republic of China (Taiwan).

Bechtel Group, Inc. and its affiliates are engaged in the engineering and construction industry in the United States and in numerous foreign countries. We are particularly concerned with the taxation of income from engineering, construction, procurement, and construction management activities performed both inside and outside Taiwan for Taiwanese clients.

ISSUE

We would urge that any tax treaty with Taiwan clearly distinguish between true royalties for the use of patented or copyrighted property or processes, and business income from unique services provided to a single client. Fees for services, such as engineering-related services, technical assistance, consulting services, etc. performed for only one client should be classified in the treaty as "business income," or as "personal services income."

BACKGROUND

In the absence of a tax treaty with Taiwan, the definition of what constitutes "royalty" payments under Taiwanese tax law has become an issue of great concern to nonresident technical consultants, including U.S. engineering firms.

Until about two years ago, the Ministry of Finance of Taiwan would routinely approve a special "deemed profits tax" treatment, pursuant to Article 25 of the Taiwan Income Tax Law, of payments received by technical consultants for services performed for a project in Taiwan. Under such treatment, 15% of the gross amount of a payment for the provision of technical services would be deemed to be taxable profit, and the corporate income tax rate of 25% would be applied to such deemed profit amount. The resulting tax rate on gross payments to nonresident consultants was 3.75% (15% x 25%), which would be withheld at the source of payment.

Since 1988, however, the Ministry of Finance frequently has denied applications for the "deemed profits tax" treatment from nonresident consultants on the grounds that gross payments for such services are "royalty" payments, to which a 20% royalty withholding tax rate is applied. The position of the Taiwan Ministry of Finance is stated in the attached memorandum entitled "Taxation on Consulting Fees for Foreign Company" [sic.].

Typically, the profit on consulting services ranges between 5% and 15% of the contract price. If a 20% royalty withholding tax is applied to gross payments from Taiwanese clients, consultants will suffer a net economic loss on each contract.

For example, if a consulting contract for specified technical assistance provides for payment of $10,000, and if the technical consultant's costs are $8,500, (expended on items such as employee salaries, travel expenses, research materials, permits, computer usage fees, printing costs, etc.), the consultant would show a profit of 15%, or $1,500. However, if a 20% withholding tax is applied to the $10,000 payment, the consultant would receive only $8,000, or $500 less than the costs incurred in performing the services.

THE DEFINITION OF "ROYALTIES"

"Royalties" are generally payments for the right to use property where other persons also may obtain the right to use the same property (e.g., a patent for a refining process that could be licensed and used by every refinery in the petroleum industry).

The concept of "royalties" generally does not include payments for the performance of services under a contract with a client where such services cannot be used by any other person (e.g., engineering services to design a factory to be built on a particular site).

On page 2 of the attached Ministry of Finance memorandum, it is implied that in "model tax treaties published by the United Nations and the organization for Economic Cooperation and Development . . . consulting fees are included in the scope of royalties for taxation purposes."

On the contrary, the Commentaries on the 1979 OECD Model Income Tax Treaty draw numerous distinctions between royalty income and fees for services. For example, the OECD Commentary on Article 12, Concerning the Taxation of Royalties, at Paragraph 12, states:

"In the know-how contract, one of the parties agrees to impart to the other, so that he can use them for him own account, his special knowledge and experience which remain unrevealed to the public. It is recognized that the grantor is not required to play any part himself in the application of the formulae granted to the licensee and that he does not guarantee the result thereof. THIS TYPE OF CONTRACT THUS DIFFERS FROM CONTRACTS FOR THE PROVISION OF SERVICES, in which one of the parties undertakes to use the customary skills of his calling to execute work himself for the other party. Thus, payment obtained as consideration for after-sales service, for services rendered by a seller to a purchaser under a guarantee, for pure TECHNICAL ASSISTANCE, or for AN OPINION GIVEN BY AN ENGINEER, an advocate or an accountant, DO NOT CONSTITUTE ROYALTIES within the meaning of paragraph 2" (which defines "royalties" under the model treaty]. ¹

Similarly, in the Observations with respect to Guideline 12, Royalties, of the 1979 U.N. Guidelines and Model Income Tax Treaty, it is stated:

The Group also considered a problem involving the broad definition of royalties. A member from a developed country explained that in his view the problem was that the [OECD Model Treaty] definition made an imperfect distinction between revenues that constituted royalties in the strict sense and payments received for brain-work and TECHNICAL SERVICES, such an surveys of any kind (ENGINEERING, geological research etc.). The member also mentioned the problem of distinguishing between royalties akin to income from capital and PAYMENTS RECEIVED FOR SERVICES. * * * On other hand, a member from a developing country pointed out . . . if the definition of royalties was left unchanged in the OECD Model Convention, he understood that brain-work and technical services would be covered by the expression "information concerning industrial, commercial and technical experience," and as such would be included in the definition of royalties.

In order to solve the problem of the definition of royalties the Group agreed to consider income from such activities as BUSINESS PROFITS and to include in guideline 5, paragraph 3 a new subparagraph (b) which provides that the term permanent establishment should likewise encompass "the furnishing of services, INCLUDING CONSULTANCY SERVICES, by an enterprise through employees or other personnel, where activities of that nature continue (for the same or a connected project) within the country for a period or periods aggregating more than six months within any twelve-month period." ²

TAX POLICY CONSIDERATIONS

As a general principle, income tax should be applied only to net income, thus permitting the deduction of allowable expenses from gross revenue. In modern trading economies, it is universally regarded as inequitable and inefficient to tax gross sales proceeds before the costs of producing goods and services are recovered.

An exception to this principle in the case of royalty payments to a foreign owner for the USE of property is somewhat justifiable because the costs of development of the underlying property in a true royalty agreement may be recovered many times over through licensing to multiple parties in many different countries. National income tax agencies generally lack the authority to audit worldwide accounting records of nonresident royalty owners in order to determine the exact portion of a royalty payment that represents net income. Thus, the practice of applying withholding tax at relatively high rates to gross royalty payments is a practical method of extracting some local tax revenue from worldwide activities that are presumed to be highly profitable over the duration of a patent, copyright, etc.

However, royalty treatment for tax purposes is appropriate only where multiple parties are able to obtain licenses to use the same intellectual property, and where more than 100% of the costs of producing such property can be recovered through such licensing.

In contrast, the services provided to a client by an engineering or other technical consulting firm are entirely different from a license for the use of property, both conceptually and economically. Typically, expert consultants are hired to solve a particular problem, or to design a particular thing, or to train a client's employees to perform a certain procedure. The client does not simply USE the consultant's information, the client OWNS it. No other client can use the information, and the consulting firm cannot recover the costs of developing the information from anyone except the client who contracted for it.

Very truly yours,

TAXATION ON CONSULTING FEES FOR FOREIGN COMPANY

According to the Republic of China's Income Tax Law (ITL), all foreign corporations having Republic of China (ROC) source income are subject to ROC income tax (paragraph 3, article 3 of ITL). ROC source income consists of eleven categories of income (article 8 of ITL), in which there is a category broadly named royalties (category 6, article 8 of ITL).

When a foreign corporation without permanent establishment in ROC has ROC source income, its income tax should be withheld (subparagraph 2, paragraph 1, article 88 of ITL) by the appropriate persons of the paying entities (subparagraph 2, paragraph 1, article 89 of ITL). All withholding rates for all kinds of income of which the income tax should be withheld are stipulated by the Standard of Withholding Rates for Various Income (SWRVI). The withholding rate for royalties of said foreign corporation is 20% (subparagraph 6, paragraph 1, article 3 of SWRVI).

As regards the scope of royalties, ITL defines it as any forms of payments for providing patents, trademarks, copyrights, know-how and all kinds of special rights (subparagraph 6, article 8 of ITL). Based on this definition, and the meaning or currently existing effective tax treaties, model tax treaties published by the United Nations and the Organization for Economic Cooperation and Development, and so on, consulting fees are included in the scope of royalties for taxation purposes.

Some foreign consulting corporations, due to the lack of understanding about the meaning of royalties, apply to the Taxation Department of this Ministry for the approval of paragraph 1, article 25 of ITL to determine tax amount withheld, that is, 15% of business revenue being regarded as income, and the tax on this income being withheld at a rate of 25% (article 4 of SWRVI) by appropriate entities (subparagraph 2, and 3, article 89-1 of ITL). Since consulting fees are considered within the scope of royalties as illustrated in the foregoing paragraph and also for the considerations such as tax fairness, international tax environment, as well as tax source control, these applications are not eligible for article 25 of ITL, Therefore, all the consulting fees have to be withheld by the rate of 20% for those without permanent establishment in ROC.

² Id., section 91.12, at pp. 91-56, 91-57 (underlining added for emphasis).