Corporate income tax, withheld at the source of payment on a non-resident's income in the form of royalties, is raising more and more questions among tax authorities due to the emergence of mixed types of civil law contracts on the Kazakhstan market. In business practice, there are contracts that cover both know-how and the provision of technical assistance. One example of such agreements is a franchise agreement, when the franchisor shares his knowledge and experience with the franchisee and, in addition, provides him with various technical assistance, which in certain cases is supported by financial assistance and supplies of goods/software. As you can see, the agreement covers several types of services and, accordingly, the parties encounter difficulties when interpreting them for tax purposes. In many sources, judicial and authorized bodies agree that software services (maintenance, updating, etc.) has signs of “know-how” and shall be recognized as royalties.
In this case, Model Convention on Taxes on Income and Capital (hereinafter – Model Convention) of Organization for Economic Cooperation and Development (hereinafter - OECD) with the latest update, adopted in 2017, contains a more extensive explanation with examples. The Republic of Kazakhstan joined the OECD Country Cooperation Program in accordance with the agreement signed in January 2015 in Davos by the Prime Minister of the Republic of Kazakhstan and the Secretary General of the OECD. Such cooperation is intended for non-member countries to adopt the experience and standards of the OECD, and the Tax Authority of the Republic of Kazakhstan should follow the comments of the Model Convention when applying and interpreting the provisions of its bilateral tax conventions based on the Model Convention.
The Convention on Avoidance of Double Taxation and Prevention of Tax Evasion in Respect of Taxes on Income and Capital (hereinafter referred to as the “Convention”) provides the following definition of royalty:
The term “royalties” as used in this article means payments of any kind received as a consideration for the use or grant of the right to use any copyright in literary, artistic or scientific works, including cinematographic films, or films or magnetic recordings used for radio or broadcasts, and software, any patent, trade mark, design or model, plan, secret formula or process, or use or grant of the right to use industrial, commercial or scientific equipment, or information relating to industrial, commercial or scientific experience.
The comments to article 12 on the taxation of royalties of the Model Convention state the following:
When classifying payments received as remuneration for information related to industrial, commercial or scientific experience, paragraph 2 refers to the concept of "know-how". Various specialized bodies and authors have formulated definitions of know-how. The words “payments ... for information relating to industrial, commercial or scientific experience” are used in the context of the transfer of certain information that has not been patented and usually does not fall under other categories of intellectual property rights. As a rule, this is undisclosed information of an industrial, commercial or scientific nature, obtained from previous experience, which has practical application in the company's activities and the disclosure of which can bring economic benefits. Since the definition refers to information related to previous experience, the Article does not apply to payments for new information obtained as a result of the provision of services at the request of the payer.
Within the framework of the know-how transfer agreement, one of the parties agrees to transfer to the other party its special knowledge and experience, which are not disclosed to the public, so that it can use them to its advantage. It is recognized that the grantor is not obliged to play any role in the application of the formulas provided to the licensee, and that it does not guarantee the result.
Thus, this type of contract differs from service contracts in which one of the parties undertakes to use their usual professional skills to independently perform work for the benefit of the other party. Payments made under recent contracts are usually covered by Article 7.
The following article of Convention indicates another type of service other than royalty:
1. The profits of an enterprise of one Contracting State are taxable only in that Contracting State, unless the enterprise carries on business in the other Contracting State through a permanent establishment located there. If an enterprise carries on business activities as mentioned above, the profits of the enterprise may be taxed in the other Contracting State, but only in the part that relates to such a permanent establishment.
In this regard, the following explanations are given in the comments to article 12 on the taxation of royalties of the Model Convention:
The need to distinguish between these two types of payments, i.e. payments for the provision of know-how and payments for the provision of services sometimes creates practical difficulties. Examples of payments, which in this regard should be considered as received as compensation not for the provision of know-how, but for the provision of services, include:
- payments received as compensation for after-sales service,
- payment for purely technical assistance,
- payment for advice provided electronically, for electronic communication with technical specialists or for access via computer networks to a troubleshooting database, for example, a database that provides non-confidential information to software users in response to frequently asked questions or frequently occurring problems of a general nature.
In general, the Model Convention is a universal document and when questions arise regarding the application of the Convention, it has proved to be a means for taxpayers to avoid violations of tax legislation, and also makes the work of tax authorities more effective when working with taxpayers, who can easily understand the presentation of the Model Convention supported by examples from many countries. When studying mixed royalty agreements, you should take into account the features contained in the Model Convention and distinguish between the types of services. If necessary, the total amount payable under the contract should be divided based on the information contained in the contract or through a reasonable allocation applying the appropriate tax regime to each allocated portion.
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