Article 12 specifies the taxing — U.S. Income Tax Treaty

source and defines the terms necessary to apply the article.

Paragraph 1

The right of a beneficial owner’s country of residence to tax royalties arising in the source country is preserved by paragraph 1, which permits a Contracting State to tax its residents on interest paid to them arising in the other Contracting State. For royalties from any other source paid to a resident, Article 22 (Other Income) grants the residence country exclusive taxing jurisdiction (other than for royalties attributable to a permanent establishment or fixed base in the other State).

Paragraphs 2 and 3

The extent, if any, to which the source State may also tax a royalty payment beneficially owned by a resident of the other Contracting State depends on the nature of the royalty payment. Paragraph 3 provides that the source State may not tax royalties arising in a State for the use of, or right to use, a copyright of literary, artistic or scientific work (excluding royalties for computer software, motion pictures, films, tapes or other means of reproduction used for radio or television broadcasting) that are beneficially owned by a resident of the other Contracting State.

Subparagraph 2(a) provides that the source State may tax royalties for the use of, or the right to use, computer software or industrial, commercial, or scientific equipment that are beneficially owned by a resident of the other Contracting State, but the tax may not exceed 5 percent of the gross amount of the royalty. Subparagraph 2(b) provides that the source State may tax all other royalties beneficially owned by a resident of the other Contracting State at a maximum rate of 8 percent of the gross amount of the royalty.

The benefits of paragraphs 2 and 3 may be granted at the time of payment by means of reduced withholding at source. It also is consistent with the paragraphs for tax to be withheld at the time of payment at full statutory rates, and the treaty benefit to be granted by means of a subsequent refund so long as such procedures are applied in a reasonable manner. See Article 5 of the Protocol, discussed below, regarding Italy’s existing practice for implementing these

benefits

The term "beneficial owner" is not defined in the Convention, and is, therefore, defined as under the internal law of the country imposing tax (i.e., the source country). The beneficial owner of the royalty for purposes of Article 12 is the person to which the royalty income is attributable for tax purposes under the laws of the source State. Thus, if a royalty arising in a Contracting State is received by a nominee or agent that is a resident of the other State on behalf of a person that is not a resident of that other State, the royalty is not entitled to the benefits of this Article. However, a royalty received by a nominee on behalf of a resident of that other State would be entitled to benefits. These limitations are confirmed by paragraph 4 of the OECD Commentaries to Article 12. See also paragraph 24 of the OECD Commentaries to Article 1 (Personal Scope).

Paragraph 4

The term "royalties" as used in Article 12 is defined in paragraph 4 to include payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic or scientific work including computer software, motion pictures, films, tapes or other means of reproduction used for radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial, or scientific experience. As in the prior treaty, but unlike the U.S. Model, rental income from industrial, commercial, or scientific equipment is also considered royalties.

The term royalties is defined in the Convention and therefore is generally independent of domestic law. Certain terms used in the definition are not defined in the Convention, but these may be defined under domestic tax law. For example, the term "secret process or formulas" is found in the Code, and its meaning has been elaborated in the context of sections 351 and 367. See Rev. Rul. 55-17, 1955-1 C.B. 388; Rev. Rul. 64-56, 1964-1 C.B. 133; Rev. Proc. 69-19, 1969-2 C.B. 301.

Consideration for the use or right to use cinematographic films, or works on film, tape, or other means of reproduction in radio or television broadcasting is specifically included in the definition of royalties. It is intended that subsequent technological advances in the field of radio and television broadcasting will not affect the inclusion of payments relating to the use of such means of reproduction in the definition of royalties.

If an artist who is resident in one Contracting State records a performance in the other Contracting State, retains a copyrighted interest in a recording, and receives payments for the right to use the recording based on the sale or public playing of the recording, then the right of such other Contracting State to tax those payments is governed by Article 12. See Boulez v. Commissioner, 83 T.C. 584 (1984), aff'd, 810 F.2d 209 (D.C. Cir. 1986).

Computer software generally is protected by copyright laws around the world. Under the Convention, consideration received for the use, or the right to use, computer software is treated either as royalties or as business profits, depending on the facts and circumstances of the

transaction giving rise to the payment.

The primary factor in determining whether consideration received for the use, or the right to use, computer software is treated as royalties or as business profits, is the nature of the rights transferred. See Treas. Reg. section 1.861-18. The fact that the transaction is characterized as a license for copyright law purposes is not dispositive. For example, as was discussed and understood among the negotiators, a typical retail sale of "shrink wrap" software generally will not be considered to give rise to royalty income, even though for copyright law purposes it may be characterized as a license.

The means by which the computer software is transferred are not relevant for purposes of the analysis. Consequently, if software is electronically transferred but the rights obtained by the transferee are substantially equivalent to rights in a program copy, the payment will be considered business profits.

The United States will also treat as royalties under this Article gains derived from the alienation of any right or property that would give rise to royalties, to the extent the gain is contingent on the productivity, use, or further alienation thereof. Gains that are not so contingent are dealt with under Article 13 (Capital Gains).

The term "industrial, commercial, or scientific experience" (sometimes referred to as "know-how") has the meaning ascribed to it in paragraph 11 of the Commentary to Article 12 of the OECD Model Convention. Consistent with that meaning, the term may include information that is ancillary to a right otherwise giving rise to royalties, such as a patent or secret process.

Know-how also may include, in limited cases, technical information that is conveyed through technical or consultancy services. It does not include general educational training of the user's employees, nor does it include information developed especially for the user, such as a technical plan or design developed according to the user's specifications. Thus, as provided in paragraph 11 of the Commentaries to Article 12 of the OECD Model, the term “royalties” does not include payments received as consideration for after-sales service, for services rendered by a seller to a purchaser under a guarantee, or for pure technical assistance.

The term “royalties” also does not include payments for professional services (such as architectural, engineering, legal, managerial, medical, software development services). For example, income from the design of a refinery by an engineer (even if the engineer employed know-how in the process of rendering the design) or the production of a legal brief by a lawyer is not income from the transfer of know-how taxable under Article 12, but is income from services taxable under either Article 14 (Independent Personal Services) or Article 15 (Dependent Personal Services). Professional services may be embodied in property that gives rise to royalties, however. Thus, if a professional contracts to develop patentable property and retains rights in the resulting property under the development contract, subsequent license payments made for those rights would be royalties.

Paragraph 5

This paragraph provides an exception to the limitations on source State taxation of paragraphs 1, 2, and 3 in cases where the beneficial owner of the royalties carries on business through a permanent establishment in the state of source or performs independent personal services from a fixed base situated in that state and the right or property in respect of which the royalties are paid is effectively connected with that permanent establishment or fixed base. In such cases the State of source will retain the right to impose tax on such royalties. Paragraph 10 of Article 1 of the Protocol clarifies that the provisions of Article 7 (Business Profits) or Article 14 (Independent Personal Services), as the case may be, apply to such royalties.

The provisions of paragraph 6 of Article 7 (Business Profits) apply to this paragraph. For example, royalty income that is attributable to a permanent establishment or a fixed base and that accrues during the existence of the permanent establishment or fixed base, but is received after the permanent establishment or fixed base no longer exists, remains taxable under the provisions of Articles 7 (Business Profits) or 14 (Independent Personal Services), respectively, and not under this Article.

Paragraph 6

Paragraph 6 defines the source of royalties. In general, a royalty is considered to arise in a Contracting State if paid by the government or a resident of that State. However, if a permanent establishment or fixed base of the payer in one of the States incurs the liability to pay the royalties and bears the payment, the royalty is considered to arise in the State where the permanent establishment or fixed base is located. And, notwithstanding those two rules, if a royalty relates to the use of, or the right to use, property in a State, the royalty may be treated as arising in that State. Thus, for example, if an Italian resident were to grant franchise rights to a resident of Mexico for use in the United States, the royalty paid by the Mexican resident to the Italian resident for those rights would be U.S. source income under this Article, subject to U.S. withholding at the 8 percent rate provided in paragraph 2.

The rules of this Article differ from those provided under U.S. domestic law. Under U.S. domestic law, a royalty is considered to be from U.S. sources if it is paid for the use of, or the privilege of using, an intangible within the United States; the residence of the payer is irrelevant. If paid to a nonresident alien individual or other foreign person, a U.S. source royalty is generally subject to withholding tax at a rate of 30 percent under U.S. domestic law. By reason of paragraph 2 of Article 1 (Personal Scope), an Italian resident would be permitted to apply the rules of U.S. domestic law to its royalty income if those rules produced a more favorable result in its case than those of this Article. However, under a basic principle of tax treaty interpretation, the prohibition against so-called "cherry-picking," the Italian resident would be precluded from claiming selected benefits under the Convention (e.g., the tax rates only) and other benefits under U.S. domestic law (e.g., the source rules only) with respect to its royalties. See, e.g., Rev. Rul. 84-17, 1984-1 C.B. 308. For example, if an Italian company granted franchise rights to a resident of the United States for use 50 percent in the United States and 50 percent in Mexico, the Convention would permit the Italian company to treat all of its royalty income from that single transaction as U.S. source income entitled to the withholding tax reduction under paragraph 2. U.S. domestic law would permit the Italian company to treat 50 percent of its royalty income as U.S. source income subject to a 30 percent withholding tax and the other 50 percent as foreign

source income exempt from U.S. tax. The Italian company could choose to apply either the provisions of U.S. domestic law or the provisions of the Convention to the transaction, but would not be permitted to claim both the U.S. domestic law exemption for 50 percent of the income and the Convention's reduced withholding rate for the remainder of the income.

Paragraph 7

Paragraph 7 provides that in cases involving special relationships between the payer and beneficial owner of royalties, Article 12 applies only to the extent the royalties would have been paid absent such special relationships (i.e., an arm’s length royalty). Any excess amount of royalties paid remains taxable according to the laws of the two Contracting States with due regard to the other provisions of the Convention. If, for example, the excess amount is treated as a distribution of corporate profits under domestic law, such excess amount will be taxed as a dividend rather than as royalties, but the tax imposed on the dividend payment will be subject to the rate limitations of paragraph 2 of Article 10 (Dividends).

Paragraph 8

Paragraph 8 provides that the benefits of this Article will be denied in cases in which the main purpose, or one of the main purposes, for the creation or assignment of the rights in respect of which the royalties are paid is to take advantage of this Article. This provision is analogous to paragraph 10 of Article 10 (Dividends), discussed above.

Relation to Other Articles

Notwithstanding the foregoing limitations on source country taxation of royalties, the saving clause of paragraph 2 of Article 1 (Personal Scope) permits the United States to tax its residents and citizens, subject to the special foreign tax credit rules of paragraph 4 of Article 23 (Relief from Double Taxation), as if the Convention had not come into force.

As with other benefits of the Convention, the benefits of Article 12 are available to a resident of the other State only if that resident is entitled to those benefits under Article 2 of the Protocol, regarding limitation on benefits.