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Substance over form: embed royalties to be taxed

Before the High Court ruling on the SCHWEPPES INTERNACIONAL LTD case, it was pretty clear how worked the tax on royalties in Spain . Under the Spanish domestic legislation, Spain applies a 19 % withholding tax on royalties paid to foreign recipients. This Withholding Tax (“WT”) may be reduced by the relevant tax treaty applicable or when the recipient is  other company of the same group. Now the Tax Office says that the withholding tax may also be levied on embed royalties. An embed royalty is one which is not declared explicitly as a royalty, but is disguised into the price of the goods bought by a Spanish company

See the list of the Tax Treaties signed by Spain

The victim of this new approach is other big name, SCHWEPPES INTERNACIONAL LTD (“SIL”, hereinafter), with residence in the Netherlands. This company was the owner or licensee of a bunch of well-known brands of carbonated and soft beverages like tonic water, Trina, La Casera and many others. SIL had a fully owned subsidiary in Spain called SCHWEPPES S.A. (“SSA”) which produced, bottled and sold in the Spanish market carbonated and soft drinks under the brands of SIL.

It is important to remark that in the date of the facts, the Royalties Directive had not yet been implemented in Spain. Therefore, the legal framework applicable was the Tax Treaty signed between The Netherlands and Spain.  According to article 12 of the Tax Treaty, royalties paid by a Spanish company to a foreign company were subject to a withholding tax of 6 %.

SIL and SSA had an agreement under which SSA produced and sold the beverages branded by SIL paying to the latter a variable royalty (10 % – 2, 68 %) depending on the type of product. So far so good.  However, for other products SSA just bought from SIL the extracts and chemical vegetal row ingredients needed to produce the beverages. On these products, SSA did not pay any royalty to SIL, since the price agreed was supposed to cover all the cost incurred by the supplier, SIL.

It is important to remark a few facts that were deemed relevant by the Tax Office and later by the Tax Court that upheld the Tax Office assessment. First, SIL did not produce the extracts and ingredients sold to SSA itself, but hired a third-party contractor to do so. As a matter of fact, SIL was a pure IP company with no industrial activity whatsoever. The gross margin earned by SIL on these sales was well above the normal commercial gross margin, according to the Tax Office officials. When SCHWEPPES was inquired by the officers why she paid royalties on certain products and not in others, it failed to produce a satisfactory answer. It insisted in that the price paid to its parent company covered everything.

In view of all these circumstances the Tax Office held, and the Court later confirmed, that the selling price from SIL to SSA had an embed royalty that should had been taxed according to the Tax Treaty between Spain and Netherlands. Note that since this “royalty” had been disguised as part of the price, Spain could not have taxed the income earned in these transactions (business income) if the transaction had not been re-characterized.

The Court mentions that in virtue of the principle of substance over form the Tax Office was entitled to disregard the actual transaction performed and breakdown the price into “deemed royalty “and off-royalty price.  And then to apply to each of these items the relevant tax treatment.

Finally, the Court Judgement (Audiencia Nacional, sentence 477/2016) also reviews other very interesting topics raised in this dispute between SCHWEPPES and the Spanish Tax Office, but these would be treated in future post.