Package deals and the use of intangible assets: the uncertain characterization of embedded royalties
The growing importance of intangible assets as key drivers of value creation within multinational enterprises has led to an increasing use of complex contractual arrangements in which the supply of goods or services may implicitly include the right to use intellectual property. This raises significant issues concerning the characterization of cross-border payments, particularly whether part of a single consideration may be treated as an embedded royalty, with direct implications for withholding tax on payments to non-residents.
Package deals and the issue of embedded royalties
Multinational groups frequently enter into so-called package deals, whereby several economically integrated supplies are governed by a single agreement providing for an aggregate consideration. These arrangements may combine the supply of goods or services with the right to use patents, trademarks, know-how or other intangible assets.
Although the transaction may appear as a single economic arrangement from a contractual perspective, its various components may be subject to different tax regimes. The key issue is therefore whether the consideration should be treated as a whole or whether it may be allocated among its underlying components for tax purposes.
The issue is particularly relevant in intra-group transactions, where the consideration paid by the purchasing entity may partly remunerate the use of intangible assets owned by a foreign group company. The identification of such an embedded royalty through transfer pricing methods may affect not only the arm’s-length pricing of the transaction, but also the characterization of the income and, consequently, the application of withholding tax.
Italian tax law contains no specific rules governing embedded royalties or expressly providing for the allocation of a lump-sum consideration between royalties and other payments. Any such characterization must therefore be based on the general rules governing royalties paid to non-residents.
Under Article 25(4) of Presidential Decree No. 600/1973, withholding tax applies to payments made to non-residents for the use or right to use intellectual property, industrial patents, trademarks and other intangible assets. This domestic regime must be considered in conjunction with EU and treaty provisions that may restrict or eliminate Italian taxing rights. In particular, the EU Interest and Royalties Directive, as implemented in Italy by Article 26-quater of Presidential Decree No. 600/1973, may provide an exemption for qualifying payments between associated companies. Therefore, double tax treaties may likewise limit source-state taxation, generally by reference to Article 12 of the OECD Model Tax Convention.
Italian case law: the need to establish an actual royalty payment
Italian tax case law has taken different approaches to embedded royalties, but a common theme is the need to establish that the consideration actually remunerates the exploitation of intangible assets.
A significant case is judgment No. 2771/2019 of the Lombardy Regional Tax Commision, concerning an Italian company purchasing semi-finished products from a foreign group company while using, free of charge, the trademark of the US parent company.
The Italian tax authorities argued that the free use of the trademark lacked economic justification and that part of the purchase price effectively represented consideration for the use of the trademark and related know-how.
The Court upheld this position, looking beyond the contractual form and focusing on the economic substance of the arrangement. It considered the agreement closer to a franchise than to a standard distribution agreement, since the Italian company benefited not only from the supply of products but also from the trademark and know-how of the parent company. Accordingly, a portion of the consideration was recharacterized as an embedded royalty, despite the absence of an express royalty clause.
A different approach was adopted in judgment No. 7134/2017 of the Milan Provincial Tax Commision. In that case, the Italian tax authorities argued that an Italian permanent establishment should have withheld tax on part of a payment made to its Swiss head office, on the basis that the payment implicitly included a royalty for the use of a trademark owned by the group.
The Court rejected the assessment, finding that the relationship was consistent with an ordinary distribution agreement and that the recipient of the payment was not the owner of the trademark. The Court also stressed that the tax authorities bear the burden of proving the existence of income properly characterized as a royalty; mere presumptions are insufficient.
The case is particularly relevant to the relationship between transfer pricing rules and withholding tax. The tax authorities had relied on the 2010 OECD Transfer Pricing Guidelines, which contemplated the possibility of allocating part of a lump-sum consideration to the use of intangible assets. The 2017 revision, however, clarified that transfer pricing principles cannot automatically be used to characterize a payment as a royalty for treaty purposes, nor can they, by themselves, constitute a sufficient basis for the imposition of withholding tax.
Limits to the taxation of embedded royalties
The absence of specific legislation represents a obstacle to the taxation of embedded royalties in Italy. Italian tax law does not expressly authorize the allocation of a lump-sum consideration to identify an embedded royalty, and the general anti-abuse rule under Article 10-bis of Law No. 212/2000 does not appear to provide an adequate legal basis for such a recharacterization.
A further issue concerns the requirement of an actual payment for withholding tax purposes. Both Article 25 of Presidential Decree No. 600/1973 and the OECD Model generally contemplate an actual payment as a prerequisite for source-state taxation.
The mere presence of intangible assets within a complex transaction should therefore not justify the recharacterization of part of the consideration as a royalty or the subsequent assessment of withholding tax. Such a recharacterization requires evidence of an actual right to exploit the relevant intangible asset and of a specific portion of the consideration being attributable to that right.
Against this background, specific legislative guidance would be desirable, setting out clear rules for allocating lump-sum consideration and identifying, where appropriate, components that may qualify as embedded royalties.