1. Case Introduction

In 2020, Company A in Country X established a wholly-owned holding company B in Luxembourg as the group’s overseas holding platform company, mainly holding subsidiaries in Europe and the Americas. At the same time, through sub-licensing, Luxembourg company B will sublicense the trademark license obtained from domestic company A to US company C and collect corresponding royalties.

When US company C paid royalties to Luxembourg company B, it enjoyed tax exemption under the US-Luxembourg tax treaty. However, in the subsequent tax audit, the US tax authorities believed that company B lacked active business substance, and that domestic company A established company B in Luxembourg for the main purpose of tax avoidance and enjoyed tax exemption under the US-Luxembourg tax treaty through sublicensing. Company C was required to withhold and pay the royalties paid to company B in 2020 and 2021, and pay the under-withheld taxes and corresponding penalties and interests.

After Company B actively stated its views and submitted supporting evidence, the US tax authorities finally ruled that Company B’s 2020 information could not support the determination of its business substance and that it should pay additional taxes and interest; the 2021 information could more clearly reflect its business substance and corresponding functional risks and no additional taxes were required.

2. Focus of the Dispute

Tax dispute between the US tax authorities and Company B:

(I) Determination of whether an enterprise has commercial substance

Company B’s view: As the overseas intangible asset management center of the group, Company B has sufficient positive commercial substance and is a Luxembourg resident company. The main reasons are as follows:

1. The assets, income and wages and salaries related to the royalties generated by Company B account for more than 7.5% of Company B’s total assets, total income and total wages and salaries, and the average of the three indicators has reached 10%. According to Article 24 of the U.S.-Luxembourg Tax Agreement, Company B can prove through the “limitation on benefits” (LOB) test that the royalties it obtains from Company C are derived from active business activities and are substantially related to the source income obtained from the corresponding equity share of activities in the United States.

2. Company B has been equipped with a number of personnel with experience in trademark management, and they are stationed in the office of Company B in Luxembourg. Although the development of the trademark mainly comes from Company A in Country X, the employees of Company B and its external third-party service providers have played an important role in the overseas value enhancement (such as advertising), maintenance, protection (such as infringement protection) and utilization (such as organization authorization) of the trademark.

The US tax authorities’ view: Company B has a small number of employees engaged in intangible asset management and lacks active business substance. It is preliminarily determined that Company B is a conduit company established for the purpose of tax avoidance.

(II) Whether the enterprise has the problem of tax avoidance through cooperation

Company B’s view: Company B’s actual management and operations are carried out in Luxembourg, and the fees for trademark sub-licensing comply with the arm’s length principle, so there is no tax shopping.

The US tax authorities’ view: If US company C directly pays royalties to company A, the corresponding withholding tax rate is 10% according to the US-X tax treaty; however, the above-mentioned sublicensing arrangement reduces the withholding tax rate of the royalties to 0%. Company B is suspected of tax shopping and should not enjoy tax treaty treatment.

3. Final Decision

After communication between the two parties, Company B combined its own views and submitted a large amount of supporting documents to the U.S. tax authorities through an intermediary agency, including Company B’s financial statements for the relevant years, board resolutions, personnel organizational structure, LOB testing working papers, transfer pricing reports, contracts and resumes of trademark management personnel, contracts for purchasing third-party and trademark maintenance-related services, office leasing contracts, and sample emails related to daily operations.

The U.S. tax authorities finally ruled: Given that the first member of Company B’s 2020 trademark management team only joined Company B in November 2020 and there was no internal transfer pricing analysis documentation, the U.S. tax authorities determined that Company B’s 2020 royalties could not enjoy the tax-free treatment under the U.S.-Luxembourg Tax Agreement. Company B was identified as a conduit company and was subject to the 10% income tax rate of the U.S.-Country X Tax Agreement, involving an amount of approximately RMB 4.5 million in back taxes and interest.

Regarding the royalties for 2021, since the materials provided by Company B were relatively complete and could clearly reflect the essence of its business and the corresponding functional risks, the US tax authorities did not require Company B to pay additional taxes for 2021.

Company B decided to obey the ruling and not appeal.

4. Implications for “Going Global” Enterprises

(I) Pay attention to the special conditions of the tax treaty of the investment destination country. At present, quite a number of countries (regions) have not explicitly stipulated the specific standards for commercial substance, but require taxpayers who intend to enjoy tax benefits to have appropriate commercial or economic substance in combination with the provisions of general anti-tax avoidance provisions and anti-abuse agreements. The United States has introduced the limitation of benefits clause in most of the tax treaties it has signed, and its purpose is to conduct additional commercial operation substance tests on the applicable agreements in addition to the resident status stipulated in Article 4. Therefore, it is necessary to focus on the special conditions or restrictive clauses of the investment destination country for enjoying tax treaties to prevent possible tax risks.

(II) Actively establish commercial substance related to production and operation. Some countries (regions) use the main purpose test as a fallback clause in determining treaty treatment, giving the host country tax authorities more discretion. The test requires whether the establishment and operation of the enterprise have reasonable business purposes, especially non-tax motivations, and whether the configuration of personnel, assets and corresponding benefits and risks associated with the transaction match. For example: only 1-2 small employees, employees with insufficient qualifications, employees’ salaries do not match their responsibilities, and lack of equipment and software to assist decision-making, etc., may affect the determination of commercial or economic substance.

(III) Legally make advance plans and preserve evidence for business operations. In this case, when responding to inquiries from the tax authorities, sufficient evidence documents played a very important role in helping Company B prove its commercial substance and avoid paying back taxes for 2021. Before going to overseas investment destinations for development, “going out” companies should conduct sufficient due diligence, understand the various types of declarations and supporting evidence required by the tax authorities of the investment destination, and plan in advance for personnel, assets, and risk prevention in combination with their own functional positioning; during operations, relevant documents should be properly retained to form a strong chain of evidence.