Q: We license virtual component (synthesizable electronic design) technology to companies in Japan and other foreign countries. The license agreements include a license fee, maintenance fee, and royalties when the products that are developed using this technology are put into production. The governments try to withhold 20 percent of the value of the license transaction (because it is considered software). If you sign an exemption certificate they ‘only’ withhold 10 percent. Supposedly, this certificate can be used to offset taxes in the United States (provided you meet certain criteria and have profits that can be used as an offset).
Are there any ways to eliminate this withholding against the revenue that is the license fee portion? (I realize that the royalty payments are a different discussion.)
Although most countries consider one-time license fees for software to be “sales” income, some, such as Japan and Korea, treat them as “royalties.” Japan subjects royalties to a 20 percent withholding tax, but reduces this rate to 10 percent for certified U.S. residents, in accordance with the U.S.-Japan Income Tax Treaty.
Usually, foreign taxes are creditable for U.S. taxpayers if 9a0 the Internal Revenue Service agrees that theses are “income taxes,” and not, for example, “voluntary payments” to a foreign country; and (b) the U.S. taxpayer actually pays U.S. taxes against which to use these foreign taxes to offset the U.S. tax on the same foreign-sourced income, among other requirements.
Unfortunately, the IRS has denied foreign tax credits for Japanese withholding taxes on up-front, one-time “license fees” for software,” because it believes that such tax should not have been paid on this “sales” income. (In addition, it is very common for software companies to have negative U.S. taxable income, due to research, stock options, and other expenses.) However, for annual license fees, the IRS respects Japan’s “royalty” characterization. There is no simple answer as to how to “avoid” Japanese royalty treatment for one-time license fees.
Principal, Ernst & Young LLP
See previous “Ask the Experts” columns:
Ask the Experts is a weekly column that aims to help finance executives like you find answers to difficult questions.
Submit your questions by E-mailing them to [email protected]. Unfortunately, we cannot answer all questions individually.
While we will enlist professionals to try to answer your questions, Ask the Experts is meant only to create a dialogue on the topics. Consult legal or financial professionals before acting on any of the advice given by our expert panel.