Indicator deep dive: ‘Royalties’ and ‘Services’

We recently published the latest update to the Tax Justice Network’s Corporate Tax Haven Index, which is a ranking of the countries most complicit in helping multinational corporations underpay tax. 

The index ranks countries by evaluating how much wiggle room for corporate tax abuse their laws provide and by monitoring how much financial activity conducted by multinational corporations enters and exits the countries. Laws are evaluated against 18 indicators. 

In this blog, we’ll do a deep dive on two of those indicators – the one on Royalties and the one on Services – and the key findings revealed by each. 

Why limit royalty and service fee deductions?

The strategic use of intellectual property (IP) rights is one of the main tax avoidance tactics used by multinational corporations to lower their tax bills. Intellectual property refers to patents, copyrights and trademarks that protect the enterprises’ production processes and brand. Especially in the digitalised economy, intellectual property rights on digital applications are often a company’s most valuable assets.

However, intellectual property assets are both difficult to value and intangible. This makes it easy for a multinational corporation to shift the ownership of its intellectual property assets from one company within its corporate group to another. And often, this means we end up seeing multinational corporations shifting ownership of their intellectual property to their companies in corporate tax havens. These companies then charge royalties to the rest of the companies that make up the multinational corporation’s corporate group for the use of the intellectual property (like its brand name, production processes or digital applications). These companies are the ones located and generating revenue from selling goods and services outside of tax havens.

By paying the royalties payments to the parts of the corporate group based in tax havens, these companies outside of tax havens pay the profits they make out of the countries where they are operating and into tax havens. Royalties payments are usually fully deductible and, as such, high-taxed profits from the external sales are turned into low-taxed royalties income showing up with the IP holding company. By selecting a low-tax jurisdiction with adequate tax treaties in place, the high-tax jurisdiction will also not levy withholding tax on the royalty payments. The result is profit being shifted into corporate tax havens and going untaxed.

In a study published in October 2023, Lejour and van ‘t Riet estimate that at least 18% of cross-border royalty payments between companies is motivated by tax evasion. The authors also point out that in 2018, payments between Ireland and the Netherlands, and between the Netherlands and Bermuda amounted to US$25 billion, the largest bilateral royalty flows between countries ever recorded. This extraordinary statistic is caused by the fact that intra-group royalty payments are a crucial ingredient of the infamous double Irish-Dutch sandwich, a tax planning scheme used by the likes of Google, Amazon and Apple to syphon profits from the multinationals’ activities in Africa and in Europe in a ‘tax-friendly’ way to Bermuda where these profits are completely left untaxed. Quite tellingly, the countries facilitating the sandwich rank high on the recently updated Corporate Tax Haven Index with Ireland in 9th place, the Netherlands in 7th and Bermuda in 3rd.

Deductions for intra-group payments for services cause similar issues of tax avoidance through base erosion. By the strategic use of intra-group services contracts, group companies in low-tax jurisdictions can be lined up to provide high-value managerial, consultancy or technical services group companies in high-tax jurisdictions. The digitalisation of the economy, and the ability to provide services remotely, makes this tax abuse technique even more easy to implement.

What do the indicators do? 

The indicators on Royalties and on Services measure to what extent countries have adopted rules to limit the deduction of intra-group payments of royalties and services. In principle, expenses incurred by a company for the purpose of its business are fully deductible against its profits.

Various policy options exist to limit excessive deductions of intra-group payments of royalties and services fees.

• One option is to design a cost deduction limitation that disallows deduction if the related income in the hands of the recipient is taxed at a rate less than a certain percentage or less than a certain percentage of the country’s tax rate.
• A second option is to include a deduction limitation that limits the amount of intra-group royalty and service fee payments that can be deducted to a percentage of turn-over, taxable income or assets.
• A third option is to partially disallow deduction in function of the tax that can be withheld on the outbound payment.
• A final option is to introduce a deduction limitation in the form of a minimum tax on outbound base eroding services and royalty payments to prevent full erosion of the local tax base by means of service and royalty payment deductions to foreign group companies.

What do the indicators’ latest results reveal? 

Analysis of country tax rule developments since 2021 shows that while certain countries have abandoned their previous policies to limit deduction, comparatively more countries have decided to start imposing deduction limitation in some way or another. On aggregate, this means deduction restrictions for intra-group services and royalties have become more common, which is a good development.

Brazil is one of the few countries that has backtracked on its fixed deduction limitation rules. As part of the country’s recent alignment with the OECD Transfer Pricing Guidelines, Brazil has abolished its longstanding royalty deduction limit of 5% of the gross revenue derived from sales that relied on the IP for which the royalties were paid. It is believed that pricing royalty transactions in line with the OECD’s arm’s length principle makes deduction limits redundant. This is an unfortunate development. It is not because isolated transactions are priced right that the overall arrangement in which they figure is artificial and amounts to tax avoidance. As confirmed by the European Court of Justice in a recent decision in October 2024: the arm’s length principle is not a safe harbour against tax avoidance. As a consequence of this, Brazil loses some of its previous good marks on the Index’s anti-abuse indicators.

On the upswing, our research shows that in recent years, many EU countries which have started to adopt deduction limitations for intra-group royalty and service fee payments. Unfortunately, these rules have limited scope and are framed as defensive measures ‘defensive measures’ which only restrict the deductibility of payments to group companies in countries that are on the ‘EU list of non-cooperative jurisdictions’ (currently practiced by Denmark and Germany) or on the country’s own list (currently practiced by Greece, Spain and Portugal). In some countries, the taxpayer has the ability to disproof the implied lack of economic substance that underlies a country’s inclusion on the blacklist (e.g. Belgium, Italy, Spain).

In our recent submission to the EU Commission’s public consultation on the revision of the EU’s Anti-Tax Avoidance Directive (ATAD) we point out that using a ‘tax haven blacklist’ to determine the scope of deduction limitations is both ineffective and inappropriate. Not only does the EU’s list target almost exclusively developing countries in the Global South, the listing criteria are conveniently shaped to ignore certain EU countries’ own roles in global corporate tax abuse. This is again made clear in our recent Index which ranks three EU countries among the top ten enablers of global corporate tax abuse.

Despite the flaws of using blacklists, the recent adoption of these rules clearly shows that EU countries find it a sensible policy to restrict deduction of intra-group royalty and service fee deduction in some form. In our ATAD submission, we accordingly suggest that harmonised non-deduction rules should be included in an updated ATAD. Such harmonised rules should apply to all intra-group service fee and royalty payments, regardless of the country of the recipient, and should be based on objective limitation criteria like related revenue or the levying of withholding tax.

Finally, in light of the fact that more countries are adopting deduction limitation rules but at the same time the rules they are adopting are often far from ideal, we have decided to slightly tighten our scoring methodology for these two indicators. Previously, countries were scored in a binary fashion: a country either has certain limitations (good score) or does not (bad score). Now, the quality of the limitations is also considered, not just their presence. A country receives the best score if it fully disallows the deduction of intra-group service fee and royalty payments. If a country has adopted deduction limitations that come with certain restrictions (like a scope limited to blacklisted countries or a substance carve-out) a medium score is granted. And if country doesn’t have any limitations, it gets the worst score.

Currently, no country fully prohibits the deduction of intra-group payments of royalties or services fees. We are also aware it’s unlikely that a country will ever adopt such a policy as long as the separate entity approach and the arm’s length principle underly the international allocation of the corporate tax base. Full abolishment of intra-group payment deductions would be concomitant to a general move to a system of unitary taxation with formulary apportionment.¹Unitary taxation requires a multinational corporation’s profits to be divided up across the countries where it does business, so that each can tax their fair share. The fair share is allocated base on a formula that relies on objective factors like assets, employees and sales made by the multinational corporation in the individual countries in which it is active. Unitary taxation makes tax havens redundant since multinational corporations don’t do real business in tax havens. Learn more. If the overall profits of a multinational are apportioned to group companies in function of their share of assets, labour and sales used to make such profits, there is no need to assess the tax consequences of intra-group service and royalty payments. This does not mean that a group company’s intra-group services will not be rewarded with taxable profits. It will, but only if these services reflect the genuine use of assets and labour, and not merely because the terms of an intra-group company agreement say they do. As such, only a corporate tax system based on unitary taxation with formulary apportionment, fully eliminates the risk of corporate tax abuse via services and royalties payments, and so, deserves a perfect score on the Services and Royalties indicators.

Services and Royalties under the UN Framework Convention

Finally, it is good to note that subject matter of these two indicators is also at the heart of upcoming negotiations on a United Nations Framework Convention on International Tax Cooperation. Countries have recently pre-agreed on the terms of reference terms of reference for these negotiations and these terms contain a commitment to a fair allocation of taxing rights on services and to address tax-related illicit financial flows. In the near future, a protocol under the Framework Convention may be negotiated to instate source taxation on outbound payments of royalties and service fees. A protocol on illicit financial flows may introduce measures to curb aggressive transfer pricing strategies that involve base erosion using intangibles and intra-group service agreements.

Besides ridding the world of corporate tax abuse, the adoption of these protocols would also improve countries score under the Services and Royalties indicator of the Corporate Tax Haven Index. Nothing to sneeze at, if we may say so.