Portugal — Software Taxation, Tax Treaties, and the OECD Model

Portugal — Software Taxation, Tax Treaties, and theOECD Modelby Francisco de Sousa da Câmara and Gustavo Lopes CourinhaFrancisco de Sousa da Câmara is a partner with Morais Leitão, Galvão Teles, Soares da Silva &Associados in Lisbon, and Gustavo Lopes Courinha is a senior associate with RPBA & Associados inLisbon.On February 2, 2011, the Administrative SupremeCourt (the highest jurisdiction on tax matters)adopted a decision with significant repercussions notonly for the taxation of software but also for all paymentsmade to nonresidents. The Court in its analysisdistilled various elements in assessing the applicabilityof the rules of the treaty (in this case the 1969Belgium-Portugal treaty), its interaction with theOECD model (its different versions), as well as thevalue of the Portuguese reservations and observations.The Court was requested to review a decision issuedby the Tax Court of Leiria (court of first instance),which upheld the tax authorities’ tax assessment; thecourt of first instance agreed that the periodic (yearly)payments made by a Portuguese corporation for theupdating of a software license granted for internal useonly to a Belgium resident company should be characterizedas remunerating know-how and be subject tocorporate withholding tax as royalties. The dispute betweenthe parties dealt with two issues. First, it wouldbe relevant to determine whether such income can betaxed under domestic tax provisions or not; second,assuming the existence of such right of taxation by thestate of source (Portugal), one would need to verifywhether the Belgium-Portugal income tax treaty hadprevented Portugal from taxing such income. In thecourse of their discussions and analyses, the partiesinvoked the history of tax treaties and the evolutionfrom the OECD model treaty.The Parties’ PositionsThe plaintiff was a Portuguese corporation thatqualified the payment made to the Belgium companyas a mere service fee (software license fee) not subjectto withholding tax, so it paid the fee gross. The taxauthorities did not agree with that view and made atax assessment against the Portuguese corporation becauseit was held responsible for the tax due by a nonresidentwithout a permanent establishment in Portugal.As noted above, the Tax Court of Leiria upheldthe tax authorities’ views and considered that the taxassessment was neither illegal nor jeopardized by theBelgium-Portugal treaty.In its appeal to the Supreme Court, the Portuguesecorporation contended that:• the Tax Court of Leiria did not explain and justifywhich and what type of know-how wasdeemed to have been rendered under the licenseagreement;• the payments for the use of the software licensemade in 1995, 1996, and 1997 remunerated thepossibility to use such software program in theactivity of the plaintiff, namely enabling the latterin designing metallic structures;• the Belgium company did not grant specific knowhowbut merely allowed the Portuguese corporationto apply and use a computer program for internalpurposes;(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.TAX NOTES INTERNATIONAL MAY 16, 2011 • 585

PRACTITIONERS’ CORNER• intellectual property income obtained by nonresidentsin Portugal is subject to tax, but consideringthat software income is not covered by such conceptin accordance with Portuguese law, the proceedspaid for the license agreement are not subjectto tax under domestic tax law;• software is not considered or protected as a literary,artistic, or scientific work under Portugueselaw;• the term and definition of royalties in the 1969Belgium-Portugal tax treaty followed the 1963OECD model and did not cover the remunerationof software;• in 1992 Portugal introduced a reserve in theOECD model to tax as royalties all software incomethat is not derived from a total transfer ofthe rights attached to the software (paragraph 43of the commentary to article 12), but this reservewas only used in the 1999 Portugal-Singaporetreaty; and• for the purposes of this case the reserve introducedin 1992 on the OECD model is absolutelyirrelevant, and does not bind the parties that enteredinto the Belgium-Portugal treaty or the taxpayersbenefiting from the treaty.The tax authority did not present any written allegationsto the Court, but the public prosecutor recommendedupholding the decision adopted by the court offirst instance. According to the Belgium-Portugal treaty,Portugal can tax royalties obtained by a Belgian residentgranting know-how to a Portuguese entity. However,instead of justifying Portuguese taxation underthe specific transfer of know-how as the court of firstinstance argued, the public prosecutor referred to a previousdecision adopted by the Court on March 18,2008, where the value attributed to the 1992 OECDmodel reserve, introduced by Portugal regarding thepossibility to tax software income, was pivotal in decidingthat income paid abroad for the partial transfer ofthe rights attached to the software should be consideredroyalties for treaty purposes and taxed at source inPortugal.Domestic Law and the TreatyThe Court held that the Belgium-Portugal treaty didnot generate a tax claim that does not otherwise existunder Portuguese domestic law, but could restrict orprevent such power. The treaty may relieve from taxsomething that might otherwise be subject to tax.Curiously, the Court avoided deciding the casebased on the domestic rules, namely on whether suchincome was subject to tax under domestic law. TheCourt confirmed that:• Portuguese law does not define royalties;• intellectual property income is subject to tax, providedit is income from a literary, artistic, or scientificwork protected under Portuguese law; and• in 1969, when the Belgium-Portugal treaty wassigned, software was not protected as a literarywork.Moreover, the Court stated that, according to thePortuguese legal system, the treaties entered into byPortugal prevail over the internal rules (with the exceptionof constitutional rules) on a hierarchical basis, asset out by article 8 of the constitution and articles 26and 27 of the Vienna Convention on the Law of Treaties.SummaryThe DecisionThis case allowed the Court to address several importanttopics, some of them for the very first time.The Court also addressed the issues comprehensively innearly 30 pages of discussion and references to severalpapers and authors.The Court considered that it would be inappropriateto decide the case by making a characterization of thelicense agreement as an eventual transfer of know-how,preferring to analyze whether the payment for the softwarelicense should be considered a royalty.Then, considering that such software income onlyremunerated the partial transfer of software for personaluse, the Court considered that the Belgium-Portugal treaty prevented Portugal from taxing the incomepaid to the Belgian entity insofar as such incomecould not be qualified as royalties for the purposes ofarticle 12 of the treaty. The reserve, introduced by Portugalin 1992 on the OECD model to tax software, wasconsidered irrelevant.For the Court, it would be necessary that the othercontracting parties should also have adopted the sameobservation. (See, for instance, paragraph 28 of thecommentary to article 12; Mexico and Spain adopt thesame observation.) Otherwise they should not be consideredbound to the interpretation adopted by Portugal.Even though the taxation of software was not aclear subject under Portuguese domestic law, the Courtdecided to tackle the international level of the discussion— to determine whether the conventional regulationof software taxation would prevent its Portuguesetaxation.In fact, the Court preferred to rule that even if domesticlaw already allowed software income to bequalified as a ‘‘literary, artistic, or scientific work’’ atthe time the payments were made (1995, 1996, and1997), following the analogous protection granted byDecree-Law 252/94 (which is ‘‘very uncertain,’’ asbluntly stated by the Court) the 1969 treaty (which didnot cover the software income in the term ‘‘royalties’’)prevents taxation from occurring in Portugal.To deal with the tax administration’s allegation thatincome derived from software is, as a rule, tantamountto royalties for treaty purposes, the Court had to cope(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.586 • MAY 16, 2011 TAX NOTES INTERNATIONAL

with the legal value of the Portuguese reserve introducedin 1992 to tax all software income.Surprisingly, none of the parties mentioned that thePortuguese reserve regarding software (paragraph 43 ofthe commentary on article 12) was deleted in the 2008OECD model, and they did not highlight that Portugaldecided to introduce an observation (section 28) in thesame version of the OECD model.According to this observation (section 28):Mexico, Spain and Portugal do not adhere to theinterpretation in paragraphs 14, 14.4, 15, 16 and17.1 to 17.4. Mexico, Spain and Portugal holdthe view that payments relating to software fallwithin the scope of the Article where less thanthe full rights to software are transferred either ifthe payments are in consideration for the right touse a copyright on software for commercial exploitation(except payments for the right to distributestandardized software copies, not comprisingthe right neither to customize nor toreproduce them) or if they relate to software acquiredfor the business use of the purchaser,when, in this last case, the software is not absolutelystandardized but somehow adapted to thepurchaser.The Portuguese tax administration and the court offirst instance believed that since neither Belgium norany other country disputed the Portuguese reservation,then one should conclude that the Portuguese right totax the software income as royalties was not limited.The Court considered that even if the reservationshould be understood as an observation, the Portugueseinterpretation cannot be immediately applied toevery single treaty concluded by Portugal, regardless ofwhen they entered into force.In this respect the Court considered that in relationto treaties already signed, such observation could onlybe invoked in connection with other contracting statesthat adopted and agreed with a similar observation.The way the Court countered those positions is worthstudying, because it denies the (un-) official positionaccording to which the terms of the conventional distributionof taxing rights can be changed without therenegotiation of a particular treaty, by mere modificationof the observations to the OECD model.Therefore the Court supported the judicial appealand considered the tax assessment illegal and void.Brief Overview of the OECD ModelThe importance of the OECD model and its commentary,including the observations and reservations inabstract, was discussed in detail and put in contextwith the applicable bilateral treaty (the 1969 Belgium-Portugal treaty) and the concrete reservations and observationspresented by Portugal since 1969. The mainaspects stressed by the Court are provided below.First, the Court argued, the OECD model cannot beconsidered anything but a draft, although a very usefulPRACTITIONERS’ CORNERand important one, both because it is adopted on aworldwide basis as a standard for bilateral treaties andbecause its commentaries are a useful interpretationinstrument.The commentaries to the OECD model are, accordingly,considered valuable doctrine, useful in findingthe sense for OECD model rules, but without bindingeffects on both courts and tax administrations. Andthis is true, the Court stated, for both OECD memberand nonmember states.Second, the Court supported the view that reservationson the OECD model are not proper reservations.Instead, they must, at all times, be adopted in everysingle treaty to become valid; otherwise, the Courtstated, they stand for no more than a mere statementof intentions on the part of the member state.This point is critical for the Court. According to itsreasoning, either the other state entering a treaty withPortugal agrees on the definition of royalties, or such astate cannot be bound to the interpretation set out onsuch ‘‘reservation,’’ thus preventing its legitimacy. Inthe Portuguese case, this was especially importantsince, between 1992 and 2008 (the period during whichPortugal adopted section 43 of article 12(2) of theOECD model), only two out of more than 30 countriesentering into a treaty with Portugal accepted suchan unusual position regarding software taxation on theterms of the treaties.That the remaining countries declined such a proposalin bilateral negotiations that precede the signatureof a treaty could not, the Court said, be ignored.In such circumstances, the reservations inserted in theOECD model are to be considered irrelevant and inapplicable.Third, the Court dealt with the 2008 Portuguese observationon article 12 of the model, relating to themeaning of the term ‘‘royalties,’’ inserted in section 28.The tax administration believed that it should beirrelevant from then on (that is, since 2008) to discusswhether reservations to the OECD model wereadopted on a case-by-case basis because the Portugueseobservation was allegedly to be considered applicableto every treaty entered into by Portugal.The Court did not agree with this view, however.On the contrary, the judges affirmed that the observationsare deprived of effects in relation to the countriesthat will not adhere to them. Again, this is relevant asfar as Portugal is concerned because it significantlyreduces the scope of application of the treaty, sinceonly Spain and Mexico have adopted a similar positionconcerning the taxation of software as royalties.The last issue addressed by the Court had to dowith whether the Portuguese ‘‘reservation’’ of section43 — adopted since 1992 — could be materially consideredan ‘‘observation’’ and, thus, applicable retroactively.(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.TAX NOTES INTERNATIONAL MAY 16, 2011 • 587

PRACTITIONERS’ CORNERThat question went without a clear answer, but theCourt made a strong point in considering that suchinterpretations could not be valid as far as pre-1992treaties were concerned, thus denying the possibility ofapplying latter observations to treaties already in force.This was so, the Court argued, because the taxationof software was not even an issue before 1992. Thetaxation of software was not addressed autonomouslyin the OECD model before 1992, and the negotiatorscould not have intended to consider such income asroyalties, let alone have had that intention in accordancewith commentaries and observations to theOECD model that did not even exist.Furthermore, the Court concluded, to admit such aninterpretation would be equivalent to a unilateralchange of the balance of the treaties and the denial ofthe reciprocity of concessions on which they all arebased.ConclusionIn spite of not taking the opportunity to clarifywhether software income obtained by nonresidents issubject to tax in accordance with domestic law, theCourt adopted a landmark decision.First, the court confirmed that a bilateral treaty prevailsabove domestic law. Second, the Court questionedwhether the Belgium-Portugal treaty prevented the applicationof domestic taxation, which otherwise shouldapply.The Court clarified how the OECD model and itscommentaries as well as the reservations and observationsshould be used for the interpretation of a bilateraltreaty.For the purpose of interpreting a specific rule andterm (‘‘royalties’’ under the 1969 Belgium-Portugaltreaty), the Court adopted a static approach. Althoughpayments were made from 1995 to 1997 and Portugalstarted protecting software as an analogous right tointellectual property in 1994, the Court considered thatit was irrelevant to consider whether such protectionshould be considered equivalent to a ‘‘literary work.’’Moreover, the Court considered irrelevant the adoptionof a later reservation and ignored an observation introducedin 2008 after the signing of the Belgium-Portugal treaty, unless the other state agreed with suchposition in the bilateral treaty or presented an identicalreservation or observation.However, it remains to be seen whether the courtswill accept that a nonresident entity is taxed on softwareincome if the treaty was signed after 1994 (thatis, when software apparently became protected in Portugal,analogously to a literary work), and if so, consideringthe current observation to the 2008 OECDmodel, in which terms.The Court seems to reject an uncritical acceptanceof an ambulatory interpretation of a tax treaty even ifthe articles of the OECD model remain unchanged butdomestic law and the commentaries (reservations orobservations) were substantially amended. From theCourt’s decision one may also infer that a change ofdomestic law that can alter the state’s power to tax ornew commentaries that may be considered elastic inallowing the expansion or reduction of the right to taxmay seem irrelevant in the interpretation and applicationof tax treaties already in force.◆(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.588 • MAY 16, 2011 TAX NOTES INTERNATIONAL