Intellectual property and taxation: an obligation that companies must review before an audit

Companies that make payments for the use of trade marks, patents, software, copyright, franchises or other intellectual property assets should check whether their contracts comply with a requirement that may have implications not only from an intellectual property perspective, but also in tax matters.

Article 99 of the Organic Code of the Social Economy of Knowledge, Creativity and Innovation (COESCCI) stipulates that transfers, authorisations of use and licences relating to intellectual property rights or pending applications must be registered with the competent national authority for intellectual property rights.

The provision also stipulates that transfers, authorisations of use and licences relating to industrial property rights take effect from the date of their registration.

However, there is one aspect of particular relevance to businesses: Article 99 stipulates that, in order to claim tax deductions arising from royalties on intellectual property rights, a document substantiating the substance of the transaction must be provided, and that document must have been previously registered with the competent national authority for intellectual property rights.

Why is this important for businesses?

This requirement may be particularly relevant when a company records payments made in respect of royalties or licences as an expense.

In the event of a tax audit, the company must not only demonstrate that the payment was made, but also that there is an actual transaction underpinning that expense and that the necessary documentation is in place to substantiate its materiality.

In this context, the Internal Revenue Service (SRI) has already ruled on the application of this provision. In a ruling on a tax enquiry, the SRI stated that the entry required under Article 99 of the COESCCI constitutes evidence to substantiate the substance of the transaction and, therefore, the deductibility of the expense.

This means that failure to register a licence agreement or intellectual property transfer may give rise to a potential issue that should be assessed prior to any audit.

What types of transactions should be reviewed?

The review should not be limited to contracts expressly referred to as ‘royalties’. Companies should identify, amongst others, contracts relating to:

• Trademark licences.
• Patent licences.
• Software and technology licences.
• Franchise agreements.
• Assignments or transfers of intellectual property rights.
• Copyright licences or authorisations.
• Agreements involving know-how or other intangible assets.
• Agreements entered into between related companies or with foreign parent companies where intellectual property rights are involved.

In each case, it is necessary to analyse the nature of the transaction, the rights involved, ownership, the financial terms and compliance with registration obligations.

The risk is not limited to a failure to register

It is important to note that the registration of a contract does not automatically make an expense deductible.

The company must also have sufficient documentation to demonstrate the substance of the transaction, its execution and the link between the payment made and the intellectual property right used.

Therefore, a preventative review should take into account, amongst other factors:

Contract: existence, validity, scope and terms of the licence or transfer.

Intellectual property rights: ownership, validity and registration status in Ecuador.

Registration: verification that the relevant contract or document has been duly registered with the competent authority.

Substance: evidence of the actual use of the right and of the service or transaction giving rise to the payment.

Tax documentation: invoices, payment receipts, withholding tax records and other related documentation.

Royalties: the methodology used to determine the amount payable and the documentation supporting its calculation.

Related parties: where applicable, a review of any additional implications arising from the relationship between the parties.

A proactive review can help avoid future contingencies.

For a company that pays royalties on a recurring basis, a review of its intellectual property contracts may enable it to identify in good time:

• Contracts that were never registered.
• Contracts where the registration details need updating.
• Intellectual property rights where ownership needs to be verified.
• Royalty payments for which there is insufficient supporting documentation.
• Inconsistencies between the contract, the accounts and the actual transaction.
• Risks relating to transactions between related parties.
• Documentation that should be retained to substantiate the materiality of the transaction.

The aim should not be merely to ‘record contracts’, but to establish a documentation framework that enables the existence, execution and economic basis of intellectual property-related transactions to be demonstrated.

What do we recommend?

Companies that currently make payments for royalties or licences should consider a proactive review of their intellectual property contracts, particularly in the case of recurring payments, transactions with related companies, or contracts entered into with foreign rights holders.

This review enables the identification of compliance gaps and, where appropriate, the implementation of corrective measures before the company faces a potential tax audit or challenges regarding the deductibility of its expenses.

Intellectual property and taxation: an increasingly necessary review

The management of intangible assets should no longer be analysed solely from a registration perspective.

When a trade mark, patent, software, work, technology or franchise generates royalty payments, the correct structuring, documentation and registration of the transaction can have consequences that go beyond the scope of intellectual property and directly affect the company’s tax management.

For this reason, having an appropriate IP & Tax Compliance system in place can serve as a preventative tool for identifying risks, bringing contracts into line with regulations and strengthening the documentary evidence underpinning intellectual property transactions.

Does your company pay royalties or licence fees for the use of intellectual property? Now is a good time to check whether your contracts and records comply with the applicable requirements.