For many international companies, it is a common practice to allow the use of their trademarks (TM) to all group companies on a free of charge basis. Some parent companies do not even have a right to charge the royalty payments from their subsidiaries, as this contradicts the company’s policy. In the case of subsidiaries located in the territory of Ukraine, such a situation suits everyone, at first glance, because royalties do not have to be paid at all.
However, the aforementioned practice has recently attracted the attention of the State Fiscal Service of Ukraine (the national tax authority) that do not share such an optimistic view towards Ukrainian companies of this sort and consider it as a method of tax evasion.
Why is it considered as tax evasion?
The Tax Law is based on the principles that everything must be paid. If the company receives services, then they must be paid; if the company orders the execution of the work – such work must also be paid. A very similar approach is applied to the use of TM because, in essence, the use of TM is a service for which a royalty payment shall be charged.
If royalty is not paid, the TM can be de facto used for free, because this is not prohibited by the law, including the Tax Code.
But there is an issue: the cost of freely provided services proportionally increases the company's revenue. In other words, the company, which used the TM for on a free basis, should calculate its entire amount of unpaid royalties and, accordingly, increase the tax base of income tax.
Hereupon, the national tax authority has an obstacle – how to correctly determine the number of royalties that were not paid by the Ukrainian company. Usually, when concluding license agreements, the parties determine the number of royalties at their own discretion. If there is no such agreement, the tax authority must, in a certain way, calculate the number of royalties that the subsidiary could otherwise pay to the TM owner.
In this situation, the representatives of the State Fiscal Service of Ukraine showed a very creative approach and calculated the number of royalties as 4% of the total income of the company for the previous year. In justification of such type of calculation, the national tax authority refers to Article 140 of the Tax Code of Ukraine, which deals with the application of financial differences in the payment of royalties in particular cases, and which has nothing to do with the order of taking into account the value of services received on a free of charge basis.
In spite of the fact that those calculations, in our opinion, are completely unreasonable and incomprehensible, far too often the tax audit result require the taxpayer to pay a very large sums, since it is about 4% of the company's total revenue for the year (even a couple of years) preceding the audit.
Does a company actually break the law?
Ukrainian legislation, in particular the Civil Code of Ukraine, the Law of Ukraine “On the Protection of Rights to Marks for Goods and Services” (hereafter referred to as the Law) state that only the owner of the rights to the TM is entitled to use and allow or prohibit the use of its TM. It is implied that the TM owner is entitled to receive a certain fee for granting permission to use its TM, the amount of which is agreed by the parties.
Further, Article 16 of the Law defines the use of a mark as follows:
- applying the mark on any goods for which the mark is registered, the package containing the goods, the signboard connected with the goods, a label, tab, tag or another item attached to the goods; storing such a goods with the mentioned application of the mark for the following offering for selling; offering the goods for selling, selling, import (coming-in) and export (coming-out);
- using the mark while offering or rendering any service for which the mark is registered;
- using the mark in business documentation or in advertising, and in the Internet network.
Based on the above, we can conclude that if a subsidiary uses the TM in its business activities rather than import a product marked with the TM, such use shall be subject to royalties. Moreover, we recommend charging at least the minimum amount of such royalties to avoid disputes with the tax authorities.
The situation is somewhat different if the subsidiary imports a trademarked product purchased from the manufacturer, rather than from a company that is the owner of the TM, without paying a royalty for using the TM.
We believe that from this perspective, the affiliate has no obligation to pay royalty, and thus such use does not violate tax laws. This position is justified by the so-called principle of exhaustion of rights.
Part 6 of Article 16 of the Law states that the exclusive right of a proprietor of a certificate to prohibit the use of the registered mark by other persons without his permission does not extend to: …the use of the mark for the goods introduced into the commercial turnover under this mark by the proprietor of the certificate or by his permission, provided that the proprietor of the certificate has no essential reasons to prohibit such a use in connection with the following selling of the goods, in particular in case when the condition of goods changed or the quality of the goods lowered after its introducing into the commercial turnover.
Introduction to commercial turnover means introducing a product to the market under a certain TM. In other words, if a company buys a trademarked product from a company other than the TM owner, such TM is considered as already introduced to the stream of commerce, and the TM owner is not entitled to prohibit the buyer of the product from using such product in its business activities or from using the TM. Accordingly, if the TM owner is not entitled to prohibit the buyer from using TM, then it is not entitled to seek payment of royalty for using such TM.
What is the position of the courts in this regard?
To date, there are several final court decisions concerning the disputes of the above category.
Case 1. The Claimant's position was that the policy of the group of companies does not provide for royalties for the use of their own trademarks, and, accordingly, a Ukrainian company, which is 100% owned by a foreign founding company, did not make any royalty payments favour of the latter. As a result, in order to estimate the value of the revenue from unpaid use of TM, the regular price determined by the parties of the transaction should be applied. Since the parties agreed on the absence of any payments, including royalties for the right to use TM, then the standard price for this transaction is zero.
The Court of the First Instance supported this position. However, the appellate body annulled the decision and stood up for national tax authority, and noted that, taking into account the fact that the owner of the trademarks in granting oral permission (according to the company policy) for the use of TM by the Ukrainian company did not determine the amount of compensation for its use, the Ukrainian company used TM in its own business for free and did not count other income (royalty) for such free use of TM. In turn, this led to a reduction in the number of tax liabilities. In this case, the Court of Appeal, without any justification, agreed with such unclear calculations of the tax authority.
Case 2. In this case, the Claimant referred to the principle of ‘exhaustion of rights’ for TM. It was the first time when an international company (the TM owner) benefited from that particular canon of law.
The Court of the First Instance and the Court of Appeal upheld the claimant’s position and invalidated the decision notice. As stated by the courts, "in order to make a conclusion about the claimant’s free use of TM with the subsequent receipt of income, it is necessary to deliberate the issue of the statutory regulation of the TM using, the scope of the TM owner’s rights, the circumstances of the introduction of the product to the market, the fact of the TM using in specific circumstances, and the amount of benefits that may be regarded as income.
Part 6 of Article 16 of the Law states that the exclusive right of a proprietor of a certificate to prohibit the use of the registered mark by other persons without his permission does not extend to: …the use of the mark for the goods introduced into the commercial turnover under this mark by the proprietor of the certificate or by his permission, provided that the proprietor of the certificate has no essential reasons to prohibit such a use in connection with the following selling of the goods, in particular in case when the condition of goods changed or the quality of the goods lowered after its introducing into the commercial turnover; […].
That is, [...] the principle of ‘exhaustion of rights’ shall be applied.
Therefore, the using of TM on a particular product is not a commercial per se after the product has been introduced to the market. The presence of TM on the product packaging does not benefit the buyer from the TM using, the cost of which is already an integral part of the product price. The introduction of the product to the market does not cause the TM owner’s right to demand the payment for the use of TM, which collectively indicates the lack of both grounds for the conclusion of license agreements, and the emergence of payment obligations related to the use of TM.
The panel of judges agrees with the conclusion of the Court of the First Instance that the promotion of already trademarked products acquired by the claimant on the market is a standard marketing service that is provided for the purpose of increasing the volume of sales of products, and is a common business practice which, however, does not mean the actual commercial and royalty-free use of TM”.
We believe, the second opinion of the court is more justified and complies with the provisions of the law and the essence of the legal relationship, since it is impossible to use something for free because the payment for this ‘something’ cannot be charged at all.
Currently, both cases are subject to a cassation appeal, and only time will tell the opinion of the Supreme Court of Ukraine.
At this point, we recommend taxpayers to avoid free of charge use of TM, owned by the parent company. In the case of purchasing goods that are already trademarked, ensure appropriate reservations and warranties in the supply contract in order to avoid contradictions with the State Fiscal Service.
GOLAW Partner, Attorney at law