1.     Introduction

Income characterization is an important and intricate tax treaty interpretation issue – because that affects application (or non-application) of specific articles of a relevant tax treaty. Hence, income characterization has significant impact on determination of the source state’s right (under a tax treaty) to tax a foreign enterprise’s income.

If a foreign enterprise’s income is characterized as ‘business profits’, then (under an applicable tax treaty) it is not taxable in the source state unless it is attributable to a permanent establishment in that state. Alternatively, under majority of the contemporary tax treaties, ‘royalty income’ of such an enterprise would be taxable in the source state even if it is not attributable to a permanent establishment in the source state.

This article analyzes some intriguing income characterization issues (business profits versus royalties). For instance, for characterization purposes, should a tax treaty be interpreted as per the ‘static approach’ or the ‘ambulatory approach’? Could an enterprise’s income on account of provision of certain information cease to be royalty because the information provided by the enterprise was non-patentable? What would be the characterization outcome for consideration for irrevocable cessation of intellectual property rights?

This article takes into account important court decisions from Australia, Canada, and India.