A US Tax Court ruling shows companies may be able to structure subsidiaries to avoid, or lower US royalty tax, Ernst & Young tax services manager Patrick Hackenberg said.

In SDI Netherlands B.V. versus the Internal Revenue Service (IRS) commissioner, the IRS argued the company should have withheld $1.9 million of the $18.6 million it paid back to sister company SDI Bermuda.

Bermuda registered SDI Ltd. is parent of SDI Bermuda while SDI Netherlands' ultimate parent is also SDI Ltd.

The IRS said part of the royalty paid to SDI Netherlands from the group's US company, SDI USA, was US source income and therefore subject to the 30 percent withholding tax.

But the court said SDI Netherlands was not liable for the withholding tax on royalties paid to SDI Bermuda out of proceeds from a re-licence into the US.

Withholding tax is used as a mechanism to decrease the filing responsibility of a foreign entity making money in the US.

"The Tax Court's opinion calls into question the legal foundation of an IRS Revenue Ruling and its continued applicability in certain cases involving back to back royalty arrangements,'' Mr. Hackenberg said.

The opinion should be reviewed by Bermuda recipients of US source royalty income paid from another foreign company, to determine whether opportunities exist to reduce or eliminate US withholding tax, he said.

"The SDI Netherlands decision is of major importance for foreign and US technology and intangibles companies. For example, software and entertainment companies may be able to use this new case to structure or restructure their current royalty payments.

"It shows there can be some planning to eliminate or reduce the 30 percent withholding tax,'' he said.

And he suggests companies should set up subsidiaries in jurisdictions that have tax treaties with the US, like Ireland, before incorporating a company in the US to lower or eliminate the withholding tax.

Most Bermuda companies go directly into the US first, Mr. Hackenberg said.

With an Irish subsidiary, there is a ten percent withholding tax, but that is much better than 30 percent, he said.

"Although many US treaties now limit benefits of such planning, the (SDI Netherlands) decision offers an opportunity for Bermuda companies who are the ultimate licensor company to set up substantive treaty-benefited licensing companies.'' SDI Netherlands designs, manufactures, markets and services commercial systems software for IBM mainframe computers.

SDI Bermuda owns the worldwide rights to the software.

SDI Netherlands has a non-exclusive licence agreement with SDI Bermuda, granting SDI Netherlands worldwide rights to use the software in exchange for royalty payments ranging from 93 to 98 percent of the amount SDI Netherlands received.

SDI Netherlands entered into an exclusive licence with SDI USA, granting SDI USA the rights to the software in exchange for 50 percent of the amount received.

From 1987 to 1990, SDI Netherlands received $19.5 million royalty from various international affiliate companies, including $10.8 million from SDI USA, and paid SDI Bermuda $18.6 million.

The Court, in its October opinion, rejected the IRS's contention that royalties paid by SDI USA to SDI Netherlands retained the same character when SDI Netherlands made payments to SDI Bermuda.

It is interesting to note that the Service's argument was based solely on the character of payments from SDI Netherlands to SDI Bermuda leaving open the question of whether SDI Netherlands was merely a conduit for SDI Bermuda, Mr.

Hackenberg said.

In its October decision favouring SDI Netherlands, it appears the court relied on a prior decision in Northern Indiana Public Service Co. versus IRS commissioner, Mr. Hackenberg said.

In that case, the Court held that a foreign corporation was not a mere conduit for its US parent corporation.