ATO considers certain payments for software distribution rights are royalties

25 June 2021

ATO considers certain payments for software distribution rights are royalties

In brief

The Australian Taxation Office (ATO) has released a draft taxation ruling (TR 2021/D4) which sets out the Commissioner of Taxation’s preliminary views on the income tax treatment of receipts from the distribution and licensing of software, as distinct from “simple use” by end-users of the software. The draft ruling has a particular focus on the circumstances where receipts will be treated as royalties under arrangements involving the distribution of packaged software, digital software distribution and cloud computing arrangements including software-as-a-service (SaaS). This has the potential to be quite broad such that any business where software is fundamental to the delivery of services should also consider the draft ruling.

The draft ruling adopts a highly technical approach to the identification and valuation of the royalty element of any software payments and will be relevant to software distributors, software owners and end-users, particularly where there is a cross-border element where transfer pricing and withholding tax obligations become important.  However, the draft Ruling does not address the impact of Australia’s tax treaties which will be critical in many cases.

The draft ruling replaces a widely used and accepted taxation ruling issued in 1993 dealing with computer software which has been withdrawn. Once finalised, the draft ruling is proposed to apply both before and after its date of issue. However, it is recognised that taxpayers will be entitled to rely on the 1993 ruling which applied to some arrangements covered by the draft ruling. 

In detail

On 25 June 2021, the ATO released draft Taxation Ruling TR 2021/D4 Income tax: royalties – character of receipts in respect of software (draft Ruling). The 17 page draft Ruling deals with the circumstances in which receipts from the licensing and distribution of software will be royalties as defined under Australian domestic tax law. Royalties paid offshore will generally be subject to a final withholding tax.

Taxation Ruling TR 93/12 Income tax: computer software is withdrawn. The draft Ruling seems intended to clarify a key element of TR 93/12 concerning the use of a local distributor in respect of “simple use” of software. This element of the draft Ruling may attract a degree of controversy and is expected to have a wide impact particularly if the position expressed in the draft Ruling applies to prior years as appears to be intended.

The draft Ruling adopts a highly technical approach based on Australian copyright law. According to the draft Ruling, an amount is a royalty to the extent that it is paid or credited as consideration for the grant of a right to “do something in relation to software that is the exclusive right of the owner of the copyright in the software”.  

Eight examples are provided in the draft Ruling: three dealing with licences to reproduce, modify and provide simple use of software, three dealing with software distribution arrangements and two dealing with ancillary services.  

The key aspect of the draft Ruling relates to the circumstances where the use of a local distributor may generate payments that are considered royalties. There seems to have been an evolution since TR 93/12 in the ATO’s approach in relation to this business model and the operation of the royalty withholding tax rules.  

In this respect, the draft Ruling seeks to interpret the domestic law royalty definition and distinguish the following circumstances:

• Simple use of software
  A payment for the simple use of software is not considered a royalty. This would include payments made under standard licensing arrangements known as ‘click-wrap,’ ‘click-through’ or ‘browse-wrap’ end-user licence agreements (EULA) where, as part of the download and installation process, the end-user either accepts or rejects the terms by selecting ‘accept’ or ‘cancel.’ The draft Ruling concludes that payments for simple use are payments for the right to use the software itself for the purpose of which the software was designed or intended to be used. This includes the use of copyright which is necessary to facilitate the use of the software as a functional product (e.g. reproducing or communicating software when downloading software but not modifying or adapting the software).
• Software distribution agreements conferring copyright
  A payment by a software distributor for the right to do something in relation to the software which is the exclusive right of the copyright owner will be considered to be a royalty. Such rights to use the copyright in the software may be granted to distributors whether the software is distributed by way of physical carrying media, digital download or cloud-based technology such as SaaS. For example, a payment for the right for a distributor to copy, reproduce, modify or adapt the software, or to communicate the software to the public (e.g. by merely making it available online for users in Australia) will be characterised as a royalty. 
  
  This is also the case where the payment by the distributor is for the right to sub-licence simple use of the software to end-users. According to the draft Ruling, such a payment is considered to be a royalty because the simple use of the software will necessarily involve the use of copyright and the right to authorise an end-user to use the copyright in the software is an exclusive right of the copyright owner.
  
  The draft Ruling also states that, as a general proposition, where the grant of the right to use the copyright in software is central to the rights the distributor is given to perform its distribution function, and the other rights granted are ancillary in comparison, it is considered that the whole of the payment will constitute a royalty.
  
  However, there is a subsequent statement in the draft Ruling that apportionment is to be done on a fair and reasonable basis taking into account all the facts and circumstances of a particular case.
• Software distribution agreements not conferring copyright
  The draft Ruling also explains that it is not always the case that payments made by a software distributor for distribution rights will be royalties. There may be instances in which a software distributor makes payments to a copyright owner for the grant of distribution rights which do not involve the right to do anything that is the exclusive right of the copyright owner. For example, a distributor may enter into a distribution agreement under which it is granted the right to market and distribute packaged software but not to sub-licence the use of the software to end-users or to otherwise use the copyright in the software. In such cases, the licence to use the software is granted directly to end-users by the software developer.
  
  This may also be the case where software is distributed by way of digital download or cloud-based technology. That is, depending on the circumstances of the particular case, the distributor may not be granted the right to sub-licence the use of the software or to otherwise use the copyright in the software. In such cases the payments made by the distributor will not be royalties.

The draft Ruling seeks to distinguish situations where the distributor is granted a right to “do something that is the exclusive right of the owner of the copyright” (e.g. a right to copy, reproduce, modify or adapt the software, communicate the software to the public or sub-licence the right to use the copyright in the software) and situations where the distributor is not permitted to do “anything that is the exclusive right of the owner of the copyright”. This distinction may be difficult to determine in practice and will depend upon the terms (both express and implied) of the licensing or distribution arrangement. 

However, based on the simple examples in the draft Ruling, a key distinction appears to be whether the Australian distributor is a party to the EULA. This aspect of the draft Ruling relies heavily on the view that the EULA will necessarily involve the distributor exercising an exclusive right of the copyright owner by authorising an end-user to use the copyright in the software. Another key distinction is whether the Australian distributor is granted a right to communicate the software to the public (e.g. by making the software available online or electronically transmitting the software). According to the draft Ruling, communication may occur in the relevant sense when software is made accessible to, or is used by, an end-user via cloud-based technology such as SaaS, that is, without being downloaded on the end‑user’s computer or device.  

Other aspects of the draft Ruling dealing with licences to reproduce or modify software, sale of goods and payments for know-how and services broadly align with the approach adopted in TR 93/12. The draft Ruling provides a new and helpful explanation that the proceeds from the sale of a mobile handset which comes pre-installed with operating system software is not a royalty (i.e. no “embedded” royalty).

The most noteworthy aspect of the draft Ruling relates to the treatment of foreign multinational companies involved in the distribution of software to the Australian market. Our observations below focus on this. 

Observations

The consideration of whether a payment in respect of a software distribution arrangement is a royalty, and in certain cases then gives rise to royalty withholding tax, is complex and, as the draft Ruling notes at the outset, is dependent on the terms of the relevant agreements and all the facts and circumstances of the case. There are a number of matters that need to be considered carefully, both through the consultation period and once the draft Ruling is finalised. Some of these are set out briefly below.

The interaction with Australian copyright law

The question of whether an amount is paid for the use of, or the right to use, copyright (and therefore a royalty as defined under subsection 6(1) of the Income Tax Assessment Act 1936) must be answered by considering whether any of the rights provided under the arrangement are otherwise the exclusive rights of the copyright owner, as set out in the Copyright Act 1968. 

In the context of software distribution arrangements which operate through an Australian distributor, this involves consideration of the rights provided implicitly or explicitly to the distributor to perform its activities. In our experience, this can be a challenging task particularly as business models have evolved and become more complex.

Scope of the draft Ruling

The draft Ruling seems to be confined to payments relating to software. However, it is not clear if this approach founded in intellectual property law could mean that other “digital” businesses (e.g. a payment that may involve the use of software in the delivery of services or businesses that deal in digital media such as pictures, templates, music, sound or video) could also be impacted.

Multinational Anti-Avoidance Law (MAAL)

The MAAL was effective from 1 January 2016 and targets multinationals with annual global income of AUD 1 billion or more that supply goods or services to Australian customers and record the revenue from those sales overseas. The MAAL was designed to encourage multinationals to restructure and the ATO has stated that “... as a direct response to the MAAL, 44 taxpayers have brought or are bringing their Australian sourced sales back onshore”. Those companies that have moved sales onshore will now need to consider whether the draft Ruling may have application.

Apportionment and transfer pricing

The draft Ruling acknowledges that apportionment may be required to isolate amounts that are characterised as royalties. There are a number of transfer pricing methodologies that could be used to apportion payments between royalty and non-royalty components.

However, the draft Ruling provides limited guidance on this issue, other than to suggest any apportionment should be done on a fair and reasonable basis.

Retrospective nature of the draft Ruling

When the final ruling is issued, it is proposed to apply both before and after its date of issue. However, the draft Ruling also acknowledges TR 93/12 applies prior to the time of its withdrawal to the extent that it has been relied upon. We note that to the extent that a public ruling is withdrawn, it continues to apply to schemes to which it applied that had begun to be carried out before the withdrawal but does not apply to schemes that begin to be carried out after the withdrawal. 

We expect that, for those impacted by the draft Ruling, it will be important to consider whether TR 93/12 provides protection from the intended retrospective operation of the draft Ruling.

Tax Treaties and OECD Commentary

The draft Ruling focuses on the definition of a royalty as set out in domestic tax legislation but helpfully acknowledges that the definition in a tax treaty will prevail to the extent of any inconsistency. This is important because the Australian domestic definition of royalty may not align with the tax treaty definition. For example, in considering the application of Australia’s tax treaties, it may be relevant to consider commentary in relation to the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention (MTC). The OECD MTC Commentary considers software distribution arrangements and notes that the rights provided in relation to the acts of distribution should be disregarded in characterising the payment for tax purposes such that payments made solely in respect of exclusive distribution rights should not be considered a royalty.

Accordingly, the interaction with tax treaties will be critical in many cases in determining whether an amount is wholly or partly a royalty and accordingly whether withholding tax is applicable and a foreign tax credit available in the foreign jurisdiction.

If the ATO view regarding the royalty definition does not align with a tax treaty partner, double taxation may arise. In these cases, any difficulties in the application of the tax treaty may be resolved through mutual agreement procedures including, in some cases, binding arbitration made available by the OECD Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting. 

We would observe that the proposed ATO view has the potential to give rise to inconsistencies with the approach adopted in most other countries following the OECD MTC. In addition, we note that, earlier this year, the Indian Supreme Court denied the tax authority’s endeavour to categorise payments for the use or purchase of computer software as royalties under India’s tax treaties. The UN Tax Committee has also recently decided against including software payments in the definition of royalties for the purposes of the UN model tax convention.  

Financial statement impact

Since the draft Ruling, once finalised, is stated to apply both before and after the date it is finalised, it may be necessary to consider if the draft Ruling could have any impact on taxes reported in financial statements. 

The takeaway

Foreign companies involved in the software industry and other “digital” businesses should review the potential application of the draft Ruling. This may require a detailed consideration of existing legal agreements and specifically the rights provided to the relevant parties under those agreements. This should include consideration of how Australian intellectual property law applies to arrangements involving the distribution of packaged software, digital software distribution and cloud computing arrangements including SaaS. In many cases, it will be necessary to consider if apportionment is required.

Given the draft Ruling is intended to apply retrospectively, companies potentially impacted will also need to consider if TR 93/12 provides protection for positions adopted in the period to its withdrawal and potentially for a period thereafter.

The ATO has invited comments in relation to the draft Ruling (including the proposed date of effect) by 23 July 2021.