The recent Federal Court decision in International Business Machines Corporation v FCT  FCA 35 demonstrates a potential reversal of the ATO's practice towards royalties in respect of payments made under software licensing and/or distribution agreements. Taxpayers should carefully review the terms of their existing, or proposed, software licensing/distribution arrangements to ensure that they are treating the payments correctly for royalty withholding tax purposes in light of this decision.
Under Australian domestic taxation law, royalties paid by an Australia resident to a foreign resident are subject to withholding tax under section 128B(5A) of the Income Tax Assessment Act 1936 (ITAA36). These provisions are subject to the terms of any applicable double tax agreement.
The application of the royalty definitions in both Australian domestic tax law and its tax treaties to arrangements involving software has been an area of much uncertainty in recent years.
In this regard, the Australian Taxation Office (ATO) released Taxation Ruling TR 93/12 in May 1993, which outlined its views on the nature and assessability of payments from the marketing of computer software, in particular in relation to whether or not such payments are royalties. In addition, the OECD in its more recent versions of the Model Tax Convention has included detailed commentary on the application of 'Article 12: Royalties' to software arrangements.
However, until the IBM case, there had been little to no judicial consideration in Australia of the circumstances in which payments under a software licence and/or distribution arrangement will constitute a 'royalty' for withholding tax purposes. Although there have been cases considering the interpretation and application of Australian treaties, for example, McDermott Industries (Aust) Pty Ltd v FCT (2005) ATC 4398 and Unisys Corporation Inc v FCT (2002) ATC 5146, these cases considered different matters such as permanent establishment issues. For these reasons, many taxpayers have relied on ATO administrative practice to date in respect of software license boundaries, however, this will likely not be the appropriate position following the IBM case.
The relevant facts were as follows:
The two taxpayers, International Business Machines Corp (IBM Corp) and IBM World Trade Corporation (IBM World) (together, the US Corporations) were both US-resident corporations.
Under a Software Licence Agreement (SLA) signed on 1 April 1987, the US Corporations granted various rights to an Australian subsidiary, IBM Australia Pty Ltd (IBM Aus), in respect of the use, distribution and marketing of IBM software. In consideration for these rights, IBM Aus paid a fee equal to 40% of its sales revenue.
From 1987 to 31 December 2002, IBM Aus remitted royalty withholding tax to the ATO, on the full amount of the payments under the SLA at the then applicable rate of 10%.
For the period 1 January 2003 to 31 December 2004, IBM Aus only remitted royalty withholding tax on part of the payments under the SLA, at the rate of 5% (which applied from 1 July 2003) in accordance with a binding private ruling it obtained from the ATO.
Following the expiry of the private ruling, IBM Aus continued to withhold tax from the payments under the SLA on the same basis as in the private ruling. On 12 May 2006, IBM Aus sought a refund of part of the withholding tax paid to the ATO for periods prior to the application of the private ruling, on the basis that part of those payments did not constitute 'royalties'.
The ATO rejected the refund request and subsequently applied royalty withholding tax to the full amount of the payments under the SLA, starting from the date that the private ruling expired. The taxpayers sought declarations from the court that they were only liable to withholding tax on part of the payments received under the SLA.
The key issue in this case was whether the whole amount or only part of the payments made by IBM Aus to the taxpayers under the SLA constituted 'royalties' for the purposes of the Treaty.
Based on the language of the SLA and the nature of the rights it granted, Bennett J held that the full amount of the payments received by the US Corporations under the SLA constituted royalties for the purposes of the Treaty and were thus wholly subject to withholding tax. In her judgment, Bennett J summarised the definition of "Royalties" in Article 12(4) of the Treaty, as payments for:
- the use or right to use an IP right (whether exercised or not);
- the use or right to use another like property or right;
- the supply of certain knowledge/information; or
- assistance furnished to enable the application or enjoyment of an IP right or certain knowledge/information.
Her Honour reviewed the SLA and determined that it granted various rights to IBM Aus that would give rise to a royalty, including:
- (Non-exclusive rights 'under IBM's Copyrights, Mask Work Rights, and Patents' to licence and distribute copies of IBM software) These allowed IBM Aus to carry out matters that would otherwise infringe the various IP rights held by the US Corporations. Although IBM Aus could have potentially distributed the software without infringing those IP rights, the SLA was drafted in such a manner to ensure that any rights as were necessary were granted. Thus, payments under the SLA that were attributable to these rights fell within Article 12(4)(a)(i) of the Treaty;
- (The right to use all of IBM's Trademarks) For the same reasons in relation to the rights above, payments under the SLA that were attributable to these rights also fell within Article 12(4)(a)(i) of the Treaty;
- (Access to the 'knowledge and technical knowhow' of the US corporations) Payments under the SLA that were attributable to these rights clearly fell within the definition of royalties in Article 12(4)(b)(i) of the Treaty, as payments for 'the supply of scientific, technical, industrial or commercial knowledge or information owned by any person'; and
- (Ancillary matters) Payments under the SLA that were attributable to the supply of assistance of an "ancillary or subsidiary nature" fell within the definition of royalties in Article 12(4)(b)(ii) of the Treaty.
Importantly, Bennett J rejected the taxpayers' submission that the SLA also granted a distinct 'right to distribute', separate from the IP-related rights above. In this regard, her Honour stated that the SLA did not 'look like a distributor licence', as contended by the taxpayers. In particular, there was no reference in the SLA that the payments were for the grant of general distribution rights. Rather, the detail of the SLA concerned the IP rights to be granted to IBM Aus. The subject matter of the SLA was the grant of these IP rights and not the grant of rights to use, distribute and market the software.
Thus, taking the whole of the SLA into account, Her Honour held that it was clear that the SLA granted all IP rights to IBM Australia as were necessary for the distribution of the relevant software products. The SLA was not a distribution agreement which conferred distribution rights independently of the grant of IP rights. Any distribution rights granted by the SLA were referable to, and part of, the bundle of IP rights granted under the SLA.
On this basis, Her Honour held that the whole amount of the payments made under the SLA were royalties for the purposes of the Treaty.
We note that the taxpayers have not yet indicated whether they will appeal the decision although we consider it likely.
Implications for taxpayers
Taxpayers should be aware that the ATO may potentially be adopting a more aggressive position in respect of the application of royalty withholding tax to software licence and distribution arrangements. Even if taxpayers have previously obtained a favourable private ruling in respect of royalty withholding tax, there is a risk that the ATO will adopt a more aggressive approach once the ruling has expired.
In this regard, foreign residents that have entered, or are intending to enter, into software distribution arrangements with an Australian distributor should carefully review the terms of their existing, or proposed, arrangements to ensure that they are treating the payments made by the Australian distributor correctly for royalty withholding tax purposes.
In particular, if the foreign resident does not intend to grant any IP rights (or other rights that can give rise to a royalty) under its software distribution arrangements, it is critical that the relevant agreement be drafted appropriately such that it is clear that the agreement is for the grant of distribution rights only and no rights in the IP are granted to the Australian distributor.
Alternatively, if the taxpayer intends to provide separate distribution rights and IP rights to the Australian distributor, the relevant agreement should be appropriately drafted such that it is clear that two distinct rights are being granted, with only the payments attributable to the IP rights constituting a royalty. Another option may be for two separate agreements to be prepared – one for the distribution rights and the other for the IP rights.
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