The Australian Taxation Office (ATO) has released a draft ruling that marks important changes to the way the Australian tax authorities will interpret what constitutes a royalty for withholding tax purposes, specifically in the context of:

  • licences for the use of or to reproduce software, or to modify or adapt software;
  • distribution agreements, including those with a right for the distributor to sub-licence the use of the software, whether the software is distributed by way of physical carrying media, digital download or cloud-based technology; and
  • ancillary software services, including those supplied for the use or modification of software.

This may have a significant impact on the commercial arrangements for Australian based and international businesses, which should be reviewing their cross border licensing, distribution and service agreements to determine whether the changes impact those arrangements and whether the contractual terms allow for any unintended deductions and/or gross-ups for withholding tax.

Draft Taxation Ruling TR 2021/D4 – Income tax: royalties – character of receipts in respect of software (draft ruling)

The draft ruling addresses whether payments in respect of licensing, distribution and services arrangements may be considered to be royalties for Australian tax purposes (and therefore subject to Australian royalty withholding tax when those payments are made by Australian businesses to offshore recipients).

The determination of whether a payment in respect of software is a royalty for Australian tax purposes has always been complex, particularly due to the technological advancements for the distribution of software since the ATO issued its initial ruling on the same subject in 1993. The complexity remains after this latest draft ruling, which is evident from the fact that it includes eight examples demonstrating when payments in respect of software would or would not constitute royalties, whilst also acknowledging that the ultimate characterisation will depend on the particular facts and circumstances. The examples can be split into three categories – being examples relating to licensing, distribution and services relating to software.

A particular focus of the draft ruling surrounds payments for the use of, or the right to use, any copyright. Such payments fall within the definition of what constitutes a royalty for tax purposes. The ATO's position has consistently been that an amount is considered to be paid for the use of, or the right to use, copyright if it is paid for the right to do something in relation to copyright that is the exclusive right of the owner of that copyright.

The main change in the ATO's interpretation in this draft ruling relates to licences for the simple use of software. In the ATO's previous ruling, the position had always been that a payment under a licence that involves the simple use of software would not constitute a royalty for tax purposes. This has changed in the draft ruling. The interpretation now adopted by the ATO is that a payment for a licence that involves a right to sub-licence the software to an end-user will likely be considered to be a royalty. The ATO supports this position with reliance on a more technical analysis of the copyright law (with specific reference to section 31 of the Copyright Act 1968), in particular that the right to sub-licence the software is the exclusive right of the owner of the copyright in the software. The examples in the draft ruling indicate that this would be the outcome even where a distributor has a right to sub-licence the software to an end-user for simple use only.

This interpretation exposes a different approach where an end-user enters into a licence for simple use directly with the owner of the copyright (under which payments are unlikely to be royalties) when compared to arrangements under which a distributor takes a licence from the owner with a right to grant a sub-licence to an end-user (even for simple use), where the payments by the distributor are likely to be considered royalties. Where the recipient of the payments in each of these scenarios is not an Australian resident, there is likely to be a different result from an Australian royalty withholding tax perspective (before the application of any relevant double tax agreement).

The example provided in the ATO's draft ruling in relation to distribution agreements is set out below

CloudCo– software distribution agreement conferring the right to enter into cloud services agreements

CloudCo has recently made its photo and video editing software available to customers on a subscription basis under a software-as-a-service offering. The cloud infrastructure on which the software is hosted is located overseas and is owned and controlled by CloudCo.

AusCo, an Australian subsidiary of CloudCo, sells subscriptions to customers in Australia. AusCo and CloudCo have entered into a cloud distribution agreement which sets out the terms on which AusCo is permitted to sell the subscriptions. Under the agreement, CloudCo grants AusCo the right to enter into cloud services agreements with customers specifying the terms on which the customer can use the software. AusCo acknowledges that it does not otherwise have the right to do anything that is the exclusive right of CloudCo as the copyright owner.

In return for the grant of these rights, AusCo pays a monthly cloud distributor fee to CloudCo which is calculated by reference to subscription sales and renewals over the preceding month.

When purchasing a subscription, customers confirm (by clicking a box on CloudCo's website) that they agree to the terms of the cloud services agreement with AusCo. If a customer does not renew its subscription at the end of the subscription period, its access to the cloud services is cancelled.

Under the cloud services agreement, AusCo grants the customer a non-exclusive, non-transferrable licence to access the software and use it for its intended purpose. The agreement otherwise limits the customer's use of the software.

The monthly cloud distributor fee which AusCo pays to CloudCo is a royalty under paragraph (a) of the definition in subsection 6(1) of the ITAA 1936. This is because the fee secures the grant of the right to distribute the software by way of sublicensing the use of the software to customers.

Licensing the use of the software is the exclusive right of CloudCo as the copyright owner and AusCo would not be permitted to do this without the permission of CloudCo.

Key takeaways

As mentioned above, characterising whether a payment in respect of software is a royalty for Australian tax purposes (and specifically Australian royalty withholding tax purposes) is complex. The elevated emphasis that the ATO has placed on the copyright law in its latest interpretation, particularly whether an agreement provides rights consistent with those of the copyright owner, will warrant the involvement of copyright and tax specialists in determining whether arrangements already in place and those to be entered into may be impacted (noting that the ruling, once finalised, will generally apply retrospectively and prospectively).

The key points are:

  • the draft ruling addresses royalty treatment of three key areas - software licensing, software distribution, and services;
  • when finalised, the draft ruling will apply to arrangements entered into both before and after the date of the final ruling;
  • businesses should be reviewing their existing arrangements and consider the impact of the revised ATO views on all new arrangements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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