On January 17, 2024, the ATO issued a new draft taxation ruling (TR 2024/D1) – income tax: royalties – character of payments in respect of software and intellectual property (IP) rights, replacing the previous draft taxation ruling (TR 2021/D4) – income tax: royalties – character of receipts in respect of software.
The new draft taxation ruling (TR 2024 /D1) sets out the Commissioner’s views on payments under software arrangements that could be characterised as a ‘royalty’ and therefore subject to royalty withholding tax in Australia. The draft ruling is open to public comment, with submissions to the ATO due by 1 March 2024.
The new ruling is likely to have implications for various software arrangements involving payments under: software licencing; cloud-based technology use, such as software as a service (SaaS) and software distribution agreements. The ATO considers arrangements for payments of tangible goods ‘embedded with software’ may constitute a royalty.
Summary
Summarised below are the key points of the draft ruling:
- The ATO considers the following types of payments to be a royalty:
- The grant of a right to use IP, regardless of whether that right is exercised;
- The use of an IP right;
- The supply of ‘know-how’ (scientific, technical, industrial or commercial knowledge or information) in relation to an IP right;
- The supply of assistance furnished as a means of enabling the application or enjoyment of the relevant property or right, or knowledge or information; or
- The sale by a distributor of hardware with embedded software, where the distributor is granted or uses rights in the IP of the software;
- The ATO considers the following types of payments would not be royalties:
- consideration that is wholly for the grant of a right to distribute copies of a computer program, without the use of, or right to use, the copyright or another IP right;
- consideration for the transfer of all rights relating to the copyright in software;
- payments from a distributor that are consideration wholly for acquiring hardware with embedded software or physical carrying media on which software is stored, where the distributor does not use, and is not granted the right to use, any copyright or other IP right in the software;
- consideration for providing services unrelated to any IP right referred to in para (a) of the standard tax treaty definition or any knowledge or information mentioned in para (b) of the standard tax treaty definition.
- The ATO has replaced the previous eight examples outlined in TR 2021/D4 which examined scenarios involving software licences, distribution agreements and software service agreements to determine whether payments under those arrangements could constitute a “royalty” with three new scenarios.
- Under the first two scenarios in the draft ruling, the Commissioner details his views on payments under specific types of arrangements involving the use of copyright and resell / licensing agreements, which would constitute a royalty. In the third scenario, the Commissioner allows for a reasonable allocation of consideration between distribution rights and IP use.
- The ATO thoroughly examines the five essential elements of the royalty definition under both Australian domestic law and common language used in Australia’s tax treaties. These components encompass the terms ‘however described or computed’, ‘consideration’, ‘for’, ‘to the extent’ and ‘use’.
- The ATO considers a ‘substance over form approach’ when determining whether a payment qualifies as a royalty i.e. considering the facts and circumstances of the specific arrangement and, looking not only on the terms of the agreements between the parties on an agreement-by-agreement basis, but also examining the surrounding circumstances from a “practical and business point of view”.
- For the purposes of the tax treaty and the domestic tax law definition of ‘royalty’, the term ‘copyright’ has the same meaning that it has under the Copyright Act 1968, as copyright is not defined in Australia’s ‘standard’ tax treaties. Additionally, the ruling underscores that in addition to Australian domestic law, consideration will also be given to the copyright laws of foreign countries participating in the relevant international agreements.
- The ATO adheres to a narrow interpretation of the OECD commentary’s example in Paragraph 14.4 concerning payments for the right to distribute software programs which are deemed as not constituting a royalty.
- The ATO stipulates that an apportionment may be required to determine the extent to which any payment is a royalty. Although it states that the apportionment should be undertaken on a ‘fair and reasonable basis considering all the relevant facts and circumstances of the particular case’, it does not offer any examples or guidelines on how this might occur.
- In this context, the ATO considers that if an undissected amount is paid as consideration for matters which are sufficiently linked with the elements mentioned in the definition of royalty, the entire payment will be considered to be a royalty. The ATO notes this will be the case where any IP rights granted are inseparable, from a practical and business point of view, from any other things for which the consideration is paid.
- The Commissioner has retracted previous views that payments made by a distributor for the rights to distribute software to purchasers who make simple use of the software cannot qualify as a royalty (per TR 93/12). The reasons being that “it is wholly inconsistent with the facts and circumstances of the software arrangements set out in this Ruling and a proper analysis of intellectual property law”.
Key takeaways
The release of draft taxation ruling TR 2024/D1 will carry substantial implications for overseas software and technology providers with existing or proposed new software licencing, distribution or SaaS agreements with their related parties or end-users in Australia. The ATO’s views on what types of payments that could constitute a royalty in respect of software arrangements has been broadened under the new draft ruling.
The new draft ruling maintains the Commissioner’s recent emphasis on intangibles. It is advisable to assess your software agreements or arrangements in light of this new draft ruling to determine whether the payments could constitute a royalty under the applicable treaty and/or under Australia’s domestic law.
This is also important for taxpayers that currently provide software embedded within other transactions (such as tangible goods or services). While the draft ruling does not directly address Australia’s transfer pricing rules, it is anticipated that transfer pricing principles will be applied to dissect the royalty payments from a legal, practical, and business point of view.
If the payment is determined to be a royalty, the payment will be subject to royalty withholding tax in Australia either at the prevailing treaty rate, or otherwise at the domestic royalty withholding tax rate of 30 per cent.
How we can help
If you would like to explore the implications of this draft ruling on your particular arrangement or require further clarification on the specific details of the draft ruling, please reach out to the contacts below or a member of the Grant Thornton tax team.
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