Private ruling: Royalty withholding tax
Date of advice: 16 December 2015
Published: March 2016

Ruling: Q1: Are payments by Distributor to Licensor pursuant to the Distribution Agreement 'royalties' as defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: No. | Q2: Are payments by Distributor to Licensor pursuant to the Distribution Agreement 'royalties' as defined in Article 12(4) of the applicable Double Taxation Agreement (DTA)? | A2: No. | Q3: Do subsection 128B(5A) of the ITAA 1936 and section 12-280 of Schedule 1 of the Taxation Administration Act 1953 impose on Distributor an obligation to withhold an amount from payments made to Licensor pursuant to the terms of the Distribution Agreement? | A3: No.

Relevant facts and circumstances: The Distribution Agreement Licensor entered into a Distribution Agreement with Distributor. Licensor granted Distributor the non-exclusive, non-transferrable right and licence to market, distribute and sub-licence software products to End-Users and Resellers in certain territories, and maintenance and support services related to the software products. Licensor granted Distributor an internal use licence for each software product. Distributor's internal use of each software product is governed by an End-User Licence Agreement (EULA). Licensor granted Distributor and its Resellers a demonstration licence for each software product, and a licence to distribute evaluation versions of each software product. Licensor granted to Distributor a non-exclusive, non-transferrable licence to use Licenced Trademarks, but only for the purpose of identifying the origin and ownership of the software products. Distributor pays Licensor a percentage of Distributor's net selling price for each software product ordered from Licensor (payments). No part of the payments are for the licence to use the Licenced Trademarks. Title to and ownership of all proprietary rights in the software products remain with Licensor and / or third parties who have licenced rights to Licensor. Distributor cannot reproduce, alter, vary, translate, or in any way modify the software products. Distributor cannot, under any circumstances, disassemble, decompile or otherwise reverse engineer the software products. Distributor must use its best efforts to protect the software products from unauthorised copying, dissemination, or disclosure and from other unauthorised use. Distributor must not, in any part of the world, take any action that infringes or is inconsistent with any of Licensor's rights in or to the software products, or any Intellectual Property Rights, Licenced Trademarks or other proprietary rights related to the software products. Distributor must distribute the software products only in the sealed packages in which Licensor delivers them to Distributor. Unless otherwise instructed by Licensor, Distributor must distribute software products as shipped by Licensor, including all packaging, documentation, registration cards and EULAs. Distributor must use reasonable commercial efforts to ensure that Resellers distribute software products as shipped by Licensor with the appropriate EULA and registration card. Distributor must provide its Resellers with all training necessary to enable them to resell, market and install the software products. Licensor will assist Distributor with its internal use of the software products (Distributor Support). Distributor Support is on a reasonable-efforts basis only, and Licensor may not be able to resolve every enquiry or request. Licensor will use reasonable commercial efforts to notify Distributor of and make available to Distributor updates, upgrades and new releases or versions of the software products prior to their release to the general public. Licensor is not obligated to accept purchase orders for software products directly from Resellers or End-Users. Distributor and its Resellers are free to determine their own resale prices for the software products. Licensor may publish suggested resale prices, but these are suggestions only and are not binding. End-Users are persons which acquire the software products for their own internal use, and not for further sale, distribution or sub-licencing. Intellectual Property Rights refer to all statutory and other legally enforceable proprietary rights, including copyright. Licenced Trademarks refer to the names, logos and slogans used by Licensor. Resellers market and resell the software products and related services to End-Users or other Resellers in Distributor's distribution network. Resellers are bound by all of the restrictions on Distributor contained in the Distribution Agreement. End-User Licence Agreement (EULA) The EULA sets out the terms and conditions under which Licensor grants to End-Users the right to use the software products. The material terms of the EULA are: • Licensor grants to End-Users a non-exclusive and non-transferrable right to use only the executable version (not the source code) of the software products for the End-User's internal business purposes. • No title passes to End-Users. With the exception of the licence granted under the EULA, Licensor and any Third Party Licensor retain all right, title and interest to the software products and all related intellectual property and proprietary rights. • End-Users may not create any derivative works to the software products, except for limited configuration or customisation to the look and function of the software. • End-Users may not modify, decompile, translate, disassemble or reverse engineer the software. • End-Users may not distribute, rent, lease or transfer the software products. End-Users may not use the software products in a commercial hosting, application service provider or service bureau environment. • End-Users may make one copy of the software for safekeeping purposes. Maintenance and Support In some cases, Licensor provides first level support to End-Users. In other cases, Licensor provides second level support to End-Users. In all cases, Licensor maintains the software products. Maintenance consists of updates, upgrades, bug fixes and new releases or versions of the software products. It may also include the same for third-party software included in the software products. Support entitles End-Users to assistance with the software products via telephone, e-mail or other automated processes. Support is for the ongoing use of the software products. It is offered on a good faith, diligent effort basis only. Every question / request for support may not be able to be resolved. Other Distributor does not obtain access to source code or algorithms in respect of the software products. In recent years the software products are mostly downloaded from a website after purchase rather than from a physical CD. Distributor is a resident of Australia within the meaning given by subsection 6(1) of the Income Tax Assessment Act 1936 . Licensor is a resident of the other Contacting State for the purposes of the applicable DTA. Licensor is not a resident in any other jurisdiction. Licensor does not have (and has never had) a permanent establishment in Australia for the purposes of the applicable DTA.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 6(1) | International Tax Agreements Act 1953 section 3AAA | International Tax Agreements Act 1953 section 5 | Taxation Administration Act 1953 section 12-280

Reasons for decision: Summary: Summary The payments by Distributor to Licensor are not royalties within the meaning given by subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936). Detailed reasoning So far as is relevant, subsection 6(1) of the ITAA 1936 defines a 'royalty' or 'royalties' as including: … any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for: (a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade mark, or other like property or right; (b) …; (c) the supply of scientific, technical, industrial or commercial knowledge or information; (d) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in paragraph (a), any such equipment as is mentioned in paragraph (b) or any such knowledge or information as is mentioned in paragraph (c); (da) …; (db) …; (dc) …; (e) …; or (f) … Paragraph (a) of the definition of royalties Copyright subsists in the software products as literary works. Accordingly, it is necessary to consider whether the payments are (to any extent) consideration for 'the use of, or the right to use, any copyright' in the software products. Taxation Ruling TR 93/12 Income tax: computer software is about the income tax implications arising from the development and marketing of computer software. TR 93/12 canvasses the nature of receipts from the marketing of computer software, with particular reference to whether or not such payments are royalties. The key principle for whether or not a payment is consideration for the use of, or the right to use, copyright is whether or not the payment is 'for the right to do acts comprised in the copyright' (paragraph 19 of TR 93/12). 'Acts comprised in the copyright' are those acts referred to in subsection 31(1) of the Copyright Act 1968 . They include the right to reproduce, modify or adapt a computer program, which would otherwise be the exclusive right of the copyright owner. Copyright in the software products is owned by Licensor and third-party licensors. For the following reasons the Distribution Agreement does not allow Distributor to do what would otherwise be the exclusive right of Licensor or third-party licensors. Accordingly, the payments by Distributor to Licensor pursuant to the Distribution Agreement are not consideration for the use of, or the right to use, any copyright in the software products within the meaning of paragraph (a) of the definition of 'royalties' in subsection 6(1) of the ITAA 1936. At a broad level, Distributor is prohibited from doing any acts comprised in the copyright in the software products. The Distribution Agreement prevents Distributor from taking any action that infringes or is inconsistent with any of Licensor's rights in or to the software products, or any Intellectual Property Rights, Licenced Trademarks or other proprietary rights related to the software products, in any part of the world. Intellectual Property Rights include copyright. Accordingly, Distributor is prohibited from taking any action that infringes or is inconsistent with Licensor's copyright related to the software products. More specifically, the Distribution Agreement prevents Distributor reproducing, altering, varying, translating, or in any way modifying the software products. Moreover, Distributor cannot disassemble, decompile or otherwise reverse engineer the software products under any circumstances. Paragraph 21 of TR 93/12 states: Where the licence to use the copyright is acquired by the end-user from a distributor or retailer, the distributor or retailer is considered to be acting as agent for the copyright owner. In such cases, payments made by the distributor or retailer in respect of software which has been licenced through his agency will include an amount in the nature of royalty for the right to use copyright. The pre-condition for the outcome provided by paragraph 21 of TR 93/12 is that the end-user of the software must acquire a licence to use the copyright in the software. In other words, the end-user must be granted the right to do acts comprised in the copyright in the software. When an End-User acquires a software product, its right to use the licenced software is governed by an EULA. The following terms and conditions of the EULA show that End-Users do not acquire a licence to use the copyright in software products. As a result, the outcome provided by paragraph 21 of TR 93/12 does not apply to characterise the payments as royalties. • The end-user licence is for the right to use the software. • The right to use the software is only in respect of the executable version of the software, not the source code. • No title passes to End-Users. With the exception of the licence granted under the EULA, Licensor and any third party licensor retain all right title and interest to the software product and all related intellectual property and proprietary rights. • Except for limited configuration or customisation to the look and function of the software, End-Users are restricted from creating any derivative works to the software. Moreover, End-Users are restricted from modifying, decompiling, translating, disassembling or reverse engineering the software. • End-users are prohibited from distributing, renting, leasing or transferring the software, and from using the software in a commercial hosting, application service provider or service bureau environment. • End-users can only make one safekeeping copy of the software. The internal use licence granted to Distributor is also subject to the terms and conditions of the EULA. For the same reasons, Distributor is not granted a licence to use the copyright in the software products as a result of receiving the internal use licence under the Distribution Agreement. Payments as consideration for 'the use of, or the right to use, any…trade mark' are also royalties within the meaning of paragraph (a) of the definition of royalties in subsection 6(1) of the ITAA 1936. Pursuant to the Distribution Agreement, Distributor is granted a non-exclusive, non-transferrable licence to use the Licenced Trademarks. However, the licence is only for the purpose of identifying the origin and ownership of the software products. No part of the payments from Distributor to Licensor are for Distributor's licence to use the Licenced Trademarks granted pursuant to the Distribution Agreement. Accordingly, the payments from Distributor to Licensor are also not consideration for the use of, or the right to use, any trade mark within the meaning of paragraph (a) of the definition of royalties in subsection 6(1) of the ITAA 1936. Paragraph (c) of the definition of royalties Payments as consideration for 'the supply of scientific, technical, industrial or commercial knowledge or information' are royalties within the meaning of paragraph (c) of the definition of royalties in subsection 6(1) of the ITAA 1936. Taxation Ruling IT 2660 Income tax: royalties identifies that the main type of knowledge or information intended to be covered by paragraph (c) is 'know-how' (paragraph 19). IT 2660 broadly defines know-how as 'undivulged technical knowledge, information, experience or technique that is necessary for the industrial reproduction of a product or process'. More specifically in the context of the development and marketing of computer software, TR 93/12 acknowledges that payments for the acquisition of software under a licencing arrangement concerning 'packaged software' do not ordinarily involve the supply of technical knowledge or information for the purposes of paragraph (c) of the definition of royalties (paragraph 28). Moreover, paragraph 28 of TR 93/12 states that 'where the purchaser or licensee obtains nothing more than a set of coded computer instructions, without the underlying source code, it cannot be said that knowledge or information about the program in the relevant sense of know-how has been transferred'. On the other hand, payments for the supply of the source code or algorithms of a computer program are, prima facie, considered to come within paragraph (c) of the definition of royalties (paragraph 3(b) of TR 93/12). 'Packaged software' contains not only the computer program, but also educational material, manuals and operating instructions (paragraph 13 of TR 93/12). The software products are packaged software. They are packaged for commercial distribution by Licensor. Distributor must distribute the software products only in the sealed packages in which Licensor delivers them, and must use reasonable commercial efforts to ensure that Resellers distribute the software products as shipped by Licensor with the appropriate EULA and registration card. Notwithstanding that in recent years the software products are mostly downloaded from a website after purchase rather than from a physical CD, they are nonetheless packaged. They still come with the user guides and other documentation. It is clear from the EULA that End-Users do not obtain the source code for the software products. Distributor also does not obtain the source code or algorithms for the software products under the terms of the Distribution Agreement or the EULA. Accordingly, it cannot be said that knowledge or information about the software products in the sense of know-how is transferred to Distributor under the Distribution Agreement. It also cannot be said that know-how is transferred as a result of first level support, second level support or Distributor Support provided by Licensor. The support is for the ongoing use of the software products on a diligent effort only basis. It is more akin to a service. Paragraph (d) of the definition of royalties A royalty must first exist under paragraph (a), (b), or (c) of the definition of royalties in subsection 6(1) of the ITAA 1936 before an amount can be characterised as a royalty within the meaning of paragraph (d). This is because the assistance referred to in paragraph (d) must be ancillary and subsidiary to, and furnished as a means of enabling the application or enjoyment of, any property or right, equipment, or knowledge or information covered by paragraphs (a) to (c). As paragraph 46 of TR 93/12 notes: 'only those payments for assistance which relates to the supply of know-how or the right to use the copyright will be royalties'. Because a royalty has not been identified within the meaning of paragraph (a) or (c) of the definition of royalties in subsection 6(1) of the ITAA 1936, payments for first level support, second level support or Distributor Support provided by Licensor cannot be characterised as royalties within the meaning of paragraph (d). The ordinary meaning of royalties The definition of royalties in subsection 6(1) of the ITAA 1936 is inclusive. Accordingly, payments that are royalties according to the ordinary meaning of that term also fall within the definition of royalties in subsection 6(1). For completeness, the payments by Distributor to Licensor are not royalties within the ordinary meaning of that term. They do not have the signs of a common law royalty outlined in paragraphs 9 and 10 of IT 2660. Summary The payments by Distributor to Licensor are not royalties within the meaning given by Article 12(4) of the applicable DTA. Detailed reasoning So far as is relevant, Article 12(4) of the applicable DTA defines 'royalties' to mean: (a) payments or credits of any kind to the extent to which they are consideration for the use of or the right to use any: (i) copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right; (ii) …; or (iii) ...; (b) payments or credits of any kind to the extent to which they are consideration for: (i) the supply of scientific, technical, industrial or commercial knowledge or information owned by any person; (ii) the supply of any assistance of an ancillary and subsidiary nature furnished as a means of enabling the application or enjoyment of knowledge or information referred to in sub-paragraph (b)(i) or of any other property or right to which this Article applies; or (iii) …; or (c) … The payments by Distributor to Licensor pursuant to the Distribution Agreement are not royalties within the meaning given by Article 12(4) of the applicable DTA. Because the relevant definition of royalties within Article 12(4) of the applicable DTA is materially similar to the relevant definition of royalties within subsection 6(1) of the ITAA 1936, the same conclusion as for Question 1 can be made. To the extent permissible, the following OECD commentary on Article 12 of the 2014 OECD Model Tax Convention concerning the taxation of royalties also support a conclusion that the payments are not royalties within the meaning given by Article 12(4) of the applicable DTA: Paragraph 13.1 Payments made for the acquisition of partial rights in the copyright (without the transferor fully alienating the copyright rights) will represent a royalty where the consideration is for granting of rights to use the program in a manner that would, without such license, constitute an infringement of copyright . Examples of such arrangements include licenses to reproduce and distribute to the public software incorporating the copyrighted program, or to modify and publicly display the program. In these circumstances, the payments are for the right to use the copyright in the program (i.e. to exploit the rights that would otherwise be the sole prerogative of the copyright holder) . Paragraph 14 In other types of transactions, the rights acquired in relation to the copyright are limited to those necessary to enable the user to operate the program , for example, where the transferee is granted limited rights to reproduce the program. This would be the common situation in transactions for the acquisition of a program copy. The rights transferred in these cases are specific to the nature of computer programs. They allow the user to copy the program, for example onto the user's computer hard drive or for archival purposes…copying the program onto the computer's hard drive or random access memory or making an archival copy is an essential step in utilising the program . Therefore, rights in relation to these acts of copying, where they do no more than enable the effective operation of the program by the user, should be disregarded in analysing the character of the transaction for tax purposes. Paragraph 14.4 Arrangements between a software copyright holder and a distribution intermediary frequently will grant to the distribution intermediary the right to distribute copies of the program without the right to reproduce that program. In these transactions, the rights acquired in relation to the copyright are limited to those necessary for the commercial intermediary to distribute copies of the software program . In such transactions, distributors are paying only for the acquisition of the software copies and not to exploit any right in the software copyrights. Thus, in a transaction where a distributor makes payments to acquire and distribute software copies (without the right to reproduce the software), the rights in relation to these acts of distribution should be disregarded in analysing the character of the transaction for tax purposes . Payments in these types of transactions would be dealt with as business profits in accordance with Article 7. This would be the case regardless of whether the copies being distributed are delivered on tangible media or are being distributed electronically (without the distributor having the right to reproduce the software), or whether the software is subject to minor customisation for the purposes of its installation. Paragraph 11.5 In the particular case of a contract involving the provision, by the supplier, of information concerning computer programming, as a general rule the payment will only be considered to be made in consideration for the provision of such information so as to constitute know-how where it is made to acquire information constituting ideas and principles underlying the program , such as logic, algorithms or programming languages or techniques, where this information is provided under the condition that the customer not disclose it without authorisation and where it is subject to any available trade secret protection. Summary As the payments by Distributor to Licensor pursuant to the Distribution Agreement are not royalties, Distributor is not required to withhold an amount from them under section 12-280 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953). Detailed reasoning Pursuant to section 12-280 of Schedule 1 to the TAA 1953, Distributor must withhold an amount from a royalty it pays to an entity or to entities jointly, if: • the recipient or any of the recipients has an address outside Australia according to any record that is in Distributor's possession (or is kept or maintained on Distributor's behalf) about the transaction to which the royalty relates; or • Distributor is authorised to pay the royalty at a place outside Australia (whether to the recipient or any of the recipients or to anyone else). As the payments by Distributor to Licensor are not royalties, Distributor is not required to withhold an amount from the payments under section 12-280 of Schedule 1 to the TAA 1953.