On 17 January 2024, the Australian Taxation Office (ATO) released its revised draft ruling TR 2024/D1 in relation to whether payments under software distribution arrangements are characterised as royalties and therefore subject to royalty withholding tax. The ATO has also published an accompanying compendium (TR 2021/D4EC) setting out certain issues raised during the consultation process for draft the ATO's earlier draft TR 2021/D4, and the ATO’s responses.
The publication of TR 2024/D1 has been highly anticipated as the legal and technology industries raised a number of concerns about the ATO’s earlier draft TR 2021/D4 and the extent to which the ATO’s views departed from international norms. While the revised draft ruling has expanded on the ATO’s reasoning, there appears to be no substantive change in the ATO’s position in TR 2024/D1 compared to TR 2021/D4, and much of the feedback provided to the ATO in the consultation process on TR 2021/D4 has not been adopted.
We set out below our preliminary observations of TR 2024/D1.
New scenarios
The revised draft ruling provides a more detailed explanation of the ATO’s views having regard to the tax treaties, the Organisation for Economic Cooperation and Development (OECD) guidelines and Australian case law.
Relevantly, the ATO's views are now summarised in two key scenarios:
- Scenario 1 – the performance of a contract to distribute software requires the use of copyright rights
- Scenario 2 – a distribution agreements lacks specificity regarding the parties’ rights and obligations
It is the ATO’s view that, whilst each case will turn on its facts and the terms of a distribution or licence agreement are relevant, they are not determinative of the characterisation of the payment.
Further:
- the right of a distributor to make copies (even for a limited purpose) would constitute the grant of an exclusive right of a copyright holder to reproduce software; and
- in circumstances where a distributor enters into the agreement with the end-user and that agreement specifies the software which the end-user will obtain use of, the distributor is responsible for determining the software programs communicated to the user. The right to communicate a copyright work to an Australian end user is an exclusive right of a copyright holder. The ATO’s position is that the exclusive right to communicate work also includes the exclusive right to authorise that communication.
Accordingly, payments made by an Australian distributor or licensee for these rights would be characterised as a royalty.
It follows that payments made under a distribution agreement could also be characterised as a royalty in circumstances where:
- the distributor obtains the right to use trademarks, brands and designs of the copyright holder; and
- the distributor obtains a supply of technical or commercial information and know-how from the copyright holder.
The need for further guidance on apportionment
In certain cases, apportionment may be required to ascertain the extent to which a payment is a royalty or a distribution fee. It would be necessary for the distributor to establish that the distribution right had substantial value independent of the right to use the copyright. This will turn on whether there is sufficient evidence that other rights conferred under a distribution agreement (such as marketing software) are separate to, or severable from, the right to use the copyright. If a single payment is made as consideration for all rights conferred under the agreement which are ‘all sufficiently connected’, the ATO will treat the whole payment as a royalty at first instance.
This will have significant implications for taxpayers. The ATO has not provided further detailed guidance on the circumstances in which apportionment would be applicable. Given this, careful consideration should be given to how future legal agreements are drafted and in particular, the way in which different rights are conferred and the manner in which associated payments are apportioned or made.
OECD Commentary
In the appendix to the draft ruling, the ATO has provided a more detailed explanation for its reasoning, however, it will not form part of the ATO’s final public ruling. The appendix includes an explanation of the ATO’s views on the relevance of the OECD Model Tax Convention Commentary (OECD Commentary).
In summary, the ATO has sought to adopt a very permissive view of the OECD Commentary and has sought to dismiss arguments based upon the ATO’s agreement with the OECD on the application of royalty rights, as being upon a ‘narrow reading’ of the OECD Commentary. The ATO has not, however, provided any basis to support this dismissal.
In particular, the ATO has adopted a broad interpretation of paragraph 14.4 of the OECD Commentary which contains an example that illustrates the circumstances in which payments for the right to distribute copies of a program will not constitute a royalty. The ATO’s view is that the example in the OECD Commentary is premised on the fact that the payer ‘acquires copies of a program but does not make a copy’. That is, the example provides for circumstances where the distributor is only disseminating existent copies of software (whether in tangible or electronic form) and does not have the right to reproduce the software. The ATO also distinguishes the facts in the example from a distribution model involving a grant of access to software such as cloud distribution.
The ATO therefore concludes that the absence of the right to reproduce the software and to exploit any right in the software copyright is determinative in concluding that the payments for the right to distribute copies in this example would not constitute a royalty.
Furthermore, in the accompanying compendium, the ATO continues to endorse its rights based approach in response to feedback received in consultation that it is contrary to the substance based approach in the OECD Commentary.
In the event that a treaty partner and the ATO cannot reach an agreement on the scope of the ATO's new expansive view of its right to charge royalty withholding taxes, obtaining tax credits in the partner jurisdiction for that charge could be very difficult and even require extensive litigation.
Further, the draft ruling admits that these issues are dependent on the specific facts of a taxpayer’s case. The examples in the draft ruling however, assert conclusions on matters (such as the right to communicate software and the right to authorise the communication of software) which are entirely dependent on the facts of each taxpayer’s arrangements. Factual analysis and evidence of each taxpayer’s particular arrangements will be vital in understanding the implications of the ATO’s views in each specific case.
We envisage that the ATO may seek to compel information to ascertain facts that apply with respect to particular arrangements engaged by taxpayers to assess their characterisation as royalties and whether that is subject to withholding tax. It is important that the taxpayer identify these key facts and the relevant evidence to be able to support its position and generally on the implications of those facts to whether they constitute royalties.
It is proposed that TR 2024/D1 will have retrospective effect and it remains open for public comment until 1 March 2024.
Please contact us if you would like to discuss the implications of TR 2024/D1 to your particular circumstances.
We will continue to provide further updates with respect to the developments from the ATO in connection with the tax treatment of software arrangements.
