Can't touch this! ATO releases long-awaited guidance on software payments and intangibles arrangements

At a glance

Under new guidance from the Australian Taxation Office (ATO) on software and royalties, a broad range of payments for access to software under software distribution arrangements could be characterised as royalties attracting withholding tax obligations for Australian distributors.  This is likely to capture arrangements businesses would not otherwise consider to be royalties (such as subscription fees for a software as a service (SaaS) solution).  While not a substantial change from the previous 2021 draft ruling there is further clarity on the intended scope and limited exclusions from this application.  Australian distributors who are not currently characterising sales under software distribution arrangements as royalties should pay close attention to this new guidance, because they may have withholding tax obligations.  If they have a tax gross up provision in their distribution agreement with the international software supplier, they could find themselves with increased tax liability.  

The Commissioner has also released an iterative update to the practical compliance guidelines on intangibles migration arrangements.

Background

On 17 January 2024, the ATO released:

1. draft ruling Income tax: royalties – character of payments in respect of software and intellectual property rights (TR 2024/D1) (Draft Ruling); and
2. Practical Compliance Guideline Intangibles migration arrangements (PCG 2024/D1) (Intangibles PCG).

The revised guidance has been long awaited, having been in development by the ATO since 2021.  The Draft Ruling sets out the ATO’s revised views from TR 2021/D4 (2021 Ruling), while the Intangibles PCG replaces the previously published PCG 2023/D4.

In brief:

1. the Draft Ruling provides guidance about when payments made in respect of software and intellectual property rights will be characterised as “royalties” to which separate withholding tax obligations may apply; and
2. the Intangibles PCG sets out when the ATO is likely to apply resources to consider the potential application of general anti-avoidance or transfer pricing rules to cross-border related party “Intangibles Migration Arrangements”.

The Intangibles PCG comes into effect on 17 January 2024.  Comments on the Draft Ruling are due on 1 March 2024.

Key takeaways

Draft Ruling

1. Despite appearing as a fundamental re-write, the Draft Ruling effectively adopts equivalent tax positions as those set out in the 2021 Ruling (albeit with further explanations setting out the Commissioner’s views).
2. Payments under software agreements may be characterised by the Commissioner as a “royalty”, particularly in relation to a range of distribution and reseller arrangements.  This includes arrangements that may not typically be considered to involve an exercise of copyright or other IP rights by the distributor.
3. Copyright and other IP rights remains a key focus in the Draft Ruling, and the revised guidance makes clear that analysis of these matters is central to determining the correct tax position.  This includes reaching a conclusion that is contrary to the description of the rights and nature of the payments under the agreement (while a focus on substance over form is common, businesses may be surprised by the outcome). The approach to apportionment also means that the whole payment could be considered a royalty, even if the IP rights are only a part of a broader, more integrated offering (eg in a SaaS arrangement).

Intangibles PCG

1. The Intangibles PCG outlines the ATO’s compliance approach to issues relating to “Intangibles Migration Arrangements”, providing taxpayers with an approach to practically assess risk based on a points system which focuses on the substance of the arrangement and its tax outcomes. 
2. While the ATO has updated the language of PCG 2023/D2 (the Draft PCG) in a bid to provide further clarity and has added two additional “higher risk” examples, the Intangibles PCG is an iterative update from the earlier draft version.  Our analysis of the earlier draft version can be found here (link).

Observations

1. The Draft Ruling represents a substantial re-write of the 2021 Ruling while retaining many of the core principles and conclusions contained in that earlier ruling; in contrast, the Intangibles PCG is an iterative update from the Draft PCG.
2. As to the Draft Ruling:
   1. Tax risks remain: The Draft Ruling focuses on an exercise of a copyright to characterise the payment as a royalty.  As a result, there is potential for payments under a broad range of software distribution arrangements to be characterised as royalties.  This is the case even when the relevant parties would not consider those payments to be royalties and where the payment could be for many things but is described as a single unapportioned fee.  Such a broad scope was an issue in the previous 2021 Ruling and these same concerns remain in the revised Draft Ruling.  Taxpayers may query whether the ATO is taking a “practical and business point of view” that focuses on substance over form and whether the ruling aligns with the OECD’s guidance in its Commentary on Article 12 of the Model Convention with Respect to Taxes on Income and on Capital (OECD Commentary on Article 12), in particular paragraph 14.4.  
   2. Importance of intellectual property law: The Draft Ruling puts beyond doubt that a proper payment analysis requires consideration of Australian copyright law and/or other intellectual property laws that may apply to relevant software arrangements.  These intellectual property issues should be considered by in-house counsel and external advisers when conducting a payment characterisation exercise to ascertain whether the software arrangement gives rise to the grant, use or authorisation to use any intellectual property rights that in turn will inform whether “royalties” are to be paid.  This is particularly in circumstances where the ATO has effectively removed previously recognised concepts such as “simple use” from the ruling – the only mention of “simple use” is when the ATO refers to the “alternative” argument that payments made by a distributor for the right to distribute software to purchasers who make simple use of the software cannot be a royalty.  However the ruling broadly asserts that such a statement of principle is “inconsistent with … a proper analysis of intellectual property law” (at [184]).
3. From a regulatory perspective, the Draft Ruling and Intangibles PCG are preceded by almost five years of increasing ATO activity in the intangibles space.  During this time, the ATO has adopted increasingly broad views as to what constitutes a “royalty” and what intangibles arrangements are considered “high risk” — despite international criticism that such an approach may be out of line with OECD practice.  The guidance also follows hot on the heels of the Federal Court’s decision in Pepsi Inc v Commissioner of Taxation [2023] FCA 1490 (see our alert here), which upheld the ATO’s argument regarding “embedded royalties”.  These developments are all clear sign posts to potentially impacted taxpayers that the ATO will continue to pursue intangible arrangements for the foreseeable future.

TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights

Outline of Draft Ruling

The below table summarises the ATO’s views on whether certain payments should be characterised as “royalties” (at [14]-[15]).

The explanation accompanying the ruling has been substantially expanded when compared to the 2021 Ruling and is now split into four distinct parts.

Part 1 - Royalties

Part 1 details the ATO’s views on five key components of a “royalty”, relevantly defined as: “payments or credits, whether periodical or not, and however described or computed, to the extent to which they are made as consideration for: … the use of, or the right to use” certain property or rights, including intellectual property rights such as copyright.  In summary, the ATO’s views on each component are:

1. “However described or computed”: The way a payment is described or computed does not determine its character as a royalty. It is necessary to perform an objective assessment under which the substance of the agreement should prevail over its legal form.
2. “Consideration”: The term “consideration” incorporates a wider notion than consideration in the contractual sense. When having regard to the relevant software arrangement as a whole, “consideration” is the thing (or things) that move the payment.
3. “For”: In determining what a payment is “for”, regard may be had to matters beyond the contractual arrangement, including relations between the parties and the manner in which rights will be used. Determining the purpose of a payment requires regard to matters beyond the boundaries of any contracts giving rise to the payment.
4. “To the extent”: Where a payment is only partially for something that would lead to a royalty characterisation, apportionment may be appropriate. Apportionment will not be appropriate where the use of rights is neither “separate nor severable” from other rights granted.  One example of when apportionment may arise is provided for in scenario 3 of the ruling, which concerns a lump sum payment for both the right to distribute physical copies of computer games (which would not attract royalty treatment), and the right to distribute online access to video-editing software (which would attract royalty treatment).
5. “Use”: The “use” of an IP right covers all forms of exploitation of the right or property short of an outright sale of the right.

Part 2 - Copyright

Part 2 considers key concepts arising under Australian intellectual property law, with a specific focus on copyright law. The meaning of “copyright” adopted by the ATO is “[t]he exclusive right to do certain acts under the Copyright Act”, and in the context of software refers to the exclusive rights relating to “literary works” (which include computer programs) under subsection 31(1) of the Copyright Act. The rights considered include the exclusive rights of the copyright owner to do all or any of the following acts:

1. reproduce the work in a material form;
2. communicate the work to the public;
3. make an adaptation of the work;
4. enter into a commercial rental in respect of the work; and
5. authorise another person to do an act that is the exclusive right of the copyright holder.

Analysis of whether an arrangement regarding software involves payment of a royalty therefore can turn on whether a payment is consideration for the exercise of any such exclusive right.  The ATO’s analysis also includes commentary as to how copyright rights arise and are used in the context of a software as a service model, making it clear that SaaS also involves the exercise of copyright and, as a result, the subscription fees for the SaaS may also be royalties.

Parts 3 and 4 - Non-copyright rights and embedded software

Parts 3 and 4 briefly deal with non-copyright rights and embedded software. In summary, the ATO’s explanation notes that:

1. Non-copyright rights: Payments for the use of, or right to use, other intellectual property rights, or other like property or rights, such as trademarks, patents, know-how and services ancillary to the use and enjoyment of those rights or property may be characterised as royalties.  The Draft Ruling does not consider these matters in detail and relies on the Commissioner’s existing views expressed in Ruling IT 2660 Income tax: definition of royalties.
2. Embedded software: Software that is “embedded” in a tangible good is generally characterised in the same way as software sold on any physical carrying media.  Payments will generally not constitute royalties unless the distributor is granted or uses IP rights in the software, for example if the distributor was to modify the software embedded in a good it distributes.

What has (and hasn’t) changed since TR 2021/D4?

Despite effecting a substantial re-write that clarifies the Commissioner’s technical position, the Draft Ruling retains many of the core principles and conclusions contained in the previous 2021 Ruling.  Key changes from the 2021 Ruling include:

1. Further clarity that payment characterisation looks beyond the terms of a contract and at arrangements as a whole
   The Draft Ruling puts beyond doubt the Commissioner’s view that when characterising a payment, consideration is to be had to all the facts and circumstances of the particular case, and that the analysis looks not only to the terms of the agreements between the parties on an agreement-by-agreement basis, but also to the surrounding circumstances from a “practical and business point of view”.  This approach purports to emphasise substance over form.
   
   
2. Eight examples replaced with three “scenarios”
   The tax community were particularly concerned with examples 4 and 5 of the 2021 Ruling that set out the Commissioner’s view on what might constitute a royalty in a distribution scenario.  Given this concern, it is not surprising that the eight examples contained in the 2021 Ruling, which included examples of where a payment was not regarded as being a royalty, have been replaced with three new “scenarios” that relate to: 1) circumstances where the performance of a contract requires the use of copyright rights; 2) circumstances where an agreement is lacking in specificity regarding the parties’ rights and obligations; and 3) circumstances where apportionment may be appropriate.
   
   
3. Detailed explanations regarding interplay between taxation law and copyright law
   The Draft Ruling substantially expands and clarifies the Commissioner’s position regarding the interaction between taxation law and intellectual property law, with a particular focus on the Australian copyright law.  The ruling makes clear that in addition to Australian domestic law, regard will also be had to the copyright law of foreign countries party to the relevantly applicable international agreements.
   
   
4. Concept of “simple use” abandoned
   The Draft Ruling no longer relies on, uses, or otherwise defines the concept of “simple use” for the purposes of payment characterisation.  Such an omission is significant when read in context of the ATO’s guidance in the 2021 Ruling and the earlier 1993 guidance, which accepted “simple use” in a range of circumstances for administrative purposes.
   
   As currently drafted, Appendix 2 notes briefly (at [183]-[184]): “[a]n alternative view is that any payments made by a distributor for the right to distribute software to purchasers who make simple use of the software cannot be a royalty.  This statement of principle cannot be accepted for the reasons set out in this Ruling.  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.”
   
   
5. Narrow interpretation of OECD commentary
   Conversely, various key issues arising from the 2021 Ruling still remain on foot.  For example, during the consultation period for the 2021 Ruling, a number of submissions made to the ATO concerned the proper interpretation of paragraph 14.4 of the OECD Commentary on Article 12.  This paragraph set out a clear example, in-principle, that illustrated circumstances where payments for the right to distribute copies of a computer program would not constitute a royalty, namely arrangements between a software copyright owner and a distribution intermediary under which payments are made to acquire and distribute copies of software without the right to reproduce the software.  A number of submissions noted that the effect of the 2021 Ruling (which treated payments made under certain distribution arrangements as royalties), would be contrary to this accepted OECD practice and Australia’s double tax agreements with other countries.  US Treasury also voiced concerns.
   
   While the Draft Ruling has removed the specific examples that gave rise to these issues (previously Examples 4 and 5), under the new guidance the ATO may still consider that such distribution arrangements give rise to “royalty” payments.  In particular, the Draft Ruling makes clear that the example in paragraph 14.4 of the OECD Commentary on Article 12 is to be read down and confined to a narrow, formal interpretation of its facts which “place a significant qualification and limitation on its application” (at [67]).  The ATO’s view is that paragraph 14.4 cannot be relied upon where the substance of an agreement or arrangement differs from the facts given in the example.  Emphasis is placed on the fact that the distributor making payments in the example “… acquires copies of a program but does not make that copy.  The copy has therefore been made by someone else with the right to make that copy.” (emphasis added) (at [66]).  It is implied that a situation in which this OECD analysis may be limited is the case of a distribution model that involves the grant of access to software (such as cloud distribution) ([at 67]).
   
   
6. Focus on treaty definitions of “royalties”
   As opposed to the domestic law definition under subsection 6(1) of the Income Tax Assessment Act 1936 which was considered in the 2021 Ruling, the Draft Ruling considers the application of the definition of “royalties” present in most of Australia’s international tax treaties.  The ATO has however identified certain jurisdictions where the definition may differ from the standard definition considered in the Draft Ruling (i.e. the United States, Mexico and Singapore).

PCG 2024/1 Intangibles migration arrangements

The Intangibles PCG, which replaces the Draft PCG, outlines the ATO’s compliance approach to “Intangibles Migration Arrangements”, broadly constituting cross-border arrangements involving the migration of intangible assets or relating to Australian development, enhancement, maintenance and protection activities in relation to intangibles held offshore (DEMPE activities).  It outlines when the ATO will apply resources to consider the potential application of the general anti-avoidance rules or the transfer pricing rules to these arrangements.

The PCG is basically an iterative update from the earlier draft.  In summary:

• It provides a two-tier assessment regime, focusing on arrangements involving the migration of intangibles offshore and, alternatively, arrangements under which an Australian taxpayer performs DEMPE activities for the benefit of an international related party.
• It provides a points-based risk rating, focusing on the substance of the arrangement and its related tax outcomes. Broadly, the PCG is concerned with arrangements under which intangibles are transferred or licensed to or otherwise held by an international related party which lacks the requisite substance or skills to perform or control DEMPE activities and assume associated risks, where value-adding DEMPE activities are performed by the Australian taxpayer and some preferential tax treatment or tax benefit is obtained. 
• Like the Draft PCG, it still imposes substantial evidentiary and documentary requirements on taxpayers. Unlike the Draft PCG, it increases the risk rating of arrangements which are not adequately documented or recognised by the taxpayer.
• The ATO has clarified the scope of the Intangibles PCG (in comparison to the Draft PCG), including more specific definitions of arrangements captured, and specifying arrangements that are “excluded” from the framework. Excluded arrangements include certain inbound and outbound distribution arrangements involving the grant of specific distribution and ancillary rights that are not accompanied by other valuable rights, and low value intra-group service arrangements under which the taxpayer provides support services that are not core to its business.
• The ATO has also included two new examples of higher risk arrangements:
  • Example 7 outlines an arrangement involving the bifurcation of intangible assets, in which an Australian taxpayer performs high value R&D functions for newly created foreign-owned intangibles and is remunerated on a cost-plus basis, in circumstances where the Australian taxpayer already owns and exploits existing intangibles which are intrinsically linked to the new foreign intangibles.
  • Example 8 describes a cost contribution arrangement (CCA) in which the Australian taxpayer’s contributions in connection with intangible assets are substantial relative to other participants under the CCA, and where the expected benefits received by the Australian taxpayer do not reflect the value of its contributions.