ATO taxation ruling: Characterisation of software receipts

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This article was written by Thomas Wu, Kai-Chen Lamb and Cheng Lim

On 25 June 2021 the Australian Taxation Office released its draft ruling Income tax: royalties – character of receipts in respect of software (TR 2021/D4) which replaces the previous Income tax: computer software (TR 93/12) ruling.

The Draft Ruling has been updated to account for key technological changes that have taken place within the software industry over the last three decades, and includes examples covering packaged software by way of physical media, digital downloaded software, and cloud based software-as-a-service (SAAS).

Key takeaways

The Draft Ruling focuses on three key activities (software licensing, software distribution, and software services).  The conclusions reached in the Draft Ruling are summarised in the table below.

Payments made for / pursuant to

ATO view

Example in Draft Ruling

Licences to use software

Licences to reproduce software, or to modify software including access to source code

Payments will constitute royalties. Royalty WHT obligations may apply.

Examples 1 and 2

Licences for the simple use of software

Payments will not constitute royalties.  No royalty WHT obligations will apply.

Example 3

Distribution agreements

Software distribution agreements conferring on the distributor a right to enter into end-user licence agreements, or cloud service agreements

Payments will likely constitute royalties.  Royalty WHT obligations may apply.

Examples 4 and 5

Software distribution agreements conferring on the distributor a right to sell packaged or "shrink-wrapped" software

Payments are unlikely to constitute royalties.

No royalty WHT obligations should apply.

Example 6

Ancillary software services

Services ancillary to the modification of software

Payments will constitute royalties. Royalty WHT obligations may apply.

Example 7

Services ancillary to the simple use of software

Payments will not constitute royalties.  No royalty WHT obligations will apply.

Example 8

Of particular note is the increased interaction between copyright law and taxation law in determining whether a "royalty" arises.

The release of the Draft Ruling is welcome in that it provides the ATO guidance on a range of different software arrangements that are more closely aligned with what is currently seen in the market, as opposed to the types of arrangements formerly addressed in TR 93/12.  For example, the Draft Ruling addresses digital and SAAS methods of distribution.

The Draft Ruling was issued on the basis that interested parties can comment and make submissions, however only a short period is allowed for the making of the submissions.  We understand that some industry consultation was undertaken by the ATO prior to the release of the Draft Ruling.

Once the final ruling is issued, the ATO has proposed that it will apply both before and after the date of issue.

Impacted businesses should review the Draft Ruling to determine whether both historical and future positions taken regarding royalty WHT are consistent with the ATO's position, or whether there are refinements that could be made to these arrangements to support the position adopted.  This may include businesses that distribute software through cloud services, or where parties to a licensing agreement have provided for a software or source code escrow arrangement.

Outline of Draft Ruling

Increased interaction with copyright law

The Draft Ruling places greater emphasis on the technical aspects of Australian copyright law and its interaction with Australian tax law.  The ATO considers an amount to be a royalty to the extent that it is consideration for the grant of a right to do something that is the exclusive right of the copyright owner.  By reference to the Copyright Act, the ATO considers that in respect of software (a literary work), these rights will relevantly include the right to reproduce the work in a material form; the right to make an adaptation of the work; and the right to communicate the work to the public.

The Draft Ruling illustrates these core concepts through eight examples covering software licensing, software distribution, and software services.

Software Licensing (Examples 1 to 3)

Examples 1 to 3 are consistent with the previous TR 93/12 and demonstrate that payments for "simple use" of software will not constitute a royalty, but payments for the right to reproduce for resale or for the right to modify or adapt software (including access to source code) will constitute a royalty.

"Simple use" of software is defined as the process of using software for the purpose for which it was designed or intended to be used.  In these circumstances, any use of copyright necessary to facilitate the use of software as a functional product, is merely incidental and therefore associated payments are not royalties.

Software Distribution (Examples 4 to 6)

Examples 4 and 5 consider software distribution agreements which confer upon the distributor the right to enter into agreements with customers or end-users.  In a departure from the previous TR 93/12, the ATO now takes the view that despite customers or end-users ultimately receiving a license for simple use only, a distinction should now be drawn between transactions where the software is acquired pursuant to a sub-licensing arrangement, and transactions where the software is acquired by the customers/end-users directly.  In the former situation, the payments made from distributor to copyright owner for the right to distribute software by way of sub-licensing will constitute a royalty.

In contrast, Example 6 deals with the distribution of shrink-wrapped software.  In this case, because these distributions do not relevantly entail the use of copyright by the distributor the associated payments will not be treated as a royalty.

Software Services (Examples 7 and 8)

Examples 7 and 8 consider services ancillary to the modification or use of software.  Payments for the supply of assistance furnished as a means of enabling the application or enjoyment of the software will constitute a royalty, whereas payments for the provision of services in the modification or creation of software will not.

In application, the Draft Ruling notes that providing an end-user with assistance necessary to their exercise of a right to reproduce and modify software will constitute a royalty (Example 7); while providing assistance relating to the simple use of software will not constitute a royalty (Example 8).

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