Persuading the ATO that foreign software licence fees are royalties proves to be a taxing task
Peter Heerey AM, QC, Tom Cordiner & Alan Nash
Correspondents for South Australia, Victoria and Western Australia
Note: Where any of the barristers were involved in a case reported below and the matter is still running, or potentially so, the other correspondents have taken the role of reporting that case.
Taxation – withholding tax – royalties for computer programs – meaning of “source code”
Australian entities that pay royalties to foreign-based licensors are required to withhold and remit to the Australian Tax Office a portion of that royalty, except to the extent an international tax agreement between Australia and the relevant country provides otherwise.
In the case of a Canadian licensor, a 10% withholding is to be made in respect of “royalty” payments, but a payment will not be treated as a “royalty” at all if it is “made as consideration for the supply of, or the right to use, source code in a computer software program, provided that the right to use the source code is limited to such use as is necessary to enable effective operation of the program by the user”: Article 12(7) of the Convention between Australia and Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (May 1981 and later amended in 2002).
In very simple terms, “source code” is the set of human-readable statements and instructions typically used by computer programmers to specify the actions to be performed by a computer when running a piece of software. Source code does not, however, necessarily form part of the software itself; it will be converted into “object code” (usually expressed in a machine code language) that a computer can recognise and run. Most licensed computer software will include the object code but not the source code.
The Applicant (Task) was the licensee under a distribution agreement with a Canadian company, CWI. Under the agreement, Task was granted the exclusive right in Australia to, among other things:
(a) market end-user licences of CWI’s software (such licence to be entered into between the end user and CWI itself);
(b) copy the software and supply it to end-users;
(c) supply professional services to end-users; and
(d) develop and license “Application Templates”, effectively separate and customised instructions designed to be used with, and improve the performance of, the software for each end-user.
Over the relevant period, Task paid CWI over $3.6m in fees. About half of that amount was attributable to sales of software licences, while the other half arose as a result of Task’s professional services and sale of Application Template licences. Task did not make any withholding in relation to the amounts paid to CWI. The Commissioner sought to have Task pay an administrative penalty in light of its failure to withhold 10% of the payments to CWI. In resisting the penalty, Task argued that the payments fell within the Article 12(7) exclusion.
At first instance, Davies J accepted that the CWI software included “source code”, and to the extent that the Commissioner argued that Task was supplied only with the “executable code” expressed doubts as to whether Article 12(7) was intended to be so narrowly interpreted. In her Honour’s view, however, Article 12(7) did not apply because the rights conferred on Task under the agreement went beyond those which “were necessary to enable effective operation of the program by the user”.
On appeal (Dowsett, Gordon and Jagot JJ), the Full Court also held that Article 12(7) did not apply. This was because the agreement did not (at least on its face) confer rights in respect of source code at all. The agreement made a clear distinction between “Computer Program”, “Executable Code”, “Licensed Program” and “Source Code”. None of Task’s exclusive rights made reference to “Source Code”; in contrast, the confidentiality regime in the agreement did. Accordingly, the Full Court rejected Task’s argument that a right to use CWI’s software necessarily carries with it the right to use its source code, and held, “Without more, the supply of a computer software program does not constitute supply of source code in that program for the purposes of Art 12(7)”. Further, even if Task was correct, it had failed to identify which payments were referable to the Source Code and Task’s right to use it, as distinct from its other exclusive rights.
It seems possible to the authors that Task would have had access to the source code, at least for the purposes of creating customised, interoperable Application Templates and providing professional support services. Even then, however, the nature of the rights granted under the agreement went beyond those contemplated by Article 12(7).
This case illustrates clearly the need to take special care when drafting software licences with overseas entities to ensure that source code rights are addressed where resort is likely to be had to carve outs like Article 12(7), and that mechanisms are included to address any withholding obligations (or at least identify who bears the risk in that regard).