Software Licensing In The ATO Crosshairs

The Australian Taxation Office (ATO) issued a new draft taxation ruling (TR 2024/D1) on 17 January 2024 in relation to the character of receipts in respect of software licensing and distribution arrangements, both domestic and cross-border. The ATO withdrew Draft Taxation Ruling TR 2021/D4 (TR 2021/D4) and replaced it with the updated draft for public consultation. The draft ruling provides the ATO’s view on when such receipts will be considered royalties under the Income Tax Assessment Act 1936 (ITAA 1936) and the relevant tax treaties, which may affect the withholding tax obligations of the payer and the assessability of the recipient. The draft ruling adopts a broad interpretation of royalties, based on the nature and substance of the rights granted or transferred, rather than the form or label of the arrangement. Consistent with other published guidance, the draft ruling also provides examples of common software arrangements and the ATO’s view on whether they give rise to royalties or not.

The new draft aims to address concerns raised from previous consultation on the primacy of tax treaties over domestic law, which was not taken into account in the prior draft ruling and includes a detailed analysis of the Copyright Act, focusing on the exclusive rights of copyright owners. Whilst the ruling acknowledges the need for apportionment of payments as a legal rights based concept, it lacks specific examples and methodologies for determining what is described as fair and reasonable apportionment. The larger concern in this revised draft is that where there are a number of things provided and paid for that are not separable and distinct, the entirety of the payment will be considered to be a royalty subject to withholding.

Companies are advised to carefully review the new draft ruling and consider its implications for their software distribution arrangements.

Interpretation of royalties
The ATO has now acknowledged that “[w]here a tax treaty applies, the royalty definition in that tax treaty is given primacy over the domestic tax law definition of royalty” by subsections 4(2) and 17A(5) of the Agreements Act. This came in response to consultation whereby the previous draft only dealt with the domestic law definition of a royalty (which is broader than treaty).

The draft ruling adopts a broad interpretation of royalties, based on the nature and substance of the rights granted or transferred, rather than the form or label of the arrangement. The ATO considers that royalties include payments for the use of, or the right to use, software products, software as a service (SaaS), cloud computing, and online platforms, regardless of whether the payer obtains a copy of the software or not.

Given the primacy of the treaty definition, the ATO has necessarily also dealt with the OECD commentary.

Application and consultation of the draft ruling
The draft ruling will apply prospectively from the date of issue, which is expected to be in January 2025. However, the ATO may apply the draft ruling retrospectively in cases of fraud or evasion. The draft ruling will replace the previous taxation ruling (TR 93/12) on the character of receipts from software licensing, which was issued in 1993 and withdrawn in 2018.

A&M’s key observations
This new draft taxation ruling issued by the ATO is a significant development for the software industry and the taxation of software and SaaS distribution arrangements in Australia. On examination of the scenarios provided by the ATO, the draft ruling adopts a very broad interpretation of royalties, based on the nature and substance of the rights granted or transferred. The specific circumstances will always dictate the resulting tax considerations and it will be important for companies to carefully evaluate how the new ruling may place their transactions in the crosshairs of the ATO.

Given the breadth and ambit of the ATO’s views, we recommend that companies in the software industry who are involved in software licensing and distribution arrangements in Australia review their existing and proposed arrangements and assess the potential impact of the draft ruling on their tax position and obligations. We also recommend that software developers and software users who have any questions or concerns about the draft ruling contact their tax advisers for further guidance and assistance, whether as a foreign parent or a local Australian company.