Extra tax could be payable on Australian software sales
Tax Alert - August 2021
By Emma Marr
The Australian Tax Office (ATO) has released a Draft Ruling on the treatment of certain payments for software that could have an impact on New Zealand businesses selling software or SaaS solutions into Australia via a re-seller or distributor. Anyone potentially affected should consider how it might apply to payments they receive from the distributor, and the resulting effect on cashflow, tax filings, transfer pricing adjustments and distribution agreements.
Deloitte Australia has produced a very helpful summary of the Draft Ruling, including diagrams to illustrate the eight examples in the Draft Ruling. The ATO proposes that when finalised the Draft Ruling may apply retrospectively in some circumstances. The previous ruling has been withdrawn with effect from 1 July 2021.
Who does the ruling apply to?
New Zealand businesses selling software or SaaS solutions to Australian customers have a few options of how to structure their operations. The most common are to sell directly to the end-user, or to sell via a re-seller or distributor. (Although generally in the software context the Australian entity would be a reseller, the ATO refers to distributors, and we have generally done the same). The distributor could be a third-party agent, or it could be an Australian subsidiary or branch of the New Zealand business. There are various reasons for setting up a separate Australian entity, including if the business in Australia has reached a size or complexity that requires a greater in-country presence – for example sales or support staff, or software developers. That level of activity may trigger a permanent establishment, meaning that standing up a separate entity to fence off the tax liability is the best approach. The previous ATO ruling concluded that the payment for a licence for the simple use of software wasn’t a royalty, whether the payment was made by the end-user or a distributor, but given the age of the previous ATO ruling, it didn’t specifically anticipate some of the newer online platform and SaaS based models.. “Simple use” refers to the right to use the software as designed, with limits on the ability to do anything else (modify, distribute, make copies and so on).
The bad news is that the ATO has drawn a distinction between these two methods of operating, and in its simplest form, having a distributor will, in some circumstances, now mean that payments from the distributor to the New Zealand business that owns the intellectual property (IP), will be treated by the ATO as royalties, and will now be subject to withholding tax in Australia even if the distributor’s rights are limited to simple use. The default rate of tax is 30%, which may be reduced by the double tax agreement (DTA) between New Zealand and Australia to 5%. In all cases, businesses should confirm how the definition of a “royalty” in the context of the treaty applies to the specific transaction. The New Zealand business might get a foreign tax credit for the tax in New Zealand, and this is something we are in discussions with Inland Revenue on currently. In any event, the impact of the inconvenience and delay in cash-flow, or indeed potentially not receiving the credit altogether, should be factored into operating models, forecasts, and intercompany agreements.
To explain a little further, the key is the ATO’s analysis of the meaning of “copyright” under domestic Australian legislation. Under that law a right to reproduce, adapt, or communicate software is an exclusive right of a copyright holder, as is the right to ‘authorise’ a person to do such an act. The right to reproduce or adapt software is consistent with OECD commentary and with DTAs generally, including those entered into by Australia However, the right to communicate software or authorise a person to perform any of those acts can be seen as extending the meaning of “copyright” beyond the normal boundaries of that word. “Communicating” software, in the ATOs view, includes sending it via electronic transmission (such as would happen when software is downloaded, possibly via a distributor) or making it available via the Cloud (generally by the end-user ie, SasS). As the Deloitte Australia analysis explains:
“For example, merely making software “accessible to or … used by an end user via cloud based technology such as software-as-a-service … without being downloaded on the end user’s computer or device” is considered sufficient in the Draft Ruling to communicate software, while in a digital download model, the distributor is considered to ‘authorise’ the end user to reproduce the software as part of the process of installing the software.”
The ATO considers that the copyright holder alone has the exclusive right to licence its software, and that granting the right to sub-licence software (such as may be granted to a distributor) even where this right is limited to simple use without the right to modify is itself a “use” of the copyright, so any payment for this right is a royalty.
Of the eight examples in the Draft Ruling, examples four and five may cause the most concern to New Zealand software businesses.
- Example Four: A New Zealand business (NZ Parent) distributes software to Australian end-users via an Australian subsidiary (AU Sub). The distribution agreement with AU Sub does not allow the software to be reproduced or modified. The end-user has a non-exclusive, non-transferrable right to download software for simple use, under an end-user licence agreement with AU Sub, and pays AU Sub for this licence.
- Example Five: NZ Parent provides Cloud-based Software as a Service (SaaS) services, and enters into an agreement that allows AU Sub to enter agreements with Australian end-users, that specify the terms on which end-users can use NZ Parent’s software.
In both cases the payments from AU Sub to NZ Parent are considered by the ATO to be a royalty, on the basis that NZ Parent (as the creator and owner of the copyright) has the exclusive right to licence their software, and the fee paid by AU Sub for the right to sub-licence the use of software is a royalty. The ATO takes the view that, when the distributor enters into an agreement with the end-user, it is “standing in the shoes” of the copyright owner and exploiting the copyright in the software, by granting licences to end-users. Any payment for such exploitation is therefore a royalty. The ATO appears to view an end-user licence agreement with the owner of the copyright differently, and doesn’t consider a royalty arises in two examples in the Draft Ruling where this is the case (albeit that one doesn’t have a distributor at all, and one involves packaged software sold in retail outlets, so both have other differences).
In either case, if NZ Parent sold the software or services direct to the Australian end-users, the ATO considers the payment from the end-user to the NZ Parent would not be a royalty. Oddly, the ATO considers that if AU Sub were selling packaged games at retail stores, payments from AU Sub to NZ Parent would not be a royalty. In a world where downloaded and cloud-based software dominates software sales, the distinction seems to be of vanishing relevance.
When does the ruling apply?
The exact date hasn’t been set yet, but the ATO has withdrawn its prior ruling with effect from 1 July 2021, and proposes that the Draft Ruling, when finalised, will apply both before and after its date of issue. Previous settlements of a dispute with the ATO on related issues would not change, and the prior ruling can continue to be applied to historic positions taken before it was withdrawn. However, as that ruling is now withdrawn, and there may be a gap before the position is finalised, retrospective application of the new ruling could mean that taxpayers have unpaid withholding tax by the time the new ruling is finalised.
What should I do now?
The ATO’s position appears to be out of step with OECD commentary, DTAs, and other countries own practices (including New Zealand’s). Nevertheless, if the ATO does finalise the Draft Ruling without changes, some New Zealand businesses are likely to have a withholding tax cost on payments from Australian distributors. The parties also need to be clear as to whether the New Zealand / Australia DTA will allow any tax relief on a withholding tax deducted by Australia.
As noted above, assuming Inland Revenue honours a foreign tax credit claim, this may result in less New Zealand tax being paid to offset the additional Australian tax. However, if the business is in tax losses or the New Zealand tax payable on the income is less than the withholding tax there could be an immediate cost. Even if a full foreign tax credit is available, there will be a reduction in imputation credits which could ultimately result in shareholders suffering double taxation.
You should seek advice if you think this is likely to impact your business, to clarify whether it will apply, how to deduct and pay the tax, and to evaluate the impact on cashflow, forecasts and transfer pricing adjustments. This would also be an opportune time to consider your operating and distribution model, and any necessary modifications. Get in touch with your usual Deloitte advisor if you would like assistance.
August 2021 Tax Alert contents
- What’s on the tax policy agenda?
- Extra tax could be payable on Australian software sales
- New OIO rules require acquisition structure and other tax-related information to be provided up-front
- Balancing risk and control in a COVID-19 world
- Are you ready for shovel-ready?
- Can I claim my lunch as a tax deduction?
- The great ute FBT debate
- Government moves to collect more bulk data from payment service providers
- The Inland Revenue FIF calculator still missing in action
- Snapshot of recent developments