& McKenzie Software Tax Characterization Helpdesk Quarterly October 2008 Characterizing foreign software revenues is a complex challenge for large and small software firms alike. Variations in the rules around the world affect the best way to do business in a given market. LawInContext s Software Tax Characterization Helpdesk is an online resource for software companies seeking to quickly access relevant legal and tax information in order to more efficiently manage their global withholding tax exposures in 40 countries around the world. This newsletter highlights a few of the recent updates and developments from the period of June August 2008 that are covered in more detail within the Software Tax Characterization Helpdesk. For more information on the Software Tax Characterization Helpdesk please visit www.lawincontext.com or contact us at info@lawincontext.com. INSIDE THIS ISSUE SPECIAL FEATURE Draft 2008 Update to the OECD Model Tax Convention Key Country Developments for : The Americas Mexico Asia Pacific Hong Kong India Malaysia Europe Belgium Italy Poland Software Tax Characterization Country Coverage LawInContext Contact Information
SPECIAL FEATURE Draft 2008 Update to the OECD Model Tax Convention The OECD issued its Draft 2008 Update to the OECD Model Tax Convention (Draft Update) on April 21, 2008. The Committee on Fiscal Affairs (CFA) approved the Draft Update on June 25, 2008 and the OECD Council approved the Draft Update on July 17, 2008. The revisions to the Commentary on Article 12 dealing with software revenue characterization contain numerous points of significance to the software industry. Payments by distributors for software products The Draft Update finalized new paragraph 14.4 concerning the characterization of distributors payments for software products. The text of new paragraph 14.4 is reproduced below: 14.4 Arrangements between a software copyright holder and a distribution intermediary frequently will grant to the distribution intermediary the right to distribute copies of the program without the right to reproduce that program. In these transactions, the rights acquired in relation to the copyright are limited to those necessary for the commercial intermediary to distribute copies of the software program. In such transactions, distributors are paying only for the acquisition of the software copies and not to exploit any right in the software copyrights. Thus, in a transaction where a distributor makes payments to acquire and distribute software copies (without the right to reproduce the software), the rights in relation to these acts of distribution should be disregarded in analysing the character of the transaction for tax purposes. Payments in these types of transactions would be dealt with as business profits in accordance with Article 7. This would be the case regardless of whether the copies being distributed are delivered on tangible media or are distributed electronically (without the distributor having the right to reproduce the software), or whether the software is subject to minor customisation for the purposes of its installation. In its response to comments that it received on the Draft Update, the OECD addressed the point that member states should conform their treaty interpretations to the Commentary s guidance, noting that a clear trend in that direction since the parts of the Commentary dealing with software payments were first adopted. The finalization of this very helpful language is a welcome development, but it is presently unclear from what date member (and perhaps non-member) states intend to apply the new guidance. Under the OECD s ambulatory approach to applying the Commentary as guidance for treaty interpretation, immediate application would be encouraged, on the basis that the revision reflects the evolving consensus of OECD member countries. Some states may take the position, however, that treaties are contractual relationships embodying only the parties intent at the time of treaty ratification, and thus, application
prior to agreement on a new treaty would be inappropriate because new paragraph 14.4 represents a change in treaty interpretation. Furthermore, it is not clear whether any state which has asserted withholding tax on these payments in the past would follow this interpretation to allow refund claims. Finally, we note that new paragraph 14.4 s language regarding customization gives rise to some ambiguity. This ambiguity may become an issue in jurisdictions that consider customization a relevant factor in the characterization analysis, such as Mexico, Spain, and Portugal, as discussed below. Member Country Observations OECD member countries have had varied reactions to the software-specific portions of the revised Commentary, as reflected in their Observations on the Commentary. Mexico, Spain, and Portugal Mexico, Spain, and Portugal inserted Observations into the revised Commentary expressing their non-adherence to, among other provisions, new paragraph 14.4. Previously, Mexico and Spain held the view that payments for software constituted royalties unless the following two requirements are met: (i) the software is absolutely standardized and (ii) the software is acquired by the purchaser for its own personal or business use. Although Mexico and Spain continue to adhere to this position in the revised Observation, they also explicitly acknowledge that payments for the right to distribute standardized software copies, without the accompanying right to reproduce or customize the copies, should not be characterized as royalties. Portugal signed on to this Observation as well, similarly excluding intermediaries payments from royalty characterization when the intermediaries neither reproduce nor customize the software products. Portugal s previous Observation simply reserved the right to treat and tax as royalties all software income that is not derived from a total transfer of the rights attached to the software. The new Observation therefore perhaps is a refinement of Portugal s position and a narrowing of the categories of payments which could be classified as royalties. Prior audit experience on this point was mixed, however, so this refinement also could be seen as an increased focus on this issue by the Portuguese authorities. Poland Like Portugal, Poland previously reserved the right to treat and tax as royalties all software income that is not derived from a total transfer of the rights attached to the software. Poland has withdrawn its Observation without replacing it with another Observation. Therefore, Poland presumably now adheres to the guidance set forth in the Commentary, including with respect to the characterization of payments by distributors as set forth in new paragraph 14.4. Italy Italy added an Observation to new paragraph 14.4, stating that it does not agree with the new paragraph s interpretation of payments by software distributors, and that it would instead characterize such payments by taking into account all circumstances, including the rights granted in relation to the acts of distribution.
Slovak Republic The Slovak Republic reserved the right to treat payments for the use of, or the right to use, software according to a different tax regime from that provided for copyrights. Non-Member Country Observations Non-OECD-member countries have also expressed their reaction to the revised Commentary on software through their Observations and Reservations. Montenegro Montenegro withdrew its Observation of non-adherence to paragraphs 14 and 15 of the Commentary, which asserted the view that payments for software products constitute royalties when less than the full rights to the software are transferred. Argentina, Morocco, Serbia, and Tunisia continue to assert this view in their Observations. Democratic Republic of Congo, Kazakhstan, India, and Malaysia Each of the Democratic Republic of Congo, Kazakhstan, India, and Malaysia reserved its position on the characterization of payments for software products under paragraph 14 of the Commentary on Article 12. Malaysia explicitly stated that it viewed license fees for the right to distribute software as royalties, although it framed this view in the context of paragraph 14.2, which deals with site and enterprise licenses, rather than new paragraph 14.4. Contributors: Gary Sprague, Robin Chesler and Kavan Lee Baker & McKenzie, Palo Alto. Key Country Developments The Americas MEXICO New Commentary Interpretation of Business Profits A new commentary is available regarding a non-binding precedent of the Mexican Supreme Court where the Court held that article 210 of the MITL, in effect as of January 1, 2005, which excludes from business activities certain income referred to in Title V of the Income Tax Law, does not violate the Mexican Constitution. See topic: Country Summary and topic: Statement of the Law, subtopic: Treaty Law.
2008 Draft Update to Model Tax Convention As discussed above in the special feature article on the 2008 Draft Update to the Model Tax Convention, Mexico inserted Observations into the revised Commentary expressing its non-adherence to, among other provisions, new paragraph 14.4. Previously, Mexico held the view that payments for software constituted royalties unless the following two requirements are met: (i) the software is absolutely standardized and (ii) the software is acquired by the purchaser for its own personal or business use. Although Mexico continues to adhere to this position in the revised Observation,it also explicitly acknowledges that payments for the right to distribute standardized software copies, without the accompanying right to reproduce or customize the copies, should not be characterized as royalties. Single Rate Business Tax Taxation of Royalties in Related Party Transactions On January 1, 2008, Mexico enacted the single rate business tax. This new tax, known in Mexico as IETU for its acronym in Spanish, is an alternative minimum tax against income tax, payable only if it is greater than the income tax. The IETU is imposed on a cash basis, that is, inasmuch as the price or consideration agreed upon in a given transaction has been received. Pursuant to Article 3 (I) of the IETU Law, the temporary grant of the use or enjoyment of property between related parties that gives rise to the payment of royalties, is an activity excluded from the IETU, whether the related parties are residents of Mexico or nonresidents. However, payments of any kind (whether they are characterized as royalties or not) for the temporary use or enjoyment of industrial, commercial or scientific equipment are subject to IETU. See topic: Country Summary and topic: Statement of the Law, subtopic: Domestic Law. One of the requirements for the deductions established by the IETU Law is that they must correspond to IETU taxable income for the supplier of the goods or services. Consequently, royalties paid to a nonresident related party are not deductible for IETU purposes, unless the royalties are paid for the temporary use or enjoyment of commercial, industrial, commercial or scientific equipment. The non-deductibility of such royalties is, at present, being challenged by several Mexican companies through an amparo procedure. See topic: Country Summary and topic: Application of Law, subtopic: Software Reproduction Licenses. Asia Pacific HONG KONG The corporate tax rate is reduced from 17.5% to 16.5% in 2008/09 (i.e., an effective rate of 4.95%). See topic: Statement of the Law, subtopic: Domestic Law.
INDIA The Authority for Advance Rulings (AAR) has recently passed a negative ruling in the application filed by The Airports Authority of India (Applicant), characterizing payments for software products as royalties. In the present application, the Applicant had entered into two separate contracts with a US company, Raytheon Company (RC) under which RC were to provide the Applicant with customized software, documentation, hardware and with certain installation, testing, and training services. The Applicant sought the ruling of the AAR on whether the payments made by it to RC should be taxable in India. The AAR rejected the argument of the Applicant that the transaction involved outright sale of hardware and copyrighted articles, and that its payments should not be subject to Indian taxation. The AAR rejected the Applicant s reliance on the Supreme Court judgment in the case of Tata Consultancy Services that characterized software products as goods and held that the said case was decided in the context of sales tax rather than income tax, connoting different legislative backgrounds and factual circumstances. The AAR further concluded that the OECD Commentary was of very limited persuasive value. Although this AAR ruling is only binding on the Applicant it would certainly have a persuasive value and the Indian courts, revenue authorities and appellate authorities do recognize the principles and rationale laid down by the AAR while deciding other cases. Therefore, until a specific amendment is made to the IT Act or a notification is passed by the Central Board of Direct Taxes (CBDT) clarifying this issue, the position regarding characterization of software payments as business profits and not royalty cannot be considered to be settled. For more information, see topic: Country Summary, topic: Statement of the Law, subtopics: Domestic Law and Treaty Law, topic: Application of the Law to Software Transactions, subtopics: Single v. Multiple User Licenses, Physical v. Electronic Delivery, Standardized v. Customized Software and Software Reproduction Licenses. 2008 Draft Update to Model Tax Convention As discussed in the special feature article on the 2008 Draft Update to the Model Tax Convention, India has reserved its position on the characterization of payments for software products under paragraph 14 of the Commentary on Article 12. MALAYSIA Tax Rulings For new information regarding public rulings and advance taxpayer rulings, see topic: Practice, subtopic: Rulings Practice 2008 Draft Update to Model Tax Convention As discussed in the special feature article on the 2008 Draft Update to the Model Tax Convention, Malaysia has reserved its position on the characterization of payments for software products under paragraph 14 of the Commentary on Article 12. Malaysia explicitly stated that it viewed license fees for the right to distribute software as royalties, although it framed this view in the context of paragraph 14.2, which deals with site and
enterprise licenses, rather than new paragraph 14.4. Europe BELGIUM Patent Deduction The 80% patent deduction is applicable to both royalties derived from intellectual property licenses and part of the income derived from the production of goods or delivery of services where the patents are used (i.e., the part that is attributable to the patents). The deduction becomes applicable from the moment the patent has actually been granted (a patent request is not sufficient) until the patent expires. Only income from patent rights qualifies for the deduction whereas income from copyrights, trademarks and knowhow is excluded. See topic: Other Relevant Points. 2008 Draft Update to Model Tax Convention It is to be expected that Belgian domestic law will follow the clarification set forth in the 2008 Draft Update to the Model Tax Convention: Where the rights acquired in relation to the copyright are limited to those necessary for a commercial intermediary to distribute copies of the software program, the payment made by the distributor will be treated as commercial income within the meaning of Article 7 OECD Model Convention rather than as royalty. For more information, see topic: Application of the Law, subtopic: Software Reproduction Licenses. ITALY Software Characterization Recent Tax Ruling In a recent Ruling n. 128 dated April 9, 2008, the Tax Administration clarified that payments made by an Italian distributor to a foreign software house should be qualified as royalty, irrespective of the fact that the resale regards a standardized program, since the relevant payments should be referred to the acquisition of partial author rights (without that the transfer of the entire copyright). As a result, such payments should be qualified as income arising from the exploitation of intellectual property right, based on the argument that the payment is aimed in any event to grant the right to use a program in cases in which the use of such program would in principle constitute an infringement of the copyright. See topic: Practice, subtopic: Rulings Practice.
2008 Draft Update to Model Tax Convention As discussed in the special feature article on the 2008 Draft Update to the Model Tax Convention, Italy added an Observation to new paragraph 14.4, stating that it does not agree with the new paragraph s interpretation of payments by software distributors, and that it would instead characterize such payments by taking into account all circumstances, including the rights granted in relation to the acts of distribution. POLAND Procedure for Obtaining Treaty Benefits In order to invoke the right under a relevant tax treaty and obtain the benefit of a reduced withholding tax rate on royalties, the recipient of the royalty payments must provide the Polish payee, who is acting as the withholding agent, with a certificate of residence. The certificate of residence is a document issued by the relevant taxing authorities confirming that the recipient is domiciled in that particular country for income tax purposes. It is recommended that the certificate of residence should be delivered prior to the payment date. There are no regulations regarding the validity of a certificate of residence but in practice, the tax authorities recommend that a new certificate of residence is obtained each year. See topic: Statement of the Law, subtopic: Treaty Law. Audit Activity Withholding tax on software payments is often audited by the taxing authorities. These taxing authorities take various approaches and there is no consistent practice with respect to this issue. Some of the taxing authorities strictly adhere to the OECD guidelines, whereas others are more restrictive and do not apply OECD Commentary properly (taxation of software payments with withholding tax is a relatively complex issue requiring comprehensive knowledge of both tax law and copyright law). It is worth noting that the tax authorities annually receive information about payments which are covered by the domestic regulations regarding royalties even if actually such payments were not taxed due to favorable provisions of double tax treaties. On this basis, tax authorities determine which Polish entities pay for software licenses for which the tax authorities may easily conduct tax audits focused on the issue. See topic: Practice, subtopic: Audit Activity. Tax Rulings For updated information on rulings practice in Poland, see topic: Practice, subtopic: Rulings Practice. 2008 Draft Update to Model Tax Convention As discussed in the special feature article on the 2008 Draft Update to the Model Tax Convention, Poland previously reserved the right to treat and tax as royalties all software income that is not derived from a total transfer of the rights attached to the software. Poland has withdrawn its Observation without replacing it with another Observation. Therefore, Poland presumably now adheres to the guidance set forth in the Commentary,
including with respect to the characterization of payments by distributors as set forth in new paragraph 14.4. The Software Tax Characterization Country Coverage The Americas Argentina Brazil Canada Chile Colombia Mexico Peru United States Venezuela Africa and The Middle East Israel South Africa Asia Pacific Australia China Hong Kong India Indonesia Japan Korea (South) Malaysia New Zealand Philippines Singapore Taiwan Thailand Europe Austria Belgium Czech Republic France Germany Greece Hungary Italy Netherlands Poland Portugal Russia Spain
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