A recent Federal Court judgment highlights that when drafting software distribution agreements, consideration should be given as to whether payments are “royalties” under Australian tax law and/or under any relevant international tax treaty. Appropriate withholding tax clauses should be included in such agreements. Tax advice should also be sought in cases where one of the parties wishes to rely on an exemption from withholding tax. Penalties may apply for failure to withhold and the amount payable may not be deductible for income tax purposes.
Generally, payment of royalties for the use of intellectual property by an Australian software distributor to an offshore licensor is subject to 30% withholding tax, unless an exemption applies. A reduced rate of withholding (or an exemption) may apply to royalties under the terms of a Double Tax Agreement (Treaty) between Australia and the country in which the licensor is resident.
In Task Technology Pty Ltd v Commissioner of Taxation  FCA 38, an Australian software distributor (Distributor) entered into a Distribution Agreement (DA) with a Canadian software developer. Under the DA, the Distributor paid annual fees for the right to market and distribute certain software, to make copies of that software for distribution and to develop and supply templates for use with that software (the Rights).
No amount was withheld by the Distributor from payments made to the developer in Canada. The Commissioner of Taxation issued an administrative penalty to the Distributor for failing to withhold, equal to the amount that should have been withheld.
The Distributor sought a declaration that the payments were exempt from withholding tax on the basis of an exemption under the relevant Treaty. The exemption provided that withholding tax does not apply to “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”. It was not in dispute that the payments were “royalties” as defined in the Treaty.
The Court refused the Distributor’s application for declaratory relief, holding that the Distributor did not obtain relevant rights in the software for the limited purpose of “effective operation of the program” and therefore the exemption did not apply. Rather, the Distributor acquired the Rights for the commercial exploitation of the software.
The Federal Court confirmed that royalty withholding tax applied and the penalties imposed by the Commissioner were upheld.
An appeal has since been filed and is scheduled to be heard on 29 April 2014.