Software licences and royalty withholding tax

Posted by Robert Yunan

The Federal Court of Australia handed down its decision in International Business Machines Corporation v Commissioner of Taxation on 12 April 2011, which addressed whether payments under a software licence agreement (Licence Agreement) between Australian subsidiaries of IBM and its US parent were royalties and consequently were subject to royalty withholding tax (RWHT).  The judgment reaffirms the importance of ensuring that the documentation under which cross border payments are made is carefully drafted to ensure that rights which do not involve the use of IP are separately identified.  This will assist in ensuring that RWHT is not charged on payments for these rights.

Federal Court judgment

The legal principles were not in dispute. 

Under the double tax agreement between Australia and the United States (DTA), a payment will be a royalty where it is a payment of any kind to the extent to which the payment is in consideration for the use of or the right to use any copyright, patent, design, models, plans, secret formulas or process, trademark or other like property or right.  The payment may be for any one or combination of the following:

• the use of an IP right;
• the right to use an IP right (even if the IP right is not used);
• for the use or right to use another like property or right;
• for the supply of certain knowledge/information;
• for assistance furnished to enable the application or enjoyment of an IP right or certain knowledge/information.

The dispute in the case was centred around the rights provided under the Licence Agreement.  IBM argued that the Licence Agreement was essentially a distribution agreement and the IP rights provided were ancillary to the enjoyment of the distribution rights.  The Commissioner successfully argued that the clear intent of the Licence Agreement was to give IBM's Australian subsidiary (IBMA) the rights to IBM's IP (to enable IBMA to carry out its function as the user, distributer and marketer of IBM's goods).  On this construction, IBMA was granted IP rights and the payments were therefore payments for the use of the IP rights (and therefore royalties and subject to RWHT).

The Federal Court's decision in favour of the Commissioner relied on the following key points in the drafting of the Licence Agreement:

• there was no reference in the Licence Agreement to the payments being for the exercise of general distributorship rights;
• the Licence Agreement did not look like a typical distributor licence;
• the Licence Agreement specifically referred to a grant of certain non-exclusive rights; and
• the recitals to the Licence Agreement stated that the Licence Agreement was intended to grant IBMA certain IP rights to assist in IBMA's marketing and distribution role, implying that such a role pre-existed the Licence Agreement and was accordingly covered by a separate agreement.

Lessons to learn from the decision?

While this case does not raise novel points of law, it illustrates the importance of clear drafting to ensure that rights which do not give rise to royalties are separable.  Where a payment is genuinely for a distribution right, the documentation should explicitly refer to a separate distribution right and potentially calculate the payment for those rights separately from any rights to use or access associated IP held offshore.

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