The global digital economy is increasing in value; this includes opportunities for Australians to import offshore intellectual property to resell to Australian businesses and consumers. However, many Australian taxpayers probably don’t realise that they will likely bear the cost of paying a non-resident’s tax under Australia’s withholding tax collection mechanisms.
In that context, this article considers the Full Federal Court’s royalty withholding tax decision in Task Technology Pty Ltd v Commissioner of Taxation  FCAFC 113 (Task Technology) and the lessons to be learnt from the case.
Background of the dispute
The commercial arrangements secured by the Distribution Agreement were such that Task Technology was practically a “reseller” without the right to access and alter the underlying source code; this is not unusual considering CWI wished to protect its confidential information from reverse engineering and unauthorised exploitation.
The Australia-Cananda Double Taxation Agreement (DTA) permits Australia to tax royalties derived by Canadian residents from Australian residents and caps the royalty at 10%; under Australia’s withholding tax regime, the Australian resident making royalty payments must withhold and remit the tax (this is why the ATO pursued Task Technology and not the Canadian software house, CWI).
However, the DTA stipulates that Australia is not permitted to apply royalty withholding tax on certain arrangements where payments to the licensor are for the supply of source code which is “necessary to enable effective operation of the program by the user“.
Thus, an interpretive dispute arose in Task Technology as to:
- whether the Distribution Agreement granted Task Technology the requisite right to use CWI’s source code and the extent to which payments under the Distribution Agreement were attributable to that right or supply of source code; and
- whether the right or supply to the source code was necessary to enable effective operation of the program.
If Task Technology succeeded on both issues, it was not liable to withhold any amount on its payments to CWI.
The Full Federal Court held that Task Technology failed to prove it was granted a specific right to or supply of source code and that any portion of its payments were specifically attributable to the source code rights. In particular, the Court focused on the drafting of the instant Distribution Agreement and accepted international tax treaty principles in the OECD’s Commentary on the Model Convention.
Lessons to be learned
It is important to note that Australia is party to dozens of DTAs with various countries which may have different clauses and interpretations; each must be analysed on a case-by-case basis.
Having said this, below are 5 valuable lessons that can be drawn from the Task Technology case:
- If a cross-border transactions are structured appropriately, it may be possible to prevent or reduce the impost of Australian royalty withholding on certain payments to non-resident software houses. This can materially affect the global effective tax rate on cross-border distribution and licensing arrangements for a software house (consider 10% under the Australia-Canada DTA vs 30% on payments to non-treaty jurisdictions).
- Precise legal drafting is important to capture the commercial terms of a cross-border agreement. If it isn’t written and you have poor contemporaneous evidence, chances are, an Australian Court or Tribunal will not imply a term into an agreement to suit the taxpayer’s case.
- If access to source code is not permitted, the Australian distributor or licensee should factor in the cost of the withholding tax into its negotiations.
- If it is intended the local distributor has a right to access and modify the source code, then draft it into the applicable agreement.
- If access to source code is granted, price the right or supply appropriately at arm’s length (or you could jeopardize the effectiveness of the agreement). Transfer pricing studies may be appropriate to justify the charges for access to source code.
Are there any aspects of the article you want to know more about? We welcome any comments.