Characterizing software payments: What you need to know

16 November 2016

With dramatic advancements in cloud computing over the last decade, software companies are moving away from traditional software delivery models to providing software remotely on a subscription basis through a cloud, the most common example being Software as a Service (SaaS). As a result, cross-border software payments are on the rise, with some estimates indicating that “by 2018 almost one dollar in every three generated by the enterprise software market will come from cloud subscriptions.”

There are a number of international tax issues that affect providers and purchasers of cloud computing software, one of which is the characterization of software payments. This is important as it affects how software receipts are taxed and in particular whether withholding tax should be applied. In short, software-payment classification can have a big impact on the overall profitability of a sale and the cash flows associated with it.

Characterization: Royalty or Business Income?

With software payments, a key distinction that must be made is whether a payment constitutes royalty income (i.e., the sale of a copyright) or business income (i.e., the sale of a copyrighted product).

While characterizing software payments may seem conceptually straightforward, in practice it can be complex for many reasons.

There is in most jurisdictions no legal definition of “business income.” As a result, when categorizing software payments as either business income or royalties, one must examine the definition of royalties under applicable domestic law and tax treaties.

Most domestic tax laws and treaties closely follow the definition of royalties given by the Organization for Economic Cooperation and Development’s (OECD’s) Model Convention. This defines royalties as “payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematographic films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.”

While this definition captures a wide range of payments, there is no specific reference to “software,” much less cloud-computing payments. To assist taxpayers in this area, the OECD has endorsed a “rights-based approach” under which payments for the use of, or the right to use, copyrights are royalties, whereas payments for copyrighted products (such as off-the-shelf or pre-packaged software) are business income.

In the realm of cloud computing, applying these principles can be challenging, especially as cloud software business and delivery models are constantly evolving. For example, it is not unusual for cloud software providers to grant customers the ability to change or configure the settings of their software to suit customer needs, or to customize the software to integrate it with the customer’s business systems. Such changes can blur the lines between whether customers are using a copyright or a copyrighted product.

In such situations taxpayers and tax authorities could potentially interpret the definition of “royalty” differently and come to conflicting conclusions as to how a particular software payment should be classified. This is just one example among many involving the complexities of software-payment characterization.

Tax Implications

Often royalties are subject to a flat rate of withholding tax in the source country. The rate varies considerably between countries and may be reduced under a relevant double tax treaty or within a trading bloc (such as the EU). A withholding tax on royalties is typically a final tax, meaning that it will not be repaid or reduced by deductible expenses. It may be possible to obtain a tax credit in the recipient’s home country, but this can give rise to cash-flow issues and may not be guaranteed (e.g., the recipient is in a loss-making position).

Alternatively, where income is characterized as business income it is typically taxable in the source country only if the foreign entity maintains a permanent establishment (PE) in that country. Thus, if a foreign entity does not maintain a PE in that country, it is possible that its business receipts will not be taxable in the source country. Even where business income is taxable, it is on a net basis, meaning expenses can be set against the respective income.

It is therefore generally advantageous to have income characterized as business income rather than royalties.

A software purchaser who does not withhold tax on the basis that a payment represents business income must beware that they could be held liable for royalty withholding taxes if local authorities later deem the payment to be a royalty. (This is true even though the tax is rightfully the liability of the foreign recipient.) In this situation the purchaser could also be subject to penalties and interest on outstanding taxes as well as late filing penalties for related withholding tax returns (possibly without recourse against the software provider). On this basis, many software purchasers take a prudent approach and withhold even when a payment can reasonably be categorized as business income.

Conversely, for software providers, incorrect classification of payments as royalties will result in withholding taxes being wrongly applied. The process for reclaiming incorrectly withheld tax is often time-consuming and costly. Moreover, double taxation can occur if the home country classifies the payment as business income and denies any foreign tax credit claims for royalty withholding tax suffered in the software purchaser’s country.

How to Manage Withholding Tax Liabilities

When purchasing software, it is important to review the licensing agreement in detail, particularly the terms related to: software rights; delivery methods (electronic or otherwise); customization capabilities; any supplemental services; and payment mechanisms.

Similarly, where certain elements of a licensing agreement are ambiguous, it may be worth considering whether such components can be segregated or invoiced separately or whether a tax ruling (if available) can be obtained to provide clarity before entering into the agreement.

Software providers for their part should have open conversations with their customers about payment classification well before any initial payments are made. This will allow time to resolve any related disputes. Such conversations will also allow businesses to accurately assess tax costs and related requirements (e.g., tax accounting accruals, incorporating gross-up clauses in agreements, tax clearance procedures and tax treaty claims).

There’s no way around it: Characterizing software payments is often challenging and complex. To lower risks, software providers and purchasers should consult with their respective tax advisors whenever they are unsure of how to characterize software payments. A tax advisor can assist in advising what rates may apply domestically and/or under a particular tax treaty. An advisor can also identify tax-planning opportunities and, perhaps most importantly, provide information and recommendations concerning a local tax authority’s actual practices, which frequently go unwritten.