When is money payable in IP transactions a “royalty” for the purposes of Australian withholding tax?
The recent Federal Court of Australia decision in International Business Machines Corporation v Commissioner of Taxation  FCA 335 is a useful reminder that payment provisions in distribution and licence agreements need to be carefully drafted so as to avoid unintentionally incurring withholding tax under the Income Tax Assessment Act 1936 (Cth) ("the ITAA").
Withholding tax payable on royalties to non-residents
In general terms, under section 128 of the ITAA income that consists of a royalty payable by an Australian resident to a non-resident will be subject to the payment of withholding tax by the resident in Australia.
For the purposes of determining the scope of application of the ITAA in the IBM case, reference was made to the definition of "royalty" in Article 12(4) of the "Double Tax Agreement" between Australia and the United States. Relevantly, a payment is a "royalty" under Article 12(4) if the payment is made for any one or more of the following:
- for the use of an IP right;
- for the right to use an IP right;
- 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.
In IBM, the Federal Court held that the moneys paid by the distributor/licensee were paid in respect of the licences for such IP rights as were necessary for the distribution of the relevant products. The Court held that the arrangement did not confer a distribution right independently of the grant of IP rights.
Lessons when drafting distribution and licence agreements
When drafting distribution and licence agreements, care must be taken if any of the rights for which moneys are to be paid by a "resident" to a "non-resident" (as defined in the ITAA) are not considered "royalties" for the purposes of the ITAA. Examples of such arrangements include the right to distribute software.
In these cases, if either party wishes to legitimately avoid the withholding tax obligation on those moneys, it is critical to ensure that the agreement entered into clearly identifies the right being granted and the amount being paid for its grant, as distinct from other rights to which the withholding tax will apply.