What the ATO’s draft ruling could mean for software distribution

Australian software distributors are being urged to take a good look at their software contract arrangements to determine their level of exposure if the ATO’s draft ruling of TR 2024/D1 comes into action. 

In January, the ATO issued a new draft ruling relating to new taxes on Australian software distributors. 

Historically, distribution fees by Australian software distributors to offshore vendors have been free of withholding tax. This is because withholding tax only applies to payments classed as “royalties” and long-standing international tax practice is that a software payment is only a royalty where the user has rights to exploit the underlying intellectual property, for example by modification of code.

The ATO’s new views, first proposed in 2021, turn this long standing practice on its head and impose royalty withholding tax on all distribution fees paid by Australian software distributors on the grounds that distributing software involves the use of copyright rights, according to A&O Shearman head of Australia tax Ka Sen Wong. 

“The ATO’s approach has been adopted in a bid to win more tax from multinational software vendors, but in many cases it will be borne by the Australian distributor,” Wong said.  

“Importantly, while the ATO is particularly concerned with related party transactions, their approach applies equally to third party distributors.”

Depending on the vendor’s home country, the new tax could vary from 5 per cent to 30 per cent of the distributor’s gross distribution fees – which in the worst case could exceed margins. Wong warned the ATO is so far planning to apply this view retrospectively to at least 2021.

“The economic impact of new taxes is rarely borne only by the immediate targets of the tax. Instead, it is usually allocated amongst all stakeholders, based on their negotiation power and importance to the value chain,” he said. 

“In the worst cases, the increased cost could price the marginal operator out of the market, weakening the industry and resulting in worse outcomes for businesses and consumers alike – and possibly even the ATO itself, if industry is driven offshore.”

US Treasury intervenes

The US Treasury has already challenged the ATO’s imposition of additional taxes on Australian software distributors, urging them to withdraw TR 2024/D1.

“This is positive, as the ATO’s position is extremely unfavourable to the Australian software distribution industry,” Wong said. 

In the case that the ATO is successful in imposing additional tax on US software companies, one downstream effect is that the US would be required to give those US companies credits for the Australian tax to reduce the US tax that would otherwise be paid on the income, Wong said. 

“This is because international tax laws and treaties require the home jurisdiction to give credits to avoid double taxation, which stifles cross-border business dealings,” he said. 

“The US Treasury is keenly aware that the ATO’s view results in a transfer from the US revenue to the Australian revenue. This means that the Australian software distribution industry has a powerful ally in this particular argument with the ATO.”

While it is still not clear where the ATO will land on this ruling, Wong said it is unlikely they will back down. 

“The ruling is in draft only, but it reiterates views from 2021, even in the face of significant criticism,” he said. “The US Treasury already wrote to the ATO in 2021 asking them to reconsider, though that first plea has fallen on deaf ears. 

“If the ATO persists, it may be that legislative change is the only solution, which may be exceedingly challenging in the current environment.”

Separately, Wong advised Australian software distributors should take a good look at their own arrangements to determine their level of exposure. 

“There are some exceptions, for example for mere distribution of software copies and a lot will turn on finer points of intellectual property law. It may be possible to insulate yourself through sensible changes to business structures or to negotiate cost-sharing with your vendor clients,” he added. 

“Enlisting the aid of expert intellectual property lawyers with international experience, working hand in hand with your legal and tax teams, will be vital.”