By Jian-Cheng Ku & Xander Stubenrouch, DLA Piper Nederland N.V., Amsterdam
The UN Committee of Experts on International Cooperation in Tax Matters has released a discussion draft, proposing to amend the UN model convention to include software payments in the definition of royalties. The proposed amendment would thereby allow the source jurisdictions to levy a withholding tax on software payments.
This change, proposed on 1 September, would affect article 12, paragraph 3, of the UN Model Convention Between Developed and Developing Countries. The Commentary on Article 12 of the UN model convention would be amended accordingly.
The inclusion of software payments in the definition of royalties is motivated by the Committee’s recognition of the growing importance for developing countries to preserve their taxing rights as a result of the digitalization of the economy and rapid technological development.
The UN model convention is intended to stimulate investment in developing countries and is, therefore, focused on granting taxing rights to source jurisdictions. Withholding tax is an important source of income for developing countries.
UN model versus OECD model
Currently, software payments are covered by article 7 of the UN model convention (the business profits article), which excludes the source jurisdiction from the levying of any withholding tax.
The proposal qualify software payments as royalties breaks with the traditional approach, taken in the OECD Model Tax Convention on Income and on Capital.
Under the OECD approach, software payments may only fall under the definition of royalties if the payment relates to obtaining the right to use the copyright in the program (i.e., in a manner that would, without a license, constitute an infringement of copyright).
Under the envisaged broadening of the definition of royalty in Article 12, paragraph 3, of the UN model convention, a payment for the simple use of, or right to use, software may be subject to withholding tax in the source jurisdiction.
Software is defined as follows:
“a program, or series of programs, containing instructions for a computer required either for the operational processes of the computer itself (operational software) or for the accomplishment of other tasks (application software). It can be transferred through a variety of media, for example in writing or electronically, on a magnetic tape or disk, or on a laser disk or CD-Rom. It may be standardised with a wide range of applications or be tailor-made for single users. It can be transferred as an integral part of computer hardware or in an independent form available for use on a variety of hardware.”
The inclusion of payments in respect of software as a component of the overarching definition of “royalty” will most likely result in a shift in taxing rights on these payments to developing countries.
This may result in a higher tax burden due to the generally higher withholding tax rate in source jurisdictions compared to the average corporate income tax rate in developed countries.
Proponents and opponents of the proposal
UN Member states in favor of the proposal to include software payments in the definition of royalties generally take the position that the definition of royalty should tie in more with the realities of the digital age.
They argue that the facilitating role of the source jurisdiction justifies the levying of withholding tax. E.g., the fact that the local legal system allows for protection and enforcement, and the availability of the suitable telecommunication infrastructure which contributes to the use of such software.
Furthermore, the amended definition would remove the existing confusion with respect to the use of copyright in software (covered by royalty definition) and the use of copyrighted software (not covered by royalty definition).
The UN members that oppose the proposal to include software payments in the definition of royalties take the position that there are no grounds to justify the allocation of taxing rights to a source jurisdiction.
They argue that, for example, standardized software (i.e., shrink-wrap software) does not differ from other goods. Therefore, such payments should be covered solely by Article 7 (business profits article) of the UN model convention. A distinction should be made between the copyright in software and the software itself, they argue.
It should be noted that there is no consensus among the UN member states on the proposed inclusion of software payments in the definition of royalties. While there may not be a need for consensus on the amendment of the royalty article in the UN model convention, it does indicate the likelihood that such an amendment will be implemented in the particular bilateral tax treaties.
Key takeaways
If the proposed inclusion of software payments in the definition of royalties in Article 12 of the UN model convention ultimately gets adopted, this could lead to a shift of the taxing rights of software payments towards source jurisdictions.
Companies receiving software payments from developing countries should, therefore carefully monitor the developments and review if these payments could become subject to withholding tax. This depends on whether the applicable bilateral tax treaties allow for a corresponding allocation of taxing rights to the source jurisdiction.
It is, however, still too early to say if the proposal will eventually be adopted. We will probably know more at the beginning of November after the Committee has met to discuss the outcomes of the discussion draft.
The discussion draft will be open for comments from 1 September through 2 October. Comments received will be discussed at the next meeting of the Committee, which is currently scheduled to take place (by electronic means) between 26 October and 6 November.
We will keep you informed of developments in this matter in future editions of MNE Tax.
Jian-Cheng Ku
Jian-Cheng Ku advises on international tax law and transfer pricing with a particular focus on international tax planning, M&A and private equity transactions, corporate reorganisations, and planning and design of transfer pricing policies.
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Xander Stubenrouch
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This article is misleading in several respects. It is incorrect to say that “Currently, software payments are covered by article 7 of the UN model convention”. It is more accurate to say, as the article quotes from proponents of the proposal, that it “would remove the existing confusion” about the scope of article 7. This confusion resulted from changes made to the Commentary of the OECD Model, following a report of 1992, to limit the scope of article 7. This excluded from the definition of royalties rights to operate computer software. Unfortunately, the UN Tax Committee (around half of whose members are from OECD countries) agreed to include extracts of the revised OECD Commentary in the Commentary to the UN model. At the same time, the UN Commentary also stated that some members considered that these payments may constitute royalties. This created the ambiguity in the interpretation of the UN Model, which the proposal now seeks to resolve.
The changes in 1992 created one of the series of loopholes in international tax rules that have been exploited, especially by digitalised companies, resulting in the enormous problems which the OECD was forced to begin to adddress in 2012 with the BEPS project.