Australian businesses looking to outsource offshore need to be aware of the royalty withholding rules under the tax law.
Depending on the substance of an Australian business’s contracts for services, agreements could create a royalty withholding obligation. It is therefore important for businesses to distinguish between payments for services and royalty payments.
This article gives an overview of the current rules for royalty withholding obligations, including the consequences of withholding and the failure to withhold.
The domestic rules relating to royalty withholding tax obligations are found within s 128B of the Income Tax Assessment Act 1997 (ITAA 1997). The obligation generally arises when an Australian resident payer makes a payment to a foreign resident, and the payment falls within the definition of a “royalty” for Australian tax purposes.
The default withholding rate is 30% of the gross royalty amount; however, a lower rate may apply if Australia has a tax treaty with the country where the payment recipient is a resident.
Royalties received by a foreign resident where the payment is connected with its Australian branch may be treated as business profits and assessed as such in Australia. In these circumstances, the royalty payment is not normally subject to withholding tax. Royalty payments to offshore tax-exempt entities are generally exempted from withholding tax.
The withholding tax is based on the GST inclusive amount of the payment.
Royalties liable to withholding tax
The term “royalty” is broadly defined in the tax legislation and may extend to amounts that are not necessarily royalties within the word’s ordinarily understood meaning. The list of payments in s 6(1) of ITAA 1997 is fairly exhaustive. The following are some common payments that may be classified as royalties:
- payments for the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right, including payments:
- for the sale of a copyright, where the payment is determined by reference to the use of the copyright (ATO TR 2008/7);
- for the licence to reproduce or modify a computer program (ATO TR 93/12); and
- to an author for the use of or the right to use their work (ATO TD 2006/10);
- payments for the use of, or the right to use, any industrial, commercial or scientific equipment;
- payments for the supply of scientific, technical, industrial or commercial knowledge or information (eg know-how payments, payments for the supply of the source code or algorithms of a computer program).
As a general rule, a payment for services is not a royalty payment. However, a payment for services that are ancillary to or part of enabling the relevant technology, information, know-how, copyright, machinery or equipment may constitute a royalty payment.
The definition of “royalty” within tax treaties is generally narrower than that in the domestic tax legislation, and the definition and applicable tax rates of treaties may differ.
Consequences of the withholding tax
When an Australian resident payer has a withholding obligation, they can claim a deduction for the expense only if they withhold and remit the relevant amount to the ATO. The Australian payer is also required to issue the recipient with a payment summary which details the amount withheld and lodge a PAYG withholding annual report after the end of the relevant financial year.
The foreign resident may be entitled to a credit against their tax lability in their home country. However, this is not particularly helpful if the recipient is not previously aware of the withholding obligation, as they would receive less income than originally expected. In turn, this could affect existing fee arrangements between the Australian business and the overseas provider.
Indemnity from withholding obligation
There are instances where the payer’s royalty withholding obligation is indemnified by the recipient. This in itself could raise a royalty withholding obligation, to the extent that the indemnity amount is considered to be a royalty payment within the Australian tax law. An indemnity amount that effectively replaces the amount “lost” to the withholding tax liability would likely be subject to withholding tax. This is generally determined on a case-by-case basis, based on a review of the indemnity clause.
Failure to withhold
An Australian resident payer who fails to withhold and remit the correct amount of withholding tax to the ATO may be subject to an administrative penalty equal to the withholding tax amount and a general interest charge on the unpaid amount. Alternatively, they could be subject to a fine of up to 10 penalty units (currently a total of $1,800).
Are payments to Office Computer under the agreement subject to royalty withholding tax?
Yes. In ATO TR 93/12, the Commissioner considers a payment from a distributor for the right to make copies of a program from a master copy to be a royalty payment. This is regardless of the nature of payment – that is, whether it is a one-time or periodical payment or a fee calculated by reference to the number of times the program is reproduced. Similarly, the Commissioner considers a payment to the copyright owner by a software house or a computer programmer for the right to modify or adapt a program to be a royalty.
In the absence of a tax treaty, the payments are royalties under the Australian law and therefore subject to royalty withholding tax of 30%.
As local businesses continue to source assistance from service providers located offshore, these businesses should seek the help of their professional tax advisers to carry out a review of their dealings. Whether a payment is a royalty payment or a payment for services depends on the nature and purpose of the arrangement, and is determined on a case-by-case basis.
When carrying out a review of your business’s arrangements with overseas contractors, you should carefully consider whether you are outsourcing services or receiving any intellectual property from those overseas providers.
Call Carrick Aland in Dalby, Toowoomba or Chinchilla on 07 4669 9800 to gain a professional perspective on your circumstances.