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Royalties - the digital connection

Friday, 06 June 2014   (0 Comments)
Posted by: Author: PwC
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Author: PwC

Royalties are a feature of our commercial environment. They represent the means by which persons are able to use the ideas and technology of others in their commercial operations. Persons who receive royalties may become liable to tax on those royalties in the country of the payer of the royalty, and the payer may become liable to withhold tax on royalty payments.

Not surprisingly, South Africa imposes a withholding tax on royalties and the rights to tax royalties are dealt with in most, if not all, of the double tax agreements that South Africa has concluded.

The term "royalty” is defined in section 49A of the Income Tax Act, and means:

"…any amount that is received or accrues in respect of—

(a) the use or right of use of or permission to use any intellectual property as defined in section 23I; or

(b) the imparting of or the undertaking to impart any scientific, technical, industrial or commercial knowledge or information, or the rendering of or the undertaking to render any assistance or service in connection with the application or utilisation of such knowledge or information.”

Intellectual property as defined in section 23I includes patents, designs, trade marks, copyright, any property of a similar nature and knowledge connected to the use of any of these forms of property.

The Organisation for Economic Cooperation and Development (OECD), which has developed the Model Tax Convention on Income and on Capital, has developed commentaries on articles found in the model tax convention (which forms the basis for the vast majority of double taxation agreements concluded by South Africa). Article 12 of the Model Tax Convention deals with royalties, which are defined as payment for the "use of or the right to use” specified intellectual property.

The critical element in identifying whether a payment is a royalty whether under the domestic rules or the double taxation agreements is interpreting the term "the use or right of use or permission to use”. This involves an appreciation of what is meant by "use” (whether as a noun or a verb). Nowhere is there likely to be more confusion than in relation to computer software.

The high degree of flexibility that attaches to the supply of computer software raises questions whether payment for software is a royalty.Research by the OECD indicated that the intellectual property in software is typically protected under copyright law. Paragraph 12.1 of the OECD commentary on Article 12, succinctly sets the scene:

"Software may be described as 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 OECD draws a distinction between use of the software and the use of the copyright embodied in the software. In the former case, the user merely applies the program to produce an outcome. In the latter, the copyright is used to reproduce the software or form the basis of other software. A payment in the former case is made to obtain the benefit of the software’s capabilities.In the latter, the payment is made to obtain the benefit of the copyright within the software.

A practice has developed internationally to distinguish between the copyright and the software program, with the software program being likened to goods and the copyright being regarded as intellectual property.

Consider software that is stored on a carrier medium, such as a compact disk, and sold off the shelf to the public. The program purchased in this manner typically restricts the right of the user to make copies of the software, other than a back-up copy for own use. The buyer intends to benefit only from the processing capacity of the software. Generically this type of software is referred to as"shrinkwrap” software.

By comparison a software owner may give another the right to copy the software onto a carrier medium and to distribute such copies. In this instance, it can be clearly identified that the distributor is not operating the program, but is using the copyright embodied in the program to derive income. Thus the distributor intends to benefit from exploiting the copyright.

The distinction becomes blurred when the software is supplied electronically. If the software is downloaded from the seller’s server it still retains the intended character, either as shrinkwrap software or a right to use the copyright. The OECD commentary on Article 12 states (at paragraph 14.1):

"The method of transferring the computer program to the transferee is not relevant. For example, it does not matter whether the transferee acquires a computer disk containing a copy of the program or directly receives a copy on the hard disk of her computer via a modem connection.”

The question whether the payment for a computer program constitutes a royalty is best answered by establishing the substance of the arrangement giving rise to the payment. If the permitted activities of the user, in the absence of the agreement, would constitute an infringement of the owner’s copyright, the substance of the agreement is the use or the right of use of the copyright. In other words the user is applying the software for commercial gain in a manner that only the owner would be entitled to apply it if there were no agreement.

Technically, the making of a copy is an infringement of copyright; however the OECD (paragraph 14 of the commentary on Article 12) considers that a distinction needs to be made between making a copy as part of the use of the software and making copies in order to use the copyright:

"Regardless of whether this right is granted under law or under a license agreement with the copyright holder, copying the program onto the computer’s hard drive or random access memory or making an archival copy is an essential step in utilising the program. Therefore, rights in relation to these acts of copying, where they do no more than enable the effective operation of the program by the user, should be disregarded in analysing the character of the transaction for tax purposes.”

It is therefore vital that the substance of the agreement relating to the use of computer software be clearly identifiable.

Persons who purchase software from non-resident suppliers should consider carefully the nature of the user licence that they acquire, and determine whether they are liable to withhold tax on any payments made in respect of the software.

Similarly persons who supply software from South Africa across international borders should be alive to the taxation implications in the foreign jurisdictions. Where double taxation agreements are in force, the OECD interpretations assist greatly in establishing whether and how royalties should be taxed in the foreign jurisdiction.

This article first appeared on



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