The importance of intangible assets in the value creation process of multinational groups, and their ability to generate profits, underscores the need for careful analysis of their tax treatment. The unique characteristics of intangible assets present inherent challenges in both identifying them and determining their value.
One example of this complexity arises in payments made for the distribution of software, which can be classified either as royalties, if the copyright is being exploited, or as business profits, if the transaction is simply a distribution activity. The correct classification is crucial, as it impacts the tax treatment both at the domestic level and under applicable tax treaties. Furthermore, for intercompany transactions, this classification affects transfer pricing considerations.
Article 12 of the OECD Model Tax Convention on Income and on Capital (the OECD Model) defines “royalties” as any payments made for the use of or the granting of the right to use:
Copyrights on literary, artistic, or scientific works (including films);
Patents;
Trademarks;
Designs or models;
Secret formulas or processes; and
Information related to industrial, commercial, or scientific experience.
With regard to software transactions, the classification of payments depends on the specific rights that the beneficiary acquires under the agreement to use and exploit the software.
Software rights are considered intellectual property. According to the Commentary on Article 12 (paragraph 12.1), software is defined as a program or series of programs containing instructions for a computer, essential for its operation (system software) or for executing other tasks (application software).
Software can be transferred in various forms, either in writing or electronically, and may be standardised or customised for individual users. It can also be transferred as part of computer hardware or independently for use on different hardware.
This complexity makes it challenging to distinguish between payments for the exploitation of software – those that should be treated as royalties – and other types of compensation. This challenge is compounded by the ease with which software can be reproduced and the fact that acquiring software often involves creating a copy for its use.
However, paragraph 14.4 of the Commentary on Article 12 clarifies that agreements between the copyright holder and a distributor often allow the latter to distribute copies of the program without the right to reproduce it. In these cases, the rights acquired are limited to those necessary for the distributor to distribute copies of the software.
When this occurs, distributors pay only for the acquisition of copies of the software, not for the exploitation of its copyright. As a result, in transactions where a distributor makes payments to acquire and distribute copies of software (without the right to reproduce it), these payments should be treated as business profits under Article 7 of the OECD Model. Consequently, they should be taxed only in the country of residence of the recipient, regardless of whether the copies are distributed on physical media or electronically, and regardless of whether the software is customised for installation.
Italy’s stance
Italy has stated that paragraph 14.4 of the Commentary on Article 12 should not be considered a general rule for all software distribution licensing contracts. Instead, it argues that each case should be evaluated individually, considering all the factual and legal circumstances and the specific rights granted in the distribution agreement.
Over the years, the Italian Revenue Agency has taken varying interpretative positions on this matter. Prior to the 2008 amendments to the OECD commentary, the tax administration classified payments from software distribution contracts as royalties. Specifically, in Resolution No. 128/E of April 3 2008, involving a case where an intermediary distributed software between the foreign licensor and the final customer licensee, the “contract between Alfa and the Italian distributor involves, among other things, the partial transfer of copyright in the form of a limited right to distribute the software program to the public via magnetic media”. Based on this interpretation, the payments in such relationships were classified as royalties.
More recently, the Italian Revenue Agency reaffirmed its position in Principle of Law No. 5/2023, which directly contradicts paragraph 14.4 of the OECD commentary. The principle states that payments for acquiring and distributing copies of software (without the right to reproduce it) should be treated as royalties for tax treaty purposes.
Specifically, Principle of Law No. 5/2023 asserts that “payments made for the acquisition of partial copyright rights (without the transferor fully alienating the copyright) constitute royalties, as the consideration is paid for granting the right to use the program in cases where its use would constitute a copyright infringement. Examples of such agreements include licences to reproduce and distribute software incorporating the copyrighted program, or to modify and publicly distribute the program.”
Therefore, considering the position of the Italian tax authorities, it seems appropriate to proceed with a case-by-case analysis, particularly focusing on the contractual provisions and the actual conduct of the parties in order to understand the activities carried out by the distributor and the rights/limitations that apply to them.
The OECD’s stance
From a transfer pricing perspective, the OECD guidelines, since 2017, make a clear distinction between the definition of royalties for transfer pricing analysis and the definition under Article 12 of the OECD Model, clarifying that how a transaction is characterised for transfer pricing purposes is irrelevant to whether a payment qualifies as a royalty or is subject to withholding tax under Article 12 of the OECD Model.
According to the OECD, the concept of intangible assets for transfer pricing and the definition of royalties under Article 12 of the OECD Model are separate concepts that do not need to align. It is possible that a payment made between related companies may not be considered a royalty under Article 12 but could still be treated for transfer pricing purposes as a payment subject to the principles for intangible assets in transfer pricing rules.
Key takeaway
The correct classification of intragroup transactions related to software distribution requires operators to conduct a twofold analysis: one aimed at determining whether, under double taxation conventions, the payment qualifies as a royalty, and the other focused on providing a consistent representation and evaluation of the transaction for transfer pricing purposes.
