The proper classification of intragroup transactions involving software distribution requires a twofold analysis. First, it is necessary to determine whether, under the applicable double taxation conventions, the relevant payment qualifies as royalty income. Second, the transaction must be consistently characterised and assessed for transfer pricing purposes.
Classifying software distribution payments and TP method selection
Paragraph 14.4 of the Commentary on Article 12 of the OECD Model Tax Convention on Income and on Capital clarifies that agreements between a copyright holder and a distributor frequently grant the distributor the right to distribute copies of software without conferring the right to reproduce them. In such circumstances, the rights acquired by the distributor are limited to those strictly necessary for the distribution of software copies. Accordingly, the distributor’s payment is made solely for the acquisition of copies of the software and not for the exploitation of the underlying copyright. Consequently, where a distributor makes payments to acquire and distribute software copies without obtaining reproduction rights, such payments should be treated as business profits under Article 7 of the OECD model, rather than as royalties under Article 12.
Once it has been established that software distribution should be classified as business profits, in the context of intragroup transactions it becomes necessary to select a transfer pricing method that appropriately remunerates the parties involved in accordance with the arm’s-length principle.
Italian case law
Judgment No. 1059/22/25 of the Tax Justice Court of Lombardy addressed the above issue, examining which transfer pricing method was most appropriate in a dispute between an Italian taxpayer and the Italian Revenue Agency. In that case, the Italian tax authorities challenged the company’s transfer pricing policy, which provided for two types of intragroup transactions:
The licensing of software to subsidiaries, together with upgrade and maintenance services, for which the company applied the transactional net margin method; and
Services provided by the parent company’s personnel to the subsidiaries, for which the company employed the comparable uncontrolled price method.
The Italian tax authorities argued that the two transactions were inseparable and formed part of an integrated package, in which both the Italian parent company and its foreign subsidiaries contributed. Accordingly, they contended that the most appropriate method would have been the transactional profit split method.
The first-instance court, however, upheld the company’s appeal, finding that the Italian Revenue Agency had not demonstrated a sufficiently high level of integration of business activities to justify the use of the profit split method.
The second-instance court dismissed the appeal filed by the Italian tax authorities, thereby confirming the correctness of the transfer pricing policies adopted by the taxpayer. The court emphasised that, under Italian transfer pricing legislation, the selection of the most appropriate method – together with the associated burden of proof – requires the tax authorities first to demonstrate that the method chosen by the company is unreasonable given the nature of the business and the relationships between the parent and its subsidiaries. Only then must the authorities justify why an alternative method would be more appropriate in the specific case.
With respect to the potential application of the profit split method, the court reiterated the principles established in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Such a method is considered appropriate only where the parties involved in the intragroup transactions jointly contribute unique and valuable intangibles and perform highly integrated functions. These requirements go well beyond the integration inherent in any synergistic corporate group activity resulting from the parent company’s coordinating role. According to the guidelines, there must be an “existence of unique and valuable contributions” by the subsidiaries.
In the present case, the transfer pricing documentation and statements made during the tax audit demonstrated that the distributing subsidiaries were responsible for the non-exclusive marketing of the software in their respective countries and performed only limited technical support functions for clients, primarily installation and configuration of the software. Ownership of the intangibles – in particular, the software – resided solely with the parent company. Functions such as programming, updates, implementation, and market research were carried out exclusively by the parent company, which assumed all associated risks and performed these activities through its own independent organisational structure in Italy.
Accordingly, there was no evidence of the high level of business integration required to justify the application of the profit split method. The second-instance court therefore upheld the distinction made by the company in its local file between the parent company’s functions – software development, updating, implementation, and marketing – and the sales functions assigned to the foreign subsidiaries in their respective countries.
Key takeaway
The case demonstrates that, in the absence of highly integrated functions and unique intangible contributions by subsidiaries, the profit split method is not automatically appropriate. Proper transfer pricing analysis must reflect the actual functions, assets, and risks assumed by each group entity, as well as take into account the specific characteristics of the relevant business and the value contributed by each entity to the group’s value chain.
