Tax alert: Tax treatment of software payments

5 min read

Preamble

The taxation of software payments has long posed challenges due to the diverse nature of these payments. Determining the appropriate tax treatment for software payments can be complex, often resulting in potential misclassifications. In response to this issue, the Zakat, Tax and Customs Authority (“ZATCA”) has issued guidelines aimed at bringing clarity to the tax treatment of software payments, particularly in cross-border transactions.

It's important to note that these guidelines are issued within the framework of the Income Tax Law (“ITL”) and its associated regulations and do not address the taxation of software payments under double tax avoidance agreements (“DTAAs”). In cases where a DTAA exists with a specific country, the tax treatment of software payments should be determined based on the provisions outlined in the agreement.

Software payments and their tax treatment

Software is inherently intertwined with intellectual property rights, and the specific rights granted to the purchaser play a crucial role in determining the categorization of software payments. The nature and extent of these rights determine how software payments are classified for tax purposes.

The limitations and exclusivity inherent in these rights must be thoroughly evaluated to determine the appropriate categorization and subsequent tax treatment. However, it's noteworthy that the Organization for Economic Cooperation and Development (“OECD”) and the United Nations (“UN”) have adopted differing approaches regarding the taxation of software payments, especially concerning royalties.

The OECD approach

According to the commentary on Article 12 of the OECD model tax convention, a clear differentiation has been established between the acquisition of a "copyright" and a "copyrighted article." Copyright, being an intangible property right, is discernibly separate from the transfer of a "copyrighted article." The OECD has classified payments for copyrighted articles as business profits rather than royalties. As such, payments made to grant the simple use of a software (copyrighted article), with no further rights to alter or exploit or modify, are regarded as business profits.

The UN approach

The United Nations (UN) has taken a distinct approach from that of the OECD regarding the taxation of software payments. In October 2023, the UN Committee of Experts proposed an amendment to Article 12(3) of the UN model treaty, which aims to classify software payments as "royalties." This proposed change expands the scope of royalties to include payments made for the use of software, or software copy, intended for internal purposes.

This departure from traditional treatment signifies the UN's evolving perspective on royalty taxation, particularly concerning software used internally within organizations.

The guidelines

The guidelines issued by ZATCA have provided clarity on various agreements involving software and databases, such as licensing agreements, distribution agreements, subscription agreements, and service agreements. These guidelines offer detailed, non-exhaustive examples to assist in understanding the taxation of software payments. Based on the examples provided in the guidelines, the categories of software payments can be summarized as follows:

Category	Nature of software payments to a non-resident
Royalties	Payments for the alienation of part of the rights in a copyright that does not constitute a distinct and specific property, resulting in the partial transfer of rights [non-exclusive] to reproduce, copy, or modify; Distribution arrangements in which the transferee acquires the right to make multiple copies of the program and distribute them in the market, resulting in the partial transfer of rights [exclusive] to reproduce, modify, and install; Payments for information concerning industrial, commercial, or scientific knowledge, resulting in the partial transfer of rights to modify; Payments for transactions in which the transferee acquires the right to make multiple copies of the program only for the usage within its own business, resulting in the partial transfer of rights to reproduce, install, and modify; Payments for access for specific purposes to an online database, with private and confidential data, resulting in the partial transfer of rights to access the database; Payments for transactions where the rights acquired are limited to those necessary to enable the business user to operate the program, resulting in the right to use and modify;
Business profits	Distribution arrangements in which the transferee acquires the right to distribute copies of the program without the right to reproduce the program, resulting in the partial transfer of rights to distribute; Development of software for a fee, resulting in partial transfer of rights [non-exclusive] to use for business purposes; Payments for transactions where the rights acquired are limited to those necessary to enable the business user to operate the program, resulting in the partial transfer of rights [non-exclusive] to use for business purposes;
Technical services	Development of software for a fee, resulting in the transfer of full ownership after the completion of the development
Capital gains	Payment for the alienation of the full ownership of the exclusive copyright; and Payment for the alienation of part of the rights in the copyright that constitute a distinct and specific property, resulting in the transfer of exclusive and transferrable copyright.
Other income	Payments for access to an online database, resulting in the partial transfer of rights to access the database with public content.

The guidelines have provided examples of mixed contracts, highlighting the importance of categorizing the transactions appropriately for withholding tax purposes. It is crucial to analyze the contracts to determine whether they entail the sale of goods, provision of services, or licensing of intellectual property, and classify them accordingly.

To enhance clarity, the categorization of software and database-related payments should be considered alongside the examples outlined in the guidelines.

The guidelines issued by ZATCA can be accessed through the following links:

Guidelines on the taxation of software payments [English]

Guidelines on the taxation of software payments [Arabic]