FEDERAL COURT OF AUSTRALIA

Task Technology Pty Ltd v Commissioner of Taxation [2014] FCA 38

THE COURT ORDERS THAT:

1.    The proceeding be dismissed.

2.    The applicant pay the respondent’s costs of the proceeding.

Note:    Entry of orders is dealt with in Rule 39.32 of the Federal Court Rules 2011.

REASONS FOR JUDGMENT

INTRODUCTION

1    The applicant (“Task Technology”) is the Australian distributor of software known as the “CaseWare Working Papers” (“the CWI software”) that was developed by a Canadian resident entity, CaseWare International Inc (“CWI”). The issue for the Court’s determination is whether payments that Task Technology made to CWI pursuant to the distribution agreement in the income years ended 30 June 2007 to 30 June 2011 (“the relevant period”) were “royalties” for the purposes of the Convention between Australia and Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (Canberra, 21 May 1980) [1981] ATS 14, also known as the Australia-Canada Double Tax Agreement (“the DTA”).

DEFINITION OF ‘ROYALTIES’ IN THE DTA

2    Article 12(3)(a) of the DTA defines “royalties” to include, relevantly:

…payments… to the extent to which they are made as consideration for:

(a) the use of, or the right to use, any copyright,… secret formula or process…

3    Article 12(3)(a) of the DTA is to be read in conjunction with Article 12(7) which provides that:

Without prejudice to whether or not such payments would be dealt with as royalties under this Article in the absence of this paragraph, the term “royalties” as used in this Article shall not include payments… made as consideration for the supply of, or the right to use, source code in a computer software program, provided that the right to use the source code is limited to such use as is necessary to enable effective operation of the program by the user.

QUESTION FOR DETERMINATION

4    The sole question for the Court is whether the payments fell under Article 12(7), as the case was conducted by the parties on the common basis that the payments were “royalties” within the scope of Article 12(3)(a) unless excluded by Article 12(7). Task Technology eschewed putting an argument that the payments that it made to CWI were not otherwise properly characterised as “consideration for the use of, or the right to use, any copyright”.

HOW THE ISSUE ARISES

5    The CWI software is a computer program consisting of source code, which causes accounting and financial data input into various templates used with the software to be output automatically in the form of financial and accounting reports. The template is used in conjunction with the software to enable information to be output in a form appropriate for the end user.

6    Task Technology is licensed by CWI to market and distribute the CWI software pursuant to “end user licences” and to make copies of the software for distribution. It is also licensed to develop and supply templates for use with the CWI software pursuant to “application template licences”.

7    Task Technology pays annual fees to CWI under its licensing arrangements with CWI. In the relevant period, the fees that it paid included a percentage of the software and template license fees that Task Technology charged its customers (“the payments”). The respondent (“the Commissioner”) claimed that the payments were “royalties” within the meaning of the DTA and subject to withholding tax and that Task Technology was required by s 12-280 of Schedule 1 to the Taxation Administration Act 1953 (Cth) (“the TAA”) to withhold amounts from the payments in respect of withholding tax. Task Technology did not withhold any amounts and the Commissioner gave Task Technology a notice of an administrative penalty under s 16-30 of Schedule 1 to the TAA. Section 16-30 provides that an entity that fails to withhold an amount as required by Division 12 of the TAA is liable to pay to the Commissioner a penalty equal to that amount. Task Technology seeks declarations that the payments were not royalties, that it was not obliged to withhold any amounts from the payments, and other ancillary declarations.

SUBMISSIONS

8    Task Technology argued that the payments came under Article 12(7) because it had the right to use, and used, the CWI software to produce templates and to procure end user licences, and that both uses were necessary for the effective use of the computer program. Task Technology also contended that the right to use CWI software was limited to such uses because neither it nor the licensees of the software were given the right to modify the source code.

9    The Commissioner contended that Article 12(7) did not apply to the payments in question because:

    the payments were consideration for the rights given to Task Technology pursuant to the distribution agreement, which included the right to copy the CWI software for distribution; and

    further, that for Article 12(7) to apply there must be a supply of source code to the entity making the payment in question, or the grant to that entity of a right to use the source code and, in the present case, Task Technology was not supplied with the source code nor given any right to use it. It was contended that what was supplied to Task Technology, and what it had the right to use, was executable code: that is, the code understood by the computer and not source code being the computer instructions written in a language readable by appropriately trained humans.

decision

10    The starting point is to ascertain the meaning of Article 12(7), which is to be interpreted in accordance with the principles set out in the Vienna Convention on the Law of Treaties 1969 (“the Vienna Convention”): Thiel v Federal Commissioner of Taxation (1990) 171 CLR 338 (1990); Commonwealth Minister for Justice v Adamas [2013] HCA 59. Article 31(1) of the Convention requires the text of a treaty to be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose. Article 32 provides that there may be recourse to supplementary means of interpretation in order to confirm the ordinary meaning resulting from the application of Article 31, or to determine the meaning where interpretation according to Article 31 leaves the meaning ambiguous or obscure, or leads to a result that is manifestly absurd or unreasonable.

11    In the present regard case, regard to the commentary on the equivalent article in the OECD Model Tax Convention on Income and on Capital (“the OECD commentary”) assists to throw light on the object and purpose of Article 12(7). Relevant parts of the Commentary are:

    Paragraph 12.2:

The character of payments received in transactions involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program…

    Paragraph 13:

The transferee’s rights will in most cases consist of partial rights or complete rights in the underlying copyright... or they may be... partial or complete rights in a copy of the program… In unusual cases, the transaction may represent a transfer of “know-how” or secret formula (paragraph 14.3).

    Paragraph 13.1:

Payments made for the acquisition of partial rights in the copyright (without the transferor fully alienating the copyright rights) will represent a royalty where the consideration is for granting of rights to use the program in a manner that would, without such license, constitute an infringement of copyright. Examples of such arrangements include licenses to reproduce and distribute to the public software incorporating the copyrighted program, or to modify and publicly display the program. In these circumstances, the payments are for the right to use the copyright in the program (i.e. to exploit the rights that would otherwise be the sole prerogative of the copyright holder).

    Paragraph 14:

In other types of transactions, the rights acquired in relation to the copyright are limited to those necessary to enable the user to operate the program, for example, where the transferee is granted limited rights to reproduce the program. This would be the common situation in transactions for the acquisition of a program copy. The rights transferred in these cases are specific to the nature of computer programs. They allow the user to copy the program, for example, onto the user’s computer hard drive or for archival purposes. In this context, it is important to note that the protection afforded in relation to computer programs under copyright law may differ from country to country. In some countries the act of copying the program onto the hard drive or random access memory of a computer would, without a license, constitute a breach of copyright. However, the copyright laws of many countries automatically grant this right to the owner of software which incorporates a computer program. 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. Payments in these types of transactions would be dealt with as commercial income in accordance with Article 7 [the business profits rule] (emphasis added).

    Paragraph 14.3:

Another type of transaction involving the transfer of computer software is the more unusual case where a software house or computer programmer agrees to supply information about the ideas and principles underlying the program, such as logic, algorithms or programming languages and techniques. In these cases, the payments may be characterised as royalties to the extent that they represent consideration for the use of, or the right to use, secret formulas or for information concerning industrial, commercial or scientific experience which cannot be separately copyrighted. This contrasts with the ordinary case in which a program is acquired for operation by the end user (emphasis added).

12    Those paragraphs were part of the OECD commentary when the protocol amending Article 12 of the DTA to the form under consideration was signed in 2002. At the time, the OECD commentary also set out Canada’s observation on paragraphs 14 and 14.3. Canada’s position was that it would treat all payments for the use of, or right to use, computer software as “royalties” for the purpose of the model article. Paragraph 27 of the Commentary under “Observations” stated as follows:

Canada does not adhere to paragraphs 14 through 14.3. In Canada, payments by a user of computer software pursuant to a contract that requires that the source code or program be kept confidential, are payments for the use of a secret formula or process and thus are royalties are within the meaning of paragraph 2 of the Article.

13    The term “royalties” in Article 12 of the OECD Model Tax Convention included:

…payments of any kind received as consideration for the use of, or the right to use, any… secret formula or process…

14    The definition of “royalties” in Article 12 of the DTA before the 2002 protocol similarly defined “royalties” to include:

…payments… to the extent to which they are paid as consideration for the use of, or the right to use, any… secret formula or process…

15    The definition of “royalties” in Article 12 of the DTA was not materially amended by the 2002 protocol and still includes:

…payments… to the extent to which they are made as consideration for:

(a) the use of, or the right to use, any… secret formula or process…

16    Against that background, it is significant that the explanatory memorandum to the International Tax Agreements Amendment Bill (No 2) 2002 (Cth) that introduced the Protocol stated:

Canadian tax treaty practice in relation to computer software, in accordance with its Observation to the Commentary to Article 12 of the OECD Model, is to treat as royalties, payments under contracts that require the source code in the computer program to be kept confidential. However, new paragraph 7 provides that such payments will not be treated as royalties where the right to use the source code is limited to such use as is necessary to enable the user to operate the software program. In these cases, Article 7 of the Convention will apply: at [1.35].

17    In paragraph 5.19 of the explanatory memorandum, the insertion of Article 12(7) was explained as:

clarifying the operation of the royalties provision in the case of use of software.

18    It is therefore significant that the text of Article 12(7) uses language similar to paragraphs 14 and 14.3 of the OECD Commentary. Once it is understood that Canada treats as “royalties” within Article 12 all payments for computer software, there is a clear purpose for Article 12(7): that is, for the purpose of the bilateral agreement between Canada and Australia to remove from the definition of “royalties”, payments in relation to computer software where the program was acquired for operation by the end user and the rights acquired in relation to the supply or use of that software were no more than to enable the effective operation of the program by the end user. Such a construction gives effect to the ordinary meaning of the text of Article 12(7) interpreted in accordance with the principles contained in Articles 31 and 32 of the Vienna Convention.

19    The Commissioner’s argument that Article 12(7) did not apply in the present case because Task Technology was supplied with and used “executable code”, not the source code of the computer program, rested on a narrow literal reading of that article. It is an established principle that international instruments should be interpreted in a more liberal manner than would be adopted if the Court was required to construe exclusively domestic legislation: Applicant A v Minister for Immigration and Ethnic Affairs (1997) 190 CLR 225 at 255. I doubt that Article 12(7) is to be construed in the narrow way in which the Commissioner contended. However, it is unnecessary for me to form a concluded view on whether the term “source code” should be so confined. Whether the term may have some broader understanding in the context of Article 12(7) was not the subject of argument in the present case and need not be decided as I consider that Article 12(7) does not apply to the payments the subject of this proceeding.

20    The payments are not excluded by Article 12(7) from the definition of the term “royalties” in the DTA because the nature of the rights that Task Technology acquired under the distribution agreement, in relation to the use of the software for which the payments were made, were not limited to such rights as were necessary for the effective operation of the software by Task Technology itself but for the commercial exploitation of that software by Task Technology through the right to copy the CWI software for sale to end users and the right to use the copyright for the purposes of developing its own templates to sell in conjunction with the CWI software.

21    As the payments are “royalties” for the purposes of the DTA, Task Technology is liable to pay an administrative penalty under s 16-30 of Schedule 1 to the TAA for failure to withhold 10 per cent of each payment that it made to CWI as required by ss 12-280 and 12-300 of Schedule 1 to the TAA.

22    Accordingly, Task Technology’s application for declaratory relief is refused.

Associate:

Dated:    6 February 2014