Many-faced payments for software and many ways to treat them in tax accounting
Ukrainian Journal for Business Law, April Issue 2009
Tetyana Mykolenko, Tax Manager with Ernst & Young, Olga Anufriieva, Senior Tax Consultant with Ernst & Young
What is there from the standpoint of tax?
At a time of rapid development of computer technology the cross-border transfer of computer software is becoming a usual practice. This, for example, happens when a multinational company acquires the right to use software (e.g. financial accounting or management accounting application) with the intention of using it at all companies of the group in different countries. The group company, which is the initial licensee, then grants the right to use software to other group companies. Imagine that one such company is located in Ukraine. The chief accountant and/or the tax manager of the Ukrainian company are likely to face an issue with the tax treatment of the payments for the right to use such software.
To decide on this issue the chief accountant and/or the tax manager most likely would want to have a full picture of the options available. This implies knowing the answers to the following:
- What are the options for the tax treatment of the payments in question and what are the conditions for application of each option?
- What are the tax implications of each option (i.e. what option would be more efficient)?
- What are the risks related to each option (in other words, what are the chances that the tax authorities will challenge the option)?
Transfer of software can occur in various ways depending on the scope of rights to software granted to the transferee. Payments for software can, accordingly, take different forms. In an attempt to address this variety of transactions and payments, tax legislation provides for different options for their tax treatment. Under Ukrainian tax laws the payments for the right to use software may be treated in one of the following ways: royalties, service fees, expenses for acquisition of an intangible asset, or expenses for acquisition of a fixed asset.
Tax laws do not contain a clear and full list of criteria on the basis of which a taxpayer can choose an appropriate option. At the same time, qualification of payments for the tax purposes is of great importance as the tax implications differ for each of the above scenarios.
In this article we endeavor to identify the criteria which could help determining the proper tax treatment of the payments for use of software. We do not consider here the tax consequences of the acquisition of a material medium in which software is embodied or the tax treatment of expenses for maintenance of software. We touch upon the tax implications of the payments for use of software under each of the above options. However, we did not dig into the details and did not raise all disputable issues which deserve to be the subject of separate analysis.
Royalties
Analysis of international practice and Ukrainian tax law allows the conclusion to be drawn that whether the payments for software use can be treated as royalties depends mostly on the scope of rights the transferee acquires under a particular arrangement.
To get an insight into international practice we refer to the OECD Model Tax Convention1. The Convention distinguishes two major alternative ways for provision of software for use: the transferee receives the rights to the underlying copyright, or the transferee receives only the rights in a copy of the software program.
Under Article 12 of the OECD Model Tax Convention, the payments qualify as “royalty” if they represent consideration for granting of the right to use the program which would otherwise belong to the copyright holder (i.e. for acquisition of partial rights in the copyright). Examples of such use of the program could be the possibility to reproduce and distribute the software, or to modify the program and display it in public. Notably, in this case the transferor does not fully sell the copyright rights.
In many cases, the transferee acquires rights which are limited so as to enable the user to operate the program. The rights transferred in these cases often allow the user to copy the program onto the user’s computer hard drive or for archival purposes. However, since these copying rights only enable the effective operation of the program by the user the payment for such rights would not normally be considered as “royalty”. Instead, the payments for the rights in the copy of the program are treated as business profit.
Royalties are defined in the Ukrainian Corporate Profit Tax Act (the CPT Act) as “payments received as consideration for the use of, or the right to use, any copyright to literary, artistic or scientific work, including computer software…” The CPT Act does not elaborate on what should be viewed as “use of or the right to use copyright to computer software”. Civil law provides for a non-exhaustive list of actions which represent use of literary work (Article 441 of the Civil Code of Ukraine). This list inter alia includes publication, reproduction in any form and in any way, translation, changes and modifications, inclusion into the database as its integral part, public performance, sale, letting on lease, import.
Computer programs are protected as literary work in Ukraine. Therefore, the right to use copyright to software may include the rights to reproduce, modify and distribute the program. If the transferee is granted these rights in respect of software, the payments could fall under the definition of royalties.
Importantly, the Ukrainian Copyright Act provides for a list of actions which may be performed without the author’s consent and without receiving any rights to copyright (provided there is no violation of the author’s interests). These actions are:
- change and modification of software in order to operate this software as well as other actions related to operation of software on the computer, namely, saving onto the hardware,
- making one back-up copy of software,
- decompiling software under certain conditions,
- observing and researching the characteristics of software operation during its work.
As follows from the above, the rights which relate only to normal operation of software (e.g. copying computer software onto the hard drive to utilize the program) should not be considered as use of copyright to software2. Therefore, the payment for the right to use software in such a case would most likely not qualify as royalties.
The CPT Act also provides that payments related to acquisition of possession or disposal rights or title to the intellectual property (IP) objects are not deemed to be royalties3. Moreover, payments under a licensing agreement are not considered as royalties if the licensee is entitled to alienate or otherwise dispose of the IP object. These provisions most likely deal with alienation of all copyright rights to the IP objects and should not apply if the transferor grants to the transferee partial rights in the copyright.
Royalty payments are subject to the following taxation under Ukrainian law.
From the corporate profit tax perspective, royalties may be tax deductible provided that software is used in the taxpayer’s business activity. Notably, royalty payments can be deducted irrespective of whether the use of software contributed to generating the taxpayer’s income. To ensure tax deductibility of royalties proper documents should be maintained by the transferee.
Royalty payments in money are not subject to VAT.
Royalties payable to non-residents are subject to a Ukrainian withholding tax at the rate of 15%. This tax may be eliminated or reduced based on the applicable Double Taxation Treaty concluded between Ukraine and the country of the royalty recipient4. Double Taxation Treaties often provide for different tax rates for payments related to literary, artistic or scientific work. None of these categories seems entirely apt for software. Therefore, unless software is specifically mentioned in the relevant Treaty, there may be difficulties with applying the Treaty tax rate to the royalties for use of software.
The Ukrainian tax authorities pay considerable attention to royalty expenses. This is mainly because royalties are widely used as a profit repatriation tool and sometimes it may be difficult to check whether the taxpayer indeed used the IP object for which the payments are made and whether the payments for such use are at arm’s length. This, together with the fact that the provisions of the Ukrainian tax law on royalties are ambiguous, results in royalties being associated with certain inherent tax risks.
Service fees
The definition of “the sale of results of works (services)” in the CPT Act covers granting of the right to use or dispose of goods, including intangible assets. The Act also specifies that the sale of results of works (services) includes sale, transfer of the rights under the copyright or licensing agreements and other ways of transferring copyrights, patents, trademarks and other IP.
This broad definition of the sale of results of works (services) could cover many cases of granting the rights to use software. If provision of the right to use software is treated as sale of the results of works (services), the payments would have the following tax implications.
For the transferee, the payments may be tax-deductible if they are in connection with the taxpayer’s business activity.
From the VAT standpoint, provision of services with the place of supply in Ukraine is subject to 20% tax. This tax will apply if the transferee is a Ukrainian resident. If, however, the transferee is a non-resident company, provision of the right to use software may, under certain conditions, be viewed as a service supplied outside Ukraine and, thus, not subject to VAT.
Ukrainian withholding tax is generally not applicable to payments for services. There are several exceptions (e.g. engineering services) which, however, would normally not apply to provision of the right to use software.
Due to understandable reasons, the tax authorities do not greatly support the position that provision of the right to use software can be treated as provision of services. Instead, the tax authorities tend to apply the special rules on tax treatment of acquisition of fixed assets or intangibles.
Expenses for acquisition of an intangible asset vs. fixed asset
Software may fall under the definition of intangible assets as specified in the CPT Act. According to the general rule, expenses for acquisition of intangibles aimed for use in the taxpayer’s business activities may be depreciated in tax accounting. The law provides a straight-line depreciation method for these assets. The taxpayer is free to determine the period of depreciation based on the useful life of intangibles but not for more than 10 years.
At the same time, the CPT Act expressly names computer software in the list of fixed assets of the 4th group. There is a discrepancy in the provisions of the Act: although software does not qualify as fixed assets for taxation purposes5 it is considered as a fixed asset of the 4th group. These assets are subject to depreciation under the reduced balance depreciation method at the 15% rate per quarter.
Apart from the corporate profit tax, the tax treatment of acquisition of intangibles and fixed assets would not differ significantly. Both transactions are subject to 20% VAT and should not trigger the withholding tax.
Since computer software is expressly named in the list of 4th group fixed assets, the tax authorities consistently opine that software has to be treated as such6. The CPT Act does not explain in which cases computer software should be treated as intangible assets and in which cases as fixed assets. The tax authorities suggested their approach on this matter by claiming that if the computer software is used more that 365 days and has a value of more than UAH 1,000 it should be accounted for as a fixed asset; otherwise - as an intangible. However, this approach can be challenged.
Tax legislation does not elaborate on criteria which distinguish acquisition of software as an intangible or a fixed asset from receipt of the service on provision of the right to use software. Logically, distinguishing criteria should be the scope of rights to software the transferee receives. If the transferee acquires full copyright rights to software, the transaction could be considered as acquisition of an intangible or fixed asset. In other case, it would be logical to treat the transaction as receipt of service.
The tax authorities may disagree with the above position. They tend to believe that when a licensing agreement does not grant the user rights to use program in copyright perspective (e.g. sublicense, modification, reproduction) and software is obtained only for functional use, the user should be considered as the final user and the expenses for acquisition of software should be depreciated.
Taking the above into account, the tax authorities are likely to require that payments for use of software be treated as expenses for acquisition of 4th group fixed assets, unless such payments qualify as royalties.
In lieu of conclusion
Ukrainian tax legislation provides for several options for qualification of payments for use of software in tax accounting. The tax implications of such payments vary, ranging from depreciation as a fixed asset to straight-forward deduction of costs, from VAT exemption to charging of 20% VAT, from application of the 15% withholding tax to not being subject to this tax. Appropriate tax treatment of payments should be chosen considering the scope of rights granted to the transferee and based on an analysis of available documentation.
1 Organization of Economic Cooperation and Development, established in 1965 in Paris, brings together 30 member countries from around the world to support sustainable economic growth, boost employment, maintain financial stability and assist other countries' economic development. OECD Model Tax Convention on Income and on Capital serves as a model for double taxation treaties concluded by OECD countries.
2 This approach is supported by courts (see Letter of the Highest Commercial Court of Ukraine of 22 January 2007 No. 01-8/25).
3 The CPT Act uses terms “title to”, “possession” and “disposal of” with respect to IP objects. This contradicts the civil law concept of intellectual property where a person may hold non-proprietary and proprietary rights to an IP object and dispose of certain of these rights.
4 Double Taxation Treaties often provide for certain conditions which the royalty recipient has to meet in order to apply the reduced tax rates established in the relevant Treaty (e.g. the recipient should be a beneficial owner of royalties, should be subject to tax in respect of the royalties, etc.).
5 According to the CPT Act fixed assets are defined as tangible assets aimed for use in the taxpayer’s business activities during a period exceeding 365 calendar days from the date of their putting into operation with a value exceeding UAH 1,000. As discussed above, computer software may be viewed as an intangible asset. In this case, irrespective of the period of its useful life and its value, software would not fall under the definition of fixed assets for the purposes of the CPT Act.
6 To support this position, the tax authorities may claim that the provision of the CPT Act which treats computer software as fixed assets of the 4th group is a special rule as compared to general rules on tax treatment of intangibles.
