International Taxation

Characterization under OECD Model of Payments for Domain Name, Website Development & Software Development

The OECD Model Tax Convention allocates taxing rights between the residence state of the tax-payer and the source state of the income with respect to various categories of income. One such category is “royalties”. While the OECD Model assigns taxing rights on royalties exclusively to the residence state of the beneficial owners, the majority of bilateral treaties provides for some source taxation on at least some categories of royalties.

The definition of royalties currently found in Art. 12(2) of the OECD Model is

The term “royalties” as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.

This definition of royalties has hardly

changed since it was first drafted more than 40 years ago.

Yet the importance of intangible property in business operations has increased dramatically over the same period. New categories of intangible property have raised questions regarding the interpretation of various parts of the definition. Some of these questions have been dealt with through changes to the Commentary on Art. 12 relating to software payments (1992 and 2000 updates) and the characterization of e-commerce payments (2003 update). A number of issues arise relating to the application of the definition to payments for these and other types of intangible property.

Given below is a case study with a view to examine issues with respect to categorization of payments for domain name, website development, and software development. The analysis of this case study is done on the basis of OECD commentary and international case laws & not on basis of Indian decisions.

Facts

1. SCO, a company resident in State S, is a software developer and distributor. A growing share of SCO’s revenue comes from the Internet distribution of its products.

2. SCO distributes these products through its Internet website, www.SCO.com. It secured the right to use this Internet domain name in 1996 after contacting NCO, a private company resident in State R, that obtained from the government of State R the exclusive right to assign domain names. After initial contact, SCO realized that that domain name had already been registered by Whatsinanameco, a small private company also resident in State R. SCO paid 10,000 to Whatsinanameco to secure the exclusive right to use that domain name, and it pays a fixed amount each year to NCO to maintain this right.

3. Most of the proprietary software that SCO uses to carry on its Internet business activities (as opposed to the software that it sells) was developed and is updated in State R by virtue of a contract concluded with Outsource co, a wholly-owned subsidiary of SCO. In that contract, Outsource co agreed to develop, install and subsequently update the relevant software according to detailed specifications. The contract stipulates that the copyright of the software, once developed, belongs to SCO and that Outsource co is remunerated according to a cost-plus method.

4. Customers from all over the world may access any of the mirror sites maintained by SCO. The master copies of the software that is for sale are stored on the company’s main servers (located in
   State S).

5. Sales of the software are made pursuant to the following procedure:

• o Customers access SCO’s web site where they find a catalogue of available products and an order form; and

• Orders are made by completing the electronic form that appears on the screen. Once the customer has approved the terms of the licence agreement and a credit card authorization has been obtained, a message is sent to the State S server on which the master copy of the software is kept. That message acts as a key that unlocks the security system of the master copy and allows a copy of the software to be downloaded, using an encrypted “wrapper” to ensure a speedy and secure delivery to the customer’s computer; the software is copied onto the customer’s hard disk. According to the terms of the licence agreement, the customer is allowed to make one back-up CD copy.

• Some of the software distributed by SCO is based on software acquired from Start co, a small company resident in State R. According to the contract with Start co, SCO acquired the full copyright to the English version of the software developed by Start co. SCO made minor modifications to that software before distributing it on its web site. The contract with Start co provides for the payment of a lump sum of 10,000 plus 10 for the sale of each copy of the software itself or of any software that incorporates most of the source code of that software.

• SCO does not have a permanent establishment in State R. The tax treaty between States R and S follows the provisions of the OECD Model, except for Art. 12, which allows a 15% source tax on royalties. In both States R and S, copyright law currently protects computer software as literary works.

Analysis

1. Payments for the domain name

In this case, the payments for the domain name are made in consideration for the use of the name itself and not for a copyright of literary, artistic or scientific work. The payments can be distinguished from payments for a copyrighted item as, in the case of a copyright, the copyright owner could prevent the use by withdrawing the licence. Thus, this does not fit within the OECD Model’s definition of royalties. The payments would therefore be either business profits or a capital gain.

Attention is drawn to two additions to the definition of royalties in the US Model: first, at the end of the list of items in the definition, the phrase “or any other like right or property” was added, and second, a further paragraph covering a gain derived from the property in the definition provided that the gain was contingent on the productivity, use or disposition of the property. The first addition would probably cover the domain name as a “like right”, which by itself is not protected by copyright. In this case, however, there is no royalty payment as it is an outright sale of the use of the name for a lump sum with no provision for a contingent payment, which would not be classified as a royalty in the United States.

Thus, the annual payment to NCO would not be a payment for a right, but for a service, analogous to a payment to the patent office for maintaining a patent or trademark.

2. Payment for developing the website

Ownership of the copyright to the developed website belongs to SCO and was not obtained from Outsource co. In the United States, this would be a payment for services because Outsource co never owned the copyright, as in the Boulez case.2 Pierre Boulez was a German resident who conducted orchestras in the US while making recordings under a contract according to which the copyright belonged to the recording company. The US Tax Court held that the payments to him were payments for services.

3. Payments from customers

The payment by a customer includes the right to download and to make a back-up copy (which it is assumed cannot be resold). These are grants of the right to copy-nevertheless, the payment constitutes business profits. The form is not relevant in the US where, under domestic principles, it would in substance be treated as a purchase. The OECD view does not rely on substance, but rather on the fact that, while a limited right to use the copyright of the software is granted, no part of the payment can reasonably be considered to be consideration for the right to copy, which is shown by the fact that the customer would pay the same price for the same software on a physical support that would not require him to make copies. In this case, it is not a payment for a secret formula because the formula (i.e., the algorithm) is not revealed to the customer and he has no right to reverse engineer the software to discover that “secret formula”. Nor is it a payment for information (know-how). Many countries started by classifying such payments as royalties, but have moved towards the OECD view in recent years.

4. Payments to the software developer

Only the English version of the software was acquired by SCO in exchange for a lump sum and a further payment for each sale. This raises the question as to whether there is a transfer of the full rights or whether a licence was granted. The English version may mean no more than that the words on the screen are in English. One view is that the transaction could still be seen as an outright sale of the intangible property (i.e., the English version of the software) even though the Boulez vs. Commissioner, 83 US Tax Court 584 (1984). See also Ingram vs. Bowers, 57 F.2d 65 (2d Cir. 1932), concerning a payment to Enrico Caruso for voice recordings which was determined to be personal services income rather than a royalty; and Karrer vs. United States, 152 F.Supp 66 (Ct. Cl. 1957), in which, although Mr Karrer owned the copyright, he had assigned the benefit of it, and the court decided that in substance he was not the owner. For examples of countries that still maintain the view that such payments could be royalties, see the observation by Greece in Para. 31 of the Commentary on Art. 12 and the position of Argentina and other non-OECD countries in Para. 13 of the Non-Member Countries’ Positions on Art. 12.

Consideration is in the form of a lump sum accompanied by a contingent payment. As Para. 16 of the Commentary on Art. 12 points out: “The essential character of the transaction as an alienation cannot be altered by the form of the consideration, the payment of the consideration in instalments or, in the view of most countries, by the fact that the payments are related to a contingency.” The US is one country that does not agree with this view. This dissent is evidenced by the modification of the definition of royalties in the US Model, which has been adopted in some recent US treaties, to include gain on the alienation of property for a contingent consideration. This makes it likely that, in the US, the contingent payments are a royalty, although the lump sum would not qualify as such. The fact that the software was acquired for modification, which is the use of a copyright, would also point to the payment being a royalty in the US. In other countries, since SCO uses the copyright by selling on to its customers, if the transaction is not classified as a sale, the payment is likely to be classified as a royalty.