When the sale of software occurs, it is important to make the distinction between what type of payment takes place. The Organization for Economic Cooperation and Development (OECD), an intergovernmental economic organization, has helped to create this distinction with the endorsement of the “rights-based approach” for characterizing software purchases. Under the rights-based approach, an approach followed by the government of Singapore, payments for software can either be characterized as a royalty income (i.e., the sale of a copyright right) or business income (i.e., the sale of a copyrighted article).
A transaction involves the sale of a copyright right if the purchasing party is allowed to commercially exploit the copyright. In this case, commercially exploit is defined as:
The ability to reproduce, modify or adapt and distribute the software, information or digitised goods; or
prepare derivative works based on the copyrighted software program, information or digitised goods for distribution.
A transaction is then characterized as a copyrighted article if the purchase of the software does not involve the transfer of the copyright rights embedded in the goods.
This distinction is important because there are different tax implications for the two categories. Royalty payments are subject to withholding tax from the source country, while business income is typically taxable in the source country only if the foreign purchasing company has a permanent establishment in that source country. This means that generally, there are benefits to classifying the purchase of copyrighted software as a business income.
When EMTEC sells GraphiCode software to a foreign company for the use of the copyrighted software, but not for the commercial exploitation of the software, this sale would classify as business income. Therefore, under the rights-based approach to the purchasing of copyrighted software, EMTEC and its customers can experience a business transaction that is not subject to withholding tax.