Assessability of payments received by a US taxpayer under an exclusive licence agreement

Are the payments received by a United States of America (US) resident taxpayer from an Australian resident taxpayer under the terms of an exclusive licence agreement assessable under subsection 6-5(3) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The payments received by a US resident taxpayer from an Australian resident taxpayer under the terms of an exclusive licence agreement are assessable under subsection 6-5(3) of the ITAA 1997 as the payments are royalties.

The taxpayer company is a resident of the US and is not a resident of Australia for income tax purposes.

The main income earning activity of the taxpayer is producing entertainment.

The taxpayer does not have any employees, an office, a factory or a workshop in Australia.

The taxpayer (the licensor) entered into a license and distribution agreement with an unrelated Australian manufacturing company (the licensee). The license and distribution agreement grants the Australian resident taxpayer an exclusive licence to utilise the confidential information connected with the development, manufacture, sale and distribution of the specified product within the specified territory for the specified term of the agreement. The specified product has a trade name with trade mark right.

The licence and distribution agreement specifies that the product will be available through two methods of distribution - through live shows conducted by the licensor and through retailers.

The agreement contains a comprehensive confidentiality clause requiring the written consent of the licensee to disclose any information in relation to the agreement, all confidential information, all proprietary, technical and other commercial information, their products, sales, promotional and pricing policies, plans for production, development and marketing, financial information relating to assets, liabilities and trading figures.

The Australian manufacturing company pays quarterly an amount to the taxpayer based on a specified percentage of the net sales of the product for the period.

Subsection 6-5(3) of the ITAA 1997 provides that the assessable income of non-resident taxpayer includes ordinary income derived directly or indirectly from all Australian sources.

Subsection 995-1 of the ITAA 1997 provides that the term 'royalty' has the meaning given by subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936). Subsection 6(1) of the ITAA 1936 defines royalty to include payments and credits for the use of, or the right to use, materials supplied by or rights held by another person, including copyright, patents, trademarks, knowledge, visual images or sounds transmitted by satellite or cable or similar technology. The definition of 'royalty' also includes a payment or credit that is consideration for an agreement not to make available to third parties the use of, or right to use, any such property or right.

In determining liability to Australian tax on Australian sourced income received by a non-resident, it is necessary to consider not only the income tax laws but also any applicable double tax agreement contained in the International Tax Agreements Act 1953 (the Agreements Act).

Section 4 of the Agreements Act incorporates that Act with the ITAA 1936 and the ITAA 1997 so that both Acts are read as one. The Agreements Act effectively overrides the ITAA 1936 and the ITAA 1997 where there are inconsistent provisions (except in some limited situations).

Schedule 2 to the Agreements Act contains the double tax agreement between Australia and the US (the US Convention). Schedule 2A to the Agreements Act contains the protocol amending the US Convention (the US Protocol). The US Convention and the US Protocol operate to avoid the double taxation of income received by Australian and US residents.

Article 12 of the US Convention governs the taxation of royalties derived by a resident of the US from sources in Australia. Under Article 12(1) of the US Convention, royalties from sources in Australia, being royalties to which a resident of the US is beneficially entitled, may be taxed in Australia. Under Article 12(2) of the US Convention, royalties derived prior to 1 July 2003 may be taxed at the rate of 10 per cent of the gross amount of the royalty payment. Under Article 8 of the US Protocol amending Article 12(2) of the US Convention, royalties derived after 1 July 2003 may be taxed at the rate of 5 per cent of the gross amount of the royalties.

Article 12(4) of the US Convention defines royalties to include payments or credits of any kind to the extent to which they are consideration for the use of or the right to use any copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right.

Taxation Ruling IT 2660 (Definition of Royalties in subsection 6(1) of the ITAA 1936) states that the term royalty is defined in Australia's double tax agreements in similar terms to the definition provided in subsection 6(1) of the ITAA 1936, except that the list of payments defined as royalties are intended to be exhaustive. IT 2660 states that royalties within the ordinary meaning of the term which do not also come within the treaty definition are not royalties for the purposes of the double tax agreements.

Section 12-280 of the Taxation Administration Act 1953 (TAA) states that an entity must withhold an amount from a royalty it pays if the recipient has an address outside Australia or the payer is authorised to pay the royalty at a place outside Australia. Regulation 42 of the Taxation Administration Regulations 1976 states that the amount to be withheld under section 12-280 of Schedule 1 to the TAA is the amount calculated at the rate provided for in the double tax agreement.

The payments received by the US resident taxpayer from the Australian resident taxpayer under the terms of the licence and distribution agreement are royalties as defined in Article 12(4) of the US Convention. The payments are consideration received for the exclusive use or the right to use the confidential information in connection with the development, manufacture, sale and distribution of the specified product, with trademark rights, within Australia.

Accordingly, the payments received by the US resident taxpayer from the Australian resident taxpayer are assessable as royalties under subsection 6-5(3) of the ITAA 1997. The royalty income derived by the US resident taxpayer prior to 1 July 2003 will be taxed at the rate of 10 per cent. The royalty income derived by the US resident taxpayer from 1 July 2003 will be taxed at 5 per cent of the gross amount of the royalty payment. The Australian resident company is obliged to withhold the tax under section 12-280 of Schedule 1 to the TAA.