Income tax: commercial software developers: derivation of income from agreements for the right to use proprietary software and the provision of related services.

This Ruling deals with when commercial software developers derive income for the purpose of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) from (i) licence agreements for proprietary software; and (ii) 'hosted' or 'cloud' arrangements for use of proprietary software.

Specifically, this Ruling considers the point of derivation of income in respect of the contractual fee for: (i) the granting of the proprietary licence; (ii) the hosted arrangement; and/or (iii) other 'additional services' which may or may not be bundled together with (i) or (ii) in contract.

Where there is bundling of 'additional services', this Ruling also considers the proper apportionment of the contractual fee between the licence or access fee and/or the additional services.

'Additional services' include: (a) software updates, upgrades and maintenance; (b) user support including implementation; and (c) user training.

Where an amount properly attributable to a contractual obligation is subject to a 'contingency of repayment', the amount is derived for the purposes of section 6-5 of the ITAA 1997 when the obligation is fully performed or the contingency of repayment otherwise lapses.

In this Ruling, a 'contingency of repayment' in the event of non-performance refers to there being either: (i) a contractual obligation to make a refund; (ii) a demonstrated commercial practice to make a refund; or (iii) contractual exposure exists for damages.

It is only in circumstances where a 'contingency of repayment' exists, that deferral of all or part of the contractual fee for: (i) the granting of the proprietary licence; (ii) the hosted arrangement; and/or (iii) other 'additional services' which may or may not be bundled together with (i) or (ii) in contract; may be valid for income tax purposes.

When the underlying obligation is fully performed, or the contingency of repayment otherwise lapses, the amount properly allocated to the obligation converts from 'unearned' income' to 'earned income' in the sense contemplated in Arthur Murray (NSW) Pty Ltd v. FCT (1965) 114 CLR 314; (1965) 14 ATD 98; 9 AITR 673 ( Arthur Murray ).

Where no 'contingency of repayment' exists, the amount is derived when a recoverable debt arises in respect of the contractual fee.

Potential exposure to: • damages pursuant to consumer protection law; or • damages in tort; do not result in there being a 'contingency of repayment'.

Established accounting practices and principles, such as that prescribed in paragraph 11 of Appendix 1 to Australian Accounting Standard AASB 118 Revenue , does not determine the incidence or quantum of derivation of the contractual fee for tax purposes.

Where a contract: (i) bundles the proprietary licence (or hosted access) together with additional services; or (ii) merely bundles multiple additional services; the contractual fee must be allocated across the discrete obligations in order to determine the point of derivation.

The allocation should be undertaken on a fair and reasonable basis and be evidence based. Records must be kept which support and explain the method employed.

What is a reasonable method of apportioning the consideration for a bundled contract depends on the circumstances of each case. In some cases, there will be only one reasonable method which may be used.

The price allocated by the contracting parties in the licence agreement will be the most appropriate measure of value of the respective obligations for the purposes of apportionment if such prices are agreed on commercial terms and at arms length.

If the prices allocated in contract do not represent fair commercial value for the component obligations such prices may not be used as a basis for apportionment.

Where discrete prices are not allocated in contract, but the bundled obligations are also sold by the software developer individually, those individual prices may be employed.

Where discrete prices are not allocated in the contract and the bundled obligations are not also sold by the software developer individually, reference may be had to comparable market prices.

Where discrete prices are not allocated in the contract and the software developer neither sells the bundled obligations individually, nor are comparable market prices available, the software developer should determine fair commercial prices for the individual obligations on the basis they were offered separately for sale by the software developer.

Software Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Software Pty Ltd enters into an agreement which provides ABC Pty Ltd with the right to use a proprietary software product for a period of three years in consideration for the payment of a licence fee of $15,000. The terms of the agreement do not require Software Pty Ltd to provide any additional services. That is, Software Pty Ltd is required only to provide ABC Pty Ltd with a copy of the software product. It is not required under the agreement to provide any updates, upgrades or maintenance, user support services or user training.

Once the proprietary software is delivered to ABC Pty Ltd, Software Pty Ltd has fulfilled its full contractual obligations. The contract does not contemplate any refund to be made to ABC Pty Ltd in any circumstances and neither does Software Pty Ltd have a commercial practice of making such refunds.

In circumstances such as these, there is no contingency of repayment in respect of the licence fee of $15,000. Software Pty Ltd has undertaken all that is required under the contract with ABC Pty Ltd upon delivery of the software and, therefore, the licence fee is derived at the time a recoverable debt arises in respect of the contractual fee (that is, the 2012-13 income year).

Richard Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Richard Pty Ltd enters into an agreement with XYZ Pty Ltd which provides for: (a) the right to use a proprietary software product for a period of three years in consideration for the payment of a licence fee of $15,000, and (b) the provision of technical support for a period of 18 months in consideration for the payment of $5,000.

Once the proprietary software is delivered to XYZ Pty Ltd, Richard Pty Ltd has fulfilled its full contractual obligations in respect of that part of the agreement. The contract does not contemplate any refund to be made in any circumstances and neither does Richard Pty Ltd have a commercial practice of making such refunds.

No contractual obligation exists for Richard Pty Ltd to make a refund in the event of non-use of the additional services or for any other reason, and Richard Pty Ltd has no commercial practice of giving a refund in any circumstances.

However, Richard Pty Ltd may have contractual exposure to damages in the event the technical support services are not provided upon request.

In circumstances such as these, there is no contingency of repayment in relation to that part of the agreement which represents the licence fee and, therefore, the income from the agreement that relates to the licence fee is derived at the time a recoverable debt arises in respect of the contractual fee (that is, the 2012-13 income year).

However, a contingency of repayment does exist in relation to the amount payable under the agreement that relates to the provision of technical support. Accordingly, the point of derivation for that amount will occur progressively as the contingency of repayment lapses. The quantum of exposure to contractual damages might be expected to diminish progressively on a straight line basis over the terms of the agreement. Therefore, the consideration for those services should also be recognised as derived for income tax purposes on that same basis.

Max Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Max Pty Ltd enters into a bundled agreement which provides BCD Pty Ltd with the right to use a proprietary software product for a period of two years and certain software updates in consideration for the payment of a contractual fee of $15,000.

Once the proprietary software is delivered, Max Pty Ltd has fulfilled its full contractual obligations in respect of that part of the agreement. The contract does not contemplate any refund to be made in any circumstances and neither does Max Pty Ltd have a commercial practice of making such refunds.

In terms of the software updates the contract provides that these will be made available to BCD Pty Ltd only if developed and released during the course of the agreement. The terms of the contract ensure that Max Pty Ltd is not exposed to contractual damages should an update be produced during the licence period but not released.

On the facts here, there is no contingency of repayment in relation to the contractual fee of $15,000 in terms of the proprietary software or updates. Accordingly, the contractual fee is derived in full at the time a recoverable debt arises in respect of the contractual fee (that is, the 2012-13 income year).

Gavin Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Gavin Pty Ltd enters into an agreement which provides XYZ Pty Ltd with the right to use a proprietary software product for a period of five years in consideration for a fee in the sum of $20,000.

The proprietary software provides high level virus, spyware, crimeware, malware and intrusion protection for large corporations.

The essence of the agreement is therefore the provision of the ongoing security protection which necessitates software updates on a continuous and regular basis. In the event updates were not provided, Gavin Pty Ltd would be exposed to damages for contractual breach.

In circumstances such as these, there is a contingency of repayment in relation to the fee for the proprietary software. On the facts here, the quantum of exposure to contractual damages might be expected to diminish progressively on a straight line basis over the terms of the agreement. Therefore, the consideration for those services should also be recognised as derived for income tax purposes on that same basis.

John Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, John Pty Ltd enters into an agreement with PQR Pty Ltd which, in consideration for the payment of $15,000, provides PQR Pty Ltd with the right to use a proprietary software product for a period of three years.

No part of the agreement between John Pty Ltd and PQR Pty Ltd concerns the provision of product updates or upgrades.

However, although not contractually obliged to do so, John Pty Ltd, as part of its business strategy for customer retention and marketing, provides customers with product updates as and when available.

John Pty Ltd has no contractual exposure to damages for any reason following the granting of the right to use the proprietary software to PQR Pty Ltd. Further, John Pty Ltd has no commercial practice of providing a refund to licence holders under any circumstances.

On the facts here, there is no contingency of repayment in relation to any part of the agreement between John Pty Ltd and PGR Pty Ltd. Therefore, the income from the agreement is derived at the time a recoverable debt arises (that is, the 2012-13 income year).

Jim Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Jim Pty Ltd enters into an agreement with CDE Pty Ltd which, in consideration for the payment of $22,000, provides CDE Pty Ltd with: (a) the right to use a proprietary software product for a period of three years; (b) the provision of technical support for a period of 18 months; and (c) the provision of in-house one-off user-training upon commencement.

As part of their business model, Jim Pty Ltd also sells each of these products or services individually. The market price of each product sold individually is as follows: (a) three year proprietary software licence: $15,000 (b) 18 month technical support: $5,000 (c) one-off user training: $2,000

In circumstances such as these, it is fair and reasonable to apportion the total contractual fee of $22,000 in accordance with the individual market price of each product or service.

Were a package discount is available vis a vis stand alone prices, the amount allocated to each package component would be proportionately reduced to take account of the discount.

Peter Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Peter Pty Ltd enters into an agreement with MNO Pty Ltd which, in consideration for the payment of $22,000, provides MNO Pty Ltd with: (a) the right to use a proprietary software product for a period of three years (allocated a contractual value of $15,000); (b) the provision of technical support for a period of 18 months (allocated a contractual value of $5,000); and (c) the provision of in-house one-off user-training upon commencement (allocated a contractual value of $2,000).

In the particular circumstances of Peter Pty Ltd and MNO Pty Ltd, the discrete prices allocated in the contract represent fair commercial value for each of the respective obligations and have not been artificially set to achieve tax outcomes. The amounts allocated to the various obligations are within a commercial range charged by competitor businesses for comparable services.

In circumstances such as these, it is fair and reasonable to allocate the contractual fee of $22,000 in accordance with the discrete prices allocated in contract.

Program Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Program Pty Ltd enters into an agreement with XYZ Pty Ltd which, in consideration for the payment of $15,000, provides for: (a) the right to use a proprietary software product for a period of three years; and (b) the provision of technical support for a period of 18 months.

Program Pty Ltd does not sell each of these component products or services individually as part of their business model.

However, market competitors do enter into stand alone agreements in relation to virtually identical products to that sold by Program Pty Ltd.

The market price for the right to use a virtually identical software product over 3 years is $12,000 and for technical support over 18 months, $3,000. These prices also align with fair commercial price settings of the discrete obligations in the view of Program Pty Ltd's management were the obligations offered separately.

In these circumstances it is fair and reasonable to allocate the $15,000 contractual fee in the sum of $12,000 to the right to use the proprietary software and in the sum of $3,000 for the provision of the technical support.

Mason Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Mason Pty Ltd enters into an agreement with XYZ Pty Ltd which provides for: (a) the right to use a proprietary software product for a period of three years; and (b) the provision of technical support for a period of three years.

The fee payable by XYZ Pty Ltd is $43,000 which is not dissected into separate amounts for each of (a) and (b).

For accounting purposes, Mason Pty Ltd writes off the contractual fee on a straight line basis over the term of the licence agreement.

As part of their business model, Mason Pty Ltd does not also sell each of these products or services individually and neither do comparable competitor products exist.

The proprietary software product is highly developed and has been in the market place for 15 years. No updates or upgrades have been released during the past 4 years and none are currently in development. New users of the software find it highly intuitive and user friendly resulting in very infrequent requests for technical support.

In order to allocate the contractual fee, the management of Mason Pty Ltd determines on a fair commercial basis the pricing of (b) assuming it were to be offered as a stand alone product in the market place as $3,000. In this regard, management considered the cost to business of holding itself ready to provide technical support was minimal. Management further considered the commercial essence of the contract was the granting of the right to use the commercial software and the balance of the contractual fee was appropriately allocated to the software licence ($40,000). That amount also corresponded to the price management envisaged could be commanded for the proprietary software were it offered as a stand alone product.

In these circumstances it is fair and reasonable to allocate the $43,000 contractual fee in the sum of $40,000 to the right to use the proprietary software and in the sum of $3,000 for the provision of the technical support.

Cloud Pty Ltd is an Australian hosted access provider. It employs the accruals method of recognising income.

On 1 July 2012, Cloud Pty Ltd enters into an agreement which provides ABC Pty Ltd with the right to access and use a proprietary software product, remotely hosted by Cloud Pty Ltd, for a six month period in consideration for a $20,000 access fee.

The terms of the agreement do not require Cloud Pty Ltd to provide any additional services. That is, Cloud Pty Ltd is required only to provide ABC Pty Ltd with access to the hosted software and it is not required under the agreement to provide any user support services or user training. Further, the contract expressly provides that ABC Pty Ltd will not be entitled to any refund for any down time during the hosted access period. The contract in this regard is sufficient for no remedy in contractual damages to be available for such downtime.

Once the hosted access is made available to ABC Pty Ltd, Cloud Pty Ltd has fulfilled its contractual obligations. The contract does not contemplate any refund to be made to ABC Pty Ltd in any circumstances and neither does Cloud Pty Ltd have a commercial practice of making such refunds.

In circumstances such as these, there is no contingency of repayment in respect of the hosted access fee of $20,000. Cloud Pty Ltd has undertaken all that is required under the contract to retain the fee and therefore it is derived at the time a recoverable debt arises (that is, the 2012-13 income year).

Cloudy Pty Ltd is an Australian hosted access company. It employs the accruals method of recognising income.

On 1 July 2012, Cloudy Pty Ltd enters into an agreement which provides ABC Pty Ltd with the right to access and use a proprietary software product, remotely hosted by Cloudy Pty Ltd, for a period of three years in consideration for the payment by ABC Pty Ltd of an access fee of $80,000. The terms of the agreement do not require Cloudy Pty Ltd to provide any additional services. That is, Cloudy Pty Ltd is required only to provide access to the software product. Cloudy Pty Ltd is not required under the agreement to provide any user support services or user training.

However, under the agreement, ABC Pty Ltd is entitled to terminate the agreement with one month's notice at any time during the access period. Upon termination, ABC Pty Ltd is entitled to a refund of so much of the access fee as relates to the amount of the access period yet to elapse.

In circumstances such as these, a contingency of repayment exists in relation to the access fee. That contingency of repayment lapses proportionately on a monthly basis. In circumstances such as these it is fair and reasonable to treat the access fee as derived proportionately on a straight line basis over the term of the agreement.

Cumulus Pty Ltd is an Australian hosted access company. It employs the accruals method of recognising income.

On 1 July 2012, Cumulus Pty Ltd enters into an agreement with ABC Pty Ltd which provides for: (a) the right to access and use a proprietary software product, remotely hosted by Cumulus Pty Ltd, for a period of three years in consideration for the payment of an access fee of $80,000; and (b) the provision of technical support for a period of 18 months in consideration for the payment of $5,000.

Both fees represent fair commercial value for the respective obligations.

The contract expressly provides that ABC Pty Ltd will not be entitled to any refund for any down time of the hosted access during the access period. The contract in this regard is sufficient for no remedy in contractual damages to be available. The access fee is derived in full at the time a recoverable debt arises (that is the 2012-13 income year).

However, the contract is silent on the consequences of failure of Cumulus Pty td to provide the technical support. That is, Cumulus Pty Ltd may be exposed to contractual damages for non-fulfilment of this obligation.

In these circumstances, a contingency of repayment exists in relation to the fee for the provision of the technical support. That contingency of repayment lapses proportionately on a monthly basis for the term of the agreement. In circumstances such as these it is fair and reasonable to treat the fee for the technical support as derived proportionately on a straight line basis over the term of the agreement.

Stratus Pty Ltd is an Australian hosted access company. It employs the accruals method of recognising income.

Stratus Pty Ltd provides ABC Pty Ltd with the right to access and use a remotely hosted proprietary software product for a fee of $5,000 per month which may be terminated by ABC Pty Ltd at the end of any given month. Stratus Pty Ltd is not exposed to contractual damages for downtime and does not provide a refund of the access fees under any circumstances.

In these circumstances, a contingency of repayment does not exist in relation to the monthly access fees. Each fee is derived as a recoverable debt arises.

Sunny Pty Ltd is an Australian hosted access company. It employs the accruals method of recognising income.

On 1 July 2012, Sunny Pty Ltd enters into an agreement with ABC Pty Ltd which provides for : (a) the right to access and use a proprietary software product, remotely hosted by Sunny Pty Ltd, for a period of three years in consideration for the payment of an access fee of $5,000 for the entirety of the three years; and (b) the provision of technical support for a period of 18 months for a fee in the sum of $60,000.

The contract expressly provides that ABC Pty Ltd will not be entitled to any refund for any down time of the hosted access during the access period. The contract in this regard is sufficient for no remedy in contractual damages to be available. Sunny Pty Ltd also has no commercial practice of providing a refund.

As there is no contingency of repayment in respect of the hosted access fee, the amount properly allocated to that obligation is derived in full at the time a recoverable debt arises (that is the 2012-13 income year year).

The contract is silent on the failure of Sunny Pty Ltd to provide the technical support. That is, Sunny Pty Ltd will be exposed to contractual damages for non-fulfilment of that obligation.

A contingency of repayment exists in relation to the amount properly allocated to the provision of the technical support which lapses proportionately on a monthly basis for the term of the agreement. In circumstances such as these it is fair and reasonable to treat the fee properly allocated for the technical support as derived proportionately on a straight line basis over the term of the agreement.

As part of their business model, Sunny Pty Ltd also sells each of these products or services individually. The market price for each product sold individually is as follows: (a) access fee at $1,666 per month; (b) 36-months of technical support: $5,000.

The question which requires resolution in this case is what amounts are properly allocated to the respective obligations given the divergence between the amounts specified in the contract and the amounts charged by Sunny Pty Ltd for the same obligations when sold separately.

The allocation of the contractual fee being so heavily in favour of the provision of technical support is inexplicable other than to achieve a tax advantage of deferring derivation of a large part of the contractual fee to future income years.

In these circumstances the amounts specified in contract do not represent a fair commercial allocation of the contractual fee. The contractual fee should instead be allocated on the basis of the commercial prices for which Sunny Pty Ltd sells the same obligations individually in the market place.

Nimbus Pty Ltd is an Australian hosted access company. It employs the accruals method of recognising income.

On 1 July 2012, Nimbus Pty Ltd enters into an agreement with ABC Pty Ltd which provides for: (a) the right to access and use a proprietary software product, remotely hosted by Nimbus Pty Ltd, for a period of three years; (b) the provision of technical support for a period of 18 months; and (c) the provision of in-house one-off user-training upon commencement.

The contractual fee payable by ABC Pty Ltd is $43,000 which is not dissected into separate amounts for each of (a), (b) and (c).

As part of their business model, Nimbus Pty Ltd also sells each of these individually. The market price of each is as follows: (a) access fee at $1,000 per month; (b) 18 month technical support: $5,000; (c) one-off user training: $2,000.

In these circumstances the contractual fee should be allocated on the basis of the commercial prices for which Nimbus Pty Ltd sells the same obligations individually in the market place. That is, $36,000 should be allocated to the hosted access, $5,000 to the technical support and $2,000 to the user training.

Were a package discount is available vis a vis stand alone prices, the amount allocated to each package component would be proportionately reduced to take account of the discount.

Altostratus Pty Ltd is an Australian hosted access company. It employs the accruals method of recognising income.

On 1 July 2012, Altostratus Pty Ltd enters into an agreement with ABC Pty Ltd which provides for: (a) the right to access and use a proprietary software product, remotely hosted by Altostratus Pty Ltd, for a period of three years; (b) the provision of technical support for a period of 18 months; and (c) the provision of in-house one-off user-training upon commencement.

The fee payable by ABC Pty Ltd is $43,000 which is not dissected into separate amounts for each of (a), (b) and (c).

As part of their business model, Altostratus Pty Ltd does not also sell each of these products or services individually and neither do comparable competitor products exist.

In order to allocate the contractual fee across each of (a), (b) and (c), the management of Altostratus Pty Ltd determines on a fair commercial basis, the pricing of each of (a), (b) and (c) assuming they were to be offered as stand alone products in the market place. The prices determined on a bona fide commercial basis were: (d) access fee at $1,000 per month; (e) 18 month technical support: $5,000; (f) one-off user training: $2,000.

In these circumstances it is fair and reasonable to allocate the $43,000 contractual fee in the sum of $36,000 to 3 years of hosted access, in the sum of $5,000 for the provision of the technical support and in the sum of $2,000 for the one off user training.

Stormy Pty Ltd is an Australian software development company. It employs the accruals method of recognising income.

On 1 July 2012, Stormy Pty Ltd enters into an agreement with ABC Pty Ltd which provides the right to access and use a remotely hosted proprietary software product for a period of three years in consideration for the payment by ABC Pty Ltd of an access fee of $17,000.

No part of the agreement between Stormy Pty Ltd and ABC Pty Ltd concerns the provision of technical support or user training.

Although not contractually obliged to do so, Stormy Pty Ltd, as part of its business strategy for customer retention and marketing, provides customers with technical support and user training on an ex gratia basis.

On the facts here, all of the $17,000 access fee is properly allocated to the provision of the hosted access. No part may be allocated to the provision of technical support and user training and therefore no part may be deferred for income tax purposes on that basis.

When the final Ruling is issued, it is proposed to apply both before and after its date of issue. However, the Ruling will not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 75 to 76 of Taxation Ruling TR 2006/10).

Software developers historically have contracted with customers by means of granting a licence for installation and use of software on a customer's computer hardware. The software is made available for installation on the customer's hardware by means of CD ROM or internet download. A contractual fee is payable by the customer in consideration for the grant of the licence.

An obligation to provide 'additional services' may be bundled with the proprietary licence or provided under separate contract.

In either case, the contractual fee may or may not expressly be allocated across the different obligations.

Additional services include such things as the provision of updates or upgrades to the software, user support and training.

An alternative to acquiring a proprietary licence for installation and execution on a buyer's hardware is remote accessing of software hosted on the software company's server. Such access is commonly achieved via the customer's internet browser but other means are technically possible. The mechanism by which access is obtained is not a material difference for the purposes of determining the point of derivation for income tax purposes.

Ordinarily, the access fee is charged on a usage basis for periods of relatively short duration (daily, weekly or monthly) or strictly on a pay as you go basis (that is, an hourly charge for actual use).

Hosting arrangements may expressly contemplate the provision of support services by the software company on request or such services may merely be provided on a voluntary basis as a client goodwill gesture. Such support services ordinarily relate only to training or help services as it is an inherent feature of hosted services that upgrades and updates are only necessary to the software on the host's server.

Hosting arrangements may amount to 'take it or leave it' contracts whereby no remedy is available to the client for the hosted access being unavailable ('downtime'). Even in cases where both parties have equality of bargaining power, downtime may or may not be a matter expressly contemplated in contract. It suffices to say that contracts exist where remedies do and do not exist for downtime. Where a remedy exists it is ordinarily a refund of a portion of the access fee reflecting the downtime and/or an exposure to contractual breach.

A licence granting the right to use proprietary software is neither a contract for the supply of goods nor for the provision of services. Rather, the licence is a permission to access and use the proprietary software in a way that would otherwise breach the copyright owner's intellectual property rights ( Young v. Odeon Music House Pty Ltd (1976) 10 ALR 153).

The precise nature of hosted access is yet to be judicially considered. Hosted access might be thought to be more akin to the provision of a service rather than a licence. However, it is unnecessary to determine whether it is a service or a licence as this does not alter the point of derivation of the access fee for income tax purposes.

Section 6-5 of the ITAA 1997 provides that a taxpayer's assessable income includes the ordinary income derived by the taxpayer during the income year.

Ordinary income is derived when a gain has 'come home' to the taxpayer in a realised or immediately realisable form ( CT v. Executor & Trustee Agency Co of South Australia (1938) 63 CLR 108 ( Carden's case )

For an accruals based taxpayer, a gain has 'come home' when a recoverable debt has been created and the taxpayer is not obligated to take any further steps to be entitled to payment ( FC of T v. Australian Gas Light Co 83 ATC 4800; (1983) 15 ATR 105 ( Australian Gas Light ); Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596; J Rowe & Son Pty Ltd v. Federal Commissioner of Taxation (1971) 124 CLR 421; 71 ATC 4157; (1971) 2 ATR 497).

Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, the general law and any relevant statutory provisions. [1]

The phrase 'contingency of repayment' as adopted in this ruling is intended to capture the principle from Arthur Murray in terms of when an amount received will represent unearned income. As set out at paragraph 6 of this Ruling, a contingency of repayment exists where: (i) a contractual obligation exists for a refund; (ii) contractual exposure exists for damages; or (iii) a demonstrated commercial practice exists for a refund.

Arthur Murray involved a taxpayer who received amounts in advance for a specified number of dance lessons to be given over a period of time. Whilst students did not have any contractual right to a refund, it was the general practice of the taxpayer to give refunds where not all lessons were taken. The taxpayer's books of account recognised fees as income when the lessons to which the fees related were taught.

In Arthur Murray , their Honours relevantly held: It is true that in a case like the present the circumstances of the receipt do not prevent the amount received from becoming immediately the beneficial property of the company; for the fact that it has been paid in advance is not enough to affect it with any trust or charge, or to place any legal impediment in the way of the recipient's dealing with it as he will. But those circumstances nevertheless make it surely necessary, as a matter of business good sense, that the recipient should treat each amount of fees received but not yet earned as subject to the contingency that the whole or some part of it may have in effect to be paid back, even if only as damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such a payment back (we speak, of course, in practical terms) is an inherent characteristic of the receipt itself. In our opinion it would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company.

The import of Arthur Murray is that once the contemplated contingencies lapse the amount may in an unqualified sense be retained by the service provider. At this point the amount converts from unearned income to earned income for income tax purposes.

In the present context it is possible various amounts received by commercial software developers are in whole or in part subject to relevant contingencies.

For example, in the case of additional services provided under a bundled contractual licence, the software developer may be exposed for non-performance, either: (i) in terms of a contractual obligation to make a refund; (ii) in terms of a demonstrated commercial practice to make a refund; or (iii) because contractual exposure exists for damages.

A commercial practice in relation to refunds must be evidence-based and not merely an assertion. Evidence may include a demonstrated practice over time or a stated practice in corporate policy documents.

It is only in cases where a relevant contingency exists in relation to the unqualified retention of the fee in whole or in part, that deferral may be valid for income tax purposes. Where no relevant contingency exists, the amount is derived when a recoverable debt arises in respect of the contractual fee.

The context of the reference to damages in Arthur Murray was to contractual damages for breach. Damages pursuant to consumer protection law, or damages in tort, were not contemplated in Arthur Murray and are not relevant to the question of determining the incidence of derivation of 'unearned income'. Chesire and Fifoot's Law of Contract (9th edition) explains the distinction in the following terms at para 23.8: Damage in Tort and under s82 of the Trade Practices Act 1974 (Cth) are not awarded as damages for the loss of expected performance. Rather, they are assessed so as to put the claimant in the position that he or she would have occupied had the tort or statutory contravention not been committed (Footnote: Gates v. City Mutual Life Assurance Society Ltd (1986) 160 CLR 1 at 11-12). This reflects a commonly accepted distinction between a cause of action based on a breach of duty imposed by law and a cause of action based on a breach of duty assumed by volition.

An exposure to contractual damages will exist where at the end of the licence agreement (or at some other time specified in the contract), the commercial software developer is exposed to a provable cause of action for failure to fully perform on the contract. The awarded compensation in such cases is restitutionary to the extent the contract price relates to the obligations not performed ( Chesire and Fifoot's Law of Contract (9th edition) at para 23.9).

The principle considered in Arthur Murray was: 'whether, in the circumstances, it may properly be held that receipt without earning makes income' ( Arthur Murray 114 CLR 314 at 317-8 per Barwick CJ, Kitto and Taylor JJ).

The context was whether income received for contractual obligations yet to be performed were income.

Similarly, in the present context, it is the contractual obligations of commercial software developers which require testing. Namely, whether or not the Arthur Murray principle applies and, if so, the incidence of derivation and quantum of 'unearned income'.

In cases where a software company provides additional services on a voluntary basis (for example, as a customer retention or marketing strategy), Arthur Murray is not authority for deferral of derivation of any part of the software licence fee. This is because the additional services do not form part of the contract and, therefore, no part of the fee is contractual consideration for the services provided. As such, the customer has no remedy in the event of non-performance of the voluntary undertakings.

This is to be contrasted with cases where additional services do form part of the contract and the software developer is contractually obliged to provide such services even if rarely called upon by the customer. In such cases, the software developer is contractually bound to at least hold themselves ready to provide the additional services, and part of the contractual fee is properly allocated to that undertaking.

The governing standard in Australia is AASB 118 - Revenue which provides general principle on income recognition. Limited specific guidance on income recognition for commercial software is provided at paragraph 11 of Appendix 1 to AASB 118 which provides: When the selling price of a product includes an identifiable amount for subsequent servicing (for example, after sales support and product enhancement on the sale of software), the amount is deferred and recognised as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services under the agreement together with a reasonable profit on those services.

Some commercial software developers may also have regard to the United States Accounting Standards Codification (ASC) 985-605 given symmetry between Australian and United States accounting principle. ASC 985-605 provides guidance on a broader range of relevant issues.

ASC 986-605 provides inter alia that where additional services do not entail significant production, modification, or customization of the software, the obligations are accounted for separately. Revenue is allocated to each obligation based on vendor specific objective evidence (VSOE) of the fair values of the obligations. Further, VSOE must be used regardless of whether specific prices are allocated in the contract as such prices may not reflect fair value and give rise to unreasonable apportionment.

VSOE of fair value is limited to: • the price charged when the obligation is sold separately; or • if not sold separately, the price established by management, if it is probable that the price, once established, will not change before introduction into the market place.

AASB 118 and ASC 986-605 are silent on cloud or hosted arrangements which are governed by standards of applicable general principle, specifically AASB 118 in Australia.

It has been argued that Arthur Murray is authority for the proposition that established accounting practice is determinative of the incidence or quantum of derivation of the contractual fee for the proprietary licence, hosted access and/or additional services.

A close reading of the judgment in Arthur Murray , and of later authorities [2] , shows that accounting practice is not the test for derivation of income. Were accounting practice the test, accounting standard setters would in effect determine such matters.

In Arthur Murray , their Honours relevantly stated: In so far as the Act lays down a test for the inclusion of particular kinds of receipts in assessable income it is likewise true that commercial and accountancy practice cannot be substituted for the test ( emphasis added ).

Further, in BHP Billiton Petroleum (Bass Strait) Pty Ltd & ANOR v. FCT 2002 ATC 5169, Hill and Heerey JJ observed: Before turning to the accounting evidence in the present case it is important to note that while the earlier cases, such as Carden, Arthur Murray and Henderson , may be thought to have suggested that business and accounting principles are to be applied by the Court in determining questions of derivation, some later cases, for example the Australian Gas Light Company case in this Court have made the point that accounting principles are not determinative , although they may be persuasive ( emphasis added ).

For these reasons, established accounting practice such as that prescribed in paragraph 11 of Appendix 1 to Australian Accounting Standard AASB 118 Revenue does not of itself determine the incidence or quantum of derivation of the contractual fee for the proprietary licence, hosted access and/or additional services.

This also aligns with paragraphs 118 and 119 of Taxation Ruling TR 2009/5, Income tax : trading stock - treatment of discounts, rebates and other trade incentives offered by sellers to buyers , which relevantly states: 118. BHP Billiton, St Hubert's Island and Philip Morris confirm the relevance of commercial and accounting principles in resolving taxation questions in certain contexts. However, in the Commissioner's view, commercial and accounting principles are necessarily subordinate to taxation principles where they differ and where the taxation principles are clear .......... 119. The Commissioner's view is that there is no basis for preferring a taxation outcome based on an accounting treatment in accordance with current accounting standards over a taxation outcome based on the application of well established legal principles to a particular set of facts.

The authorities that have dealt with apportionment issues accept the principle that a single payment may be apportioned where the facts permit (see for example, Allsop v. FCT (1965) 113 CLR 341; McLaurin v. FCT (1961) 104 CLR 381 ( McLaurin ); National Mutual Life Association of Australasia v. FCT (1959) 102 CLR 29; and Commissioner of Taxation v. CSR Ltd [2000] FCA 1513).

In McLaurin , the High Court stated: It is true that in a proper case a single payment or receipt of a mixed nature may be apportioned amongst the several heads to which it relates and an income or non-income nature attributed to portions of it accordingly ( McLaurin (1961) 104 CLR 381 at 391).

What is a 'proper case' will depend upon whether as a matter of contract the single payment is consideration for a mix of discrete promises or an indivisible promise. For example, where a cause of action for breach could result only in unliquidated damages, apportionment will be unavailable ( McLaurin ).

It is also possible for Statute to intervene to deem a payment ostensibly for a mix of promises as indivisible. For example, in Rowe and McCaw (a firm) v. C & E Commrs (1975) 1 BVC 51, a solicitor itemised rail and air travel costs as disbursements on a bill rendered to a client. In considering for United Kingdom VAT purposes what the payment was for, Wein J held at p55-56, 'there is a taxable supply of legal services which cannot be split up except for accounting purposes'.

Contracts for the bundled supply of a proprietary software, hosted access and/or additional services concern divisible promises and as such apportionment of the contractual fee may be undertaken for tax purposes.

Where, there is no legislative provision specifying a basis for apportionment, any reasonable method of apportioning consideration into separately identifiable parts may be used. However, the apportionment must be supportable by the facts in the particular circumstances and be undertaken as a matter of practical common sense ( Commissioner of Taxation v. Luxottica Retail Australia Pty Ltd (Luxottica ) (2011) 79 ATR 768 ; 2011 ATC 20 243 at [40]).

What is a reasonable method of apportioning the consideration for a bundled contract depends on the circumstances of each case. In some cases, there will be only one reasonable method which may be used.

The method used should be based on a consideration of all the circumstances and not because it gives a particular tax outcome. Different methods may need to be used, or a combination of methods, to ensure the apportionment reflects an appropriate allocation of the consideration for the bundled contractual licence.

Records must be kept which support and explain the method employed.

In the Commissioner's view, VSOE methodologies as set out in ASC 986-605 represent a fair and reasonable basis of apportionment in the sense contemplated in Luxottica .

As already noted at para 147 of this Ruling, VSOE of fair value is limited to: • the price charged when the obligation is sold separately; or • if not sold separately, the price established by management, if it is probable that the price, once established, will not change before introduction into the market place.

Depending on the facts and circumstances of the licence agreement, the price allocated by the contracting parties may be regarded as the most appropriate measure of value for the additional services. This is on the basis that such prices are agreed on commercial terms and at arms length and are not merely agreed to enable a particular tax outcome.

Conversely, in cases of inequality of bargaining power where the customer has no influence in terms of the component prices allocated to the additional services, this method may not be appropriate as component prices may be unilaterally allocated by the software developer which bear no resemblance to fair commercial value with a view merely to achieve tax outcomes.

In cases where additional services are rarely called upon, the above methodologies may result in a de minimus allocation of the bundled consideration to the additional services. These types of cases may result in a significant divergence between accounting treatment and the incidence of derivation for taxation purposes. This will particularly be the case where accounting treatment is to allocate the contractual fee on a straight line basis across the term of the bundled licence agreement.

In cases where upgrades are an essential component of the agreement, a significant allocation of the bundled consideration to the additional services may be valid (such as, for example, where the software licence relates to virus or malware protection software and the upgrades represent the essence of what the licensee required from the software developer in entering into the contractual licence). That is, the upgrades each represent of themselves significant commercial value to the licensee.

In such cases, upgrades are constantly required to be delivered over the term of the agreement and each upgrade will have material commercial value of itself. In these circumstances, apportionment may more closely align with established accounting practice. However, as already noted in this ruling, accounting practice is not of itself determinative.

As already noted, the question at issue in Arthur Murray was whether 'receipt without earning' makes income.

In cases where the governing contract provides for: the provision of software updates if an only if updates or upgrades are released during the term of the licence agreement; there is no cause of action for breach if no update is released during the term of the agreement. As such, the software developer may retain the full licence fee regardless of whether or not any update is provided. There is therefore no contingency of repayment in the sense discussed in this ruling and therefore Arthur Murray is not authority for any part of the licence fee to be deferred for taxation purposes. That is, the licence fee is derived at the time a recoverable debt arises.

You are invited to comment on this draft Ruling, including the proposed date of effect. Please forward your comments to the contact officer by the due date. A compendium of comments is prepared for the consideration of the relevant Rulings Panel or relevant tax officers. An edited version (names and identifying information removed) of the compendium of comments will also be prepared to: • provide responses to persons providing comments; and • be published on the ATO website at www.ato.gov.au. Please advise if you do not want your comments included in the edited version of the compendium. Due date: 26 June 2013 Contact officer details have been removed following publication of the final ruling.

The following is a detailed contents list for this Ruling: Paragraph What this Ruling is about 1 Ruling 5 Derivation 5 Accounting Principles 11 Allocation of the contractual fee 12 Examples 20 Proprietary Licence Derivation Examples 20 Example 1: Proprietary licence provided in a discrete contract 20 Example 2: Proprietary licence and technical support provided under a bundled contract 24 Example 3: Software updates to be provided only if developed during the course of the licence agreement 31 Example 4: When regular upgrades are the essence of the agreement 36 Example 5: Where additional services are provided voluntarily 41 Proprietary Licence/Allocation/Apportionment Examples 47 Example 6: The contractual fee is not dissected and the proprietary licence and/or additional services are also provided as stand alone products 47 Example 7: Where the contractual fee is dissected into discrete prices for each of the proprietary licence and the additional services 52 Example 8: Where the contractual fee is not dissected and the proprietary licence and/or additional services are not provided as stand alone products 56 Example 9: Where the additional services are rarely called upon under a bundled contract 62 Hosted Access/Cloud Derivation Examples Example 10: Where the access fee is for the hosted access only and no contingency of repayment exists in relation to the access fee 70 Example 11: Where the access fee is for the hosted access only and a contingency of repayment does exist in relation to the access fee 75 Example 12: Where additional services are bundled with the hosted access 79 Example 13: Monthly hosted access fees and no contingency of repayment 85 Hosted Access/Cloud Allocation/Apportionment Examples 88 Example 14: Where the hosted access is bundled with additional services, and the access fee is contractually dissected between the hosted access and the additional services 88 Example 15: Where the hosted access is bundled with additional services, the access fee is not dissected and the additional services are available as stand alone products 98 Example 16: Where the hosted access is bundles with additional services, the fee is not dissected, and the additional services are not also available as stand alone products 104 Example 17: Where additional services are provided voluntarily 110 Date of effect 115 Appendix 1 - Explanation 116 Background 116 The nature of a licence for granting the right to use proprietary software 124 The nature of a contract for hosted access of proprietary software 125 Derivation Section 6-5 of the ITAA 1997 126 Contingency of repayment 130 Only contractual obligations may be tested 140 Accounting Principles 145 Accounting principles applicable to apportionment of a licence fee between earned and unearned income 145 The relevance of accounting principles to apportionment of a licence fee between earned and unearned income 150 Allocation of the Contractual Fee 156 Apportionment of bundled contractual licence between additional services and licence for proprietary software or hosted access 156 Vendor Specific Objective Evidence (VSOE) Methodologies 165 Separately agreed prices 167 Where additional services are rarely called upon 169 Where regular upgrades are an essentially component of the agreement 170 Where the contractual licence provides for the provision of software updates or upgrades if and only if updates or upgrades are released during the term of the licence agreement 172 Appendix 2 - Your comments 174 Appendix 3 - Detailed contents list 175