Software Distribution Payments Are Not Royalty
July 8, 2020
HSISSB v Ketua Pengarah Hasil Dalam Negeri (2020)
Recently, the Special Commissioners of Income Tax (SCIT) allowed the taxpayer’s appeal against withholding tax imposed by the Director General of Inland Revenue (DGIR) on payments made to a non-resident vendor during the years of assessment (YAs) 2011 to 2013.
Our partner, S. Saravana Kumar together with associate Chew Ying from the firm’s Tax, SST & Customs practice successfully represented the taxpayer. This alert discusses the facts of the appeal and the arguments advanced by both parties.
The taxpayer is involved in the sales of computer hardware and related products, and provision of information technology consulting services. In YAs 2011 to 2013, the taxpayer entered into reseller agreements with its non-resident vendor for the right to resell and distribute the vendor’s software to customers in Malaysia. The taxpayer is required to make payments to the vendor for each copy of the software sold.
Pursuant to the agreements, it was clearly stated that as a reseller and distributor, the taxpayer has no right to use, copy, develop, modify, prepare derivative works or sublicense the vendor’s software. Neither did the taxpayer obtain any proprietary right, title or know-how from the vendor.
In 2016, the DGIR informed the taxpayer that the payments it made to the non-resident vendor falls under the definition of royalty and is subject to withholding tax under the Income Tax Act 1967 (ITA). The taxpayer filed an appeal to the SCIT upon paying the disputed withholding taxes on a without prejudice basis.
The Taxpayer’s Contention
The issues before the SCIT were:
Whether the payments of made by the taxpayer to its vendor in YAs 2011 to 2013 were royalty under Article 12 of the Malaysia-Singapore Double Taxation Agreement (DTA)?
In the event of conflict, whether the definition of royalty under Article 12 of the DTA prevails over the definition of royalty under Section 2(1) of the ITA?
The taxpayer submitted that the payments made to its non-resident vendor are not royalty for the following reasons:
Case law and Section 132(1) of the ITA have settled that in the event of conflict, the definition under Article 12 of the DTA would prevail over the definition under Section 2 of the ITA.
It is established law that reference shall be made to the OECD Commentary to determine the construction of the provisions in the DTA.
It is clear that under Article 12 of the DTA, a payment does not amount to “royalty” if the payment was not made for the rights to exploit a “know-how” or granting of copyrights or partial copyright of the subject matter.
The provisions in the reseller agreements show that there has not been any transfer of know-how information or copyright from the non-resident vendor to the taxpayer.
The payments received by the non-resident vendor is its business profit and were already subjected to tax by its relevant tax authority.
The DGIR’s Response
The DGIR argued that the taxpayer’s arguments in respect of the DTA were premature as only the non-resident vendor may claim for relief under the DTA. Hence, the taxpayer, as a Malaysia tax resident is not allowed to advance the argument of conflict between the ITA and DTA on behalf of the non-resident. Further, the DGIR argued the following:
There is no conflict between the definition of royalty under Article 12 of the DTA and Section 2(1) of the ITA as the taxpayer should be subject to withholding tax under the ITA.
Section 2 of the ITA should be construed in the context of the ITA as a whole where payments made to non-residents should be subject to withholding tax under Section 109(1) of the ITA.
The payments made by the taxpayer to the non-resident vendor was royalty under Section 2 of the ITA as it was paid in exchange for the right to use the copyright and trademark of the software.
The SCIT’s Decision & Our Observation
The SCIT agreed with the arguments advanced by the taxpayer’s counsel and unanimously held that the payments made to the non-resident vendor should not be subject to withholding tax as they do not amount to royalty under Article 12 of the DTA. This recent decision reinforces the well-established principles that the provisions of the DTA prevails over the ITA and that reference is to be made to the OECD Commentary in constructing the provisions in the DTA which Malaysia is a signatory to.
It is also important to appreciate that not all payments made to non-residents are royalty payments and are thus, subject to withholding tax under the ITA. Taxpayers will need to understand the nature of the various payments made to non-residents in the course of their businesses before deducting any withholding tax from the invoices. In instances where taxpayers find the DGIR’s interpretation of royalty to be inconsistent with any Double Taxation Agreements and the OECD Commentary, then they ought to seek further legal advice to gain more insight and clarity.