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Research by Industry/Sector January 24, 2018  
What are Withholding Taxes on Software Royalties?

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Transactions that permit the use of software in another country may result in a tax by that country. How (or whether) a foreign country taxes a cross-border software transaction involving a U.S. company depends on the specific characteristics of the transaction, whether a tax treaty exists between the United States and the foreign country, and the law of the foreign country. (If a foreign income or withholding tax is lawfully imposed on the transaction and the foreign tax meets U.S. foreign tax credit requirements, the U.S. company may use the foreign tax to offset all or a portion of its U.S. income tax on the transaction.)

Characterization of Software Transactions
The “characterization” of a software transaction is an important step to determine if a withholding tax obligation will be incurred. There are three basic characterizations for software transactions: sales, royalties, and rentals. If a software transaction is characterized as generating royalties, a withholding tax may be applied. For software transactions characterized as rentals, a withholding tax also may be applied. In addition to withholding tax (or income tax, if applicable), other taxes such as value-added tax (VAT) may apply to the transaction as well.
  • For example, suppose a U.S. company licenses software to a user in a foreign country. If the foreign country’s tax rules treat the payments pursuant to the license as “royalties” and subject royalties to a 25% withholding tax, the foreign user will have to withhold (and pay to the foreign government) 25% of the payment due under the license agreement.
  • On the other hand, if the foreign country’s tax rules treat the software licensing payment as sales or regular business income, the payment typically will not be subject to withholding tax. However, the U.S. company may be subject to income tax in the foreign country on the payment if the company has a “permanent establishment” or is otherwise treated as engaging in business in the foreign country.

Bilateral Tax Treaties
The United States has bilateral tax treaties with more than fifty countries. These tax treaties generally offer lower withholding tax rates than would be incurred in the absence of a tax treaty. Bilateral tax treaties also aim to offer certainty regarding the withholding tax obligations incurred in a given transaction.

Country Specific Tax Laws
Many countries have their own tax laws regarding software sales. Because this area of tax law is complex and fact-specific, it is advisable to consult with an advisor experienced with the tax laws of the country in which your transaction will occur.

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