Platforms are ideal for enterprises that intend to share and monetize software or data assets within their own group of companies or with third parties. The key is to publish software assets and facilitate the seamless trade thereof among all of the enterprises and business units involved. In the following, we will outline the legal (I.) and tax (II.) challenges that platform participants need to consider and overcome.
I. Legal issues
Most of the legal issues involved in sharing software assets revolve around protecting rights to intellectual property (“IP rights”) and preventing infringements of the IP rights of third parties. Establishing the relevant legal relationships based on each party’s individual interest also plays an important role. This is a challenge that enterprises frequently underestimate and that can lead to unintended consequences, particularly when it comes to the use of existing software assets in new applications within a group of corporations. In each specific case, it is vital for enterprises to identify the relevant (mandatory) legal requirements (particularly in terms of data protection and antitrust law) and ensure they comply with them.
a. IP rights to software assets
To ensure adequate protection of the IP rights, we recommend a multi-stage approach. In the first stage, an enterprise must compile a reliable overview of the IP rights associated with the respective software assets (in particular the original rights to the source code) as part of a broader inventory. The only way to ensure that assets are shared or published in a legally secure way is to clarify whether the IP rights are held by the company providing the assets, by a third party or even by an entire community in the case of open-source software (OSS). The second stage involves determining the identity and the requirements of the recipient, with appropriate licensing provisions in place to ensure no party’s rights are infringed.
This should not be taken lightly, as infringement of IP rights can lead to claims for damages, injunctions or even criminal proceedings. In addition to direct financial losses, companies run the risk of injunctive relief, i.e., a ban on the use of IP rights. Authorities could impose a ban on use with criminal sanctions in a matter of days, which would preclude any further use of the software asset. Particularly when it comes to business-critical services, this may result in major challenges for company processes or even halt operations all together.
An enterprise can identify and mitigate these risks by means of a (system-supported) software asset management (SAM) tool and the associated processes and governance rules. It is important to pay particular attention to the use of open-source software in addition to the proprietary IP rights. Even as OSS has become an indispensable tool in software development, the often unclear licensing terms and the threat of a loss of IP rights involved in so-called copy-left licenses pose considerable legal changes that enterprises must (and can) overcome with due care.
b. Intelligent process and contract design
Process and contract design plays a decisive role in procurement to ensure that a company’s software assets emerge from the shadows and gain widespread adoption among the target users. Designing contracts with standardized and modular elements will help achieve this objective if enterprises are smart about providing scenario-based standard clauses that meet users’ actual requirements. The “arm’s length” principle applies here as well, even if the software assets are only shared within a corporate group. In other words, the parties to the contract have to agree on clear contractual terms, at least with regard to essential rights and obligations. This is true even if the assets are only shared within the group, where it, however, may be possible at one point or another to forego the many rules governing assets that are shared with third parties.
It is important to consider this idea when it comes to process design as well, where an enterprise will have to find a compromise between the legal requirements around e-commerce (which are particularly strict in the European Union), for example with regard to order processes, and the desire to provide user-friendly access with minimal barriers.
At the latest, this is also the stage in which companies must consider whether they intend to provide add-on services such as implementation, operation and maintenance in addition to the software assets themselves. Where this is the case, they will need to add the corresponding elements to the contracts and processes. Particularly those companies that are not focused primarily on providing IT services should think carefully about offering add-on services before making this decision, because the effort they require is often underestimated. This is particularly true when they intend to extend the offering to third parties outside their own corporate group.
Depending on the design of the software assets, the support services on offer and the specific circumstances, it is important for an enterprise to determine at an early stage if they are subject to any mandatory legal requirements or sector and company-specific requirements (e.g., financial services or healthcare). Enterprises should address and find solutions for issues relating to data protection (e.g., privacy-by-design or privacy-by-default principles of the General Data Protection Regulation) or IT security (e.g., data separation or trade secrecy) ideally during the development phase, or at the latest before software assets go on offer.
Where enterprises opt to provide add-on services such as the operation of the software assets, they may face additional sector-specific requirements at the legal (e.g., the German requirements for financial institutions in the ‘MaRisk’ and ‘BAIT’) and at the technical level (e.g., interface rules in the healthcare sector).
II. Tax issues
As always, enterprises need to conduct a precise analysis of the facts when it comes to complying with tax regulations. This will enable them to identify the relevant regulations and necessary steps to comply with them. Compliance requirements may cover tax declaration issues, such as the obligation to submit a tax return or a self-assessment. They may, however, also involve more formal requirements for issuing invoices, for example, particularly in relation to VAT regulations. And finally, the prices themselves – for the use of the marketplace or individual software assets – may be subject to tax laws, certainly when the transactions in question take place within a group of corporations. We will outline individual tax requirements by way of examples in the following.
a. Challenge: transfer pricing for tax purposes
If all transactions take place between unrelated companies, transfer pricing is generally not a tax issue. The situation is different, however, within a group of corporations. Particularly when companies are tax resident in different countries, transfer pricing is often subject to tax laws governing transactions to follow the “arms lengths principle”. The laws are generally very specific and relate to pricing as well as special disclosure requirements. Many countries impose sanctions for violation of these regulations, ranging from a drastic increase in the local tax base to penalty payments. This could lead to a reduction in after-tax profits as well as negative cashflow effects.
For software assets, it is vital to comply with the prevailing tax transfer pricing laws when it comes to pricing the assets including any add-on services – the same applies to the compensation of one or more marketplace facilitators.
Intragroup pricing often acts as a management tool to create incentives, to optimize resource allocation and to maximize group profits. It may prove challenging to reconcile the operational objectives of the group with the tax regulations.
b. Challenge: additional tax issues
Many of the services at issue here, licensing payments in particular, are subject to withholding tax. In this case, the party liable for payment is responsible for withholding a portion of the payment and both declaring and paying withholding tax to the authorities where they are tax resident. If the party liable for the payment fails to deduct the necessary withholding tax upon payment, they assume legal liability for the withholding tax. Withholding tax can then become an additional and irreversible burden for them, depending on the contractual agreement and the de facto rights of recourse. Where the party liable for the payment correctly deducts the withholding tax, there is a corresponding reduction in the fees paid to the licensor – and whether or to what extent the withholding tax payment can be refunded or credited depends on the individual case. This may, however, also mean that part of the withholding tax becomes definite, leading to a reduction in after-tax profit as well as cashflow.
We recommend analyzing your particular set of circumstances from the VAT perspective as well to ensure you draw the right conclusions with regard to the tax requirements. Does the transaction qualify as goods or services? Who is the recipient? Do special rules apply for this particular type of service? What formal requirements do have to met? If enterprises correctly identify and comply with the relevant regulations, they are unlikely to incur a definite tax burden, but there are a number of potential pitfalls.
Certain activities may also result in a “permanent establishment” for tax purposes, which is subject to certain regulatory requirements and may oblige an enterprise to determine the corresponding taxable profit and file a tax return. Failure to do so may result in double taxation, i.e., income tax charged twice for the profits of the permanent establishment, and additional penalty payments. Here, too, there is a risk of a reduction in after-tax profits and negative cashflow effects.
In recent years, international organizations (OECD, EU) have been working on various recommendations and guidelines to prevent tax avoidance. The implementation of these provisions has already led to numerous changes in the local tax codes of many countries. This may impact transactions involving the use of software and add-on services in particular, as well as the services provided by marketplace facilitators. Efforts are also currently underway to create further tax points for digital business models. These discussions are already well advanced and will likely lead to additional compliance requirements, at least for companies of a certain size.
c. Solution: early involvement of tax and legal experts
The prevailing tax regulations are comprehensive and impact different parties differently. At the same time, they can influence one another and also play a role in non-tax issues (e.g., operational management). There are also massive changes taking place in today’s tax regulations, making it even more difficult to plan for the future. The only way to master issues with this level of complexity is to involve the relevant experts early on and find specialists who are well-versed in these tax issues and the special features of SaaS business models. With their support, your enterprise is free to pursue its core business goals with the assurance that any tax compliance issues are under control.
Claudia Lauten is a Partner at Deloitte GmbH WPG for Tax Transfer Pricing and the current lead for Tax & Legal Germany in the area of Industrial Products & Construction. She has more than 20 years’ experience in the tax rules for transfer pricing, with a particular focus on dispute resolution.
Dr. Till Contzen is a Partner at Deloitte Legal, advising clients on all legal issues relating to digital transformation, outsourcing arrangements for IT infrastructure and business processes as well as the development, implementation and sale of complex IT solutions.