The Ins and Outs of Standardized Software LicensesBy Arturo Tiburcio | Thu, 11/11/2021 - 16:41
It is very common for our customers to make inquiries related to payments for the acquisition of a software license (standard or standardized), known as "Commercial off the shelf." One of the essential points to qualify the software as standard is that the source code cannot be modified.
It must be remembered that under the tax legislation, Mexican residents must comply with several obligations for an expense to be deductible from the income tax base, in addition to being considered jointly and severally liable for an undue or null withholding performed to the foreign tax resident who licenses a software with such characteristics.
Our legislation includes as a copyright the programs or sets of instructions for computers required for their operational processes or to carry out application tasks, regardless of the means by which they are transmitted, which are considered as royalties for tax purposes.
On this basis, when a foreign resident grants a software license to be used and exploited in Mexico, it implies that such foreign resident obtains an income derived from a source of wealth in Mexican territory and therefore, such income is subject to a tax withholding, either at a rate derived from the law (25 percent), or at a reduced rate established in a Double Taxation Agreement entered into by Mexico (generally 10 percent, in the case of royalties)
However, under the coverage of the treaty, there is a benefit clause, provided that the foreign resident carries out a business activity in its country of residence and does not have a permanent establishment in the country of the source (Mexico).
Now, our federal courts have indicated that the Commentaries to the OECD Model Convention are a source of privileged interpretation, and are considered as “soft law". In this regard, the Commentaries specify that those applications or software that only allow the effective exploitation of the program by the user should not be considered as a royalty but as a business profit. This Commentary coincides with the Reservation raised by Mexico (exclusion of a general interpretation criterion) to determine that Mexico may tax as royalties those programs (software) that are not absolutely standard but adapted in some way for the acquirer.
On the other hand, it is very common for the tax authorities to issue rules of interpretation, not mandatory for the taxpayer, in which they express their position with respect to a certain tax regime. In the case at hand, rule 2.1.37 establishes criteria for "Commercial off the shelf."
Considering the premises above, it is important to analyze whether a software is standardized or not, since we can have a scenario in which the foreign resident is released from paying the tax in the country (in the source) and pays the corresponding tax in its country of residence, considering the income obtained in the source.
We always suggest that taxpayers must gather supporting evidence that the software is standard for the purpose of supporting the application of the business profit clause, because otherwise the foreign resident must pay taxes in Mexico.
In that sense, the interesting aspect is to always have the evidence to comply with the requirements set forth in the law and maintain a defense file in case the tax authorities perform an audit in which the subject matter addressed herein is reviewed.