Software as a Service (SaaS): what international tax law says about the fast-growing model


With the rapid development of cloud computing over the last decade, software companies are moving away from traditional software deployment models and increasingly offering the Software as a Service (SaaS) model. This model can offer businesses much more flexibility and efficiency, but it is important to pay attention to the nuances related to tax regulation.

The most popular example of a SaaS model is a cloud subscription contract, where users are given online access to applications hosted on a remote server. The software can be accessed from any device with an internet connection and does not need to be installed and maintained on local computers. This allows companies to reduce the cost of software licences and maintenance, saving resources that would otherwise be spent on IT system administration. Moreover, SaaS-based applications are often more secure because they are hosted on a secure server and are updated regularly.

According to the market research firm Fortune Business Insights, the global SaaS market was worth  USD 237 billion in 2023. It is forecast to grow at an average annual rate of more than 18%, with a market value approaching USD 1 trillion in 2025.

However, as Raimond Seniut, a lawyer at NOOR, points out, the trend towards SaaS contracts raises a number of international tax issues for both software providers and buyers. One of the main issues is the nature of the payments received under a SaaS contract. This is important because it determines how income from a SaaS contract is taxed and whether such payments should be subject to tax exemption.

Characterisation: royalties or business income?

“With regard to payments under a SaaS contract, the most important question to answer is whether the payment qualifies as royalties (i.e. payment for the authorisation to use intellectual property rights) or as revenue for services? While it may seem straightforward to determine the nature of payments for software, in practice it can be difficult for a number of reasons. There are no clear guidelines on how income from a software contract should be classified in most countries, including Lithuania, especially if it is a SaaS contract”, said Seniut.

In Lithuania, as in many other countries around the world with which Lithuania has tax treaties, the Organisation for Economic Co-operation and Development (OECD) definition of royalties applies.

While this definition covers a wide range of payments, the law does not specifically mention “software”, let alone payments under a SaaS contract.

“To help taxpayers in this area, Lithuania has adopted the OECD’s ‘rights-based approach’ model, according to which payments for the right to use copyright are royalties and payments for copyrighted products, such as ready-to-use software, are income from the provision of services or the sale of products,” added Seinut.

Tax implications

In Lithuania, royalties are subject to a 10% withholding tax, i.e. the royalty payer must pay 10% of the royalty amount to the Lithuanian Tax Revenue Service. However, the amount of this withholding tax may be reduced under double taxation treaties already in place.

Seinut explains, “On the other hand, if the income is classified as income from the sale of services or products, it would only be taxed in Lithuania if the seller has a permanent establishment in Lithuania. Therefore, if the supplier does not have a permanent establishment in Lithuania, such income will not be taxed in Lithuania and will not be subject to withholding tax.”

He stresses that if the buyer of the software does not apply the rules on withholding tax correctly, the buyer is liable for the unpaid tax, not the seller. In such a case, the buyer could also be penalised for late payment of the tax and for late filing of the relevant declarations (without being able to claim damages from the seller). For this reason, a buyer of software may be tempted to treat all payments under software contracts as royalties and to apply withholding tax, despite the fact that such payments may be treated as income from the supply of services or sale of products.

“On the other hand, the misclassification of payments as royalties by software vendors does not justify the application of the withholding tax provisions. The process of recovering incorrectly withheld tax is often lengthy and costly. There is also a risk of double taxation if the vendor’s home country classifies the payment as income from the supply of services or the sale of products and does not allow a foreign withholding tax credit,” added Seniut.

How to manage income tax withholding risks

The NOOR lawyer points out that when entering into SaaS contracts, it is important to discuss and spell out in detail the most important provisions of the contract, in particular the terms relating to the rights granted to the software, the method of delivery (electronic or otherwise), customisation options, additional services, and the payment terms.

“There is no doubt that the description of software payments is often complex and complicated. It requires special attention and legal assessment to mitigate the risks both at the contract negotiation stage and when there are doubts about the classification of individual payments. In this case, it is important to properly structure the provisions of the software supply contract and to assess the type of income to which the payments under the contract are attributed.”