Classification of Third Parties in Software Licensing: Principal or Agent under IFRS 15, Exercises of Business

Download Classification of Third Parties in Software Licensing: Principal or Agent under IFRS 15 and more Exercises Business in PDF only on Docsity! IFRS IC Potential Agenda Item Request We kindly request the IFRS Interpretations Committee (hereinafter referred to as the “Committee”) to examine the following issue in connection with the application of IFRS 15 with regard to the distinction between the principal and the agent. 1. Problem The submission deals with the question whether, when software licences are sold by third parties, i.e. by IT service providers or IT system houses, the respective third party is to be classified as principal or agent. Doubts arise especially with respect to contract models in which the third party is a value-added reseller and directly performs complex and extensive consulting services in advance within the scope of the contractually agreed performance (so-called indirect contract models). The question is especially whether the pre-sales consulting to be performed in the indi- rect contract model and the sale of a software licence represent goods and services in the meaning of IFRS 15.29 (c), which are highly interdependent or highly interrelated. While the affected value-added resellers of the entire IT industry usually assume that a significant integration service is on hand – which would imply classification as principal – [another party] published indications to be used for the assessment, which imply that in general, the goods and services are separable. The distinction made between the role of the principal and that of the agent of an entity has significant consequences for the presentation of the revenue in the income state- ment. For value-added resellers, it is therefore important to have a clear, reliable procedure. 2. Fact Pattern The fact pattern is as follows: (1) The volume licence is the typical licence model in the B2B segment. A customer who obtains a volume licence acquires the software and, via the licence contract, the right to use a certain number of copies without obtaining a physical storage medium. The software is usually made available via a software portal. The software activation takes place by means of a key; however, a volume licence programme does not require the customer to use a new key for every activation, but only a single (corporate) key for the activation of all installed software products. (2) Regardless of the licence model, the software manufacturer enters a contract with the end customer. (3) In the context of the sales partnership, the IT service providers in the indirect con- tract model act as value-added resellers who create combined products that in- clude their own services and sell these to their customers as custom solutions. (4) The distribution agreement between the value-added reseller and the software pro- vider confers an enforceable right on the value-added reseller to grant software licences to his customers. (5) The consulting service is a key element of the performance towards the customer. The obligations of the value-added reseller in this regard are governed primarily by the agreement between the value-added reseller and the software manufacturer and thus become an essential element of every contract between the value-added reseller and the customer. Furthermore, the value-added reseller undertakes to provide every new customer with “certified consulting” services upon registration on the official company website. Thus, every customer is entitled to qualified advice according to the terms and conditions of the respective partner agreement and can expect a performance package with these features. (6) The combination of qualified pre-sales consulting with the software licence is what delivers the customer benefit in the form of a suitable, legally compliant software solution. (7) By means of the pre-sales consulting, a customer-specific contract package is con- figured for the customer for a planning horizon of three years. The pre-sales con- sulting is not based on standard offers or assumptions, but rather on the precisely identified needs of the customer. Especially aspects such as its corporate goals and the derived IT strategy are taken into consideration. In most cases, the pre- sales consulting culminates in the conclusion of a contract that provides the cus- tomer with various upgrade options and maximum flexibility. (8) The pre-consulting services may only be performed by duly trained and certified employees (licence consultants). Depending on the complexity of the case, several person-days are often required for this pre-sales consulting. Apart from the direct consulting overhead that arises from the performance of the pre-sales consulting, the value-added reseller is faced with substantial upfront investments. (9) In the case of public RFP of public-sector clients, both the partner status and the consulting are often explicitly requested and are part of the conditions of the RFP. They are thus explicitly agreed. It is remunerated within the framework of the total price for the software solution advised. If the contract is not concluded, the remu- neration does not apply. (10) The partner agreement between the software manufacturer an den value-added reseller stipulate that vis-à-vis the customer, the value-added reseller has complete discretion in his pricing. seller’s consulting obligation increases the more the buyer needs protection and the more expertise the seller claims to have. The value-added reseller’s consulting obligation arises with the commencement of the professional advice and is documented at the lat- est when an offer is submitted. Provided that the other preconditions are met, a breach of the consulting obligation results in a claim for damages. The party protected by the ancillary obligation is to be put in a position as if the obligation had been duly performed. Moreover, depending on the circumstances, the breach of ancillary obligations can insti- tute a reason for rescission or termination of the contract. Moreover, the uniform billing and the fact that the value-added reseller usually does not have a separate claim to remuneration underlines the nature of the combined integrated performance for the customer. In summary, the following applies to the indirect contract model in the field of software licensing involving a value-added reseller (in accordance with IFRS 15BC116J et seq). (1) The customer benefit only arises from the interaction or combination of the individual promises. (2) From the perspective of the customer, the promise largely represents a single per- formance (= provision of a suitable and legally secure software solution). (3) The consulting service directly and greatly influences the licence (and vice versa). Thus, consulting risks also give rise to licence risks. The value-added reseller bears the risk for the entire service package and may be held liable accordingly. (4) The consulting thus has a significant impact on the customer benefit. Against the backdrop of both the implicit and, in certain cases, the explicit obligation to provide such comprehensive consulting services, the value-added reseller comes to the conclusion that pre-sales consulting represents an implicit (significant) promise to the customer. The performance consists, not only of the sale of the standard software li- cence, but of a combined performance bundle comprising the standard software licence and the qualified consulting services of the value-added reseller. The customer-specific licensing concept establishes a transformative connection between the pre-sales con- sulting and the sale of the vendor’s software licence. In this process, the customer’s needs are fully taken into consideration. The responsibility for the transformation services lies with the value-added reseller alone. 3.1.2. Further Aspects – Regulations of IFRS 15.B35 et seq Against the above-mentioned backdrop, the value-added reseller considers the criteria for the classification as a significant integration service (IFRS 15.B35A (c)) to be fulfilled, by way of which the value-added reseller obtains the control before transferring the per- formance bundle to the customer. Apart from the value-added reseller's original consulting service, this is also supported by the fact that due to his partner status and the associated distribution agreement, he holds overriding distribution rights of the vendors. The distribution agreement between the value-added reseller and the software provider confers an enforceable right on the value-added reseller to grant software licences to his customers. The software provider has granted the value-added reseller a right to use his IP (i.e. to sell licences for his IP), which is separated from the actual underlying software licences. In connection with the application of the control criteria to intangible goods and services, IFRS 15.BC385Q also indicates that the evaluation of the control should not merely take individual parts of the promise, but the entire promise into consideration. Therefore, the evaluation of the con- trol should examine the combined output, and it must be determined whether the entity controls the combined output before it transfers it to the customer. The classification as principal is supported by the other indicators of IFRS 15.B37:  The value-added reseller is mainly responsible for fulfilling his obligation towards the customer, as he ensures the compatibility of the standard software license and the customer requirements.  Moreover, the value-added reseller is free to determine the price for the combined performance obligation at his own discretion (see Fact Pattern, item 10).  Furthermore, the value-added reseller is exposed to a special form of inventory risk with regard to the standard software licence, since in the event of non-acceptance by the customer, he cannot return it to the software vendor or sell it to another cus- tomer (see Fact Pattern, item 12). Under certain contract models, the software vender pays additional remuneration for the sale of licences. In this contract models, the customer usually requests comprehensive consulting within the scope of the tender process. Here too, a customer-specific licencing concept is on hand, in which all above-mentioned indicators for classification as principal are met. From the perspective of the value-added reseller, an additional remuneration by the vendor does not change the assessment of whether he acts as principal or agent. This opinion of the value-added reseller is in accordance with the accounting and meas- urement principles of the software reseller industry, with which intensive interchange takes place with regard to this discretionary judgment. 3.2. View 2: The Value-Added Reseller is an Agent This deviating interpretation of IFRS 15 does not assume the existence of a significant integration performance in the indirect business if the main purpose of the consulting service is to fulfil the licensing requirements of the software vendors. [Revenue] from the sale of standard software licences must be presented on a net basis in accordance with IFRS 15.B36 (accounting as agent) if the consulting service per- formed in connection with the sale of the software is primarily aimed at the fulfilment of the software vendor’s licensing requirements and does not represent any significant ser- vice of integrating the goods or services at the request of the customer in the meaning of IFRS 15.29. For the assessment of whether the consulting service could potentially be a significant integration service, the following aspects must also be taken into consid- eration: the proportion of the consulting overhead and the licence value; the primary in- terest of the software vendor in appropriate licensing, which is important for the amount of his income; the fact that (in certain contract models) the software vendor pays remu- neration for the sale of a licence and the fact that the consulting service is performed prior to the submission of a quotation, i.e. even in cases in which the software sale does not materialise. The view that a pure agency activity is on hand is supported by the fact that in the context of the sale of standard software licences in the indirect business, a direct contractual relationship is instituted between the customer and the software vendor in addition to the contractual relationship between the customer and the value-added reseller and until then, the value-added reseller does not control the software licence. In this context, the pre-sales consulting would be regarded as a pure sales service on the part of the value- added reseller. [This] reasoning can be supported as follows:  The consulting service of the value-added reseller aims primarily at the software vendor’s interest in due licensing.  Compared to the value of the standard software licence, the pre-sales consulting overhead and the gross margin usually accounts for a minor share.  Pre-sales consulting is provided even in cases in which the sale ultimately does not materialise. Thus, pre-sales consulting services are offered even without remuner- ation.  A customer who knows which contract model would be suitable and how many standard software licences he or she needs would not gain any added value from the pre-sales consulting. From the perspective of the value-added resellers, the following points conflict with view 2: The activities of the value-added reseller do not only primarily aim at the fulfilment of the software vendor’s licensing requirements. Rather, according to the partner agreement with [a particular software manufacturer], the value-added reseller has assumed the con- tractual obligation to provide every customer with certified consulting services according to the terms and conditions of the partner agreement, and this involves substantial up- front expenses. From the customer perspective, this manifests the expectation of receiv- ing the respective performance bundle (see Fact Pattern, items 5 and 8 above). The value-added reseller is liable for his consulting services, as the pre-contractual con- sulting obligation also refers to the contract to be concluded and has legal consequences for the subsequent contractual relationship (damages in the event of wrong advice). These aspects of the legal relationships between the software vendor and the value- added reseller go far beyond a mere sales service. Thus, it is irrelevant that compared to the volume of the overall order, pre-sales consulting services usually account for a minor share or are performed even in the rare case that no contract is concluded. As described in chapter 3.1.2 above, the distribution agreement between the value- added reseller and the software provider also confers an enforceable right on the value- added reseller to grant software licences to his customers (see also Fact Pattern, item 4). The software provider has granted the value-added reseller a right to use his IP (i.e. to sell licences for his IP), which is separated from the actual underlying software li- cences. In view of the above reason, the value-added reseller considers the criteria for the clas- sification as a significant integration service (IFRS 15.B35A (c)) to be fulfilled and as- sumes that he obtains the control before transferring the performance bundle to the cus- tomer. After all, according to IFRS 15.B35A (c), the entity controls the inputs before the entity renders the combined performance. In the case of software sale, this means that the Questions and answers related to the IFRS IC Potential Agenda Item Request • Additional information about the contract between the software manufacturer and end customer • Questions on facts provided in the fact pattern within the submission Facts provided in the fact pattern within the submission Questions 2: Regardless of the licence model, the software manufacturer enters a contract with the end customer. Could you provide more information about the contract between the software manufacturer and end customer? Could you provide more information about the contract between the software manu- facturer and end customer? Essentially, the contract between the software manufacturer and the end customer com- prises the general terms and conditions of the software manufacturer and the signatures of the contracting parties. The general terms and conditions include, in particular, the rights to use the software license, the right to verification of the performance of the contract by the software manufacturer (compliance), e.g. correct number of licenses in use by the customer, the purely functional warranty by the software manufacturer as well as the term of the soft- ware licenses and the general pricing. This pricing structure provides that the value-added reseller is free in its pricing to the end customer. In addition, for example in the case of contracts with [a particular software manufacturer], the value-added reseller is named as a partner in the general terms and conditions and thus oc- cupies the middle position between the software manufacturer and the end customer. Ac- cording to the contract, the partner is a company authorized by [the particular software man- ufacturer] to sell licensed products to the customer. In the contractual relationship between the software manufacturer and the customer, the partner is commissioned by the customer to place orders on behalf of the customer and to manage purchases by the customer. We would like to clarify that the role as a partner is by no means "limited to placing orders for the customer, managing purchases" as well as mediating ("establishing") a contractual rela- tionship between end customers and the software manufacturer and bringing about follow-up orders. It is our clear understanding, as well as that of the entire industry, that the consulting services provided by a value-added reseller go beyond the simple brokerage service and ra- ther focus on the provision of an integration service. Facts provided in the fact pattern within the submission Questions 4: The distribution agreement between the value-added reseller and the soft- ware provider confers an enforceable right on the value-added reseller to 1) Could you provide more information about the distribution agreement between the soft- ware manufacturer and reseller? grant software licences to his custom- ers. 2) Does the reseller hold the master key to the software licence before any contract is signed with a customer? 3) Does the reseller have a pool of pre-pur- chased software licences? 4) Or instead does the reseller purchase soft- ware licences only after a contract with a customer is signed? 1) Could you provide more information about the distribution agreement between the software manufacturer and reseller? The distribution agreement between the software manufacturer and the value-added reseller contains the general terms and conditions for resellers (partners) and the resulting distribu- tion rights. The general terms and conditions include, in particular, the conditions under which the value-added reseller may sell the software licenses. The agreement also stipulates that the value-added reseller is responsible for both, the sales and after-sales process. In ad- dition, the agreement stipulates that the value-added reseller must pay the software manu- facturer for each license, even if a quantity is ordered that exceeds the customer's require- ments. Furthermore, the agreement stipulates that the value-added reseller has full discre- tion in its pricing. In addition, the agreement stipulates that the value-added reseller must en- sure that the customer has purchased a sufficient number of software licenses. In the event of incorrect licensing, the value-added reseller would be liable for damages. The software manufacturer reserves the right to refuse a customer through the distribution agreement. From our point of view, this contractual clause is at best of a theoretical naturer, since we are not aware of any case in which the software manufacturer has refused to ac- cept a customer from the value-added reseller in recent decades. In the course of the busi- ness transaction, therefore, it is (in fact) the value-added reseller alone who decides on the acceptance of a customer. This results not least from the fact that the value-added reseller in the discussed model as a partner is the primary and in relation to the software manufacturer the only contact for the customer. The value-added resellers therefore conclude that they have an overriding, enforceable right to grant licenses before individual software licenses are transferred to the customer. It is the value-added reseller's enforceable rights against the software vendor that give the value- added reseller the right to virtually instruct the software manufacturer to grant the software licenses. These rights exist before the customer places a license order. Therefore, the value- added reseller concludes that it controls the software licenses within the meaning of IFRS 15 before the software licenses are transferred to its customers. 2) Does the reseller hold the master key to the software licence before any contract is signed with a customer? 3) Does the reseller have a pool of pre-purchased software licences? 4) Or instead does the reseller purchase software licences only after a contract with a customer is signed? According to IFRS 15.B35A(c), the entity normally controls the inputs before the entity pro- vides the combined service consisting of pre-sales consulting and license. In the case of soft- ware sales, this means that the software license would have to be controlled by the value- added reseller prior to the combination. The individual license right only arises after the order by the value-added reseller and the granting of the license by the software manufacturer. The value-added reseller does not keep licenses in stock, but orders the licenses only after the customer has placed an order. This is a more or less efficiently designed purchasing process that eliminates the classic risks of stockpiling. Nevertheless, the value-added reseller bears a special form of inventory risk with regard to the order, since in the event of incorrect licensing the customer does not accept (i.e pay for) the licenses and the value-added reseller has no right of return against the software manufacturer. Furthermore, the value-added reseller holds distribution rights of the software manufacturer through the partner status and the associated distribution framework agreement. The master distribution agreement between the value-added reseller and the software vendor transfers an enforceable right to the value-added reseller to grant software licenses to its customers. The software provider has transferred to the value-added reseller a right to use its intellectual property - IP (i.e., to sell licenses to its IP) - this right is separate from the underlying software licenses themselves. Furthermore IFRS 15.BC385Q specifies that the application of the control principle should not relate to individual parts of the performance obligations, but to the entire performance ob- ligation. Rather, control should relate to the combined output and it should be determined whether the entity controls the combined output before it is transferred to the customer. Therefore, as already clarified, we do not consider the consideration of the transfer of the li- cense in isolation to be appropriate. Facts provided in the fact pattern within the submission Questions 5: The consulting service is a key ele- ment of the performance towards the customer. 6: The combination of qualified pre- sales consulting with the software li- cence is what delivers the customer benefit in the form of a suitable, legally compliant software solution. 7: By means of the pre-sales consult- ing, a customer-specific contract pack- age is configured for the customer for a planning horizon of three years. The pre-sales consulting is not based on standard offers or assumptions, but ra- ther on the precisely identified needs of the customer. 1) Paragraph B34 of IFRS 15 states ‘An entity determines whether it is a principal or an agent for each specified good or service promised to the customer. A specified good or service is a distinct good or service (or a distinct bundle of goods or services) to be provided to the customer.’ Could you walk us through the thought process in determining that there is a distinct bundle of goods or services? 2) Could you describe the nature of the consult- ing service in more detail? What happens if the customer decides not to buy any soft- ware licences? Does the customer pay for the consulting services in that case? 3) Does the contract between reseller and cus- tomer involve changing or modifying the soft- ware licences? 1) Paragraph B34 of IFRS 15 states ‘An entity determines whether it is a principal or an agent for each specified good or service promised to the customer. A specified good or service is a distinct good or service (or a distinct bundle of goods or We would like to refer to a statement in IFRS 15 that is important for value-added resellers. According to IFRS 15.BC107, an integration service is characterized by the fact that the risks arising from the transfer of the individual goods and services are not distinct, since the es- sential part of the performance promise to the customer is to ensure that the individual goods and services flow into the overall product, in our case "adequate license bundle". This idea of not distinct risk is taken up again in IFRS 15.BC108. According to this, risks are not distinct if the risk resulting from the integration is negligible. In the present facts, it is obvious in our view that risks from pre-sales consulting are directly reflected in the overall product "ade- quate license bundle" and are therefore by no means negligible. At the same time, it should be noted that there is considerable scope for discretion in these paragraphs between the simple installation of software and the rather clear case of customiz- ing. The necessity of the introduction of IFRS 15.29 itself as well as the remaining uncer- tainty, which IFRS 15.BC111 clearly expresses, indicate the necessity of exercising appropri- ate discretion on the diverse cases of practice. We would like to emphasize once again that, particularly in the case of our transaction dis- cussed here, the two elements of consulting services and license transfer are not distinct. The connecting link here is the customer's need for an IT solution, which is made up of an IT concept that is suitable for him and the transfer of the necessary licenses. This result is based on competent consulting by the value-added reseller. The type and number of soft- ware licenses is derived from this IT concept and is embedded in the overall result of an IT solution tailored to the specifics of the individual customer. It would lead precisely to a risk if the two elements were not transferred in a coordinated manner. The customer's needs would not be met if, for example, the consultation resulted in 500 licenses of a certain type being transferred, but ultimately only 250 were transferred. Conversely, the transfer of too many costly licenses would lead to the risk of incorrect licensing with recourse claims by custom- ers. This again underlines the customer's interest in a total package - in the combined prod- uct. Facts provided in the fact pattern within the submission Questions 12: The value-added reseller is ex- posed to a special form of inventory risk, since in the event of mislicensing (i.e. where the type or number of soft- ware licences sold was not appropri- ate), he cannot return the licences to the software vendor or sell them to an- other customer. 1) In whose name are the software licences is- sued? 2) In the event of mislicensing, what happens to the software licences? Does the reseller have to pay the software manufacturer for the software licences? 1) In whose name are the software licences issued? The software licences are issued by the software manufacturer to the end customer, i.e. in the end customer’s name. 2) In the event of mislicensing, what happens to the software licences? Does the re- seller have to pay the software manufacturer for the software licences? In the event of non-acceptance by the customer, the licences remain with the Value-added Reseller. He cannot return the software license to the software manufacturer or sell it to an- other customer so that he has to write them off to the profit or loss. Nevertheless, the value-added reseller must pay the software manufacturer for its licenses. Facts provided in the fact pattern within the submission Questions 15: In the relationship with [the particu- lar software manufacturer], the role of the value-added reseller comprises the responsibility for the sales and the af- ter-sales processes. In the relationship with the customer, the value-added re- seller is the first point of contact for all questions. The value-added reseller is responsible both for the order process and for any licensing issues that arise after the conclusion of the order. 1) Could you provide more information about the after-sales processes and licensing is- sues? 2) Who (software manufacturer or reseller) is responsible for making the software availa- ble to the customer and for any glitches in the software? 1) Could you provide more information about the after-sales processes and licensing issues? As part of the after-sales process, the value-added reseller performs an yearly inventory of the software licenses for the software manufacturer only in the direct contract model which is not issued here. This service represents a separate performance obligation and is distinct. The licensing issues essentially comprise technical and commercial services provided by the value-added reseller after the purchase. In particular, these are after-sales services, which essentially cover the handling of support issues and assistance with manufacturer software maintenance. These services are generally provided through the operation of a hotline, on- site support in the form of training courses. Within the scope of their design, these services result in independent usability in the form of customer services. Therefore, they are distinct from other performance obligations. 2) Who (software manufacturer or reseller) is responsible for making the software available to the customer and for any glitches in the software? Although the software functionality is guaranteed by the software manufacturer, the value- added reseller is responsible for the correct granting of licenses. In the overall context of the discussed indirect model, the customer only gains his benefit from the combination of soft- ware (functionality), consulting and correct licensing, which is provided by the value-added reseller in the course of his ordinary business activities. The assumption of liability for the correct selection of licenses is not negligible from our customers' point of view. In fact, it is itself an essential component of the service, since companies would bear a considerable loss in the event of incorrect licensing under certain circumstances.