After the amendment to the definition of royalty in 2012, retrospectively applicable from 01 June 1976, tax authorities have been treating payment for copyrighted article as royalty even for earlier years. This has added to the controversy.
In contrast, the taxpayers largely classify supply of software as business profits, especially under an applicable Double Tax Avoidance Agreement (DTAA), based on the nature and extent of rights granted to the end user. The line of reasoning on the judgements pronounced by various High Courts has been divergent as to how such transaction be taxed – whether as royalty or as business profits.
This matter is of great significance and the industry has been seeking clarity since 1999. There have been multiple litigations including:
- Tax in the hands of the payer on account of non-deduction of tax (TDS),
- Tax in the hands of payer on account of disallowance of expense as the tax was not withheld on such transaction
- Penalty in the hands of the payer for non-compliance with Points no. i. and ii. supra and
- Tax as income in the hands of foreign vendors.
Ruling by the Supreme Court
Settling the dust on this issue, the Supreme Court (SC) in a bunch of appeals, pronounced its judgment, with the lead case of Engineering Analysis Centre of Excellence. The apex court has ruled that any sum paid by resident end users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale/use of computer software, cannot be typically branded as royalty (i.e. use of copyright in the computer software) under the tax treaties (DTAA). It tantamount to procurement of goods. Therefore, it does not give rise to liability to withhold tax deducted at source (TDS), under the Income Tax Act , 1961. Such payments do not constitute “royalty” under international tax treaties signed by India with various countries. They are in the nature of normal business profits, which, in the absence of permanent establishments of such non-resident enterprises in India, are not taxable in India.
The retrospective amendment is quite widespread than the provisions of the tax treaties which has the use of, or the right to use any copyright. The doctrine of impossibility was relied upon to hold that it cannot be expected from the payer to do what is impossible for him, i.e., to withhold tax by applying the extended definition of royalty retrospectively at a time when the transaction took place.
The SC has thus, resolved an age-old question against the backdrop of characterisation of payment in relation to import of software for use in business in favour of taxpayers.
Consequences of the judgement
This judgment assumes significance since it simplifies many fundamental and crucial aspects corresponding to the interaction connecting the copyright law and the scope of the Income Tax Act, when transactions encompass sale/use of copyrighted products, as opposed to transactions granting rights in the underlying copyright itself.
The SC has also emphasised on the importance of Organisation for Economic Co-operation and Development (OECD) commentaries while interpreting DTAA. There has always been a resistance by the authorities to accept observations in the OECD commentary and related material, given the fact that India is not a member of the OECD. This ruling will have an extensive impact since it would help in backing the stand taken based on the OECD commentary and placing reliance on the same in arguments before courts.
This judgment will permit foreign non-resident suppliers of software to receive consideration from Indian customers without withholding any tax at source, thus considering the challenges coupled with having the foreign tax credit in their country of residence.
One must take note that the ratio of this ruling is applicable only in respect of payments by resident Indian end users or distributors (residents/NR) of shrink-wrapped software. It may not be applicable where the payer gets any of the following:
- Exclusive right of a software or
- Transferable right of a software or
- Unrestricted right to make copy/ copies of a software
However, one may rely on the said ruling where the end user makes copy of the software for the purpose of internal use and as permitted by the licence, by arguing that it does not involve granting of a right in the copyright. On the other hand, where partial rights have been granted in the copyright (say, right to make limited modification/ alteration to a programme) or where a mixed contract of supply of software is bundled with supply of service, difficulties may still arise in relying on the ratio of this decision.
The decision of the SC will apply to all unresolved lawsuits at various levels. The payers and non-residents impacted will need to evaluate the way forward as well as the strategy. This includes getting refunds of excess taxes paid with suitable interest. An extensive range of software transactions will be covered.
This ruling serves as a benchmark to analyse the progressing licensing and delivery models (whether served through clouds or through the traditional disk/CD-ROM) in the industry. It has provided much needed certainty as regards the taxation part of the transaction. Regardless of the mode of delivery of the software, it addresses a wide range of software transactions as the computer software industry continues to evolve new delivery types.
It also highlights the significance of a DTAA entitlement. However, it must be kept in mind that entitlement to the benefit of tax treaties is subject to numerous tests, such as
- Beneficial ownership test
- Tax Residency test
- Anti-avoidance provisions test (including those introduced pursuant to the multilateral instrument).
Further, equalisation levy at the rate of 2% is applicable on goods services supplied by non-residents to India through an electronic platform, with effect from 01 April 2020. A proposed amendment recently introduced specifies that only those transactions which are otherwise not taxable as royalty or fees for technical services, shall be subject to the equalisation levy. Since software license fee is not taxable as royalty now, it should be examined whether the same could be subject to the equalisation levy.
People remember the introduction of Equalisation Levy in Finance Act, 2020. Since the Finance Bill, 2021 is yet to be enacted, we hope that the government accepts this verdict in right earnest and does not bring any last minute surprise by bringing amendment either by overriding or by tweaking this judgement.
(Yogesh Shah is Partner, Vimal Desai is Senior Manager and Darshin Haji is Deputy Manager at Deloitte Haskins and Sells LLP)