Indian Supreme Court Ended Two-Decade-Old Tax Dispute

The controversy surrounding the taxation of payments for computer software in international transactions has been the subject matter of extensive litigation for over two decades in India. The bone of contention between taxpayers and the tax authorities has been in relation to characterization of income in the hands of nonresident taxpayers as either royalties or business profits.

The tax authorities have generally taken a position that income arising from grant of software license should be characterized as “royalty,” irrespective of the nature of rights acquired by the customer. The taxpayer’s position, on the other hand, has been that in terms of the tax treaty, income from computer software should be characterized as royalty or business income on the basis of the nature and extent of rights granted to the customer.

Considering the divergent views of the courts, the taxpayer/Revenue moved the Supreme Court, and the Court in the case of Engineering Analysis Centre of Excellence Private Limited v. CIT 125 taxmann.com 42 (SC)—Batch of 103 appeals, while setting aside the ruling of the High Court of Karnataka in the case of Samsung Electronics Co. Ltd 345 ITR 494 (Kar.) and the Authority for Advance Rulings (AAR) in the case of Citrix Systems Asia Pacific Pty. Ltd. 343 ITR 1 (AAR), ruled in favor of the taxpayer by holding that the payment made to nonresident computer software suppliers for the resale/use of computer software through End User Licensing Agreement (EULAs)/distribution agreements, is not payment of royalty for the use of copyright in the computer software under various relevant tax treaties.

Meaning of ‘Royalty'—Position Under Income-tax Act, 1961 and Tax Treaties

Under Section 195 of the Income-tax Act, 1961 (the Act), an obligation is cast on a person making payment to a nonresident of any sum, which is chargeable under the provisions of the Act, to deduct tax at the rates in force at the time of payment of such sum or at the time of credit thereof to the account of the payee, whichever is earlier.

Section 5 of the Act inter alia specifies that the “total income” of a nonresident shall include (i) income received or deemed to be received in India, by or on behalf of the nonresident; (ii) income accruing or arising to the nonresident in India; and (iii) income deemed to be accruing or arising to the nonresident in India.

Section 9(1)(vi) of the Act inter alia provides that income by way of royalty payable by an Indian resident would be deemed to accrue or arise in India if the royalty is for the purpose of earning any income from any source in India. Explanation 2 to Section 9(1)(vi) defines “royalty” to be a consideration for the transfer of all or any rights (including the granting of a license) or use of any copyright, literary, artistic or scientific work, patent, invention, model, design, secret formula or process or trademark or similar property.

In 2012, Explanation 4 was inserted in Section 9(1)(vi) to clarify that the “transfer of all or any rights” in respect of any right, property or information included and had always included the “transfer of all or any right for use or right to use a computer software.” Hence, computer software was included in the definition and within the scope of the words “right,” “property” or “information” as provided under clauses (b) and (c) to Section 9(1)(vi) of the Act.

The tax treaties entered into by India with other countries define “royalty” to mean consideration for the use of, or the right to use, any copyright of a literary, artistic or scientific work. There is no provision like Explanation 4 to Section 9(1)(vi)(b) in the tax treaty, which artificially expands the scope of the term “royalty” by providing that transfer of all or any rights includes transfer of all or any right for use or right to use a computer software.

Divergent Rulings of the Courts

There have been divergent rulings of various Indian courts on taxability of software payments:

In Favor of the Revenue

The Karnataka High Court in the case of CIT v. Samsung Electronics Co. Ltd (supra) has held that software payments are taxable as “royalty” if payments are made by end users of the computer program who are granted a license to make copies of the computer program for back-up or archiving purpose. Similarly, the AAR in the case of Citrix Systems Asia Pacific Pty. Ltd. (supra) has held that payment towards software in a distribution arrangement is taxable as royalty since it is not possible to divorce software from the intellectual property of the creator of the software embedded therein and sale or licensing for use of copyrighted software amounts to the grant of a right to use a copyright.

In Favor of the Taxpayer

The Delhi High Court in the case of DIT vs. Ericsson A.B. 343 ITR 470 (Del.) and the AAR in the case of Dassault Systems K.K. 322 ITR 125 (AAR) ruled in favor of taxpayers by emphasizing the distinction between acquisition of a “copyright right” and a “copyrighted” article. It was held that the license granted by the taxpayer was limited to those rights that are necessary to enable the licensee to operate the program. Hence, there is no transfer of copyright or right to use the copyright to characterize the same as royalty under the Act or the Treaty.

Reiterating the above principle, the Delhi High Court in the case of DIT vs. Infrasoft Ltd. 264 CTR 329 (Del.) on the issue as to whether the retrospective amendment in Section 9(1)(vi) vide Finance Act, 2012 can be read into the tax treaty, held that retrospective amendment made in the Act cannot be read into the tax treaty since the tax treaty has not been correspondingly amended in line with the amendment made in the definition of “royalty” under the Act.

Analysis of Supreme Court Ruling

Facts of the Case

The Supreme Court categorized the batch of appeals into four categories of software payments:

• Category 1—sale of software directly to an end user by a nonresident;
• Category 2—sale of software by a nonresident to Indian distributors for resale to end customers in India;
• Category 3—sale of software by a nonresident to a foreign distributor for resale to end customers in India;
• Category 4—software bundled with hardware and sold by foreign suppliers to Indian distributors or end users.

Findings of the Court

• Whether payment is for transfer of copyright or use of copyright

A copyright means an exclusive right to do or to authorize to do certain acts in respect of a “work,” including an exclusive right, inter alia, to reproduce the copyright in the work in any material form and exploit the same by way of sale, transfer or license, etc. Making copies or adaptation of a computer program to utilize or to make back-up copies as a temporary protection against loss, destruction or damage, does not constitute an act of infringement of copyright.

A computer program (software) qualifies as a “literary work” for the purposes of the Indian Copyright Act (ICA). As per Section 30 of the ICA, the owner of copyright in a “literary work” is entitled to grant any interest in his rights by way of a license in return for a royalty payment. In cases where a license is granted, an infringement of copyright under the ICA would take place only when there is any use of the rights contrary to the license so granted.

The Supreme Court analyzed the meaning of the term “royalty” under the Act and relevant tax treaties along with various decisions of the Courts (DIT v. Ericsson A.B. 343 ITR 470 (Del); DIT v. Nokia Networks OY 358 ITR 259 (Del); DIT v. Infrasoft Ltd 264 CTR 329 (Del); CIT v. ZTE Corporation 392 ITR 80 (Del)) and derived the following conclusions:

• Copyright is an exclusive right, which is negative in nature, being a right to restrict others from doing certain acts.
• Copyright is an intangible, incorporeal right, in the nature of a privilege. Ownership of copyright in a work is different from the ownership of the physical material in which the copyrighted work may happen to be embodied. For example, the purchaser of a book or a CD/DVD becomes the owner of the physical article, but does not become the owner of the copyright inherent in the work, such copyright remaining exclusively with the owner.
• The transfer of the ownership of the physical substance, in which copyright subsists, gives the purchaser the right to do with it whatever he pleases, except the right to reproduce the same and issue it to the public, unless such copies are already in circulation and the other acts mentioned in Section 14 of the ICA.
• Where the core of a transaction is to authorize the end user to have access to and make use of the “licensed” computer software product over which the licensee has no exclusive rights, no copyright is parted with, and consequently, no infringement takes place, as is recognized by Section 52(1)(aa) of the ICA. It makes no difference whether the end user is enabled to use computer software that is customized to its specifications or otherwise.
• A non-exclusive, non-transferable license, merely enabling the use of a copyrighted product, cannot be construed as a licence to enjoy all or any of the enumerated rights mentioned in Section 14 of the ICA [State Bank of India (SBI) v. Collector of Customs 1 SCC 727].

Making a copy or adaptation of a computer program in order to utilize it for the purpose for which it was supplied, making back-up copies as a protection against loss, does not result in infringement of copyright under the ICA. Even storage of a computer program, per se, would not result in infringement. Nomenclature of the agreement does not matter and what is relevant is the real nature of the transaction, having regard to the overall terms of the agreement and surrounding circumstances.

In the present appeals, the terms of some sample agreements with the distributor and end users of the software were as follows:

• distributors were granted a non-exclusive, non-transferable license to resell computer software to end users;
• distributors did not have a right to use the software;
• the agreement specifically stated that the copyright in the software was not transferred, either to the distributor or to the ultimate end user;
• end users were allowed only to use the software and they were restricted from sub-licensing, transferring, reverse engineering, modifying, or reproducing the software.

The Court held that what is “licensed” by the nonresident supplier to the distributor and resold to the resident end user or directly supplied to the resident end user is, in fact, the sale of a physical object which contains an embedded computer program. Such sale of goods does not involve transfer of a copyright in the software. Reliance in this regard was placed on the decision of the Supreme Court in the case of Tata Consultancy Services 2005 (1) SCC 308.

• Meaning of “royalty” under the Act or the tax treaty whichever is more beneficial

The term “royalty” is exhaustively defined under the tax treaties to mean payment made for the use or right to use any copyright in a literary work. The meaning of the term under the Act is different and wider than the tax treaty in as much as transfer of all or any rights includes granting of a license, in respect of any copyright of any literary work.

Since the license granted to distributors and end users does not create any interest or right in the software, grant of such license would not amount to the “use of or right to use” of copyright and hence it would not qualify as royalty under the tax treaty.

The Court further observed that the phrase “in respect of” used in the Act means “in” or “attributable to.” Thus, in order to qualify as royalty even under the Act, it is a sine qua non that there has to be transfer of all or any rights in a copyright by way of license or otherwise. Since the license granted to the distributors and end users did not involve granting of any interest in the rights of an owner of a copyright, payment made for such license does not qualify as royalty both under the Act (up to 2012) as well as the tax treaty.

Explanation 4 to Section 9(1)(vi) inserted by the Finance Act, 2012, to provide that transfer of all or any rights includes transfer of all or any rights for use of a computer software, expands the definition of “royalty” and may not be considered as clarificatory in nature. Moreover, since the definition of royalty under the tax treaty is narrower and more beneficial, the provisions of the Act would not be applicable and there would be no obligation to withhold taxes under Section 195 of the Act.

The Revenue had sought to rely on the decision of the Supreme Court in Pilcom v. C.I.T. 271 Taxman 200 (SC) which dealt with Section 194E of the Act for the proposition that tax has to be deducted at source irrespective of whether tax is otherwise payable by the nonresident assessee.

The Supreme Court observed that acceptance of such contention of the Revenue would lead to absurd results, since taxes would have to be withheld even where the income is not chargeable to tax in India, which is not the intent of the legislature. Accordingly, the said decision has no application to the case wherein withholding tax obligations are to be determined in terms of Section 195 of the Act.

• Retrospective amendment—impossibility of performance of withholding tax obligations

Explanation 4 to Section 9(1)(vi) inserted by the Finance Act, 2012 (with retrospective effect from June 1, 1976) expands the definition of “royalty” under the Act. A person who made a payment prior to 2012 cannot be expected to apply the expanded definition of royalty which was not in existence at the time of making payments to determine withholding obligations under Section 195 of the Act. The substantive amendment to the Act does not compel a person to do the impossible, i.e., when there is a disability that makes it impossible to obey the law, the alleged disobedience of the law is excused (Arjun Panditrao Khotkar v. Kailash Kushanrao Gorantyal (2020) 7 SCC 1).

• Relevance of OECD Commentary and India’s position on the Commentary

Definition of “royalty” under the tax treaties is similar to the definition of royalty under the Organization for Economic Co-operation and Development (OECD) Model Tax Convention. Hence, reference may be made to the OECD Commentary which also provides that making a copy or adaptation of a computer program to enable the use of the software for which it was supplied does not constitute royalty. This also supports the argument that the payment made by distributors and end users does not qualify as royalty.

Even though the Indian government has expressed its reservations on the OECD Commentary dealing with royalty, such reservations to the Commentary would not affect its relevance unless the reservations were incorporated into the treaties through bilateral negotiation with the respective countries (New Skies Satellite BV vs. DIT 382 ITR 114 (Del.)).

The Court observed that India had entered or amended tax treaties with various countries after expressing its reservation, yet the definition of royalty had not been changed and remained similar to the definition in the OECD Model Convention. Therefore, the OECD Commentary on Article 12 of the OECD Model Convention will continue to have persuasive value as to the interpretation of the term “royalties” contained in the tax treaties.

Conclusion of the Court

In terms of Article 12 of the relevant tax treaties, the payments made by resident Indian end users/distributors to nonresident computer software manufacturers/suppliers, as consideration for the resale/use of the computer software through EULAs/distribution agreements, does not constitute royalty, since the payment is not for the use of or the right to use copyright in the computer software. Accordingly, in terms of Section 195 of the Act, the payer is not required to withhold tax at source at the time of making payments to the nonresident supplier.

Far-reaching Impact of the Ruling—Law of the Land

The controversy surrounding the taxation of payments for computer software in international transactions has been the subject matter of extensive litigation for over two decades in India. The ruling of the Supreme Court in a batch of appeals involving the cases of IBM India, Samsung Electronics, GE India, Hewlett Packard India, Mphasis, is a welcome respite.

In its succinct and well-reasoned decision the Supreme Court has settled the vexed issue of characterization of payments to nonresident vendors for import of software licenses for use or resale in India, holding it as business profits as opposed to royalty and hence in absence of a PE not taxable, as per the source rule in India—a view which is also aligned to international understanding.

The Court also laid down that definition of royalty under Section 9(1)(vi) of the Act, which was expanded vide Finance Act, 2012 (with retrospective effect from April 1, 1976) is not clarificatory in nature and withholding tax liability cannot be fastened on the payer pursuant to a substantive legislative change (with retrospective effect) which did not subsist at time of payment by the payer.

The Supreme Court, also emphasizing the importance of the OECD Commentary in interpreting the treaties, observed that the reservations expressed by the Indian government may not affect the application of the tax treaties unless the reservations are incorporated therein. This requirement of bilateral negotiation and incorporation of changes will safeguard the assessee from any unilateral amendment made by the Indian government.

To take the benefit of the decision of the Supreme Court, taxpayers (who have paid taxes on software by treating the same as royalty) in whose cases litigation is pending before the appellate authorities, may move an application for admission of additional ground and seek necessary relief from the said authorities. In cases where no litigation is pending, the taxpayer may consider moving a refund application before the assessing officer. However, it should be noted, if the income, i.e. consideration received for sale of software, is not taxable as royalty under the Act read with the relevant tax treaty, it may be subject to the Equalization Levy.

The ratio decidendi of the aforesaid decision may also apply to payments made for subscription for database or for satellite bandwidth charges, and assist taxpayers in ongoing disputes.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Neeraj K. Jain is a Partner and Anshul Sachar is Principal Associate at Vaish Associates, Advocates.

The authors may be contacted at: neeraj@vaishlaw.com; anshul@vaishlaw.com