An Indian Tribunal ruled that the reimbursement of software license and IT support services costs, lease line charges, online training fees and the reimbursement of salaries under the narrow interpretation of the applicable tax treaty does not result in withholding tax implications in India.

Facts

John Deere India Pvt. Ltd (John India or taxpayer) an Indian affiliate of Deere & Co., U.S. (parent) is engaged in software development services, IT support services and manufacture of tractors. John India did not withhold tax on cost reimbursement to its parent for a SAP license, email facility, digital storage, system upgrade charges, etc.

The revenue authority treated such cost reimbursements liable to tax as royalty/fees for technical services (FTS) under Indian domestic laws including of the India–U.S. tax treaty (tax treaty).

The taxpayer was asked to explain non-withholding of tax under Indian domestic laws where such cost reimbursement was claimed as tax deductible expenses supported by furnishing documentary evidence.

The revenue authority treated services provided by the parent as technical in nature to the taxpayer under the meaning of “make available” clause of the Memoranda of Understanding to the tax treaty.

Since the parent offered a wide spectrum of IT services of SAP implementation, project development, support and software customization, etc., the revenue authority claimed this was technical services, used by the taxpayer for its business purposes.

It was contested that the taxpayer was enabled to use the technology as a service provider and made available knowledge, experience, and skill for its use to carry on its work on its own that may be used in future, without recourse to the parent.

The revenue authority, while reviewing the facts, also observed that knowledge, experience and skills made available were of enduring nature having direct nexus with the taxpayer’s business. It claimed that consideration for the use or right to use software was royalty under the Indian domestic laws and Article 12(3) of the tax treaty.

The IT support services for use or right to use software, access to the server (scientific equipment) and leased line charges were also made available imparting technical knowledge, experience and skill to the taxpayer, effectively resulting in FTS under Indian domestic laws and under Article 12(4)(b) of the tax treaty.

The taxpayer argued that expense reimbursement to its parent and affiliates was not a taxable service in India. It was merely cost reimbursement without having any element of income where such services were not made available to the taxpayer; hence, no withholding tax was obligated either under the Indian tax laws or the tax treaty.

Dissatisfied with the first appeal order, the taxpayer disputed the matter before the Indian Income-tax Appellate Tribunal of Pune (Tribunal) under a consolidated appeal on taxability as royalty/FTS and applicability of withholding tax on expense reimbursement for:

  • acquisition of software license, lease line charges and IT support services;
  • payment for web-based training; and
  • reimbursement of expatriate salary for technical services.

Tribunal Ruling

Software License, Lease Line Charges and IT Support Services

The Tribunal distinguished between consideration to acquire:

  • right to use patent or copyright;
  • patented or copyrighted products/material with payment; and
  • patented or copyrighted products equal to payment towards purchase of product with consideration for use of patent or copyright.

The above interpretation was based on the rulings of M.Tech India (P) Ltd, Infrasoft Ltd that concurrently relied on the Samsung Electronics Co. Ltd case, to unequivocally express that consideration towards purchase of products is not regarded as a royalty for use or right to use software.

The revenue authority’s contention to apply the extended version of royalty retroactively under Indian domestic law under the tax treaty was rejected. The Tribunal decided that although the royalty explanation extends its scope under Indian tax laws, no specific amendment was effected to the original narrow definition of royalty under the tax treaty.

Applying the ratio of the Tribunal in the case of T-3 Energy Services India Pvt. Ltd and similar cases, the Tribunal examined the royalty definition under the tax treaty to include payment as consideration for use or right to use any copyright of literary, artistic or scientific work, etc. that excludes the purchase of copyrighted material.

Accordingly, the Tribunal stated that as the tax treaty provision is more beneficial, and therefore overrides Indian domestic laws, the taxpayer is not liable to withhold tax towards reimbursement for purchase of software.

Charges like internet usage, backup support services, e-mail charges, etc. are not under the realm of royalty since no technology is made available where the main server of the group is established in the U.S. and is used for merely storing data, not under the taxpayer’s domain.

The Tribunal relied on the case of Sandvik Australia Pty. Ltd which held that payments for data storage charges under service arrangement to offer backup and IT support services, without technical know-how made available to the Indian subsidiary is neither royalty nor treated as technical services rendered by a nonresident to its Indian group (see paragraph 3(g), Article 12 of the India–Australia tax treaty).

Since the tax treaty terms between India and Australia and India and the U.S. are identical, applying such a ratio to the facts of the present case, the Tribunal held that a backup support service provided to the taxpayer by its U.S. associate entity as not making available the know-how as royalty under Article 12 of the tax treaty, did not warrant the taxpayer to withhold any tax.

The Tribunal whilst considering VPN (virtual private network) charges, online meeting charges, lease line charges, etc. ceteris paribas applied the above justification of software license referring the case of New Skies Satellite BV and Shin Satellite Public Co. Ltd where the court decided the issue on general international tax principles under tax treaty vis-à-vis royalty dealing with the amendment under Indian domestic law expanding the scope of royalty.

The Tribunal relied on the Global Service case to conclude that, as the payment towards a lease line does not make available any technical services or require lease of equipment, but is merely a lease line facility to transmit data, it cannot be characterized as royalty under the tax treaty and is not subject to withholding tax on expense reimbursement.

Training and Reimbursement of Salary

The taxpayer’s employees enrolled for e-learning courses available on the parent’s learning portal where they login, search and select courses to meet their training requirements.

The Tribunal observed that training fees for various modules available through web-training, paid by the taxpayer, was accessible on the public domain.

Further, such web-training is not an interactive session but similar to reading an article or book, and even if employees using services had a query, there was no mechanism to answer their queries online. The Tribunal referred to the case of Veeda Clinical Research (P) Ltd where payment towards general services rendered without involving transfer of technology cannot be regarded under the definition of FTS.

The facts being identical, where web-based training used by employees of the taxpayer without imparting technical knowledge by the service provider, and absent any cogent reason to prove that the services did involve transfer of technology by the revenue authority, the Tribunal concluded such payments are not characterized as FTS.

Accordingly, such cost reimbursement did not result in an obligation on the taxpayer to withhold tax.

Reimbursement of Expatriate Salary

The scope of secondment between the parent and the taxpayer was to provide qualified professionals in accordance with requirements for the performance of appropriate functions. The Tribunal referred to the case of Marks & Spencer Reliance India Pvt. Ltdwhere the court held that in cases where the payments to employees are subject to tax in India, there is no question of treating the taxpayer in default for non-withholding of tax on such reimbursement.

The Tribunal held that, as the taxpayer withheld tax on salary paid to its employees deputed in India for assistance, it cannot be concluded that the taxpayer is in default for non-withholding under Article 12 of the tax treaty as being merely a case of appointing the officials/employees for business promotion under a cost reimbursement arrangement.

Planning Points

The Tribunal, whilst discussing the merits of the case, deliberated on multiple rulings and distinguished them for a constructive opinion by expressing a detailed rationale to address the common scenario faced by multinationals of withholding tax on cost reimbursement to its affiliates.

It may be worth noting the landmark cases of A.P. Moller Maersk AS and Kotak Securities Ltd that expressly dealt with pure cost reimbursement of expenses/facility without any income element, as reimbursement is characterized outside the scope of tax liability in India.

Incidentally, the conclusion is in line with the settled position of the courts, though a careful evaluation of the expense reimbursement arrangement between affiliates would be pertinent before relying on the conclusion of the order.

This is primarily due to certain key aspects, though not expressly covered in the ruling, like transfer pricing analysis. The direct nexus theory enhances business and the definition of PE as proposed under the Organization for Economic Co-operation and Development’s Base Erosion and Profit Shifting Action Plan (to be implemented under Indian domestic laws) which might have an impact on the taxability of these payments going forward.

Shailendra Sharma is a chartered accountant for a multinational consulting firm, India.