Amount paid for use of software

“During the assessment year 1997-98 and 1998-99, several payments were made to foreign parties for the license to use the software. However, no tax has been deducted at source and thus, following section 40(a) these expenses must be disallowed. Therefore, I have reason to believe that income has escaped assessment as the assessee has failed to disclose material facts in the return filed. Reassessment proceedings are being initiated for all four assessment years from 1998 to 2001.”

In the early 2000s, various companies received a similar income tax notice including Samsung Electronics, Lucent Technologies, Sonata Software, etc. and over the years also to stalwarts like IBM Software and Hewlett Packard, marking the beginning of an era of taxation which lasted a long healthy span of 21 years, until the Supreme Court’s recent ruling served a ‘death sentence’ to the aforesaid tax interpretation and beginning a new tax era! Before we understand the judgement, let’s first dive into the history of this case.

What is the judgement about?

Many companies in India import computer software from foreign countries. Software is usually ‘sold’ to an end-user, or sold to an Indian or foreign ‘distributor in India ‘for resale’. Sometimes, the software is bundled along with the hardware when such hardware is supplied. For example, let’s say you want Microsoft Office on your computer. Now either you can directly buy the software from Microsoft’s website, or you can buy it from licensed dealers in India (whether a subsidiary of Microsoft or an Indian company) which was earlier delivered through Compact Disc (CD). Sometimes, the Microsoft Office software also comes free along with new laptops. Thus, there are many ways in which the software reaches us. The two-decade-long dispute revolved around the taxability of these cross-border software payments. To be specific, whether the payment received by a non-resident for giving licence of the computer software to a buyer in India is taxable as ‘Royalty’ or as a ‘Sale Receipt’. The dispute related to the following four broad categories of transactions –

  1. Purchase of computer software, by a resident from a non-resident supplier or manufacturer, directly.
  2. Purchase of computer software, by a resident Indian company acting as a distributor or reseller, and reselling to Indian end-users
  3. Purchase of computer software, by a non-resident distributor from a non-resident supplier, and reselling to Indian distributors or end-users
  4. Purchase of computer software bundled with hardware, sold by non-resident suppliers, to resident Indian distributors or end-users.

Why does the classification ‘Sale Receipt’ or ‘Royalty’ matter, if both are taxable?

All foreign companies are liable to pay taxes in India if such income accrues in India or is deemed to be accruing in India. When software is sold to an Indian company, the foreign company is earning money in India and thus, they must pay taxes. Now, business profits are covered by the ‘Double Taxation Avoidance Agreement’ (DTAA) and enjoy a special status in such agreements. DTAA, in simple words, is a tax agreement entered into, by two or more countries, to not levy tax on certain kind of transactions, since the same would be taxed in their home country, and thus, double taxation is avoided. India has such agreements with all major countries around the world.

As per most DTAAs, business profits are not taxed in the country where such profits are earned (in this case, India), but in the country where such corporate is a resident taxpayer. However, royalty income is not covered by such special status and is taxed in the country where such income is earned. The taxes collected on royalty are retained by India and the foreign companies claim deductions for such taxes paid in India, in the tax returns they file in their home country. However, when the sale proceeds are taxed as Royalty as against Sale receipts, a 10% TDS is withheld on same. Besides, as per section 206AA, furnishing PAN is mandatory even by a Non-Resident, or TDS would be deducted at 20%. Now, the foreign companies would have to either obtain PAN and file returns under Indian tax laws (which they may not be aware of) or suffer 20% tax withholding. For the foreign companies who sell software in India in bulk, this would result in a major portion of their working capital being blocked by withholding taxes.

What was the cause of the dispute?

Indian conglomerates believed that these receipts for software sale, earned by foreign parties were their business profits from sales and not Royalty income. Thus, they made payments without withholding any taxes on the same (i.e. TDS). However, the Income Tax Department, in the course of their assessments, believed that such income is the nature of ‘Royalty’ as the software developers were transferring their rights (granting a license) to their software (i.e. copyright) and thus, the tax must have been withheld at 10% while making payments for such software purchases. And thus, began a tax saga – the income tax department started disallowing software purchases where tax wasn’t withheld. The department also re-opened prior period assessments in several cases and disallowed all expenses and levied taxes, interest and penalty for escaping income. The disputes went to tribunals and high courts and kept going back and forth over the last two decades. 103 appeals were pending before the apex court owing to divergent rulings by various High Courts. The Supreme Court, judging all 103 appeals in a batch, ruled in the favour of the Indian companies for considering software payments as ‘business profits’ in hands of foreign parties, after examining the provisions of the Copyright law, the Income Tax law, the DTAAs and the agreements between the companies.

What were the diverging viewpoints?

‘Royalty’ has been defined as the consideration for the transfer of all or any rights (including the granting of a license) in respect of a patent, invention, model, design, secret formula, process, trademark, copyright, literary, artistic or scientific work, in explanation 2 to section 9(1)(vi) of the income tax act. Owing to the said definition which was also retrospectively amended in 2012, to include ‘right to use a computer software under the definition of Royalty, the income tax department claimed that the receipts were taxable as Royalty. However, the DTAA defines royalty in a restrictive manner as payments made for the use or right to use any copyright. Further, as per section 90(2), if there are inconsistencies between the income tax act and the DTAA, the provisions of DTAA prevail, as the same is more beneficial to the taxpayer. Thus, the court rulings favoured the taxpayers and rejected the claim of the income tax department.

The income tax department didn’t stop there and after the aforesaid ruling, the department claimed that by selling the software or granting license to use software, the foreign parties have ‘transferred the right to use a copyright’ and thus, the same must be taxed as Royalty as covered under DTAA. On the other hand, the assessees claimed that the sale of software was a ‘transfer of right to use copyrighted material, and not the copyright itself.’ Thus, the same cannot be treated as ‘Royalty’. The matter went up to tribunals and high courts and the confusion further increased as different high courts opined differently. The Delhi High Court adopted a firm view that the amount received by the assessee for allowing the use of the software was not royalty, because what is transferred is neither the copyright nor the use of the copyright. The court believed that the transfer related to the right to use the copyrighted material or article, which is distinct from the rights in a copyright. Madras High Court also followed the view adopted by the Delhi High Court. However, the Karnataka High Court, in the case of Samsung Electronics, in 2011, held that payment made to foreign company amounted to ‘royalty’ and therefore, the Indian purchasers were under obligation to deduct tax at source under Section 195 of the Income Tax Act. The court opined that transferring the right to make a copy of the software and use it for internal business by making copies of the same stored on the hard disk amounted to a use of the copyright under section 14(1) of the Copyright act, as in the absence of such a licence, there would have been an infringement of the copyright.

Thus, the whole dispute surrounded the decision over whether the sale or distribution of software in India was ‘transfer of a copyright’ or ‘transfer of a copyrighted article’ and only a decision from the Supreme Court could have resolved the same.

What did the Supreme Court rule?

The Supreme Court explained that if an English publisher sells 2,000 copies of a particular book to an Indian distributor, who then resells the same at a profit, copyright in the aforesaid book is not transferred to the Indian distributor, either by way of a license or otherwise, since the Indian distributor only makes a profit on the sale of each book. More importantly, the Indian distributor doesn’t have any right to reproduce the aforesaid book and then sell copies of the same. On the other hand, if an English publisher were to sell the same book to an Indian publisher along with the right to reproduce and make copies of the aforesaid book with the permission of the author, then it would amount to the transfer of copyright in the book by way of a license or otherwise. In such a case, the amount that the Indian publisher will pay for is to gain the right to reproduce the book, which is in nature ‘Royalty’ for the exclusive right to reproduce the book in the territory mentioned by the license.

Further, the Supreme Court relied on the ruling in the case Tata Consultancy Services vs the State of Andhra Pradesh in 2005 which held such transactions as similar to ‘sale of goods. The license that the foreign supplier granted a license to the distributor to resale or to the end-user to use the license, in substance, was a sale of a physical object which contains an embedded computer program, and is, therefore, sale of goods.

The Supreme court, thus, in its judgement, ruled that –

  1. By selling computer software, the developer of software only granted the end-user a non-exclusive and non-transferable right to use the computer program and to the distributor of the computer software (whether Indian or foreign) a right to resell the computer software without changing its content, with an express stipulation that no copyright is being transferred to it.
  2. The ‘license that was granted by way of End User Licenses Agreement (EULA), was not a license in terms of section 30 of the Copyright Act, which transfers all or any of the rights to the copyright, but was a ‘license’ to only impose restrictions or conditions for the use of computer software.
  3. Even though the definition of ‘Royalty’ under the Income Tax Act was retrospectively amended in 2012 and included the right to use computer software, the same cannot prevail over the Double Taxation Avoidance Agreements (DTAA) which India had signed with various countries. Thus, the taxation in this matter would be decided based on the aforesaid tax treaties.
  4. Under the tax treaties, ‘Royalty’ is defined to include payments made for the use or right to use any copyright. The use of computer software didn’t lead to a transfer of copyright. Thus, the payments for them won’t qualify as ‘Royalty’ under the tax treaties. Therefore, the Indian purchasers are under no obligation to deduct tax at source on such payments.

Impact of the Supreme Court ruling

Firstly, the Indian purchasers of software from foreign countries can relax a bit now as there is no need to withhold taxes on such payments. This might also result in lowering the cost of software purchases, as software companies taking the benefit from this judgement, may consider price revisions. Secondly, the foreign parties can now claim the benefit under DTAA and rely on the aforesaid judgment. The Judgement of the Karnataka High Court in the case of Samsung Electronics is now overridden. Thus, they no longer need to obtain PAN or file returns in India, if their transactions are limited to aforesaid activity. Besides, these sale receipts would no longer be withheld by taxes. However, that’s only the future transactions. The ruling also impacts all the past rulings and the income tax department might have to issue refunds to all companies who have paid the tax demand in the last 20 years. The estimated refund due to IBM India alone is to the tune of INR 1,300 crore and the total outgo for the government can be anywhere between INR 15,000 – 20,000 crore. The blood drawn during the past 20 years is now due to be repaid as the income tax department is now cornered on this matter, with the latest judgement.

The Equalisation Levy angle

In a surprise move, last year, the Government had introduced a new tax levy on foreign e-commerce operators who didn’t have a business presence in India. With an amendment to the Finance Bill, 2020, all non-resident entities have been made subject to an equalisation levy at 2% on the sale of goods or services that take place through e-commerce platforms, quarterly. Simply put forth, the income of foreign e-commerce entities generated from India is now taxable. Such tax would apply if the supply is –

  1. to a person resident in India (for example, buying goods from Alibaba or Amazon Global)
  2. to a person who buys the goods or services through an IP address located in India (for example, foreign online gaming platforms earning income through Indian gamers)
  3. to a non-resident in specified circumstances, (for example, when Facebook or Google collects data from a person residing in India or having an Indian IP address and sells the same to a Non-resident company say, a fashion brand, for targetted advertising, the income from such sale would be liable to equalisation levy)

Until then, an equalisation levy had to be paid by Indian companies advertising on foreign digital platforms for only business to business transactions. However, with the aforesaid amendments, for the first time, an equalisation levy has been brought in for business to consumer transactions as well. The Government has recently clarified that the scope of equalisation levy extends to digital platform services, digital content sales, digital sales of a company’s goods, data-related services, software-as-a-service, etc. The clarification further mentions that services which are subject to tax as royalty income under the income tax law will not be liable to equalisation levy. Now that the Supreme Court has cleared the sale of software from Royalty tax, these transactions would get covered by a 2% equalisation levy. However, the aforesaid judgement only applies to countries with whom the Indian Government has a Double Taxation Avoidance Agreement (DTAA). Thus, the Non-Resident suppliers of software who belong to a country that does not have a tax treaty with India will continue to pay tax on the supply of software as ‘Royalty’ income and equalisation levy shall not apply.