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Foreign Software No More a Hard Tax for Indian Residents!!

Written by  2021-03-04   381

Foreign Software No More a Hard Tax for Indian Residents!!

This Article penned down by our Founder Director Sh. Mayank Mohanka, FCA, has been published in taxmann.com with the citation (2021) 125 taxmann.com 114 (Article). Knowledge multiplies manifold by sharing, so for the benefit of our Readers, the same Article is shared here:

The date 2.3.2021 will be remembered as a landmark date in the history of legislative jurisprudence on which the ages old conundrum and litigation concerning the taxability of foreign software as royalty has finally been put to rest by the Apex Court of India in its landmark judgement in the case of “Engineering Analysis Centre of Excellence Private Ltd. vs. CIT” in Civil Appeal Nos. 8733-8734 of 2018.

Hearing almost 80 Civil Appeals simultaneously, the Hon’ble Supreme Court in this landmark judgement has categorically held that the payments made by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale of the computer software through End User License Agreements (EULAs)/distribution agreements, can’t be considered as payment of royalty for the use of copyright in the computer software as per provisions of Article 12(3) of the applicable DTAAs and the provisions contained in section 9(1)(vi) of the Income Tax Act along with explanations 2 and 4 thereof, not being more beneficial to the assessees, have no application in the present cases.

For the sake of ready reference and brevity, the operating and concluding paras of this landmark judgement of the Hon’ble Supreme Court are being reproduced as under:

168. Given the definition of royalties contained in Article 12 of the DTAAs mentioned in paragraph 41 of this judgment, it is clear that there is no obligation on the persons mentioned in section 195 of the Income Tax Act to deduct tax at source, as the distribution agreements/EULAs in the facts of these cases do not create any interest or right in such distributors/end-users, which would amount to the use of or right to use any copyright. The provisions contained in the Income Tax Act (section 9(1)(vi), along with explanations 2 and 4 thereof), which deal with royalty, not being more beneficial to the assessees, have no application in the facts of these cases.

169. Our answer to the question posed before us, is that the amounts paid by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale of the computer software through EULAs/distribution agreements, is not the payment of royalty for the use of copyright in the computer software, and that the same does not give rise to any income taxable in India, as a result of which the persons referred to in section 195 of the Income Tax Act were not liable to deduct any TDS under section 195 of the Income Tax Act. The answer to this question will apply to all four categories of cases enumerated by us in paragraph 4 of this judgment.

170.The appeals from the impugned judgments of the High Court of Karnataka are allowed, and the aforesaid judgments are set aside. The ruling of the AAR in Citrix Systems (AAR) (supra) is set aside. The appeals from the impugned judgments of the High Court of Delhi are dismissed.”

Friends, in order to understand and appreciate the importance and significance of this landmark judgement of the Hon’ble Supreme Court, it will be worthwhile to understand the nuances and nitty-gritties surrounding this contentious issue (uptill 2.3.2021) of taxability of foreign computer software. So, let us dive a bit deeper into the realms and dimensions of this simple and basic term, “Computer software” in ensuing paragraphs.

The Information Technology (IT) industry equals 6.6% of the country's GDP, directly employs over 4.1 million people and earns in excess of $130 billion in foreign exchange with $180 billion in overall revenue. Thus, the IT industry is playing a very significant and crucial role in materializing the Government's dream of a 5 $ trillion economy.

The tax treatment considerations of IT Industry, especially concerning software related transactions, have always remained a litigative issue between the assessees and the assessing authorities.

As per the New Oxford Dictionary for the Business World, "software" means programmes used with a computer (together with their documentation), including programme listings program libraries and user and programming manuals.

The term "software" has been defined under the Income Tax Act, 1961 and under the Copyright Act, 1957. Sections 9, 10A, 10B and 80HHE of the ITA, dealing with export of computer software, define "computer software" to mean -

(a)

 

any computer programme recorded on any disc, tape, perforated media or other information storage device; or

(b)

 

any customised electronic data or any product or service of similar nature as may be notified by the Central Board of Direct Taxes, India.

Section 2(ffc) of the Indian Copyright Act, 1957 defines "Computer Programme" as a set of instructions expressed in words, codes, schemes or any other form, including a machine readable medium, capable of causing a computer to perform a particular task or achieve a particular result. Thus, software necessarily connotes "programme" in relation to a computer.

The Computer Software has been classified as under

(i)

 

Shrink-wrap software is the readily available software that is sold "Off-the shelf". Against this, "customized software" is the software that is tailor made based on specific needs of the customer. In a 'shrink-wrap', the software is packaged with the licence agreement. The license gives the endorser the limited right to use the software for perpetual period. The right is neither transferable nor can the buyer sub-license the software. Any user operating the package is deemed to have the knowledge of the copyright of the software.

(ii)

 

Bundled software is one which is embedded with the hardware and is bought along with the computer when it is purchased from the manufacturer. Most of the system softwares generally come in the bundled form. Most of the application software is available in "unbundled" form, especially if it is bought subsequent to the purchase of computer.

(iii)

 

Canned software is an independent software that can be used by a variety of hardwares and may be applied for management, consulting and administration. Canned software means software that is created for sale to more than one person.

(iv)

 

Customised software means software created for a single person. Customisation of canned software means any alteration, modification, or development of application using or incorporating canned computer software for a specific person. Customisation of canned software includes individualized configuration of software to work with other software and computer hardware but doesn't include routine installation. Customisation of canned software does not change the underlying character or taxability of the original canned software.

Taxability of Software related Transactions in Income-tax Act

Under Indian Income Tax Laws, the domestic transactions involving sale of software/copyright/license or rendition of IT enabled software services are taxable as income under the business head and are taxed as per normal provisions of the Income Tax Act. So, the income arising out of domestic transactions of sale of software or copyright/license of software and rendering of IT enabled software services by the Indian IT Companies like TCS, Infosys, HCL, Satyam, etc., in India are taxed as normal business profits in their hands.

However, the complexities concerning the tax treatment of software related financial transaction arise, when a foreign entity such as Microsoft sells its software or provides the software's copyright/license or renders IT enabled software services to an Indian entity.

Depending upon the requirement of the Indian entity, the software may be exclusively developed for the Indian entity and the foreign entity would transfer all rights in relation to such software to the Indian entity or the Indian entity may just acquire license or shrink-wrap product (e.g., Windows or Microsoft Office) from the foreign entity. There could be instances where the Indian entity acquires only partial rights in the software.

Under the Income Tax Act, the tax treatment of the payments made by the Indian entity to a foreign entity for software related financial transactions would depend upon the nature of such transactions.

Broadly speaking, transactions in relation to computer software would fall in any one of the following categories:

(i)

 

Transfer of a copyright right in the computer programme:

 

 

 

In this situation the Indian entity acquires almost all the rights in relation to the computer programme, rather than just acquiring a right to use the same for personal use.

(ii)

 

Transfer of a copy of the computer programme (a copyrighted article):

 

 

A copyrighted article would generally include a copy of a computer programme from which the work could be perceived, reproduced or otherwise communicated, either directly or with the aid of a machine or device. In such a situation, the Indian entity acquires merely a copy of the computer programme, giving it only the right to use the same for personal use and does not grant it any other rights in relation thereto.

(iii)

 

Provision of services for the development or modification of the computer programme - Under this scenario typically a customer engages a software development company to develop or modify software for the former, whereby all the rights in relation to such software will belong to the customer. Currently, the export of software by the Indian software companies largely falls in this category.

(iv)

 

Provision of software related services: Services other than those related to the development or modification of the computer programme, such as installation, maintenance, training, etc., would fall in this category.

Taxability of the consideration paid by the Indian entity to the foreign company in relation to the software related transactions in India would depend on the nature of such transactions and the applicable and relevant clauses of the corresponding Double Taxation Avoidance Agreements (DTAAs). The payments made by an Indian company to a foreign company towards such transactions could be considered as royalty, fees for technical services, or business profits, depending on the nature of the transaction.

Royalty - If the payment is considered as royalty, it is subject to withholding tax at 20% on gross basis. However, if reduced rate of withholding tax has been prescribed in the DTAA between India and the country of residence of the foreign entity, then that reduced rate shall be applicable. The payer would be required to withhold tax at such applicable rate on gross basis while making the payment or crediting the amount in its books to the foreign company.

Business Income - A payment considered as a business income is subject to taxation in India only if the foreign company has a business connection (permanent establishment in case there exists a DTAA between India and the country of residence of the concerned foreign entity) in India. In such a scenario, only that portion of income that is attributable to a business connection or the permanent establishment ("PE"), as the case may be, in India, will be subject to tax in India at the rate of 40% on net basis.

Fees for Technical Services - If the fees paid by an Indian entity to a foreign entity for availing of services in relation to computer software are regarded as "fees for technical/included services", they could be subject to withholding tax in India at the rate of 20% on gross basis. However, if reduced rate of withholding tax has been prescribed in the DTAA between India and the country of residence of the foreign entity, then that reduced rate shall be applicable.

Determination of Nature of Software Related International Transactions

The nature and the corresponding tax treatment of the software related international transactions, have always remained the bone of contention between the assessees and the revenue authorities.

Business Income vs. Royalty - In the absence of permanent establishment of the foreign entity in India, its business profits are not liable to be taxed in India by virtue of the beneficial provisions of the Double Taxation Avoidance Agreements (DTAA). Therefore, the assessee usually contends that withholding taxes are not applicable on the payments made for the software related transactions by the Indian entity to the foreign entity, as the payments are in the nature of the business profits of the foreign entity, which in the absence of permanent establishment of the foreign entity in India are not taxable in India.

The Revenue Authorities generally contend that such payments are in the nature of Royalty or Fees for Technical Services and, as such, are liable for deduction of withholding taxes in India.

Under section 9(1)(vi) of the ITA, in the Explanation 2, royalty is defined as the consideration (including lump sum payment) 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. It further includes consideration for the use of any patent, invention, model, design, secret formula, process, trademark or similar property.

The purpose for which the consideration is paid is of paramount importance for the interpretation of the expression 'royalty'.

Thus, only if some right to use, without the right to commercially exploit the intellectual property in respect of a patent, invention, model, design, secret formula, process, copyright, literary or scientific work, are transferred, it cannot be regarded as royalty. If the consideration is for the right to commercially exploit the intellectual property in the software, then the same could be considered as royalty.

It is also pertinent to mention here that where the consideration paid is for the purchase of a product and not for the transfer of the intellectual property per se, it may not be regarded as royalty. For example, the purchase of a book by a customer does not tantamount to the purchase of the copyright in the book, even though the publisher publishes the book by purchasing the copyright. Drawing a parallel from this example, purchase of a shrink-wrap product by an Indian company from a foreign company should not be regarded as purchase of a copyright but only a purchase of a copyrighted article and the payment therefor should not be regarded as royalty.

The well-settled and established ratio, which has emerged out of the plethora of judicial pronouncements in relation to the taxability of consideration paid for software is that while considering the income, the predominant purpose for which the consideration is paid in a transaction, has to be looked into. Thus, where the consideration is primarily for the purchase of the product and not for the use of the intellectual property therein, and the use of such intellectual property is merely incidental to the purchase of the product, the payment would be regarded as purchase of a product and not as royalty. Accordingly, the payment must be classified as business income.

When the software is delivered electronically and the Indian customer copies it on to his computer, on-line, the situation becomes more complicated. The High-Powered Committee set up by the Govt. of India to make recommendations for characterization of income from e-commerce transactions and their taxability in India, in its report has considered the payment for the purchase of computer software in the form of shrink-wrap products on-line as "royalty", contending that the customer "copies" the software on to his computer and, hence, the payment should be treated as "consideration" for the "copyright".

This argument may not muster the test of well-settled legal position as per several legal precedents, since apart from the mode of delivery, there is no difference in the purchase of software in physical form and in digitised form. Further, it goes against the principle of neutrality of the mode of transaction as between traditional commerce and e-commerce. Even when the customer is buying the software by downloading it in digital form, he is paying the consideration only for the purchase of the "product" and not for any rights in the intellectual property of such software. In view of this, the payment should be considered as business income and not as royalty.

Definition of the term royalty varies under the DTAAs entered into by India with other countries. Under Article 12(3) of the India-USA DTAA, the term royalty has been defined as Payments of any kind received as a consideration for the use of or the right to us any copyright of a literary, artistic, or scientific work, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience including gains derived from the alienation of any such right or property which are contingent on the productivity, use or disposition thereof. Similar definition is there under several DTAAs, including that with the UK.

Even in a DTAA scenario, the payments made for purchase of a product, which embodies intellectual property in it can't be regarded to have been made for the use of or the right to use any intellectual property and the amount would fall outside the above definition of royalty under the India-US DTAA and should be taxed as business income. However, if the payment is made for commercial exploitation of intellectual property, then the same could be regarded as royalty.

The above judgement of the Hon’ble Supreme Court has finally put to rest this undying conundrum and litigative issue by holding that the payments made by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale of the computer software through End User License Agreements (EULAs)/distribution agreements, can’t be considered as payment of royalty for the use of copyright in the computer software as per provisions of Article 12(3) of the applicable DTAAs and the provisions contained in section 9(1)(vi) of the Income Tax Act along with explanations 2 and 4 thereof, not being more beneficial to the assessees, will have no application.

Business Income v. Fees for Technical Services

Under Sec 9(1)(vii) of the ITA in the Explanation 2 the term 'fees for technical services' is defined as any consideration (including any lump sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel). In other words, if the services rendered in relation to computer software are in the nature of managerial, technical or consultancy services, the payment for the same could be regarded as fees for technical services.

"Fees for technical (or included) services" is given a restricted meaning under most of the DTAAs as against a wider import attributed to it under the ITA.

Article 12(4) of the India-USA DTAA defines "fees for included services" to mean payments of any kind to any person in consideration for the rendering of any technical or consultancy services (including through the provision of services of technical or other personnel) if such services:

(a)

 

are ancillary and subsidiary to the application or enjoyment of the right, property or information for which royalty is paid; or

(b)

 

make available technical knowledge, experience, skill, know-how, or processes, or consists of the development and transfer of a technical plan or technical design.

Similar definition of fees for included services appears in several of the DTAAs signed by India, such as that with the UK.

In order for technology to have been made available, the person acquiring the service should be enabled to apply the technology embedded in the services provided to him. The mere fact that the provision of the service may require technical input by the person providing the service would not per se mean that technology has been made available. Similarly, the use of a product, which embodies technology, shall not per se constitute technology being made available. Thus, if the Indian company is in a position to apply technical knowledge, experience, skill, know-how, or processes, by virtue of the services rendered by the foreign company to the Indian company, it will be regarded as fees for included/technical services.

If such services consist of the development and transfer of a technical plan or technical design, the same would be regarded as fees for included/technical services.

Concluding Remarks:

The Hon’ble Supreme Court of India has indeed done a remarkable feat by bringing in the much-desired certainty and stability to the otherwise highly contentious and litigative issue of taxability of computer software through this remarkable judgement in the case of “Engineering Analysis Centre of Excellence Private Ltd. vs. CIT” in Civil Appeal Nos. 8733-8734 of 2018.

However, lets hope and wish that the Revenue Authorities don’t try to tinker this settled position now with some retroactive amendment in the Legislature, which in any case will not have any impact by virtue of the more beneficial provisions of DTAAs and therefore any such experiment will only open up a pandora box of litigation, without bringing in the desired result of revenue generation.

The Copy of the Supreme Court Judgement in the Case of “Engineering Analysis Centre of Excellence Private Ltd. vs. CIT” in Civil Appeal Nos. 8733-8734 of 2018, can be accessed in the PDF File below.

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