By Shefali Godadia, Jimit Shah & Pooja Dhokad

The issue of taxation of cross border software licensing transactions has been a bone of contention between the Indian Revenue and the taxpayer over the years. The controversy is pursuant to the broader definition of royalty under the domestic tax law of India, as compared to the narrower definition under the tax treaties. The principal issue relates to the characterisation of software, which leads to the determination of what is being procured when payment for software is made and what rights are granted to a user. If the grant is of a copyright (i.e. an intangible), then the source country can tax it as royalty on a source basis. If instead, it is a sale of a copyrighted article (i.e. a product), the source country can tax it only in the event the vendor has a permanent establishment in the source country. Many of these issues are currently pending before the Supreme Court, for a final adjudication on the legal interpretation of classification of software. While it would take some time to settle the controversy in India and some other countries, the inconsistency created as a result of divergent views has caused much uncertainty to taxpayers.

With a view to promote certainty, the UN Tax Committee has released a discussion draft on ‘Inclusion of software payments in the definition of royalties’ in the UNModel Double Taxation Convention by proposing an amendment to Article 12 on ‘royalties’. The Committee invited public comments on the discussion draft by October 2. The proposed amendment aims to steer clear of the controversy on whether payment for the right to use the software, constitutes royalty.

The above proposal has not received consensus from all members of the tax committee due to divergent views. Some members are in favour because it will remove the distinction between payments towards the use of copyright in software or copyrighted software and also that increasing engagement with the economic life of user’s country would justify the allocation of taxing rights to that country. On the other hand, other members have objected to the proposal as allocation of taxing rights to the country of source in itself cannot justify the proposal and it would give rise to practical challenges for licenses centrally procured and used in a number of countries, purchase of software by individuals, etc.

While the above proposal if implemented in bilateral treaties, may make software payments taxable in source countries, it may put to rest the ongoing litigation in India and some other countries, on software payments, and provide tax certainty by aligning the treatment under tax treaties and the domestic tax law. It may further resolve the ambiguities and challenges around claiming the different tax credit in the resident country provided the countries adopt a bilateral approach. The proposal dilutes the non-taxability position adopted by distributors for various kinds of software, who buy and sell software in various modes / media. The controversy around royalty characterisation in cases of software being pre-installed / embedded in a product (for instance, computer hardware and telecommunication equipment) may still continue.

The committee has recently proposed insertion of Article 12B – Income from Automated Digital Services in the convention, to deal with the tax treatment of payments for digital services. This article has illustrated the services falling under ‘automated digital services’ which include automated provision of computer programmes/software and could result in a potential overlap with the proposed amendment to Article 12 and therefore, requires to be adequately addressed.

The scope of recently introduced equalisation levy provisions is very broad to include sale/use of software through digital means. If the software payments are subject to EL, then they are exempt under the domestic tax law of India from April 1, 2021. It is imperative to evaluate the implications of EL where software payments may qualify as royalty under tax treaties.

To conclude, while the proposal to amend the definition of royalty brings certainty and may put to rest the tax controversy to a significant extent, it still does not address all issues and depends on the bilateral approach of the countries.

Godadia is partner, Deloitte India. Shah is director, and Dhokad a manager, Deloitte Touche Tohmatsu India LLP