The SC held that such payments by an Indian entity to a non-resident for the purchase of off-the-shelf software does not qualify as royalty under the relevant tax treaties. Accordingly, there is no withholding tax obligation on the Indian payer
Recently, the Supreme Court of India in a landmark judgement has settled a two-decade-old issue relating to payments for software to non-residents. It put to rest the controversy on the issue of characterization of software payments by ruling in favour of the taxpayers. This was done in a batch of appeals involving over 80 taxpayers.
The controversy
The debate in this case centred around whether such payments are for “copyright" or “copyrighted article", and accordingly, whether income of the non-resident from sale of such software is royalty or business income. The answer to this question also has a bearing on Indian payers as in the case of royalty, the Indian payer is required to withhold tax while making the remittance. However, in the case of business income, if the non-resident entity does not have a presence (permanent establishment) in India, then there is no withholding tax requirement.
In its detailed ruling, the SC held that such payments by an Indian entity to a non-resident for the purchase of off-the-shelf software does not qualify as royalty under the relevant tax treaties. Accordingly, there is no withholding tax obligation on the Indian payer.
Category of cases involved
In this ruling, the SC discussed and deliberated on the following categories of transactions:
Category 1: Direct purchase of computer software by an end-user resident in India from foreign non-resident supplier/manufacturer.
Category 2: Purchase of computer software by resident Indian distributors/resellers from foreign non-resident supplier/manufacturer to resell the same to resident Indian end-users.
Category 3: Purchase of computer software by foreign non-resident vendor from a foreign non-resident seller to resell the same to Indian distributor or end-users.
Category 4: Cases where the computer software is affixed into hardware and is sold as an integrated unit by foreign non-resident suppliers to resident Indian distributors or end-users.
Taxpayer vs revenue
The tax department’s view was that the sale of software should be construed as transfer of interest in the copyright embedded in the software, and therefore, should be classified as royalty. Consequentially, there should be a withholding tax obligation on the Indian payer.
On the other hand, the taxpayers contented that the end-user was only allowed to use the software product. There is no transfer of interest in the copyright of the software, hence, the essence of the transaction is that it is ‘sale of copyrighted article’. As it is ‘business income’ of the non-resident, there is no tax withholding required, if the non-resident does not have a presence (permanent establishment) in India.
Key takeaways
The key principles laid down in this ruling include:
Significance of domestic Copyright Act
The SC went through relevant provisions of the Indian Copyright Act and noted that a computer program should be classified as a “literary work". As regards meaning of the term ‘copyright’, the SC noted that although the term has not been defined but the same appears to mean ‘exclusive right in respect of work’ to do or authorize the doing of certain acts.
In essence, right to copyright includes the right to reproduce the work in any material form, issue copies of the work to the public, perform the work in public, or make translations or adaptations of the work. It then held that the right to reproduce a computer program and exploit the reproduction by way of sale, transfer, license etc. is at the heart of the said exclusive right.
It explained that right to reproduce and the right to use computer software are distinct and separate rights. The former amounts to parting with the copyright and the latter in view of non-exclusive arrangements does not qualify as copyright.
Making of copies in order to utilize the computer program for the purpose for which it was supplied or as a temporary protection against loss, does not constitute an act of infringement of copyright.
It reviewed various agreements relating to the four category of cases under deliberation. As regards the distributors, it observed that a non-exclusive, non-transferable license to resell the software is granted to distributor in India. In fact, the distributor does not get the right to use the product at all.
As far as the end-user consumers in India are concerned, the license was granted only for the use of software without any other rights to sub-license or transfer, or reverse engineer, or modify the software program per se. The agreements revealed that the proprietary interest in the copyright always remained with the non-resident.
In view of these observations, the SC held that what is licensed to the distributor for onward sale or to the end-user for usage only, does not qualify as ‘license’ as per the domestic copyright law and is in fact sale of goods.
The court also concluded that a payer is required to withheld tax only if the sum paid is chargeable to tax. In the instant case as the income was not chargeable to tax, therefore, there was no requirement to withhold tax.
Supremacy of tax treaties
The SC noted that the definition of the term ‘royalty’ is comparatively wider in the India’s domestic tax laws i.e. the Income-tax Act, 1961 (‘the Act’) as compared to the tax treaties (Double Taxation Avoidance Agreements) under consideration. Further, the definition under the Act has been expanded by retrospective amendments. The SC reiterated the principle that in case of a transaction where the tax treaty applies, the provisions of the Act shall apply only if they are beneficial to the taxpayer and not otherwise.
Law does not demand the impossible
The SC reiterated that withholding tax liability does not arise when the recipient is not liable to pay income tax in India, i.e. when there is no income chargeable to tax in India, in context of the matter under discussion. It also affirmed that the taxpayer cannot be penalized because of retrospective amendments. It held that the law does not demand the impossible. Liability to withholding tax cannot be fastened upon the taxpayer by virtue of retrospective amendments in the Act. It also negated the contention that treaty benefits should not be evaluated at withholding stage.
Persuasive value of OECD commentary
On the question of the applicability of OECD commentary, the SC observed that the definition of the term ‘royalties’ in the tax treaties under consideration is identical or similar to that under the OECD model. Therefore, OECD commentary becomes relevant. It has a persuasive value for the purpose of interpretation. India’s reservations in OECD Commentary are of no value unless specific treaties are amended.
This is likely to set a precedent and OECD commentaries likely to gain more acceptance in evaluating and deciding various taxation issues in respect of treaties that are based on the OECD model.
Way forward
Going forward, while such software payments will now be out of the income-tax net, the taxpayers would need to evaluate the applicability of domestic equalization levy provisions inserted by Finance Act 2020 in these cases. Further, evaluation may also be required in context of the relatively new concept of Significant Economic Presence, once it becomes operational, to determine if any tax liability exists in India, based on the business model.
This judgement has clarified many important taxation principles. It may be worthwhile to evaluate if the principles laid down in this ruling can be applied in other cases relating to taxation of databases, transponder charges or telecommunication charges. Also, taxpayers need to evaluate if these principles will hold good in cases where software is downloadable and do not come in physical CDs/hard drives.
The immediate impact of this ruling is likely to be in terms of review of the existing contracts and whether they need to be re-negotiated as now no tax withholding is required. Further, companies that have been disputing/litigating this matter need to evaluate how refund claim needs to be made for the past years.
Overall, a welcome ruling in favour of taxpayers that settles a two-decade litigative issue.
Richa Sawhney and Sameer Shah contributed to this article.
Vikas Vasal is national leader-tax at Grant Thornton Bharat LLP.
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