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India Supreme Court settles the debate – software sale is not taxable as royalty


By Ritu Shaktawat, Partner & Krutika Chitre, Senior Associate, Khaitan & Co, Mumbai, India 

The Supreme Court of India on 2 March has put to rest a long-standing contentious issue surrounding the characterisation of income in the hands of non-resident software manufacturers and suppliers in a landmark judgment in the case of Engineering Analysis Centre of Excellence Private Limited (Civil Appeal Nos. 8733-8744 of 2018).

The core issue before the Court was whether software manufacturers were compensated for the ‘right to use a copyright’ or the ‘right to use a copyrighted article’.

While the former would result in income being in the nature of royalty and taxable accordingly, the latter would be in the nature of business income, not taxable in India in the absence of a taxable presence in India.

Indian law has a strict withholding tax regime with respect to payments to non-residents requiring the payer to withhold applicable taxes at source. Non-compliance/shortfall in withholding taxes exposes the payer to being treated as a defaulter and subject to recovery of applicable taxes along with interest and penalties. Therefore, the income characterisation issue affected not only non-resident software suppliers but also the users and distributors in India purchasing software.   

Before the Supreme Court were appeals against decisions of two High Courts (Karnataka and Delhi) and the Authority for Advance Rulings.

Divergent views in these decisions, amongst others, saw the Supreme Court posed with over a hundred appeals on the issue, both from the tax authorities and software companies such as IBM, GE India Technology, Sonata Information Technology, Sasken Communications Tech, Rational Software Corporation, and Infineon Technologies. 

Divergent views in these decisions, amongst others, saw the Supreme Court posed with over a hundred appeals on the issue, both from the tax authorities and software companies such as IBM, GE India Technology, Sonata Information Technology, Sasken Communications Tech, Rational Software Corporation, and Infineon Technologies. 

The Court discussed the interplay between the Indian tax law, Indian copyright law, provisions of various tax treaties and the OECD commentary on the Model Tax Convention and ruled that consideration paid by end-users and distributors to non-resident computer software manufacturers and suppliers for use or resale of software did not amount to payment of ‘royalty’ and therefore, should not be subject to any tax in India (consequently, not subject to any withholding tax in India).

Definition of royalty – an overview 

At the centre of the storm lies the definition of ‘royalty’.

Under Indian tax law, royalty is defined as consideration for the transfer of all or any rights (including the granting of a licence) in respect of any copyright.

In 2012, the relevant provision was amended retrospectively to allegedly clarify that the phrase “transfer of all or any rights” in respect of any right, property or information always included the “transfer of all or any right for use or right to use a computer software (including granting of a licence) irrespective of the medium through which such right is transferred.“

This purported clarification sought to clarify the position from 1 June 1976.

On the other hand, the definition of royalty under India’s tax treaties is narrower. By way of example, the royalties’ definition under the India-Singapore tax treaty reads as payments of any kind received as a consideration for the use of, or the right to use any copyright of a literary, artistic or scientific work. 

Under Indian tax law, the provisions of a tax treaty would prevail over domestic law to the extent that they are beneficial to the taxpayer. Further, a term defined in a tax treaty would be interpreted as per the meaning accorded to it under the treaty, and only in the absence of such a definition can recourse be taken to its meaning under domestic law.

Payment of consideration – whether for copyright or goods?

To address the core issue of what constitutes a copyright, the Supreme Court considered the provisions of Indian copyright law (as no copyright exists in India outside the provisions thereof).

It concluded that copyright means the ‘exclusive right’ to do or authorise the doing of certain acts ‘in respect of a work’. A computer programme falls under the definition of a ‘literary work’.

The law specifically speaks of two sets of acts relevant to a computer programme. The first set consists of acts such as the right to reproduce the work in any material form, to issue copies of the work to the public, and to make any adaptation of the work. The second refers to selling or giving on commercial rental or offering for sale or for commercial rental any copy of the computer programme.

Therefore, unless the copyright owner parts with or grants interest in any of these rights, there is no transfer of a right or interest in a copyright. 

As regards the second set of acts which includes exclusive right to sell a computer programme, the question is whether the rights of a distributor (of selling/software distribution) would amount to a right in the copyright (in the form of a right to sell). In this regard, the Court analysed the principle of first sale/principle of exhaustion.

The Court held that this principle is statutorily recognised in the Indian copyright law which means that once the title in the computer software passes to the distributor for further sale, foreign supplier’s distribution right would be exhausted and would not extend to the sale of copies of the work to other persons beyond the first sale.

The Court’s conclusion was based on an amendment made in 1999, which tilted the balance between the copyright owner’s distribution right and the right of the purchaser to further resale in favour of the latter. This essentially means that under copyright law, for a distributor to sell a computer programme, it does not require a right in the copyright, as post the first sale by the owner/author, the owner can no longer assert its exclusive right to sell the same software.

The Court observed that this provision’s object in the context of a computer programme is to prohibit reproduction of the computer programme and consequent transfer of the reproduced computer programme to subsequent acquirers/end-users. The object of this provision is not to prohibit the sale of computer software that is licensed to be sold by a distributor.

This helps conclude that any sale by the author of computer software to a distributor for onward sale to an end-user is not hit by this provision resulting in parting with any interest in the copyright (or, for that matter, infringement of copyright). Since the principle of exhaustion is statutorily recognised by the copyright law, the acts by a distributor do not require rights of the nature recognised as exclusive to the owner of copyright.

The right to reproduce a computer programme and exploit the reproduction by way of sale, transfer, license etc., is at the heart of the ‘exclusive right’ which vests with the copyright owner.

It was outlined that making of copies or adaptation of a computer programme to use the computer programme for the purpose for which it was supplied or to make back-up copies so as to be able to use the computer programme for the purpose for which it was supplied, did not constitute an act of copyright infringement.

Importantly, the Court concluded that ownership of the copyright in a work is different from the ownership of the physical material in which the copyrighted work may happen to be embodied.

On analysis of the agreements, the Court observed that a distributor was granted only a non-exclusive, non-transferable licence to resell computer software. The end-users’ rights were restricted to use by themselves, and the right to sub-license, transfer, modify were restricted.

Throwing light on the term ‘license’, the Court held that the license granted under the agreements was not in terms of a license of a copyright recognised under the Indian copyright law, which transfers an interest in exclusive rights of an author such as the ones described above. On the contrary, it is a license that imposes restrictions on the use of the software.

Accordingly, the Court concluded that the transaction in question is the sale of a physical object that contains an embedded computer programme and is, therefore, a sale of goods.

Definition of royalty under a tax treaty vs Indian domestic law

The appeals in question concerned India’s tax treaties with 18 countries, all of which are based on OECD model convention and are similar in respect of provisions relating to royalty taxation. As per the tax treaty definition, payments towards the use of, or the right to use any copyright of a literary work amounts to royalty, and the definition is exhaustive and narrower in scope than the definition under domestic law.

Importantly, the Court recognised the relevance of the OECD commentary on the subject. As per the commentary, copying the program onto the computer’s hard drive or random-access memory or making an archival copy is an essential step in utilising the program. Therefore, rights in relation to these acts of copying, where they do no more than enable the effective operation of the program by the user, should be disregarded in analysing the character of the transaction for tax purposes. The OECD commentary also clarifies that arrangements between a software copyright holder and a distribution intermediary will grant to the distribution intermediary the right to distribute copies of the program without the right to reproduce that program. In these transactions, the rights acquired in relation to the copyright are limited to those necessary for the commercial intermediary to distribute copies of the software program.

In such transactions, distributors are paying only to acquire the software copies and not to exploit any right in the software copyrights. Payments in the aforesaid types of transactions would be dealt with as business profits and not as royalty.
This would be the case regardless of whether the copies being distributed are delivered on tangible media or are distributed electronically (without the distributor having the right to reproduce the software), or whether the software is subject to minor customisation for the purposes of its installation.

The tax authorities highlighted that India had expressed its reservations on the OECD commentary, particularly to the parts dealing with copyright and royalty and should not be relied upon. In this regard, the Supreme Court held that mere positions taken with respect to the OECD commentary do not alter the provisions of a tax treaty India has negotiated and signed unless it is amended by bilateral re-negotiation.

The Supreme Court thus laid down that the OECD commentary on Article 12 incorporated in the relevant tax treaties will continue to have persuasive value as to the interpretation of the term “royalties.”

The Supreme Court thus laid down that the OECD commentary on Article 12 incorporated in the relevant tax treaties will continue to have persuasive value as to the interpretation of the term “royalties.” 

Dissecting the definition under India’s income-tax law, the Supreme Court observed that “royalty” has been defined as the consideration for transfer of all or any rights (including the granting of a licence) in respect of any copyright.

The Supreme Court noted that for consideration to be categorised as royalty, there must be a transfer by way of licence or otherwise of all or any of the rights which vest exclusively in the owner/author (discussed above), which as previously concluded, was missing in the transactions in question.

The Court emphasised that the phrase “in respect of” is equivalent to “in” or “attributable to” and hence to qualify as royalty under the domestic law, the transfer of all or any rights in a copyright by way of a license was a mandatory condition.

Since the agreements in question did not create or transfer any interest in the copyright of the software, the Supreme Court held that the consideration in question would not qualify as royalty even under the domestic tax law.

The Court then addressed the tax authorities’ contention that 2012 amendment was clarificatory of the position as it always stood since 1 June 1976 and expanded the scope of the definition of royalty with respect to computer software. 

The Court held that the amendment could not be considered as merely “clarificatory”. The Supreme Court’s decision was based on a consideration of the timeline for the introduction of the term ‘computer software’ in Indian income tax and copyright law, being much after 1976.

In the Court’s opinion, it was ‘ludicrous’ for the aforesaid amendment to apply with effect from 1 June 1976, which had also introduced other changes relating to transmission by a satellite, optic fibre, etc. when the technology in question was only regulated by the Indian Parliament much after 1976.

The Court noted that applying the amendment to the years prior to 2012 would lead to an expectation to do the impossible. It held that the taxpayers could not be expected to do the impossible, namely, to apply the expanded definition of “royalty”, for the years in question, at a time when such explanation was not actually and factually in the statute.

An important consideration to bear in mind is that this decision clarifies matters for transactions pre-2012 and  places domestic law and tax treaty provisions at par. Accordingly, software manufacturers from treaty as well as non-treaty jurisdictions should be treated at par. For transactions post-2012, the non-treaty sellers may be subject to the broader definition under the domestic law.

Software manufacturers from non-treaty jurisdictions may be subject to the broader definition under the domestic law for transactions post-2012.

Concluding remarks

The Supreme Court’s ruling has put to rest a long-brewing controversy. The Court has set aside judgements of the High Court and rulings of the Authority for Advance Rulings which, according to the Court, did not state the law correctly.

While in some cases, the tax dispute related to income from more than 20 years ago, the silver lining is the relief to non-residents as well as domestic users and distributors in on-going and future transactions involving the sale of software directly to an end-user, sale of software to an Indian distributor for resale to an Indian end-user customer, sale of software to a foreign distributor for resale to an Indian end-user customer, and sale of software bundled with hardware sold to Indian distributors or end-users.

This decision provides the software suppliers, distributors, and users certainty with respect to taxation in India and should strengthen India’s position as a potential market in the realms of software and technology.

Apart from being a favourable ruling for resident and non-resident taxpayers, the decision is a frank and lucid guide to several key principles relevant for international transactions.

Krutika Chitre, Senior Associate, Khaitan & Co, Mumbai, India, contributed to this article.

*This was first published by MNE Tax on 10 March 2021.

Read the article here - https://mnetax.com/india-supreme-court-settles-the-debate-software-sale-is-not-taxable-as-royalty-42920


Ritu Shaktawat (partners)

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