Payments for Software not Taxable as Royalty
Background:
The Hon'ble Supreme Court in the case of Engineering Analysis Centre of Excellence Private Limited v. The Commissioner of Income Tax & ANR. has put the controversial issue of tax on payments made for buying software to rest by deciding it in favour of the taxpayers. The case revolves around the taxability of cross-border payments for purchase of software i.e whether the payment received by a non-resident for giving licence of the computer software for further distribution would be taxable as royalty or would it be a normal sale transaction. The court held that the non-resident owner continues to have proprietary rights in the software and the use of the software by the Indian company is limited to making backup copy and redistribution. So, the payment received for the sale of computer software is business income and in the absence of a permanent establishment of the seller in India, tax could not be levied.
Introduction:
There have been a lot of ambiguities regarding the payment made to a non-resident entity for the grant of the use by a business in India either for internal use or for further distribution. The Income Tax Department has been treating such payments as royalty and accordingly, bringing the same to tax in India at the rate of 10% u/s 115A of the Income-tax Act, 1961. It would be worthy to recall that India began expanding its tax base in 2012 wherein the definition of royalty under the IT Act was broadened. As a result, the Indian revenue authorities started treating the software payments at large as royalty and demanding tax on it.
On the other hand, the assessees who make use of such computer software, have been taking a stand that the aforesaid payment is of the nature of business profits and therefore, the same would not be liable to tax in India, typically because of the provisions of Article 7 of the Double Taxation Avoidance Agreement (DTAA), entered into between India and several foreign countries.
It is to be noted that in this connection, the taxpayers have been taking a stand that the scope of the definition of royalty under section 9(1)(vi) is quite wide, whereas the scope of the definition of royalty under Article 12 of the DTAAs is restrictive. In this connection, it may also be stated that the Delhi High Court in the case of Intrasoft Ltd. and Ericsson A.B has been adopting a very firm view that the amount received by the assessee under the license agreement for allowing the use of the software is not royalty, because what is transferred is neither the copyright in the software nor the use of the copyright in the software, but what is transferred is the right to use the copyrighted material or article, which is distinct from the rights in a copyright. However, the Karnataka High Court in the case of Samsung Electronics Co. Ltd has held the same in the favor of revenue stating that the payment for software amounted to royalty.
Supreme Court Ruling:
The Supreme court bench was hearing a batch of more than 80 appeals which challenged the decisions of various High Courts holding that consideration paid for the purchase of foreign software amounts to 'royalty'. Engineering Analysis Centre of Excellence Pvt. Ltd (“EAC”), a resident Indian being an end-user of shrink-wrapped computer software, directly imported it from United States of America. The Assessing Officer found that what was in fact transferred in the transaction between the parties was copyright which attracted the payment of royalty and thus, it was required that tax be deducted at source by the Indian importer and end-user, EAC and it was held liable to pay the amount of Rs 1,03,54,784.
The Apex court rejected the contention of the revenue that, ‘the purchase of software is taxable as income arising out of India. The Court also held that there is no obligation on the persons mentioned in section 195 of the IT Act to deduct tax at source, as the distribution agreements/ the End User License 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.
Therefore, the consequences of Section 201 of the IT Act will not fall on the resident companies for not deducting TDS from foreign software companies. Hence, no copyright over software given, so payment for user-license agreement does not amount to royalty.
The Court noted that the EULA of the software do not transfer or assign the copyright over the software. What is granted to the distributor is only a non-exclusive, non-transferable license to resell computer software, it is expressly stipulated that no copyright in the computer program is transferred either to the distributor or to the ultimate end-user.
"In all these cases, the "licence" that is granted vide the EULA, is not a license in terms of section 30 of the Copyright Act, which transfers an interest in all or any of the rights contained in sections 14(a) and 14(b) of the Copyright Act, but is a "license" which imposes restrictions or conditions for the use of computer software and thus, cannot be treated as royalty.
The Court held that the transaction is similar to ‘a sale of goods’ as held by the Hon’ble SC in the case of Tata Consultancy Services . In this regard, Court pronounced that: - "What is "licensed" by the foreign, non-resident supplier to the distributor and resold to the resident end-user, or directly supplied to the resident end-user, is, in fact, the sale of a physical object which contains an embedded computer program, and is, therefore, a sale of goods.
The court also upheld the significance of the OECD Commentary as persons (deductors/assessees) of different countries can conclude their business transactions on the basis of the taxability of income as royalty or business profits as per the Commentary and it will continue to have persuasive value for the interpretation of the term ‘royalties’.
Interplay with Equalisation Levy (EL)
In the Union Budget 2021, it was proposed that transactions which are taxable as “Royalty” or “Fees for technical services” under the Act read with DTAA will not be subjected to Equalisation levy. Hence, it would be interesting to see that EL could be triggered if the software payment is not subject to tax as royalty. This means tax liability of foreign software seller without a permanent establishment in India would reduce to the 2% EL introduced via Finance Act 2020, from the 10% royalty tax, which the Indian buyer has hitherto been liable to withhold. The ruling will lower the cost of software purchases for Indian firms as the overseas sellers may choose to lower prices, taking advantage of the tax relief.
Our Inference
Undoubtedly, this ruling has a far-reaching implication in restoring the confidence of foreign investors in the taxation system and judiciary of the country. It also clears all the mist surrounding taxability of software payments since long and will provide significant respite to all the concerned taxpayers. The ruling also highlights the importance of treaty protection, persuasive value of OECD commentary and the need for the taxpayers wishing to rely on the beneficial treaty interpretation would need to strengthen their positions on eligibility for treaty benefits. However, this needs to be borne in mind that EL @2% could be triggered on the software payments to non-resident wherein a non-resident seller has to pay the same and eventually have to register itself in India to comply with the same.
Our Firm’s tax Partner, Amit Maheshwari shared his views on the topic, that were published in the below media: