Computer Software- Direct Tax Implication

R. Kumar, B.Com. MBA (Finance)

Introduction:-

There is a never ending debate on whether software related payment made by a resident to a foreign recipient is in the nature of “Royalties or Fees for Technical Services” or “Business Income”. If the payer takes a view, even if rightly so, that the payment constitutes a “Business Income” in the hands of the recipient and in the absence of a Permanent Establishment of such recipient in India, no tax is to be withheld, it often ends in prolonged litigation. Additionally, the Indian payer is often treated as an “assessee in default” by the tax department for not withholding the tax at source.

Software:-

The term “software” is not defined under the provisions of the Act. Generally, the term “software” is understood to mean as computer software. The term, is however, not restricted only to computer software but also includes other software viz., video software, audio software, telecom software etc.

Software, as generally understood, means any information, programme, or routine, or any set of one or more programmes, routines, or collections of information used, or intended for use, to convey information that causes one or more computers or pieces of computer related peripheral equipment, or any combination thereof , to perform a task or set of tasks. Software includes only those copies of such information, programmes, or routines intended for use by an end user and specifically excludes retained rights in software and master copies of software. Software includes the associated documentation that describes the code and its use, operation and maintenance and typically is delivered with the code to the consumer.

As per New Oxford Dictionary, “Software is a programme used with a computer (together with their documentation), including programme listings, programme libraries, and user and programming manuals”.

As per Article 12 OECD Model Convention, “Software is a programme, or series of programmes, containing instructions for a computer required either for a operational processes of the computer itself (operational software) or for the accomplishment of other tasks (application software).

Software programme is essentially a series of commands issued to the hardware of the computer that enables the computer to perform in a particular manner. It is stated that to make it effective, the sequence of commands must be physically stored on a portion of the computer that can be readily accessed by the processing unit of the computer. It is stated that in order for this, the programmes should be reduced to a physical form so that it is capable of being stored. It is stated that the programmes are therefore a nature that they may be recorded on magnetic media (much like the recording of audio or video on cassettes and tapes) but that in cases of software, the programmes are recorded on floppy drives, CDs or hard drives. Tata Consultancy Services Vs. State of Andhra Pradesh [(2004) TIOL-87-SC-CT]

Computer Software:-

As per Explanation 3 to section 9 (1) (vi) of Income Tax Act, “Computer software means means any computer programme recorded on any disc, tape, perforated media or other information storage device and includes any such programme or any customized electronic data.

Computer software means-

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

(ii) any customised electronic data or any product or service of similar nature as may be notified by the Board,

which is transmitted or exported from India to a place outside India by any means.

There are different types of Computer software the same are:

i. Shrink-wrap Software

ii. Bundled Software

iii. Canned Software

iv. Customised Software

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 not transferable and nor can the buyer sub-license the software. Any user operating the package is deemed to have the knowledge of the copy right of the software.

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 software generally comes 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.

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

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.

Income Tax Provisions:

There are no specific provisions under the Act that specifically deals with the taxability of income arising from software related transactions. The taxability of income in relation to software arising in an international transaction is governed by general taxation principles, concepts and provisions of the Act.

Under the provisions of section 5(2) of the Act says that:

The total income of any previous year of a person who is a non-resident includes all income from whatever source derived which—

(a)  is received or is deemed to be received in India in such year by or on behalf of such person ; or

(b)  accrues or arises or is deemed to accrue or arise to him in India during such year.

Section 9 of the Act deals with the certain types of income, which are deemed to accrue or arise in India. This Income falls under three different categories same are as under:

i. Business Profits

ii. Royalty Income

iii. Fees for Technical Services

Section 9(1)(i) of the Act says that:

9. (1) The following incomes shall be deemed to accrue or arise in India :—

(i) all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India.

♦ The Supreme Court of India, the highest judicial authority in India, in a tax ruling, has held that the “business connection” involves a relation between a business carried on by non-resident, which yields profits or gains and some activity in India that contributes directly or indirectly to the earning of those profits or gains. In the ruling, the Supreme Court has observed that:

“It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories. A stay or isolated transaction is normally not to be regarded as a business connection. Business connection may take several forms: It may include carrying on a part of the main business or activity incidental to the main business of the non-resident through an agent or it may merely be a relation between the business of the non-resident and the activity in the taxable territories which facilitates or assists the carrying on of that business. In each case, the question whether there is business connection from or through which income profits or gains or accrue to a non-resident must be determined upon the facts and circumstances of the case.”

♦ Calcutta High Court has also observed in relation to “business connection”:

“That meaning of the expression ‘business connection’ is not restricted by the definition of ‘business’ contained in section 2(13) of the Act, because that definition is enumerative and not exhaustive. Business connection has not been defined in the Act. It is difficult to get a definition both exclusive and inclusive which will meet with every mode or method of business dealing. Business connection is not equivalent to carrying on a business.”

Section 9(1)(vi)

Income by way of royalty payable by—

(a)  the Government ; or

(b)  a person who is a resident, except where the royalty is payable in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India ; or

(c)  a person who is a non-resident, where the royalty is payable in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on by such person in India or for the purposes of making or earning any income from any source in India :

Provided that nothing contained in this clause shall apply in relation to so much of the income by way of royalty as consists of lump sum consideration for the transfer outside India of, or the imparting of information outside India in respect of, any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process or trade mark or similar property, if such income is payable in pursuance of an agreement made before the 1st day of April, 1976, and the agreement is approved by the Central Government :

Provided further that nothing contained in this clause shall apply in relation to so much of the income by way of royalty as consists of lump sum payment made by a person, who is a resident, for the transfer of all or any rights (including the granting of a licence) in respect of computer software supplied by a non-resident manufacturer along with a computer or computer-based equipment under any scheme approved under the Policy on Computer Software Export, Software Development and Training, 1986 of the Government of India.

♦ The Hyderabad Tribunal, on the given facts, has held that all the documents related to the kiln were specifically designed for the use of the Indian company. The Indian company had not made payment for the designs, et al. The Indian company has paid for them as part of the cost of construction of the kiln. The designs were not capable of being understood by its engineers. The Indian company had no intention to exploit the technical data even for construction of another kiln for itself or for others. Accordingly, the payment to the non-resident did not come under any of the clauses of the section 9(1)(vi) of the Act, hence , it was not treated as royalty income. In case of Klayman Porcelains Ltd. Vs. ITO 229-ITR-735 (AP) Andhra Pradesh high court further upheld this aforesaid view of the Hyderabad Tribunal.

♦ In the case of Pro-Quip Corporation, USA (122-Taxman-588) Advance Authority Ruling, has also dealt with the similar issue. Under the given facts, a USA based non-resident was engaged in the business of general engineering to make, conduct and supervise research, surveys, designs and investigations in the field of science and technology. It supplied designs, engineering technical know-how and the building and commissioning of a turnkey plant to an Indian company for agreed consideration. The issue that was examined by Advance Authority Ruling was whether or not the non-resident was liable to tax in India on the amounts received from the Indian Company in respect of the consideration for the sale of engineering, drawing and designs.

Software development and maintenance service are generally in the nature of technical services. The payment for such services may be classified as in the nature of fees for technical services under the provision of the Act.

The provision of section 9(1)(vii) of the Act deals with the payment as “ fee for technical services” and thus have an impact on cross border transactions involving payments towards software related services.

 Section 9 (1)(vii)

Income by way of fees for technical services payable by—

(a)  the Government ; or

(b)  a person who is a resident, except where the fees are payable in respect of services utilised in a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India ; or

(c)  a person who is a non-resident, where the fees are payable in respect of services utilised in a business or profession carried on by such person in India or for the purposes of making or earning any income from any source in India :

Provided that nothing contained in this clause shall apply in relation to any income by way of fees for technical services payable in pursuance of an agreement made before the 1st day of April, 1976, and approved by the Central Government.

♦ Court relied on case CIT Vs. Copes Vulcan Inc. 167-ITR-884(Mad.) held that having regard to the language used in section 9(1)(vii) of the Act, the income by way of “fee for technical services” arising out of even a “business connection” should be considered to have been covered by section 9(1) (vii) of the Act and not by section 9(1)(i) of the Income Tax Act, section 9(1)(vii) being a specific provision for that type of income.

Section 195 of the Act governs the issue of withholding tax at source in connection with the payments made to foreign party, if the payment results in income, which is chargeable to tax under the Act.

The scope of section 195 and the obligation of the payer has been clearly laid down by the Supreme Court of India in the case of Transmission Corporation of A.P. Ltd. Vs. Commissioner of Income-Tax [(1999)239-ITR-587]. The Apex Court in this case held that: The purpose of sub-section(1) of section 195 is to see that on the sum which is chargeable under section 4 of the Act , for levy and collection of income tax, the payer should deduct income tax thereon at the rate in force, if the amount is to be paid to a non-resident. The only thing which is required to be done is to file an application (this refer to the application under section 197) for determination by the Assessing Officer that such sum would not be chargeable to tax in case of the recipient, or for determination of the appropriate proportion of such sum so chargeable, or for grant of a certificate authorizing the recipient to receive the amount without deduction of tax, or deduction of income tax at lower rate. On such determination, tax at appropriate rate could be deducted at source. If no such application is filed, income tax on such sum is to be deducted and it is the statutory obligation of the person responsible for paying such “sum” to deduct tax thereon before making the payment.

Recent Case Analysis:-

Airport Authority of India (A.A.R. No. 753-754 of 2007)

In this case of Airport Authority of India (AAI), which entered into two contracts with a US Company-  one for hardware and other for software. Whereas supply of hardware was held as non-taxable, but the supply of software was treated as “royalty” and “fee for technical services”.

Commercially there are two types of softwares, namely, “unbranded software which is specialised and exclusively custom made to cater to the needs of individual clients”. And “branded software” or “of the shelf software” which is standardised and marketed as such. The software supplied to Airport Authority of India consisted of customised software. Airport Authority of India contended that when the US company shipped the software and documentation, the property passed to Airport Authority of India out side India. It also contended that the entire activities under the contract except some support activities were performed outside India. The essence of the contract is outright sale of some copyrighted software, but the software could be used only for the specified intended purpose.

The issue before the Advance Authority of Ruling was whether payment received by US Company under the transaction is liable to tax in India in the hands of the US company. The Airport Authority of India pleaded that the supply of software should be treated as sale of goods and the resulting income should be treated as business income. Reliance was placed on Supreme Court decision in the case of Tata Consultancy Services Vs. Union of India [(2004) 271-ITR-401 (SC)] in which the supply of software was treated as sale of goods. It was also contended that there is a distinction between grant of licence to use a copyright and sale of a copyrighted article.

The Indian Income Tax Act does not contain any clear provision with regard to transfer of computer software. Therefore, a taxpayer is entitled to take help from internationally accepted commentaries like the OECD commentary, which provides for treatment in case of transfer of full ownership rights as well as for partial alienation of rights. It is clear that even in case of partial alienation of rights, in certain circumstances, the consideration will be a business income and not royalty.

The Advance Authority Ruling dismissed the assesse’s reference to OECD commentary which clarifies the distinction between the right to use the copy right and transfer of a copy righted article. According to OECD only a transfer that enables a transferee to commercially exploit software copyright will give rise to royalty income. But where the transferee gets exclusive rights for use, though short or full ownership, it will nevertheless be a case of sale of software. In the Microsoft case also, the Tribunal rejected the assesse’s contention to rely on the OECD commentary. In this case, the payment in respect of supply of software with an exclusive right to use was treated as royalty and was hence held taxable in India. The Tribunal rejected the plea to rely on Tata Consultancy case.

Conclusion:-

The above judgement is going to have tremendous effect on India’s outsourcing business which constantly requires new software besides modification and upgrade of the old one. The government should take a proper measure to synchronise the Income Tax Law with OECD commentary.

(Author can be reached at [email protected])

(Republished With Amendments)

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