Case Law Details

Case Name : Microsoft Corporation (MS Corp) Vs M/s Grace mac Corporation (G Corp) (ITAT Delhi)
Appeal Number :
Date of Judgement/Order :
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Courts : All ITAT (4437) ITAT Delhi (983)

Court : Delhi ITAT

Citation: Delhi Income Tax Appellate Tribunal (ITAT) in the case of Microsoft Corporation (MS Corp) and its affiliates M/s Grace mac Corporation (G Corp) and M/s Microsoft Regional Sales Corporation (MRSC) (Taxpayers)

Brief  : TAX is payable on import of all software , even if the sale does not involve exercise of copyright, according to a Delhi tax tribunal order in a case relating to Microsoft .

While the order, passed on October 28, is significant in terms of the liability to withhold tax from payments made while importing software, the Delhi Income Tax Appellate Order (ITAT) attracted the attention of tax professionals on account of its observation that questioned the sanctity of tax treaties.

In the order, which may spark multiple litigation , the division bench of ITAT observed that it is not necessary that provisions of tax treaties always override the provisions of domestic tax laws. In a situation, where a provision in the domestic tax law is incorporated after the signing of a Double Taxation Avoidance Agreement (DTAA), it is the domestic law that will override DTAA. According to the existing position, if there is a conflict between domestic tax laws and treaty provisions, the latter is supreme.

This is the first time that a judicial body or quasi judicial body has observed that domestic law can override treaty provisions. This observation was made while holding that royalty is payable by Microsoft. The ITAT has for the first time challenged the superiority of DTAAs India has signed with many countries.

The order says, “Assuming there was a conflict between the Act and the DTAA, the proposition that DTAA will prevail over the Act is not infallible. Later domestic tax legislation can override treaty provisions if there is an irreconcilable conflict (Gramophone India case).”

While the judgement assumes importance because of its offbeat approach on the sanctity of tax treaties, the order has a direct bearing on the software industry in India which now has to pay tax on all imports of software, irrespective of whether the purchase is a copyright or not. Currently, there are some judgements in favour of the assessee, if the software is a single user licence for use by oneself. In such cases, the licence was tantamount to a copyrighted product and, hence, should not suffer withholding tax because there is no exploitation of copyright in the licence. The Delhi ITAT order changes this.

“The order is a significant departure from how payments for purchase of off-the-shelf software have been viewed by the appellate authorities earlier. It holds that such payments would be for use of a copyright (and not for use of copyrighted article) and would be taxable on a gross basis. The far reaching implications of this proposition apart, the judgement speaks of a treaty override by a subsequent domestic legislation if there is an ‘irreconcilable conflict’

Background and facts of the case

  • · Before January 1999, MS Corp, a US company, had arrangements directly with various Indian distributors for sale of Microsoft software (MS software), being ‘off-the-shelf’/’shrink-wrapped’ software, on a principal-to-principal basis. These distributors, in turn, sold them to re sellers/ customers.
  • · From 1 January 1999, its business model was changed, with MS Corp granting an exclusive licence to G Corp, in exchange of its shares, to manufacture MS software, including all updates as developed from time to time, and to distribute such products in accordance with terms of the licence agreement. G Corp was also granted an exclusive right to license any third party in the retail territory to directly grant to customers the right to reproduce the software portion of MS software for internal use. All master copies provided by MS Corp to its subsidiary, G Corp, would, at all times, remain the sole property of MS Corp.
  • · G Corp, in turn, entered into a licence agreement with Microsoft Operations Pte. Ltd. (MO), a Singapore-based wholly-owned subsidiary (WOS) of MS Corp, granting it a nonexclusive licence to manufacture (reproduce) MS software in Singapore, a non-exclusive right to distribute manufactured products to retailers etc.
  • · MO, in turn, entered into a non-exclusive distribution agreement with MRSC, another US-based WOS of MS Corp having a branch office in Singapore, appointing it as a distributor for selling the copies of MS software reproduced/manufactured by MO. MO sold all MS software copies to MRSC in Singapore. MO paid royalty to G Corp, which was based on a percentage of net selling price received by MRSC from its distributors in various countries, including India. MS software copies were delivered by MRSC to Indian distributors, ‘ex-warehouse’ in Singapore, who, in turn, sold these products to re-sellers/end users in India.
  • · MS Corp, being the registered owner of intellectual property rights (IPRs) in MS software, entered into an end user licence agreement (EULA) directly with end users.
  • · MS Corp (before January 1999)/G Corp (post January 1999) considered its income from sale of MS software as business profits, which were not taxable in India, in the absence of a permanent establishment (PE). The Tax Authority, however, taxed the payments received from Indian distributors as royalty under the ITL and the Tax Treaty.
  • · MRSC (post January 1999) also did not consider its income on sale of MS products as taxable in India. However, the Tax Authority assessed entire payments as royalty income.
  • · Furthermore, the Tax Authority, disregarding MO and MRSC entities, considered that all the transactions between the entities involved in the distribution channel had been designed to reduce the quantum of taxable royalty and held G Corp as taxable in respect of the entire payments made by end user in respect of grant of licence to copy the software program.
  • · Under the ITL, royalty is deemed to accrue or arise in India if payable by a resident. Furthermore, royalty payable by a non-resident is also deemed to accrue or arise in India if it is utilized for the purpose of a business in India or for earning income from a source in India. Furthermore, royalty is defined, in a wide manner, to mean consideration for the transfer of all or any rights (including the granting of a license) or use of any copyright, literary, artistic or scientific work, patent, invention, model, design, secret formula or process or trade mark or similar property. The Tax Treaty also has a comparable definition of royalty and contains source rule for taxing royalty. Under the primary rule, royalty generally arises in the state where the payor is resident. However, if the state where royalty arises is neither in the US nor in India under the primary rule, royalty is deemed to arise under the secondary rule in the place where the intangible property is utilized.
  • · The issue was whether the use of or the right to use (including the granting of license), in respect of computer program, amounts to royalty or business profits (sale of copyrighted articles) and, if royalty, whether the payment to G Corp arises in India.

ITAT decision

Copyrighted article versus copyright

  • · Copyrighted article is neither defined in the ITL nor in the Tax Treaty. Copyrighted article is one in which copyright subsists. The expression ‘copyrighted article’ finds its origin in the US regulations and then found its way into the OECD commentary. The OECD commentary can, at best, be considered as the views of its authors. Also, India has expressed reservation on this aspect. Therefore, the OECD commentary or the US regulations would not be a safe or acceptable guide or aid for interpretation of the ITL or tax treaty provisions.
  • · Copies made from master copies of MS software cannot be used by end users without obtaining an activation code, which is given on signing of the agreement known as EULA with MS Corp. Therefore, it cannot be said that the consideration received was in respect of MS software recorded on CD.
  • · A licence is an authorization of an act which, without such authorization, would be an infringement. In the case of a licence, the licencee gets the authorisation to exercise a particular right, subject to the conditions of the licence, but does not become the owner of that right. The various terms and conditions in the EULA provide that the software is licenced and not sold. The end user is not simply using the CD but the program contained in the CD, which is protected by copyright and the right to copy the program has to be exercised before it can be put to use. Therefore, the payments made by the end users are for the licence granted in the copyright and other IPRs in the product and will amount to royalty under the ITL and the Tax Treaty.
  • · There is no ambiguity in the definition of term royalty as provided in the ITL or Tax Treaty. Therefore, there is no need for importing the expression ‘copyrighted article’ from OECD commentary or US regulations for the purpose of interpretation of the term ‘royalty’. Hence, for the purposes of income tax, a copyrighted article cannot be treated as a product. References to certain case laws in the context of sales tax laws on goods are, therefore, not relevant.

Definition of copyright in the Indian Copyright Act (IC Act)

  • · The expression ‘exclusive right’ used in the IC Act refers to the rights of an author/creator and not the nature of right given by him to some party to reproduce the copyrighted work or sell the computer program etc. Even a non-exclusive right given by the owner to a person to do one or more acts has copyright in respect of the property. Even grant of one such right in respect of a copyright or work would amount to transfer or use of the copyright.
  • · Reference to the IC Act has to be made for the limited purpose of finding out the meaning of the word ‘copyright’ and that too only because the term ‘copyright’ is not defined in the ITL or the Tax Treaty.

Relevant clause characterization as royalty

  • · Software can fall within one or more categories of a literary work, patent, invention etc., within the definition of royalty.
  • · ‘Computer program’ is defined to mean set of instructions expressed in words, codes, schemes etc., capable of causing a computer to perform or achieve a particular task. There are various stages in developing a software, like preparation of specification, source coding and object coding. Authorship of both the source code and the object code are protected by the IC Act as a literary work. Furthermore, as per the IC Act, literary work includes computer program. Thus, computer program is a literary work and consequently covered within the ambit of the meaning of royalty as provided under the ITL.
  • · The definition of royalty under the ITL and the Tax Treaty covers both industrial as well as copyright royalty. Restricting the meaning of computer program only as copyright, by reason of fact that it is been provided protection under the IC Act, would be inappropriate. EULA also contains reference that the product is protected by copyright and other IPR5. There can be overlap between copyright and patent. Furthermore, in the US, MS software is protected both by copyright and patent laws.
  • · Computer program is a passive collection of instructions; a process is the actual execution of those instructions. The ITAT relied on various decisions wherein, a series of steps, in order to obtain a result was regarded as a process and also held computer program as also a process when it executed instructions lying in it in a passive state. Therefore, any consideration made for the use of process would amount to royalty.
  • · Therefore, it is clear that copyright subsists in computer program. It is a literary as also a scientific work. The computer program is also a patent, invention or process.

Treaty override and taxation of payments

  • · Even if one were to consider that there is a difference between the definition of royalty in the ITL and the Tax Treaty and that the definition in the latter is narrower, the binding nature of a tax treaty is not without exceptions. The later domestic tax legislation may override tax treaty provisions whenever there is an irreconcilable conflict.
  • · Sovereign power of the Parliament extends not only to the making but also the breaking of a treaty. Unilateral cancellation of a tax treaty through an amendment to the internal law, subsequent to conclusion of the tax treaty, is a recognized sovereign power. If, after the treaty has come into force, an Act of Parliament is passed which contains a contrary provision, the scope and effect of the legislation cannot be curtailed by the reference to the treaty.
  • · The ITL was amended retrospectively to provide that royalty will be deemed to accrue or arise in India irrespective of the fact whether the nonresident has a residence or a place of business or business connection in India or the nonresident has rendered services in India. Therefore, by way of this amendment in the ITL, income by way of royalty will be deemed to accrue or arise irrespective of the contrary provision in the Tax Treaty.
  • · The contention of Tax Authority that MO and G Corp are legal fagade cannot be accepted as they were incorporated under the respective jurisdictions and have been issued residency certificates from the respective jurisdictions.
  • · Payments received by MS Corp from end users through distributors, in respect of sale of MS software, are taxable as royalty (for payments before January 1999).
  • · In respect of payments after January 1999, the agreements entered into between the group companies have been drafted in such a way so as to give an impression that G Corp has no connection with the granting of licence. But, when the real intention is gathered from the in-depth reading of the agreements, payments made in respect of copyright in MS software are taxable as royalty in the hands of G Corp.
  • · The payments received by G Corp are for use of right in India and, therefore, arise in India. Accordingly, G Corp is taxable in India on the payments received from MO.
  • · However, MRSC cannot be taxed again on the same income, by way of royalty, for exploitation of the same rights which had been taxed in the hands of G Corp, as it would result in double taxation. Therefore, the addition in the hands of MRSC is deleted.


The computer software industry in India has labored with uncertainty in the most fundamental tax issue i.e. the character of the revenue a software company derives from its ordinary business transactions. The discussion, principally, has focused on characterizing transactions as generating either ‘royalty’ or ‘sales’ income. The characterization as ‘royalty’ or ‘sales’ income can have obvious consequences. Income characterized as ‘royalty’ would generally attract withholding tax, whereas any income characterized as ‘sales’ income or ‘business profits’ generally would not be subject to domestic tax in the absence of a PE. Most of the recent case laws in India, having regard to the nature and extent of rights granted in a typical software transaction involving an end user or a distributor, have characterized the same as generating ‘business profits’.

This ruling deviates from the principles emerging from earlier rulings and has given a wide interpretation to the expression ‘royalty’, so as to cover software payments in the various limbs of the definition. This ruling also significantly differs from many other rulings when it states that reliance cannot be placed on the OECD commentary in interpreting a tax treaty and that a later provision in domestic tax law would override the tax treaty provisions.

Taxpayers would need to review the implications arising from this ruling on their cross-border software  transactions.

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Category : Income Tax (25512)
Type : Judiciary (10261)
Tags : ITAT Judgments (4617)

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