Case Law Details
Case Name : M/s Dassault Systems K.K, In re. (Authority for Advance Rulings)
Appeal Number : A.A.R. No. 821/2009
Date of Judgement/Order :
Related Assessment Year :
Authority for advance ruling recently held that payments received by the Applicant from its Indian reseller for supply of software products to end users should not be classified as royalty. The AAR further held that the relationship between the Applicant and the re seller does not create a permanent establishment (PE) for the Applicant under the agency rule. Hence, the payment should not be taxed in India under the provisions of the India-Japan Tax Treaty (Treaty).
Background and facts of the case
- The Applicant, a company incorporated in Japan, is engaged in the business of providing software solutions, applications and services. The software product dealt with by the Applicant is a standardised but special purpose software. It is neither customised nor is it available off the shelf.
- The Applicant markets its software products in India through a distribution channel comprising value added re sellers (VAR). The VAR are unrelated third parties who are in the business of selling software to end users on a non-exclusive basis.
- The software product is sold to the VAR for a consideration, based on the standard list price, less discount agreed with the VAR. The VAR in turn sells this software product to the end user at a price independently determined by the VAR. The credit control and risk in relation to the end user lies solely with the VAR.
- The VAR gets a purchase order ( from the end user and places a back-to-back order with the Applicant. The end user enters into a tripartite End User License Agreement (EULA) with the Applicant and the VAR for the software product ordered. The Applicant is not duty bound to accept the purchase order placed by the VAR. If and when the purchase order is accepted, the Applicant provides a licence key via e-mail and a download link directly to the end user. Thereafter, the Applicant invoices the VAR for the software product supplied.
Issue for consideration:- Whether payments received by the Applicant from the sale of software products to the VAR would be treated as business profits under Article 7 of the Treaty or classified as royalty under Article 12 of the Treaty. The Treaty provides for a 10% withholding tax on royalty while business profits may be taxed only if the Applicant has a PE to which the profits are attributable.
Contentions of the Applicant
- The arrangement is in the nature of purchase of copyrighted products by the VAR from the Applicant for resale to the end user and such sale and purchase is on a principal-to-principal basis. The Applicant does not have a presence in India, either through employees or in the form of an office or place of business, so as to constitute a PE of the Applicant in India.
- The transaction with the end user is transfer of a copyrighted software product containing a computer program and not the copyright in such a software. The copyright continues to be vested in its entirety with the Applicant and none of the rights therein are made available to the end user. All that is transferred is a limited right to use a copyrighted product.
- Neither the end user nor the VAR has any rights associated with the copyright of the software product, which would enable commercial exploitation of the software. Therefore, the consideration received by the Applicant from the VAR is not in the nature of royalty under the Indian Tax Law (ITL) or the Treaty. The income representing the payments can be treated as business profits but in view of the fact that the Applicant has no PE, as defined under Article 5 of the Treaty, it cannot be taxed in India.
- The VAR cannot be treated as a dependent agent of the Applicant as it is a distinct entity, unrelated to the Applicant, evidencing legal independence and it solely bears the economic risk associated with the sale of its software products to the end user. Further, neither does the VAR conclude contracts on behalf of the Applicant nor does it secure orders, wholly or almost wholly for the Applicant.
Contentions of the Tax Authority
- Whether considered from the ITL or the Treaty perspective, the license fee paid by the end user in India is for the transfer of rights in respect of copyright in software or for the use of the computer program embedded in it
- The question of whether there is transfer of any rights in the copyright has to be determined with reference to the provisions of the ITL and the Treaty and not under the Indian Copyright Act, 1957 (ICA), except to find out the meaning of the term ‘copyright’. The ITL maintains a distinction between royalty arising in respect of ‘copyright in a book’ and ‘computer software’. The term ‘copyrighted article’ may aptly be used for a book or music compact disc but it is a misnomer in the case of a computer program or software, where one or more rights in the copyright have to be necessarily transferred to make it workable.
- Also, a distinction has been maintained in the ICA between copyright in a literary work like a book and computer software and a separate section has been enacted for ‘computer program’. The right to sell is also recognized as part of the copyright in relation to the computer program and as the VAR is given such a right, a copyright, as per the ICA, has been granted to the VAR.
- The payment is for obtaining a right to copy the computer program on to the hard disk and use it and, therefore, falls within the scope of the copyright provisions in the ICA. The Applicant’s claim that the transaction is in the nature of purchase of intangible products by the VAR and resale to the end user goes contrary to the stipulation in the EULA that the software product is licensed and not sold.
- Reliance on the Commentary on Organisation for Economic Co-operation and Development Model Tax Convention (OECD Commentary) on Article 12 cannot be placed as the Indian Government has not agreed to the viewpoint expressed in the commentary.
- Additionally, it was argued that the Applicant has granted the rights for the use of process and, therefore, the payment should fall within the definition of royalty for use of process.
- Also, the VAR is a dependent agent of the Applicant as the VAR is acting on behalf of the Applicant for securing customers to whom the Applicant’s software products and services are to be licensed. The discretion given to the VAR to fix the price payable to it by the end user is a dead letter because the standard price details would be available to the public and the said price would not be exceeded. Further, the VAR is obligated to report certain information to the Applicant i.e. forecast reports, sales reports etc. and to maintain records of marketing and sales of software products to end users i.e. identity of end user, end user contract etc. Thus, the VAR is an agent performing functions on behalf of the Applicant and has the authority to conclude the standard form contracts. Hence, the Applicant has an agency PE in India.
Ruling of the AAF
On whether payment is royalty for use of copyright
- The copyright, which is a species of intellectual property rights, belongs to the owner or its assignee, if any. The ownership carries with it a bundle of rights which are, by and large, directed towards commercial exploitation of this intangible property right. These rights are enumerated in the ICA. If any of these rights are parted with in favour of another so that the other person can enjoy that right in the same manner in which the owner can, it can then be said that these specific rights, concerning the use of copyright, have been conferred on him.
- In the instant case, the end user is given neither the authority to do any of the acts contemplated in the ICA nor the exclusive rights to do the said acts. In fact, the restrictions placed on the end user and the VAR, coupled with the non-exclusive and non-transferable character of the licence, are all meant to ensure that none of the rights vesting in the Applicant as copyright holder can be claimed or enjoyed by the end user and that they will remain intact and are preserved.
- The entire tenor of the EULA and the various stipulations contained therein make it clear that no rights in derogation of the Applicant’s exclusive rights in relation to the copyright have been conferred on the end user or the VAR. The core of the transaction is to authorise the end user to have access to and to make use of the licensed software products over which the Applicant has exclusive copyright, without giving any scope for the end user or the VAR to deal with them any further.
- Where the purpose of the licence or the transaction is only to establish access to the copyrighted product for internal business purpose, it would not be legally correct to state that the copyright itself has been transferred to any extent. It does not make any difference even if the computer program passed on to the user is a highly specialised one. The parting of intellectual property rights inherent in and attached to the software product in favour of the licencee/end user is what is contemplated by the definition clause in the ITL as well as the Treaty. Merely authorising or enabling an end user to have the benefit of data or instructions contained therein, without any further right to deal with them independently, does not amount to transfer of rights in relation to copyright or conferment of the right to use the copyright. The provisions of the ICA make it clear that ‘making of copies or adaptation’ of a computer program by the lawful possessor of a copy of such a program will not constitute infringement of the copyright.
- The OECD commentary on Article 12 on this aspect was referred to and the AAR commented that the analysis and reasoning appear to project a sound approach to the issue under consideration.
- Hence, the payment is not royalty for use of copyright, either under the ITL or the Treaty.
On process royalty
- By making use of or having access to the computer programs embedded in the software product, it cannot be said that the end user is using the process that has gone into the end product or that he acquired any rights in relation to the process as such.
- Also, following the series of instructions so as to be able to effectively make use of the computer programs contained in the software product would not amount to the use of process. Usage of process contained in the software product or acquisition of rights in that process is not the real nature and substance of the transaction.
- Hence, it would not be appropriate to examine whether or not the payment for computer software is royalty, under the ‘use of process’ part of the definition of royalty.
On Agency PE
- The business of the VAR is not confined only to the dealings with the Applicant and its products. They are appointed and known as distributors. It is not uncommon that a distributor carries out some functions and obligations similar to those of an agent. Improvement of the Applicant’s business, assisting the Applicant in formulating its marketing strategies and preventing the misuse of the product supplied to end users are all functions that are not extraneous to the distributorship. The business of the VAR is not controlled by the Applicant, except to the extent necessary to promote its own business.
- The VAR does not negotiate or conclude contracts with the end user on behalf of the Applicant. Acceptance of the purchase order placed by the end user and procured by the VAR is left to the discretion of the Applicant. That authority is not delegated to the VAR. The VAR is free to determine its own price while negotiating with the end user on the acceptance of the purchase order by the Applicant. The VAR does not notify or render account to the Applicant for the amount collected from the end user. It is difficult to perceive any predominant features which point to the relationship of principal and agent.
- There is, therefore, no relationship of principal and agent between the Applicant and the VAR, let alone a dependent-agency relationship. Therefore, an agency PE of the Applicant is not constituted in the present fact pattern.
- Appropriate characterisation of payments for purchase of computer software has been a contentious issue in India. The discussion has focused, principally, on characterising transactions as generating either ‘royalty’ or ‘sales’ income. The characterisation as royalty or sales income can have obvious consequences, particularly in light of the fact that income characterised as royalty would generally attract withholding tax whereas income characterised as sales income or business profits generally would not be subject to tax in the absence of a PE. While the Indian Tax Authority has generally taken a position that such payments (even if the rights granted to the end user are limited) should be classified as royalty, a number of cases decided by the Income Tax Appellate Tribunals have ruled in favour of taxpayers and held such payments as being in the nature of business profits.
- This ruling by the AAR further reinforces the position that characterisation of payments for computer software should be determined, having regard to the nature and extent of rights granted to the purchaser and the provisions of copyright law would be relevant for this purpose.
- The ruling also clarifies that a properly established re seller or distributor arrangement should not create an agency PE for the foreign principal.
- The ruling confirms the relevance of the OECD commentary on Article 12 for interpreting India’s tax treaties, even on those aspects of the commentary on which India, as a non member country, has expressed certain reservations.
- A ruling by the AAR is binding only on the Applicant, in respect of transaction in relation to which the ruling is sought and on the Tax Authority, in respect of the Applicant and the said transaction. However, it does have persuasive value and the Courts in India, the Tax Authority and the appellate authorities do recognise the principles and ratio laid down by the AAR, while deciding similar cases. Other taxpayers who would like to achieve certainty on the classification of their software transactions could consider approaching the AAR for a ruling, after evaluating the facts of their respective cases.