Taxability of Software Payments
The tax treatment of cross border software transactions has always been a matter of controversy. One of the major issues has been whether payments for software, where the seller retains all copyright, trademark and other proprietary rights in the software, should be characterized as royalty or as business income. This article addresses the said issue in the light of the definition of ‘royalty’ as per domestic law and as per DTAA (India – USA) and by making reference to some relevant case-laws. The author makes a pointer to the fact that though a Special Task Force was set up to examine the issues of taxation of software, no clarification has been issued by the CBDT so far. He, therefore, opines that it is high time that the CBDT/Finance Act should come up with a clarification/ amendment so as to address the confusion and litigation which is prevailing on the taxability of software payments.
1. The tax treatment of cross-border software transactions has always been a matter of controversy. One of the major issues has been whether payments for software, where the seller retains all copyright, trademark and other proprietary rights in the software, should be characterized as ‘royalty’ or ‘business’ income.
Section 9 of the Income-tax Act, 1961 defines royalty and fees for technical services as having deemed source in India. Such income is taxed under section 115A of the Act at a flat rate of 10 per cent on gross amount of receipt subject to reduced (prescribed) rate under appropriate DTAA.
In case of business income, the same is subject to tax in India only if there is sufficient business connection in India. If there happens to be in existence a comprehensive DTAA and there is a PE, the business income would be subject to tax.
Position under dom-estic law – Meaning of ‘royalty’
2. Explanation 2 to section 9(1)(vi) defines royalty as under:
“consideration (including lump sum payment but excluding any consideration which would be the income of the recipient chargeable under the head ‘capital gains’) for—
i. The transfer of all or any rights (including the granting of a license) in respect of a patent, invention, model, design, secret formula or process or trademark or similar property;
ii. The imparting of any information concerning the working of or use of a patent, invention, model, design, secret formula or process or trademark or similar property;
iii. The use of any patent, invention, model, design, secret formula or process or trademark or similar property;
iv. The imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill;
(a) The use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB;
v. The transfer of all or any rights (including the granting of a license) in respect of any copyright, literary, artistic or scientific work including films or video tapes for the use in connection with television or tapes for the use in connection with radio broadcasting, but not including consideration for sale, distribution or exhibition of cinematographic films; or
vi. Rendering of any services in connection with activities referred to in sub-clauses (i) to (v).”
At the outset, it may be observed that the term ‘royalty’ means a consideration for ……..the transfer of any right in respect of the copyright, literary, artistic or scientific work or in respect of the patent, invention, model, design, secret formula or process or trademark or similar property. Even a consideration for the use of the patent, invention, model, design, secret formula or process or trademark or similar property could be regarded as royalty. Therefore, unless there is a transfer of any right or the use of the right in patent, invention, model, design, secret formula or process or trademark or similar property, it cannot be regarded as royalty. It is evident that where the consideration paid is for the purchase of a product and not for the transfer of an intellectual property per se, it cannot be regarded as a royalty. A closer look at sub-clauses (i) to (vi) of the definition of the term ‘royalty’ under section 9 would show that the word ‘copyright’ is not used in sub-clauses (i) to (iv), but is specifically dealt with in sub-clause (v) of the said section. Accordingly, sub-clauses (i) to (iv) and (iva) and (vi) should not be relevant and it cannot be construed that term ‘copyright’ is included in the words ‘similar property’ in clauses (i) to (iv). This position has been upheld by the Tribunal in Lotus Development (Asia Pacific) P. Ltd. v. DDIT, Samsung Electronics Co. Ltd. v. ITO (TDS), Lucent Technologies Hindustan Ltd. v. ITO. Therefore, copyright cannot be construed to have been included in the words ‘similar property’ in sub-clauses (i) to (iv). For example, the purchase of a book by a customer does not tantamount to the purchase of the copyright in the book, even though the publisher publishes the book by purchasing the copyright.
Thus, the most important aspect of this definition is the use of the words ‘consideration for …’. This clearly implies that the purpose for which the consideration is paid is of paramount importance for the interpretation of the expression ‘royalty’. The Indian courts have emphasized that where the predominant transaction is the sale of the product and use of intellectual property is incidental to the sale of the product, the same cannot be regarded as royalty. Now let us examine what would be the nature of transaction when right given in an intellectual property is only incidental to the primary transaction. In this regard, the Madras High Court in CIT v. Neyveli Lignite Corpn. Ltd. has observed that :
“In a contract for the design, manufacture, supply, erection and commissioning of machinery which does not involve license of the patent concerning the machinery, or copyright of its design, mere supply of drawings before the manufacture is commenced to ensure that the buyer’s requirements are fully taken care of and the supply of diagram and other details to enable the buyer to operate the machines, and also to assure the buyer, that the machines will perform to the specification required by the buyer, such supply is only incidental to the performances of the total contract which includes design, manufacture and supply of the machinery.
The price paid by the assessee to the supplier is a total contract price which covers all the stages involved in the supply of machinery from the stage of design to the stage of commissioning. The design supplied is not to enable the assessee to commence the manufacture of the machinery itself with the aid of such design. The limited purpose of the design and drawings is only to secure the consent of the assessee for the manner in which the machine is to be designed and manufactured, as it was meant to meet the special design requirements of the buyer.”
One can observe from the above that the term ‘royalty’ normally connotes the payment made to a person who has exclusive right over a thing for allowing another to make use of that thing which may be either physical or intellectual property or thing. The exclusivity of the right in relation to the thing for which royalty is paid should be with the grantor of that right. Mere passing of information concerning the design of a machine which is tailor-made to meet the requirement of a buyer does not by itself amount to transfer of any right of exclusive use, so as to render the payment made, as ‘royalty’. In a case where information concerning the working of the machine is supplied with the machinery, the courts have held that this information would not attract sub-clause (vi) of section 9(1) as the supply of the design was only preliminary to the manufacture and integrally connected therewith.
It can, therefore, be inferred that when the payment is made for the machinery and the supply of design etc., it is only incidental to the sale of machinery. In order to utilize the machine in the best possible way, there is no license of any patent involved and the amount payable would essentially be taxed as business profits in the hands of the recipient.Online GST Certification Course by TaxGuru & MSME- Click here to Join
The Technical Advisory Group of Organization for Economic Co-operation and Development (‘OECD’) has similar position in their specific regulations for the tax treatment of certain transactions involving ‘software’. They emphasized that the main question to be addressed is the identification of the consideration for payment. Where the essential consideration is for something other than use of, or right to use, rights in copyright, and the use of copyright is limited to such rights as are required for downloading, storage and the operation on computer, network or other storage device, such use of copyright should be disregarded in the analysis of the character of payment for treaty purposes. Thus, if the consideration is paid for a right other than a right in the intellectual property, then in that event, the payment made should not be treated as royalty as it is a purchase for the purpose of use of the product.
The principle that emerges on such transactions is ‘where the use of intellectual property is merely incidental to the use of the product and it is put to use merely due to advancement in technology, i.e., like a medium, payment in respect of such product should not be classified as royalty since the consideration is not made for using the intellectual property, but for the use of product. The intellectual property merely passes incidental to use the product.
In short, such payments will not fall under the definition of term ‘royalty’ under section 9 because :
l There is no transfer of any right in respect of the copyright, literary, artistic or scientific work;
l There is no transfer of any right in respect of the patent, invention, model, design, secret formula or process or trademark or similar property;
l There is no ‘use’ of the patent, invention, model, design, secret formula or process or trademark or similar property;
l The consideration is being paid for the use of the product and not for any right in respect of the copyright, or the patent, invention, model, design, secret formula or process or trademark or similar property; (it may also be noted that under the Indian law no assignment of copyright is valid unless it is in writing)
l Lastly, the copy which takes place is only incidental to the use of the product and not for the purpose of acquiring any right in the copyright and, thus, should be ignored for the purpose of characterization.
Definition of royalty as per DTAA (India-USA)
3. As per clause 3 of article 12 of the Double Taxation Avoidance Agreement between India and USA, the term ‘Royalty’ is defined as :
Payments of any kind received as consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work, including cinematograph films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property which are contingent on the productivity, use or disposition thereof, and payments of any kind received as consideration for the use of, or the right to use, any industrial, commercial or scientific equipment, other than payments derived by an enterprise.
It can be seen from above, that the term ‘royalties’ means payment of any kind received as a consideration for the use of, or the right to use any right in any copyright of a literary, artistic or scientific work, including cinematograph films or films or tapes used for radio or television broadcasting, any patent, trademark design or model, plan, secret formula or process, or for information concerning industrial, commercial, or scientific experience, including gains derived from the alienation of any such right, property or information.
The definition applies to payments for the use of/or right to use. It covers payments made under a copyright. Since the payment is for the ‘use’ or ‘right’ to use the asset, a distinction should be made between letting the asset and transferring the same by alienation. Distinction has to be made between ‘copyright’ in the intellectual property of the product and the ‘product’ which is merely a copy of the copyrighted intellectual property. The nature of payment made for transfer of computer software depends on the nature of the right
s acquired by the transferee as regards use and exploitation of the software. There is a clear distinction between acquisition of copyright in the computer software on one hand and the acquisition of software, which incorporates a copy of the copyright program, on the other. The transferee’s right may consist of partial or complete rights in the underlying copyrighted or partial or complete right in a copy of the program.
For instance, where end-user procures software and other digital products (where the end user, is not getting any right for duplication of the software, but instead has been allowed to use the software) and downloads it on to hard disk or other storage media, the fact that the end-user is entitled to keep the copy of the software for archival purpose is only incidental to the use of the software and not for the purpose of acquiring any right in the copyright and, thus, needs to be ignored for the purpose of characterization of payments and such payments would not qualify as ‘royalty’ as defined under the treaty.
The standard clauses of a normal end user license agreement (EULA), which needs to be accepted before downloading/ installing software are as under :
“Limited license clause : You are granted a limited, non-exclusive license to install the Software on one individual computer for your own use provided that such computer does not render the Software accessible to other users through local or Internet networks or other methods. Only the individual that installed the Software, as indicated by the user information provided when installing the Software, will have the license to use the Documents. Use by any other person, company, affiliate, corporation, Limited Liability Company, trust, or other separate legal entity will require a separate license. This includes companies that may be affiliated to you by ownership or otherwise. The license granted herein shall remain in effect perpetually, but shall terminate upon your use of the Software beyond the scope licensed herein or upon your violation of any term or condition hereof. All protections with which Licensor is provided under this EULA shall survive the termination of your license to use the Software.
Proprietary rights clause : Licensor and its suppliers retain all title, ownership, and intellectual property rights in the Software, including but not limited to all supporting documentation, files, marketing material, images, multimedia and applets. The Software is protected by copyright and other intellectual property laws and by international treaties. The Software may include security measures designed to control access and prevent unauthorized copying and use. You agree not to interfere with any such security components. Licensor permits you to download, install, use, or otherwise benefit from the functionality or intellectual property of the Software only in accordance with the terms of this EULA.”
From the above, it is clear that the consideration is being paid for the use of the product and not for any right in respect of the copyright, or the patent, invention, model, design, secret formula or process or trademark or similar property. Such income has to be construed as earned from the activity of sale of the product and cannot be classified as royalty. The consideration paid is for the purpose of the product and does in no manner result in the transfer of a copyright in the product. Hence, it must be classified as ‘Business income’.
4. Reference can be made to some of the favourable judgments :
l In the case of Lotus Development (Asia Pacific) Pte Ltd. v. Deputy Director, it was held that there was no element of royalty in the transaction of sale of ‘shrink wrap’ software by the assessee to its Indian distributors and the gains resulting therefrom were commercial/business profits.
l In the case of Lucent Technologies Hindustan Ltd. v. ITO, the Tribunal has held that payments for import of software do not constitute royalty, if there is no transfer of copyright rights in the software. These payments would be business income of the foreign entity and, thus, be liable to tax in India only if the foreign entity has a permanent establishment or business connection in India.
l In the case of Samsung Electronics Co Ltd. v. ITO (TDS), the Tribunal had observed that the rights granted upon acquisition of readymade off the shelf software was not for commercial exploitation of the copyright in the software and transaction was in the nature of purchase of copy of a copyrighted article. It was stated that the incorporeal right to software, i.e. copyright remained with the owner and the same was not transferred to the assessee. Right to use a copyright is totally different from the right to use the programmable embedded cassette or CD or it may be software.
l In case of Sonata Information Technology Ltd. v. ITO, it was held that payment for the procurement of software does not amount to royalty and no withholding provisions are applicable.
l Reference can be made to Rational Software Corpn. (India) Ltd. v. ITO as well as the decision of the Special Bench of the Tribunal in case of Motorola Communication Inc.
But there are instances where it has been held that such payments constitute royalty :
l In Headstart Business Solutions P. Ltd. v. CIT, it was held that the expression ‘any other sum chargeable under the provisions of the Income-tax Act’, brings within its ambit not only the amounts, the whole of which are taxable without deduction, but also amounts of a mixed composition, where only a part of it may be liable to tax, as well as other reimbursements which are in the nature of gross revenue receipts are not liable to tax.
l In IMT Labs (India) Pvt Ltd. v. CIT, it was held that the expression ‘any other sum chargeable under the provisions of this Act’ would mean a sum on which income-tax is leviable. In other words, the said sum is chargeable to tax and could be assessed to tax under the Act. The only consideration would be whether payment of the sum to the non-resident is chargeable to tax under the provisions of the Act. The sum may or may not be income or income hidden or otherwise embedded therein. The scheme of tax deduction at source applies not only to the amount paid, which wholly bears ‘income’ character, but also to gross sums, the whole of which may not be income or profits
of the recipient.
This has resulted in litigation and spiralling impact of the cost of procurement of software, where the contracts were entered without factoring the tax cost.
Conclusion and way forward
5. Though a Special Task Force was set up to examine the issues of taxation of software, no clarification has been issued by the CBDT. This issue finds a place in almost all the Pre-Budget Memorandum’s submitted to Finance Ministry during Budget Season.
Excerpts from Pre-Budget Memorandum-2008 on Direct Taxes submitted by Institute of Chartered Accountants of India (ICAI) are also enclosed for reference :
“Taxability of software payments made to non-residents :
An amendment may be made to provide that license payments made for use of software for the payer’s own operations (as against duplication for onward sale/license) being payments for use of a copyrighted article are outside the ambit of the definition of ‘royalty’ as provided in section 9(i)(vi).”
It is high time that the CBDT/Finance Act should come up with a clarification/ amendment so as to address the confusion and litigation which is prevailing on the taxability of software payments.