Increasingly over the last few years, it has been noticed that Indian companies are acquiring software licences/products from international companies for their business requirements.
The software licences could typically be off the shelf (commonly known as shrink wrap software) or customized software. Taxability of software payments would generally depend on the nature of rights the transferee acquires under a particular agreement regarding the use and exploitation of the software/programme. However, in the Indian context, the taxability of revenue streams earned by international companies has been a subject matter of much debate and litigation.
Recently, the Airports Authority of India (AAI), a public sector undertaking, approached the Authority of Advance Ruling (AAR) on the tax liability of a US company with which it had entered into contracts for transferring and delivering Surveillance Situation Display Data (S-SDD) which included provision of software documentation, software, hardware, installation, testing, training, etc.
Illustration: Malay Karmakar / Mint
AAI had entered into two separate contracts for procuring S-SDD on behalf of the Indian Air Force, which included provision of software documentation, software, hardware, installation, testing, training, etc. The consideration was bifurcated into three parts, namely, hardware, software and installation. Software, which formed almost 90% of the consideration, consisted of customized software.
AAI had contended before AAR that the US company would transfer the title and the risk in the property consisting of hardware, software and documentation outside India, except for some support activities relating to installation, site inspection, testing and training, which would be rendered in India. As regards the software, the US company had granted licence to AAI on a non-transferable and non-exclusive basis.
In particular, the following rights in the software would not be granted to AAI: making copies for distribution to the public by way of sale; the right to prepare derivative computer programs; and the right to make public performance/display of computer programs.
AAR observed that the sale proceeds for hardware were in the nature of business income. Since hardware constituted a small portion of the contract, the number of days devoted by the US company personnel in India for the installation of hardware would be much less and, therefore, the existence of a permanent establishment under Article 5 of the double taxation avoidance treaty or DTAA vis-à-vis hardware supply was ruled out. In the absence of a permanent establishment, income arising from sale of hardware was not liable to tax in India.
On sale of software
After analysing the provisions of the contract between the US company and AAI, AAR held that the US company had not transferred ownership in the documents and software supplied, but had merely given the right to use them, for the purpose and in the manner provided in the contract.
Further, AAR held that AAI was given non-exclusive right of use and no right of sale, public distribution and circulation of the computer program delivered to it.
AAR also observed that the licence to use software is not “royalty-free” and that the contract price is inclusive of consideration for royalty. Accordingly, the payment for software would constitute “royalty” under the provisions of the Income-tax Act and the tax treaty.
AAR based its reasoning on the grounds that income related to the supply of documents and software under the present contract answers the description of royalty, as the said documents and software in question are copyrights which have been given to the applicant for use. Besides, licence has also been granted to the applicant.
AAR held that the Supreme Court’s decisions in the case of Tata Consultancy Services Ltd was not applicable to the facts of the present case since, inter alia, the legislative scheme of sales tax law and income-tax law are very different from the present case, and there is no provision on royalty under the sales tax law.
On provision of testing
Since payments made in respect of supply of software would be royalty income, the services rendered in connection with installation, testing and training in relation to the supply of software would be “technical” in nature and also ancillary and subsidiary to the enjoyment of copyright in the software, and hence would constitute “fees for technical services” under the domestic tax law and “fees for included services” under the provisions of tax treaty.
Right vs article
One of the key arguments advanced by the applicant on non-taxability of software revenues was that the right obtained by AAI was not in the nature of a copyright; it was that of “copyrighted article”. Commonly, if a person acquires a copy of a computer program, but does not acquire the right to make copies of the program for purposes of distribution to the public by sale or other transfer of ownership, or the right to prepare derivative computer programs based on the copyrighted computer program, etc., the transfer should normally be classified solely as a transfer of a copyrighted article.
A copyrighted article includes a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device. As an example, a typical retail sale of a shrink wrap program or book generally will be considered a “copyrighted article”.
Various judicial precedents in India have held that payments made for a copyrighted article do not qualify as royalties and in the absence of a permanent establishment in India, such payments are not subject to tax in India.
In fact, in the special bench decision in the case of telecommunication companies Ericsson, Motorola and Nokia, the special bench of the Delhi tribunal, in a very detailed decision dated 22 June 2005, clearly brought out the distinction between the copyright right and copyrighted article and held that the payment made by cellphone operators to telecommunication companies was not royalty but business income.
In that case also, the software was in the form of non-transferable, non-exclusive perpetual licence and the software was equipment-specific. The fact that the hardware and software components were segregated for customs duty purposes was also considered not relevant in determining the true characterization of the software, i.e., such licensing was equivalent to sale.
It appears that AAR was influenced primarily by the fact that it was a customized software and that the applicant did not have any right in the software except that it could use it for operation, repair and maintenance of the automated system. Strangely, there is no reference to the special bench decision in the AAR ruling; and it also appears that the AAR ruling has not considered the favourable judicial precedents in this regard. In any case, the AAR ruling seems to be distinguishable on facts.
Though the rulings passed by AAR are only binding on the particular set of facts and the applicant of the ruling, they do have a persuasive value.
Hence, though this ruling passed by AAR is not binding on other taxpayers, it could result in ambiguity for persons making payments for acquiring software licences for the position they need to adopt for withholding tax purpose, in view of the onerous consequences for withholding tax defaults such as interest, penalties and disallowance of expenditure.
In summary, it appears that the ruling passed by AAR should not apply with respect to transaction involving “copyrighted article”; the facts of each case would need to be examined to ascertain the taxability of the software payment.
Ketan Dalal is executive director and Manish Desai is associate director, PricewaterhouseCoopers.
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