AAR clears air on taxing foreign software firms

AAR clears air on taxing foreign software firms

New Delhi: A landmark verdict issued on Monday by a quasi-judicial authority is expected to clear the confusion over how to tax foreign companies selling copyrighted software in India.

The Authority for Advance Rulings, or AAR, said the earnings of Japanese software firm Dassault Systemes KK would be classified as “business income" rather than “royalty".

It also ruled that Dassault Systemes did not have to pay taxes as it didn’t have a permanent establishment in India, but sold its copyrighted software through an intermediary, Tata Technologies Ltd.

A transaction classified as “royalty" can attract tax of up to 10% of the gross amount, according to a tax consultant who did not want to be named.

If the transaction is classified as “business income", a foreign firm can sidestep the tax net if it does not have a permanent establishment in India.

“This is the most comprehensive decision on characterization of income as regards licensing software on a non-exclusive and non-transferable basis," said Mukesh Butani, partner at consultancy BMR Advisors, who represented Dassault Systemes in the hearing at AAR. The implications of the verdict, he said, were far-reaching for the software industry.

“You can interpose this principle on any software which is given on a non-exclusive, non-transferable basis," the lawyer said.

AAR is headed by a retired Supreme Court judge and was set up to settle disputes while assessing the tax due from non-residents.

The body has a six-month deadline to reach a conclusion and its verdict is binding on both the non-resident and the income-tax department.

The only appeal possible against AAR’s verdict is by a special leave petition in the Supreme Court.

A copy of the Monday ruling shows Dassault Systemes told AAR that Tata Technologies, its intermediary, had entered into independent contracts with Indian customers and took its own decisions on pricing. The Japanese firm wanted to know if its income from software sales would be taxed as business profits under the India-Japan tax treaty, or be categorized as royalty and taxed accordingly.

AAR’s verdict drew a fine distinction between copyrights and copyrighted products. From an individual company’s standpoint, once the ground rules on deciding which transactions should be taxed as royalty are laid out, the financial implications are critical.

According to a note prepared by BMR on the Dassault Systemes case, the ruling—along with a ruling in another case—“marks a paradigm shift in the approach of AAR on the issue of taxability of sale proceeds of copyrighted products. Prior to these rulings being pronounced, the AAR had been inclined towards treating the sale proceeds as royalty income".

AAR’s rulings have a “persuasive" value on income tax commissioners and tribunals, the tax consultant quoted earlier said. A series of rulings could have a positive knock-on effect on cross-border trade in software, the consultant added.

New Ground

Greater clarity: The AAR verdict is expected to bring certainty to the business environment related to the sale of copyrighted software to Indian customers.

The ruling: The body ruled that Dassault’s receipts could not be classified as royalty, and said the firm did not have to pay tax on its business income in the absence of a permanent establishment.

Former treatment: Prior to these rulings, AAR had been inclined towards treating sale proceeds as royalty income.

The body: AAR is a quasi-judicial body which was set up to sidestep disputes when assessing the tax liability of non-residents—whether an individual, a firm or an association.