Introduction
The government in this year’s budget introduced proposals to change the income tax on royalty. These proposals negated the effect of the Supreme Court of India’s (“SC”) decision in the case of GE India Technology Centre Private Limited v. Commissioner of Income Tax (“GE Case”).1 The SC decision overruled the government’s position on which payments for software are made as royalty payments, which as per the government are all software sales, and therefore subject to income tax and withholding tax2 as per the Income Tax Act, 1961 (“ITA”). The budget changes are retrospective in nature, being effective from April 1, 1976, and introduced to counter the SC’s ruling. In this bulletin, we shall discuss the amendments, their genesis and impact.
1.0 Section 9 of ITA and the amendment
The underlying principle of section 9 of ITA is that any income due to any activity in India is deemed to accrue in India and hence taxable in India. Previously, income tax authorities relied on section 9(1)(vi) (deeming provision for royalty income) of the ITA read with Explanation 2 (iva)3 to demand payment of withholding tax upon royalty on international purchases of software. The SC decision in the GE case overruled this practice. The judgment identified that software purchases were liable to income tax on royalty, and withholding tax, only when such sales were chargeable to income tax. SC determined that only royalty paid to obtain copyright was chargeable to income tax, and in distinction sales of an object containing copyright were not payments for royalty. One of the bases for determining royalty on copyright was the rights that accrued to the purchaser. If the copyright and royalty therefore, merely enabled the use of the copyright article, rather than use of the subject of copyright, the sale was termed as one of a copyright article. On the other hand, if the purchase entitled the user to either reproduce or gain ownership in the copyright, and royalty was paid, the purchase was chargeable to income tax as per the provisions of ITA. Thus, the court identified the payment as being for copyright or not based upon the ultimate use of the article, and also distinguished items which were termed as “copyrighted object”. The interpretation of the SC implied that payment made for use of software when there was no purchase of copyright in the software would not be termed as royalty payments.
The government sought to counter the adverse rulings against the Income Tax Department (“ITD”) by the inclusion of the following explanations into the ITA through Finance Act, 2012.
“Explanation 4.—For the removal of doubts, it is hereby clarified that the transfer of all or any rights in respect of any right, property or information includes and has always included transfer of all or any right for use or right to use a computer software (including granting of a licence) irrespective of the medium through which such right is transferred.
Explanation 5.—For the removal of doubts, it is hereby clarified that the royalty includes and has always included consideration in respect of any right, property or information, whether or not —
- the possession or control of such right, property or information is with the payer;
- such right, property or information is used directly by the payer;
- the location of such right, property or information is in India.
Explanation 6.—For the removal of doubts, it is hereby clarified that the expression “process” includes and shall be deemed to have always included transmission by satellite (including up-linking, amplification, conversion for down-linking of any signal), cable, optic fibre or by any other similar technology, whether or not such process is secret;”
2.0 Overruled Court Decisions
The budget amendments to the ITA attempt to overrule the principles of law set forth by the SC in the GE Case decision and followed by the high courts in several decisions, namely, Tata Consultancy Service v State of Andhra Pradesh4 and Motorola Inc. and Ors v Deputy CIT5. These decisions established the following principles for assessment of royalty upon software sales:
- Software was of three basic types, (i) canned software or shrink wrapped software,
(ii) customized software and (iii) embedded software,
- Software can either be a “copyrighted object” or have distinct “copyright”; income tax on royalty was only chargeable on royalty paid for copyright and not on a copyrighted object,
- Canned or shrink wrapped software is treated as goods and hence as a “copyrighted object”. Similarly even software embedded in hardware is a “copyrighted object”. Accordingly, the copyright royalty paid on either of these types of software would not be chargeable to income tax. However, sale of customized software has a distinct copyright, royalty payment therefore and transfer of copyright to the purchaser. Therefore, customized software is chargeable to income tax for the royalty therein, and subject to withholding tax on all payments.
Several high courts relied upon these principles and refuted the ITD’s contentions.6 The primary ground undertaken by ITD was that the sale of software led to the payment of royalty which was chargeable to tax under Section 9(1)(vi) of the ITA. Therefore the remittance to the foreign seller was liable to deduction of withholding tax as per ITA. The aforementioned decisions of the SC nullified this stand and established that tax was
chargeable only in instances where the “copyright” in the software was transferred to the end user, like in the case of customized software, photograph, etc., thereby making royalty due to the seller. Mere right to use the software as a utility was not a transfer of copyright and therefore no royalty payments were due. The position of the SC overruled the earlier decision of the Karnataka High Court7 supporting the ITD’s contentions. The SC laid down that, to identify royalty payments for copyright the sale should result in vesting of the copyright in the purchaser in a material manner. If the sale resulted in the purchaser using the copyrighted object rather than the subject matter of the copyright, no royalty was deemed to be paid by the purchaser in such transactions.
3.0 Modified position and Impact
The explanations added to Section 9(1)(vi) of the ITA, seek to levy withholding tax on all royalty payments for use of software, including shrink wrapped and embedded software and software embedded in hardware, nullifying the court decisions. The explanations to the definition of “royalty” seek to include transfer of right to use any computer software. This includes the granting of a license, irrespective of the medium through which such right is transferred, targeting the taxation of shrink-wrap or embedded software, and online purchases of downloadable software. The amendment will overrule the current position differentiating between sale of a “copyrighted object” and the license of a copyright, confirming the ITD’s position. This amendment seeks to remove the distinction identified by the SC between goods containing copyright and royalty paid for actual license of copyright.
The amendment is going to have a substantial impact on the use of licensed software as it would render them more expensive for the purchasers, since the seller would increase the royalty fee rather than receiving a lesser amount after payment of withholding tax. It may be a good proposal to garner more revenue by the ITD but could increase the cost of doing business in India.
Authored by: Saurav Bhowmik