The Delhi High Court recently ruled that payment for the supply of software cannot be regarded as a royalty.
Ericsson Radio Systems AB is a company incorporated and tax resident in Sweden. Its activities involve the supply of hardware and software, as well as their installation, commissioning and after-sale services. It entered into three agreements with various cellular operators - an overall agreement, a supply agreement and an installation agreement. The assessing officer contended that the assessee's income arising from the supply of software to the cellular operators under licence was to be taxed as a royalty, under the Income Tax Act 1961.
The Delhi High Court held that the assessee did not have a business connection in India and that the supply of equipment was in the nature of supply of goods. The software was loaded on the hardware and had no independent existence. The software supply was an integral part of the Global System for Mobile Communications (GSM) mobile telephone system and was used by the cellular operator to provide cellular services to its customers. Such software could not be used independently, but merely facilitated the functioning of the equipment and was an integral part thereof.
The court also relied on the Supreme Court decision in Tata Consultancy Services v State of Andhra Pradesh,(1) in which the Supreme Court held that software incorporated on a medium will be classed as goods and will therefore be liable to sales tax. Since the assessee had supplied the software on a compact disc, it had supplied tangible property and the payment made by the cellular operator for acquiring such property could not be regarded as payment of a royalty. In order to treat the consideration paid by the cellular operator as a royalty, it must be established that the cellular operator, by making such payment, obtained all or any of the copyright rights to such work, which was not established in this case. Furthermore, a distinction must be made between the acquisition of a 'copyright right' and a 'copyrighted article', based on the Organisation for Economic Cooperation and Development Model Convention commentary, as well as the ruling of the Authority for Advance Rulings in Dassault Systems KK.(2)
In light of the above, the Delhi High Court held that:
"[the] payment received by the Assessee was towards the title and GSM system of which software was an inseparable parts incapable of independent use and it was a contract for supply of goods. Therefore, no part of the payment therefore can be classified as payment towards royalty".(3)
Whether software payments are taxable as a royalty has become one of the most controversial issues for software companies in India, due to the contradictory views adopted in different Income Tax Appellate Tribunal and high court decisions.
Recently the Karnataka High Court, in Samsung Electronics and Co Ltd,(4) held that the amount paid to a non-resident supplier would constitute a royalty under the Double Taxation Avoidance Agreement and under Section 9(1)(vi) of the IT Act, as the copyright was in fact transferred, including the right to make copies of software (though only for internal business purposes).
Evaluating the same issue, the Delhi High Court in this case held that in order for software payments to qualify as a royalty, it must be established that there has been a transfer of all or any rights (including the granting of any licence) in respect of copyright in a literary, artistic or scientific work.
The effect of software payments being treated as royalty is that the taxpayer will be treated as an 'assessee in default' for failure to deduct tax at source at the time of making the payment to the recipient, followed by the disallowance of the entire expenditure, as appropriate taxes will not have been withheld.
The payment should not be treated as a royalty if the transaction is structured so that the recipient of the software does not have the right to:
- make copies of the software for distribution to the public;
- prepare derivative computer programs based on the copyrighted program;
- make a public performance of the computer program; or
- publicly display the computer program.
For further information on this topic please contact Ranjeet Mahtani at Economic Laws Practice by telephone (+91 22 6636 7000), fax (+91 22 6636 7172) or email ([email protected]).
Endnotes
(2) [2010] (322) ITR 125 (AAR).