A issue of some significance in international taxation is the distinction required to be made by the taxing authorities as to the character of income derived from “shrink-wrapped” software, i.e., whether it is income from the license of a copyright itself or is income from a copyrighted article. This in turn leads to the interrelated question of whether related receipts constitute “royalty income” or “trade or business income”.
The distinction is critical of course since royalties are generally subject to flat rate tax and withholding from the source country (or no source taxation under applicable treaty) whereas business income can be taxed on a net basis in the jurisdiction in which the foreign company maintains a permanent establishment.
A recent article on this issue authored by S. P. Singh and Sharad Goyal which was published in the Journal of International Taxation, April 2010, briefly addressed the treatment given under the Indian domestic tax law and tax treaties, i.e., a royalty is taxed irrespective of whether the foreign company has any presence in India. Business income, in comparison, is only taxed under Indian tax treaty it is reported only if there is a permanent establishment in India. In contrast, business income is taxable in the hands of a foreign company only if it has a permanent establishment in India.
Messrs. Singh and Goyal report that Indian revenue authorities have consistently taken the position that payments from the sale of software, regardless of whether it is over the counter type shrink-wrapped software or customized software, are both royalty income. While neither the Supreme Court of India nor an appellate court has not addressed this issue, the Indian Tax Appellate Tribunal (ITAT) has held that the payments amount to business income and not royalties. This decision was reached in Infrasoft Limited, where the ITAT (Delhi Bench) held that the amount received by a nonresident under a license agreement for allowing the use of standard software was not a "royalty" under either the Indian Income Tax Act, 1961 (ITA) or the India-U.S. income tax treaty . Infrasoft Limited v. ADIT, Order of the Delhi Bench of ITAT, 2009-TIOL-21-ITAT-DEL (2009). As pointed out by the authors, the position taken by the Indian revenue authorities is not entirely consistent with the approach taken in other jurisdictions.
Shrink-wrapped computer software is usually sold under a licensing agreement whereby the buyer is granted limited right to use the program for business or personal purposes. The copyright or patent remains owned by the seller/manufacturer of the material. The buyer is precluded from transferring or altering the program. If all rights with respect to the copyright are not transferred to the buyer, the issue is whether the transaction is taxable as royalty income for the use of the copyright or involves the purchase of copyrighted material taxable as business income. The Model Treaties, i.e., OECD Model and U.N. Model, treat the taxation of royalties differently. Under the OECD model, the country of residence alone has the right to tax royalty income whereas the U.N. Model permits taxation in the source country as well. With respect to “software”, the starting point is to determine if the transaction involved is in fact a software transaction as well as how the transfer of the intellectual property is made. Transactions in intangibles are usually either transfers of full ownership or limited transfers of rights. Transfers of full ownership are taxable as "business income," as the payment is not consideration for “the use of, or the right to use” the property. If the payment is for partial rights in the copyright, it will be considered a royalty. This approach is applicable as well with respect to transactions in software. See Article 12 (Royalties) of the 2008 OECD Model. Again, where only part of the rights in the copyrighted software material is transferred, the transaction is generally treated as a royalty. Compare Article 7 (Business Profits).
The authors point out that one of the problem areas involves the taxation of software distributors who are generally granted the right to copy the material and re-sell the copyrighted material in certain locations. Does this right to copy convert royalty income into business income? Presumably receipts from such reproduction and sale constitutes business income to the software distributor. But there are countries such as Canada, Spain, Korea, Portugal and Mexico that are reported to disagree with this approach and treat such receipts as royalty income and impose a concomitant withholding obligation. The approach in the OECD commentary, however, is not acceptable to some tax jurisdictions, including Canada, Spain, Greece, Korea, Portugal, and Mexico, which impose withholding tax on royalty income. For U.S. income tax treatment of copyrighted materials see Treas. Reg. §1.861-18.