Indian resident persons who purchase software from non-residents under a standalone contract are in effect paying royalty and are liable to withhold tax on the gross purchase amount
The above is the key message for Indian businesses from the recent decision of the Income Tax Appellate Tribunal, Mumbai bench ("ITAT Mumbai") in the matter of DDIT vs. Reliance Infocomm Ltd/Lucent Technologies (Reliance").1 This decision has added another nuance to the debate on the proper characterization of payment for software purchase for income tax purposes. This Hotline discusses Reliance in the context of this debate with the aim of identifying measures that may guide businesses in the way they approach purchase of software going forward (click here to go directly to measures).
The debate is essentially whether payments for software purchase are in the nature of royalty or business income. On one side of the debate are taxpayers, i.e., software companies who argue that in purchasing software, end-users merely receive a copy of the software, that is to say, a copyrighted article and not a right to the copyright in the software. Payments made represent purchase price for the article and are in the nature of business income. Consequently, such payments are not liable to tax in India in the absence of a permanent establishment ("PE") in India.
On the other side of the debate stands the Revenue which argues that such purchases are in effect a licence granted by software companies to end-users. Payments made represent royalty for that licence. Consequently, such payments are liable to tax in India under the provisions of the Income Tax Act, 1961 ("ITA"'), subject to beneficial provisions of tax treaties.
There is a plethora of case law on both viewpoints in Indian law. A summary of the principles emerging from case law are discussed:
Copyrighted Article The starting point for supporters of the 'copyrighted article/business income' viewpoint is the Supreme Court decision in Tata Consultancy Services v. State of AP2 which in 2005 had held that the copyright in a computer programme remains with the originator of the programme, but the moment copies are made and marketed, they become 'goods' qualifying for sales tax. Although this decision was in the context of the sales tax law of the state of Andhra Pradesh, it was relied on by judges in income tax cases such as DIT v Ericsson A.B.3 and Motorola Inc. v. DIT4 to uphold the distinction between 'copyright' and 'copyrighted article' and to deny characterization of payment as royalty.5
This distinction is further bolstered by the approach of the OECD where the character of payments received in transactions involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. The copyright law of most OECD member countries recognizes a distinction between the copyright in the software and the software itself. . With specific reference to embedded software,6 the trend in judicial decisions7 is that supply of hardware with embedded software amounts to purchase of a copyrighted article and does not involve purchase of rights in the software. Further, there should be no splitting up of the transaction to separately tax the payment for software.
Copyright is not defined in most tax treaties concluded by India but royalty is defined. The definition refers to royalty as including "payments of any kind received as consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work,...". With respect to taxation under tax treaties, certain judgments8 have upheld the view that purchase of software amounts to purchase of a copyrighted article. The reason that has been accepted is that a purchase of software as a product, (for e.g. Microsoft Office software which is used by the end users even though it is Microsoft which has the copyright over the software and not end users) is not the same as transferring or assigning rights relating to the copyright in the software itself. To be characterised as royalty, what is required is that there is transfer of some or all the rights which the copyright owner has such as the right to make copies or to adapt the work. Thus, payment for transfer of a non-exclusive and non-transferable licence enabling the use of a copyrighted product could not be construed as royalty.
Copyright Case law in favour of the 'copyright/royalty' viewpoint has relied on the broad definition of royalty under S. 9(1)(vi) (Income deemed to accrue or arise in India) of the ITA9 and the definition of copyright in S. 14 (Meaning of Copyright) of the Indian Copyright Act, 1957 ("ICA").9
Section 9(1)(vi) of the ITA provides that royalty is consideration for transfer of all or any rights (including granting of a licence) in respect of any copyright, literary, artistic or scientific work. A licence in the software allows the licencee the right to use the software though he may not have any copyright in it. Since 'copyright' has not been defined in the ITA, courts refer to the definition contained in S. 14 of the ICA. S.14 provides the owner of the copyright the exclusive right to prevent others from, among others, reproducing the computer program in any material form and storing of it in any medium by electronic means.
S. 52 (Certain acts not to be infringement of copyright) of the ICA provides for certain acts not to be counted as copyright infringement. One such act listed in sub clause (1)(aa) is:
"the making of copies or adaptation of a computer programme by the lawful possessor of a copy of such computer programme, from such copy-
- in order to utilise the computer programme for the purposes for which it was supplied; or
- to make back-up copies purely as a temporary protection against loss, destruction or damage in order only to utilise the computer programme for the purpose for which it was supplied"
It is relevant to note that on purchase of a copyrighted article, the purchaser does not necessarily get a "copyright licence". S.52 grants a statutory right (irrespective of whether there is a "copyright licence") to the lawful possessor of the software to carry out certain acts as mentioned above. For this reason, making a copy for use of the software for the purposes it was supplied for or for backup as permitted under S. 52 is not considered an infringement under the statute.
In CIT v. Samsung Electronics,10 (a case which involved the India-US tax treaty like in Reliance), the Karnataka High Court considered both S. 14 and S.52, ICA. It held that: "... right to make a copy of the software and use it for internal business by making copy of the same and storing the same in the hard disk of the designated computer and taking back up copy would itself amount to copyright work under Section 14(1) of the Act and licence is granted to use the software by making copies, which work, but for the licence granted would have constituted infringement of copyright".11 Further, case law12 supporting this view rejects Tata Consultancy Service as an appropriate precedent on the ground that the legislative scheme of sales tax law and income tax law are very different and the issue of transfer of right to use the goods did not come up for consideration in that case.
Cases on this issue have further held that in the absence of any definition of 'copyright' in the ITA or the tax treaty, reference had to be made to the definition of 'copyright' under domestic law.13 Under the ICA, literary work is entitled to copyright and is defined to include computer programmes, tables and compilations including computer databases. Therefore, purchase of "computer software" should be recognized as a transfer of copyright under the treaty.
Summary of Position On the basis of principles developed by case law, the current state of play may be summarized as below:
- Where the ITA applies/ where the non-resident is from a non-treaty jurisdiction, the Indian payer is under an obligation to withhold tax on payments for purchase of software. This is due to the wide definition of royalty brought under the charge to tax coupled with the narrow exception to it14 in the ITA. Further, a large body of case law rejecting the distinction between copyrighted article and copyright means that there is little scope to establish that the payment is not in the nature of royalty;
- Where the definition of royalty in a tax treaty specifically addresses computer programmes, the same result as above should follow15;
- Where the definition of royalty in a tax treaty does not specifically address computer programmes, there may be scope for the taxpayer to pursue the argument based on 'copyrighted article'. However, there is case law to the contrary, such as Reliance (discussed in more detail below) and the law is unsettled on this issue.
THE DISPUTE IN RELIANCE
Reliance Infocomm Ltd. (now known as Reliance Communications Ltd), an Indian company wanted to establish wireless telecommunications network in India. For this purpose, it entered into the following contracts with certain Indian and US companies of the Lucent group:
- Wireless Software Contract entered into with Lucent Technologies Hindustan Pvt. Ltd. ("Lucent India").for the supply of wireless software;
- Wireless Network General Terms and Conditions contract with Lucent India applicable to the Software Contract and the licensing of software to Reliance Infocomm; and
- Wireless Software Assignment and Assumption agreement with Lucent India and Lucent Technologies GRL LLC ("Lucent USA") for supply of software required to run the wireless network.
The combined effect of the above contracts was that Reliance Infocomm purchased software from Lucent USA and hardware (with which the software was to be later integrated) from Lucent India. There was a software purchase order to match every hardware purchase order. The intellectual property rights in the software vested with Lucent USA and Reliance Infocomm was not permitted to transfer, assign, sub-license such software or modify, decompile, reverse engineer, or disassemble or in any other manner decode the software furnished, as object code. Reliance Infocomm was also not permitted to make copies of the software except for back up purposes16.
Reliance Infocomm applied to the Revenue for a 'no-withholding certificate' in relation to the payments to be made by it to Lucent USA for the software. The application was rejected by the Assessing Officer ("AO") who characterized the payment as royalty. Reliance Infocomm appealed17 to the Commissioner of Income Tax (Appeals) who characterized the payment as purchase price for the sale of copyrighted article. Therefore, in the absence of a PE of Lucent USA in India, this would not be taxable in India. Parallely, the AO re-assessed Lucent USA since it considered that payment received for software was liable to Indian tax as royalty. Lucent applied to the Dispute Resolution Panel who confirmed the AO's order.
The common appellate forum for the Revenue against the CIT(A) order and for Lucent USA against the DRP order was ITAT Mumbai. It clubbed the appeals to decide the common issue which was whether the payment for software licence was royalty under the ITA or the India-US tax treaty and whether there was a consequent obligation on Reliance Infocomm to withhold tax on a gross basis.
THE DECISION IN RELIANCE
ITAT Mumbai held in favour of the Revenue, holding that even where a copyrighted article is sold, the end-user might still end up infringing the intellectual property rights of the vendor but for the fact of the licence. Therefore, payment was properly characterized as royalty.
We discuss below in brief the contentions of each party followed by ITAT Mumbai's response to that contention:
- Hardware and software supplied separately
Reliance Infocomm contended that even though software and hardware were procured separately, they were meant to be integrated for the use of Reliance Infocomm. The Revenue's contention was that even though the hardware and software were to be integrated, the supply of the software was not an integral part of purchase of equipment required and purchase of software and hardware was done by way of separate standalone agreements.
ITAT Mumbai distinguished the facts in Reliance from those in Motorola, Ericcson and Nokia Networks OY. In these previous cases, supply of software alongwith hardware as embedded software was executed through one agreement and no separate payment was made for its installation, whereas in this case, Reliance Infocomm purchased the software (which was not embedded in the hardware) separately from Lucent USA. Though this was eventually to be integrated with the hardware purchased from Lucent India, the supply of software was not inextricably linked18 to the hardware. For these reasons, cases dealing with embedded software would not be appropriate precedents.
- 'In respect of a copyright' covers rights transferred with the copyrighted article
Reliance Infocomm contended that what it obtained was only a copyrighted article which did not have any copyright as defined in S. 14 of the ICA. That definition did not apply as Reliance Infocomm was prohibited from duplicating, disassembling or sublicensing the software. ITAT Mumbai, echoing the contentions of the Revenue and relying on CIT v. Synopsis International Ltd19 and Samsung Electronics, held that even though an exclusive right in the copyright is not transferred in a software licence, certain rights have been transferred to the licencee in order to enable it to use the software. If this were not the case, such use would be an infringement of the copyright itself.
Relying on Samsung Electronics, ITAT Mumbai interpreted the term 'in respect of a copyright' in the inclusive definition of royalty under the ITA: "consideration for transfer of any right in respect of a copyright" (which term is not present in the provisions dealing with patents, process, know how etc). The term "in respect" of admits of a wide connotation and means "attributable to". Therefore, the intention of the legislature was not to exclude the consideration paid for the use of copyrighted article. When a copyrighted article is transferred, the right in the copyright is not transferred, but a right in respect of a copyright contained in the copyrighted article is transferred. On this basis, ITAT Mumbai held that "the discussion whether the payment is for a copyright or for a copyright article would be totally irrelevant."
- Licence granted for use of copyright not copyrighted articles
Another contention of the Revenue to counter Reliance Infocomm's argument on copyrighted article was that the software granted a licence (with the rights granted as summarized above) to Reliance Infocomm which was for the use of copyright and not for copyrighted articles. Without such licence granted to it, use of the software would amount to infringement of copyright. Accepting the Revenue's contentions, ITAT Mumbai relied on Citrix Systems Asia Pacific Pte Ltd20, where the Authority for Advance Rulings held that the use of software, without anything more, would render the user liable for infringement of the copyright embedded in the software; the sale or the licensing of the software involves the grant of a right to use the copyright in the software and right to use the intellectual property embedded in the software. Therefore, the licensing of software for use by the end-use customer, is not the mere sale of a copyrighted article.21
The AO had observed that characterization of payment should not be on the basis of mode of delivery. That is to say, if it is presumed that software on carrier media disks or tapes is a copyrighted article, then sale of software on a CD will not be royalty but if the same software is downloaded from the internet with the permission of the developer, it would be royalty. This basis of differentiation was not correct. For a transfer to be considered a sale and not licence, there must be alienation of all rights in the property. Therefore, in all cases where there is limited transfer of rights with the ownership remaining with the developer, it would be a situation of royalty.
A RIGHTS-BASED APPROACH
It would be relevant at this stage to look at a recent international development22 in the field of royalty taxation which took place earlier this year. From 28 February 2013, Singapore brought into effect a rights-based approach for characterizing software payments, supplanting the earlier regime.
Under the earlier regime, almost all outbound payments for the use of software were classified as royalties subject to Singaporean withholding tax. However, payments by end-users for certain categories of software (shrink-wrap software, site licences, downloadable software, software bundled with hardware) were exempted if the payments did not entitle end-users to exploit the copyright in the software.
The new rights-based approach makes a distinction between a copyright and a copyrighted article based on the nature of the rights transferred in consideration for the payment. Where the payer is allowed to commercially exploit the copyright, that transaction involves a 'copyright right'. In contrast, where the rights are limited to those necessary to enable the payer to operate the software or to use the information or digitised goods, for personal consumption or for use within the payer's business operations, that would be characterized as 'copyrighted article'. Transfer of 'copyright rights' is taxable as royalty and that of 'copyrighted articles' is taxable as business income. Where multiple rights are transferred in one payment, characterization will be based on the primary purpose of the payment. It is evident that such an approach while giving taxpayers more certainty also lends flexibility to the law to keep in step with the ever-changing nature of the software industry. A rights-based approach (as opposed to a one-size-fits-all mandate) helps to give taxpayers the comfort that their liability to tax will reflect their commercial intention.
As you will note, the arguments raised by the taxpayer and the Revenue in Reliance reiterate those already considered in previous cases. However, what Reliance is important for is singling out the fact of supply of software through standalone contracts even though it was required to run hardware that was purchased in matching sets of contracts (i.e. in contrast to situations of embedded software where hardware and software are supplied under the same contract and which has included under the 'copyrighted article' category).23 In Reliance, the discussion on the position under the India-US tax treaty was brief and cursory and a more detailed examination would have added more value to the debate.
The issue of characterization of payment for software purchase is not settled and litigation is bound to continue. Earlier this year, the Supreme Court admitted a Special Leave Petition of IBM and Sonata, two software companies who are challenging the decision of the Karnataka High Court that payments for shrink-wrapped (standardized) software packages is royalty. The Supreme Court's decision on this issue (even if restricted to the narrower context of shrink-wrapped software) will help to clarify taxation of payments for software purchases in general. In the meantime, while the position of law remains unsettled, Indian businesses must ensure that the Revenue is able to understand the true intention of the parties so as to avoid giving rise to litigation. Some of the factors to be kept in mind are:
- Provide for clear recitals in the contracts that convey the purpose behind the acquisition of software and the extent of the interest of the purchaser. Reliance has shown that the perpetual nature of the licence or the exclusivity of it is not decisive. What the Revenue and judiciary look for is the true intention behind the transaction.
- Clauses in the contracts must clearly specify which party retains copyright rights and the extent of the rights available to the other party. This assumes more importance in a situation where the non-resident is from a non-treaty nation.
- For technologies that require hardware and software to work in tandem, it should be considered whether the software and hardware may be supplied in an integrated manner or whether supplying each through standalone contracts meets business objectives. In cases involving embedded software, courts check whether the supply of software was inextricably linked to that of hardware.
- If the technology involved permits, it may be helpful to append flowcharts/graphs etc. as schedules to the contract to indicate how the software will be used by the purchaser. This may be supplemented by an 'entire agreement'24 clause to ensure that there is nothing else which might operate to weaken the terms of the agreement between the parties. The intention behind such a measure is to ensure that any material that might potentially be relevant in a dispute for indicating the parties' understanding is available for the Revenue's scrutiny before matters take on a litigious tone.
- In a situation where the agreed contractual rights are more likely to lean towards a 'business income' interpretation, parties must then also consider the degree of risk of a PE exposure in India. PE determination is another aspect on which the Revenue has taken an aggressive stand and parties would be well-advised to obtain prior legal advice on this issue.