The controversy on taxability foreign software relates to the characterization of income in the hands of the non-resident payee i.e. whether the payments received by the non-resident payee for giving license of computer software is chargeable to tax as ‘royalty’ or it is ‘sale’. The Revenue seeks to tax these payments as royalty and subject to the same withholding tax, while the non-resident payees seek to label such receipts as business income not chargeable to tax, in the absence of a permanent establishment in India.
Recently, the Hon’ble Supreme Court of India in the case of Engineering Analysis Centre of Excellence Private Limited (‘EAC’) (2021) 125 Taxmann.com 42 (SC) has put end to the age-old controversy concerning the taxability of foreign software as royalty. While deciding a batch of more than 80 appeals, Hon’ble Supreme Court has categorically held that the payments made by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale of the computer software through End User Licence Agreements (‘EULA’)/distributors agreements, can’t be considered as payment of royalty for the use of the copyright in the computer software as per the provisions of Article 12(3) of the applicable Double Taxation Avoidance Agreements (‘DTAA’) and the provisions contained in section 9(1)(vi) of the Income-tax Act, 1961 (‘ITA’), not being more beneficial as per section 90 of the ITA, have no application.
Hon’ble Supreme Court while disposing of the batch of 80 appeals grouped all the appeals into four categories:
In the instant case, EAC a resident Indian end-user of the shrink-wrapped software directly imported from the United States of America (‘USA’). The assessing officer, while framing the assessment for assessment year (‘AY’) 2001-02 and 2002-03 concluded after applying Article 12(3) of the Double Taxation Avoidance Agreement (‘DTAA’) between India and the USA and upon applying section 9(1)(vi) of the Income-tax Act, 1961 (‘ITA’) that what was in fact transferred in the transaction was copyright which attracted the payment of royalty and thus, the Appellant was required to deduct tax at source and the since the Appellant failed to deduct tax at source, it was held liable to pay the number of TDS along with interest. Commissioner of Income-tax (Appeals) dismissed the appeal of the Appellant. However, the appeal before the Income-tax Appellate Tribunal (‘ITAT’) was succeeded in which the ITAT followed its previous order passed in Samsung Electronics Co. Ltd vs. Income-tax officer, ITA No. 264-266/Bang/2002.
On an appeal by the Revenue to the High Court of Karnataka (‘HC’) decided the appeal primarily on the basis of the following two questions:
While disposing of the appeal in Revenue's favor, Division Bench of HC relied upon Transmission Corpn. of A.P. Ltd. v. CIT  239 ITR 587 (SC) and held that since no application under section 195(2) of the ITA had been made, the resident Indian importers became liable to deduct tax at source, without more, under section 195(1) of the Act. This view of the High Court was set aside by the Hon'ble Supreme Court Court in GE India Technology Centre (P.) Ltd. v. CIT (2010) 327 ITR 456, which ultimately found that the judgment of the High Court dated 24.09.2009 had misread AP Transco. Consequently, the Apex Court remanded the matter to the Karnataka HC.
After setting out the facts in one of the appeals treated as the lead matter, namely CIT v. Samsung Electronics Co. Ltd.  345 ITR 494 (Kar) concerning Samsung Electronics Co. Ltd.'s case, and the relevant provisions of the ITA, India's DTAAs with USA, France, and Sweden respectively, the Karnataka HC on an examination of the End-User Licence Agreement (for brevity ‘EULA’) involved in the transaction, found that what was sold by way of computer software included a right or interest in copyright, which thus gave rise to the payment of royalty and would be an income deemed to accrue in India under section 9(1)(vi) of the Act, requiring the deduction of tax at source. The Appellants being aggrieved by the said decision of the Hon'ble Karnataka HC preferred an appeal before the Hon'ble Supreme Court.
Some of the key arguments advanced on behalf of the Appellants are as under:
Key Observations of the Hon'ble Apex Court:
In the wake of submissions of the Appellants and Respondent, the Hon'ble Apex Court, inter alia, made the following key observations:
In the case of a computer programme, section 14(b) specifically speaks of two sets of acts – the seven acts enumerated in sub-clause (a) and the eighth act of selling or giving on commercial rental or offering for sale or for commercial rental any copy of the computer programme. Insofar as the seven acts that are set out in sub-clause (a) are concerned, they all delineate how the exclusive right that is with the owner of the copyright may be parted with. In essence, such a right is referred to as copyright and includes the right to reproduce the work in any material form, issue copies of the work to the public, perform the work in public, or make translations or adaptations of the work. This is made even clearer by the definition of an "infringing copy" contained in section 2(m) of the Copyright Act, which in relation to a computer programme, i.e., a literary work, means the reproduction of the said work. Thus, the right to reproduce a computer program and exploit the reproduction by way of sale, transfer, license, etc. is at the heart of the said exclusive right.
The Hon'ble Court further noted that vide section 16 of the Copyright Act, no copyright exists in India outside the provisions of the Copyright Act or any other special law for the time being in force. When the owner of the copyright in a literary work assigns wholly or in part, all or any of the rights contained in section 14(a) and (b) of the Copyright Act, in the said work for consideration, the assignee of such right becomes entitled to all such rights comprised in the copyright that is assigned and shall be treated as the owner of the copyright of what is assigned to him (see section 18(2) read with section 19(3) of the Copyright Act)
Also, under section 30 of the Copyright Act, the owner of the copyright in any literary work may grant any interest in any right mentioned in section 14(a) of the Copyright Act by licence in writing by him to the licensee, under which, for parting with such interest, a royalty may become payable (see section 30A of the Copyright Act). When such licence is granted, copyright is infringed when any use, relatable to the said interest/right that is licensed, is contrary to the conditions of the licence so granted. Infringement of copyright takes place when a person "makes for sale or hire or sells or lets for hire" or "offers for sale or hire" or "distributes...so as to prejudicially affect the owner of the copyright", vide section 51(b) of the Copyright Act. However, in certain cases enumerated u/s 52(1)(aa) of the Copyright Act would not amount to reproduction so as to amount to an infringement of copyright. Section 52(1)(ad) is independent of section 52(1)(aa) of the Copyright Act and states that the making of copies of a computer programme from a personally legally obtained copy for non-commercial personal use would not amount to an infringement of copyright.
3. The "licence" that is granted vide the EULA, is not a licence in terms of section 30 of the Copyright Act, which transfers an interest in all or any of the rights contained in section 14(a) and 14(b) of the Copyright Act, but is a "licence" which imposes restrictions or conditions for the use of computer software. Thus, it cannot be said that any of the EULAs with which the present case is concerned are referable to section 30 of the Copyright Act, inasmuch as section 30 of the Copyright Act speaks of granting an interest in any of the rights mentioned in section 14(a) and 14(b) of the Copyright Act. In this regard, the Hon'ble Court also gave a simple illustration to explain the aforesaid position. I fan English publisher sells 2000 copies of a particular book to an Indian distributor, who then resells the same at a profit, no copyright in the aforesaid book is transferred to the Indian distributor, either by way of licence or otherwise, inasmuch as the Indian distributor only makes a profit on the sale of each book. Importantly, there is no right in the Indian distributor to reproduce the aforesaid book and then sell copies of the same. On the other hand, if an English publisher were to sell the same book to an Indian publisher, this time with the right to reproduce and make copies of the aforesaid book with the permission of the author, it can be said that copyright in the book has been transferred by way of licence or otherwise, and what the Indian publisher will pay for, is the right to reproduce the book, which can then be characterized as royalty for the exclusive right to reproduce the book in the territory mentioned by the licence. Interestingly, on this aspect, the Hon'ble Court also refer edits own judgment given in State Bank of India v. Collector of Customs  1 SCC 727 which though was delivered under the Customs Act, 1962, yet recognised the important differentiation made between the right to reproduce and the right to use computer software. The court thus observed that whereas the former would amount to a parting of copyright by the owner thereof, the latter would not.
4. In response to the argument advanced by the Department that in some of the EULAs, it was clearly stated that what was licensed to the distributor/end-user by the non-resident, the foreign supplier would not amount to a sale, thereby making it clear that what was transferred was not goods, the Hon'ble Court observed that such an argument has no legs to stand on. In this regard, the Apex Court noted that it is settled law that in all such cases, the real nature of the transaction must be looked at upon reading the agreement as a whole (In this regard, the Court referred Sundaram Finance Ltd. v. State of Kerala  2 SCR 828). Thus, the Hon'ble Court observed that what is "licensed" by the foreign, non-resident supplier to the distributor and resold to the resident end-user, or directly supplied to the resident end-user, is in fact the sale of a physical object which contains an embedded computer programme, and is, therefore, a sale of goods.
5. The definition of Royalty as given in the India-Singapore DTAA is not wider than that given in the ITA. The definition of royalty in DTAA is exhaustive for its uses the expression ‘means’. Further, the term ‘royalty’ the term "royalties" under DTAA refers to payments of any kind that are received as a consideration for the use of or the right to use any copyright in a literary work. As opposed, the definition contained in Explanation 2 to section 9(1)(vi) of the Act, is wider in at least three respects;
6. Hon’ble Supreme Court also concluded while referring to the judgments in the case of CIT vs. ZTE Corporation (2017) 392 ITR 80 (Delhi HC), DIT vs. Infrasoft Ltd. (2014) 264 CTR 329 (Delhi HC), DIT vs. Nokia Networks OY (2013) 358 ITR 259 (Delhi HC) that:
In view of the above, the Hon’ble Supreme Court finally concluded that:
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