Controversy on Taxability of cross-border Software Payments

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:

1. The first category deals with cases in which computer software is purchased directly by an end-user, resident in India, from a foreign non-resident supplier or manufacturer.
2. The second category of cases deals with resident Indian companies that act as distributors or resellers, by purchasing computer software from foreign, non-resident suppliers or manufacturers and then reselling them to resident Indian end-users.
3. The third category concerns cases wherein the distributor happens to be a foreign, non-resident vendor, who, after purchasing software from a foreign, non-resident seller, resells the same to resident Indian distributors or end-users.
4. The fourth category includes cases wherein the computer software is affixed onto the hardware and is sold as an integrated unit/equipment by foreign, non-resident suppliers to resident Indian distributors or end-users. 

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:

1. Whether the Tribunal was correct in holding that since the assessee had purchased only a right to use the copyright i.e. the software and not the entire copyright itself, the payment cannot be treated as Royalty as per the DTAA and Treaties, which [are] beneficial to the assessee and consequently section 9 of the Act should not take into consideration.
2. Whether the Tribunal was correct in holding that the payment partakes the character of purchase and sale of goods and therefore cannot be treated as royalty payment liable to Income Tax.

While disposing of the appeal in Revenue's favor, Division Bench of HC relied upon Transmission Corpn. of A.P. Ltd. v. CIT [1999] 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. [2011] 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:

1. Computer Software that was imported for onward sale from Singapore constitutes "goods" and thus was directly covered by the Supreme Court's judgment in Tata Consultancy Services v. State of A.P. [2004] 271 ITR 401.
2. As per Section 90(2) of the Act, in case of dispute as to the applicability of the provisions of ITA and DTAA whichever is more beneficial to Assessee will prevail (reliance was made on Union of India vs. Azadi Bachao Andolan [2003] 263 ITR 706 (SC). In view thereof, it was contended that the definition of 'Royalties' as provided in DTAA did not extend to derivative products of the copyright, for example, a book or a music CD or software products. Thus, it was argued that the as per DTAA amounts payable were not like royalty, and no income in the hands of the foreign supplier would be deemed to accrue in India. Thus, no tax had to be deducted by the Indian importer under section 195(1). Further, it was also submitted that retrospective amendment to section 9(1)(vi) of the Act brought in by the Finance Act, 2012, which added Explanation 4 to the provision and expanded its ambit with effect from 01.06.1976, could also not be applied to the DTAA in question. Regarding the applicability of aforesaid Explanation 4, it was also argued that the said explanation has to be read both textually and contextually and would only apply to section 9(1)(vi)(b), and cannot be used to expand the scope of the definition of royalty contained in Explanation 2 to section 9(1)(vi).
3. There is a difference between copyright in original work and a copyrighted article, which is even recognised in section 14(b) of the Copyright Act, 1957 which refers to a "computer program" per se and a "copy of a computer program" as two distinct subject matters. Even Commentaries on the Articles of the Model Tax Convention on Income and on Capital ["OECD Commentary"] distinguishes between the sale of a copyrighted article and the sale of copyright itself. Further, this distinction was also acknowledged by CBDT in its Circular No. 10/2002 dated09.10.2002 wherein "remittance for royalties" and "remittance for the supply of articles or...computer software" were addressed as separate and distinct payments.
4. The doctrine of First Sale/Principle of Exhaustion is deeply ingrained in Section 14(b)(ii) of the Copyright Act post the 1999 amendment, thereby making it clear that the foreign supplier's distribution right would not extend to the sale of copies of the work to other persons beyond the first sale. On this premise, it was argued that since no distribution right by the original owner extended beyond the first sale of the copyrighted goods, it can be said that only the goods, and not the copyright in the goods, had passed onto the importer.
5. It was also argued that if the position of the Revenue were correct, arbitrary results would ensue, in  as much as the resident assessee, receiving a 2% commission, would, however, after the disallowance of the deduction under section 40(a)(ia) of the Act, end up paying tax of a huge amount, way beyond the commission, resulting in extreme financial hardship

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:

1. The machinery provision contained in section 195 of the ITA is inextricably linked with the charging section contained in section 9 read with section 4 of the ITA, as a result of which, a resident in India responsible for paying a sum of money is required to deduct tax at source only when such sum is chargeable to tax in India. In this regard, the Court also referred to GE India Technology Centre (P.) Ltd.'s case (supra) and Vodafone International Holdings BV v. Union of India (2012) 341 ITR 1 (SC).
2. The combined reading of sections 2, 14, 16, 18, 19, 30, 30A, 51, 52, and 58 of the Copyright Act, 1957 would lead to the following conclusions:

• Under section 2(o) of the Copyright Act, a literary work includes a computer program (defined u/s section 2(ffc)
• Though the expression "copyright" has not been defined separately in the "definitions" section of the Copyright Act, yet, section 14 makes it clear that "copyright" means the "exclusive right", subject to the provisions of the Act, to do or authorize the doing of certain acts "in respect of a work". When an "author" in relation to a "literary work" which includes a "computer program", creates such work, such author has the exclusive right, subject to the provisions of the Copyright Act, to do or authorize the doing of several acts in respect of such work or any substantial part thereof

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 [2000] 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 [1966] 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;

• It speaks of "consideration", but also includes a lump sum consideration which would not amount to the income of the recipient chargeable under the head "capital gains
• When it speaks of the transfer of "all or any rights", it expressly includes the granting of a licence in respect thereof; and
• It states that such transfer must be "in respect of" any copyright of any literary work. However, even where such transfer is "in respect of" copyright, the transfer of all or any rights in relation to copyright is a sine qua non under Explanation 2 to section 9(1)(vi) of the Income Tax Act. Thus, Explanation 2(v) to section 9(1)(vi) of the Income Tax Act, when it speaks of "all of any rights...in respect of copyright" is certainly more expansive than the DTAA provision, which speaks of the "use of, or the right to use" any copyright

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:

• Copyright is an exclusive right, which is negative in nature, being a right to restrict others from doing certain acts.
• Copyright is an intangible, incorporeal right, in the nature of a privilege, which is quite independent of any material substance. Ownership of copyright in a work is different from the ownership of the physical material in which the copyrighted work may happen to be embodied. An obvious example is the purchaser of a book or a CD/DVD, who becomes the owner of the physical article, but does not become the owner of the copyright inherent in the work, such copyright remaining exclusively with the owner.
• Parting with copyright entails parting with the right to do any of the acts mentioned in section 14 of the Copyright Act. The transfer of the material substance does not, of itself, serve to transfer the copyright therein. The transfer of the ownership of the physical substance, in which copyright subsists, gives the purchaser the right to do with it whatever he pleases, except the right to reproduce the same and issue it to the public, unless such copies are already in circulation, and the other acts mentioned in section 14 of the Copyright Act.
• A licence from a copyright owner, conferring no proprietary interest on the licensee, does not entail parting with any copyright and is different from a licence issued under section 30 of the Copyright Act, which is a licence that grants the licensee an interest in the rights mentioned in section 14(a) and 14(b) of the Copyright Act. Where the core of a transaction is to authorize the end-user to have access to and make use of the "licensed" computer software product over which the licensee has no exclusive rights, no copyright is parted with and consequently, no infringement takes place, as is recognized by section 52(1)(aa) of the Copyright Act. It makes no difference whether the end-user is enabled to use computer software that is customised to its specifications or otherwise.
• A non-exclusive, non-transferable licence, merely enabling the use of a copyrighted product, is in the nature of restrictive conditions which are ancillary to such use, and cannot be construed as a licence to enjoy all or any of the enumerated rights mentioned in section 14 of the Copyright Act, or create any interest in any such rights so as to attract section 30 of the Copyright Act.
• The right to reproduce and the right to use computer software are distinct and separate rights, as has been recognized in SBI vs. Collector of Customs, 2000(1) SCC 727 (paragraph 21), the former amounting to parting with copyright and the latter, in the context of non-exclusive EULAs, not being so.

Conclusion 

In view of the above, the Hon’ble Supreme Court finally concluded that:

1. Given the definition of royalties contained in DTAA, it is clear that there is no obligation on the persons mentioned in section 195 of the Income Tax Act to deduct tax at source, as the distribution agreements/EULAs in the facts of these cases do not create any interest or right in such distributors/end-users, which would amount to the use of or right to use any copyright. The provisions contained in the ITA (section 9(1)(vi), along with Explanations 2 and 4 thereof), which deal with royalty, not being more beneficial to the assessees, have no application in the facts of these cases.
2. That the amounts paid by resident Indian end-users/distributors to non-resident computer  software manufacturers/suppliers, as consideration for the resale/use of the computer software through EULAs/distribution agreements, is not the payment of royalty for the use of copyright in the computer software, and that the same does not give rise to any income taxable in India, as a result of which the persons referred to in section 195 of the Act were not liable to deduct any TDS under section 195 of the Act. The Court held that answer to this question will apply to all four categories of cases enumerated in Paragraph 4 of the judgement. 

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