India’s tech industry is at the forefront of solving complex technological issues for global enterprises. The first wave of the global tech era in the late 1990s’ created an intercontinental Internet infrastructure in India. Growth of the IT sector led to a changing business environment and cross border transactions, creating a variety of issues in taxation for non-resident entities, which were operating in India without any form of physical presence. In the absence of a permanent establishment, the income of such non-residents was tax-free in India. The government, wishing to tap this emerging market with an exponential potential to generate revenue, began characterizing software payments made to non-residents as a “royalty.”
The early years of the previous decade produced contradictory rulings by various courts and tax tribunals in India. The government twisted the knife by expanding the definition of “royalty” to include software payments. Although the scope under domestic tax law was widened, no changes were made under tax treaties and, therefore, on a combined reading, software payments could still be kept outside the ambit of royalty taxation. As businesses evolved with technology, software payments became a regular business expenditure and an apple of discord for payers (from a withholding tax standpoint) as well as for foreign recipients (from an income taxability angle).
Recently, the Supreme Court of India, brought a happy end to this 20-year-old dispute by delivering a landmark judgment in favor of taxpayers. The Supreme Court, while dealing with over 100 appeals filed by taxpayers and revenue authorities, categorized software payments into four broad categories—(1) purchase of computer software by an end-user from a non-resident, (2) the Indian distributor/reseller model, (3) the foreign distributor/reseller model, and (4) software embedded in hardware.
The 226-pages judgment is an exemplar of international tax controversies. The top court dived deep into the nitty-gritty of the issue and analyzed all aspects of taxing such transactions. The court was cognizant of circulars issued by the Central Board of Direct Taxes way back in 2002 to substantiate the Department of Revenue’s stance in differentiating royalty from remittance for computer software, treated as goods, and taxable as business income based on existence of a permanent establishment in India. The court arrived at the highly anticipated conclusion by discussing the interplay between the Income Tax Act and the Copyright Act with international tax treaties, OECD commentaries, agreements between parties, and various rulings of subordinate courts.
The Supreme Court clarified that a resident payer is required to withhold tax only if the non-resident is liable for tax in India, as withholding provisions are inextricably linked with the charging provisions of the Income Tax Act, along with the relevant tax treaty. Where India has a tax treaty with another country, the provisions of domestic law can only be imposed to the extent that provisions therein are more beneficial to the non-resident than provisions of the applicable tax treaty. The meaning of “copyright” has been deciphered in depth under the Copyright Act, and on examining the end-user license agreements and distribution agreements, the court rightly observed that distributors were only granted a non-exclusive and non-transferable license to resell software, and the license granted was not a “licence” that transfers an interest in all or any of the copyright rights, but merely a “licence” that imposes restrictions or conditions on the use of computer software. Therefore, a license supplied by non-resident to a resident distributor or end-users is in the nature of the sale of goods without any qualification or condition.
The Supreme Court also acknowledged the impracticality of implementing retrospective amendments, i.e., applying the expanded definition of a royalty at the time when such explanation was not actually and factually in the statute, by relying on the principles that the “law does not demand the impossible” and “when there is a disability that makes it impossible to obey the law, the alleged disobedience of law is excused.” The judgment also considered divergent judicial precedents on the matter and interpretation of treaties along with OECD commentary. The relevance of OECD commentary in interpreting tax treaties was noted to have a persuasive impact, even as Revenue authorities have always shown resistance in accepting explanations in OECD commentary, considering that India is not a member of OECD.
The case predominantly revolved around computer software transactions that took place before the cloud computing era, i.e., where software was supplied in a floppy disk/CD-ROM known as a shrink-wrapped license. Irrespective of the mode of delivery of software, this ruling could provide an analytical framework in addressing a wide range of software transactions as new licensing and delivery models continue to evolve in tech industry.
This judgment could also have a bearing on other similar unsettled cross-border matters such as payments for connectivity charges, access to databases, cloud computing payments, webhosting charges, data warehousing charges, etc. This judgment should put to rest a long-standing issue and provide reassurance to foreign taxpayers that genuine benefit shall not be denied to those entitled. Taxpayers could now expect large refunds from open proceedings on this matter. Where resident payers wish to claim a refund of withholding taxes deposited on software payments made to non-residents, and the payee has claimed a foreign tax credit for such taxes in the home country, the issue of unjust enrichment could require an in-depth analysis. Going forward, resident payers may choose not to deduct taxes on royalty payments, because they will not face the risk of disallowance of such expenditures and, therefore, the net inflow to foreign tech entities could be higher. Further, in the absence of a permanent establishment in India, there should be no requirement to file an annual India tax return for the foreign payee, if software income is the only receipt from India.
It will be interesting to watch the response of the government as the finance bill for 2021 has yet to be enacted. Having said the above, the focus now shifts to the expanded equalization levy that was introduced in April last year. The equalization levy targets all online sales of goods and services and may cover software payments that are not taxable as a royalty. Moreover, foreign taxpayers need to watch for the release of rules on “significant economic presence” that will come into effect April 1, 2021. These rules will widen the tax base and cover transactions that are currently outside the scope of domestic taxation. Although we may have had a whale of a time hearing this verdict, only time will tell if the hatchet is buried.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Author Information
Rakesh Nangia is chairman and Sandeep Jhunjhunwala is a partner at Nangia Andersen LLP.
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