29 March 2021
Payments made to non-residents of India for supply of software ("SW") have been a subject matter of controversy since early 1990's. The Indian tax department ("Department") has been characterising these payments as royalty, on the basis that the payment pertains to a licence given by the SW provider for the user to use the SW on its machine and hence it is a payment for the use of, or right to use the copyright in the SW. On the other hand, the payer and the recipient of the payment have always argued that SW is sold as a copyrighted product and hence the payment is for 'goods', therefore it is business income and cannot be taxed in India if the non-resident supplier of SW does not have a permanent establishment ("PE") in India. There has been plethora of cases on this dispute where the courts and the Authority for Advance Rulings ("AAR") have given conflicting decisions. Both the taxpayer (SW provider or the Indian purchaser of SW) and the Department approached the Supreme Court ("SC") for final resolution of the issue. The SC bunched the approximately 100 appeals together since the core issue in all these cases was the same and after hearing the matter for several days, has pronounced its unequivocal decision in favour of taxpayers in a 226 pages judgement on 2 March 2021. It is therefore a huge relief for the taxpayers in all these 100 cases where the SC dealt with four main categories of payments, declaring that each one of them is not in the nature of royalty but represent payment for goods, resulting in business income, and hence not taxable in India. Consequently, the SC reiterated and upheld the law that as the payee was not taxable in India, there was no obligation on the payer under section 195 of the Income Tax Act, 1961 ("IT Act") to withhold any Indian tax. SC ruled that the payers in all these cases were not taxpayers in default as the Department had alleged.
Upon going through the judgment, one is relieved to find that the SC has not left any issue unattended in respect of all the four categories of payment under consideration and have dealt threadbare with each and every argument presented by the taxpayer and the Department in respect of characterisation of the payment. In this article, we will attempt to summarise the main arguments. We will also discuss how the SC has dealt in detail why the Organization of Economic Cooperation and Development ("OECD") Commentaries on Model Convention ("MC") have persuasive value, why and how the Vienna Convention on the Law of Treaties ("VCLT") applies while interpreting tax treaties ("DTAAs") even though India is neither the member of the OECD or signatory to the VCLT, the difference in interpreting and applying the provisions of a DTAA and the domestic law especially in response to the argument that India has expressed its reservation to the OECD Commentary with regard to the characterisation of payment for software.
The four types of transactions dealt with by the SC are :
(1) purchase of computer SW by an Indian resident from a non-resident supplier or manufacturer;
(2) purchase of computer SW by Indian companies from non-resident suppliers or manufacturers where the Indian purchasers of SW act as distributors or resellers, and resell the SW to Indian resident end-users;
(3) the distributor being a non-resident vendor, purchases SW from a non-resident seller and resells it to Indian resident distributors or end-users; and
(4) computer SW is affixed onto hardware which is sold as an integrated unit or equipment by non-resident suppliers to Indian resident distributors or end-users.
As can be seen, the main issue that needed consideration (though the types of transactions are divided in four categories) is : (i) whether the payment for computer SW falls within the meaning of 'royalty' under the retrospective change in the definition of royalty under section 9(1)(vi) of the IT Act and the definition of 'royalty' under the relevant and applicable DTAA; and (ii) whether the fact that a payer acts as a distributor or re-seller of SW in India changes the character of payment determined under (i).
The bulk of the arguments are around the definition of 'royalty' under the IT Act and also the impact of the retrospective clarificatory change in the IT Act on this characterisation.
In respect of the meaning of the term 'royalty', the SC agreed with the analysis and interpretation adopted by various High Courts ("HC") which concluded that the consideration paid for SW was not royalty. Where the HC decisions were in favour of the Department, the SC negated each of the arguments relied on by HCs in those cases. These are summarised below :
1. Payment for "off the shelf" or "shrink wrapped" computer SW is a payment for a copyrighted article and not for any right in the copyright of the computer SW. A copyrighted article is characterised as 'good' and hence the payment is for purchase of goods, not for right in copyright. This was held to be true even in case where the computer SW was purchased by a distributor or a re-seller, to on sell the same in sealed form to the end users in India. The distributor acquired no right for use of the SW, nor was transferred any right in the copyright of the SW.
2. The SC opined that for a payment to be 'royalty' even under the amended section 9(1)(vi) of the IT Act and explanation 4, it must be for a right in the copyright. IT Act cannot characterise royalty without considering the meaning of copyright under the Copyright Act,1957 ("Copyright Act"). SC examined sections14, 16, 18 (distribution right), 30 and 52 (1)(aa) of the Copyright Act for making this determination. In the first place, it held that if none of the seven (7) rights mentioned in section 14 (a) and (b) of the Copyright Act are given to the purchaser of SW, the payment cannot be characterised as royalty even under the amended section 9(1)(vi) and explanation 4.
In this context, the SC categorically stated that the determination of the AAR in Dessault and Geoquest and the judgments in Ericsson A.B., Nokia Networks OY, Infrasoft, ZTE stated the law correctly and met its express approval to that view. This view is supported by section 52 (1) (aa) of the Copyright Act, which clearly states that the following acts shall not constitute an infringement of copyright :
(aa)The making of copies or adaptation of a computer programme by lawful possessor of a copy of such programme, from such copy –
(i) In order to utilize the computer programme for the purpose for which it was supplied ; OR
(ii) To make back up copies purely as a temporary protection against loss, destruction or damage in order only to utilize the computer programme for the purpose for which it was supplied.
Interestingly, not only the term 'copyright' is not defined in the IT Act, but even in the Copyright Act, it is defined as being the exclusive right to do or authorize the doing of the seven things referred to above. Only when such right is given, it can be said that any right is given in the copyright and a payment received for giving such right would be characterised as royalty. So where section 52(1)(aa) specifically excludes certain actions in respect of SW from being regarded as infringement of copyright, it follows that when a purchaser of SW is given licence to download on her computer, since she gets no right in the copyright, the payment made for the SW is not to be regarded as royalty. This aspect has been categorically upheld by the SC, dealing with and countering each of the arguments of the Department.
3. In respect of category 2 and 3 payments, i.e. payments made by distributors also, the same analysis of whether the distributors received any right as envisaged under the Copyright Act in the copyright of the SW was applied. Additionally, the SC referred extensively to the principles of First Sale and Exhaustion. It concluded that the distributors reselling shrink-wrapped copies of SW that are already put in circulation by the non-resident suppliers/ manufacturers, are not hit by section 14(a)(ii) of the Copyright Act and the principle of First Sale/Exhaustion is very much applicable here. In all the cases, the reseller / distributor could not use the SW itself. For making the sale, it would simply make the copy or provide the code to the end-user who would, in turn, download and copy on its own computer to use the SW. Therefore, the re-seller or distributor acquired no right in the copyright of such SW.
4. Next, the SC held that a payer was not in default under the IT Act when it did not withhold tax where the payee was not subject to tax in India. It said that the machinery provision contained in section 195 is inextricably linked with the charging provision contained in section 9 read with section 4 of the IT Act. It also relied on the interpretation given to the language of section 195 by the SC in the case of GE India Technology Centre in 2010, where the SC had held that the payer is obligated to withhold tax only if the sum payable is chargeable to tax under the provisions of the IT Act. It is clear, as held above, that the payment for SW is not royalty but business income and hence not subject to tax in India unless the recipient had a PE in India. The SC also upheld the position that the payer only needed to approach the Department for a certificate under section 195(2) if there was any doubt on what part of the sum payable is chargeable to tax. Where there is no ambiguity, there is no such obligation. The payer cannot be held in default for not obtaining the withholding tax certificate under section 195(2) of the IT Act.
In this context, the SC distinguished a recent decision of the SC in case of PILCOM. In that case, the issue was of taxability under section 194E of the IT Act, which is part of a set of provisions which deal with withholding without reference to chargeability of the non-resident to tax under the IT Act.
5. Next the SC dealt with characterisation of the payment for SW (under all four categories) under the DTAA and was persuaded by the OECD Commentary on Article 12 of the OECD Model Convention ("OECD MC") dealing with royalty. The Department argued that India is not a member of the OECD and she had expressed reservation to the commentary in the OECD MC on royalty and therefore, the said commentary should not have bearing in determining the character of payment for SW. The SC dealt with this at length and after putting forward several arguments, concluded that the OECD commentaries on the MC have persuasive value. The arguments are summarised as follows :
Change in domestic law or registering a reservation does not mean that the same is accepted by both the parties to the DTAA. For India's position to be accepted and effective, the same must be included in the relevant DTAA through amendment. No such amendment was made in any of the DTAAs applicable in these cases and all of them had materially the same language as that of Article 12 in the OECD MC for royalty.
● Even the DTAAs which were amended subsequently did not reflect this change in the definition of royalty.
● The DTAAs entered into by India, have to be interpreted liberally with a view to implement the true intention of the two states.
● The principles adopted in interpretation DTAAs are not the same as those in interpretation of a statutory legislation. In this context, the SC referred to the commentary of David R. Davis in the book Principles of International Double Taxation Relief and reproduced the following :
● because treaty negotiations are largely a bargaining process with each side seeking concessions from the other, the final agreement will often represent a number of compromises, and it may be uncertain as to whether a full and sufficient quid pro quo is obtained by both sides.
● The SC also said that all the DTAAs have as their preamble the language as per OECD or the UN MC between developing and developed countries, which is materially the same language. The OECD speaks of the importance of its commentaries and inter alia states that taxpayers from both contracting states rely extensively on the commentaries while planning their business transaction and investments. The SC cited a plethora of Indian and international cases in this regard to support its view to be persuaded by the OECD Commentary. Article 31 of the VCLT is also relevant here which requires DTAA to be interpreted and applied in good faith. SC opined that India not being a signatory to VCLT makes no difference, since VCLT is customary international law, and it applies to all the treaties entered by two countries. It was put in place to ensure that countries follow a code of conduct when entering into treaties and implementing them.
6. SC held that for determination of taxability of the non-resident, where such non-resident comes from a treaty jurisdiction, effect must be given to section 90(2) of the IT Act to determine its taxability in India. SC overruled several HC decisions where the HC had held that there was no need to refer to the definition of royalty under the DTAA when there was a retrospective change in the IT Act.
7. In the context of applicability of the retrospective clarification for characterisation of a payment as royalty and consequently requiring fulfilment of withholding obligation, the SC referred to several HC and SC decisions and the two Latin maxims to conclude that a clarification which imposes a tax which was not there when the transaction was undertaken, cannot be upheld to be applicable. These are : lex non cogit ad impossibilia, i.e. the law does not demand the impossible and impotentia excusat legem i.e. when there is a disability that makes it impossible to obey the law, the alleged disobedience of the law is excused.
The analysis in this decision should pave the way for characterisation of payment for those digital transactions, which have similar characteristics as SW and are sold with a licence agreement like the SW licence.
The taxpayers who are litigating their matters in respect of SW payment would benefit from this SC decision. This decision now lays down the law in respect of SW payments and therefore it would apply squarely to their matters, which would be decided in their favour. However, the question that needs to be debated is in case of those taxpayers on whose account the Indian payers have withheld royalty tax on SW payments. Can they be eligible to refund for wrongly withheld tax? If they have filed tax return claiming refund, they should be able to get the refund. If they have not filed tax return in India, depending on facts, if significant time has lapsed, then they may need to explore the constitutional remedy under writ jurisdiction. Taxpayers will need to consider the process of getting these refunds based on the specific facts and circumstances of each taxpayer.
Disclaimer: The views expressed in this article are personal of the author and do not represent any legal opinion. No reliance must be placed by anyone on these views for making any decisions.
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