Taxation of payment for computer software has been one of the vexed tax issues where the Courts have been divided alike. For the past two decades, the Revenue Authorities and taxpayers were at logger jam when it came to taxability of shrink-wrapped computer software. While taxpayers would contend that the transaction is that of sale of copyrighted article, the Revenue Authorities would contend that it is towards use of copyright and thus taxable as royalty. In order to address this issue, the Finance Act, 2012 retrospectively inserted Explanation 4 to Section 9(1)(vi) of the Income-tax Act, 1961 (IT Act) to clarify that the term royalty would include transfer of all or any right for use or right to use a computer software (including granting of license) irrespective of the medium through which such rights is transferred.
With the matter reaching Supreme Court (SC) in 2018, it was expected that there will be some finality to this issue. SC has recently pronounced its verdict1 on the much-awaited matter and thereby bringing an end to the ongoing controversy.
We, at BDO in India, have summarised the order passed by SC and provided our comments on the impact of this decision.
As there were several appeals before the SC, with facts being similar, the court picked up one of the taxpayer’s case to understand the issue. In the said case, a resident taxpayer directly imported shrink-wrapped computer software from USA. Taxpayer made the payment without withholding the tax. The revenue authority treated the taxpayer as assessee-in-default and thereby made a tax demand on account of failure to withhold tax. While the First Appellate Authority upheld the action of the revenue authority, the Tax Tribunal granted relief. However, High Court relying on SC decision in the case of Transmission Corporation of AP2, held that since no application was made under section 195(2) of the IT Act, the resident Indian importers become liable to deduct tax under section 195(1) of the IT Act. This view of the HC was set aside by SC in GE India3, which ultimately found that the HC had misread the decision rendered in Transmission Corporation of AP and remanded the matter back to the HC. Later, the Karnataka HC confirmed order of the revenue authority.
Before dealing with the issue of taxability, the SC grouped the transactions in the following four baskets, which have been evaluated by the court:
SUPREME COURT’S OBSERVATION
While pronouncing this historic judgement, the SC has analysed the following key aspects:
A. End-user License Agreement / Remarketer Agreement / Distribution Agreement
These agreements show that what is granted to the distributor is a non-exclusive, non-transferable licence to resell computer software, it being expressly stipulated that no copyright in the computer programme is transferred either to the distributor or to the ultimate end-user. ‘Licence’ that is granted vide the End-user License Agreement (EULA) is not in terms of section 30 of the Copyright Act, 1957, which transfers an interest in all or any of the rights contained in sections 14(a) and 14(b) of the Copyright Act4 but is a ‘licence’ which imposes restrictions or conditions for the use of computer software. The EULAs under consideration do not grant any such right or interest, least of all, a right or interest to reproduce the computer software. The reproduction is expressly interdicted and is also expressly stated that no vestige of copyright is at all transferred, either to the distributor or to the end-user.
The SC referring to its own judgement in the case of State Bank of India5 observed that there is difference between the right to reproduce and the right to use computer software. The SC held that while the former amounted to parting of copyright by the owner, the latter would not. 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 in the nature of sale of goods, which is the law declared by SC in the context of a sales tax statute in Tata Consultancy Services6 case.
B. Definition of Royalty in DTAA vis-a-vis the IT Act
The definition of ‘royalty’ contained in the India-Singapore DTAA is exhaustive as it uses the expression “royalty means”. The term ‘royalties’ 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.
The definition contained in Explanation 2 to section 9(1)(vi) of the IT Act is wider in following respects:
It speaks of“consideration”, but also includes a lump-sum consideration which would amount to 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.
- The transfer in respect of copyright, the transfer of all or any rights in relation to copyright is sine-qua-non under Explanation 2 to section 9(1)(vi) of the IT Act. In other words, there must be transfer by way of licence or otherwise, of all or any of the rights mentioned in section 14(b) read with section 14(a) of the Copyright Act.
C. Retrospective effect of Explanation 4 to section 9(1)(vi) of the IT Act
On the retrospective application of explanation 4 to section 9(1)(vi) of the IT Act with effect from 1 June 1976, the SC observed that:
- The circular7 cannot apply as it would then be explanatory of a position even before section 9(1)(vi) of the It Act was actually inserted in the IT Act vide the Finance Act, 1976.
- Further, section 9(1)(vi) of the IT Act relates to computer software, explanation 3 thereof, refers to “computer software” for the first time with effect from 01 April 1991, when it was introduced, which was then amended vide the Finance Act 2000.
- Hence, explanation 4 cannot apply to any right for the use of or the right to use computer software even before the term “computer software” was inserted in the statute.
- Likewise, even qua section 2(o) of the Copyright Act, the term “computer software” was introduced for the first time in the definition of a literary work and defined under section 2(ffc) only in 1994.
- Thus, it is not clarificatory amendment but in fact, expands that position to include what is stated therein, vide Finance Act 2012.
D. Requirement of tax withholding for period prior to Finance Act 2012
The SC applied following two Latin maxims to hold that the “person” mentioned in section 195 of the IT Act cannot be expected to do the impossible, namely, to apply the expanded definition of “royalty” inserted by explanation 4 to section 9(1)(vi) of the IT Act, for the fiscal years in question, at a time when such explanation was not actually and factually in the statute:
- lex non cogit ad impossibilia - the law does not demand the impossible; and
- impotentia excusat legem - when there is a disability that makes it impossible to obey the law, the alleged disobedience of the law is excused.
E. Conclusions in Rulings of the AAR and Judgements of High Courts
While coming to its decision, the SC relied on conclusions of several judicial precedents:
- 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 which 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 authorise 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 recognised 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, the former amounting to parting with copyright and the latter, in the context of non-exclusive EULAs, not being so.
The SC concluded that given the definition of royalties contained in Article 12 of the DTAAs mentioned, it is clear that there is no obligation on the persons mentioned in section 195 of the IT 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 IT Act (section 9(1)(vi) along with explanations 2 and 4 thereof), which deal with royalty, not being more beneficial to the taxpayers, have no application in the facts of these cases.
F. Doctrine of First Sale/Principle of Exhaustion
The doctrine of first sale would not apply as the copyright owner did not part with title to the copies of the software. On the other hand, the EULAs and distribution agreements under consideration do not grant a licence in terms of section 30 of the Copyright Act but convey title to the material object embedded with a copy of the computer software to the distributors/end-users.
G. Interpretation of DTAA, OECD Commentary and Revenue’s Understanding
On non-applicability of OECD Commentary, Revenue Authority contended that India has expressed its reservations on Article 12 of OECD Model Convention. In this regard, the SC referring to the Delhi HC decision in case of New Skies Satellites BV8 held that:
- After India took positions qua the OECD Commentary, no bilateral amendment was made by India and the other Contracting States to change the definition of royalties contained in any of the DTAAs under consideration.
- With respect to DTAA that were subsequently amended, the royalty definition that was incorporated is not very different from the definition contained in the OECD Commentary.
- Even though India-Singapore DTAA was amended the royalty definition was left unchanged.
- Hence, OECD Commentary on Article 12 of the OECD Model Tax Convention, incorporated in the DTAAs under consideration, will continue to have persuasive value as to the interpretation of the term “royalties” contained therein.
Further, with respect to Revenue Authority’s reliance on HPC Report 2003 and E-Commerce Report 2016, the SC observed that these reports are recommendatory reports expressing the views of the committee members, which the Government of India may accept or reject. However, even if the position put forth in these reports were to be accepted, a DTAA would have to be bilaterally amended before any such recommendation can become law in force for the purposes of the IT Act.
SUPREME COURT’S DECISION
After relying of various judicial pronouncements (Indian as well as international), the Copyright Act, OECD Commentary, the SC ruled in favour of the taxpayers by holding:
“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 Income Tax Act were not liable to deduct any TDS (withholding) under section 195 of the Income Tax Act.”
This is a welcome Ruling and has put to rest one of the most litigated issues. With shrink-wrapped software now not taxable under the IT Act, one needs to evaluate whether it could fall within the ambit of Equalisation Levy whose scope has recently been enlarged. Further, the taxpayer should re-visit its License Agreement to determine whether its facts are similar to the transaction types covered by the SC. It is pertinent to note that this Ruling is applicable to only those facts which fall within the four categories mentioned by the SC.
1CA Nos 8733-8734/2018
2Transmission Corpn of AP Ltd vs CIT, (1999) 7 SCC 266
3GE India Technology Centre (P) Ltd vs CIT, (2010) 10 SCC 29
4Section 14 of Copyright Act, 1957:
Meaning of copyright- For the purposes of this Act, “copyright” means the exclusive right subject to the provisions of this Act, to do or authorise the doing of any of the following acts in respect of a work or any substantial part thereof, namely:
(a) in the case of a literary, dramatic or musical work, not being a computer programme,-
(i) to reproduce the work in any material form including the storing of it in any medium by electronic means;
(ii) to issue copies of the work to the public not being copies already in circulation;
(iii) to perform the work in public, or communicate it to the public;
(iv) to make any cinematograph film or sound recording in respect of the work;
(v) to make any translation of the work;
(vi) to make any adaptation of the work;
(vii) to do, in relation to a translation or an adaptation of the work, any of the acts specified in relation to the work in sub-clauses (i) to (vi)
(b) in the case of a computer programme-
(i) to do any of the acts specified in clause (a);
(ii) to sell or give on commercial rental or offer for sale or for commercial rental any copy of the computer programme:
Provided that such commercial rental does not apply in respect of computer programmes where the programme itself is not the essential object of the rental.”
5State Bank of India vs Collector of Customs (2000) 1 SCC 727
6Tata Consultancy Services v. State of Andhra Pradesh, (2005) 1 SCC 308
7Circular No 152 dated 27 November 1974.
8Director of Income Tax vs New Skies Satellite BV, (2016) 382 ITR 114