The In-House Lawyer

two separate benches of the tax tribunal in India, one operating out of Mumbai and another in New Delhi, recently ruled on the characterisation of software-related payments involving different taxpayers. Although it is well known that the tax consequences of these transactions are highly fact sensitive, these two rulings, which were pronounced within a few days of each other, appeared to be contrary. This led to a fresh round of debate on the topic of the characterisation of payments relating to software transactions. 


While the ruling by the Mumbai tax tribunal had to deal with the characterisation of a software payment to a US-based supplier to determine a withholding tax obligation, the Delhi bench of the tax tribunal dealt with issues arising out of the taxation of income in the hands of Microsoft Corporation and its affiliates from transactions with Indian distributors.


Deputy director of income tax (international taxation) v m/s Reliance Industries ltd [2010]


Reliance Industries involved the pursuance of an agreement made in December 2001, regarding TIBCO Software Inc, for US-supplied software that was loaded onto a computer disk on an free on board basis for the Indian buyer Reliance Industries Ltd (RIL). RIL approached the tax authorities asking whether tax should be withheld from the payment to TIBCO. The tax authority stated that a license in perpetuity amounted to a sale and that the period of the license does not alter the nature of the payment. After examining this right in the context of the provisions of the Indian Copyright Act and other specific definitions under the Indian Income Tax Act, the tax officer reached the conclusion that the licence was for the use of software and consequently that the consideration was similar to one for the use of a patent, invention or scientific work. The tax office also decided that the software could be seen as a secret formula or process. The tax office put software in the categories of copyrights, patents, designs, trade marks, formula, process, commercial or scientific knowledge, and concluded that the proposed payment by RIL to an overseas supplier was actually a royalty. 


Accordingly, RIL was directed to withhold tax at the time of making the payment. RIL deposited the amount of tax under protest, but successfully contested the conclusion reached by the tax office before the first appellate authority. However, the revenue authorities did not accept the result of first appeal. The tax authorities moved to the tax tribunal in the second appeal, necessitating a ruling by the Mumbai bench of the tribunal on 29 October 2010.


The tax tribunal noted that the software in question was operational software, and further that the Indian taxpayer was granted a non-exclusive, perpetual, irrevocable and royalty-free worldwide licence to use the number of copies of the software enumerated in the agreement solely for internal operation, including the use of software for application service provider (ASP) services and web housing services, where software is not directly accessible to a third party. The tribunal referred to the following restrictions imposed on RIL regarding the use of the software in question:


1. the buyer is not entitled to use the software for ASP services on behalf of a third party; 

2. the buyer has no right to use, copy, duplicate or display the software, except as specifically provided in the agreement;

3. the buyer cannot make more copies of the software than are specified in the agreement;

4. the buyer cannot provide access to the software to anyone, except its employees, contractors or consultants under a written contract by which all of them would be bound by the terms and conditions that are applicable to the buyer on the purchase of the software;

5. the buyer cannot sell the licence, distribute, pledge, lease, rent or commercially share (including timeshare) the software, or any rights therein; 

6. the buyer cannot use the software for the purposes of providing a service, including without limitation, providing third-party hosting or third-party application, integration, or ASP services or any other similar service; and

7. the buyer cannot modify, translate, reverse engineer, decrypt, decompile, disassemble, create directive works based on, or otherwise attempt to discover the above-mentioned software source code or underlying ideas or algorithms.


After analysing the facts in Reliance Industries, the tax tribunal followed earlier rulings in Motorola Inc v Deputy Commissioner of Income Tax [2005], Samsung Electronics Co Ltd v Income Tax Officer [2005] and Tata Consultancy Services Ltd v State of AP [2004] to reach the conclusion that the transaction amounted to the sale of a copyrighted article and not a royalty. The earlier rulings also referred to the Organisation for Economic Co-operation and Development (OECD)’s commentary on the topic.


Microsoft Corporation v adit [2010]


While the Mumbai bench of the tax tribunal ruled in Reliance Industries, a dispute relating to the characterisation of income from software transactions was being considered at the Delhi bench of the tax tribunal, resulting in an interesting ruling on 26 October 2010. In Microsoft, the tax tribunal concluded that the consideration received from Indian distributors by Microsoft and its affiliated entities towards the sale of shrink-wrapped software resulted in income that was a royalty.


Microsoft adopted a distribution chain of US and Singapore-based entities for the selling of its products through distributors in the Indian market. The taxpayer contended that they sold a copyrighted article and had not granted any copyright in the use of the article. It tried to explain that, in the terms of End User License Agreements (EULA), the purchaser gets a perpetual licence that only comes to an end in exceptional circumstances, as mentioned therein. It argued that the right to make copies, in case of volume pack purchasers, does not result in a right to commercially exploit the product.


The tax authorities found that, even after acquiring the software, the end user required a further license by way of an end user licence for using the software. The tax authorities also found that the end user license clearly stated that the product is licensed not sold. From the clauses of EULA, it was noted that the licence was being protected, both under copyright and patent regulations.


Referring to the OECD commentary, the court noted that the new differentiation of software transactions between copyrighted articles and the use of copyright has been brought about by a change in commentary, not by changing the words of the articles. It was also noted that such commentary did not exist in 1990 when the India US Treaty was entered into and hence the tribunal opined that the commentary could not be relied on for supporting the taxpayer’s position. The tribunal also found that since reservations have been expressed by India on the OECD commentary on this topic, just as some other OECD countries have done, the commentary could not be relied on for the purposes of this characterisation.


With reference to the earlier rulings in Motorola the tribunal stated that for the software to actually be a part of the hardware was critical. On this basis, the tribunal stated that the conclusion reached in Motorola was fact specific and cannot be applied in Microsoft. 


Similarly, the tax tribunal found that conclusions reached in Tata Consultancy clearly referred to the imposition of sales tax and have no application for dealing with the current issue under income tax law. The taxpayer’s comparison to Sonata Information Technology Ltd v Additional Commissioner of Income Tax [2006] (a decision made by the Bangalore tax tribunal, wherein the issue related to the withholding of tax obligations at the hands of a distributor of Microsoft) also did not find favour with the tribunal. The tribunal did not agree that the ruling could have relevance for the characterisation of income in the hands of Microsoft. By referring to court rulings that explained the rules of the interpretation of statutes, the tribunal noted that, under income tax law, copyrighted articles cannot be treated as products. Further, analysing the provisions of the Copyright Act and applying the same to computer programming, the tribunal concluded that a computer program could qualify as a literary work and compensation made between parties was a royalty.


Under the Double Taxation Avoidance Agreements and Indian tax law, a royalty attracts a flat rate of tax, while income from sale transactions would attract Indian tax only if the overseas entity has a permanent establishment in India.


Along the same lines of global experience in the area of indirect taxation of software transactions, tax policy in India has not been any better, with each taxing entity construing and classifying software in a manner most advantageous to its own coffer.


In Microsoft the tribunal concluded that software transactions result in royalty income by distinguishing the facts from the those in the earlier rulings (Motorola, Samsung, Infrasoft Ltd v Assistant Director of Income Tax [2009] and Sonata), which leaves the controversy on this topic wide open until a higher court decides on the issue.


By D D Nageswar Rao, partner, Amarchand Mangaldas. 


E-mail: nageswar.rao@amarchand.com.


The views expressed are those of the authors and do not reflect the official policy or position of Amarchand Mangaldas.