taxation of software payments - the chamber of tax … - sc on... · mixed contracts – royalties...

Taxation of software payments

CA Vishal Palwe

25 August 2014

Contents

• Transfer of full ownership of rights

• Transfer of partial rights

• Distribution of copyrighted article

• Acquisition of copyrighted article by

end-user

• Mixed Contracts

2

• Consideration received for transfer of full ownership of right in copyright is in the

nature of capital gains

• Consideration cannot be said to be for the use of rights

• Form of consideration would not alter the essential character of transfer of full

ownership even if consideration is in installments or related to a contingency

• Under Income-tax Act, even though full transfer of rights is included in the

definition or royalty payments characterized as capital gains are excluded from

the definition of royalty

Transfer for full ownership of rights in copyright

Capital Gains or Business Income

3 Member Firms and DTTL: Insert appropriate copyright (Go Header & Footer to edit this text) © 2014 Deloitte Haskins & Sells LLP

• Consideration for transfer of right to commercially exploit the rights in the copyright that would otherwise be the sole prerogative of the IPR owner would be royalty

• Granting of rights to use IPR in a manner that would, without a license, lead to infringement of copyright

• Royalty is essentially income from letting of IPR such as patents, copyright, similar property to commercially exploit it

• Distinction between letting out IPR and transfer of full ownership in IPR

• Under Income-tax Act, payments for right to use of computer software is royalty

Transfer of partial rights

Royalty


• Consideration for right to distribute copies of copyrighted article without the right

to reproduce it would be characterized as business income

• No right to commercially exploit the copyright per se

• Distribution of software irrespective of whether distributed on tangible media or

electronically (without right to reproduce it)

Distribution of copyrighted article

Business Income


• End-user acquiring a copyrighted article i.e. copy of software program

• Copyright v. copyrighted article i.e. author's right v. reader's right in a book

• OECD view: payment for copyright is royalty whereas payment for copyrighted article is business income

• Indian Courts divided on characterization of payments to copyrighted article as business income or royalty

− Right to make a copy for personal consumption such as a right to make copy for back-up or right to transfer a copy on hard-drive

− Over-emphasis on clauses of End-User Licensing Agreement (EULA) in relation to making copies

Acquisition of copyrighted article by end-user

Business Income


Mixed Contracts – Royalties

Bundled / Embedded Software

• Foreign Co. engaged in manufacturing

advanced telecom systems and equipment

• Equipment manufactured outside India is

sold to Indian telecom operators on a

principal-to-principal basis.

• Software is loaded on the hardware and

does not have any independent existence.

• Software is embodied in the system and

facilitates the functioning of the equipment

and is an integral part thereof.

• There could be two types of arrangement:

− No separate payment for software

− Separate amount provided for hardware

and software

© 2014 Deloitte Haskins & Sells LLP 7

Foreign Co.

India Co

Outside India

India

Supply of

Telecom

equipment

Payments

towards

telecom

equipment

© 2014 Deloitte Haskins & Sells LLP

© 2014 Deloitte Haskins & Sells

Ericsson Radio System A.B. (343 ITR 470) (Del.)

Facts

• Taxpayer, incorporated in Sweden, was in

the business of supplying hardware and

software used in rendering telecom

services

• Taxpayer supplied various hardware and

software to Cellular Operators in India and

contended that payments are not

chargeable to tax in India.

• Employees of the Taxpayer and other

associated companies visited India for

network survey and to negotiate the terms

of the contract.

• Taxpayer was a WOS of L.

• Two other subsidiaries of L provided

installation and marketing support in India.

8

Outside India

India

Operators

Agreement

for supply of

hardware and

software

Installation Agreement

Ericsson Radio

Systems A.B. (Taxpayer)

ECL (subsidiary of L)

Branch

EFC (Subsidiary of L)




Facts (contd.)

• AO held that Taxpayer had business

connection in India.

• AO also held that as per Article 5 of DTAA

between India and Sweden, Taxpayer had

PE in India.

• AO further held that the income arising on

account of licensing of software by

Taxpayer to the Operators was to be taxed

as ‘royalty’ as per Article 12 of the DTAA.

• CIT(A) held that the payment for software

is a ‘royalty’ under DTAA.

• Special Bench of the ITAT decided that the

payment for software is not in the nature of

royalty.

9

Outside India

India

Operators

Agreement

for supply of

hardware and

software


Ericsson Radio



Branch





Issue before the HC

• Whether consideration for supply of

software was royalty under the ITA and

under the DTAA

10

Outside India

India

Operators

Agreement

for supply of

hardware and

software


Ericsson Radio



Branch





Ruling of the HC

• Supply of equipment in question was

supply of goods

• Operators did not acquire any of the

copyrights

• Taxpayer sold a GSM system consisting

both hardware and software and software

was an integral part of GSM system

• Software incorporated on a media is goods

• Reliance placed on Tata Consultancy

Services v. State of Andhra Pradesh (271

ITR 401)

• Payment under contract could not be

apportioned between hardware and

software

11

Outside India

India

Operators

Agreement

for supply of

hardware and

software


Ericsson Radio



Branch





Ruling of the HC (contd.)

• Transfer of all or any rights (including

granting of any license) in respect of

copyright of a computer program is

essential to qualify a payment as royalty

under the ITA

• Distinction between ‘copyright’ and

‘copyrighted article’

• Payment was towards title of GSM system

and not towards software and hence not in

nature of royalty under ITA and under

DTAA

12

Outside India

India

Operators

Agreement

for supply of

hardware and

software


Ericsson Radio



Branch




Reliance Infocom Ltd. (159 TTJ 589) (Mum.)

Facts

• Taxpayer entered into contract with LTIPL

for supply of hardware, software and

services to establish wireless

telecommunications network in India.

• The contract was assigned by LTIPL to its

foreign group company, LTGL. LTGL

supplied software to Taxpayer under this

agreement.

• Taxpayer contended that payments are not

taxable under India-US DTAA as LTGL did

not have a PE in India and applied for nil

withholding tax order.

• AO considered the payments as royalty as

the Taxpayer was getting only license to

use the software. CIT(A) held that

payments cannot be royalty as Taxpayer

purchased ‘goods’ which is a copyrighted

article. AO filed an appeal before the

Tribunal. 13

Outside India

India

LTGL (USA)

LTIPL Reliance

Infocom (Taxpayer)

Contract for

supply of

hardware,

software and

services

LTGL – Lucent Technologies GRL LLC, USA

LTIPL – Lucent Technologies India Pvt. Ltd.




Issue before the Tribunal

• Whether the payments to LTGL are in the

nature of royalty as per the DTAA and

liable to tax in India

14

Outside India

India

LTGL (USA)

LTIPL Reliance

Infocom (Taxpayer)

Contract for

supply of

hardware,

software and

services






Ruling of the Tribunal

• Software is supplied independently and

not along with equipment (hardware) –

ratio of Ericson AB and Nokia Networks

cannot be applied

• Separate contract for supply of software

indicative of fact that software not supplied

with hardware

• Reliance placed on Karnataka HC decision

in cases of Samsung and Synopsis – end

users are granted a ‘copyright’ when they

were granted license to make copy for

internal business

• Reliance also placed on Karnataka HC

decision in case of LTGL’s group

company with similar facts. Payment can

be said to be for right to use of copyright

and amounts to royalty under the DTAA 15

Outside India

India

LTGL (USA)

LTIPL Reliance

Infocom (Taxpayer)

Contract for

supply of

hardware,

software and

services




Royalties

Shrink-wrapped Software

• Copyright owner develops and markets software

• Software is provided in a packed form to the

customers in India along with end user license

agreement. The license agreement appears on

computer screen and must be accepted by the

user before the user can operate the software.

• The license can be a single user license or can

be a multiple user license

• Copyright owner will retain all copyright, trade

mark, trade secrets and other proprietary rights.

• The end user is not permitted to make any

modification or make, works derivative of the

software and user is not entitle to reverse

engineer, decompile, disassemble or otherwise

discover the source code of the software


Copyright owner

End User

Outside India

India

Copyright

owner gives

license of use

of software to

the end user



Infrasoft Limited (264 CTR 329) (Del.)

Facts

• Taxpayer, a US based Company, was engaged

in developing customized software - used for

designing highways, railways, etc.

• Software so customized was licensed to an

Indian customer.

• Taxpayer’s branch office in India performed

services involving installation, training, etc.

Agreement entered into was a non-exclusive,

non-transferable and only one copy was

supplied with various copyright / proprietary

notices of Taxpayer

• Copying, decompiling, de-assembling or

reserve engineering of the software was

prohibited

• AO and CIT(A) held the payments to be in the

nature of ‘royalty’. However, the Tribunal held

in favor of Taxpayer 17

License

fees

Infrasoft Limited (USA) (Taxpayer)

Provides

services

Customer in India

Outside India

India

Branch

office

(Infrasoft)




Issue before the HC

• Whether it was a case of mere transfer of

copyrighted article and did not give rise to

royalty income in terms of the provision of

ITA and India-US DTAA

18

License

fees


Provides

services

Customer in India

Outside India

India

Branch

office

(Infrasoft)




Ruling of the High Court

• Distinction between acquisition of a

copyright right and a copyrighted article

• A non-exclusive and non-transferable

license enabling the use of a copyrighted

product cannot be construed as authority

to enjoy any or all of enumerated rights

• Ownership of a copyrighted article does

not mean transfer of copyright

• Right to use copyrighted article with owner

retaining the copyright is different from

transferring rights in relation to a copyright

• Transfer of some or all rights which

copyright owner has, is necessary to

invoke royalty definition

19

License

fees


Provides

services

Customer in India

Outside India

India

Branch

office

(Infrasoft)




Ruling of the High Court (contd.)

• DTAA contemplates parting of IPRs

attached to software

• Licensee only acquired a copy of the

copyrighted article while the incorporeal

right remained with the Taxpayer

• Transfer was of right to use the

copyrighted article not to use the copyright

• Payment not royalty within meaning of

Article 12(3) of India-US DTAA

20

License

fees


Provides

services

Customer in India

Outside India

India

Branch

office

(Infrasoft)



Synopsis International (212 Taxman 454) (Kar.)

Facts

• Owner of EDA granted license to Taxpayer

to use and exploit the IP in the EDA

• Taxpayer entered into EULA with

customers containing elaborate clauses

protecting owner’s rights in the product

• The AO and CIT(A) held what was

transferred was a license to use software

i.e. a copyright owned by the Taxpayer and

not the copyrighted article.

• The Tribunal, however, held in favor of

Taxpayer holding that what was given was

a copyrighted article and not a copyright

21

Synopsis U.S.

(owner of EDA)

Synopsis

International (Tax

payer)

Customer 1

Customer s

Delivery of software

Payment for software

EULA

License of

EDA

EDA – Electronic Design Automation Tool and Software

EULA – End User Software License Agreement

Outside India

India




Issues before HC

• Whether consideration paid for transfer of

right to use software / computer

programme was in respect of copyright

and accordingly taxable as ‘royalty’ under

the ITA and under the DTAA

• Whether consideration for permission to

use software/ computer programme was

for transfer of any right in respect of

copyright and falls within the mischief of

definition of ‘royalty’

22

Synopsis U.S.

(owner of EDA)

Synopsis

International (Tax

payer)

Customer 1

Customer s



EULA

License of

EDA



Outside India

India




Ruling of the HC

• Words ‘in respect of’ denote a broader

meaning

• Expression ‘copyright’ used in Copyright

Act cannot be used in ITA

• Not necessary that there be transfer of

exclusive right in copyright to constitute

‘royalty’ under ITA

• Transfer of any interest in right or license

constitutes royalty

• Right to use IP possessed by licensor is a

right in respect of copyright, though not a

copyright itself

• Under DTAA, only use of or right to use of

any copyright sufficient to constitute

‘royalty’

23

Synopsis U.S.

(owner of EDA)

Synopsis

International (Tax

payer)

Customer 1

Customer s



EULA

License of

EDA



Outside India

India




Ruling of the HC

• One of the rights of a copyright licensor is

to grant permission to use software or

computer programme

• Transfer of such right is not for transfer of

a copyright but for use of IP in copyright –

not a right in copyright but ‘in respect of’ a

copyright

• Under DTAA, consideration for use or right

to use confidential information in the form

of computer programme itself constitutes

‘royalty’

• Consideration paid is for rights in respect

of copyright and for use of information

embedded in software – falls within

mischief of definition of ‘royalty’ under the

ITA and under the DTAA

24

Synopsis U.S.

(owner of EDA)

Synopsis Old

International Ltd. (Tax payer)

Customer 1

Customer s



EULA

License of

EDA



Outside India

India



Samsung Electronics Co Ltd (345 ITR 494) (Kar.)

Facts

• Taxpayer developed and exported computer

software to its HO

• Taxpayer imported software from USA,

France, Sweden and made payments without

deducting tax at source

• AO and CIT(A) taxed such payments

‘royalty’. However, the Tribunal held that

payments for shrink wrap software did not

amount to ‘royalty’.

• The HC held that all payments made to non-

residents should attract tax withholding

unless a certificate from tax officer is

obtained.

• On appeal to the Apex Court, the Apex Court

observed that HC did not go into the merits

of the case and thereby remanded the matter

back to HC.

25

Delivery of

shrink

wrapped

software

Outside India

India

Samsung Electronics

(Head Office)



USA, France, Sweden

(Customers)

Samsung

Electronics Co. Ltd. (Taxpayer)




Issue before HC

• Whether payment to foreign software

suppliers for shrink-wrap software was in

the nature of ‘royalty’ under ITA and under

the DTAAs

26

Delivery of

shrink

wrapped

software

Outside India

India

Samsung Electronics

(Head Office)



USA, France, Sweden

(Customers)

Samsung





Ruling of the HC

• What is transferred is only license to use

copyright while the suppliers continue to

be owners of copyright and other IPRs

• License is granted for use of copyright

contained in shrink-wrapped software or

off the shelf software

• Intent of legislature in imposing sales tax

and income-tax are entirely different – levy

of sales tax on software does not preclude

payments from amounting to ‘royalty’

• Right to make a copy and use it for

internal business would amount to

copyright under Section 14(1) of Copyright

Act

27

Delivery of

shrink

wrapped

software

Outside India

India

Samsung Electronics

(Head Office)



USA, France, Sweden

(Customers)

Samsung





Ruling of the HC (contd.)

• Price paid towards shrink software is for

combination of CD along with software and

the license granted

• Transfer of copyright including right to

make copy of software for internal

business and payment made in that regard

would constitute ‘royalty’, both under ITA

and respective DTAAs

28

Delivery of

shrink

wrapped

software

Outside India

India

Samsung Electronics

(Head Office)



USA, France, Sweden

(Customers)

Samsung



Royalties

Distribution

Scenario 1

• Copyright owner appoints distributor as an

approved/ exclusive distributor with no

rights to copy

Scenario 2

• Standardized product sold by copyright

owner through independent, third party,

non-exclusive reseller network; no right to

open/ use the product


Distributor

Copyright owner

End user

Distributor distributes

the software

Outside India

India



Sonata Information Technology Ltd (207 Taxman

59) (Kar.) Facts

• Taxpayer imported software from overseas

vendors under separate distribution

agreements.

• Taxpayer had obtained right to distribute

copyrighted material - different from

ownership of copyright in the software

• Also vendors had no PE in India and hence,

no tax deducted under Section 195 of the ITA

• The AO and CIT(A) held that payments were

royalty under Section 9(1)(vi) of the ITA and

Section 195 should apply.

Ruling of the Tribunal

• Payments were for acquisition of software

products and not for acquisition of any IPRs

specified in the definition of ‘royalty’ under

the DTAA

• Purchase of copyrighted article partakes the

character of purchase and sale of goods

• Payment by Taxpayer is for use of a

copyrighted article and not any right in

copyright 30

Distributor (Taxpayer)

Copyright owner

End user

Outside India

India

Copyright owner gives

license of use of

software to the end user

End user



Sonata Information Technology Ltd (207 Taxman

59) (Kar.) Issue before the HC

• Whether consideration for computer software

constitutes ‘royalty’ under the ITA or the

DTAA

Ruling of the HC

• Consideration paid by Indian end users for

transfer of the right to use the software falls

within the mischief of 'royalty' defined under

the ITA

• Reliance placed on Synopsis International

Old Ltd. and Samsung Electronics Co. Ltd.

31

Distributor (Taxpayer)

Copyright owner

End user

Outside India

India

Copyright owner gives

license of use of

software to the end user

End user



Distribution Other Judicial Rulings

Dassault Systems KK (322 ITR 125) (AAR)

• Payments made by Value Added Reseller (VAR) to non-resident supplier for computer

software

• Rights, enumerated in copyright law directed towards commercial exploitation

• Where such rights conferred to enable enjoyment as an owner, implies use of copyright

• End user/ VAR not given such ‘copyright’

• Enabling end user to have benefit of software with no right to deal with them

independently, no right in relation to copyright and therefore not ‘royalty’

Gracemac Corporation v. ADIT (42 SOT 550) (Del)

• Parent Co., Microsoft Corp., granted to Taxpayer exclusive right to license any right to

reproduce software portion of MS retail products for internal use

• Taxpayer entered into agreements with distributors in India through fellow subsidiary

• Indian distributors entered into end user license agreement (EULA) with customers in

India for usage of various software programmes

• Payment made by end user for grant of license to use software programme (title,

copyright, and other intellectual property rights in software programmes not transferred to

end user) would amount to royalty under the ITA since payments made by end users were

for granting of license in copyright and other IPRs in product 32



Relevant Judicial Decisions – Post amendment

Particulars Forum Decision

CIT, International

Taxation v. P.S.I

Data System Ltd

(208 Taxman 452)

Karnataka

High Court

• Payment to non-resident for purchase of software held as royalty

• Reliance placed on CIT v. Samsung Electronics Co. Ltd.

DIT v. Nokia

Networks OY (253

CTR 417)

Delhi High

Court

• Distinction has to be made between a ‘copyright’ and a

‘copyrighted article’

• The definition in Article 13(3) of the DTAA is narrower than the

ITA and refers to payments for use / right to use a copyright

of a literary work

• The amendment to the definition of ‘royalty’ under Section

9(1)(vi) by the Finance Act, 2012 cannot be read into the DTAA

• The payments are for supply of goods and are not ‘royalty’

Novel Inc. v.

DDIT(Intl. Tax) (49

SOT 45)

Mumbai

Tribunal

• Payment received by non-resident from sale of software to

the Indian distributors for onward sale to its end customers

held not taxable as royalty

CIT, International

Taxation v.

Customer Asset

India (P.) Ltd. (42

taxmann.com338)

Karnataka

High Court

• Consideration paid by Indian end users to foreign supplier, for

transfer of the right to use the software falls within the mischief of

'royalty' defined under the ITA

• Reliance placed on CIT v. Synopsis International Old Ltd. and CIT

v. Samsung Electronics Co. Ltd.

33 © 2014 Deloitte Haskins & Sells LLP


Key Indian judicial precedents

34

Name Facts & Ruling

ABC, In re

238 ITR 296 (AAR)

• Payment for access to US based global central processing

unit

• Held royalty as such access allowed use of protected

software developed by the US entity

Lucent Technologies

Hindustan Ltd v ITO

92 ITD 366 (Bang)

• Purchase for supply of electronic switching systems, Lucent

placed a single purchase order with US entity

• Software and hardware supplied separately, software

integrated into hardware by Lucent and sold

• No right of software duplication given to Lucent

• Lucent purchased copyrighted article and not copyright of

the rights, hence payment not royalty

Wipro Ltd v ITO

94 ITD 9 (Bang)

• Annual subscription/access fee for use of database

• Database maintained outside India

• Held payment is for use of copyrighted article and not for

transfer of right in the copyright in the article, not royalty



35

Name Facts & Ruling

Tata Consultancy

Services v State of AP

(271 ITR 401)

• Constitution Bench of Supreme Court on applicability of

sales tax

• Held computer software in a tangible medium software is

“goods” (tangible property)

Motorola Inc v DCIT

(95 ITD 269) (Del) (SB)

• Supply of telephony equipment together with software

• Held application software supplied was copyrighted article

and not a copyright right, hence not royalty under the ITA of

DTAA. Relied on earlier Lucent decision

• Considered OECD commentary and US regulations

• Followed in many subsequent decisions on software

characterization



36

Name Facts & Ruling

Airports Authority Of

India, In Re 304 ITR 216

(AAR)

• Payment to US entity for supply of hardware, software,

software documentation, installation, testing, training, etc

• Income relatable to software supply constituted royalty as

recipient received right to use copyright

Geoquest Systems BVI v

DIT 327 ITR 1 (AAR)

• Supply of special purpose computer software to be used in

exploration/production of mineral oils

• Exclusive, non-transferrable license to use software, title

transfer takes place outside India.

• Held mere transfer of computer software de-hors any

copyright associated with it and hence not royalty.

taxation of software payments - the chamber of tax … - sc on... · mixed contracts – royalties...

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