Software disputes generate uncertainty

For years, US software companies have been flooding into India. Corporations looking for cost effectiveness in software development enjoy lower operating costs, including competitive rates for Indian manpower. The Indian government has also introduced policies that are favourable for foreign companies, which include new laws making it easier for companies to invest in the country and improvements to infrastructure.

However, US software companies may be beginning to wonder if these advantages are being tempered by increased uncertainty from the Indian courts. For years, Indian tribunals have been issuing contradictory rulings on the issue of software royalties, in particular.

The questions surrounding computer software income centre around whether to classify this income as a royalty, which under Indian tax laws and most double tax treaties is subject to withholding tax, or as sales or business profits, which are generally not taxable without a permanent establishment on the part of the non-resident company in India.

Dwaraknath Narasimham: A lot of companies were definitely more cautious on the issue of withholding tax on overseas payments consequent to the ruling

"In general, over the past few years, Indian courts have come out with very well reasoned rulings on the taxability or otherwise of transactions in India," said Dwaraknath Narasimham, a director at the India tax desk of PwC in the US.

Though a large majority of Indian court decisions since 2006 have classified a supply of standard software as sales or business profits, Indian tax authorities have never accepted this position.

In October 2010, the Income Tax Appellate Tribunal (ITAT) in Delhi provided them with a reason to hope that their position was still viable, when that court issued a ruling that confused many advisers and taxpayers in a case in which a US technology company was involved.

The case, Microsoft Corporation v ADIT, ignored precedent set in other tribunals and held that payments for the right to use packaged software should be regarded as royalties, and therefore will be taxable in India.

Microsoft had sold copyrighted software in India through an Indian distributor, who then sold the software to various re-sellers and end-users in India. Microsoft also entered into end-user licence agreements directly with the end-users.

The court found that since Microsoft had granted certain non-exclusive rights to the licensees, a transfer or use of the copyright had occurred. Since, in the court's opinion, the licence provided for the use of intellectual property rights in the product, the payment for the licence should be characterised as a royalty.

Before the Microsoft case, Indian courts had delivered six to eight decisions in favour of the taxpayer. Some of these cases were appealed all the way to the Indian Supreme Court. In fact, most practitioners had considered the issue of software royalties to be fairly settled.

The Microsoft decision ignored previous tribunal rulings Source:www.microsoft.com

"In general, over the past few years, Indian courts have come out with very well reasoned rulings on the taxability or otherwise of transactions in India," says Narasimham. "While this ruling does create some amount of uncertainty on this specific issue, I don't see it as deterring companies from investing in India."

Predictably, the outcome of Microsoft had a considerable effect on non-residents in India.

"A lot of companies were definitely more cautious on the issue of withholding tax on overseas payments consequent to the ruling," said Narasimham.

Himanshu Bhatia believes Indian customers should review their position on withholding tax while making payments for software from the US

"Indian customers may want to review their position on whether they should withhold tax or not while making payments for purchase of software from US companies," said Himanshu Bhatia, a member of the India desk at Ernst & Young in New York. "[Software suppliers] may want to evaluate the possibility of building the withholding tax cost into their pricing & contractual arrangements, subject to competitive considerations."

Many observers believe that the ruling in Microsoft should properly be considered as an exception, rather than as the rule. They argue that most other rulings, as well as most decisions issued by the Authority for Advance Rulings (AAR), regard software transactions as giving rise to business, rather than royalty income.

However, the Microsoft case may still cause some problems in the future. The Indian tax authority, emboldened by the precedent set in the case, may seek to litigate more and more cases on the strength of this decision alone.

If Microsoft appeals the ITAT ruling, the Delhi High Court will almost certainly hear the case. It is difficult to predict the outcome. Most tax experts believe that the tribunal's decision will eventually be overturned, even if that means Microsoft going all the way to the Supreme Court. Advisers are confident that in the event of a Supreme Court hearing, the court will find in favour of the taxpayer.

Rajesh Gandhi: People are getting used to uncertainty in India

"I think that developing certainty in this area will take time," said Rajesh Gandhi, client services executive on the India desk at Deloitte in New York. "I think this issue will certainly get to the Supreme Court level, but it may take three or four years to get finality on this."

Some tax advisers noted that although their clients were concerned by the decision, they were not necessarily surprised at the fact of a contradictory ruling coming out of an Indian court.

"People are getting used to uncertainty in India," said Gandhi."From a business perspective, I don't think it will deter companies from coming to India."

While US technology companies were rightly concerned with the outcome of the Microsoft case, the subsequent decision of the Mumbai Tribunal in the Reliance case on the same subject does provides some reassurance.

In Reliance, the court concluded that a sale of computer software, without any transfer of the copyright associated with the product, will not amount to royalty.

Many tax advisers are less than hopeful that greater certainty will be achieved in the short term. It is likely that the Supreme Court will want to weigh in on the issue, since the amounts in controversy are so large and the lower courts may not appreciate the importance of these questions for investment in India. Still, the process of appealing a case to the Supreme Court can take years.

Some practitioners are hopeful that the new Indian Direct Taxes Code (DTC), which will be effective on April 1 2012, will contain some language which will clarify the law around the taxability of software payments. Specifically, they hope that the DTC will expand the definition of technical service fees to specifically include services for the development and transfer of software.

And, on December 21, the Indian government issued a notification to address the uncertainty surrounding taxability of software payments. Specifically, the notification exempted from service tax the right to use packaged or canned software.

Still, there is a long way to go in clarifying the debate.

"The proper resolution of the software revenue characterisation issue requires acknowledging that, at least for tax purposes, those transactions which give rise to sales income do not lie along a single continuum with those that give rise to royalties, but rather are different in kind," said Bhatia.

Bhatia also explained that the critical first step in the characterisation process is to articulate the commercial, legal and economic facts which distinguish those two broad categories of transactions for tax purposes.

The taxation of software is a top priority for multinationals doing business in India

For the time being, advisers are telling clients that one of the best ways to avoid an unexpected outcome is to petition the AAR, a body which can provide companies with a characterisation of their transaction in advance, thereby hopefully avoiding costly litigation down the road. Many advisers believe that the authority is fairer and less biased than the courts.

Litigation before the various courts can take as long as 10 years, so an AAR ruling is less time consuming, as well as less costly. And an AAR ruling, which may be obtained in as little as six to eight months, is binding on the tax authorities.

"It is definitely advisable to get an advance ruling when the amount in question is significant, because there are so many costs involved in terms of consulting and litigating," said Gandhi.

However, there are roadblocks to this approach, as well.

"Given that a new chairman of the AAR has been appointed only recently, there is a backlog of cases and therefore, new rulings may take some time to be decided," said Narasimham.

In the meantime, advisers expect more litigation. Until either the Supreme Court rules conclusively on the subject, or the Indian tax authorities issue a clarification, the question of software payments will continue to suffer from contradictory judgments. Given the large payments involved, the tax authority will certainly litigate the matter until a ruling is obtained from the Supreme Court.

Still, this may not be enough to drive entrepreneurship from India.