The Supreme Court of India delivered a landmark ruling on March 2 2021 in the case of Engineering Analysis Centre of Excellence Private Limited. The judgment settled a long-running contentious issue over how payments made by Indian customers to non-resident suppliers for the use or resale of computer software should be characterised, providing much-needed tax certainty on the issue.
Facts of the cases
A batch of 103 appeals was pending before the court for a decision on the issue filed by either the revenue department or taxpayers as a result of the High Court's divergent decisions. The controversy was about the taxation of software payments as royalty or business income in the non-resident taxpayers' hands.
The court divided the pending cases into four broad categories based on the agreements between the supplier/licensor of software and distributors/end-users:
- Purchase of computer software directly by a resident from a non-resident supplier or manufacturer;
- Purchase of software by a resident Indian company acting as a distributor or reseller and reselling to Indian end-users;
- Purchase of software by a non-resident distributor from a non-resident supplier and reselling to Indian distributors or end-users; and
- Computer software bundled with hardware sold by non-resident suppliers to resident Indian distributors or end-users.
The revenue department had taxed payments as royalties under the Income Tax Act and relevant agreements for the avoidance of double taxation (DTAs) as it believed the transactions involved a transfer of copyright. Taxpayers, however, were claiming the payments as business income.
The Supreme Court held that the amount paid by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers for the use or resale of computer software through end-user licence agreements (EULAs) or distribution agreements, cannot be classed as a royalty payment. The court concluded that the persons referred to in section 195 of the ITA are not liable to withhold tax out of payments made.
The court analysed samples of distributor agreements and EULAs and delineated the following relevant facts:
- The distributor gets only a non-exclusive and non-transferable license to resell computer software;
- No copyright in the computer program is transferred to either the distributor or to the ultimate end-user;
- The end-user can use the computer program itself, but there is no further right to sub-license or transfer or reverse-engineer, modify, reproduce in any manner otherwise than permitted by the license to the end-user;
- The distributor pays the computer program’s price as a good, in a medium that either stores the software or embeds it in the hardware;
- The distributor does not get the right to use the product; and
- The end-user can only use the computer program by installing it in the computer hardware owned by the end-user and cannot in any manner reproduce it for sale or transfer.
Determining the transfer of copyright under the Copyright Act
The court’s first task was to analyse the Copyright Act in the cases before it to establish whether there was a transfer of copyright or not.
The court observed that a copyright is an exclusive right that restricts others from doing certain acts. It noted that a copyright is an intangible right, in the nature of a privilege, entirely independent of any material substance. Owning copyright in a work is different from owning the physical material in which the copyrighted work may be embodied.
Computer programs are categorised as literary work under the Copyright Act. Section 14 of the Copyright Act states that a copyright is an exclusive right to do or authorise the doing of certain acts in respect of a work, including literary work.
The court observed that a transfer of copyright would occur only when the owner of the copyright parts with the right to do any of the acts mentioned in section 14. In the case of a computer program, section 14(b) speaks explicitly of two sets of acts:
- The seven acts enumerated in sub-clause (a); and
- The eighth act of selling or giving of commercial rental or offering for sale or commercial rental any copy of the computer program.
The seven acts as enumerated in section 14(a) in respect of literary works are:
- To reproduce the work in any material form, including the storing of it in any medium electronically;
- To issue copies of the work to the public, provided they are not copies already in circulation;
- To perform the work in public, or communicate it to the public;
- To make any cinematographic film or sound recording in respect of the work;
- To make any translation of the work;
- To make any adaptation of the work; and
- 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 (1) to (6).
The right to reproduce a computer program and exploit the reproduction by sale, transfer, or licence is the computer program owner's exclusive right.
In addition, making copies or adapting a computer program to use it for the purpose for which it was supplied, or to make back-up copies as temporary protection against loss, destruction or damage to use the computer program, does not constitute an act of infringement of copyright under section 52(1)(aa) of the Copyright Act.
The court held that a licence from a copyright owner, conferring no proprietary interest on the licensee, does not involve parting with any copyright. It said this is different from a licence issued under section 30 of the Copyright Act, which grants the licensee an interest in the rights mentioned in section 14(a) and 14(b) of the Copyright Act.
In the cases before the court, the license granted via a EULA is not a licence under section 30 of the Copyright Act, which transfers an interest in all or any of the rights contained in sections 14(a) and 14(b) of the Copyright Act, but it is a license that imposes restrictions or conditions for the use of computer software.
The court noted that the EULAs in all the appeals do not grant any such rights or interest, least of all, a right or interest to reproduce the computer software. The reproduction is expressly interdicted.
As such, 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 the sale of a physical object which contains an embedded computer program. Therefore, this is a sale of goods. The payments made by end-users and distributors are akin to a payment for the sale of goods and not for a copyright license under the Copyright Act.
Characterising payments under a tax treaty and Income Tax Act
Source rules for royalty taxation are contained in section 9(1) (vi) of the ITA. The rule states that income payable by an Indian resident would be deemed to accrue or arise in India if the royalty is for the purpose of earning any income from any source in India. Explanation 2 to section 9(1)(vi) defines ‘royalty’ as a consideration for the transfer of all or any rights (including granting a licence) in respect of any copyright.
Explanation 4 was inserted in section 9(1)(vi) of the ITA in 2012 to clarify that the "transfer of all or any rights" in respect of any right, property, or information included and had always included the "transfer of all or any right for use or right to use a computer software". The court ruled that Explanation 4 to section 9(1)(vi) expanded the scope of royalty under Explanation 2 to section 9(1)(vi).
Before expanding the royalty definition under the ITA in 2012 to include payments for software, a payment could only be treated as royalty if it involved a transfer of all or any rights in copyright by way of license or other similar arrangements under the Copyright Act.
The court held that once a DTA applies, the ITA provisions can only apply to the extent they are more beneficial to the taxpayer.
The court, after referring to Explanation 4 to section 9 of the ITA and Article 3(2) of the DTA and the CBDT Circular No. 333 dated April 2 1982 held that the definition of ‘royalties’ will have the meaning assigned to it by the DTA. As such, ‘royalty’, when occurring in section 9 of the ITA, has to be interpreted with reference to Article 12 of the DTA.
The court held that any expansive language contained in the explanations to section 9(1)(vi) of the Act would have to be ignored if it is broader and less beneficial to the taxpayer than the definition contained in the DTA. The term ‘copyright’ has to be understood in the context of the Copyright Act.
The court said that by virtue of Article 12(3) of the DTA, royalties are payments of any kind received as a consideration for "the use of, or the right to use, any copyright "of a literary work includes a computer program or software.
The court stated that regarding the expression "use of or the right to use", the position would be the same under explanation 2(v) of section 9(1)(vi) because there must be, under the licence granted or sales made, a transfer of any rights contained in sections 14(a) or 14(b) of the Copyright Act. It said that to this extent there will be no difference in the position between the definition of ‘royalties’ in the DTAs and in Explanation 2(v) of section 9(1)(vi) of the ITA.
As the end-user only gets the right to use computer software under a non-exclusive licence, ensuring the owner continues to retain under section 14(b) of the Copyright Act read with sub-section 14(a) (i)-(vii), payments for computer software sold/licenced on a CD/other physical media cannot be classed as a royalty.
In all the cases before the court, the payments to non-residents by both the end-users and distributors were held as not being taxable as royalties.
Interpretation of tax treaties
The judgment also contained some crucial observations on the interpretation of tax treaties.
The court said the definition of royalties in the tax treaties considered in the cases is either identical or similar to the definition contained in Article 12 of the OECD Model Tax Convention and noted that the Commentary on the OECD Model would have persuasive value for the interpretation of the term ‘royalties’.
The court noted that India took positions about the OECD Commentary, but India and the other contracting states made no bilateral amendment in accordance with its position to change the definition of royalties in any of the DTAs reviewed in the appeals.
The court held that taxpayers have a right to know their position and obligations under a treaty and they can rely on the OECD Commentary and OECD Model Tax Convention, which are used without any substantial change by bilateral DTAs, in the absence of judgments of municipal courts clarifying the same, or in the event of conflicting municipal decisions.
The court noted that India had entered or amended tax treaties with several countries after expressing its reservation, yet the definition of royalty was not changed and remained similar to the OECD Model definition. Hence, its reservation would not apply.
The judgment finally settles a long-drawn tax dispute on the taxation of cross-border payments for computer software use and will provide much-needed tax certainty on the issue.
The mode of delivery of software, for example, through downloads or software as a service, and business models are fast-changing, particularly due to the digitalisation of businesses. Taxpayers paying for software need to analyse their case based on the fact matrix and the four categories of cases dealt with by the court. The same principle would apply to disputes pending with the subordinate courts.
As payments cannot be classed as royalties, taxpayers should reassess their positions to determine whether customs laws, the goods and services law or equalisation levy would apply for such transactions.
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