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Controversy around Treatment of consideration for software license

18 Nov 2011

India's participation in international business has increased and accordingly, India has also witnessed a surge in "technology" agreements. Contracts involving sales of software products, provision of license to use the software etc have also increased. An important question about the taxability of cross border payments for purchase of software products has been subject matter of litigation in India for close to a decade. Generally, the Revenue Authorities ("RA") contest that these payments are to be regarded as payment for royalty and consequently, taxes should have been withheld by the Indian companies under the Indian Income Tax Act, 1961 ("the Act") read with the Double Taxation Avoidance Agreement (DTAA) entered into by India with the relevant country. While the taxpayers have been successful before certain Tribunals and the Authority for Advance Ruling ("AAR") in defending the position that the payment for a mere right to use the software should not be treated as royalty, the recent ruling of the AAR in In Re Millennium Software Ltd. has again stirred up the controversy. Taxand India discusses the controversy around software licensing in India, sighting rulings from recent court cases.

The question before the AAR was whether the fee received by a Sri Lankan Company, Millennium Software Ltd ("the Applicant") from Indian Commodity and Exchange Limited ("ICEL"), in respect of a Software License and Maintenance Agreement ("SLMA") was taxable in India. The SLMA was for the development, installation and implementation of a software product and also covered its maintenance and support. The rights granted were non-exclusive, non-transferable, non-assignable and indivisible. However, under the SLMA, a right was granted to ICEL to make copies of the licensed programme only at designated sites of ICEL. The applicant was entitled to a lump sum consideration for installation and implementation, which involved deploying its personnel to train the employees of ICEL. Further, ICEL was to make quarterly payments for software maintenance.

The RA contented that the payments made amounted to "Royalty" under the DTAA between India and Sri Lanka and also as a "process" defined under clauses (i) and (iii) of explanation 2 to Section 9 of The Act. Accordingly, it was contended that the payments were liable to withholding under the provisions of the Act. The Applicant contended that the consideration was merely an "implementation fee" and "license and maintenance" fee were not chargeable under the DTAA. It further argued that, provision of "maintenance services" was not subject to taxation because it would not create a Permanent Establishment (PE) in India. Reliance was also placed on an earlier ruling of the AAR in Dassault Systems.

The AAR noted that computer programmes consist of both source code and object code, and it is well established in the Gracemac Corporation ruling that both the source and object code are protected by the Copyright Act as literary work. In the ICEL Agreement, the source code was expressly excluded. It further held that, the license to use computer programme means right to use the Intellectual Property ("IP"), which is the copyright in the computer programme in a particular way. It has concluded that the license gave ICEL a right to something which would otherwise amount to copyright infringement. It also relied on the customer's right to copy the software at the designated sites and held that one of the essential rights of a copyright owner has been transferred to the customer and consequently, the payment should be regarded as consideration for use of copyright and covered under the scope of royalty.

The AAR also rejected the applicability of the ruling of the Supreme Court in the case of Tata Consultancy services, where branded software products were considered as 'goods'. The AAR held that the mere fact that customs law or sales tax law deems it to be goods for the purpose of the Act does not change the inherent character of software.

Taxand's Take

The ruling of the AAR has only added to the prevailing ambiguity regarding the position of taxation of software payments. The taxability of the payment for the right to use software depends on the nature of rights therein transferred to the payer. A relevant question would be whether the payer has received only the right to use the software products in its business or in addition to this, the right to commercially exploit the property by using any statutory right of a copyright holder, such as the right to reproduce and distribute the software to others.

The Copyright Act, 1957 in India does not consider the right of copying software to a hard disk of a customer for the purpose of use as an infringement of the copyright. Consequently, if the contract allows the customer to do so, it should be construed only as a necessary incidence of the contract of right to use the software and cannot change the basic nature of the transaction.

The Supreme Court itself has applied the ruling in Tata Consultancy Services in an income tax ruling in the case of Oracle software, although in a different context. Hence, it appears that shrink wrap software should be treated as goods and the payment should be treated as business income and should not be subject to withholding tax in the absence of permanent establishment for a non-resident.

However, this issue has not reached finality. The Karnataka High Court has, on a similar issue, recently pronounced its decision in favour of the RA in a number of cases involving many large companies and the formal order is yet to be released. An appeal against this order is also likely to be filed before the Supreme Court and the issue is likely to be finally resolved over the next few months. In the meantime, RA is likely to be more aggressive on the issue of withholding tax on cross border software payments and greater action is likely to unfold soon.

Your Taxand contact for further queries is:
Abhishek Goenka
T. +91 80 4032 0100

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