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Cross Border Payments on Purchases of Shrink-Wrapped Software are Liable to Tax Withholding in India

28 Jan 2010

Payments to non-residents are subject to tax withholding if the payments are liable to tax in India. The law also permits the payer to approach the Revenue authorities ("RA") prior to making the payment for a determination of the appropriate tax to be withheld. Litigation is very common on whether appropriate tax has been withheld, and the RA generally take a view that the taxpayer should have approached them to determine the tax liability instead of taking a view as a payer on the liability to withhold tax. Specifically, tax withholding on cross border payments towards purchase of shrink-wrapped software has been a much debated and litigated issue. Recently, the High Court at Bangalore ruled on some of these aspects which could have significant implications on payments to non-residents in general and on the software industry in particular.

The cases before the Court affected companies that made payments to non-residents for the purchase of licensed software for onward distribution. These companies had not withheld tax while making the payments on the basis that the payments were for the purchase of goods. The RA took a view that these payments are in the nature of royalty and also held that since the payers failed in approaching the RA for a determination of the tax liability they have defaulted in withholding taxes. The Tax Tribunals however, ruled that the payments were not in the nature of royalty (either under the domestic law or under the relevant tax treaties) and that hence, the buyers had no obligation to withhold tax. The RA approached the High Court against the ruling of the Tribunals.

Although, the Court did not address the question on whether the payment was in the nature of royalty, it ruled that taxes have to be withheld on all payments to non-residents.

In reaching its conclusion, the High Court referred to a ruling in the case of Transmission Corporation, where the Supreme Court had ruled in a payment that comprised both taxable and non-taxable sums, the taxpayers should have approached the RA to determine the sum on which tax had to be withheld. The High Court did not appreciate that the Transmission Corporation case was on different set of facts. The Court also rejected the arguments that when the payment involved no portion chargeable to tax, it was not mandatory to approach the RA to determine the withholding tax liability.

The High Court also did not appreciate that the Central Board of Direct Taxes ("CBDT") had recently prescribed a procedure requiring taxpayers to furnish an accountant's certificate on the withholding tax liability at the time of remitting the payments to non-residents. If the RA is to be approached for determining the withholding tax liability, this procedure would be rendered redundant.

The taxpayers have now appealed to the Supreme Court against the High Court ruling.

Taxand's Take

The Court ruling has unsettled the position on tax withholding on payments to non-residents much to the detriment of the taxpayers. The ruling is also being interpreted by the RA to endorse their view that payments towards licensed software, whether by software manufacturers or distributors, must be subject to withholding of taxes. Further, the recent changes to the tax law, which are effective from 1 April 2010, require tax withholding at a higher rate of 20 percent, wherever the payee has not furnished to the resident payer obtained from the Indian tax authorities. While the taxpayers are looking to the Supreme Court for some respite from the High Court ruling, it also becomes necessary that tax strategies are reviewed and appropriate safeguards are built in light of the recent ruling and developments.

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

Taxand's Take Author