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Shrink Wrapped Software: Subject to Withholding Tax
In a much awaited ruling with far reaching consequences, the Karnataka High Court has ruled that payments made for purchase of shrink-wrapped software are in the nature of royalty. By implication, these payments would be subject to withholding taxes in India under the provisions of Section 195 of the Income tax Act, 1961. Taxand India provides an analysis of the ruling with a view of how the outcome is likely to impact multinationals in the software industry.
Context and background
The ruling arises out of a batch of appeals filed by companies which distribute shrink wrapped software to (end use) customers as well as companies that imported software for their end use.
These appeals were earlier disposed off by the KHC taking a view that it is not open to the taxpayer to take a unilateral view on the chargeability to tax in India of payments made to non-residents for the purposes of withholding tax under section 195 of the Act. Accordingly, it held that all payments to non residents would be subject to withholding tax, irrespective of chargeability under the provisions of section 195 of the Act, unless a specific dispensation was obtained from the Revenue authorities. In doing so, the KHC did not rule on the characterisation of the payments as either royalties or business profits.
The decision of the KHC on software purchases has gone into the crux of the issue which has seen a divergence of views on characterisation of income, not only in Indian jurisprudence, but world over. The foundation of this ruling lies in the interpretation of the provisions of the ICA and the KHC. The KHC has not concurred with the view of the Delhi High Court in the case of Dynamic Vertical Private Limited, in which it was held that payments for shrink wrap software do not constitute royalty, since the ruling was rendered in the context of section 40a(i) of the Act. However, the KHC has not appreciated that the substantial issue was still the same.
Internationally, the taxability of software payments as royalty has been a widely debated subject. The 2010 update of the OECD model tax convention on income and on capital recognises that copying the software program onto the computer's hard drive or random access memory or making an archival copy is an essential step in utilising the program and therefore, rights in relation to these acts of copying, where they do no more than enable the effective operation of the program by the user, should be disregarded in analysing the character of the transaction for tax purposes. However, India has reserved its position on this interpretation and has indicated that some of the software payments may constitute royalty.
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