Aseem Chawla

ASC Legal Solicitors & Advocates, New Delhi; Former Secretary, IBA Taxes Committee

aseem@aseemchawla.com

Assisted by Pulkit Agarwal and Dewang Chauhan      

The Supreme Court of India ('SC' or the ‘Court’) has recently rendered its decision in Engineering Analysis Centre of Excellence v The Commission of Income Tax & Anr ^[1] finding that the amount paid by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale/use of computer software, cannot be characterised as ‘royalty’ (that is, the use of copyright in the computer software) under Article 12 of the Tax Treaties (DTAA). Instead, the Court found the amounts paid are akin to simpliciter purchase of goods and, therefore, do not give rise to a liability to deduct any taxes at source (TDS), under Section 195 of the Income-tax Act 1961 (Act). The case involved civil appeals covering the India-US DTAA, the India-UK DTAA and the India-Singapore DTAA, among 18 other DTAAs between India and various nations.

Background

The SC litigation over the potential taxation of payments for computer software had arisen on account of the divergent pronouncements of various courts, primarily, the judgments of the Karnataka High Court,^[2] the Delhi High Court^[3] and the contrary rulings of the Authority of Advance Ruling.^[4] The SC judgment covers 86 appeals, which can broadly be grouped into four broad categories as under:

• Category 1 - Resident Indian buyers/end-users who purchase computer software directly from a foreign non-resident supplier or manufacturer;
• Category 2 - Resident Indian traders/distributors/resellers who purchase computer software from foreign, non-resident suppliers or manufacturers for the purpose of resale to other resident Indian end-users;
• Category 3 - Foreign, non-resident vendors, who, after purchasing software from other foreign, non-resident sellers, resell it to resident Indian distributors or end-users; and
• Category 4 – Foreign, non-resident suppliers who affix computer software onto hardware and then sell it as an integrated unit/equipment to resident Indian distributors/end-users.

Facts in brief

In the original case, the taxpayer was a resident Indian end-user of shrink-wrapped computer software imported from the United States. For the year in question, the taxpayer did not withhold tax on the payment because they did not consider it taxable in India. On examination of the End-User Licence Agreement (EULA) involved in the transaction, it was held that what was sold by way of computer software included a right or interest in copyright, which then gave rise to the payment of royalty and thus was an income deemed to accrue in India under section 9(1)(vi) of the Act.

The SC Decision: reliance on DTAA for the withholding tax obligation under Indian domestic tax laws

The SC has upheld the principle that once a DTAA applies, the provisions of the Act can only apply to the extent that they are more beneficial to the assessee and not otherwise. Further, where any term is defined under the DTAA, the definition contained in the DTAA itself has to be looked at.

The SC has reaffirmed the position laid down in the case of GE Technology Centre Pvt Ltd^[5] that the operative provisions of TDS under section 195 of the Act are inextricably linked with the charging provisions, as a result of which, the TDS obligation arises only when the sum is chargeable to tax under the provisions of the Act, read with the DTAA.

Reference has also been made to the Central Board of Direct Taxes, the direct tax administration body in India, in its Circular No 728 (30 October 1995), in which it has been clarified that the tax deductor must take into consideration the effect of the DTAA provisions in respect of payment of royalties and technical fees when deducting taxes at source.

The SC has rejected the Indian Department of Revenue’s reliance on its decision in the case of PILCOM^[6] on the basis that that case was in the context of section 194E (not section 195); section 194E does not have any reference to payments being chargeable to tax under the Act.

The Revenue’s reliance on Article 30 (in relation to entry into force) of the Indo-US DTAA was also rejected by the SC for the reason that it cannot be read out of context and was only dealing with the ‘entry into force’ provisions, which is as per the domestic municipal laws.

Discussion on the nature of agreements and EULAs under the four categories of taxpayers

The SC, in its judgment, has analysed the relevant underlying agreements/EULAs under each of the four categories of taxpayers as illustrative documents:

• Category 1 – EULA between Samsung Electronics (non-resident supplier) and the end-users;
• Category 2A – Re-market agreement between IBM Singapore (non-resident supplier) and IBM India (Indian distributor/re-marketer);
• Category 2B – EULA with Indian end-users of software distributed by IBM India;
• Category 3 – Standard EULAs accompanying Microsoft software products sold to resident Indian end user by Microsoft Corporation (non-resident foreign vendor); and
• Category 4 – Supply contract between Indian company and Swedish supplier (Ericsson Radio Systems AB).

On a review of the above agreements/EULAs, the SC noted that in the case of an Indian distributor:

• The distributor is only granted a non-exclusive, non-transferable licence to resell computer software. It is expressly stated that no copyright is transferred either to the distributor or to the ultimate end user;

• No right has been granted to sub-license or transfer, nor is there any right to reverse engineer, modify, reproduce in any manner otherwise than permitted by the licence to the end-user;
• What is paid for by way of consideration by the distributor in India to the non-resident manufacturer or supplier is, therefore, the price of a copy of the computer program as goods (direct software sale or hardware embedded with software); and
• Importantly, the distributor does not get the right to use the product at all.

Similarly, in the case of an end-user, the SC noted that:

• The end-user can only use the computer program by installing it in the computer hardware and cannot reproduce it for sale or transfer. That is, there has been no act contrary to the terms imposed by the EULA; and
• The licence granted vide the EULA is not a licence in terms of section 30 of the Indian Copyright Act 1957 (ICA) but is a licence which imposes restrictions or conditions on the use of the computer software.

Further, the SC also rejected the argument of the Indian Department of Revenue, that some of the EULAs term the transaction not as a sale but as one of licensing. The SC has noted that it is a settled law that in all such cases, the real nature of the transaction must be looked at, by reading the agreement as a whole (that is, the agreement along with EULAs and other accompanying documents in the case and not just the EULA on a standalone basis, for determining the use of the term licence).

Accordingly, the SC has followed the SC judgment in the case of Sundaram Finance Limited^[7] (in the context of looking at the real nature of the transaction) and Tata Consultancy Services^[8] (in the context of a sales tax statute wherein imported computer software was categorised as goods).

Taxability of software payments and the OECD Model Tax Convention

The SC noted that the appeals were concerned with DTAAs between India and 18 other countries (Singapore, the United Kingdom, the US, etc) which are based on the Organisation for Economic Cooperation and Development (OECD) Model Tax Convention on Income and on Capital. The definition of ‘royalties’ is substantially similar to that of the OECD Model Tax Convention and is exhaustive as it uses the expression ‘means’. The term ‘royalties’ refers to payments of any kind received as consideration for ‘the use of, or the right to use, any copyright’ of a literary work. Having noted the above, the SC has held that the transfer of all or any rights as mentioned in the ICA is sine qua non for the payment to qualify as ‘royalty’.

Taxability under the provisions of the Income-tax Act 1961

The SC noted that the definition of ‘royalty’ under the Act is wider than in the DTAA in at least the following three aspects:

• Consideration includes lump sum consideration which would not amount to income of the recipient chargeable under the head ‘capital gains’;
• Transfer of ‘all or any rights’ expressly includes the granting of a licence in respect thereof; and
• Such a transfer must be ‘in respect of’ any copyright of any literary work.

The SC noted that there is no difference between the provisions of Explanation 2 (to Section 9(1)(vi) of the Act) and the DTAAs. However, the Revenue strongly relied on the retrospective clarificatory amendments made vide the Finance Act 2012 (specifically Explanation 4 in the context of computer programs).

The contention argued by the taxpayers that the clarificatory amendment does not alter the definition of royalty under the Act, as the amendment applies to section 9(1)(vi)(b) and not to the definition of royalty under Explanation 2, has been rejected by the SC.

However, the SC also rejected the Revenue’s argument that Explanation 4 is merely clarifying the position of the section as it always stood (since 1 June 1976), on the basis that computer software itself was introduced in Section 9(1)(vi) 1 April 1991. Therefore, quite clearly, Explanation 4 cannot apply retrospectively before ‘computer software’ was included in the definition. In light of this, the SC has held that the retrospective amendment to section 9(1)(vi) is not clarificatory of the position as of 1 June 1976, but, in fact, expands the definition with effect from the Finance Act 2012.

The SC has also quoted various other court rulings and stated that the person (as mentioned in section 195) cannot be expected to carry out an impossible act, namely, apply the expanded definition of royalty (as per the retrospective amendments) for the years pre-2012 in question, that is, at a time when such an explanation was not actually - and factually - in the statute.

Interplay with the Indian Copyright Act 1957

The SC carried out an in-depth analysis of the provisions of the ICA and explained that when the owner of a copyright in a literary work assigns, wholly or in part, all or any of the rights contained in section 14(a) and (b) of the ICA in the work for consideration, the assignee of such a right becomes entitled to all such rights comprised in the copyright and becomes the owner of the copyright of what is assigned to him/her. The grant of any interest in any right, to a licensee by way of a licence, may entail royalty for parting with such interest.

Upon examination of the End-User Licence Agreement (EULA)/ distribution agreement, the SC found that what was granted to the distributor was only a non-exclusive, non-transferable licence to resell the computer software. It was also noted that apart from a right to use the computer program by the end-user themselves, there was no further right to sub-license or transfer, nor was there any right to reverse-engineer, modify or reproduce in any manner otherwise than permitted by the licence to the end-user. The SC observed that in all the cases, the licence that was granted was not a ‘licence’ that transfers an interest in all or any of the copyright rights but was a ‘licence’ that imposes restrictions or conditions on the use of computer software.

The SC deciphered that 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, in fact, the sale of a physical object which contains an embedded computer program, and is therefore, a ‘sale of goods’.

Interpretation of DTAAs, OECD Commentary and the Revenue’s own understanding

The SC upheld the principle laid down in Azadi Bachao Andolan^[9] that the DTAAs have to be interpreted liberally with a view to implementing the true intention of the parties. The Court noted that all the DTAAs have either the OECD Model Tax Convention or the UN Model Tax Convention as their starting point.

The SC also highlighted the importance and relevance of the OECD Commentary in interpreting the DTAAs and the fact that the OECD Commentary has been referred to extensively in earlier judgments of the SC as well as in several international legal systems.

As per Paragraph 14 of the OECD Commentary on Article 12 in the DTAAs, the SC highlighted that the copying of a programme onto the computer’s hard drive is an essential step in utilising the programme. Therefore, the SC opined that it should be disregarded in analysing the character of the transaction for tax purposes.

As part of its case, the Revenue relied on India’s reservations with the OECD Commentary. But the SC rejected that and observed that India’s position is not clear cut when you look at the language of its reservations expressed in this context compared with the categorical language it used while expressing its reservations in certain other aspects.

Further, no bilateral amendment was made by India and the other contracting states to change the definition of ‘royalties’ in the DTAAs. While several DTAAs (Mauritius, Morocco and Singapore) have been amended subsequent to the reservations being expressed, the definition of ‘royalties’ has not been changed.

Thus, the SC held that the OECD Commentary on Article 12 incorporated in the DTAAs will continue to have persuasive value in interpreting the term ‘royalties’.

Our comments

India’s highest Court has finally put an end to 20-year-old litigation around software royalty. The decision in favour of the taxpayers has eloquently elucidated that cross-border payments made in the sale of software to a non-resident shall not be taxed as royalty. The Court explained that what is licensed by the foreign, non-resident supplier to the distributor and resold/directly supplied to the resident end-user, is, in fact, the sale of a physical object which contains an embedded computer program, and therefore must be categorised as a ‘sale of goods’.

The SC recognised the relevance of the OECD Commentary on the subject. The Court held that the DTAAs have to be interpreted liberally with a view to implementing the true intention of the parties. Distributing copies of the program without the right to reproduce that program is paying only for the acquisition of the software copies and not to exploit any right in the software copyrights.

It held that the OECD Commentary on Article 12 incorporated in the DTAAs will continue to have persuasive value as to the interpretation of the term ’royalties‘. The Commentary also clarifies that arrangements between a software copyright holder and a distribution intermediary will grant to the latter the right to distribute copies of the program without the right to reproduce that program.

In these transactions, the rights acquired in relation to the copyright are limited to those necessary for the commercial intermediary to distribute copies of the software program.

Even though India had expressed its reservations on the OECD Commentary, particularly on the aspects dealing with copyright and royalty, and emphasised that it should not be relied upon, the SC held that mere positions taken with respect to the OECD Commentary do not alter the provisions of a tax treaty which India has negotiated and signed - unless it is amended by bilateral re-negotiation.

This SC judgment will pave the way for foreign vendors of computer software to receive payments from Indian customers without withholding tax implications, thus addressing the challenges associated with getting foreign tax credit in their home countries.

Inapplicability of the exhaustion doctrine

In respect of the ‘exhaustion’ or ‘first sale’ doctrine, once the owner of the copyright sells a copyrighted article, he/she exhausts all rights to control that particular article, although the copyright continues to vest with him/her. The Revenue argued that this doctrine would not be applicable to the present case as the Copyright Act was amended in 1994 and in 1999, and it no longer recognises the principle of exhaustion. Accordingly, when distributors sell computer software or a copyrighted software licence to end-users, there would be parting of a right or interest in copyright itself as per the Indian Copyright Act. It further relied on a judgment of the Ninth Circuit Court of Appeals of the US,^[10] which contended that doctrine of first sale cannot be invoked by distributors/licencees who are not the owner of copyright.

In this regard, the Hon’ble Supreme Court dismissed the argument by stating that the doctrine of first sale/exhaustion doctrine has been statutorily recognised in the Copyright Act and is applicable to the case of the distributor or reseller.

The shrink-wrapped copies of the computer programs are already put in circulation by foreign, non-resident suppliers / manufacturers, since they have been sold and imported into India via distribution agreements, and are thus not affected by section 14(a)(ii) of the Copyright Act, which gives an exclusive right to issue copies of the work to the public 'not being copies already in circulation'.

The SC held that the distribution right subsists with the owner of copyright to issue copies of the work to the public, to the extent such copies are not copies already in circulation, thereby manifesting a legislative intent to apply the doctrine of first sale/principle of exhaustion. On this basis, the Court held that the Copyright Act only prohibited the reproduction and subsequent sale of a copy of the licensed copy, and not the resale of the copy.

Given the rapid pace at which technology has moved in the two decades since this SC litigation was first brought, it is unclear to what extent the principles elucidated will be useful in the present era where the lines between service and software are becoming blurred. The mode of delivery of software is also now completely digital.

Let us hope we do not have to wait another twenty years before some of the new technology issues are again contested and resolved in the courts. Until such time that the global tax community decides on a consensus on the tax aspects of rapidly-changing technology which challenges conventional tax systems and settled approaches, we will have to brace ourselves. It is likely this is not the last word on this subject.