Issue of Characterization under a tax treaty
The controversy discussed here revolves round the issue whether the payment received by non resident for giving license or selling of a copyrighted product is considered to be business profits in the hands of non resident payee for sale of the product, or is it considered to be transfer of copyright itself and is chargeable to tax as “royalty”.
Whenever one buys a copyrighted product (i.e. copyright has been embedded in the product), there is no transfer of copyright itself. For example, when one buys a book, one buys a book, he has no permission to re print or reproduce it further for commercial use and hence the payment for such book in itself cannot be treated as royalty. Similarly, in a sale of standard off the “shelf software”, commonly referred to as “shrink wrap software”, the end user is generally enabled to only utilize the software for its own business / personal use and cannot exploit the copyright contained therein.
In the case of purchase of copyrighted software, taxpayers have been adopting a position that the same is merely grant of right to use a copyrighted article to a user and not transfer of ‘copyright’ in the software itself. Hence, when non residents (originators of copyright) receive income from sale of such copyrighted articles, the receipt is of the nature of business income not chargeable to tax in the absence of a permanent establishment.
Even the OECD Commentary clarifies that characterization of income and payments under transactions of the nature discussed in this update would form part of business income and not royalties. However, by adopting a reserved position, some Indian judicial forums (in the Reliance Lucent Case as discussed further) are taking the view that these payments constitute royalties. However, time and again taxpayers taken a view that the transfer of all or any rights (including the grant of a license) includes the right to use by the purchase, hence the same are royalty payments and not business profits.
Hence, there is an issue of characterization under the tax treaty, i.e, whether the income received by a non resident as consideration for sale of copyrighted articles are of the nature of royalty or business profits? There have been several judgments passed both in favour of the tax payer as well as the revenue. The key judgments have been discussed below.
Past Judicial Precedents
In the case of Tata Consultancy v/s. State of Andhra Pradesh, the Supreme Court had held that by sale of software programme, the incorporeal right to the software is not transferred as the same remained with the originator and what was sold was the copy of the software. It held that when one bought a copy of the copyrighted novel in a bookstore or recording of a copyrighted song in a record store, one only acquired ownership of that particular copy of the novel or song.
Delhi High Court in the case of Ericson A.B. held that in order to qualify as a royalty payment within the Act, it is to be established that the acquirer by making payments obtains all or any of the copyright rights of the literary work (being software in that case), It held that a distinction has to be made between the acquisition of a copyright right and a copyrighted article.
In the case of Motorola v. DCIT it was held by the Delhi Special Bench of the ITAT the software supplied was a copyrighted article and not a copyright right and not a copyright and the payment received by the assessee in respect of the software cannot be considered to be as royalty either the Income Tax or the DTAA .
In several other decisions like DCIT v/s Metapath Software Intl , Sonata Information Technology v. ACIT , Velankani Mauritius v. DDIT, Kansai Nerolac Paints v. ADIT, the tribunals have upheld the distinction between ‘copyright’ and ‘copyrighted article’.
However, the ITAT Delhi in Gracemac v. ADIT held that end users have not purchased copy of software products on electronic media as contended by the assessee but a license to use such software products. The view taken by the tribunal in the said Gracemac Case was followed in the decisions of Millenium IT Software Ltd, AAI. But a contrary view was taken by the Mumbai Tribunal in ADIT v. TII Team Telecom International 14 which held that since the end user is given a right to use the copyright, it should be characterized as royalty.
In 2012, the Karnataka High Court in CIT v. Samsung Electronics Co. Ltd, upheld the view of the revenue department that the payments for off-the-shelf software to non residents is royalty and hence liable to withholding of taxes in India. The reason given by the said court was that as a right to use a copy of the program for internal business was transferred, therefore a right to make a copy of the program and use it for internal business by making copies and back ups was available and that would itself amount to granting the right to use copyright work under provisions of Indian Copyright Act. The high court opined that, under the Indian Income Tax Act, payments would be characterized as royalty if there is a transfer of rights in respect of‖ a copyright and there is no requirement of transfer of right in the copyright. The language employed under the said Act was wide enough to include payments for a mere right to use the copyright.
Hence the amount paid by the amount paid to the non resident supplier toward supply of shrink wrapped software or off-the shelf software is not the price of the CD alone nor software alone nor the price of license granted. This is a combination of all and in substance.
Issue in the Reliance – Lucent Case
For the purpose of establishing telecommunications network in India, Reliance Infocomm Ltd. (“Reliance”), entered into various separate contracts with various companies of the Lucent group for purchase of certain hardware and software. Under the contracts, Reliance inter alia purchased software from Lucent but the intellectual property rights in the software remained with Lucent as the owner. Except for making copies of the software for back up purpose, Reliance was not permitted to transfer, assign, sub-license modify, decompile, reverse engineer, or disassemble or in any other manner decode the software.
Reliance applied to the tax department for a ‘no-withholding certificate’ in relation to the payments to be made by it to Lucent for the software. The application was rejected by the Assessing Officer (“AO”) on the ground that such payment was of nature of royalty and hence liable to be taxed. On an appeal the Commissioner of Income Tax (Appeals) [CIT(A)] reversed the decision of AO and held that the payment was against purchase of copyrighted article and as there was no permanent establishment of Lucent in India, the same, the same would not be taxable.
On one hand the tax department appealed to Income Tax Appellate Tribunal (ITAT) (Mumbai bench) aggrieved by the order of CIT(A). On the other hand as there was a reassessment done by AO of Lucent, aggrieved by the reassessment, Lucent applied to the Dispute Resolution Panel (DRP) who, in turn confirmed the AO’s order. Therefore, Lucent also approached the ITAT.
ITAT joined the appeals to decide on the common issue which was whether the payment for software license was royalty under the Indian Income Tax Act or the India-US tax treaty and whether there was a consequent obligation on Reliance to withhold tax on a gross basis.
ITAT‘s Ruling in favor of tax department
ITAT noted that payment of hardware and software were done by separate stand alone agreements, unlike in other cases where the hardware which sold also embedded in it the software and that such sale was made under a single agreement.
Relying on the decision of Karnataka High Court in the case of Samsung Electronics (supra), the ITAT held that even though an exclusive right in the copyright is not transferred in a software license, certain rights have been transferred to the licensee in order to enable it to use the software. If this were not the case, such use would be an infringement of the copyright itself.
It accepted the revenue‘s contention that the sale or the licensing of the software includes the grant of a right to use the copyright in the software and right to use the intellectual property embedded in the software by the end user. Hence, the same was more than a mere sale of copyrighted article.
Reiterating the view taken by the Karnataka in the Samsung Electronics case ITAT Mumbai interpreted that the term “in respect” of occurring in the definition of royalty under the Indian Income Tax Act was wide enough to include the consideration paid for the use of copyrighted article. It held that when a copyrighted article was transferred, a right in respect of a copyright contained in the copyrighted article is transferred, which attracts taxability.
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