Payments for software license is not royalty: Delhi High Court

 

The Delhi High Court has delivered an important ruling in the case of Infrasoft Ltd (“the taxpayer”), holding that payments to a non-resident for software licenses are not in the nature of royalty, and hence, would be liable to tax in India only if the non-resident has a Permanent Establishment (“PE”) in India.

Background and brief facts of the case:

· The taxpayer was a software development and marketing company incorporated in USA and had a branch office in India. The branch in India imported certain software used for civil engineering work and for design of highways, railways, airports, ports, mines, etc, and deliver the same to customers in India. The taxpayer also provided installation support, minor customization of software and training for operation of the system.

· The taxpayer considered the receipts towards sale of software products to Indian customers as its business income and offered the same to tax in India. However, the Tax Officer treated the income as royalty, the gross amount of which is taxable at 20 percent in India under section 115A of the Income-tax Act, 1961 (“Act”) read with section 44D of the Act.

· Though the Commissioner of Income-Tax (Appeals) upheld the order of the the Revenue authorities, on further appeal, the Income Tax Appellate Tribunal (“ITAT”) followed the ruling of the Special Bench of the ITAT in the case of Motorola Inc[1]and held that the amounts received cannot be considered as royalty as the taxpayer transferred only a copyrighted article as distinguished from copyright right. The Revenue appealed against this order before the Delhi High Court.

Issue before the Delhi High Court

· Whether the consideration received on grant of licenses for use of software could be considered as royalty under the Agreement for Avoidance of Double Taxation between India and USA (“Tax Treaty”)?

Revenue’s contention

· The taxpayer received payments towards license provided under software license agreement. The right to use of software under the software license agreement resulted in earning of royalty income which was chargeable to tax in the hands of the taxpayer both under the Act as well as the Tax Treaty.

· Storing the software in the hard disk and taking backup would amount to copyright work under section 14(1) of the Copyrights Act, 1957, which right is provided to the licensee by the taxpayer.

· There was no sale of software, whereas the taxpayer had provided mere license to use the software, and the consideration received towards the same ought to be treated as royalty.

Taxpayer’s contention

· The provisions of section 9(1)(vi) of the Act and the retrospective amendments therein need not be examined since the provisions of Tax Treaty override the provisions of the Act.

· The taxpayer neither transferred the copyright in the software nor allowed the use of the copyright in the software, but what was transferred was the right to use the copyrighted material which was clearly distinct from the rights in a copyright.

· Hence, the provisions of Article 12 of the Tax Treaty dealing with royalty should not apply and the income of the taxpayer is business income falling under the provisions of Article 7 of the Tax Treaty.

Ruling of the High Court

· Provisions of the Tax Treaty will override the provisions of the Act to the extent such provisions are more beneficial to the taxpayer. The taxpayer being governed by the provisions of the India US Tax Treaty, the more onerous provisions of the Act would not apply.

· As per the Tax Treaty, in order to qualify as royalty payment, it is necessary to establish that the licensee, by making such payment, obtains all or any of the copyright rights of such literary work. However, in the present set of facts, the licensee has not been provided with any of the rights mentioned in clause (a) of section 14 of the Copyrights Act, 1957. The licensee has been prohibited from copying, decompiling, de-assembling, or reverse engineering the software without the written consent of the taxpayer.

· Distinction has to be made between the acquisition of a "copyright right" and a "copyrighted article". Copyright is distinct from the material object, copyrighted. Copyright is an intangible incorporeal right in the nature of a privilege, quite independent of any material substance, such as a manuscript. Just because one has the copyrighted article, it does not follow that one has also the copyright in it and does not amount to transfer of all or any right.

· The license granted is limited to those necessary to enable the licensee to operate the program. Copying the program onto the computer's hard drive or random access memory or making an archival copy is an essential step in utilizing the program. Therefore, right of copying merely enable the effective operation of the program by the user and should be disregarded in analyzing the character of the transaction for tax purposes.

· A non-exclusive and non-transferable license enabling the use of a copyrighted product cannot be construed as an authority to enjoy any or all of the enumerated rights ingrained in Article 12 of Tax Treaty and hence, the payment for the same is not in the nature of royalty. The consideration is for sale of goods, which is a business income taxable as per Article 7 of the Tax Treaty.