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Software Royalties and Taxation

Although the intricacies of copyright may make for interesting academic discussion, the inescapable reality is that not all laws relating to copyright are contained in the Copyright Act, 1957. Copyright is, at the end of the say, an economic right, and it has significant financial implications.

One of the issues relating to copyright finance which has been the subject of some debate and much confusion is the issue of software taxation. There have been a series of unrelated cases on the issue where various courts/adjudicating bodies have reached conflicting conclusions. Early cases such as the TCS case and the Sonata case focussed on whether the sale of a disc with a computer programme embedded in it was a transfer of copyright or was merely the sale of a product with a copyrighted work embedded in it. In both of these cases, payments towards shrink-wrapped software were not treated as royalties.

However, the passage of time caused the debate to become more nuanced. In CIT v. Samsung Electronics (Karnataka High Court), the assessee paid a foreign company for the purchase of shrink-wrapped software without deducting tax at source as required by Section 195(1) of the Income Tax Act, 1961, and without making an application to the AO u/s 195(2) for non-deduction of TDS or for deduction at a lower rate. The payments were treated as “royalty” under Section 9(1)(vi), and it was that an assessee cannot avoid liability under Section 201 for non-deduction of TDS merely because of the non-taxability of the recipient. In this case, reliance was placed on the decision of the Supreme Court in Transmission Corporation of India [239 ITR 587] where it was held that those who make payments to non-residents must deduct TDS under Section 195(1). The Supreme Court, however, appears to have stayed the order of the Karnataka High Court in this case.

However, a view contrary to that of the Karnataka High Court was taken by the Mumbai Special Bench in Mahindra & Mahindra [122 TTJ (Mum) (SB)] where it was held that "The underlying principle behind tax deduction at source is the presumption that the amounts paid are chargeable to tax in the hands of the payee. In order to treat the payer as an assessee in default, it is of utmost importance that the sums paid are capable of being brought within the purview of the tax net and an assessment can lawfully be made on the payee. On facts, as no assessment was made on the payee and as the time limit for making an assessment u/s 147 had expired, the order u/s 201 (1) / 201 (1A) passed on the payer was invalid".

Further, the Mahindra & Mahindra case noted that "Though s. 201 (1) does not impose any time limit for the initiation of proceedings or the passing of an order, a reasonable time limit would have to be read in as otherwise the authorities would have an indefinite period to take action and the sword of uncertainty would hang forever over an assessee" and stated that six years would be a reasonable time. In coming to the conclusion that six years would be reasonable, reference was made to the case of CIT v. NHK [305 ITR 137] where the Delhi High Court laid down that the period of four years is a reasonable period. However, this was not followed in the Mumbai case as, being the pronouncement of a non-jurisdictional High Court, it was not binding, and also because there is no unanimity on the subject amongst various Courts.

In Velankani Mauritius v. DDIT (ITAT Bangalore), it was held that sales of shrink-wrapped software are not transfers of copyright but merely the sale of goods protected by copyright. As such, payments made cannot be taxed as royalty either under municipal law or double taxation treaties. The Delhi ITAT, however, came to a completely different conclusion in the Microsoft case where it, inter alia, chose not to rely on double taxation treaties and effectively held that all software sales would be treated as "royalties". The Advance Ruling in the GeoQuest Systems BV case went on to enhance the existing confusion by stating that payment for a software license does not fall within the parameters of a “royalty” if the licensee is not given the right to exploit the software by modifying the source code, reproducing it or transferring it to a third party.

Considering the sheer divergence of legal opinion on the subject, what the legal position truly is appears to be anybody's guess. And that confusion is, not too suprisingly, not limited to the question of whether payments for shrink-wrapped software are royalties. There is also the issue of the extra-territoriality of Section 195 to consider.

(This post is by Nandita Saikia and was first published at Indian Copyright. It is entirely based on posts at ip-tax, ipfinance and  itatonline.)

Extracts from the Income Tax Act:

Section 195

(1) Any person responsible for paying to a non-resident, not being a company, or to a foreign company, any interest (not being interest on securities) or any other sum chargeable under the provisions of this Act (not being income chargeable under the head "Salaries" shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force :
Provided that in the case of interest payable by the Government or a public sector bank within the meaning of clause (23D) of section 10 or a public financial institution within the meaning of that clause, deduction of tax shall be made only at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode : 
Provided further that no such deduction shall be made in respect of any dividends referred to in section 115-O.
Explanation : For the purposes of this section, where any interest or other sum as aforesaid is credited to any account, whether called "Interest payable account" or "Suspense account" or by any other name, in the books of account of the person liable to pay such income, such crediting shall be deemed to be credit of such income to the account of the payee and the provisions of this section shall apply accordingly.
(2) Where the person responsible for paying any such sum chargeable under this Act other than interest on securities, and salary to a non-resident considers that the whole of such sum would not be income chargeable in the case of the recipient, he may make an application to the Assessing Officer to determine, by general or special order, the appropriate proportion of such sum so chargeable, and upon such determination, tax shall be deducted under sub-section  (1) only on that proportion of the sum which is so chargeable :
(3) Subject to rules 1754a made under sub-section (5), any person entitled to receive any interest or other sum on which income-tax has to be deducted under sub-section (1) may make an application in the prescribed form 1754a to the Assessing Officer for the grant of a certificate authorising him to receive such interest or other sum without deduction of tax under that sub-section, and where any such certificate 1754a is granted, every person responsible for paying such interest or other sum to the person to whom such certificate is granted shall, so long as the certificate is in force, make payment of such interest or other sum without deducting tax thereon under sub-section (1).
(4) A certificate granted under sub-section (3) shall remain in force till the expiry of period specified therein or, if it is cancelled by the Assessing Officer before the expiry of such period, till such cancellation.
(5) The Board may, having regard to the convenience of assessees and the interests of revenue, by notification in the Official Gazette, make rules specifying the cases in which, and the circumstances under which, an application may be made for the grant of a certificate under sub-section (3) and the conditions subject to which such certificate may be granted and providing for all other matters connected therewith.

Section 201
(1) If any such person and in the cases referred to in section 194, the principal officer and the company of which he is the principal officer does not deduct or after deducting fails to pay the tax as required by or under this Act, he or it shall, without prejudice to any other consequences which he or it may incur, be deemed to be an assessee in default in respect of the tax :
Provided that no penalty shall be charged under section 221 from such person, principal officer or company unless the Assessing Officer is satisfied that such person or principal officer or company, as the case may be, has without good and sufficient reasons failed to deduct and pay the tax.
(1A) Without prejudice to the provisions of sub-section (1), if any such person, principal officer or company as is referred to in that sub-section does not deduct or after deducting fails to pay the tax as required by or under this Act, he or it shall be liable to pay simple interest at eighteen per cent per annum on the amount of such tax from the date on which such tax was deductible to the date on which such tax is actually paid.
(2) Where the tax has not been paid as aforesaid after it is deducted, the amount of the tax together with the amount of simple interest thereon referred to in sub-section (1A) shall be a charge upon all the assets of the person, or the company, as the case may be, referred to in sub-section (1).