Apex Court holds payment made for use of Software not taxable as Royalty

Taxation of payment for license to use computer software has been one of the most talked about subject of tax litigations where the Courts have been divided alike. For the past two decades, the Revenue Authorities and taxpayers were at crossroads when it came to taxability of shrink-wrapped computer software. While taxpayers would contend that the transaction is that of sale of copyrighted article, the Revenue Authorities would contend that it is towards use of copyright and thus taxable as royalty. In order to address this issue, the Finance Act, 2012 retrospectively inserted Explanation 4 to Section 9(1)(vi) of the Income-tax Act, 1961 (‘ITA’) to clarify that the term royalty would include transfer of all or any right for use or right to use a computer software (including granting of license) irrespective of the medium through which such rights is transferred.

As tax litigations covering issues of taxability of shrinked wrapped computers pending for decision with Supreme Court (‘SC’) since 2018, it was expected that there will be some finality to this issue. SC has recently pronounced its verdict on the much-awaited matter and thereby bringing an end to the ongoing controversy[1].

After relying on various judicial pronouncements, the Copyright Act, OECD Commentary, the SC ruled in favour of the taxpayers by holding that “the amounts paid by resident Indian end-users/distributors to non-resident computer software manufacturers/suppliers, as consideration for the resale/use of the computer software through EULAs/distribution agreements, is not the payment of royalty for the use of copyright in the computer software, and that the same does not give rise to any income taxable in India, as a result of which the persons referred to in section 195 of the Income Tax Act were not liable to deduct any TDS (withholding) under section 195 of the Income Tax Act.”

We have analysed judgement of Apex Court in detail as under:

Facts of the case:

Assessee, being resident Indian Company, had directly imported shrink-wrapped computer software from USA and had made payment without withholding taxes during AY 2001-02 and AY 2002-03. AO, after applying section 9(1)(vi) of the ITA to the transaction, had come to a conclusion that it was a case of transfer of a copyright by USA supplier, taxable as Royalty. Accordingly, assessee was liable to deduct TDS on the payment made for importing copyrights.

AO treated the assessee as assessee-in-default and thereby made a tax demand on account of failure to withhold tax. The First Appellate Authority upheld the action of the AO. Upon further appeal to Tribunal, placing reliance in the case of Samsung Electronics Co Ltd vs ITO[2], assessee was granted relief from tax demand. Further, appeal was filed by revenue to Karnataka High Court, whereby relying on the SC decision in case of Transmission Corporation of AP2 Ltd[3], it was held that since no application was made under section 195(2) of the ITA, assessee was liable to withhold taxes and thereby demand was imposed on assessee. This view of Karnataka HC was set aside by SC in case of GE India Technology Centre P Ltd[4], whereby SC remanded matter back to Karnataka High Court. Later, Karnataka High Court had confirmed the order of revenue authority upon further analysis.

Considering there were several appeals before Supreme Court, with facts being similar, transactions were grouped in the following four baskets as under:

Category 1: Cases in which computer software is purchased directly by an Indian resident end-user from a foreign / non-resident supplier or manufacturer;

Category 2: Resident Indian companies acting as distributors or resellers, by purchasing computer software from a foreign / non-resident supplier or manufacturer and then reselling the same to Indian end-user;

Category 3: Non-resident/foreign distributor reselling to resident Indian distributor or end-users, after purchasing software from a foreign / non-resident seller;

Category 4: Computer software affixed onto hardware and is sold as an integrated unit/ equipment by foreign / non-resident suppliers to resident Indian distributors or end-users.

Detailed analysis of Supreme Court pronouncement:

For arriving at the conclusion, a detailed analysis was made in respect of the term Copyright. Based on reading of Copyrights Act, 1957, and conclusions of several judicial precedents, following analysis was made:

1. Copyright is an exclusive right, which is negative in nature, being a right to restrict others from doing certain acts;
2. Copyright is an intangible, incorporeal right, in the nature of a privilege, which is quite independent of any material substance. Ownership of copyright in a work is different from the ownership of the physical material in which the copyrighted work may happen to be embodied. An obvious example is the purchaser of a book or a CD/DVD, who becomes the owner of the physical article, but does not become the owner of the copyright inherent in the work, such copyright remaining exclusively with the owner;
3. Parting with copyright entails parting with the right to do any of the acts mentioned in section 14 of the Copyright Act. The transfer of the material substance does not, of itself, serve to transfer the copyright therein. The transfer of the ownership of the physical substance, in which copyright subsists, gives the purchaser the right to do with it whatever he pleases, except the right to reproduce the same and issue it to the public, unless such copies are already in circulation, and the other acts mentioned in section 14 of the Copyright Act.
4. A licence from a copyright owner, conferring no proprietary interest on the licensee, does not entail parting with any copyright, and is different from a licence issued under section 30 of the Copyright Act, which is a licence which grants the licensee an interest in the rights mentioned in section 14(a) and 14(b) of the Copyright Act. Where the core of a transaction is to authorise the end-user to have access to and make use of the “licensed” computer software product over which the licensee has no exclusive rights, no copyright is parted with and consequently, no infringement takes place, as is recognised by section 52(1)(aa) of the Copyright Act. It makes no difference whether the end-user is enabled to use computer software that is customised to its specifications or otherwise.
5. A non-exclusive, non-transferable licence, merely enabling the use of a copyrighted product, is in the nature of restrictive conditions which are ancillary to such use and cannot be construed as a licence to enjoy all or any of the enumerated rights mentioned in section 14 of the Copyright Act, or create any interest in any such rights so as to attract section 30 of the Copyright Act;
6. The right to reproduce and the right to use computer software are distinct and separate rights, the former amounting to parting with copyright and the latter, in the context of non-exclusive EULAs, not being so.

Doctrine of First Sale / Principle of Exhaustion:

Based on various judicial precedents, it was observed that principle of exhaustion is not principally recognized by section 14(b)(ii) of the Copy Right Act 1957. Principle of exhaustion would refer to cases where the first sale of a copy of a program by the right-holder or with his consent exhaust the distribution right with the exception of the right to control further rental of the program or a copy thereof.

It enables free trade in material objects on which copies of protected works have been fixed and put into circulation with the right holder’s consent. Exhaustion of rights is linked with the distribution rights. 

In the instant case, the distributors resell shrink-wrapped copies of the computer programmes that are already put in circulation by foreign, non-resident suppliers/manufacturers, since they have been sold and imported into India via distribution agreements, are covered by Principle of Exhaustion. Since no distribution right by the original owner extended beyond the first sale of the copyrighted goods, it can be said that only the goods, and not the copyright in the goods, had passed onto the importer. Accordingly, provisions of Copyrights Act are applicable to the transaction under review.

End-user License Agreement (‘EULA’)/ Remarketer Agreement / Distribution Agreement (together all agreements are referred to as ‘Agreements’):

Further, based on the examination of end-user agreement, remarketer agreement and distribution agreement, it was observed that what is granted to the distributor is a non-exclusive, non-transferable licence to resell computer software, it being expressly stipulated that no copyright in the computer programme is transferred either to the distributor or to the ultimate end-user. ‘Licence’ that is granted vide the End-user License Agreement is not in terms of section 30 of the Copyright Act, 1957, which transfers an interest in all or any of the rights contained in sections 14(a) and 14(b) of the Copyright Act[5] but is a ‘licence’ which imposes restrictions or conditions for the use of computer software.

The agreements under consideration do not grant any such right or interest, least of all, a right or interest to reproduce the computer software. The reproduction is expressly interdicted and is also expressly stated that no vestige of copyright is at all transferred, either to the distributor or to the end-user.

The SC referring to its own judgement in the case of State Bank of India[6] observed that there is difference between the right to reproduce and the right to use computer software. The SC held that while the former amounted to parting of copyright by the owner, the latter would not. 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 programme, and is therefore in the nature of sale of goods, which is the law declared by SC in the context of a sales tax statute in Tata Consultancy Services[7] case.

Thus, from above, based on the concept of Copyright and agreements entered into, it is clear that there was no parting of copyright by the owner to resident importer. It was only right to use the computer software subject to terms stipulated in the agreements.

Thus, based on the interpretation of Copyrights Act, principle of exhaustion and clauses of agreements entered into, it was very clear that what was transferred in the instant case was merely goods and no copyrights were transferred.

Detailed analysis of provisions of ITA and DTAA:

Definition of Royalty in DTAA vis-a-vis the IT Act and retrospective applicability of provisions related to Royalty,

SC noted the construct of the ITA and basis Section 90(2) of the ITA, held that once a tax treaty applied, the provisions of the ITA would not apply unless they were made beneficial to the tax payer. Reliance was placed in case of Azadi Bachao Andolan[8];

It also noted that the definition of a particular term under the ITA would be applicable only when the said term is not defined in the tax treaty. Thus, as per Explanation 4 to section 90 of the ITA and under Article 3(2) of the India USA DTAA, the definition of the term ‘Royalties’ shall have meaning assigned to it by the DTAA. This position of law is also confirmed by Circular no. 333 dated April 2, 1982.

It further noted that TDS obligation u/s 195 of the ITA would only arise if income is chargeable u/s 9 and 4 of the ITA subject to treaty provisions.

Thus, it becomes imperative to observe that whether tax provision in relation to computer software would be applicable under Treaty provisions or under the provisions of ITA for the subject assessment year under question.

As per Section 9(1)(vi) of the ITA relating to Royalty. The definition contained in Explanation 2 to section 9(1)(vi) of the IT Act is wider in following respects:

•  It speaks of “consideration”, but also includes a lump-sum consideration which would amount to income of the recipient chargeable under the head “capital gains”;

•   When it speaks of the transfer of “all or any rights”, it expressly includes the granting of a licence in respect thereof; and

•       It states that such transfer must be “in respect of” any copyright of any literary work.

Introduction of word ‘computer software’ under section 9(1)(vi) of the ITA:

•     The term “computer software” was referred in the Explanation 3 to section 9(1)(vi) of the ITA for the first time in the income tax statue with effect from 01 April 1991, when it was introduced. This subsequently was amended vide the Finance Act 2000.

•       Further, explanation 4 to section 9(1)(vi) of the ITA was introduced vide Finance Act, 2012. Hence, explanation 4, referring to transfer of all or any rights in respect of copyrights, cannot apply to any right, property or information used or service utilized, for the use of or the right to use computer software for years prior to 2012. Thus, amendment vide Finance Act 2012 is not clarificatory amendment but in fact, expands that position to include what is stated in section 9(1)(vi) therein w.e.f 2012.

Thus, the transfer in respect of copyright, the transfer of all or any rights in relation to copyright is an essential condition under Explanation 2 to section 9(1)(vi) of the IT Act. In other words, there must be transfer by way of licence or otherwise, of all or any of the rights mentioned in section 14(b) read with section 14(a) of the Copyright Act.

Considering above, whether income tax statue intended to cover essential condition of ‘all or any rights in relation to copyright’ in the subject assessment years as well is a question worth pondering. Considering that such condition did not exists during subject assessment year i.e. AY 2001-02 and 2002-03, it becomes impossible to interpret law accordingly at the time when transaction was entered into in the instant case. This analogy was explained by below latin maxim:

•   lex non cogit ad impossibilia, i.e., the law does not demand the impossible and

•       impotentia excusat legem, i.e., when there is a disability that makes it impossible to obey the law, the alleged disobedience of the law is excused.

Applying the afore-stated maxims in the context of the provisions of the relevant DTAAs, to hold that persons are not obligated to do the impossible, i.e., to apply a provision of a statute when it was not actually and factually on the statute book.

As per Article 12 of the DTAA, definition of Royalty is exhaustive as it means Royalties are payment of any kind received as consideration for ‘use of, or the right to use, any copyright’ of a literally work, which includes computer programme or software.

The SC concluded that given the definition of royalties contained in Article 12 of the DTAAs mentioned, it is clear that there is no obligation on the persons mentioned in section 195 of the IT Act to deduct tax at source, as the agreements in the facts of these cases do not create any interest or right in such distributors/end-users, which would amount to the use of or right to use any copyright. The provisions contained in the IT Act (section 9(1)(vi) along with explanations 2 and 4 thereof), which deal with royalty, not being more beneficial to the taxpayers, have no application in the facts of these cases.

Thus, it was contended that retrospective amendment to a statue cannot be applied to an assessment year in which as a matter of fact, the expanded definition of Royalty did not exist.

Conclusion:

This is a welcome judgement. With this judgement, SC has put an end to the two-decade long tax litigation issue under consideration. The issue has been dealt with an essence of practicality and has provided much needed impetus to the applicability of changes in law from time to time.

On the principle of domestic law changes to effect changes in the treaty framework, the court remarked that it is fallacious to assume that a change in domestic law to rectify a situation of mistaken interpretation can spontaneously further the tax administration’s case in a treaty situation. This affirmative declaration acts as an insulator to the foreign investors from unilateral changes to India’s tax policy and promises certainty in their tax treatment.

Further in relation to retrospective applicability of provisions of law, even though it cannot restrict Parliament from enacting retrospective tax laws, the SC has effectively reined in the government’s latitude in prosecuting bonafide actions of taxpayers, which translate into infraction owing to retrospective amendments.

Considering that judgement under consideration is pronounced favourably, it is still necessary to evaluate each and every transaction based on facts of each case and not apply the outcome of this judgement blindly to any case. Also, subject assessment years under consideration are relatively old and thus, recent amendments in the tax statues, such as equalization levy, significant economic presence, would hold the weightage and also have an implication on the similar transactions.

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