TDS not to be deducted for use of Foreign Software: Supreme Court of India

There have been several disputes surrounding the taxability of payments made to foreign companies for use of their computer software by persons in India. Tax authorities argue that these payment amount to royalty fees for the use of the software as a form of licensing. While taxpayers in India contend that the amounts fall within the benefits available under the double taxation avoidance agreements and would not be taxable in India.

The Supreme Court has finally dealt with this matter in the judgement that was recently passed in the case of Engineering Analysis Centre of Excellence Pvt. Ltd. v. Commissioner of Tax.

With globalisation and the onset of the digital age, transfer of technology and their intellectual property rights, have become a central element of international trade and investment. With increase in the flow of transfer of technology, there is also an increase in the flow of fees for technical and royalty services both in and out of India.

Royalty is generally a payment made as consideration, against the transfer of an intellectual property right from one party to another. Such payments are generally made for transfer of copyright, trademark, patent or other related rights under a licensing agreement. Similarly, technical experts are compensated through technical fees for providing certain expert or technical consultancy services.

Such fees are taxed under Section 9 of the Income Tax Act, 1961 (ITA). Under this Section, royalty has been defined as consideration flowing from the following transactions:

• Transfer of any and all rights in respect of patents, inventions, models, design, secret formulas, etc.
• Imparting any information concerning the working or use of patent, invention, model, design, secret formula, etc.
• The use of any patents, inventions, models, designs, etc.
• The imparting any technical skill, commercial or scientific knowledge.
• Rendering of any of the above services.

Any consideration which could be taxable under the ITA as a capital gain will be excluded from the purview of royalty payments. Similarly, fee for technical services has been defined as any consideration in exchange for rendering any managerial, technical, professional or other related services.

The incidence of income tax in India is based on the source rule of income, i.e. the income which accrues or arises in India is taxable in India. Even foreign technical service or intellectual property right providers may be taxed in India if the income is sourced in India i.e. if the fees for technical service and/or royalty fees are taxable in India.

Under Section 195 of the ITA, tax has to be deducted at source for payments made to non-residents if the income is taxable in India. This is where disputes have been raised in regard to royalty payments for use of software from foreign companies. Authorities allege that since the income is arising in India, TDS has to be deducted on such payments. Taxpayers allege that this income is not taxable in India since they are made to foreign companies for services provided by them. Furthermore, if the technical services were rendered abroad then under the source rule of taxation such income would not be taxable in India.

At the same time, taxpayers also argue that they are exempt from such tax as they could avail benefits under the double taxation agreements. Most double taxation avoidance treaties also provide a lower rate of withholding tax for such payments. For example,  the India-UK double tax treaty provides that for royalty payments made to non-resident companies, the lower withholding tax of 10% may be applicable if the total tax treatment does not exceed the maximum allowable limit. Most other countries too, have similar agreements with India wherein the foreign entities may avail a beneficial lower tax withholding rate. However, such provisions under the treaties are only applicable in situations when the foreign collaborators do not have permanent establishments or taxable business income in India.

Most of these contentions were recently decided by the Supreme Court in the following case: Engineering Analysis Centre of Excellence Pvt. Ltd. v. Commissioner of Tax.

• The Engineering Analysis Centre for Excellence is an India based company importing shrink wrapping computer software directly from the United States.
• Tax authorities argued that there was a transfer of copyright and the payments being made to the American company was in the nature of ‘royalty’. Hence, they held the company liable for several years of assessment where this tax had not been deducted.
• Tax payers argued that the transactions were similar to sale of goods and not in the nature of royalty payments and hence would not attract TDS.

The Supreme Court held that the taxpayer was not liable to deduct any tax on the payments being made under the agreements, as the payments were not in the nature of ‘royalty fees’. They held that under the agreements entered into between the parties, no actual interest or rights under the Copyright Act had been passed onto the taxpayer. The tax paying Indian company played the role of a distributor or a seller that was authorized to resell the software and not a licensee that was transferred the right to use and reproduce the software.

Since the payments were not in the nature of ‘royalty’, they could not be liable to deduct tax under Section 195 of the ITA. Further, under the double taxation agreement, the Indian company was exempt from paying any TDS on these amounts.

The double taxation agreements allow that the incomes would only be taxable if they are payments made as technical or royalty fees or if the incomes were earned by way of a permanent establishment. Since neither scenario is applicable in this case, such payments earned by the Indian company are not taxable in India.

On analyzing the substance of the agreements between the parties, the Court finds that no copyright has been transferred from the American company to the Indian recipient. The consideration was being paid only to purchase the computer software as a good (which could then be resold), without the transfer of any intangible rights, specifically any rights or interest to reproduce the computer software. 

The Court held that under the agreements entered into between the parties, the right to sell had been transferred but not any actual intellectual property rights. Hence, the taxpayer was in the nature of a distributor/seller of the goods (in this case the computer software) rather than a licensee.

The Supreme Court held that the specific agreement and clauses should be given effect over and above general clauses. i.e., in the event that double taxation agreements and the Income Tax Act are not in agreement, then the taxation treaties should prevail.

In reference to this case, the Court said that ‘royalties’ as defined under the ITA had to be understood with reference to Article 12 of the India-US double taxation treaty. Under the treaty, royalties were defined as the, “payments of any kind received as consideration for “the use of, or the right to use, any copyright” of a literary work, which includes a computer programme or software.”

There is explicit reference to the royalty being the consideration made on behalf of allowing the use of and/or the right to use such computer software or programme. In this case, the agreements do not bestow any such rights onto the taxpayer. The taxpayer is in fact in the position of that of a distributor or end consumer that only has the right of sale over the software. Hence, no liability of TDS can be imposed on such payments, as they are not royalty fees.

Most double taxation agreements provide a beneficial lower withholding tax rate for royalty payments to foreign entities or non-resident entities. If TDS is applicable on the royalty payments made to non-residents, the foreign entities should be allowed to avail such beneficial withholding taxes under the tax treaties.

The important takeaways from this judgement can be summarised as follows:

• The agreements entered into by the parties have to be analysed to understand the true relationship and the nature of rights that have been bestowed. It is only if actual intellectual property rights (such as right to use and reproduce the work) are transferred, that consideration against the same can be considered as royalty fees.
• If an Indian company is making payments to a foreign entity to buy and resell their computer software (without using the software), TDS will not be applicable under Section 195 as such payments cannot be considered royalty.
• The clauses of the double taxation treaty will apply over and above the general clauses of the ITA.
• If the clauses of the double taxation treaty are more beneficial to the taxpayer than the ITA, then the double taxation treaty will prevail. Further, benefits such as lower withholding tax rates cannot be denied, if they are available under the tax treaties.