Taxation of Software Payments | Understanding Tax Implications based on IP Law

The payment for “transfer of all or any rights” including the grant of license in respect of intellectual property like patent, design, trademark copyright is taxable as royalty as per Section 9(1)(vi) of the Income Tax Act, 1961 (the Act). Royalty is taxable as income deemed to arise in India and a person making payment to a non-resident is obliged to deduct tax on the payment. Explanation 4 which was inserted in 2012 with retrospective effect to clarify that transfer of right in respect of any right, property or information includes the transfer of all or any right for use or right to use computer software (including granting of a license) irrespective of the medium through which such right is transferred. The definition of royalty in the Double Taxation Avoidance Agreements (DTAA) is not quite as wide.

The issue

The tax department’s view regarding taxation of payments for use of software/purchase of software is that payment for grant of license- whether exclusive or non-exclusive, distribution and sale of CD carrying the software, sale of equipment with software would be taxable as royalty since a part of such payment, if not in entirety, is for copyright in the software. However, assessees in various categories – end-users, resellers, distributors took a stand that the payment is not for any copyright since no right is conveyed to the payer/buyer of software and it is not taxable as royalty. The distinction between the use of/right to use copyright and a copyrighted article or physical object containing copyrighted software was emphasized to contend that no tax is deductible on such payments. Moreover, since the non-residents would choose to be governed by the DTAA which does not classify such payment as royalty, in any event, the benefit under Section 90 (2) could be availed and the sum would not be chargeable to tax in India.

Judgment of the Supreme Court

The Supreme Court in Engineering Analysis Centre of Excellence (P.) Ltd. v. CIT [2021] 125 taxmann.com 42 (SC) has held that payment 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 payment of royalty for the use of copyright in the computer software. This judgment has brought clarity to the much-debated issue of taxation of payment for computer software.

The key points in the above-mentioned judgment which approves the decision of various High Courts and AAR in favor of the taxpayer are:

• • The transfer of rights has to be understood with reference to the Copyright Act, 1957, and grant of license without proprietary interest is not covered.
  • There must be a parting with the right enabling the recipient to exercise the right enumerated in the Copyright Act like the right to reproduce the work, issue copies, etc.
  • The transfer of the ownership of the physical substance, in which copyright subsists is not a grant of right.
  • A non-exclusive, non-transferable license, 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 license to enjoy all or any of the enumerated rights.
  • Where the core of a transaction is to authorize 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.
  • Right to reproduce and the right to use computer software is distinct and separate rights and in the case of non-exclusive EULAs no right is parted with.

The Supreme Court further held that changes to the domestic Act which could not have been contemplated at the time of entering into the DTAA cannot be imported into the understanding of the term ‘royalty’ under the DTAA. Thus, the various rulings upholding the static rule of interpretation have also been given approval. Further, it also held that where the sum is not chargeable to tax as royalty, there was no need to deduct tax. It said that the ruling in Pilcom v. CIT [2020] 116 taxmann.com 394/271 Taxman 200/425 ITR 312 (SC) would not apply since the tax deduction in the case of Pilcom was not under Section 195 in respect of “sum chargeable to tax” and the payer did not have any option but to deduct tax whether the sum was ultimately taxable or not.

Deduction under Section 194J

The CBDT had issued Notification No.21/2012 dated 13-6-2012 in terms of which where tax has already been paid on the first transfer of software either under Section 194J or Section 195, the tax was not required to be deducted in subsequent transfers where the transferor is a resident.

Interestingly Explanation 4 does not find mention in Section 194J which requires the person making payment of any royalty to a resident to deduct tax. The definition of royalty is as per Section 9(1)(vi), Explanation 2. Explanation 4 which was inserted in 2012 was not included in the definition for purposes of Section 194J. It may now be possible to take an argument that even for resident payees, the definition of royalty is not satisfied in case of payment for software with limited rights to use the same both on account of absence of reference to Explanation 4, in Section 194J and the elucidation by the Supreme Court that unless there is a transfer of the right, payment for the limited right to operate the software will not fall within the ambit of royalty.

Implications for other IPRs

The focus of the arguments on taxability remained on the transfer of right in respect of copyright or “use of or right to use” as it appears in DTAA(s) and the amendment to Explanation 4 to Section 9(1)(vi). The Supreme Court held that to satisfy the term use of or right to use copyright, interest or right must be created in such distributors/end-users. The Supreme Court has categorically held that in event of a non-exclusive license non-transferable license does not enable a person to enjoy the rights as a right-holder and hence there is no transfer of rights or right to use.

The IT Act covers payment for the transfer of rights as well as use in case of other IPRs like patent, trademark, etc., under separate clauses. The distinction between copyright and other IPRs is that in case of copyright the making of a single copy is not treated as infringement as per Section 52 (1)(aa) of Copyright Act, 1957. Similar provisions have not been drafted for other IPRs. Therefore, a non-exclusive, restrictive permission to use patent and payment for such patent could still be covered under ambit of royalty where the person is enabled to produce the goods using the patent, uses the trademark on goods or services since in the absence of such permission it would be infringement.

The Commentary to OECD Model Tax Convention states that royalty is a form of income from letting of property and is for the permission given by the right holder to use the property. The words “use of” would cover payments even in case of infringement of patents, trademark, copyright etc., and “right to use” seeks to cover payment for entitlement to use. The proposed changes to the UN Model (revised draft published in February 2021 seeking further public comments), seek to tax payments for use of software irrespective of the transfer of copyright. It remains to be seen whether the changes proposed are adopted in the current DTAAs.

[R. Subhashree & Dr. G. Gokul Kishore (the authors) are Advocates in Gokul & Subha Advocates, Chennai. Views expressed are personal]