Sale of Software License is Exempt from Royalty Tax in India

The Pune Income-tax Appellate Tribunal (Tribunal) issued a ruling in the case of BMC Software Asia Pacific Pte Ltd. (taxpayer), relating to a Singapore-registered company which received income from the sale of software licenses and support, maintenance and training services rendered in connection with software licenses being sold directly or indirectly through distributors in India.

The Tribunal, ruling on an assessment by the tax authorities (revenue) that decided to tax such transaction in India, relied on the Supreme Court case of Engineering Analysis Centre of Excellence Pvt. Ltd., to confirm that sale of a copyrighted article (i.e. a product) with regard to use of “licensed” computer software does not result in granting a licensee any exclusive rights. Specifically, as no copyright is parted with, such sales amounts are excluded from the meaning of “royalty” both under Indian domestic tax laws and under Article 12 of the India–Singapore tax treaty (tax treaty).

The Tribunal accordingly concluded that transactions that lack the character of royalty are characterized as business income, and will be exempt under Article 7 read with Article 5 of the tax treaty, in the absence of the taxpayer constituting a permanent establishment (PE) in India.

Facts of the Case

The taxpayer is a Singapore-based company, an authorized software distributor that earns income from the sale of software licenses, and from support, maintenance and training services rendered in connection with software licenses sold directly or indirectly through third parties in India. The taxpayer did not file a tax return in India on the premise that it was regarded as an offshore distributor of software licenses in the Asia-Pacific region that did not own any software licenses.

The revenue, on consideration of the details, initiated reassessment proceedings and issued a show cause notice to explain why income arising from the sale of software was not being offered for tax in India, by relying on the High Court (Court) case of Samsung Electronics Co. Ltd. and other decisions, and contested that payment received by the taxpayer was towards supply of software and rendition of software-related services characterized as royalty under Indian domestic tax law and Article 12 of the tax treaty.

The taxpayer, objecting to the reassessment order, approached the Dispute Resolution Panel (DRP), contending that the sum received was exclusively towards the sale of software licenses treated as business income, and could not be recognized as royalty in nature. The DRP, on reviewing the Court’s ruling, agreed that the revenue’s decision to treat such payment for sale of computer software was royalty and taxed such income in India.

The taxpayer disputed the DRP order and approached the Tribunal for relief.

Tribunal Ruling

The Tribunal, in a virtual hearing, analyzed the character of the payment arising from the sale of software and rendering of connected services for taxability as royalty under Indian domestic law or the tax treaty. The Tribunal considered if the sale of computer software transaction had the character of royalty or business profit, in light of the Supreme Court ruling in Engineering Analysis Centre of Excellence Pvt. Ltd., where, dealing with an identical matter, the Court held that:

  • ownership of copyright under Article 12(3) of the tax treaty in a work is different from the ownership of the physical material in which the copyrighted work is embedded;
  • the core of a sale transaction is to authorize the end-user to have access to and make use of “licensed” computer software product over which the licensee has no exclusive rights where no copyright is expressly parted with;
  • taxability of the consideration under “royalty” in Indian domestic law provides that “the transfer of all or any rights in respect of any right, property or information includes and has always included transfer of all or any right for use or right to use a computer software (including granting of a licence) regardless of its medium through which such right is transferred”;
  • such provision is merely clarificatory in nature and does not expand the scope and meaning of the term “royalty” which will apply prospectively;
  • if it is concluded that the receipt is not characterized as royalty, it will be in the nature of business profit under the applicable tax treaty; and
  • to attract “business profits” tax in the source country such as India under the ambit of Article 7 it is necessary that the foreign entity should constitute a PE in India in terms of Article 5 of the tax treaty, absent which there is no tax triggered under Article 7.

The Tribunal, after extensive evaluation, disregarded Samsung Electronics Co. Ltd., relied on by the revenue, but reversed by the Supreme Court case of Engineering Analysis Centre of Excellence Pvt. Ltd., thus making the reassessment proceedings initiated by the revenue and confirmed by the DRP invalid. The Tribunal observed that the facts of the instant case were identical to the Supreme Court case, to conclude that the amount is outside the purview of royalty under Article 12 of the tax treaty, and the taxpayer, absent a PE in India under Article 5 of the tax treaty, cannot be subject to tax in India.

Additionally, in the absence of the make available clause being satisfied in the course of rendering of services by the taxpayer, the services rendered for fees in conjunction with the sale of computer software is equally not subject to tax in India under Article 12(3)(b) of the tax treaty.

Key Takeaways

The topic of cross-border tax on sale of software products/licenses has been the subject of a prominent dispute in India between the revenue and the taxpayer for several years. The controversy is primarily due to the wider scope of “royalty” under Indian domestic tax law compared to the narrower definition under the Organization for Economic Cooperation and Development (OECD) Model Tax Convention.

The favorable Tribunal ruling reasserts the principle that outright sale of software products/licenses cannot be characterized as royalty in nature under Article 12 of the tax treaty, and it is worthwhile to refer the Delhi Tribunal case of Digite Inc. v. ADIT which confirmed that sale of copyrighted software licenses was business income not liable for any tax in India as royalty under Article 12 of the India–U.S. tax treaty absent a PE in India.

The primary point to determine taxability arising from sale of software is that if there is grant of a copyright, only then can the source country tax it as royalty on a source basis; instead, if the transaction is characterized as sale of a copyrighted article (i.e. a product), the source country has the right to tax only in the event the seller has a PE in that country.

Aiming to promote certainty, the UN Tax Committee released a discussion draft on “Inclusion of software payments in the definition of royalties” in the UN Model Double Taxation Convention by proposing an amendment to Article 12 on “royalties.” The proposal, if implemented in bilateral treaties, could make software payments taxable in the source countries, put to rest the ongoing litigation in India with other countries on software payments, and provide tax certainty by aligning the treatment under tax treaties and the domestic tax law.

The objective of the proposed amendment is to provide clarity on the controversy of whether payment towards a right to use the software constitutes royalty and dilutes the non-taxability position adopted by distributors who buy and sell software in various modes/media; however, the controversy around royalty characterization in cases where software is pre-installed/embedded in a product (such as computer hardware and telecommunications equipment) could still continue until the proposal is accepted by the OECD under the blueprint of Pillar One and Two guidance released late last year.

It is also relevant to refer to the recent Two-Pillar approach agreed by the OECD/G-20 Inclusive Framework on BEPS, where:

  • Pillar One aims to ensure a fairer distribution of profits and taxing rights among countries with respect to the largest multinational enterprises, with the caveat that developing countries will be able to benefit from an elective mechanism in certain cases, ensuring that the rules are not too onerous for such countries. The agreement to re-allocate profit under Pillar One includes the removal and standstill of digital services taxes and other relevant similar measures, bringing an end to trade tensions resulting from the instability of the international tax system.
  • Pillar Two dissolves tax competition on corporate income tax with the introduction of a global minimum corporate tax at a rate of 15% that countries can use to protect their tax bases (the GloBE rules). Tax incentives provided to spur substantial economic activity will be accommodated through a carve-out protecting the right of developing countries to tax certain base-eroding payments (like interest and royalties) when they are not taxed up to the minimum rate of 15%, through a “Subject to tax rule.”

It is also important to note that the U.S. will terminate its proposed trade actions against India regarding the 2% equalization levy (EL) and India is not required to withdraw the EL rules applicable in situations for payment of royalty until Pillar One is made effective. Further, India will allow a credit of the 2% EL chargeable on foreign e-commerce operators during the “interim period” against multinational enterprises’ future Pillar One tax liability when Pillar One rules are in effect. According to the press release issued the interim period will be from April 1, 2022 until the implementation of Pillar One or March 31, 2024, whichever is earlier.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Shailendra Sharma is a Chartered Accountant associated with a multinational financial services firm, India.