Impact of new tax regulations on the Indian IT-BPO sector Overview India’s IT-BPO sector, which currently employs about three million people and is valued at USD100 billion1, is one of the largest and booming industries in the country. Yet, it has lacked the support of the Government on tax laws. IT-BPO companies function amid a complex and tight tax regime, which spins around controversy on characterisation of income, transfer pricing, and international taxation on direct tax front, as well as service tax, excise, and VAT on the indirect tax front.  The current Imbroglio The sale of software has always raised questions around characterisation of income — should it be considered a business income or a royalty income? From an indirect tax perspective, there has been a history of litigation as to whether software transactions can be construed as sale of ‘goods’ or supply of ‘services’ in light of the fact that different transaction taxes apply to sale of goods and supply of services. In addition, it affects organisations that source software from non-resident companies and often face litigation issues arising from the fact that the taxes for royalty payments at the rate of 10 percent2 were not withheld, on the premise that the foreign company does not have a taxable presence in India.  Changing tax scenario for software companies 

characterisation of incomeof software companies has been under the scrutiny of direct tax department

Whether to be

considered a business income or a royalty incomeLiability of

withholding tax by buyer, if classified as royalty incomeMultiple state high

courts including Karnataka and Delhi high court had different rulings on the classification as business income or royaltyThus, software

providers as well as software importers face tax issues. Key companies that have pending cases include Microsoft, GE, Samsumg, HP and Sonata Software

Finance act 2012 tweaked the definition of royalty to include*:

Amendment is

introduced with retrospective effect from 1 June, 19763

Classification as

royalty led to multiple level TDS, thus affecting cash outflows and increasing the overall price of imported software

Mrs Pranab Mukherjee, who was the finance minister the, announced refief from multiple level TDS w.e.f. 1 July 2012 for domestic software companies subject to fulfilment of certain conditions4

Considering the aftermath of amendment under income tax laws, Dr. Manmihan Singh announced a committee of four people headed by former CBDT chairman Mr. N. Rangachary to review taxation issues relating to IT sector5

* Note: Income from transfer of all or any right for use or right to use a computer software

  Given the aforesaid controversy, the Indian packaged software industry faced another major setback as a result of the amendments to the Finance Act, 2012. The act has provided that any income arising from the transfer of all or any right for the use, or the right to use, computer software6 would be treated as royalty with retrospective effect from 1 June 1976 and would accordingly be chargeable to tax in India at 10 percent7. With this amendment, payments for the mere use of computer software, without the transfer of copyright embedded in the software, would be construed as ‘royalty,’ thus upturning various favourable judicial precedents in the past. Another important amendment8 in the act clarifies that ‘royalty’ includes (and has always included) consideration in respect of any right, property or information — irrespective of its possession or control — direct use by the payer or its location. As a result, the scope of the term ‘royalties’ under the act has been significantly expanded, in particularly with reference to possession and direct use by the payer, which were till now crucial for distinguishing between payments for the use of equipment and those for availing services, which have now been rendered irrelevant. Considering the aforesaid amendments, all types of software payments, at large, will be characterised as royalty under the domestic tax laws (the Act). For a non-resident, it is relevant, to ascertain whether any beneficial tax provisions could be adopted under the respective tax treaty entered with India even though taxable under the Act. The Finance Act, 2012 has also made another amendment in the Act9, which provides that if a term is not defined in a tax treaty, the Central Government may define it through a notification, and that the term defined shall take effect from the date on which the treaty was signed. Accordingly, once any such notification is issued, one will have to evaluate its impact on the beneficial tax position, if any, under the tax treaty relating to taxability of computer software transactions. The aforesaid amendments have impacted software companies which have pending tax claims. Further, the importers of packaged software who have paid for software, without withholding any taxes considering the income is not taxable in India, may now face contingent tax liabilities. Classification of software income as royalty also raised questions around multiple-level levy of tax withholding in a typical software distribution model, wherein, a 10 percent withholding tax rate would apply at distributor, retailer, and other levels. While the Government has removed multiple-level TDS for domestic companies through a subsequent notification10, multi-national companies continue to face this challenge. The relief given to domestic companies is subject to the transfer of software without any modification and obtaining a declaration from the transferor that the tax has been deducted at source correctly. To address concerns arising from the tax amendments, the Prime Minister of India, Dr. Manmohan Singh, has announced the formation of a committee of four people, headed by former Central Board of Direct Taxes (CBDT) Chairman Mr. N. Rangachary11. The committee will be in charge of evaluating issues related to the taxation of the IT sector and addressing any clarifications that may be required.  Other tax Implications As characterisation of income from sale of software is amid settlement, the IT and BPO sector are also feeling the heat of 18.5 percent minimum alternative tax (MAT) imposed in 2011 on companies operating in special economic zones (SEZs). NASSCOM, the IT sector’s representing body, demanded the removal of MAT, which was not approved in the Finance Act, 2012, leading to additional disappointment for IT-BPO sector companies12. Moreover, the introduction of the General Anti-Avoidance Rule (GAAR), effective 1 April 2013, is expected to increase complexities for corporate tax payers. Apart from increasing direct tax complexities, the increase in service tax and excise duty is further burdening IT and BPO sector companies in the country. While IT-BPO sector companies are experiencing a challenging tax situation, the corporate world has welcomed the introduction of the Advance Pricing Agreement (APA) for transfer pricing, which came into effect on 1 July 2012. It is being seen as a relief measure from litigation issues. However, the applicability of transfer pricing norms on domestic transaction has raised new compliance challenges for companies operating through multiple domestic establishments. On the indirect tax front, the recent Government Circular has sought to create distinction between online software supplies and software supplied on a physical media from the perspective of applicability of Service tax law stating that the former scenario entails supply of services (liable to Service tax) and the latter scenario entails supply of goods (out of the purview of Service tax law). However, as software is treated as “goods”, even when supplied electronically (VAT is being discharged on the same), the issue of double taxation on software still persists. Also, with the introduction of Service tax Negative List regime with effect from 1 July 2012, transactions between branch and head office and marketing activities undertaken by BPO/ call centres and certain perks given to employees could now be taxable which would increase the tax costs.

  KPMG in India point of view As the Government looks to reduce fiscal deficit by increasing tax collections through new tax laws, it could end up ignoring the growing contribution of the IT sector in the country. Further compounding the problem is the potential FDI decrease the country’s IT-BPO sector may face, as international companies look to reconsider their investment decisions as a result of the current tax plans. A number of retrospective tax amendments appear to have affected various large players in the country, both within the IT and BPO sector as well as externally. All software transactions — the use of software under standard licensing arrangements, the supply of equipment with embedded software, the sale of bundled software, Software as a Service, and electronic download, among others — must be reviewed in light of the significant amendments in the Finance Act 2012; tax payers need to re-evaluate tax positions adopted both by payers and payees. In a bid to mitigate withholding tax implications under retroactive tax amendments, companies may want to consider the feasibility of deducting tax at source at the appropriate tax rate as a matter of caution, with the recipient being given the option of filing a return to claim a refund of the taxes deducted. This approach may also be considered in situations where the benefits of tax treaties apply to the payments in question. As far as indirect taxes are concerned, in light of the recent amendments under Service tax law, the industry should approach the regulator for clarification/ relief given the likely impact.  Sources:1. NASSCOM Strategic Review 20122. 10 percent is the beneficial tax rate under the Income tax Act, 1961 (‘the Act’), excluding surcharge and education cess3. “Budget 2012: Tweaked royalty law can lead to fresh tax burden on software cos like Microsoft, GE, Samsung”, March 17, 2012, The Economic Times4. “FM’s tax breather for IT industry”, May 31, 2012, The Indian Express5. “NASSCOM welcomes PM decision to review IT industry tax laws”, July 31, 2012, NASSCOM, First Post6. Explanation 4 inserted to section 9(1)(vi) of the Act by the Finance Act, 20127. As per section 115A or section 194J of the Act, as the case may be8. Explanation 5 to section 9(1)(vi) of the Act9. Explanation 3 to section 90(3) of the Act10. Notification No. 21/2012 [F. No. 142/10/2012-SO(TPL)] S.O. 1323(E), Dated 13 June 201211 “NASSCOM welcomes PM decision to review IT industry tax laws”, July 31, 2012, NASSCOM, First Post12 “IT-BPO Industry Unhappy With The Budget”, March 17, 2012, NASSCOM, EFY Times

http://www.kpmg.com/in/en/issuesandinsights/articlespublications/kbuzz/pages/it-bpo-august2012.aspx