ROYALTY TAXATION IN INDIA POST RELIANCE INFOCOM:
SETTING A PERILOUS PRECEDENT
Deekshitha Srikant, Enakshi Jha, & Sindhuja Satti
Abstract
Taxation of software payments in India has proven to be an extremely
contentious topic with the level of uncertainty it has entailed over the years. This
article seeks to discuss the connotations of the recent Mumbai Tribunal ruling in
the case of DDIT v Reliance Infocomm Ltd/Lucent Technologies, a fine example
reiterating the ugliness of the façade of software payments by universalizing the
taxation of transactions having varying standings under copyright law. The
article explores the implications of such ambiguity in the field of taxation by
elucidating essential concepts like royalty taxation, copyright law, and the law on
permanent establishments by tracing the judicial lineage on these issues both in
the domestic and international spheres. The article also seeks to provide a
glimpse of the wide spectrum of judicial perspectives by shedding light on the
plethora of conflicting cases, statutes and lacunae in the law on the issue. Once
the fissures in the present law in India has been displayed through this process,
the article then critiques the judgement and suggests a viable alternative tax
model successfully utilized abroad.
1. INTRODUCTION
Since the dawn of the information technology age, the proliferation of transactions that
involve fairly young ideas has created its share of ripples in older and more established
realms, such as taxation. In addition, the transferability of such ideas across borders has
further complicated the situation, as evident from the endless diatribes on taxation of cross-
border software purchases in India. The problem here is twofold: one, with respect to the
characteristics of the software itself and accordingly, how it must be taxed; and two, the
added impediment of taxing such software in a cross-border transaction. In the face of such a
Students of Law, NALSAR University of Law, Hyderabad. E-mails: [email protected],
2014 Royalty Taxation In India Post Reliance Infocom:
Setting A Perilous Precedent
39
conundrum, this paper seeks to study a recent case, DDIT v. Reliance Infocomm Ltd/Lucent
Technologies1 (hereinafter ‗Reliance Infocomm‘) by the Income Tax Appellate Tribunal,
Mumbai (hereinafter ‗ITAT Mumbai‘) in the backdrop of a history of conflicting
jurisprudence on the matter. It seeks to locate essential concepts that the case has ruled on,
such as the difference between a ‗copyrighted article‘ and ‗copyright‘, the definition and law
surrounding royalties and permanent establishments in the domestic sphere vis-à-vis the
position under international treaties and models, before discussing the legal coherence of the
Reliance Infocomm judgement in light of the enumerated concepts and judicial decisions. It is
the authors‘ assertion that a careful analysis of the debate on taxation of software purchases
in India displays the flaws in the Reliance Infocomm decision. However, the authors
recognize the need to examine the debate in light of the retrospective amendment to the
Income Tax Act, 1961 (hereinafter ‗IT Act‘) through the Finance Act, 2013, yet maintain that
the adoption of a different approach towards such taxation would be incommensurably
helpful.
2. FACTUAL BACKGROUND
The case centres around a transaction between Reliance Infocomm (now dubbed
Reliance Communications Ltd.), an Indian telecom company that sought to establish wireless
networks in India, and the Indian and USA-based offices of Lucent Technologies for the
supply of said wireless software. The transaction involved purchase of hardware from Lucent
India, and a corresponding purchase of software from Lucent USA. The intellectual property
rights of the software remained vested in Lucent USA. Reliance Infocomm‘s license
prohibited the company from making any copies of the software other than for internal
purposes, or transferring, assigning, sub-licensing, modifying, decompiling, reverse
engineering, disassembling or decoding the software in any manner. Reliance Infocomm
approached the Revenue in an application for a ‗no withholding‘ certificate for the payments
to Lucent USA, which the Assessing Officer (hereinafter ‗AO‘) rejected on the ground that
the payment constituted a royalty and therefore mandated withholding of tax. Reliance
moved an appeal to the Commissioner of Income Tax (Appeals), who ruled against the AO‘s
decision and categorized the transaction as the sale of a copyrighted article, which meant that
1 DDIT v. Reliance Infocomm Ltd/Lucent Technologies, (2014) 159 TTJ 589 (Mum).
VOL. 1] INDIAN JOURNAL OF TAX LAW 40
the transaction could not be taxed as royalty in the absence of a permanent establishment of
Lucent USA in India.
Meanwhile, the AO simultaneously reconsidered Lucent USA, which moved to the
Dispute Resolution Panel in appeal, who confirmed the AO's order that the transaction
constituted a royalty. The common appellate forum for both claims was the ITAT Mumbai,
which clubbed both claims together to decide whether payment for software licenses
constitutes ‗royalty‘ under the Indian Income Tax Act or the India-US tax treaty and thereby,
whether Reliance Infocomm was obliged to withhold tax on the transaction.
The ITAT ruled in favour of the Revenue, stating that in absence of the license, the
end-user of the software would be infringing upon the intellectual property rights of the
vendor, even in case of sale of a copyrighted article. Other noteworthy parts of the judgement
are:
(a) Reliance contended that despite the existence of separate agreements for the
purchase of hardware and software, the two would be integrated; but the software was
not an integral part of the transaction. The ITAT distinguished this case from previous
precedent with embedded software as there two separate agreements existed.
(b) Reliance argued that the software comprised of a copyrighted article while the
Revenue argued that there existed a right to copyright. ITAT held that even though an
explicit right to the copyright was not transferred in the licence, certain rights had
been conveyed to use the software. In the absence of this license, such use would have
been an infringement of the copyright itself. The ITAT further relied on previous
cases and stated that the dichotomy between copyrighted articles and right to
copyright was irrelevant for this purpose. The ITAT also stated that in every case
where there is a transfer of rights and the intellectual property rights remained with
the vendor, it would be a situation of royalty.
3. THE COPYRIGHT CONTROVERSY
While the Indian judiciary has often encountered a quandary in adjudicating upon the
payment of taxes in software purchases, no precedent has been set to explicate the difference
between royalty and expense as revenue expenditure, taxable under Section 37(1) of the IT
2014 Royalty Taxation In India Post Reliance Infocom:
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Act.2 However, when faced with this predicament on a case-to-case basis, the courts have
deduced general principles regarding the taxability of software purchases, making it
paramount for India‘s biggest software giants and other small and medium technology
enterprises to apprehend whether payment for importing software amounts to ‗royalty‘, which
is taxable under Indian law.
Software protection in India lies within the ambit of the Indian Copyright Act, 1957.
This Act attempts to protect and promote innovation that can be commercially exploited by
the innovator. Computer programmes are considered to be ‗literary works‘ under this Act.
The right to exploitation of such works is extended to assignees for a fixed time period on the
payment of a fee. This fee is known as ‗royalty‘ and lies in the crux of the debate that this
article shall attempt to decipher. On licensing his patent, the author retains the intellectual
property of his invention. In the case of software protection, this premise can be extended to
conclude that licensing of software does not amount to the transfer of intellectual property of
the software or its program. Further, Section 51 of the Copyright Act also provides for the
infringement of the author‘s copyright without prior authorization. However, Section 52
elucidates upon the situations a prima facie infringement will not be deemed (unless
infringement is made for a commercial exploitation), such as in the case of computer
infringements specified by this Section. While Section 51 has been drafted to curb
unauthorized multiplication of software programs considering the smaller scale of the
consideration paid to the author, Section 52 provides for exceptions that include copying the
software to prevent its loss in case of any damage or destruction.3 This is often done with the
permission of the author (owner of the copyright).
Computer programs are usually of two types. The first includes ‗shrink-wrapped‘
software that is devised for personal usage by the licensee, and the second includes computer
programs that are made for commercial exploitation. Shrink-wrapped programs are available
in the market, on the purchase of which the customer enters an End-User License Agreement
with the author of the program that grants him a license to merely use a copy of the software
program. The customer does not receive any ownership of the intellectual property of the said
program. If the customer distributes or replicates the software, he is bound to pay a royalty to
2 PATHAK AND GODIAWALA, BUSINESS TAXATION, 36 (2013).
3 A. J. Majumdar, Taxation of Royalty Income from Computer Software under Income-tax Act and Double
Taxation Avoidance Agreements, TAXMANN , available at
http://www.taxmann.com/TaxmannFlashes/Articles/flashart13-1-11_1.htm (30 June 2014, 04.30 PM)
VOL. 1] INDIAN JOURNAL OF TAX LAW 42
the author of the software, in return of a right to commercially exploit the software.4 This
leads us to the crucial difference between a ‗copyright‘ and a ‗copyrighted article‘, a
dichotomy that is pivotal in determining the taxation policies that govern the import of
software programs in India, as has been discussed in the latter sections.
On licensing the software the author retains his ‗copyright‘, which is the intellectual
property of the software. The licensee attains a copy of the same software, which is a
‗copyrighted article‘, but does not receive any ownership of the intellectual property of the
said software.5 Copyrights are a privilege created and are intangible in nature and are
independent of any material existence. Copyrighted articles on the other hand allow for the
use of a program after paying a consideration to the author. This sale is analogous to the
consideration paid in the sale of goods and does not amount to royalty.6 In copyrighted
articles, the assignee does not have ownership over the copyright and cannot claim the same
rights as the author. On paying the owner of the program a royalty, the user can attain the
owner‘s right over the program, thereby giving the user the copyright. This classification is
crucial in determining whether payments advanced towards computer software and their
programmes can be classified as ‗royalty‘, which is taxable under Indian Law. In 2005, the
Supreme Court of India in the Tata Consultancy Services v. State of AP7 held that shrink-
wrapped software were ‗goods‘ and that the licensing of such software programs amounts to
the transfer of a copyrighted article and not the copyright itself. Hence the Court concluded
that the consideration provided in the case of shrink-wrapped software would not amount to
royalty.8 A Special Bench of the Delhi Tribunal in the case of Motorola Inc v. Dy. CIT and
Dy. CIT v. Nokia9 gave a judgment along the same lines as the Supreme Court by reiterating
4 Id.
5 Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE (December,
2013), available at http://www.deloitte.com/assets/Dcom-
India/Local%20Assets/Documents/Thoughtware/Tax_thoughtpapers_Dec_19/Deloitte_Taxation%20of%
20shrink-wrapped%20software.pdf (30 June 2014, 05.00 PM).
6 India‘s Delhi High Court distinguishes Copyright Rights and Copyrighted Article in Software
Transactions, EY (04 December, 2013), available at
http://www.ey.com/Publication/vwLUAssets/India_Delhi_High_Court_distinguishes_copyright_rights_a
nd_copyrighted_article_in_software_transactions/$FILE/2013G_CM4015_India‘s%20Delhi%20High%2
0Court%20distinguishes%20copyright%20rights.pdf (30 June 2014, 04.00 PM).
7 Tata Consultancy Services v. State of AP, (2005) 1 SCC 308.
8 Sagar Mal Pareek, Dealings In Information Technology Software – In New Service Tax Regime – A Study, MANUPATRA, available at
http://www.manupatrafast.com/articles/PopOpenArticle.aspx?ID=07b15aed-5695-4d73-96e0-
0f68c91bd4e6&txtsearch=Subject:%20Indirect%20Tax (30 June 2014, 05:00 PM).
9 Motorola Inc v. DCIT, [2005] 95 ITD 269 (Del) (SB).
2014 Royalty Taxation In India Post Reliance Infocom:
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that payment for a copyright would amount to a ‗royalty‘, while payment for a mere
copyrighted article would not. The Court specified that in deciding between a copyright and a
copyrighted article it is essential to take note of the benefits and burdens of the transferred
ownership, while analyzing the facts and circumstances of the case.10
Similarly, in the DIT v.
Ericsson AB11
case, the Delhi High Court placed reliance on Section 14(a) (i) and (vi) of the
Copyright Act, 1957 in establishing that a copyright exists only in cases of reproduction for
commercial exploitation, thereby cementing that the consideration paid for such copyright to
be a royalty, taxable under Section 9 of the Income Tax Act. This case further specified that
shrink-wrapped software was not taxable in the form of royalty as it was a copyrightable
article and not a copyright.12
4. ROYALTY TAXATION
The concept of royalty taxation has been the source of much controversy in India
because the line drawn between what is subject to such taxation and what is not has remained
blurry and undefined. If an Indian company purchases certain designs from a company based
in the United Kingdom, would such a transaction be taxed as royalty (thereby being eligible
for tax being withheld) or as a mere purchase of a good?13
As discussed in the previous
section, the issue in the Reliance Infocomm case is analogous to the question posed above: is
the purchase of software from the US based Lucent Technologies to be considered a
transaction conferring a right to the copyright of the software, subject to royalty tax; or a
purchase of software subject to sales tax? To be able to successfully answer this quandary,
the definition of ‗royalty‘ must be examined, both in the context of domestic legislations and
jurisprudence and international instruments.
A ‗royalty‘ in its very essence is a payment made to the owner of an intangible asset
(such as a patent or copyright), for the use of this asset. While income from such royalty
10 Ajay Prasad and Rohit Bhat, Domestic and International Tax Treatment of Royalties and Fees for
Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010).
11 DIT v. Ericsson AB, TS-769-HC-2011 (Del).
12 Deloitte, International Tax Alert 29 December 2011, DELOITTE, available at
http://www.deloitte.com/assets/DcomIndia/Local%20Assets/Documents/International%20Tax/2011/ITX-53-2011.pdf (30 June 2014, 12:45 PM).
13 See Akil Hirani and Hemen Asher, Taxation of Royalty Payments in India, MAJUMDAR & CO., available
at http://www.majmudarindia.com/pdf/Taxation%20of%20royalty%20payments%20in%20India.pdf (30
June 2014, 06:33 PM).
VOL. 1] INDIAN JOURNAL OF TAX LAW 44
payments is taxable in India under the Income Tax Act, 1961, income accruing from an
import of the software must be viewed in the context of the definition of ‗royalty‘ under the
concerned Double Taxation Avoidance Agreement (hereinafter ‗DTAA‘). For the
government, taxation of royalty payments becomes a sizeable source of revenue due to the
typically higher rate of returns,14
while it is detrimental to the tax-payer.
In order to fully appreciate how the concept of royalty taxation pans out in reality, it is
necessary to first delve into the various aspects of domestic law and judicial decisions that
discuss royalty taxation and then examine the same under relevant international treaties,
before examining their positions vis-à-vis each other.
4.1 ROYALTY - THE DOMESTIC PERSPECTIVE
Before the advent of the Finance Act in 1976, Indian tax law did not expressly deal
with the question of royalty payments. Post 1976, however, clause (vi) was inserted into
Section 9(1), elucidating circumstances where royalty income shall be deemed to accrue in
India.15
‗Fees for technical services‘ was also inserted vide clause (vii).
Section 9 of the IT Act discusses income that is deemed to arise in India, where the
payment is to the government, an Indian resident or an Indian business establishment of a
non-resident. The place of usage of the intellectual property dictates place of accrual where
the payee is not the government. The definition under the IT act brings into its purview both
lump-sum and inveterate payments, but does not include an outright conveyance of assets
which would be taxed as capital transfers.16
Section 9(1)(vi) deals specifically with royalties.
This provision merely deems income to accrue in India when in actuality it accrues abroad,
and does not consider any capital receipt to be an income receipt.17
Section 9(1)(vi) discusses
the consideration for the conveyance of all or any rights (including the granting of a license)
in the context of any copyright, literary, scientific or artistic work.18
Income is said to accrue
14 Ajay Prasad and Rohit Bhat, Domestic and International Tax Treatment of Royalties and Fees for
Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010).
15 See generally, K. CHATURVEDI & S. M. PITHISARIA, I CHATURVEDI AND PITHISARIA‘S INCOME TAX LAW,
(5th ed., 1998).
16 IT Act (1961), Explanation 2 of §9 cl. 1 ¶vi.
17 IT Act (1961), §9 cl. 1 ¶vi.
18 Id.
2014 Royalty Taxation In India Post Reliance Infocom:
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from royalty if the government or a resident makes the said payment to a non-resident for the
purposes of generating income from the overseas country.
In the process of determining which category the transaction falls under, the type of
information that was transferred becomes extremely pertinent. In CIT v HEG India,19
the
Madras High Court exemplified this by stating that to qualify for withholding tax, the
information transferred must have some unique features that elevate it to a transaction not of
mere commercial nature, which is utilized for the earning of income from any source in India.
A right to the copyright of a software, as in the present case, would qualify the transaction to
the level of a royalty, and the Indian payee would be considered a defaulting assessee if tax is
not deducted at the source.20
For the purpose of determining the existence of the same, the
definition of ‗copyright‘ under Section 14 of the Indian Copyright Act is usually relied upon,
as the term has not been defined under the IT act. Section 14 stipulates that copyrights can be
assigned to literary work, within which computer programmes, databases, tables and
compilations are included,21
while Section 52 discusses infringement of such copyright. The
interplay between these two sections was examined in CIT v. Samsung Electronics, which
ruled that making copies of a software would in itself amount to copyright work, which in the
absence of the license would constitute an infringement of copyright, thereby suggesting that
such a license would be more than a mere purchase of a good.22
This judgement has
effectively managed to erase the discretion that previously existed to the Indian payer in
deciding whether payments to a non-resident constituted royalty or not, by requiring an
application to the Assessing Officer for withholding at a lower rate or refraining from
withholding, pursuant to the procedure in the Act.
This stance was a fresh one compared to the previous line of thought espoused by Tata
Consultancy Services v State of AP,23
relied on by the judiciary in a plethora of cases,
foremost of which were the Ericsson24
and Motorola25
cases. Considering that the
predominant position rejects the distinction between copyrighted articles and copyrights, and
19 CIT v. HEG India, (2003) 182 CTR MP 353.
20 IT Act (1961), §201.
21 Indian Copyright Act (1951), §14.
22 CIT v. Samsung Electronics, (2012) 345 ITR 494.
23 Tata Consultancy Services v. State of AP, AIR 2005 SC 371.
24 Motorola Inc. v. DCIT, supra note 9.
25 DIT v. Ericsson AB, supra note 11.
VOL. 1] INDIAN JOURNAL OF TAX LAW 46
the wide definition of royalty under Section 9(1)(vi) when payment is made to a non-resident
of India, the Indian payee is compelled to withhold tax at the source for transactions
involving purchase of software. The Supreme Court in GE India Technology Centre Private
Limited v. Commissioner of Income Tax26
dealt with a remittance by the assessee to a non-
resident which, according to the assessee, was not taxable in India and did not involve tax
withholding. The AO and the CAT were of the opinion that, post the Samsung Electronics
case, the assessee did not have the discretion to decide upon whether to withhold the tax or
not (as per Section 195) and was liable for not doing so under Section 201 of the IT Act. The
Court stated that such a remittance would be subject to tax only if it is ‗chargeable in India‘
under the non-resident‘s hands, overruling Samsung Electronics and restoring some amount
of discretion to the payee. The Court also recognized that composite payments with an
element of income in them are also subject to withholding under Section 195.27
The case is strikingly similar to the Reliance Infocomm case, wherein the non-resident
retained all rights to the copyright of the shrink-wrapped software, and the Indian payee only
redistributed the software or used it for internal purposes. By drawing the difference between
what transactions are liable to tax deduction at the source under Section 195, the judgement
sheds some clarity on a provision hitherto shrouded with uncertainty. Further, the Court also
directed the identification of the type of transaction based on the ultimate use of the article.28
Clarity was brought in through a retrospective amendment to the IT Act by the government
through the Finance Act 2012, which inserted Explanations 4, 5, and 6 to Section 9 of the IT
Act. These Explanations contained an express reference to software licenses that constitute a
right over the copyright of the software. Explanation 4 essentially sought to clarify that the
transfer of the right to use software has always been covered by Explanation 2, irrespective of
the medium of transfer. Explanation 5 further illuminated that even rights that do not vest
with the resident are to be considered.29
Post this, the Central Board of Direct Taxes issued a
circular dated June 13, 2012, that stated that tax deduction at the source is not required for the
26 GE India Technology Centre Private Limited v. Commissioner of Income Tax, 327 ITR 456 (SC).
27 News Alert, PWC (13 September 2010), available at
https://www.pwc.in/services/Tax/News_Alert/2010/pdf/PwC_News_Alert_13_September_2010_GE_Ind
ia_Technology_Centre_Pvt_Ltd.pdf. (27 June 2014, 03.00 PM).
28 Id.
29 Recent Amendments to the Royalty Provision, KPMG (13 September 2012), available at http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxnewsflash/Documents/india-
sept14-2012no1.pdf (28 June, 2014, 04.00 PM); Richard Murphy, Decoding Finance Bill 2012, TAX
SUTRA, available at http://www.taxsutra.com/microsite/Budget2012/expert/32/Richard_Murphy_-
_Director__Tax_Research_LLP (30 June 2014, 05:31 PM).
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purchase of software from a resident transferor if the software is bought in a subsequent
transfer without any modification, and tax has been deducted as per Section 195 or Section
194J for the previous transfer. Effective from April 2013, the Finance Act, 2013 also
increased the rate of royalty tax from 10% to 25%,30
higher than most DTAA‘s, which means
that taxation under the latter would be more beneficial to the taxpayer.
This however left some scope for uncertainty. The Mumbai ITAT in 2012 considered
the impact of the newly inserted Explanation 4 on the interplay between Sections 9 and
40(a)(ia) of the IT Act, which deals with disallowance. The Tribunal ruled that Explanation 4
does not alter the latter provision, which shall continue to follow the definition of royalty laid
down in Explanation 2.31
In DIT v Nokia Networks 32
the High Court held that the right to use a copyrighted
article itself is a copyright and that there need not be any distinction outlined between
copyrighted article and right to copyright. The ITAT was swayed in the Reliance Infocomm
case due to the existence of a license. CIT v Neyveli Lignite involved a situation similar to
Reliance Infocomm, where a company located abroad supplied designs along with machinery.
However, no license was involved, so the Court ruled that the payment was outside the
purview of the section.33
Generally, the judiciary has made the distinction between cases
where a license is not involved (such as in CIT v Ahmedabad Calico)34
and cases where
licenses were involved, placing the latter under the class of taxable income. Another pertinent
factor in such cases is whether a permanent establishment of the non-resident company in
India exists. For example, in Microsoft Corporation v ADIT, Microsoft contented that the
transaction selling copies of software produced by various foreign subsidiaries for
redistribution to the Microsoft Regional Sales Corporation did not amount to a royalty as the
Regional Sales Corporation did not amount to a ‗permanent establishment‘. The ITAT,
30 Deloitte, Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE,
available at
http://www.deloitte.com/assets/DcomIndia/Local%20Assets/Documents/Thoughtware/Tax_thoughtpaper
s_Dec_19/Deloitte_Taxation%20of%20shrink-wrapped%20software.pdf. (30 June 2014, 03.00 PM).
31 Sonata Information Technology Ltd v. DCIT, (2012) 25 taxmann.com 124 (Mum).
32 DIT v. Nokia Networks OY, ITA 512/2007, decided on 07/09/2012 (Del).
33 CIT v. Neyveli Lignite, (2000) 243 ITR 459 (Mad); KANGA, PALKHIVALA AND VYAS, THE LAW AND
PRACTICE OF INCOME TAX, 387 (2008).
34 CIT v. Ahmedabad Calico, (1983) 139 ITR 806 (Guj).
VOL. 1] INDIAN JOURNAL OF TAX LAW 48
however, rejected this argument.35
Part IV of this paper will further discuss permanent
establishments and their implications on royalty taxation.
An additional point of debate in the Reliance Infocomm case was the fact that there
existed two different agreements that separately procured the software and hardware from
Lucent Technologies. Reliance argued that the transaction must be viewed in totality, as the
software and hardware were to be integrated, whereas the Revenue asserted that there existed
two standalone contracts and that software was not an essential part of the purchase of the
equipment. The existence of two agreements stepped the balance and the ITAT ruled that
software was not intrinsically linked to the purchase of hardware.36
4.2 ROYALTY UNDER DTAA’S AND THE INTERNATIONAL POSITION
Taxation follows one of two generic models: a source based approach, or a residence
based approach. The former entails taxation by the country at which the income is sourced,
while the latter taxes its residents worldwide.37
India follows a hybrid model involving both.
The purpose of DTAA‘s, therefore, is to ensure that taxation does not happen twice in the
both parties‘ resident countries.38
Such treaties do not confer the right to tax upon any
country, but provide a framework for the accommodation and conciliation of competing tax
claims.39
In addition to examining the provisions for royalty under the India-USA DTAA, the
authors believe it is significant to scrutinize the discourse on royalty taxation under, first, the
OECD Model Tax Convention on Income and on Capital (hereinafter ‗OECD Model‘) and
second, The United Nations Model Double Taxation Convention between Developed and
Developing Countries (hereinafter ‗UN Model‘). The differences between these two models
35 Microsoft Corporation v. ADIT, (2010) TII 154 (ITAT Del).
36 The ITAT relied on CIT v. Sunrays Computers, (2011) 16 taxmann.com 268, as similar case with two
agreements, where purchase of software was considered royalty.
37 R. S. Avi-Yonah, The Structure of International Taxation: A Proposal for Simplification, 74 TEX. L.
REV. 1301, 1303-06 (1996).
38 A.C. Warren Jr., Income Tax Discrimination against International Commerce, 54 TAX L. REV. 131
(2001).
39 A. Forgione, Weaving the Continental Web: Exploring Free Trade, Taxation and the Internet, 9 L. &
BUS. AM. 513 (2003).
2014 Royalty Taxation In India Post Reliance Infocom:
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will significantly impact any DTAA that follows either model,40
as both are examples of the
approaches elucidated above.
The OECD Model follows the residence approach, while promulgating drastic
curtailment to the scope of a source country‘s jurisdiction in taxing international income or
diminishing its tax rates where jurisdiction is retained.41
The UN Model came into existence
subsequently, providing for a model structure for taxation between developing and developed
nations and employs both a source-based and residence-based approach. Other than the
differences in their holistic approaches, the two models are uniform in their approach to
software purchases as royalty.42
On scrutiny, it is discernable that both the OECD Model and
the UN Model differentiate between a right to copyright and a copyrighted article. The
OECD Model provides that where the usage of software would amount to an infringement of
the copyright in the absence of the said license, the transaction would be taxed as royalty.
However, if only the right to use the software without affecting its copyright in any manner is
transferred, the same would be taxable as business income in accordance with Article 7of the
OECD. The UN Model follows a similar path, only considering transactions where
substantial rights are transferred to constitute a royalty.43
Article 12 of the former Model only
deals with royalties arising in one party‘s territory and beneficially owned by a resident of the
other party, but does not cover royalties arising in third party countries or attributable to a
permanent establishment.44
Article 12 of the India-USA DTAA provides for royalty payments. Although the USA
typically follows the residence approach, the India-USA DTAA adopts an amalgamation of
40 Ajay Prasad and Rohit Bhat, Domestic and International Tax Treatment of Royalties and Fees for
Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010); Veronica Daurer and Richard Krever, Choosing between the UN and OECD Tax Policy Models: An African Case Study, European Institute
University Working Paper No. RSCAS 2012/60: 22(1) AFR. J. INT‘L & COMP. L. 1 (2014)..
41 Id.
42 Michael Lennard, The UN Model Tax Convention as Compared with the OECD Model Tax Convention –
Current Points of Difference and Recent Developments (Asia-Pacific Tax Bulletin January/February
2009), available at http://www.taxjustice.net/cms/upload/pdf/Lennard_0902_UN_Vs_OECD.pdf (30
June 2014, 05.00 PM).
43 Deloitte, Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE,
available at
http://www.deloitte.com/assets/DcomIndia/Local%20Assets/Documents/Thoughtware/Tax_thoughtpaper
s_Dec_19/Deloitte_Taxation%20of%20shrink-wrapped%20software.pdf (30 June 2014, 05.00 PM).
44 OECD, Model Tax Convention on Income and on Capital 2010, Commentary on Article 12: Concerning
the taxation of royalties, OECD, available at http://www.keepeek.com/Digital-Asset-
Management/oecd/taxation/model-tax-convention-on-income-and-on-capital-2010/commentary-on-
article-12-concerning-the-taxation-of-royalties_9789264175181-46-en#page4 (27 June 2014, 06:30 PM).
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both approaches, allowing India to tax royalties. The DTAA has a provision similar to the
UN Model on source taxation of income, at an agreed rate between the parties, only for the
beneficial owner of a royalty, which means intermediaries do not benefit from these
provisions.45
4.3 POSITION vis-à-vis EACH OTHER
The majority view in determining the liability of a non-resident company in India on
the interplay between the domestic and international definitions of royalty taxation specifies
that any relevant DTAA under Section 90 of the IT Act overrides the provisions of the IT
Act.46
The Supreme Court in Azadi Bachao Andolan & Another reaffirmed this position.47
In
the Reliance Infocomm case, as well, the definition of royalty under the India-USA DTAA
was studied. The ITAT ruled that the present case falls under the ambit of the said definition.
5. PERMANENT ESTABLISHMENT – A TWIST IN THE TALE
The concept of permanent establishments has always proven to be a game changer for
the purpose of taxation. The concept of permanent establishments is to sort out the competing
tax jurisdictions where an entity is legally resides in one country and carries out business
activities in another country. The OECD Convention has defined a permanent establishment
to be ―a fixed place of business through which the business of an enterprise is wholly or
partially carried on.‖48
This understanding of a PE forms the foundational cornerstone to
which most DTAA‘s subscribe to and revolve around, including most DTAA‘s that India is
party to. The primary understanding of permanent establishments is central in determining
the right of a country to tax an entity of a foreign country for carrying out business in its
territory. It is one of the fundamental principles in avoiding double taxation.
5.1 DOMESTIC PERSPECTIVES ON PERMANENT ESTABLISHMENTS
45 DTAA Between India and USA, Article 12. No. GSR 992(E), dated 20/12/1990.
46 CIT v. Visakhapatnam Port Trust, (1983) 144 ITR 146 (AP).
47 Azadi Bachao Andolan & Another v. Union of India,(2003) 263 ITR 706 (SC).
48 OECD Model Tax Convention, Article 5(1).
2014 Royalty Taxation In India Post Reliance Infocom:
Setting A Perilous Precedent
51
As discussed throughout this article, the main contention of taxing computer software is
twofold. One is that the end users of software merely receive a copy of the ‗copyrighted
article‘ and not a right to the copyright of the software and the income that they receive
through such purchase is in the nature of business profits. This income is taxable if the
payment is made to a permanent establishment.49
Before the tax can be levied, it must be
ascertained that the entity in question is indeed a permanent establishment.
Countries across the world are grappling with the uncertainty that determination of
permanent establishments entails, generating a plethora of cases in every jurisdiction on the
matter. When cross border software payments are rendered as royalty, they are subjected to
withholding tax, but rendering the same software payments as business profits would no
longer be taxable unless the foreign company has a permanent establishment in India.50
In light of such a proposition two types of permanent establishments elucidated upon by
the OECD model can be discerned. The first is where the establishment is part of the same
company and is under the common ownership of an entity. This could include a branch of the
main entity or an office. These permanent establishments are covered under Articles 5(1) to
5(4) and are referred to as ‗associated permanent establishments‘. The second includes an
entity that is legally separated from the main company, yet is dependent on the enterprise.
Such permanent establishments are referred to as unassociated permanent establishments and
are covered by Article 5(5) and 5(6).51
In the event that the foreign company has a permanent
establishment in India, the assessment is to consider that such business profits that the
company received from the Indian company are connected to the fixed place of business or
the said permanent establishment. A tax rate of 40% would be levied on the income that is
computed as head profit or gains of the IT Act.
49 Taxing Times: Copyright or Copyrighted Article? The Debate Continues, NISHITH DESAI ASSOCIATES,
available at http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-
single-view/article/taxing-times-copyright-or-copyrighted-article-the-debate-continues-copy-1.html (29
June 2014, 07:36 PM).
50 Ernst and Young, Tax Alert, EY (11 September 2013), available at
http://www.ey.com/Publication/vwLUAssets/Tax_Alert_Reliance_Infocom/$FILE/Tax_Alert_Reliance_
Infocom.pdf (30 June 2014, 07.30 PM).
51 Shefali Goradia, Business Connection and Permanent Establishment, NISHITH DESAI ASSOCIATES,
available at
http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Business_Connection_and_Permanent_Establis
hment.pdf. (30 June, 2014, 08.00 PM).
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The case of Velankani Mauritius v. DDIT52
establishes that business profits would not
be subject to tax in the absence of such an Indian permanent establishment. In this case the
shrink-wrapped licensed software was supplied to Infosys Technologies. The tax authorities
assessed that the payments would be treated as royalties and not business profits, and thereby
were not subjected to taxation in the absence of a permanent establishment. Upon close
scrutiny of the Reliance Infocomm case, it is seen that this argument was also put forth but
not delved into by the ITAT.
6. CRITIQUE AND SUGGESTIONS – TOWARDS A BETTER MODEL
The Reliance Infocomm case is yet another milestone in the much-trodden path of the
debate regarding the taxation of software purchases. Until Reliance Infocomm, if a transaction
fell under the ambit of the IT Act and the non-resident party was from a state with which
India did not have a DTAA, the Indian party was obliged to withhold taxes. If a DTAA
existed but the definition of royalty under the treaty did not cover software purchases, the
taxpayer could assert that the transaction amounted to purchase of a copyrighted article, until
the Reliance Infocomm case turned the tables by blurring the distinction between the two. In
light of the Finance Act and jurisprudence post the retrospective Amendment, it is safe to
state that the distinction between a copyrighted article and right to copyright has been
rendered irrelevant.
In the pre-Reliance Infocomm era, the Indian judiciary adopted diverse stances in
drawing the distinction between copyrighted articles and right to copyright, as elucidated in
Section III. It is the authors‘ opinion that the position taken by the Supreme Court in the GE
India case, allowing an element of discretion to the taxpayer with respect to determining
whether a transaction qualifies as a royalty or not is more in consonance with international
norms than the present law in India. By following the Samsung Electronics case, the Reliance
Infocomm case does not allow an assessee to argue that a transaction involving software
could be a copyrighted article, while there is evidently conflicting case law on this point. The
fact that this distinction is rendered obsolete is cause for concern. This could also have
damaging implications for the taxation of shrink-wrapped software, for instance, where no
rights are transferred at all, but it still taxed as royalty because Indian law refuses to see the
existence of a distinction.
52 Velankani Mauritius v. DDIT, (2010) 132 TTJ 124 (Bang).
2014 Royalty Taxation In India Post Reliance Infocom:
Setting A Perilous Precedent
53
Instead of the present approach in India, the authors‘ contend that a rights-based
approach to such taxation issues could prove to be less problematic. The first and most
pertinent advantage of such a system is the recognition of the right to copyright-copyrighted
article dichotomy. In early 2013, Singapore brought in such a model to characterize payments
for software, which earlier followed the Indian position and mandatorily deducted tax at
source for software purchases, which fell under royalty payments. A rights-based approach
essentially involves differentiating between a right over the copyright and a copyrighted
article, something that Indian law, through the judiciary, has attempted to blur. Where the
payee can commercially exploit the copyright, by modifying, reproducing, adapting before
redistributing, or preparing derivatives from the software, the transaction would constitute a
right to copyright and therefore, a royalty. A copyrighted article, on the other hand, would be
where limited rights that are necessary for operating the software are conferred for personal
consumption or within the business. The latter would not constitute a royalty.53
Thus, it is the
authors‘ suggestion that first, the copyrighted article-right to copyright distinction must not
be lost; and second, while determining the distinction between a copyright and a
copyrightable article, the courts must focus on the benefits and the burden transferred from
the owner of the software to the purchaser or licensee. This model will expose the real nature
of the transfer of the software in question and establish the link with royalty taxation.
The crux of the issue in the Reliance Infocomm case can be boiled down to a tug-of-war
between the source-based approach and the residence-based approach, as royalty involves the
withholding tax by the source country. A conceivable answer here could be to share the right
to tax: the source country could have the priority to tax low-rate royalties and the country of
residence can also obtain some tax revenues. The former will encourage the source countries,
which are usually developing nations like India, to improve their technology market and
effectively regulate their economies. In addition to this, such a system will also aid combating
tax avoidance more effectively.54
53 Inland Revenue Authority of Singapore, Rights-Based Approach for Characterising Software Payments
and Payments for the Use of or the Right to Use Information and Digitised Goods, IRAS, available at
http://www.iras.gov.sg/irashome/uploadedfiles/e-Tax_Guide/etaxguides_CIT_rights based%20approach_2013-02-08.pdf (30 June,2014, 07:30 PM); KMPG, Rights-Based Approach for
Characterizing Payments for Software, Information and Digitised Goods, KPMG (Tax Alert: April
2013), available at
https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxnewsflash/Documents/sing
apore-april17-2013.pdf (30 June 2014, 07:30 PM).
54 Bin Yang and Chun Ping Song, A comparative study of the OECD model, UN model and China‘s treaties
with respect to rights to tax income and capital, IX E-JOURNAL OF TAX & RESEARCH 254 (2011).
VOL. 1] INDIAN JOURNAL OF TAX LAW 54
The need of the hour is to shed some light into the prevailing uncertainty. The sheer
number of cross-border transactions takes place with Indian parties involving software is
evident from the plethora of cases on the matter. In order to reduce litigation and ensure
certainty, clarifications are needed on the position of Indian law on this matter.
7. CONCLUSION
The Reliance Infocomm case has brought about much anguish to the already wavering
nature of interpretation of software payments. The 2012 Finance Act came as an aftershock to
the already ambiguous and unclear position on taxation of software payments. This legal
position needs to adopt a sense of urgency in clarifying the status quo, even more so in this
ever changing scenario of the software industry. The following decade is touted to be one of
the most exciting periods for the development of technology and there would be new
emerging trends in the way businesses would be conducted. At the forefront of all of this is
the emergence of e-commerce at an accelerating rate, which would provide new challenges
on the front of software payments. Thus, the issues discussed in this paper give an outline as
to the way the Indian judiciary has dealt with the conundrums of software payments and
provides a viable way forward.