In a recent decision of Supreme Court of India, it has been held that payment by end user or distributor for use of shrink wrapped software is not Royalty under the Double Taxation Avoidance Agreements (DTAAs), thus will not be subject to withholding tax provisions in India.
The controversy around the software payments has been contentious issue from the withholding tax perspective. Such withholding of taxes was often done by the resident payers while making the payments to non-resident and such non-residents were required to undergo subsequent compliances in India. However, with this ruling, the requirement to withhold tax on payments by end user or distributor for use of shrink wrapped software stands settled. Further, where in case there has been deduction of withholding tax in the past and the time lines to file the income tax return by such non-resident entities exist, the refund of such withholding tax can be claimed through the filing of tax returns.
Now the key points in the ruling of the Supreme Court. Under the provisions of Income Tax Act, 1961 (IT Act), royalty has been defined as consideration for transfer of all rights (including the granting of the license) in respect of patent, copyright, literary, artistic or scientific work etc. The said definition is wide enough to cover ambit of payments under it, however, the definition under DTAAs defines royalty in a narrow manner to mean consideration for the use of, or the right to use, any copyright of a literary, artistic or scientific work. In the past, the tax authorities in India have taken a position that payment for software, irrespective of the rights, is generally treated as royalty payment, thus subject to withholding tax. There had been multiple rulings of various courts in the past and all such rulings had treated such payments differently i.e. some had held it as royalty and other had held it as purchase of goods, thus not a royalty. Such, divergent views of the courts led this matter to travel to Supreme Court of India as a batch appeal matter and the matter was divided under four different categories of payments i.e.
For all the above categories, the Supreme Court passed a common order. In the order, the Supreme Court discussed that the rights that are granted to the end user through license are non-exclusive and non-transferrable to re-sell the computer software. It was further observed that rights in such computer software does not permit the user to modify, sub-license, reverse engineer or reproduce the copies in any manner. The sale of software by a non-resident vendor or a distributor is a mere resale of the software as a product to the end users. Accordingly, the limited rights that are granted to the end user in the software does not create any interest or right in it. There is never a transfer of right in the copyright associated with the software and the license granted to the distributors do not involve granting of rights as that is with the owners of the software. Since, this limited right granted to the end user do not satisfy the definition of royalty as is in the Double Taxation Avoidance Agreements, there is no withholding tax liability on such payments made to the non-resident for such software.
The ruling is a landmark decision with binding reference for transactions involving payments in relation to use of software licenses to a non-resident recipient. Further, with scope of expansion in the equalization regime vide Finance Act, 2020 and proposed amendments in Budget, 2021, it will be important to categorize the services in the right bucket of classification.
