Delhi tribunal rules that sale of software cannot be characterised as royalty from license income, but is a ‘sale of product’ and therefore taxable

The Indian software and information technology industry is facing uncertainty in several tax issues, the most fundamental of them being the characterisation of its income from sale of software licenses.

The controversy is over whether the sale of software—specially shrink-wrapped software—constitutes license income (that is, royalty) or whether it is sale of a product. While globally, sale of software has been regarded as sale of a product, a controversy erupted in India over the characterisation. Just when it seemed that the controversy in India was being settled through the judicial process, in line with the global practise, a Delhi tribunal has again upset the applecart with a ruling that the sale of software is not a sale of a product but license /royalty income and, therefore, it is subject to tax under the Income Tax Act (ITA). This ruling was delivered in a case involving software giant Microsoft.

Web of agreements

The dispute arose after a series of business developments with regard to the company’s direct distributor agreement with Indian distributors. Microsoft Corporation, USA (MS Corp) had granted Gracemac Corporation, USA, a wholly-owned subsidiary, the exclusive rights to manufacture and distribute Microsoft products. Gracemac passed on a non-exclusive license to Microsoft Operations Pte Ltd Singapore (MO) to manufacture and distribute MS products, for which MO paid Gracemac royalty on each product sold.

MO entered into a distribution agreement with Microsoft Regional Service Corporation, Singapore (MRSC) for distribution of MS products in Asia, including India. The products were sold through distributors /resellers in India, appointed by MRSC. Importantly, all intellectual property in MS products vested with MS Corp and the end-users signed an end-user license agreement with MS Corp that laid down the terms of use of the product.

MSRC claimed that income from the sale of software in India was not liable to tax, on the grounds that the sale of ‘off-the-shelf’/shrink-warped software constitutes sale of products. Besides, MSRC did not have a permanent establishment in India. It also argued that the other US-based entities earned royalties from the Singapore entity, which was out of the Indian tax jurisdiction. It tried to distinguish between sale of a copyrighted product (which is the software) and the grant of copyright in the product.

The tax officer, predictably, did not agree with Microsoft Corporation and held that the payments were for the grant of license, that they should be regarded as royalties and were, therefore, liable to tax in India. The tax authorities also pointed out that the end-user license agreement mentioned the fact that the software is not sold but only licensed. Further, sensing a window of opportunity for tax collection, the tax officer disregarded the myriad agreements and ruled that all entities were liable to tax in India. Consequently, the tax authority determined the royalty income at Rs2,240 crore, nearly three times that which was originally assessed. The tribunal agreed with the assessment of the tax officer.

Tribunal’s explanation

In its order, the Delhi tribunal said that according to the end-user license agreement and the restrictions put on the end-users, the transactions were essentially a license for MS products and not an outright sale as claimed by the entities. The tribunal rejected the difference between ‘copyright’ and a ‘copyrighted article’, and rejected that reference to the Tata Consultancy Services versus State of Andhra Pradesh case, saying that it was about a sales tax matter. The Tribunal also declined to rely on the OECD Commentary and US Regulations, stating that the definition of royalty and consequent taxation was appropriately clear under the Income Tax Act.

The tribunal said in its order that the royalty payments received by Gracemac was liable to tax in India under section 9 of the Act, according to which royalty income of a non-resident shall be deemed to accrue in India irrespective of whether the non-resident has a residence or a place of business, or business connection in the country.

Besides the characterisation issue, the tribunal also made some observations with respect to the principles of ‘treaty override’. It said that in the event of a conflict between the provisions of domestic law and a tax treaty, domestic law would override the treaty.

While the ruling comes as a shot in the arm for tax authorities who appeared to be fighting a losing battle, the IT industry is naturally unhappy with the ruling. It believes that the tribunal has gone overboard, disregarding a Supreme Court ruling in a similar matter, and that the suggestion that domestic law supersedes a tax treaty is inconsistent with the Income Tax Act.

The industry is considering challenging the ruling of the tribunal in the Supreme Court, where it hopes to rely on earlier rulings by various authorities. Already it is struggling with transfer pricing adjustments and the expiry of a tax holiday at the year end and such rulings only compound the difficulties for business. — Moneylife Digital Team