The Pune Income Tax Appeal Tribunal (Tribunal) has issued a decision in the case of BMC Software Asia Pacific Pte Ltd. (taxpayer), concerning a company registered in Singapore which received income from the sale of software licenses and from support, maintenance and training. services rendered under software licenses sold directly or indirectly through distributors in India.
The Tribunal, ruling on an assessment by the tax (revenue) authorities who decided to tax such a transaction in India, relied on the judgment of the Supreme Court of Center of Excellence in Engineering Analysis Pvt. ltd., to confirm that the sale of a copyrighted item (i.e., product) with respect to the use of “licensed” computer software does not result in the grant to the licensee of exclusive rights. Specifically, as no copyright is segregated, these sale amounts are excluded from the meaning of “royalty” both under Indian domestic tax laws and under Article 12 of the Tax Treaty between India. India and Singapore (tax treaty).
The Court therefore concluded that transactions which do not have the character of royalties qualify 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 derives revenue from the sale of software licenses and support, maintenance and training services rendered in connection with software licenses sold directly or indirectly by through third parties in India. The taxpayer did not file a tax return in India on the basis that he was considered an offshore distributor of software licenses in the Asia-Pacific region that did not own any software licenses.
Revenues, after reviewing the details, initiated a reassessment proceeding and issued a show cause notice as to why income from the sale of software was not offered for tax in India, relying on the case of the High Court (Court) of Samsung Electronics Co.Ltd. and other rulings, and disputed that the payment received by the taxpayer was for the supply of software and the provision of software-related services qualifying as royalty under the Indian domestic tax laws and section 12 of the tax treaty.
The taxpayer, objecting to the reassessment order, approached the Dispute Resolution Committee (DRP), claiming that the sum received was exclusively for the sale of software licenses treated as business income and could not be recognized as a royalty in kind. The DRP, after reviewing the Court’s decision, agreed that the decision of the income to process this payment for the sale of computer software was a royalty and taxed this income in India.
The taxpayer challenged the DRP’s order and applied to the Tribunal for relief.
The Tribunal, in a virtual hearing, analyzed the character of the payment resulting from the sale of software and the provision of connected services to be taxable as a royalty under Indian domestic law or the tax treaty. The General Court considered whether the transaction of the sale of computer software was in the nature of a royalty or a commercial profit, in the light of the decision of the Supreme Court in the case Center of Excellence in Engineering Analysis Pvt. ltd.where, ruling on an identical case, the Court held that:
- ownership of copyright under Article 12(3) of the tax treaty in a work is different from ownership of the physical material in which the copyrighted work is embedded;
- the core of a sales transaction is to permit the end user to access and use a “licensed” computer software product to which the licensee has no exclusive right where no copyright is expressly ceded;
- imposition of ‘royalty’ consideration in Indian domestic law provides that ‘the transfer of all or part of the rights in any right, property or information includes and has always included the transfer of all or part of the right of use or the right to use computer software (including the grant of a license) regardless of the medium by which this right is transferred”;
- such provision is merely of a clarifying nature and does not expand the scope and meaning of the term “royalty” which will apply prospectively;
- if the revenue is found not to qualify as a royalty, it will be in the nature of business profit under the applicable tax treaty; and
- to attract tax on “business profits” in the source country such as India under Article 7, it is necessary for the foreign entity to constitute a PE in India within the meaning of Article 5 of the tax treaty, otherwise no tax is triggered under Article 7.
The Tribunal, after a thorough assessment, did not consider Samsung Electronics Co.Ltd.invoked by income, but reversed by the Supreme Court’s judgment of Center of Excellence in Engineering Analysis Pvt. ltd., thus invalidating the recovery procedure initiated by the tax authorities and confirmed by the DRP. The Tribunal observed that the facts of the present case were identical to the Supreme Court case, concluding that the amount is not within the scope of the royalty under Article 12 of the tax treaty, and the taxpayer, in the absence of a PE in India under Article 5 of the tax treaty, cannot be liable to tax in India.
Moreover, in the absence of a provision clause fulfilled during the rendering of services by the taxpayer, services rendered for a fee related to the sale of computer software are also not subject to tax in India. pursuant to Article 12, paragraph 3. (b) of the tax treaty.
Key points to remember
The subject of cross-border tax on the sale of software products/licenses has been the subject of significant litigation in India between the tax authorities and the taxpayer for several years. The controversy is mainly due to the broader scope of “royalty” in Indian tax law compared to the narrower definition of the Organization for Economic Co-operation and Development (OECD) model tax convention.
The court’s favorable decision reaffirms the principle that the outright sale of software products/licenses cannot qualify as a royalty under Article 12 of the tax treaty, and the Digite Inc. v case should be referred. . ADIT in Delhi court which upheld that the sale of copyrighted software licenses was business income not subject to tax in India as a royalty under Article 12 of the tax treaty between India and the United States in the absence of a PE in India.
The main point in determining taxation arising from the sale of software is that if there is a grant of copyright, then only the source country can tax it as a source-based royalty; instead, if the transaction qualifies as a sale of a copyrighted item (i.e. a product), the source country is only entitled to tax if the seller has an ES in this country.
In an effort to promote certainty, the United Nations Tax Committee has published a draft discussion on “the inclusion of software payments in the definition of royalties” in the United Nations Model Double Taxation Convention by proposing a amendment to Article 12 on “royalties”. The proposal, if implemented in bilateral treaties, could make software payments taxable in source countries, end India’s ongoing litigation with other countries over software payments, and provide a tax certainty by aligning treatment under tax treaties and national tax law. .
The purpose of the proposed amendment is to clarify the controversy over whether the payment of a right to use software constitutes a royalty and dilutes the non-taxation position taken by distributors who buy and sell software in various modes/media; however, the controversy surrounding the characterization of royalties in cases where software is pre-installed/embedded in a product (such as computer hardware and telecommunications equipment) may yet continue until the proposal is accepted by the under the Pillar One and Two Guidance published at the end of 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:
- The first pillar aims to ensure a fairer distribution of profits and taxing rights between countries in respect of the largest multinational enterprises, with the reservation that developing countries may benefit from an elective mechanism in certain cases, ensuring that the rules are not too burdensome for such countries. The profit reallocation agreement under the first pillar includes the removal and discontinuation of digital services taxes and other relevant similar measures, ending trade tensions resulting from the instability of the international tax system.
- The second pillar dissolves tax competition on corporate tax with the introduction of a global minimum corporate tax at the rate of 15% which countries can use to protect their tax bases (the GloBE rules). Tax incentives provided to stimulate substantial economic activity will be covered by an exception protecting the right of developing countries to tax certain base-eroding payments (such as interest and royalties) when they are not taxed until minimum rate of 15%, through a “Subject to the tax rule”.
It is also important to note that the United States will end its proposed trade actions against India regarding the 2% Equalization (EL) levy and that India is not required to withdraw the applicable EL rules in royalty payment situations until the first pillar is made effective. In addition, India will allow a 2% EL credit chargeable to foreign e-commerce operators during the “interim period” on future Pillar 1 tax liabilities of multinational enterprises when the Pillar 1 rules come into force. According to the published press release, the interim period will run from April 1, 2022 until the implementation of the first pillar or March 31, 2024, whichever comes first.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Shailendra Sharma is a Chartered Accountant associated with a multinational financial services company, India.