Synopsis–Rejecting the revenue’s plea that persons required to deduct tax at source do not fall within the subject matter of tax treaties, it held that tax deduction is required only if the non-resident payee is liable to tax in India after considering the provisions of the relevant tax treaty.
On March 2, the Supreme Court ruled that payments made to non-residents for software purchase can’t be taxed as royalty. The ruling is a detailed exposition of the interplay between the domestic tax law, tax treaties entered into by India with various countries, and the copyright law in India.
Rejecting the revenue’s plea that persons required to deduct tax at source do not fall within the subject matter of tax treaties, it held that tax deduction is required only if the non-resident payee is liable to tax in India after considering the provisions of the relevant tax treaty.
On the main issue of whether the distributors/end-users obtained any right in the copyright, the court observed that the distributors obtained only a non-exclusive and non-transferable licence to resell the software. Even end-users who directly purchased the software could only use the software by installing it on their hardware, and they could not in any manner reproduce it for sale or transfer.
The court agreed with the taxpayers that the ownership of copyright is different from ownership of physical work in which the copyrighted work may be embedded. It concluded that the transactions in question were sales of goods, and that no right in the copyright was granted to the distributors/end-users. Accordingly, the court ruled that the payments did not qualify as royalties under the tax treaties.
The primacy of tax treaties over domestic tax law has once again been upheld. The court also ruled that the OECD commentary used in the proceedings will continue to have persuasive value in the interpretation of ‘royalties’ in treaties. It recognised that taxpayers have the right to know exactly where they stand in respect of treaty provisions, so they can conduct business with full understanding of tax implications. This outcome will enhance trust in the Indian judiciary in the international tax arena, and will provide resolution in a substantial number of disputes pending before various fora across the country.
As next steps, foreign software sellers and Indian payers should explore options to put forth claims for closure of pending disputes and unlocking of refunds of excess taxes paid along with interest. Such options could include filing of revised returns, rectification applications and early disposal of appeals. Where the contracts required the Indian payers to commercially bear the tax liability, they would need to explore options for securing refund of the taxes paid by them.
Finally, with the clarification that foreign software sales are not subject to royalty taxation in India under relevant tax treaties, the evaluation of whether the equalisation levy will now become applicable will be important for sellers.
(Mahajan is partner, and Patel is senior manager, Ernst & Young)