India’s technology industry leads the way in solving complex technological problems for global companies. The first wave of the global tech age in the late 1990s created an intercontinental internet infrastructure in India. The growth of the IT sector resulted in a changing business environment and cross-border transactions, which created a variety of tax problems for non-resident companies operating in India without any physical presence. In the absence of a permanent establishment, the income of these non-residents in India was tax-free. The government, seeking to enter this emerging market with exponential potential for generating revenue, began to characterize software payments to non-residents as “royalty payments.”
The first few years of the last decade resulted in conflicting decisions by various courts and tax courts in India. The government has twisted the knife by adding software payments to the definition of “license fees”. Although the scope of national tax law has been broadened, no changes have been made to tax treaties and therefore software payments, when read in combination, could still be kept outside the scope of royalty taxation. As businesses advanced with technology, software payments became a regular business expense and an apple of discord for both payers (from a withholding tax perspective) and foreign recipients (from an income tax perspective).
Recently, the Indian Supreme Court put a happy ending to this 20-year-old dispute by issuing a landmark judgment in favor of taxpayers. The Supreme Court considered over 100 appeals filed by taxpayers and tax authorities and categorized software payments into four broad categories: (1) purchase of computer software by an end-user from a non-resident, (2) the Indian distributor / reseller model, (3) the foreign distributor / reseller model and (4) hardware embedded software.
The 226-page judgment is an example of international tax controversy. The Supreme Court delved into the issue and analyzed all aspects of the taxation of such transactions. The court was aware of circulars issued back in 2002 by the Central Board of Direct Taxes to support the Treasury Department’s stance to distinguish license fees from remittances for computer software that is treated as goods and taxed as business income due to the existence of a permanent establishment in India . The court reached the eagerly anticipated outcome by discussing the interplay between the Income Tax Act and Copyright Act with international tax treaties, OECD comments, agreements between parties and various judgments by lower courts.
The Supreme Court made it clear that a resident payer is only required to withhold tax if the non-resident is taxable in India, as withholding tax provisions are inextricably linked to the fee provisions of the Income Tax Act along with the relevant tax treaty. When India has a tax treaty with another country, the provisions of domestic law can only be imposed to the extent that the provisions contained therein are more favorable to the non-resident than the provisions of the applicable tax treaty. The meaning of “copyright” has been thoroughly deciphered within the framework of the Copyright Act. In examining the end-user license agreements and distribution agreements, the court rightly found that distributors were only granted a non-exclusive and non-transferable license to resell software, and the license granted was not a “license” representing an interest in all or some of the Transfers copyrights, but merely a “license” that imposes restrictions or conditions on the use of computer software. Therefore, a license delivered from a non-resident to a resident distributor or end-user is the sale of goods without any limitation or condition.
The Supreme Court also recognized the impracticability of implementing retrospective amendments, that is, applying the expanded definition of a license fee at a time when such a statement was not actually and factually contained in the law, by relying on the principles that the “Law does not require the impossible “and” if there is an obstruction that makes it impossible to obey the law, the alleged disobedience of the law is excused. “The judgment also took into account different precedents regarding the matter and interpretation of treaties, as well as comments by the OECD. It was found that the relevance of the OECD commentary for the interpretation of tax treaties is convincing, even if the tax authorities consistently oppose the adoption of Explanations in the OECD Commentary have shown that India is not a member of the OECD.
The case mainly revolved around computer software transactions that took place before the cloud computing era, that is, where software was delivered on a floppy disk / CD-ROM known as a shrink-wrapped license. Regardless of how software is deployed, this decision could provide an analytical framework for handling a wide variety of software transactions as new licensing and deployment models continue to emerge in the technology industry.
This ruling could also affect other similar unresolved cross-border matters, such as: B. Payments for connectivity fees, database access, cloud computing payments, web hosting fees, data warehousing fees, etc. This ruling should resolve a longstanding problem and reassure overseas taxpayers that no real benefit will be denied to those entitled. Taxpayers could now expect large refunds from pending litigation on the matter. If resident payers wish to claim a refund of withholding taxes on software payments to non-residents and the payee has applied for a foreign tax credit for such taxes in their home country, the unjust enrichment problem may require in-depth analysis. In the future, resident payers may choose not to deduct taxes on royalties as they are not exposed to the risk of not allowing such expenses and therefore the net inflow to foreign tech companies could be higher. Also, in the absence of a permanent establishment in India, there should be no need to file an annual Indian tax return for the overseas payee if software revenue is the only receipt from India.
It will be interesting to watch the government’s reaction as the finance bill for 2021 has not yet been passed. Against this background, the focus is now shifting to the extended countervailing charge, which was introduced in April last year. The countervailing charge is aimed at all online sales of goods and services and can cover software payments that are not taxable as a license fee. In addition, foreign taxpayers must be aware of the publication of “significant economic presence” rules, which will come into effect on April 1, 2021. These rules will expand the tax base and cover transactions that are currently outside the scope of domestic taxation. While we may have heard this verdict long ago, only time will tell whether the hatchet is buried.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Rakesh Nangia is the chairman and Sandeep Jhunjhunwala is a partner at Nangia Andersen LLP.
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