ROYALTY TAXATION IN INDIA POST RELIANCE INFOCOM: … · 04/03/2018 · Deekshitha Srikant, Enakshi Jha, & Sindhuja Satti Abstract Taxation of software payments in India has proven

ROYALTY TAXATION IN INDIA POST RELIANCE INFOCOM:

SETTING A PERILOUS PRECEDENT

Deekshitha Srikant, Enakshi Jha, & Sindhuja Satti

Abstract

Taxation of software payments in India has proven to be an extremely

contentious topic with the level of uncertainty it has entailed over the years. This

article seeks to discuss the connotations of the recent Mumbai Tribunal ruling in

the case of DDIT v Reliance Infocomm Ltd/Lucent Technologies, a fine example

reiterating the ugliness of the façade of software payments by universalizing the

taxation of transactions having varying standings under copyright law. The

article explores the implications of such ambiguity in the field of taxation by

elucidating essential concepts like royalty taxation, copyright law, and the law on

permanent establishments by tracing the judicial lineage on these issues both in

the domestic and international spheres. The article also seeks to provide a

glimpse of the wide spectrum of judicial perspectives by shedding light on the

plethora of conflicting cases, statutes and lacunae in the law on the issue. Once

the fissures in the present law in India has been displayed through this process,

the article then critiques the judgement and suggests a viable alternative tax

model successfully utilized abroad.

1. INTRODUCTION

Since the dawn of the information technology age, the proliferation of transactions that

involve fairly young ideas has created its share of ripples in older and more established

realms, such as taxation. In addition, the transferability of such ideas across borders has

further complicated the situation, as evident from the endless diatribes on taxation of cross-

border software purchases in India. The problem here is twofold: one, with respect to the

characteristics of the software itself and accordingly, how it must be taxed; and two, the

added impediment of taxing such software in a cross-border transaction. In the face of such a

Students of Law, NALSAR University of Law, Hyderabad. E-mails: [email protected],

[email protected], [email protected]

2014 Royalty Taxation In India Post Reliance Infocom:

Setting A Perilous Precedent

39

conundrum, this paper seeks to study a recent case, DDIT v. Reliance Infocomm Ltd/Lucent

Technologies1 (hereinafter ‗Reliance Infocomm‘) by the Income Tax Appellate Tribunal,

Mumbai (hereinafter ‗ITAT Mumbai‘) in the backdrop of a history of conflicting

jurisprudence on the matter. It seeks to locate essential concepts that the case has ruled on,

such as the difference between a ‗copyrighted article‘ and ‗copyright‘, the definition and law

surrounding royalties and permanent establishments in the domestic sphere vis-à-vis the

position under international treaties and models, before discussing the legal coherence of the

Reliance Infocomm judgement in light of the enumerated concepts and judicial decisions. It is

the authors‘ assertion that a careful analysis of the debate on taxation of software purchases

in India displays the flaws in the Reliance Infocomm decision. However, the authors

recognize the need to examine the debate in light of the retrospective amendment to the

Income Tax Act, 1961 (hereinafter ‗IT Act‘) through the Finance Act, 2013, yet maintain that

the adoption of a different approach towards such taxation would be incommensurably

helpful.

2. FACTUAL BACKGROUND

The case centres around a transaction between Reliance Infocomm (now dubbed

Reliance Communications Ltd.), an Indian telecom company that sought to establish wireless

networks in India, and the Indian and USA-based offices of Lucent Technologies for the

supply of said wireless software. The transaction involved purchase of hardware from Lucent

India, and a corresponding purchase of software from Lucent USA. The intellectual property

rights of the software remained vested in Lucent USA. Reliance Infocomm‘s license

prohibited the company from making any copies of the software other than for internal

purposes, or transferring, assigning, sub-licensing, modifying, decompiling, reverse

engineering, disassembling or decoding the software in any manner. Reliance Infocomm

approached the Revenue in an application for a ‗no withholding‘ certificate for the payments

to Lucent USA, which the Assessing Officer (hereinafter ‗AO‘) rejected on the ground that

the payment constituted a royalty and therefore mandated withholding of tax. Reliance

moved an appeal to the Commissioner of Income Tax (Appeals), who ruled against the AO‘s

decision and categorized the transaction as the sale of a copyrighted article, which meant that

1 DDIT v. Reliance Infocomm Ltd/Lucent Technologies, (2014) 159 TTJ 589 (Mum).

VOL. 1] INDIAN JOURNAL OF TAX LAW 40

the transaction could not be taxed as royalty in the absence of a permanent establishment of

Lucent USA in India.

Meanwhile, the AO simultaneously reconsidered Lucent USA, which moved to the

Dispute Resolution Panel in appeal, who confirmed the AO's order that the transaction

constituted a royalty. The common appellate forum for both claims was the ITAT Mumbai,

which clubbed both claims together to decide whether payment for software licenses

constitutes ‗royalty‘ under the Indian Income Tax Act or the India-US tax treaty and thereby,

whether Reliance Infocomm was obliged to withhold tax on the transaction.

The ITAT ruled in favour of the Revenue, stating that in absence of the license, the

end-user of the software would be infringing upon the intellectual property rights of the

vendor, even in case of sale of a copyrighted article. Other noteworthy parts of the judgement

are:

(a) Reliance contended that despite the existence of separate agreements for the

purchase of hardware and software, the two would be integrated; but the software was

not an integral part of the transaction. The ITAT distinguished this case from previous

precedent with embedded software as there two separate agreements existed.

(b) Reliance argued that the software comprised of a copyrighted article while the

Revenue argued that there existed a right to copyright. ITAT held that even though an

explicit right to the copyright was not transferred in the licence, certain rights had

been conveyed to use the software. In the absence of this license, such use would have

been an infringement of the copyright itself. The ITAT further relied on previous

cases and stated that the dichotomy between copyrighted articles and right to

copyright was irrelevant for this purpose. The ITAT also stated that in every case

where there is a transfer of rights and the intellectual property rights remained with

the vendor, it would be a situation of royalty.

3. THE COPYRIGHT CONTROVERSY

While the Indian judiciary has often encountered a quandary in adjudicating upon the

payment of taxes in software purchases, no precedent has been set to explicate the difference

between royalty and expense as revenue expenditure, taxable under Section 37(1) of the IT



41

Act.2 However, when faced with this predicament on a case-to-case basis, the courts have

deduced general principles regarding the taxability of software purchases, making it

paramount for India‘s biggest software giants and other small and medium technology

enterprises to apprehend whether payment for importing software amounts to ‗royalty‘, which

is taxable under Indian law.

Software protection in India lies within the ambit of the Indian Copyright Act, 1957.

This Act attempts to protect and promote innovation that can be commercially exploited by

the innovator. Computer programmes are considered to be ‗literary works‘ under this Act.

The right to exploitation of such works is extended to assignees for a fixed time period on the

payment of a fee. This fee is known as ‗royalty‘ and lies in the crux of the debate that this

article shall attempt to decipher. On licensing his patent, the author retains the intellectual

property of his invention. In the case of software protection, this premise can be extended to

conclude that licensing of software does not amount to the transfer of intellectual property of

the software or its program. Further, Section 51 of the Copyright Act also provides for the

infringement of the author‘s copyright without prior authorization. However, Section 52

elucidates upon the situations a prima facie infringement will not be deemed (unless

infringement is made for a commercial exploitation), such as in the case of computer

infringements specified by this Section. While Section 51 has been drafted to curb

unauthorized multiplication of software programs considering the smaller scale of the

consideration paid to the author, Section 52 provides for exceptions that include copying the

software to prevent its loss in case of any damage or destruction.3 This is often done with the

permission of the author (owner of the copyright).

Computer programs are usually of two types. The first includes ‗shrink-wrapped‘

software that is devised for personal usage by the licensee, and the second includes computer

programs that are made for commercial exploitation. Shrink-wrapped programs are available

in the market, on the purchase of which the customer enters an End-User License Agreement

with the author of the program that grants him a license to merely use a copy of the software

program. The customer does not receive any ownership of the intellectual property of the said

program. If the customer distributes or replicates the software, he is bound to pay a royalty to

2 PATHAK AND GODIAWALA, BUSINESS TAXATION, 36 (2013).

3 A. J. Majumdar, Taxation of Royalty Income from Computer Software under Income-tax Act and Double

Taxation Avoidance Agreements, TAXMANN , available at

http://www.taxmann.com/TaxmannFlashes/Articles/flashart13-1-11_1.htm (30 June 2014, 04.30 PM)


the author of the software, in return of a right to commercially exploit the software.4 This

leads us to the crucial difference between a ‗copyright‘ and a ‗copyrighted article‘, a

dichotomy that is pivotal in determining the taxation policies that govern the import of

software programs in India, as has been discussed in the latter sections.

On licensing the software the author retains his ‗copyright‘, which is the intellectual

property of the software. The licensee attains a copy of the same software, which is a

‗copyrighted article‘, but does not receive any ownership of the intellectual property of the

said software.5 Copyrights are a privilege created and are intangible in nature and are

independent of any material existence. Copyrighted articles on the other hand allow for the

use of a program after paying a consideration to the author. This sale is analogous to the

consideration paid in the sale of goods and does not amount to royalty.6 In copyrighted

articles, the assignee does not have ownership over the copyright and cannot claim the same

rights as the author. On paying the owner of the program a royalty, the user can attain the

owner‘s right over the program, thereby giving the user the copyright. This classification is

crucial in determining whether payments advanced towards computer software and their

programmes can be classified as ‗royalty‘, which is taxable under Indian Law. In 2005, the

Supreme Court of India in the Tata Consultancy Services v. State of AP7 held that shrink-

wrapped software were ‗goods‘ and that the licensing of such software programs amounts to

the transfer of a copyrighted article and not the copyright itself. Hence the Court concluded

that the consideration provided in the case of shrink-wrapped software would not amount to

royalty.8 A Special Bench of the Delhi Tribunal in the case of Motorola Inc v. Dy. CIT and

Dy. CIT v. Nokia9 gave a judgment along the same lines as the Supreme Court by reiterating

4 Id.

5 Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE (December,

2013), available at http://www.deloitte.com/assets/Dcom-

India/Local%20Assets/Documents/Thoughtware/Tax_thoughtpapers_Dec_19/Deloitte_Taxation%20of%

20shrink-wrapped%20software.pdf (30 June 2014, 05.00 PM).

6 India‘s Delhi High Court distinguishes Copyright Rights and Copyrighted Article in Software

Transactions, EY (04 December, 2013), available at

http://www.ey.com/Publication/vwLUAssets/India_Delhi_High_Court_distinguishes_copyright_rights_a

nd_copyrighted_article_in_software_transactions/$FILE/2013G_CM4015_India‘s%20Delhi%20High%2

0Court%20distinguishes%20copyright%20rights.pdf (30 June 2014, 04.00 PM).

7 Tata Consultancy Services v. State of AP, (2005) 1 SCC 308.

8 Sagar Mal Pareek, Dealings In Information Technology Software – In New Service Tax Regime – A Study, MANUPATRA, available at

http://www.manupatrafast.com/articles/PopOpenArticle.aspx?ID=07b15aed-5695-4d73-96e0-

0f68c91bd4e6&txtsearch=Subject:%20Indirect%20Tax (30 June 2014, 05:00 PM).

9 Motorola Inc v. DCIT, [2005] 95 ITD 269 (Del) (SB).



43

that payment for a copyright would amount to a ‗royalty‘, while payment for a mere

copyrighted article would not. The Court specified that in deciding between a copyright and a

copyrighted article it is essential to take note of the benefits and burdens of the transferred

ownership, while analyzing the facts and circumstances of the case.10

Similarly, in the DIT v.

Ericsson AB11

case, the Delhi High Court placed reliance on Section 14(a) (i) and (vi) of the

Copyright Act, 1957 in establishing that a copyright exists only in cases of reproduction for

commercial exploitation, thereby cementing that the consideration paid for such copyright to

be a royalty, taxable under Section 9 of the Income Tax Act. This case further specified that

shrink-wrapped software was not taxable in the form of royalty as it was a copyrightable

article and not a copyright.12

4. ROYALTY TAXATION

The concept of royalty taxation has been the source of much controversy in India

because the line drawn between what is subject to such taxation and what is not has remained

blurry and undefined. If an Indian company purchases certain designs from a company based

in the United Kingdom, would such a transaction be taxed as royalty (thereby being eligible

for tax being withheld) or as a mere purchase of a good?13

As discussed in the previous

section, the issue in the Reliance Infocomm case is analogous to the question posed above: is

the purchase of software from the US based Lucent Technologies to be considered a

transaction conferring a right to the copyright of the software, subject to royalty tax; or a

purchase of software subject to sales tax? To be able to successfully answer this quandary,

the definition of ‗royalty‘ must be examined, both in the context of domestic legislations and

jurisprudence and international instruments.

A ‗royalty‘ in its very essence is a payment made to the owner of an intangible asset

(such as a patent or copyright), for the use of this asset. While income from such royalty

10 Ajay Prasad and Rohit Bhat, Domestic and International Tax Treatment of Royalties and Fees for

Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010).

11 DIT v. Ericsson AB, TS-769-HC-2011 (Del).

12 Deloitte, International Tax Alert 29 December 2011, DELOITTE, available at

http://www.deloitte.com/assets/DcomIndia/Local%20Assets/Documents/International%20Tax/2011/ITX-53-2011.pdf (30 June 2014, 12:45 PM).

13 See Akil Hirani and Hemen Asher, Taxation of Royalty Payments in India, MAJUMDAR & CO., available

at http://www.majmudarindia.com/pdf/Taxation%20of%20royalty%20payments%20in%20India.pdf (30

June 2014, 06:33 PM).


payments is taxable in India under the Income Tax Act, 1961, income accruing from an

import of the software must be viewed in the context of the definition of ‗royalty‘ under the

concerned Double Taxation Avoidance Agreement (hereinafter ‗DTAA‘). For the

government, taxation of royalty payments becomes a sizeable source of revenue due to the

typically higher rate of returns,14

while it is detrimental to the tax-payer.

In order to fully appreciate how the concept of royalty taxation pans out in reality, it is

necessary to first delve into the various aspects of domestic law and judicial decisions that

discuss royalty taxation and then examine the same under relevant international treaties,

before examining their positions vis-à-vis each other.

4.1 ROYALTY - THE DOMESTIC PERSPECTIVE

Before the advent of the Finance Act in 1976, Indian tax law did not expressly deal

with the question of royalty payments. Post 1976, however, clause (vi) was inserted into

Section 9(1), elucidating circumstances where royalty income shall be deemed to accrue in

India.15

‗Fees for technical services‘ was also inserted vide clause (vii).

Section 9 of the IT Act discusses income that is deemed to arise in India, where the

payment is to the government, an Indian resident or an Indian business establishment of a

non-resident. The place of usage of the intellectual property dictates place of accrual where

the payee is not the government. The definition under the IT act brings into its purview both

lump-sum and inveterate payments, but does not include an outright conveyance of assets

which would be taxed as capital transfers.16

Section 9(1)(vi) deals specifically with royalties.

This provision merely deems income to accrue in India when in actuality it accrues abroad,

and does not consider any capital receipt to be an income receipt.17

Section 9(1)(vi) discusses

the consideration for the conveyance of all or any rights (including the granting of a license)

in the context of any copyright, literary, scientific or artistic work.18

Income is said to accrue


Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010).

15 See generally, K. CHATURVEDI & S. M. PITHISARIA, I CHATURVEDI AND PITHISARIA‘S INCOME TAX LAW,

(5th ed., 1998).

16 IT Act (1961), Explanation 2 of §9 cl. 1 ¶vi.

17 IT Act (1961), §9 cl. 1 ¶vi.

18 Id.



45

from royalty if the government or a resident makes the said payment to a non-resident for the

purposes of generating income from the overseas country.

In the process of determining which category the transaction falls under, the type of

information that was transferred becomes extremely pertinent. In CIT v HEG India,19

the

Madras High Court exemplified this by stating that to qualify for withholding tax, the

information transferred must have some unique features that elevate it to a transaction not of

mere commercial nature, which is utilized for the earning of income from any source in India.

A right to the copyright of a software, as in the present case, would qualify the transaction to

the level of a royalty, and the Indian payee would be considered a defaulting assessee if tax is

not deducted at the source.20

For the purpose of determining the existence of the same, the

definition of ‗copyright‘ under Section 14 of the Indian Copyright Act is usually relied upon,

as the term has not been defined under the IT act. Section 14 stipulates that copyrights can be

assigned to literary work, within which computer programmes, databases, tables and

compilations are included,21

while Section 52 discusses infringement of such copyright. The

interplay between these two sections was examined in CIT v. Samsung Electronics, which

ruled that making copies of a software would in itself amount to copyright work, which in the

absence of the license would constitute an infringement of copyright, thereby suggesting that

such a license would be more than a mere purchase of a good.22

This judgement has

effectively managed to erase the discretion that previously existed to the Indian payer in

deciding whether payments to a non-resident constituted royalty or not, by requiring an

application to the Assessing Officer for withholding at a lower rate or refraining from

withholding, pursuant to the procedure in the Act.

This stance was a fresh one compared to the previous line of thought espoused by Tata

Consultancy Services v State of AP,23

relied on by the judiciary in a plethora of cases,

foremost of which were the Ericsson24

and Motorola25

cases. Considering that the

predominant position rejects the distinction between copyrighted articles and copyrights, and

19 CIT v. HEG India, (2003) 182 CTR MP 353.

20 IT Act (1961), §201.

21 Indian Copyright Act (1951), §14.

22 CIT v. Samsung Electronics, (2012) 345 ITR 494.

23 Tata Consultancy Services v. State of AP, AIR 2005 SC 371.

24 Motorola Inc. v. DCIT, supra note 9.

25 DIT v. Ericsson AB, supra note 11.


the wide definition of royalty under Section 9(1)(vi) when payment is made to a non-resident

of India, the Indian payee is compelled to withhold tax at the source for transactions

involving purchase of software. The Supreme Court in GE India Technology Centre Private

Limited v. Commissioner of Income Tax26

dealt with a remittance by the assessee to a non-

resident which, according to the assessee, was not taxable in India and did not involve tax

withholding. The AO and the CAT were of the opinion that, post the Samsung Electronics

case, the assessee did not have the discretion to decide upon whether to withhold the tax or

not (as per Section 195) and was liable for not doing so under Section 201 of the IT Act. The

Court stated that such a remittance would be subject to tax only if it is ‗chargeable in India‘

under the non-resident‘s hands, overruling Samsung Electronics and restoring some amount

of discretion to the payee. The Court also recognized that composite payments with an

element of income in them are also subject to withholding under Section 195.27

The case is strikingly similar to the Reliance Infocomm case, wherein the non-resident

retained all rights to the copyright of the shrink-wrapped software, and the Indian payee only

redistributed the software or used it for internal purposes. By drawing the difference between

what transactions are liable to tax deduction at the source under Section 195, the judgement

sheds some clarity on a provision hitherto shrouded with uncertainty. Further, the Court also

directed the identification of the type of transaction based on the ultimate use of the article.28

Clarity was brought in through a retrospective amendment to the IT Act by the government

through the Finance Act 2012, which inserted Explanations 4, 5, and 6 to Section 9 of the IT

Act. These Explanations contained an express reference to software licenses that constitute a

right over the copyright of the software. Explanation 4 essentially sought to clarify that the

transfer of the right to use software has always been covered by Explanation 2, irrespective of

the medium of transfer. Explanation 5 further illuminated that even rights that do not vest

with the resident are to be considered.29

Post this, the Central Board of Direct Taxes issued a

circular dated June 13, 2012, that stated that tax deduction at the source is not required for the

26 GE India Technology Centre Private Limited v. Commissioner of Income Tax, 327 ITR 456 (SC).

27 News Alert, PWC (13 September 2010), available at

https://www.pwc.in/services/Tax/News_Alert/2010/pdf/PwC_News_Alert_13_September_2010_GE_Ind

ia_Technology_Centre_Pvt_Ltd.pdf. (27 June 2014, 03.00 PM).

28 Id.

29 Recent Amendments to the Royalty Provision, KPMG (13 September 2012), available at http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxnewsflash/Documents/india-

sept14-2012no1.pdf (28 June, 2014, 04.00 PM); Richard Murphy, Decoding Finance Bill 2012, TAX

SUTRA, available at http://www.taxsutra.com/microsite/Budget2012/expert/32/Richard_Murphy_-

_Director__Tax_Research_LLP (30 June 2014, 05:31 PM).



47

purchase of software from a resident transferor if the software is bought in a subsequent

transfer without any modification, and tax has been deducted as per Section 195 or Section

194J for the previous transfer. Effective from April 2013, the Finance Act, 2013 also

increased the rate of royalty tax from 10% to 25%,30

higher than most DTAA‘s, which means

that taxation under the latter would be more beneficial to the taxpayer.

This however left some scope for uncertainty. The Mumbai ITAT in 2012 considered

the impact of the newly inserted Explanation 4 on the interplay between Sections 9 and

40(a)(ia) of the IT Act, which deals with disallowance. The Tribunal ruled that Explanation 4

does not alter the latter provision, which shall continue to follow the definition of royalty laid

down in Explanation 2.31

In DIT v Nokia Networks 32

the High Court held that the right to use a copyrighted

article itself is a copyright and that there need not be any distinction outlined between

copyrighted article and right to copyright. The ITAT was swayed in the Reliance Infocomm

case due to the existence of a license. CIT v Neyveli Lignite involved a situation similar to

Reliance Infocomm, where a company located abroad supplied designs along with machinery.

However, no license was involved, so the Court ruled that the payment was outside the

purview of the section.33

Generally, the judiciary has made the distinction between cases

where a license is not involved (such as in CIT v Ahmedabad Calico)34

and cases where

licenses were involved, placing the latter under the class of taxable income. Another pertinent

factor in such cases is whether a permanent establishment of the non-resident company in

India exists. For example, in Microsoft Corporation v ADIT, Microsoft contented that the

transaction selling copies of software produced by various foreign subsidiaries for

redistribution to the Microsoft Regional Sales Corporation did not amount to a royalty as the

Regional Sales Corporation did not amount to a ‗permanent establishment‘. The ITAT,

30 Deloitte, Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE,

available at

http://www.deloitte.com/assets/DcomIndia/Local%20Assets/Documents/Thoughtware/Tax_thoughtpaper

s_Dec_19/Deloitte_Taxation%20of%20shrink-wrapped%20software.pdf. (30 June 2014, 03.00 PM).

31 Sonata Information Technology Ltd v. DCIT, (2012) 25 taxmann.com 124 (Mum).

32 DIT v. Nokia Networks OY, ITA 512/2007, decided on 07/09/2012 (Del).

33 CIT v. Neyveli Lignite, (2000) 243 ITR 459 (Mad); KANGA, PALKHIVALA AND VYAS, THE LAW AND

PRACTICE OF INCOME TAX, 387 (2008).

34 CIT v. Ahmedabad Calico, (1983) 139 ITR 806 (Guj).


however, rejected this argument.35

Part IV of this paper will further discuss permanent

establishments and their implications on royalty taxation.

An additional point of debate in the Reliance Infocomm case was the fact that there

existed two different agreements that separately procured the software and hardware from

Lucent Technologies. Reliance argued that the transaction must be viewed in totality, as the

software and hardware were to be integrated, whereas the Revenue asserted that there existed

two standalone contracts and that software was not an essential part of the purchase of the

equipment. The existence of two agreements stepped the balance and the ITAT ruled that

software was not intrinsically linked to the purchase of hardware.36

4.2 ROYALTY UNDER DTAA’S AND THE INTERNATIONAL POSITION

Taxation follows one of two generic models: a source based approach, or a residence

based approach. The former entails taxation by the country at which the income is sourced,

while the latter taxes its residents worldwide.37

India follows a hybrid model involving both.

The purpose of DTAA‘s, therefore, is to ensure that taxation does not happen twice in the

both parties‘ resident countries.38

Such treaties do not confer the right to tax upon any

country, but provide a framework for the accommodation and conciliation of competing tax

claims.39

In addition to examining the provisions for royalty under the India-USA DTAA, the

authors believe it is significant to scrutinize the discourse on royalty taxation under, first, the

OECD Model Tax Convention on Income and on Capital (hereinafter ‗OECD Model‘) and

second, The United Nations Model Double Taxation Convention between Developed and

Developing Countries (hereinafter ‗UN Model‘). The differences between these two models

35 Microsoft Corporation v. ADIT, (2010) TII 154 (ITAT Del).

36 The ITAT relied on CIT v. Sunrays Computers, (2011) 16 taxmann.com 268, as similar case with two

agreements, where purchase of software was considered royalty.

37 R. S. Avi-Yonah, The Structure of International Taxation: A Proposal for Simplification, 74 TEX. L.

REV. 1301, 1303-06 (1996).

38 A.C. Warren Jr., Income Tax Discrimination against International Commerce, 54 TAX L. REV. 131

(2001).

39 A. Forgione, Weaving the Continental Web: Exploring Free Trade, Taxation and the Internet, 9 L. &

BUS. AM. 513 (2003).



49

will significantly impact any DTAA that follows either model,40

as both are examples of the

approaches elucidated above.

The OECD Model follows the residence approach, while promulgating drastic

curtailment to the scope of a source country‘s jurisdiction in taxing international income or

diminishing its tax rates where jurisdiction is retained.41

The UN Model came into existence

subsequently, providing for a model structure for taxation between developing and developed

nations and employs both a source-based and residence-based approach. Other than the

differences in their holistic approaches, the two models are uniform in their approach to

software purchases as royalty.42

On scrutiny, it is discernable that both the OECD Model and

the UN Model differentiate between a right to copyright and a copyrighted article. The

OECD Model provides that where the usage of software would amount to an infringement of

the copyright in the absence of the said license, the transaction would be taxed as royalty.

However, if only the right to use the software without affecting its copyright in any manner is

transferred, the same would be taxable as business income in accordance with Article 7of the

OECD. The UN Model follows a similar path, only considering transactions where

substantial rights are transferred to constitute a royalty.43

Article 12 of the former Model only

deals with royalties arising in one party‘s territory and beneficially owned by a resident of the

other party, but does not cover royalties arising in third party countries or attributable to a

permanent establishment.44

Article 12 of the India-USA DTAA provides for royalty payments. Although the USA

typically follows the residence approach, the India-USA DTAA adopts an amalgamation of


Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010); Veronica Daurer and Richard Krever, Choosing between the UN and OECD Tax Policy Models: An African Case Study, European Institute

University Working Paper No. RSCAS 2012/60: 22(1) AFR. J. INT‘L & COMP. L. 1 (2014)..

41 Id.

42 Michael Lennard, The UN Model Tax Convention as Compared with the OECD Model Tax Convention –

Current Points of Difference and Recent Developments (Asia-Pacific Tax Bulletin January/February

2009), available at http://www.taxjustice.net/cms/upload/pdf/Lennard_0902_UN_Vs_OECD.pdf (30

June 2014, 05.00 PM).

43 Deloitte, Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE,

available at

http://www.deloitte.com/assets/DcomIndia/Local%20Assets/Documents/Thoughtware/Tax_thoughtpaper

s_Dec_19/Deloitte_Taxation%20of%20shrink-wrapped%20software.pdf (30 June 2014, 05.00 PM).

44 OECD, Model Tax Convention on Income and on Capital 2010, Commentary on Article 12: Concerning

the taxation of royalties, OECD, available at http://www.keepeek.com/Digital-Asset-

Management/oecd/taxation/model-tax-convention-on-income-and-on-capital-2010/commentary-on-

article-12-concerning-the-taxation-of-royalties_9789264175181-46-en#page4 (27 June 2014, 06:30 PM).


both approaches, allowing India to tax royalties. The DTAA has a provision similar to the

UN Model on source taxation of income, at an agreed rate between the parties, only for the

beneficial owner of a royalty, which means intermediaries do not benefit from these

provisions.45

4.3 POSITION vis-à-vis EACH OTHER

The majority view in determining the liability of a non-resident company in India on

the interplay between the domestic and international definitions of royalty taxation specifies

that any relevant DTAA under Section 90 of the IT Act overrides the provisions of the IT

Act.46

The Supreme Court in Azadi Bachao Andolan & Another reaffirmed this position.47

In

the Reliance Infocomm case, as well, the definition of royalty under the India-USA DTAA

was studied. The ITAT ruled that the present case falls under the ambit of the said definition.

5. PERMANENT ESTABLISHMENT – A TWIST IN THE TALE

The concept of permanent establishments has always proven to be a game changer for

the purpose of taxation. The concept of permanent establishments is to sort out the competing

tax jurisdictions where an entity is legally resides in one country and carries out business

activities in another country. The OECD Convention has defined a permanent establishment

to be ―a fixed place of business through which the business of an enterprise is wholly or

partially carried on.‖48

This understanding of a PE forms the foundational cornerstone to

which most DTAA‘s subscribe to and revolve around, including most DTAA‘s that India is

party to. The primary understanding of permanent establishments is central in determining

the right of a country to tax an entity of a foreign country for carrying out business in its

territory. It is one of the fundamental principles in avoiding double taxation.

5.1 DOMESTIC PERSPECTIVES ON PERMANENT ESTABLISHMENTS

45 DTAA Between India and USA, Article 12. No. GSR 992(E), dated 20/12/1990.

46 CIT v. Visakhapatnam Port Trust, (1983) 144 ITR 146 (AP).

47 Azadi Bachao Andolan & Another v. Union of India,(2003) 263 ITR 706 (SC).

48 OECD Model Tax Convention, Article 5(1).



51

As discussed throughout this article, the main contention of taxing computer software is

twofold. One is that the end users of software merely receive a copy of the ‗copyrighted

article‘ and not a right to the copyright of the software and the income that they receive

through such purchase is in the nature of business profits. This income is taxable if the

payment is made to a permanent establishment.49

Before the tax can be levied, it must be

ascertained that the entity in question is indeed a permanent establishment.

Countries across the world are grappling with the uncertainty that determination of

permanent establishments entails, generating a plethora of cases in every jurisdiction on the

matter. When cross border software payments are rendered as royalty, they are subjected to

withholding tax, but rendering the same software payments as business profits would no

longer be taxable unless the foreign company has a permanent establishment in India.50

In light of such a proposition two types of permanent establishments elucidated upon by

the OECD model can be discerned. The first is where the establishment is part of the same

company and is under the common ownership of an entity. This could include a branch of the

main entity or an office. These permanent establishments are covered under Articles 5(1) to

5(4) and are referred to as ‗associated permanent establishments‘. The second includes an

entity that is legally separated from the main company, yet is dependent on the enterprise.

Such permanent establishments are referred to as unassociated permanent establishments and

are covered by Article 5(5) and 5(6).51

In the event that the foreign company has a permanent

establishment in India, the assessment is to consider that such business profits that the

company received from the Indian company are connected to the fixed place of business or

the said permanent establishment. A tax rate of 40% would be levied on the income that is

computed as head profit or gains of the IT Act.

49 Taxing Times: Copyright or Copyrighted Article? The Debate Continues, NISHITH DESAI ASSOCIATES,

available at http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-

single-view/article/taxing-times-copyright-or-copyrighted-article-the-debate-continues-copy-1.html (29

June 2014, 07:36 PM).

50 Ernst and Young, Tax Alert, EY (11 September 2013), available at

http://www.ey.com/Publication/vwLUAssets/Tax_Alert_Reliance_Infocom/$FILE/Tax_Alert_Reliance_

Infocom.pdf (30 June 2014, 07.30 PM).

51 Shefali Goradia, Business Connection and Permanent Establishment, NISHITH DESAI ASSOCIATES,

available at

http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Business_Connection_and_Permanent_Establis

hment.pdf. (30 June, 2014, 08.00 PM).


The case of Velankani Mauritius v. DDIT52

establishes that business profits would not

be subject to tax in the absence of such an Indian permanent establishment. In this case the

shrink-wrapped licensed software was supplied to Infosys Technologies. The tax authorities

assessed that the payments would be treated as royalties and not business profits, and thereby

were not subjected to taxation in the absence of a permanent establishment. Upon close

scrutiny of the Reliance Infocomm case, it is seen that this argument was also put forth but

not delved into by the ITAT.

6. CRITIQUE AND SUGGESTIONS – TOWARDS A BETTER MODEL

The Reliance Infocomm case is yet another milestone in the much-trodden path of the

debate regarding the taxation of software purchases. Until Reliance Infocomm, if a transaction

fell under the ambit of the IT Act and the non-resident party was from a state with which

India did not have a DTAA, the Indian party was obliged to withhold taxes. If a DTAA

existed but the definition of royalty under the treaty did not cover software purchases, the

taxpayer could assert that the transaction amounted to purchase of a copyrighted article, until

the Reliance Infocomm case turned the tables by blurring the distinction between the two. In

light of the Finance Act and jurisprudence post the retrospective Amendment, it is safe to

state that the distinction between a copyrighted article and right to copyright has been

rendered irrelevant.

In the pre-Reliance Infocomm era, the Indian judiciary adopted diverse stances in

drawing the distinction between copyrighted articles and right to copyright, as elucidated in

Section III. It is the authors‘ opinion that the position taken by the Supreme Court in the GE

India case, allowing an element of discretion to the taxpayer with respect to determining

whether a transaction qualifies as a royalty or not is more in consonance with international

norms than the present law in India. By following the Samsung Electronics case, the Reliance

Infocomm case does not allow an assessee to argue that a transaction involving software

could be a copyrighted article, while there is evidently conflicting case law on this point. The

fact that this distinction is rendered obsolete is cause for concern. This could also have

damaging implications for the taxation of shrink-wrapped software, for instance, where no

rights are transferred at all, but it still taxed as royalty because Indian law refuses to see the

existence of a distinction.

52 Velankani Mauritius v. DDIT, (2010) 132 TTJ 124 (Bang).



53

Instead of the present approach in India, the authors‘ contend that a rights-based

approach to such taxation issues could prove to be less problematic. The first and most

pertinent advantage of such a system is the recognition of the right to copyright-copyrighted

article dichotomy. In early 2013, Singapore brought in such a model to characterize payments

for software, which earlier followed the Indian position and mandatorily deducted tax at

source for software purchases, which fell under royalty payments. A rights-based approach

essentially involves differentiating between a right over the copyright and a copyrighted

article, something that Indian law, through the judiciary, has attempted to blur. Where the

payee can commercially exploit the copyright, by modifying, reproducing, adapting before

redistributing, or preparing derivatives from the software, the transaction would constitute a

right to copyright and therefore, a royalty. A copyrighted article, on the other hand, would be

where limited rights that are necessary for operating the software are conferred for personal

consumption or within the business. The latter would not constitute a royalty.53

Thus, it is the

authors‘ suggestion that first, the copyrighted article-right to copyright distinction must not

be lost; and second, while determining the distinction between a copyright and a

copyrightable article, the courts must focus on the benefits and the burden transferred from

the owner of the software to the purchaser or licensee. This model will expose the real nature

of the transfer of the software in question and establish the link with royalty taxation.

The crux of the issue in the Reliance Infocomm case can be boiled down to a tug-of-war

between the source-based approach and the residence-based approach, as royalty involves the

withholding tax by the source country. A conceivable answer here could be to share the right

to tax: the source country could have the priority to tax low-rate royalties and the country of

residence can also obtain some tax revenues. The former will encourage the source countries,

which are usually developing nations like India, to improve their technology market and

effectively regulate their economies. In addition to this, such a system will also aid combating

tax avoidance more effectively.54

53 Inland Revenue Authority of Singapore, Rights-Based Approach for Characterising Software Payments

and Payments for the Use of or the Right to Use Information and Digitised Goods, IRAS, available at

http://www.iras.gov.sg/irashome/uploadedfiles/e-Tax_Guide/etaxguides_CIT_rights based%20approach_2013-02-08.pdf (30 June,2014, 07:30 PM); KMPG, Rights-Based Approach for

Characterizing Payments for Software, Information and Digitised Goods, KPMG (Tax Alert: April

2013), available at

https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxnewsflash/Documents/sing

apore-april17-2013.pdf (30 June 2014, 07:30 PM).

54 Bin Yang and Chun Ping Song, A comparative study of the OECD model, UN model and China‘s treaties

with respect to rights to tax income and capital, IX E-JOURNAL OF TAX & RESEARCH 254 (2011).


The need of the hour is to shed some light into the prevailing uncertainty. The sheer

number of cross-border transactions takes place with Indian parties involving software is

evident from the plethora of cases on the matter. In order to reduce litigation and ensure

certainty, clarifications are needed on the position of Indian law on this matter.

7. CONCLUSION

The Reliance Infocomm case has brought about much anguish to the already wavering

nature of interpretation of software payments. The 2012 Finance Act came as an aftershock to

the already ambiguous and unclear position on taxation of software payments. This legal

position needs to adopt a sense of urgency in clarifying the status quo, even more so in this

ever changing scenario of the software industry. The following decade is touted to be one of

the most exciting periods for the development of technology and there would be new

emerging trends in the way businesses would be conducted. At the forefront of all of this is

the emergence of e-commerce at an accelerating rate, which would provide new challenges

on the front of software payments. Thus, the issues discussed in this paper give an outline as

to the way the Indian judiciary has dealt with the conundrums of software payments and

provides a viable way forward.