The Hindu Business Line : Of software and tax

Bharat Varadachari, Tax Partner, Ernst & Young, says there is need for the Government to release an exhaustive set of guidelines on the taxability of software.

Although the agreement uses the word `royalty' to describe the payments, the same represent no more than payments for use of copyrighted software by the Indian company.

Smarterchild software, Buddyscript technology and chatterbots. If these don't ring a bell, it's just that you haven't read the November 6 dated order of the Authority for Advance Rulings (AAR) in the IMT Labs case (Business Line, November 25, `Tax on the trail of chatterbot charges').

Briefly, the facts. IMT, an Indian company, executed a licence agreement with Conversagent, a US company. This was for the use of software tools and code. The tools were required for the development and distribution of interactive agents (software applications that interact with users on instant messaging or other text messaging services).

And the software code of the server platform was needed for enabling ongoing development and deployment of IMT's interactive agents. The agreement also provided for a hosting service, the services of one of the licensor's (Conversagent) staff for the transfer of technical information at the request of the Indian company, and e-mail support.

The agreement provided for a minimum monthly royalty payment for the software, hosting fees based on an agreed rate card after a moratorium and no separate fees for the transfer of technical information or e-mail support.

IMT wasn't sure whether the periodical payments made to Conversagent for use of the software would be liable to tax deduction at source, given that Conversagent did not have any office/establishment in India. Hence, IMT had applied before the AAR for a ruling.

The Authority studied the facts of the case in the context of the provisions of the Income Tax Act, 1961, and the India-US tax treaty, before giving its ruling.

To decode the Authority's ruling, eWorld contacted Bharat Varadachari, Tax Partner, Ernst & Young. Here are his answers to a few questions:

What was the ruling?

The Authority held that the payments for use of the software on the specified server platform and hosting services constituted `royalty' (being payments for the use of scientific equipment) and that the elements related to consulting services/e-mail support were akin to `fees for technical/included services' per the Act/Treaty, being ancillary and subsidiary to the application/enjoyment of the scientific equipment.

On the nuances in the two payments that the agreement speaks of.

One payment is for software, and the other, for hosting services. With respect to the software-related payments, although the agreement uses the word `royalty' to describe the payments, the same represent no more than payments for use of copyrighted software by the Indian company, both as a tool for furthering its business of development of the interactive agents and an enabler for deployment of the interactive agents.

The Indian company enjoyed no additional rights, the exploitation of which was otherwise the prerogative of the copyright owner. The fact that the software were hosted on a specified server of the US company to enable their usage or that the payments are on a monthly usage basis, bear little relevance to, and cannot alter, the characterisation of the software payments.

Is there any confusion about the use of copyrighted software?

As laid down in several precedents, payments for use of copyrighted software (as in the instant case) need to be distinguished from payments for use of copyrights in the software. In the former case, the payments do not constitute royalties but business income that is rightfully exempt from taxation in the hands of a non-resident, in the absence of attribution to any permanent establishment (PE) in India.

Can we call `hosting fee' royalty?

If the US company does not specifically rent the server to the Indian company but continues to operate and maintain the same, the hosting fees cannot be said to be a royalty for the use of scientific equipment. The payment is more in the nature of a charge for an `application warehousing facility' and would constitute business income exempt from taxation in the hands of the US company, in the absence of attribution to any permanent establishment in India.

E-mail support is a common feature. Does this come under the taxman's lens?

The ruling extends its brief by bringing to tax, the provision of limited technical information and email support even when no payments are envisaged under the agreement for the same. Even assuming that the software-related fee includes a service element, given that the same is only ancillary to the enjoyment of the software, and that the essential consideration for the payment is the use of the software and not for services/support, the service portion needs to be disregarded as a de minimus element for tax characterisation, in line with international thinking.

How does the ruling impact taxability of software?

While the AAR ruling is only binding on the Indian company and the Revenue in respect of the specific transaction, this apparently incorrect characterisation of the payments under the agreement is worrisome given the persuasive (even if not binding) role of AAR rulings in judicial interpretation.

Moreover, this ruling adds a new dimension to the software characterisation debate by holding that payments for use of software hosted on a licensor's server constitute payments for the use or right to use scientific equipment.

Do we need clearer guidance on the subject?

Given the continuing uncertainty on the taxability of software and e-commerce transactions, the Government would do well to consult with experts and swiftly release an exhaustive set of guidelines, which correctly analyse the technical aspects of various software and e-commerce transactions, to facilitate accurate conclusions on the tax characterisation and treatment thereof.

In a tax environment already reeling under the burden of complex provisions and limited effective interpretative guidance, inconsistent characterisation of commercial transactions by the country's tax adjudicators only serves to aggravate the situation.

The recent ruling by the Authority in the context of software-related payments only underscores this point.

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