Treaty check on past royalty

A litigious issue non-residents often face is the interpretation of ‘royalty’ provisions under Indian tax law vis-à-vis tax treaties. Royalty income generally attracts withholding tax obligations on the payer of royalty, as against business income, which generally escapes withholding tax provisions in the absence of a permanent establishment.

Until Finance Act 2012 was passed, a spate of conflicting decisions from various courts on the interpretation of royalty provisions fuelled uncertainty. The Finance Act, while introducing an array of retrospective amendments, also brought in retrospective amendments to royalty provisions, effective from June 1, 1976.

The intention behind the retrospective amendments was explained in Finance Bill 2012 as restating legislative intent behind the royalty provisions. The impact of these amendments is that payments to non-residents that were hitherto not considered royalties, namely purchase of a copyrighted article such as shrink-wrapped software or lease of transponder capacity, will now seemingly be taxed as royalties and brought under the tax net.

This has led to uncertainty over past transactions. Considering the retrospective applicability, would past cases — where payments in the name of royalty “escaped” tax — be reopened.

India is a signatory to Double Taxation Avoidance Agreements with various countries. The extant tax code provides that in case of conflicting provisions between Income Tax Act, 1961 and the treaties, the latter shall prevail if the taxpayer chooses to be governed by it. Indian tax treaties generally contain royalty provisions that are narrower in scope.

Furthermore, commentaries on the OECD (Organisation for Economic Co-operation and Development), as well as UN-model conventions have laid down that the payments towards purchase of shrink-wrapped software or use of bandwidth available in a transponder should not be treated as royalties under certain conditions.

Thus, typically, the scope of the definition of royalty under Indian tax treaties is much narrower than the extended definition in the Income Tax Act. However, the Karnataka High Court, while deciding on the pre-amended provisions of royalty, had rendered a wider interpretation to royalty provisions under the treaty.

Furthermore, tax authorities had, in certain instances, argued that the tax treaty provisions are also impacted by the retrospective amendments to royalty provisions under Finance Act, 2012.

The Delhi High Court recently ruled that once a foreign company elected to be governed by the provisions of the treaty, the language used in the treaty for narrower definition of royalty prevails and the tax department cannot invoke the retrospective amendments. Another judgement by the tax tribunal concurred with this view.

These judgements bring welcome certainty and clarity on the issue. It is widely believed that the rulings have stated the correct position in law; similar cases pending with the Supreme Court are expected to settle the law for good.

Until that happens, taxpayers should look closely at their cross-border transactions and study the provisions of the applicable Double Taxation Avoidance Agreements to mitigate tax obligations and protracted litigation costs with penalties.

Sandeep Ladda is Executive Director – Tax and Regulatory Services, PwC India

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