Uneasy sits the ‘royalty’ tag on software-makers

Licensing of software’ in layperson’s words simply means paying for the software you want to use legally. Such software could be shrink wrapped (packaged software such as Tally or Microsoft Office) or customised for specific needs of the user. Typically, in software licensing transactions, the licensee receives a limited right to use the software but cannot modify, replicate or re-engineer it.

When it comes to tax, many see a software licensing transaction as similar to selling a copyrighted article, say a book, where the buyer gets only the copyrighted book and the publisher/ author owns the copyright for reprinting the book. The mere purchase of a copyrighted book does not automatically transfer the copyright to the buyer.

With this analogy, taxpayers contend that revenues from software licensing transactions are not for ‘use of copyright’, which can be taxable as ‘royalty’ in India. They argue that such transactions should be viewed as payments for ‘use of a copyrighted article’, which should not fall within the ambit of royalty. This contention has not found favour with Indian Revenue, which has sought to tax such transactions as ‘royalty’ in India.

Consequently, most software companies are currently facing litigation at various levels in Indian courts. While the initial decisions of Income-tax tribunals on this issue largely favoured the taxpayer, in the recent past the tribunal’s decision in the case of Microsoft has gone against the taxpayer. This trend continued in other cases, with the Authority for Advance Rulings as well as the Karnataka High Court confirming the stand taken in the Microsoft case. However, adding confusion, the Delhi High Court later issued a ruling in favour of the taxpayer in the case of Ericsson.

As a result of these contradictory verdicts, software companies today face significant uncertainty over this issue.

Additionally, in this year’s Budget, an amendment was introduced with retrospective effect (from April 1, 1976) to clarify that software payments would be taxable in India as royalty. In most cases involving foreign software companies, the position of non-taxability of such software payments has been taken on the basis of provisions in the Double Tax Avoidance Agreements that India has signed with various countries. The industry is now worried about how the amendment would impact this position taken by foreign software companies under DTAA.

Pursuant to the announcement of this amendment, several representations were made to the Government calling for a rollback as it could adversely impact business and cash flow. To allay these concerns, the Government recently issued a notification eliminating the cascading effect of a ‘royalty’, withholding tax on software payments as the software moves down the value chain from the licensor to the distributor to the end-user.

While this is a welcome step that can address the cash-flow concerns of some software distributors, the main issue — taxability of this transaction as ‘royalty’ — still remains unresolved.

(Ravi Vishwanath is Tax Partner, Ernst & Young)

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