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Software Payments: Royalty Reigns!

Published on Sat, May 05 11:09, Updated at Sat, May 05 at 11:20
Source : CNBC-TV18   |   Watch Video :

Imagine climbing a steep hill. The first 50 steps take you to the Advance Ruling Authority. Then a few hundred and you’re at the Tribunal. Then you trudge for hours to reach the High Court. Some win there, others lose and take a deep breath with the Supreme Court in sight. And then suddenly a guard appears from nowhere and sends you down with no hope of return! That’s what software sellers & buyers are currently experiencing in India. After several rounds of legal battles that’s brought them to the doorstep of the supreme court, a retroactive amendment in the Finance Bill, which maybe passed any day, makes them losers before the battle is fought. Payaswini Upadhyay finds out if there is any way out?

While presenting the Budget this year, Finance Minister Pranab Mukherjee proposed 29 amendments to the Income Tax Act.

One of the 29 was a clarification to the definition of Royalty.

The clarification reads ‘any transfer of all or any rights in respect of any right includes transfer of all or any right for use or right to use a computer software including granting of a license.’- thus including for the first time the right to use computer software within the ambit of royalty.

Shiv Mahalingham
Managing Director, Alvarez & Marsal Taxand
“The first thing to bear in mind is the difference in tax treatment for a particular software payment. On the one hand, if it’s construed to be royalty, then there might be a withholding tax at 15%. On the other hand, if it’s construed to be business profits, it would only be taxable at the local level if there was indeed a permanent establishment in the local jurisdiction. So the difference in tax treatment could be quite significant.”

Ketan Dalal
Joint Tax Leader, PwC
“The attempt is to try and bring all kinds of payments for cross border software within the net of taxability by expanding the definition of the word royalty and by seeking to say it’s a clarificatory amendment. In practice, two things will happen. One is that the wording itself will lead to an issue because there are some kinds of software which don’t have any other use than, lets say, working the equipment with which they are attached. So I think there will be some language and interpretation issues under the Act itself.”

Venkatraman Narayanan- SC in case of tcs - vtw
Head- Strategic Finance, Sonata
“Interestingly, in the current Finance Bill, there is a notification which has come under the Service Tax Act where they have classified payment for packaged or shrink-wrapped software to be in the nature of payment for goods. And they are saying that since it is payment for goods, it should not be subject to service tax and it should be subject to only local taxes such as VAT. They have clearly said so and they have relied on the judgment of SC in the case of TCS vs The State of Andhra Pradesh. The same government, interestingly, holds a different view when it comes to software under the Income Tax Act. What they are saying is what you’re for software is essentially royalty and its not for goods and so you should have withheld tax from the word go. So there is this dichotomy that we can see in this current Tax Bill itself between the indirect tax and the direct tax.”

The Finance Ministry’s clarificatory amendment comes after two conflicting judgments by the Karnataka and Delhi High Courts. Last year, while ruling on a batch of appeals, the Karnataka HC said that the license to use the software enabled companies to copy and download the software and so the payments made for the purchase of software were in the nature of royalty. Two months later, Delhi HC said the payments made can be treated as royalty only if copyrights for the software are obtained.

TP Ostwal
Managing Partner, TP Ostwal & Associates
“The department’s accusations are that the payment for purchase of software is payment for use of a copyright because they say software involves copyright and therefore what payment you’ve made is nothing but payment for copyright. Whereas in the case of TCS, the SC had deliberated the very same subject whether purchase of software constitutes payment for copyright or payment for copyrighted article. SC, after due deliberation and considering a plethora of the decisions which have been rendered by various international courts and had taken a view that payment for purchase of a software cannot constitute copyright because the developer of the software does not pass the copyright to the person who is purchasing for a petty consideration.”

But while the Delhi HC relied upon the TCS judgment of the apex court, Karnataka HC distinguished it saying that the interpretation was in a sales tax matter and hence not applicable. And so, the matter is now at the SC’s doorstep once again and by the time the appeals are heard, the retrospective amendment in the finance bill may have become law.  
Thereby giving revenue the winning hand before the battle is fought.

In such a case, what can the software companies do to resist the payments being categorized as royalty?

Experts say that foreign players namely Ericsson, GE and Samsung could claim under the Double Taxation Avoidance Treaties.

TP Ostwal
Managing Partner, TP Ostwal & Associates
“Supreme Court is definitely going to be concerned with the Treaties because both the disputes are from the Treaty countries and the taxpayer is bound to take up the argument that if it is royalty under the domestic law, then it is not a royalty under the treaties because the definition of royalty under the Treaties do not have the term software within the term royalty- under both in the Koreas as well as the Sweden Treaty- and therefore this issue is bound to be agitated before the SC.”

But that defense may not succeed since the Finance Bill also includes a limited Treaty override as well. 
Ketan Dalal
Joint Tax Leader, PwC
“A separate retrospective amendment from 2009 is sought to be introduced which in simple language seems to give to the government the unilateral power to define a term which has not been defined in the Treaty. And the concern is that the government’s ability to define a term adverse to the taxpayer could become a serious issue and I think it would also not be fair because what it would then mean is one is changing unilaterally a document which is supposed to be inherently bilateral.”

Besides treaty override, software companies could also have to contend with the impact of GAAR or general anti avoidance rules.

TP Ostwal
Managing Partner, TP Ostwal & Associates
“Let us take a case of Microsoft. Microsoft is an American company, develops the software in USA, and distributes the software through one of their subsidiary companies in Singapore and for India specific; the distribution takes place from Singapore. Now the Singapore company is not the owner of the software, Indian company is making payment for purchase to Singapore company and suppose the Income Tax department comes to a conclusion tomorrow that the Singapore company is merely a conduit – I am giving you this purely by way of an example- and so department takes a view that GAAR is applicable and therefore we deny you the benefit of that location, we deny you the Treaty benefit and therefore Singapore India Treaty is not available to you.”

But for domestic players- both sellers and distributors of software- such as Infosys, Wipro, Sonata, the only legal option is to challenge the constitutional validity of the retroactive amendment- on grounds that it is not clarificatory but substantive and create a retrospective liability on payments that have already been made.

Venkatraman Narayanan
Head- Strategic Finance, Sonata
“The treaty argument comes only in the case of payments to international or companies outside the country whereas the same definition of royalty is used under Section 194 where transaction happens between two domestic corporations. So, for eg, If I am buying software from an Indian company, I am expected to deduct tax on payment I make for that software. And the definition for royalty there is the definition as under Section 9. So a retrospective amendment of Section 9 would mean that all payments that have been made to domestic companies would be subject to tax deduction at source. So the benefit of the treaty is not available to me when it comes to domestic transactions. I don’t know if this is the intention of the proposed law by the Finance Ministry; they have been trying to catch payments being made to overseas entities.”

At the heart of this dispute of treating software payments as royalty or business income, lies around Rs 10,000 cr in tax. It’s not just the amount but the payment complexities that are worrying both domestic and international companies. 
Ketan Dalal
Joint Tax Leader, PwC
“The home county could say that there is a tax withheld in India on a particular payment. They could say is this tax justifiably withheld and lets assume it’s a SC decision. So the taxpayer could say, look, it has been justifiably withheld because the SC has so decided but what could happen is that a tax that the home country believes is legitimately its own share has actually gone to India. And from taxpayers pov, there could be another challenge because by the time the decision comes, it would be 10 years. And what could’ve happened in the meantime is that they would have already paid tax on it and now there would be a further withholding tax obligation. So the practical challenges of having the home country refund the tax is going to be another major challenge.”
Venkatraman Narayanan
Head- Strategic Finance, Sonata
“In the case of domestic transactions, if the proposed amendment goes through, what would happen is that software distributors like ourselves, we would be faced with a working capital crunch. We make a couple of percentage points in terms of margins in trading of software. But about 10% of the transaction value will get stick with the government as TDS. And that would be stuck with them for anything upwards of 24-36 months before it comes back to us as tax refunds. So it’s going to have a huge working capital impact.”

If the retroactive amendment becomes law next week it will prompt an interesting situation. Revenue can fall back on this newly clarified interpretation to claim royalty. How will software companies argue the appeal? By challenging the retroactive amendment? But hasn’t the supreme court more often than not upheld such amendments, unless they were proven unreasonable and arbitrary. If this one passes muster – a long drawn court battle will come to an anti-climactic end.

In Mumbai, Payaswini Upadhyay

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