Taxing Times: Copyright or Copyrighted Article? The Debate Continues
The above is the key message for Indian businesses from the recent decision of the Income Tax Appellate Tribunal, Mumbai bench ("ITAT Mumbai") in the matter of DDIT vs. Reliance Infocomm Ltd/Lucent Technologies (Reliance").1 This decision has added another nuance to the debate on the proper characterization of payment for software purchase for income tax purposes. This Hotline discusses Reliance in the context of this debate with the aim of identifying measures that may guide businesses in the way they approach purchase of software going forward (click 2 to go directly to measures).
The debate is essentially whether payments for software purchase are in the nature of royalty or business income. On one side of the debate are taxpayers, i.e., software companies who argue that in purchasing software, end-users merely receive a copy of the software, that is to say, a copyrighted article and not a right to the copyright in the software. Payments made represent purchase price for the article and are in the nature of business income. Consequently, such payments are not liable to tax in India in the absence of a permanent establishment ("PE") in India.
On the other side of the debate stands the Revenue which argues that such purchases are in effect a licence granted by software companies to end-users. Payments made represent royalty for that licence. Consequently, such payments are liable to tax in India under the provisions of the Income Tax Act, 1961 ("ITA"'), subject to beneficial provisions of tax treaties.
There is a plethora of case law on both viewpoints in Indian law. A summary of the principles emerging from case law are discussed:
Copyrighted Article The starting point for supporters of the 'copyrighted article/business income' viewpoint is the Supreme Court decision in Tata Consultancy Services v. State of AP2 which in 2005 had held that the copyright in a computer programme remains with the originator of the programme, but the moment copies are made and marketed, they become 'goods' qualifying for sales tax. Although this decision was in the context of the sales tax law of the state of Andhra Pradesh, it was relied on by judges in income tax cases such as DIT v Ericsson A.B.3 and Motorola Inc. v. DIT4 to uphold the distinction between 'copyright' and 'copyrighted article' and to deny characterization of payment as royalty.5
This distinction is further bolstered by the approach of the OECD where the character of payments received in transactions involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. The copyright law of most OECD member countries recognizes a distinction between the copyright in the software and the software itself. . With specific reference to embedded software,6 the trend in judicial decisions7 is that supply of hardware with embedded software amounts to purchase of a copyrighted article and does not involve purchase of rights in the software. Further, there should be no splitting up of the transaction to separately tax the payment for software.
Copyright is not defined in most tax treaties concluded by India but royalty is defined. The definition refers to royalty as including "payments of any kind received as consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work,...". With respect to taxation under tax treaties, certain judgments8 have upheld the view that purchase of software amounts to purchase of a copyrighted article. The reason that has been accepted is that a purchase of software as a product, (for e.g. Microsoft Office software which is used by the end users even though it is Microsoft which has the copyright over the software and not end users) is not the same as transferring or assigning rights relating to the copyright in the software itself. To be characterised as royalty, what is required is that there is transfer of some or all the rights which the copyright owner has such as the right to make copies or to adapt the work. Thus, payment for transfer of a non-exclusive and non-transferable licence enabling the use of a copyrighted product could not be construed as royalty.
Copyright Case law in favour of the 'copyright/royalty' viewpoint has relied on the broad definition of royalty under S. 9(1)(vi) (Income deemed to accrue or arise in India) of the ITA9 and the definition of copyright in S. 14 (Meaning of Copyright) of the Indian Copyright Act, 1957 ("ICA").9
Section 9(1)(vi) of the ITA provides that royalty is consideration for transfer of all or any rights (including granting of a licence) in respect of any copyright, literary, artistic or scientific work. A licence in the software allows the licencee the right to use the software though he may not have any copyright in it. Since 'copyright' has not been defined in the ITA, courts refer to the definition contained in S. 14 of the ICA. S.14 provides the owner of the copyright the exclusive right to prevent others from, among others, reproducing the computer program in any material form and storing of it in any medium by electronic means.
S. 52 (Certain acts not to be infringement of copyright) of the ICA provides for certain acts not to be counted as copyright infringement. One such act listed in sub clause (1)(aa) is:
"the making of copies or adaptation of a computer programme by the lawful possessor of a copy of such computer programme, from such copy-
It is relevant to note that on purchase of a copyrighted article, the purchaser does not necessarily get a "copyright licence". S.52 grants a statutory right (irrespective of whether there is a "copyright licence") to the lawful possessor of the software to carry out certain acts as mentioned above. For this reason, making a copy for use of the software for the purposes it was supplied for or for backup as permitted under S. 52 is not considered an infringement under the statute.
In CIT v. Samsung Electronics,10 (a case which involved the India-US tax treaty like in Reliance), the Karnataka High Court considered both S. 14 and S.52, ICA. It held that: "... right to make a copy of the software and use it for internal business by making copy of the same and storing the same in the hard disk of the designated computer and taking back up copy would itself amount to copyright work under Section 14(1) of the Act and licence is granted to use the software by making copies, which work, but for the licence granted would have constituted infringement of copyright".11 Further, case law12supporting this view rejects Tata Consultancy Service as an appropriate precedent on the ground that the legislative scheme of sales tax law and income tax law are very different and the issue of transfer of right to use the goods did not come up for consideration in that case.
Cases on this issue have further held that in the absence of any definition of 'copyright' in the ITA or the tax treaty, reference had to be made to the definition of 'copyright' under domestic law.13 Under the ICA, literary work is entitled to copyright and is defined to include computer programmes, tables and compilations including computer databases. Therefore, purchase of "computer software" should be recognized as a transfer of copyright under the treaty.
Summary of Position On the basis of principles developed by case law, the current state of play may be summarized as below:
THE DISPUTE IN RELIANCE
Reliance Infocomm Ltd. (now known as Reliance Communications Ltd), an Indian company wanted to establish wireless telecommunications network in India. For this purpose, it entered into the following contracts with certain Indian and US companies of the Lucent group:
The combined effect of the above contracts was that Reliance Infocomm purchased software from Lucent USA and hardware (with which the software was to be later integrated) from Lucent India. There was a software purchase order to match every hardware purchase order. The intellectual property rights in the software vested with Lucent USA and Reliance Infocomm was not permitted to transfer, assign, sub-license such software or modify, decompile, reverse engineer, or disassemble or in any other manner decode the software furnished, as object code. Reliance Infocomm was also not permitted to make copies of the software except for back up purposes16.
Reliance Infocomm applied to the Revenue for a 'no-withholding certificate' in relation to the payments to be made by it to Lucent USA for the software. The application was rejected by the Assessing Officer ("AO") who characterized the payment as royalty. Reliance Infocomm appealed17 to the Commissioner of Income Tax (Appeals) who characterized the payment as purchase price for the sale of copyrighted article. Therefore, in the absence of a PE of Lucent USA in India, this would not be taxable in India. Parallely, the AO re-assessed Lucent USA since it considered that payment received for software was liable to Indian tax as royalty. Lucent applied to the Dispute Resolution Panel who confirmed the AO's order.
The common appellate forum for the Revenue against the CIT(A) order and for Lucent USA against the DRP order was ITAT Mumbai. It clubbed the appeals to decide the common issue which was whether the payment for software licence was royalty under the ITA or the India-US tax treaty and whether there was a consequent obligation on Reliance Infocomm to withhold tax on a gross basis.
THE DECISION IN RELIANCE
ITAT Mumbai held in favour of the Revenue, holding that even where a copyrighted article is sold, the end-user might still end up infringing the intellectual property rights of the vendor but for the fact of the licence. Therefore, payment was properly characterized as royalty.
We discuss below in brief the contentions of each party followed by ITAT Mumbai's response to that contention:
A RIGHTS-BASED APPROACH
It would be relevant at this stage to look at a recent international development22 in the field of royalty taxation which took place earlier this year. From 28 February 2013, Singapore brought into effect a rights-based approach for characterizing software payments, supplanting the earlier regime.
Under the earlier regime, almost all outbound payments for the use of software were classified as royalties subject to Singaporean withholding tax. However, payments by end-users for certain categories of software (shrink-wrap software, site licences, downloadable software, software bundled with hardware) were exempted if the payments did not entitle end-users to exploit the copyright in the software.
The new rights-based approach makes a distinction between a copyright and a copyrighted article based on the nature of the rights transferred in consideration for the payment. Where the payer is allowed to commercially exploit the copyright, that transaction involves a 'copyright right'. In contrast, where the rights are limited to those necessary to enable the payer to operate the software or to use the information or digitised goods, for personal consumption or for use within the payer's business operations, that would be characterized as 'copyrighted article'. Transfer of 'copyright rights' is taxable as royalty and that of 'copyrighted articles' is taxable as business income. Where multiple rights are transferred in one payment, characterization will be based on the primary purpose of the payment. It is evident that such an approach while giving taxpayers more certainty also lends flexibility to the law to keep in step with the ever-changing nature of the software industry. A rights-based approach (as opposed to a one-size-fits-all mandate) helps to give taxpayers the comfort that their liability to tax will reflect their commercial intention.
As you will note, the arguments raised by the taxpayer and the Revenue in Reliance reiterate those already considered in previous cases. However, what Reliance is important for is singling out the fact of supply of software through standalone contracts even though it was required to run hardware that was purchased in matching sets of contracts (i.e. in contrast to situations of embedded software where hardware and software are supplied under the same contract and which has included under the 'copyrighted article' category).23 In Reliance, the discussion on the position under the India-US tax treaty was brief and cursory and a more detailed examination would have added more value to the debate.
The issue of characterization of payment for software purchase is not settled and litigation is bound to continue. Earlier this year, the Supreme Court admitted a Special Leave Petition of IBM and Sonata, two software companies who are challenging the decision of the Karnataka High Court that payments for shrink-wrapped (standardized) software packages is royalty. The Supreme Court's decision on this issue (even if restricted to the narrower context of shrink-wrapped software) will help to clarify taxation of payments for software purchases in general. In the meantime, while the position of law remains unsettled, Indian businesses must ensure that the Revenue is able to understand the true intention of the parties so as to avoid giving rise to litigation. Some of the factors to be kept in mind are:
1 2013 (9) TMI 374 - ITAT MUMBAI
2 AIR 2005 SC 371
3 16 taxmann.com 371 (Delhi High Court)
4 95 ITD 269 (ITAT Delhi, Special Bench)
5 Also accepted in Hewlett-Packard (India) (P) Ltd v ITO 5 SOT 660 (ITAT Bangalore), ADIT v TII Team Telecom International (2010) 40 SOT 28 (ITAT Mumbai), DDIT v Solid Works Corporation 51 SOT 34 (ITAT Mumbai), Dassault Systems KK, In re  322 ITR 125
6 This refers to a situation where hardware and software are supplied in an integrated form since each is rendered functionless without the other.
7 DIT v Ericsson A.B 16 taxmann.com 371 (Delhi High Court); Motorola Inc. v. DIT 95 ITD 269 (ITAT Delhi, Special Bench); DIT v. Nokia Networks OY [(2013) 212 Taxman 68 (Delhi High Court), Qualcomm Incorporated v ADIT  30 taxmann.com 30 (ITAT Delhi)
8 DDIT v. Alcatel USA International Mktg. Inc.,  43 SOT 31 (ITAT Mumbai);Velankani Mauritius Ltd. and Bydesign Solutions Inc. v. DDIT;  40 SOT 33 (ITAT Bangalore), Novell Inc. v DIT ITA No. 4368/Mum/2010 (ITAI Mumbai).
9 SEBI Board Meeting. PR No. 73/2013 For the complete definition, please seehttp://law.incometaxindia.gov.in/DIT/Income-tax-acts.aspx andhttp://copyright.gov.in/Documents/CopyrightRules1957.pdf, respectively.
10 (2012) 345 ITR 494 (Karnataka High Court)
11 Further, without resorting to the copyright provisions, tax authorities have also contended that software is an invention or a patent, and in some cases even use of a process since a computer program is nothing but a process or a series of instructions to achieve a purpose and hence, payments for obtaining software amounts to royalty.
12 CIT v Samsung Electronics (2012) 345 ITR 494 (Karnataka High Court); Microsoft Corporation v ADIT (2010) 134 TTJ 257 (ITAT Delhi)
13 Most treaties provide that terms which are not specifically defined in the treaty must be understood as per the definition in the domestic law of the concerned country.
14 Computer software supplied by a non-resident manufacturer along with a computer or computer based equipment under any scheme approved under a certain Government policy.
15 Eg. India's treaties with Russia, Namibia, Morocco.
16 Clause 15.1.4 Wireless Network General Terms and Conditions Contract dated 31.07.2002
17 Although Reliance Infocomm had withheld tax at 20%, it continued to litigate the matter.
18 ITAT Mumbai also relied on a previous case CIT v. Sunrays Computers  16 taxmann.com 268 with similar facts. There, the Karnataka High Court held that the supply of software from the USA to the taxpayer was an independent transaction. The hardware utilised by the taxpayer was received from Taiwan. Only after receipt of both software and hardware, had they been integrated by the taxpayer in India. Consequently, the payments made by the taxpayer amounted to royalty and were liable to be taxed in India under the ITA and the India-US tax treaty.
19 212 taxmann 454 (Karnataka High Court)
20 343 ITR 001
21 Similarly, in the case of Microsoft Corporation vs. ADTT/Gracemac Corporation, ITAT Delhi has held that payment made for grant of license in respect of copyright by end user is taxable as Royalty as per section 9(i)(vi).
22 The position under Singapore law has been summarized with information sourced from the e-Tax Guide on Rights-Based Approach for Characterising Software Payments and Payments for the Use of or the Right to Use Information and Digitised Goods, Available at http://www.iras.gov.sg/irashome/uploadedfiles/e-Tax_Guide/etaxguides_CIT_rights-based%20approach_2013-02-08.pdf
23 Another case involving standalone contracts for software supply (although in a distributorship model) was that inDDIT v Solid Works 51 SOT 34 (ITAT Mumbai) which was cited by the taxpayer but not discussed in detail by the deciding authorities. In Solid Works, ITAT Mumbai considered both Samsung Electronics and Ericcson. It favoured Ericcson and held that consideration received by the non-resident software provider for software was not royalty. While this ruling is by ITAT Mumbai, i.e. the same authority as in Reliance, it may be possible to distinguish this case on facts as this involved a distributor business model.
24 An entire agreement clause conveys that only as much as is in the written agreement constitutes the entire agreement and that there are no other/prior agreements or conditions that may fasten any obligation on the parties.