Decoding Finance Bill 2012


Anish Mehta, Partner, Haribhakti & Co.
Battle of Copyright vs. Copyrighted Article not yet over under Treaty ...

1. The growth of technology in the last few decades and the fast-paced globalisation has deeply influenced the conduct of business transactions. Computers and software are words which have become synonymous with modern business. With the surge in e-commerce and information technology based transactions, the taxation of computer software has attracted the attention of the revenue authorities. In the recent years, the taxability of payments made towards software has been a hotly debated topic in the tax courts. The million dollar question is – “Whether the payments for use of computer software are ‘royalty’ under Section 9(1)(vi) or the Article of the relevant tax treaty?”
This controversy has been further fuelled by the Budget Proposals vide the Finance Bill 2012 which seeks to retrospectively tax payments towards software payments as ‘royalty’ through insertion of new explanations to Section 9(1)(vi), which are as under:
1.1 Explanation 4 to Section 9(1)(vi) clarifies that the consideration for use or right to use of computer software is royalty by clarifying that transfer of all or any rights in respect of any right, property or information as mentioned in Explanation 2, includes and has always included transfer of all or any right for use or right to use a computer software (including granting of a license) irrespective of the medium through which such right is transferred.
1.2 Explanation 5 to Section 9(1)(vi) clarifies that royalty includes and has always included consideration in respect of any right, property or information, whether or not
(a) the possession or control of such right, property or  information is with the payer;
(b) such right, property or information is used directly by the payer;
(c) the location of such right, property or information is in India.
These amendments will take effect retrospectively from 1st June, 1976 and will accordingly apply in relation to the assessment year 1977-78 and subsequent assessment years.
2. Before we embark upon the analysis of the impact of these explanations on the current status of taxability of payments for software and impact of proposed Explanation 4 & 5, it would be useful to get an insight into the types of software and the standard structure/model of software transactions:
2.1 Types of Software:
2.1.1 Off-the-shelf or shrink-wrapped software:
Computer software which is ready to use is known as ‘off-the-shelf’ software or ‘shrink wrapped’ software. Such type of software is not customised for any particular person. Examples of this type of software are commonly used software like Microsoft Office range of products and Tally.
The end user of such software cannot make any modifications or customizations to the software. Typically, the purchase of such software entails a license agreement to be entered into between the end user and the software developer (mostly electronically) which governs the terms of usage of software and lays down the purposes for which the software may be used.
2.1.2 Customised software:
Computer software which is developed based on specific requirement of its user is known as ‘Customised software’. It is not generic or standard software which can be used by anyone as it is designed to meet the objectives of the specific user. Examples of this type of software are the special accounting and ERP software packages designed for corporate users.
However, there are some customised software packages which are not specific to the needs of a particular user but are designed for a particular industry. Such computer software would be categorized as off-the-shelf software and not as customised software.
2.2 Standard structure/model of software transactions: There are typically the following parties involved in the transaction involving software - 
2.2.1 Software Developer: The software developer is the party which programs and develops the software and has all the rights in relation to the software and the source code of the same.
2.2.2 Distributor: The distributor is the party which obtains the rights from the software developer to copy and distribute/only distribute the software to the end users. The functions of the distributor may differ depending upon the rights held by him in relation to the software.
2.2.3 End user: The end user of the off-the-shelf or the customised software is the party who pays a consideration (either to the software developer/distributor) to use such software.
3. Controversies surrounding the taxability of sale of software
Before dealing with the implications of the proposed Explanation 4 and Explanation 5 to section 9(1)(vi), we are dealing with these issues extensively discussed and debated by the courts till date. The controversy of copyright vs. copyrighted article was largely dependent on the views given by the courts on the following issues. Therefore we have summarized the views of the courts on the following issues:
3.1 Whether the term “transfer of all or any rights” encompasses the term “use or right to use software”?
3.2 Whether the term “right” used in “transfer of all or any rights” refers to rights in respect of a copyright, as defined in the Copyright Act, 1957?
3.3 Whether any right is transferred in case of sale of computer software?
3.4 Whether the sale of computer software amounts to transfer of right in respect of copyright or process, invention or a literary work or all of this?
3.5 What are the implications of the rights of software manufacturer to sue the end user of the software over infringement of the copyright, rights of end user of the software to copy the software for back up purposes or for internal use?
3.1 Issue in relation to use or right to use
The term “use or right to use” does not find place in the definition of royalty provided under the Act[1]. However, this term has been used in the Article for royalty in all most all the tax treaties signed by the India and, while giving its view on the taxability of the sale of software from tax treaty perspective, the term has been extensively discussed by the courts.
While interpreting the Article 12 of the DTAA between India and USA, The Karnataka High Court in the case of Samsung[2] has opined that since the end user is authorised to make use of the copyright software contained in the software, which is purchased off the shelf or imported as shrink wrapped software, the same amounts to transfer of part of the copyright and transfer of right to use the copyright.  Further, the Delhi Tribunal[3] in the case of Gracemac Corporation and AAR in the case of Millennium IT Software[4] has given similar views the issue.
However, Mumbai Tribunal in the case of TII Team[5] has ruled that the connotation “use of copyright” is different from “use of a copyrighted article” and the meaning of “use of copyright” cannot be treated as extending to “use of a copyrighted article”. The AAR in the case of Dassault Systems KK has also opined that “use of copyright” is different from “use of a copyrighted article”. It is interesting to note that the Delhi HC, while holding that the sale of computer software cannot be classified as royalty, in the case of Ericsson A.B[6] has not given its findings on this aspect.
The arguments advanced by the Revenue:
  • The revenue contends that the user acquires the computer software to obtain right to use the programme and right to copy the same. The user is permitted to copy the software onto the computer only because he has been permitted by the copyright owner under the concerned license granted to him.
  • The Copyright Act, 1957 does not envisage that the reproduction can be said to have happened only in cases of mass copies or only if the software is copied for resell or commercial exploitation.

Conclusion:
The Courts have given divergent views on the interpretation on the term “use or right to use” in the context of sale of software.
3.2 Whether the term right used in “transfer of all or any rights” refers to rights in respect of a copyright?
While interpreting the term right used in “transfer of all or any rights”, almost all the courts have referred to the provisions of the Copyright Act 1957. Hence, it may be said that there is a judicial consensus that the term right needs to be understood as defined in the Copyright Act, 1957.
3.3 Whether any right is transferred in case of sale of computer software?
The courts have again taken divergent views while deciding the issue whether any right is transferred in case of sale of computer software. The Delhi HC (Ericsson), AAR (Dassault) and Mumbai ITAT (TII Team) has held that no right is transferred in the case of sale of software. However, Karnataka HC, Del Tribunal and AAR (Millennium) has held otherwise.
3.4 Whether the sale of computer software amounts to transfer of right in respect of copyright or process, invention or a literary work or all of this?
The Revenue has sought to tax the sale of computer software as royalty interpreting the same as copyright, patent, process, invention and literary work. The Revenue has contended that the software can be protected by its owner under copyright laws or patent laws. Further, the Revenue has also argued that computer software also amounts to process and literary work.
Though, the courts have agreed that the computer software is a literary work, there are divergent views on the issue whether the same amounts to patent / process as well[7].
3.5 What are the implications of the rights of software manufacturer to sue the user of the software over infringement of the copyright, rights of user of the software to copy the software for back up purposes or for internal use?
The rights of software manufacturer to sue the user of the software over infringement of the copyright or the rights of user of the software to copy the software for back up purposes or for internal use have been considered as the deciding factors while concluding whether the sale of software amounts to transfer or any copyright under the Copyright Act, 1957[8].
4. Analysis of Budget proposals – Explanation 4 & 5
The Finance Bill 2012 has proposed to insert Explanation 4 and Explanation 5 to the section 9(1)(vi) w.r.e.f 1st June 1976. The definition of the royalty prescribed in Explanation 2 is apparently sought to be expanded by these two explanations. Explanation 4 clarifies that the transfer of all or any rights in respect of any right, property or information includes transfer of all or any right for use or right to use a computer software (including granting of a licence) irrespective of the medium through which such right is transferred. Further, Explanation 5 clarifies that royalty includes consideration in respect of any right, property or information whether or not the payer has the possession or control of it, the payer is using it directly or such right etc are located outside India.
4.1 Implications of Explanation 4:
Explanation 2 to the section 9(1)(vi) defines “royalty” exhaustively. The Explanation 4 seeks to cover “use or right to use a computer software” within the ambit of royalty. Further, it has been held in various judicial pronouncements that the definition of royalty contained in the Act is wider than the definition of royalty under the most of the tax treaties. Though the term “use or right to use” is found in most of the tax treaties India has signed, the term is succeeded with the word “copyright” in the tax treaties. However, the term “use or right to use” is succeeded with words “a computer software” in place of “copyright” in Explanation 4 to Section 9(1)(vi).
While deciding the taxability of the sale of software under the tax treaty, in some cases, the courts have opined that the term “use or right to use a copyright” does not include royalty.
While it remains to be seen how courts interpret the Explanation 4, the important questions which arise are
  1. Can it be argued that the scope of the definition of royalty prescribed under Explanation 2 has been sought to be expanded by proposed Explanation 4 and considering that the ratio laid down in various judicial pronouncements that an explanation would only clarify a position of law and is not generally substantive in nature, Explanation 4 is liable to be struck down?; or
  2. Can it be argued by the Revenue that irrespective of whether sale of software is covered under the definition of royalty under Explanation 2, the Explanation 4 would cover sale of software in its ambit as royalty? (if this be the case, the authors believe that the Explanation 4 has effect of transforming the meaning of royalty given in the Explanation 2); and
  3. Can the interpretation given to the term “use or right to use copyright” while interpreting the tax treaty language be relied while interpreting the term “use or right to use a software”?

4.2 Implications of Explanation 5:
Explanation 5 seeks to clarify that once a right, property or information is deemed to be covered under Explanation 2 read with Explanation 4 to the Section 9(1)(vi), the interpretation would continue to remain so irrespective of possession or control of the right, property or information, direct or indirect use of the right, property or information or location of the right, property or information.
While it remains to be seen how Explanation 5 is interpreted by the courts, it would not be correct to state that on fulfilment of the situations laid down in Explanation 5, the taxability of sale of software is, per se, attracted. It would be pertinent to note that the Delhi HC in case of Ericsson[9], in the context of interpretation of Explanation to Section 9(1), has held that it would not be necessary to interpret Explanation to section 9(1) in respect of clauses (v),(vi), and (vii) of sub-Section (1) of Section 9, once it is held that payment in question is not royalty within the clause (vi) of Section 9 and accordingly the Explanation will have no application.
Accordingly, it may be possible for tax payers to argue that, on principles, the sale of computer software does not amount to royalty under Explanation 2 and hence conditions specified in Explanation 5 would not alter the taxability of the transaction.
Further, it is interesting to note that the Explanation 4 and Explanation 5 refers to transfer of all or any rights in respect of right, property or information or consideration in respect of any right, property or information. Ostensibly, the explanation does not refer to terms such as patent, process, invention etc. found in definition of royalty under Explanation 2 to Section 9(1)(vi). Accordingly, it remains to be seen whether this would mean that taxability of sale of software need not be looked into from the perspective of patent, process, invention etc.
5. Language used in the tax treaties
Definition of the term royalty varies under the tax treaties entered into by India. Under Article 12 of the India-UK tax treaty, the term royalty has been defined as payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic or scientific work, including cinematography films or work on films, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience. The language employed in the other tax treaties is on similar lines.
The implications under the tax treaty, for payments made for purchase of an article, which contains copyright/intellectual property in it, can be no different if the proposition that a copyright is different from a copyrighted article is upheld.
The case laws delivering judgement in favour of the assessee have relied on the language used in the relevant tax treaties and have concluded that the sale of software does not amount to royalty. Conversely, the case laws delivering judgement against the assessee have equally relied on the language used in the relevant tax treaties and have concluded that the sale of software does amount to royalty.
6. Conclusion
To conclude, while the debate of taxability of sale of software will not alter, pre and post amendment under section 9(1)(vi), under the tax treaty situations, the battle of copyright vs. copyrighted article is far from over under the domestic provisions of the Act.



[1] Income-tax Act, 1961

[2] Commissioner of Income-tax, International Taxation v. Samsung Electronics Co. Ltd - [2011] 16 taxmann.com 141 (Kar.)

[3] Gracemac Corporation v. Assistant Director of Income-tax, International Tax Division, Circle 2(1), New Delhi – [42 SOT 550]

[4] Millennium IT Software Ltd – [62 DTR 1]

[5] TII Team Telecom International Private Limited [TS-490-ITAT-2011-(MUM)]

[6] Director of Income-tax v. Ericsson A.B., New Delhi [2011] 16 taxmann.com 371 (Delhi)

[7] Gracemac Corporation v. Assistant Director of Income-tax, International Tax Division, Circle 2(1), New Delhi – [42 SOT 550]

[8] Millennium IT Software Ltd – [62 DTR 1], Commissioner of Income-tax, International Taxation v. Samsung Electronics Co. Ltd - [2011] 16 taxmann.com 141 (Kar.) and Gracemac Corporation v. Assistant Director of Income-tax, International Tax Division, Circle 2(1), New Delhi – [42 SOT 550]

[9] Director of Income-tax v. Ericsson A.B., New Delhi [2011] 16 taxmann.com 371 (Delhi)
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