Non-resident payments for customised CPU/CDN access with embedded encryption software treated as royalties under Article 12(3)(a)

Payments received by a non-resident applicant from an Indian payer for access to CPU/CDN infrastructure and related processing were examined under Article 12(3)(a) versus Article 12(3)(b) of the India-USA DTAA. The AAR held that the arrangement was not merely consideration for "use of, or right to use, industrial, commercial or scientific equipment" under Article 12(3)(b), because the CPU/CDN involved customised, continuously updated technological systems and, critically, embedded secret encryption software used to process transmitted data. The royalty was computed based on CPU processing time, consistent with royalty characterisation. Consequently, the consideration was taxable in India as "royalties" under Article 12(3)(a), attracting the applicable higher gross-basis rate.

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Issues Involved:
1. Tax liability of payments made to the applicant in India.
2. Classification of payments under the Double Taxation Avoidance Agreement (DTAA) between India and the USA.

Detailed Analysis:

Issue 1: Tax Liability of Payments in India

The applicant, "Y," a USA-based company, provides access to its Central Processing Unit (CPU) and Consolidated Data Network (CDN) to "XT," an Indian company. The primary question is whether the payments made by "XT" to "Y" for using these facilities are taxable in India.

The applicant argued that since the CPU and CDN are located outside India and the payments are received in foreign exchange, the income should not be taxable in India. They contended that "Y" does not have a "permanent establishment" in India as defined under Article 5 of the DTAA, and therefore, the business profits should only be taxable in the USA.

The Departmental representative countered that there is a significant business connection between "Y" and "XT," establishing a continuous and contractual relationship. This connection implies that the income arising from the use of "Y's" facilities by "XT" should be deemed to accrue or arise in India and thus be taxable under the head "Royalty" as per section 9(1)(vi) of the Income-tax Act, 1961.

Issue 2: Classification under DTAA

The second issue is whether the payments fall under Article 12(3)(a) or Article 12(3)(b) of the DTAA between India and the USA. Article 12(3)(a) pertains to "royalties" for the use of or the right to use any copyright, patent, trademark, design, model, plan, secret formula or process, or for information concerning industrial, commercial, or scientific experience. Article 12(3)(b) refers to payments for the use of industrial, commercial, or scientific equipment.

The applicant contended that the payments should not be classified as "royalty" under Indian tax laws and argued that the definition of "royalty" in the DTAA should override the domestic definition. They also argued that the payments did not involve the transfer of any software or technical services, thus should not be considered "royalty" or "fees for included services."

The Departmental representative argued that the payments are indeed for the use of "Y's" sophisticated CPU and CDN, which involve the use of confidential software and data processing capabilities. This usage falls squarely within the definition of "royalty" under Article 12(3)(a) of the DTAA, as it involves the use of secret processes and information concerning commercial experience.

Judgment:

1. Tax Liability in India:
The payments made by "XT" to "Y" for the use of the CPU and CDN are liable to tax in India. The continuous and contractual relationship between "Y" and "XT" establishes a business connection, making the income taxable under Indian law.

2. Classification under DTAA:
The payments are classified under Article 12(3)(a) of the DTAA between India and the USA. The use of the CPU and CDN, involving sophisticated and confidential software, qualifies as "royalty" for the use of secret processes and information concerning commercial experience.

Ruling:
1. The payment due to the applicant under the transaction mentioned in annexure B is liable to tax in India.
2. The transaction is covered under Article 12(3)(a) of the DTAA between India and the USA.

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