Payments to nonresident for shrink-wrapped software held royalty under Article 12(3) DTAA and s.9(1)(vi); TDS required under s.195

Karnataka HC held that payments to non-resident software suppliers for shrink-wrapped/off-the-shelf software constituted royalty under Article 12(3) of the DTAA and s.9(1)(vi) of the IT Act, since the agreements granted a licence to use part of the copyright (copyright includes computer programs). Consequently the respondents were obliged to deduct tax at source under s.195. The HC reversed the ITAT, answered the substantial question in favour of the revenue and allowed the appeals against the assessee.

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Issues Involved:
1. Whether the amount paid by the appellant to foreign software suppliers constitutes 'royalty'.
2. Whether such payments give rise to any 'income' taxable in India.
3. Whether the appellant is liable to deduct any tax at source under Section 195 of the Income Tax Act, 1961.

Issue-wise Detailed Analysis:

1. Whether the amount paid by the appellant to foreign software suppliers constitutes 'royalty':

The primary issue revolves around whether payments made by the appellant to foreign software suppliers qualify as 'royalty' under Section 9(1)(vi) of the Income Tax Act and relevant clauses of the Double Taxation Avoidance Agreement (DTAA). The court examined the definitions of 'royalty' under both the Act and DTAA, noting that the definition under the DTAA is more restrictive and thus more beneficial to the assessee.

The court scrutinized the software license agreements, which granted the appellant a non-transferable, non-exclusive license to use the software for internal business purposes. The agreements explicitly stated that the copyright remained with the foreign supplier, and the appellant was only permitted to use the software as per the terms of the agreement. This right to use the software, including copying it for internal purposes, was deemed to be a transfer of part of the copyright, thus constituting 'royalty'.

The court rejected the appellant's reliance on the Supreme Court's decision in TATA Consultancy Services v. State of Andhra Pradesh, which dealt with the sale of software under sales tax law, not the definition of 'royalty' under income tax law. The court emphasized that the intent of income tax and sales tax laws are different, and the mere classification of software as 'goods' for sales tax purposes does not preclude it from being considered 'royalty' for income tax purposes.

2. Whether such payments give rise to any 'income' taxable in India:

The court noted that under Section 195 of the Act, tax must be deducted at source for payments to non-residents if the payments are chargeable to tax under the Act. The Supreme Court had clarified that the obligation to deduct tax arises only if the payment is chargeable to tax in India. The court found that since the payments were for the use of copyrighted software, they constituted 'royalty' and were thus chargeable to tax in India under Section 9(1)(vi) of the Act and the DTAA.

The court also referred to the OECD commentary and the views of renowned authors on double taxation conventions, which supported the interpretation that payments for the use of copyrighted software constitute 'royalty'. The court concluded that the payments made by the appellant to the foreign software suppliers gave rise to income taxable in India.

3. Whether the appellant is liable to deduct any tax at source under Section 195 of the Income Tax Act, 1961:

Given the court's findings that the payments constituted 'royalty' and were chargeable to tax in India, the appellant was obligated to deduct tax at source under Section 195 of the Act. The court emphasized that failure to deduct tax would render the appellant liable for penalties and interest under the Act.

The court rejected the appellant's argument that no tax deduction was required because the software was not customized and was merely 'shrink-wrapped'. The court held that the nature of the software (shrink-wrapped or customized) did not alter the fact that the payments were for the use of copyrighted software, thus constituting 'royalty'.

Conclusion:

The court concluded that the payments made by the appellant to foreign software suppliers constituted 'royalty' and gave rise to income taxable in India. Consequently, the appellant was liable to deduct tax at source under Section 195 of the Income Tax Act. The court allowed the appeals, set aside the order of the Income Tax Appellate Tribunal, and restored the order of the Commissioner of Income Tax (Appeals) confirming the Assessing Officer's decision.

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