2013 (11) TMI 1382 - HC - Income Tax

Software license payments ruled not royalty under India-US tax treaty as only limited usage rights granted, not copyright ownership transfer

Director of Income Tax Versus Infrasoft Ltd.

Delhi HC held that software license payments do not constitute royalty under India-US DTAA. The court distinguished between acquiring copyright rights ... Supply of software on license - receipts on grant of licenses for use of software - 'royalty' income or 'business income' under the Income Tax Act, 1961 and the Indo-US Double Taxation Avoidance Agreement (DTAA), particularly Article 12(3) of the DTAA – principle of liberal interpretation of tax treaties - Held that:- For a payment to qualify as royalty payment, it is necessary to establish that there is transfer of all or any rights (including the granting of any licence) in respect of copyright - It is to be established that the licensee, by making such payment, obtains all or any of the copyright rights - Distinction has to be made between the acquisition of a 'copyright right' and a 'copyrighted article'. Copyright is distinct from the material object, copyrighted. Copyright is an intangible incorporeal right in the nature of a privilege, quite independent of any material substance. The license granted to the licensee permitting him to download the computer programme and storing it in the computer for his own use is only incidental to the facility extended to the licensee to make use of the copyrighted product for his internal business purpose - The licensee were allowed to make only one copy of the software and associated support information for backup purposes with a condition that such copyright shall include Infrasoft copyright and all copies of the software shall be exclusive properties of Infrasoft - Licensee was allowed to use the software only for its own business as specifically identified and was not permitted to loan/rent/sale/sub-licence or transfer the copy of software to any third party without the consent of Infrasoft - The licensee has been prohibited from copying, decompiling, de-assembling, or reverse engineering the software without the written consent of Infrasoft. The licence agreement between the Assessee company and its customers stipulates that all copyrights and intellectual property rights in the software and copies made by the licensee were owned by Infrasoft and only Infrasoft has the power to grant licence rights for use of the software. The incorporeal right to the software i.e. copyright remains with the owner and the same was not transferred by the Assessee. The right to use a copyright in a programme is totally different from the right to use a programme embedded in a cassette or a CD which may be a software and the payment made for the same cannot be said to be received as consideration for the use of or right to use of any copyright to bring it within the definition of royalty as given in the DTAA – Following Delhi High Court in DIT v. M/s Nokia Networks OY [2012 (9) TMI 409 - DELHI HIGH COURT] - The right to make a backup copy purely as a temporary protection against loss, destruction or damage does not amount to acquiring a copyright in the software - What has been transferred is not copyright or the right to use copyright but a limited right to use the copyrighted material and does not give rise to any royalty income - The consideration received on grant of licences for use of software is not royalty within the meaning of Article 12(3) of the Double Taxation Avoidance Agreement between India and the United States of America – Decided against Revenue. The core legal questions considered by the Court were:1. Whether the receipts received by the Assessee on grant of licenses for use of software constituted 'royalty' income or 'business income' under the Income Tax Act, 1961 and the Indo-US Double Taxation Avoidance Agreement (DTAA), particularly Article 12(3) of the DTAA.2. Whether the supply of software on license amounts to royalty or included services within the meaning of Section 9(1)(vi) of the Income Tax Act and Article 12 of the Indo-US DTAA. (This issue was later not considered due to the Assessee's stand.)3. The applicability and interpretation of provisions of the Income Tax Act vis-`a-vis the DTAA, especially the overriding effect of the DTAA under Section 90 of the Act.4. The distinction between transfer of copyright rights and transfer of copyrighted articles in the context of software licensing and its tax implications.5. The nature and taxability of income arising from software licensing where the Assessee has a permanent establishment (PE) in India.Issue-wise Detailed AnalysisIssue 1: Characterization of receipts from software licensing as royalty or business income under Income Tax Act and DTAAThe relevant legal framework includes Section 9(1)(vi) of the Income Tax Act, Explanation 2 thereto, and Article 12 of the Indo-US DTAA, which defines 'royalties' as payments received as consideration for the use of or the right to use copyrights, patents, trademarks, designs, secret formulas, or information concerning industrial, commercial or scientific experience.Precedents relied upon include the Supreme Court judgment in Tata Consultancy Services Ltd. vs. State of Andhra Pradesh, which held that software embedded in a physical medium is a 'good' for sales tax purposes, and various decisions of the Income Tax Appellate Tribunal (ITAT) and High Courts distinguishing between copyright rights and copyrighted articles.The Assessing Officer (AO) initially held that the receipts were royalty income because the software was licensed, not sold, and the copyright remained with the Assessee. The AO reasoned that the software was a patented scientific work involving secret formulas and processes, and the payment was for the use of such rights, thereby falling within the definition of royalty.The Commissioner of Income Tax (Appeals) (CIT(A)) upheld the AO's view, emphasizing that the license granted was for use of copyright and that the payments were royalty. The CIT(A) rejected the Assessee's reliance on the OECD commentary and the Tata Consultancy decision, noting that sales tax and income tax laws have different definitions and treatments of software transactions.The ITAT, however, reversed these findings, relying on the Special Bench decision in Motorola Inc. and others, which drew a crucial distinction between payment for a copyright (which is royalty) and payment for a copyrighted article (which is business income). The ITAT noted that the license agreements granted limited, non-exclusive, non-transferable rights to use the software, with the copyright and intellectual property rights retained by the Assessee. Licensees were restricted from sublicensing, selling, or copying the software beyond backup purposes.The ITAT further referred to the Bangalore Bench decision in Samsung Electronics, which held that payment for use of copyrighted material without transfer of copyright rights is not royalty but business income. The ITAT observed that customization of software did not alter the nature of the license or the rights transferred.The Supreme Court's interpretation in Azadi Bachao Andolan was applied to hold that the DTAA provisions prevail over the domestic law if more beneficial to the Assessee, and the DTAA's narrower definition of royalty must be applied.Issue 2: Applicability and overriding effect of the DTAA over Income Tax Act provisionsSection 90 of the Income Tax Act empowers the Central Government to enter into agreements with other countries to avoid double taxation. Section 90(2) provides that where such an agreement exists, the provisions of the Act apply only to the extent they are more beneficial to the Assessee.The Supreme Court in Azadi Bachao Andolan clarified that in case of conflict between the DTAA and the Income Tax Act, the DTAA provisions prevail if more beneficial. The Court emphasized that the DTAA is intended to promote mutual economic relations and avoid double taxation, and its provisions override inconsistent domestic law provisions.The Court examined the Indo-US DTAA, particularly Articles 7 and 12. Article 7 deals with business profits taxable in the state of residence unless the enterprise carries on business through a PE in the other state. Article 12 defines royalties and fees for technical services and provides for limited taxation rights in the source state.It was undisputed that the Assessee had a branch office in India constituting a PE under Article 5 of the DTAA. Therefore, profits attributable to the PE could be taxed in India under Article 7. Article 12's definition of royalty applies only if the income arises from use of or right to use copyright or similar rights.The Court held that since the Assessee's income was not royalty under Article 12, but business income attributable to the PE under Article 7, the DTAA provisions governed the taxability, and the AO and CIT(A) erred in applying the more onerous domestic provisions relating to royalty.Issue 3: Distinction between transfer of copyright rights and transfer of copyrighted articles in software licensingThe Court extensively examined the legal distinction between copyright rights and copyrighted articles. Copyright is an intangible, incorporeal right distinct from the physical copy of the work. Transfer of a copyrighted article (e.g., a CD or floppy with software) does not transfer copyright rights.The Court relied on the Special Bench ITAT decision in Motorola Inc., upheld by the Delhi High Court, which held that payments for copies of software without transfer of copyright rights are not royalty but business income. The license agreements granting limited, non-exclusive, non-transferable rights to use software for internal business purposes do not amount to transfer of copyright or right to use copyright.The Court further referred to the Authority for Advance Ruling in Dassault Systems and Geoquest Systems, which held that mere authorization to use copyrighted software internally does not transfer copyright rights and is not royalty income.The Court noted that the license agreements in the present case contained clauses restricting copying, sublicensing, reverse engineering, and transfer, with copyright and intellectual property rights retained by the Assessee. Licensees could only make backup copies, which is incidental to use and not a transfer of copyright.The Court rejected the Revenue's argument that the right to reproduce software on a hard disk or make backup copies amounted to transfer of copyright rights, holding that such acts are necessary for use and do not confer copyright ownership.Issue 4: Taxability of income from software licensing where Assessee has a permanent establishment in IndiaThe Court acknowledged that the Assessee carried on business in India through its branch office, constituting a PE under Article 5 of the DTAA. Therefore, the profits attributable to the PE are taxable in India under Article 7.Since the income was held to be business income and not royalty, the receipts from licensing software were taxable as business profits attributable to the PE, with expenses deductible under the DTAA and domestic law.Issue 5: Relevance of OECD Commentary and foreign regulationsThe Court considered the OECD Model Convention commentary and US Internal Revenue Service proposed regulations distinguishing between transfer of copyright rights and copyrighted articles. The commentary stated that rights to copy software onto a hard drive or make archival copies are incidental to use and should be disregarded for tax characterization, with payments treated as business income.Although not binding, these international materials were persuasive and supported the conclusion that limited licenses to use software do not constitute royalty income.Key Evidence and Findings- The license agreements granted non-exclusive, non-transferable, limited rights to use software for internal business purposes.- The Assessee retained all copyright and intellectual property rights.- Licensees were prohibited from sublicensing, selling, or transferring the software.- Licensees could make only one backup copy for archival purposes.- The Assessee had a permanent establishment in India through its branch office.- The software was customized but remained fundamentally the same standard software.ConclusionsThe Court concluded that the payments received by the Assessee for licensing software were not royalty income under the DTAA or the Income Tax Act but constituted business income attributable to the permanent establishment in India.The DTAA provisions override the domestic law provisions to the extent they are more beneficial to the Assessee.The distinction between copyright rights and copyrighted articles is critical; the Assessee transferred only limited rights to use copyrighted articles, not copyright rights themselves.The income is taxable as business profits under Article 7 of the Indo-US DTAA, not as royalty under Article 12.Significant Holdings'The question whether the payment is for a copyright or for a copyrighted article is key. If it is for copyright, it is royalty; if for copyrighted article, it is business income.''Copyright is distinct from the material object copyrighted. The transfer of the manuscript or software copy does not, of itself, transfer the copyright therein.''The license granted by the Assessee is non-exclusive, non-transferable and limited to internal business use. Licensees are prohibited from sublicensing, selling or transferring the software. Such limited license does not amount to transfer of copyright rights.''Payments for software licensing where only limited rights to use are granted, with copyright retained by the licensor, are business income and not royalty under the DTAA.''The provisions of the DTAA prevail over the Income Tax Act where they are more beneficial to the Assessee.''Copying software onto a hard disk or making backup copies is incidental to use and does not constitute transfer of copyright rights.''The Assessee's branch office in India constitutes a permanent establishment, and profits attributable thereto are taxable in India as business profits under Article 7 of the DTAA.''OECD commentary and foreign regulations, though not binding, support the distinction between transfer of copyright rights and copyrighted articles and the tax treatment thereof.''The Income Tax Appellate Tribunal was right in holding that the consideration received by the Assessee on grant of licences for use of software is not royalty within the meaning of Article 12(3) of the Indo-US DTAA.'