Embedded software in machine sales is not royalty where only a copyrighted article is transferred, not copyright rights.

Software supplied with diamond scanning machines was treated as part of the machine sale because the software was embedded, not independently usable, and subject to strict contractual limits on copying, re-engineering, standalone use and transfer. The receipts were therefore not royalty under the India-Israel treaty, since royalty requires use of, or a right to use, copyright and a mere transfer of a copyrighted article is insufficient. Even if domestic law widened the royalty definition, the treaty definition prevailed as more beneficial and unamended. The receipts were characterised as business income and, absent a permanent establishment in India, were not taxable.

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Issues: Whether consideration received for software supplied along with diamond scanning machines constituted royalty taxable in India, or whether it was part of the sale consideration of the machine and therefore not taxable in the absence of a permanent establishment.

Analysis: The software was found to be embedded in the machine and incapable of independent use by customers. The customer acquired only a limited right to use the software for operating the machine, with substantial contractual restrictions against copying, re-engineering, standalone use, or transfer. On these facts, the dominant character of the transaction was sale of the machine, not separate exploitation of software. The Court further held that even if the domestic law definition of royalty was widened by amendment, the India-Israel treaty definition controlled because it was more beneficial and had not been correspondingly amended. Under the treaty, royalty requires use of, or right to use, copyright; a transfer of a copyrighted article is not enough. Since there was no transfer of copyright or rights in copyright, the receipts did not fall within royalty.

Conclusion: The software-related receipts were not taxable as royalty and were to be treated as business receipts; in the absence of a permanent establishment in India, the addition was deleted in favour of the assessee.

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