Bundled software receipts treated as sale consideration, not royalty, where no copyright rights were transferred under the treaty.

Receipts from software bundled with diamond-scanning machines were treated as part of the sale consideration of an integrated system, not royalty under section 9(1)(vi) or Article 12(3) of the India-Israel DTAA, because the software had no independent commercial use and no rights in the copyright were transferred. The distinction between a copyrighted article and a copyright right was applied, and the treaty definition of royalty was held to be narrower than the domestic law definition. A later amendment to section 9(1)(vi) could not expand the treaty meaning without a corresponding treaty amendment. In the absence of a permanent establishment in India, the receipts were also not taxable as business income.

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Issues: Whether receipts from supply of operating and application software bundled with diamond-scanning machines constituted royalty under section 9(1)(vi) of the Income-tax Act, 1961 and Article 12(3) of the India-Israel DTAA, or were part of the sale consideration of an integrated machine and therefore not taxable as royalty in the absence of a permanent establishment in India.

Analysis: The software supplied to customers was found to be integral to the functioning of the machines and had no independent commercial use. The transaction was characterized as a sale of an integrated machine system, not a separate exploitation of software rights. The Court relied on the distinction between a copyrighted article and a copyright right, holding that the customers obtained only the right to use the software as part of the machine and not any right in the copyright itself. It was further held that the definition of royalty under the treaty was narrower than the domestic law definition, and that a later amendment to section 9(1)(vi) could not enlarge the treaty definition in the absence of a corresponding treaty amendment. As the assessee had no permanent establishment in India, the receipts could not be taxed as business income either.

Conclusion: The receipts from supply of software bundled with the machines were not royalty and the addition made on that basis was deleted, resulting in relief to the assessee on the substantive issue.

Ratio Decidendi: Where software is supplied only as an integral part of hardware and no copyright or rights in copyright are transferred, the consideration is not royalty under a treaty definition limited to use of copyright, and domestic law amendments cannot override a more beneficial unamended treaty provision.

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