2021 (2) TMI 415 - AT - Income Tax

Appeal success: Cloud hosting income not royalty/fees. Interest levy overturned. Previous rulings supported.

The Tribunal allowed the appeal, determining that income from cloud hosting services was not classified as royalty or fees for technical services under ... Business income versus royalty - definition of 'royalty' under tax treaty - fees for technical services - reading retrospective statutory amendment into a bilateral tax treatyBusiness income versus royalty - definition of 'royalty' under tax treaty - Income received from cloud hosting / distribution of off the shelf software and related maintenance/upgrades is not 'royalty' under Article 12 of the India US (India Finland in coordinate bench) tax treaty nor in the nature of royalty under the Act for the assessment year 2016 17. - HELD THAT: - The Tribunal applied the reasoning of the coordinate bench decisions in the assessee's own case, examining the distributor agreements and the nature of rights granted. The distributors received non exclusive rights to market and distribute the copyrighted article (software) but were not granted rights to the source code, to modify, reproduce (beyond permitted backup), or to exploit the underlying intellectual property. The supply was for resale/distribution of a copyrighted article and not for the transfer of the copyright itself or the right to use the copyright embedded in the software. Accordingly, amounts received for sale/distribution and for provision of sub releases/main releases (updates) and maintenance/support were held to be business receipts and not payments for use of, or right to use, copyright or industrial/commercial/scientific equipment within Article 12. The Tribunal also rejected the view of importing retrospective statutory explanations contained in the Income tax Act into the treaty definition of royalty, holding that a unilateral amendment to domestic law cannot be read into a bilateral treaty absent a corresponding treaty amendment. [Paras 5]Payments in question are business income and cannot be characterized as 'royalty' for the purposes of the relevant tax treaty or under the impugned statutory construction.Fees for technical services - business income versus fees for technical services - Income from cloud hosting services / provision of maintenance and support does not constitute fees for technical services under the domestic provision or the corresponding treaty provision, and is to be treated as business income. - HELD THAT: - Following the coordinate bench reasoning and an examination of the contractual matrix, the Tribunal found that the assessee's obligations concerning maintenance, updates and support were ancillary to the sale/distribution of the copyrighted article and did not amount to the provision of managerial, technical or consultancy services that would attract the definition of fees for technical services under the treaty or the domestic explanation. The agreements showed that distributors bore primary responsibility for customer relations and collections, and that technical assistance (where provided) was limited and incidental. Consequently, such receipts do not qualify as fees for technical services but form part of the assessee's business receipts. [Paras 5]The amounts received for maintenance, support and associated services are business income and not taxable as fees for technical services.Reading retrospective statutory amendment into a bilateral tax treaty - Retrospective insertions ('Explanation 4', 'Explanation 5' and 'Explanation 6') to the domestic definition of royalty cannot be read into the definition of 'royalty' in the bilateral tax treaty in the absence of a corresponding amendment to the treaty. - HELD THAT: - The Tribunal applied Article 3(2) principles as interpreted by coordinate decisions and higher court authority, holding that where a term is specifically and exhaustively defined in a treaty, subsequent unilateral domestic amendments do not alter the treaty meaning. The Tribunal observed that treaty provisions require bilateral amendment and that retrospective domestic clarificatory amendments cannot be used to extend or change the scope of an international instrument concluded between sovereign states. Reliance was placed on precedent to underline that statutory amendments do not automatically modify treaty definitions. [Paras 5]The retrospective explanations to the Income tax Act are not to be read into the treaty; the treaty definition governs the characterization of payments.Final Conclusion: The Tribunal, following coordinate bench decisions in the assessee's own case, allowed the appeal for AY 2016 17: receipts from sale/distribution of off the shelf software, and related maintenance and updates, are business income and neither 'royalty' nor fees for technical services under the treaty or domestic law; domestic retrospective amendments to the statutory definition of royalty cannot be read into the treaty. Issues Involved:1. Classification of income from cloud hosting services as royalty.2. Classification of income from cloud hosting services as fees for technical services.3. Levy of interest under section 234B of the Income Tax Act.Detailed Analysis:Issue 1: Classification of Income from Cloud Hosting Services as RoyaltyThe appellant challenged the Assessing Officer's (AO) decision, which classified income from cloud hosting services as royalty under section 9(1)(vi) of the Income Tax Act, 1961, and Article 12(3)(b) of the India-US tax treaty. The AO, following the directions of the Dispute Resolution Panel (DRP), held that the cloud hosting system, being a combination of hardware, software, and networking elements, constitutes industrial/commercial/scientific equipment. Consequently, the income of INR 6,23,14,703 earned by the appellant was considered royalty for the use or right to use such equipment.The appellant contended that the AO erroneously applied the definition of royalty under the Act, as retrospectively amended by the Finance Act, 2012, to determine royalty income under the India-US tax treaty, despite no corresponding amendment in the treaty. The appellant also argued that providing clients with a license to use third-party software does not constitute royalty under the Act or the treaty.Issue 2: Classification of Income from Cloud Hosting Services as Fees for Technical ServicesThe appellant disputed the AO's classification of income from cloud hosting services as fees for technical services under section 9(1)(vii) of the Act and Article 12(4)(a) of the India-US tax treaty. The AO, guided by the DRP, held that the income from cloud hosting services qualifies as fees for technical services, which include managerial, technical, or consultancy services.Issue 3: Erroneous Levy of Interest under Section 234BThe appellant contested the AO's levy of interest amounting to INR 24,29,388 under section 234B of the Act. This section pertains to the interest charged for defaults in payment of advance tax.Judgment Analysis:Issue 1: Classification of Income from Cloud Hosting Services as RoyaltyThe Tribunal referred to its previous decision in the appellant's case for the assessment year 2012-13, where similar issues were adjudicated. The Tribunal had held that payments for the sale of specialized software and maintenance and support services (including upgrades) were not in the nature of royalty under Article 12 of the India-Finland tax treaty or the Explanation 2 to section 9(1)(vi) of the Act. The Tribunal emphasized that the appellant had granted only a non-exclusive license to market and distribute software products, retaining all intellectual property rights. The distributors did not have rights to the source code, modify, or reproduce the software, indicating that the payments were sales revenue, not royalty.The Tribunal also noted that the retrospective amendments to the definition of royalty under the Act could not be unilaterally applied to the tax treaty unless the treaty was correspondingly amended. This view was supported by judicial precedents, including the Delhi High Court's judgment in DIT vs. New Skies Satellite BV.Issue 2: Classification of Income from Cloud Hosting Services as Fees for Technical ServicesFollowing the rationale in the previous decision, the Tribunal held that the payments for software upgrades, maintenance, and support services did not fall within the definition of fees for technical services under Article 12 of the India-Finland tax treaty. The services provided were ancillary to the distribution of software products and did not involve the transfer of technical knowledge or skills to the distributors.Issue 3: Erroneous Levy of Interest under Section 234BThe Tribunal found that the issue of interest under section 234B was consequential to the primary issues. Since the primary issues were decided in favor of the appellant, the levy of interest under section 234B was also set aside.Conclusion:The Tribunal allowed the appeal, holding that the income from cloud hosting services did not constitute royalty or fees for technical services under the relevant tax treaty and the Income Tax Act. The levy of interest under section 234B was also set aside. The Tribunal's decision was consistent with its previous rulings in the appellant's cases for earlier assessment years.