2021 (3) TMI 138 - SC - Income Tax

Payments by residents to nonresident software suppliers under distribution agreements not royalties under s.9(1)(vi); no TDS under s.195

SC held that payments by Indian residents to non-resident software suppliers under distribution agreements/EULAs are not royalties for use of copyright ... Royalty - tax deduction at source (TDS) under section 195 - income deemed to accrue in India under section 9(1)(vi) - Double Taxation Avoidance Agreement (DTAA) interpretation - end-user licence agreements (EULA) and distribution agreements - copyright versus copyrighted article; doctrine of first sale / principle of exhaustion - retrospective amendment - Explanation 4 to section 9(1)(vi) - principle of proportionality in section 195(2) - OECD Commentary on software and royaltiesRoyalty - income deemed to accrue in India under section 9(1)(vi) - Double Taxation Avoidance Agreement (DTAA) interpretation - OECD Commentary on software and royalties - Whether amounts paid by resident Indian end users/distributors to non resident software suppliers for shrink wrapped/off the shelf software or software supplied with hardware constitute 'royalty' under the relevant DTAAs or section 9(1)(vi) so as to make the payers liable to deduct tax at source under section 195. - HELD THAT: - The Court held that the relevant DTAA definitions of 'royalties' (derived from Article 12 of the OECD Model) mean payments for the use of, or the right to use, a copyright as defined by the treaty, and must be read with the OECD Commentary. The characterisation turns on the nature of rights transferred. Where the transferee only acquires the right to use a copyrighted article (a copy of the program embedded in a medium or hardware) under restrictive EULAs or non exclusive distribution agreements, no interest in the rights enumerated in section 14 of the Copyright Act is parted with. Copying incidental to making the program operable (e.g., installing on hard disk, backup) is to be disregarded for tax characterisation (OECD Commentary), and such transactions are commercial supplies of goods/ business income rather than royalties. Consequently the DTAA definition (being more beneficial to the payer) governs and does not treat such payments as royalties. The Court approved the AAR determinations in Dassault and Geoquest and the Delhi High Court authorities (Ericsson, Nokia, Infrasoft, ZTE) and set aside the Karnataka High Court judgment and the Citrix AAR ruling to the contrary. [Paras 55, 168, 169, 170]Amounts paid for the transactions and agreements described do not constitute 'royalty' under the DTAAs or section 9(1)(vi) for the purposes of TDS; no obligation to deduct under section 195 arises on that basis.End-user licence agreements (EULA) and distribution agreements - copyright versus copyrighted article; doctrine of first sale / principle of exhaustion - section 14 of the Copyright Act - Whether EULAs or distribution agreements in the cases before the Court effect a transfer or licence within the meaning of section 14/30 of the Copyright Act (i.e., part with any of the exclusive rights in copyright) so as to attract treatment as royalties. - HELD THAT: - The Court examined sample EULAs and distribution/remarketer agreements and found they impose restrictive conditions, reserve title and copyright to the supplier, and do not grant proprietary rights under section 14(a)/(b) or licences under section 30 that part with rights to reproduce, distribute or exploit the copyright. The agreements confer a right to use the copy (a copyrighted article) but not to enjoy or exploit the exclusive incidents of copyright; section 52(1)(aa) (permitted copying to make the program operable) excludes such incidental acts from being treated as infringement or as evidence of a transfer of copyright. The 1999 amendment to section 14(b)(ii) (removal of wording contrary to exhaustion) and authorities (including Tata Consultancy Services and SBI v. Collector of Customs) were considered; on the facts the distributors merely resell copies and do not acquire rights that would amount to transfer of copyright. [Paras 45, 46, 52]The EULAs and distribution agreements at issue do not transfer copyright or grant proprietary copyright licences under the Copyright Act; they create limited rights to use copies and do not convert the transactions into royalties.Tax deduction at source (TDS) under section 195 - principle of proportionality in section 195(2) - Double Taxation Avoidance Agreement (DTAA) interpretation - Whether section 195 requires deduction of tax at source merely upon remittance to a non resident, irrespective of whether the non resident's receipt is chargeable to tax in India, and whether DTAA protections can be invoked at the TDS stage. - HELD THAT: - Relying on GE India Technology and related authorities, the Court reaffirmed that section 195(1) applies only to sums 'chargeable under the provisions of the Act'; the payer's obligation is limited to that proportion of a composite payment that is income chargeable in India. Section 195(2) embodies proportionality and provides for an application to determine the appropriate proportion. DTAA provisions must be considered by the deductor in determining chargeability and rates (section 2(37A)(iii) and section 90), and withholding rates under a DTAA (where applicable) govern the rate of deduction. The Court rejected the Revenue's contention that DTAA protections do not apply at the TDS stage, noting absurd consequences if DTAAs were disregarded for section 195 purposes. [Paras 24, 25, 55]Section 195 obligations arise only where the payment (or part thereof) is chargeable to tax in India; the deductor must consider DTAA provisions and may seek determination under section 195(2) where proportionality is in doubt.Retrospective amendment - Explanation 4 to section 9(1)(vi) - lex non cogit ad impossibilia; impotentia excusat legem - Whether Explanation 4 (Finance Act 2012) operates retrospectively to impose on payers for assessment years prior to 2012 an obligation to have deducted TDS on the expanded definition of royalty as if Explanation 4 had always been on the statute book. - HELD THAT: - The Court analysed the text and legislative history of Explanation 4 and its Memorandum and concluded that Explanation 4 in fact expanded the statutory position rather than merely clarifying it back to 1976. Applying the maxims lex non cogit ad impossibilia and impotentia excusat legem, and authorities where retrospective amendments were not held to impose obligations impossible to comply with at the relevant time, the Court held that payers could not be compelled, for assessment years prior to 2012, to have applied an explanation that was factually not on the statute book at the time of payment or deduction. [Paras 76, 78, 80, 81]Payers are not liable to be treated as having failed to deduct TDS for past assessment years on the basis of Explanation 4 inserted in 2012 as if it had been in force at the relevant time.Final Conclusion: The appeals are resolved by holding that payments by resident Indian end users or distributors to non resident software suppliers under the sample EULAs and distribution agreements do not constitute 'royalty' under the applicable DTAAs or, on the facts, under section 9(1)(vi); accordingly no obligation to deduct TDS under section 195 arose in those cases. The Karnataka High Court judgments and the Citrix AAR ruling are set aside; the Delhi High Court decisions and the AAR rulings that treated such payments as business income/ supplies (not royalties) are upheld. Retrospective Explanation 4 (Finance Act 2012) cannot be read back to impose TDS obligations for assessment years before it was on the statute book. Issues Involved:1. Definition and scope of 'royalty' under the Income Tax Act and DTAA.2. Applicability of the doctrine of first sale/principle of exhaustion.3. Interpretation of treaties and OECD Commentary.4. Applicability of retrospective amendments to Section 9(1)(vi) of the Income Tax Act.5. Obligation of TDS under Section 195 of the Income Tax Act.Detailed Analysis:1. Definition and Scope of 'Royalty' under the Income Tax Act and DTAA:The Supreme Court examined whether payments for the use of computer software amounted to 'royalty' under Section 9(1)(vi) of the Income Tax Act and the corresponding provisions in various DTAAs. It was held that the term 'royalties' in the DTAAs refers to payments for the use of or the right to use any copyright. The Court noted that the definition of 'royalty' under the Income Tax Act is broader than that under the DTAAs. However, the Court emphasized that the DTAAs' provisions, being more beneficial to the assessee, would prevail over the Income Tax Act due to Section 90(2) of the Act. The Court concluded that payments for the resale/use of computer software through EULAs/distribution agreements do not constitute 'royalty' as they do not involve the transfer of any rights in the copyright.2. Applicability of the Doctrine of First Sale/Principle of Exhaustion:The Court discussed the principle of exhaustion, which implies that once a copyrighted item is sold, the copyright owner's control over the distribution of that item is exhausted. The Court noted that Section 14(b)(ii) of the Copyright Act, post the 1999 Amendment, does not prevent the resale of legally acquired software. The doctrine of first sale was held applicable, meaning that the resale of software by distributors does not constitute the transfer of copyright and thus does not attract royalty payments.3. Interpretation of Treaties and OECD Commentary:The Court referred to the OECD Commentary on Article 12 of the OECD Model Tax Convention, which defines 'royalties' and provides guidance on interpreting tax treaties. The Court emphasized that treaties should be interpreted liberally to implement the true intentions of the parties. The OECD Commentary was deemed persuasive in interpreting the term 'royalties' in the DTAAs. The Court also noted that India's positions on the OECD Commentary do not alter the DTAA provisions unless bilaterally amended.4. Applicability of Retrospective Amendments to Section 9(1)(vi) of the Income Tax Act:The Court examined the retrospective amendments to Section 9(1)(vi) introduced by the Finance Act 2012, which expanded the definition of 'royalty.' The Court held that these amendments could not apply to assessment years before 2012, as the law does not demand the impossible. The Court applied the maxims 'lex non cogit ad impossibilia' (the law does not compel the doing of impossibilities) and 'impotentia excusat legem' (when there is a disability that makes it impossible to obey the law, the alleged disobedience of the law is excused).5. Obligation of TDS under Section 195 of the Income Tax Act:The Court concluded that there is no obligation on the persons mentioned in Section 195 of the Income Tax Act to deduct tax at source for payments made to non-resident computer software manufacturers/suppliers. The Court held that such payments do not constitute 'royalty' and do not give rise to income taxable in India. Consequently, the persons referred to in Section 195 were not liable to deduct any TDS.Conclusion:The Supreme Court allowed the appeals from the High Court of Karnataka, set aside the AAR ruling in Citrix Systems, and dismissed the appeals from the High Court of Delhi. The Court held that payments for the resale/use of computer software do not constitute 'royalty' and are not subject to TDS under Section 195 of the Income Tax Act.