Software royalty, consortium AOP, and arm's length transfer pricing principles clarified on tax treatment and receipt basis

Payments for software supplied under a restricted end-user licence, without transfer of copyright, are not royalty under the Act or the treaty. A consortium arrangement does not constitute an association of persons where the parties have separate scopes of work, separate billing, no common management, no profit or loss sharing, and only contractual joint liability. Compensation embedded in an arbitral award for delayed payment retains its compensatory character up to the date of the award and is not taxed as interest for that period. Transfer pricing adjustments must be made under the prescribed arm's length method and cannot rest on an ad hoc mark-up or reporting mismatch. Royalty and fees for technical services are taxable on receipt basis under the treaty.

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Issues: (i) Whether consideration for supply of software was taxable as royalty; (ii) Whether the DMRC consortium arrangement constituted an association of persons; (iii) Whether compensation included in the arbitral award for delayed receipt was taxable as interest; (iv) Whether the transfer pricing adjustment based on mismatch in reported transaction values and ad hoc mark-up was sustainable; and (v) Whether royalty and fees for technical services were taxable on receipt basis.

Issue (i): Whether consideration for supply of software was taxable as royalty.

Analysis: The software was supplied under a limited, non-exclusive and non-transferable licence for use only with the assessee's equipment, with restrictions on copying, reverse engineering and commercial exploitation. The issue was covered by earlier years' orders and by the Supreme Court's ruling in Engineering Analysis, which held that payments for such software use do not amount to royalty under the Act or the treaty.

Conclusion: The software receipts were not taxable as royalty and the issue was decided in favour of the assessee.

Issue (ii): Whether the DMRC consortium arrangement constituted an association of persons.

Analysis: The MoU provided for separate and independent scopes of work, separate invoicing and payments, no common management, no sharing of profits or losses, and reciprocal indemnities between the parties. Joint and several liability was held to be only a contractual safeguard for the employer and not proof of a joint enterprise. The legal tests for an association of persons were therefore not satisfied.

Conclusion: No association of persons came into existence and the issue was decided in favour of the assessee.

Issue (iii): Whether compensation included in the arbitral award for delayed receipt was taxable as interest.

Analysis: The amount described as interest formed part of the compensation awarded for delayed payment and did not represent a separate debt claim until the award itself was made. Only interest accruing after the date of the award could be treated as interest income; the component embedded in the award up to that date retained the character of compensation.

Conclusion: The impugned component was not taxable as interest for the relevant year and the issue was decided in favour of the assessee.

Issue (iv): Whether the transfer pricing adjustment based on mismatch in reported transaction values and ad hoc mark-up was sustainable.

Analysis: The difference between the assessee's figures and the Indian associated enterprises' figures was explained by receipt-basis accounting for treaty-taxable income and accrual-basis reporting by the Indian entities, as well as differences in the scope of transactions reported. The transfer pricing provisions require benchmarking by a prescribed method under the rules; an ad hoc 10% mark-up could not be substituted for a proper arm's length analysis, especially where the transaction had already been benchmarked in the associated enterprises' hands.

Conclusion: The transfer pricing adjustment was deleted and the issue was decided in favour of the assessee.

Issue (v): Whether royalty and fees for technical services were taxable on receipt basis.

Analysis: The treaty language taxed royalties and fees for technical services when paid or received, and the assessee's own case had already been consistently held to be taxable on receipt basis. The contrary accrual-based approach was not accepted.

Conclusion: The income was taxable only on receipt basis and the issue was decided in favour of the assessee.

Final Conclusion: The assessee succeeded on the substantive issues, the AOP allegation failed, the royalty and software characterisation additions did not survive, the arbitral-compensation component was not taxed as interest for the year, and the ad hoc transfer pricing adjustment was deleted, while the Revenue's appeal was dismissed.

Ratio Decidendi: Payments for software supplied under a restricted end-user licence without transfer of copyright are not royalty; a consortium does not become an association of persons absent common management, profit-sharing and a common design to earn income; compensation embedded in an arbitral award retains its compensatory character until the award is made; and transfer pricing adjustments must rest on a prescribed arm's length method, not on ad hoc estimations.

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