Why income from sale of computer soft ware not taxable as royalty?

From the following three Circulars issued by the Central Board of Direct Taxes at different points in time, one understands that the intention of the Legislature was very clear to tax any income from ‘right for use’ or ‘right to use’ any copyright (viz., computer program) as royalty under the Act:

• Circular No. 152, dated 27th November 1974;
• Circular No. 588, dated 2nd January 1991; and
• Circular No. 621, dated 19th December 1991.

However, the controversy whether income from sale of computer software is taxable as royalty under the Act or not, developed only from the year 2005, with the judgment of the Special Bench of Delhi Tribunal in the case of Motorola Inc. v. DCIT, (95 ITD 269). The decision pertained to A.Ys. 1997-98 and 1998-99, though the first Circular justifying the taxability of income as royalty under the Act was issued in 1974.

Such an unusual scenario could be the result of imperfect drafting of section 9(1)(vi) to support the taxability of sale of computer software as royalty. This article examines whether the retrospective introduction of Explanation 4 to section 9(1)(vi), achieves the object of the Legislature to tax the income from sale of computer software as royalty under the Act. The said retrospective amendment in section 9(1)(vi) reads as under:

“Explanation 4 — For the removal of doubts, it is hereby clarified that the transfer of all or any rights in respect of any right, property or information includes and has always included transfer of all or any right for use or right to use a computer software (including granting of licence) irrespective of the medium through which such right is transferred.”

• Section 9(1)(vi) provides that any income payable by way of royalty in respect of any right, property or information is deemed to accrue or arise in India. So, to determine the taxability of income u/s.9(1)(vi), an income needs to satisfy the following twin conditions, apart from the principle of ‘source rule of taxation’ in section 9(1)(vi): The income should be covered under the definition of ‘royalty’ i.e., under Explanation 2 to section 9(1) (vi); and
•  l It has to be in respect of any right, property or information.

The expression ‘any right, property or information’ is explained in the definition of ‘royalty’ viz., intellectual properties, equipments, know-how, experience or skills, etc. In other words, the definition of ‘royalty’ gives colour to or limits the scope of, the expression, which is otherwise very wide in scope.

Explanation 4 retrospectively includes, ‘right for use or right to use computer software’ under the expression ‘any right, property or information’. The text of Explanation 4, however, does not include the said rights of a computer software under the definition of ‘royalty’, which is specifically required as discussed, for applicability of section 9(1)(vi). Even though, the Memorandum explaining the amendments relating to Direct Taxes in the Finance Bill, 2012 mentions that ‘transfer of all or any right in respect of any right, property or information’ used in Explanation 4 defines the rights, property or information referred to in Explanation 2 to section 9(1)(vi), the text of Explanation 4 does not refer to Explanation 2. Therefore, one may argue that until the language of Explanation 4 is amended to include the aforesaid rights of computer software under Explanation 2, section 9(1)(vi) may not apply to the said rights of computer software.

 The said argument also draws support from the Karnataka High Court judgment in the case of Jindal Thermal Power Company Ltd. v. DCIT, (321 ITR 31). The High Court while considering the retrospective amendment in context of Explanation to section 9(2) r.w.s. 9(1)(vii) held that since the purport of Explanation 2 is plain in its meaning, it is unnecessary and impermissible to refer to the Memorandum Explaining the provisions. Apart from the above or assuming that the Legislature amends Explanation 4 on the lines as suggested above or the Courts hold otherwise, the question that arises is, what is the meaning of the expression ‘right for use’ or ‘right to use’ a computer software? The provisions of the Act do not define ‘right for use’ or ‘right to use’.

Broadly, there are two schools of thought emerging for interpretation of the aforesaid rights of computer software. One school of thought suggests that the said expression should be construed in its general sense. Whereas, the other school of thought suggests the said expression should be construed in the light of the meaning as given in 2010 OECD Commentary on Model Tax Convention on Income and on Capital.

First school of thought

The Memorandum justifies the retrospective insertion, so as to restate the intention of the Legislature to tax the income from use or right to use computer software as royalty under the Act, which was interpreted otherwise by some judicial authorities. The judicial authorities1 in India have given conflicting findings on different questions relating to taxability of income from sale of computer software as royalty. Out of these questions, the Legislature has by Finance Act, 2012 sought to address only the question whether the expression ‘transfer of all or any rights’ includes ‘right for use’ or ‘right to use’?

The Memorandum does not refer to the conflicting judgements. The findings of these conflicting judgements were summarised in a Table in the feature Direct Tax Controversy in the BCAS Journal for the month of December 2011, (page no. 54).

In such a scenario, it would be relevant to understand the meaning of the expression ‘right for use’ or ‘right to use’ a computer software in the light of the findings of Heydon’s case (1584) (3 Co Rep 7a, 7b), better known as Mischief Rule. The Heydon’s case requires that to construe a provision of a statute, it would be just and proper to see what was the position before an amendment and find out what was ‘the mischief’ sought to be remedied and then discover the true rationale for such remedy. The aforesaid rule which is more than four hundred years old requires the following four questions to be answered in order to construe the provisions of section 9(1)(vi):

1. What was the common law before making the amendment in section 9(1)(vi)?

Judicial authorities were divided as regard the taxability of the subject. Some of the findings of the said decisions are:

— Passing on the right to use and facilitating the use of a product for which the owner has a copyright is not the same thing as transferring or assigning rights in relation to copyright and therefore, consideration to authorise the end-user to have an access to and make use of the licensed computer software, does not amount to royalty under the Act.

2.    What was the mischief and defect for which the Act did not provide?

The mischief and the defect for which the Act did not provide and which seems to be the intent of the Legislature was to tax ‘right for use’ or ‘right to use’ computer program [involved in a sale of/ licence to use computer software] as royalty under the Act.

3.    What remedy the Legislature/Parliament has resolved and appointed to cure the defect?

The remedy effected by the Legislature to cure the aforesaid defect is retrospective insertion of Explanation 4.

4.    What is the true reason for the remedy?

The true reason for the remedy seems that the Legislature wanted to subject ‘right for use’ or ‘right to use’ computer program involved in sale of computer software as royalty under the Act. The Legislature instead of using the expression to achieve its remedy to tax “right for use or right to use computer program embedded in a computer software” has chosen to use the expression “right for use or right to use computer software”, in a way suggesting that words ‘computer software’ and ‘computer program’ are used interchangeably.

In other words, the true expression ‘right for use or right to use a computer software’ is referred to as having a general meaning of act of using the property i.e., computer program embedded in a computer software and right to transfer such usage, respectively. Therefore, if one agrees with the conclusion of first school of thought, then purchase of any computer software viz., either shrinkwrap, bundled, canned or customised software, would be taxable as ‘royalty’ under the Act.

Second school of thought

The second school of thought suggests that the impugned expression should be construed in the light of the meaning as given in 2010 OECD Commentary on Model Tax Convention on Income and on Capital. The Para 2 of Article 12 of 2010 OECD Model defines ‘royalty’ as under:

The term ‘royalties’ as used in this Article means payments of any kind received as a consideration for the use of, or the right to use any copyright of literary, artistic or scientific work including cinematograph films, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.

The expressions ‘right for use’ or ‘right to use’ as referred in Explanation 4 to section 9(1)(vi) is also found in Article 12(2). Paras 12 to 17 of the OECD Model Commentary on Article 12 cover the various facets of taxability of computer software as royalty. Para 13.1 of the Commentary explains the meaning of the expression ‘right for use’ or ‘right to use’ any copyright in the context of a computer software. This is similar to rights referred to in section 14 of the Copyright Act, 1957 (‘the Copyright Act’) and India has not raised any reservations or disagreements to such construction. The rights referred in section 14 of the Copyright Act for computer program are reproduced below:

•     to reproduce the work in any material form including the storing of it in any medium by electronic means;

•    to issue copies of the work to the public not being copies already in circulation;

•     to perform the work in public, or communicate it to the public;

•     to make any cinematograph film or sound recording in respect of the work;

•     to make any translation of the work;

•     to make any adaptation of the work;

•     to do, in relation to a translation or an adaptation of the work, any of the acts specified in relation to the work in any of the points mentioned above; and

•     to sell or give on commercial rental or offer for sale or for commercial rental any copy of the computer program.

So, it is the transfer or granting of licence of rights in section 14 of the Copyright Act which refers to use or right to use the copyright in context of computer software.

Further, there is a case to presume that the expression ‘right for use’ and ‘right to use’ in the context of taxability of computer software as royalty, has acquired a particular meaning, when India has accepted the meaning of that expression as explained in the 2010 OECD Model Commentary. Therefore, it is worth arguing that when India has accepted the meaning of the expression in a particular sense, then the use of the said expression subsequently should also be given similar meaning. The Courts also have in a catena of decisions2 held that internationally accepted meaning and interpretation placed on identical or similar terms employed in various DTAAs should be followed when construing similar terms occurring in the Act. However, the said reference/is subject to certain limitations, and for better understanding of the subject, one may refer to the Article ‘Legitimacy of References to OECD Commentary for interpretation of provisions under the Act and DTAAs’ published in BCAJ, February 2012, (page no. 9).

Therefore, if one agrees with the conclusion of the second school of thought, then it is only the income from the transfer or granting of licence of rights in section 14 of the Copyright Act which means use or right to use copyright in the context of computer soft-ware and accordingly will be taxable as royalty under the Act. In other words, purchase of any computer software viz., either shrinkwrap, bundled, canned or customised software would still continue to remain non-taxable as ‘royalty’ under the Act.

Analysis

Based on the above discussion, if the text of the Explanation 4 to section 9(1)(vi) is brought to test then one feels that the Legislature may still fail to pass the muster to tax the income from sale of computer software as royalty under the Act for want of the following broad reasons:

In Explanation 4, the Legislature has used the words ‘all or any’ which are prefixed to expression ‘right for use’ or ‘rights to use’ computer software. The expression ‘transfer of all or any right for use or right to use a computer software (including granting of licence)’ gives an impression of there being many ‘rights for use’ or ‘rights to use’ a computer software, which can either be transferred or licensed. However, as concluded under the first school of thought, ‘right for use’ or ‘right to use’ computer software in its general sense refers to only a simple case of ‘usage’ of property. One fails to determine the various rights ‘for use’ or rights ‘to use’ involved in context of a computer software and is forced to doubt whether the Explanation 4 supports the construction of the expression as sought under the first school of thought. On the contrary, considering the multiple rights referred in section 14 of the Copyright Act, one may agree that the expression ‘all or any’ could be construed as referring to those multiple rights u/s.14 of the Copyright Act, thereby supporting the meaning as drawn under the second school of thought.

Further, Explanation 3 to section 9(1)(vi) of the Act defines ‘computer software’ to mean computer program recorded on any medium. In a sense, suggesting that even though the Copyright Act distinguishes between ‘original copyrighted computer program’ and ‘copy of said computer program embedded in computer software’, the Income-tax Act, 1961 does not recognise such a distinction for the purpose of taxation and the words ‘computer software’ and ‘computer program’ may be used interchangeably. The same conclusion is also drawn under question no. 4 – What is the true reason for remedy, while discussing the findings of Heydon’s case in the context of computer software, under the first school of thought? So, the expression ‘right for use or right to use a computer software’ may be read as ‘right for use or right to use a computer program’ in respect of computer software.

Conclusion

Considering the above, one may conclude that Explanation 4 to section 9(1)(vi) of the Act, in its present form, may fail to achieve its object for want of the following broad reasons:

•     Expressions viz., ‘transfer of all or any rights in respect of any right, property or information’, ‘all or any’, ‘rights for use’ or ‘right to use’ are neither defined nor properly referenced in section 9(1)(vi) of the Act;

•     Expression ‘right for use’ or ‘right to use’ referred to in Explanation 4 to section 9(1)(vi) may suggest a meaning different than meaning in general sense of usage of property and transfer thereof; and

•     Explanation 4 to section 9(1)(vi) supports the construction of the expressions ‘right for use’ or ‘right to use’ to cover the rights referred to in section 14 of the Copyright Act.

Apart from the above, it would be possible for non-resident taxpayers to take recourse to the beneficial provisions of DTAAs entered in by India with other countries. The Article on taxability of ‘royalty income’ generally defines “royalty as payment of any kind from ‘use or right to use’ any copyright”. It thus restricts the scope of royalty income and one may rely on the 2010 OECD Model Commentary and India’s position thereof for non-taxability of computer software as royalty.

Further, the Central Government has recently issued a Notification giving relief from multiple level of tax deduction at source (‘TDS’) u/s.194J in the context of computer software. The said Notification No. 21 of 2012, dated 13rd June 2012 is issued u/s.197A(1F) effective from 1st July 2012 and provides as under:

•     The transferee has been defined to be a person who acquires the software. He may be a resident or a non-resident of India and the transferor is defined to be a person from whom the software is acquired, but he has to be a resident of India (as a precursor for applicability of section 194J of the Act).

•     Acquisition of the software has to be in the course of transfer of software (referred to as ‘subsequent transfers’) and tax should have been deducted at source either u/s.194J or section 195 of the Act, as the case may be, in any of the previous transfers;

•     The software so acquired under subsequent transfer should not have been modified; and

•     The transferee should obtain a declaration from the transferor that the tax has been deducted in any of the previous transfers along with PAN of the transferor.

This Notification has a narrow scope and has several limitations, which are as under:

•     The exemption from multiple level of deduction of tax has only been provided to payments subject to tax deduction as royalty u/s.194J of the Act and not u/s.195 of the Act; and

•     The acquisition of software under subsequent transfers should be without modification. One generally finds that in a direct arrangement between a copyright owner and end-user, the standard End-User Licence Agreement (‘EULA’) specifically prevents the end-user for resale of acquired software and therefore, the question of multiple level of deduction of tax will not arise in such a scenario. However, in case of copyright owner-distributor- end -user chain, it may be possible to undertake the benefit of the said Notification.

A fact pattern which is generally involved in the case of copyright owner-distributor-end user chain of transfer of software and its TDS implications thereof are explained in the Diagram for ease of understanding and ready reference:

Generally, the copyright owner of a computer program assigns/licenses rights to commercially exploit the copyright to the distributor. The rights to commercially exploit copyright provide for making multiple copies of software along with rights to sell and/or rent computer software qua a geographical location i.e., in the given example could be India. Pursuant to aforesaid rights, the end-user in India acquires the software copy from the distributor, subject to terms and conditions as provided in a EULA.

(Note: It is assumed that under the Scenario 1 and 2, the income from sale of computer software is taxable as ‘royalty’ under the Act and respective DTAAs between India and other countries. The analysis has been limited with respect to TDS implications, which arise in the light of aforesaid notification.)

The important question which is relevant to determine the TDS implications in context of non-residents transferors that is discussed here is ‘Can a non-resident transferor take recourse to Article on ‘Non-discrimination’ under the DTAAs as regard the discriminatory treatment sought by the Notification by limiting the benefit to only resident transferors u/s.194J of the Act?’

Section 40a(ia) r.w.s. 194J and Notification No. 21 of 2012 provides for deduction of royalty expenses for payment to resident transferor for acquisition of software without any deduction of tax. On the other hand, for similar payment to non-resident transferor, if the transferee has not deducted tax u/s.195, then the said expense will not be allowed as deduction u/s.40a(i). Such discrimination is addressed in an indirect manner by Article 24(3) of the respective DTAAs entered in between India and other countries. Article 24(3), generally reads as under:

“Except where the provisions of para 1 of Article 19, para 7 of Article 11, or para 8 of Article 12 apply, interest, royalties, and other disbursements paid by a resident of a Contracting State to a resident of the other Contracting State, shall for the purposes of determining the taxable profits of the first mentioned person, be deductible under the same conditions as if they had been paid to a resident of the first mentioned State.”

Article 24(3) deals with the treatment of the enterprises of Contracting State under the tax laws of that State. The said Article provides that interest, royalties and other disbursements paid to a resident of the other contracting State should be deductible to the same extent as would be deductible if paid to a resident of the same State. The said para of the Article is designed to end a particular form of discrimination resulting from a fact that in certain countries the deduction of interest, royalties and other disbursements is allowed without restriction when the recipient is a resident, but is restricted or prohibited when the recipient is non-resident4.

A similar discriminatory treatment is sought by Notification No. 21 of 2012. Therefore, by taking recourse to Article 24(3) of DTAAs read with Notification No. 21 of 2012, similar exemption from multiple level of TDS may be claimed on payment to non-resident transferors.

Given the aforesaid situation, one is reminded of the proverb, ‘Once burnt is twice shy.’ But the hard lesson of consequences from imperfect drafting do not seem to have learnt and therefore, the Income-tax Department may still fail to tax income from sale of computer software as ‘royalty’ under the Act and may also fail to simultaneously impose onerous and discriminatory treatment of multiple level of TDS u/s.195 of the Act.