Taxability of Income from ‘sale of computer software’ as ‘royalty’

Section 4 and section 5 r.w.s. 9(1)(vi) of the Act provide for taxability of income from royalty in India. Section 9(1)(vi) of the Act by a deeming fiction provides for the taxation of income from royalty in India. Explanation 2 to section 9(1)(vi) of the Act defines the word ‘royalty’, which is wide enough to cover both industrial royalties as well as copyright royalties, both being forms of intellectual property. Computer software is regarded as an ‘industrial royalty’ and/or a ‘copyright royalty’. Industrial properties include patents, inventions, process, trademarks, industrial designs, geographic indicators of source, etc. and are generally granted for an article or for the process of making such article. Whereas on the other hand, copyright property include literary and artistic works, plays, films, musical works, knowledge, experience, skill, etc. and are generally granted for ideas, principles, skills, etc.

Just as tangible goods are sold, leased or rented in order to earn monetary gain, on similar lines, the Intellectual Property laws enable authors of the intellectual properties to exploit their work for monetary gain. The modes of exploitation of intellectual property for monetary gains are different for each type of Intellectual Property, which has been covered in various sub-clauses of the definition of ‘royalty’ under Explanation 2 to section 9(1)(vi) and subjected to tax as per the scheme of the Act.

On similar lines, monetary gains arising from exploitation of computer program, an intellectual property, which subsists in computer software is sought to be taxed as royalty under the Act. Explanation 3 to section 9(1)(vi) defines computer software as computer program recorded on any disc, tape, perforated media or other information storage device and includes any such program or any customised electronic data. The Supreme Court in the case of Tata Consultancy Services v. State of AP, 271 ITR 401 held that shelf software were ‘goods’ for the purpose of Sales tax and that there was no distinction between the branded and unbranded software. Without prejudice to the applicability of the aforesaid conclusions as drawn by the Apex Court in context of indirect tax laws, to the provisions of the Act, at least one may refer to the aforesaid decision for a proper understanding as to what software is and what is the nature and character of software, which is also advised by the Apex Court in the decision. The controversy, sought to be discussed here, revolves around the issue whether the income from a sale of the computer software is a ‘royalty’, or is a ‘sale’.

The Revenue holds such sales to be royalty on the ground that during the course of sale of computer software, computer program embedded in it is also licensed and/ or parted with the enduser of the software, and as against the claim of the taxpayers who treat the transaction as one of sale of computer software and not of the computer program embedded in it. The Authority for Advance Rulings (‘AAR’) recently in its ruling in the case of Millennium IT Software Ltd., in re, 62 DTR 1 had an occasion to deal with the aforesaid issue under consideration, wherein the AAR while deciding against the taxpayer’s contention, held that the income from the transaction be regarded as a royalty, liable to tax in India. In deciding the issue in this case the AAR gave findings that were contrary to its own findings on the subject given in the earlier decisions in the cases of Dassault Systems K. K., in re, 322 ITR 125 and FactSet Research Systems Inc, in re, 317 ITR 169.

Millennium IT Software’s case

Millennium IT Software Ltd. (‘Millennium’), a Sri Lankan company, had entered into a software licence and maintenance agreement (‘SLMA’) with Indian Commodity and Exchange Ltd. (‘ICEL’), an Indian company, on 27 March 2009. Under the agreement, Millennium had allowed ICEL to use the software product ‘licensed program’, owned by it. As per the SLMA, an ‘implementation fee’ of Rs.4 crores was agreed to be paid by ICEL to Millennium for licence to use the ‘licensed program’ for 4 years and its installation, with a clause to extend the licence period at the discretion of ICEL. The other relevant terms of SLMA are provided as under:

— Millennium had granted ICEL a ‘right to use’ the licensed program for its business operation;

— Rights granted under the SLMA were nonexclusive, non-transferable, non-assignable, indivisible;

— Millennium had granted rights to make copies of the licensed program to be installed on equipments only at designated sites of ICEL and each copy of licensed program was to carry copyright, trademark and other notice relating to proprietary rights of Millennium;

 — ICEL had no right to sell, distribute or disclose the licensed program or associated documents to any third party;

 — No intellectual property right or licence was granted to ICEL.

Use of source code and reverse engineering of the licensed program was strictly prohibited; Based on the aforesaid clauses in SLMA, Millennium submitted before the AAR that the implementation fee was not chargeable to tax under the provisions of the Act or under the DTAA with Sri Lanka relying on some of the earlier favourable legal decisions on the subject. The Income-tax Department objected to the said contention of Millennium and submitted before the AAR, that consideration towards implementation fee should be termed as industrial intellectual property that was covered under the vires of the definition of ‘royalty’ under Explanation 2 to section 9(1)(vi).

The AAR however, to begin with, chose to classify computer software as a copyright intellectual royalty as against the Revenue’s contention that it was an industrial intellectual property. The AAR observed that ICEL under SLMA was granted a ‘licence to use’ the computer program which was owned and developed by Millennium and that the consideration paid as ‘implementation fee’ was to enable ICEL to have a ‘right to use’ the licensed program. Further, the AAR held that as per SLMA, Millennium had not only conveyed the ‘right to use’ the software to ICEL but along with the said right had also enabled ICEL to ‘use’ copyright embedded in the program though limited in nature. The AAR in addition to above, held that the second proviso to section 9(1)(vi) of the Act was substantive in nature and if the conditions of second proviso to section 9(1)(vi) were not satisfied, then the intention of the Legislature was to tax even the income from sale of a computer software as a royalty under the Act.

Distinguishing its earlier decision on the facts in the case of Dassault Systems K. K. (supra), the AAR concluded that the consideration received for ‘right to use’ the software is embedded with right or interest in computer program and therefore, would be termed as royalty under the provisions of the Act as well as Article 12.3 of the DTAA with Sri Lanka and made the following observations as regard to DTAA with Sri Lanka:

“The DTAA involved herein is the one between India and Sri Lanka. The definition of royalty contained in this treaty in Article 12.3 shows that it is a payment of any kind received as consideration for the ‘use of or the right to any copyright’. This is seen to differ from some of the later treaties like the one with USA wherein royalty is payment of any kind received as consideration for the ‘use of, or the right to use, any copyright’. The definition in the India-Sri Lanka DTAA is wider than the one found in the IT Act. For, it takes in even the consideration received for permitting another to use a copyright. Even a right to use need not be conferred.

…. It is not necessary even to grant the right to use the copyright if one were to look at it literally, though the grant of a right to use could be said to be included in the grant of a right in the copyright.”

The AAR concluded that the consideration received by Millennium from ICEL be termed as a royalty under the DTAA and u/s.9(1)(vi) of the Income-tax Act.

Dassault Systems’ case

Dassault Systems K. K., (‘Dassault’), a Japanese Company, is engaged in the business of providing ‘Product Lifecycle Management’ software solutions, applications and services. Dassault marketed the aforesaid licensed products mostly through a distribution channel comprising of Value Added Resellers (‘VAR’). VARs are independent third-party resellers who are in the business of selling software products to end-users. As per the business model, Dassault entered into General Value Added Resellers Agreement (‘GVA’) with VARs and sold the software product to VARs for a consideration based on the standard list less discount. The VARs in turn sold the products to end-users at a price independently determined by VARs. The end-users then entered into End User Licence Agreement (‘EULA’) with Dassault and VARs for the product supplied.

Based on the abovementioned facts, Dassault had sought for a ruling from the AAR as to whether the consideration received by Dassault from VARs, from sale of software products would be termed as a business income or a royalty under the Act and/or DTAA between India and Japan. Further, the AAR was explained the modus operandi of the transactions undertaken between Dassault, VARs and the end-users. Dassault submitted before AAR that the end-users including VARs in the sale of software products were only transferred copyrighted software containing computer program but not the copyright therein. It was further contended that consideration was paid for ‘use of copyrighted product and not for use of copyright in computer program’. The end-users/VARs did not avail any of the rights referred to in section 14 of the Copyright Act, 1957 (‘the 1957 Act’). The Income-tax Department objected to the contention of Dassault and submitted that consideration received by Dassault from VARs was on account of rights conferred u/s.14(b) of the 1957 Act and therefore, would be termed as a royalty under the Act.

The AAR to begin with, considered the ordinary meaning of ‘copyright’, reference was made to various definition provisions, modes of transfer of copy-right under the 1957 Act and to the earlier decision of the AAR in the case of FactSet Research Systems Inc., 317 ITR 169. It referred to various clauses of GVA and EULA agreements and the provision of section 14 of the 1957 Act and observed that passing of a ‘right to use’ and facilitating the use of a product for which the owner had a copyright was not the same thing as transferring or assigning rights in relation to the copyright. Further, it observed that “use of a copyrighted product does not entail enjoyment of rights referred in section 14 of the 1957 Act” for computer program and therefore no copyright was transferred and/or parted in the course of said transaction. Merely authorising or enabling a customer to have the benefit of data or instructions therein without any further right to deal with them independently did not entail transfer of rights in relation to copyright or conferment of the right of using the copyright. After negating the objections of the Revenue and in light of the aforesaid observations and references to some of earlier favourable legal decisions on the subject, the AAR held that considering the facts of the case no rights in relation to copyright had been transferred, nor any right of using the copyright as such had been conferred on VARs/end-users in the course of transactions.

In deciding the application, the AAR referred to the provisions of Article 12.3 of the DTAA with Japan which read 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 and films or tapes for radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment or for information concerning industrial, commercial or scientific experience.”

On due consideration of the said Article 12 of the DTAA and the provisions of section 9(1)(vi) of the Act, the AAR concluded that the income from the transaction under consideration was not a royalty.

Observations

The Income-tax Act, 1961 defines royalty in relation to computer program under Explanation 2(v) to section 9(1)(vi) as ‘transfer of all or any rights (including granting of license) in respect of any copyright ………..A question which requires consideration is therefore, whether the expression ‘transfer of all or any rights’ under the said Explanation can be read to implicitly cover ‘use’ or ‘right to use’.

Observations here are restricted to the provisions of the Act and no references are sought to the text of respective DTAAs, for following reasons:

•     The definition of royalty and the text of the provisions on royalty under the respective DTAAs are different;

•     Once the nature of income being discussed here fails to be termed as a ‘royalty’ under the provisions of the Act, then one may not be required even to refer to the provisions of the respective DTAAs, considering the fact that recourse to DTAA is envisaged only for any reliefs and benefits, not conferred by the Act.

The issue under consideration is otherwise a multi- faceted issue and has several dimensions which are sought to be addressed through a few questions and answers thereon.

Does the expression ‘transfer of all or any rights’ under Explanation 2(v) to section 9(1)(vi) include ‘use or right to use’?

A construction of definition of royalty under the Act explains that different actions qua the type of intellectual properties are covered and subjected to tax according to the scheme of the Act, which is tabulated below:
 

The Legislature in its wisdom has distinguished between the royalty for industry intellectual properties and copyright intellectual properties. It appears that the distinction is in sync with the available means through which each type of intellectual property is exploited for earning a monetary gain. To take an illustration, a technical design which belongs to industrial intellectual property type can be exploited for earning monetary gain in any of the ways as mentioned in Explanation 2(i), (ii) and (iii) of section 9(1)(vi) of the Act, but the same test may fail for films, artistic work, etc., a part of copyright intellectual property type, and vice versa.

When different provisions are made depending upon the type of intellectual property, then the part relevant thereto only should be applied while determining whether or not that part shall fall under the definition of royalty. Such a construction is in accordance with the Latin legal maxim ‘Expresso unius est exclusive alterius’. The general meaning of the maxim is that the express mention of one thing implies the exclusion of another. As a fallout of the said construction, it is possible to hold that rights as prescribed in Explanation 2(i) to (iva) of section 9(1)(vi), as in the nature of right to share information and the use or right to use thereof cannot be covered by the expression ‘transfer of all or any right (including granting of licence)’ under Explanation 2(v) of the Act. In other words, the Legislature did not seek to consider ‘use or right to use’ of computer program embedded in computer software as royalty under the Act.

What is meant by the expression ‘transfer of all or any rights (including granting of licence’ and which rights are sought to be covered?

Though the Act defines the word ‘royalty’, but the expressions viz., ‘all or any’, ‘or’ are uncertain as regard to their scope. Similarly, the terms patents, copyrights, process, invention, skill, etc., remain undefined. In such circumstances, one is required to scrutinise the legislative history to ascertain the principal intention of the Legislature. The above-referred terms are defined in their respective governing special Acts on the subject viz., Copyrights Act, 1957 (‘the 1957 Act’); Patents Act, 1970; Trade Marks Act, 1999, etc.

Section 14 of the 1957 Act defines a copyright in the computer program as a list of rights granted to the author of computer program. The Act also provides for the modes for transfer of the said list of rights in computer program viz. assignment and licence of rights. References to other types of intellectual properties provide for similar provisions under the respective Acts. The intention of the Legislature can therefore be considered as referring to the rights as listed in section 14 of the 1957 Act. The aforesaid construction is also supported by the decision of the Special Bench of the Delhi Tribunal in the case of Motorola Inc v. DCIT, 95 ITD 269.
 

Whether the rights referred in section 14 of the Copyrights Act, 1957 are transferred in sale of computer software to end-users?

To answer this pertinent question, one requires to appreciate the nature of the transaction which generally takes place in a sale of computer software to end-users. A sale of computer software to end-users either takes place directly from the author of the computer program to end-users or through the channel of distributors. In either case, the computer program embedded in the computer software may or may not be parted and/or licensed with the computer software. Generally, in such sale transactions, what is sought to be parted with the end-users is the copy of copyrighted program embedded in the computer software and not the copyrighted computer program.

Therefore, it requires to be seen whether in a standard End-user License Agreement (‘EULA’) of computer software between the author and end-users, any of the rights mentioned in section 14 r.w.s. 52 of the 1957 Act are made available to the end-users. A table summarising the rights u/s.14 for computer program, as available to each party, generally, to exercise after the transaction of sale of computer software is reproduced below:

Whereas the author of the computer program, as observed in the Table, has all the rights, the end-user does not have any rights under Section 14. Further, the distributors have rights to sell or give on commercial rental a copy of computer program or give limited right to reproduce and store the said computer programs. In other words, the end-users cannot exercise any rights in respect of copyrights in computer program and therefore, any consider-ation paid to the authors/ distributors by the end-user towards sale of computer software may not qualify for being termed as a ‘royalty’ under the Act. In contrast, under the agreement between the author and distributor, since the right to sell or give on commercial rental is conferred on the distributors, any consideration received by the author from a distributor in such a scenario may qualify to be termed as a ‘royalty’ under the Act.

Whether ‘computer program’ is copyright and/or industrial intellectual property?

Though it may sound ironical, but all the contrary judgments on the subject confirm to the proposition that ‘computer program’ is a literary work and qualifies to be termed as a copyright intellectual property. However, the difference of opinion stems in considering the computer program as industrial intellectual property, not being limited to patents but also as process, invention and secret formula. Since, ‘invention’, and ‘patents’ are not defined under the Act it shall be necessary to rely on the respective special Acts governing the law on the subject. Section 3(k) of the Patents Act, 1970 (‘the 1970 Act’) which defines ‘invention’ specifically excludes computer program from being regarded as invention. Section 2(m) of the 1970 Act defines ‘patent’ as an invention, thereby indirectly excluding computer program from its purview. Further, since the end-users do not have any access to the computer program embedded in computer software, they cannot be said to have rights in relation to a process. Lastly, to classify computer program as a secret formula shall be too far-fetched, considering the fact that a secret formula is placed as genus of ‘technical know-how’ under the provisions of the Act.

As a result, computer program embedded in computer software may only be termed as a copyright intellectual property under Explanation 2(v) to section 9(1)(vi).

Without prejudice to aforesaid discussions, recently the Delhi High Court in a judgement delivered in the case of CIT v. Dynamic Vertical Software India (P)    Ltd., 332 ITR 222, has based on the facts and circumstances of the case where the assessee, a dealer of Microsoft, had been purchasing the on the subject software from Microsoft and selling it further in Indian market held that the payment made by the assessee to Microsoft could not be termed as a ‘royalty’. Therefore, it can be said that computer software is not a copyright intellectual property.

Lastly, if the rights to use intellectual property are capable of and are allowed to be transferred in sale of computer software to end-users, then every second person would have been capable of developing softwares like Microsoft, Oracle, etc. The general understanding of the word ‘royalty’ in the context of copyright refer to a consideration received by the author from the publisher, who published his work and not as a consideration received by the publisher from the end-user on sale of copy of work.

Based on the aforesaid discussions and observations made in the decision in the case of Dassault Systems (supra), it appears that the ratio of the recent decision of the AAR in the case of Millennium IT Systems (supra) may require reconsideration.

Adding to the bandwagon of major judgments, the AAR has recently in the case of Upaid Systems Limited, In re, 885 of 2010, dated 12th October 2011, based on the facts and circumstances of the case, held that the consideration paid by Satyam to Upaid for perpetual licence of right to use computer software shall be taxable as ‘royalty’ under section 9(1)(vi) of the Act.