Royalty–The Digital Taxation Debate

1.  Background

Characterisation
of payments for digital goods and services has been a contentious issue,
especially in Indian context. Taxation of payments in the digital economy
segment has been a subject matter of considerable litigation for quite some
time now in India and even globally. In digital economy, delivery of services
can be easily done from overseas without necessitating any part of the activity
being performed or any employees being hired in the country where customers are
located, thereby avoiding taxable presence.

The BEPS
Action 1 Report ‘Addressing the Tax Challenges of the Digital Economy’ states
that because the digital economy is increasingly becoming the economy itself,
it would be difficult, if not impossible, to ring-fence the digital economy
from the rest of the economy for tax purposes. The digital economy and its
business models present however some key features which are potentially
relevant from a tax perspective.

In India, with respect to online advertising, we have following ITAT
decisions:

a) Yahoo India (P.) Ltd. vs. DCIT
[2011] 11 taxmann.com 431 (Mumbai-Trib)

b) Pinstorm Technologies (P.) Ltd.
vs. ITO [2012] 24 taxmann.com 345 (Mumbai-Trib)

c) ITO vs. Right Florists (P.)
Ltd. [2013] 32 taxmann.com 99 (Kolkata-Trib.)

In
these decisions, the ITAT has held that payments made for online advertising
would not constitute “royalty” and in absence of any Permanent Establishment
[PE] in India of the foreign companies, the same would not be taxable in India.

In
the earlier decision of Yahoo India, the ITAT had held that services rendered
by Yahoo Holdings (Hong Kong) Ltd. for uploading and display of the banner
advertisement of the Department of Tourism of India on its portal would not
amount to ‘royalty’. In that decision, the ITAT had observed that advertisement
hosting services did not involve use or right to use by the Indian company of
industrial, commercial or scientific equipment. Further, the Indian company had
no right to access the portal of Yahoo Hong Kong. Based on these facts, the
ITAT concluded that the payment made to Yahoo Hong Kong would be in the nature of business income and not royalty income.

Similar findings have been arrived at in the case of Pinstorm and Right
Florists.

In para 21 of the decision in Right Florist (supra), it
was held as under:

“21. That takes us to the
question whether second limb of Section 5(2) (b), i.e. income ‘deemed to accrue
or arise in India’, can be invoked in this case. So far as this deeming fiction
is concerned, it is set out, as a complete code of this deeming fiction, in
Section 9 of the Income Tax Act, 1961, and Section 9(1) specifies the incomes
which shall be deemed to accrue or arise in India. In the Pinstorm
Technologies (P.) Ltd.’s case (supra) and in Yahoo India (P.)
Ltd’s case (supra), the coordinate benches have dealt with only one
segment of this provision i.e. Section 9(1) (vi), but there is certainly much
more to this deeming fiction. Clause (i) of section 9(1) of the Act provides
that all income accruing or arising whether directly or indirectly through or
from any ‘business connection’ in India, or through or from any property in
India or through or from any asset or source of income in India, etc. shall be
deemed to accrue or arise in India. However, as far as the impugned receipts
are concerned, neither it is the case of the Assessing Officer nor has it been
pointed out to us as to how these receipts have arisen on account of any
business connection in India. There is nothing on record do demonstrate or
suggest that the online advertising revenues generated in India were supported
by, serviced by or connected with any entity based in India. On these
facts, Section 9(1)(i) cannot have any application in the matter. Section
9(1)(ii), (iii), (iv) and (v) deal with the incomes in the nature of salaries,
dividend and interest etc, and therefore, these deeming fictions are not
applicable on the facts of the case before us. As far as applicability of
Section 9(1)(vi) is concerned, coordinate benches, in the cases of Pinstorm
Technologies (P.) Ltd. (supra) and Yahoo India (P.) Ltd. (supra),
have dealt with the same and, for the detailed reasons set out in these erudite
orders – extracts from which have been reproduced earlier in this order,
concluded that the provisions of Section 9(1)(vi) cannot be invoked. We are in
considered and respectful agreement with the views so expressed by our
distinguished colleagues.”

2.  Recent Decision in case of Google India- ITAT
Bangalore

Recently,
ITAT Bangalore in the case of Google India Pvt. Ltd. [Google India] vs.
ADCIT [2017] 86 taxmann.com 237 (Bengaluru-Trib) dealt with the issue as to
whether payment by Google India to Google Ireland Ltd. [Google Ireland] under
‘Adwords Program’ Distribution Agreement is royalty. The ITAT held that the
said payment is taxable as royalty under the provisions of the Income-tax Act,
1961 [the Act] as well as under the India-Ireland tax treaty [DTAA] and treated
the Indian company as an assessee in default for not complying with the
withholding tax provisions.

A. Google AdWords

Google
AdWords is an online advertising service developed by Google, where advertisers
pay to display brief advertising copy, product listings, and video content
within the Google ad network to web users. The program uses the keywords to
place advertisements on pages where Google thinks they might be most relevant.
Advertisers pay when users divert their browsing to click on an advertisement.
AdWords enables an advertiser to change and monitor the performance of an
advertisement and to adjust the content of the advertisement.

The
advertisers get their advertisement uploaded into Adword program and log on the
Adword program website owned by Google. It follows the various steps to create
the Adword account for itself. The advertisers select the key words, content
and presentation related to its ads and place a bid on the online system for
the price it is willing to pay every time its user clicks on its advertisement.
Once the advertiser creates the account and uploads advertisement, the same
automatically gets stored on Adword platform owned by Google on the servers
outside India and the ads are displayed in the manner determined by the
programs running on automated platform. Google India periodically raises the
bill on advertisers for advertising spend incurred by the advertiser on clicks
through the users.

B. Brief Facts

a. Google India is a wholly owned subsidiary
of Google International LLC, USA. Google India was providing following services
to its overseas associate Google Ireland, under 2 separate agreements:

i.    Information technology (IT)
and IT enabled services (ITES) [Service Agreement]

ii.   Marketing and
distributorship services under a non-exclusive distributor agreement for resale
of online advertising space under the Adwords program to advertisers in India [Distribution
Agreement]. In addition to marketing and distribution services provided to
Google Ireland, under the Distribution Agreement, Google was also required to
provide pre-sale and post-sale / customer support services to the advertisers.

b. For the purpose of sales and marketing the
space, work wise flow of activities of the Google India and advertiser were as
under:

 i. Enter into resale agreement with Google Ireland and resale on
advertising space under the Adword program under the Indian advertisers.

 ii.   Perform marketing related
activities in order to promote the sales of advertising space to Indian
Advertisers. After training to its own sale force about the features/tools available
as part of Adword program, to enable them to effectively market the same to
advertisers.

 iii.   Enter into a contract with
Indian advertisers in relation to sale of space under the Adword program.

 iv.  Provide assistance/training
to Indian advertisers if needed in order to familiarize that with the
features/tools available as part of Adword product.

 v.   Resale invoice to the above
advertisers.

 vi.  Collect payments from the
aforesaid advertisers.

 vii.  Remit payment to Google
Ireland for purchase of advertising space from it under the resale agreement.

c. Under the distribution agreement, Google
India made a payment aggregating to Rs. 1,457 crore for the period from F.Y.
2005-06 to F.Y. 2011-12. On the premise that it is merely a reseller of advertisement
space, Google India had categorised this payment as Google Ireland’s business
income and in the absence of a PE of Google Ireland in India, the payment was
made without withholding any tax at source. Neither Google India nor Google
Ireland had obtained any order from the tax department for Nil tax withholding.

d.  As
Google India had not complied with the provisions of section 195, the tax
authorities started the proceedings u/s. 201 of the Act. Before the Assessing Officer [AO], Google India
filed the detailed reply for all the years. However, not convinced with the
reasoning of Google India, the AO, on a conjoint reading of Adword program
distribution agreement and service agreement, treated the payment as ‘royalty’
under Explanation 2 to section 9(1)(vi) of the Act as well as DTAA between
India and Ireland and determined the withholding tax liability.

e. The findings of the AO were as under:

i.    The `distribution rights`
were `Intellectual Property’ [IP] rights covered by `similar property` under
the definition of royalty and the distribution fee payable was in relation to
transfer of distribution rights.

ii.   Google Ireland had granted
Google India the right access to confidential information and intellectual property rights.

iii.   Google India had been
allowed the use or the right to use of a variety of specified IP rights and
other IP rights covered by “similar property”.

iv.  Grant of distribution right
also involved transfer of right in copyright.

v.   By exercising its right as
the owner of copyright in the software, Google Ireland had authorized Google
India to sell or offer for sale, i.e., marketing and distribution of Adwords
Software to various advertisers in India.

vi.  The consideration paid by
Google India was for granting license/authorization to use the copyright in the
AdWords program and not for purchase of such software.

vii.  Google India had been given
right to use Google Trademarks and other Brand Features in order to market and
distribute of Adwords program.

viii. Grant of distribution right
also involved transfer of know-how.

ix.  Google Ireland was obliged to
train the distributor so that Appellant could market and distribute AdWords
program.

x.   Referring to Non-Disclosure
Agreement [NDA] clauses forming part of Distribution Agreement, it was held
that Google Ireland, being the copyright holder of the AdWords program, was in
a position to share confidential information whenever required with Google
India.

xi.  Grant of distribution right
also involved transfer of process.

xii.  Without access to the
back-end, Google India could not perform its marketing and distribution
activities. Google India had access to the processes running on the data
centres, based on the distribution rights granted to it by Google Ireland.

xiii. Google India was granted the
use or the right to use the process in the Adwords platform for the purpose of
marketing and distribution.

xiv. Grant of distribution right
also involved use of Industrial, commercial and scientific equipment.

xv. Adwords program, in one way,
was also commercial cum scientific equipment and without having access to
servers running the AdWords platform, Google India could not perform its
functions as per the Distribution Agreement.

f. 
Aggrieved by the order of the AO, Google India preferred an appeal
before CIT(A). However, even the CIT(A) concurred with the view of the AO and
treated the payment to be in the nature of ‘royalty’. Aggrieved by the CIT(A)’s
order, Google India preferred an appeal before ITAT.

C. Main Issue for
consideration before ITAT

The
main issue before ITAT was whether the amounts credited in Google India’s books
to Google Ireland’s account constituted business income or royalties for use of
software, trademarks and other intellectual property rights.

D. Google’s Arguments

Before
the ITAT, Google India extensively argued that the said payment merely
represented purchase of advertisement space and it does not amount to ‘royalty’
and is in the nature of ‘business income’. Google India’s main arguments were
as under:

a)   It
was merely a reseller of advertising space. It only performed market related
activities to promote the sales of advertising space. No right or intellectual
properties were transferred by Google Ireland to Google India or to the
advertiser.

b)   The
brand features were predominantly commercial rights and were incidental to the
distribution activity and did not involve transfer of any separate right.

c)   Google
India had no control or access to the software, Algorithm and data centre. The
server on which the Adword program runs were located outside India over which
it was not having control. Google India or the advertisers did not have any
right of any use or exploitation or the underlying IP and software. None of
these parties were concerned with the back end functioning of the Adwords
program which was solely carried out by Google Ireland. Their objective was to
benefit from the services of Google and they were not interested in the use of
search service.

d)   Reliance
was also placed on the reports of High Powered Committee of the CBDT as well as
Technical Advisory Group of the OECD which had concluded that the payments in
relation to advertisement fees were not in the nature of royalty. Accordingly,
when the payments made directly by advertisers to Google Ireland could not be
regarded as royalty, the payments made by the distributor for the same ad space
also could not be characterised as royalty.

e)   Clauses
containing protection of confidential information and non-disclosure were
generic and these clauses per se could not establish that there was grant of
right to use any IP.

f)    Also,
what was envisaged in the exhibits of the agreement pertaining to after sales
services were that Google India responded to all routine queries of customers
and Google Ireland was to respond to the advertisers issues or technical
issues. Thus, no right to use any IP was granted to Google India.

g)   The
Google brand features are predominantly commercial rights and are incidental/
consequential to the distribution activity and does not involve transfer of any
separate right. In this regard, reliance was placed by Google India on the
decisions in the case of Sheraton International Inc vs. DDIT [2009) 313 ITR
267 (Delhi HC) and Formula One World Championship Ltd. vs. CIT [2016]
176 taxmann.com 6 (Delhi HC).

h)   Google
India relied upon the decisions of the coordinate bench in Right Florist
(P.) Ltd. (supra), Pinstorm Technologies (P.) Ltd. vs. ITO (supra) and Yahoo
India (P.) Ltd. vs. DCIT (supra) to prove that the issue of online
advertisement had been considered in all the decisions and it was held that the
payment made by the advertiser to the website owner was business profit and in
the absence of any business connection and PE in India and not the Royalty.

E. Tax Authorities’ Arguments

The
tax authorities argued that the payments to Google Ireland constituted
royalties on the following grounds:

a)  Google India’s marketing and
distribution functions involved the sale of certain rights in the AdWords
Program, for which Google India required a license to use the AdWords Program.
The distribution rights granted to Google India under the Distribution Agreement
were therefore in effect a license to use Google Ireland’s IP i.e., inter
alia the copyright in the underlying software code of the AdWords Program.

b)  The tax authorities concluded
that the license of Google Ireland’s IP to Google India under the Services
Agreement was actually for the purpose of providing the post-sale services
under the Distribution Agreement, and therefore the payments made to Google
Ireland constituted royalties.

c)  The Non-Disclosure Agreement
which is Exhibit-B of the distribution agreement clearly demonstrated that by
virtue of the disclosure of the confidential information and access provided to
the confidential information to the Google India by Google Ireland, the sums
payable by Google India to Google Ireland is for information, know-how and
skill imparted to Google India.

d)  Google India has been
permitted to use Google Ireland’s trademarks and brand features in order to
market and distribute the AdWords Program.

e)  The grant of distribution
rights involves transfer of rights in ‘similar property’ (Explanation 2 to
section 9(1)(vi)). The grant of distribution rights also involves the transfer
of right to use Google Ireland’s industrial, commercial and scientific
equipment i.e., the servers on which on which the Ad Words Program runs.

f)   The grant of distribution
rights also involves transfer of right in processes, including Google Ireland’s
databases software tools etc., without which it would not be able to perform
its marketing and distribution functions.

 F. ITAT Decision

The
ITAT, to get an understanding as to how Google AdWord program works, relied on
the information obtained through the written submission of Google India, the
books available in public domain on Google AdWord and Google analytics and also
through the website of the Google and the AdWords links therein. Based on its
understanding, the ITAT observed that:

a)  The entire agreement was not
merely to provide the advertisement space but was an agreement for facilitating
the display and publishing of an advertisement to the targeted customer.

b)  The arrangement was not
confined to use of space but also for the use of patented tools and software of
Google Ireland.

c)  Google India got an access to
various information and data pertaining to the user of the website in the form
of their name, age, gender, location, phone number, IP address, habits,
preferences, online behavior, search history etc. and it used this information
for the purpose of selecting the ad campaign and for maximising the impression
and conversion of the customers to the ads of the advertisers.

d)  By using the patented
algorithm, Google India decided which advertisement was to be shown to which
consumer visiting millions of website/search engine.

e)  The ITAT held that there is no
sale of space, as concluded hereinabove rather it is a continuous targeted
advertisement campaign to the targeted and focused consumer in a particular
language to a particular region with the help of digital data and other
information with respect to the person browsing the search engine or visiting the
website.

 f)   The ITAT did not agree that
advertisement distribution agreement and the service agreement were two
independent arrangements. According to the ITAT, both the agreements were
connected with the naval chord with each other.

 g)  The ITAT further held that the
payments made by the assessee under the agreement was not only for marking and
promoting the Ad Word programmes but was also for the use of Google brand
features. Needless to add that the said Google brand features were used by the
appellant as marketing tool for promoting and advertising the advertisement
space, which is main activity of Assessee and is not incidental activities.

The
use of trademark for advertising marketing and booking in the case of Hotel
Sheraton (Supra) as well as in the case of Formula 1 were
incidental activities of the assessee therein as the main activities in the
cases were providing Hotel Rooms and organizing Car Racing respectively whereas
in the present case the main activity of the assessee is to do marketing of
advertisement space for Google Adwords Programme. Therefore, these two
judgments are not applicable to the facts of the present case. Hence, for this
reason also the payment made by Google India to Google Ireland also falls
within the four corners of royalty as defined under the provisions of Act as
well as under the DTAA.

h)  The ITAT has held that the
findings of the High Powered Committee would not be applicable here as this was
not case of placement of the advertisement simpliciter but there was a module
for targeted advertisement/focus marketing campaigns using the Google software
and algorithm, patented technology, secret process, use of trade mark etc.

i)   The reliance placed by Google
India on the decisions of Pinstorm, Yahoo India, Right Florists have been
brushed aside since the ITAT felt that the facts relating to the working of the
AdWords program stood on a different footing.

j)   The ITAT held that IP of
Google vested in the search engine technology, associated software and other
features, and hence, use of these tools by Google India, clearly fell within
the ambit of ‘Royalty’. The ITAT held that as no tax was withheld by Google
India on payments to Google Ireland, Google India was an assessee in default.

k)  The ITAT was of the view that
the Ad Words Program gives an advertiser a variety of tools to enable it to
maximize attention, engagement, delivery and conversion of its advertisements.
The tools are provided using Google’s IP, software and database with Google
India acting as a gateway.

l)   The ITAT was of the view that
the use of customer data for providing services under the Service Agreement was
also utilized for marketing and distribution functions under the Distribution
Agreement. It concluded that the use of customer data and confidential
information should be regarded as the use of Google Ireland’s intellectual
property by Google India.

m) The ITAT concluded that it is
through use of Google’s intellectual property that the AdWords tools for
performing various activities are made available to Google India and the
advertisers. Therefore, payments made to Google Ireland for use of its intellectual
property would therefore clearly fall within the ambit of “Royalty”.

3.  Observations

a)     The ITAT appears to have
undertaken an intensive fact-finding mission to unearth the technological
workings of the Google AdWords Program on the basis of which it has concluded
that the distribution rights involved a grant of license to IP and
advertisements fees were in the nature of royalties.

b)    The ITAT’s ruling is clear
break with earlier positions taken on the characterization of advertisement
revenue, and payments made under distribution arrangements. Where it ruled the
payments to be in the nature of business income. In these cases, the question
is usually whether the foreign entity has a PE in India for income to be
taxable in India. In fact, the issue in such cases has been on the
determination of a PE on account of a fixed place or dependent agent rather
than whether such an arrangement will result in royalty income.

c)     In fact, it was for this
very reason that the equalization levy was introduced to capture advertising
fees within the Indian tax net, in cases where the non-resident does not have a
PE in India.

d)    The ITAT has taken an
aggressive approach where it has read two independent agreements in relation to
services provided by two different units of Google India together to show that
there was utilization of IP by the Indian entity and re-characterized the
nature of income. The decision does not provide for reasons of tax avoidance
for clubbing the two agreements.

e)     The ITAT’s decision could
have far reaching implications from businesses across the board. Utilization of
IP such as customer data, confidential information for performing services is a
fairly common industry practice and the decision raises concerns on these type
of arrangements.

f)     The above decision is very
crucial and is going to impact many cases which have the similar structure and
in such cases issue would arise as to whether such payment is in the nature of
‘royalty’.

However, one could still examine and contend that ultimately the
objective was to place the advertisement and Google India or the advertisers
were not interested in the back end process of Google Ireland and hence such
payment should constitute business income.

g)    It appears that ITAT in
Google’s case has tried to distinguish the earlier decisions by holding that
Google was not only a simpliciter provider of advertisement space but it also
provided access to software, patented tools, information, etc. which helped
Google India in targeting the customers. The ITAT has also gone into
considerable depth to understand as to how these advertisements are placed on
the website of Google, how it was ensured that large number of customers visit
those advertisements, how the bidding by the advertisers take place etc. and
based on this it came to conclusion that Google India plays a pivotal role in
all these and it was not merely placing the advertisement simpliciter.

4.     Equalisation Levy [EL]

a)     The Finance Act, 2016 has
introduced an ‘Equalisation Levy’ (Chapter VIII) in line with the
recommendation of the OECD’s Base Erosion and Profit Shifting [BEPS] project to
tax e-commerce transactions. It provides that the equalisation levy is to be
charged on specified services (online advertising, any provision for digital
advertising space or facilities/service for the purpose of online
advertisement, etc.) at 6% of the amount of consideration for specified
services received or receivable by a non-resident payee not having a PE in
India. The Equalisation Levy Rules, 2016 have also been issued by CBDT to lay
down the compliance procedure to be followed for such levy. The Rules came into
effect from 1^st June 2016.

b)    Further income from such
specified services shall be exempt u/s. 10(50) of the Act. Accordingly, with
effect from 1^st June, 2016, such income will not be taxed as royalty
or business income but it would be subject to equalisation levy.

An
interesting issue would arise as to whether payments made after 1^st June
2016 would be liable to EL or would it still attract withholding tax treating
it as royalty based on Google India’s decision. It is notable that withholding
tax may be creditable in the country of residence of the payee but no credit is
available for EL.

5. Proposed
amendments in Section 9(1)(i) by the Finance Bill, 2018 – ‘Business Connection’
to include ‘Significant Economic Presence’

Currently,
section 9(1)(i) provides for physical presence based nexus for establishing
business connection of the non-resident in India. A new Explanation 2A to
section 9(1)(i) is proposed to inserted to provide a nexus rule for emerging
business models such as digitised businesses which do not require physical
presence of the non-resident or his agent in India.

This
amendment provides that a non-resident shall establish a business connection on
account of his significant economic presence in India irrespective of whether
the non-resident has a residence or place of business in India or renders
services in India. The following shall be regarded as significant economic
presence of the non-resident in India.

–    Any transaction in respect of
any goods, services or property carried out by non-resident in India including
provision of download of data or software in India, provided the transaction
value exceeds the threshold as may be prescribed; or

–    Systematic and continuous
soliciting of business activities or engaging in interaction with number of
users in India through digital means, provided such number of users exceeds the
threshold as may be prescribed.

In such cases, only so much of income as is attributable to above
transactions or activities shall be deemed to accrue or arise in India.

 6. Conclusion

The
Google India’s decision will have a significant impact on how other digital
economy related payments are characterised for tax purposes in India. It would
also influence other pre 1^st June 2016 cases that relate to online
advertising.

In
view of the ITAT’s observation that both the Associated Enterprises are trying
to misuse the provision of tax treaty by structuring the transaction with the
intention to avoid payment of taxes, and in view of General Anti Avoidance
Rules provision under the Income-tax Act and India’s commitment to implement
Multilateral Instrument under the BEPS initiative, the taxpayers should take
appropriate caution before entering into any arrangement/structure especially
if it is to avail any tax benefit.

It
appears that the law on this issue will continue to remain somewhat unsettled
until resolved by the higher judiciary.

The
understanding of modern day developments around digital space, the complexities
surrounding it and tax implications on such transactions need a holistic
review. It is time for India to develop a framework for digital transactions.
This would be one important aspect in India’s attempts in its endeavour of ease
of doing business.