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APAC Tax Matters - March 2012 - India - EY - China

APAC Tax Matters: March 2012India


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Authority for advance rulings (AAR) and Karnataka High Court (HC) rulings on payments on computer software characterized as royalties

The characterization of cross border software payments has been a contentious issue in recent times. While there have been several rulings which have appreciated the distinction between use of a copyright and use of a copyrighted article, the present rulings do not seem to consider this distinction as being relevant for the purpose of determining the characterization issue.

Case before the AAR

In the case before the AAR, “the Taxpayer”, a Sri Lankan entity, had to develop and install a licensed software program (program) into the computer machines of an Indian company (ICo) under a Software License and Maintenance Agreement. ICo was given the license to use the program for four years.

The Taxpayer sought a ruling on the characterization of payments received from ICo, both under the Income Tax Laws (ITL) and the India-Sri Lanka Double Taxation Avoidance Agreement (SLDTAA) on the issue whether such payments were in the nature of royalty.

The right granted to ICo was limited to use the program for its own business operations. ICo could not sell, distribute or disclose the program to any third party and use of the source code/object code of the program was also strictly prohibited. The Taxpayer was of the view that only a right to use the copyrighted article was provided to ICo and not the copyright in it and, hence, the payments were not in the nature of royalty.

Ruling of the AAR

Under the Indian Copyright Act (ICA), computer programs are protected as literary works. A license is described in popular dictionaries as an authority to do something which would otherwise be wrongful or illegal or inoperative, but for such license. Thus, the license to use the program means the right to use the intellectual property that was the copyright in the program in a particular way.

The definition of royalty under the ITL is wide because it also includes payments for the transfer of all or any rights (including the granting of a license) in respect of any copyright. It was only because of possessing a lawful license, ICo could utilize the program for its business purpose without infringing the copyright belonging to the Taxpayer.

The Taxpayer had not parted with its title over the copyright in the program. It had merely conveyed to ICo a right to use the program. Thus, this involves the right to use the copyright transaction and hence the payment should be characterized as royalty.

The distinction between a copyright vis-à-vis a copyrighted article is an expression borrowed from the US and from the OECD Commentary on the Model Convention (OECD MC) and the ITL does not distinguish between a copyright and a copyrighted article.

The definition of royalty under the SLDTAA includes payments for ‘use of or right to any copyright’ as against the wording in other DTAAs i.e., ‘use of or right to use any copyright’. Thus the definition in the SLDTAA is also wide as it includes even consideration received for permitting another to use a copyright as being a royalty.

Therefore under the ITL and SLDTAA, such payments ought to be classified as royalties and withholding tax provisions should apply on such payments.

While the definition of ‘royalty’ in the ITL is wide, the OECD MC recognizes the distinction between a copyright and a copyrighted article. However, where DTAAs do not strictly follow the OECD MC, such as in the case of the SLDTAA, difficulties do arise in applying this distinction, as this ruling suggests. It would, therefore, be advisable for taxpayers to review their existing arrangements as regards cross-border software transactions.

Case before the Karnataka HC

While the case before the AAR concerned customized software, the case before the HC concerned a shrink-wrapped software program (program). The HC ruling was rendered in a batch of cases, where one of the Taxpayers, imported the program from non-residents in various countries for use in its business. Certain other Taxpayers, in this batch of cases, were engaged in the distribution of the program. These Taxpayers imported copies of the program for subsequent sale to customers in India.

No tax was withheld on payments to the non-residents upon purchase of the program, the payments being argued not to be royalties under either the ITL or the applicable DTAAs. The Taxpayers’ contentions were that the payments made were for the purchase of a copy of the copyrighted article and not for copyright subsisting within the program. Moreover, since the non-resident suppliers had no permanent establishment in India, the payments were not taxable in India as business profits.

Ruling of the HC

Since the term ‘copyright’ is not defined in the ITL or in the DTAAs, a reference was made to the ICA.

As per the provisions of the respective license agreements entered into by the Taxpayers with the non-residents, what was transferred was a right to use a copy of the program for internal business, by making copies and back-up copies of the program. In the absence of this license, such acts would have constituted an infringement under the provisions of the ICA. Thus, the contention that there was no transfer of any part/whole of the copyright and the transaction only involved the sale of a copy of the copyrighted program, cannot be accepted.

There is no similarity between the purchase of a computer program and books/pre-recorded music CD. The latter can be used once they are purchased, whereas in the case of the former, unless a license is granted permitting the end-user to copy and download the program, the CD cannot be used.

The contention by the Taxpayers, placing reliance on the Supreme Court’s decision in the case of Tata Consultancy Services (TCS), that the same is to be treated as sale of goods since the program is not customized, cannot be accepted. In the case of TCS, the issue was not whether payments for program imports were royalty, but, whether canned program sold amounted to sale of goods under the State’s indirect tax laws.

As a result, the payment for purchase of a copy of a computer program for internal use by an end user as well as for resale to end users is taxable as a royalty under the applicable DTAA and would also fall within the ambit of a royalty under the broader definition in the ITL. Thus the Taxpayers would be required to withhold tax on the payments made.

Transfer of shares of a foreign company that indirectly held Indian assets not taxable in India

In a landmark judgment, the Supreme Court (SC) held that gains arising to a foreign company from the transfer of shares of a foreign holding company, which indirectly held underlying Indian assets (indirect transfer), were not taxable in India.

This decision is a significant development in the taxation of international transactions and on the judicial approach to tax avoidance. This case is, perhaps, the first in the world where the issue of taxation on indirect transfer of shares was being litigated before a country’s highest judicial forum. The principles emanating from this ruling could, therefore, have ramifications beyond India.

Background and facts

In a business acquisition deal of 1992, Hong Kong based Hutchinson Group acquired, directly and indirectly, a controlling interest in an Indian company, Hutch Essar Limited (HEL), which was carrying on telecom operations in India. Hutchinson Telecommunications International (Cayman) Holdings Limited (HTIL), a Hutchinson Group company, held shares of CGP Investments (Holdings) Limited (CGP Investments), a company based in Cayman Islands. And through CGP Investments and various Mauritius entities, the Group held the controlling interest in the Indian company, HEL.

On HTIL expressing its willingness to sell its equity interests in HEL, in 2007, Vodafone NL, a Dutch entity, made a bid to acquire share capital of CGP Investments and entered into an agreement for acquisition of Indian interests of HTIL. On Vodafone NL’s application, the Indian foreign investment regulatory authority accorded approval for direct acquisition and Vodafone NL made the payment of consideration to HTIL for acquiring the entire share capital of CGP Investments.

In connection with the transaction, the Indian Tax Authority issued a notice to Vodafone NL enquiring as to why Vodafone NL should not be treated as a ‘taxpayer-in-default’ for not withholding taxes on its payments to HTIL. Subsequently, the issues on the validity of the notice and the jurisdiction of the Tax Authority to tax the transaction were litigated by both the parties before various judicial fora viz., the High Court and the SC. Aggrieved by the adverse decision of the HC on the jurisdiction issue, Vodafone NL once again approached the SC.

Ruling of the SC

An issue that was extensively argued before the SC was that of the concept of tax avoidance. The SC reiterated that while tax planning is legitimate, structures that are subterfuges or colorable devices need not be respected for tax purposes.

The SC noted the following:

  • Tax Authority cannot tax a subject without a specific provision in support and every taxpayer is entitled to arrange its affairs so that its taxes are as low as possible. Genuine tax planning is not abandoned. If, in a holding structure, there is an abuse of organization form without any reasonable business purpose or an entity has been interposed only to avoid tax, the Tax Authority may disregard such form/inter-positioning. However, the burden is on the Tax Authority to establish the abuse.
  • Every strategic foreign direct investment coming to India should be looked at in a holistic manner, applying a ‘look at’ principle, where the entire transactions as a whole needs to be looked at, without dissecting it.
  • The source rule provision in the Indian Tax Laws (ITL) is not a ‘look through’ provision. Under the source rules in the ITL, the essential condition for triggering capital gains taxation is that the capital asset, which is being transferred, must be situated in India. In the absence of ‘look through’ provision, an indirect transfer would not be taxable in India.

    A legal fiction has limited scope and cannot be expanded by giving it a purposive interpretation. The inclusion of an anti-abuse provision such as ‘look through’ or ‘limitation of benefits’ in the statute/tax treaty is a matter of national economic policy and in the absence of the same, it cannot be implied. The Tax Residency Certificate (TRC) issued by the Mauritius Tax Authority can be accepted as evidence for recognizing the status of residents as well as the beneficial ownership for applying the tax treaty.

    However, an existence of a TRC does not prevent an enquiry into a tax fraud, where an overseas entity is used by an Indian resident for round-tripping or any other illegal activities and for determining the role of the Mauritius entity in the entire transaction. Parties are free to choose whatever lawful structure that suit their business and commercial purpose.

    One of the tests to examine the genuineness of the structure is the ‘timing test’ i.e., the timing of the incorporation of the entities or transfer of the shares etc. In the present case, HTIL operated from 1994 and only in 2007, was the divestment made. Furthermore, the transactions were genuine and not under any fraudulent or dubious method to avoid capital gains tax. As per the Indian Company Law, situs of shares would be where the company is incorporated and where its shares can be transferred. Therefore, situs of CGP Investments is situated in Cayman Islands.

    On a transfer made in Cayman Islands, the situs would not shift to India by reason of its underlying assets being situated in India. A controlling interest is an incident of ownership of shares of the company and is not an identifiable or distinct capital asset independent of the holding of shares.

    So the controlling interest which stood transferred to Vodafone NL from HTIL cannot be dissected so as to percolate and be treated as transfer of controlling interest of downstream entities in India. There is no liability to withhold tax in a transfer of capital assets between two non-resident entities situated outside India, when there is no income chargeable to tax in India. Vodafone NL also cannot be regarded as a representative taxpayer on behalf of the non-resident as there is no transfer of a capital asset situated in India.

The decision of the SC is a milestone development in the taxation of international transactions and on the judicial approach to tax avoidance. It is fairly well-established that if the acquisition involved a direct transfer of shares of an Indian company, the same would trigger taxable capital gains under the ITL.

However, there have not been precedents in the past where the Tax Authority has attempted to tax capital gains arising on transfer of shares of a foreign holding company of an Indian subsidiary on the basis that such transfer involves an indirect transfer of the underlying Indian assets.

The ruling of the SC would set a binding precedent for other similar transactions, as well as for those transactions which are currently being investigated by the Tax Authority or are in various stages of litigation. It could also be of relevance in shaping India’s tax policies on international taxation and tax avoidance in the future.

The ruling also acknowledges that use of holding companies and investment structures as well as offshore financial centers, can often be driven by business/commercial purposes and the use of these elements in international structures, does not imply tax avoidance.


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