Global Tax Alert | 4 December 2013
India's Delhi High Court distinguishes copyright rights and copyrighted article in software transactions
This Tax Alert summarizes a recent decision of India's Delhi High Court (HC) in the case of Infrasoft Ltd.1 (Taxpayer). The issue addressed was whether consideration received by the Taxpayer for the grant of a license for use of customized software is a “royalty” within the meaning of India-US Double Taxation Avoidance Agreement (treaty). The HC held that the license granted by the Taxpayer is limited to those necessary to enable the licensee to operate the program. Hence, there is no transfer of a copyright or right to use the copyright, but merely the transfer of a copyrighted article. Copyright or right to use copyright is distinguishable from the sale consideration paid for a “copyrighted” article. The consideration is for the purchase of goods and is not royalty under the treaty.
As per the India-US treaty, the relevant clause defines “royalty,” among others, to include payments of any kind received as consideration for the use of, or the right to use, any copyright of a literary, artistic or scientific work.
Under the Indian Tax Laws (ITL), the relevant clause regarding royalty includes consideration for the transfer of all or any rights (including granting of any license) in respect of the copyright of a literary, artistic or scientific work. Further, retroactive amendments to the ITL introduced by way of explanations in 2012 stated that the transfer of all or any rights in respect of any right, property or information includes and has always included the transfer of all or any right to use the computer software (including granting of a license), irrespective of the medium through which such right is transferred.
The Taxpayer is a US resident and an international software company engaged in the business of developing and manufacturing civil engineering software.
The Taxpayer has a branch in India which imports the software package in the form of floppy disks or CDs depending on the requirements of their customers. One such software is used by private consultants for the design of highways, railways, airports, ports, and mines. The Taxpayer customizes the software depending on the country-wise, project-wise and customer specific requirements. This software is then licensed to its Indian customer. The branch of the Taxpayer in India performs services involving interface to peripheral installation and training.
The Taxpayer filed its return of income in India declaring a loss on account of its branch operations. The Tax Authority (TA) however assessed the total receipts from Indian customers as “royalty.” On appeal, the First Appellate Authority (FAA) upheld the assessment of software receipts as royalty. On further appeal before the Tribunal, the contention of the Taxpayer that its receipts were on account of the sale of copyrighted article and, hence, constituted income from sales was accepted.
The TA appealed before the HC.
The HC held that what has been transferred is not copyright or the right to use copyright but a limited right to use the copyrighted material. This does not give rise to any royalty income.
Beneficial provisions of the treaty precludes applicability of ITL
The Supreme Court's (SC) decision in the case of Union of India v. Azadi Bachao Andolan2 held that the provisions of a treaty would apply if they are more beneficial to the Taxpayer. Thus, the provisions of a treaty would prevail over the provisions of the ITL, even if they are inconsistent with the provisions of the ITL to the Taxpayer's advantage. In the present case, the Taxpayer is a resident of the US with which India has signed a treaty. Hence, the provisions of the treaty need to be examined to determine taxability of the income in the hands of the Taxpayer.
The TA and the FAA had treated the receipts as “royalty” on the basis that there was transfer of some rights (including the granting of a license) in respect of the copyright and, hence, constituted royalty under the ITL. As the Taxpayer is governed by the provisions of the treaty, the onerous provisions of the ITL should not have been applied.
Relevant provisions of the treaty that applies to the Taxpayer
The Taxpayer has a branch office in India which is a Permanent Establishment (PE) of the Taxpayer as defined in Article 5 of the treaty. Therefore, profits attributable to the PE are taxable in India as business profits in accordance with Article 7 of the treaty.
What is thus required to be examined is whether income from licensing of software to Indian customers is a royalty as covered by Article 12 of the treaty. If not, it would be taxable as business profits in accordance with Article 7 of the treaty.
To be taxable as royalty income under the treaty, the income of the Taxpayer should have been generated by the “use of or the right to use of” any copyright.
Distinction between copyright and copyrighted article
A distinction has to be made between the acquisition of a “copyright right” and a “copyrighted article.” Copyright is distinct from the material object, copyrighted. Copyright is an intangible incorporeal right in the nature of a privilege, quite independent of any material substance. Copyright or even right to use copyright is distinguishable from the sale consideration paid for a “copyrighted” article. This sale consideration is for the purchase of goods and is not royalty.
The transfer of rights in or over copyright or the conferment of the right of use of copyright implies that the customer should acquire rights either in entirety or partially, co-extensive with the owner who divests himself of the copyrights that he possesses.
A non-exclusive and non-transferable license enabling the use of a copyrighted product cannot be construed as an authority to enjoy any or all of the enumerated rights ingrained in the treaty. The enjoyment of some or all the rights which the copyright owner has is necessary to invoke the royalty definition. The parting of intellectual property rights inherent in and attached to the software product in favor of the customer triggers royalty characterization under the treaty.
Merely authorizing or enabling a customer to have the benefit of data or instructions contained therein without any further right to deal with them independently does not amount to transfer of rights in relation to copyright.
CDs embodying software are goods
The SC in the Tata Consultancy case has held that computer programs are the product of an intellectual process. But once implanted in a medium they are widely distributed to computer owners. The fact that a computer program may be copyrightable as intellectual property does not alter the fact that once it is in the form of a floppy disc or other medium, the program is tangible, moveable and available in the marketplace. The copyright in that program may remain with the originator of the program. But the moment copies are made and marketed, it becomes goods, which are susceptible to sales tax. There is no difference between a sale of a software program on a CD/floppy disc from a sale of music on a cassette/CD or a sale of a film on a video cassette/CD. In all such cases, though the intellectual property has been incorporated on a media for the purposes of transfer, the transaction involves sale of goods.
The form of delivery of the software-magnetic tape or electronic transfer via modem is of no relevance. One cannot escape from the fact that software, recorded in physical form, becomes inextricably intertwined with, or part and parcel of the corporeal object upon which it is recorded, be that a disc, tape, hard drive or other device. That the information, knowledge, story or idea, physically manifested in recorded form, can be transferred from one medium to another and this feature does not affect the proposition that the disc is tangible. Once the “information” or “knowledge” is transformed into physical existence and recorded in physical form, it is corporeal property.
Judicial precedents of relevance
The issue about taxation of software was addressed in detail by the Special Bench (SB) of the Delhi Tribunal in the case of Motorola Inc v. Dy. CIT and Dy. CIT v. Nokia.3 The Tribunal held that the question of whether there was a transfer of a copyright right or only of a copyrighted article must be determined taking into account all the facts and circumstances of the case and the benefits and burden of ownership which have been transferred. The appeal filed by the TA against the SB decision was dismissed by the Delhi HC in the case of Nokia Networks OY.4 The HC approved the findings of the SB that the copyright is distinct from the material object viz., copyrighted article. Copyright is an intangible incorporeal right in the nature of a privilege, quite independent of any material substance. The transfer of the ownership of a physical thing in which the copyright exists gives to the purchaser the right to do with it (the physical thing) whatever the purchaser pleases, except the right to make copies and issue them to the public. Just because one has the copyrighted article, it does not follow that one has also the copyright in it.
In the case of Ericsson,5 one issue that the Delhi HC was considering was whether consideration for supply of the software was payment by way of royalty hence assessable both under the ITL and the India-Sweden treaty. The HC, relying on the SC decision in case of Tata Consultancy Service v. State of Andhra Pradesh,6 held that software incorporated on a media would be goods.
The Authority for Advance Rulings (AAR), in the case of Dassault Systems K K, In re,7 negated TA's contention that the right of permitting the licensee to make a copy of the program by loading the program on the hard disk of the computer amounted to assignment of a right in the copyright. The AAR approved the reasoning of the SB in the case of Motorola (supra).
The HC did not agree with the Karnataka HC ruling in the case of Samsung Electronics Co. Ltd.8 wherein it was held that a right to make a copy of the software for the purpose of storing it in the hard disk of the designated computer and taking backup copy amounts to use of copyright and, hence, is a royalty transaction. According to the HC, the right to make such a copy for the purpose of storage for its own use was only incidental to the facility extended to make use of the copyrighted product for the internal business purpose of the customer. This process was necessary to make the program functional and to have access to it and is integral to the use of the copyrighted product. This is qualitatively different from the right contemplated by the royalty provision as it does not amount to acquiring a copyright in the software.
Application to the fact pattern of the Taxpayer
From the Licensing Software Agreement (LSA) entered into between the Taxpayer and the customers, the following are noted:
- • The license is non-exclusive, non-transferable and the software has to be used in accordance with the terms of the LSA.
- • The customers are permitted to make only one copy of the software and associated support information for backup purposes.
- • All copies of the software are the exclusive property of the Taxpayer.
- • Without the consent of the Taxpayer, the software cannot be loaned, rented, sold, sublicensed or transferred to any third party or used by any parent, subsidiary or affiliated entity of the customer or used for the operation of a service bureau or for data processing.
- • The customer is further restricted from making copies, decompile, disassemble or reverse-engineer the software without the Taxpayer's written consent.
- • Upon termination of the LSA for any reason, the customer shall return the software including the supporting information and the license authorization device to the Taxpayer.
The license granted by the Taxpayer is limited to those necessary to enable the licensee to operate the program. The rights transferred are specific to the nature of the computer programs. Copying the program onto the computer's hard drive or random access memory or making an archival copy is an essential step in utilizing the program. Therefore rights in relation to these acts of copying, where they do nothing more than enabling the effective operation of the program by the user, should be disregarded in analyzing the character of the transaction for tax purpose. Payments for these types of transactions should be dealt with as business income in accordance with Article 7.
The payment is, therefore, for a copyrighted article and represents the purchase price of an article and cannot be considered as a royalty either under the ITL, independent of the 2012 amendment or under the treaty. The effect of the 2012 amendments in the ITL has not been examined because the Taxpayer is covered by the treaty, the provisions of which are more beneficial.
Hence, the consideration is neither towards the transfer of copyright nor towards the right to use the copyright but for giving a limited right to use the “copyrighted article.”
Characterization of computer software transactions has been a contentious issue with the Indian Tax Authority over the last several years. While the TA is of the view that such payments should be classified as “royalty,” regardless of the nature and extent of rights granted to the end user or the purpose for which the end user uses the software, the taxpayers have generally taken a view that where an end user does not obtain rights that enable commercial exploitation of the intellectual property in the computer software, the transaction should be classified as generating “business profits.”
The Delhi HC, while affirming the distinction between “copyrighted right” and “copyrighted article,” has reinforced the principle that merely authorizing or enabling a customer to have the benefit of data or instructions in the software without any further right to deal with them independently does not amount to transfer of rights in relation to copyright or conferment of the right of using the copyright. The enjoyment of some or all the rights which the copyright owner has is necessary to invoke the royalty definition.
The Delhi HC has also expressly stated that it does not agree with the decision of the Karnataka HC in the case of Samsung Electronics Co. Ltd (Supra) which had held that a right to make a copy of the software for the purpose of storage and backup copy amounts to copyright. Hence, the payment made for the grant of such license constitutes royalty.
This well-reasoned decision of the Delhi HC is a positive development for taxpayers facing challenges from the TA on classification of income in respect of software transactions.
1. [ITA No. 1034/2009].
2. [(2003) 263 ITR 706].
3. [(2005) 147 Taxmann 39 (Del)]. Please refer EY Tax Alert of June 2005 on Tribunal order on Motorola/Ericsson/Nokia v. DCIT.
4. See EY Tax Alert, Delhi HC rules that distinction between copyrighted article and copyright right still relevant under DTAA despite retrospective amendment to domestic tax law definition of royalty, dated 14 September 2012.
5. See EY Tax Alert, Delhi HC ruling on 'business connection' and tax treatment of payments for software bundled with hardware, dated 28 December 2011.
6. [(2004) 271 ITR 401 (SC)].
7. [(2010) 322 ITR 125 (AAR)]. See EY Tax Alert, AAR rules on taxability of software payments, dated 2 February 2010.
8. [(2012) 345 ITR 494 (Kar)]. See EY Tax Alert, Karnataka HC ruling characterizes payment for shrink wrapped computer program as royalty, dated 30 November 2011.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India), Mumbai
- • Sudhir Kapadia
+91 22 6192 0900
Ernst & Young LLP (India), Hyderabad
- • Jayesh Sanghvi
+91 40 6736 2078
Ernst & Young LLP (United Kingdom), Indian Tax Desk, London
- • Nachiket Deo
+44 20 778 30862
Ernst & Young Solutions LLP, Indian Tax Desk, Singapore
- • Gagan Malik
+65 6309 8524
Ernst & Young LLP, Indian Tax Desk, New York
- • Tejas Mody
+1 212 773 4496
EYG no. CM4015