Supreme Court’s software verdict: Impact and way forward

Over the last two decades, the Indian Revenue Authorities (IRA) have asserted that payments for  software supplies, imported in whatever form (off the shelf, licensed or embedded in hardware), qualify as ‘royalty’ irrespective of the nature of rights acquired by the Indian end users and re-sellers. 

Following the internationally accepted principles and interpretation of the double tax treaties, the Supreme Court has now ruled that purchase/license of a copy of a software does not confer any rights in the underlying IPR or copyright to the user and hence, payment for purchase/license of such copyrighted article/product shall not fall within the definition of ‘royalty’. The apex court has also observed that unilateral measures by India by amending the domestic tax laws, do not influence the beneficial interpretation under the double tax treaties. Thus, while cross border software transactions will fall in the net of “royalties” under the domestic law, the apex court ruling will unequivocally apply to cases involving double tax treaties.

Some key fall outs from the ruling which require careful evaluation both by foreign sellers as well as importers of software are:

• The appeals pending before various forums where IRA have made similar assertions should be decided in favor of the tax payors. Non-residents will have to ensure that they meet the eligibility criteria for treaty entitlement, i.e., fulfilment of the beneficial ownership test with a valid evidence of a tax domicile. For open years including going forward, the IRA may now carefully evaluate potential permanent establishment (PE) of the non-residents in India, particularly where related parties are appointed as distributors or re-sellers in India.
• Non-resident sellers who have claimed refunds in their tax returns should now be able to get the said refunds processed. Given that the verdict of the Supreme Court is now the law of the land, besides, for matters in litigation, one of the possible options that can be explored is to also file a rectification application before the IRA seeking rectification of the initial assessment order. What will also be relevant is to revisit the credit for claimed in domicile jurisdiction for tax withheld in India.
• In cases where a non-resident seller did not claim refund of taxes deducted by the Indian importer (under net-off tax contracts) and consequently, did not file any tax return, the option of approaching the CBDT^[2] can be explored for filing belated tax returns to lodge such claim.
• Where withholding taxes have been borne by the Indian importer on grossed up basis, law provides for a mechanism to claim such taxes as refund by the Indian party. Alternatively, non-residents may also be able to claim a refund which they may contractually need to pass on to the Indian importers.
• Though the ruling is in favor of the taxpayers, cross border transactions of similar nature (where software is supplied through a digital platform by the non-resident) may now fall within the ambit of the new Equalisation Levy (EL) regime, which intends to levy two percent charge on India revenues earned on online supply of goods or services. Considering that EL is part of the Finance Act and not the Income Tax Act, foreign tax credit against EL paid in India may not be straightforward.

The landscape of disputes on cross border transactions broadly revolves around three key areas, viz. existence of PE, taxability of payments as ‘royalties’ and ‘fee for technical services’. In the past few years, the Supreme Court has laid down few important international tax principles on existence of a PE^[3]. With the principles laid down in the software ruling, some of which have a wide implication such as those relating to treaty override and retrospective application of withholding provisions, there would be a much greater certainty even in relation to other disputes concerning international tax matters which still need resolution. 

Rapid technological developments over the years have evolved new business models for software delivery including digitally delivered software or as a part of a cloud solution, software-as-a-service and platform-as-a-service. The applicability of the apex court ruling on such new models will be analyzed in greater detail both by taxpayers as well as the IRA, considering the nature and extent of rights being granted to the end-users. The present ruling would go a long way to assist in determining taxation of these models.

(Arvind Rajan, senior tax professional, EY India also contributed to this article).