The Income Tax Appellate Tribunal (ITAT) in Delhi recently held that payments by a resident to a non-resident, for import of shrink-wrapped software, are taxable as royalty income in the hands of the non-resident.
Ruling in (1) Gracemac Corporation (2) Microsoft Corporation, (3) Microsoft Regional Sales Corporation v Assistant Director of Income-Tax, International Tax Division, New Delhi the tribunal held that as there are copyright restrictions on such software, earnings from it cannot be treated as business income.
While Gracemac – a US-based subsidiary of Microsoft – owns exclusive rights to manufacture and distribute Microsoft products, Microsoft Regional Service Corporation (MRSC) distributes Microsoft’s products in India. They are connected through Singapore-based Microsoft Operations (MO), which has a non-exclusive licence to manufacture and distribute the products.
The question before the ITAT was whether earnings from the sale of “off the shelf software products” by US-based non-resident companies to independent Indian distributors were taxable within the meaning of explanation 2 to section 9(1)(vi) of the Income Tax Act, 1961, as well as under article 12 of the India-USA double taxation avoidance agreement (DTAA).
Microsoft argued that its earnings are “business income”, which is exempt from tax in India under the DTAA. However, the assessing officer (AO) said that licensing of software does not lead to business income and so the earnings were not exempt. Upholding the AO’s decision the Commissioner of Income Tax (Appeals) expanded the assessment to include the entire consideration received by MRSC from Indian distributors, holding that MRSC and MO were mere legal façades.
While making its decision the ITAT presented an unusual view on tax treaties: the provisions of tax treaties do not always override those of domestic laws; when a provision in the domestic tax law is incorporated after the signing of a DTAA, the former will override the latter.
This ruling has considerable consequences for India’s software industry. The tax on royalty income is 10% of the gross payment and the entity responsible for “sending” the software into India is liable to pay this tax. A challenge to the ruling is being considered.
The update of court judgments is compiled by Bhasin & Co, Advocates, a corporate law firm based in New Delhi. The authors can be contacted at [email protected] Readers should not act on the basis of this information without seeking professional legal advice.