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Update: Supreme Court holds that payment to non-residents for imported software cannot be characterised as ‘royalty’

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The Supreme Court (SC) has recently issued a landmark ruling on March 2, 2021 confirming that amounts paid by resident Indian end-users / distributors to non-resident computer software manufacturers / suppliers, as consideration for resale / use of computer software through End-user Licensing Agreements (EULA) / distribution agreements, is not payment of royalty for use of copyright in the computer software, and that the same does not give rise to any income taxable in India. Accordingly, the SC concluded that the person referred to in S.195 of the Income-tax Act, 1961 (IT Act) is not liable to withhold tax.


The issue of software-royalty has been contested before various courts in the past. The income tax department has broadly characterised payments made to non-residents for software purchase as royalty. The Revenue has averred that an Indian entity is granted rights to exploit the intellectual property or copyright in the software and consequently payment for such purchases amounts to royalty income, thereby subjecting such income to tax withholding.

However, taxpayers have persistently contended that these transactions are in the nature of sale and do not entail licensing of any copyright. Non-resident owner retains proprietary rights in the software and the use of software by the Indian company is limited to making backup copy and redistribution. Accordingly, it has been argued that payment received for sale of computer software is business income and in the absence of a business presence or permanent establishment of the seller in India, such business income is outside the ambit of taxation.

A total of 86 appeals, divided into the following 4 categories were heard by the Supreme Court over a week:

  • Category 1: Software purchased directly by an end-user from a non-resident supplier.
  • Category 2: Software purchased from a non-resident supplier by an Indian distributor and resold to Indian end-users;
  • Category 3: Software purchased from a non-resident supplier by a non-resident distributor and resold to Indian distributors or end-users
  • Category 4: Software sold as integrated hardware unit by non-resident suppliers to Indian distributors or end-users.

Decision of the SC:

The SC upheld the principle that once Double Taxation Avoidance Agreements (DTAA) applies, provisions of IT Act will apply only to the extent they are more beneficial to taxpayers. Further, explanation 4 to S.90 of IT Act stipulates that where a term is defined in DTAA, the definition contained therein has to be applied. It is only where there is no such definition that the definition in IT Act can be applied. The SC also laid down that machinery provisions contained in S.195 of the Act, regarding Tax Deduction at Source (TDS), are inextricably linked with the charging sections of IT Act. Resultantly, TDS will be deducted only if non-resident is liable to pay tax under the charging provision contained in S. 9 read with S. 4 of IT Act, read with DTAA.

The SC did an in-depth analysis of provisions under Copyright Act, 1957 and explained that grant of any interest in a right to the licensee, by way of a license, may entail royalty for parting with such interest. However, making copies or adaptation of a computer programme in order to utilise the said computer programme for the purpose for which it was supplied, or to make back-up copies as a temporary protection against loss, destruction or damage so as to be able to utilise the computer programme for the purpose for which it was supplied, does not constitute an act of infringement of copyright.

Further, on examination of EULA/ distribution agreement, the SC found that the distributor was granted only a non-exclusive, non-transferable license to resell the computer software. There was no further right to sub-license or transfer, nor the right to reverse-engineer, modify or reproduce in any manner otherwise than permitted by the licence to the end-user. The SC observed that in all the cases, the license that was granted was not a ‘licence’ that transfers an interest in all or any of the copyright rights but is a ‘licence’ that imposes restrictions or conditions on the use of computer software.

The SC therefore held that “what is “licensed” by the foreign, non-resident supplier to the distributor and resold to the resident end-user, or directly supplied to the resident end-user, is in fact sale of a physical object which contains an embedded computer programme, and is therefore, a sale of goods”.

A non-exclusive, non-transferable licence, merely enabling the use of a copyrighted product, is in the nature of restrictive condition which is ancillary to such use, and cannot be construed as a licence to enjoy all or any of the enumerated rights mentioned in S.14 of the Copyright Act, or create any interest in any such rights so as to attract S. 30 of the Copyright Act.

The SC concluded by saying that the amount paid by resident Indian end-users/distributors to non-resident computer software manufacturers/ suppliers, as consideration for resale/use of computer software through EULAs/distribution agreements, is not payment of royalty for use of copyright in computer software, and the same does not give rise to income taxable in India. As a result, persons referred to in S.195 of IT Act were not liable to deduct TDS under S.195 of the Act. The same will apply to all four categories of cases enumerated above.

Next Steps:

This ruling comes as a relief to many taxpayers, who were caught up in the Indian tax net and potential protracted litigation merely for supplying shrink-wrapped / off-the-shelf computer software to Indian customers for end-use / distribution, without giving them any right in the code / copyright of the software. This ruling now brings relief to non-resident tax payers from offering such income to tax in India as royalty and resident tax payers from withholding taxes while making such payments (subject to beneficial provisions of tax treaties).

However, the Judgement is likely to impact several technology companies and distributors / re-sellers in India:

  1. Application for Refund: The taxpayers would need to revisit their positions for royalties paid in the past and apply for refunds, wherever possible and applicable. While the claim of refund can be substantiated basis the Judgement, the taxpayers may now have to assess applicability of Equalization Levy (EL) on such transactions.
  2. Applicability of EL: While the Judgement settles the issue on characterisation as royalty and taxability under the provisions of IT Act, taxpayers will now be posed with another question regarding the applicability of EL on such transactions. The issue is further aggravated by the clarification proposed in the Finance Bill, 2021 (Bill), which clarifies that if the consideration received for sale of software is not taxable as royalty under the IT Act read with the relevant tax treaty, then such consideration could be taxable under EL provisions. As a result, taxpayers would be claiming refund of tax paid on royalty on one hand, while paying / contesting applicability of EL on the other hand.
  3. Reviewing pending litigations: Taxpayers may also consider to review their pending litigations where they are relying on treaties based on the OECD Model. The principles laid down by the SC on interpretation of tax treaties and on the sanctity of the Commentary on OECD Model, they can now further bolster their positions and strengthen their case. It is not unusual for several divergent rulings by different tax tribunals on international tax cases and this could be a good reason to reassess approaches in those cases.
  4. Impact on Indian e-commerce companies with Foreign Direct Investment (FDI): The Court has relied on cases under Customs law, Copyright Act among other laws to characterise the transaction as royalty. In this regard, Indian entities with foreign investment engaged in e-commerce with respect to ‘sale of goods’ may want to re-check their compliance with FDI rules. Typically, e-commerce in services is not an issue under FDI rules and if an entity is dealing only with licensing or providing the right to use with respect to software in wholly digital format, it is unlikely to face any problems. However, if the entity is selling the same software on a CD format or tangible format, then whether it would amount to e-commerce in goods as an inventory model is something companies should assess and verify at the soonest as there are restrictions around the same.

We hope you will find the update useful.

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