SOFTWARE requires to be used for almost everything from the ubiquitous mobile phone to the space Programme. There are of course different softwares- some of them custom made, some generic. Some of these softwares are horrendously expensive while there are others which are comparatively cheap but without which no application can be run. The windows software of Microsoft is an example. Most of the PCs will not run without the windows software. Although the individual price of such software may not be much but overall, the revenue generated will be considerable in view of the volume of users.

Software Industry can be divided between generic software products and packages and customized softwares. The real moolah is in the development of software products. Even in the customized software, there are various steps involved like conceptualization, high-level design, coding, testing and support and the value addition is also more in the first levels. Without taking anything away from the achievement of the Indian software sector, it has traditionally been involved in the customized software and in the low-level design, coding and maintenance although there has been a move away in the recent times towards the higher end of the value chain. It is worth remembering that the breakthrough for the Indian software industry also came from fixing the Y2K bugs. The Indian software industry is also largely driven by the export sector, which implies that the huge domestic demand is catered to mostly by imports. The success of Indian software industry in developing products has been only moderate with some success in the field of accounting software and the like. Many of the MNCs have also opened development centers in India in the subsidiary mode, which allow them to avail of the tax exemptions granted to this sector.

Information relating to the Import -export gap of the software sector is hard to come by. But a study done by the OECD Working Party on the Information Economy titled- "The information and Communication Technology sector in India: Performance, Growth and Key challenges”, gives a Table of Emerging Economies' Trade in ICT goods over the decade 1997-2007 and from the same, it is observed that the gap between imports and exports of this sector which also includes software, has only increased.

Thus imports for the ICT sector is ten times the export of this sector. The moot point is that there is considerable revenue involved in the business of software and Taxation authorities will obviously have an eye for this sector.

Unfortunately, however, there is no clarity on the taxation of imported software although it has to be admitted that because of the peculiarities of this sector, the taxation of software is a debatable area in other parts of the world as well.

With the advent of e-commerce propelled by various software applications and the changed method of doing business, the OECD constituted a Technical Advisory Group (TAG) to examine whether in the changed circumstances, the concept of PE, which was the cornerstone of international business taxation, still had relevance. It also studied some common characterization issues that such e-commerce posed and tried to come up with an agreed response. No prize for guessing that in TAG's view most of them were business income, which under the rules of the game, can be taxed in the source country only if there is a PE thereby overlooking the main point that in the new mode of doing business facilitated by the e-com, it is increasingly not necessary to create a PE. India was also represented in the deliberations and voiced its concerns over the decreasing taxation rights for the source countries. Ultimately, OECD concluded that the conventional scheme of business taxation was still valid. The cornerstone of such assertion was that the mode of delivery should not have any effect on the right of taxation of the source and residence countries.

The TAG had examined 28 categories of common e-com transactions and gave its recommendations on the characterization issues arising out of the same. This included questions on taxation of software. The Indian Government also constituted a High Powered Group (HPG), which included representatives from the private sector. The HPG examined the recommendations of the TAG. While the TAG view was based mostly on practical considerations, the HPC came up with conclusions based primarily on a legalistic view and its conclusions were in many cases diametrically opposite to the TAG view. Out of the 28 categories, the HPC disagreed with 13 of them and most of these related to taxation of software.

Notwithstanding the lack of consensus, OECD went ahead with the amendments to its commentary on Article 12 and the same are now contained in paragraphs 12 to 18. It reiterates the TAG view and in most of the situations of software taxation, the characterization is business income. India is not a member of the OECD and the OECD commentary is not binding on it. Nevertheless, in the absence of any official position or clarification on emerging issues including software taxation, Tribunals have been taking recourse to the OECD commentary. However, consequent to India becoming an observer in the OECD in late 2006, India was required to state its position on the OECD model as also on the commentary. India's official position thus came to be articulated in 2007 and finds place in the 2008 version of the OECD MC. India has expressed reservations on almost all of the positions of the OECD in respect of taxation of software.

Software taxation is thus a vexed issue in India. At the outset, it may be noted that software is an intellectual property. Income from software can be taxed either as some form of royalty or as fee for technical service or as business income. In so far as cross border taxation of software is concerned, most of the developed countries would like to see the same to be taxed as business income since in such event only the country of residence will have the right to tax if the business is organized in a way as not to create a PE in the country of source. In so far as most OECD countries are concerned, taxation of software even as Royalty, would not create much of a problem since according to the OECD model, it is only the country of residence that has the right to tax royalty. Be that as it may, the real problem arises when one of the parties is not a member of the OECD in which event, if significant revenue is involved, there will be effort to tax income from software either as royalty or technical services in the knowledge that business can now be organized in a way as not to create a PE and the source country can thereby get at least a limited right of taxation over the huge tax pie. The issue can also be looked at from another angle. For the payments made by the Indian entities for the purchase or use of software, the money that is going out of India, will be in most cases tax-deductible expenses. There will thus be erosion of the tax base in India and the Revenue will understandably try to recoup a part of the same. However, the rules of engagement that prevails now is weighed against the source states, OECD having so far refused to take into account the new realities and sticking to the old rules of engagement valid for the brick and mortar economy. The story of software taxation and the various disputes arising in India is thus the story of this tension arising out of this skewed distribution of the right of taxation. It is true that that the UN model does give a limited right of taxation of royalty to the source countries but the UN is not so nimble footed and does not have either the pelf or the paisa to impose its views in the world of taxation.

The issue of characterization of payment for software came up before the Income Tax Tribunal in a number of cases since under the domestic law; every payer is obliged to deduct tax at source in case of payment made to a non-resident in case there is any income element involved. So, most of the cases laws were regarding the liability of such companies to deduct tax at source. It is in that context that the Tribunal examined the taxability of payment made for software, particularly the so-called shrink-wrapped software. Incidentally, shrink wrapped software is the plastic coating in which the CD-Rom containing the software used to come. One had to take off the coating before being able to install and use the software. Once installed, the user had to accept the licensing conditions before use. Currently, with the spread of Internet, the use of shrink-wrap also has almost gone out of fashion. It is also easier for the vendor to monitor the conditions if the software is directly down loaded and there may be possibility of the software company being able to remotely disable the application. In a series of decisions including a special Bench decision, the Tribunal took the view that sale of off –the –shelf software amounted to business income. The Authority of Advance Ruling in a couple of cases had held otherwise but in a later case of Dassault Systems K K (2010-TII-02-ARA-INTL), the authority also took the same view. However, recently, the Delhi Bench of the Tribunal in the case of Microsoft corporation (2010-TII-141-ITAT-DEL-INTL), examined the issue of taxability in the context of the liability of Microsoft and its associated concerns selling the Microsoft software in India and came up with a different decision. The controversy relating to software taxation thus has come back to the fore once again.

Very briefly, the facts of the case were as follows. Up until 1998, Microsoft Corporation used to enter into agreements with Original Equipment Manufacturers (OEM) and Indian Distributors for sale of the so-called shrink-wrapped software. The Income from the OEM was being shown as royalty and offered to tax as Royalty by Microsoft itself. Subsequently, the business model was changed and through a complex process of restructuring, it was now a Singapore based subsidiary that was made to hold the IPR and received royalties from another Singapore based subsidiary which used to manufacture the software. This company then had a distribution agreement with another Singapore based company which had the distribution right over India and used to enter into agreement with the Indian distributors who in turn sold the products to end users who had to enter into the usual End user Licence Agreement (EULA) with the subsidiary having the IPR. There were a number of issues involved in the case including the taxation of income in the hands of various subsidiaries. We restrict our discussion only to the issue of characterization of income. No tax was offered by different entities of the Microsoft group as it was claimed that the income from the transaction of sale of software was only business income not chargeable to tax in the absence of a PE. It was claimed that the consideration received was towards the sale of software products which were copyrighted articles as opposed to copyrights. Although the EULA used to mention that the product is licensed and not sold, this was allegedly to protect against piracy and other abuse. It was argued that this was similar to the restrictions and limitations imposed by the author of a book. Reliance was placed on a number of decided cases where the Indian Tribunals did accept the distinction between a copyright and copyrighted article.

The tax department has however been consistently taking the view that when software is licensed, the income therefrom is royalty whether it be of shrink-wrapped variety or otherwise. Apart from the usual arguments and counter arguments, for the first time, an interesting distinction was brought out by the Department's counsel between a book or music CD and a computer programme. These were as follows:

Therefore, it was argued that even though the term ‘copyrighted article' may be aptly used for a book or music CD , it is a misnomer in the case of software where one or more rights in copyright have necessarily to be transferred to make it workable. It was argued that a dumb CD without right of reproduction is of no value to the end user unlike a book or music CD.

Amongst the various other arguments two interesting ones may also be mentioned. It was argued that the word ‘copyrighted' has been defined under law lexicon which states that a copyright when registered becomes copyrighted. Hence, whether a computer programme is registered under the Copyright Act or not, it remains a copyright and cannot be given any other character by the mere change of noun into adjective. As for the argument that sale of software is like sale of goods, it was argued that sale postulates transfer of ownership. When only the use or right to use a property is given under a licence there cannot be any element of sale in the transaction. Another interesting alternate argument was that if computer software was to be regarded as a tangible property, it will constitute equipment and license for user of equipment would constitute royalty.

In its ruling the Tribunal did not deliberate upon the equipment royalty angle having decided the issue in favour of the department. What is rather unusual in the judgement is the fact that the Tribunal relied on certain plaints filed by Microsoft in Courts in India for violation of copyright. These details were filed by the Revenue after the conclusion of the arguments and led the Tribunal to observe that Microsoft was blowing hot and cold at the same time. On the one hand, for taxation purposes, it was claimed that the product is an article on the other; they enforce their rights on the basis that unlicensed copy of software involves infringement of copyright.

The decision of the Tribunal has come in for a fair bit of criticism mostly on the ground that if a Bench seeks to depart from the other decisions of coordinate benches, the matter should normally have been referred to a larger Bench. The observation of the Tribunal that OECD MC has no binding value has also been questioned as also the observation that in case of a conflict between treaty and municipal law, the latter will prevail. This was perhaps in the context of interpreting Article 12(7) vis-à-vis the amended section 9 relating to the alleged extraterritorial nature of taxation in the case of one of the subsidiaries and is not exactly relevant for the basic issue of characterization.

The Tribunal has quoted from the Indo-US DTAA to arrive at its conclusion that the definition of royalty as appearing in explanation 2 to section 9(1) (vi) and paragraph 3 of the DTAA are identical. It quoted the definition as follows:

“The term “royalties' as used in this Article means:

(a) payments of any kind received as a consideration for the use of, or the right to use, any copyright or a literary, artistic, or scientific work, including cinematographic films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property which are contingent on the productivity, use or disposition thereof; …”

In fact the definition as per the DTAA is as follows:

“The term "royalties" as used in this Article means:

(a) payments of any kind received as a consideration for the use of, or the right to use any copyright of a literary, artistic, or scientific work, including cinematograph films or work on film, tape or other means of re-production for use in connection with radio or television broadcasting, any patent trademark, design or model plan, secret formula or process, or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property which are contingent on the productivity, use, or disposition thereof; …”

As an aside, I have seen at least one publication on India's double tax treaties where the definition has been wrongly quoted. It is therefore necessary to have the authentic copy of the DTAA. However, given the logic used in the judgement, it is doubtful that this difference in the definition of Royalty that exists between the domestic legislation and the Indo-US DTAA would have made any difference to the final outcome of the judgement. The logic used in the judgement seems to be that software is an IPR; that software is licensed rather than sold; that under the Indian Copyright Act making even a single copy of the software amounts to user of the software; that in practice even where the software is sold, the end user has to first copy the software on the hard disk and hence the payment partakes of the character of royalty. From a purely legalistic point of view, this conclusion may be correct but from a practical point of view, it may be difficult to endorse the view that the moment a retail user copies the software either directly through the internet or through a CD on to his hard disk, it amounts to use of a copyright triggering payment of royalty. From a policy perspective, the latest decision of the Tribunal should therefore prompt the policymakers to take a view which is practical and capable of implementation and which is in our best interest. In fact, pursuant to a report of the Emerging issues task force, there was discussion within the CBDT for the issue of a circular clarifying that sale of shrink-wrapped software would not constitute royalty. Ultimately, however, this could not be issued due to a lack of consensus. It is high time that the issue is debated once again thoroughly within the CBDT and it comes out with a clarification as to the various situations involving software taxation in India. Till such time, we have to wait and see what the next judicial decision will be.