COMPUTER software has been a fertile ground for litigation throughout the world. Software comes in different forms, sometimes bundled, sometimes customised, sometimes stand alone, but one thing is certain, hardware is useless without software. In so far as taxation of software is concerned, the major area of controversy is characterisation- is it a good or is it a payment for some intellectual property that can be classified as royalty or is it a service provided by the supplier that makes available knowledge and skill to the user thereby being characterised as fees for technical services? Depending on the characterisation, the tax treatment will differ. The use of software being ubiquitous, the same may also have to be imported from those that possess the intellectual property attached to the software. Obviously therefore, there will be question of deduction of tax at source when the payment is made for such imports. Many a times the software is pricier than even the hardware. The payment form out of a country therefore entails erosion of its tax base since payment for software is generally fully expensed in the hands of the payer and cannot be fully taxed since taxing software either as royalty or FTS means taxing at less than ordinary rate. In case, it is characterised as business income, the usual loophole of not having any business connection/PE will be there.

Recently, the Supreme court has decided a bundle of cases (a batch of 103 cases) relating to some of the issues relating to taxation of software and has held against the revenue in a dispute that is now 20 years old. Although the decision has been welcomed by the tax practitioners and accountants, it seems that many vital aspects have been overlooked or was not brought to the attention of the Supreme Court. Of course, a case is primarily decided by the Court on the basis of arguments advanced and in the present case, the arguments of the revenue was woefully inadequate, the court also compounded the problem by doing its own research without appreciating the full implications. The result, in my opinion, is yet another disappointment in the comprehension of the nuances of international taxation.

The dispute before the SC in the group of cases was essentially relating to payments being made out of India for import of software and consequent liability to deduct tax at source before such remittance. As more than 100 cases were involved, the SC itself categorised such cases in 4 distinct groups- those where an Indian resident entity and end-user of the software purchased the same directly from a non-resident supplier/manufacturer; those cases where Indian resident entities were distributors/reseller of software and made payments to the non-resident for the purchase price, payments made by foreign distributors to purchase the software form a non-resident and then on-sale to Indian distributor/ end user and lastly those where software is bundled with hardware and sold as an integrated equipment by the non-resident supplier to resident Indian distributors/ end-users.

All the cases related to the beginning of the century and related to transactions in the financial years 2000-2001 and 2001-2002. The Supreme Court took one case for detailed analysis- that of one Engineering Analysis Centre of Excellence Pvt Ltd, and after examining the facts of the case, the SC analysed the essence of the contractual arrangements, and the legal provisions involved both under the domestic law and under the tax treaty wherever involved and came to its conclusion. The SC then applied the logic, it so developed to the rest of the cases and quite naturally decided all in similar manner, there being no serious difference in the issues involved in the different groups of cases as stipulated by the SC.

Very briefly, Engineering Analysis was the end-user of the shrink-wrapped software that it had imported directly form a party in the USA. The tax department took the view that the payment concerned was for use of royalty as defined under the domestic law as also under the Indian-US tax treaty article 12 and hence was liable to deduction of tax at source and since the taxpayer did not withhold the tax at source, the tax officer had considered the taxpayer to be in default and was asked to make good the deficiency u/s 201(1A) of the ITA along with interest. Following the usual round of appeal, the matter ended up before the Karnataka High Court, which relying on the decision of the Supreme court in Transmission Corporation (2 judge bench), held that since the taxpayer had not filed an application before the tax authorities before making the payment, it was liable to deduct tax at source. It may be mentioned that it is purely a question of application of domestic tax law at this stage.

The Supreme Court (2 judge bench) in GE Technology case, however, held that what is deductible as tax u/s 195 is the 'sum chargeable to tax' and it is first necessary to determine the chargeability to tax as royalty. If under the domestic law or under the treaty, there is no chargeability to tax at all, the question of deduction of tax at source did not arise. Since the High Court had not gone into the merits of the case as regards the issue of chargeability to tax in respect of royalty, the order of the High Court was set aside to be done de novo on merits.

Thereafter the Karnataka High Court considered the issue in the Samsung case, wherein the High Court after considering the End-User license agreement (EULA) found that what was sold by way of computer software included a right or interest in copyright , and accordingly would be royalty deemed to accrue in India in terms of section 9(1)(vi) of the ITA.

Meanwhile, other High Courts and some rulings of the AAR took a view different from that taken by the Karnataka High Court and decided in favour of the taxpayers, most often , relying on the example of the sale of a book and making a distinction between a copyright and the so-called copyrighted articles. Heavy reliance was placed in all these cases on the OECD commentary under article 12.

The arguments taken before the Supreme Court by the taxpayers were more or less all the same. Reliance was placed on the decision of the Supreme Court in the context of sales-tax that software represents good. Ironically in TCS, where the taxpayer supplied software to its clients as stand-alone products or as part of service contracts argued against levy of sales tax on the ground that software was not goods . The SC, in that context allowed the levy to be charged holding that when software is put in a medium and sold, it becomes goods.

Before proceeding further, it is also important to note the developments in the context of software taxation in India. The source rule in respect of taxation of royalties is contained in section 9(1)(vi) of the ITA.

Explanation 2 thereof defines royalty to mean :

Consideration (including lump sum consideration but excluding capital gains) for-

(i) The transfer of all or any rights( including the granting of a license) in respect of a patent, invention, model, design, secret formula or process or similar property;

(ii) the imparting of any information concerning the working of, or the use of, a patent, invention, model, design, secret formula or process or trade mark or similar property ;

(iii) the use of any patent, invention, model, design, secret formula or process or trade mark or similar property ;

(iv) the imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill ;

(iva) the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB;

(v) the transfer of all or any rights (including the granting of a licence) in respect of any copyright, literary, artistic or scientific work including films or video tapes for use in connection with television or tapes for use in connection with radio broadcasting; or

(vi) the rendering of any services in connection with the activities referred to in [sub-clauses (i) to (iv), (iva) and (v).

Since courts/AAR had interpreted the term in different ways raising doubts as whether use of computer software amounts to royalty or not, whether the user has to be directly by the payer or is to be located in India or the control or possession of it has to be with the payer, in 2012 along with the famous Vodafone amendments relating to indirect transfer, an explanation 4 was inserted as follows:

"For the removal of doubts, it is hereby clarified that the transfer of all or any rights in respect of any right, property or information includes and has always included transfer of all or any right to use a computer software( including granting of a license) irrespective of the medium through which such right is transferred."

An Explanation 5 was also added as follows:

"For the removal of doubts, it is hereby clarified that the royalty includes and has always included consideration in respect of any right, property or information, whether or not- (a) the possession or control of such right, property or information is with the payer; (b) such right, property or information is used directly by the payer; (c) the location of such right, property or information is in India."

Although the amendment used the words- for the removal of doubts, questions could be raised as to whether the amendment could be made retrospective from 1.4.1976 when the source rule was first introduced in the ITA. However retrospectivity would be a matter only if the correct interpretation of the existing provision would reach a different result.

From the plain language of section Clause (v) of Explanation 2 to section 9(1) (vi) consideration of the transfer of all or any rights in a copyright, will amount to royalty.

The purpose of the present article is not to consider whether the judgement of the Supreme Court is correct or not but to point out certain inconsistencies and the damage it might cause by further eroding the tax base of the country. As mentioned in the beginning, there were 103 parties before the Supreme Court. Many of them had paid tax on software as royalty. All of them will be entitled to refund of such taxes which may run into thousands of crores of rupees. Interestingly, one party, had even withdrawn its litigation and decided to avail of the Vivad se Vishwas scheme. In this vein, today's Economic Times contain an interesting news item: Microsoft Nets $620m Tax Windfall after SC Verdict ( ET 29 April, 2021). In its regulatory filing, Microsoft has stated that even though it was not a party to the proceedings before the Supreme Court, since software sales in India was determined by the Supreme Court to be not subject to withholding, net income tax benefit of 620m USD was recorded in accounts impacting revenues for fiscal years 1996 through 2016 .

We may note that Microsoft had also litigated the issue and had lost in the Delhi Tribunal in the case of Gracemac and apparently had accepted the findings. Unfortunately, none of the arguments taken in that case was taken before the Supreme Court.

Apart from the specific issues of the taxation of shrink-wrapped or canned software, the decision of the Supreme Court being binding on all courts under Article 141 of the Constitution, there are far-reaching observations of the Court regarding the nature of the OECD Model Commentary and the effect of India's positions thereon as these will have effect in other cases.

The SC quoted the following paragraphs from the Introduction to the OECD Model Commentary to lay emphasis on the persuasive nature of the interpretation given in the OECD Commentary.

"2. It has long been recognised among the member countries of the Organisation for Economic Co-operation and Development that it is desirable to clarify, standardise, and confirm the fiscal situation of taxpayers who are engaged in commercial, industrial, financial, or any other activities in other countries through the application by all countries of common solutions to identical cases of double taxation. These countries have also long recognised the need to improve administrative co-operation in tax matters, notably through exchange of information and assistance in collection of taxes, for the purpose of preventing tax evasion and avoidance.

3. These are the main purposes of the OECD Model Tax Convention on Income and on Capital, which provides a means of settling on a uniform basis the most common problems that arise in the field of international juridical double taxation. As recommended by the Council of OECD, member countries, when concluding or revising bilateral conventions, should conform to this Model Convention as interpreted by the Commentaries thereon and having regard to the reservations contained therein and their tax authorities should follow these Commentaries, as modified from time to time and subject to their observations thereon, when applying and interpreting the provisions of their bilateral tax conventions that are based on the Model Convention."

"29.2 Similarly, taxpayers make extensive use of the Commentaries in conducting their businesses and planning their business transactions and investments. The Commentaries are of particular importance in countries that do not have a procedure for obtaining an advance ruling on tax matters from the tax administration as the Commentaries may be the only available source of interpretation in that case.

It is surprising that the SC concludes therefrom that the OECD commentary will be binding on a non-member State. That the Commentary is an important document is well taken. Courts had and do refer to the Commentaries as an aide to interpretation. More often than not, it is the only document available to any court. But OECD Commentary is not a public document. It is true that now a days the same is available to the judges in India, but these are paid for and are not public documents.

The observation of the Supreme Court does not take into account the background of the formation of the OECD and the purpose of that organisation. It is important to remember that OECD is the renamed version of OEEC – Organisation of European Economic Co-operation, an organisation formed as part of the Marshal Plan to rebuild Europe. The European nations having bitterly fought with each other, the basic idea was to force these nations to cooperate in the matter of taxation so as to encourage more trade and investments. The USA, the prime mover of the plan and the proposal, later became a member of the renamed OECD from being an observer of the OEEC. Of course, the OECD membership has increased over the years, particularly after the breakup of the former Soviet Union. But it is still a club of these 37/38 countries and its very purpose is to look after the interests of its members.

To understand the nature of the OECD Model and its Commentaries, the Supreme Court would have done better to refer to the founding document of the OECD- Convention on the Organisation for Economic Co-operation and Development signed at Paris on 14the December 1960.

Article 1 states the aim of the organisation as follows:

Article 1

The aims of the Organisation for Economic Co-operation and Development (hereinafter called the "Organisation") shall be to promote policies designed:

(a) to achieve the highest sustainable economic growth and employment and a rising standard of living in Member countries , while maintaining financial stability, and thus to contribute to the development of the world economy;

(b) to contribute to sound economic expansion in Member as well as non-member countries in the process of economic development; and

(c) to contribute to the expansion of world trade on a multilateral, non-discriminatory basis in accordance with international obligations.

Article 5 thereof states:

Article 5

In order to achieve its aims, the Organisation may:

(a) take decisions which, except as otherwise provided, shall be binding on all the Members;

(b) make recommendations to Members ; and

(c) enter into agreements with Members, non-member States and international organisations.

It is under Article 5(b) that the OECD Model Commentary is finally adopted by the Council. A recommendation is obviously not binding whereas it is possible for the OECD Council to take binding decisions as well. The fact that it is not so, clearly demonstrates the non-binding nature of the Commentary on the OECD members. When the Commentary is not binding on even the members, it really takes a stretch to arrive at a conclusion that the document which is historically skewed in favour of colonialists and exporters of capital should be binding on non-member capital importing countries.

It is also surprising that the SC forgets to quote from para 29 while quoting only para 29.2. Para 29 , in clear terms mention as follows:

"As the Commentaries have been drafted and agreed upon by the experts appointed to the Committee on Fiscal Affairs by the Governments of member countries, they are of special importance in the development of international fiscal law. Although the Commentaries are not designed to be annexed in any manner to the conventions signed by member countries, which unlike the Model are legally binding international instruments, they can nevertheless be of great assistance in the application and interpretation of the conventions and, in particular, in the settlement of any disputes."

The import of the highlighted portion is that the Commentary is not binding on the OECD member countries; that it is only a recommendation that member countries may like to follow.

There are also inconsistencies in the understanding about the nature of the Commentaries. The SC has gone into the judgement in Thiel v. Federal Commissioner of Taxation rendered by the Australian High Court to underline the importance of the Commentary. It has also referred to its own judgement in Azadi and Formula One ignoring the fact that the Supreme Court has wrongly interpreted the words 'may be used' rendered in Kulandagan Chettiar case. In that case, referring to the OECD Commentary, the SC held as follows:

"16. Taxation policy is within the power of the Government and section 90 of the Income- tax Act enables the Government to formulate its policy through treaties entered into by it and even such treaty treats the fiscal domicile in one State or the other and thus prevails over the other provisions of the Income-tax Act, it would be unnecessary to refer to the terms addressed in OECD or in any of the decisions of foreign jurisdiction or in any other agreements ."

The Supreme Court through the above decision converted India from a credit country to an exemption country thereby making law which is not within its remit. It even refused to review its order and again chose to follow its own wrong order in subsequent cases, leading to legislative action. Even in the Formula One case, the Supreme Court referred to the OECD Model but did not actually follow the Commentary's recommendation that to constitute a fixed place of business, a minimum period of activity of 6 months is necessary. The Supreme Court case in Formula one has been severely criticised on that count.

The Supreme Court did not realise that under the OECD Model, the absolute right in respect of taxation of royalties is with the country of residence and hence the Commentary that it has developed is primarily aimed at achieving that objective and restrict the claim of the source States. For that reason alone, the reliance on OECD Model Commentary on Article 12 is wrong.

As for India's positions on the OECD Commentary, the Supreme Court dismissed the views expressed by India. In that context, it held : "From these positions taken, which use the language "reserves the right to" and "is of the view that some of the payments referred to may constitute royalties", it is not at all clear as to what exactly the nature of these positions are.

It is significant to note that after India took such positions qua the OECD Commentary, no bilateral amendment was made by India and the other Contracting States to change the definition of royalties contained in any of the DTAAs that we are concerned with in these appeals, in accordance with its position."

Again, the observation of the Supreme Court shows a lack of understanding of the background of the OECD Model and the role of observations/reservations/positions to the OECD Model. As has been repeated again and again, the OECD Model is for furthering the interests of its member countries and India is not a member of the OECD. In respect of the OECD Member countries, there is a role of observations to the Commentary. Paragraph 30 of the Introduction to the OECD Model itself says:

"30. Observations on the Commentaries have sometimes been inserted at the request of member countries that are unable to concur in the interpretation given in the Commentary on the Article concerned. These observations thus do not express any disagreement with the text of the Convention, but usefully indicate the way in which those countries will apply the provisions of the Article in question. (…)

At the cost of repetition, India is not a member country of the OECD. There is no question of its giving its views on either the articles or the Commentaries to the OECD Model. As readers are well aware there is the UN model which even though unfortunately taking the OECD Model as its base, nevertheless differs from the same on important aspects. The OECD has been in the forefront of challenging the legitimacy of the UN Model and in asserting its authoritative voice. Therefore, it encourages non-member countries to state their views on the OECD Model as well as its commentaries. Few countries have the resource to do so. Even then, it has persuaded some countries to state their positions. India was invited to join the OECD's Committee on Fiscal Affairs in 2006. In that context, it requested India to state its positions on the OECD Model and its Commentary. Thus, in 2008 for the first time, when India stated its position, it came as a surprise to many that India stated more than 80 positions. The Supreme Court has not realised that India is under no legal obligation to state its position unlike the OECD member countries. It stated its positions as a courtesy not by way of compulsion. Of course, there are some, who would want India to agree to whatever is stated by the OECD, it had no role in formulating the OECD Model and it has no obligation to state its position. And yet, when it does, the Supreme Court, in the name of extraneous consideration of increasing the international trade , dismisses the same. The task of the Supreme Court is to interpret the domestic law and the tax treaty , not to make policy or rewrite the law.

Now, following the SC observations in the case, clever lawyers will argue and lower courts are also likely to follow the recommendations of the OECD Commentary in other areas as well, one shudders to think what will be the status of the fisc in the days to come. Already one comes across, decisions that extend the lower rate granted in treaty concluded with certain non-OECD countries that subsequently became members of the OECD relying on one sided interpretation given by the Netherlands government. Why on earth, the views of the Indian tax authorities will not be taken into account is beyond my comprehension. All these decisions betray a real lack of understanding of how tax treaties are made and how these are interpreted.