THE cases dealt with by the SC were all involving DTAAs with some country or the other. As per the Court's order, in all 18 tax treaties were involved. All the treaties had an Article dealing with Royalty. Essentially, such articles give India a right to tax royalties on a gross basis at varying rates, mostly 10-15%.

The Supreme Court however observed that the treaty provision relating to royalty in all these treaties were based on the OECD Model and were more or less alike and hence the Court took the India Singapore tax treaty as an example and also chose to follow the OECD Model Commentary on the same. This is factually incorrect in that Article 12 of the India-Singapore tax treaty is based on the UN Model and not the OECD Model and states as follows:

1. Royalties and fees for technical services arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.

2. However, such royalties and fees for technical services may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the recipient is the beneficial owner of the royalties or fees for technical services, the tax so charged shall not exceed:

(a) in the case of royalties referred to in paragraph 3(a) and fees for technical services as defined in this Article (other than services described in subparagraph (b) of this paragraph), 15% of the gross amount of the royalties and fees;

(b) in the case of royalties referred to in paragraph 3(b) and fees for technical services as defined in this Article that are ancillary and subsidiary to the enjoyment of property for which royalties under paragraph 3(b) are received, 10% of the gross amount of the royalties and fees.

3. The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use:

(a) any copyright of a literary, artistic or scientific work , including cinematograph films or films or tapes used for 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, property or information ;

(b) any industrial, commercial or scientific equipment, other than payments derived by an enterprise from activities described in paragraph 4(b) or 4(c) of Article 8."

From the above, it may be observed that the first clause gives the taxing right in respect of royalties to the residence State. It is important to remember that the purpose of the tax treaties based on the OECD Model is to restrict the taxing rights of the Source States. However, since the OECD Model is modified to some extent by the UN Model, following the UN Model, the second clause gives a secondary right to the source state to tax such royalties but limits the source country tax on such royalties to a negotiated % of the receipts on a gross basis (10- 15% in this case) when the recipient of the royalty is the beneficial owner. Thus, both the residence state and the source state have taxing right. The residence state may continue to tax the royalties arising in India in the hands of the taxpayer but will have to give a credit for the taxes paid in India.

And how will India tax such royalties? As per the wording of this tax treaty , the taxation will be as per the domestic law of India and there is no restriction here in the treaty except that the resulting tax of the royalty by India should not exceed 10-15 % of the gross receipts from such royalty. Viewed from this perspective, there is no conflict at all between the treaty and domestic law here. In fact, the treaty specifically allows royalty to be taxed in terms of the domestic law. So, the only question should be whether domestic Income tax act allows taxation of income from software as royalty and if so tax the royalty income as per the domestic tax law and ensure that the tax so levied has not breached the level of 10-15% of the gross amount.

The next issue to be seen is whether the payments that are to be taxed comes within the definition of royalty for this purpose. Here, Clause 3 of the tax treaty defines the term royalty exhaustively in that it uses the word 'means.'

Consideration for the use or right to use any copyright of a literary, artistic or scientific work is definitely royalty under 12(3)(a). There is no separate mention of computer software in the article. Even the OECD Commentary acknowledges this-. "It should be noted that where a software payment is properly to be regarded as a royalty there may be difficulties in applying the copyright provisions of the Article to software payments since paragraph 2 requires that software be classified as a literary, artistic or scientific work. None of these categories seems entirely apt. The copyright laws of many countries deal with this problem by specifically classifying software as a literary or scientific work."

Thus, one has to come to the Copyright Act for the limited purpose of ascertaining whether the payment is covered under literary, artistic or scientific work. If it is so covered then the amount represents royalty and should be taxed according to the domestic income tax law subject to the ceiling mentioned above. However, the Income Tax Act and the Copyright Act operate in different fields and there is no scope of elaboration of the different issues that may arise under the Copyright Act.

The Supreme Court judgement, on the other hand, is a thesis on the Copyright Act. What the Court does is to take us through the various definitions and restrictions and conditionalities of the Copyright Act. The term copyright is not defined in the definition section. However, section 2(o) of the Copyright Act states that "literary work" includes computer programmes, tables and compilations including computer databases". Thus, as indicated in the OECD commentary, in India too, computer programming is covered by the Copyright Act as literary work and the author of a computer programme or software enjoys the protection of the Copyright Act.

Section 14 of the Copyright Act states as follows:

""14. Meaning of copyright. -- For the purposes of this Act, copyright means the exclusive right subject to the provisions of this Act, to do or authorise the doing of any of the following acts in respect of a work or any substantial part thereof, namely-

(a) in the case of a literary, dramatic or musical work, not being a computer programme, -

(i) to reproduce the work in any material form including the storing of it in any medium by electronic means;

(ii) to issue copies of the work to the public not being copies already in circulation;

(iii) to perform the work in public, or communicate it to the public;

(iv) to make any cinematograph film or sound recording in respect of the work;

(v) to make any translation of the work;

(vi) to make any adaptation of the work;

(vii) to do, in relation to a translation or an adaptation of the work, any of the acts specified in relation to the work in sub-clauses (i) to (vi);

(b) in the case of a computer programme-

(i) to do any of the acts specified in clause (a);

i) to do any of the acts specified in clause (a);

(ii) to sell or give on commercial rental or offer for sale or for commercial rental any copy of the computer programme: Provided that such commercial rental does not apply in respect of computer programmes where the programme itself is not the essential object of the rental."

Though a computer programme is classified as literary work under the Indian Copyright Act, a computer programme is also given some additional protection on its own and the author/owner is given certain rights in addition to what is enjoyed by the owner of a literary work.

Under section 14(b)(ii), the right to sell or give on commercial rental a copy of the computer programme is also covered. Thus, where a copy of a computer programme is sold, it will involve exploitation of a copyright and question of royalty may arise.

The taxpayers' counsels therefore introduced the concept of first sale and the doctrine of exhaustion to assert that exploitation of copyright will not be involved in the transaction and the Supreme Court agreed with the same. Very briefly, under these concepts, when a copy of a computer program is sold, the copyright owner exhausts his distribution right in respect of that copy. These concepts are however useful to examine whether the purchaser has infringed the rights of the owner under the copyright Act and even in the USA where the concept originated, courts are facing problem in the uniform application of this rule, in the context of software in the digital economy.(Wikipedia).

Moreover, these concepts are not written into law and relate only in the matter of copyright Act whose purpose is protection of intellectual property and regulate the rights of different persons whereas the purpose of the ITA is to levy income tax within the parameters of the ITA.

For arriving at its logic, the SC referred to the amendments made in the Copyright Act and pointed out that before its amendment in 1999, section 14(b)(ii) of the Copyright Act read as follows:

"(ii) to sell or give on hire, or offer for sale or hire any copy of the computer programme, regardless of whether such copy has been sold or given on hire on earlier occasions ;

Subsequent to the amendment, the words, regardless of… are conspicuously absent and from that one should infer therefrom that the doctrine of first sale and the principle of exhaustion is recognised in India.

Therefore the SC concluded that the right of the author/owner of computer software gets exhausted after the first sale of a copy of the programme. This is of course, for the purpose of the protection of the IP rights and one is not sure if such an interpretation is even in the interests of the copyright holder of a computer programme. It appears that one software company had sued an Indian company for breach of copyright when multiple copies were made only for internal use. If all the rights get exhausted after the first sale, then no such right can persist to be violated. The logic followed by the SC in applying the concept of first sale may be within the meaning of Article 14 (a)(ii)( not being a copy already in circulation), but then section 14(b)(ii) becomes meaningless.

The SC also referred to section 52 of the Copyright Act, which stipulates that certain acts by the buyer will not amount to infringement and quoted from the same as follows

Section 52:

(1) The following acts shall not constitute an infringement of copyright, namely,

-- xxx xxx xxx

(aa) the making of copies or adaptation of a computer programme by the lawful possessor of a copy of such computer programme, from such copy-

- in order to utilise the computer programme for the purpose for which it was supplied; or

- to make back-up copies purely as a temporary protection against loss, destruction or damage in order only to utilise the computer programme for the purpose for which it was supplied;

xxx xxx xxx

(ad) the making of copies or adaptation of the computer programme from a personally legally obtained copy for non-commercial personal use;"

xxxxxx

(ad) the making of copies or adaptation of the computer programme from a personally legally obtained copy for non-commercial personal use;"

In terms of this section, making copies for personal use etc will not amount to infringement of the copyright of the owner, thereby, according to the Supreme Court, bolstering the doctrine of exhaustion. However, there seems to be a mix-up. The rights provided for in Section 14 protect the rights of the author and cannot be limited by the provisions of Section 52 which protects the rights of the user. Section 52 actually confirms that the right of reproduction even for personal use is a copyright. Otherwise, there was no need to provide for an exception to protect the consumer. It is for this reason that the end-users are granted the license or else the licensing agreement would not have been required.

We have seen earlier that according to a proper and harmonious interpretation, the payment concerned has to be charged to tax as per the provisions of the domestic law. Therefore, it becomes necessary to examine if the payments can be taxed under the ITA as royalty. For this purpose, first, the payments must accrue or arise in India and if they so accrue then the same will be taxed u/s 115A at the rates prescribed therein.

As quoted by the Supreme Court, the relevant portions of section 9(1)(vi) dealing with royalty states as follows:

(1) The following incomes shall be deemed to accrue or arise in India:-

xxx xxx xxx

(vi) income by way of royalty payable by-

xxx xxx xxx

(b) a person who is a residen, except where the royalty is payable in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India;

Explanation 2.- For the purposes of this clause, "royalty" means consideration (including any lump sum consideration but excluding any consideration which would be the income of the recipient chargeable under the head "Capital gains") for-

(i)….(iva)

(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)].

Explanation 3.- For the purposes of this clause, "computer software" means any computer programme recorded on any disc, tape, perforated media or other information storage device and includes any such programme or any customized electronic data.

Explanation 4.- 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 for use or right to use a computer software (including granting of a licence) irrespective of the medium through which such right is transferred.

Explanation 5.- 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."

Clearly, computer software is a copyright and under Explanation 2(v) of section 9(1)(vi), it will be royalty and if the same is payable by a resident in India, the same will accrue in India and accordingly will be taxable in India.

As indicated by the SC, the source rule in respect of royalty was introduced in 1976 and the provision as it reads in the statute is in existence for 45 years. Now, the Supreme Court says without any elaboration that: "The comma after the word "copyright" does not fit as copyright is obviously spoken of as existing in a literary, artistic or scientific work." The Court says that the mistake was corrected in the proposed DTC Bill. But there is no DTC as yet and the old language continues as it is in the Income Tax Act whereas many other proposals of the DTC have gradually been incorporated in the Income Tax Act. If the intention of the legislature was to correct the so-called mistake, surely they could have done it in a decade following the discovery of the apparent mistake.

Instead, Explanation 4 introduced in 2012 shortly after the introduction of the DTC Bill makes it clear that the use or the right to use computer software is explicitly covered by the definition of royalty. Naturally, if that has been the intention of the legislature, it has to be given retrospective effect with effect from the date when the source rule was introduced. The Supreme Court did some nit-picking and pointed out that the provision relating to computer software having been introduced only with effect from 1991, it is absurd that the Explanation could have retrospective effect from 1976. Even assuming that it could not be effective from 1976, the Court does not explain why it cannot be applied from 1991 onwards.

To sum up, the Supreme Court judgement raises a number of troubling questions rather than answering them. As discussed earlier, the Court seems to have set on an extensive law making of its own incorporating and altering words not only in the Income Tax Act but also in the Copyright Act, ignoring the specific Explanation brought in by the Legislature and drastically reducing the scope of taxation of this important source of income. Intellectual property of every kind including in computer software has been grossly misused by MNCs resulting in base erosion in source countries and profit shifting from residence countries. The Supreme Court's judgement in the present case is a missed opportunity to consider holistically all such issues.