IT is not often that we come across important international tax cases from Pakistan. However, on 8th September, 2023, the Pakistan Supreme Court has rendered an important verdict on the vexed question of source country taxation of software as royalty under the Pakistan-Nederland's tax treaty in favour of the Pakistan Revenue through a 2-1 verdict.

Although the majority judgement takes a rather unorthodox approach to treaty interpretation, its disregard of the OECD Model Commentary and its insistence on drawing out actual facts rather than solely rely on arguments based on commentaries and scholarly opinion, is to be appreciated.

The Pakistan case was decided in 'The Commissioner of Income Tax v M/s. Inter Quest Informatics Services' and was decided on appeal from the orders of the High Court of Sindh at Karachi.

The basic facts are that the taxpayer, a Netherlands based company, having no place of business in Pakistan, had filed its return of income and under the heading 'Income Claimed to be Exempted and not Included in Total Income' sought exemption in respect of its receipts in respect of rental from Lease of some software program. The tax years involved were from 1987 to 2003.

Apparently, the taxpayer had entered into an agreement to lease certain software programs called "FLIC tapes" developed by it for use in oilfield data processing and log interpretation to another company, Schlumberger Seaco Inc. (SSI), the lessee, having a place of business in Pakistan.

The taxpayer claimed that the income from lease of software earned by it was exempt from taxation in Pakistan in view of Article 7 of the Agreement for Avoidance of Double Taxation between Pakistan and Netherlands, on the ground that the nature of its income in Pakistan was business and since it did not have a Permanent establishment in Pakistan, the income in question was not taxable in Pakistan.

However, the Tax Officer was of the opinion that, such income constituted royalty and was assessable under Article 12-3(a) (b) of the Tax Treaty between Pakistan and Netherlands, and called upon the taxpayer to explain why the same should not be taxed as royalty income @ 15%.

Article 12 of the tax treaty between Pakistan and the Netherlands states as follows:

1. Royalties arising in one of the States and paid to a resident of the other State may be taxed in that other State.

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

(a) 15 per cent of the gross amount of the payments referred to in paragraph 3(a);

(b) 15 per cent of the gross amount of the payments referred to in paragraph 3(b);

(c) 5 per cent of the gross amount of the payments referred to in paragraph 3(c).

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) a patent, trademark or tradename, secret formula or process, design or model, or information concerning industrial, commercial or scientific experience;

(b) industrial, commercial or scientific equipment, cinematograph films and tapes for television and broadcasting;

(c) a copyright of a literary, artistic or scientific work, but excluding cinematograph films and tapes for television or broadcasting.

4. (…)

5.(…)

6.(…)

The majority judgement states that when asked to explain as to why the amount would not be taxed as royalties under Article 12 of the Pakistan- Netherlands tax treaty, the taxpayer straight away proceeded to explain what constitutes royalties without first explaining the nature of the receipts, what they were for, the agreement they were paid under and the particular item of its schedule and what it entailed.

At any rate, the taxpayer having failed in its appeal before the Commissioner (Appeals) and the Tribunal, approached the High Court through a reference and the High Court framed the questions for its determination as -whether the said payment receipts were business profits under Article 7 of the treaty and, secondly, whether the same constituted income from royalties under Article 12 of the treaty, and as such were not business profits under Article 7.

The High Court determined in favour of the taxpayer holding that the amounts did not constitute royalties. Thereupon, the matter travelled to the Supreme Court under Article 185(3) of the Constitution and leave was granted. The dispute before the Supreme Court was limited to whether the amounts received by the taxpayer, which it claimed to be exempt, constituted royalties as defined in paragraph 3 of Article 12 of the Convention between Pakistan and the Netherlands.

It appears that the majority judgement took the view that the question here was one that involved principally a determination of a question of fact in that it had to be first factually ascertained what the receipts were for and whether the same constituted royalties as defined in paragraph 3 of Article 12 of the Convention and considering that three findings of fact were concurrently recorded against the taxpayer, by the Income Tax Officer, the Commissioner (Appeals) and the Tribunal, the High Court erred in deciding a factual dispute.

The Pakistan Supreme Court mentioned that there were two agreements, one for an 'Agreement for Lease of FLIC Tapes' dated 1 February 1986 and a 'Software Rental Agreement' dated 1 January 1995). While in the 1986 Agreement Schlumberger was described as the lessee in the 1995 Agreement it was described as the customer. It appears that the taxpayer did not specify which agreement was being referred to and that in response to the notices issued by the Income Tax Officer the taxpayer stated that the payment receipts were rentals paid for tapes by SSI and were neither in the nature of a patent, trademark or tradename, secret formula or process, design or model, nor any equipment, films and tapes for television and broadcasting and that the said receipts were not royalties under Article 12 of the Convention.

In this regard, the Pakistan Supreme Court observed:

"When the benefit of an exemption is sought the person claiming it must clearly set out its case. The respondent had to establish that the receipts were not royalties and thus not liable to income tax under paragraph 2 of Article 12 of the Convention. If the respondent had initially made out a case for exemption then the taxing authority would have examined the documents/proof tendered to it and considered whether the exemption was correctly claimed. Instead, the High Court took it upon itself to determine the nature of the said receipts, and did so without having the benefit of requisite documents, material and information."

The Court also pointed out that full definition of royalties in paragraph 3 (a) of Article 12 of the Convention included payments for 'information concerning industrial, commercial or scientific experience', which the taxpayer did not negate.

The High Court had relied on the OECD Model Convention and its Commentary as also Klaus Vogel's Commentary on the OECD Model and had observed: In the light of the above extracts it is clear that OECD which is the authority which has drafted the Double Taxation Agreements has in respect of Software Transactions categorized....'

In this regard, the Court pointed out that that Article 12 of the relevant Convention, adheres to the UN MC, and not to the OECD MC and therefore the High Court had incorrectly assumed the applicability of OECD MC. On the contrary, the Supreme Court mentions, quoting Klaus Vogel on Double Taxation Conventions that Paragraphs 2 and 5 UN MC is unique to the UN MC, as they deal with the source State taxation that is not allowed under the OECD MC.' And if taxed under the UN MC then the country of residence of the supplier must give credit for the tax paid in the source country. The Pakistan Supreme Court observed:

"Therefore, it would not really matter to the respondent if under Article 12 of the Convention it had to pay income tax at the rate of fifteen percent in Pakistan because the respondent could with the tax authority of the Netherlands claim adjustment of the amount paid in Pakistan."

The majority judgement, rather controversially, observed that the High Court did not notice the alternate dispute resolution mechanism available in the Mutual Agreement Procedure under Article 24 of the Convention, which the taxpayer did not avail and observed:

"If the respondent had presented its case to the competent authority of the Netherlands and if such competent authority was of the opinion that the respondent's objection to taxation in Pakistan was justified it would have taken up the matter with the competent authority in Pakistan. The matter could also have been resolved between the countries by 'mutual agreement'. It is possible that the respondent did not submit its case to the competent authority of the Netherlands because it may not have agreed with the respondent's contention, and then the respondent may not have been able to claim exemption."

The Supreme Court added:

"If a treaty or convention provides for a dispute resolution mechanism it is, always, preferable to avail of it, and amicably resolve matters. If this had been done in these cases it would have helped the High Court, and this Court too, to understand the point of view of the competent authority of the Netherlands, and prevent the possible undermining of bilateral relations on account of a misunderstanding. This would be preferable as the exemption claimed in respect of the receipts had not been interpreted, resolved or decided earlier."

In short, the majority judgement of the Court, found fault with the taxpayer for approaching a wrong forum and also with the High Court in venturing in the area of fact finding that was beyond its remit. Besides, the majority also observed that the High Court also did not adequately comprehend the facts. In that context, the majority observed that the FLIC tapes were mentioned in the 1986 Agreement. However, the High Court's judgments refer to the 1995 Agreement which did not mention FLIC tapes. The High Court had therefore proceeded on the basis of an incorrect premise. The 1986 Agreement's clause 3 stated that the duration of the 1986 Agreement was for four years, that is, till 31 January 1990. Under the 1986 Agreement the taxpayer would provide to the lessee/SSI software programs 'for use in oilfield data processing and log interpretation, including the software programs set out in Schedule I, together with the related FLIC/VAX Handbook.' Schedule I of the 1986 Agreement is a 'List of Oil Well Interpretation Program Products' spread over nine pages, and its Schedule 2 stipulates the 'Monthly Charge' for their use - 'Price List for FLIC Tapes Lease by Module.'

The contents of the 1986 Agreement and the listed programs are technical and not self-evident, yet the High Court interpreted the same, while purportedly deciding questions of law. Therefore, the Court opined that the High Court should not have ventured into an area requiring specialized knowledge, which the learned Judges did not possess.

Besides, the taxpayer also did not explain the technically complex nature of the Agreements before any forum, nor was the same explained to the Supreme Court Therefore, the Court concluded:

"The High Court could not have undertaken a factual determination while exercising powers under section 136(1) of the ITO 1979 and section 133(1) of the ITO 2001 whereunder the High Court could only determine legal questions. Incidentally, there was no material before the High Court, nor was any placed even before this Court, which may have persuaded one to hold that the said receipts were exempt under Article 12 of the Convention."

The Minority judge, Syed Mansoor Ali Shah however found in favour of the taxpayer. He held that the Supreme Court having formulated a question of law could not have faulted the High Court in trying to answer the same. He also questioned the relevance of the majority opinion that the taxpayer would not suffer double taxation since the country of residence is obliged to give credit for the taxes paid in the source country. He also opined that if the taxpayer could show that the payment in question does not fall within the definition of royalty, then it could not be taxed in Pakistan. Examining the various limbs of article 12, he held that the rentals form the lease of the software program could not be categorised as patent, trademark or tradename, secret formula or process, design or model, or information concerning industrial, commercial or scientific experience; nor could the same be categorised as industrial, commercial or scientific equipment, leaving the possibility of it being a payment for the use of a copyright of a literary, artistic or scientific work.

Here he relied heavily on the Klaus Vogel Commentary to the effect that renting out software is not covered by Article 12 but by article 7.

The dissenting judge also relied on the ruling by the Indian AAR in Geoquest Systems B.V v Director of Income Tax wherein the AAR held that amount payable for renting of software in a similar case did not amount to royalty and that this ruling was later expressly approved by the Supreme Court of India in Engineering Analysis Centre of Excellence v The Commissioner of Income Tax.

In conclusion, while the insistence of the majority for the taxpayer to avail the MAP rather than approaching the courts may be questionable in the absence of any specific bar in that regard (as appears from the minority judgement) as also the observation that there would not be any double taxation considering the obligation of the country of residence in providing tax credit, one must also consider as to whether, in fact, there is any double taxation.

Royalties along with interest are the most important and easy ways of draining out revenues from source states. In India, although the revenue has been consistent in asserting taxing rights over royalties in particular but its efforts have mostly been thwarted by courts often times paying undue deference to the OECD Commentary on royalties, particularly on its invention of an alleged difference between a copyright and copyrighted articles. The fact that the OECD Model is formulated to protect the interests of the capital exporting countries and the fact that in the matter of royalties, its model does not give any taxing right to the source countries and therefore the OECD Commentary, while being a non-binding guide for its member countries is unsuitable for interpretation in cases involving royalty payments from source countries, was appreciated in the majority judgement.