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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 issued a landmark ruling on March 2, 2021 confirming that amount 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 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. 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 use of software by Indian company is limited to making backup copy and redistribution. Several matters in case of various taxpayers were awaiting the judgement of SC.

A total of 86 appeals, divided into the following 4 categories were heard by SC 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:

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. SC also laid down that machinery provisions contained in S.195 of IT Act, regarding Tax Deduction at Source (TDS), are inextricably linked with charging sections. Resultantly, TDS will be deducted only if non-resident is liable to pay tax under charging provisions.

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

Further, on examination of EULA/ distribution agreement, 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 or modify or reproduce in any manner otherwise than permitted by the licenser. SC also observed that in all cases, the license that was granted was not a ‘licence’ that transfers interest in all or any of the copyright rights but is a ‘licence’ that imposes restrictions or conditions on use of computer software.

SC, therefore held that “what is “licensed” by foreign, non-resident supplier to distributor and resold to resident end-user, or directly supplied to resident end-user, is in fact sale of a physical object which contains an embedded computer programme, and is therefore, sale of goods”. A non-exclusive, non-transferable licence, merely enabling use of copyrighted product, is a restrictive condition for such use, and cannot be construed as a licence to enjoy all/any of the enumerated rights mentioned in S.14 of the Copyright Act, or create any interest in such rights so as to attract S. 30 of Copyright Act.

On the question of retrospective application, SC held that the payer could not be expected to do the impossible and deduct TDS at a time when the obligation did not factually exist in the statute.  Hence, a person making a payment to non-resident could not be held as an “assessee in default” for not deducting TDS. SC remarked that definition of royalty under IT Act is more expansive than DTAA provision. However, in accordance with S.90(2) of IT Act, the more expansive definition would have to be ignored, if it is wider and less beneficial to taxpayers.

SC noted the importance of Commentary on Article 12 of the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention (Commentary) and held that the Commentary would have persuasive value as to the interpretation of the term “royalties”. It also held that payers and recipients have a right to know their position and obligations under a treaty and that they could place reliance on the Commentary to understand the same. India’s reservations to the Commentary would not affect its relevance unless these reservations are incorporated into DTAA through bilateral negotiation with the respective countries.

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 puts an end to two decades old litigation and provides relief to 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. 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.
  2. Applicability of EL: Taxpayers will now be posed with issues regarding applicability of EL on such transactions. The issue is further aggravated by the clarification proposed in Finance Bill, 2021 (Bill), which clarifies that if consideration received for sale of software is not taxable as royalty, 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. Impact on Indian e-commerce companies with Foreign Direct Investment (FDI): Typically, e-commerce in services is not an issue under FDI rules and if an entity is dealing only with licensing or providing right to use of software in wholly digital format, it is unlikely to face any problems. However, if an entity is selling the same software on a CD format or tangible format, then it is important to assess if it would amount to e-commerce in goods as an inventory model.

We hope you will find the update useful.

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