Losses on un-matured forward contracts cannot be considered as notional or contingent in nature

Losses on un-matured forward contracts cannot be considered as notional or contingent in nature

Court : Mumbai Bench of the Income-tax Appellate Tribunal

Brief : In this case Special Bench of the Income-tax Appellate Tribunal dealt with the issue of allowability of losses on account of unmatured forward contracts in foreign exchange entered into by the taxpayer. The Special Bench while dismissing the contentions of the tax department held that the loss on unmatured forward contracts is in the nature of anticipated losses and not a contingent loss. The Special Bench observed that a binding obligation (although not fully ascertainable) arose against the taxpayer the moment it entered into forward foreign exchange contract. The Special Bench has relied on the recent decision of the Supreme Court in the case of CIT v. Woodward Governor of India [2009] 312 ITR 254 (SC) wherein the Supreme Court had held that exchange fluctuation loss arising on mark- to-market restatement of liability which is revenue in nature is an allowable loss. The Special Bench further observed that where profits were being taxed by the tax department in respect of such unmatured foreign exchange contracts then there was no reason to disallow the loss on such contracts.

Citation : DCIT v. Bank of Bahrain & Kuwait [2010-TIOL-447-ITAT-MUM-SB]

Judgment :

Facts of the case

• The taxpayer, a non-resident company carrying on banking business in India, entered into forward contracts with its clients to buy or sell foreign exchange at an agreed price on a future date. In cases where the date of maturity of the contract falls beyond the end of the accounting period, the taxpayer evaluates the unmatured forward contracts on the last day of the accounting period on the basis of rate of foreign exchange prevailing on that date and books the loss or profit accordingly. Accordingly the taxpayer booked losses of INR 1.2 million.

• However, the Assessing Officer (AO) observed that the principles of taxation require that actual profit or loss was to be brought to tax and not contingent losses. And since in a forward contracts, liability arises only on the date on which the contracts mature such losses should not be allowed as a deduction..

• The AO also referred to the Madras High Court’s decision in the case of Indian Overseas Bank v. CIT [1990] 246 ITR 206 (Mad) wherein it was held that before settlement of contracts in foreign currency, no actual profit could accrue and the amount in question represented notional profits only. Accordingly, the AO disallowed the loss of INR 1.2 million treating the same as notional loss.

Taxpayer’s contentions

• The taxpayer contended that as per the Reserve Bank of India guidelines, it was required to revalue its outstanding foreign exchange forward contract as per the rates notified by the Foreign Exchange Dealers Association of India (FEDAI) on 31 March every year. Therefore it had to re-assess the anticipated loss at the end of the year in accordance with the method of accounting consistently followed by it.

• The taxpayer relied on the Supreme Court’s decision in the case of Investment Ltd v. CIT [1970] 77 ITR 533 (SC) wherein, it has been held that the method of accounting consistently and regularly followed by the taxpayer cannot be discarded by the tax department merely on the ground that a better method of accounting could be the alternate one.

• In the case of Woodward Governor India (P) Ltd, the Supreme Court has held that the additional liability on account of fluctuation in foreign currency as on 31 March 1991 in respect of foreign currency working capital loans outstanding on that date was an allowable revenue loss and was not notional or contingent.

• A forward exchange creates a binding obligation arises which is required to be discharged. Therefore, the physical delivery of foreign currency on the date of maturity does not wipe out the present liability incurred by the taxpayer.

• The loss on the revaluation of the outstanding forward exchange contracts is to be allowed on the well recognised principle that taxpayer’s stock/circulating capital has to be valued at cost or market price, wherever is lower.

Tax department’s contentions

• The taxpayer was carrying on banking business in India and it is not the taxpayer’s business to deal in forward contracts. It entered into forward contracts with its clients to buy or sell foreign currency at an agreed price on a future date in order to in order to avoid wide fluctuation in foreign currency.

• The Tribunal’s decision in the case of Deutsche Bank A.G v. DCIT [2003] 86 ITD 431 (Mum) and the decision of the Bombay High Court in the case of CIT v. Bank of India [1996] 218 ITR 371 (Bom) proceeded on the footing that the securities were stock-in-trade. However, in the present case there is no material to prove that forward contract to buy or sell foreign currency itself constitutes the stock-in-trade and therefore these cases are not applicable to the case under consideration.

• The Supreme Court in the case of Woodward Governor of India observed that as per Accounting Standard (AS) -11 on “Effect of Changes in Foreign Exchange Rates”, effect of changes in exchange rate vis-à-vis monetary items denominated in a foreign currency has to be taken into account for giving accounting treatment on the balance sheet date. The tax department contended that in the present case, since no transaction has been entered into in the books of account, there was no monetary item requiring adjustment of exchange rate difference.

• The tax department relied on the Bombay High Court’s decision in the case of CIT v. Kamani Metals and Alloys Ltd [1994] 208 ITR 1017(Bom) wherein, the taxpayer had entered into a contract with MMTC for purchase of copper cathodes at a particular rate. The High Court observed that the material was received in the next accounting period and therefore there was no closing stock of the material in the hands of the taxpayer. Accordingly, the High Court held that the material contracted to be purchased could not be regarded as taxpayer’s stock-in-trade and hence, could not be valued in the accounts as such.

• The liability accrues or arises only on the date of maturity of the contract and estimated liability as per FEDAI guidelines cannot be allowed under the Act.

Special Bench’s ruling

• The Forward exchange contract creates a continuing binding obligation on the date of contract against the taxpayer to fulfill the same on the date of maturity.

• As observed by Supreme Court in the case of Woodward Governor, AS -11 which is mandatory requires that when the transaction is not settled in the same accounting period as that in which it occurred, the exchange differences arises in more than one period. The principle laid down by Supreme Court that in case of a working capital loan, loss on account of fluctuation in foreign currency as on the date of foreign exchange is an item of expenditure under Section 28 of the Income-tax Act, 1961 (the Act) would be applicable in this case too.

• Contingent liability is not allowed as a deduction. However, if an anticipated liability is coupled with present obligation and only quantification can vary depending upon the terms of contract, then a liability is said to have crystallised on the date of balance sheet date. Hence anticipated losses on account of existing obligation, determinable with reasonable accuracy have to be taken into account. Reliance was placed on the decision of the Supreme Court in the case of Bharat Earth Movers v. CIT [2000] 245 ITR 428 (SC).

• It is a settled law that a method of accounting regularly employed by the taxpayer cannot be disregarded by the AO unless he is of the opinion that profits are not correctly deductible from such method of accounting as per the provisions of section 145(3) of Act. However, the AO cannot reject the method of accounting followed by the taxpayer merely on the ground that a better method of accounting could be the alternate one. However, in the present case, though observations have been made by the AO to this effect but actual disallowance has been made by treating the impugned amount as contingent liability.

• The Special Bench observed that there was no dispute that the foreign exchange currency held by the taxpayer bank was its stock-in-trade and the taxpayer had entered into forward foreign exchange contracts in order to protect its interest against the wide fluctuation in the foreign currency itself. Therefore, this contract was incidental to taxpayer’s holding of the foreign currency as current asset. Towards this, the Special Bench relied on the Calcutta Special Bench decision in the case of Shree Capital Services Ltd. v. ACIT [2009] 121 ITD 498 (Kol) (SB)

• The Special Bench also observed that tax department had for the Assessment Year 2002-03 and 2003-04 assessed the taxpayer in respect of the profit shown by the Bank on restatement of outstanding forward foreign exchange. Accordingly, there was no reason to disallow the loss as claimed by taxpayer in respect of same contracts on the same footing.

Our Comments

This is welcome decision of the Mumbai Special Bench where it is held that losses arising on account of unmatured forward contracts are not notional in nature. This decision holds importance since prior to this decision there were no clear judicial precedents directly on the point. Before this decision reliance was generally placed on RBI guidelines, Accounting Standards and the Supreme Court decision in the case of Woodward Governor of India.

It is interesting to note that the Central Board of Direct Taxes had issued Instruction no. 03/20 10 dated 23 March 2010 to the effect that losses arising on account of year-end valuation of forex-derivatives are to be disallowed on the ground that these are contingent and notional in nature.

Pan for Non Residents

Non-resident individuals and organisations need to have a Permanent Account Number (PAN) number if they receive an income and need to file returns in India. PAN is issued by the Income Tax (IT) Department to all assessees and quoting of PAN is compulsory in all returns filed with the IT department.

The PAN number comprises of ten alphanumeric characters and is issued in the form of a laminated card. A PAN card is required for both resident as well as non-resident assessees. In case of non-resident assessees, there are a few minor changes in the requirements for an application.

A non-resident assessee is:

A citizen of India residing outside India at the time of making application

Not a citizen of India i.e. foreign citizen

Other than individual (a company, trust, firm, etc) - not a citizen of India - having no office of its own in India.

The following points should be noted while applying for the PAN:

AO Code : AO code pertaining to International Taxation Directorate should be used.

Address: A foreign address can be provided as residential (only for individuals) and office address by such applicants, if they do not have any Indian address of their own. Individual applicants may indicate any address (residential or office -whether Indian or abroad) as the address for communication.

Additional courier charges for PAN card dispatch shall be payable by applicant at the time of making application if the address for communication is a foreign address. Complete address including name of state, province (if applicable) and name of country should be clearly mentioned in the application as part of the address.

A proper zip or pin code, if applicable, should be provided by the applicant. Further, a valid email address must be provided by such applicants. It is to be noted that providing details of Residential Address (RA) is not mandatory in the PAN application for such applicants. However, if RA details are provided, proof of identity and address in respect of RA shall be required in addition to those of the applicant.

Photograph and signature: Individual applicants should provide their own recent colour photograph of prescribed size. This is not applicable for other applicants. Application should always be signed by the applicant himself / herself in all cases (for individuals). In case of applicants other than individuals, application should be signed by an authorized signatory on behalf of the applicant (eg director of the company or partner of the firm or trustee of the trust, etc).

Even if the RA details are provided, the application should be signed by the applicant (in case of individual applicants) or by the authorized signatory (for non-individual applicants).

Payment received for sale of copyright article does not amount to royalty under the India – USA tax treaty

Payment received for sale of copyright article does not amount to royalty under the India – USA tax treaty

Court : Mumbai bench of the Income-tax Appellate Tribunal

Brief : Recently, the Mumbai bench of the Income-tax Appellate Tribunal held that the payment received by the taxpayer company towards the sale of copyright article does not amount to royalty within the provisions of Article 12(3) of the India-USA tax treaty (tax treaty).

Citation : DDIT v. Alcatel USA International Marketing Inc [2010-TII-123-ITAT-MUM-INTL]

Facts of the case

The taxpayer, a tax resident of USA, was marketing and selling Alcatel products to customers outside USA. The taxpayer supplied software under the Subscriber Data Note (SDN) network software agreement to Reliance Infocomm Ltd (RIL) for the purpose of telecommunication network of RIL.

• The Agreements clearly mentioned that

The taxpayer grants a perpetual, irrevocable, non-exclusive, unrestricted right to Reliance for the use of Software within Reliance’s network. However, title to the copyright in software remains with the taxpayer.

Reliance shall not transfer, assign, sublicense or outsource the license without the written permission of the taxpayer except where it is required for its own network.

Reliance shall not use the software for commercial time sharing with non-affiliate third parties, rental, lease and sub-licensing to non affiliate third parties and service-bureau purposes.

• The taxpayer company received consideration of INR 167.26 million for the supply of the said software. The software supplied by the taxpayer company to RIL creates a database to store subscriber profiles and other information, e.g. customer phone number, calling plan, etc and make this information available to different network element requesting it.

• The AO treated the consideration received by the taxpayer as royalty taxable in India.

Taxpayer’s contentions

• The taxpayer contended that the consideration received for the supply of software was not taxable in India as the same was in the nature of business profit and not royalty and in the absence of PE of taxpayer in India the consideration received was not taxable in India.

Tribunal’s ruling

• The Tribunal observed that identical issue has been dealt by Delhi Tribunal in taxpayer’s own case for assessment year 2003-04. The Delhi Tribunal after relying on the decision of the Delhi Special Bench in the case of Motorola Inc. Ericsson Radio Systems AB and Nokia Corporation v. DCIT [2005] 96 TTJ 1 (Del) (SB) held that the transaction under consideration cannot be considered as royalty under the provisions of Act or under the tax treaty.

• The Tribunal, after examining the relevant clauses of the agreement between the taxpayer and RIL and the provisions of the Act and the tax treaty, held that payment received by the taxpayer company towards the sale of copyright article does not amount to royalty within the meaning of Article 12(3) of the DTAA between India and USA

Arm's length price should be based on the functional and asset profile of the company

Arm's length price should be based on the functional and asset profile of the company

Court : Mumbai Bench of the Income Tax Appellate Tribunal

Brief : The Mumbai Bench of the Income Tax Appellate Tribunal ('the Tribunal'), in the case of ITO v. Zydus Altana Healthcare Pvt. Ltd. [2010-TI I-29-ITAT–MUM-TP], while deciding the case in favour of the assessee, ruled that the determination of arm's length price should be based on the functional and asset profile of a company and profit margins earned by comparable companies should be adjusted for functional differences between the tested party and the comparables. The Tribunal also ruled that in case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment since in such a situation, there is no benefit to the assessee in charging its associated enterprise a lower mark-up.

Citation : ITO v. Zydus Altana Healthcare Pvt. Ltd. [2010-TI I-29-ITAT–MUM-TP]

Judgement :

Facts- The assessee is a Joint Venture between Cadila Healthcare Ltd., and Byk Gulden Lomberg GmbH Germany ("BGL"). The assessee, a 100% export oriented unit is engaged in the manufacture and export of pharmaceutical intermediates exclusively for BGL. The assessee also provides clinical trial services with respect to molecules developed from the research undertaken by BGL for which it is remunerated on a cost plus 5% basis. In addition, the assessee receives reimbursement from BGL of certain clinical trial expenses.

During the course of transfer pricing ("TP") assessment proceedings, the Transfer Pricing Officer ("TPO") accepted the assessee's export prices of pharmaceutical products to be at arm's length. The TPO, however, proposed an adjustment to the transfer price for the transaction involving clinical trial services provided by the assessee to its Associated Enterprise ("AE"). For this purpose, the TPO identified a set of companies providing clinical trial services to third parties and determined the arm's length cost plus mark up at 17.14%.

The Assessing Officer ("AO") passed an order, incorporating the transfer pricing adjustment proposed by the TPO, against which the assessee filed an appeal before the Commissioner of Income-Tax, Appeals ("CIT (A)"). The CIT(A), based on the facts of the case, deleted the adjustment proposed by the TPO, aggrieved by which the Indian Revenue authorities brought an appeal before the Tribunal.

Revenue Contentions

Key contentions of the Revenue were as follows:

•           The assessee as per the recitals of the research and development ("R&D") services agreement was entrusted to perform certain R&D service work on contract research basis on behalf of BGL. However, the CIT(A) did not examine the relevant articles of the R&D services agreement and wrongly held that the assessee is merely engaged in providing support services in the nature of facilitation/coordination services between BGL and the hospitals.

•           The nature of expense reimbursements made by the AE to the assessee for the clinical trial services clearly indicated that the assessee had full-fledged infrastructure facilities for conducting R&D activities.

•           Though the CIT(A) rightly referred to the guidelines provided by the Special Bench of Bangalore ITAT in the case Aztec Software Technology Services Ltd. v. ACIT [2007 - TII – 01 - ITAT – BANG – SB - TP] for selecting comparable companies based on functional analysis, the CIT(A) had not applied such guidelines to the facts of the present case thereby wrongly rejecting the search conducted by the TPO for comparable transactions with respect to the clinical R&D work undertaken by the assessee on behalf of the AE.

 Assessee Contentions

Key contentions of the assessee were as follows:

•           The assessee did not undertake clinical trials on its own. It only acted as a facilitator / co-ordinator between BGL and the hospitals which performed the clinical trials. This was evidenced by the fact that the reimbursement received by the assessee primarily related to expenses incurred towards hospitals for clinical tests undertaken by them on the molecules that were developed by BGL. Therefore, the functions performed by the assessee with respect to the clinical trials service transaction were limited and were essentially in the nature of administrative services, including data collation and compilation, maintenance of documentation, liaising with doctors, etc.

•           The assessee did not have the necessary infrastructure to undertake R&D activities. The TPO, during the course of the assessment proceedings, agreed to the fact that the assessee could not be characterised as a contract research organisation.

•           Comparables selected by the TPO were in a different line of business to that of the assessee.

Tribunal Ruling

The Tribunal held as follows:

•           The entire research activity relating to molecules was carried out in three phases. Under Phase I, the main molecules were generated by BGL and its effectiveness over Indian patients was to be examined by carrying out clinical trials in Phase II and Phase III. Thus, the major part of the research activity was Phase I in which molecules per se were generated, and not Phase II and Phase III, which involved only clinical trials being conducted by third parties i.e. hospitals, which the assessee only paid for. Further, the assessee's infrastructure was limited to furniture, vehicle, office equipments and computers, which were not sufficient for carrying out an entire research activity.

Therefore, the assessee's activity was more in the nature of coordinating / facilitating such clinical trials carried out at various hospitals rather than performing the R&D function itself, for which a return of 5 per mark-up on costs was suitable.

•           Referring to Rule 10B(1)(a)(ii) of the Indian Income-tax Rules, 1962 ("the Rules"), the Tribunal held that the TPO when selecting comparables should have made necessary adjustments for functional differences.

•           In case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment since in such a situation, there is no benefit to the assessee in charging its associated enterprise a lower mark-up.

Based on the above, the Tribunal upheld the order of the CIT(A) and rejected the transfer pricing adjustment made by the AO thereby deciding the case in favour of the assessee.

Conclusion

In establishing the functional profile of the assessee and evaluating its return, the Tribunal had correctly examined the nature of activities and contribution of the assessee in the value chain. It had also given due consideration to the tangible asset profile of the assessee. However, the Tribunal, in its ruling, did not provide its views on certain determinative aspects relating to who exercises control over the R&D function, who has the risk bearing capacity, who contributes to intangible creation, etc.

Further, with respect to comparability adjustments, although no guidance was provided, the Tribunal reiterated the need to make appropriate adjustments to comparables while applying a transfer pricing method and determining the arm's length price.

The Tribunal also ruled that in case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment.

Tags : Cadila Healthcare, Byk Gulden Lomberg GmbH Germany,  Zydus Altana Healthcare , transfer pricing , Arm's length price .

Payment received by the taxpayer for sale of shrink wrapped software is not in the nature of royalty within the meaning of Article 12(3) of the India-USA tax treaty

Court : Mumbai bench of the Income-tax Appellate Tribunal

Brief : Recently, the Mumbai bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of ADIT v. Solid Works Corporation [2010-TII-130-ITAT-MUM-INTL] Judgment date 1 April 2010, Assessment Year 2005-06) held that payment received by the taxpayer for sale of shrink wrapped software is not in the nature of royalty within the meaning of Article 12(3) of the India-USA tax treaty (tax treaty).

Citation : ADIT v. Solid Works Corporation [2010-TII-130-ITAT-MUM-INTL]

Judgement : Facts of the case

The taxpayer, a tax resident of USA, develops and markets 3D mechanical design solution. The software named Solidworks 2003 is provided in a packed form to the customers in India alongwith an end user license agreement (EULA).

The designed data prepared by software provides data which are 100 percent editable.

The taxpayer owns and retains all copyright, trade mark, trade secrets and other proprietary rights. Further, the end user is not permitted to make any modification, make works derivative of the software, reverse engineer, decompile, disassemble or otherwise discover the source code of the software.

For the purposes of marketing the shrink wrap software, the taxpayer entered into agreement with various distributors/resellers in India. However, distributors do not get any right to disassemble, decompile or reverse engineer the software. Also, distributors do not get any exclusive distributor right.

The taxpayer observed that shrink wrap software was sold to customers for their personal use without transfer of any copyright, trade mark, or patent etc. Accordingly, the taxpayer took the view that the payment received for supply of software was not payments received for royalty as per the tax treaty.

Further, the taxpayer took a view that since it did not have a permanent establishment (PE) in India, its business income was not taxable as per Article-7 of the tax treaty.

The AO held that the payment received by the taxpayer, for the use of software, was in the nature of royalty as per the tax treaty.

Further, the AO levied interest under section 234B of the Income tax Act, 1961 (the Act).

Issue before the Tribunal

Whether the payment for obtaining Computer Software is in the nature of ‘Royalty’ and therefore liable for taxation in India within the meaning of Article 12(3) of the tax treaty?

Whether interest under section 234B of the Act can be levied when all payments to taxpayer are subject to deduction of tax at source?

Tribunal’s ruling

The Tribunal observed its earlier decision in the taxpayer’s own case (DDIT v. Solid Works Corporation (ITA no. 3095/Mum/2007)), the key points of which are as follows:

The distributor is not authorised to enter into any contract directly or indirectly on behalf of the taxpayer. Also, the distributor cannot tamper with or remove from the original packaging and all the product shall be distributed by the distributor as it is.

The EULA provides facility to ultimate consumer to install software on his computer and use it personally without allowing any right to the consumer of disassemble, reverse engineer, decompile the software.

Customer was also not entitled to sell, license, sub-license, transfer, assign, lease or rent the software. Therefore it is clear that end user and distributor did not have any right over the copyright of the software.

The Tribunal relied on the Supreme Court’s decision in the case of Tata Consultancy Services Pvt. Ltd. v. State of Andhra Pradesh (2004) 271 ITR 401 (SC) in which it was held that the copyright in the software programme remains with the originator but the moment copies are made and marketed, it becomes goods liable to sales tax.

The definition of royalty as per the tax treaty requires that there should be a transfer of copyright. Sale of software by the taxpayer to the distributor or end user does not involve any transfer of copyright either in part or in whole. Accordingly, consideration paid by the distributor cannot be said to be a payment for right to use copyright or transfer of use of copyright.

2. Relying on the decision in taxpayers own case, the Tribunal held that the payment received by the taxpayer for sale of shrink wrapped software was not in the nature of royalty within the meaning of Article 12(3) of the tax treaty.

3. With regard to levy of interest under section 234B of the Act, the Tribunal relied on its earlier decision in the taxpayer’s own case and also relied on Delhi Special Bench decision in the case if Motorola Incorporation v.. DCIT (2005) 95 ITD 269 (Del) (SB) & Mumbai High Court decision in the case of DIT v.. NGC Network Asia LLC (2009) 313 ITR 187 (Bom). It was held that when a duty is cast on the payer to pay the tax at source, on failure, no interest can be imposed on the taxpayer.

Our Comments

This is a welcome decision in which the Mumbai tribunal held that the payment received by the taxpayer for sale of shrink wrapped software was not in the nature of royalty within the meaning of Article 12(3) of the tax treaty.

In a recent decision in the case of Dassault Systems K.K. [2010-TIOL-02-ARA-IT] the Authority for Advanced Ruling on similar facts held that the payments received by the applicant cannot be construed as ‘royalty’ taxable within the provisions of the Act or the India-Japan tax treaty. A similar view was also adopted by the Bangalore Tribunal in the recent decision in the case of M/s Velankani Mauritius Ltd & M/s Byedesign Solutions Ltd. v. DDIT (2010-TII-64- ITAT-BANG-INTL) where it held that income from sale of software cannot be treated as royalty under the Income-tax Act, 1961 or the India-Mauritius tax treaty

It is important to note that recently, the Supreme Court in the case of CIT v. M/s Oracle Software India Ltd. [2010-TIOL-04-SC-IT] has held that process of transforming a blank Compact Disks (CDs) into software loaded disks by duplicating the master copy of the software on it, constitutes ‘manufacture or processing of goods’. Based on this decision it may be possible to contend that providing shrink wrap software may result into provision of goods and not service and therefore, to be treated as business income and not royalty income.

It is pertinent to note that how some of the developed economies have treated such payment as not resulting into royalty payments. As per the US regulations when there is a transfer of software program that would effectuate a minimal use of the copyright in the program then such minimal use should be disregarded for characterization purposes as it is merely ‘de minimis’ to the entire transaction. Further, the technical advisory group of Organization for Economic Co-operation and Development also had similar view which held that if the consideration is paid for a right other than a right in the intellectual property, then in that event, the payment made should not be treated as royalty as it is a purchase for the purpose of use of the product. The Singapore Government has also specifically granted exemption from withholding taxes to importers of shrink-wrapped software.

Tags : Solid Works Corporation, shrink wrapped software, royalty , DTAA, India-USA tax treaty

TDS On Software -Microsoft Ruling Delhi ITAT

Tax is payable on import of all software , even if the sale does not involve exercise of copyright, according to a Delhi tax tribunal order in a case relating to Microsoft .

 

While the order, passed on October 28, is significant in terms of the liability to withold tax from payments made while importing software, the Delhi Income-Tax Appellate Order (ITAT) attracted the attention of tax professionals on account of its observation that questioned the sanctity of tax treaties.

 

In the order, which may spark multiple litigations , the division bench of ITAT observed that it is not necessary that provisions of tax treaties always override the provisions of domestic tax laws. In a situation, where a provision in the domestic tax law is incorporated after the signing of a Double Taxation Avoidance Agreement (DTAA), it is the domestic law that will override DTAA. According to the existing position, if there is a conflict between domestic tax laws and treaty provisions, the latter is supreme.

This is the first time that a judicial body or quasi judicial body has observed that domestic law can override treaty provisions. This observation was made while holding that royalty is payable by Microsoft. The ITAT has for the first time challenged the superiority of DTAAs India has signed with many countries.

The order says, “Assuming there was a conflict between the Act and the DTAA, the proposition that DTAA will prevail over the Act is not infallible. Later domestic tax legislation can override treaty provisions if there is an irreconcilable conflict (Gramophone India case).”

While the judgement assumes importance because of its offbeat approach on the sanctity of tax treaties, the order has a direct bearing on the software industry in India which now has to pay tax on all imports of software, irrespective of whether the purchase is a copyright or not.

Currently, there are some judgements in favour of the assessee, if the software is a single user licence for use by oneself. In such cases, the licence was tantamount to a copyrighted product and, hence, should not suffer withholding tax because there is no exploitation of copyright in the licence. The Delhi ITAT order changes this.

Vispi Patel of Vispi T Patel & Associates said, ”The Delhi bench has quoted Supreme Court order in the case of Gramophone India. The context in both the cases are different and, therefore, it is not right in applying the same yardstick in the case of Microsoft.”

“The order is a significant departure from how payments for purchase of off-the-shelf software have been viewed by the appellate authorities earlier. It holds that such payments would be for use of a copyright (and not for use of copyrighted article) and would be taxable on a gross basis. The far reaching implications of this proposition apart, the judgement speaks of a treaty override by a subsequent domestic legislation if there is an ‘irreconcilable conflict’ .

 

Delhi ITAT order questions the sanctity of tax treaties

 

Tribunal rules that provisions of tax treaties need not always over ride domestic tax laws

Against current practices, if a domestic tax law is incorporated in a DTAA, the former will override the latter

Software industry will have to pay tax on all software imports , whether the purchase is a copyright or not.