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